================================================================================

                                  UNITED STATES
                       SECURITIES AND EXCHANGE COMMISSION
                             Washington, D.C. 20549

                                   FORM 10-K/A

                                (AMENDMENT NO. 2)

[X]      Annual  Report  Pursuant  to  Section  13 or  15(d)  of the  Securities
         Exchange Act of 1934

                   FOR THE FISCAL YEAR ENDED DECEMBER 31, 2006

[_]      Transition  Report  Pursuant  to Section 13 or 15(d) of the  Securities
         Exchange Act of 1934

                         Commission file number 1-13669

                            TALON INTERNATIONAL, INC.
             (Exact Name of Registrant as Specified in Its Charter)

            DELAWARE                                           95-4654481
(State or Other Jurisdiction of                             (I.R.S. Employer
 Incorporation or Organization)                             Identification  No.)

                       21900 BURBANK BLVD., SUITE 270
                         WOODLAND HILLS, CALIFORNIA              91367
                  (Address of Principal Executive Offices)    (Zip Code)

                                 (818) 444-4100
              (Registrant's Telephone Number, Including Area Code)

           Securities registered pursuant to Section 12(b) of the Act:

     TITLE OF EACH CLASS               NAME OF EACH EXCHANGE ON WHICH REGISTERED
     -------------------               -----------------------------------------
COMMON STOCK, $.001 PAR VALUE                   AMERICAN STOCK EXCHANGE

           Securities registered pursuant to Section 12(g) of the Act:

                                      NONE

Indicate by check mark if the  registrant is a well-known  seasoned  issuer,  as
defined in Rule 405 of the Securities Act.

                              Yes [_]     No [X]

Indicate  by check mark if the  registration  is not  required  to file  reports
pursuant to Section 13 or Section 15(d) of the Act. Yes [_] No [X]

Indicate  by check  mark  whether  the  registrant:  (1) has filed  all  reports
required to be filed by Section 13 or 15(d) of the  Securities  Exchange  Act of
1934  during  the  preceding  12 months  (or for such  shorter  period  that the
registrant was required to file such reports),  and (2) has been subject to such
filing requirements for past 90 days.

                              Yes [X]     No [_]

Indicate by check mark if disclosure of delinquent  filers  pursuant to Item 405
of Regulation  S-K is not contained  herein,  and will not be contained,  to the
best of registrant's  knowledge,  in definitive proxy or information  statements
incorporated by reference in Part III of this Form 10-K or any amendment to this
Form 10-K [_]

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

Large accelerated filer [_]   Accelerated filer [_]    Non-accelerated filer [X]

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

At June 30, 2006 the aggregate market value of the voting and non-voting  common
stock held by  non-affiliates  of the registrant was  $12,147,000.  At April 10,
2007 the issuer had 18,466,433 shares of Common Stock,  $.001 par value,  issued
and outstanding.

                       DOCUMENTS INCORPORATED BY REFERENCE
None.

================================================================================


<PAGE>


                                EXPLANATORY NOTE

         This  Amendment  No. 2 to Form 10-K on Form 10-K/A  (this  "Amendment")
amends  Talon  International,  Inc.'s  (formerly,  Tag-It  Pacific,  Inc.)  (the
"Company")  Annual  Report on Form 10-K for the fiscal year ended  December  31,
2006, originally filed on April 12, 2007, and amended by Amendment No. 1 to Form
10-K on Form 10-K/A filed on April 30, 2007 (as amended, the "Original Filing").
The Company is filing this Amendment to amend the  disclosure  contained in Item
3, Item 6, Item 7, Item 8, Item 9A and Item 15 of the Original Filing.

         Except  as  described  above,  no other  changes  have been made to the
Original  Filing.  This  Amendment  continues  to  speak  as of the  date of the
Original  Filing,  and the Company has not  updated  the  disclosures  contained
therein to reflect any events which occurred at a date  subsequent to the filing
of the  Original  Filing.  In  this  Amendment,  unless  the  context  indicates
otherwise,   the  terms   "Company,"  "we,"  "us,"  and  "our"  refer  to  Talon
International, Inc. and its subsidiaries.


                                       1
<PAGE>


ITEM 3.       LEGAL PROCEEDINGS

         On October 12, 2005, a shareholder class action complaint-- HUBERMAN V.
TAG-IT PACIFIC, INC., ET AL., Case No. CV05-7352 R(Ex)--was filed against us and
certain of our current and former  officers and  directors in the United  States
District  Court for the Central  District of  California  alleging  claims under
Section 10(b) and Section 20 of the Securities Exchange Act of 1934, as amended,
and Rule 10b-5  promulgated  thereunder.  The action is brought on behalf of all
purchasers of our publicly-traded securities during the period from November 14,
2003 to August 12, 2005. On January 23, 2006 the court heard  competing  motions
for  appointment of lead  plaintiff/counsel  and appointed Seth Huberman as lead
plaintiff. The lead plaintiff thereafter filed an amended complaint on March 13,
2006. The amended  complaint  alleges that  defendants made false and misleading
statements about the company's  financial  situation and its  relationship  with
certain of its large customers  during a purported class period between November
13,  2003 and August  12,  2005.  It  purports  to state  claims  under  Section
10(b)/Rule  10b-5 and Section 20(a) of the Securities  Exchange Act of 1934. The
Company filed a motion to dismiss the amended complaint, which motion was denied
by the court on July 17,  2006.  On December  21, 2006 the court  established  a
trial date of May 1, 2007 and ordered completion of discovery by March 19, 2007.
On February 20, 2007 the court denied class  certification.  Plaintiff has moved
the court to  reconsider  the ruling,  and also to intervene a new  plaintiff to
pursue class certification.  Both of those motions were denied on April 2, 2007.
In addition,  the same day,  the Court  granted  Defendants'  motion for summary
judgment, and it is anticipated that the Court will enter a judgment in favor of
all  Defendants  shortly.  It is possible that Plaintiff will appeal the summary
judgment and class  certification  rulings.  We believe that this matter will be
resolved in trial or in settlement within the limits of our insurance  coverage,
however the outcomes of this action or an estimate of the potential  losses,  if
any,  related to the  lawsuit  cannot be  reasonably  predicted,  and an adverse
resolution of the lawsuit could  potentially  have a material  adverse effect on
our financial position and results of operations.

         On April 16,  2004 we filed  suit  against  Pro-Fit  Holdings,  Limited
("Pro-Fit") in the U.S. District Court for the Central District of California --
TAG-IT  PACIFIC,  INC. V.  PRO-FIT  HOLDINGS,  LIMITED,  CV 04-2694 LGB (RCx) --
asserting various  contractual and tort claims relating to our exclusive license
and intellectual  property agreement with Pro-Fit,  seeking  declaratory relief,
injunctive  relief and  damages.  It is our  position  that the  agreement  with
Pro-Fit gives us the exclusive  rights in certain  geographic areas to Pro-Fit's
stretch and rigid waistband technology.  On September 17, 2004, Pro-Fit filed an
answer denying the material allegations of the complaint and filed counterclaims
alleging  various  contractual  and tort claims  seeking  injunctive  relief and
damages.  We  filed  a reply  denying  the  material  allegations  of  Pro-Fit's
pleading.  Pro-Fit has since  purported to terminate the  exclusive  license and
intellectual  property  agreement  based on the  same  alleged  breaches  of the
agreement that are the subject of the parties' existing  litigation,  as well as
on an  additional  basis.  On February 9, 2005,  and again on June 16, 2005,  we
amended our pleadings in the litigation to assert additional breaches by Pro-Fit
of its  obligations  under the  agreement and under  certain  additional  letter
agreements,  and for a declaratory  judgment that Pro-Fit's patent No. 5,987,721
is invalid and not infringed by us. Thereafter,  Pro-Fit filed an amended answer
and counterclaims  denying the material allegations of the amended complaint and
alleging  various  contractual  and tort claims  seeking  injunctive  relief and
damages.  Pro-Fit  further  asserted  that we infringed its United States Patent
Nos.  5,987,721  and  6,566,285.  We  filed  a  reply  denying  the  substantive
allegations of the amended  counterclaims.  On June 5, 2006 the Court denied our
motion for partial summary  judgment holding that summary  adjudication  that we
did not breach our agreement  with Pro-Fit by engaging in certain  activities in
Columbia  was  not  appropriate.  The  Court  also  held  that  Pro-Fit  was not
"unwilling  or unable" to fulfill  orders by  refusing to fill orders with goods
produced  in the  United  States.  The Court did not find that we  breached  our
agreement  with Pro-Fit and a trial is required to determine  issues  concerning
our  activities in Columbia and whether other actions by Pro-Fit  constituted an
unwillingness  or inability to fill orders.  As a result of a change in the law,
we dismissed our antitrust claims against  Pro-Fit.  The court has not yet set a
date for trial of this matter.  We have derived a significant  amount of revenue
from the sale of products  incorporating the stretch waistband  technology,  and
our business,  results of operations and financial condition could be materially
adversely  affected  if the  dispute  with  Pro-Fit is not  resolved in a manner
favorable to us.  Additionally,  we have incurred significant legal fees in this


                                       2
<PAGE>


litigation, and unless the case is settled, we will continue to incur additional
legal fees in increasing amounts as the case accelerates to trial.

         We have  agreements  with our  foreign  subsidiaries  that  provide for
royalty  payments to the U.S. parent company for the sales of products  carrying
the TALON(R)  brand name,  and that also provide for a cost sharing  arrangement
associated with various corporate  administrative  and operations support costs.
These agreements may give rise to inquiries and possible disputes by the foreign
taxing authority,  resulting in the possible disallowance of some of these costs
and potentially resulting in higher foreign income taxes than has been provided.
We believe that our basis of charging  these  royalties  and its  allocation  of
costs to foreign  subsidiaries  is  appropriate  under the various taxing agency
laws, and that any  disagreement or  disallowance  regarding such costs will not
have a material affect on the financial statements of the Company. A subsidiary,
Tag-It de Mexico,  S.A. de C.V.,  has  operated  under the Mexican  government's
Maquiladora  Program,  which  entitles  Tag-It de Mexico  to  certain  favorable
treatment as respects taxes and duties  regarding  certain  imports.  In July of
2005,  the Mexican  Federal Tax  Authority  asserted a claim  against  Tag-It de
Mexico alleging that certain taxes had not been paid on imported products during
the years 2000,  2001,  2002 and 2003. In October of 2005, we filed a procedural
opposition to the claim and submitted  documents to the Mexican Tax Authority in
opposition  to this claim,  supporting  our position  that the claim was without
merit.  The Mexican  Federal Tax Authority  failed to respond to the  opposition
filed,  and the required  response  period by the Tax Authority  has lapsed.  In
addition,  a controlled entity  incorporated in Mexico (Logistica en Avios, S.A.
de C.V.) through which we conducted our  operations in 2005, may be subjected to
a claim or claims from the Mexican Tax Authority,  as identified directly above,
and  additionally  to other tax issues,  including those arising from employment
taxes.  We  believe  that any such claim is  defective  on both  procedural  and
documentary  grounds and is without  merit.  An estimate of the possible loss or
range of loss if any associated  with these matters cannot be made at this time.
We do not believe these matters will have a material adverse affect on us.

         We  currently  have  pending  a  number  of  other  claims,  suits  and
complaints that arise in the ordinary course of our business. We believe that we
have meritorious defenses to these claims and that the claims are either covered
by insurance  or, after  taking into account the  insurance in place,  would not
have a material  effect on our  consolidated  financial  condition  if adversely
determined against us.


                                       3
<PAGE>


                                     PART II


ITEM 6.       SELECTED FINANCIAL DATA

         The following selected financial data is not necessarily  indicative of
our future  financial  position or results of future  operations,  and should be
read in  conjunction  with Item 7,  "Management's  Discussion  and  Analysis  of
Financial  Condition and Results of Operations" and the  Consolidated  Financial
Statements  and Notes  thereto  included in Item 8,  "Financial  Statements  and
Supplementary Data" of this Report on Form 10-K.

<TABLE>
<CAPTION>
                                                                           YEARS ENDED DECEMBER 31,
                                                                     (In thousands except per share data)
                                                              2002        2003(1)   2004(1,2)    2005(1)      2006
                                                         ------------ ---------- ----------- ----------- --------------
<S>                                                      <C>          <C>        <C>         <C>         <C>
CONSOLIDATED STATEMENT OF OPERATIONS DATA:
Total revenue......................................      $   60,073   $  64,443  $   55,109  $   47,331  $   48,825
Income (loss) from operations......................      $    3,044   $ (5,881)  $ (14,482)  $ (27,098)  $    1,332
Net income (loss)..................................      $    1,496   $ (4,745)  $ (17,609)  $ (29,538)  $      309
Net income (loss) per share - basic................      $     0.14   $  (0.46)  $   (1.02)  $   (1.62)  $     0.02
Net income (loss) per share - diluted..............      $     0.14   $  (0.46)  $   (1.02)  $   (1.62)  $     0.02
Weighted average shares outstanding - basic........           9,232      10,651      17,316      18,226      18,377
Weighted average shares outstanding - diluted......           9,531      10,651      17,316      18,226      18,956

CONSOLIDATED BALANCE SHEET DATA:
Cash and cash equivalents..........................      $      285   $  14,443  $    5,461  $    2,277  $    2,935
Total assets.......................................      $   54,055   $  67,770  $   56,448  $   30,321  $   25,694
Capital lease obligations, line of credit and notes
   payable ........................................      $   21,263   $  11,759  $   18,792  $   16,001  $   16,214
Convertible redeemable preferred stock.............      $    2,895   $   2,895  $        -  $        -  $        -
Stockholders' equity...............................      $   18,467   $  43,564  $   30,195  $      912  $    1,686
Total liabilities and stockholders' equity.........      $   54,055   $  67,770  $   56,448  $   30,321  $   25,694

PER SHARE DATA:
Net book value per common share....................      $     1.98   $    3.79  $     1.66  $     0.05  $     0.09
Common shares outstanding..........................           9,320      11,508      18,171      18,241      18,466
</TABLE>

----------------------

(1) We incurred  restructuring  costs of $6.4  million,  $.4  million,  and $7.7
million during the years ended December 31, 2005, 2004 and 2003, respectively.

(2) We incurred net charges of $4.3 million  from the  write-off of  obligations
due from a former major customer and other fourth quarter  adjustments  totaling
$9.5 million during the year ended December 31, 2004.


                                       4
<PAGE>


ITEM 7.       MANAGEMENT'S  DISCUSSION  AND ANALYSIS OF FINANCIAL  CONDITION AND
              RESULTS OF OPERATIONS

OVERVIEW

         The  following  management's  discussion  and  analysis  is intended to
assist the reader in understanding our consolidated  financial statements.  This
discussion  is provided as a  supplement  to, and should be read in  conjunction
with, our consolidated financial statements and accompanying notes.

         Tag-It  Pacific,  Inc.  designs,  sells,  manufactures  and distributes
apparel  zippers,  specialty  waistbands  and various  apparel trim  products to
manufacturers of fashion apparel, specialty retailers and mass merchandisers. We
sell and market these products under various  branded names  including TALON and
TEKFIT. We operate the business globally under three product groups.

         We plan to increase our global  expansion of TALON zippers  through the
establishment of a network of Talon owned sales,  distribution and manufacturing
locations,  distribution  relationships and joint ventures. The network of these
distributors and manufacturing  joint ventures,  in combination with TALON owned
and  affiliated  facilities  under the TALON  brand,  is expected to improve our
time-to-market  by  eliminating  the typical setup and  build-out  phase for new
manufacturing  capacity  throughout  the world,  and by sourcing,  finishing and
distributing to apparel manufacturers in their local markets.

         We have structured our trim business to focus as an outsourced  product
development,  sourcing and sampling department for the most demanding brands and
retailers.  We  believe  that  trim  design  differentiation  among  brands  and
retailers has become a critical  marketing tool for our customers.  By assisting
our  customers in the design,  development,  sampling  and sourcing of trim,  we
expect  to  achieve  higher  margins  for our trim  products,  create  long-term
relationships  with our  customers,  grow our sales to a particular  customer by
supplying trim for a larger proportion of their brands, and better differentiate
our  trim  sales  and  services  from  those  of our  competitors.  We  plan  to
aggressively  expand our trim  business  globally,  so we may  better  serve our
apparel  factory  customers  in the field,  in  addition to our brand and retail
customer. We believe we can lead the industry in trim sourcing by having both an
intimate  relationship  with  our  brand  and  retail  customers,  and  having a
distributed  service  organization  to serve our factory  customers  (those that
manufacture for the apparel brand and retailers) globally.

         Our TEKFIT services provide manufacturers with the patented technology,
manufacturing  know-how and materials required to produce pants incorporating an
expandable  waistband.  These  products  were  previously  produced  by  several
manufacturers  for one  single  brand.  In  October  2006 our  exclusive  supply
contract with this brand expired. With the expiration of this exclusive contract
we now have broader access to other  customers and we intend to actively  expand
this product offering to other brands.  Orders have already been placed by a new
brand  customer in October 2006 as a result of these  efforts.  However sales to
the previous brand are expected to decline significantly in 2007 and orders from
new brands are not  expected to fully  offset  these  declines in the near term.
Consequently,  we expect sales and earnings contributions from this product line
to decline  significantly for at least the first half of 2007; though we believe
our sales of this  product will grow  subsequently  as we market our products to
new customers throughout the year.

         Our efforts to expand this  product  offering to other  customers  have
also been limited by a licensing dispute. As described more fully in this report
under Item 3. "Legal  Proceedings",  we are presently in litigation with Pro-Fit
Holdings  Limited  related  to  our  exclusively  licensed  rights  to  sell  or
sublicense stretch waistbands manufactured under Pro-Fit's patented technology.

         The  revenues  we derive from the sale of  products  incorporating  the
stretch waistband technology,  represented approximately 19% of our consolidated
revenues  for the years  ended  December  31,  2006 and  2005,  and 25% in 2004;
accordingly  the  results  of  operations  and  financial   condition  could  be
materially  adversely  affected if our dispute with Pro-Fit is not resolved in a
manner  favorable to us, or if we are  unsuccessful in securing new customers to
replace the revenues previously generated by the single brand.


                                       5
<PAGE>


         In an effort to better  align our  organizational  and cost  structures
with its future  growth  opportunities,  in August  2005 our Board of  Directors
adopted a restructuring  plan that was  substantially  completed by December 31,
2005.  The plan included  restructuring  our global  operations  by  eliminating
redundancies in our Hong Kong operation,  closing our facilities in Mexico,  and
closing our North Carolina  manufacturing  facility.  We have also refocused our
sales  efforts on higher  margin  products,  which may result in lower net sales
initially as we focus on  acquiring  high  quality  customers,  and decrease our
customer concentration.  As a result of this restructuring,  we now operate with
fewer  employees  and will have  lower  associated  operating  and  distribution
expenses.

         During 2005, we recorded charges in connection with this  restructuring
plan in  accordance  with  SFAS No.  146 (as  amended),  "Accounting  for  Costs
Associated  with Exit or Disposal  Activities." In addition,  the  restructuring
plan  resulted in the carrying  value of certain  long-lived  assets,  primarily
equipment,  being  impaired.  Accordingly,  in  2005 we  recorded  a  charge  to
recognize  the  impairment  of these  assets in  accordance  with SFAS No.  144,
"Accounting for the Impairment or Disposal of Long-Lived Assets."

         Our North Carolina manufacturing facility has been classified as "Fixed
assets held for sale" in our consolidated  financial statements.  Management has
committed  to sell the  asset  and has  listed  the  property  for  sale  with a
commercial  real estate agent.  We believe the sale of the asset is probable and
that the sale is expected to be completed  within one year. The major components
of  manufacturing  equipment used in this plant to  manufacture  zippers are not
classified as assets held for sale since  management  intends to re-deploy  this
equipment in the manufacture of TALON zippers through investment or sale of this
equipment  to  distributors  of TALON  zippers.  This  equipment  is  separately
identified  as idle  equipment as a component of "Property and  Equipment".  See
"Notes to consolidated financial statements," Note 1.

         Restructuring  costs  recorded  in the third  quarter of 2005 were $6.2
million.  Additional  restructuring  costs of $0.2 million were  incurred in the
fourth  quarter of 2005.  Total  restructuring  costs in 2005 were $6.4 million.
These costs  include $3.4 million of  inventory  write-downs  charged to cost of
goods sold;  $2.2 million for the  impairment  of long-lived  assets  (primarily
machinery and equipment), $0.2 million of one-time employee termination benefits
and other costs of $0.2 million  which were charged to  operating  expenses.  In
addition,  an impairment  charge to goodwill of $0.4 million was recorded.  This
goodwill  was  associated  with an  acquisition  made to benefit our Central and
South American  operations.  Since these operations were closed during 2005, the
goodwill was impaired  and written  off. As a result of the  restructuring,  the
Company expected  revenues within the Mexican region to decline by approximately
$3.5 million from 2005 levels as sales to two principal customers in this region
were  eliminated.  Revenues in this region were also expected to further decline
as industry  production  shifted to Asia.  In 2006 the  decline in sales  within
Mexico  was   approximately   $6.0  million,   consistent   with  the  Company's
expectations.  Increased  revenue in the Asia region for 2006 was  approximately
$9.0 million as compared to 2005. The increase  attributable to a shift from the
Mexican  markets  was not  determinable.  The  restructuring  efforts  were also
expected to reduce general and  administrative  operating costs by approximately
25% to 30%, or $5.0 to $6.0  million on an  annualized  basis.  Initial  savings
anticipated  during the fourth quarter of 2005 were expected to be approximately
$1.0  million  offset by $0.8 million in costs to  implement  the  restructuring
including a $0.4 million write-off of goodwill.  During fiscal year 2006 general
and   administrative   expense   savings,   principally   as  a  result  of  the
restructuring,  were  approximately  $4.4  million.  The  initial  savings  were
slightly  less  than  anticipated  in the  restructuring  plan due to  necessary
outside  consulting  and  temporary  employee  costs  occurring due to the staff
reductions.  During the first quarter of 2004, we incurred and recorded residual
restructuring  charges of $0.4 million from a restructuring  plan implemented in
2003.

         In 2004,  following  negotiations  with Tarrant Apparel Group, a former
customer,  we determined that a significant  portion of the obligations due from
this  customer  were  uncollectible.   Accordingly,   included  in  general  and
administrative  expenses for 2004 are charges of $4.3 million related  primarily
to the write-down of this receivable and leaving a remaining balance  receivable
from this customer of $4.5 million. An affiliate of the customer repaid the $4.5
million  receivable  balance over the period from May through  December 2005. In
addition to this $4.3 million  write-down  in 2004, we also recorded an accounts


                                       6
<PAGE>


receivable  reserve of $5.0 million (or 9.1% of net sales) in the fourth quarter
of 2004  based  on  management's  estimate  of the  collectibility  of  accounts
receivable primarily related to two other customers.

         Our bad debt  expense for the year ended  December  31,  2005  includes
reserves  of $3.6  million  recorded  in the  second  quarter  of 2005  based on
management's  estimate at the time of the collectibility of accounts  receivable
from one customer.  The fourth quarter of 2005 includes  charges of $0.6 million
representing the present value discount of a subsequent note received in 2006 in
exchange for that same  customer's  accounts  receivable.  Bad debt expense also
includes a write-off in the third quarter of $1.8 million principally associated
with a single customer.

         In  connection  with  our  2005  restructuring  plan,  we  recorded  an
inventory  write-down of $3.4 million in the third  quarter of 2005.  During the
fourth quarter of 2004, we recorded inventory  write-downs totaling $2.5 million
based  on  management's   estimate  of  the  net  realizable  value  of  certain
inventories.

         In 2004, we incurred net  operating  losses and increased our valuation
allowance for deferred tax assets to reduce our net deferred tax asset from $2.8
million to $1.0 million.  The decrease in the net deferred tax asset resulted in
a charge of $1.8 million  against the  provision  for income taxes in the fourth
quarter of 2004.  In 2005,  we further  reduced  the net  carrying  value of the
deferred tax asset to zero, resulting in an addition to the provision for income
taxes of $1.0 million for the year ended December 31, 2005.

