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UNITED STATES
SECURITIES AND EXCHANGE COMMISSIONWashington, D.C. 20549



FORM 10-K

(Mark One)ý

ANNUAL REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934For the Fiscal Year Ended December 31, 2008Oro

TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934For the transition period
from                                to


Commission file number: 001-33182



HEELYS, INC.(Exact name of Registrant as specified in its charter)

Delaware(State of incorporation)

75-2880496(I.R.S. Employer Identification No.)3200 Belmeade Drive, Suite 100
Carrollton, Texas 75006(Address of principal executive offices)        (Zip Code)


(214) 390-1831(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 registeredCommon Stock, par value $0.001

The Nasdaq Stock Market LLC


Securities
registered pursuant to Section 12(g) of the Act:None

Indicate
by check mark whether the registrant is a well-known seasoned issuer, as defined in Rule 405 of the Securities
Act. Yes o    No ý

Indicate by check mark whether the registrant is not required to file reports pursuant to Section 13 or Section 15(d) of the
Act. Yes o    No ý

Indicate by check mark whether the registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of
1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past
90 days. Yes ý    No o

Indicate by check mark 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. o

Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer, or a non-accelerated filer. See definition of
"accelerated filer and large accelerated filer" in Rule 12b-2 of the Exchange Act.

Large accelerated filer o

Accelerated filer o

Non-accelerated filer o (Do not check if a smaller
reporting company)

Smaller reporting company ý


Indicate
by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the
Act. Yes o    No ý

As of June 30, 2008, the last business day of the registrant's most recently completed second fiscal quarter, the aggregate market value of the registrant's
common stock held by non-affiliates was approximately $42,139,000 (based upon the closing price for the registrant's common stock on The Nasdaq Global Market of $4.06 per share). For the
purpose of the foregoing calculation only, all directors and executive officers of the registrant and owners of more than 5% of the registrant's common stock are assumed to be affiliates of the
registrant. This determination of affiliate status is not necessarily conclusive for any other purpose.

As
of March 20, 2009, there were 27,571,052 shares of the registrant's common stock outstanding.

DOCUMENTS INCORPORATED BY REFERENCE

The information required by Part III of this Report, to the extent not set forth herein, is incorporated herein
by reference from the registrant's definitive proxy statement relating to the Annual Meeting of Shareholders to be held in 2009, which definitive proxy statement shall be filed with the Securities and
Exchange Commission within 120 days after the end of the fiscal year to which this Report relates.



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INDEX TO FORM 10-K



PART IItem 1. Business

1Item 1A. Risk Factors

11Item 1B. Unresolved Staff Comments

24Item 2. Properties

24Item 3. Legal Proceedings

24Item 4. Submission of Matters to a Vote of Security Holders

26PART IIItem 5. Market for Registrant's Common Equity, Related Stockholder Matters
and Issuer Purchases of Equity Securities

27Item 6. Selected Financial Data

30Item 7. Management's Discussion and Analysis of Financial Condition and
Results of Operations

33Item 7A. Quantitative and Qualitative Disclosures about Market
Risk

51Item 8. Consolidated Financial Statements and Supplementary
Data

52Item 9. Changes in and Disagreements with Accountants on Accounting and
Financial Disclosure

52Item 9A. Controls and Procedures

52Item 9B. Other Information

55PART IIIItem 10. Directors, Executive Officers and Corporate
Governance

55Item 11. Executive Compensation

55Item 12. Security Ownership of Certain Beneficial Owners and Management and
Related Stockholder Matters

55Item 13. Certain Relationships and Related Transactions, and Director
Independence

55Item 14. Principal Accounting Fees and Services

55PART IVItem 15. Exhibits and Financial Statement
Schedules

56SIGNATURES

61


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PART I

Item 1.    Business

This Annual Report on Form 10-K contains forward-looking statements within the meaning of
Section 27A of the Securities Act of 1933, as amended, or the "Securities Act," and Section 21E of the Securities Exchange Act of 1934, as amended, or the "Exchange Act," that are based
on information currently available to management as well as management's assumptions and beliefs. When used in this document and in documents incorporated by reference, forward-looking statements
include, without limitation, statements regarding financial forecasts or projections, and our expectations, beliefs, intentions or future strategies that are signified by terminology such as "subject
to," "believes," "anticipates," "plans," "expects," "intends," "estimates," "may," "will," "should," "can," the negatives thereof, variations thereon, similar expressions, or discussions of strategy.
These forward-looking statements reflect our current views with respect to future events, based on what we believe are reasonable assumptions;
however, such statements are subject to certain risks and uncertainties. In addition to the specific uncertainties discussed elsewhere in this Annual Report on Form 10-K, the risk
factors set forth in Part I, "Item 1A. Risk Factors" in this report may affect our performance and results of operations. Those risks, uncertainties and factors include, but are not
limited to the fact that substantially all of our net sales are generated by one product, continued changes in fashion trends and consumer preferences and general economic conditions, our intellectual
property may not restrict competing products that infringe on our patents from being sold, we are dependent upon independent manufacturers, we may not be able to successfully introduce new product
categories and the other factors described in our filings with the Securities and Exchange Commission. Investors are urged to consider these risks, uncertainties and factors carefully in evaluating
the forward-looking statements and are cautioned not to place undue reliance on such forward-looking statements. Should one or more of these risks or uncertainties materialize, or should underlying
assumptions prove incorrect, actual results may differ materially from those in the forward-looking statements. We disclaim any intention or obligation to update or review any forward-looking
statements or information, whether as a result of new information, future events or otherwise.

Throughout this report, references to the "Company," "we," and "our" refer to Heelys, Inc. and its consolidated subsidiaries, unless the context indicates
otherwise.

Overview

We are a designer, marketer and distributor of innovative, action sports-inspired products under the HEELYS brand targeted to the youth
market. Our primary product, HEELYS-wheeled footwear, is patented, dual-purpose footwear that incorporates a stealth, removable wheel in the heel. HEELYS-wheeled footwear allows the user
to seamlessly transition from walking or running to rolling by shifting weight to the heel. Users can transform HEELYS-wheeled footwear into street footwear by removing the wheel. We believe our
distinctive product offering and our HEELYS brand is synonymous with a popular lifestyle activity. We were initially incorporated as Heeling, Inc. in Nevada in 2000 and were reincorporated in
Delaware in August 2006 and changed our name to Heelys, Inc. Through our general and limited partner interests, we own 100% of Heeling Sports Limited, a Texas limited partnership, which was
formed in May 2000. In February 2008, we formed Heeling Sports EMEA SPRL, a Belgium corporation and indirect wholly-owned subsidiary, with offices in Brussels, Belgium, to manage our European
operations.

We
are subject to the informational requirements of the Exchange Act, and, accordingly, file reports, proxy statements and other information with the Securities and Exchange Commission
(the "SEC"). We maintain a website on the World Wide Web atwww.heelys.com. We make available, free of charge through our website, our Annual Report on
Form 10-K, Quarterly Reports on Form 10-Q, Current Reports on Form 8-K, including exhibits thereto, and any amendments to those reports filed
or furnished pursuant to Section 13(a) or 15(d) of the Exchange Act, as soon as reasonably practicable

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after
the reports are electronically filed with, or furnished to, the SEC. Our reports that are filed with, or furnished to, the SEC are also available at the SEC's website at www.sec.gov, which contains
material regarding issuers that file electronically with the SEC. You may also obtain copies of any of our reports filed
with, or furnished to, the SEC, free of charge, at the SEC's public reference room at 100 F Street, N.E., Washington, DC 20549. Information regarding the operation of the Public
Reference Room may be obtained by calling the Securities and Exchange Commission at 1-800-SEC-0330.

Our Business

We currently offer HEELYS-wheeled footwear in the United States and certain other countries. Heelys-wheeled footwear is protected by
numerous patents and trademarks. In 2008, approximately 98% of our net sales was derived from the sale of our HEELYS-wheeled footwear. The remainder of our net sales was derived from branded
accessories, such as replacement wheels, helmets and other protective gear.

We
sell our products through distribution channels that generally merchandise our products in a manner that we believe enhances and protects our HEELYS brand image. Domestically, our
products can be purchased from full-line sporting goods retailers such as The Sports Authority, Academy, Big 5, Modell's and Hibbett Sports; specialty apparel and footwear retailers, such
as The Finish Line and Journeys; and family footwear stores, such as Famous Footwear and Shoe Carnival. Our products can also be purchased from select online retailers such as Zappos.com. In 2008, we
distributed certain styles through discount retailers such as Marshalls and Ross in order of dispose of excess inventory. In 2008, 52.4% of our net sales were derived from retailers in the United
States. Historically, our products have been sold internationally through independent distributors with exclusive rights to specified international territories. During the first quarter of 2008, our
Belgian subsidiary opened an office in Belgium to focus on expanding our international opportunities by working more closely with our distributors, establishing relationships with distributors in new
international markets and, in select markets, selling our products direct to retail customers. Effective as of March 31, 2008 and April 30, 2008, respectively, we entered into agreements
with our distributor in Germany and Austria and our distributor in France, Monaco and Andorra whereby we terminated their rights to distribute our products in their specified territories. Our Belgian
subsidiary took over the distribution of our products in Germany and Austria effective April 1, 2008 and in France, Monaco and Andorra effective May 1, 2008.

In
January 2008, we opened a representative office in Qingdao, China. This office serves multiple sourcing functions including quality control, price negotiation, logistics and product
development. We believe our Qingdao office will help us improve our research and development efforts, enhance communication between us and our distribution and manufacturing partners and give us more
direct control over the manufacturing and sourcing process.

Target Market

The growth and longstanding popularity of skateboarding, inline skating, roller skating and scooter riding reflect consumers' interest
in wheeled sports activities. For example, skateboarding and inline skating have remained a part of youth culture for more than 40 and 25 years, respectively. Our HEELYS-wheeled footwear, which
we believe has broad patent protection relative to other wheeled sports products, appeals to many of these same consumers.

We
believe that our products appeal to a broad range of young, active consumers around the world who enjoy wheeled sports activities. Our primary market is six to fourteen
year-old boys and girls and we believe we benefit from greater repeat purchases by such consumers relative to other wheeled sports products, driven by the natural replacement cycle of
children's footwear.

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Business Strengths

We believe that we have the following business strengths:



Products

Our primary product is HEELYS-wheeled footwear, patented, dual-purpose footwear that incorporates a stealth, removable
wheel in the heel. HEELYS-wheeled footwear allows the user to

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seamlessly
transition from walking or running to rolling by shifting weight to the heel. Users can remove the wheel to transform HEELYS-wheeled footwear into street footwear. HEELYS-wheeled footwear
is offered in more than 20 styles, incorporating various comfort and performance features and colors at multiple retail price points. We traditionally offer a new line of HEELYS-wheeled footwear twice
each year for the spring/summer selling season and the back-to-school / holiday selling seasons.

HEELYS-wheeled
footwear can be classified into the following three categories:



Product Design and Development

We attempt to update and refine our product offerings in response to evolving consumer preferences. We believe that introducing new
products, performance features and designs better positions us to achieve targeted price points, drive incremental consumer demand for our products, and encourage repeat purchases. We attempt to
monitor changing consumer trends and identify new product opportunities through contact with our target consumers, dialogue between our sales representatives and our retail customers and input from
our sponsored "team skaters," some of whom are paid to use and promote our products.

Our
product development efforts include both incremental improvements to our existing products and entirely new technologies aimed at increasing the overall visual appeal and product
function while simultaneously lowering our production costs.

Sales

We control the distribution of our products in an effort to protect our HEELYS brand and maintain our targeted price points. We sell
our products domestically directly to retail customers and internationally we have traditionally sold our products through independent distributors. During the first quarter of 2008, our Belgian
subsidiary opened an office in Belgium to focus on expanding our international opportunities by working more closely with our distributors, establishing relationships with distributors in new
international markets and, in select markets, selling our products direct to retail customers. Effective as of March 31, 2008 and April 30, 2008, respectively, we entered into agreements
with our distributor in Germany and Austria and our distributor in France, Monaco and Andorra whereby we terminated their rights to distribute our products in their specified territories. Our Belgian

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subsidiary
took over the distribution of our products in Germany and Austria effective April 1, 2008 and in France, Monaco and Andorra effective May 1, 2008.

Currently,
we do not sell our products to traditional mass merchants or directly to consumers, although in 2008 and continuing into 2009 we sell certain styles to select discount
retailers in order to dispose of excess inventory.

Domestic Sales

Our products are sold through retail customers, including a variety of full-line sporting goods retailers, specialty
apparel and footwear retailers, select department stores, family footwear stores and select online retailers. We attempt to choose retail customers who appeal to our target market and who are able and
willing to merchandise our products in a manner that we believe is consistent with our brand message and positioning. The Sports Authority, Academy, Big 5, Modell's, Hibbett Sports, The Finish Line,
Journeys, Famous Footwear, Shoe Carnival, and Zappos.com are examples of our domestic retail customers. In 2006, 2007 and 2008, our domestic net sales were $161.3 million,
$153.0 million, and $37.1 million respectively, representing 85.7%, 83.4% and 52.4% of our total net sales, respectively.

We
intend to actively manage our domestic distribution by controlling the number of stores in which HEELYS-wheeled footwear is sold. We elected to reduce the number of stores offering
Heelys in 2008 to better balance supply and demand. When market conditions are favorable, we will consider adding new retail customers and additional doors to enhance our existing geographical
distribution.

We
are committed to providing the highest levels of service to our retail customers. Our domestic retail accounts are served by a national sales force of 27 sales representatives who are
employed by 3 independent sales agencies. Each independent sales agency is assigned an exclusive territory and is compensated on a commission basis. This external sales force is responsible for
substantially all of our domestic sales.

International Sales

As of December 31, 2008, we offered our products internationally through 31 independent distributors, each of which has
exclusive rights to a designated territory. In 2008, our largest international territories managed by independent distributors, were the Middle East and Japan, which accounted for 6.3% and 5.1% of our
total net sales, respectively. We select our independent distributors based on their relationships with appropriate retailers, their ability to effectively represent the HEELYS brand and their
execution of our distribution strategy. In order to maintain a consistent brand image throughout the world, we provide marketing, distribution and product training support to our independent
distributors. Each distributor must meet minimum sales goals and is responsible for funding its local marketing campaigns, maintaining its own inventory and providing sufficient sales, distribution
and customer service infrastructure.

During
the first quarter of 2008, our Belgian subsidiary opened an office in Belgium, with branch offices in Germany and France, in order to focus on expanding our international
opportunities by working more closely with our distributors, establishing relationships with distributors in new international markets and, in select markets, selling our products direct to retail
customers. Effective as of March 31, 2008 and April 30, 2008, respectively, we entered into agreements with our distributor in Germany and Austria and our distributor in France, Monaco
and Andorra whereby we terminated their rights to distribute our products in their specified territories. Our Belgian subsidiary took over the distribution of our products in Germany and Austria
effective April 1, 2008 and in France, Monaco and Andorra effective May 1, 2008. In 2008, the German and France territories accounted for 6.0% and 7.7% of our net sales, respectively.

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In
2006, 2007 and 2008, our international net sales were $26.9 million, $30.5 million, and $33.6 million, respectively, representing 14.3%, 16.6% and 47.6% of our
total net sales, respectively. In 2004, Japan accounted for 19.4% of our total net sales. Since 2004, no country other than the United States has accounted for 10% or more of our net sales. We believe
that international distribution represents a growth opportunity for us that we intend to take advantage of by encouraging our existing distributors
to expand their market presence, by establishing relationships with distributors in new international markets and, in select markets, selling our products direct to retail customers.

In
our international markets we employ 3rd party distributors in most countries and they have their own direct and independent sales representatives. In our direct
international markets of Germany and France, we utilize both employees (4) and independent sales representatives (15).

Principal Customers

In 2006, Journeys accounted for 12.7% of our net sales. In 2007, Finish Line represented 13.2% of our net sales. In 2008, Journeys
accounted for 9.9% of our net sales. No other retail customer or independent distributor accounted for 10% or more of our net sales in any of these periods.

Marketing

Our marketing strategy is to position our products and the HEELYS brand to represent a lifestyle that includes excitement,
individuality and the unique culture of action sports. We utilize a multi-faceted strategy to promote awareness of and generate demand for the HEELYS brand. This strategy includes mass advertising,
point-of-purchase, or "POP," displays, product placement, public relations and event marketing activities. While we fund the cost of these activities domestically, as well as
in our direct distribution international markets, our international independent distributors are solely responsible for these costs in their markets.

Television Advertising

Television advertisements have traditionally been an important and effective tool for increasing awareness of our brand and products
among our target consumers because these advertisements allow us to show consumers HEELYS-wheeled footwear in action. Advertisements have aired nationally and in selected regions of the United States
and Europe during our primary selling seasons. As part of our regional television advertising strategy, we typically feature the name of a local retail customer at the end of our television
advertisements. This tactic is intended to drive
consumers to specific retail customers and has allowed us to evaluate the effectiveness of our advertising.

Point-of-Purchase Displays

Many of our retail customers have committed valuable floor space to HEELYS branded POP displays. When the opportunity presents itself,
we supply custom POP solutions that best fit both our needs and those of our retail customers. Through the use of these POP displays, we are able to present the HEELYS brand message to consumers in a
consistent manner and sometimes increase our shelf space in our retail customers' locations.

Product Placement

Because kids, tweens and teens look to celebrities, musicians and other stars for inspiration and fashion cues, we have hired an
outside product placement agency to help us identify and secure "product in-use" opportunities for our domestic markets ranging from feature films to television to celebrity endorsement.
We believe that product placement activities enable us to build awareness of and demand for our products in a cost-effective manner.

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Cooperative Marketing

In partnership with our domestic retailers, we offer cooperative marketing support. Our cooperative marketing initiatives are aimed at
increasing overall demand for HEELYS as well as driving HEELYS sales to our key retail partners. Examples of cooperative marketing include company approved POP display materials, television, radio,
print, and web based advertising, gift with purchase promotions, and customized event marketing demonstrations. We will continue to collaboratively work with our retail partners in an effort to drive
the overall awareness and demand for HEELYS.

Website

In 2008, we hired an outside website development agency to assist us in redesigning and upgrading the www.heelys.comwebsite. The project
is ongoing with the goal of providing an interesting, informative and fun site for the online community of HEELYS
users. The website also offers updated product and store location information, safety information, skating
etiquette, instructions on how to heel and how to perform new tricks and maneuvers, and other relevant information to provide for the safe, fun and responsible use of our products.

Manufacturing and Sourcing

We do not own or operate any manufacturing facilities and we purchase our products as finished goods from independent manufacturers. We
do not have any long-term manufacturing contracts, choosing instead to retain the flexibility to change our manufacturing sources if necessary. We believe that alternate manufacturing
sources are available at comparable costs to those we currently utilize.

We
monitor all aspects of the production of our HEELYS-wheeled footwear, including the development and manufacturing of prototypes, initial production runs and final product
manufacturing. We perform an array of inspection procedures at various stages of the production process, including examination and testing of raw materials and components prior to manufacture,
work-in-process at various stages of production and finished goods prior to shipment. Historically, our defective return rate has been less than 1.0% of our net sales.

In
January 2008, we opened a representative office in Qingdao, China. This office serves multiple sourcing functions including quality control, price negotiation, logistics and product
development. We believe our Qingdao office will help us improve our research and development efforts, enhance communication between us and our distribution and manufacturing partners and give us more
direct control over the manufacturing and sourcing process. Prior to 2008, Boss Technical Services, an independent sourcing agent, helped us identify and develop relationships with manufacturers of
our footwear products and provided quality inspection, testing, logistics and product development and design assistance. We paid for these services on a commission basis.

Order Fulfillment and Inventory Management

Our products are inspected, bar coded and packaged by our independent manufacturers. Our independent manufacturers mark, label and
pre-ticket our products for certain of our larger retail customers. The product is then transported either to Long Beach, California, to a third-party distribution facility in Belgium, or
directly to the customer.

For
products shipped to the United States, after the products clear U.S. customs, we use an independent freight forwarder and customs broker to ship them via rail by container to our
distribution center located in Carrollton, Texas or directly to our retail customers. During 2007 and 2008, we also shipped products to a warehouse in San Pedro, California which was managed by a
third party logistics provider. In 2009, we are no longer using this third party logistic provider in California. Upon receipt at our warehouse, merchandise is inspected and recorded in our management
information systems and

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packaged
for delivery. We maintain electronic data interchange, or "EDI," connections with many of our larger retail customers in order to automate order tracking and inventory management.

Prior
to establishing our Belgian subsidiary, substantially all of our products destined for international distribution were sent directly by our independent manufacturers to our
independent distributors. After our Belgian subsidiary opened an office in Belgium they expanded the use of a third-party distribution facility in Belgium to help facilitate fulfillment of orders to
international customers, and now some products destined for sale by our Belgian subsidiary are sent to this third-party distribution facility.

To
allow us to better plan our production volume with our manufacturers, we offer our retail customers discount incentives to place advance orders. Historically, we received most of our
orders three to four months in advance of the scheduled delivery dates. In the second half of 2007 and continuing in 2008, our retail customers were and still are being cautious when placing orders
and have shifted towards shorter lead times and at-once inventory purchases. This has transferred more of the risk of purchasing and carrying inventory to us. We seek to manage our
inventory risk, by monitoring available sell-through data and seeking input on anticipated consumer demand from our retail customers.

Intellectual PropertyPatents and Trademarks

We have both domestic and international patent coverage for the technology incorporated in our HEELYS-wheeled footwear and own more
than 85 issued patents and pending patent applications in more than 25 countries, of which more than 55 are related to wheeled footwear. Our first patent was a method patent that was issued in June
2002 and includes coverage for wheeled footwear, including HEELYS-wheeled footwear, with a wheel in the heel that allows the user to transition from walking or running to rolling by shifting weight to
at least one wheel in the heel. We also own a variety of trademarks, with more than 80 registered and pending trademarks with rights in more than 60 countries.

We
have vigorously enforced and expect to continue to vigorously enforce our intellectual property rights against infringers domestically and around the world. Despite the challenges
inherent in combating infringers in international jurisdictions that may not protect intellectual property rights to the same extent as the United States, we have cooperated with the appropriate
authorities and they have conducted successful raids, customs seizures and product confiscations of products that infringe our intellectual property rights in various countries. We have obtained
agreements from importers and retailers to cease and desist all infringing activities and, in some cases have been paid monetary compensation. We have also successfully asserted our patent rights
against manufacturers of infringing products.

Seasonality

Similar to other vendors of footwear products, sales of our products are subject to seasonality. There are three major buying seasons
in footwear: spring/summer, back-to-school and holiday. We offer two primary lines: spring/summer and a combined back-to-school/holiday line. A few new
styles will typically be added for holiday. Shipments for spring/summer take place during the first quarter and early weeks of the second quarter, shipments for back-to-school
generally begin in May and finish in late August and shipments for the holiday season begin in October and finish in early December. Historically, we have experienced greater revenues in the second
half of the year than those in the first half due to a concentration of shopping around the back-to-school and holiday seasons.

During
the second half of 2007, we experienced challenges related primarily to higher than expected inventory positions of product at many of our domestic accounts as weekly unit sales
were lower than internal projections of many of our domestic retail customers, which had a significant

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adverse
effect on our results for the second half of 2007. We believe that this was attributed to: (1) aggressive sell-through expectations of some of our domestic retailers
going into the summer months and (2) retail softness in footwear and apparel. Certain of our major retailers were reluctant to place significant fourth quarter 2007 orders until their current
inventory was reduced to their targeted levels. We also saw decreased prices on our products at certain of our retailers in the fourth quarter of 2007 and continuing into 2008. These factors led us to
work closely with each of our key retail customers to assist them in managing their inventory and sell-through. This included providing marketing discretionary funds, rescheduling orders
to later dates, accepting cancellations, increasing marketing, promotion and advertising support, and accepting returns.

While
inventory levels at many of our domestic retailers decreased during 2008, we continued to see decreased retail prices on many of our products during a difficult footwear and
apparel environment. Many retailers were reluctant to place orders which resulted in decreased sales. We expect our retail
customers to continue to be more cautious when placing future orders and to shift toward shorter lead times and at-once inventory purchases. Additionally, we expect to continue to provide
marketing, promotional and advertising support to our retail customers to promote the sell-through of our products and monitor inventory levels at our retail customers in an effort to
manage the balance between supply and demand in the retail channel. Results for any one quarter are not necessarily indicative of results to be expected for any other quarter or for any year.

Employees

As of December 31, 2008, we employed a total of 63 full-time employees. We also employ temporary warehouse employees
during peak shipment periods. We are not a party to any labor agreements and none of our employees are represented by a labor union.

Insurance and Product Liability

We purchase insurance to cover standard risks associated with our business, including policies to cover commercial general liability
and other casualty and property risks. Our insurance rates depend upon our safety record as well as trends in the insurance industry.

We
face an inherent risk of exposure to personal injury or product liability claims if, among other things, use of our products results in injury, disability or death. We believe our
insurance coverage is sufficient for the risks relating to our products. Our coverage involves retentions with primary and excess liability coverage above the retention amount.

We
retain certain property and casualty risks based on our analysis of the risk, the frequency and severity of a loss and the cost of insurance for the risk. We believe that the risk we
have assumed through retention is not significant and payments of retained claims will not have an adverse impact on our performance.

Information Technology Systems

Our information technology systems are designed to provide us with, among other things, comprehensive order processing, production,
accounting and management information for the sourcing, importing, distribution and marketing aspects of our business. We maintain an EDI system that provides a computer link between us and certain of
our customers, which enables us to monitor their purchases, inventory and retail sales and also improves our efficiency in responding to their needs. We believe our information technology systems are
sufficient to meet our anticipated needs for the foreseeable future. However, we will continue to assess the need to expand and upgrade our information technology systems to support actual or expected
future needs.

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Competition

We compete with companies that focus on the young consumer across a number of markets, including footwear, sporting goods and
recreational products. Many of these companies have substantially greater financial, distribution and marketing resources than we have. Product design, performance, styling, comfort, quality, brand
awareness, timeliness of product delivery and pricing are all important elements of competition in the markets for our products. We believe that the strength of our HEELYS brand, the intellectual
property related to the design of HEELYS-wheeled footwear, the quality of our products and our relationships with retailers and distributors allow us to compete effectively in the markets we serve. In
certain international markets, where enforcing our intellectual property rights is more difficult than in the United States, and occasionally in the domestic market, we compete against counterfeit,
knockoff and infringing products, which typically are offered at lower prices.

Backlog

Historically, we received most of our orders three to four months prior to the date the products were shipped to customers. At
December 31, 2008, our backlog was approximately $4.3 million, compared to approximately $7.2 million at December 31, 2007. Although generally these orders are not subject
to cancellation prior to the date of shipment, cancellations have and may
continue to occur. During the second half of 2007 and continuing through 2008, many of our retail customers were cautious when placing future orders with us and shifted toward shorter lead times. We
believe this was attributed to retail softness in footwear and apparel in particular and dramatically slowing economic conditions in general. This trend required us to take a more aggressive inventory
position to be able to meet at-once orders. While we will continue to attempt to accommodate certain customers through rescheduled orders, allowed cancellations and allowed returns, we do
not anticipate, at this time, for those to be as significant as those we encountered during the second half of 2007 and continuing into the first half of 2008. We expect our retail customers to
continue to be more cautious when placing future orders and to shift toward shorter lead times and at-once inventory purchases. We expect to continue to provide marketing, promotional and
advertising support to our retail customers to promote the sell-through of our products and to monitor inventory levels at our retail customers in an effort to manage the balance between
supply and demand in the retail channel.

For
a variety of reasons, including the timing of release dates for our product offerings, shipments, order deadlines and receipt of orders, backlog may not be a reliable measure of
future sales and may not be comparable from one period to another.

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Item 1A.    Risk Factors

Before deciding to purchase, hold or sell our common stock, you should carefully consider the risks described
below in addition to the more detailed description of our business and other cautionary statements and risks described elsewhere, and the other information contained, in this Annual Report on
Form 10-K and in our other filings with the SEC, including our subsequent reports on Forms 10-Q and 8-K. The risks and uncertainties described below
are not the only ones we face. Additional risks and uncertainties not presently known to us or that we currently deem immaterial may also affect our business. If any of these known or unknown risks or
uncertainties actually occurs with material adverse effects on us, our business, financial condition and results of operations could be seriously harmed. In that event, the market price for our common
stock will likely decline, and you may lose all or part of your investment. Our business, prospects, financial condition or results of operations could be materially and adversely affected by the
following:

We depend primarily upon sales from a single product line and the absence of continued demand for our products would have a material adverse effect on our net sales and
results of operations.

In 2007 and 2008, we generated approximately 98% of our net sales from our HEELYS-wheeled footwear and we expect to continue to depend
upon HEELYS-wheeled footwear for substantially all of our net sales in the foreseeable future. Because we are dependent on a single line of products, factors such as changes in consumer preferences
may have a disproportionately greater impact on us than if we offered multiple product categories. If consumer interest in HEELYS-wheeled footwear or wheeled sports activity products in general
declines, we would likely experience a significant loss of sales, cancellation of orders from customers, loss of customers, excess inventories, higher reserves for marketing discretionary fund
assistance, increased reserves for inventory returns, inventory markdowns and discounts to our retail customers, deterioration of our brand image, and lower revenues and gross and operating margins,
as a result of price reductions and may be forced to liquidate excess inventories at a discount, any or all of which would have a material adverse impact on our business and operations. There can be
no assurance that our products will hold long-term consumer appeal.

The current downturn in the global economy and adverse trends in retailing could have a material adverse effect on our results of operations.

As economic conditions around the world deteriorate, discretionary consumer spending has been reduced. When discretionary consumer
spending is reduced, purchases of our products may decline. We have noticed a higher level of caution from our retail customers than in past years and this may continue to result in lower than
expected orders and increased inventory controls by some of our customers. A recession in the general economy or continued uncertainties regarding future economic prospects could have a material
adverse effect on our results of operations. The current global economic slowdown could adversely affect the demand for our products and pressure our gross margins due to, among other potential
factors, higher promotional spending, recessionary economic cycles, higher interest borrowing rates, higher fuel and other energy costs, inflation, increases in commodity process, higher levels of
unemployment, higher consumer debt levels, higher tax rates and other changes in tax laws or other economic factors that may affect consumer spending or buying habits. Reduced sales by some of our
retail customers or independent distributors, along with the possibility of their reduced access to, or inability to access, the credit markets, may result in various retailers or independent
distributors experiencing significant financial difficulties. Financial difficulties of retail customers could result in reduced sales to those customers or could result in store closures,
bankruptcies or liquidations. Higher credit risk relating to receivables from retail customers experiencing financial difficulty may result. The economic downturn in the United States, European and
broader global economy or continued uncertainties regarding future economic prospects could have a material adverse effect on our results of operations.

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Because we are a consumer products company, if we fail to accurately forecast consumer demand and trends in consumer preferences, our HEELYS brand, net sales, customer
relationships and results of operations may be adversely affected.

Demand for our products, and for consumer products in general, is subject to rapidly changing consumer demand and trends in consumer
preferences. Therefore, our success depends upon our ability to:



We
generally must make decisions regarding product designs several months before our products are available for sale, and it can take us up to six months to achieve full production of
certain models. Accordingly, at the time we have to make decisions that determine our inventory levels, we cannot be certain that our product offerings will be well received by consumers, in which
case we may be forced to liquidate excess inventories at a discount. In addition to offering our standard styles, we may collaborate with certain of our retail customers to develop HEELYS-wheeled
footwear styles that these retail customers have the exclusive rights to sell. If these retail customers are unable to sell through these footwear styles we may agree to provide marketing
discretionary fund assistance or to accept return of this inventory. Because these styles have been specifically designed for a particular customer we may not be able to sell the returned inventory or
may not be able to sell the returned inventory at or above cost. Conversely, if we underestimate consumer demand for our products, we could have inventory shortages, which would result in lost sales,
delays in shipments to retail customers and independent distributors, strains on our relationships with retail customers and independent distributors and diminished brand loyalty. Even if we introduce
appealing new styles and products on a timely basis, we may set prices for our products too high to be successful. A decline in demand for our products, or any failure on our part to satisfy increased
demand for our products, could adversely affect our net sales and results of operations.