RESULTS OF OPERATIONS

         NET SALES

         For the years ended December 31, 2006,  2005, and 2004,  total sales by
geographic region based on customer delivery  locations were as follows (amounts
in thousands):

                               2006     CHANGE       2005     CHANGE       2004
                             -------   -------     -------   -------     -------

United States ............   $ 5,287       (41)%   $ 8,903        85%    $ 4,823
Asia .....................    28,975        45      20,005        57      12,786
Mexico ...................     2,476       (71)      8,526       (60)     21,453
Dominican Republic .......     9,138        54       5,915       (39)      9,678
Other ....................     2,949       (26)      3,982       (38)      6,369
                             -------   -------     -------   -------     -------
    Total ................   $48,825         3%    $47,331       (14)%   $55,109
                             =======   =======     =======   =======     =======


          The net revenues for the three primary product groups is as follows:

                                               Year Ended December 31,
                                     -------------------------------------------
                                         2006            2005            2004
                                     -----------     -----------     -----------
Product Group Net Revenue:
     Talon zipper ..............     $17,005,203     $13,593,479     $12,712,689
     Trim ......................      22,502,947      24,788,397      28,805,347
     Tekfit ....................       9,316,852       8,949,300      13,591,445
                                     -----------     -----------     -----------
                                     $48,825,002     $47,331,176     $55,109,481
                                     ===========     ===========     ===========


         Sales are influenced by a number of factors,  including demand, pricing
strategies,  foreign  exchange  effects,  new product  launches and indications,
competitive  products,  product supply, and acquisitions.  See Item 1 "Business"
for a discussion of our principal products.

         Sales  in  2006  increased  modestly  from  2005 as a net  result  of a
substantial  decline within selected  markets offset by large increases in other
geographical  markets.  Sales,  principally  of Trim  products,  to customers in
Mexico  declined  sharply in 2006 from 2005 ($6.0 million) as the industry shift


                                       7
<PAGE>


of apparel  production  from Latin America to Asia continued from 2005, from the
discontinuance of approximately $4.0 million in sales of products from 2005, and
as we completed the closure of our assembly and distribution  operations  within
Mexico.  Total Trim product sales declined by approximately $2.3 million in 2006
as compared to 2005 as a consequence of the reductions  from Mexico and the U.S.
described  above offset by increased  sales in Asia and the  Dominican  Republic
resulting mainly from the shift in industry  trends.  Sales of TALON products to
customers  within  the U.S.  also  declined  significantly  (approximately  $3.6
million) as a result of the industry shift of apparel production and as a result
of our closure of our manufacturing  facility in North Carolina during the third
quarter of 2005.  The decline of Talon  product sales from the North and Central
American regions was substantially  offset by the shifting of this production to
manufacturers  within Asia,  and our expansion of operations  with  customers in
this region,  resulting in a net increase in Talon  product  sales for 2006 over
2005  of  approximately  $3.4  million.  Additionally,  expanded  demand  by our
exclusive  customer  for the TEKFIT  waistband  also  resulted in an increase of
approximately  $0.4  million  in 2006 over  2005 in our  sales to the  Dominican
Republic,  where the principal  manufacturers  of this product are located,  and
sales of Trim products into this region  increased as key customer sales shifted
out of the Mexico  marketplace to this region.  Sales within Other  geographical
regions also reflect the worldwide shifting of apparel production to Asia.

         The net  decrease of sales in 2005 was  primarily  due to a decrease in
sales to our customers in Mexico of Trim products and, to a lesser extent, TALON
zippers,  resulting  from the industry  shift of apparel  production  from Latin
America to Asia, and due to the restructuring in the third quarter of 2005 which
disrupted  sales in the Mexico  regions as we prepared for a shift of operations
to  Asia.  Sales  in Asia of our  Trim  products  and  Talon  zippers  increased
significantly  during 2005 partially offsetting the declines from the Mexico and
the Latin American  regions for the Trim products and resulting in a net gain in
Talon product sales  overall.  We responded to these market changes in 2005 with
the implementation of a restructuring plan that included reducing our operations
in Mexico and  focusing  our efforts on the market in Asia.  Sales of our TEKFIT
waistband  decreased in 2005 because of lower demand from our exclusive customer
for this product. During 2005, we continued our plan to decrease reliance on two
significant customers in Mexico. These two customers  contributed  approximately
$7.7 million or 16.3% of revenues for the year ended December 31, 2005.

         COST OF GOODS SOLD AND SELECTED OPERATING EXPENSES

         The  following  table  summarizes  cost  of  goods  sold  and  selected
operating  expenses  for the years  ended  December  31,  2006,  2005,  and 2004
(amounts in thousands):

<TABLE>
<CAPTION>
                                       2006        CHANGE        2005       CHANGE        2004
                                     --------     --------     --------    --------     --------
<S>                                  <C>              <C>      <C>              <C>     <C>
Sales ............................   $ 48,825            3%    $ 47,331         (14)%   $ 55,109
                                     --------     --------     --------    --------     --------
Cost of goods sold ...............     34,356          (27)%     47,070           5%      44,814
    % of sales ...................         70%        --             99%       --             81%
                                     --------     --------     --------    --------     --------
Selling expenses .................      2,778           (5)%      2,929           1%       2,899
    % of sales ...................          6%        --              6%       --              5%
                                     --------     --------     --------    --------     --------
General and administrative expense     10,873          (32)%     16,098          80%       8,951
    % of sales ...................         22%        --             34%       --             16%
                                     --------     --------     --------    --------     --------
Bad debt expense (recoveries) ....       (513)        (109)%      5,858         (53)%     12,513
                                     --------     --------     --------    --------     --------
                                            1%        --             12%       --             23%
                                     --------     --------     --------    --------     --------
Restructuring charges ............          0         (100)%      2,474         496%         415
    % of sales ...................          0%        --              5%       --              1%
                                     --------     --------     --------    --------     --------
</TABLE>


         COST OF GOODS SOLD

         Cost of goods sold for the year ended  December  31, 2006  declined 27%
from 2005 as the result of a number of the actions we  implemented in connection
with our 2005 restructuring  plan, and as a result of our focus on higher margin
product sales and  continued  efforts to reduce costs  worldwide.  Cost of goods


                                       8
<PAGE>


sold in 2006  declined by  approximately  $4.8  million  (10.3%)  from 2005 as a
result of higher direct margins on products sold; by approximately  $1.9 million
(4.0%)  from  lower  freight  & duty  charges  as a  result  of  relocating  our
operations  closer  to our  customers  in  Asia;  by a  reduction  in  inventory
adjustments and obsolescence of $1.6 million (3.5%) due primarily to inventories
located at our Mexico production operations;  by the elimination of $3.4 million
(7.3%) in  restructuring  charges  incurred in 2005; and by  approximately  $1.8
million (3.8%) from reductions in manufacturing and overhead charges as a result
of reduced employee  related costs and operating  expenses of our North Carolina
and Mexico operations;  offset by increases of approximately $0.8 million (1.8%)
on higher sales volumes.

         Cost of goods sold  increased  5% for the year ended  December 31, 2005
primarily  due to a $3.4 million  (7.7%)  write-down  of inventory in connection
with the 2005 restructuring plan, and an increase in our inventory  obsolescence
reserve of $2.1 million (4.7%),  including $0.5 million in the fourth quarter of
2005.  Cost of sales also  increased as a percentage  of sales due to unabsorbed
overhead costs incurred in our North Carolina manufacturing facility and charges
of  approximately  $0.2 million (0.5%)  associated with unrealized  charge-backs
recorded in the second quarter of 2005 and $0.6 million (1.3%) in credits issued
to customers  during the first  quarter for defective  products  received from a
major supplier. Cost of goods sold declined by approximately $4.1 million (9.1%)
as a result of the decline in revenue from 2004 to 2005.

         Cost of goods  sold for the year  ended  December  31,  2004,  included
inventory  write-downs  totaling $2.7 million (5% of net sales)  recorded in the
fourth  quarter of 2004 based on  management's  estimate  of the net  realizable
value of certain inventory.

         SELLING EXPENSES

         Selling  expense for the year ended  December 31, 2006  decreased  $0.2
million (5.0%) from 2005 as a result of lower travel and entertainment  costs of
$0.3 million;  lower legal costs of $0.3 million; and other employee benefit and
administrative  cost  reductions  of  approximately  $0.1  million;   offset  by
increases in sales  commissions  of  approximately  $0.3  million and  increased
spending for sales and  marketing  programs of $0.2  million.  Selling  expenses
increased  1.0% for the year ended  December  31, 2005 because we were unable to
reduce expenses in direct proportion to the decrease in sales. In 2004,  selling
expenses  represented  5% of net sales,  and  included  $0.4  million in royalty
expense related to the intellectual property rights agreement with Pro-Fit.

         GENERAL AND ADMINISTRATIVE EXPENSES

         General and  administrative  expenses  for the year ended  December 31,
2006 decreased $5.2 million or 32% from 2005. $0.5 million of the reduction from
2005 was the result of the  write-off  of  goodwill  primarily  associated  with
closed  operations;,  reductions in legal costs by $1.9 million principally as a
reduction of our costs associated with the ProFit litigation; lower employee and
benefit costs by $1.9 million from reduced employment  levels;  reduced facility
costs of $0.6 million;  and reductions in other  administrative and travel costs
of $1.4 million;  offset by approximately $0.7 million in increased professional
and audit fees as we changed auditors and utilized more professional consultants
in lieu of full time regular employees;  and stock based compensation expense of
$0.4 million associated with the implementation of FAS 123(R).

         General  and  administrative   expenses  increased  approximately  $7.1
million  (80%)  in  2005  compared  to  2004.   This  increase  in  general  and
administrative  expenses  resulted from higher legal  expenses of  approximately
$3.0 million  related  primarily to the Pro-Fit  litigation,  and an  impairment
charge  to  goodwill  of $0.5  million  incurred  in  connection  with  the 2005
restructuring plan; higher wages,  facility and operating costs of approximately
$4.5 million  associated with the new manufacturing  plant during the first nine
months of 2005;  partially  offset by reductions of  approximately  $1.0 million
associated with lower employment levels and related costs in connection with the
restructuring plan.

         Included  in general  and  administrative  expenses  for the year ended
December  31,  2004  are  charges  of  $4.3  million  related  primarily  to the
write-down of  receivables  due from one customer.  We also recorded an accounts
receivable reserve of $5.0 million (or 9% of net sales) in the fourth quarter of


                                       9
<PAGE>


2004 based on management's estimate of the collectibility of accounts receivable
primarily  related to two other  customers.  In the first  quarter  of 2004,  we
incurred additional  restructuring  charges of $0.4 million related to the final
residual costs associated with our restructuring  plan implemented in the fourth
quarter of 2003.

         BAD DEBT EXPENSE

         Bad debt expenses for the year ended  December 31, 2006 reflected a net
recovery of $0.5  million as compared to bad debt  expenses of $5.9  million for
the year ended  December 31, 2005.  The bad debt  recoveries  in 2006  represent
collections  of accounts  written-off in prior years as  uncollectible,  and the
2005 expense is primarily  related to outstanding  unsettled  receivables from a
former  customer.  Bad debt  expense in 2004 were  $12.5  million,  and  include
charges  of  $8.3  million  including  $4.3  million  related  primarily  to the
write-down of receivables due from one customer;  recovery of approximately $1.3
associated with a customer account  written-off in 2003 and settled in 2004; and
provisions of $5.5 million ($5.0  million,  or 9% of net sales,  recorded in the
fourth quarter of 2004 based on management's  estimate of the  collectability of
accounts receivable primarily related to two other customers).

         RESTRUCTURING CHARGES

         Restructuring costs in 2005 were the result of the adoption of our 2005
restructuring  plan.  Restructuring  costs recorded in the third quarter of 2005
were $6.2 million.  Additional costs of $0.2 million were incurred in the fourth
quarter of 2005. Total  restructuring costs of $6.4 million were recorded in the
Consolidated  Statement of  Operations  for the year ended  December 31, 2005 as
follows (in millions):

                 Cost of goods sold ........................    $ 3.4
                 Operating expenses:
                    General & administrative expenses ......      0.5
                    Restructuring charges ..................      2.5
                                                                ------
                 Total restructuring costs .................    $ 6.4
                                                                ======


         During the first quarter of 2004, we incurred  restructuring charges of
$0.4 million for final residual  costs  associated  with our 2003  restructuring
plan.

     INTEREST EXPENSE AND INTEREST INCOME

         Interest  expense of  $1,357,000  for the year ended  December 31, 2006
decreased approximately $89,000 from $1,446,000 during 2005 as a result of lower
average debt levels in 2006 compared to 2005.  For both years ended December 31,
2006 and  2005,  interest  expenses  included  $311,000  in  amortized  deferred
financing  charges related  primarily to the secured  convertible notes payable.
Interest  income for the year ended  December  31,  2006 of  $368,000  increased
approximately  $302,000 from $66,000  during 2005 related  primarily to the note
receivable discussed in Note 2 to the consolidated financial statements.

         Interest  expense  increased  for the  year  ended  December  31,  2005
approximately  $594,000  (or 64%) to  $1,446,000  from  $882,000  for 2004.  The
increase in interest expense was primarily due to higher debt levels  associated
with the $12.5 million 6% secured convertible notes payable dated November 2004,
the $0.8 million 6.5%  mortgage  note payable to First  National Bank dated June
2004,  and the $0.9 million 6.5%  equipment  note payable to First National Bank
dated November 2004 which were  outstanding for the entire year in 2005 compared
to a partial year in 2004; partially offset by the repayment of a remaining $1.4
million due  pursuant to a note payable and a reduction in amounts due to factor
in 2005.  Included in interest expense for the years ended December 31, 2005 and
2004 was $311,000 and $45,000,  respectively,  in amortized  deferred  financing
charges related  primarily to the secured  convertible  notes payable.  Interest
income for the years ended  December  31, 2005 and 2004 was $66,000 and $32,000,
respectively.


                                       10
<PAGE>


         INCOME TAXES

         Income tax provisions for the year ended December 31, 2006  principally
include a royalty tax from the Inland Revenue Department in Hong Kong applicable
to 2005,  net of an estimated  tax benefit for 2006  foreign  losses and minimum
federal and state filing fees.

         The  provision  for income  taxes for the year ended  December 31, 2005
principally  reflects the  elimination  of the net deferred tax asset in 2005 of
$1.0 million,  and estimated foreign taxes. Based on the Company's net operating
losses,  there is not  sufficient  evidence to determine  that it is more likely
than not that the Company will be able to utilize its net  operating  loss carry
forwards to offset future taxable income.

         The  provision  for income  taxes was $2.3  million  for the year ended
December 31, 2004 .The income tax provision  primarily reflects a charge of $1.8
million as a result of a decrease in the value of net deferred  tax assets,  and
foreign income taxes of $0.5 million on foreign earnings.

LIQUIDITY AND CAPITAL RESOURCES

     The  following  table  summarizes   selected  financial  data  (amounts  in
thousands):

                                                     DECEMBER 31,   DECEMBER 31,
                                                         2006           2005
                                                     ------------   ------------

Cash and cash equivalents ........................   $      2,935   $      2,277
Total assets .....................................         25,694         30,321
Current debt .....................................         22,471         14,851
Non-current debt .................................          1,536         14,558
Stockholders' equity .............................          1,686            912


     CASH AND CASH EQUIVALENTS

         Our cash is held with financial institutions.  Substantially all of the
balances  at  December  31,  2006 and 2005 are in  excess of  federally  insured
limits.  As of December  31, 2006 and 2005 we had  restricted  cash  balances of
$50,000 related to cash collateral for a letter of credit with Wells Fargo Bank.


     FINANCING ARRANGEMENTS

         The Company currently does not have an active financing  arrangement to
provide  for  working  capital  requirements  and  cash  provided  by  operating
activities is our only recurring source of funds. We financed building, land and
equipment purchases through notes payable and capital lease obligations expiring
through June 2011. These obligations bear interest at rates of 6.5% and 6.6% per
annum, and under these obligations,  we are required to make monthly payments of
principal  and  interest.  In June 2006 we entered  into a note payable with our
legal counsel in exchange for legal fees outstanding to this firm related to our
Pro-Fit litigation. The note agreement provides for monthly payments against the
note in amounts equal to payments we receive from our note receivable until such
time as the  note is paid in full.  The note  receivable  is  fully  pledged  as
collateral against this note payable.

         A factoring agreement for the purchase of eligible receivables from our
Hong Kong subsidiary exists with East Asia Heller,  wherein the factor purchases
our eligible accounts  receivable and may assume the credit risk with respect to
those accounts for which the factor has given its prior approval.  If the factor
does not assume the credit risk for a receivable, the collection risk associated
with the  receivable  remains  with us. The  agreement  provides for us to pay a
fixed  commission  rate  and for us to  borrow  up to 80% of  eligible  accounts
receivable.  Interest is charged at 1.5% over the Hong Kong  Dollar  prime rate.
However,  during 2005 and 2006 the factor  declined to advance funds to us under
this agreement. Accordingly, no outstanding advances as of December 31, 2006 and
2005 existed.


                                       11
<PAGE>


         In 2005, we entered into a letter of credit with Wells Fargo Bank. This
letter of credit provides for a maximum of $50,000,  expires in June 2007 and is
secured by cash on hand  managed by Wells Fargo  Bank.  At  December  31,  2006,
outstanding letters of credit under the Wells Fargo facility were $50,000.  This
letter  is  pledged  as  collateral  for a bond  posted in  connection  with our
litigation with Todo Textile, S. A. in which a settlement  agreement was reached
in 2006.  Upon release of the bond held by the court in this matter,  the letter
of credit will be released  and the  settlement  amount of $40,000 paid from the
proceeds.

         The outstanding  balance of our demand notes payable to related parties
at December 31, 2006 and 2005 was $665,000.  Included is a $500,000  convertible
secured promissory note payable with interest at 11% payable quarterly. The note
is due on demand and is  convertible  into common  stock at the  election of the
holder  at a rate of $4.50  per  share.  The  remaining  demand  notes  totaling
$165,000 bear interest at 0%-10%,  have no scheduled monthly  payments,  and are
due within fifteen days from demand.

     CASH FLOWS

         The  following  table  summarizes  our cash flow activity for the years
ended December 31, 2006, 2005, and 2004 (amounts in thousands):

<TABLE>
<CAPTION>
                                                         2006        2005        2004
                                                       --------    --------    --------
<S>                                                    <C>         <C>         <C>
Net cash provided by (used in) operating activities    $  1,794    $  1,112    $(11,382)
Net cash used in investing activities ..............       (345)     (1,454)     (3,616)
Net cash provided by (used in) financing activities        (791)     (2,841)      6,016
Net increase (decrease) in cash and cash equivalents        657      (3,183)     (8,982)
</TABLE>

     OPERATING ACTIVITIES

         Cash  and  cash  equivalents  for the  year  ended  December  31,  2006
increased by $0.7 million from December 31, 2005  principally  arising from cash
generated by operating activities,  net of payments on notes payable and capital
leases.

         Cash provided by operating  activities is our only recurring  source of
funds and was $1.8  million  for the year  ended  December  31,  2006.  The cash
generated  by  operating  activities  during 2006  resulted  primarily  from net
earnings (before non-cash expenses) of approximately $2.3 million; reductions in
inventory net of applied reserves of $2.5 million; $1.0 million in reductions in
accounts  receivable net of reserves applied,  and approximately $0.6 million in
collections  on the note  receivable;  net of reductions in accounts  payable of
$2.6  million;  repayments  on notes  payable of $0.9 million and  reductions in
other  liabilities,  net of  approximately  $1.2  million.  The note  receivable
collections  are associated  with unsettled  accounts  receivable  from a former
customer  converted into a note  receivable in early 2006. The repayments on the
notes payable are principally  associated with previously accrued legal expenses
converted  into a note payable in May of 2006.  Payments on the note payable are
made from collections  received from the note receivable which is pledged to the
note payable.  These notes are non-recurring  settlements  associated  primarily
with  sales  and  expenses  from  2005  and  prior  transactions.  See  notes to
consolidated  financial statements,  Note 2 - "Accounts and Note Receivable" and
Note 6 - "Notes Payable."

         The net decrease in inventory  of $2.5 million  reflects the  Company's
efforts to dispose of and lower slower-moving and obsolete inventory components.
The cost of net  inventories  eliminated  during the year was $8.6 million,  and
reserves  applicable  to this  inventory  of $6.1  million were applied to these
dispositions.  Accounts receivable for the year ended December 31, 2006 declined
by $2.1 million  primarily as a result of improved  collections and faster turns
of  accounts   receivable,   and  by  approximately  $0.7  million  in  accounts
written-off.  Accounts  receivable  reserves  declined by $1.1  million from the


                                       12
<PAGE>


write-off of uncollectible  accounts and by approximately  $0.4 million from the
collection  of accounts  reserved for in prior years.  In addition,  during 2006
collections of accounts written-off in prior years was $0.5 million.

         The increase in cash provided by operating  activities  during the year
ended  December 31, 2005 resulted  from,  among other  changes,  a $10.6 million
decrease in accounts  receivable,  including  the  collection  of a $4.5 million
receivable from one customer;  a $3 million increase in accounts payable; a $2.8
million decrease in inventories; a $2.1 million increase in accrued legal costs;
substantially offset by a net loss of $29.5 million.

         At December  31,  2005,  accounts  receivable  from Azteca  Productions
International  ("Azteca"), a significant customer, was approximately $10,968,000
less a reserve of $7,528,000,  totaling  $3,440,000,  net. In February 2006, the
Company  accepted a note agreement from Azteca which provides for total payments
including  principal  and  interest  of $4.0  million  in  exchange  for the net
outstanding  accounts receivable balance.  The balance of the note receivable at
December 31, 2005 of $3,440,000 reflects a $560,000 charge to discount the note,
using a 10.5%  discount  rate,  to its net present  value.  The Azteca  accounts
receivable,  net at  December  31,  2005 was  reclassified  on the  accompanying
consolidated  balance  sheets to note  receivable  to  reflect  this  subsequent
settlement.

         The decrease in cash provided by operations for 2004 resulted primarily
from a net loss of $17.6 million together with a net increase of $7.6 million in
accounts receivable due primarily to slower customer  collections of receivables
during the year. This decrease was partially offset by a $4 million net increase
in  the  allowance  for  doubtful  accounts  and  a  $7.8  million  decrease  in
inventories.

     INVESTING ACTIVITIES

         Net cash used in investing  activities  for the year ended December 31,
2006 and  2005  consisted  of  capital  expenditures  of $0.3  million  and $1.5
million, respectively for leasehold improvements and equipment purchases.

         Net cash used in investing  activities  for the year ended December 31,
2004 consisted of capital  expenditures of $3.6 million for computer  equipment,
the  purchase of  additional  TALON  zipper  equipment  and  building,  land and
leasehold  improvements  related to the TALON  manufacturing  facility  in North
Carolina. The building and land purchase of the TALON manufacturing facility was
reported as a non-cash financing transaction.

     FINANCING ACTIVITIES

         Net cash used in financing  activities for the years ended December 31,
2006 and  2005  reflects  the  repayment  of notes  payable  and  capital  lease
obligations.  In 2005 cash  used in  financing  activities  also  included,  the
repayment of borrowings under a bank line of credit partially offset by proceeds
from the exercise of stock options and warrants.

         Net cash provided by financing  activities  for the year ended December
31, 2004  primarily  reflects funds raised from secured  convertible  promissory
notes of $12.5  million,  the exercise of stock options and  warrants,  proceeds
from notes  payable and a capital lease  obligation,  offset by the repayment of
borrowings under our credit facility and notes payable.

         We currently satisfy our working capital requirements primarily through
cash flows  generated  from  operations.  As the major apparel  industry  brands
continue to outsource apparel  manufacturing to offshore locations,  our foreign
customers,  though  backed  by U.S.  brands  and  retailers,  will  continue  to
increase.  This makes  traditional  financing  arrangements  with U.S. banks and
financial  institutions  difficult  and  accordingly  we  continue  to  evaluate
non-traditional financing of our foreign assets.

         We believe that our existing cash and cash  equivalents and anticipated
cash  flows  from our  operating  activities  and  available  financing  will be
sufficient to fund our minimum working capital and capital expenditure needs for
at least the next  twelve  months.  This  conclusion  is based on the belief and


                                       13
<PAGE>


expectation that we have successfully  completed the restructuring  plan adopted
in 2005 and that our strategic  plan and the company's  current  structure  will
allow for  continued  profitability;  that we will collect our note and accounts
receivable  in  accordance  to  existing  terms;  and  that we will  complete  a
refinancing of the convertible  notes payable by their maturity date in November
2007.  We have  discussed the  refinancing  of these notes with the current note
holders and with various financial and investment institutions.  We believe that
we will be successful in completing a modification or replacement of these notes
prior to their maturity.

         If we are  unable  to  successfully  complete  the  refinancing  of the
convertible notes or to collect our note and accounts receivable,  or experience
greater than  anticipated  reductions in sales, we may need to raise  additional
capital,  or obtain  alternate  financing  to repay the  convertible  notes,  or
further  reduce the scope of our  business in order to fully  satisfy our future
short-term  liquidity  requirements.  If we cannot raise  additional  capital or
arrange for alternate  financing or reduce the scope of our business in response
to a  substantial  decline  in  sales,  we may  default  on the  payment  of the
convertible notes payable.  The event of a default on the payment of these notes
will  materially  affect the business  operations in the long-term,  however the
on-going  operations  for 2007 are  nevertheless  anticipated  to  substantially
continue  throughout the 2007 year-end as operations  from assets not pledged to
these notes continues.

         The extent of our future long-term capital  requirements will depend on
many  factors,  including  our  results  of  operations,  future  demand for our
products,  the size and timing of future  acquisitions,  and our expansion  into
foreign  markets.  Our need for  additional  long-term  financing  includes  the
integration  and  expansion  of our  operations  to exploit our rights under our
TALON trade name,  the expansion of our operations in Asia and other markets and
the further development of our waistband technology. If our cash from operations
is less  than  anticipated  or our  working  capital  requirements  and  capital
expenditures are greater than we expect, we may need to raise additional debt or
equity  financing  in order to provide for our  operations.  We are  continually
evaluating  various  financing  strategies to be used to expand our business and
fund future growth or  acquisitions.  There can be no assurance that  additional
debt or equity  financing will be available on acceptable terms or at all. If we
are unable to secure  additional  financing,  we may not be able to execute  our
plans for expansion,  including  expansion  into foreign  markets to promote our
TALON brand trade name,  and we may need to  implement  additional  cost savings
initiatives.

CONTRACTUAL OBLIGATIONS AND OFF-BALANCE SHEET ARRANGEMENTS

         The following  summarizes our  contractual  obligations at December 31,
2006 and the effects such obligations are expected to have on liquidity and cash
flow in future periods:

<TABLE>
<CAPTION>
                                                    Payments Due by Period
                            -------------------------------------------------------------------
                                           Less than        1-3           4-5          After
Contractual Obligations        Total        1 Year         Years         Years        5 Years
-------------------------   -----------   -----------   -----------   -----------   -----------
<S>                         <C>           <C>           <C>           <C>           <C>
Demand notes payable
   to related parties (1)   $ 1,181,000   $ 1,181,000   $      --     $      --     $      --
Capital lease obligations   $ 1,027,000   $   506,000   $   521,000   $      --     $      --
Operating leases ........   $ 1,421,000   $   437,000   $   754,000   $   229,000   $     1,000
Notes payable ...........   $ 2,426,000   $ 1,193,000   $   604,000   $   629,000   $      --
Convertible notes payable   $13,143,000   $13,143,000   $      --     $      --     $      --
                            -----------   -----------   -----------   -----------   -----------
     Total Obligations ..   $19,198,000   $16,460,000   $ 1,879,000   $   858,000   $     1,000
                            ===========   ===========   ===========   ===========   ===========
</TABLE>

(1)      The majority of notes payable to related parties are due on demand with
         the  remainder  due and payable on the fifteenth day following the date
         of delivery of written demand for payment, and include accrued interest
         payable through December 31, 2006.

         At December 31, 2006 and 2005, we did not have any  relationships  with
unconsolidated  entities  or  financial  partnerships,  such as  entities  often
referred to as structured finance or special purpose entities,  which would have
been established for the purpose of facilitating  off-balance sheet arrangements
or other contractually  narrow or limited purposes.  As such, we are not exposed
to any  financing,  liquidity,  market or credit risk that could arise if we had
engaged in such relationships.


                                       14
<PAGE>


RELATED PARTY TRANSACTIONS

         For a description of  transactions to which we were or will be a party,
and in which any director,  executive officer, or shareholder of more than 5% of
our  common  stock or any  member of their  immediate  family had or will have a
direct  or  indirect  material  interest,  see  Note  16 of  the  Notes  to  the
consolidated financial statements included in Item 8 of this Report.

APPLICATION OF CRITICAL ACCOUNTING POLICIES AND ESTIMATES

         The  preparation of financial  statements in conformity with accounting
principles   generally  accepted  in  the  United  States  of  America  requires
management to make estimates and assumptions for the reporting  period and as of
the financial statement date. We base our estimates on historical experience and
on various  other  assumptions  that are  believed  to be  reasonable  under the
circumstances,  the results of which form the basis for making  judgments  about
the carrying values of assets and liabilities that are not readily apparent from
other sources.  These estimates and assumptions  affect the reported  amounts of
assets  and  liabilities,  the  disclosure  of  contingent  liabilities  and the
reported amounts of revenue and expense.  Actual results could differ from those
estimates.

         Critical  accounting  policies  are  those  that are  important  to the
portrayal of our financial  condition and results,  and which require us to make
difficult,  subjective and/or complex judgments.  Critical  accounting  policies
cover  accounting  matters  that are  inherently  uncertain  because  the future
resolution  of such  matters is  unknown.  We  believe  the  following  critical
accounting policies affect our more significant  judgments and estimates used in
the preparation of our consolidated financial statements:

         o        Accounts  receivable  balances  are  evaluated  on a continual
                  basis   and   allowances   are   provided   for    potentially
                  uncollectible  accounts based on management's  estimate of the
                  collectibility   of  customer   accounts.   If  the  financial
                  condition of a customer were to  deteriorate,  resulting in an
                  impairment  of its  ability to make  payments,  an  additional
                  allowance may be required.  Allowance  adjustments are charged
                  to  operations in the period in which the facts that give rise
                  to  the  adjustments  become  known.  During  the  year  ended
                  December  31, 2006,  net  recoveries  were $0.5 million  (with
                  provisions  of $0.2  million),  and bad debt  expense  for the
                  years ended  December  31, 2005 and 2004 were $5.9 million and
                  $12.5  million,  respectively.  The bad debt  expense  in 2004
                  included expenses of $4.3 related to one former customer,  and
                  bad  debt  expense  in  2005  was  primarily  associated  with
                  specific  receivables from another former  customer.  The 2005
                  accounts with the customer were settled in early 2006 with the
                  acceptance of a note receivable at a substantial  discount and
                  with the full write-off of the second customer  accounts where
                  most all collection  efforts had failed.  During 2006 accounts
                  receivable   delinquencies   were   substantially   eliminated
                  lowering the risk for additional material write-offs. The note
                  receivable  accepted  from the former  customer  in early 2006
                  represents a continuing risk of collection and its performance
                  is evaluated each quarter.

         o        Inventories are stated at the lower of cost,  determined using
                  the  first-in,  first-out  basis,  or market value and are all
                  substantially  finished goods. The costs of inventory  include
                  the purchase  price,  inbound  freight and duties,  conversion
                  costs  and  certain  allocated   production   overhead  costs.
                  Inventory  is  evaluated  on a  continual  basis  and  reserve
                  adjustments are made based on management's  estimate of future
                  sales value, if any, of specific  inventory  items.  Inventory
                  reserves  are  recorded  for  damaged,  obsolete,  excess  and
                  slow-moving  inventory.  We  use  estimates  to  record  these
                  reserves.  Slow-moving  inventory  is reviewed by category and
                  may be partially or fully  reserved for  depending on the type
                  of  product  and the  length  of time  the  product  has  been
                  included in inventory.  Reserve  adjustments  are made for the


                                       15
<PAGE>


                  difference between the cost of the inventory and the estimated
                  market  value,  if lower,  and  charged to  operations  in the
                  period in which the facts that give rise to these  adjustments
                  become known.  Market value of inventory is estimated based on
                  the  impact  of  market  trends,  an  evaluation  of  economic
                  conditions  and the value of current  orders  relating  to the
                  future  sales  of  this  type  of  inventory.  Provisions  for
                  reserves for inventory  valuation for the years ended December
                  31, 2006, 2005 and 2004,  were $0.6 million,  $2.5 million and
                  $1.0  million,  respectively.  The  increase in the  provision
                  during 2005 was primarily  related to the remaining  inventory
                  we owned at our  operations  in  Mexico.  The  closure  of our
                  manufacturing  operations  and from the exit of  operations in
                  Mexico as part of the 2005  restructuring  plan  substantially
                  eliminates our  acquisition or production of inventory that is
                  not directly associated with a customer's order.  Accordingly,
                  the  risk of  future  inventory  obsolescence  adjustments  is
                  substantially  reduced in 2006.  The  provisions  recorded  in
                  prior  years  are  considered   adequate  to  dispose  of  the
                  remaining inventories without further adjustment.

         o        We record  deferred tax assets arising from  temporary  timing
                  differences between recorded net income and taxable net income
                  when and if we believe that future earnings will be sufficient
                  to realize the tax benefit.  For those jurisdictions where the
                  expiration date of tax benefit carry-forwards or the projected
                  taxable  earnings  indicate that  realization is not likely, a
                  valuation  allowance is provided.  If we determine that we may
                  not realize all of our deferred  tax assets in the future,  we
                  will make an adjustment to the carrying  value of the deferred
                  tax asset,  which would be reflected as an income tax expense.
                  Conversely,  if we  determine  that we will realize a deferred
                  tax asset, which currently has a valuation allowance, we would
                  be required to reverse the valuation allowance, which would be
                  reflected  as an  income  tax  benefit.  We  believe  that our
                  estimate of deferred tax assets and  determination to record a
                  valuation   allowance   against   such  assets  are   critical
                  accounting  estimates because they are subject to, among other
                  things,  an  estimate  of  future  taxable  income,  which  is
                  susceptible  to change and  dependent  upon events that may or
                  may not occur, and because the impact of recording a valuation
                  allowance  may be  material  to  the  assets  reported  on the
                  balance  sheet  and  results  of  operations.   See  Notes  to
                  consolidated financial statements, Note 12, "Income Taxes". As
                  of  December  31,  2005 the  deferred  tax  assets  were fully
                  reserved.

         o        We record  impairment  charges  when the  carrying  amounts of
                  long-lived  assets  are  determined  not  to  be  recoverable.
                  Impairment is measured by assessing the usefulness of an asset
                  or by  comparing  the  carrying  value of an asset to its fair
                  value. Fair value is typically  determined using quoted market
                  prices,  if available,  or an estimate of undiscounted  future
                  cash flows  expected  to result  from the use of the asset and
                  its eventual  disposition.  The amount of  impairment  loss is
                  calculated  as the excess of the carrying  value over the fair
                  value.  Changes in market  conditions and management  strategy
                  have historically caused us to reassess the carrying amount of
                  our long-lived  assets.  Long-lived  assets are evaluated on a
                  continual basis and impairment adjustments are made based upon
                  management's  valuations.  As part of our  2005  restructuring
                  plan,  certain  long-lived  assets,  primarily  machinery  and
                  equipment,   were   impaired   and   their   values   adjusted
                  accordingly.   The   long-lived   assets  are  planned  to  be
                  re-deployed  through   manufacturing   arrangements  with  our
                  principal  suppliers  in Asia.  The fair value of these assets
                  will  be  affected  by  our  ability  to  secure   appropriate
                  manufacturing  arrangements  and to utilize the  equipment  to
                  meet  future  production  requirements.  If we are  unable  to
                  secure   favorable   arrangements  or  to  secure   sufficient
                  production  through  these  operations  the fair value of this
                  equipment may be impaired.

         o        Sales  are   recognized   when   persuasive   evidence  of  an
                  arrangement exists, product delivery has occurred,  pricing is
                  fixed or determinable,  and collection is reasonably  assured.
                  Sales  resulting  from  customer   buy-back   agreements,   or
                  associated  inventory storage arrangements are recognized upon
                  delivery  of the  products  to the  customer,  the  customer's
                  designated  manufacturer,  or upon notice from the customer to
                  destroy  or  dispose  of  the  goods.  Sales,  provisions  for
                  estimated  sales  returns,  and the cost of products  sold are
                  recorded  at the time title  transfers  to  customers.  Actual
                  product  returns are charged  against  estimated  sales return
                  allowances.


                                       16
<PAGE>


         o        Upon approval of a restructuring plan by management, we record
                  restructuring  reserves  for  certain  costs  associated  with
                  facility  closures and business  reorganization  activities as
                  they are incurred or when they become  probable and estimable.
                  Such  costs are  recorded  as a current  liability.  We record
                  restructuring reserves in compliance with SFAS 146 "Accounting
                  for  Costs  Associated  with  Exit  or  Disposal  Activities",
                  resulting in the recognition of employee severance and related
                  termination  benefits  for  recurring  arrangements  when they
                  became  probable and  estimable  and on the accrual  basis for
                  one-time   benefit   arrangements.   We  record   other  costs
                  associated with exit activities as they are incurred. Employee
                  severance  and  termination  benefits are  estimates  based on
                  agreements  with the relevant union  representatives  or plans
                  adopted by us that are  applicable to employees not affiliated
                  with unions.  These costs are not associated  with nor do they
                  benefit continuing  activities.  Inherent in the estimation of
                  these  costs  are  assessments  related  to  the  most  likely
                  expected outcome of the significant  actions to accomplish the
                  restructuring.  Changing  business  conditions  may affect the
                  assumptions  related  to the  timing  and  extent of  facility
                  closure  activities.  We review  the  status of  restructuring
                  activities on a quarterly basis and, if  appropriate,  records
                  changes  based  on  updated  estimates.  See  Note  11,  "2005
                  Restructuring Costs".

         o        We are  currently  involved  in various  lawsuits,  claims and
                  inquiries,  most of which  are  routine  to the  nature of the
                  business,  and in accordance with SFAS No. 5,  "Accounting for
                  Contingencies."  We  accrue  estimates  of  the  probable  and
                  estimable  losses  for the  resolution  of these  claims.  The
                  ultimate  resolution  of these  claims could affect our future
                  results of operations for any  particular  quarterly or annual
                  period  should our exposure be materially  different  from our
                  earlier estimates or should  liabilities be incurred that were
                  not previously accrued.

NEW ACCOUNTING PRONOUNCEMENTS

         In  September   2006,  the  FASB  issued  SFAS  No.  157,  "Fair  Value
Measurements",  ("SFAS No. 157"). SFAS No. 157 defines fair value, establishes a
framework for measuring fair value in generally accepted  accounting  principles
(GAAP), and expands  disclosures about fair value  measurements.  This Statement
applies under other accounting  pronouncements that require or permit fair value
measurements,  and  does  not  require  any new  fair  value  measurements.  The
application  of SFAS No. 157,  however,  may change current  practice  within an
organization.  SFAS No. 157 is effective  for all fiscal years  beginning  after
November 15, 2007, with earlier application  encouraged.  We do not believe that
SFAS No. 157 will have a material impact on our financial  position,  results of
operations or cash flows.

         In September  2006, the SEC issued Staff  Accounting  Bulletin No. 108,
CONSIDERING   THE  EFFECTS  OF  PRIOR  YEAR   MISSTATEMENTS   WHEN   QUANTIFYING
MISSTATEMENTS  IN CURRENT YEAR  FINANCIAL  STATEMENTS  ("SAB  108"),  to address
diversity in practice in quantifying financial statement misstatements.  SAB 108
requires the  quantification of misstatements  based on their impact on both the
balance sheet and the income  statement to determine  materiality.  The guidance
provides  for  a  one-time   cumulative   effect   adjustment   to  correct  for
misstatements that were not deemed material under a company's prior approach but
are material  under the SAB 108 approach.  SAB 108 is effective for fiscal years
ending after  November 15, 2006.  The  implementation  of SAB 108 did not have a
material impact on our financial position, results of operations or cash flows.

         In June 2006, the Financial  Accounting Standards Board ("FASB") issued
Interpretation  No.  48,  ACCOUNTING  FOR  UNCERTAINTY  IN  INCOME  TAXES  -- AN
INTERPRETATION  OF FASB  STATEMENT  NO.  109,  (FIN 48).  FIN 48  clarifies  the
accounting  for  uncertainty  in  income  taxes  recognized  in an  enterprise's
financial  statements in accordance with FASB Statement No. 109,  ACCOUNTING FOR
INCOME TAXES.  FIN 48 also  prescribes a recognition  threshold and  measurement


                                       17
<PAGE>


attribute for the  financial  statement  recognition  and  measurement  of a tax
position  taken or expected  to be taken in a tax return  that  results in a tax
benefit.  Additionally,  FIN 48  provides  guidance  on  de-recognition,  income
statement  classification  of  interest  and  penalties,  accounting  in interim
periods, disclosure, and transition. This interpretation is effective for fiscal
years beginning after December 15, 2006. We are currently  evaluating the effect
that the  application  of FIN 48 will  have on its  results  of  operations  and
financial condition.

         In February  2006,  the FASB issued  Statement of Financial  Accounting
Standards No. 155, "Accounting for Certain Hybrid Financial  Instruments" ("SFAS
155"),  which amends SFAS No. 133,  "Accounting for Derivatives  Instruments and
Hedging Activities" ("SFAS 133") and SFAS No. 140, "Accounting for Transfers and
Servicing of Financial Assets and  Extinguishment  of Liabilities"  ("SFAS 140).
SFAS 155 amends SFAS 133 to narrow the scope  exception  for  interest-only  and
principal-only   strips  on  debt   instruments  to  include  only  such  strips
representing  rights to receive a specified portion of the contractual  interest
or  principle  cash flows.  SFAS 155 also  amends  SFAS 140 to allow  qualifying
special-purpose  entities  to hold a  passive  derivative  financial  instrument
pertaining to beneficial interests that itself is a derivative instrument.  SFAS
No. 155 is effective for all financial  instruments acquired or issued after the
beginning of an entity's first fiscal year that begins after September 15, 2006.
We do not believe that SFAS No. 155 will have a material impact on the Company's
financial position, results of operations or cash flows.

ITEM 7A.      QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK

All of our sales are denominated in United States dollars or the currency of the
country in which our  products  originate.  We are  exposed  to market  risk for
fluctuations  in  the  foreign  currency  exchange  rates  for  certain  product
purchases that are denominated in Hong Kong dollars,  Chinese Yuan's and British
Pounds.  During 2004, we purchased forward exchange contracts for British Pounds
to hedge the  payments  of  product  purchases.  We do not  intend  to  purchase
additional   contracts  to  hedge  the  exchange  exposure  for  future  product
purchases.  There were no hedging contracts outstanding as of December 31, 2006.
Currency  fluctuations  can  increase  the  price  of our  products  to  foreign
customers which can adversely  impact the level of our export sales from time to
time. The majority of our cash  equivalents are held in United States dollars in
various  bank  accounts  and we do not believe we have  significant  market risk
exposure  with regard to our  investments.  At December  31,  2006,  none of our
indebtedness was subject to interest rate fluctuations.


                                       18
<PAGE>


ITEM 8.       FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA

                                TABLE OF CONTENTS
                                                                            PAGE
                                                                            ----

Report of Independent Registered Public Accounting Firm...................    20
Report of Independent Registered Public Accounting Firm...................    21
Consolidated Balance Sheets...............................................    22
Consolidated Statements of Operations.....................................    23
Consolidated Statements of Stockholders' Equity and Convertible
   Redeemable Preferred Stock.............................................    24
Consolidated Statements of Cash Flows.....................................    25
Notes to Consolidated Financial Statements................................    27


                                       19
<PAGE>


             REPORT OF INDEPENDENT REGISTERED PUBLIC ACCOUNTING FIRM

To the Board of Directors and Stockholders
Tag It Pacific Inc.
Woodland Hills, California


We have  audited the  consolidated  balance  sheets of Tag It Pacific  Inc.  and
subsidiaries  (the  "Company") as of December 31, 2006 and 2005, and the related
consolidated  statements of  operations,  stockholders'  equity and  convertible
redeemable  preferred  stock,  and cash  flows  for each of the two years in the
period ended December 31, 2006. Our audits also included the financial statement
schedules  of Tag It  Pacific  Inc.,  listed  in  Item  15(a).  These  financial
statements  and  financial  statement  schedules are the  responsibility  of the
Company's  management.  Our  responsibility  is to  express  an opinion on these
financial statements based on our audits.

We conducted our audits in accordance  with the standards of the Public  Company
Accounting Oversight Board (United States). Those standards require that we plan
and perform the audit to obtain reasonable assurance about whether the financial
statements are free of material misstatement.  An audit includes examining, on a
test basis,  evidence  supporting  the amounts and  disclosures in the financial
statements.  An audit also includes assessing the accounting principles used and
significant  estimates  made by  management,  as well as evaluating  the overall
financial  statement  presentation.  We  believe  that  our  audits  provided  a
reasonable basis for our opinion.

In our opinion, the consolidated  financial statements referred to above present
fairly, in all material respects,  the financial position of Tag It Pacific Inc.
and  subsidiaries  as of December  31,  2006 and 2005,  and the results of their
operations  and their cash  flows for each of the two years in the period  ended
December  31,  2006,  in  conformity  with U.S.  generally  accepted  accounting
principles.  Also, in our opinion,  the related financial  statement  schedules,
when  considered  in relation to the basic  consolidated  financial  statements,
taken as a whole,  present fairly in all material  respects the  information set
forth therein.


/S/ SINGER LEWAK GREENBAUM & GOLDSTEIN LLP
------------------------------------------
SINGER LEWAK GREENBAUM & GOLDSTEIN LLP

Los Angeles, California
April 9, 2007


                                       20
<PAGE>


             REPORT OF INDEPENDENT REGISTERED PUBLIC ACCOUNTING FIRM

The Board of Directors
Tag-It Pacific, Inc.
Los Angeles, California

         We have audited the accompanying consolidated statements of operations,
stockholders'  equity and convertible  redeemable preferred stock and cash flows
of Tag-It Pacific,  Inc. and  subsidiaries for the year ended December 31, 2004.
The financial statements are the responsibility of the Company's management. Our
responsibility  is to express an opinion on these financial  statements based on
our audit.

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

         In our opinion, the consolidated financial statements referred to above
present fairly,  in all material  respects,  the results of operations of Tag-It
Pacific,  Inc. and subsidiaries and their cash flows for the year ended December
31, 2004, in conformity with  accounting  principles  generally  accepted in the
United States of America.



                                                     /s/ BDO Seidman, LLP
                                                     ---------------------------
                                                     BDO Seidman, LLP

Los Angeles, California
March 31, 2005


                                       21
<PAGE>


<TABLE>
                              TAG-IT PACIFIC, INC.
                           CONSOLIDATED BALANCE SHEETS



                                                             December 31,    December 31,
                                                                 2006            2005
                                                             ------------    ------------
<S>                                                          <C>             <C>
Assets
Current Assets:
   Cash and cash equivalents .............................   $  2,934,673    $  2,277,397
   Accounts receivable, net ..............................      4,664,766       5,652,990
    Note receivable ......................................      1,378,491         662,369
   Inventories, net ......................................      3,051,220       5,573,099
   Prepaid expenses and other current assets .............        541,034         618,577
                                                             ------------    ------------
Total current assets .....................................     12,570,184      14,784,432

Property and equipment, net ..............................      5,623,040       6,438,096
Fixed assets held for sale ...............................        826,904         826,904
Note receivable, less current portion ....................      1,420,969       2,777,631
Due from related parties .................................        675,137         655,489
Other intangible assets, net .............................      4,139,625       4,255,125
Other assets .............................................        437,569         583,117
                                                             ------------    ------------

Total assets .............................................   $ 25,693,428    $ 30,320,794
                                                             ============    ============

Liabilities and Stockholders' Equity
Current liabilities:
  Accounts payable .......................................   $  4,006,241    $  6,719,226
  Accrued legal costs ....................................        427,917       2,520,111
  Other accrued expenses .................................      3,359,267       4,168,552
  Demand notes payable to related parties ................        664,970         664,971
  Current portion of capital lease obligations ...........        432,728         590,884
  Current portion of notes payable .......................      1,107,207         186,837
  Current portion of secured convertible promissory notes      12,472,622            --
                                                             ------------    ------------
Total current liabilities ................................     22,470,952      14,850,581

Capital lease obligations, less current portion ..........        474,733         856,495
Notes payable, less current portion ......................      1,061,514       1,261,018
Secured convertible promissory notes .....................           --        12,440,623
                                                             ------------    ------------
Total liabilities ........................................     24,007,199      29,408,717
                                                             ------------    ------------

Commitments and contingencies (Note 13)

Stockholders' Equity:
   Preferred stock Series A, $0.001 par value; 250,000
   shares authorized; no shares issued or outstanding ....           --              --

   Common stock, $0.001 par value, 100,000,000 shares
     authorized; 18,466,433 shares issued and outstanding
     at December 31, 2006; 18,241,045 at December 31, 2005         18,466          18,241
  Additional paid-in capital .............................     51,792,502      51,327,878
  Accumulated deficit ....................................    (50,124,739)    (50,434,042)
                                                             ------------    ------------
Total stockholders' equity ...............................      1,686,229         912,077
                                                             ------------    ------------

Total liabilities and stockholders' equity ...............   $ 25,693,428    $ 30,320,794
                                                             ============    ============
</TABLE>


                             See accompanying notes.