Our operations are dependent upon the strength of our relationships with our retail customers and independent distributors and their success in selling our products, and a
small number of retail customers and independent distributors are responsible for a significant percentage of our net sales.

Our success is dependent upon the willingness and ability of our retail customers to market and sell our products to consumers, as well
as the success of our independent distributors in developing foreign markets for our products. For the year ended December 31, 2006, Journeys accounted for approximately 12.7% of our net sales.
For the year ended December 31, 2007, Finish Line accounted for approximately 13.2% of our net sales. For the year ended December 31, 2008, Journeys and Famous Footwear accounted for
approximately 9.9% and 8.8% of our net sales, respectively. No other retail customer or independent distributor accounted for 10% or more of our net sales in any of these periods. If any of these or
our other significant retail customers or independent distributors were to experience financial difficulties, reduce the quantity of our products it sells, discount the retail sales price, request
markdown assistance or additional marketing assistance, or stop selling our products, our financial condition and results of operations could be adversely affected.

We do not have long-term contracts with any of our retail customers or independent distributors, and the loss or material reduction in their business with us
could result in reduced sales of our products.

Our retail customers and independent distributors generally purchase products from us on a purchase order basis and do not have
long-term contracts with us. Consequently, with little or no notice

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and
without penalty, our retail customers and independent distributors may terminate their relationship with us or materially reduce the level of their purchases of our products. For example, in 2007
one of our then large retail customers determined that it would no longer sell HEELYS-wheeled footwear. This customer accounted for 7.2% of our total net sales for the year ended December 31,
2007. If this were to occur with more retail customers or independent distributors who purchase significant quantities of our products, it may be difficult for us to establish substitute relationships
in a timely manner, which could have a material adverse effect on our financial condition and results of operations.

Changes in the mix of retail customers to whom we distribute our products could impact our gross margin and brand image, which could have a material adverse effect on our
results of operations.

We sell our products through a mix of retail customers. Although we do not currently anticipate material changes in the mix of our
retail customers, any such changes could adversely affect our gross margin and could negatively affect both our brand image and our reputation with our consumers. Additionally, in 2008 we began
selling directly to certain retail customers in Andorra, France, Monaco, Germany and Austria. A negative change in our gross margin or our brand image and acceptance could have a material adverse
effect on our results of operations and financial condition.

We may be adversely affected by the financial condition of our retailer customers.

Some of our retail customers have experienced financial difficulties in the past. A retail customer experiencing such difficulties will
generally not purchase and sell as many of our products as it would under normal circumstances and may cancel orders. In addition, a retail customer experiencing financial difficulties generally
increases our exposure to the risk of uncollectible receivables. We extend credit to our retail customers based on our assessment of such customer's financial condition, generally without requiring
collateral. While such credit losses have historically been within our expectations and reserves, we cannot assure you that this will continue. Financial difficulties on the part of our retail
customers could have a material adverse effect on our results of operations and financial condition.

Because of increased inventory at our retail customers, or for other reasons, our net sales may not grow or may continue to decrease and that may have a material adverse
effect on our results of operations and margins.

In the second half of 2007 and during 2008, we experienced challenges related primarily to higher than expected inventory positions of
our HEELYS-wheeled footwear at many of our retail customers as weekly unit sales were lower than internal projections of many of our retail customers and certain of our major retail customers have
been reluctant to place significant orders for additional product. These factors have required us to assist certain of our key retail customers in managing their inventory and
sell-through, including rescheduling orders to later dates, accepting cancellations, increasing marketing, promotion and advertising support, accepting returns, and further requiring us to
increase our reserves for marketing discretionary fund assistance and returns. Additionally, as a result of the decline in net sales during 2008 and cancelled orders and returns, we wrote down excess
wheeled footwear, non-wheeled footwear and accessories to the lower of cost or market as of December 31, 2008. The existence or persistence of any of these
factors may cause our net sales to stall or decrease, which could have a material adverse effect on our results of operation, margins and financial condition.

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If we fail to manage our operations, we may experience difficulty in filling purchase orders, declines in product quality, increased costs or other operating challenges.

Our operations grew rapidly in 2005 through mid-2007 before declining in late 2007 and continuing in 2008. We
have:



These
and other changes may continue to place a significant strain on our management, information technology systems and other resources.While we have attempted to right size our
operations for current conditions, in order to properly manage our operations, we may need to hire additional employees, upgrade our existing financial and reporting systems, improve our business
processes and controls and identify and develop relationships with additional independent manufacturers. We may also be required to expand our distribution facilities or add new facilities. Our former
sourcing agent performed quality inspections, testing, logistics and product development and design assistance. We may fail to adequately perform these functions. Failure to effectively manage our
operations or growth could result in difficulty in distributing our products and filling purchase orders, declines in product quality or increased costs, any of which would adversely impact our
business and results of operations.

Because we outsource all of our manufacturing to two independent manufacturers, we may face challenges in maintaining a sufficient supply of products to meet demand for our
products or experience interruptions in our supply chain. Any shortfall in the supply of our products may decrease our net sales and have an adverse impact on our customer relationships and results of
operations.

All of our products are produced by independent manufacturers with which we do not have long-term contracts. As such, any
of them could unilaterally terminate its relationship with us or increase the prices it charges us at any time. Two independent manufacturers now produce all of our HEELYS-wheeled footwear.
Consequently, if such manufacturers close, stop producing merchandise for us or greatly increase prices, it could result in delayed deliveries to our retail customers, could adversely affect our
revenue and could require the establishment of new manufacturing relationships, which could require significant additional time and expense.

Our business could suffer if our independent manufacturers violate legal requirements or fail to conform to generally accepted ethical standards.

We expect our independent manufacturers to comply with applicable legal requirements and generally accepted ethical standards for
working conditions and other matters. However, we do not control our independent manufacturers or their business practices. If any of our manufacturers were to use forced or indentured labor or child
labor, fail to pay compensation in accordance with local law, fail to operate in compliance with local safety regulations or diverge from other applicable legal

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requirements
or business practices generally accepted as ethical, we would take appropriate action, which could result in an interruption in our product supply. In addition, we could suffer negative
publicity and damage to our reputation and the value of our HEELYS brand, which would adversely affect our business and results of operations.

If our independent manufacturers are unable to obtain raw materials, our costs could increase or the delivery of our products could be delayed, which could adversely affect
our net sales and results of operations.

The production capacity of our independent manufacturers is dependent, in part, upon the availability of raw materials. Our
manufacturers may experience shortages of raw materials, which could result in increased costs to us or delays in deliveries of our products from our manufacturers. As a result, we could experience
cancellation of orders, refusal to accept deliveries or a reduction in our sales prices and profit margins, any of which could harm our net sales and results of operations.

Our new distribution efforts in the European Union involve inherent risks which could result in harm to our business.

We recently established a Belgian subsidiary that opened an office in Belgium to focus on expanding our international opportunities by
working more closely with our distributors, establishing relationships with distributors in new international markets and, in select markets, selling our products direct to retail customers. Our
ability to meet customer expectations, manage inventory, complete sales and achieve objectives for operating efficiencies depends upon the proper operation of our new distribution model and the
development of additional distribution capabilities. This new distribution model is subject to a number of risks, including greater difficulties in staffing and managing foreign operations, unexpected
changes in regulatory practices and tariffs, longer
collection cycles, seasonality, potentially subjecting our operations to taxes in additional jurisdictions, potential changes in export and tax laws and other risks and uncertainties inherent in doing
business outside of the United States. This new distribution model may also adversely impact our relationship with our independent distributors.

Because our products are manufactured in Asia, we operate an office in China and because a portion of our sales activities occur outside of the United States, we established
a Belgian subsidiary that opened an office in Belgium and therefore we are subject to international business, political, operational, financial and economic risks that could adversely affect our net
sales and results of operations.

Conducting business internationally entails numerous risks which could interrupt or otherwise adversely affect our business,
including:



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These
factors and the failure to effectively respond to them could result in, among other things, poor quality in our products, product shortages, delivery delays, decreased net sales
and increased costs.

Fluctuations in foreign currency exchange rates could harm our results of operations.

We pay for our products and our independent distributors pay us in U.S. dollars. International sales accounted for approximately 14.3%
of our net sales in 2006, 16.6% of our net sales in 2007, and 47.6% of our sales in 2008. We do not engage in any foreign currency hedging transactions. If the U.S. dollar strengthens compared to the
currency in the foreign markets where our products are sold, our products will be more expensive in those markets making them less attractive to consumers. If the U.S. dollar significantly weakens
compared to the currency in the foreign markets where our products are produced, our manufacturers could increase the prices they charge us for our products, which could reduce our profitability.
There can be no assurance that we can effectively mitigate our foreign exchange risk.

Furthermore,
we are exposed to gains and losses resulting from the effect that fluctuations in foreign currency exchange rates have on the reported results in our consolidated financial
statements due to the translation of the statements of operation and balance sheet of our Belgian subsidiary into U.S. dollars. We have not used foreign currency exchange contracts to hedge the profit
and loss effects of this translation effect. We translate our revenues and expenses at average exchange rates during the period. As a result, the reported revenues and expenses of our Belgian
subsidiary would decrease if the U.S. dollar increased in value in relation to the Euro.

If we are unable to enforce our patents, trademarks and other intellectual property rights, competitors may be able to sell products that are substantially similar to our
products, which could adversely affect our sales and damage our brand image.

We believe our trademarks, trade names, copyrights, trade secrets, issued and pending patents, trade dress and designs are valuable and
integral to our success. The costs associated with obtaining and maintaining our intellectual property rights and protecting our HEELYS brand are significant. Further, we do not know whether our
pending or future patent applications will result in the issuance of patents. Even if patents are issued in the future, we cannot predict how the patent claims will be construed and such patents may
not provide us with the ability to prevent the development, manufacturing or marketing of infringing products. Enforcement of our patents and other intellectual property rights is often met with
defenses, counterclaims and countersuits attacking the validity and enforceability of our patents and other intellectual property rights. The validity and enforceability of our patents may be
challenged by third parties for many different reasons, including for example, prior art, prior disclosure, prior offers to sell, incorrect inventorship, prior invention by another, patent misuse,
antitrust violations, laches and estoppel.

In
addition, we may not be able to detect infringement of our intellectual property rights quickly or at all, and at times in the past we have not been, and we may not be, successful
combating counterfeit, infringing or knockoff products, thereby damaging our competitive position. For example, on many occasions, we have identified knockoff products sold by others that we believe
may infringe upon our intellectual property rights. Knockoff products often are sold under a brand name that is the same as or substantially similar to the HEELYS name. Knockoff and counterfeit
products may continue

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to
emerge, as others seek to trade on the goodwill of the HEELYS name and benefit from the consumer demand for our products. We may not be able to detect all knockoff and counterfeit products and may
lose our competitive position in a given geographic market before we become aware of any such infringement.

To
protect our HEELYS brand, we have already spent significant resources and may be required to spend significantly greater resources in the future to monitor and police our intellectual
property rights. If we are unsuccessful in enforcing our intellectual property rights, sales of counterfeit, knockoff or infringing products by others could harm our HEELYS brand and adversely affect
our business, financial condition and results of operations. Even if we successfully enforce our intellectual property rights, the presence in the market of counterfeit, knockoff or infringing
products of poor quality for even a short time period could have a detrimental impact on our HEELYS brand.

We may not be able to obtain and maintain patent, trademark or other intellectual property rights protection in some foreign countries, which could result in us being unable
to prevent others from using our HEELYS mark and product, which could have a material adverse effect on our business.

We depend upon the laws of the countries where our products are sold to protect our intellectual property. Intellectual property rights
may be unavailable or limited in some countries because patent laws and standards of patentability vary internationally. Consequently, in certain foreign jurisdictions, we have elected not to apply
for patents or trademark registrations. Further, patent and trademark protection may not be available for the HEELYS mark and product in every country where our products are sold. While we generally
apply for patents and trademarks in most countries where we intend to sell patented products, we may not accurately predict all of the countries where patent or trademark protection will ultimately be
desirable. If we fail to timely file a patent or trademark application in any such country, we will likely be precluded from doing so at a later date. Failure to adequately pursue and enforce
our patent and trademark rights could damage our HEELYS brand, enable others to compete with us and impair our ability to compete effectively.

In
some countries where we have sought patent protection, third parties have challenged the validity, enforceability and scope of our patent rights. Patent laws, and standards of
patentability and validity, vary from one country to the next. Patent validity challenges are commonly filed as counterclaims in
patent litigation proceedings. There can be no assurance that we will prevail against any challenges. Our HEELYS brand, business, financial condition and results of operations could be adversely
affected if we fail to obtain and maintain intellectual property right protection in foreign countries where we derive a large amount of our net sales.

We are dependent on our management and other personnel, and the failure to attract and retain such individuals could adversely affect our operations.

Our success depends on our ability to attract and retain qualified managerial and other personnel. Our management and other employees
can terminate their employment with us at any time, and we do not maintain key person life insurance. Our inability to attract or retain qualified employees, or the loss of any key employee, could
harm our business and results of operations.

Since
early 2008, we have had significant turnover in our executive officers. In February of 2008, Michael G. Staffaroni, our Chief Executive Officer since 2001, and Charles D. Beery,
our Senior Vice PresidentGlobal Sales since 2001, resigned. In April of 2008, Patrick F. Hamner, our Senior Vice President, resigned and entered into a consulting agreement with us. In
May of 2008, Michael W. Hessong, our Chief Financial Officer resigned and our Board of Directors elected Donald K. Carroll as our Chief Executive Office. In February 2009, Mr. Carroll resigned
as Chief Executive Officer and Mr. Hessong returned as our interim Chief Executive Officer.

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We
are in the process of identifying a replacement for our Chief Executive Officer. If we fail to successfully identify a replacement, or are unable to successfully integrate this person
into our organization, our business and results of operations could be adversely affected.

We rely on our independent sales representatives, and if our relationships with a material number of these representatives were terminated, it could result in reduced sales
of our products.

We sell substantially all of our products domestically through a national sales force of 27 independent sales representatives who are
employed by 3 independent sales agencies. In Germany and France we primarily rely on 15 independent sales representatives. We rely on these independent sales representatives to provide new customer
prospects and market our products to our
retail customers. Our independent sales representatives generally do not sell our products exclusively and may terminate their relationships with us at any time with limited notice. Our ability to
maintain and increase our sales depends in large part on our success in maintaining relationships with our independent sales representatives on commercially reasonable terms. Any failure to maintain
and develop new satisfactory relationships with independent sales representatives, or any failure of our independent sales representatives to effectively market our products, could adversely affect
our sales. During 2008, a number of our sales representatives changed and certain domestic sales territories were adjusted. There can be no assurance that these changes will result in improved future
sales.

Negative publicity relating to our products could cause our HEELYS brand to suffer and adversely affect our net sales and results of operations.

Various media outlets have reported on injuries suffered by users of our products and have quoted from or referred to medical studies
and U.S. Consumer Product Safety Commission data relating to injury rates of users of wheeled footwear. This negative publicity and any future negative publicity relating to the safety of our products
or products similar to ours could cause our HEELYS brand image to suffer and adversely affect our net sales and operating performance.

Additional bans on the use of our HEELYS-wheeled footwear due to public safety and liability concerns could adversely affect our net sales and results of operations.

Various places of business and other institutions, such as shopping malls and schools, have imposed bans on the use of our
HEELYS-wheeled footwear due to public safety and liability concerns. If the number of businesses and other institutions instituting such bans increases in the future, consumers could find our
HEELYS-wheeled footwear less appealing, which could adversely affect our net sales and result of operations.

If our products fail to comply with U.S. consumer product laws, it could materially affect our gross margin and financial performance.

With the passage of the Consumer Product Safety Improvement Act of 2008, or "CPSIA," there are new requirements mandated for the
textiles and apparel industries. These mandates relate to all products marketed to children 12 years of age and under. Among other requirements, the Consumer Product Safety Commission, or
"CPSC," will require certification and testing of lead paint levels as applied to certain products, along with testing the lead content of the product as a whole. We are working with accredited third
party testing services to ensure compliance with all CPSIA requirements and to further product safety goals. We will continue to monitor the situation and intend to abide by all rules and changes made
by the CPSC. This could have a negative impact on the cost of our goods and poses a potential risk if we do not adhere to these requirements.

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We are subject to product liability, warranty and recall claims and our insurance coverage may not cover such claims, which could cause us to incur substantial costs and
adversely affect our business.

Due to the inherent risk of injury related to the use of our products, our business exposes us to claims for product liability and
warranty claims if our products actually or allegedly fail to perform as expected, or the use of our products results or is alleged to result in personal injury, disability or death. There can be no
assurance that we will be able to successfully defend or settle the product liability claims and lawsuits to which we are and in the future may be subject.

We
attach warning labels to our products and packaging relating to safe usage and the risk of injury. However, if a product liability claim is brought against us, the content of the
warnings, the placement of them or both may be considered inadequate by courts, exposing us to liability. We cannot be certain that our safety warning labels are adequate. Product liability claims
could result in us having to expend significant time and expense to defend these claims and to pay, if necessary, settlement amounts or damages, which could adversely affect our financial condition.
In addition, claims that use of our products resulted in an injury, disability or death could cause our HEELYS brand image and operating performance to suffer by damaging our reputation and prospects
and by diverting the time and attention of our management, even if we are not at fault.

There
can be no assurance that our product liability insurance coverage will be adequate, that our insurers will be financially viable when payment of a claim is required or that we will
be able to obtain such insurance in the future on acceptable terms, if at all.

If
any of our products are or are alleged to be defective, we may be required to recall that product. Any product recall could cause us to incur substantial cost, and irreparably harm
our relationships with our customers, which could adversely affect our business.

If our new products are not accepted by our customers or if we are unable to maintain our margins, it could materially affect our financial performance.

As is typical with new products, market acceptance of our new lines is uncertain and achieving market acceptance may require
substantial marketing efforts and expenditures. We also cannot assure that our new products will have the same or better margins than our current products. The failure of the new product lines to gain
market acceptance or our inability to maintain our current product margins with the new lines could adversely affect our business, financial performance and brand image.

We may not be able to compete effectively, which could have a negative impact on our sales and our business.

We compete with companies that sell to young consumers in several different product markets, including footwear, sporting goods and
recreational products. These markets are intensely competitive and we expect competition to increase in the future. A number of our competitors have significantly greater financial, marketing,
distribution and manufacturing resources than we do, as well as greater brand awareness in the markets in which they operate. We also compete with counterfeit, knockoff and infringing products, which
are often sold at lower prices. If we fail to remain competitive with respect to the quality, design, price and timely delivery of products, our business, financial condition and results of operations
could be materially adversely affected.

Third parties may claim that we are infringing their intellectual property rights, and such claims may be costly to defend, may require us to pay licensing fees, damages or
other amounts and may prevent or limit the manufacture, marketing or sale of our products.

Third parties may successfully claim that we are infringing their intellectual property rights. While we do not believe that any of our
products infringe the valid intellectual property rights of third parties, we may be unaware of the intellectual property rights of others that may cover some of our technology

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or
products. For example, because many patent applications in the United States are not publicly disclosed immediately after they are filed, we could adopt technology without knowledge of a pending
patent application, which technology would infringe a third-party patent once that patent is issued.

Our
competitors in both the United States and foreign countries may have applied for or obtained, or may in the future apply for or obtain, patents that will prevent, limit or otherwise
interfere with our ability to make, market or sell our products. Although we may conduct our own independent review of patents issued to certain third parties, we cannot assure you that we will be
aware of all pre-existing technology that may subject us to patent litigation. Further, we may adopt a trademark or trade dress that a third party claims infringes their rights in such
trademark or trade dress. If we are forced to defend against infringement claims, whether or not such claims are resolved in our favor, we could encounter expensive and time-consuming
litigation which could divert the attention of our management and other key personnel from our business operations. Furthermore, if we are found to be infringing intellectual property rights of
others, we could be required to pay licensing fees or damages. In addition, if we are not able to obtain license agreements on terms acceptable to us, or at all, we may be prevented from
manufacturing, marketing or selling our products. As a result, our net sales could be significantly reduced and our cost of sales could be significantly increased, either of which could have an
adverse effect on our business.

HEELYS-wheeled footwear could become subject to import duties in the United States, and if we cannot increase our prices to compensate for such duties, it could reduce our
profitability.

HEELYS-wheeled footwear is currently classified by U.S. Customs and Border Protection as a skate, and as such we do not pay import
duties to the United States. This customs classification can be changed at any time and, although we would vigorously oppose any proposed change, there can be no assurance that we would prevail. If
the classification for HEELYS-wheeled footwear changed and HEELYS-wheeled footwear became subject to an import duty, it might be difficult to increase our prices to compensate for any such duty, which
could reduce our profitability.

Expanding our distribution to mass merchants could have a material adverse effect on our gross margin, brand image and results of operations.

We sell our products to sporting goods retailers, specialty apparel and footwear retailers, and family footwear stores in an effort to
maintain a high-quality image for our HEELYS brand and targeted price points for our products. In addition, in 2008 and continuing into 2009, we sold certain styles of our product to
discount retailers in order to dispose of excess inventory. Although we do not currently anticipate distributing to mass merchants, if we choose to do so in the future it could have a material adverse
effect on our gross margin and could negatively affect our HEELYS brand image and our reputation with consumers, which could adversely affect our results of operations and financial condition.

Our operating results are subject to seasonal and quarterly variations in our net sales and net income, which could adversely affect the price of our common stock.

We have experienced, and expect to continue to experience, substantial seasonal and quarterly variations in our net sales and net
income. Our quarterly results of operations may also fluctuate significantly as a result of a variety of other factors, including, among other things, the amount of inventory carried by our retailers,
timing of holidays and advertising initiatives and changes in our product mix. In addition, variations in weather conditions may significantly affect our results of operations.

As
a result of these seasonal and quarterly fluctuations, we believe that comparisons of our operating results between different quarters within a single year are not necessarily
meaningful and that

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these
comparisons cannot be relied upon as indicators of our future performance. Any seasonal or quarterly fluctuations that we report in the future may differ from the expectations of market analysts
and investors. This could cause the price of our common stock to fluctuate significantly.

Improvements to our information technology systems may be inadequate, which would adversely affect our ability to operate effectively.

We implemented a new information technology system in our Belgium office to facilitate our international growth. As our business needs
change, we could experience difficulties associated with our information technology systems. If we experience difficulties in our
information technology systems or experience system failures, or if we are unable to successfully modify our information technology systems to respond to changes in our business, our ability to
operate effectively could be adversely affected and our internal controls could be adversely affected.

We may have difficulty identifying and successfully integrating acquisitions into our business and any acquisitions we make could result in adverse consequences.

We may make acquisitions of complementary companies and products. The pursuit of acquisitions may divert the attention of management
and cause us to incur significant expenses identifying, investigating and pursuing suitable acquisitions, whether or not they are consummated.

We
have limited experience acquiring other businesses and may not be able to successfully integrate any acquired operations with our business or effectively manage the combined business
following an acquisition. We also may not achieve the anticipated benefits of an acquisition due to any of the following factors:



If
we experience any of the difficulties noted above, our business and financial condition could be adversely affected.

We have experienced volatility in our stock price and it may fluctuate in the future. Therefore, you may be unable to resell shares of our common stock at or above the price
you paid for them.

The market price of our common stock has fluctuated significantly in the past and may fluctuate significantly in the future. Volatility
in the trading price of our common stock may prevent you from being able to sell your shares of our common stock at prices equal to or greater than your purchase price.

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Such fluctuations may be influenced by many factors, many of which are outside of our control, including:



In
addition, in recent years, the stock market has experienced significant price and volume fluctuations. This volatility has had a significant impact on the trading price of securities
issued by many companies, including companies in our industry. The changes frequently occur irrespective of the operating performance of the affected companies. Hence, the trading price of our common
stock could fluctuate based upon factors that have little or nothing to do with our business.

Class action and derivative lawsuits have been filed against us and certain of our officers and directors, which could result in significant costs and a diversion of our
management's efforts.

We and certain of our current and former officers and directors have been sued in class action lawsuits and derivative lawsuits, and an
individual state court lawsuit alleging
violations of federal and state securities laws in connection with our December 2006 initial public offering. While we believe we have meritorious defenses and plan to defend vigorously any such
claims made against us, we cannot assure you that these actions will be resolved without incurring significant costs (including paying the costs relating to such litigation incurred by our officers,
directors and underwriters pursuant to various indemnification obligations) and/or resulting in the diversion of the attention of management and other key employees. The resolution of this pending
securities litigation and the defense of any additional litigation that may arise could result in significant costs and any unfavorable outcome could have a material adverse effect on our business.
These lawsuits, and the proposed settlements of the class action lawsuits and the derivative lawsuits, are described in greater detail under the heading "Legal Proceedings."

Existing stockholders significantly influence our corporate governance.

As of December 31, 2008, our executive officers, key employees, directors and their affiliates beneficially owned, in the
aggregate, approximately 61% of our outstanding common stock. In addition, Capital Southwest Venture Corporation, or "CSVC," which owns approximately 33.8% of our common stock, has the contractual
right to designate (i) two nominees for director to be included in management's slate of director nominees, so long as it owns at least 15% of the outstanding shares of our common stock, and
(ii) one such nominee so long as it owns at least 10%, but less than 15%, of the outstanding shares of our common stock. CSVC's parent company is Capital Southwest Corporation ("CSC"). The
Chairman of our Board of Directors is the President and CEO of CSC. In addition, one of our directors is the Vice President of CSC. The Chairman of our Audit Committee

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serves
on the Board of CSC and was originally designated to our Board by CSVC. As a result, through its designees, CSVC may significantly influence our corporate governance.

Our Certificate of Incorporation and By-Laws and Delaware law contain provisions that could discourage a third party from acquiring us and consequently decrease
the value of an investment in our common stock.

Our Certificate of Incorporation and By-Laws and Delaware corporate law contain provisions that could delay or prevent a
change in control of our company or changes in our management. Among other things, these provisions:



These
provisions could discourage proxy contests, make it more difficult for our stockholders to elect directors and take other corporate actions and may discourage, delay or prevent a
change in control or changes in our management that a stockholder might consider favorable. Any delay or prevention of a change in control or change in management that stockholders might otherwise
consider to be favorable could deprive you of the opportunity to sell your common stock at a price in excess of the prevailing trading price and cause the trading price of our common stock to decline.

As a public company, we are required to meet periodic reporting requirements under SEC rules and regulations. Complying with federal securities laws as a public company is
expensive and we will incur significant time and expense enhancing, documenting, testing and certifying our internal control over financial reporting. Any deficiencies in our financial reporting or
internal controls could adversely affect our business and the trading price of our common stock.

SEC rules require that, as a publicly traded company, we file periodic reports containing our financial statements within a specified
time following the completion of quarterly and annual periods. Prior to the completion of our initial public offering in December 2006, we were not required to comply with SEC requirements to have our
financial statements completed and reviewed or audited within a specified time. We may experience difficulty in meeting the SEC's reporting requirements. Any failure by us to file our periodic reports
with the SEC in a timely manner could harm our reputation and reduce the trading price of our common stock.

As
a public company we incur significant legal, accounting, insurance and other expenses. The Sarbanes-Oxley Act of 2002, as well as compliance with other SEC and Nasdaq rules, has
increased our legal and financial compliance costs and made some activities more time-consuming and costly.

We
may identify deficiencies which would have to be remediated to satisfy the SEC rules for certification of our internal control over financial reporting. As a consequence, we may have
to disclose in periodic reports we file with the SEC significant deficiencies or material weaknesses in our system of internal controls. The existence of a material weakness would preclude management
from concluding that our internal control over financial reporting is effective. In addition, disclosures of this type in our SEC reports could cause investors to lose confidence in our financial
reporting and may negatively affect the trading price of our common stock. Moreover, effective internal controls are necessary to

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produce
reliable financial reports and to prevent fraud. If we have deficiencies in our disclosure controls and procedures or internal control over financial reporting it may negatively impact our
business, results of operations and reputation.

Item 1B.    Unresolved Staff Comments

None.

Item 2.    Properties

We lease our corporate headquarters, an approximately 48,400 square-foot facility located in Carrollton, Texas, consisting
of approximately 34,500 square feet of warehouse space and approximately 13,900 square feet of office space. Our lease expires in August 2015, but we have two five-year extension options.

On
October 29, 2007, we signed an operating lease for office space for our representative office in Qingdao, China. Our lease expires December 1, 2009. We have one
one-year extension option.

On
May 1, 2008 our Belgian subsidiary entered into an operating lease for office space in Brussels, Belgium for nine years with the option to terminate the lease at the end of
each three year period.

On
April 1, 2008 our Belgian subsidiary entered into an operating lease for office space in Munich, Germany for three years with an automatic renewal at the end of the initial
three year lease, unless six months notice is provided.

On
May 1, 2008 our Belgian subsidiary entered into an operating lease for office space in Annecy, France for nine years with the option to terminate the lease at the end of each
three year period.

Property
leases for facilities in foreign countries are included in our international reportable segment.

We
believe that our existing facilities are adequate to meet our current requirements.

Item 3.    Legal Proceedings

The Company, its former Chief Executive Officer, its former Chief Financial Officer, and its directors who signed the Company's
registration statement filed with the Securities and Exchange Commission in connection with our December 7, 2006 initial public offering (the "IPO")along with Capital Southwest
Corporation, Capital Southwest Venture Corporation and the underwriters for the IPOare defendants in a lawsuit originally filed on August 27, 2007 in the United States District
Court for the Northern District of Texas, Dallas Division, by plaintiff Brian Rines, Individually and On Behalf of All Others Similarly Situated, purportedly on behalf of all persons who purchased the
Company's common stock pursuant to or traceable to the IPO registration statement. The complaint alleges violations of Sections 11 and 15 of the Securities Act of 1933. The plaintiff seeks an
order determining that the action may proceed as a class action, awarding compensatory damages in favor of the plaintiff and the other class members in an unspecified amount, and reasonable costs and
expenses incurred in the action, including counsel fees and expert fees. Four similar lawsuits were also filed in September and October 2007 in the United States District Court for the Northern
District of Texas, Dallas Division, by plaintiffs Vulcan Lee, John Avila, Gerald Markey, and Robert Eiron on behalf of the same plaintiff class, making substantially similar allegations under
Sections 11, 12, and 15 of the Securities Act of 1933, and seeking substantially similar damages. These lawsuits have been transferred to a single judge and have been consolidated into a single
action. Lead plaintiffs and lead counsel have been appointed. An amended consolidated complaint was filed on March 11, 2008. The amended complaint alleges that the prospectus used in connection
with our IPO contained misstatements of material fact or omitted to state material facts necessary in order to make the statements made not misleading

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relating
to among other allegations, safety concerns and injuries associated with our products and their alleged impact on demand, visibility into our sales channel and competition from knockoffs, in
violation of Sections 11, 12(a)(2) and 15 of the Securities Act of 1933 and requests substantially similar damages and relief as previously mentioned. On August 14, 2008, the Court
denied Defendants' motions to dismiss the amended complaint, and discovery commenced. During a mediation conducted by the Hon. Nicholas H. Politan (ret.), Plaintiffs and Defendants reached a
settlement pursuant to which Defendants will pay Plaintiffs and a proposed plaintiff settlement class a total of $7.5 million, including attorneys' fees and expenses. The Company has
reached an agreement in principal with its insurers for the Company's insurance policies to fund the majority of this settlement amount. This settlement is subject to final documentation and approval
by the Court. The Company expects that the proposed settlement will be submitted to the Court for preliminary approval within the next month. If the Court preliminarily approves the settlement, notice
will be provided to shareholders, who will be provided an opportunity to object to the settlement or to opt out of the proposed settlement class.