                                       22
<PAGE>


<TABLE>
                              TAG-IT PACIFIC, INC.
                      CONSOLIDATED STATEMENTS OF OPERATIONS

<CAPTION>
                                               Year Ended      Year Ended       Year Ended
                                              December 31,    December 31,     December 31,
                                                  2006            2005            2004
                                              ------------    ------------    ------------
<S>                                           <C>             <C>             <C>
Net sales .................................   $ 48,825,002    $ 47,331,176    $ 55,109,481
Cost of goods sold ........................     34,356,034      47,070,381      44,813,736
                                              ------------    ------------    ------------
Gross profit ..............................     14,468,968         260,795      10,295,745

Selling expenses ..........................      2,777,772       2,928,659       2,899,329
General and administrative expenses .......     10,872,887      16,098,363       8,950,810
Bad debt expense (recoveries) .............       (513,347)      5,857,946      12,512,797
Restructuring charges .....................           --         2,474,281         414,675
                                              ------------    ------------    ------------
Total operating expenses ..................     13,137,312      27,359,249      24,777,611

Income (loss) from operations .............      1,331,656     (27,098,454)    (14,481,866)
Interest expense, net .....................        988,453       1,379,786         849,888
                                              ------------    ------------    ------------

Income (loss) before income taxes .........        343,203     (28,478,230)    (15,331,754)
Provision for income taxes ................         33,900       1,059,479       2,277,214
                                              ------------    ------------    ------------

Net income (loss) .........................        309,303     (29,537,709)    (17,608,968)
Less: Preferred stock dividends ...........           --              --           (30,505)
                                              ------------    ------------    ------------

Net income(loss)  to common shareholders ..   $    309,303    $(29,537,709)   $(17,639,473)
                                              ============    ============    ============


Basic income(loss) per share ..............   $       0.02    $      (1.62)   $      (1.02)
                                              ============    ============    ============
Diluted income( loss) per share ...........   $       0.02    $      (1.62)   $      (1.02)
                                              ============    ============    ============


Basic weighted average shares outstanding .     18,377,484      18,225,851      17,316,202
                                              ============    ============    ============
Diluted weighted average shares outstanding     18,955,796      18,225,851      17,316,202
                                              ============    ============    ============
</TABLE>


                             See accompanying notes.


                                       23
<PAGE>


<TABLE>
                                               TAG-IT PACIFIC, INC.
            CONSOLIDATED STATEMENTS OF STOCKHOLDERS' EQUITY AND CONVERTIBLE REDEEMABLE PREFERRED STOCK
                                   YEARS ENDED DECEMBER 31, 2006, 2005 AND 2004

<CAPTION>

                                                                   Preferred Stock               Preferred Stock
                                       Common Stock                   Series A                      Series D
                               ---------------------------   ---------------------------   ----------------------------
                                  Shares         Amount         Shares         Amount         Shares          Amount
                               ------------   ------------   ------------   ------------   ------------    ------------

<S>                              <C>          <C>                    <C>            <C>        <C>         <C>
BALANCE, JANUARY 1, 2004 ...     11,508,201   $     11,510           --             --          572,818    $ 22,918,693
   Conversion of preferred
     stock Series C and
     accrued dividends .....        700,144            700           --             --             --              --
   Conversion of preferred
     stock Series D ........      5,728,180          5,728           --             --         (572,818)    (22,918,693)
   Warrants issued in
     private placement
     transaction ...........           --             --             --             --             --              --
   Common stock issued upon
     exercise of options and
     warrants ..............        214,276            214           --             --             --              --
   Common stock and warrants
     issued for services ...         20,500             21           --             --             --              --
   Tax benefit from exercise
     of stock options ......           --             --             --             --             --              --
   Preferred stock dividends           --             --             --             --             --              --
   Net loss ................           --             --             --             --             --              --
                               ------------   ------------   ------------   ------------   ------------    ------------
BALANCE, DECEMBER 31, 2004 .     18,171,301         18,173           --             --             --              --
   Common stock issued upon
     exercise of options and
     warrants ..............         69,744             68           --             --             --              --
   Net loss ................           --             --             --             --             --              --
                               ------------   ------------   ------------   ------------   ------------    ------------
BALANCE, DECEMBER 31, 2005 .     18,241,045         18,241           --             --             --              --
   Common stock issued for
     services ..............        225,388            225           --             --             --              --
   Stock based compensation            --             --             --             --             --              --
   Net income ..............           --             --             --             --             --              --
                               ------------   ------------   ------------   ------------   ------------    ------------
BALANCE, DECEMBER 31, 2006 .     18,466,433   $     18,466           --             --             --              --
                               ============   ============   ============   ============   ============    ============


<CAPTION>
                                                Convertible
                                                Redeemable                            Preferred Stock
                                Additional       Retained                                 Series C
                                  Paid-In        Earnings                       ----------------------------
                                  Capital       (Deficit)           Total          Shares          Amount
                               ------------   --------------    ------------    ------------    ------------
<S>                            <C>            <C>               <C>                 <C>         <C>
BALANCE, JANUARY 1, 2004 ...   $ 23,890,356   $   (3,256,860)   $ 43,563,699         759,494    $  2,895,001
   Conversion of preferred
     stock Series C and
     accrued dividends .....      3,353,008             --         3,353,708        (759,494)     (2,895,001)
   Conversion of preferred
     stock Series D ........     22,912,965             --              --              --              --
   Warrants issued in
     private placement
     transaction ...........        189,815             --           189,815            --              --
   Common stock issued upon
     exercise of options and
     warrants ..............        557,514             --           557,728            --              --
   Common stock and warrants
     issued for services ...         85,710             --            85,731            --              --
   Tax benefit from exercise
     of stock options ......         84,034             --            84,034            --              --
   Preferred stock dividends           --            (30,505)        (30,505)           --              --
   Net loss ................           --        (17,608,968)    (17,608,968)           --              --
                               ------------   --------------    ------------    ------------    ------------
BALANCE, DECEMBER 31, 2004 .     51,073,402      (20,896,333)     30,195,242            --              --
   Common stock issued upon
     exercise of options and
     warrants ..............        254,476             --           254,544            --              --
   Net loss ................           --        (29,537,709)    (29,537,709)           --              --
                               ------------   --------------    ------------    ------------    ------------
BALANCE, DECEMBER 31, 2005 .     51,327,878      (50,434,042)        912,077            --              --
   Common stock issued for
     services ..............        102,504             --           102,729            --              --
   Stock based compensation         362,120             --           362,120            --              --
   Net income ..............           --            309,303         309,303            --              --
                               ------------   --------------    ------------    ------------    ------------
BALANCE, DECEMBER 31, 2006 .   $ 51,792,502   $  (50,124,739)   $  1,686,229            --              --
                               ============   ==============    ============    ============    ============
</TABLE>


                              See accompanying note


                                       24
<PAGE>


<TABLE>
                                               TAG-IT PACIFIC, INC.
                                       CONSOLIDATED STATEMENTS OF CASH FLOWS

<CAPTION>
                                                                   Year Ended      Year Ended      Year Ended
                                                                  December 31,    December 31,    December 31,
                                                                      2006            2005            2004
                                                                  ------------    ------------    ------------
<S>                                                               <C>             <C>             <C>
CASH FLOWS FROM OPERATING ACTIVITIES:
   Net income (loss) ..........................................   $    309,303    $(29,537,709)   $(17,608,968)
   Adjustments to reconcile net income (loss) to net cash
     provided by (used in) operating activities:
     Depreciation and amortization ............................      1,523,225       1,931,990       1,547,223
     Decrease in deferred income taxes ........................           --         1,000,000       1,800,000
     Common stock and warrants issued for services ............         32,729            --            85,731
     Stock based compensation .................................        362,120
     Increase(decrease) in allowance for doubtful accounts ....     (1,117,500)      2,630,759       4,042,428
     Increase(decrease) in inventory valuation reserve ........     (6,064,000)        940,973        (240,000)
     Asset impairment due to restructuring ....................           --         2,343,531            --
     Impairment of goodwill ...................................           --           450,000            --
     Disposal of assets .......................................        129,179            --              --
   Changes in operating assets and liabilities:
     Accounts receivable ......................................      2,086,076      10,666,295      (7,640,984)
     Note receivable collections ..............................        640,539            --              --
     Inventories ..............................................      8,585,879       2,791,747       7,551,060
     Prepaid expenses and other current assets ................         77,543       1,880,443          13,121
     Other assets .............................................       (140,217)        314,998         147,046
     Accounts payable .........................................     (2,587,985)      2,986,302      (2,647,692)
     Accrued legal costs ......................................       (442,194)      2,113,197         245,796
     Other accrued expenses ...................................       (733,767)        671,348         831,346
     Repayment of notes payable converted from accounts payable       (867,297)           --              --
     Income taxes payable .....................................           (480)        (71,589)         12,032
                                                                  ------------    ------------    ------------
   Net cash provided by (used in) operating activities ........      1,794,153       1,112,285     (11,381,861)
                                                                  ------------    ------------    ------------
CASH FLOWS FROM INVESTING ACTIVITIES:
   Proceeds from sale of equipment ............................          2,500            --              --
   Acquisition of property and equipment ......................       (347,188)     (1,453,848)     (3,615,899)
                                                                  ------------    ------------    ------------
   Net cash used in investing activities ......................       (344,688)     (1,453,848)     (3,615,899)
                                                                  ------------    ------------    ------------
CASH FLOWS FROM FINANCING ACTIVITIES:
   Proceeds from secured convertible promissory notes .........           --              --        11,663,685
   Proceeds from exercise of stock options and warrants .......           --           254,544         557,728
   (Repayment) of line of credit and due to factor, net .......           --          (614,506)     (6,481,007)
   Proceeds from capital lease obligation .....................           --              --           950,000
   Payment of capital lease obligations .......................       (604,351)       (906,765)       (332,583)
   Proceeds from notes payable ................................           --              --           880,000
   Repayment of notes payable .................................       (186,838)     (1,574,975)     (1,222,170)
                                                                  ------------    ------------    ------------
   Net cash (used in) provided by financing activities ........       (791,189)     (2,841,702)      6,015,653
                                                                  ------------    ------------    ------------
Net increase (decrease) in cash and cash equivalents ..........        657,276      (3,183,265)     (8,982,107)
Cash and cash equivalents, beginning of year ..................      2,277,397       5,460,662      14,442,769
                                                                  ------------    ------------    ------------
Cash and cash equivalents, end of year ........................   $  2,934,673    $  2,277,397    $  5,460,662
                                                                  ============    ============    ============
</TABLE>


                             See accompanying notes.


                                       25
<PAGE>


<TABLE>
TAG-IT PACIFIC, INC.
Consolidated Statements of Cash Flows
<CAPTION>
                                                                  Year Ended      Year Ended      Year Ended
                                                                 December 31,    December 31,    December 31,
                                                                     2006            2005            2004
                                                                 ------------    ------------    ------------
<S>                                                              <C>             <C>             <C>
SUPPLEMENTAL DISCLOSURES OF CASH FLOW INFORMATION:
   Cash received (paid) during the year for:
     Interest paid ...........................................   $   (975,609)   $ (1,264,539)   $   (693,045)
     Interest received .......................................   $    320,232    $     42,516    $     32,340
     Income taxes paid .......................................   $    (33,900)   $    (64,064)   $   (495,345)
     Income taxes received ...................................   $       --      $     39,571    $     17,903
   Non-cash financing activity:
     Capital lease obligation ................................   $     64,432    $    273,376    $    249,418
     Accounts receivable, net converted to notes receivable ..   $       --      $  3,440,000    $    470,799
     Trade payable & accrued legal, converted to notes payable   $  1,775,000    $       --      $       --
     Preferred Series D stock converted to common stock ......   $       --      $       --      $ 22,918,693
     Preferred Series C stock converted to common stock ......   $       --      $       --      $  2,895,001
     Accrued dividends converted to common stock .............   $       --      $       --      $    458,707
     Mortgage note payable ...................................   $       --      $       --      $    765,000
     Warrants issued to placement agent ......................   $       --      $       --      $     93,815
</TABLE>


                             See accompanying notes.


                                       26
<PAGE>


                              TAG-IT PACIFIC, INC.
                   NOTES TO CONSOLIDATED FINANCIAL STATEMENTS


NOTE 1--SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES

NATURE OF BUSINESS

         Tag-It  Pacific,  Inc.  (the  "Company")  is an  apparel  company  that
specializes  in the  distribution  of trim  items to  manufacturers  of  fashion
apparel, specialty retailers and mass merchandisers.  The Company acts as a full
service  outsourced trim management  department for  manufacturers,  a specified
supplier  of trim  items to owners  of  specific  brands,  brand  licensees  and
retailers,  a manufacturer and distributor of zippers under the TALON brand name
and  a  distributor  of  stretch   waistbands  that  utilize  licensed  patented
technology under the TEKFIT brand name.

ORGANIZATION AND BASIS OF PRESENTATION

         Tag-It Pacific,  Inc. is the parent holding company of Tag-It,  Inc., a
California corporation,  Tag-It Pacific (HK) Ltd., a BVI corporation,  Tag-It de
Mexico,  S.A.  de  C.V.,  A.G.S.  Stationery,  Inc.,  a  California  corporation
(collectively,  the  "Subsidiaries"),  all of which  were  consolidated  under a
parent  limited  liability  company on October 17, 1997 and became  wholly-owned
subsidiaries  of the  Company  immediately  prior to the  effective  date of the
Company's  initial  public  offering in January 1998.  Immediately  prior to the
initial public offering,  the outstanding membership units of Tag-It Pacific LLC
were  converted to 2,470,001  shares of Common Stock of the Company.  In January
2000, the Company formed Tag-It Pacific Limited, a Hong Kong corporation, and in
April  2000,   the  Company  formed  Talon   International,   Inc.,  a  Delaware
corporation.  During  2006 we formed two  wholly  owned  subsidiaries  of Tag-It
Pacific,  Inc.;  Talon  Zipper  (Shenzhen)  Company  Ltd.  in  China,  and Talon
International  Pvt.  Ltd.,  in India.  All newly  formed  corporations  are 100%
wholly-owned  Subsidiaries of Tag-It Pacific,  Inc.  Logistica en Avios, S.A. de
C.V. was an affiliated entity over which the Company exercised  control,  and as
such, is accounted for in the same manner as a wholly-owned subsidiary.

         All  significant  intercompany  accounts  and  transactions  have  been
eliminated in consolidation.  Assets and liabilities of foreign subsidiaries are
translated  at rates of exchange in effect at the close of the period.  Revenues
and expenses are translated at the weighted  average of exchange rates in effect
during the year. The resulting translation gains and losses are deferred and are
shown  as a  separate  component  of  stockholders'  equity,  if  material,  and
transaction gains and losses, if any, are recorded in the consolidated statement
of income in the period incurred.  During 2006, 2005 and 2004,  foreign currency
translation and transaction gains and losses were not material. The Company does
not engage in hedging activities with respect to exchange rate risk.

USE OF ESTIMATES

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

CASH AND CASH EQUIVALENTS

         The Company considers all highly liquid  investments  purchased with an
initial maturity of three months or less to be cash equivalents. The Company had
approximately $2.9 million and $2.2 million at financial  institutions in excess
of federally insured limits at December 31, 2006 and 2005.


                                       27
<PAGE>


                              TAG-IT PACIFIC, INC.
                   NOTES TO CONSOLIDATED FINANCIAL STATEMENTS


ALLOWANCE FOR DOUBTFUL ACCOUNTS

         We are required to make judgments as to the  collectibility of accounts
receivable based on established aging policy,  historical  experience and future
expectations.  The allowances  for doubtful  accounts  represent  allowances for
customer  trade  accounts  receivable  that are  estimated  to be  partially  or
entirely  uncollectible.  These  allowances  are  used  to  reduce  gross  trade
receivables to their net realizable  value. We record these  allowances based on
estimates related to the following  factors:  (i) customer specific  allowances;
(ii) amounts based upon an aging schedule;  and (iii) an estimated amount, based
on our historical experience, for issues not yet identified.

INVENTORIES

         Inventories  are  stated  at the  lower of cost,  determined  using the
first-in,  first-out basis, or market value and are all  substantially  finished
goods.  The costs of inventory  include the purchase price,  inbound freight and
duties,  conversion  costs and  certain  allocated  production  overhead  costs.
Inventory  reserves are recorded for damaged,  obsolete,  excess and slow-moving
inventory.  We use estimates to record these reserves.  Slow-moving inventory is
reviewed by category and may be partially or fully reserved for depending on the
type of  product  and the  length  of time  the  product  has been  included  in
inventory.  Reserve  adjustments are made for the difference between the cost of
the  inventory  and the  estimated  market  value,  if  lower,  and  charged  to
operations in the period in which the facts that give rise to these  adjustments
become  known.  Market value of  inventory  is estimated  based on the impact of
market  trends,  an evaluation of economic  conditions  and the value of current
orders relating to the future sales of this type of inventory.

         Inventories consist of the following:
                                                     Year Ended December 31,
                                                --------------------------------
                                                    2006                 2005
                                                -----------          -----------

Finished goods .......................          $ 4,293,220          $12,879,099
Less reserves ........................            1,242,000            7,306,000
                                                -----------          -----------
Total inventories ....................          $ 3,051,220          $ 5,573,099
                                                ===========          ===========


PROPERTY AND EQUIPMENT AND FIXED ASSETS HELD FOR SALE

         Property and equipment are recorded at historical cost. Maintenance and
repairs are  expensed as  incurred.  Upon  retirement  or other  disposition  of
property  and  equipment,  the  related  cost and  accumulated  depreciation  or
amortization  are removed from the accounts and any gains or losses are included
in results of  operations.  During the year ended  December 31, 2005 the Company
wrote-off fully depreciated equipment,  films, dies and art designs no longer in
service,  and changed its estimates of the expected useful lives of the dies and
molds to 3 months or 1 year, depending upon the nature of the tool.

         Depreciation   of  property  and   equipment  is  computed   using  the
straight-line method based on estimated useful lives as follows:

         Furniture and fixtures     5 years

         Machinery and equipment    5 to 10 years

         Computer equipment         5 years

         Leasehold improvements     Term of the lease or the  estimated  life of
                                    the  related   improvements,   whichever  is
                                    shorter.

         Dies, and molds            3 months to 1 years

         Idle equipment             5 to 10 years


                                       28
<PAGE>


                              TAG-IT PACIFIC, INC.
                   NOTES TO CONSOLIDATED FINANCIAL STATEMENTS


         Property and equipment consist of the following:

                                                        Year Ended December 31,
                                                     ---------------------------
                                                         2006            2005
                                                     -----------     -----------

Furniture and fixtures .........................     $   582,832     $   551,623
Machinery and equipment ........................       1,682,296       3,319,786
Computer equipment .............................       3,422,058       3,325,997
Leasehold improvements .........................         214,807         139,803
Dies, and molds ................................         106,273         106,273
Idle equipment .................................       4,434,980       2,806,475
                                                     -----------     -----------

                                                      10,443,246      10,249,958
Accumulated depreciation and amortization ......       4,820,206       3,811,862
                                                     -----------     -----------

Net property and equipment .....................     $ 5,623,040     $ 6,438,096
                                                     ===========     ===========


         Depreciation  expense for the years ended  December 31, 2006,  2005 and
2004 was $1,090,000, $1,499,000, and $1,277,000, respectively.

         During the year ended  December 31, 2005, the Company  wrote-off  fixed
assets  with a net  book  value  of  $2,036,000  in  connection  with  the  2005
restructuring plan.

         Idle  equipment is  principally  machinery and  equipment  used for the
production of zipper chain and the assembly of finished zippers.  This equipment
was originally  associated with the production and assembly  facilities in North
Carolina and in Mexico,  and was  temporarily  rendered idle with the closing of
these  operations in connection  with the 2005  Restructuring  Plan. The Company
intends  to  redeploy  this  equipment  during the next year  within  production
operations being  established in Asia and India.  The equipment  continues to be
depreciated based upon its estimated useful lives.

         Fixed  assets  held for sale  consists of the North  Carolina  land and
manufacturing  facility.  Management has the authority and has committed to sell
the asset;  the asset is listed for sale with a commercial real estate agent who
is actively  marketing the  property;  the sale of the asset is probable and the
sale  is  expected  to  be  completed  within  one  year.  See  Note  11,  "2005
Restructuring  Plan".  This asset held for sale is financed  by a mortgage  note
with a balance of  $712,950 at December  31, 2006 and  $734,787 at December  31,
2005.

GOODWILL AND OTHER INTANGIBLE ASSETS

         Intangible assets consist of goodwill, tradename, and exclusive license
and intellectual  property rights.  Goodwill represents the excess of costs over
fair value of assets of  businesses  acquired.  Goodwill and  intangible  assets
acquired in a purchase business combination and determined to have an indefinite
useful  life are not  amortized,  but  instead  tested for  impairment  at least
annually in accordance  with the provisions of FASB Statement No. 142,  Goodwill
and Other Intangible  Assets.  Intangible assets with estimable useful lives are
amortized over their respective  estimated useful lives,  which average 5 years,
to their estimated  residual  values,  and reviewed for impairment in accordance
with FASB Statement No. 144, Accounting for Impairment or Disposal of Long-Lived
Assets.


                                       29
<PAGE>


                              TAG-IT PACIFIC, INC.
                   NOTES TO CONSOLIDATED FINANCIAL STATEMENTS


         At December 31, 2006, the Company evaluated its Other Intangible Assets
and determined  that there was no impairment of these assets and made no changes
to the net carrying  amount of Tradename  for the years ended  December 31, 2006
and 2005.  At  December  31,  2005,  the  Company  evaluated  its  Goodwill  and
determined  that an impairment  adjustment in the amount of $450,000  related to
goodwill  was  necessary  to reduce  the  carrying  value of  goodwill  to zero.
Amortization  expense  related to exclusive  license and  intellectual  property
rights of $115,500 were recorded for each of the years ended  December 31, 2006,
2005 and 2004.

         Goodwill and other  intangible  assets as of December 31, 2006 and 2005
are as follows:

<TABLE>
<CAPTION>
                                                                  Year Ended December 31,
                                                                --------------------------
                                                                    2006           2005
                                                                -----------    -----------
<S>                                                             <C>            <C>
Goodwill ....................................................   $      --      $   500,000
  Accumulated amortization ..................................          --          (50,000)
  Impairment write-off ......................................          --         (450,000)
                                                                -----------    -----------
  Goodwill, net .............................................   $      --      $      --
                                                                ===========    ===========

Other Intangible Assets:
  Tradename .................................................   $ 4,110,750    $ 4,110,750
  Accumulated amortization ..................................          --             --
                                                                -----------    -----------
      Tradename, net ........................................     4,110,750      4,110,750

  Exclusive license and intellectual property rights ........       577,500        577,500
  Accumulated amortization ..................................      (548,625)      (433,125)
                                                                -----------    -----------
      Exclusive license and intellectual property rights, net        28,875        144,375
                                                                -----------    -----------
  Other intangible assets, net ..............................   $ 4,139,625    $ 4,255,125
                                                                ===========    ===========
</TABLE>

         The  estimated  amortization  expense for these  assets for  succeeding
years is $28,875 for 2007.