On
October 3, 2007 and October 24, 2007, in the United States District Court for the Northern District of Texas, Dallas Division, Jack Freeman and Brian Mossman,
respectively brought shareholders' derivative actions, for the Company's benefit, as nominal defendant, against the Company's former Chief Executive Officer, the Company's former Director of Research
and Development, the Company's former Chief Financial Officer, the Company's former Senior Vice President and certain current and former members of the Company's board of directors. The Company is a
nominal defendant, and the complaints do not seek any damages against the Company. The complaints allege violations of Sections 11, 12(a)(2), and 14(a) of the Securities Act of 1933 and
breaches of fiduciary duty, abuse of control, gross mismanagement, waste of corporate assets and unjust enrichment on the part of each of the named defendants. The complaints seek unspecified amounts
of compensatory damages, voiding the election of the director defendants, as well as interest and costs, including legal fees from the defendants. The Company is a nominal defendant, and the complaint
does not seek any damages
against the Company; however, the Company may have indemnification obligations to one or more of the defendants under the Company organizational documents. The derivative lawsuits have been
transferred to a single judge and have been consolidated into a single derivative lawsuit. An amended consolidated complaint making substantially similar allegations and claims for damages was filed
on March 14, 2008. On August 14, 2008, the Court denied Defendants' motions to dismiss the amended complaint, and discovery commenced. During a mediation conducted by the Hon. Nicholas
H. Politan (ret.), Plaintiffs and Defendants reached a settlement pursuant to which Defendants agreed to institute certain corporate governance changes at the Company and to pay plaintiffs' counsel
attorneys' fees and expenses of $1 million. The Company has reached an agreement in principal with its insurers for the Company's insurance policies to fund the majority of this settlement
amount. This settlement is subject to final documentation and approval by the Court. The Company expects that the proposed settlement will be submitted to the Court for preliminary approval within the
next month.

The
Company's insurance policies will fund the majority of the settlement amounts. The Company has agreed to contribute approximately $722,000 of this settlement amount, which has been
accrued for as of December 31, 2008.

The
Company, its former Chief Executive Officer, its former Chief Financial Officer, and its directors who signed the Company's registration statement filed with the Securities and
Exchange Commission in connection with our December 7, 2006 initial public offering (the "IPO")along with Capital Southwest Corporation, Capital Southwest Venture Corporation and
the underwriters for the IPOare defendants in a lawsuit originally filed on May 16, 2008 by individual shareholder Carl Dick in the County Court of Law No. 1, Dallas County,
Texas. This lawsuit asserts claims that are substantially similar to those asserted in the consolidated class action described above. Plaintiff alleges that he purchased over 600,000 shares of Heelys
for approximately $17.4 million. Plaintiff claims to have sold his stock for a loss of approximately $11 million, which he seeks to recover plus interest,

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costs,
and attorney fees. The petition alleges violations of Sections 11, 12(a)(2), and 15 of the Securities Act of 1933 and Sections 33(A), (C), and (F) of the Texas Securities
Act. Defendants withdrew their previously-filed special exceptions to Plaintiff's petition seeking to have all claims dismissed, and discovery in this case is proceeding. The case is scheduled for
trial in October 2009. While the Company cannot predict the outcome of this matter, the Company believes that the plaintiff's claims are without merit, denies the allegations in the complaints, and
the Company intends to vigorously defend the lawsuits. If this matter were successfully asserted against the Company, there could be a material adverse effect on the Company's financial position, cash
flows or results of operations.

Due
to the nature of the Company's products, from time to time the Company has to defend against personal injury and product liability claims arising out of personal injuries that
allegedly are suffered using the Company's products. To date, none of these claims has had a material adverse effect on the Company. The Company is also engaged in various claims and legal proceedings
relating to intellectual property matters, especially in connection with enforcing the Company's intellectual property rights against the various third parties importing and selling knockoff products
domestically and internationally. Often, such legal proceedings result in counterclaims against the Company that the
Company must defend. The Company believes that none of the pending personal injury, product liability or intellectual property legal matters will have a material adverse effect upon the Company's
financial position, cash flows or results of operations.

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

Annual Meeting of Shareholders

No matters were submitted by the Company's shareholders during the fourth quarter of the fiscal year ended December 31, 2008.

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PART II

Item 5.    Market for Registrant's Common Equity, Related Stockholder Matters and Issuer Purchases of Equity Securities

Market Information

Our common stock is listed on The Nasdaq Global Market under the stock symbol "HLYS." As of March 20, 2009 there were
approximately 123 holders of record of our common stock. The following table sets forth the range of high and low market prices for the common stock during the years ended December 31, 2008 and
2007.

2008

High

LowFirst Quarter

$
7.26

$
4.01Second Quarter

$
5.18

$
3.86Third Quarter

$
5.74

$
3.96Fourth Quarter

$
4.44

$
2.16




2007

High

LowFirst Quarter

$
40.09

$
27.25Second Quarter

$
38.68

$
24.42Third Quarter

$
28.38

$
7.65Fourth Quarter

$
10.80

$
5.75


Dividends

On December 5, 2008, our board of directors declared a special cash dividend in the amount of $1.00 per share of common stock.
This dividend was paid on December 22, 2008 to shareholders of record on December 15, 2008.

Other
than the special cash dividend paid on December 22, 2008, we have not paid any dividends. We anticipate that all of our earnings, if any, in the foreseeable future will be
used for working capital and to finance the growth and development of our business. Any future determination relating to dividend policy will be made at the discretion of our board of directors and
will depend on a number of factors, including our outstanding indebtedness, earnings, capital requirements, financial condition and future prospects, applicable Delaware law, which provides that
dividends are only payable out of surplus or net profit for the then current and immediately preceding fiscal years, and other factors that our board of directors may deem relevant. Future agreements
governing our borrowings, and the terms of any preferred stock we may issue in the future, will also likely contain restrictive covenants prohibiting us from paying dividends.

Initial Public Offering of Our Common Stock and Use of Proceeds

On December 13, 2006, we completed the initial public offering of our common stock pursuant to a Registration Statement (File
No. 333-137046) that was declared effective by the Securities and Exchange Commission on December 7, 2006. In that offering we sold a total of 3,125,000 shares of our common
stock and selling stockholders sold 4,263,750 shares of our common stock, which included 963,750 shares resulting from the exercise of the underwriters' over-allotment option. All common
stock registered under that registration statement were sold at a price to the public of $21.00 per share. We did not receive any proceeds from the selling stockholders' sale of their shares.

The
net proceeds to us from the offering were approximately $58.8 million, after deducting underwriting discounts and commissions and other expenses incurred in connection with
the offering. As of December 31, 2008, we had used $8.5 million of these proceeds to repay amounts outstanding

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under
our revolving credit facility and $27.7 million for working capital purposes ($8.5 million in December 2006 and $19.2 million during 2007), and $8.6 million in 2008
to expand our international operations. We intend to use the remaining proceeds to fund infrastructure improvements, working capital needs and other general corporate purposes.

Unregistered Sales of Equity Securities

During the period covered by this Annual Report on Form 10-K, we did not sell or issue any unregistered equity
securities.

Repurchases

None.

Securities Authorized for Issuance under Equity Compensation Plans

The Company has reserved 2,972,725 shares of common stock subject to its 2006 Stock Incentive Plan, or the "2006 Plan," and had 764,125
shares remaining available at December 31, 2008 that may be granted to employees, consultants and nonemployee directors of the Company. The 2006 Plan is administered by the compensation
committee of the Company's board of directors, which selects the persons to whom options will be granted, determines the number of shares to be subject to each grant, and prescribes the other terms
and conditions of each grant, including the type of consideration to be paid to the Company upon exercise and the vesting schedule. If a change of control of the Company, as defined by the 2006 Plan,
occurs, the vesting of the options will accelerate and become fully vested and exercisable.

Our
board of directors and stockholders approved our 2006 Plan and we do not have any other equity based plans.

Equity Compensation Plan Information

Plan Category

Number of securities to be
issued upon exercise of
outstanding options, warrants
and rights

Weighted-average
exercise price of
outstanding options, warrants
and rights

Number of securities
remaining available for future
issuance under equity
compensation plans (excluding
securities reflected in
column (a))(a)

(b)

(c)Equity compensation plans approved by security holders


1,666,423

$
4.54


764,125Equity compensation plans not approved by security holders




$



Total


1,666,423

$
4.54


764,125


The
table above sets forth information regarding our 2006 Plan as of December 31, 2008.

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Performance Graph

The graph below compares the cumulative total stockholder return on our common stock for the period from December 8, 2006, the
date of our initial public offering, through December 31, 2008 with the cumulative total return on the NASDAQ 100 and the Dow Jones Footwear Index. Each comparison assumes the investment
of $100 on December 8, 2006 in our common stock and in each of the indices and, in each case, assumes reinvestment of all dividends.

Comparison of Cumulative Total Return  Among Heelys, Inc.,  Nasdaq 100 Index and Dow Jones Footwear Index

CHART

ASSUMES
$100 INVESTED ON DEC. 8, 2006
ASSUMES DIVIDEND REINVESTED
FISCAL YEAR ENDING DEC. 31, 2008

Notwithstanding
anything to the contrary set forth in any of our previous or future filings under the Securities Act that might incorporate this report in future filings made by us under
those statutes, this Performance Graph shall not be deemed filed with the SEC and shall not be deemed incorporated by reference into any of those prior filings or into any future filings made by us
under those statutes.

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Table of Contents

Item 6.    Selected Financial Data

The following selected consolidated financial data should be read in conjunction with, and are qualified by reference to, our
consolidated financial statements and related notes and "Management's Discussion and Analysis of Financial Condition and Results of Operations" appearing elsewhere in this Annual Report on
Form 10-K. The consolidated statements of operations data for the years ended December 31, 2006, 2007 and 2008 and the consolidated balance sheet data at December 31,
2007 and 2008 are derived from our consolidated financial statements which have been audited by Deloitte & Touche LLP, an independent registered public accounting firm, and are included
elsewhere in this Report. The consolidated statements of operations data for the years ended December 31, 2004 and 2005 and the consolidated balance sheet data at December 31, 2004 and
2005 are derived from our consolidated financial statements not included herein.

Year Ended December 31,(2)2004

2005

2006

2007

2008(in thousands, except per share data)Consolidated Statements of Operations Data:Net sales

$
21,310

$
43,950

$
188,208

$
183,472

$
70,741Cost of sales


14,529


28,951


122,565


125,412


52,825Gross profit


6,781


14,999


65,643


58,060


17,916Selling, general and administrative expenseSales and marketing


3,191


5,247


13,695


15,179


11,336General and administrative


2,373


2,995


6,436


11,096


14,935Severance














693Total selling, general and administrative expense


5,564


8,242


20,131


26,275


26,964Income (loss) from operations


1,217


6,757


45,512


31,785


(9,048
)Other expense (income), net


2


134


605


(3,474
)

(2,607
)Income (loss) before income taxes


1,215


6,623


44,907


35,259


(6,441
)Income tax expense (benefit)


440


2,407


16,285


13,319


(517
)Net income (loss)

$
775

$
4,216

$
28,622

$
21,940

$
(5,924
)Earnings (loss) per share:Basic

$
0.06

$
0.30

$
1.47

$
0.81

$
(0.22
)Diluted

$
0.03

$
0.17

$
1.14

$
0.78

$
(0.22
)Weighted average shares outstanding:Basic


13,989


13,989


19,479


27,060


27,321Diluted


25,353


25,353


25,114


28,214


27,321Other Data:Cash dividends declared per share













$
1.00Net sales, domestic

$
13,835

$
36,573

$
161,347

$
152,995

$
37,094Net sales, international


7,475


7,377


26,861


30,477


33,647Depreciation and amortization


454


396


402


622


643


30

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Table of Contents



At December 31,(2)2004

2005

2006

2007

2008(in thousands)Consolidated Balance Sheet Data:Cash and cash equivalents

$
1,628

$
738

$
54,184

$
98,771

$
68,446Working capital


4,281


8,101


92,528


116,198


83,467Total assets


6,345


12,081


106,706


127,690


96,496Total long-term liabilities(1)


577


275


1,104


1,572


1,773Total stockholders' equity


4,528


8,744


93,034


116,962


86,375


---

Year Ended December 31,2004

2005

2006

2007General and administrative expenseAs previously reported

$
2,368

$
2,987

$
6,397

$
10,877Adjustments (penalties)


5


8


39


219As restated

$
2,373

$
2,995

$
6,436

$
11,096Income from operationsAs previously reported

$
1,222

$
6,765

$
45,551

$
32,004Adjustments


(5
)

(8
)

(39
)

(219
)As restated

$
1,217

$
6,757

$
45,512

$
31,785Other expense (income), netAs previously reported

$
1

$
131

$
589

$
(3,550
)Adjustments (interest)


1


3


16


76As restated

$
2

$
134

$
605

$
(3,474
)Income before income taxesAs previously reported

$
1,221

$
6,634

$
44,962

$
35,554Adjustments


(6
)

(11
)

(55
)

(295
)As restated

$
1,215

$
6,623

$
44,907

$
35,259Income tax expenseAs previously reported

$
418

$
2,287

$
15,788

$
13,237Adjustments


22


120


497


82As restated

$
440

$
2,407

$
16,285

$
13,319Net incomeAs previously reported

$
803

$
4,347

$
29,174

$
22,317Adjustments


(28
)

(131
)

(552
)

(377
)As restated

$
775

$
4,216

$
28,622

$
21,940


31

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Table of Contents

Year Ended December 31,2004

2005

2006

2007Earnings per share:BasicAs previously reported

$
0.06

$
0.31

$
1.50

$
0.82Adjustments





(0.01
)

(0.03
)

(0.01
)As restated

$
0.06

$
0.30

$
1.47

$
0.81DilutedAs previously reported

$
0.03

$
0.17

$
1.16

$
0.79Adjustments








(0.02
)

(0.01
)As restated

$
0.03

$
0.17

$
1.14

$
0.78




At December 31,2004

2005

2006

2007Deferred income tax benefits (non-current)*As previously reported

$
163

$
178

$
371

$
595Adjustments (3)


12


24


91


368Adjustments


12


67


277


91As restated

$
187

$
269

$
739

$
1,054*included in total assetsIncome taxes payable (non-current)*As previously reported

$


$


$


$
Adjustments(3)


37


77


275


1,104Adjustments


40


198


829


468As restated

$
77

$
275

$
1,104

$
1,572*included in total long-term liabilitiesRetained earnings*As previously reported

$
4,427

$
8,774

$
33,948

$
56,265Adjustments(3)


(25
)

(53
)

(184
)

(736
)Adjustments


(28
)

(131
)

(552
)

(377
)As restated

$
4,374

$
8,590

$
33,212

$
55,152*included in total stockholders' equity






Note:
The numbers in the tables above, except per share data, have been rounded to thousands. All calculations related to the period-to-period comparisons in "Management's
Discussion and Analysis of Financial Condition and Results of Operations" are derived from the tables above, are rounded to millions and could differ immaterially if such calculations were computed
without rounding.

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Item 7.    Management's Discussion and Analysis of Financial Condition and Results of Operations

The following discussion should be read in conjunction with our consolidated financial statements and the
related notes included elsewhere in this Annual Report on Form 10-K. This Annual Report on Form 10-K contains forward-looking statements within the meaning of
Section 27A of the Securities Act of 1933, as amended, or the "Securities Act," and Section 21E of the Securities Exchange Act of 1934, as amended, or the "Exchange Act," that are based
on information currently available to management as well as management's assumptions and beliefs. When used in this document and in documents incorporated by reference, forward-looking statements
include, without limitation, statements regarding financial forecasts or projections, and our expectations, beliefs, intentions or future strategies that are signified by terminology such as "subject
to," "believes," "anticipates," "plans," "expects," "intends," "estimates," "may," "will," "should," "can," the negatives thereof, variations thereon, similar expressions, or discussions of strategy.
These forward-looking statements reflect our current views with respect to future events, based on what we believe are reasonable assumptions; however, such statements are subject to certain risks and
uncertainties. In addition to the specific uncertainties discussed elsewhere in this Annual Report on Form 10-K, the risk factors set forth in Part I, "Item 1A. Risk
Factors" in this report may affect our performance and results of operations. Those risks, uncertainties and factors include, but are not limited to the fact that substantially all of our net
sales are generated by one product, continued changes in fashion trends and consumer preferences and general economic conditions, our intellectual property may not restrict competing products that
infringe on our patents from being sold, we are dependent upon independent manufacturers, we may not be able to successfully introduce new product categories and the other factors described in our
filings with the Securities and Exchange Commission. Investors are urged to consider these risks, uncertainties and factors carefully in evaluating the forward-looking statements and are cautioned not
to place undue reliance on such forward-looking statements. Should one or more of these risks or uncertainties materialize, or should underlying assumptions prove incorrect, actual results may differ
materially from those in the forward-looking statements. We disclaim any intention or obligation to update or review any forward-looking statements or information, whether as a result of new
information, future events or otherwise.

Throughout this report, references to the "Company," "we," and "our" refer to Heelys, Inc. and its consolidated subsidiaries, unless the context indicates
otherwise.



We are a designer, marketer and distributor of innovative, action sports-inspired products under the HEELYS brand targeted to the youth
market. Our primary product, HEELYS-wheeled footwear, is patented, dual-purpose footwear that incorporates a stealth, removable wheel in the heel. HEELYS-wheeled footwear allows the user
to seamlessly transition from walking or running to rolling by shifting weight to the heel. Users can transform HEELYS-wheeled footwear into street footwear by removing the wheel. In 2008,
approximately 98% of our net sales was derived from the sale of our HEELYS-wheeled footwear. The remainder of our net sales was derived from branded accessories, such as replacement wheels, helmets
and other protective gear. We introduced HEELYS-wheeled footwear in 2000, and for several years our domestic sales were concentrated with one large, national specialty retailer. Although we initially
focused on driving our domestic sales growth, we also established relationships with independent distributors in Japan, South Korea and Southeast Asia. As a result, the sources of our net sales were
largely concentrated and we were susceptible to customer-specific and region-specific factors. This concentration caused variability in our results of operations. Since that time, we have diversified
our retail customer base in the United States by widening our distribution to include full-line sporting goods retailers, specialty apparel and footwear retailers, family footwear stores,
and select online retailers. We have also expanded our international distribution channels to mitigate this concentration. Historically, our products have been sold to independent distributors with
exclusive rights to specified international territories. During the first quarter of 2008, our Belgian subsidiary opened an office in Belgium to focus on expanding our international opportunities by

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working
more closely with our distributors, establishing relationships with distributors in new international markets and, in select markets, selling our products direct to retail customers. Effective
as of March 31, 2008 and April 30, 2008, respectively, we entered into agreements with our distributor in Germany and Austria and our distributor in France, Monaco and Andorra whereby we
terminated their rights to distribute our products in their specified territories. Our Belgium subsidiary took over the
distribution of our products in Germany and Austria effective April 1, 2008 and in France, Monaco and Andorra effective May 1, 2008.

Continued
growth of our net sales will depend on consumer demand for HEELYS-wheeled footwear and our ability to satisfy this demand. A number of factors may impact consumer demand for
our products, including:



We
intend to continue to diversify our product offering with new HEELYS-wheeled footwear models in order to benefit from the recognition of our HEELYS brand. Designing, marketing and
distributing new products will require us to devote additional resources to product development, marketing and operations. These additional resources may include hiring new employees to support
expansion in these areas and increasing amounts allocated to product advertising and promotion. Each of these additional resource commitments will increase our selling, general and administrative
expenses. Because the
selling price and unit cost of new products may differ from those of our existing products, sales of these new products may also impact our gross margin. In addition, we may seek to selectively
acquire products and companies that offer products that are complementary to ours.

Recent Developments

During the second half of 2007, we experienced challenges related primarily to higher than expected inventory positions of product at
many of our domestic accounts as weekly unit sales were lower than internal projections of many of our domestic retail customers, which had a significant adverse effect on our results for the second
half of 2007. Certain of our major retailers were reluctant to place significant fourth quarter 2007 orders until their current inventory was reduced to their targeted levels. We also saw decreased
prices on our products at certain of our retailers in the fourth quarter of 2007 and continuing into 2008. These factors led us to work closely with each of our key retail customers to assist them in
managing their inventory and sell-through. This included providing marketing discretionary funds, rescheduling orders to later dates, accepting cancellations, increasing marketing
promotion and advertising support and accepting returns.

During
2008 we have continued to work with our retailers in order to lower their inventory levels and stabilize retail prices. The retailers have continued to be cautious in placing
future orders and have continued to look to us to carry on hand inventory. We have maintained a tight focus on our inventory levels and have reduced inventory levels 34% from
December 31, 2007. Although a significant decline from 2007 levels, we experienced sequential improvement in net sales and gross margin in the first, second and third quarters. In the fourth
quarter, the slowdown in consumer spending and the highly promotional environment resulted in reduced sales and gross margins. We also recorded inventory reserves to reduce certain styles of our
inventory to the lower of cost or market. We plan on selling the

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discounted
inventory throughout 2009. In the periods in which we sell this inventory, our gross margin will be negatively impacted.

With
the passage of the Consumer Product Safety Improvement Act of 2008, or "CPSIA", there are new requirements mandated for the textiles and apparel industries. These mandates relate to
all products marketed to children 12 years of age and under. Among other requirements, the Consumer Product Safety Commission, or "CPSC," will require certification and testing of lead paint
levels as applied to certain products, along with testing the lead content of the product as a whole. We are working with accredited third party testing services to ensure compliance with all CPSIA
requirements and to further product safety goals. We will continue to monitor the situation and intend to abide by all rules and changes made by the CPSC. This could have a negative impact on the cost
of our goods and poses a potential risk if we do not adhere to these requirements.

General

Net Sales

Net sales represent primarily sales of HEELYS-wheeled footwear, less an estimated reserve for sales returns, allowances (including
certain allowances for marketing, promotion and advertising support) and discounts. A small portion of our net sales are derived from the sale of accessories such as replacement wheels, helmets and
other protective gear. Amounts billed to domestic customers for shipping and handling are included in net sales.

We
sell our products through distribution channels that generally merchandise our products in a manner that we believe enhances and protects our HEELYS brand image.

Domestically,
our products can be found in full-line sporting goods retailers, specialty apparel and footwear retailers, select department stores, family footwear stores and
select online retailers. For 2008, 52.4% of our net sales were derived from domestic retail customers.

Internationally,
our products are sold primarily to independent distributors with exclusive rights to specified territories. During the first quarter of 2008, our Belgian subsidiary
opened an office in Belgium to focus on expanding our international opportunities by working more closely with our distributors, establishing relationships with distributors in new international
markets and, in select markets, selling our products direct to retail customers. Effective as of March 31, 2008 and April 30, 2008, respectively, we entered into agreements with our
distributor in Germany and Austria and our distributor in France, Monaco and Andorra whereby we terminated their rights to distribute our products in their specified territories. Our Belgian
subsidiary took over the distribution of our products in Germany and Austria effective April 1, 2008 and in France, Monaco and Andorra effective May 1, 2008. Additionally, effective
April 1, 2008, our subsidiary in Belgium became responsible for sales to our independent distributors in EMEA (Europe, Middle East and Africa). Sales to our customers in Germany, Austria,
France, Monaco and Andorra are denominated in Euro. Sales to our independent distributors in the other EMEA countries are denominated in U.S. dollars. Sales to our independent distributors in
non-EMEA territories will continue to be processed at our office in Carrollton, Texas and denominated in U.S. dollars. Payments are required to be made in the same currency as invoiced.

No
country, other than the United States accounted for 10% or more of our net sales for 2008.

Cost of Sales and Gross Profit

Cost of sales consists primarily of the cost to purchase finished products from our independent manufacturers. Cost of sales also
includes inbound and outbound freight, warehousing expenses, tooling depreciation, royalty expenses related to licensed intellectual property, an inventory reserve for shrinkage and write-downs, costs
associated with operating our representative office in China and, until 2008, commissions paid to our independent sourcing agent.

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We
source all of our products from manufacturers located in China. Our product costs are largely driven by the prices we negotiate with our independent manufacturers. Each season, we
negotiate a unit price for each model of HEELYS-wheeled footwear. Factors that influence these prices include raw materials and labor costs and foreign exchange rates. We believe that our sourcing
model allows us to minimize our capital investment, retain the production flexibility, cost-effectiveness and scalability inherent in the use of independent manufacturers and focus our
resources on developing new products and enhancing our HEELYS brand image.

Through
December 31, 2007, we paid an independent sourcing agent a commission equal to a specified percentage of our per unit cost, with the percentage decreasing when our annual
purchases exceeded a predetermined unit volume threshold. In January 2008, we terminated our consulting agreement with the independent sourcing agent and opened a representative office in Qingdao,
China. This office serves multiple sourcing functions including quality control, price negotiation, logistics and product development. We believe our Qingdao office will help us improve our research
and development efforts, enhance communication between us and our distribution and manufacturing partners and give us more direct control over the manufacturing and sourcing process.

When
demand for our products slows, we may elect to discount our products to reduce our inventory, which causes our gross profit as a percentage of net sales, or gross margin, to
decline. Our gross margin is affected by our sourcing and distribution costs, our product mix and our ability to avoid excess inventory by accurately forecasting demand for our products. The unit
prices that we charge our domestic and international retail customers are generally higher than what we charge our independent distributors for similar products, because our independent distributors
are responsible for distribution and marketing costs relating to our products.

Our
inventories are stated at the lower of cost or market. Inventory quantities are regularly reviewed and provisions for excess or obsolete inventory are recorded primarily based on the
forecast of future demand and market conditions. If we estimate that the net realizable value of our inventory is less than the cost of the inventory recorded on our books, we charge cost of sales for
the difference between the cost of the inventory and the estimated net realizable value. If changes in market conditions result in reductions in the estimated net realizable value of our inventory
below our previous estimate, we would write-down the inventory in the period in which we made such a determination and charge cost of sales.

Selling, General and Administrative Expenses

Selling, general and administrative expenses consist of wages and related payroll and employee benefit costs, sales and marketing
expenses, advertising costs, travel and insurance expenses, product development costs, costs to enforce our intellectual property rights, depreciation, amortization, professional fees, facility
expenses and costs associated with operating as a public company.

SFAS
No. 123(R) requires the measurement of compensation cost of stock-based compensation awards based on the estimated fair value of that award on the date of grant. We recognize
this compensation cost using the straight-line method over the period during which the employee is required to provide service in exchange for the award. No compensation cost is recognized
for awards for which the employee does not render the required service. If the requisite service is not provided, all previously recognized compensation cost is reversed. For all awards granted
to-date, the requisite service period is the same as the vesting period of the award.

Our
selling, general and administrative expenses may increase in future periods as we hire additional personnel, develop our infrastructure, increase our brand recognition through
marketing, increase our product development efforts, secure and enforce our intellectual property rights and incur expenses associated with operating as a public company.

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Income Taxes

We operate through Heeling Sports Limited, a Texas limited partnership, and as such we are subject to Texas franchise taxes on gross
margin sourced to the State of Texas. In addition, the Company is subject to income taxes in certain other states as a result of business activities being performed in those states. In February 2008,
the Company formed a subsidiary in Belgium, with branch offices in Germany and France, to function as the headquarters for European sales operations. As a result, we are subject to tax in Belgium,
Germany and France for 2008 and future periods so long as we have operations in these jurisdictions. Increased activities in foreign jurisdictions or the formation of additional foreign subsidiaries
could cause us to be liable for income taxes in additional jurisdictions.

Results of Operations

Year Ended December 31,2006

2007

2008Net sales


100.0
%

100.0
%

100.0
%Cost of sales


65.1


68.4


74.7Gross profit


34.9


31.6


25.3Selling, general and administrative expenseSales and marketing


7.3


8.3


16.0General and administrative


3.4


6.0


22.0Total selling, general and administrative expense


10.7


14.3


38.0Income (loss) from operations


24.2


17.3


(12.7
)Other expense (income)


0.3


(1.9
)

(3.7
)Income (loss) before income taxes


23.9


19.2


(9.0
)Income tax expense (benefit)


8.7


7.2


(0.7
)Net income (loss)


15.2
%

12.0
%

(8.3
)%


Comparison of the Years Ended December 31, 2008 and 2007

Net sales.Net sales decreased $112.7 million, or 61.4%, to $70.7 million in 2008, from $183.5 million in 2007. This
decrease
was primarily the result of lower unit sales of our HEELYS-wheeled footwear, which decreased by 3.9 million pairs, or 59.5%, to 2.6 million pairs in 2008, from 6.5 million pairs
in 2007. In 2008, 52.4% of our net sales were derived from domestic retail customers, compared to 83.4% in 2007. Domestically, our net sales decreased $115.9 million, or 75.8%, to
$37.1 million in 2008 from $153.0 million in 2007. This decrease was primarily the result of lower unit sales of our HEELYS-wheeled footwear, which decreased by 3.8 million pairs,
or 71.1%, to 1.5 million pairs in 2008 from 5.3 million pairs in 2007. Internationally, our net sales increased $3.1 million, or 10.4%, to $33.6 million in 2008, compared
to $30.5 million in 2007. International growth was driven primarily by net sales increases in the Middle East, Japan, France, Denmark, Germany, Switzerland, and Greece, partially offset by a
decline in the United Kingdom. Returns reserve expense decreased $3.8 million to $456,000 in 2008 from $4.3 million in 2007. Of the 2007 expense, $2.7 million was for negotiated
returns from two of our retail customers. The reserve for marketing discretionary fund allowances decreased $7.4 million to $139,000 in 2008 from $7.5 million in 2007. The 2007 expense
was due to the challenges our retail customers experienced in the second half of 2007. Marketing discretionary funds are provided to our customers to assist them in sell-through of our
products.

Gross profit.Gross profit decreased $40.2 million to $17.9 million in 2008 from $58.1 million in 2007. This decrease
was
primarily attributable to lower sales volume of $112.7 million negatively impacting gross profit by $35.3 million and lower average price per unit. Although European operations

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experienced
an increase in average price per unit due to the expansion of the direct business in France and Germany, this was offset by lower pricing per unit in the U.S. market as a result of selling
excess product at reduced wholesale prices.

Sales and marketing expense.Sales and marketing expense, excluding commissions, payroll and payroll related expenses, and stock-based
compensation
expense, decreased $841,000 to $7.6 million in 2008, from $8.5 million in 2007, primarily due to a $1.6 million decrease in cooperative marketing related costs and a
$1.1 million decrease in expenses incurred for point-of-purchase ("POP") displays. These decreases were partially offset by a $482,000 increase in consumer
advertising/production for a new television commercial and expansion into radio advertising, a $1.0 million increase in costs incurred by our newly formed international operations, and website
maintenance expense increased by $399,000 from 2007 to 2008 as we made improvements to enhance our website. We continued to promote our HEELYS-wheeled footwear and brand image through national
television advertising campaigns in 2008. Historically we have limited our consumer advertising during the first quarter of the year. During the first quarter of 2008, we ran several television
advertising campaigns which included one new commercial. The new commercial's production costs were expensed in the first quarter, but we were able to leverage those costs during the second and third
quarters by reusing the same creative with only minor re-editing costs. Consumer advertising and related costs in 2008 were $3.6 million; compared to $3.1 million in 2007.
Through cooperative advertising programs, we reimburse our domestic retail customers for certain of their costs of advertising our products. Examples of cooperative marketing include POP display
materials, television, radio, print, and web based advertising. We record these costs in selling and marketing expense at the point in time when we are obligated to our customers for the costs, which
is when the related revenues are recognized. Cooperative marketing related costs decreased from $2.2 million in 2007, to $556,000 in 2008, mainly as a result of the decrease in our domestic
sales. Expenses incurred for point-of-purchase displays decreased by $1.1 million from $1.4 million in 2007, to $250,000 in 2008. Through the uses of
point-of-purchase (POP) displays, we are able to present the HEELYS brand image message to consumers in a consistent manner and increase shelf space in our retail customers'
locations. Because these POP displays are given to customers, we are selective as to which of our customers receive the displays. In 2007 we built up our inventory of POP displays; consequently, the
Company did not incur significant replacement costs in 2008 as we continued to utilize the POP's purchased in 2007. Sales commissions decreased $3.2 million from $4.5 million in 2007, to
$1.3 million in 2008. This decrease in commissions is mainly a result of the decrease in domestic net sales. Payroll and payroll related expenses, including stock-based compensation, increased
$642,000 to $2.6 million in 2008, from $2.1 million in 2007. This increase in compensation was mainly the result of opening our Belgian subsidiary's offices in Belgium, Germany and
France.

General and administrative expense.General and administrative expense increased $3.8 million to $14.9 million in 2008, from
$11.1 million in 2007. Our international general and administrative expenses increased $2.9 million, from $700,000 in 2007 to $3.6 million in 2008 due to the opening of our
Belgian subsidiary's offices in Belgium, Germany and France. Legal, accounting and other professional fees increased $1.9 million from $1.9 million in 2007, to $3.8 million in
2008. The increase in these fees is mainly the result of a $973,000 increase in legal fees resulting from lawsuits filed in connection with our initial public offering, and a $497,000 increase in
international professional expenses due to the opening of our Belgian subsidiary's offices in Belgium, Germany, and France. Other legal and related fees increased $722,000 in 2008 related to the
Company's estimate of the amounts to be paid in the settlements of the consolidated securities class action and the consolidated derivative lawsuits. During the first quarter of 2008, we entered into
an agreement with one of our directors to act as our interim Chief Executive Officer. We paid this individual a monthly fee for his services and in 2008, we recognized $141,000 of related fees. During
2008, we recognized $199,000 as a result of the services performed by the executive search firm we engaged to identify a replacement for our then Chief Executive Officer who resigned effective
February 1, 2008. Payroll and payroll related expense

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increased
$844,000 to $3.1 million in 2008, from $2.3 million in 2007. Payroll and payroll related expenses attributed to our domestic operations decreased $68,000 which was mainly the
result of changes in the composition of our general and administrative related staff. Internationally, our payroll and payroll related expenses increased $1.2 million due to the opening of our
international offices in Belgium, Germany and France. Additionally, amortization expense in our international operations increased by $274,000 as we amortized customer list intangible assets in 2008.
These increases were offset by a decrease in bad debt expense and insurance of $333,000 and $161,000, respectively, mainly due to decreased sales levels. During 2007, we incurred $400,000 of costs in
connection with the proposed (and subsequently withdrawn) secondary offering by certain of our stockholders in the second quarter of 2007.

Severance.Effective February 1, 2008, our then Chief Executive Officer ("CEO") resigned. In connection with his resignation, we
entered into
a severance agreement with our former CEO pursuant to which he is entitled to receive approximately $470,000, payable in ten semi-monthly installments of approximately $17,000 beginning
six months after the effective date of the severance agreement, followed by one lump sum payment of $300,000 payable in January 2009 and up to 14 months of reimbursements for health and life
insurance (estimated cost at February 1, 2008 of $16,000). We recognized 100% of this liability and the related severance cost on February 1, 2008. In addition, our former CEO agreed to
perform certain consulting services for us for one year with no additional monetary compensation. During the term of this consulting relationship, options granted to the former CEO will continue to
vest in accordance with the Heelys, Inc. 2006 Stock Incentive Plan. On February 1, 2008, the Company recognized $207,000 in stock-based compensation expense, which is 100% of the related
stock-based compensation for those stock options expected to vest during the term of the consulting arrangement.

Operating income (loss).As a result of the above factors, operating income decreased $40.8 million to a loss from operations of
$9.0 million in 2008, from income from operations of $31.8 million in 2007.

Other expense (income).Other expense (income) decreased $867,000 from $3.5 million in 2007 to $2.6 million in 2008. In 2008,
other
income (expense) was mainly attributable to other income recognized in connection with an agreement we reached during the first quarter of 2008 to settle a pending patent and trademark lawsuit, and
interest earned on cash and cash equivalents. In 2007, other expense (income) was mainly attributable to interest earned on our cash and cash equivalents. Additionally, in 2008 the exchange rate
translation and transaction loss related to foreign operations was $593,000. There was no exchange rate loss in 2007.

Income taxes.We recognized an income tax benefit of $517,000 in 2008, representing an effective income tax rate of 8.0%, compared to
income tax
expense of $13.3 million in 2007, representing an effective income tax rate of 37.8%. The effective tax rate differs from the federal statutory rate of 35% primarily as a result of
nondeductible stock option expense, a decrease in the state tax rate used to determine our deferred tax assets, and an increase in our deferred tax valuation allowance.

Net income (loss).As a result of the above factors we reported a net loss of $5.9 million in 2008 compared to $21.9 million
in net
income in 2007. As a percentage of net sales, net income (loss) decreased to 8.4% in 2008 from 12.0% in 2007.

Comparison of the Years Ended December 31, 2007 and 2006

Net sales.Net sales decreased $4.7 million, or 2.5%, to $183.5 million in 2007 from $188.2 million in 2006. This
decrease was
primarily the result of an increase in our reserve for marketing discretionary fund allowances and returns reserve which are recorded as reductions to revenue. Reserve for marketing discretionary fund
allowances increased $6.0 million to $7.5 million in 2007 from $1.5 million

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in
2006. This increase was due to the challenges our retail customers experienced in the second half of 2007. Marketing discretionary funds are provided to our customers to assist them in
sell-through of our products. Returns reserve expense increased $4.0 million to $4.3 million in 2007 from $325,000 in 2006. Of this increase, $2.7 million was for
negotiated returns from two of our retail customers. Both the reserve for marketing discretionary fund allowances and the returns reserve were related to domestic sales. In 2007, 83.4% of our net
sales were derived from domestic retail customers, compared to 85.7% in 2006. Domestically, our net sales decreased $8.4 million, or 5.2%, to $153.0 million in 2007 from
$161.3 million in 2006. This decrease was primarily the result of the increase in our marketing discretionary fund allowances and returns reserve. Unit sales of our HEELYS-wheeled footwear to
existing and new retail customers, increased by 128,000 pairs, or 2.5%, to 5.3 million pairs in 2007 from 5.2 million pairs in 2006. Internationally, our net sales increased
$3.6 million, or 13.5%, to $30.5 million in 2007, compared to $26.9 million in 2006. This increase was primarily the result of higher unit sales of our HEELYS-wheeled footwear,
which increased by 148,000 pairs, or 15.0%, to 1.1 million pairs in 2007 from 986,000 pairs in 2006. In 2007, our largest international territory was the United Kingdom, which accounted for
8.7% of our total net sales.

Gross profit.Gross profit decreased $7.6 million to $58.1 million in 2007 from $65.6 million in 2006. Our gross margin
was
31.6% in 2007 compared to 34.9% in 2006. The decrease in gross profit was primarily the result of the $6.0 million increase in our reserve for marketing discretionary fund allowances which
increased to $7.5 million in 2007 from $1.5 million in 2006 and the increase in our returns reserve of $4.0 million, which resulted in a $2.2 million net impact on our
gross profit, discussed above. Gross profit was also negatively impacted by the $2.6 million increase in our inventory valuation reserve expense which increased to $2.8 million in 2007
from $203,000 in 2006. This $2.6 million increase is mainly due to a $1.9 million impairment charge that was recorded at year-end on certain inventory items resulting from
the increase in our inventory during the second half of 2007 and a $617,000 reserve related to similar inventory items for which we were committed to purchase but for which we had not taken title to
as of December 31, 2007. These increases were partially offset by reduced costs of 1.1% of net sales related to product mix and reduced costs of 0.8% of net sales related to freight.

Sales and marketing expense.Sales and marketing expense, excluding commissions, payroll and payroll related expenses, and stock based
compensation
cost, increased $4.8 million to $8.5 million in 2007 from $3.7 million in 2006. This increase was mainly attributed to a $1.5 million increase in co-op
marketing costs, a $1.5 million increase in consumer advertising mainly as a result of additional and longer advertising campaigns, a $945,000 increase in point-of-sale
marketing efforts and a $447,000 increase in other
marketing costs. Sales commissions decreased $4.0 million from $8.6 million to $4.5 million mainly as a result of decreased commission rates. Payroll and payroll related expenses,
including stock-based compensation costs, increased $688,000 to $2.1 million from $1.5 million resulting from an increase in headcount and continued recognition of stock-based
compensation costs.

General and administrative expense.General and administrative expense increased $4.7 million to $11.1 million in 2007 from
$6.4 million in 2006. This increase was the result of $2.3 million in costs directly attributable to our status as a public company after the completion of our initial public offering in
December 2006, a $877,000 increase in legal fees to enforce our intellectual property, a $613,000 increase in stock-based compensation costs, $400,000 of costs incurred in connection with the proposed
(and subsequently withdrawn) secondary offering by certain of our stockholders in the second quarter of 2007, a $180,000 increase in penalties related to certain state tax liabilities, a $302,000
increase in professional and consulting fees related to product development, and a $259,000 increase in payroll and related employee costs resulting from an increase in headcount. These increases were
offset by a $547,000 decrease in liability insurance related costs, a $200,000 increase in bad debt recoveries and a $103,000 decrease in bad debt expense.

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Operating income.As a result of the above factors, operating income decreased $13.7 million to $31.8 million in 2007 from
$45.5 in
2006. As a percentage of net sales, operating income decreased to 17.3% in 2007 from 24.2% in 2006.

Other expenses (income).Other expenses (income) increased $4.1 million to $3.5 million in other income (net of other
expense) in 2007
from $605,000 of other expense (net of other income) in 2006. The increase was mainly attributable to a $3.4 million increase in interest income earned on our cash and cash equivalents and a
decrease of $674,000 in interest expense.

Income taxes.Income taxes were $13.3 million in 2007, representing an effective income tax rate of 37.8%, compared to
$16.3 million in
2006, representing an effective income tax rate of 36.2%. The 1.6% increase in our effective income tax rate was mainly due to an increase in state income taxes which resulted in a 1.3% increase in
our rate. Our effective income tax rate was also impacted by a $144,000 increase in the tax effect of non-deductible incentive stock option expense and the $123,000 valuation allowance
established in 2007 on deferred income tax assets related to
non-qualified stock-options that may not be realized by the Company in future periods, which increased our effective tax rate by 0.6% and 0.4%, respectively.

Net income.As a result of the above factors, net income was $21.9 million in 2007 compared to $28.6 million in 2006. As a
percentage
of net sales, net income decreased to 12.0% in 2007 from 15.2% in 2006.

Liquidity and Capital Resources (in thousands)

Our primary cash need is for working capital, which we generally finance with cash flow from operating activities. In December 2006, we
completed an initial public offering of our common stock. The net proceeds to us were approximately $58.8 million, after deducting an aggregate of $4.6 million in underwriting discounts
and commissions and $2.2 million in other expenses incurred in connection with the offering. We used $8.5 million of these proceeds to repay amounts outstanding under our revolving
credit facility in 2006, $27.7 million for working capital purposes ($8.5 million in 2006 and $19.2 million in 2007), and $8.6 million to expand our international
operations. The Company intends to use the remaining proceeds to fund infrastructure improvements, working capital needs, and other general corporate purposes.

These
sources of liquidity may be impacted by fluctuations in demand for our products, investments in our infrastructure and expenditures on marketing and advertising.

The
table below sets forth, for the periods indicated, our beginning balance of cash and cash equivalents, net cash flows from operating, investing and financing activities and our
ending balance of cash and cash equivalents:

Year Ended December 31,2006

2007

2008(in thousands)Cash and cash equivalents at beginning of period

$
738

$
54,184

$
98,771Cash provided by (used in) operating activities


(2,180
)

46,589


(2,062
)Cash used in investing activities


(505
)

(1,069
)

(2,397
)Cash provided by (used in) financing activities


56,131


(933
)

(25,561
)Effect of exchange rate changes on cash and cash equivalents








(305
)Cash and cash equivalents at end of period

$
54,184

$
98,771

$
68,446


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Cash
flow from operating activities consists primarily of net income (loss) adjusted for certain non-cash items, including depreciation and amortization, deferred income
taxes, stock-based compensation expense, tax impact of stock-based compensation awards and the effect of changes in operating assets and liabilities, principally including accounts receivable,
inventory, income taxes, accounts payable and accrued expenses. Operating cash flow is presented net of unrealized gains and losses on foreign exchange rates related to our international operations.

In
2008 cash used in operating activities was $2.1 million compared to cash provided by operating activities of $46.6 million in 2007. Cash used in operating activities in 2008 resulted
from a net loss of $5.9 million adjusted for non-cash items including inventory impairment charge of $2.1 million, stock-based compensation expense of $1.2 million (including $207,000 recognized in
connection with the resignation of our former CEO effective February 1, 2008), depreciation and amortization expense of $643,000, an unrealized loss on foreign currency transactions of $609,000,
$583,000 deferred income taxes, and a $86,000 decrease in operating assets and liabilities.

The
decrease in operating assets and liabilities was primarily due to:



In
2007, cash provided by operating activities was $46.6 million compared to cash used in operating activities of $2.2 million in 2006. Cash provided by operating
activities in 2007 resulted from a decrease in operating assets and liabilities of $22.8 million, $21.9 of net income and non-cash items of $2.0 million. The
$2.0 million in non-cash adjustments were primarily the result
of the $1.9 million inventory impairment charge recorded at year-end and $1.6 million of stock-based compensation expense; offset by a $2.0 million increase in
deferred income tax benefits. The decrease in net working capital was primarily due to:



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Investing
activities relate primarily to investments in capital expenditures and patents and trademarks. Capital expenditures are primarily related to leasehold improvements, furniture
and fixtures, computer equipment, warehouse equipment and product molds and designs.

In
2008, cash used in investing activities was $2.4 million compared to $1.1 million in 2007 and $505,000 in 2006. This increased use of cash during the twelve months ended
December 31, 2008 was primarily the result of the termination of distributorship agreements during the period. Effective March 31, 2008 and April 30, 2008, we entered into
agreements to terminate our current arrangements regarding the distribution of Heelys-branded footwear and products in the Germany and Austria territories and in the France, Monaco and Andorra
territories, respectively, allowing us, through our Belgian subsidiary, to market our products directly in those countries. In connection with these terminations we recognized intangibles totaling
$3.7 million (2.4 million Euro). As of December 31, 2008, we paid $1.9 million (1.2 million Euro) in connection with these terminations with the balance of
$1.5 million (1.1 million Euro) to be paid out over time in accordance with the terms of the agreements. The balance of the cash used in investing activities for the twelve months ended
December 31, 2008 was due to the opening of our offices in Belgium, Germany and France as well as for upgrades to our information technology systems. Cash used during the twelve months ended
December 31, 2007, was mainly for leasehold improvements to our offices in Carrollton, Texas to expand our office space and for the purchase of office equipment and furniture and fixtures to
accommodate increased headcount.

Financing
activities relate primarily to repayments under promissory notes we executed to finance the payment of certain of our insurance premiums, the payment of dividends, the exercise
of stock options and the excess tax benefit on stock-based compensation awards. In 2008, cash used in financing was $25.7 million compared to cash used in financing of $933,000 in 2007. Cash
provided by financing activities was $56.1 million in 2006. Cash used in financing in 2008 is primarily the result of dividends of $27.6 million paid during the period, less proceeds
from stock option exercises of $2.0 million. Cash used in financing activities in 2007 is primarily the result of the payment of $1.1 million of liabilities incurred in connection with
our initial public offering, which we closed in December 2006, and principal payments on our promissory notes of $211,000 offset by $133,000 in cash provided by the exercise of stock options and
$207,000 in excess tax benefits on stock-based compensation awards. The cash provided by financing activities in 2006 was primarily the result of the completion of our initial public offering in
December. We sold 3,125,000 shares of common stock at a price of $21.00 per share for total gross proceeds of $65.6 million. The net proceeds were $61.0 million, after deducting
$4.6 million in underwriting discounts and commissions. We incurred a total of $2.2 million in other direct expenses in connection with this offering of which $1.1 million was
paid in 2006, bringing the net cash provided by the offering to $59.9 million. Cash provided by financing activities in 2006 also included $120,000 in net proceeds from short-term
debt, $117,000 excess tax benefit on stock-based compensation
awards and $35,000 proceeds from the exercise of stock options, offset by our repurchase of $4.0 million in shares of our common stock from certain of our stockholders.

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We
believe that our cash flow from operating activities, together with the net proceeds from the initial public offering of our common stock, will be sufficient to meet our liquidity
needs and capital expenditure requirements for at least the next 12 months.

Revolving Credit Facility

On August 20, 2004, we entered into a $3.0 million revolving credit facility with a predecessor of JPMorgan Chase Bank,
N.A. On August 28, 2006, we amended this revolving credit facility, increasing our maximum amount available to $25.0 million. In December 2006, we repaid all amounts outstanding under
this revolving credit facility with a portion of the proceeds from our initial public offering. There were no outstanding borrowings under our revolving credit facility at December 31, 2006.
The maximum amount available under our revolving credit facility was decreased to $10.0 million on January 1, 2007 and on February 7, 2007, we amended our revolving credit
facility to (a) decrease the maximum amount available to $2.0 million, (b) eliminate the 0.25% non-usage fee and (c) eliminate certain other terms, including
terms requiring us to provide monthly reports regarding our inventory and accounts receivable. This revolving credit facility expired on June 30, 2007. Borrowings were subject to certain
limitations, primarily based upon 85% of eligible accounts receivable and 50% of eligible inventory not to exceed the amount advanced on eligible accounts receivable. Indebtedness under the revolving
credit facility bore interest at a floating rate of interest based on either the prime rate quoted by JPMorgan Chase Bank, N.A. or an adjusted LIBOR rate. Accounts receivable and inventory were
pledged as collateral and the Company was subject to compliance with certain covenants, including minimum levels of net worth and minimum interest coverage ratios. The Company was not permitted to pay
dividends or make distributions.

In
September 2007, we entered into a $2.0 million revolving credit facility with JPMorgan Chase Bank, N.A. which expires June 30, 2009. Indebtedness under this revolving
credit facility bears interest at a floating rate of interest based on either the prime rate quoted by JPMorgan Chase Bank, N.A. or an adjusted LIBOR rate. The credit facility agreement contains
various restrictive covenants including (i) an obligation to maintain a tangible net worth of at least $75 million and (ii) a prohibition on incurring any other indebtedness for
borrowed money. The credit agreement prohibits us from creating or permitting any lien, encumbrances or other security interest on the Company's accounts receivable or inventory. There were no
borrowings under this revolving credit facility as of December 31, 2008.

An
irrevocable standby letter of credit in the amount of $50,000 was outstanding in favor of the landlord for our corporate headquarters. The letter of credit expired on March 1,
2008.

Line of Credit Note

On April 18, 2006, we executed a $5.0 million line of credit note with JPMorgan Chase Bank, N.A. In May 2006, we borrowed
$4.0 million under this note. This line of credit note was repaid in October 2006 and was canceled.

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Contractual Obligations and Commercial Commitments

The following table summarizes our significant contractual cash obligations as of December 31, 2008:

Payments due by periodTotal

Less than
1 year

1-3 years

4-5 years

More than
5 years(in thousands)Operating leases and related obligations

$
1,650

$
341

$
762

$
419

$
128Purchase commitments


4,499


4,499Severance and consulting agreements


498


433


65Termination of distributorship agreements


2,824


2,718


106





Liability uncertain tax positions


1,727


1,311








Total obligations

$
11,198

$
9,302

$
933

$
419

$
128


Operating Leases and Related Obligations:

Leases

We lease our corporate headquarters, an approximately 48,400 square-foot facility located in Carrollton, Texas, consisting
of approximately 34,500 square feet of warehouse space and approximately 13,900 square feet of office space. Our lease expires in August 2015, but we have two five-year extension options.
The information in the table above does not include these lease extensions. The lease for our corporate headquarters provides that if we are in default of the lease, we must pay certain damages to the
landlord, and the landlord may elect to require us to continue to pay rent through the end of the lease term or to pay the present value of the excess, if any, of the aggregate rent otherwise payable
through the end of the lease over the aggregate fair market value of the premises for the lease period.

On
October 29, 2007, we signed an operating lease for office space for our representative office in Qingdao, China. This lease expired December 1, 2008 but included two
one-year extension options. On December 1, 2008, we exercised our right to renew this lease for one year. The information in the table above does not include the remaining
one-year lease extension option. Payments under this lease agreement are made in the Chinese Yuan Renminbi. Future payments, included in the table above, have been estimated using the
currency exchange rate as of December 31, 2008.

Effective
May 1, 2008, our Belgian subsidiary entered into an operating lease for office space in Brussels, Belgium for nine years with the option to terminate the lease at the
end of each three year period. The information in the table above assumes that this lease will not be renewed after the initial three year period. Payments under this lease agreement are made in Euro.
Future payments, included in the table above, have been estimated using the currency exchange rate as of December 31, 2008.

Effective
April 1, 2008, our Belgian subsidiary entered into an operating lease for office space in Munich, Germany for three years with an automatic renewal at the end of the
initial three year lease unless six months notice is provided. The information in the table above does not include lease extensions. Payments under this lease agreement are made in Euro. Future
payments, included in the table above, have been estimated using the currency exchange rate as of December 31, 2008.

Effective
May 1, 2008, our Belgian subsidiary entered into an operating lease for office space in Annecy, France for nine years with the option to terminate the lease at the end
of each three year period. The information in the table above assumes that this lease will not be renewed after the initial three year period. Payments under this lease agreement are made in Euro.
Future payments, included in the table above, have been estimated using the currency exchange rate as of December 31, 2008.

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Third-Party Distribution Facilities

Our Belgian subsidiary has expanded the use of a third-party distribution facility in Belgium and pays this third-party distributor
fees and charges for services including handling, processing and packing materials. These fees and charges are activity based and therefore fluctuate and as a result related future obligations cannot
be quantified. This agreement is for one year with automatic one year renewal terms. We expensed $5,000, $58,000 and $1,265,000 related to this third-party distribution facility in 2006, 2007 and
2008, respectively.

Purchase Commitments:

At December 31, 2008, we had open purchase commitments of $4.5 million related to inventories that were still being held
by the manufacturers.

Severance and Consulting Agreements:

Severance Agreement with former CEO

On February 1, 2008, we entered into a Severance and General Release Agreement (the "Severance Agreement") with our former Chief
Executive Officer ("CEO"). Under the Severance Agreement, our former CEO is entitled to receive approximately $470,000, payable in ten semi-monthly installments of approximately $17,000
beginning six months after the date of the Severance Agreement, followed by one lump sum payment of $300,000 payable in January 2009, up to 14 months of reimbursements for health and life
insurance. As of December 31, 2008, we owed the former CEO the final lump sum payment of $300,000 and an estimated $4,000 for reimbursement of health and life insurance.

Consulting Agreement with former Senior Vice President

Effective as of April 30, 2008, we entered into a Consulting Agreement with our former Senior Vice President. The Consulting
Agreement will terminate on June 30, 2010, unless terminated earlier or the parties agree to extend the term. Under the Consulting Agreement, our former Senior Vice President (the "Consultant")
will provide the Company (i) consulting services relating to mergers and acquisitions, (ii) support services in connection with the prosecution or defense of any pending or future
litigation, arbitration, business, or investigatory matter relating to the Company, and (iii) other services agreed upon by the parties. The primary compensation under the Consulting Agreement
shall be (i) a fee for merger and acquisition services to be paid in 25 monthly installments of $10,780 per month beginning June 30, 2008, (ii) success fees more fully
described in the Consulting Agreement and equal to varying percentages of the total value of certain mergers or acquisitions originated by the Consultant, (iii) a fee of $125 per hour (up to a
maximum of $1,000 per day) for litigation support services rendered, and (iv) a fee of $125 per hour (up to a maximum of $1,000 per day for actual time billed) for services rendered for matters
other than merger and acquisition services or litigation support. Assuming that the Consulting Agreement is not terminated early, as of December 31, 2008 we would owe the former Senior Vice
President $194,000 in fees for future merger and acquisition services. We have included this commitment in the table above under the assumption that the Consulting Agreement will not be terminated
early. We have made no assumptions regarding future payment of compensation to the former Senior Vice President for success fees or hourly fees that might be earned by the Senior Vice President
subsequent to December 31, 2008.

Termination of Distributorship Agreements:

Effective March 31, 2008, we entered into agreements to terminate our arrangement regarding the distribution of Heelys-branded
footwear and products in Germany and Austria, allowing us to market, through our Belgian subsidiary, our products directly in such countries. This included a Termination

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Agreement
(the "Termination Agreement") with The Territory Distribution GmbH (the "Distributor"), and Achim Lippoth, the sole owner of the Distributor ("Lippoth"), pursuant to which, among
other things, a prior Distributor Agreement between the our company and the Distributor was terminated, we agreed to purchase from the Distributor all of the Distributor's inventory of unsold Heelys
products and other specified assets for the Distributor's cost, and all of the unshipped orders for Heelys products on the Distributor's order book as of March 31, 2008 for a price equal to the
Distributor's net wholesale margin on such unshipped orders (which is to be paid on or before the end of the month following our receipt of payment for the Heelys products shipped in response to such
unshipped orders), and the Distributor and Lippoth agreed, until March 31, 2010, not to compete with us relating to the our products anywhere in the world. In connection with the Termination
Agreement our Belgian subsidiary entered into two consulting agreements, one with The Sansean Group Limited ("Sansean"), and one with Lippoth, pursuant to which, among other things, Sansean and
Lippoth agreed to perform certain consulting services and our Belgian subsidiary agreed to pay Sansean and Lippoth consulting fees as set forth in their respective consulting agreements. Payments
under these agreements are to be made in Euro.

Effective
April 30, 2008, we entered into agreements to terminate our current arrangement regarding the distribution of Heelys-branded footwear and products in France, Monaco and
Andorra, allowing our company, through our Belgian subsidiary, to market products directly in such countries. This included a Termination Agreement (the "Termination Agreement") with Trotwood
Import/Export (the "Distributor"), Trotwood Investments Ltd., the sole owner of the Distributor ("TIL"), and David Stanley ("D. Stanley") and Margarete Stanley ("M. Stanley"),
pursuant to which, among other things, a prior International Distributor Agreement between our company and the Distributor was terminated, we agreed to purchase from the Distributor all of the
Distributor's inventory of unsold Heelys products for the Distributor's cost of such products, the Distributor's order books relating to Heelys products at the value on Distributor's books and certain
other incidental assets of the Distributor related to its distribution operations as described in the Termination Agreement (we agreed to pay Distributor for such items on or before May 16,
2008), we agreed to purchase from the Distributor all of the unshipped orders for Heelys products on the Distributor's order book as of April 30, 2008 that are not novated to our company or one
of its affiliates for a price equal to the Distributor's net wholesale margin on such unshipped orders (which is to be paid on or before the end of the month following our receipt of payment for the
Heelys products shipped in response to such unshipped orders). In addition, the Distributor, Shareholder, D. Stanley and M. Stanley agreed, until April 30, 2012, not to compete with us relating
to our products anywhere in the world and we agreed to pay Distributor an additional amount set forth in the Termination Agreement for each pair of Heelys branded footwear sold by our company or its
affiliates in France, Monaco and Andorra. In connection with the Termination Agreement our Belgian subsidiary, entered into a Consulting Agreement with TIL pursuant to which, among other
things, TIL agreed to perform certain consulting services and our Belgian subsidiary agreed to pay TIL consulting fees as set forth in such consulting agreement. Payments under these agreements are to
be made in Euro.

The
primary assets acquired as a result of these agreements were the customer lists and goodwill. In addition, both of these former distributors agreed to not compete with the Company
for a limited period of time. The fair value of the acquired assets was based upon the amount at which the assets could be bought or sold in a current transaction between willing parties. As a result,
the Company recorded goodwill and intangibles (including acquired customer relationships and non-compete agreements) in the amount of $3.7 million (2.4 million Euro). As of
December 31, 2008, the Company paid $1.9 million (1.2 million Euro) for these acquired assets with the balance of $1.5 million (1.1 million Euro) to be paid out over
time in accordance with the terms of the agreements; $1.3 million is recorded as other long term liability and $246,000 is recorded as a current liability. Additionally, as of
December 31, 2008, we owed these distributors amounts related to unshipped orders and consulting services. We record a liability, related to unshipped orders, when the order is fulfilled

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(shipped).
This liability is paid on or before the end of the month following receipt of payment by the customer. Liabilities for consulting services are recorded monthly as the consulting services
are performed. As of December 31, 2008, a liability has been recorded related to unshipped order and consulting services in the amount of $378,000. Additionally, we have estimated future
liabilities related to the unshipped orders and consulting services in the amount of $869,000. We have included these amounts in the table above under the assumption that the consulting services would
be performed and that the net wholesale margin would be earned. Payments due to these distributors are to be made in Euro. Future payments, included in the table above, have been estimated using the
currency exchange rate as of December 31, 2008.

Liability Uncertain Tax Positions:

Liabilities (including penalties and interest) for uncertain tax positions in certain jurisdictions as of December 31, 2008 was
$1.7 million. We are generally unable to reasonably estimate the timing of the payments or the amount by which a liability will increase or decrease over time; therefore we have only reflected
in the "Payments due by period" section of the table above those amounts we were reasonably able to estimate.

Seasonality

Similar to other vendors of footwear products, sales of our products are subject to seasonality. There are three major buying seasons
in footwear: spring/summer, back-to-school and holiday. We offer two primary lines: spring/summer and a combined back-to-school/holiday line. A few new
styles will typically be added for holiday. Shipments for spring/summer take place during the first quarter and early weeks of the second quarter, shipments for back-to-school
generally begin in May and finish in late August and shipments for the holiday season begin in October and finish in early December. Historically, we have experienced greater revenues in the second
half of the year than those in the first half due to a concentration of shopping around the back-to-school and holiday seasons.

In
2006, due to the growth of our business and the delays we experienced from our independent manufacturers, we experienced a higher percentage of net sales in the third quarter in
comparison to the total year than we experienced in the past, as many orders were delayed from the second quarter to the third quarter, thereby causing the second quarter to be lower than normal and
the third quarter to be higher than normal. In 2006, we estimate that approximately $20 million of net sales shifted from the second quarter to the third quarter due to late shipments.

During
the second half of 2007, we experienced challenges related primarily to higher than expected inventory positions of product at many of our domestic accounts as weekly unit sales
were lower than internal projections of many of our domestic retail customers, which had a significant adverse effect on our results for the second half of 2007. We believe that this was attributed
to: (1) aggressive sell-through expectations of some of our domestic retailers going into the summer months and (2) retail softness in footwear and apparel. Certain of our
major retailers were reluctant to place significant fourth quarter 2007 orders until their current inventory was reduced to their targeted levels. We also saw decreased prices on our products at
certain of our retailers in the fourth quarter of 2007 and continuing into 2008. These factors led us to work closely with each of our key retail customers to assist them in managing their inventory
and sell-through. This included providing marketing discretionary funds, rescheduling orders to later dates, accepting cancellations, increasing marketing, promotion and advertising
support, and accepting returns.

While
inventory levels at many of our domestic retailers decreased during 2008, we continued to see decreased retail prices on many of our products during a difficult footwear and
apparel environment. Many retailers were reluctant to place orders which resulted in decreased sales. We expect our retail customers to continue to be more cautious when placing future orders and to
shift

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toward
shorter lead times and at-once inventory purchases. Additionally, we expect to continue to provide marketing, promotional and advertising support to our retail customers to promote
the sell-through of our products and monitor inventory levels at our retail customers in an effort to manage the balance between supply and demand in the retail channel. Results for any
one quarter are not necessarily indicative of results to be expected for any other quarter or for any year.

Backlog

Historically, we received most of our orders three to four months prior to the date the products were shipped to customers. At
December 31, 2008, our backlog was approximately $4.3 million, compared to approximately $7.2 million at December 31, 2007. Although generally, these orders are not subject
to cancellation prior to the date of shipment, cancellations have and may continue to occur. During the second half of 2007 and continuing through 2008, many of our retail customers were cautious when
placing future orders with us and shifting toward shorter lead times. We believe this was attributed to retail softness in footwear and apparel. This trend required us to take more aggressive
inventory position to be able to meet at-once orders. While we will continue to experience some rescheduled orders, cancellations and returns in the normal course of business, we do not
anticipate, at this time, for those to be as significant as those we encountered during the second half of 2007 and continuing into the first half of 2008. We expect our retail customers to continue
to be more cautious when placing future orders and shifting toward shorter lead times and at-once inventory purchases. We will continue to provide marketing, promotional and advertising
support to our retail customers to promote the sell-through of our products. We will actively monitor inventory levels at our retail customers in an effort to manage the balance between
supply and demand in the retail channel. For a variety of reasons, including the timing of release dates for our product offerings, shipments, order deadlines and receipt of orders, backlog may not be
a reliable measure of future sales and may not be comparable from one period to another.