IMPAIRMENT OF LONG-LIVED ASSETS

         We record  impairment  charges when the carrying  amounts of long-lived
assets are determined not to be recoverable. Impairment is measured by assessing
the usefulness of an asset or by comparing the carrying value of an asset to its
fair value.  Fair value is typically  determined using quoted market prices,  if
available,  or an estimate of undiscounted  future cash flows expected to result
from the use of the asset and its eventual disposition. The amount of impairment
loss is  calculated  as the excess of the  carrying  value over the fair  value.
Changes in market conditions and management strategy have historically caused us
to reassess the carrying amount of our long-lived assets.  During the year ended
December 31, 2005, the Company recorded asset  impairment  charges in connection
with its 2005 Restructuring Plan (See Note 11).


                                       30
<PAGE>


                              TAG-IT PACIFIC, INC.
                   NOTES TO CONSOLIDATED FINANCIAL STATEMENTS


ACCRUED EXPENSES

         Included  in the  December  31,  2006  accrued  expenses  is a customer
payment of approximately  $1,105,000.  The payment is an advance on raw material
inventory  purchases for this customer.  We recorded these funds as a short term
obligation and not as revenue because the product for this customer's  order was
not shipped as of December 31, 2006.  The  underlying  order is expected to ship
within six months.

INCOME TAXES

         Income taxes are accounted  for under the asset and  liability  method.
Deferred  tax  assets  and   liabilities  are  recognized  for  the  future  tax
consequences   attributable  to  differences  between  the  financial  statement
carrying  amounts of existing assets and  liabilities  and their  respective tax
bases and tax benefit carry-forwards. Deferred tax liabilities and assets at the
end of each period are determined  using enacted tax rates.  The Company records
deferred tax assets arising from temporary timing  differences  between recorded
net income and taxable net income  when and if we believe  that future  earnings
will be sufficient to realize the tax benefit. For those jurisdictions where the
expiration date of tax benefit  carry-forwards or the projected taxable earnings
indicate that realization is not likely, a valuation allowance is provided.

         The provisions of SFAS No. 109,  "Accounting for Income Taxes," require
the  establishment of a valuation  allowance when, based on currently  available
information and other factors,  it is more likely than not that all or a portion
of a deferred  tax asset will not be  realized.  SFAS No. 109  provides  that an
important factor in determining whether a deferred tax asset will be realized is
whether there has been sufficient income in recent years and whether  sufficient
income is expected in future years in order to utilize the deferred tax asset.

         The Company  believes  that its  estimate  of  deferred  tax assets and
determination to record a valuation  allowance  against such assets are critical
accounting  estimates  because  they are subject  to,  among  other  things,  an
estimate of future taxable income,  which is susceptible to change and dependent
upon  events that may or may not occur,  and  because the impact of  recording a
valuation  allowance may be material to the assets reported on the balance sheet
and results of operations.

STOCK-BASED COMPENSATION

         On  January  1,  2006,  the  Company  adopted  Statement  of  Financial
Accounting  Standards  No. 123 (revised  2004),  "Share-Based  Payment,"  ("SFAS
123(R)") which requires the measurement and recognition of compensation  expense
for all  share-based  payment  awards made to employees and  directors  based on
estimated fair values.  SFAS 123(R) supersedes the Company's previous accounting
under Accounting  Principles Board Opinion No. 25,  "Accounting for Stock Issued
to  Employees"  ("APB 25") for periods  beginning in fiscal 2006. In March 2005,
the Securities and Exchange  Commission issued Staff Accounting Bulletin No. 107
("SAB 107")  relating to SFAS 123(R).  The Company has applied the provisions of
SAB 107 in its adoption of SFAS 123(R).

         The  Company  adopted  SFAS  123(R)  using  the  modified   prospective
transition method,  which requires the application of the accounting standard as
of January 1, 2006.  The Company's  financial  statements as of and for the year
ended  December 31, 2006 reflect the impact of SFAS 123(R).  In accordance  with
the modified  prospective  transition method, the Company's financial statements
for prior  periods have not been  restated to reflect,  and do not include,  the
impact of SFAS 123(R). There was no stock-based  compensation expense related to
employee or director  stock options  recognized  during the years ended December
31, 2005 or 2004.  Options issued to consultants are accounted for in accordance
with the provisions of Emerging Issues Task Force (EITF) No. 96-18,  "Accounting
for Equity  Instruments  That Are Issued to Others Than Employees for Acquiring,
or in Conjunction with Selling, Goods or Services."


                                       31
<PAGE>


                              TAG-IT PACIFIC, INC.
                   NOTES TO CONSOLIDATED FINANCIAL STATEMENTS


         As a result of adopting  SFAS 123(R) on January 1, 2006,  the Company's
income before  income taxes and net income for the year ended  December 31, 2006
are  $395,000  lower  than  if it  had  continued  to  account  for  share-based
compensation under APB Opinion 25.

         The following  table  illustrates the effect on net income and loss per
share if the Company had applied the fair value  recognition  provisions of SFAS
123(R) to stock-based  awards granted under the Company's  stock option plans in
all periods presented. For purposes of this pro-forma disclosure, the fair value
of the  options  is  estimated  using  the  Black-Scholes-Merton  option-pricing
formula  ("Black-Scholes  model") and  amortized to expense  generally  over the
options' vesting periods.

                                                       2005            2004
                                                   ------------    ------------

Net loss as reported ...........................   $(29,537,709)   $(17,608,968)

Add:  Stock-based employee compensation expense
     included in reported net income, net of
     related tax effects .......................           --              --

Deduct:  Total stock-based employee
     compensation expense determined under fair
     value method for all awards, net of
     related tax effects .......................       (221,167)        (55,228)
                                                   ------------    ------------

Pro forma net loss .............................   $(29,758,876)   $(17,664,196)
                                                   ============    ============

 Loss per share:
     Basic - as reported .......................   $      (1.62)   $      (1.02)
     Basic - pro forma .........................   $      (1.63)   $      (1.02)


         SFAS  123(R)   requires   companies  to  estimate  the  fair  value  of
share-based payment awards to employees and directors on the date of grant using
an  option-pricing  model.  The  value  of the  portion  of the  award  that  is
ultimately  expected to vest is recognized as expense over the requisite service
periods in the Company's  Statements  of  Operations.  Stock-based  compensation
expense  recognized in the  Statements of Operations for the year ended December
31, 2006 included  compensation  expense for share-based  payment awards granted
prior to,  but not yet vested as of January 1, 2006 based on the grant date fair
value  estimated in  accordance  with the  pro-forma  provisions of SFAS 123 and
compensation  expense for the share-based  payment awards granted  subsequent to
January 1, 2006 based on the grant date fair value  estimated in accordance with
the provisions of SFAS 123(R).  For  stock-based  awards issued to employees and
directors,   stock-based   compensation  is  attributed  to  expense  using  the
straight-line   single  option  method,   which  is  consistent   with  how  the
prior-period  pro formas were  provided.  As  stock-based  compensation  expense
recognized in the Statements of Operations for 2006 is based on awards  expected
to vest, SFAS 123(R)  requires  forfeitures to be estimated at the time of grant
and revised,  if necessary,  in subsequent  periods if actual forfeitures differ
from those estimates. For the year ended December 31, 2006, expected forfeitures
are immaterial and as such the Company is recognizing forfeitures as they occur.
In the pro-forma  information  provided  under SFAS 123 for the periods prior to
2006, the Company accounted for forfeitures as they occurred.

         Prior  to the  adoption  of SFAS  123(R),  the  Company  accounted  for
stock-based  awards to employees and directors  using the intrinsic value method
in accordance with APB Opinion 25. Under the intrinsic value method, the Company
recognized share-based  compensation equal to the award's intrinsic value at the
time of grant over the requisite service periods using the straight-line method.
Forfeitures  were recognized as incurred.  During the years ended December,  31,


                                       32
<PAGE>


                              TAG-IT PACIFIC, INC.
                   NOTES TO CONSOLIDATED FINANCIAL STATEMENTS


2005 and 2004, there was no stock-based  compensation  expense recognized in the
Statements  of  Operations  for awards  issued to employees and directors as the
awards had no intrinsic value at the time of grant because their exercise prices
equaled the fair values of the common stock at the time of grant.

         The Company's determination of fair value of share-based payment awards
to employees  and directors on the date of grant uses the  Black-Scholes  model,
which is affected by the Company's stock price as well as assumptions  regarding
a number of complex and subjective  variables.  These variables include, but are
not limited to, the expected  stock price  volatility  over the expected term of
the awards, and actual and projected  employee stock option exercise  behaviors.
The Company  estimates  expected  volatility using historical data. The expected
option term is estimated using the "safe harbor" provisions under SAB 107.

         The Company has elected to adopt the detailed  method  provided in SFAS
123(R) for calculating the beginning  balance of the additional  paid-in capital
pool  ("APIC  pool")  related  to  the  tax  effects  of  employee   stock-based
compensation,  and to  determine  the  subsequent  impact  on the APIC  pool and
Statements of Cash Flows of the tax effects of employee stock-based compensation
awards that are outstanding upon adoption of SFAS 123(R).

COMPREHENSIVE INCOME

         The  Company has  adopted  Statement  of  Financial  Standard  No. 130,
"Reporting  Comprehensive Income" ("SFAS 130"), issued by the FASB and effective
for financial  statements  with fiscal years  beginning after December 15, 1997.
SFAS 130 establishes standards for reporting and display of comprehensive income
and its components in a full set of general-purpose financial statements.  There
were no material other  comprehensive  income items for the years ended December
31, 2006, 2005 and 2004.

REVENUE RECOGNITION

         Sales are recognized when persuasive evidence of an arrangement exists,
product delivery has occurred, pricing is fixed or determinable,  and collection
is reasonably  assured.  Sales resulting from customer buy-back  agreements,  or
associated  inventory  storage  arrangements are recognized upon delivery of the
products to the customer, the customer's designated manufacturer, or upon notice
from the  customer  to destroy or dispose of the goods.  Sales,  provisions  for
estimated sales returns,  and the cost of products sold are recorded at the time
title  transfers  to  customers.  Actual  product  returns are  charged  against
estimated sales return allowances.

         Sales rebates and discounts  are common  practice in the  industries in
which the Company operates. Volume, promotional, price, cash and other discounts
and customer incentives are accounted for as a reduction to gross sales. Rebates
and discounts are recorded  based upon  estimates at the time products are sold.
These  estimates are based upon historical  experience for similar  programs and
products. The Company reviews such rebates and discounts on an ongoing basis and
accruals for rebates and  discounts are  adjusted,  if necessary,  as additional
information becomes available.

RECLASSIFICATION

         Certain  reclassifications  have been made to the prior year  financial
statements  to  conform  to  2006  presentation  in  this  annual  report  . The
amortization of deferred financing costs and discounts are reported as "Interest
Expense, net" on the consolidated statement of operations. These items ($310,771
and  $45,000  for 2005 and  2004,  respectively)  were  previously  reported  as
"General and Administrative  Expenses". The Consolidated Statement of Cash Flows
for 2004 reflects a decrease in inventory  valuation reserves of $240,000 in the
Adjustments  to reconcile  net income  (loss) to net cash  provided by (used in)
operating activities. This amount was previously reported net, in the Changes in
operating assets and liabilities-  Inventory.  In 2006 Cash flows from operating
activities  include Note  receivable  collections  of $640,539 and Repayments of
notes  payable  converted  from accounts  payable of $867,297.  These items were
reported  as Cash flows from  financing  activities  in prior  versions  of this
annual report filed on Form 10-KA.


                                       33
<PAGE>


                              TAG-IT PACIFIC, INC.
                   NOTES TO CONSOLIDATED FINANCIAL STATEMENTS


CLASSIFICATION OF EXPENSES

         COST OF SALES - Cost of goods sold primarily  includes expenses related
to inventory purchases,  customs, duty, freight,  overhead expenses and reserves
for obsolete  inventory.  Overhead  expenses  primarily consist of warehouse and
operations salaries, and other warehouse expenses.

         SELLING EXPENSE - Selling expenses  primarily  include royalty expense,
sales salaries and commissions,  travel and  entertainment,  marketing and other
sales-related costs.

         GENERAL  AND  ADMINISTRATIVE  EXPENSES  -  General  and  administrative
expenses   primarily  include   administrative   salaries,   employee  benefits,
professional  service fees,  facility  expenses,  information  technology costs,
investor relations, travel and entertainment, depreciation and amortization, bad
debts, restructuring costs and other general corporate expenses.

         INTEREST  EXPENSE AND INTEREST INCOME - Interest  expense  reflects the
cost of borrowing and  amortization  of deferred  financing costs and discounts.
Interest  expense  for the years  ended  December  31,  2006,  2005 and 2004 was
$1,357,000, $1,446,000, and $882,000, respectively. Interest income of $368,000,
$66,000  and  $32,000  for the years ended  December  31,  2006,  2005 and 2004,
respectively,  consists of earnings from outstanding  amounts due to the Company
under notes and other interest bearing receivables.

SHIPPING AND HANDLING COSTS

         In accordance with Emerging Issues Task Force (EITF) 00-10,  Accounting
for Shipping  and  Handling  Fees and Costs,  the Company  records  shipping and
handling  costs billed to customers as a component of revenue,  and shipping and
handling  costs  incurred by the Company for outbound  freight are recorded as a
component  of cost of sales.  Total  shipping  and  handling  costs  included as
component  of revenue  for the years  ended  December  31,  2006,  2005 and 2004
amounted to $146,000,  $98,000 and $194,000.  Total  shipping and handling costs
included  as a component  of cost of sales for each of these  years  amounted to
$691,000, $925,000 and $1,002,000.

RESTRUCTURING CHARGES

         The Company records restructuring  reserves in compliance with SFAS 146
"Accounting for Costs Associated with Exit or Disposal Activities", resulting in
the  recognition  of employee  severance  and related  termination  benefits for
recurring  arrangements  as they  are  incurred  and on the  accrual  basis  for
one-time benefit  arrangements.  The Company records other costs associated with
exit  activities  as they  are  incurred.  Employee  severance  and  termination
benefits  are   estimates   based  on   agreements   with  the  relevant   union
representatives or plans adopted by the Company that are applicable to employees
not  affiliated  with unions.  These costs are not  associated  with nor do they
benefit  continuing  activities.  Inherent in the  estimation of these costs are
assessments  related to the most  likely  expected  outcome  of the  significant
actions to accomplish the restructuring. Changing business conditions may affect
the assumptions related to the timing and extent of facility closure activities.
The Company reviews the status of restructuring  activities on a quarterly basis
and, if appropriate,  records changes based on updated  estimates.  See Note 11,
"2005 Restructuring Plan".

LITIGATION

         We are currently  involved in various  lawsuits,  claims and inquiries,
most of which are routine to the nature of the business,  and in accordance with
SFAS No. 5, "Accounting for  Contingencies," we accrue estimates of the probable
and estimable losses for the resolution of these claims. The ultimate resolution
of these claims could affect our future results of operations for any particular
quarterly or annual period should


                                       34
<PAGE>


                              TAG-IT PACIFIC, INC.
                   NOTES TO CONSOLIDATED FINANCIAL STATEMENTS


our  exposure  be  materially  different  from our earlier  estimates  or should
liabilities be incurred that were not previously accrued.

FAIR VALUE OF FINANCIAL INFORMATION

         The following  methods and  assumptions  were used to estimate the fair
value of each class of  financial  instruments  for which it is  practicable  to
estimate that value.  Accounts  receivable:  Due to the short-term nature of the
receivables,  the fair value  approximates  the carrying value. Due from related
parties and notes payable to related parties:  Due to the short-term  nature and
current  market  borrowing  rates  of  the  loans  and  notes,  the  fair  value
approximates the carrying value. Notes payable: Fair value approximates carrying
value based upon current market borrowing rates for loans with similar terms and
maturities.

NEW ACCOUNTING PRONOUNCEMENTS

         In  September   2006,  the  FASB  issued  SFAS  No.  157,  "Fair  Value
Measurements",  ("SFAS No. 157"). SFAS No. 157 defines fair value, establishes a
framework for measuring fair value in generally accepted  accounting  principles
(GAAP), and expands  disclosures about fair value  measurements.  This Statement
applies under other accounting  pronouncements that require or permit fair value
measurements,  and  does  not  require  any new  fair  value  measurements.  The
application  of SFAS No. 157,  however,  may change current  practice  within an
organization.  SFAS No. 157 is effective  for all fiscal years  beginning  after
November 15, 2007,  with earlier  application  encouraged.  The Company does not
believe that SFAS No. 157 will have a material impact on the Company's financial
position, results of operations or cash flows.

         In September  2006, the SEC issued Staff  Accounting  Bulletin No. 108,
Considering   the  Effects  of  Prior  Year   Misstatements   when   Quantifying
Misstatements  in Current Year  Financial  Statements  ("SAB  108"),  to address
diversity in practice in quantifying financial statement misstatements.  SAB 108
requires the  quantification of misstatements  based on their impact on both the
balance sheet and the income  statement to determine  materiality.  The guidance
provides  for  a  one-time   cumulative   effect   adjustment   to  correct  for
misstatements that were not deemed material under a company's prior approach but
are material  under the SAB 108 approach.  SAB 108 is effective for fiscal years
ending after  November 15, 2006.  The  implementation  of SAB 108 did not have a
material impact on the financial  position,  results of operations or cash flows
of the Company.

         In June 2006, the Financial  Accounting Standards Board ("FASB") issued
Interpretation  No.  48,  Accounting  for  Uncertainty  in  Income  Taxes  -- An
Interpretation  of FASB  Statement  No.  109,  (FIN 48).  FIN 48  clarifies  the
accounting  for  uncertainty  in  income  taxes  recognized  in an  enterprise's
financial  statements in accordance with FASB Statement No. 109,  Accounting for
Income Taxes.  FIN 48 also  prescribes a recognition  threshold and  measurement
attribute for the  financial  statement  recognition  and  measurement  of a tax
position  taken or expected  to be taken in a tax return  that  results in a tax
benefit.  Additionally,  FIN 48  provides  guidance  on  de-recognition,  income
statement  classification  of  interest  and  penalties,  accounting  in interim
periods, disclosure, and transition. This interpretation is effective for fiscal
years beginning after December 15, 2006. The Company is currently evaluating the
effect that the application of FIN 48 will have on its results of operations and
financial condition.

         In February  2006,  the FASB issued  Statement of Financial  Accounting
Standards No. 155, "Accounting for Certain Hybrid Financial  Instruments" ("SFAS
155"),  which amends SFAS No. 133,  "Accounting for Derivatives  Instruments and
Hedging Activities" ("SFAS 133") and SFAS No. 140, "Accounting for Transfers and
Servicing of Financial Assets and  Extinguishment  of Liabilities"  ("SFAS 140).
SFAS 155 amends SFAS 133 to narrow the scope  exception  for  interest-only  and
principal-only   strips  on  debt   instruments  to  include  only  such  strips
representing  rights to receive a specified portion of the contractual  interest
or  principle  cash flows.  SFAS 155 also  amends  SFAS 140 to allow  qualifying
special-purpose  entities  to hold a  passive  derivative  financial  instrument
pertaining to beneficial interests that itself is


                                       35
<PAGE>


                              TAG-IT PACIFIC, INC.
                   NOTES TO CONSOLIDATED FINANCIAL STATEMENTS


a derivative instrument. SFAS No. 155 is effective for all financial instruments
acquired or issued  after the  beginning  of an entity's  first fiscal year that
begins after  September 15, 2006. The Company does not believe that SFAS No. 155
will have a material  impact on the  Company's  financial  position,  results of
operations or cash flows.

NOTE 2 - ACCOUNTS AND NOTE RECEIVABLE

         At  December  31,  2006  a  note  receivable  from  Azteca  Productions
International  ("Azteca") was outstanding in the amount of $2,799,460.  The note
is receivable in monthly  installments over thirty-one months beginning March 1,
2006. The payments are $50,000 per month for the first 5 months, then range from
$133,000-$267,000  per month until paid in full. At December 31, 2005,  accounts
receivable  from  Azteca,  a  significant  customer in 2005,  was  approximately
$10,968,000 less a reserve of $7,528,000. In February 2006, the Company accepted
a note  agreement  from  Azteca  which  provided  for total  payments  including
principal  and  interest  of $4.0  million in exchange  for the net  outstanding
accounts receivable balance. The value of the note receivable recorded effective
at December 31, 2005  reflected a $560,000  charge to the face value to discount
the note,  using a 10.5%  discount  rate, to its net present  value.  The Azteca
accounts  receivable,   net  at  December  31,  2005  was  reclassified  on  the
accompanying  consolidated  balance  sheets to note  receivable  to reflect this
subsequent  settlement.  The following summarizes the future minimum payments of
the note receivable:


Years ending December 31,                                              Amount
                                                                    -----------
2007 ....................................................           $ 1,599,996
2008 ....................................................             1,483,339
                                                                    -----------

Total payments ..........................................             3,083,335
Less amount representing interest .......................              (283,875)
                                                                    -----------

Balance at December 31, 2006 ............................             2,799,460
Less current portion ....................................             1,378,491
                                                                    -----------

Long-term portion .......................................           $ 1,420,969
                                                                    ===========

         Accounts  receivable  are  included  on the  accompanying  consolidated
balance sheet net of an allowance for doubtful accounts. The total allowance for
doubtful  accounts at December 31, 2006 was  $71,500.  The total  allowance  for
doubtful accounts at December 31, 2005 was $1,188,758, after reclassification of
the net Azteca receivable to note receivable.

         In 2004,  following  negotiations  with Tarrant Apparel Group, a former
customer,  we determined that a significant  portion of the obligations due from
this  customer  were  uncollectible.   Accordingly,   included  in  general  and
administrative  expenses for 2004 are charges of $4.3 million related  primarily
to the write-down of this receivable and leaving a remaining balance  receivable
from this customer of $4.5 million. An affiliate of the customer repaid the $4.5
million receivable balance over the period from May through December 2005.

NOTE 3 - FACTORING AGREEMENT

         The Company entered into a factoring agreement with East Asia Heller in
2004 for the  purchase of eligible  receivables  from its Hong Kong  subsidiary,
Tag-It  Pacific  (HK)  Limited.   The  factor  may  purchase  eligible  accounts
receivable  and assume the credit risk with respect to those  accounts for which
they have given their prior  approval.  If the factor does not assume the credit
risk for a  receivable,  the  collection  risk  associated  with the  receivable
remains with the Company. The Company pays a fixed commission rate and


                                       36
<PAGE>


                              TAG-IT PACIFIC, INC.
                   NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

may borrow up to 80% of its eligible accounts receivable. Interest is charged at
1.5% over the Hong Kong Dollar  prime rate (7.75% and 7.75% at December 31, 2006
and 2005). However, during 2005 and 2006 the factor declined to advance funds to
the Company under this agreement. Accordingly, as of December 31, 2006, and 2005
there were no outstanding advances from the factor.

NOTE 4 - DEMAND NOTES PAYABLE TO RELATED PARTIES

         Demand notes payable to related parties consist of the following:

                                                      Year Ended December 31,
                                                 -------------------------------
                                                      2006             2005
                                                 --------------   --------------
Two notes payable  issued from  1995-1998 to
parties   related  to  or  affiliated   with
directors of the Company with interest rates
ranging  from 0% to 10% per  annum,  due and
payable  on  the   fifteenth  day  following
delivery of written demand for payment ......    $       85,176   $       85,176

Convertible  secured note payable  issued in
October  2000 to a director  of the  Company
bears interest at 11%, payable quarterly, is
due on demand and  convertible  into  common
stock at the  election  of the  holder  at a
rate of $4.50 per share, the market value of
the  Company's  common  stock on the date of
approval   by   the   Company's   Board   of
Directors.    The   note   is   secured   by
substantially all of the Company's assets ...           500,000          500,000

Unsecured notes payable to a director of the
Company  accrue  interest at 7% and 8.5% per
annum,  principal and interest due on demand
and fifteen days from demand ................            79,795           79,795
                                                 --------------   --------------
                                                 $      664,971   $      664,971
                                                 ==============   ==============

         Interest expense related to the demand notes payable to related parties
for the years  ended  December  31,  2006,  2005 and 2004  amounted  to $67,753,
$67,753, and $81,628. Included in accrued expenses at December 31, 2006 and 2005
was  $515,738 and $447,986 of related  accrued  interest.  There was no interest
paid on the demand notes during the years ended December 31, 2006 and 2005.


                                       37
<PAGE>


                             TAG-IT PACIFIC, INC.
                   NOTES TO CONSOLIDATED FINANCIAL STATEMENTS


NOTE 5 - CAPITAL LEASE OBLIGATIONS

         The Company financed equipment  purchases through various capital lease
obligations  expiring  through August 2010.  These  obligations bear interest at
various rates ranging from 4.6% to 15% per annum. Future minimum annual payments
under these capital lease obligations are as follows:

Years ending December 31,                                              Amount
------------------------                                            -----------
2007 ....................................................           $   505,029
2008 ....................................................               336,970
2009 ....................................................               184,606
2010 ....................................................                   430
                                                                    -----------

Total payments ..........................................             1,027,035
Less amount representing interest .......................              (119,574)
                                                                    -----------

Balance at December 31, 2006 ............................               907,461
Less current portion ....................................               432,728
                                                                    -----------

Long-term portion .......................................           $   474,733
                                                                    ===========

         At December 31, 2006,  total property and equipment under capital lease
obligations and related accumulated  depreciation was $3,533,154 and $1,178,469,
respectively.  At December 31, 2005,  total property and equipment under capital
lease  obligations  and related  accumulated  depreciation  was  $3,468,721  and
$661,533, respectively.

NOTE 6 - NOTES PAYABLE

         Notes payable consist of the following:

                                                      Year Ended December 31,
                                                 -------------------------------
                                                     2006               2005
                                                 --------------   --------------
$765,000 note payable to First National Bank
dated  June  3,  2004;   interest  at  6.5%;
payable in eighty-four  monthly  payments of
principal  and interest of $5,746  beginning
July  2004;  twenty-year  amortization,  all
unpaid  principal  and  interest due June 3,
2011 (seven  years);  secured by building in
North Carolina ..............................    $      712,950   $      734,787


$880,000 note payable to First National Bank
dated  November 22, 2004;  interest at 6.5%;
payable  in  sixty   monthly   payments   of
principal and interest of $17,254  beginning
December  2004;  all  unpaid  principal  and
interest due  November 22, 2009;  secured by
manufacturing equipment .....................           548,068          713,068

$1,650,000 note payable to Hennigan, Bennett
& Dorman,  LLP dated May 31, 2006;  interest
at  3.0%;   payable  in   fourteen   monthly
payments of principal and interest beginning
June  2006,  of  $50,000  for the  first two
payments,  and  $133,333 for the next twelve
months   thereafter   until  July  1,  2007;
secured by the note receivable ..............           907,703             --
                                                 --------------   --------------
      Notes Payable .........................         2,168,721        1,447,855
      Less Current portion ..................         1,107,207          186,837
                                                 --------------   --------------

Notes payable, net of current portion            $    1,061,514   $    1,261,018
                                                 ==============   ==============


                                       38
<PAGE>


                             TAG-IT PACIFIC, INC.
                   NOTES TO CONSOLIDATED FINANCIAL STATEMENTS


         Future  minimum annual  payments under these notes payable  obligations
are as follows:

Years ending December 31,                                               Amount
------------------------                                              ----------
2007 ..................................................               $1,107,207
2008 ..................................................                  213,030
2009 ..................................................                  210,218
2010 ..................................................                   28,301
2011 and thereafter ...................................                  609,965
                                                                      ----------

Total .................................................               $2,168,721
                                                                      ==========

NOTE 7 - SECURED CONVERTIBLE PROMISSORY NOTES

         On November 10, 2004, the Company raised $12.5 million from the sale of
Secured Convertible Promissory Notes (the "Notes") to existing shareholders. The
Notes are  convertible  into  common  stock at a price of $3.65 per share,  bear
interest at 6% payable  quarterly,  are due  November 9, 2007 and are secured by
the Talon  trademarks.  The Notes are convertible at the option of the holder at
any time after  closing.  The  Company may repay the Notes at any time after one
year  from  the  closing  date  with  a  15%  prepayment  penalty.  Among  other
restrictions, the Notes restrict the Company from declaring or paying a dividend
prior to conversion or payment of the Notes. At maturity,  the Company may repay
the Notes in cash or  require  conversion  if  certain  conditions  are met.  In
connection  with the  issuance  of the  Notes,  the  Company  issued to the Note
holders, warrants to purchase up to 171,235 shares of common stock. The warrants
have a term of five years,  an  exercise  price of $3.65 per share and vested 30
days  after   closing.   The  fair  value  of  the  warrants  was  estimated  at
approximately  $96,000  utilizing  the  Black-Scholes  model and  recorded  as a
discount against the face value of the Notes. The discount is amortized over the
three-year  term  of  the  Notes  on a  straight-line  basis.  The  Company  has
registered the resale by the holders of the shares  issuable upon  conversion of
the Notes and exercise of the warrants.  In connection with this financing,  the
Company paid the  placement  agent  $704,000 in cash,  and issued the  placement
agent a warrant to purchase  215,754 common shares at an exercise price of $3.65
per share.  The warrant is exercisable  beginning May 10, 2005 through  November
10, 2009.  The fair value of the warrant was estimated at $93,815  utilizing the
Black-Scholes model and recorded as deferred financing costs which are amortized
over the three- year term of the Notes. The full amount of principal under these
secured  convertible  promissory  notes is due  November  7, 2007.  (See Item 7.
Management's Discussion and Analysis).

NOTE 8 - STOCKHOLDERS' EQUITY AND CONVERTIBLE REDEEMABLE PREFERRED STOCK

PREFERRED STOCK

STOCKHOLDER'S RIGHTS PLAN

         In October 1998, the Company adopted a stockholder's rights plan. Under
the rights plan the Company  distributed  one preferred share purchase right for
each outstanding share of Common Stock outstanding on November 6, 1998. Upon the
occurrence  of certain  triggering  events  related to an  unsolicited  takeover
attempt of the Company,  each  purchase  right not owned by the party or parties
making the  unsolicited  takeover  attempt  will  entitle its holder to purchase
shares  of the  Company's  Series A  Preferred  Stock at a value  below the then
market  value of the  Series A  Preferred  Stock.  The  rights of holders of the
Common Stock will be subject to, and may be adversely affected by, the rights of
holders of the share


                                       39
<PAGE>


                             TAG-IT PACIFIC, INC.
                   NOTES TO CONSOLIDATED FINANCIAL STATEMENTS


purchase rights, the Series A Preferred Stock and any other preferred stock that
may be issued in the future.  The issuance of preferred  stock,  while providing
desirable  flexibility  in  connection  with  possible  acquisitions  and  other
corporate purposes,  could make it more difficult for a third party to acquire a
majority of the Company's outstanding voting stock.

SERIES D PREFERRED STOCK PRIVATE PLACEMENT TRANSACTION

         On December 18, 2003,  the Company sold an aggregate of 572,818  shares
of non-voting  Series D Convertible  Preferred  Stock,  at a price of $44.00 per
share,  to  institutional  investors and  individual  accredited  investors in a
private placement transaction.  The Company received net proceeds of $23,083,693
after  commissions  and  other  offering  expenses.  The  Series  D  Convertible
Preferred  Stock  was  convertible  after  approval  at  a  special  meeting  of
stockholders  at a  rate  of 10  common  shares  for  each  share  of  Series  D
Convertible  Preferred Stock.  Except as required by law, the Series D Preferred
shares had no voting rights.  The Series D Preferred  shares accrued  dividends,
commencing on June 1, 2004, at an annual rate of 5% of the initial  stated value
of  $44.00  per  share,  payable  quarterly.  In  the  event  of a  liquidation,
dissolution  or winding-up of the Company,  the Series D Preferred  shares would
have been entitled to receive,  prior to any distribution on the common stock, a
distribution  equal to the initial  stated  value of the shares plus all accrued
and unpaid dividends.

         At a special  meeting of  stockholders  held on February 11, 2004,  the
stockholders of the Company  approved the issuance of 5,728,180 shares of common
stock upon conversion of the Series D Preferred  Stock. At the conclusion of the
meeting,  all  of the  shares  of  the  Series  D  Convertible  Preferred  Stock
automatically  converted  into  common  shares  and  the  Series  D  Convertible
Preferred Stock was eliminated.

         The Company has registered the common shares issued upon  conversion of
the  Series D  Convertible  Preferred  Stock  for  resale by the  investors.  In
conjunction with the private placement  transaction the Company issued a warrant
to purchase 572,818 common shares to the placement agent at an exercise price of
$4.74 per share.  The warrant is  exercisable  beginning  June 18, 2004  through
December 18, 2008. The fair value of the warrant was estimated at  approximately
$165,000  utilizing the  Black-Scholes  model and was recorded as a reduction of
the proceeds from the placement of the Series D Convertible Preferred Stock. The
Company has  determined  that this  transaction  did not result in a  beneficial
conversion feature.

SERIES  C  PREFERRED  STOCK  PURCHASE  AGREEMENT  AND  CO-MARKETING  AND  SUPPLY
AGREEMENT

         In  accordance  with the Series C Preferred  Stock  Purchase  Agreement
entered into with Coats North America Consolidated,  Inc. ("Coats") on September
20, 2001, the Company  issued 759,494 shares of Series C Convertible  Redeemable
Preferred  Stock to Coats North  America  Consolidated,  Inc. in exchange for an
equity  investment from Coats of $3,000,001  cash. The Series C Preferred shares
were  convertible  at the option of the holder after one year at the rate of the
closing price  multiplied by 125% of the ten-day  average closing price prior to
closing.  The Series C  Preferred  shares were  redeemable  at the option of the
holder after four years. If the holders elected to redeem the Series C Preferred
shares,  the  Company  had the option to redeem for cash at the stated  value of
$3,000,001  or in the form of the  Company's  common  stock at 85% of the market
price of the  Company's  common stock on the date of  redemption.  If the market
price of the  Company's  common  stock on the date of  redemption  was less than
$2.75 per share, the Company was required to redeem for cash at the stated value
of the Series C Preferred shares. The Company could elect to redeem the Series C
Preferred  shares  at any time for cash at the  stated  value.  The terms of the
Series C Preferred  shares provided for cumulative  dividends at a rate of 6% of
the stated value per annum,  payable in cash or the Company's  common stock. The
dividends  were  payable  at the  earlier  of  the  declaration  of  the  Board,
conversion or  redemption.  Each Series C Preferred  share had the right to vote
for each of the Company's common shares that the Series C Preferred shares could
then be  converted  into  on the  record  date.  Total  legal  and  other  costs
associated with this  transaction of $105,000 were netted against the $3,000,001
proceeds received from Coats.


                                       40
<PAGE>


                             TAG-IT PACIFIC, INC.
                   NOTES TO CONSOLIDATED FINANCIAL STATEMENTS


         In connection with the Series C Preferred Stock Purchase Agreement, the
Company also  entered  into a 10-year  Co-Marketing  and Supply  Agreement  with
Coats. The Co-Marketing and Supply Agreement provides for selected introductions
into Coats' customer base and the Company's trim packages will exclusively offer
thread manufactured by Coats.

         On February  25,  2004,  the  holders of the Series C  Preferred  Stock
converted  all 759,494  shares of Series C  Preferred  Stock,  plus  $458,707 of
accrued  dividends,  into 700,144 shares of common stock. The Series C Preferred
Stock was eliminated in March 2004.

SERIES  B  PREFERRED  STOCK  PURCHASE  AGREEMENT,   DISTRIBUTION  AGREEMENT  AND
TRADENAME PURCHASE AGREEMENT

         On April 3, 2000, the Company entered into a ten-year exclusive license
and  distribution  agreement  with Talon,  Inc.  and its parent  company,  Grupo
Industrial Cierres Ideal, S.A. de C.V. ("GICISA").  Under this agreement, Tag-It
Pacific,  Inc. was the exclusive sales,  marketing,  distribution and e-commerce
arm for "Talon"  products for all customers in the United  States,  Mexico-based
maquiladores, Canada and the Pacific Rim and had the exclusive license to market
trim  products  under the "Talon"  brand name.  In exchange for these  exclusive
distribution  rights,  the Company issued 850,000 shares of Series B Convertible
Preferred  stock to  GICISA.  After a  period  of 30  months,  the  shares  were
convertible  into the Company's common stock once the average price per share of
the Company's  common stock reached or exceeded  $8.00 for a 30-day  consecutive
period.  The preferred stock was  automatically  convertible  into shares of the
Company's  common  stock based on a rate of one minus the fraction of $2.50 over
the average per share closing price of the Company's common stock for the 30-day
period preceding the conversion.

         The Series B Convertible  Preferred stock had a liquidation  preference
of $.001 per share, and was entitled to receive  non-cumulative  dividends on an
as converted  basis,  if and when, such dividends were declared on the Company's
common stock and was  redeemable  by the Company  under  certain  conditions  as
outlined in the agreement.

         The estimated fair value of the Series B Convertible Preferred stock on
April 3, 2000 was $1,400,000.  The Company recorded the value of the license and
distribution  rights as a long-term  asset,  which was being  amortized over the
ten-year period of the agreement. The unamortized balance of the long-term asset
at December 21, 2001 was $1,166,667.

         On September 30, 2000, the Company  purchased  inventory from GICISA in
exchange for an unsecured  note  payable in the amount of  $2,830,024.  The note
payable was non-interest  bearing and was due April 1, 2002. The Company imputed
interest for the holding period of the note amounting to $272,000.  The note was
subordinate to the obligations due under a credit facility with UPS Capital. The
note  payable  balance  at  December  21,  2001 was  $2,767,182,  net of imputed
interest of $62,842.

         On December  21,  2001,  the  Company  entered  into an Asset  Purchase
Agreement with Talon, Inc. and GICISA. Pursuant to the Asset Purchase Agreement,
the Company  acquired  from Talon,  Inc. and GICISA:  (1) certain  inventory and
equipment,  (2) all patent  rights  held by Talon,  Inc.  and (3) all of Talon's
rights to its trade names and  trademarks  bearing the Talon name.  In addition,
the Asset  Purchase  Agreement  terminated  the  exclusive  10-year  license and
distribution  agreement,  dated as of April 3, 2000 by and  among  the  Company,
GICISA and Talon, Inc.

         Under the Asset Purchase  Agreement,  the Company issued to Talon, Inc.
500,000 shares of common stock, par value $0.001 per share, a promissory note in
the amount of $4,900,000 and $100,000 in cash held in escrow. The Asset Purchase
Agreement  required Talon,  Inc. to place 50,000 shares of the Company's  common
stock  and  $100,000  in  escrow  for a  period  of 12  months  to  satisfy  any
indemnification  claims the Company may have under the Asset Purchase Agreement.
The common  stock was valued at the market value of the  Company's  stock on the
date of closing.  The  promissory  note was unsecured,  and accrued  interest at


                                       41
<PAGE>


                             TAG-IT PACIFIC, INC.
                   NOTES TO CONSOLIDATED FINANCIAL STATEMENTS


prime plus 2%. In connection with the Asset Purchase Agreement, the Company also
entered  into a mutual  release with Talon,  Inc.  and GICISA  pursuant to which
Talon,  Inc.  and GICISA  released the Company  from its  obligations  under the
unsecured note payable of $2,830,024  dated September 30, 2000 and other current
liabilities  under the Exclusive  License and Distribution  Agreement.  Further,
850,000  shares of the Company's  series B convertible  preferred  stock held by
GICISA were canceled at the closing of the Asset Purchase Agreement. The balance
of the  unsecured  promissory  note was $1.4 million at December  31, 2004.  The
unsecured  promissory  note and all  outstanding  obligations due under the note
payable were paid in full as of June 1, 2005.

         The Series B  Convertible  Preferred  Stock was  eliminated in February
2004.

COMMON STOCK

2003 PRIVATE PLACEMENT

         On May 30,  2003,  the Company  raised  approximately  $6,037,500  in a
private placement transaction with five institutional  investors.  Pursuant to a
securities  purchase agreement with these institutional  investors,  the Company
sold 1,725,000  shares of its common stock at a price per share of $3.50.  After
commissions  and expenses,  the Company  received net proceeds of  approximately
$5.5  million.  The  Company  has  registered  the shares  issued in the private
placement  with  the  Securities  and  Exchange  Commission  for  resale  by the
investors.  In conjunction with the private placement  transaction,  the Company
issued  warrants to purchase  172,500  shares of common  stock to the  placement
agent.  The warrants are exercisable  beginning  August 30, 2003 through May 30,
2008 and have a per share exercise price of $5.06.

STOCK GRANT AGREEMENT

         Pursuant to Stock Grant Agreements between the Company and Herman Roup,
dated December 1, 2001, January 1, 2002 and July 17, 2002, the Company issued to
Mr.  Roup an  aggregate  20,500  shares  of  common  stock in 2004 for  services
provided to the Company valued at $74,825.

EXCLUSIVE LICENSE AND INTELLECTUAL PROPERTY RIGHTS AGREEMENT

         On April 2, 2002,  the Company  entered into an  Exclusive  License and
Intellectual  Property Rights Agreement (the  "Agreement") with Pro-Fit Holdings
Limited  ("Pro-Fit").  The Agreement  gives the Company the exclusive  rights to
sell or sublicense  waistbands  manufactured under patented technology developed
by Pro-Fit for garments manufactured anywhere in the world for the United States
market and all United States  brands.  In  accordance  with the  Agreement,  the
Company  issued  150,000  shares of its common stock which were  recorded at the
market  value of the  stock on the date of the  Agreement.  The  shares  contain
restrictions  related to the transfer of the shares and registration rights. The
Agreement  has an  indefinite  term that  extends for the  duration of the trade
secrets  licensed  under the  Agreement.  The Company has recorded an intangible
asset  amounting to $577,500  and is  amortizing  this asset on a  straight-line
basis over its estimated  useful life of five years. The Company is currently in
litigation with this supplier (See Notes 1 and 13).

NOTE 9 - STOCK OPTION INCENTIVE PLAN AND WARRANTS

STOCK OPTION INCENTIVE PLAN

          On October 1, 1997, the Company  adopted the 1997 Stock Incentive Plan
(the "1997 Plan"),  which  authorized  the granting of a variety of  stock-based
incentive  awards.  The Board of Directors,  who  determines  the recipients and
terms of the awards granted,  administers the 1997 Plan. On July 31, 2006 at the


                                       42
<PAGE>


                             TAG-IT PACIFIC, INC.
                   NOTES TO CONSOLIDATED FINANCIAL STATEMENTS


Company's annual meeting of stockholder's  two amendments to the 1997 Stock Plan
were approved  which (1) increased the maximum  number of shares of common stock
that may be issued pursuant to awards granted under the 1997 Plan from 3,077,500
shares to 6,000,000  shares,  and (2)  increased  the number of shares of common
stock that may be issued pursuant to awards granted to any individual  under the
plan in a single year to 50% of the total number of shares  available  under the
plan.

          The Company  believes  that such awards  better align the interests of
its  employees  with those of its  shareholders.  Option  awards  are  generally
granted with an exercise price equal to the market price of the Company's  stock
on the  date of the  grant  for  years  prior to  2006,  and for the year  ended
December 31, 2006, the average market price of the Company's  stock for the five
trading days prior to the date of the grant;  those option awards generally vest
over periods  determined  by the Board from  immediate to 4 years of  continuous
service, and have 10 year contractual terms.

         As of December 31, 2006,  the Company may issue awards to acquire up to
a total of 2,321,977  shares of common stock under the 1997 Plan, and there were
awards  issued and  outstanding  under the Plan to acquire a total of  3,452,635
shares of common  stock,  including  options  issued to a consultant  to acquire
75,000 shares of common stock at $0.57 per share. During 2006 the Company issued
options outside the Plan to employees to acquire 1,625,000 shares of stock at an
average  exercise price of $0.46 per share,  and granted 135,135 shares of stock
to an employee with a fair market value of $50,000.

         The  following  table  summarizes  all options  issued to employees and
directors including those issued outside the plan.

         The following table summarizes the activity for the periods:

                                                                     Weighted
                                                                     Average
                                                    Number of        Exercise
EMPLOYEE AND DIRECTOR                                Shares            Price
                                                  -------------    -------------
Options outstanding - January 1, 2004 .........       1,978,000    $        3.55
     Granted ..................................            --      $        --
     Exercised ................................        (115,375)   $        3.36
     Canceled .................................        (120,625)   $        4.00
                                                  -------------    -------------
Options outstanding - December 31, 2004 .......       1,742,000    $        3.53
     Granted ..................................         425,000    $        3.22
     Exercised ................................          (1,250)   $        3.63
     Canceled .................................        (332,750)   $        3.50
                                                  -------------    -------------
Options outstanding - December 31, 2005 .......       1,833,000    $        3.46
     Granted ..................................       3,471,135    $        0.31
     Canceled .................................        (301,500)   $        3.56
                                                  -------------    -------------
Options outstanding - December 31, 2006 .......       5,002,635    $        1.41
                                                  =============    =============

         The  Company  has  also  issued   certain   warrants   and  options  to
non-employees.  As of December 31, 2006, there were warrants issued to acquire a
total of 1,243,813  shares of common stock, and options to acquire 75,000 shares
of common stock  outstanding  to  non-employees.  During 2006 the Company issued
90,253  shares of stock to a consultant  in exchange  for  services  with a fair
market value of $51,000.


                                       43
<PAGE>


                             TAG-IT PACIFIC, INC.
                   NOTES TO CONSOLIDATED FINANCIAL STATEMENTS


         The following table summarizes the activity for the periods:

<TABLE>
<CAPTION>
                                                                              Weighted
                                                                              Average
                                                             Number of        Exercise
NON-EMPLOYEES                                                 Shares            Price
                                                           -------------    -------------
<S>                                                            <C>          <C>
Options & warrants outstanding - January 1, 2004 .......       1,277,885    $        4.58
     Granted ...........................................         416,989    $        3.65
     Exercised .........................................         (80,901)   $        2.68
     Canceled ..........................................         (35,000)   $        4.55
                                                           -------------    -------------
Options & warrants outstanding - December 31, 2004 .....       1,578,973    $        4.35
     Granted ...........................................            --      $        --
     Exercised .........................................         (68,494)   $        3.65
     Canceled ..........................................        (133,332)   $        4.54
                                                           -------------    -------------
Options & warrants outstanding - December 31, 2005 .....       1,377,147    $        4.36
     Granted ...........................................          75,000    $        0.57
     Exercised .........................................            --      $        --
     Canceled ..........................................        (133,334)   $        4.54
                                                           -------------    -------------
Options & warrants outstanding - December 31, 2006 .....       1,318,813    $        4.13
                                                           =============    =============
</TABLE>

         The Company's determination of fair value of share-based payment awards
to employees and directors on the date of grant uses the Black-Scholes model and
the assumptions noted in the following table for the years ended December 31, as
indicated.  Expected  volatilities are based on the historical volatility of the
Company's stock price and other factors.  These variables  include,  but are not
limited to, the expected  stock price  volatility  over the expected term of the
awards, and actual and projected employee stock option exercise  behaviors.  The
expected option term is estimated using the "safe harbor"  provisions  under SAB
107. The risk free rate for periods within the contractual life of the option is
based on the U.S. Treasury yield in effect at the time of the grant.

                                                  2006        2005       2004(1)
                                                 -------     -------     -------
Expected volatility .........................         65%         64%        n/a
Expected term in years ......................    6.1 yrs     1.2 yrs         n/a
Expected dividends ..........................       --          --           n/a
Risk-free rate ..............................        4.5%        2.0%        n/a

(1)      No share-based grants were made in 2004.