Vulnerability Due to Customer Concentration

In 2006, Journeys represented 12.7% of our net sales. For 2007, Finish Line accounted for 13.2% of our net sales. In 2008, Journeys
represented 9.9% of our net sales. No other retail customer or independent distributor accounted for 10% or more of our net sales in any of these periods. We anticipate that our net sales may remain
concentrated for the foreseeable future. If any of our significant retail customers or independent distributors decreases its purchases of our products or stops purchasing our products our net sales
and results of operations could be adversely affected.

Critical Accounting Policies

Our management's discussion and analysis of our financial condition and results of operations are based upon our consolidated financial
statements, which have been prepared in accordance with accounting principles generally accepted in the United States of America. The preparation of these consolidated financial statements requires
management to make estimates and judgments that affect the reported amounts of assets, liabilities, net sales and expenses and related disclosure at the date of our financial statements. We
continually evaluate our estimates and judgments, including those related to net sales, collectability of accounts receivable, inventory reserve allowances, long-lived assets, income taxes
and stock-based compensation. We base our estimates and judgments on historical experience and on various other factors that we believe to be reasonable under the circumstances, the results of which
form the basis of our judgments about the carrying values of assets and liabilities that are not readily apparent from other sources. Actual results or changes in the estimates or other judgments of
matters inherently uncertain that are included within these accounting policies could result in a significant change to the information presented in the consolidated financial statements. We believe
that the

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following
discussion addresses the critical accounting policies that are necessary to understand and evaluate our reported consolidated financial results.

Revenue Recognition.Revenues are recognized when merchandise is shipped and the customer takes title and assumes risk of loss,
collection of
relevant receivables are probable, persuasive evidence of an arrangement exists and the sales price is fixed or determinable. Title passes upon shipment or upon receipt by the customer depending on
the agreement with the customer. Revenues are stated net of estimated returns and other allowances, including permitted returns of damaged or defective merchandise and marketing discretionary funds.
Other allowances include funds for promotional and marketing activities and a volume-based incentive program. We base our estimates and judgments on historical experience and other various factors
including customer communications, and analysis of relevant market information.

Reserve for Uncollectible Accounts Receivable.We continually make estimates relating to the collectability of our accounts receivable
and maintain a
reserve for estimated losses resulting from the failure of our customers to make required payments. In determining the amount of the reserve, we consider our historical level of credit losses and make
judgments about the creditworthiness of significant customers. Because we cannot predict future changes in the financial stability of our customers, actual future losses from uncollectible accounts
may differ from our estimates. If the financial condition of our customers were to deteriorate, resulting in their inability to make payments, a larger reserve might be
required. If we determined that a smaller or larger reserve was appropriate, we would record a benefit or charge to general and administrative expense in the period in which we made such a
determination.

Inventory Write-Downs.Our inventories are stated at the lower of cost or market. Inventory quantities are regularly reviewed and
provisions for
excess or obsolete inventory are recorded primarily based on the forecast of future demand and market conditions. If we estimate that the net realizable value of our inventory is less than the cost of
the inventory recorded on our books, we record a write-down equal to the difference between the cost of the inventory and the estimated net realizable value. This write-down is
recorded to cost of sales. If changes in market conditions result in reductions in the estimated net realizable value of our inventory below our previous estimate, we would increase our
write-down in the period in which we made such a determination and record it to cost of sales.

Property and Equipment.Property and equipment, including furniture and fixtures, office equipment, plant equipment, leasehold
improvements, computer
hardware and software are recorded at cost and this cost is depreciated over the asset's estimated useful life. We continually evaluate whether events and circumstances have occurred that indicate the
remaining estimated useful life of long-lived assets may warrant revision or that the remaining balance may not be recoverable. These factors may include a significant deterioration of
operating results, changes in business plans or changes in anticipated cash flow. When factors indicate that a long-lived asset should be evaluated for possible impairment, we review the
asset or property to assess recoverability from future operations using the undiscounted pre-tax future net cash flows expected to be generated by that asset or property. Impairments are
recognized in earnings to the extent that the carrying value exceeds fair value.

Goodwill and Other Intangible Assets.In accordance with SFAS No. 142,Goodwill and Other Intangible
Assets("SFAS 142"), goodwill and intangible assets with indefinite lives are not amortized but are instead measured for impairment at least annually, or when events
indicate that an impairment might exist. As required by SFAS 142, in impairment tests for goodwill, we compared the estimated fair value of goodwill to the carrying value over our estimate of
fair value. Our estimates of fair value utilized in goodwill tests may be based upon a number of factors, including assumptions about the expected future operating performance of our reporting units.
Estimates may change in future periods due to, among other things, the expected future operating performance of our reporting units. Estimates may also change in future periods as a result of, among
other things, technological change,

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economic
conditions, change to our business operations or inability to meet business plans. Such changes may result in impairment charges recorded in future periods. Any impairment charge related to
goodwill would be classified as a separate line item on the consolidated statement of operations for
amounts necessary to reduce the carrying value of the asset to fair value. In the fourth quarter of 2008, we performed the required annual impairment test and determined that no goodwill impairment
existed.

Income Tax.Tax laws require items to be included in our tax returns at different times than when these items are reflected in the
consolidated
financial statements. Some of these differences are permanent, such as expenses that are not deductible in our tax return, and some differences reverse over time, such as depreciation expense. These
timing differences create deferred tax assets and liabilities. We assess the realizability of our deferred tax assets to determine whether a valuation allowance is required. Based on all available
evidence, both positive and negative, and the weight of that evidence to the extent such evidence can be objectively verified, if we determine if it is more likely than not the deferred tax asset will
not be realized a valuation allowance is established.

Uncertain Tax Positions.In July 2006, the Financial Accounting Standards Board ("FASB") issued FASB Interpretation No. 48, Accounting for Uncertainty in Income Taxes("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 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. Significant judgment is required in
determining whether the recognition threshold has been met for recording an uncertain tax benefit and in determining the appropriate measurement of the uncertain benefit under FIN 48.

Stock-Based Compensation.We account for stock-based compensation in accordance with SFAS No. 123(R), which requires the
measurement of
compensation cost based on the estimated fair value of the award on the date of grant. We recognize that cost using the straight-line method over the period during which an employee is
required to provide service in exchange for the awardthe requisite service period. No compensation cost is recognized for equity instruments for which employees do not render the
requisite service. We determine the grant-date fair value of employee stock options using the Black-Scholes option-pricing model. The amount of compensation expense recognized will depend
upon numerous factors and estimates, including the number and vesting period of option grants, the publicly traded price of our common stock, the estimated volatility of our common stock price,
estimates of the timing and volume of exercises and forfeitures of the options and fluctuations in future interest and income tax rates.



See Note 2Summary of Significant Accounting Policies of the Notes to Consolidated Financial Statements for
information regarding recently issued accounting pronouncements.

Item 7A.    Quantitative and Qualitative Disclosures about Market Risk

We had a $2.0 million revolving credit facility with JPMorgan Chase Bank, N.A. that expired on June 30, 2007. To the
extent we borrowed under our revolving credit facility, which bore interest at floating rates based either on the prime rate quoted by JPMorgan Chase Bank, N.A. or an adjusted LIBOR rate, we were
exposed to market risk related to changes in interest rates. In September 2007, we entered into a new $2.0 million revolving credit facility with JPMorgan Chase Bank, N.A. which expires on
June 30, 2009 and we have not borrowed under this revolving credit facility. To the extent we borrow under our revolving credit facility, which bears interest at floating rates based either on
the prime rate quoted by JPMorgan Chase Bank, N.A. or an adjusted LIBOR rate, we are exposed to market risk related to changes in interest rates. If applicable interest rates were to increase by 100
basis

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points,
for every $1.0 million outstanding under our revolving credit facility, our income before income taxes would be reduced by approximately $10,000 per year. We are not party to any
derivative financial instruments.

Our
independent distributors pay us in U.S. dollars. Because our independent manufacturers buy materials and pay for manufacturing expenses in their local currencies, to the extent the
U.S. dollar weakens compared to such local currencies, our operating results may be adversely affected. Conversely, to the extent the U.S. dollar strengthens compared to local currencies in foreign
markets where our products are sold, our products may appear more expensive relative to local products.

Item 8.    Consolidated Financial Statements and Supplementary Data

Information with respect to this Item is set forth beginning on page F-1.

Item 9.    Changes in and Disagreements with Accountants on Accounting and Financial Disclosure

None.

Item 9A.    Controls and Procedures

Evaluation of Disclosure Controls and Procedures

The term "disclosure controls and procedures" refers to the controls and other procedures of a company that are designed to provide
reasonable assurance that information required to be disclosed by a company in the reports that it files or submits under the Exchange Act, is recorded, processed, summarized and reported within
required time periods. We have established disclosure controls and procedures to ensure that material information relating to Heelys, Inc. and its consolidated subsidiaries is made known to the
officers who certify our financial reports, as well as other members of senior management and the Board of Directors, to allow timely decisions regarding required disclosures. As of the end of the
period covered by this annual report on Form 10-K, we carried out an evaluation under the supervision and with the participation of our management, including our Interim Chief
Executive Officer and Chief Financial Officer, of the effectiveness of the design and operation of our disclosure controls and procedures pursuant to Rule 13a-15 of the Exchange
Act. Based upon that evaluation, our Interim Chief Executive Officer and Chief Financial Officer concluded that our disclosure controls and procedures are effective.

Inherent Limitations on Effectiveness of Controls

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

52

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controls
may become inadequate because of changes in conditions or deterioration in the degree of compliance with policies or procedures.

Changes in Internal Control over Financial Reporting

There were no changes to our internal controls over financial reporting that have materially affected, or are reasonably likely to
materially affect, our internal controls over financial reporting during the fourth quarter of 2008. We have completed our efforts regarding compliance with Section 404 of the Sarbanes-Oxley
Act of 2002 for the year ended December 31, 2008. The results of our evaluation are discussed below in Management's Report on Internal Control Over Financial Reporting.

Management's Report on Internal Control over Financial Reporting

Our management is responsible for establishing and maintaining adequate internal control over financial reporting, as such term is
defined in Rule 13a-15(f) of the Exchange Act. Internal control over financial reporting includes those policies and procedures that (i) pertain to the maintenance of records
that, in reasonable detail, accurately and fairly reflect the transactions and dispositions of our assets; (ii) provide reasonable assurance that transactions are recorded as necessary to
permit preparation of financial statements in accordance with generally accepted accounting principles, and that our receipts and expenditures are being made only in accordance with authorizations of
our management and directors; and (iii) provide reasonable assurance regarding prevention or timely detection of unauthorized acquisition, use or disposition of our assets that could have a
material effect on our financial statements.

We
conducted an evaluation of the effectiveness of our internal control over financial reporting based on the framework inInternal ControlIntegrated
Frameworkissued by the Committee of Sponsoring Organizations of the Treadway Commission (COSO). Based on our evaluation under the framework inInternal
ControlIntegrated Framework,our management has concluded that as of December 31, 2008, our internal control over financial reporting is effective.

Our
independent registered public accountants, Deloitte & Touche LLP, audited the consolidated financial statements included in this annual report on
Form 10-K and have issued an attestation report on the effectiveness of our internal control over financial reporting as of December 31, 2008, which is included below.

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REPORT OF INDEPENDENT REGISTERED PUBLIC ACCOUNTING FIRM

To
the Board of Directors and Stockholders of
Heelys, Inc.
Carrollton, Texas

We
have audited the internal control over financial reporting of Heelys, Inc. and subsidiaries (the "Company") as of December 31, 2008, based on criteria established in Internal ControlIntegrated
Frameworkissued by the Committee of Sponsoring Organizations of the Treadway Commission. The Company's
management is responsible for maintaining effective internal control over financial reporting and for its assessment of the effectiveness of internal control over financial reporting, included in the
accompanying Management's Report on Internal Control over Financial Reporting. Our responsibility is to express an opinion on the Company's internal control over financial reporting 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 effective internal control over financial reporting was maintained in all material respects. Our audit included obtaining an understanding of internal control
over financial reporting, assessing the risk that a material weakness exists, testing and evaluating the design and operating effectiveness of internal control based on the assessed risk, and
performing such other procedures as we considered necessary in the circumstances. We believe that our audit provides a reasonable basis for our opinion.

A
company's internal control over financial reporting is a process designed by, or under the supervision of, the company's principal executive and principal financial officers, or
persons performing similar functions, and effected by the company's board of directors, management, and other personnel to provide reasonable assurance regarding the reliability of financial reporting
and the preparation of financial statements for external purposes in accordance with generally accepted accounting principles. A company's internal control over financial reporting includes those
policies and procedures that (1) pertain to the maintenance of records that, in reasonable detail, accurately and fairly reflect the transactions and dispositions of the assets of the company;
(2) provide reasonable assurance that transactions are recorded as necessary to permit preparation of financial statements in accordance with generally accepted accounting principles, and that
receipts and expenditures of the company are being made only in accordance with authorizations of management and directors of the company; and (3) provide reasonable assurance regarding
prevention or timely detection of unauthorized acquisition, use, or disposition of the company's assets that could have a material effect on the financial statements.

Because
of the inherent limitations of internal control over financial reporting, including the possibility of collusion or improper management override of controls, material
misstatements due to error or fraud may not be prevented or detected on a timely basis. Also, projections of any evaluation of the effectiveness of the internal control over financial reporting to
future periods are subject to the risk that the controls may become inadequate because of changes in conditions, or that the degree of compliance with the policies or procedures may deteriorate.

In
our opinion, the Company maintained, in all material respects, effective internal control over financial reporting as of December 31, 2008, based on the criteria established in Internal ControlIntegrated
Frameworkissued by the Committee of Sponsoring Organizations of the Treadway Commission.

We
have also audited, in accordance with the standards of the Public Company Accounting Oversight Board (United States), the consolidated financial statements and financial statement
schedule as of and for the year ended December 31, 2008 of the Company and our report dated March 31, 2009 expressed an unqualified opinion on those consolidated financial statements and
financial statement schedule.

/s/ DELOITTE & TOUCHE LLP

Dallas,
Texas
March 31, 2009

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Item 9B.    Other Information

None.

PART III

Item 10.    Directors, Executive Officers and Corporate Governance

Incorporated by reference from the information in our proxy statement for the 2009 Annual Meeting of Stockholders, which we will file
with the SEC within 120 days of the end of the fiscal year to which this Report relates.

Code of Business Conduct and Ethics

We have adopted a code of business conduct and ethics that applies to all of our officers, directors and employees. Our code of
business conduct and ethics is posted on our website atwww.heelys.comand we will send a paper copy to any stockholder who submits a request in writing
to our Secretary. If we make any substantive amendments to this code of conduct or if we grant any waivers from a provision of such code of conduct to any director or executive officer, we will
promptly disclose the nature of the amendment or waiver on our website at the address provided above.

Item 11.    Executive Compensation

Incorporated by reference from the information in our proxy statement for the 2009 Annual Meeting of Stockholders, which we will file
with the SEC within 120 days of the end of the fiscal year to which this Report relates.

Item 12.    Security Ownership of Certain Beneficial Owners and Management and Related Stockholder Matters

Incorporated by reference from the information in our proxy statement for the 2009Annual Meeting of Stockholders, which we will file
with the SEC within 120 days of the end of the fiscal year to which this Report relates.

Item 13.    Certain Relationships and Related Transactions, and Director Independence

Incorporated by reference from the information in our proxy statement for the 2009 Annual Meeting of Stockholders, which we will file
with the SEC within 120 days of the end of the fiscal year to which this Report relates.

Item 14.    Principal Accounting Fees and Services

Incorporated by reference from the information in our proxy statement for the 2009 Annual Meeting of Stockholders, which we will file
with the SEC within 120 days of the end of the fiscal year to which this Report relates.

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PART IV

Item 15.    Exhibits and Financial Statement Schedules



|       |  |                                                                                                                                      |  |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                               |      |  |  | 
|------ |  | ------------------------------------------------------------------------------------------------------------------------------------ |  | --------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------- | ---- |  |  | 
|
|(a)(1) |  | Financial Statements                                                                                                                 | 
|       |  | The following documents are filed as a part of this report:                                                                          | 
|       |  | Report of Independent Registered Public Accounting Firm                                                                              | 
|       |  | Consolidated Balance Sheets as of December 31, 2007 and December 31, 2008                                                            | 
|       |  | Consolidated Statements of Operations for the Years ended December 31, 2006, 2007 and 2008                                           | 
|       |  | Consolidated Statements of Stockholders' Equity and Comprehensive Income (Loss) for the Years ended December 31, 2006,
2007 and 2008 | 
|       |  | Consolidated Statements of Cash Flows for the Years ended December 31, 2006, 2007 and 2008                                           | 
|       |  | Notes to Consolidated Financial Statements                                                                                           | 
|(2)    |  | Financial Statement Schedule                                                                                                         | 
|       |  | The following financial statement schedule is filed herewith:                                                                        |  |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                               |      | 
|       |  | Valuation and Qualifying Accounts and Reserves                                                                                       |  |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                               | F-40 | 
|(3)    |  | Exhibits                                                                                                                             |  |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                               |      | 
|       |  | (a)                                                                                                                                  |  | The following exhibits are incorporated by reference or filed herewith. References to the Form S-1 are to the Registrant's
Registration Statement on Form S-1 (File No. 333-137046), filed with the Securities and Exchange Commission (SEC) on September 1, 2006. References to Amendment No. 1 to Form S-1 are to Amendment No. 1 to the
Form S-1 filed with the SEC on October 4, 2006. References to Amendment No. 2 to Form S-1 are to Amendment No. 2 to the Form S-1 filed with the SEC on October 27, 2006. References to Amendment No. 3 to
Form S-1 are to Amendment No. 3 to the Form S-1 filed with the SEC on November 24, 2006. |     



Exhibit No.

Description3.1

Certificate of Incorporation of the Registrant (incorporated by reference to Exhibit 3.1 to the Form S-1).3.2

By-Laws of the Registrant (incorporated by reference to Exhibit 3.1 to Amendment No. 2 to the Form S-1).4.1

Form of Registrant's Common Stock certificate (incorporated by reference to Exhibit 4.1 to Amendment No. 3 to the Form S-1).10.1

Registration Rights Agreement, dated May 26, 2000, among the Registrant, Samuel B. Ligon and Patricia P. Ligon and Capital Southwest Venture Corporation (incorporated by reference to Exhibit 10.1
to the Form S-1).10.2

Manufacturing Agreement, dated March 8, 2001, between Bu Kyung Industrial and Heeling Sports Limited (incorporated by reference to Exhibit 10.2 to the Form S-1).10.3

Consulting Agreement, dated September 30, 2006, between Boss Technical Services and Heeling Sports Limited (incorporated by reference to Exhibit 10.3 to Amendment No. 2 to the
Form S-1).10.4

Lease Agreement, dated November 4, 2004, between CP Commercial PropertiesXIX, Inc. and Heeling Sports, Limited, as amended by the First Amendment to Lease Agreement, dated February 27, 2006, for
3200 Belmeade, Suite 100, Carrollton, Texas (incorporated by reference to Exhibit 10.5 to the Form S-1).


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Exhibit No.

Description10.5

Letter Agreement, dated June 28, 2006, by and between Richard E. Middlekauff and Roger R. Adams, and approved by the Registrant (incorporated by reference to Exhibit 10.9 to the
Form S-1).10.6

Amended and Restated Employment Agreement, dated as of November 16, 2006, between Michael W. Hessong and Heeling Sports Limited (incorporated by reference to Exhibit 10.11 to Amendment No. 3 to the
Form S-1).*10.7

Employment Agreement, dated as of September 18, 2006, between Patrick F. Hamner and Heeling Sports Limited (incorporated by reference to Exhibit 10.14 to Amendment No. 2 to the
Form S-1).*10.8

Waiver and Agreement, dated as of September 14, 2006, among the Registrant, Roger R. Adams, Richard E. Middlekauff, Robert J. Ward, CYPO, Inc., Heeling Holding Corporation, Heeling Management
Corporation, Samuel B. Ligon and Patricia P. Ligon and Capital Southwest Venture Corporation (incorporated by reference to Exhibit 10.15 to Amendment No. 3 to the Form S-1).10.9

2006 Stock Incentive Plan, as amended by Amendment to Heeling, Inc. 2006 Stock Incentive Plan and form of Stock Option Agreement thereunder (incorporated by reference to Exhibit 10.16 to the
Form S-1).*10.10

Form of Indemnification Agreement entered into by the Registrant with each of its directors and executive officers (incorporated by reference to Exhibit 10.18 to the Form S-1).*10.11

Intellectual Property Exclusive License Agreement, dated and effective as of September 23, 2002, between Heeling Sports Limited and Curtis Holdings, LLC; Intellectual Property Purchase Agreement, dated
September 23, 2002, between Heeling Sports Limited and Curtis Holdings, LLC, and Letter Agreement, dated January 5, 2006, between Heeling Sports Limited and Curtis Holdings, LLC (incorporated by reference to Exhibit 10.19 to
Amendment No. 1 to the Form S-1).10.12

Investor Rights Agreement, dated as of May 24, 2000, among the Registrant, Roger R. Adams, Richard E. Middlekauff, Robert J. Ward, Cypo, Inc., Heeling Holding Corporation, Heeling Management
Corp., Samuel P. Ligon and Patricia P. Ligon and Capital Southwest Venture Corporation (incorporated by reference to Exhibit 10.20 to Amendment No. 2 to the Form S-1).10.13

Heelys, Inc. Annual Incentive Plan (incorporated by reference to Exhibit 10.1 of the Registrant's Current Report on Form 8-K filed on April 17, 2007) (The Securities and Exchange Commission has
granted confidential treatment for a portion of this document. A complete version of this document has been filed separately with the Securities and Exchange Commission.)*10.14

First Amendment to the Employment Agreement, Including Agreement to Arbitrate, Noncompetition Agreement and Nondisclosure Agreement, dated as of April 11, 2007, between Patrick F. Hamner and Heelys,
 Inc. (incorporated by reference to Exhibit 10.3 of the Registrant's Current Report on Form 8-K filed on April 17, 2007)*10.15

First Amendment to the Amended and Restated Employment Agreement, Including Agreement to Arbitrate, Noncompetition Agreement and Nondisclosure Agreement, dated as of April 11, 2007, between Michael W.
Hessong and Heelys, Inc. (incorporated by reference to Exhibit 10.4 of the Registrant's Current Report on Form 8-K filed on April 17, 2007)*


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Exhibit No.

Description10.16

First Amended and Restated Consulting Agreement, dated as of August 1, 2007, between Boss Technical Services and Heeling Sports Limited. (incorporated by reference to Exhibit 10.1 of the Registrant's Current
Report on Form 8-K filed on August 14, 2007)10.17

Employment Agreement, Including Agreement to Arbitrate, Noncompetition Agreement and Nondisclosure Agreement, dated as of April 12 2007, between William D. Albers and Heeling Sports Limited. (incorporated by
reference to Exhibit 10.1 of the Registrant's Current Report on Form 8-K filed on September 5, 2007) The Securities and Exchange Commission has granted confidential treatment for a portion of this document. A complete version of this
document has been filed separately with the Securities and Exchange Commission.)*10.18

Employment Agreement, Including Agreement to Arbitrate, Noncompetition Agreement and Nondisclosure Agreement, dated as of July 5, 2007, between John O'Neil and Heeling Sports Limited. (incorporated by reference
to Exhibit 10.2 of the Registrant's Current Report on Form 8-K filed on September 5, 2007) The Securities and Exchange Commission has granted confidential treatment for a portion of this document. A complete version of this document
has been filed separately with the Securities and Exchange Commission.)*10.19

Employment Agreement, Including Agreement to Arbitrate, Noncompetition Agreement and Nondisclosure Agreement, dated as of August 31, 2007, between James S. Peliotes and Heeling Sports Limited. (incorporated by
reference to Exhibit 10.3 of the Registrant's Current Report on Form 8-K filed on September 5, 2007) The Securities and Exchange Commission has granted confidential treatment for a portion of this document. A complete version of this
document has been filed separately with the Securities and Exchange Commission.)*10.20

Credit Agreement dated as of September 19, 2007, between JPMorgan Chase Bank, N.A. and Heeling Sports Limited (incorporated by reference to Exhibit 10.1 of the Registrant's Current Report on Form 8-K
filed on September 28, 2007)10.21

Line of Credit Note dated as of September 19, 2007, between JPMorgan Chase Bank, N.A. and Heeling Sports Limited (incorporated by reference to Exhibit 10.2 of the Registrant's Current Report on Form 8-K
filed on September 28, 2007)10.22

Negative Pledge Agreement dated as of September 19, 2007, between JPMorgan Chase Bank, N.A. and Heeling Sports Limited (incorporated by reference to Exhibit 10.3 of the Registrant's Current Report on
Form 8-K filed on September 28, 2007)10.23

Severance and General Release Agreement dated as of February 1, 2008, between Michael G. Staffaroni and Heeling Sports Limited (incorporated by reference to Exhibit 10.1 of Registrant's Current Report
on Form 8-K filed on February 4, 2008).*10.24

Settlement Agreement and Technology License Agreement dated as of March 11, 2008, between Heeling Sports Limited and Elan-Polo, Inc. (incorporated by reference to Exhibit 10.2 of the Registrant's
Quarterly Report on Form 10-Q for the quarter ended March 31, 2008 filed on May 12, 2008) (The Securities and Exchange Commission has granted confidential treatment for a portion of this document. A complete version of this document
has been filed separately with the Securities and Exchange Commission.)


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Exhibit No.

Description10.25

Termination Agreement dated as of March 13, 2008, between Heeling Sports Limited and The Territory Distribution GmbH (the "Distributor") and Achim Lippoth, a German individual and the sole owner of the
Distributor. (incorporated by reference to Exhibit 10.3 of the Registrant's Quarterly Report on Form 10-Q for the quarter ended March 31, 2008 filed on May 12, 2008) (The Securities and Exchange Commission has granted confidential
treatment for a portion of this document. A complete version of this document has been filed separately with the Securities and Exchange Commission.)10.26

Consulting Agreement dated as of March 31, 2008, between Heeling Sports EMEA and The Sansean Group Limited. (incorporated by reference to Exhibit 10.4 of the Registrant's Quarterly Report on Form 10-Q
for the quarter ended March 31, 2008 filed on May 12, 2008) (The Securities and Exchange Commission has granted confidential treatment for a portion of this document. A complete version of this document has been filed separately with the
Securities and Exchange Commission.)10.27

Consulting Agreement dated as of March 31, 2008, between Heeling Sports EMEA and Achim Lippoth, a German individual. (incorporated by reference to Exhibit 10.5 of the Registrant's Quarterly Report on
Form 10-Q for the quarter ended March 31, 2008 filed on May 12, 2008) (The Securities and Exchange Commission has granted confidential treatment for a portion of this document. A complete version of this document has been filed
separately with the Securities and Exchange Commission.)10.28

Termination Agreement dated as of April 30, 2008, between Heeling Sports Limited and Trotwood Import/Export (the "Distributor"), Trotwood Investments Ltd., the sole owner of the Distributor (the
"Shareholder") and David Stanley and Margarete Stanley, the sole owners of the Shareholder. (incorporated by reference to Exhibit 10.6 of the Registrant's Quarterly Report on Form 10-Q for the quarter ended March 31, 2008 filed on
May 12, 2008) (The Securities and Exchange Commission has granted confidential treatment for a portion of this document. A complete version of this document has been filed separately with the Securities and Exchange Commission.)10.29

Consulting Agreement dated as of April 30, 2008, between Heeling Sports EMEA and Trotwood Investments Ltd. represented by Margarete Stanley. (incorporated by reference to Exhibit 10.7 of the
Registrant's Quarterly Report on Form 10-Q for the quarter ended March 31, 2008 filed on May 12, 2008) (The Securities and Exchange Commission has granted confidential treatment for a portion of this document. A complete version of
this document has been filed separately with the Securities and Exchange Commission.)10.30

Consulting Agreement dated as of April 30, 2008, between Heelys, Inc. and Patrick F. Hamner (incorporated by reference to Exhibit 10.1 of Registrant's Current Report on Form 8-K filed on
May 2, 2008).*10.31

Employment Agreement dated as of July 17, 2008, between Heelys, Inc. and Donald K. Carroll (incorporated by reference to Exhibit 10.1 of Registrant's Current Report on Form 8-K/A filed on
July 23, 2008).*10.32

Amendment No. 2 to the Heelys, Inc. 2006 Stock Incentive Plan, as amended (incorporated by reference to Exhibit 4.1 of Registrant's Registration Statement on Form S-8 filed on August 11,
2008).*10.33

Executive Employment Agreement, dated as of August 29, 2008, between Heeling Sports Limited and Lisa K. Peterson (incorporated by reference to Exhibit 10.1 of Registrant's Current Report on
Form 8-K/A filed on September 4, 2008).*


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Exhibit No.

Description10.34

Executive Employment Agreement, dated as of August 29, 2008, between Heeling Sports Limited and John Benton Price (incorporated by reference to Exhibit 10.2 of Registrant's Current Report on Form 8-K/A
filed on September 4, 2008).*10.35

Executive Employment Agreement, dated as of October 28, 2008, between Heeling Sports Limited and Willian D. Albers (incorporated by reference to Exhibit 10.1 of Registrant's Current Report on
Form 8-K filed on October 31, 2008).*10.36

Executive Employment Agreement, dated as of October 28, 2008, between Heeling Sports Limited and John W. O'Neil (incorporated by reference to Exhibit 10.1 of Registrant's Current Report on Form 8-K
filed on October 31, 2008).*10.37

Severance and General Release Agreement dated as of February 10, 2009, between Donald K. Carroll and Heeling Sports Limited (incorporated by reference to Exhibit 10.1 of Registrant's Current Report on
Form 8-K filed on February 10, 2009).*10.38

Letter Agreement dated as of February 9, 2009, between Michael W. Hessong and Heelys Inc. (incorporated by reference to Exhibit 10.2 of Registrant's Current Report on Form 8-K filed on
February 10, 2009).*21.1

List of subsidiaries of the Registrant.23.1

Consent of Deloitte & Touche LLP, independent registered public accounting firm.31.1

Certification pursuant to Rule 13a-14(a) under the Securities Exchange Act of 1934 by Michael W. Hessong, Interim Chief Executive Officer.31.2

Certification pursuant to Rule 13a-14(a) under the Securities Exchange Act of 1934 by Lisa K. Peterson, Chief Financial Officer.32.1

Certification by Interim Chief Executive Officer and Chief Financial Officer pursuant to 18 U.S.C. Section 1350.


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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.

HEELYS, INC.By:

/s/ MICHAEL W. HESSONG Michael W. Hessong Interim Chief Executive Officer


Date:
March 31, 2009

Pursuant
to the requirements 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/s/ MICHAEL W. HESSONG Michael W. Hessong

Interim Chief Executive Officer (Principal Executive Officer)

March 31, 2009/s/ LISA K. PETERSON Lisa K. Peterson

Chief Financial Officer (Principal Financial Officer)

March 31, 2009/s/ GARY L. MARTIN Gary L. Martin

Chairman of the Board

March 31, 2009/s/ ROGER R. ADAMS Roger R. Adams

Director

March 31, 2009/s/ JERRY R. EDWARDS Jerry R. Edwards

Director

March 31, 2009/s/ PATRICK F. HAMNER Patrick F. Hamner

Director

March 31, 2009/s/ SAMUEL B. LIGON Samuel B. Ligon

Director

March 31, 2009


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Signature

Title

DateRichard E. Middlekauff

Director

March     , 2009/s/ RALPH T. PARKS Ralph T. Parks

Director

March 31, 2009/s/ JEFFREY G. PETERSON Jeffrey G. Peterson

Director

March 31, 2009


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HEELYS, INC.        INDEX TO CONSOLIDATED FINANCIAL STATEMENTS



PageReport of Independent Registered Public Accounting Firm

F-2Consolidated Balance Sheets as of December 31, 2007 and 2008

F-3Consolidated Statements of Operations for the Years Ended December 31, 2006, 2007 and
2008

F-4Consolidated Statements of Stockholders' Equity and Comprehensive Income (Loss) for the Years Ended
December 31, 2006, 2007 and 2008

F-5Consolidated Statements of Cash Flows for the Years Ended December 31, 2006, 2007 and
2008

F-6Notes to Consolidated Financial Statements

F-7 - F-41


F-1

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REPORT OF INDEPENDENT REGISTERED PUBLIC ACCOUNTING FIRM

To
the Board of Directors and Stockholders of
Heelys, Inc.
Carrollton, Texas

We
have audited the accompanying consolidated balance sheets of Heelys, Inc. and subsidiaries (the "Company") as of December 31, 2008 and 2007, and the related consolidated
statements of operations, stockholders' equity and comprehensive income (loss), and cash flows for each of the three years in the period ended December 31, 2008. Our audits also included the
financial statement schedule listed in the Index at Item 15. These consolidated financial statements and the financial statement schedule are the responsibility of the Company's management. Our
responsibility is to express an opinion on these consolidated financial statements and the financial statement schedule 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 provide a reasonable basis for our opinion.