                                       44
<PAGE>


                             TAG-IT PACIFIC, INC.
                   NOTES TO CONSOLIDATED FINANCIAL STATEMENTS


         A summary of the option activity under the 1997 Plan as of December 31,
2006, and changes during the year then ended is as follows:

<TABLE>
<CAPTION>
                                                                         Weighted
                                                           Weighted      Average
                                                           Average       Remaining
                                            Number of      Exercise     Contractual     Intrinsic
EMPLOYEE AND DIRECTOR                        Shares         Price       Life (Years)      Value
                                          ------------   ------------   ------------   ------------
<S>                                          <C>         <C>                    <C>    <C>
Outstanding at December 31, 2006 ......      5,002,635   $       1.41           7.90   $  1,875,639
Vested and Expected to Vest ...........      4,927,355   $       1.43           7.88   $  1,837,150
Exercisable ...........................      2,223,968   $       2.51           6.25   $    447,389
</TABLE>

         The  weighted  average  grant-date  fair  value of  options  granted to
employee's and director's during the years ended December 31, 2006 and 2005 were
$0.31 and $0.76, respectively. There were no grants in 2004. The total intrinsic
value of options exercised during the years ended December 31, 2005 and 2004 was
$1,700, and $130,000, respectively. There were no options exercised in 2006.

<TABLE>
<CAPTION>
                                                                         Weighted
                                                           Weighted      Average
                                                           Average       Remaining
                                            Number of      Exercise     Contractual     Intrinsic
NON-EMPLOYEE OPTIONS & WARRANTS:             Shares         Price       Life (Years)      Value
                                          ------------   ------------   ------------   ------------
<S>                                          <C>         <C>                    <C>    <C>
Outstanding at December 31, 2006             1,318,813   $       4.13           2.28   $     34,500
Vested and Expected to Vest....              1,318,813   $       4.13           2.28   $     34,500
Exercisable........................          1,318,813   $       4.13           2.28   $     34,500
</TABLE>

         The  weighted  average  grant-date  fair value of options and  warrants
granted to non-employees  during the years ended December 31, 2006, and 2004 was
$0.57 and $3.70, respectively. There were no grants in 2005. The total intrinsic
value of options and warrants exercised during the years ended December 31, 2005
and 2004 was $91,000 and $135,000, respectively. There were no options exercised
in 2006.  The fair value of the awards  approximates  the  values  expensed  for
pro-forma purposes for these periods.

         As of December  31,  2006,  there was  $645,248  of total  unrecognized
compensation costs related to non-vested share-based  compensation  arrangements
granted,  including  warrants.  This cost is expected to be recognized  over the
weighted-average  period of 2.0 years.  The total  fair  value of shares  vested
during the years ended December 31, 2006,  2005 and 2004 was $236,000,  $217,000
and $1,597,000, respectively.

         When options are exercised, the Company's policy is to issue previously
registered,  unissued  shares of common  stock.  As of December  31,  2006,  the
Company had  2,321,977  unissued  shares of common  stock  available in its 1997
Plan. On July 31, 2006, at the annual  shareholders  meeting an amendment to the
1997 Stock  Incentive  Plan was  adopted to  increase  the number of  authorized
shares under the 1997 Plan to a total of 6,000,000  shares.  The additional plan
shares  authorized  on July  31,  2006 of  2,922,500  shares  have  not yet been
registered.


                                       45
<PAGE>


                             TAG-IT PACIFIC, INC.
                   NOTES TO CONSOLIDATED FINANCIAL STATEMENTS


NOTE 10 - INCOME (LOSS) PER SHARE

         The following is a reconciliation of the numerators and denominators of
the basic and diluted income (loss) per share computations:

<TABLE>
<CAPTION>
                                    December 31, 2006                            December 31, 2005
                       ------------------------------------------   ------------------------------------------
                         Income          Shares       Per Share        Loss           Shares       Per Share
YEARS ENDED:           (Numerator)    (Denominator)     Amount      (Numerator)    (Denominator)     Amount
--------------------   ------------   ------------   ------------   ------------   ------------   ------------
<S>                    <C>              <C>          <C>            <C>              <C>          <C>
Basic income (loss):
    Income (loss)
    available
    to common
    stockholders ...   $    309,303     18,377,484   $       0.02   $(29,537,70)     18,225,851   $      (1.62)

Effect of dilutive
securities:
    Options ........           --          578,312           0.00           --             --             --
    Warrants .......           --             --             --             --             --             --
                       ------------   ------------   ------------   ------------   ------------   ------------
Income (loss)
available to common
stockholders .......   $    309,303     18,955,796   $       0.02   $(29,537,70)     18,225,851   $      (1.62)
                       ============   ============   ============   ============   ============   ============


<CAPTION>

                                   December 31, 2004
                       ------------------------------------------
                          Loss           Shares       Per Share
YEARS ENDED:           (Numerator)    (Denominator)     Amount
--------------------   ------------   ------------   ------------
<S>                    <C>              <C>          <C>
Basic income (loss):
    Income (loss)
    available
    to common
    stockholders ...   $(17,639,47)     17,316,202   $      (1.02)

Effect of dilutive
securities:
    Options ........           --             --             --
    Warrants .......           --             --             --
                       ------------   ------------   ------------
Income (loss)
available to common
stockholders .......   $(17,639,47)     17,316,202   $      (1.02)
                       ============   ============   ============
</TABLE>

         Warrants to purchase  1,243,813 shares of common stock at between $3.50
and $5.06; options to purchase 1,642,500 shares of common stock at between $1.27
and $5.23;  convertible debt of $12,500,000  convertible at $3.65 per share, and
other  convertible  debt  of  $500,000  convertible  at  $4.50  per  share  were
outstanding  for the year ended  December 31, 2006, but were not included in the
computation  of  diluted  loss per  share  because  the  effect of  exercise  or
conversion would have an antidilutive effect on the income per share.

         Warrants to purchase  1,377,147 shares of common stock at between $3.50
and $5.06, options to purchase 1,833,000 shares of common stock at between $0.41
and $5.23,  convertible debt of $12,500,000  convertible at $3.65 per share, and
other  convertible  debt  of  $500,000  convertible  at  $4.50  per  share  were
outstanding  for the year ended  December 31, 2005, but were not included in the
computation  of  diluted  loss per  share  because  the  effect of  exercise  or
conversion would have an antidilutive effect on loss per share.

         Warrants to purchase  1,578,973 shares of common stock at between $3.50
and $5.06, options to purchase 1,742,000 shares of common stock at between $1.30
and $4.63,  convertible debt of $12,500,000  convertible at $3.65 per share, and
other  convertible  debt  of  $500,000  convertible  at  $4.50  per  share  were
outstanding  for the year ended  December 31, 2004, but were not included in the
computation  of  diluted  loss per  share  because  the  effect of  exercise  or
conversion would have an antidilutive effect on loss per share.

NOTE 11 - 2005 RESTRUCTURING PLAN

         In an effort to better  align  the  Company's  organizational  and cost
structures  with its future growth  opportunities,  in August 2005 the Company's
Board  of  Directors  adopted  a  restructuring  plan for the  Company  that was
substantially  completed by December 2005. The plan included  restructuring  the
Company's  global  operations  by  eliminating  redundancies  in its  Hong  Kong
operation,  closing its Mexican  facilities,  converting its Guatemala  facility
from a  manufacturing  site to a  distributor,  and closing  its North  Carolina
manufacturing  facility.  The Company also refocused its sales efforts on higher
margin  products,  which  may have  resulted  in lower net  sales  with  certain
customers.  As a result,  the  Company now  operates  with fewer  employees  and
reduced associated  operating and manufacturing  expenses.  The Company recorded
charges in connection  with its  restructuring  plan in accordance with SFAS No.
146 (As  Amended),  "Accounting  for  Costs  Associated  with  Exit or  Disposal
Activities."  In addition,  the  Company's  restructuring  plan  resulted in the
carrying  value  of  certain  long-lived  assets,  primarily  equipment,   being
impaired.  Accordingly,  in 2005 the Company  recorded a charge to recognize the
impairment of these assets in accordance with SFAS No. 144,  "Accounting for the
Impairment or Disposal of Long-Lived Assets.


                                       46
<PAGE>


                             TAG-IT PACIFIC, INC.
                   NOTES TO CONSOLIDATED FINANCIAL STATEMENTS


         The North Carolina manufacturing facility is a long-lived asset that is
classified as "held for sale" because it meets the criteria  listed in Paragraph
30 of SFAS 144.  Management has committed to sell the asset,  and is listing the
property for sale with a commercial real estate agent.  The Company believes the
sale of the asset is probable  and the sale is expected to be  completed  within
one year. The major components of manufacturing  equipment used in this plant to
manufacture  zippers  are not  classified  as held for sale  since  the  Company
intends to re-deploy this equipment in the  manufacture of Talon zippers through
investment or sale of this equipment to its distributors of Talon zippers.  This
equipment is separately identified as idle equipment as a component of "Property
and  equipment"  which are  included in the  accompanying  consolidated  balance
sheets (See Note 1).

         Restructuring  costs  recorded in 2005 were  $6,371,000.  Restructuring
costs include  $3,447,000  of inventory  write-downs,  restructuring  charges of
$2,474,000  consisting of $2,036,000  for the  impairment of long-lived  assets,
primarily  machinery and equipment,  $170,000 of one-time  employee  termination
benefits and other costs of $268,000,  which were fully paid by the end of 2005.
In  addition,  an  impairment  charge to goodwill in the amount of $450,000  was
recorded.  This goodwill was associated with an acquisition  made to benefit the
Central and South American operations.  Since these operations are being exited,
management  concluded that this goodwill was impaired and should be written off.
These  restructuring  costs  were  recorded  in the  Consolidated  Statement  of
Operations  for the year ended December 31, 2005 in the following line items and
amounts:

Cost of goods sold .........................................          $3,447,000
Operating expenses:
   General & administrative expenses .......................             450,000
   Restructuring charges ...................................           2,474,000
                                                                      ----------
Total restructuring costs ..................................          $6,371,000
                                                                      ==========

NOTE 12 - INCOME TAXES

         The components of the provision  (benefit) for income taxes included in
the consolidated statements of operations are as follows:

                                              Year Ended December 31,
                                  ----------------------------------------------
                                     2006              2005              2004
                                  ----------        ----------        ----------
Current:
     Federal .............        $   29,900        $   55,479        $  405,632
     State ...............             4,000             4,000            71,582
                                  ----------        ----------        ----------
                                      33,900            59,479           477,214
Deferred:
     Federal .............              --             850,000         1,530,000
     State ...............              --             150,000           270,000
                                  ----------        ----------        ----------
                                        --           1,000,000         1,800,000
                                  ----------        ----------        ----------
                                  $   33,900        $1,059,479        $2,277,214
                                  ==========        ==========        ==========


                                       47
<PAGE>


                             TAG-IT PACIFIC, INC.
                   NOTES TO CONSOLIDATED FINANCIAL STATEMENTS


         A  reconciliation  of the  statutory  Federal  income tax rate with the
Company's effective income tax rate is as follows:

                                                     Year Ended December 31,
                                                  ----------------------------
                                                   2006       2005       2004
                                                  ------     ------     ------
Current:
  Federal statutory rate ......................     34.0%     (34.0)%    (34.0)%
  State taxes net of federal benefit ..........      2.3       (5.8)      (6.0)
  Income earned from foreign subsidiaries .....     18.7        0.2        3.1
  Net operating loss valuation allowance
    adjustments ...............................    (71.7)      43.5       51.3
  Change in effective state tax rate ..........     22.4       --         --
  Other .......................................      4.2       (0.2)       0.5
                                                  ------     ------     ------
                                                     9.9%       3.7%      14.9%
                                                  ======     ======     ======

         Income (loss) before income taxes is as follows:

                                           Year Ended December 31,
                           ----------------------------------------------------
                               2006                2005                2004
                           ------------        ------------        ------------
Domestic ...........       $ (1,341,475)       $(28,724,518)       $(17,574,926)
Foreign ............          1,684,678             246,288           2,243,172
                           ------------        ------------        ------------
                           $    343,203        $(28,478,230        $(15,331,754)
                           ============        ============        ============

         The primary components of temporary  differences which give rise to the
Company's deferred tax assets and deferred tax liabilities are as follows:

                                                     Year Ended December 31,
                                                 -------------------------------
                                                     2006              2005
                                                 ------------      ------------
Net deferred tax asset:
     Net operating loss carry-forwards .....     $ 19,053,346      $ 20,820,849
     Depreciation and amortization .........         (551,643)         (442,909)
     Bad debt reserve ......................           17,961           403,494
     Related party interest ................          189,605           160,996
     Inventory reserve .....................          289,813           448,674
     Other .................................          225,656            56,343
                                                 ------------      ------------
                                                   19,224,738        21,447,447
     Less:  Valuation Allowance ............      (19,224,738)      (21,447,447)
                                                 ------------      ------------
                                                 $       --        $       --
                                                 ============      ============

         At December 31, 2006,  Tag-It  Pacific,  Inc. had Federal and state net
operating loss  carry-forwards  (or "NOLs") of  approximately  $53.6 million and
$13.9  million,  respectively.  The Federal NOL is  available  to offset  future
taxable income  through 2024, and the state NOL expires in 2014.  Section 382 of
the  Internal  Revenue  Code places a  limitation  on the  realizability  of net
operating  losses in future  periods if the ownership of the Company has changed
more than 50% within a three-year  period.  As of December 31, 2006, some of our
net operating losses may be limited by the Section 382 rules. The amount of such
limitations, if any, has not yet been determined.

         Income taxes are accounted  for under the asset and  liability  method.
Deferred  tax  assets  and   liabilities  are  recognized  for  the  future  tax
consequences   attributable  to  differences  between  the  financial  statement
carrying  amounts of existing assets and  liabilities  and their  respective tax


                                       48
<PAGE>


                             TAG-IT PACIFIC, INC.
                   NOTES TO CONSOLIDATED FINANCIAL STATEMENTS


bases and tax benefit carry-forwards. Deferred tax liabilities and assets at the
end of each period are determined  using enacted tax rates.  The Company records
deferred tax assets arising from temporary timing  differences  between recorded
net income and taxable net income when and if it believes  that future  earnings
will be sufficient to realize the tax benefit. For those jurisdictions where the
expiration date of tax benefit  carry-forwards or the projected taxable earnings
indicate that realization is not likely, a valuation allowance is provided.

         The provisions of SFAS No. 109,  "Accounting for Income Taxes," require
the  establishment of a valuation  allowance when, based on currently  available
information and other factors,  it is more likely than not that all or a portion
of a deferred  tax asset will not be  realized.  SFAS No. 109  provides  that an
important factor in determining whether a deferred tax asset will be realized is
whether there has been sufficient income in recent years and whether  sufficient
income is expected in future years in order to utilize the deferred tax asset.

         In 2006 and in prior  years,  the  Company  determined,  based upon its
cumulative  operating losses, that it was more likely than not that it would not
be in a  position  to fully  realize  all of its  deferred  tax assets in future
years.  Accordingly,  at December  31, 2006 the Company has recorded a valuation
allowance of $19.2 million, which reduces the carrying value of its net deferred
tax assets to $0. For the year ended  December  31,  2006 the  Company  recorded
operating  income and various rate and tax timing  differences  and the value of
its  net  deferred  tax  assets  declined  by  $2.2  million.   Accordingly,   a
corresponding  reduction in the valuation allowance was made, which retained the
carrying  value of the  Company's net deferred tax assets at $0. During 2005 the
Company  incurred  additional  operating losses which resulted in an increase in
the  Company's  net deferred tax assets by $11.5  million.  Accordingly,  it was
determined that the valuation  allowance from 2004 be increased by $12.5 million
to $21.4  million,  which  reduced the  carrying  value of its net  deferred tax
assets to $0 at December  31,  2005.  In 2004 the  Company  recorded a valuation
allowance  of $8.9  million  based upon its  cumulative  operating  losses,  and
reduced the  carrying  value of its net  deferred  tax asset to $1.0  million at
December 31, 2004.

         The Company intends to maintain a valuation  allowance for its deferred
tax assets until sufficient evidence exists to support the reversal or reduction
of the allowance.  At the end of each period, the Company will review supporting
evidence,  including the performance  against sales and income  projections,  to
determine if a release of the  valuation  allowance is  warranted.  If in future
periods it is  determined  that it is more likely than not that the Company will
be able to recognize  all or a greater  portion of its deferred tax assets,  the
Company will at that time reverse or reduce the valuation allowance.

         The Company  believes  that its  estimate  of  deferred  tax assets and
determination to record a valuation  allowance  against such assets are critical
accounting  estimates  because  they are subject  to,  among  other  things,  an
estimate of future taxable income,  which is susceptible to change and dependent
upon  events that may or may not occur,  and  because the impact of  recording a
valuation  allowance may be material to the assets reported on its balance sheet
and results of operations.

         The Company has not provided  withholding of U.S.  federal income taxes
on  undistributed  earnings  of its  foreign  subsidiaries  because  the Company
intends to reinvest those earnings  indefinitely  or any taxes on these earnings
will be offset by the  approximate  credits  for foreign  taxes paid.  It is not
practical to determine the U.S.  federal tax  liability,  if any, which would be
payable if such  earnings were not invested  indefinitely.  At December 31, 2006
and 2005,  undistributed  earnings from our foreign subsidiaries were $4,581,000
and $4,689,000, respectively.


                                       49
<PAGE>


                             TAG-IT PACIFIC, INC.
                   NOTES TO CONSOLIDATED FINANCIAL STATEMENTS


NOTE 13 - COMMITMENTS AND CONTINGENCIES

OPERATING LEASES

         The Company is a party to a number of  non-cancelable  operating  lease
agreements  involving  buildings  and  equipment,  which expire at various dates
through 2010.  The Company  accounts for its leases in accordance  with SFAS No.
13, whereby step provisions,  escalation clauses, tenant improvement allowances,
increases  based on an existing index or rate, and other lease  concessions  are
accounted  for in the  minimum  lease  payments  and are  charged  to the income
statement on a straight-line basis over the related lease term.

         The future  minimum  lease  commitments  at  December  31,  2006 are as
follows:

         Years Ending December 31,                                      Amount
         -----------------------------------------------              ----------
             2007 ......................................              $  437,226
             2008 ......................................                 407,224
             2009 ......................................                 346,184
             2010 ......................................                 213,364
             2011 and thereafter .......................                  16,757
                                                                      ----------
             Total minimum payments ....................              $1,420,755
                                                                      ==========

         Total rental  expense for the years ended  December 31, 2006,  2005 and
2004 aggregated $640,864, $750,536, and $696,590, respectively.

PROFIT SHARING PLAN

         In October 1999, the Company  established a 401(k)  profit-sharing plan
for the benefit of eligible employees. The Company may make annual contributions
to the plan as determined by the Board of Directors. Total contributions for the
years  ended  December  31,  2006 and 2005  amounted  to  $22,276  and  $16,807,
respectively.  There were no  contributions  made during the year ended December
31, 2004.

CONTINGENCIES

         In May,  2006,  the Company  received  notice from the  American  Stock
Exchange  ("AMEX") that it was not in  compliance  with certain of the continued
listing  standards as set forth in the AMEX Company  Guide due to the failure to
comply with Section  1003(a)(i)  and Section  1003(a)(ii)  of the Company Guide,
which effectively required that the Company maintain  shareholders' equity of at
least  $4,000,000.  Following  the notice from AMEX the Company was afforded the
opportunity to submit a "plan of compliance" to AMEX outlining in detail how the
Company  expected  to achieve  the  minimum  equity  requirements  and to regain
compliance.  On August 3, 2006 the Company received  notification from AMEX that
the Company's plan to regain  compliance with the minimum  shareholders'  equity
requirements  of the AMEX  Company  Guide had been  accepted and the Company has
been granted an extension  until November 16, 2007 to achieve the AMEX continued
listing requirements. During this period the Company will be subject to periodic
review by the AMEX Staff and failure to make progress  consistent  with the plan
or to regain  compliance  with  continued  listing  standards  by the end of the
extension  period  could  result  in  being  delisted  from the  American  Stock
Exchange.

         On October 12, 2005, a shareholder class action complaint-- Huberman v.
Tag-It Pacific, Inc., et al., Case No. CV05-7352 R(Ex)--was filed against us and
certain of our current and former  officers and  directors in the United  States
District  Court for the Central  District of  California  alleging  claims under
Section 10(b) and Section 20 of the Securities Exchange Act of 1934, as amended,
and Rule 10b-5  promulgated  thereunder.  The action is brought on behalf of all


                                       50
<PAGE>


                             TAG-IT PACIFIC, INC.
                   NOTES TO CONSOLIDATED FINANCIAL STATEMENTS


purchasers of our publicly-traded securities during the period from November 14,
2003 to August 12, 2005. On January 23, 2006 the court heard  competing  motions
for  appointment of lead  plaintiff/counsel  and appointed Seth Huberman as lead
plaintiff. The lead plaintiff thereafter filed an amended complaint on March 13,
2006. The amended  complaint  alleges that  defendants made false and misleading
statements about the company's  financial  situation and its  relationship  with
certain of its large customers  during a purported class period between November
13,  2003 and August  12,  2005.  It  purports  to state  claims  under  Section
10(b)/Rule  10b-5 and Section 20(a) of the Securities  Exchange Act of 1934. The
Company filed a motion to dismiss the amended complaint, which motion was denied
by the court on July 17,  2006.  On December  21, 2006 the court  established  a
trial date of May 1, 2007 and ordered completion of discovery by March 19, 2007.
On February 20, 2007 the court denied class  certification.  Plaintiff has moved
the court to  reconsider  the ruling,  and also to intervene a new  plaintiff to
pursue class certification.  Both of those motions were denied on April 2, 2007.
In addition,  the same day,  the Court  granted  Defendants'  motion for summary
judgment, and it is anticipated that the Court will enter a judgment in favor of
all  Defendants  shortly.  It is possible that Plaintiff will appeal the summary
judgment and class certification  rulings. The Company believes that this matter
will be resolved in trial or in  settlement  within the limits of its  insurance
coverage,  however the  outcomes of this action or an estimate of the  potential
losses,  if any, related to the lawsuit cannot be reasonably  predicted,  and an
adverse  resolution  of any of the  lawsuit  could  potentially  have a material
adverse effect on our financial position and results of operations.

         On April 16,  2004 the Company  filed suit  against  Pro-Fit  Holdings,
Limited  ("Pro-Fit")  in the U.S.  District  Court for the  Central  District of
California -- Tag-It Pacific, Inc. v. Pro-Fit Holdings,  Limited, CV 04-2694 LGB
(RCx) -- asserting various contractual and tort claims relating to our exclusive
license and intellectual  property agreement with Pro-Fit,  seeking  declaratory
relief,  injunctive  relief and damages.  It is the Company's  position that the
agreement with Pro-Fit gives us the exclusive rights in certain geographic areas
to Pro-Fit's  stretch and rigid  waistband  technology.  On September  17, 2004,
Pro-Fit filed an answer  denying the material  allegations  of the complaint and
filed  counterclaims  alleging  various  contractual  and  tort  claims  seeking
injunctive relief and damages. We filed a reply denying the material allegations
of Pro-Fit's  pleading.  Pro-Fit has since  purported to terminate the exclusive
license and intellectual  property  agreement based on the same alleged breaches
of the agreement that are the subject of the parties'  existing  litigation,  as
well as on an additional basis. On February 9, 2005, and again on June 16, 2005,
we amended our  pleadings in the  litigation  to assert  additional  breaches by
Pro-Fit of its  obligations  under the agreement  and under  certain  additional
letter  agreements,  and for a declaratory  judgment that  Pro-Fit's  patent No.
5,987,721  is invalid and not  infringed  by us.  Thereafter,  Pro-Fit  filed an
amended answer and counterclaims denying the material allegations of the amended
complaint and alleging  various  contractual and tort claims seeking  injunctive
relief and damages. Pro-Fit further asserted that we infringed its United States
Patent Nos.  5,987,721 and 6,566,285.  We filed a reply denying the  substantive
allegations of the amended  counterclaims.  On June 5, 2006 the Court denied the
Company's   motion  for  partial   summary   judgment   holding   that   summary
adjudification  that we did not breach our agreement with Pro-Fit by engaging in
certain  activities  in Columbia was not  appropriate.  The Court also held that
Pro-Fit  was not  "unwilling  or unable" to fulfill  orders by  refusing to fill
orders with goods produced in the United States.  The Court did not find that we
breached our agreement with Pro-Fit and a trial is required to determine  issues
concerning  our  activities  in Columbia  and whether  other  actions by Pro-Fit
constituted  an  unwillingness  or inability  to fill  orders.  As a result of a
change in the law, we dismissed our antitrust claims against Pro-Fit.  The court
has not yet set a date for trial of this matter. We derive a significant  amount
of  revenue  from the  sale of  products  incorporating  the  stretch  waistband
technology our business,  results of operations and financial condition could be
materially  adversely  affected if the dispute with Pro-Fit is not resolved in a
manner favorable to us. Additionally, we have incurred significant legal fees in
this  litigation,  and unless the case is  settled,  we will  continue  to incur
additional legal fees in increasing amounts as the case accelerates to trial.