In
our opinion, such consolidated financial statements presents fairly, in all material respects, the financial position of Heelys, Inc. and subsidiaries as of December 31,
2008 and 2007, and the results of their operations and their cash flows for each of the three years in the period ended December 31, 2008, in conformity with accounting principles generally
accepted in the United States of America. Also, in our opinion, such financial statement schedule, 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.

We
have also audited, in accordance with the standards of the Public Company Accounting Oversight Board (United States), the Company's internal control over financial reporting as of
December 31, 2008, based on the criteria established inInternal ControlIntegrated Frameworkissued by the Committee of Sponsoring
Organizations of the Treadway Commission and our report dated March 31, 2009 expressed an unqualified opinion on the Company's internal control over financial reporting.

/s/ DELOITTE & TOUCHE LLP

Dallas,
Texas
March 31, 2009

F-2

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HEELYS, INC.        CONSOLIDATED BALANCE SHEETS        AS OF DECEMBER 31, 2007 AND 2008        (In thousands, except share data)

December 31,2007

2008ASSETSCURRENT ASSETS:Cash and cash equivalents

$
98,771

$
68,446Accounts receivable, net of allowances of $1,458 and $664, respectively


5,577


6,594Inventories


14,969


12,104Prepaid and other current assets


1,439


831Income tax receivable


2,216


268Deferred income tax benefits, net of valuation allowance of $0 and $851, respectively


2,382


3,572Total current assets


125,354


91,815PROPERTY AND EQUIPMENT, net of accumulated depreciation of $1,094 and $1,352, respectively


923


1,007PATENTS AND TRADEMARKS, net of accumulated amortization of $1,019 and $1,136, respectively


359


310INTANGIBLE ASSETS, net of accumulated amortization of $0 and $254, respectively





1,412GOODWILL





1,668DEFERRED INCOME TAX BENEFITS, net of valuation allowance of $123 and $726, respectively


1,054


284TOTAL ASSETS

$
127,690

$
96,496LIABILITIES & STOCKHOLDERS' EQUITYCURRENT LIABILITIES:Accounts payable

$
306

$
1,910Accrued severance





304Accrued expenses


7,966


4,787Income taxes payable


884


1,347Total current liabilities


9,156


8,348LONG TERM LIABILITIESIncome taxes payable


1,572


442Other long term liabilities





1,331TOTAL LIABILITIES


10,728


10,121COMMITMENTS AND CONTINGENCIES (Note 11)STOCKHOLDERS' EQUITY:Common stock, $0.001 par value, 75,000,000 shares authorized; 27,074,856 shares issued and outstanding as of December 31, 2007 and
27,571,052 shares issued and outstanding as of December 31, 2008


27


28Additional paid-in capital


61,783


64,809Retained earnings


55,152


21,657Accumulated other comprehensive loss





(119
)Total stockholders' equity


116,962


86,375TOTAL LIABILITIES AND STOCKHOLDERS' EQUITY

$
127,690

$
96,496


See
notes to consolidated financial statements.

F-3

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HEELYS, INC.        CONSOLIDATED STATEMENTS OF OPERATIONS        FOR THE YEARS ENDED DECEMBER 31, 2006, 2007 AND 2008        (In thousands, except per
share data)

Year Ended December 31,2006

2007

2008NET SALES

$
188,208

$
183,472

$
70,741COST OF SALES


122,565


125,412


52,825Gross Profit


65,643


58,060


17,916SELLING, GENERAL AND ADMINISTRATIVE EXPENSESSelling and marketing


13,695


15,179


11,336General and administrative


6,436


11,096


14,935Severance








693Total selling, general and administrative expenses


20,131


26,275


26,964INCOME (LOSS) FROM OPERATIONS


45,512


31,785


(9,048
)OTHER EXPENSE (INCOME)Interest expense


760


86


101Interest income


(221
)

(3,580
)

(2,150
)Other expense (income), net


66


20


(1,151
)Exchange (gain) loss, net








593Total other expense (income)


605


(3,474
)

(2,607
)INCOME (LOSS) BEFORE INCOME TAXES


44,907


35,259


(6,441
)INCOME TAX EXPENSE (BENEFIT)


16,285


13,319


(517
)NET INCOME (LOSS)

$
28,622

$
21,940

$
(5,924
)EARNINGS (LOSS) PER SHARE:Basic

$
1.47

$
0.81

$
(0.22
)Diluted

$
1.14

$
0.78

$
(0.22
)WEIGHTED AVERAGE SHARES OUTSTANDING:Basic


19,479


27,060


27,321Diluted


25,114


28,214


27,321


See
notes to consolidated financial statements.

F-4

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Table of Contents



HEELYS, INC.        CONSOLIDATED STATEMENTS OF  STOCKHOLDERS' EQUITY AND COMPREHENSIVE INCOME (LOSS)        FOR THE YEARS ENDED DECEMBER 31, 2006, 2007 AND
2008        (In thousands)

Common Stock





Accumulated
Other
Comprehensive
LossAdditional
Paid-In
Capital

Retained
Earnings

Total
Stockholders'
EquityShares

AmountBALANCEDecember 31, 2005


13,989

$
14

$
140

$
8,590

$


$
8,744Comprehensive income:Net earnings











28,622





28,622Total comprehensive income

















28,622Purchase and retirement of treasury stock


(1,449
)







(4,000
)




(4,000
)Conversion of Series B redeemable preferred stock to common stock


11,364


10


115








125Initial public offering


3,125


3


58,794








58,797Stock option exercises


13





53








53Amortization of stock-based compensation expense








576








576Income tax benefit on stock-based compensation awards








117








117BALANCEDecember 31, 2006


27,042


27


59,795


33,212





93,034Comprehensive income:Net earnings











21,940





21,940Total comprehensive income

















21,940Stock option exercises


33





133








133Amortization of stock-based compensation expense








1,648








1,648Income tax benefit on stock-based compensation awards








207








207BALANCEDecember 31, 2007


27,075


27


61,783


55,152





116,962Comprehensive income (loss):Net earnings











(5,924
)




(5,924
)Foreign currency translation adjustment














(119
)

(119
)Total comprehensive income (loss)

















(6,043
)Stock option exercises


496


1


2,010








2,011Amortization of stock-based compensation expense








1,179








1,179Income tax benefit on stock-based compensation awards








(163
)







(163
)Dividends paid











(27,571
)(1)




(27,571
)BALANCEDecember 31, 2008


27,571

$
28

$
64,809

$
21,657

$
(119
)
$
86,375


---

See
notes to consolidated financial statements.

F-5

---





Table of Contents



HEELYS, INC.        CONSOLIDATED STATEMENTS OF CASH FLOWS        FOR THE YEARS ENDED DECEMBER 31, 2006, 2007 AND 2008        (In thousands)

Year Ended December 31,2006

2007

2008OPERATING ACTIVITIES:Net Income (Loss)

$
28,622

$
21,940

$
(5,924
)Adjustments to reconcile net income to net cash provided by (used in) operating activities:Depreciation and amortization


402


622


643Deferred income tax benefits


(872
)

(2,060
)

(583
)Stock-based compensation awards


576


1,648


1,179Excess tax benefit on stock-based compensation awards


(117
)

(207
)

(Loss) gain on disposal of property and equipment


1


35


24Unrealized loss on foreign exchange rates








609Inventory impairment charges





1,851


2,076Changes in operating assets and liabilities:Accounts receivable


(34,970
)

37,679


(1,122
)Inventory


(4,578
)

(10,763
)

598Prepaid and other current assets


(644
)

(477
)

596Accounts payable


1,086


(997
)

1,671Accrued expenses


4,852


841


(2,629
)Income taxes payable/receivable


3,462


(3,523
)

800Net cash provided (used in) operating activities


(2,180
)

46,589


(2,062
)INVESTING ACTIVITIES:Purchases of equipment


(310
)

(794
)

(378
)Increase in patents and trademarks


(195
)

(275
)

(74
)Acquisition of goodwill and intangible assets








(1,945
)Net cash used in investing activities


(505
)

(1,069
)

(2,397
)FINANCING ACTIVITIES:Purchase of treasury stock


(4,000
)




Borrowings on revolving credit facility


23,829





Principal payments on revolving credit facility


(23,829
)




Proceeds from issuance of short-term debt


4,958





Principal payments on short-term debt


(4,838
)

(211
)

Proceeds from exercise of stock options


35


133


2,010Excess tax benefit on stock-based compensation awards


117


207


Proceeds from initial public offering, net of expenses


59,859





Costs related to initial public offering





(1,062
)

Dividend payment








(27,571
)Net cash (used in) provided by financing activities


56,131


(933
)

(25,561
)EFFECT OF EXCHANGE RATE CHANGES ON CASH AND CASH EQUIVALENTS








(305
)NET INCREASE (DECREASE) IN CASH AND CASH EQUIVALENTS


53,446


44,587


(30,325
)CASH AND CASH EQUIVALENTS, beginning of period


738


54,184


98,771CASH AND CASH EQUIVALENTS, end of period

$
54,184

$
98,771

$
68,446SUPPLEMENTAL DISCLOSURES OF CASH FLOW INFORMATION:Cash paid during the period for:Interest

$
771

$
6

$
Income Taxes

$
13,750

$
19,200

$
1,079SUPPLEMENTAL DISCLOSURE OF NON-CASH INFORMATION:Acquisition of goodwill and intangible assets included in accrued expenses and other long term liabilities

$


$


$
1,451Conversion of Series B redeemable preferred stock into common stock

$
125

$


$
Accrued costs initial public offering

$
1,062

$


$
Receivable due from stock option excercises

$
18

$


$



See notes to consolidated financial statements.

F-6

---





Table of Contents



HEELYS, INC.        NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

1. COMPANY BACKGROUND

Heelys, Inc. and subsidiaries (the "Company" or "Heelys") designs, markets and distributes innovative, action sports-inspired products under the HEELYS brand targeted to the youth
market. The primary product, HEELYS-wheeled footwear, is patented, dual-purpose footwear that incorporates a stealth, removable wheel in the heel. HEELYS are distributed directly to retail
stores in the United States and certain European countries, and international wholesale distributors.

The
Company initially incorporated as Heeling, Inc. in Nevada in 2000. The Company was reincorporated in Delaware in August 2006 and changed its name to Heelys, Inc.
Through its general and limited partner interests, Heelys, Inc. owns 100% of Heeling Sports Limited, a Texas limited partnership, which was formed in May 2000.

In
February 2008, the Company formed Heeling Sports EMEA SPRL, a Belgium corporation and indirect wholly-owned subsidiary of the Company, with offices in Brussels, Belgium, with branch
offices in Germany and France, to manage the Company's European operations.

2. SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES

Consolidated Financial StatementsThe consolidated financial statements include the accounts of Heelys, Inc. and its subsidiaries. All
intercompany balances and transactions are eliminated in consolidation.

Use of EstimatesThe preparation of the consolidated financial statements in conformity with accounting principles generally accepted in the
United
States of America requires management to make estimates and assumptions that affect reported amounts of certain assets and liabilities and disclosure of contingent assets and liabilities at the date
of the consolidated financial statements and the reported amounts of revenues and expenses for the period. Management's significant estimates are as follows: allowances for estimated customer returns,
marketing discretionary funds; doubtful accounts; assessment of lower of cost or market on inventory; useful lives assigned to long-lived assets; income taxes including deferred taxes and
uncertain tax positions; legal reserves for current pending claims and estimated incurred-but-not-reported claims; and the value of common stock options for the
purpose of determining stock-based compensation cost. Actual results could differ from these estimates and the differences could be material. Differences are reported in the period in which they
become known.

Foreign Currency TranslationThe U.S. dollar is the Company's reporting currency. Assets and liabilities of foreign operations which are
denominated
in a functional currency other than the U.S. dollar are translated at the rate of exchange at the balance sheet date. Revenues and expenses are translated at the average rate of exchange during the
applicable period. Adjustments resulting from translating foreign functional currency financial statements into U.S. dollars are included in the foreign currency translation adjustment, a component of
accumulated other comprehensive income in
stockholders' equity. The impact of foreign currency translations was $119,000 in 2008. Prior to 2008, the Company did not have any foreign operations.

Foreign Currency TransactionsGains and losses generated by transactions denominated in a currency different from the functional currency of the
applicable entity are recorded in other income and expense in the period in which they occur. Net loss on foreign currency transactions was $593,000 for 2008. There were no gains or losses generated
during 2006 or 2007.

F-7

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Table of Contents

HEELYS, INC.

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued)

2. SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES (Continued)

Foreign Currency RemeasurementFor foreign operations whose records are not maintained in its functional currency, the Company remeasures the
financial statements into the functional currency before translation. Historical and current exchange rates are used in the remeasurement process depending on the nature of the account. All exchange
gains and losses from the remeasurement of monetary assets and liabilities that are not denominated in the functional currency are recognized in other expense or income.

Cash EquivalentsCash equivalents consist of highly liquid investments with original maturity dates of three months or less when purchased.

Concentration of RiskThe Company maintains substantially all of its cash and cash equivalents in one financial institution in amounts that exceed
federally insured limits. The Company has not experienced any losses in such accounts and believes it is not exposed to significant credit risk.

The
Company considers its concentration risk related to accounts receivable to be mitigated by the Company's credit policy, the significance of outstanding balances owed by each
individual customer at any point in time and the geographic dispersion of these customers.

The
Company outsources all of its manufacturing to a small number of independent manufacturers. Establishing replacement sources could require significant additional time and expense.

Accounts ReceivableAccounts receivable are stated net of allowances for estimated customer returns, marketing discretionary funds and doubtful
accounts of $1,458,000 and $664,000 at December 31, 2007 and 2008, respectively.

InventoriesInventories are stated at the lower of cost or market. Inventories are valued on a first-in first-out ("FIFO")
basis. Inventory costs include inbound freight. Inventory quantities are regularly reviewed and provisions for excess or obsolete inventory are recorded primarily based on the forecast of future
demand and market conditions. Ongoing estimates are made relating to the net realizable value of inventories. If the estimated net realizable value of inventory is less than the cost, a
write-down equal to the difference between the cost of the inventory and the estimated net realizable value is recorded. If changes in market conditions result in reductions in the
estimated net realizable value of inventory below previous estimates, an increase in the write-down is recorded in the period in which such a determination was made. At December 31,
2007, the Company recorded a $1.9 million write-down of inventories on-hand and a $617,000 loss on purchase commitments related to inventory that was still being held by
the manufacturers. During 2008, the Company charged cost of sales $2.1 million in order to properly state inventories at lower of cost or market. There was no loss on purchase commitments
recorded during 2008. All other purchasing and distribution costs associated with ending inventories are expensed. Inventories include $1,100,000 and $142,000 of estimated inventories to be returned
from retail customers at December 31, 2007 and 2008, respectively.

Property and EquipmentProperty and equipment, such as leasehold improvements, furniture and fixtures, equipment and product molds and designs,
are
stated at cost less accumulated depreciation and amortization. Depreciation and amortization are provided using the straight-line method over the estimated useful life of the asset.
Leasehold improvements are amortized over their estimated useful lives or the lease term, whichever is shorter.

F-8

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Table of Contents

HEELYS, INC.

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued)

2. SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES (Continued)

Patents and TrademarksThese intangibles are stated at cost less accumulated
amortization. Amortization is provided using the straight-line method over the estimated useful lives of five years.

Goodwill and Other Intangible AssetsIn accordance with SFAS No. 142,Goodwill and Other Intangible
Assets("SFAS 142"), goodwill is not amortized but is instead measured for impairment at least annually, or when events indicate that an impairment might exist. As
required by SFAS 142, the Company compares the estimated fair value of goodwill to the carrying value. The Company's estimates of fair value utilized in goodwill tests may be based upon a
number of factors, including assumptions about the expected future operating performance of our reporting units. Estimates may change in future periods due to, among other things, the expected future
operating performance of the Company's reporting units. Estimates may also change in future periods as a result of, among other things, technological change, economic conditions, changes to the
Company's business operations or inability to meet business plans. Such changes may result in impairment charges recorded in future periods. Any impairment charge related to goodwill would be
classified as a separate line item on the consolidated statement of operations for amounts necessary to reduce the carrying value of the asset to fair value. In the fourth quarter of 2008, the Company
performed the required annual impairment test and determined that no goodwill impairment existed.

Intangible
assets that are determined to have definite lives are amortized over their useful lives and are measured for impairment only when events or circumstances indicate the carrying
value may be impaired. In these cases, the Company estimates the future undiscounted cash flows to be derived from the asset to determine whether or not a potential impairment exists. If the carrying
value exceeds the Company's estimate of future undiscounted cash flows, the Company then calculates the impairment as the excess of the carrying value of the asset over the estimate of its fair value.
In the fourth quarter of 2008, the Company performed an impairment analysis and determined that no impairment existed.

Long-Lived AssetsIn accordance with SFAS No. 144,Accounting for the Impairment or Disposal of
Long-Lived Assets("SFAS 144"), the Company reviews its long-lived assets for impairment whenever events or changes in circumstances indicate
that the carrying amount of an asset may not be recoverable. Recoverability of assets held and used is generally measured by a comparison of the carrying amount of an asset to undiscounted pretax
future net cash flows expected to be generated by that asset. An impairment loss is recognized if the estimated undiscounted future cash flows are less than the carrying value of the related assets.
There were no impairments identified in the periods reported.

Income TaxesThe Company accounts for income taxes using the asset and liability method. This approach requires the recognition of deferred tax
assets
and liabilities for the expected future tax consequences of temporary differences between the carrying amounts and the tax bases of other assets and liabilities. The Company evaluates its ability to
realize the tax benefits associated with deferred tax assets and a valuation allowance is required to be established unless management determines that it is more likely than not that the Company will
ultimately realize the tax benefit associated with a deferred tax asset. Effective January 1, 2007, the Company adopted the provisions of Financial Accounting Standards Board ("FASB")
Interpretation No. 48,Accounting for Uncertainty in Income Taxes, an Interpretation of FASB Statement No. 109("FIN 48") which
addresses how the benefit of tax positions taken or expected to be taken on a tax return should be recorded in the financial statements. Under FIN 48, the Company recognizes the tax benefit
from an uncertain tax position only if it is more likely than not that the tax position will be sustained on examination by a taxing authority, based on the

F-9

---



Table of Contents

HEELYS, INC.

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued)

2. SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES (Continued)

technical
merits of the position. The amount recognized in the financial statements from an uncertain tax position is measured based on the largest amount of benefit that has a greater than 50%
likelihood of being realized upon ultimate resolution. To the extent a tax return position has not been reflected in income tax expense for financial reporting purposes, a liability ("unrecognized tax
benefit") is recorded.

Recognition of RevenuesRevenues are recognized when merchandise is shipped, title passes to the customer, the customer assumes risk of loss, the
collection of relevant receivables is probable, persuasive evidence of an arrangement exists and the sales price is fixed or determinable. Title passes upon shipment or upon receipt by the customer
depending on the agreement with the customer. The Company records reductions to revenue for estimated returns, including permitted returns of damaged or defective merchandise, and for all other
allowances, in accordance with Emerging Issues Task Force Issue 01-09,Accounting for Consideration Given by a Vendor to a Customer or a Reseller of the Vendor's
Product, at the time of revenue recognition. Accordingly, the Company provided total allowances of $3,416,000, $12,596,000 and $1,138,000 during 2006, 2007 and 2008,
respectively.

Advertising CostsAdvertising production costs are expensed the first time the advertisement is run. Media (TV, radio and print) placement costs
are
expensed in the month the advertising appears or is aired. Through cooperative advertising programs, the Company reimburses its retail customers for certain of their costs of advertising the Company's
products. The Company records these costs in selling and marketing expense at the point in time when it is obligated to its customers for the costs, which is when the related revenues are recognized.
This obligation may arise prior to the related advertisement being run. Total advertising and promotion expenses were $3,167,000, $7,890,000 and $6,948,000 during 2006, 2007 and 2008, respectively.
Prepaid advertising and promotion expenses recorded in prepaid and deferred expenses totaled $131,000 and $49,000 at December 31, 2007 and 2008, respectively.

Shipping and Handling CostsShipping and handling costs are expensed as incurred and included in costs of sales. Shipping and handling costs
included
in cost of sales were $5,389,000, $4,384,000 and $3,365,000 during 2006, 2007 and 2008, respectively. Shipping and handling costs billed to customers are included in net sales in accordance with
Emerging Issues Task Force Issue 00-10,Accounting for Shipping and Handling Fees and Costs, and were $800,000, $533,000 and $73,000 during
2006, 2007 and 2008, respectively.

InsuranceThe Company's insurance retention for general liability claims is $25,000 per claim for claims incurred through May 31, 2006, and
$50,000 per claim for claims after May 31, 2006. In accordance with SFAS No. 5,Accounting for Contingencies("SFAS 5"), an
estimated liability is provided for current pending claims and estimated incurred-but-not-reported claims due to this retention risk. As required by SFAS 5,
a liability is accrued by a charge to income if it is probable that a liability had been incurred at the date of the financials statements, and the amount of loss can be reasonably estimated. A
liability for estimated claims in the amount of $167,000 and $141,000 as of December 31, 2007 and 2008, respectively, is therefore reflected in the balance sheet as an accrued liability.

Earnings (loss) per ShareBasic earnings (loss) per common share is calculated by dividing net income (loss) available to common stockholders for
the
period by the weighted-average number of common shares outstanding during the period. Diluted earnings (loss) per share reflects the effects of potentially dilutive securities that could share in the
earnings (loss) of the Company. A reconciliation of

F-10

---



Table of Contents

HEELYS, INC.

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued)

2. SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES (Continued)

the
numerator and denominator used in the calculation of basic and diluted earnings per share is as follows (in thousands):

Year Ended December 31,2006

2007

2008Numeratornet income (loss) available to common stockholders

$
28,622

$
21,940

$
(5,924
)Denominator:Weighted average common stock outstanding for basic earnings per share


19,479


27,060


27,321Effect of dilutive securities:Preferred stock


5,061





Stock options


574


1,154


Adjusted weighted average common stock and assumed conversions for diluted earnings per share


25,114


28,214


27,321


Stock
options to purchase 216,250 and 1,666,423 shares of common stock at December 31, 2007 and December 31, 2008, respectively, were not included in the computation of
diluted earnings per share because the effect of their inclusion would be anti-dilutive.

Fair Value of Financial InstrumentsThe carrying value of financial instruments, including cash equivalents, accounts receivable, accounts payable
and
accrued expenses, approximate fair value due to their short maturities.

Recent Accounting PronouncementsIn September 2006, the FASB issued Statement No. 157,Fair Value
Measurements, ("SFAS 157"). The Company adopted SFAS 157 effective January 1, 2008. In February 2008, the FASB issued Staff Position
No. 157-2, which delayed the effective date of SFAS 157 for certain nonfinancial assets and liabilities, including fair value measurements under SFAS 141 and
SFAS 142 of goodwill and other intangible assets, to fiscal years beginning after November 15, 2008. Therefore, the Company has adopted the provisions of SFAS 157 with respect to
its financial assets and liabilities only. SFAS 157 defines fair value, establishes a framework for measuring fair value in generally accepted accounting principles, and expands disclosures
about fair value measurements. Fair value is defined under SFAS 157 as the exchange price that would be received for an asset or paid to transfer a liability (an exit price) in the principal or
most advantageous market for the asset or liability in an orderly transaction between market participants on the measurement date. Valuation techniques used to measure fair value under SFAS 157
must maximize the use of observable inputs and minimize the use of unobservable inputs. The standard describes a fair value hierarchy based on the following three levels of inputs, of which the first
two are considered observable and the last unobservable, that may be used to measure fair value: Level 1Quoted prices in active markets for identical assets or liabilities;
Level 2Inputs other than Level 1 that are observable, either directly or indirectly, such as quoted prices for similar assets or liabilities; quoted prices in markets that
are not active; or other inputs that are observable or can be corroborated by observable market data for substantially the full term of the assets or liabilities; and
Level 3Unobservable inputs that are supported by little or no market activity and that are significant to the fair value of the assets or liabilities. Upon issuance of

F-11

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Table of Contents

HEELYS, INC.

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued)

2. SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES (Continued)

SFAS 157
and as of December 31, 2008, the Company did not hold any assets or liabilities that are required to be measured at fair value on a recurring basis, and therefore the adoption
of the respective provisions of SFAS 157 did not have a material impact on the Company's financial position, cash flows or results of operations

In
February 2007, the FASB issued Statement No. 159,The Fair Value Option for Financial Assets and Financial LiabilitiesIncluding an
amendment of FASB Statement No. 115, ("SFAS 159"). SFAS 159 permits companies to measure many financial instruments and certain other items at fair value
at specified election dates. Unrealized gains and losses on these items will be reported in earnings at each subsequent reporting date. The fair value option may be applied instrument by instrument
(with a few exceptions), is irrevocable and is applied only to entire instruments and not to portions of instruments. The Company adopted SFAS 159 effective January 1, 2008. Upon
adoption, the Company did not elect the fair value option for any items within the scope of SFAS 159 and, therefore, the adoption of SFAS 159 did not have an impact on the Company's
financial position, cash flows or results of operations.

In
December 2007, the FASB issued Statement No. 141(R),Business Combinations, ("SFAS 141(R)"). SFAS 141(R) revises
the current accounting practices for business combinations. Significant changes as a result of issuance of SFAS 141(R) include a revised definition of a business, expensing of acquisition-
related transaction costs, and a change in how acquirers measure consideration, identifiable assets, liabilities assumed and goodwill acquired in a business combination. SFAS 141(R) is
effective for the
Company on January 1, 2009, and will be applied prospectively to all business combinations subsequent to the effective date. The Company does not expect SFAS 141(R) to have a material
impact on its financial position, cash flows or results of operations.

In
December 2007, the FASB issued Statement No. 160,Noncontrolling interests in Consolidated Financial Statementsan amendment of ARB
No. 51, ("SFAS 160"). SFAS 160 requires expanded disclosures in the consolidated financial statements that clearly identify and distinguish between the
interests of the controlling owners and the interests of noncontrolling owners of a subsidiary. SFAS 160 is effective for fiscal years beginning on or after December 15, 2008. The
Company does not expect SFAS 160 to have a material impact on its financial position, cash flows or results of operations.

In
March 2008, the FASB issued Statement No. 161,Disclosures about Derivative Instruments and Hedging Activitiesan amendment of FASB
Statement No. 133,("SFAS 161"). SFAS 161 requires enhanced disclosures for derivative instruments and hedging activities that include how and why an
entity uses derivatives, how instruments and the related hedged items are accounted for under SFAS 133 and related interpretations, and how derivative instruments and related hedged items
affect the entity's financial position, results of operations and cash flows. SFAS 161 is effective for financial statements issued for fiscal years and interim periods beginning after
November 15, 2008. The Company does not expect SFAS 161 to have a material impact on its financial position, cash flows or results of operations.

In
April 2008, the FASB issued FASB Staff Position ("FSP") No. 142-3,Determination of the Useful Life of Intangible
Assets("FSP 142-3"). FSP 142-3 amends the factors that should be considered in developing renewal or extension assumptions used to determine the useful
life of a recognized intangible asset under FASB Statement No. 142,Goodwill and Other Intangible Assets ("SFAS 142"). The intent of FSP
142-3 is to improve the consistency between the deemed useful life of a recognized intangible asset under SFAS 142 and the period of expected cash flows used to measure the fair
value

F-12

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Table of Contents

HEELYS, INC.

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued)

2. SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES (Continued)

of
the asset under SFAS 141(R) and other U.S. generally accepted accounting principles. FSP 142-3 is effective for financial statements issued for fiscal years and interim periods
beginning after December 15, 2008. The Company does not expect the adoption of FSP 142-3 to have a material impact on its financial position, cash flows or results of operations.

In
May 2008, the FASB issued Statement No. 162,The Hierarchy of Generally Accepted Accounting Principles, ("SFAS 162").
SFAS No. 162 is effective sixty days following the Securities and Exchange Commission ("SEC") approval of the Public Company Accounting Oversight Board amendments to AU Section 411, The Meaning of Present Fairly in
Conformity With Generally Accepted Accounting Principles, The Company does not expect SFAS 162 to have a
material impact on its financial position, cash flows or results of operations.

3. INITIAL PUBLIC OFFERING AND USE OF PROCEEDS

On December 13, 2006, the Company completed the initial public offering of its common stock pursuant to a Registration Statement (File No. 333-137046) that was
declared effective by the Securities and Exchange Commission on December 7, 2006. In that offering the Company sold a total of 3,125,000 shares of common stock and selling stockholders sold
4,263,750 shares of common stock, which included 963,750 shares resulting from the exercise of the underwriters' over-allotment option. All common stock registered under that registration
statement were sold at a price to the public of $21.00 per share. The Company did not receive any proceeds from the selling stockholders' sale of their shares.

The
net proceeds to the Company from the offering were approximately $58.8 million, after deducting underwriting discounts and commissions and other expenses incurred in
connection with the offering. As of December 31, 2008, we had used $8.5 million of these proceeds to repay amounts outstanding under our revolving credit facility, $27.7 million
for working capital purposes ($8.5 million in December 2006 and $19.2 million during 2007), and $8.6 million in 2008 to expand our international operations. The Company intends to
use the remaining proceeds to fund infrastructure improvements, working capital needs; and other general corporate purposes.

4. SIGNIFICANT CUSTOMERS

Customers of the Company consist of retail stores in the U.S. and certain European countries, and international wholesale distributors. The customers, individually or considered as a
group under common ownership, which accounted for greater than 10% of accounts receivable or 10% of net sales during the periods reflected were as follows:

Accounts
Receivable
December 31,

Net Sales
Years Ended
December 31,2007

2008

2006

2007

2008Journey's



%

8
%

13
%

9
%

10
%Finish Line








4


13


3Customer A


23


9





1


9Customer B


11


11


5


3


3Customer C


12


3


1


5


6Customer D


19


6





1


3


F-13

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Table of Contents

HEELYS, INC.

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued)

5. PROPERTY AND EQUIPMENT

Property and equipment included the following (in thousands):

December 31,Estimated
useful lives2007

2008Leasehold improvements

1 - 10 years

$
439

$
497Furniture and fixtures

7 years


160


191Computer equipment (including software)

5 years


478


652Equipment

5 years


123


135Product molds and designs

2 years


817


884Total




2,017


2,359Less accumulated depreciation and amortization




(1,094
)

(1,352
)Property and equipmentnet



$
923

$
1,007


Depreciation
expense related to property and equipment was $151,000, $228,000 and $258,000 in 2006, 2007 and 2008, respectively.

6. PATENTS AND TRADEMARKS

Patents and trademarks included the following (in thousands):

December 31,2007

2008Patents

$
1,176

$
1,226Trademarks


177


195Other


25


25Total


1,378


1,446Less accumulated amortization


(1,019
)

(1,136
)Patents and trademarksnet

$
359

$
310


Amortization
expense related to patents and trademarks was $251,000, $394,000 and $130,000 in 2006, 2007 and 2008, respectively. The amortization amounts include write-offs
of $13,000, $244,000 and $8,000 in 2006, 2007 and 2008, respectively, for patents and trademarks that were evaluated as having no future benefits. Amortization expense from 2009 through 2013 is
expected to be $104,000, $89,000, $65,000, $39,000 and $13,000, respectively.

In
September 2002, the Company entered into an Intellectual Property Exclusive License Agreement (the "License Agreement"), which granted the Company an exclusive worldwide license to
use various marks, trademarks, URLs, patents and patent applications related to the technology used in the Company's grind-and-roll HEELYS-wheeled footwear (collectively, the
"Intellectual Property"). At December 31, 2002, the Company capitalized, as patents in progress, an escrow deposit of $100,000 required under the License Agreement that converted to the
purchase price of the Intellectual Property upon execution of the Purchase Agreement. The Company also capitalized $102,000 in brokerage and legal fees related to these agreements as patents in
progress at December 31, 2004. Upon the initial

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Table of Contents

HEELYS, INC.

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued)

6. PATENTS AND TRADEMARKS (Continued)

distribution
of products incorporating the Intellectual Property in 2003, the Company began to amortize these patents in progress over their estimated useful life. In January 2006, the Company
converted the License Agreement into an Intellectual Property Purchase Agreement (the "Purchase Agreement"). Upon the conversion, the Company paid a non-compete fee of $25,000, which is
included in other intangible assets and is being amortized over five years, and became subject to a minimum royalty payment of $10,000 per month through January 2007.

Royalty
payments of 12% of the Company's cost of certain products, $1.00 per footwear unit for certain styles and 25% of any sublicense revenue of any non-footwear products,
apparel,
accessories, or similar products that would infringe the trademarks for such products absent the Company's agreements with respect to such trademarks were expensed as incurred under the License
Agreement. This royalty expense was $299,000, $278,000 and $44,000 in 2006, 2007 and 2008, respectively. The Company is no longer required to make royalty payments on sales of these certain products
subsequent to December 31, 2008.

7. INTANGIBLE ASSETS

Intangible assets included the following (in thousands):

December 31,
2008Non-compete agreements

$
233Customer lists


1,433Total


1,666Less accumulated amortization


(254
)Non-compete agreements and customer listsnet

$
1,412


Effective
March 31, 2008, the Company entered into agreements to terminate its arrangement regarding the distribution of Heelys-branded footwear and products in Germany and
Austria; and effective April 30, 2008, to terminate its arrangement regarding the distribution in France, Monaco and Andorra. The primary assets acquired as a result of the termination of these
distributorship agreements were the customer lists and goodwill. In addition, both of these former distributors agreed to not compete with the Company for a limited period of time.

Amortization
expense related to non-compete agreements and customer lists was $263,000 in 2008. Amortization expense from 2009 through 2013 is expected to be $357,000,
$327,000, $318,000, $318,000, and $92,000, respectively. Non-compete agreements are amortized over 2 to 5 years, and customer lists are amortized over 5 years.

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Table of Contents

HEELYS, INC.

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued)

8. ACCRUED EXPENSES

Accrued expenses consisted of the following (in thousands):

December 31,2007

2008Marketing costs

$
1,520

$
218Customer prepayments


638


91Credits due customers in excess of amounts owed


381


520Estimated credits due customers for markdown and return allowances in excess of amounts owed


3,392


134Legal settlement





722Payroll and payroll related costs


54


428Professional fees


654


903Loss on purchase commitments


617


235Payments duetermination of distributorship agreements (see Note 11)





624Other


710


912Total accrued expenses

$
7,966

$
4,787


Accrued
expenses at December 31, 2008, include $722,000, which represents the Company's estimate of the amounts to be paid in the settlements of the consolidated securities class
action and the consolidated derivative lawsuits discussed more fully in Note 11.

During
fiscal year 2008, the Company agreed to purchase a portion of the business operations, certain assets, and retain employees on a contractual basis of two of its former
distributors in Germany and France (discussed more fully in Note 11). The primary assets acquired as a result of these agreements were the customer lists and goodwill. In addition, both of
these former distributors agreed to not compete with the Company for a limited period of time. The fair value of the acquired assets was based upon the amount at which the assets could be bought or
sold in a current transaction between willing parties. As a result, the Company recorded goodwill and intangibles (including acquired customer relationships and non-compete agreements) in
the amount of $3.7 million (2.4 million Euro). As of December 31, 2008, the Company paid $1.9 million (1.2 million Euro) for these acquired assets with the balance
of $1.5 million (1.1 million Euro) to be paid out over time in accordance with the terms of the agreements; $1.3 million is recorded as other long term liability and $246,000 is
recorded as a current liability and is reflected in the table above. Additionally, as of December 31, 2008, the Company owed these distributors amounts related to unshipped orders and
consulting services. The Company records a liability, related to unshipped orders, when the order is fulfilled (shipped). This liability is paid on or before the end of the month following receipt of
payment by the customer. Liabilities for consulting services are recorded monthly as the consulting services are performed. As of December 31, 2008, a liability has been recorded related to
unshipped orders and consulting services in the amount of $378,000. This current liability is reflected in the table above.

9. ACCRUED SEVERANCE

On February 1, 2008, the Company entered into a Severance and General Release Agreement (the "Severance Agreement") with its former Chief Executive Officer ("CEO"). Under the
Severance Agreement, the former CEO is entitled to receive approximately $470,000, payable in ten semi-monthly

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Table of Contents

HEELYS, INC.

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued)

9. ACCRUED SEVERANCE (Continued)

installments
of approximately $17,000 beginning six months after the date of the Severance Agreement, followed by one lump sum payment of $300,000 payable in January 2009 and up to 14 months of
reimbursements for health and life insurance.

The
table below sets forth the significant components and activity under the severance agreement (in thousands):

December 31,
2007

Charges

Cash Payments

December 31,
2008Severance

$


$
470

$
(170
)
$
300Health and life insurance





16


(12
)

4Total

$


$
486

$
(182
)
$
304


The
Company's former CEO agreed to perform certain consulting services for the Company for one year with no additional monetary compensation. During the term of this consulting
relationship, options granted to the former CEO continue to vest in accordance with the Heelys, Inc. 2006 Stock Incentive Plan. On February 1, 2008, the Company recognized $207,000 in
stock-based compensation expense, which is 100% of the related stock-based compensation for those stock options expected to vest during the term of the consulting arrangement. This expense is included
in severance costs in the Statement of Operations.

10. DEBT

Revolving Credit FacilityIn August 2004, the Company entered into a $3,000,000 revolving credit facility with a predecessor of JPMorgan Chase
Bank,
N.A. In August 2006, the Company amended this revolving credit facility, increasing the maximum amount available to $25.0 million. In December 2006, all amounts outstanding under this revolving
credit facility were repaid with a portion of the proceeds from the Company's initial public offering. The maximum amount available under this revolving credit facility decreased to
$10.0 million on January 1, 2007. On February 7, 2007, the Company amended the revolving credit facility to (a) decrease the maximum amount available to
$2.0 million, (b) eliminate the 0.25% non-usage fee and (c) eliminate other terms, including terms requiring the Company to provide monthly reports regarding the
Company's inventory and accounts receivable. The revolving credit facility expired on June 30, 2007. Borrowings were subject to certain limitations, primarily based upon 85% of eligible
accounts receivable and 50% of eligible inventory not to exceed the amount advanced on eligible accounts receivable. Indebtedness under the revolving credit facility bore interest at a floating rate
of interest based on either the prime rate quoted by JPMorgan Chase Bank, N.A. or an adjusted LIBOR rate. Accounts receivable and inventory were pledged as collateral and the Company was subject to
compliance with certain covenants, including minimum levels of net worth and minimum interest coverage ratios. The Company was not permitted to pay dividends or make distributions.

In
September 2007, the Company entered into a $2,000,000 revolving credit facility with JPMorgan Chase Bank, N.A. which expires June 30, 2009. Indebtedness under this revolving
credit facility bears interest at a floating rate of interest based on either the prime rate quoted by JPMorgan Chase Bank, N.A. or an adjusted LIBOR rate. This revolving credit facility contains
various restrictive covenants including (i) an obligation for the Company to maintain a tangible net worth of at least $75 million and (ii) a prohibition on the Company incurring
any other indebtedness for borrowed money. The Company

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Table of Contents

HEELYS, INC.

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued)

10. DEBT (Continued)

is
also prohibited from creating or permitting any lien, encumbrances or other security interest on the Company's accounts receivable or inventory. There have been no borrowings under this revolving
credit facility.

An
irrevocable standby letter of credit in the amount of $50,000 was outstanding in favor of the landlord for the Company's corporate headquarters. The landlord could draw upon this
letter of credit if the Company was in default under the lease. The letter of credit expired on March 1, 2008.

Line of Credit NoteIn April 2006, the Company executed a $5.0 million line of credit note that matured in April 2007, but was required to be
repaid upon consummation of the Company's initial public offering. This note was secured by the same collateral as the revolving credit facility. The Company borrowed $4.0 million under this
note to repurchase 1,448,625 shares of the common stock owned by two stockholders. The note was repaid in October 2006 and canceled.

Promissory NotesDuring 2006, the Company signed an agreement with a commercial finance company to finance the payment of its commercial general
liability and umbrella premiums. The agreement provided for an initial payment of a portion of the premium, with the remaining principal balance plus interest to be paid in monthly installments.
Interest accrued at 6.29% on the unpaid balance of $211,000 at December 31, 2006. Prepaid premiums from the insurance policies financed were pledged as collateral under the promissory notes.
This promissory note was paid-in-full during the first quarter of 2007.

11. COMMITMENTS AND CONTINGENCIES

LeasesEffective February 1, 2005, the Company entered into an operating lease whereby the Company leases office and warehouse space in
Carrollton, Texas for 10 years with renewal options. On February 27, 2006, the Company signed an amendment to this lease for additional warehouse space for the duration of the lease
term. The information in the table below does not include renewal options.

On
October 29, 2007, the Company signed an operating lease for office space in Qingdao, China. This lease expired December 1, 2008 but included two one-year
extension options. On December 1, 2008, the Company exercised its right to renew this lease for one year. The information in the table below does not include the remaining one-year
extension option. Payments under this lease agreement are made in the Chinese Yuan Renminbi. Future minimum payments, included in the table below, have been estimated using the currency exchange rate
as of December 31, 2008.

Effective
May 1, 2008, Heeling Sports EMEA entered into an operating lease for office space in Brussels, Belgium for nine years with the option to terminate the lease at the end
of each three year period. The information in the table below assumes that this lease will not be renewed after the initial three year period. Payments under this lease agreement are made in Euro.
Future minimum payments, included in the table below, have been estimated using the currency exchange rate as of December 31, 2008.

Effective
April 1, 2008, Heeling Sports EMEA entered into an operating lease for office space in Munich, Germany for three years with an automatic renewal at the end of the
initial three year lease unless six months notice is provided. The information in the table below does not include lease extensions. Payments under this lease agreement are made in Euro. Future
minimum payments,

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Table of Contents

HEELYS, INC.

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued)

11. COMMITMENTS AND CONTINGENCIES (Continued)

included
in the table below, have been estimated using the currency exchange rate as of December 31, 2008.

Effective
May 1, 2008, Heeling Sports EMEA entered into an operating lease for office space in Annecy, France for nine years with the option to terminate the lease at the end of
each three year period. The information in the table below assumes that this lease will not be renewed after the initial three year period. Payments under this lease agreement are made in Euro. Future
minimum payments, included in the table below, have been estimated using the currency exchange rate as of December 31, 2008.

Future
minimum rental payments under these agreements are as follows (in thousands):

Years Ending December 31,2009

$
3412010


3102011


2432012


2092013


210Thereafter


337$
1,650


Rent
expense was $227,000, $353,000 and $865,000 for 2006, 2007 and 2008, respectively.

Third-Party Distribution Facilities (California)On August 1, 2007, the Company entered into an agreement with a third-party distribution
facility in San Pedro, California. The Company paid a fixed storage fee for approximately 16,000 square feet of dedicated floor space. Additionally, the Company paid this third-party distributor fees
and charges for services including handling, transactional storage and processing. These fees and charges were activity based and therefore fluctuated. The Company expensed $260,000 related to this
third-party distribution facility in 2007 and $563,000 in 2008. These costs are included in cost of sales. This agreement expired on July 31, 2008 and the Company continued to lease floor space
at, and used the services of, this third-party distribution facility on a month-to-month basis through November 2008.

Third-Party Distribution Facilities (Belgium)The Company has expanded its use of a third-party distribution facility in Belgium. The Company pays
this third-party distributor fees and charges for services including handling, processing and packing materials. These fees and charges are activity based and therefore fluctuate and as a result
related future obligations cannot be quantified. This agreement is for one year term with automatic one year renewal terms. The Company expensed $5,000, $58,000 and $1,265,000 related to this
third-party distribution facility in 2006, 2007 and 2008, respectively. These costs are included in cost of sales.

Employment ArrangementAll of the personnel of the Company (with the exception of personnel employed by the representative office in China and
Heeling
Sports EMEA) are contractually employees of a Professional Employer Organization ("PEO"). The PEO incurs payroll, payroll tax and payroll-related benefit costs. The Company reimburses these costs plus
an administrative fee. With respect to these payroll-related benefits, the personnel of the Company are pooled with other employees of the PEO.

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HEELYS, INC.

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued)

11. COMMITMENTS AND CONTINGENCIES (Continued)

Termination of Distributorship AgreementsDuring fiscal year 2008, the Company agreed to purchase a portion of the business operations, certain
assets, and retain employees on a contractual basis of two of its former distributors in Germany and France. The details related to these activities are outlined below.

Effective
March 31, 2008, the Company entered into agreements to terminate its arrangement regarding the distribution of Heelys-branded footwear and products in Germany and
Austria, allowing the Company, through its Belgian subsidiary, to market its products directly in such countries. This included a Termination Agreement (the "Termination Agreement") among the Company,
The Territory Distribution GmbH (the "Distributor"), and Achim Lippoth, the sole owner of the Distributor ("Lippoth"), pursuant to which, among other things, a prior Distributor Agreement
between the Company and the Distributor was terminated, the Company agreed to purchase from the Distributor all of the Distributor's inventory of unsold Heelys products and other specified assets for
the Distributor's cost, all of the unshipped orders for Heelys products on the Distributor's order book as of March 31, 2008 for a price equal to the Distributor's net wholesale margin on such
unshipped orders (which is to be paid on or before the end of the month following the Company's receipt of payment for the Heelys products shipped in response to such unshipped orders), and the
Distributor and Lippoth agreed, until March 31, 2010, not to compete with the Company relating to the Company's products anywhere in the world. In connection with the Termination Agreement the
Company's Belgian subsidiary entered into two consulting agreements, one with The Sansean Group Limited ("Sansean"), and one with Lippoth, pursuant to which, among other things, Sansean and Lippoth
agreed to perform certain consulting services and the Company's Belgian subsidiary agreed to pay Sansean and Lippoth consulting fees as set forth in their respective consulting agreements. Payments
under these agreements are to be made in Euro.

Effective
April 30, 2008, the Company entered into agreements to terminate its current arrangement regarding the distribution of Heelys-branded footwear and products in France,
Monaco and Andorra, allowing the Company, through its Belgian subsidiary, to market its products directly in such countries. This included a Termination Agreement (the "Termination Agreement") among
the Company, Trotwood Import/Export (the "Distributor"), Trotwood Investments Ltd., the sole owner of the Distributor ("TIL"), and David Stanley ("D. Stanley") and Margarete
Stanley ("M. Stanley"), pursuant to which, among other things, a prior International Distributor Agreement between the Company and the Distributor was terminated, the Company agreed to purchase from
the Distributor all of the Distributor's inventory of unsold Heelys products for the Distributor's cost of such products, the Distributor's order books relating to Heelys products at the value on
Distributor's books and certain other incidental assets of the Distributor related to its distribution operations as described in the Termination Agreement (the Company agreed to pay Distributor for
such items on or before May 16, 2008), the Company agreed to purchase from the Distributor all of the unshipped orders for Heelys products on the Distributor's order book as of April 30,
2008 that are not novated to the Company or one of its affiliates for a price equal to the Distributor's net wholesale margin on such unshipped orders (which is to be paid on or before the end of the
month following the Company's receipt of payment for the Heelys products shipped in response to such unshipped orders). In addition, the Distributor, Shareholder, D. Stanley and M. Stanley agreed,
until April 30, 2012, not to compete with the Company relating to the Company's products anywhere in the world and the Company agreed to pay Distributor an additional amount set forth in the
Termination Agreement for each pair of Heelys branded footwear sold by the Company or its affiliates in France, Monaco and Andorra. In connection

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Table of Contents

HEELYS, INC.

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued)

11. COMMITMENTS AND CONTINGENCIES (Continued)

with
the Termination Agreement the Company's Belgian subsidiary, entered into a Consulting Agreement with TIL pursuant to which, among other things, TIL agreed to perform certain consulting services
and the Company's Belgian subsidiary agreed to pay TIL consulting fees as set forth in such consulting agreement. Payments under these agreements are to be made in Euro.

The
primary assets acquired as a result of the termination of these distributorship agreements were the customer lists and goodwill. In addition, both of these former distributors agreed
to not compete with the Company for a limited period of time. The fair value of the acquired assets was based upon the amount at which the assets could be bought or sold in a current transaction
between willing parties. As a result, the Company recorded goodwill and intangibles (including acquired customer relationships and non-compete agreements) in the amount of
$3.7 million (2.4 million Euro). As of December 31, 2008, the Company paid $1.9 million (1.2 million Euro) for these acquired assets with the balance of
$1.5 million (1.1 million Euro) to be paid out over time in accordance with the terms of the agreements.

Royalty AgreementFor the period prior to December 31, 2008, the Company paid monthly royalties related to a feature incorporated in its
grind-and-roll HEELYS-wheeled footwear equal to a percentage of the purchase price that is paid to the manufacturers, net of the costs of the wheels and any other skating
apparatus. Monthly royalties due were based on the number of grind-and-roll HEELYS-wheeled footwear sold. Royalty expense was $299,000, $278,000 and $44,000 for 2006, 2007 and
2008, respectively. The Company is no
longer required to make royalty payments on sales of these certain products subsequent to December 31, 2008.

Purchase CommitmentsThe Company had open purchase commitments of $2.8 million and $4.5 million related to inventories that were still
being held by the manufacturers at December 31, 2007 and December 31, 2008, respectively.

Legal ProceedingsThe Company, its former Chief Executive Officer, its former Chief Financial Officer, and its directors who signed the Company's
registration statement filed with the Securities and Exchange Commission in connection with our December 7, 2006 initial public offering (the "IPO")along with Capital Southwest
Corporation, Capital Southwest Venture Corporation and the underwriters for the IPOare defendants in a lawsuit originally filed on August 27, 2007 in the United States District
Court for the Northern District of Texas, Dallas Division, by plaintiff Brian Rines, Individually and On Behalf of All Others Similarly Situated, purportedly on behalf of all persons who purchased the
Company's common stock pursuant to or traceable to the IPO registration statement. The complaint alleges violations of Sections 11 and 15 of the Securities Act of 1933. The plaintiff
seeks an order determining that the action may proceed as a class action, awarding compensatory damages in favor of the plaintiff and the other class members in an unspecified amount, and reasonable
costs and expenses incurred in the action, including counsel fees and expert fees. Four similar lawsuits were also filed in September and October 2007 in the United States District Court for the
Northern District of Texas, Dallas Division, by plaintiffs Vulcan Lee, John Avila, Gerald Markey, and Robert Eiron on behalf of the same plaintiff class, making substantially similar allegations under
Sections 11, 12, and 15 of the Securities Act of 1933, and seeking substantially similar damages. These lawsuits have been transferred to a single judge and have been consolidated into a
single action. Lead plaintiffs and lead counsel have been appointed. An amended consolidated complaint was filed on March 11, 2008. The amended complaint alleges that the prospectus used in
connection with our IPO contained misstatements of material fact or omitted to state material facts necessary in order to make the

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Table of Contents

HEELYS, INC.

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued)

11. COMMITMENTS AND CONTINGENCIES (Continued)

statements
made not misleading relating to among other allegations, safety concerns and injuries associated with our products and their alleged impact on demand, visibility into our sales channel and
competition from knockoffs, in violation of Sections 11, 12(a)(2) and 15 of the Securities Act of 1933 and requests substantially similar damages and relief as previously mentioned. On
August 14, 2008, the Court denied Defendants' motions to dismiss the amended complaint, and discovery commenced. During a mediation conducted by the Hon. Nicholas H. Politan (ret.), Plaintiffs
and Defendants reached a settlement pursuant to which Defendants will pay Plaintiffs and a proposed plaintiff settlement class a total of $7.5 million, including attorneys' fees and
expenses. The Company has reached an agreement in principal with its insurers for the Company's insurance policies to fund the majority of this settlement amount. This settlement is subject to final
documentation and approval by the Court. The Company expects that the proposed settlement will be submitted to the Court for preliminary approval within the next month. If the Court preliminarily
approves the settlement, notice will be
provided to shareholders, who will be provided an opportunity to object to the settlement or to opt out of the proposed settlement class.

On
October 3, 2007 and October 24, 2007, in the United States District Court for the Northern District of Texas, Dallas Division, Jack Freeman and Brian Mossman,
respectively brought shareholders' derivative actions, for the Company's benefit, as nominal defendant, against the Company's former Chief Executive Officer, the Company's former Director of Research
and Development, the Company's former Chief Financial Officer, the Company's former Senior Vice President and certain current and former members of the Company's board of directors. The Company is a
nominal defendant, and the complaints do not seek any damages against the Company. The complaints allege violations of Sections 11, 12(a)(2), and 14(a) of the Securities Act of 1933 and
breaches of fiduciary duty, abuse of control, gross mismanagement, waste of corporate assets and unjust enrichment on the part of each of the named defendants. The complaints seek unspecified amounts
of compensatory damages, voiding the election of the director defendants, as well as interest and costs, including legal fees from the defendants. The Company is a nominal defendant, and the complaint
does not seek any damages against the Company; however, the Company may have indemnification obligations to one or more of the defendants under the Company organizational documents. The derivative
lawsuits have been transferred to a single judge and have been consolidated into a single derivative lawsuit. An amended consolidated complaint making substantially similar allegations and claims for
damages was filed on March 14, 2008. On August 14, 2008, the Court denied Defendants' motions to dismiss the amended complaint, and discovery commenced. During a mediation conducted by
the Hon. Nicholas H. Politan (ret.), Plaintiffs and Defendants reached a settlement pursuant to which Defendants agreed to institute certain corporate governance changes at the Company and to pay
plaintiffs' counsel attorneys' fees and expenses of $1 million. The Company has reached an agreement in principal with its insurers for the Company's insurance policies to fund the majority of
this settlement amount. This settlement is subject to final documentation and approval by the Court. The Company expects that the proposed settlement will be submitted to the Court for preliminary
approval within the next month.

The
Company's insurance policies will fund the majority of the settlement amounts. The Company has agreed to contribute approximately $722,000 of this settlement amount, which has been
accrued for as of December 31, 2008.

The
Company, its former Chief Executive Officer, its former Chief Financial Officer, and its directors who signed the Company's registration statement filed with the Securities and
Exchange Commission in connection with our December 7, 2006 initial public offering (the "IPO")along with

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Table of Contents

HEELYS, INC.

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued)

11. COMMITMENTS AND CONTINGENCIES (Continued)

Capital
Southwest Corporation, Capital Southwest Venture Corporation and the underwriters for the IPOare defendants in a lawsuit originally filed on May 16, 2008 by individual
shareholder Carl Dick in the County Court of Law No. 1, Dallas County, Texas. This lawsuit asserts claims that are substantially similar to those asserted in the consolidated class action
described above. Plaintiff alleges that he purchased over 600,000 shares of Heelys for approximately $17.4 million. Plaintiff claims to have sold his stock for a loss of approximately
$11 million, which he seeks to recover plus interest, costs, and attorney fees. The petition alleges violations of Sections 11, 12(a)(2), and 15 of the Securities Act of 1933 and
Sections 33(A), (C), and (F) of the Texas Securities Act. Defendants
withdrew their previously-filed special exceptions to Plaintiff's petition seeking to have all claims dismissed, and discovery in this case is proceeding. The case is scheduled for trial in October
2009. While the Company cannot predict the outcome of this matter, the Company believes that the plaintiff's claims are without merit, denies the allegations in the complaints, and the Company intends
to vigorously defend the lawsuits. If this matter were successfully asserted against the Company, there could be a material adverse effect on the Company's financial position, cash flows or results of
operations.

Due
to the nature of the Company's products, from time to time the Company has to defend against personal injury and product liability claims arising out of personal injuries that
allegedly are suffered using the Company's products. To date, none of these claims has had a material adverse effect on the Company. The Company is also engaged in various claims and legal proceedings
relating to intellectual property matters, especially in connection with enforcing the Company's intellectual property rights against the various third parties importing and selling knockoff products
domestically and internationally. Often, such legal proceedings result in counterclaims against the Company that the Company must defend. The Company believes that none of the pending personal injury,
product liability or intellectual property legal matters will have a material adverse effect upon the Company's financial position, cash flows or results of operations.

12. INCOME TAXES

Components of income taxes were as follows (in thousands):

December 31,2006

2007

2008Current federal income tax expense (benefit)

$
16,383

$
15,206

$
(5
)Current state income tax expense (benefit)


774


173


3Current foreign income tax expense (benefit)








68Deferred federal income tax expense (benefit)


(872
)

(2,060
)

(809
)Deferred state income tax expense (benefit)








226Deferred foreign income tax expense (benefit)








Total income tax expense (benefit)

$
16,285

$
13,319

$
(517
)


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Table of Contents

HEELYS, INC.

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued)

12. INCOME TAXES (Continued)

A reconciliation of income tax computed at the U.S. federal statutory income tax rate of 34% for 2006, 35% for 2007 and 2008 to the provision for income taxes is as follows (in
thousands):

December 31,2006

2007

2008Tax at statutory rate

$
15,758

$
12,444

$
(2,225
)Non-deductible incentive stock option expense


62


206


107Non-deductible penalties








19State income taxes net of federal benefit





458


149Increase (decrease) in valuation allowance





123


1,371Increase (decrease) in FIN 48 unrecognized tax benefits, net of indirect benefits


497


82


Reclassification of tax deductible/nondeductible awards








41Foreign tax rate differential








2Other


(32
)

6


19Total income tax expense (benefit)

$
16,285

$
13,319

$
(517
)


Deferred
income taxes reflect the tax effects of temporary differences between the carrying amount of assets and liabilities for financial reporting purposes and the amount used for
income tax purposes.

F-24

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Table of Contents

HEELYS, INC.

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued)

12. INCOME TAXES (Continued)

The
tax effects of significant items included in the Company's net deferred tax benefits at December 31, 2007 and 2008 were as follows (in thousands):

December 31,2007

2008Current tax assets (liabilities):Allowances for receivables not currently deductible

$
2,161

$
263Allowances for inventory not currently deductible


292


274Prepaid expenses currently deductible


(447
)

(139
)Accrued expenses not currently deductible


81


403State income taxes


295


377Net operating loss carryforwards





3,225Other





20Total current deferred tax assets


2,382


4,423Less: Valuation allowance





(851
)Net current deferred tax assets


2,382


3,572Long-term tax assets (liabilities):Accumulated depreciation and amortization


218


105Net operating loss carryforwards





353State income taxes


459


120Unremitted earnings of foreign subsidiary





Stock-based compensation


500


432Total long-term deferred tax assets


1,177


1,010Less: Valuation allowance


(123
)

(726
)Net long-term deferred tax assets


1,054


284Total deferred tax assets

$
3,436

$
3,856


Based
on all available evidence, both positive and negative, and the weight of that evidence to the extent such evidence can be objectively verified, the Company assesses whether it is
more likely than not that the deferred tax assets will be realized. During the year ended December 31, 2007, a valuation
allowance of $123,000 was established for deferred income taxes related to non-qualified stock options that may not be realized by the Company in future periods. During the year ended
December 31, 2008, the valuation allowance increased by approximately $1.5 million as the Company believes that it is more likely than not that certain U.S. and Belgian deferred tax
assets will not be realized as of December 31, 2008.

At
December 31, 2008, the Company has approximately $9.2 million of federal net operating loss carryforwards and $239,000 of state operating loss carryforwards that are
expected to be carried back to 2006 and fully recovered. This net operating loss carryforward is currently reflected as a current deferred tax asset as of December 31, 2008.

The
Company has approximately $1.0 million of Belgian net operating losses as of December 31, 2008 that will carryforward indefinitely.

F-25

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Table of Contents

HEELYS, INC.

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued)

12. INCOME TAXES (Continued)

A
reconciliation of the consolidated liability for gross unrecognized income tax benefits (excluding penalties and interest) from January 1, 2007 to December 31, 2008, is
as follows (in thousands):

2007

2008Balance at beginning of year

$
1,029

$
1,225Decreases in prior year tax positions





Increases in prior year tax positions


173


Increases in current year tax positions


23


Settlements with taxing authorities





Lapse of statute of limitations





Balance at end of year

$
1,225

$
1,225


If
the Company were to prevail on all unrecognized tax benefits recorded, approximately $903,000 of the unrecognized tax benefits (excluding accrued interest and penalties) at
December 31, 2008 would benefit the effective tax rate.

The
Company recognizes interest accrued related to unrecognized tax benefits in interest expense and penalties related to tax liabilities in general and administrative expenses. During
the years ended December 31, 2007 and 2008, the Company recognized approximately $299,000 and $153,000 in interest and penalties, respectively. The Company has accrued $375,000 and $528,000 for
interest and penalties at December 31, 2007 and 2008, respectively.

Based
on the nature of the unrecognized tax benefits and the states to which the uncertain tax positions relate, the Company believes it is reasonably possible that the unrecognized tax
benefits will significantly decrease in the next twelve months by approximately $920,000 as a result of pursuing possible settlement alternatives. These liabilities have been classified as current
liabilities in the Company's consolidated balance sheet as of December 31, 2008. All other unrecognized tax benefits have been classified as noncurrent liabilities.

The
statute of limitations remains open for the Company's consolidated federal income tax returns for the tax years ended December 31, 2005 forward. States' statutes in the United
States are open for various years, depending on the jurisdiction. As of December 31, 2008, the Company's 2006 federal income tax return was in the process of being examined. However, this
examination was settled subsequent to year-end with an expected refund to the Company of approximately $127,000. The Company has recorded this refund in income taxes receivable. There are
no other income tax examinations currently in process.

During
the fourth quarter of 2008, the Company reevaluated its tax positions and concluded that the previously issued annual consolidated financial statements for the years ending
December 31, 2006 and 2007 contained an understatement of liabilities (including penalties and interest) for uncertain tax positions in certain jurisdictions. Accordingly, the Company is
restating its consolidated balance sheets, statement of operations, statements of stockholders' equity and comprehensive income (loss) and

F-26

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Table of Contents

HEELYS, INC.

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued)

12. INCOME TAXES (Continued)

statements
of cash flows as of and for the years ended December 31, 2006 and 2007 as follows (in thousands):

Consolidated Balance Sheet Information
as of December 31, 2007As Previously
Reported

Adjustments

RestatedDeferred income tax benefit (non-current)

$
595

$
459

$
1,054Income taxes payable (non-current)

$


$
1,572

$
1,572Retained earnings

$
56,265

$
(1,113
)
$
55,152




Consolidated Statements of Operations Information for the Years EndedDecember 31, 2006

December 31, 2007As Previously
Reported

Adjustments

Restated

As Previously
Reported

Adjustments

RestatedGeneral and administrative expense

$
6,397

$
39

$
6,436

$
10,877

$
219

$
11,096Income from operations

$
45,551

$
(39
)
$
45,512

$
32,004

$
(219
)
$
31,785Interest expense

$
744

$
16

$
760

$
10

$
76

$
86Income before income tax expense

$
44,962

$
(55
)
$
44,907

$
35,554

$
(295
)
$
35,259Income tax expense

$
15,788

$
497

$
16,285

$
13,237

$
82

$
13,319Net income

$
29,174

$
(552
)
$
28,622

$
22,317

$
(377
)
$
21,940Earnings per share:Basic

$
1.50

$
(0.03
)
$
1.47

$
0.82

$
(0.01
)
$
0.81Diluted

$
1.16

$
(0.02
)
$
1.14

$
0.79

$
(0.01
)
$
0.78




Consolidated Statements of Stockholders'
Equity and Comprehensive
Income (Loss) Information
for the Years Ended
December 31, 2006 and 2007Retained EarningsAs Previously
Reported

Adjustments

RestatedBalanceDecember 31, 2005

$
8,774

$
(184
)
$
8,590Net income (for the year ended December 31, 2006)

$
29,174

$
(552
)
$
28,622BalanceDecember 31, 2006

$
33,948

$
(736
)
$
33,212Net income (for the year ended December 31, 2007)

$
22,317

$
(377
)
$
21,940BalanceDecember 31, 2007

$
56,265

$
(1,113
)
$
55,152


F-27

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Table of Contents

HEELYS, INC.