         Tag-It Pacific,  Inc. has agreements with its foreign subsidiaries that
provide  for  royalty  payments  to the U.S.  parent  company  for the  sales of
products  carrying  the  Talon(R)  brand name,  and that also provide for a cost
sharing  arrangement  associated  with  various  corporate   administrative  and
operations  support  costs.  These  agreements  may give rise to  inquiries  and


                                       51
<PAGE>


                             TAG-IT PACIFIC, INC.
                   NOTES TO CONSOLIDATED FINANCIAL STATEMENTS


possible  disputes by the foreign  taxing  authority,  resulting in the possible
disallowance of some of these costs and potentially  resulting in higher foreign
income  taxes than has been  provided.  The Company  believes  that its basis of
charging these royalties and its allocation of costs to foreign  subsidiaries is
appropriate  under the various taxing agency laws, and that any  disagreement or
disallowance  regarding  such  costs  will not  have a  material  affect  on the
financial  statements of the Company.  A subsidiary,  Tag-It de Mexico,  S.A. de
C.V., has operated under the Mexican  government's  Maquiladora  Program,  which
entitles Tag-It de Mexico to certain  favorable  treatment as respects taxes and
duties  regarding  certain  imports.  In July of 2005,  the Mexican  Federal Tax
Authority  asserted a claim against Tag-It de Mexico alleging that certain taxes
had not been paid on imported  products  during the years 2000,  2001,  2002 and
2003. In October of 2005, the Company filed a procedural opposition to the claim
and  submitted  documents  to the Mexican Tax  Authority in  opposition  to this
claim,  supporting the Company's  position that the claim was without merit. The
Mexican Federal Tax Authority failed to respond to the opposition filed, and the
required  response  period by the Tax  Authority  has  lapsed.  In  addition,  a
controlled  entity  incorporated  in Mexico  (Logistica en Avios,  S.A. de C.V.)
through which the Company  conducted its operations in 2005, may be subjected to
a claim or claims from the Mexican Tax Authority,  as identified directly above,
and  additionally  to other tax issues,  including those arising from employment
taxes.  The Company believes that any such claim is defective on both procedural
and  documentary  grounds and is without merit. An estimate of the possible loss
or range of loss if any  associated  with these  matters  cannot be made at this
time.  The Company does not believe these  matters will have a material  adverse
affect on the Company.

         The Company  currently has pending a number of other claims,  suits and
complaints that arise in the ordinary course of our business. We believe that we
have meritorious defenses to these claims and that the claims are either covered
by insurance  or, after  taking into account the  insurance in place,  would not
have a material  effect on our  consolidated  financial  condition  if adversely
determined against us.

         In November  2002, the FASB issued FIN No. 45  "Guarantor's  Accounting
and Disclosure  Requirements for Guarantees,  including  Indirect  Guarantees of
Indebtedness of Others - and interpretation of FASB Statements No. 5, 57 and 107
and  rescission  of FIN  34."  The  following  is a  summary  of  the  Company's
agreements that it has determined are within the scope of FIN 45:

         In  accordance  with the bylaws of the Company,  officers and directors
are  indemnified  for certain events or  occurrences  arising as a result of the
officer or director's serving in such capacity.  The term of the indemnification
period is for the  lifetime of the officer or  director.  The maximum  potential
amount of future  payments  the  Company  could be  required  to make  under the
indemnification provisions of its bylaws is unlimited.  However, the Company has
a director and officer liability  insurance policy that reduces its exposure and
enables it to recover a portion of any future  amounts  paid. As a result of its
insurance policy coverage,  the Company believes the estimated fair value of the
indemnification  provisions of its bylaws is minimal and therefore,  the Company
has not recorded any related liabilities.

         The Company enters into indemnification provisions under its agreements
with  investors  and its  agreements  with other parties in the normal course of
business,  typically  with  suppliers,  customers  and  landlords.  Under  these
provisions, the Company generally indemnifies and holds harmless the indemnified
party for losses  suffered or incurred by the  indemnified  party as a result of
the  Company's  activities  or, in some  cases,  as a result of the  indemnified
party's activities under the agreement.  These indemnification  provisions often
include  indemnifications  relating to representations  made by the Company with
regard  to  intellectual  property  rights.  These  indemnification   provisions
generally survive termination of the underlying agreement. The maximum potential
amount of future  payments  the  Company  could be  required to make under these
indemnification  provisions is unlimited.  The Company has not incurred material
costs to defend  lawsuits  or settle  claims  related  to these  indemnification
agreements.  As a result, the Company believes the estimated fair value of these
agreements  is minimal.  Accordingly,  the Company has not  recorded any related
liabilities.


                                       52
<PAGE>


                             TAG-IT PACIFIC, INC.
                   NOTES TO CONSOLIDATED FINANCIAL STATEMENTS


NOTE 14 - GEOGRAPHIC AND PRODUCT GROUP INFORMATION

         The Company  specializes  in the  distribution  of a full range of trim
items  to  manufacturers  of  fashion  apparel,  specialty  retailers  and  mass
merchandisers.  There is not enough  difference  between  the types of  products
developed  and  distributed  by the Company to justify  segmented  reporting  by
product type. The Company believes that revenue by each major product class is a
valuable  business  measurement.  The net revenues for the three primary product
groups is as follows:

                                                Year Ended December 31,
                                     -------------------------------------------
                                        2006            2005            2004
                                     -----------     -----------     -----------
Product Group Net Revenue:
     Talon zipper ..............     $17,005,203     $13,593,479     $12,712,689
     Trim ......................      22,502,947      24,788,397      28,805,347
     Tekfit ....................       9,316,852       8,949,300      13,591,445
                                                     -----------     -----------
                                     $48,825,002     $47,331,176     $55,109,481
                                     ===========     ===========     ===========

         The Company distributes its products  internationally and has reporting
requirements  based on geographic  regions.  Long-lived assets are attributed to
countries  based on the location of the assets and revenues  are  attributed  to
countries based on customer delivery locations, as follows:

                                                Year Ended December 31,
                                     -------------------------------------------
                                        2006            2005            2004
                                     -----------     -----------     -----------
Sales:
     United States .............     $ 5,287,236     $ 8,902,734     $ 4,822,935
     Asia ......................      28,974,546      20,005,036      12,785,977
     Mexico ....................       2,476,313       8,526,367      21,452,805
     Dominican Republic ........       9,138,404       5,914,792       9,678,078
     Other .....................       2,948,503       3,982,247       6,369,686
                                     -----------     -----------     -----------
                                     $48,825,002     $47,331,176     $55,109,481
                                     ===========     ===========     ===========
Long-lived Assets:
     United States .............     $ 9,531,659     $ 9,797,110     $12,911,377
     Asia ......................         386,516         226,221         234,746
     Mexico ....................           5,078          23,754         187,721
     Dominican Republic ........         668,067         776,279         866,807
                                     -----------     -----------     -----------
                                     $10,591,320     $10,823,364     $14,200,651
                                     ===========     ===========     ===========

NOTE 15 - MAJOR CUSTOMERS AND VENDORS

         For the year ended  December 31, 2006, no single  customer  represented
more than 9% of the  Company's  consolidated  net sales;  however the  Company's
three largest customers represented approximately 18% of consolidated net sales.
For the year ended December 31, 2005, no single customer  represented  more than
10% of consolidated net sales;  however,  the Company's three largest  customers
represented  approximately  22% of consolidated  net sales.  Two major customers
accounted  for  approximately  22% of the Company's net sales for the year ended
December 31, 2004.

         One major  vendor  accounted  for  substantially  all of the  Company's
purchases  associated  with its TekFit  product for the year ended  December 31,
2006 and represented 24% of the Company's overall purchases;  and three vendors,
each  representing  more  than 10% of the  Company's  purchases,  accounted  for
approximately  45% of the Company's  purchases  for the year ended  December 31,
2006. Three vendors accounted for  approximately 39% of the Company's  purchases
for  the  year  ended  December  31,  2005,  and  four  vendors   accounted  for
approximately  70% of the Company's  purchases  for the year ended  December 31,


                                       53
<PAGE>


                             TAG-IT PACIFIC, INC.
                   NOTES TO CONSOLIDATED FINANCIAL STATEMENTS


2004. Included in accounts payable and accrued expenses at December 31, 2006 and
2005 is $2,682,000 and  $2,206,000  due to these vendors.  Terms are sight to 60
days.

NOTE 16 - RELATED PARTY TRANSACTIONS

         Prior to 2004 the  Company  operated an apparel  trim supply  agreement
with  Tarrant  Apparel  Group.  Two  of  Tarrant's   directors  and  significant
shareholders  are  also  significant  shareholders  of  the  Company.  In  2004,
following negotiations with Tarrant Apparel Group, the Company determined that a
significant   portion  of  the   obligations   due  from  this   customer   were
uncollectible.  Accordingly, included in general and administrative expenses for
2004 are charges of $4.3 million  related  primarily to the  write-down  of this
receivable and leaving a remaining balance receivable from this customer of $4.5
million at December  31, 2004.  An  affiliate  of the  customer  repaid the $4.5
million  receivable  balance over the period from May through December 2005. The
Company  terminated its supply  relationship  with Tarrant in 2004;  however the
Company  continues to conduct  business with Tarrant on a limited  basis.  Total
sales to Tarrant  for the years  ended  December  31,  2006,  2005 and 2004 were
$3,000, $574,000 and $758,000,  respectively.  As of December 31, 2005, accounts
receivable,  related party included  $0.05 million due from Tarrant.  No amounts
were due from Tarrant at December 31, 2006.

         Colin Dyne, a director of the Company is a significant  shareholder  in
People's Liberation,  Inc., the parent company of Versatile Entertainment,  Inc.
During  2006  and  2005  the  Company  had  sales  of  $147,000   and  $  76,000
respectively,  to  Versatile  Entertainment.   At  December  31,  2006  accounts
receivable of $83,400 were outstanding from Versatile Entertainment.

         Due from  related  parties  at  December  31,  2006  and 2005  includes
$675,137 and $655,489  respectively,  of unsecured  notes,  advances and accrued
interest  receivable  from Colin Dyne,.  The notes and advances bear interest at
7.5% and are due on demand.

         Demand notes payable to related parties  includes notes and advances to
Mark Dyne,  the  Chairman of the Board of Directors of the Company or to parties
related to or affiliated  with Mark Dyne. The balance of Demand notes payable to
related  parties at  December  31,  2006 and 2005 was  $664,971.  See Note 4 for
further  discussion of these notes,  and related  accrued  interest and interest
expense.

         Transportation fees in the amount of $211,000 were paid to or on behalf
of a company  that Mark Dyne has an  ownership  interest  in for the year  ended
December 31, 2004.  Consulting fees paid to Diversified  Investments,  a company
owned by Mark Dyne,  amounted to $150,000  for each of the years ended  December
31, 2006, 2005 and 2004.

         Consulting  fees of $335,000  were paid for services  provided by Colin
Dyne, for the year ended December 31, 2006. Brent Cohen and Raymond Musci,  both
members of the Board of  Directors  were paid for services  provided  during the
year  ended   December  31,  2005  in  the  amount  of  $24,000,   and  $21,000,
respectively.  Mr. Cohen and Kevin Bermiester, a former director of the Company,
were paid for services  provided  during the year ended December 31, 2004 in the
amounts of $57,000 and $41,000, respectively.


                                       54
<PAGE>


                             TAG-IT PACIFIC, INC.
                   NOTES TO CONSOLIDATED FINANCIAL STATEMENTS


NOTE 17 - QUARTERLY RESULTS (UNAUDITED)

         Quarterly  results for the years ended  December  31, 2006 and 2005 are
reflected below:

<TABLE>
<CAPTION>
                                   4th             3rd             2nd             1st
                               ------------    ------------    ------------    ------------
<S>                            <C>             <C>             <C>             <C>
2006
----
Revenue ....................   $ 10,573,755    $ 13,366,944    $ 14,246,087    $ 10,638,216
Gross profit ...............   $  3,350,600    $  4,148,406    $  4,127,237    $  2,842,725
Operating income (loss) ....   $    248,177    $    630,273    $    895,481    $   (442,275)
Net Income(loss) ...........   $     44,950    $    339,115    $    654,643    $   (729,404)
Basic and diluted income
(loss) per share ...........   $       0.00    $       0.02    $       0.04    $      (0.04)

2005
----
Revenue ....................   $  9,163,355    $  9,472,898    $ 15,639,646    $ 13,055,277
Gross profit (loss) (1) ....   $ (1,652,918)   $ (2,094,230)   $    756,120    $  3,251,823
Operating (loss) income
(1,2) ......................   $ (4,925,076)   $(10,203,361)   $(10,829,928)   $ (1,140,089)
Net (loss) income (1,2) ....   $ (5,127,754)   $(10,284,874)   $(12,476,638)   $ (1,648,443)
Basic and diluted (loss)
per share ..................   $      (0.28)   $      (0.56)   $      (0.68)   $      (0.09)
</TABLE>

(1)      The Company recorded restructuring charges of $6.2 million in the third
         quarter  of  2005,  of  which  $3.4   million,   related  to  inventory
         write-downs  (Note 11);  theCompany  recorded $2.5 million in inventory
         obsolescence   reserves  and  $1.5   million  in   inventory   overhead
         adjustments in the fourth quarter affecting gross profit.

(2)      The Company  recorded  $3.6  million in bad debt  reserves  principally
         associated  with one  customer  in the second  quarter of 2005;  direct
         write-off  to bad debts of $1.8  million  in the third  quarter of 2005
         principally from another customer, and $0.5 million in bad debts in the
         fourth  quarter  of  2005  associated  with  the  acceptance  of a note
         receivable.  In  the  third  quarter  of  2005,  the  Company  recorded
         restructuring  charges included in operating costs of $2.8 millionand a
         decrease  in net  deferred  tax  asset  resulting  in a  charge  to the
         provision for income taxes of $1 million during 2005.

         During  2006,  the  Company  had no  material  unusual or  infrequently
occurring items or adjustments that were recognized during the year.

         Quarterly and  year-to-date  computations of per share amounts are made
independently.  Therefore, the sum of per share amounts for the quarters may not
agree with the per share amounts for the year.

NOTE 18 - SUBSEQUENT EVENT (UNAUDITED)

         On April 11, 2007 a favorable verdict was awarded to the plaintiff in a
trademark infringement lawsuit in which Azteca Production International, Inc. is
a defendant.  We have an outstanding  note  receivable from Azteca (see Note 2),
and this adverse  ruling against them may impact their ability to repay our note
receivable.  The outcome of this event or an estimate of the potential impact if
any, on the collectibility of our note receivable cannot be reasonably predicted
at this time. The failure to collect payments under this note as scheduled could
have a  material  adverse  effect  on our  financial  position  and  results  of
operations.


                                       55
<PAGE>


ITEM 9A.      CONTROLS AND PROCEDURES

EVALUATION OF CONTROLS AND PROCEDURES

         We maintain  disclosure  controls and  procedures  that are designed to
ensure that  information  required  to be  disclosed  in our  reports  under the
Securities  Exchange Act of 1934,  as amended,  or the Exchange Act is recorded,
processed,  summarized  and reported,  within the time periods  specified in the
Securities  Exchange  Commission's  rules and forms,  including  to ensure  that
information  required to be disclosed by us in the reports filed or submitted by
us under the Exchange Act is accumulated  and  communicated  to our  management,
including our principal executive and principal  financial officers,  or persons
performing similar functions, as appropriate to allow timely decisions regarding
required  disclosure as defined in Rules 13a-15(e) and 15d-15(e) of the Exchange
Act.

         As  of  December  31,  2006,  we  conducted  an  evaluation,  with  the
participation of our Chief Executive Officer and Chief Financial Officer, of the
effectiveness  of the  design  and  operation  of our  disclosure  controls  and
procedures.  Based on that  evaluation,  our Chief  Executive  Officer and Chief
Financial  Officer have  concluded  that as of December 31, 2006, our disclosure
controls and procedures were effective.

CHANGES IN INTERNAL CONTROLS

         During  the last  fiscal  quarter,  there  have been no  changes in our
internal control over financial reporting that have materially affected,  or are
reasonably  likely to materially  affect,  our internal  control over  financial
reporting.


                                       56
<PAGE>


                                     PART IV

ITEM 15.      EXHIBITS, FINANCIAL STATEMENT SCHEDULES

         (a)      FINANCIAL STATEMENTS AND SCHEDULES.


                                       57
<PAGE>


      INDEPENDENT REGISTERED PUBLIC ACCOUNTING FIRM'S REPORT ON SCHEDULE II


To the Board of Directors
Tag it Pacific, Inc.
Woodland Hills, California

The audits  referred  to in our  report,  dated  April 9, 2007  included  in the
related  financial  statement  schedule as of December  31, 2006 and for the two
years ended  December  31, 2006,  included in the annual  report on Form 10-K of
Tag-It Pacific, Inc. This financial statement scheduled is the responsibility of
the Company's  management.  Our  responsibility is to express an opinion on this
financial statement schedule based on our audit. In our opinion,  such financial
statement  schedule presents fairly, in all material  respects,  the information
set forth therein.


/S/ SINGER LEWAK GREENBAUM & GOLDSTEIN LLP
------------------------------------------
SINGER LEWAK GREENBAUM & GOLDSTEIN LPP

Los Angeles, California

April 9, 2007


                                       58
<PAGE>


      INDEPENDENT REGISTERED PUBLIC ACCOUNTING FIRM'S REPORT ON SCHEDULE II


To the Board of Directors
Tag-It Pacific, Inc.
Los Angeles, California

The audit referred to in our report,  dated March 31, 2005, included the related
financial  statement  schedule  as of and for the year ended  December  31, 2004
included  in the  annual  report  on Form  10-K of  Tag-It  Pacific,  Inc.  This
financial statement schedule is the responsibility of the Company's  management.
Our responsibility is to express an opinion on this financial statement schedule
based on our audit. In our opinion,  such financial  statement schedule presents
fairly, in all material respects, the information set forth therein.


                                           /s/ BDO Seidman, LLP
                                           -------------------------
                                           BDO Seidman, LLP

Los Angeles, California
March 31, 2005


                                       59
<PAGE>


SCHEDULE II - VALUATION AND QUALIFYING ACCOUNTS AND RESERVES

<TABLE>
<CAPTION>
             COLUMN A                            COLUMN B      COLUMN C     COLUMN D      COLUMN E
                                                Balance at
                                                Beginning                                 Balance at
            Description                          of Year      Additions    Deductions    End of Year
--------------------------------------------   -----------   -----------   -----------   -----------
<S>                                            <C>           <C>           <C>           <C>
2006
----
Allowance for doubtful accounts
  deducted from accounts receivable
  in the balance sheet .....................   $ 1,189,000   $   198,000   $ 1,315,500   $    71,500
Reserve for obsolescence deducted
  from inventories on the balance
  sheet ....................................     7,306,000       557,000     6,621,000     1,242,000
Valuation reserve deducted from
  deferred tax assets ......................    21,447,000          --       2,222,000    19,225,000
                                               -----------   -----------   -----------   -----------
                                               $29,942,000   $   755,000   $10,158,500   $20,538,500
                                               ===========   ===========   ===========   ===========

2005
----
Allowance for doubtful accounts
  deducted from accounts receivable
  in the balance sheet .....................   $ 6,086,000   $ 4,160,000   $ 9,057,000   $ 1,189,000
Reserve for obsolescence deducted
  from inventories on the balance
  sheet ....................................     6,365,000     2,538,000     1,597,000     7,306,500
Valuation reserve deducted from
  deferred tax assets ......................     8,900,000    12,547,000          --      21,447,000
                                               -----------   -----------   -----------   -----------
                                               $21,351,000   $19,245,000   $10,654,000   $29,942,000
                                               ===========   ===========   ===========   ===========

2004
----
Allowance for doubtful accounts
  deducted from accounts receivable
  in the balance sheet .....................   $ 2,044,000   $ 5,500,000   $ 1,458,000   $ 6,086,000
Reserve for obsolescence deducted
  from inventories on the balance
  sheet ....................................     6,125,000     1,040,000       800,000     6,365,500
Valuation reserve deducted from
  deferred tax assets ......................     1,119,000     7,781,000          --       8,900,000
                                               -----------   -----------   -----------   -----------
                                               $ 9,288,000   $14,321,000   $ 2,258,000   $21,351,000
                                               ===========   ===========   ===========   ===========
</TABLE>

(1)      Additions to the allowance for doubtful accounts include provisions for
         uncollectible  accounts. Bad debt expense includes (and additions above
         exclude) net  recoveries  of $712,000  for the year ended  December 31,
         2006,  and net direct  write-offs of $1,698,000  and $7,012,000 for the
         years ended December 31, 2005 and 2004, respectively.  Additions to the
         inventory obsolescence reserve include current year provisions. In 2005
         there were direct write-offs of inventory of $3.4 million in connection
         with the  restructuring,  and in 2006 there were direct  write-offs  of
         $0.2 million. The reserve for obsolescence deducted from inventories on
         the  balance  sheet for 2004,  reflects  the  reclassification  of $1.2
         million previously reported in Column D as a deduction,  to Column C as
         net additions consistent with the presentation in 2005 and 2006.

(2)      Deductions from the allowance for doubtful  accounts  includes  amounts
         applied to write-offs,  reversals of prior period provisions,  and, for
         the year ended December 31, 2005, deductions include $7,528,000 related
         to the conversion of a trade account  receivable to a note  receivable.
         Deductions from the inventory  obsolescence reserve include application
         of the  reserve  against  obsolete,  excess,  slow-moving  or  disposed
         inventory.

         (b)      EXHIBITS:

                  See Exhibit Index attached to this Annual Report of Form 10-K.


                                       60
<PAGE>


                                  SIGNATURES

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


                                             TALON INTERNATIONAL, INC.

                                             /s/ Lonnie D. Schnell
                                             ----------------------------
                                             By:  Lonnie D. Schnell
                                             Its: Chief Executive Officer


                                   SIGNATURES

         Pursuant to the  requirements  of Section 13 or 15(d) of the Securities
Exchange Act of 1934, this report has been signed below by the following persons
on behalf of the Registrant and in the capacities and on the dates indicated.

      Signature                       Title                         Date
      ---------                       -----                         ----

          *              Chairman of the Board of Directors     March 14, 2008
---------------------
Mark Dyne


/s/ Lonnie D. Schnell    Chief Executive Officer and Chief      March 14, 2008
---------------------    Financial Officer (Principal
Lonnie D. Schnell        Executive and Financial Officer)


/s/ David Hunter         Vice President Corporate Controller    March 14, 2008
---------------------    (Principal Accounting Officer)
David Hunter


          *                         Director                    March 14, 2008
---------------------
Colin Dyne


                                    Director                    March 14, 2008
---------------------
Brent Cohen


          *                         Director                    March 14, 2008
---------------------
Raymond Musci


          *                         Director                    March 14, 2008
---------------------
Joseph Miller


          *                         Director                    March 14, 2008
---------------------
William Sweedler


By:   /s/ Lonnie D. Schnell
      -----------------------------------
      Lonnie D. Schnell, Attorney-In-Fact


                                       61
<PAGE>


                                  EXHIBIT INDEX

Exhibit
Number   Exhibit Description
-------  -----------------------------------------------------------------------

23.1     Consent of Singer Lewak Greenbaum & Goldstein LLP.

23.2     Consent of BDO Seidman, LLP.

31.1     Certificate of Chief Executive Officer pursuant to Rule 13a-14(a) under
         the Securities and Exchange Act of 1934, as amended

31.2     Certificate of Chief Financial Officer pursuant to Rule 13a-14(a) under
         the Securities and Exchange Act of 1934, as amended

32.1     Certificate  of Chief  Executive  Officer and Chief  Financial  Officer
         pursuant to Rule  13a-14(b)  under the  Securities  and Exchange Act of
         1934, as amended.


                                       62