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued)

12. INCOME TAXES (Continued)



Consolidated Statements of Cash Flows Information for the Years EndedDecember 31, 2006

December 31, 2007As Previously
Reported

Adjustments

Restated

As Previously
Reported

Adjustments

RestatedNet income

$
29,174

$
(552
)
$
28,622

$
22,317

$
(377
)
$
21,940Adjustments to reconcile net income to net cash provided by (used) in operating activities:Deferred income tax benefits

$
(595
)
$
(277
)
$
(872
)
$
(1,969
)
$
(91
)
$
(2,060
)Changes in operating assets and liabilities:Income taxes payable/receivable

$
2,633

$
829

$
3,462

$
(3,991
)
$
468

$
(3,523
)Net cash provided by (used in) operating activities

$
(2,180
)
$


$
(2,180
)
$
46,589

$


$
46,589


13. STOCKHOLDERS' EQUITY

Common StockDuring May 2000, the Company issued 11,363,875 shares of its common stock to the initial common stockholders for $125,000, or $0.011
per
share, the estimated fair value of the shares at the date of issuance, in exchange for patent applications and trademarks, which were recorded as patents and trademarks. The Company had the right of
first refusal on any disposition of common stock by the stockholders, but this right terminated on the Company's initial public offering.

In
April 2006, the Company purchased 724,325 shares of Company common stock owned by one of the Company's directors for a purchase price of $2.0 million or $2.76 per share. In May
2006, the Company purchased 724,300 shares of Company common stock owned by the Company's founder for a purchase price of $2.0 million, or $2.76 per share. The excess of the purchase cost over
the par value has been charged to retained earnings.

In
October 2006, the Company effected a 25-for-one stock split. All common share and per common share amounts in these consolidated financial statements have been
retroactively adjusted (unless otherwise stated) for all periods presented to give effect to the stock split.

On
December 13, 2006, the Company closed an initial public offering of its common stock consisting of 7,388,750 shares of common stock. Of these shares, 3,125,000 were newly
issued shares sold by the Company and 4,263,750 were existing shares sold by the selling stockholders, including 963,750 shares pursuant to an exercise by the underwriters of their
over-allotment option. The public offering price was $21.00 per share. The gross proceeds for shares of common stock sold by the Company was $65.6 million. The net proceeds to the
Company were $61.0 million, after deducting an aggregate of $4.6 million in underwriting discounts and commissions. The Company incurred other direct expenses of $2.2 million in
connection with the offering. As of December 31, 2006, the Company had paid $1.1 million of these other direct expenses. Unpaid other direct expenses in the amount of $1.1 million
is included in accrued expenses at December 31, 2006. These accrued expenses were paid in 2007. The Company did not receive any of the proceeds from the sale of shares by selling stockholders
or on any exercise of the underwriters' over-allotment option.

14. REDEEMABLE CONVERTIBLE PREFERRED SHARES

Preferred StockThe Company had authorized an aggregate 3,000,000 shares of $0.001 par value Series A and B Preferred Stock. In May 2000, the
Company sold preferred stock and debentures

F-28

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Table of Contents

HEELYS, INC.

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued)

14. REDEEMABLE CONVERTIBLE PREFERRED SHARES (Continued)

pursuant
to an investment agreement between the preferred stockholders and the Company (the "Investment Agreement"). The Company sold 1,818,182 shares of Series A Preferred Stock for $500,000,
and 454,545 shares of Series B Preferred Stock for $125,000, or in each case $0.275 per share, the estimated fair value of the shares at the date of purchase (not giving effect to the
25-for-one stock split effected in October 2006).

The
Company was subject to compliance with certain covenants included in the Investment Agreement, including restricting the Company from paying any dividends or distributions and
issuing additional shares, except for those restricted common shares issued in February 2001. Concurrent with the execution of the Investment Agreement, the preferred stockholders and the Company
executed a registration rights agreement. After May 2001, the Series B Preferred Stockholders could request a demand registration upon a greater than 50% vote. This demand registration would
cause the Company to perform all conversions, redemptions and payments associated with a qualified public offering.

Also,
concurrent with the execution of the Investment Agreement, the common and preferred stockholders executed an investor rights agreement. Under that agreement, a preferred
stockholder was entitled to designate two members of the five-member Board of Directors, and the initial common stockholders were entitled to designate two members of the Board of
Directors. The initial common stockholders and a preferred stockholder were entitled to designate one mutually acceptable member of the Board of Directors.

The
Series A Preferred Stock was nonconvertible and redeemable. The Company could redeem the shares at any time with 30-days' notice, and the shares were mandatorily
redeemable upon the completion of a qualified public offering. The stockholders could require the Company to redeem the shares beginning May 31, 2007. The redemption price and liquidation
preference were $0.275 per share, plus all accrued and unpaid dividends. A cumulative dividend at the rate of $0.022 per annum was to accrue from May 31, 2005 through May 31, 2007 and
was payable quarterly in cash. The dividend rate was to increase to $0.033 per annum on May 31, 2007. The Series A Preferred Stock was redeemed by the Company on May 31, 2005 for
$500,000. Dividends had not begun accumulating; therefore the shares were redeemed for the original purchase price of $500,000.

The
Series B Preferred Stock was convertible and redeemable. One share of Series B Preferred Stock was convertible into one share of common stock at the option of the
stockholder at $0.275 per share (not giving effect to the 25-for-one stock split effected in October 2006). All shares of Series B Preferred Stock would have
automatically been converted into shares of common stock if the Company completed a qualified public offering, completed a sale of substantially all of its assets or were to have undergone a change in
control or a merger. The stockholders could have required the Company to redeem the shares beginning May 31, 2007. The redemption price was the greater of estimated fair value per share or
$0.275 per share (liquidation preference) (not giving effect to the 25-for-one stock split effected in October 2006). No dividends were to be accrued or paid on the
Series B Preferred Stock. In June 2006, all outstanding shares of the Series B Preferred Stock were converted into common stock, prior to giving effect to the
25-for-one stock split effected in October 2006.

15. STOCK-BASED COMPENSATION

In June 2006, the Company adopted the 2006 Stock Incentive Plan (the "2006 Plan"). Awards are generally granted with an exercise price equal to the market price of the Company's stock at
the date of grant, generally vest based over four years of continuous service and have a 10-year contractual life.

F-29

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Table of Contents

HEELYS, INC.

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued)

15. STOCK-BASED COMPENSATION (Continued)

The Company has reserved 2,972,725 shares of common stock subject to the 2006 Plan and as of December 31, 2008 had 764,125 shares remaining available that may be granted to
employees, consultants and nonemployee directors of the Company in the future. The 2006 Plan is administered by the compensation committee of the Company's board of directors, which selects the
persons to whom options will be granted, determines the number of shares to be subject to each grant, and prescribes the other terms and conditions of each grant, including the type of consideration
to be paid to the Company upon exercise and the vesting schedule. If a change of control of the Company, as defined by the 2006 Plan, occurs, all of the options issued and outstanding under the 2006
Plan will accelerate and become fully vested and exercisable.

The
Company accounts for stock-based compensation in accordance with FASB issued Statement No. 123(R),Share Based Payment, which
requires the measurement of compensation cost based on the estimated fair value of the award on the date of grant. The Company recognizes this cost using the straight-line method over the
period during which an employee is required to provide service in exchange for the awardthe requisite service period. No compensation cost is recognized for equity instruments for which
employees do not render the requisite service.

The
following summarizes stock option grants made by the Company:

Date of Grant

Number of Shares
Granted

Exercise PriceJune 2006


2,042,500

$
4.05December 2006


130,000

$
21.00December 2006


57,500

$
32.60March 2007


25,000

$
31.76August 2007


15,000

$
9.23March 2008


120,000

$
4.26May 2008


48,500

$
4.39August 2008


365,000

$
5.07September 2008


30,000

$
5.14


The
exercise price per share was the fair value of the underlying stock at the grant date. The options granted in June 2006 are subject to a 48-month vesting period. All
options granted
subsequent to June 2006 vest and become exercisable in four equal cumulative installments on each successive anniversary date of the grant. All options granted have a contractual term of ten years.

For
the June 2006 grants the Company determined the fair value of its common stock as of June 23, 2006, the date of grant of the June 2006 options, utilizing the methodologies and
procedures set forth in the AICPA Practice Aid for the Valuation of Privately-Held Company Equity Securities Issued as Compensation. The value of the Company's common stock was based upon
a number of significant factors, assumptions and methodologies. These factors included recent sales and negotiations for sales of the Company's common stock, the timing of such transactions, the
Company's discounted value of estimated future cash flows, valuations of comparable companies and transactions and the Company's expected value as a public company. The value indications derived from
the various methodologies were correlated into a single value by "weighting" each value indication, applied a lack of marketability discount and further decreased the value per share by the dilution
to the value that would be realized by a Company stockholder by virtue of the June 2006 option issuances. Between

F-30

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Table of Contents

HEELYS, INC.

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued)

15. STOCK-BASED COMPENSATION (Continued)

June 23,
2006 and the date of the Company's initial public offering, several events occurred that the Company believed contributed to the increase in the fair value of the Company's common
stock. These events included, among others, the Company's increased earnings and the Company's ability to exceed internally projected sales targets after July 2006.

For
the stock options granted in 2006, 2007 and 2008, the Company computed the fair value of the options granted using the Black-Scholes option pricing model and the following
assumptions:

June
2006

December
2006

March
2007

August
2007

March
2008

May
2008

August
2008

September
2008Expected volatility


44.27
%

42.94
%

41.74
%

44.78
%

35.75
%

45.77
%

46.34
%

46.34
%Dividend yield























Risk-free interest rate


5.21
%

4.45
%

4.46
%

4.36
%

3.00
%

3.68
%

3.45
%

3.21
%Expected life (years)


6.02


6.25


6.25


6.25


6.25


6.25


6.25


6.25


For
2006 and 2007 grants, the Company estimated the volatility of its common stock at the date of grant based on the historical volatility of comparable public companies. For 2008
grants, the Company estimated the volatility of the underlying common stock at the date of grant based on the historical volatility of the Company's common stock as well as the historical volatility
of comparable public companies.

The
risk-free interest rate for periods within the contractual life of the options is based on the U.S. Treasury yield curve in effect at the time of grant.

Expected
life was calculated using the simplified method as prescribed by the Securities and Exchange Commission's Staff Accounting Bulletin No. 107, as amended by Securities and
Exchange Commission's Staff Accounting Bulletin No. 110. This decision was based on the lack of relevant historical data.

F-31

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Table of Contents

HEELYS, INC.

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued)

15. STOCK-BASED COMPENSATION (Continued)

The
following summarizes stock option transactions for the year ended December 31, 2008:

Options

Shares

Weighted Average
Exercise Price

Weighted Average
Remaining
Contractual Life
(Years)

Aggregate Intrinsic
Value(1)Outstanding at December 31, 2007


2,190,997

$
5.89


8.5

$
5,779,000Granted


563,500


4.84Exercised


496,196


4.05




$
406,000Forfeited or expired


591,878


10.24Outstanding at December 31, 2008


1,666,423

$
4.54


8.2

$
Exercisable at December 31, 2008


612,606

$
4.32


7.5

$
Vested at December 31, 2008


612,606

$
4.32


7.5

$
Unvested at December 31, 2008


1,053,817

$
4.67


8.6

$



---

The
weighted average fair value of options granted during the years ended December 31, 2006, 2007 and 2008 was approximately $2.88, $11.30 and $2.32, respectively.

The
total fair value of shares that vested during 2006, 2007 and 2008 was $520,000, $1,558,000 and $827,000, respectively.

Stock-based
compensation cost was $576,000, $1,648,000 and $1,179,000 for the years ended December 31, 2006, December 31, 2007 and December 31, 2008, respectively.
The portion of stock-based compensation cost included in cost of sales, sales and marketing, and general and administrative expenses in the accompanying consolidated statement of operations during
2006 was $8,000, $128,000 and $440,000, respectively. The portion of stock-based compensation cost included in cost of sales, sales and marketing, and general and administrative expenses in the
accompanying consolidated statement of operations during 2007 was $227,000, $368,000 and $1,053,000, respectively. The portion of stock-based compensation included in cost of sales, selling and
marketing, and general and administrative expenses in the accompanying consolidated statement of operations during 2008 was $205,000, $90,000, and $677,000, respectively. On February 1, 2008,
the Company entered into a Severance and General
Release Agreement (the "Severance Agreement") with its former Chief Executive Officer ("CEO") in connection with the CEO's resignation. Under the Severance Agreement, the former CEO is entitled to
receive approximately $470,000 and up to 14 months of reimbursements for health and life insurance. Additionally, the Company's former CEO agreed to perform certain consulting services for the
Company for one year with no additional monetary compensation. During the term of this consulting relationship, options granted to the former CEO continue to vest in accordance with the
Heelys, Inc. 2006 Stock Incentive Plan. On February 1, 2008, the Company recognized $207,000 in stock-based compensation expense, which is 100% of the related stock-based compensation
for those stock options expected to vest during the term of the consulting arrangement. This expense is included in severance costs in the statement of operations.

F-32

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Table of Contents

HEELYS, INC.

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued)

15. STOCK-BASED COMPENSATION (Continued)

The
remaining unrecognized compensation cost related to unvested awards at December 31, 2008 is $2,578,000 and the weighted-average period of time over which this cost will be
recognized is 2.9 years.

The
Company has not capitalized any stock-based compensation costs at December 31, 2008. There have been no significant modifications to stock option awards during 2008.

All
unvested options at December 31, 2008 are expected to vest, except for approximately 337,000 options that forfeited subsequent to year end. The weighted average exercise price
of these forfeited options is $4.54; weighted average remaining contractual term of 8.6 years; aggregate intrinsic value of $0; and unrecognized compensation cost of $432,000.

Tax
benefits resulting from stock-based compensation deductions in excess of amounts reported for financial reporting purposes was $207,000 for 2007. There were no tax benefits from
stock-based compensation for 2008.

16. OTHER EMPLOYEE BENEFIT PLANS

401(k) PlanEffective January 2002, the Company sponsored a 401(k) Retirement Plan (the "401(k) Plan") through its PEO. All employees of Heeling
Sports Limited who are 21 years of age or older are eligible to enroll in the 401(k) Plan.

For
the 2007 plan year it was determined that the 401(k) Plan was top heavy and as a result the Company elected to make a contribution for 2007 of 3% of eligible wages for all eligible
non-key employees who were employed by the Company on the last day of the 2007 plan year, regardless of whether any such employee elected to contribute to the 401(k) Plan during the 2007
plan year. Prior to December 31, 2007 the Company only made discretionary contributions to the 401(k) plan.

Effective
January 1, 2008, the Company amended its 401(k) Plan to include a Safe Harbor Match Contribution. The Company will make a matching contribution equal to 100% of an
employee's deferral contributions which do not exceed 3% of the employee's compensation, plus 50% of an employee's deferral contributions that exceed 3%, but do not exceed 5%.

The
Company expensed contributions of $105,000, $101,000 and $109,000 during 2006, 2007 and 2008, respectively, related to contributions.

17. RELATED-PARTY TRANSACTIONS

The Company's patent attorney is also a stockholder of the Company. The Company capitalized or expensed a total of $498,000, $842,000 and $1,102,000 included in patents and trademarks
and general and administrative expenses, during 2006, 2007 and 2008, respectively, for costs incurred. Additionally, this patent attorney's law firm provides general corporate legal counsel to the
Company. The Company expensed a total of $135,000, $338,000 and $436,000 for these services during 2006, 2007 and 2008, respectively. This expense is included in general and administrative expense. In
connection with the Company's initial public offering this law firm provided legal counsel to the Company. A total of $761,000 was incurred for these legal services and has been offset against the
proceeds of the initial public offering. The Company owed $218,000 and $216,000 to this law firm as of December 31, 2007 and 2008, respectively.

F-33

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Table of Contents

HEELYS, INC.

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued)

17. RELATED-PARTY TRANSACTIONS (Continued)

In
April 2006, the Company purchased 724,325 shares of Company common stock owned by one of the Company's directors for a purchase price of $2,000,006, or approximately $2.76 per share.

In
May 2006, the Company purchased 724,300 shares of Company common stock owned by the Company's founder for a purchase price of $1,999,937, or approximately $2.76 per share.
Simultaneously with this sale and purchase, the Company's founder sold to one of the Company's directors and executive officers 362,150 shares of Company common stock owned by the founder for a
purchase price of $999,969, or approximately $2.76 per share.

Effective
as of April 30, 2008, the Company's Senior Vice President resigned his position with the Company, and entered into a Consulting Agreement with the Company. The
Consulting Agreement will terminate on June 30, 2010, unless terminated earlier or the parties agree to extend the term.
Under the Consulting Agreement, the former Senior Vice President (the "Consultant") will provide the Company (i) consulting services relating to mergers and acquisitions, (ii) support
services in connection with the prosecution or defense of any pending or future litigation, arbitration, business, or investigatory matter relating to the Company, and (iii) other services
agreed upon by the parties. The primary compensation under the Consulting Agreement shall be (i) a fee for merger and acquisition services to be paid in 25 monthly installments of
$10,780 per month beginning June 30, 2008, (ii) success fees more fully described in the Consulting Agreement and equal to varying percentages of the total value of certain mergers or
acquisitions originated by the Consultant, (iii) a fee of $125 per hour (up to a maximum of $1,000 per day) for litigation support services rendered, and (iv) a fee of $125 per hour (up
to a maximum of $1,000 per day for actual time billed) for services rendered for matters other than merger and acquisition services or litigation support. In 2008, the Company recognized $75,000 in
expense related to the Consulting Agreement. These charges are included in general and administrative expense in the statement of operations. As of December 31, 2008, no payable existed related
to the Consulting Agreement. The Company will also reimburse the Consultant for his expenses incurred in connection with the performance of his services under the Consulting Agreement. The Company's
former Senior Vice President will continue to remain as a member of the Company's Board of Directors. Options previously granted to the former Senior Vice President will continue to vest in accordance
with the Heelys, Inc. 2006 Stock Incentive Plan so long as he is a member of the Company's Board of Directors.

18. LITIGATION SETTLEMENT

On March 13, 2008, Heeling Sports Limited ("HSL"), entered into a confidential Settlement Agreement (the "Settlement Agreement") effective March 11, 2008
with Elan-Polo, Inc. ("Elan-Polo") to settle the pending patent and trademark lawsuitHeeling Sports Limited v. Wal-Mart
Stores, Inc., and Elan-Polo, Inc., Civil Action No. 3:07-CV-1695 in the United States District Court for the Northern
District of Texas, Dallas Division (the "Lawsuit") . The Lawsuit was filed in connection with wheeled footwear made by Elan-Polo with a wheel both in the heel and in front of the heel
("Two-Wheel Shoe Skates") that were sold exclusively at Wal-Mart under the brand name "Spinners." Wal-Mart was previously dismissed from the Lawsuit. HSL and
Elan-Polo filed a Final Judgment with the court that provides, among other items, that Elan-Polo is prohibited from making or selling the Two-Wheel Shoe Skates
without HSL's prior written permission.

Pursuant
to the Settlement Agreement, HSL and Elan-Polo agreed to, among other things, settle the Lawsuit and release any claims against the other party,
Elan-Polo acknowledged the validity and

F-34

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Table of Contents

HEELYS, INC.

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued)

18. LITIGATION SETTLEMENT (Continued)

enforceability
of HSL's patents, agreed not to contest the validity of such patents, and agreed not to seek any patent rights with respect to the Two-Wheel Shoe Skates that
were the subject matter of the Company's infringement claims. Elan-Polo agreed to cease use of the "Spinners" logo and to never use any of HSL's trademarks, including marks
such as HEELYS, HEELIES, WHEELIES, WHEELYS, or any mark or logo that may be confusingly similar to any of HSL's or the Company's trademarks. Elan-Polo represented to HSL
that 1,210,000 pairs of Two-Wheel Shoe Skates were manufactured on behalf of Elan-Polo in 2007, and that those were the only wheeled footwear that Elan-Polo had
manufactured. Elan-Polo agreed to pay the Company an aggregate of $1,400,000 in connection with settling the Lawsuit, and such payments are to be made, as follows: $750,000 was paid upon
execution of the Settlement Agreement, $250,000 was paid in June of 2008 and $250,000 was required to be paid in February of 2009, and $150,000 is required to be paid in February 2010. In addition, if
HSL and Elan-Polo agree to extend the Technology License Agreement, which was entered into in connection with the Settlement Agreement, for a fourth year, then Elan-Polo is
required to pay HSL another $150,000. Elan-Polo further agreed to indemnify, defend and hold harmless HSL and the Company against certain claims, losses and expenses.

As
part of the settlement, HSL and Elan-Polo entered into a Technology License Agreement, pursuant to which Elan-Polo was granted a limited license to manufacture
and sell only to certain approved mass-retailers located in the United States and Canada (the "Approved Retailers") no more than 750,000 pairs of Two-Wheel Shoe Skates with
non-removable wheels for the period ending March 10, 2009, no more than 750,000 pairs of Two-Wheel Shoe Skates with non-removable wheels for the one year
period from March 11, 2009 through March 10, 2010, and no more than 150,000 pairs of such shoe skates for the one year period from March 11, 2010 through March 10, 2011.
With both parties agreement prior to March 10, 2011, Elan-Polo shall have the right to sell to the Approved Retailers no more than 150,000 pairs of Two-Wheel Shoe Skates
with non-removable wheels during the one year period from March 11, 2011 through March 10, 2012. Additionally, Elan-Polo agreed to assign all of its improvements
or innovations related to any wheeled footwear to HSL during the pendency of the Technology License Agreement, and for a period thereafter.

In
the Technology License Agreement, HSL granted Elan-Polo a license to explore interest from the Approved Retailers to place an order to purchase wheeled footwear with
certain wheel configurations different from the Two-Wheel Shoe Skates with non-removable wheels, but no right to sell such wheeled footwear.

The
Technology License Agreement provides Elan-Polo with a royalty free license each year to manufacture a certain number of pairs of the Two-Wheel Shoe Skates,
after
which a royalty is due as provided by the Technology License Agreement. HSL can terminate the Technology License Agreement if Elan-Polo fails to pay the royalties due thereunder, or
otherwise breaches the Technology License Agreement. The Technology License Agreement remains in effect until March 10, 2011, unless extended by the Parties by agreement.

The
Company recognized $1.0 million of income related to the Settlement Agreement during 2008. This income is reported in other income. As of December 31, 2008, the Company
has not recognized any royalties in connection with the Technology License Agreement.

F-35

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Table of Contents

HEELYS, INC.

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued)

19. SEGMENT REPORTING

The Company designs, markets and distributes innovative, action sports-inspired products under the HEELYS brand targeted to the youth market. The primary product, HEELYS-wheeled
footwear, is patented, dual-purpose footwear that incorporates a stealth, removable wheel in the heel. Operating results are assessed based on geographic areas to make decisions about
necessary resources and in assessing performance. Consequently, under the provisions of SFAS No. 131,Disclosure About Segments of an Enterprise and Related
Information, ("SFAS 131"), and based on the nature of the financial information that is received by the chief executive officer as chief operating decision maker, the
Company has two reportable segments for financial statement purposes. Each segment derives revenue primarily from the sale of HEELYS-wheeled footwear.

Year Ended December 31, 2006Domestic

International

Unallocated

Consolidated(in thousands)Net Sales

$
161,347

$
26,861

$


$
188,208Cost of Sales


105,152


17,413





122,565Gross Profit


56,195


9,448





65,643Selling, General and Administrative Expenses


19,888





243


20,131Income from Operations


36,307


9,448


(243
)

45,512Other (Income) Expense, Net


605








605Income Before Income Taxes


35,702


9,448


(243
)

44,907Income Tax Expense


16,285








16,285Net Income

$
19,417

$
9,448

$
(243
)
$
28,622




Year Ended December 31, 2007Domestic

International

Unallocated

Consolidated(in thousands)Net Sales

$
152,995

$
30,477

$


$
183,472Cost of Sales


105,669


19,743





125,412Gross Profit


47,326


10,734





58,060Selling, General and Administrative Expenses


22,468


829


2,978


26,275Income from Operations


24,858


9,905


(2,978
)

31,785Other (Income) Expense, Net


83





(3,557
)

(3,474
)Income Before Income Taxes


24,775


9,905


579


35,259Income Tax Expense


13,319








13,319Net Income

$
11,456

$
9,905

$
579

$
21,940


F-36

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Table of Contents

HEELYS, INC.

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued)

19. SEGMENT REPORTING (Continued)



Year Ended December 31, 2008Domestic

International

Unallocated

Consolidated(in thousands)Net Sales

$
37,094

$
33,647

$


$
70,741Cost of Sales


29,176


23,649





52,825Gross Profit


7,918


9,998





17,916Selling, General and Administrative Expenses


17,191


5,593


4,180


26,964Income (Loss) from Operations


(9,273
)

4,405


(4,180
)

(9,048
)Other (Income) Expense, Net


(1,972
)

1,621


(2,256
)

(2,607
)Income (Loss) Before Income Taxes


(7,301
)

2,784


(1,924
)

(6,441
)Income Tax Expense (Benefit)


(552
)

35





(517
)Net Income (Loss)

$
(6,749
)
$
2,749

$
(1,924
)
$
(5,924
)




As of December 31, 2007Domestic

International

Eliminations

Consolidated(in thousands)Total Assets

$
127,690

$


$


$
127,690Accumulated Amortization & Depreciation

$
2,113

$


$


$
2,113




As of December 31, 2008Domestic

International

Eliminations

Consolidated(in thousands)Total Assets

$
83,241

$
13,255

$


$
96,496Goodwill

$


$
1,668

$


$
1,668Accumulated Amortization & Depreciation

$
2,510

$
232

$


$
2,742


The
following costs are unallocated in the tables included above: legal, accounting and professional fees which are directly attributable to operating as a public company; fees paid to
members of the Company's Board of Directors; D&O insurance; other public company costs; and interest income earned on monies held at the Heelys, Inc. entity level. Additionally, although the
international operations benefit from product development efforts incurred at the domestic company these costs have not been allocated to the international operations. Prior to 2007, selling, general
and administrative expenses are not allocated to the international operations due to their relative immateriality.

F-37

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Table of Contents

HEELYS, INC.

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued)

20. SUBSEQUENT EVENTS

On February 10, 2009, the Company entered into a Severance and General Release Agreement (the "Severance Agreement") with its former Chief Executive Officer ("CEO"). Under the
Severance Agreement, the former CEO will receive a sum of $150,000.00, payable in equal semi-monthly installments over the course of a six month period beginning on the first payroll
period date after the date of the Severance Agreement. The Severance Agreement also provides for (1) reimbursement of the former CEO's business expenses, (2) payment for the former CEO's
accrued and unused vacation and personal days in accordance with the Company's policies, and (3) a release by the former CEO of certain claims. The Severance Agreement does not modify the
restrictive covenants in the former CEO's employment agreement with the Company, including the provisions regarding confidentiality, non-competition, non-solicitation, media
statements, and non-disparagement.

In
connection with the former CEO's departure from the Company, and by letter agreement dated February 9, 2009 (the "Agreement"), the Company's former Chief Financial Officer has
agreed to serve as Interim President and Chief Executive Officer of the Company beginning February 11, 2009. Pursuant to the Agreement, he will receive $35,000.00 for each month of service, and
will initially serve a term of two months, which term may be extended on a month to month basis by the mutual consent of the Interim Chief Executive Officer and the Company. Either the Interim Chief
Executive Officer or the Company may terminate the Agreement upon 30 days written notice. The Agreement does not provide the Interim Chief Executive Officer with any employee benefits, but the
Company will reimburse him for his routine business expenses.

F-38

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Table of Contents

HEELYS, INC.

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued)

21. QUARTERLY FINANCIAL INFORMATION (UNAUDITED)

The following table sets forth certain financial information for the periods indicated. The data is prepared on the same basis as the audited consolidated financial statements. All
recurring, necessary adjustments are reflected in the data below.

Three months ended3/31/07

6/30/07

9/30/07

12/31/07(1)

3/31/08

6/30/08

9/30/08

12/31/08(2)(in thousands)Consolidated Statements of Operations Data:Net sales

$
49,428

$
74,310

$
49,908

$
9,826

$
13,107

$
18,211

$
23,825

$
15,598Cost of sales


31,952


47,983


33,991


11,486


10,283


14,016


15,880


12,646Gross profit (loss)


17,476


26,327


15,917


(1,660
)

2,824


4,195


7,945


2,952Selling, general and administrative expensesSelling and marketing


2,844


3,915


3,960


4,460


2,602


2,203


2,766


3,765General and administrative


2,395


3,334


2,366


3,001


2,786


3,173


4,057


4,919Severance














693








Total selling, general and administrative expenses


5,239


7,249


6,326


7,461


6,081


5,376


6,823


8,684Income (loss) from operations


12,237


19,078


9,591


(9,121
)

(3,257
)

(1,181
)

1,122


(5,732
)Other expense (income), net


(766
)

(734
)

(954
)

(1,020
)

(1,568
)

(830
)

(57
)

(152
)Income (loss) before income tax expense


13,003


19,812


10,545


(8,101
)

(1,689
)

(351
)

1,179


(5,580
)Income tax expense (benefit)


4,552


7,054


3,899


(2,186
)

(642
)

43


424


(342
)Net income (loss)

$
8,451

$
12,758

$
6,646

$
(5,915
)
$
(1,047
)
$
(394
)
$
755

$
(5,238
)Earnings (loss) per share:Basic

$
0.31

$
0.47

$
0.25

$
(0.22
)
$
(0.04
)
$
(0.01
)
$
0.03

$
(0.19
)Diluted

$
0.30

$
0.45

$
0.24

$
(0.22
)
$
(0.04
)
$
(0.01
)
$
0.03

$
(0.19
)Weighted average shares outstanding:Basic


27,045


27,055


27,065


27,073


27,076


27,193


27,439


27,571Diluted


28,351


28,328


28,059


27,073


27,076


27,193


27,549


27,571Other Data:Net sales, domestic

$
39,944

$
68,140

$
40,373

$
4,538

$
5,486

$
8,207

$
14,443

$
8,958Net sales, international


9,484


6,170


9,535


5,288


7,621


10,004


9,382


6,640Depreciation and amortization


102


114


114


292


150


132


183


178


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F-39

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Table of Contents

HEELYS, INC.

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued)

21. QUARTERLY FINANCIAL INFORMATION (UNAUDITED) (Continued)





F-40

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Table of Contents

HEELYS, INC.    Valuation and Qualifying Accounts and Reserves    (In thousands)

For
the years ended December 31, 2006, 2007 and 2008:

Description

Balance at
Beginning of
Period

Charged to
Costs and
Expenses

Deductions

Balance at
End of
PeriodYear ended December 31, 2006Allowance for doubtful accounts

$
130

$
435

$
(155
)
$
410Reserve for estimated returns


213


1,898


(979
)

1,132Reserve for cooperative advertising and marketing discretionary fund allowances


361


2,033


(1,977
)

417Reserve for inventory valuation


38


203


(199
)

42Year ended December 31, 2007Allowance for doubtful accounts

$
410

$
333

$
(554
)
$
189Reserve for estimated returns


1,132


5,117


(3,265
)

2,984
(1)Reserve for cooperative advertising and marketing discretionary fund allowances


417


8,391


(5,016
)

3,792
(2)Reserve for inventory valuation


42


1,809


(1,851
)

Year ended December 31, 2008Allowance for doubtful accounts

$
189





(69
)

120Reserve for estimated returns


2,984


995


(3,368
)

611
(3)Reserve for cooperative advertising and marketing discretionary fund allowances


3,792


126


(3,570
)

348
(4)Reserve for inventory valuation





2,183


(1,486
)

697


---

F-41

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