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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, 2009
Oro

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

75-2880496(State of incorporation)

(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 whether the registrant has submitted electronically and posted on its corporate Web site, if any, every Interactive Data File required to be
submitted and posted pursuant to Rule 405 of Regulation S-T (§232.405 of this chapter) during the preceding 12 months (or for such shorter period that the
registrant was required to submit and post such files). Yes o 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

Smaller reporting company ý(Do not check if a smaller
reporting company)


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, 2009, 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 $21.6 million (based upon the closing price for the registrant's common stock on The Nasdaq Stock Market of $1.99 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 8, 2010, 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 2010, 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 ANNUAL REPORT ON FORM 10-K



PART IItem 1.

Business

1Item 1A.

Risk Factors

9Item 1B.

Unresolved Staff Comments

20Item 2.

Properties

20Item 3.

Legal Proceedings

21Item 4.

Reserved

22PART IIItem 5.

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

23Item 6.

Selected Financial Data

24Item 7.

Management's Discussion and Analysis of Financial Condition and Results of Operations

25Item 7A.

Quantitative and Qualitative Disclosures about Market Risk

39Item 8.

Consolidated Financial Statements and Supplementary Data

39Item 9.

Changes in and Disagreements with Accountants on Accounting and Financial Disclosure

39Item 9A(T).

Controls and Procedures

39Item 9B.

Other Information

40PART IIIItem 10.

Directors, Executive Officers and Corporate Governance

41Item 11.

Executive Compensation

41Item 12.

Security Ownership of Certain Beneficial Owners and Management and Related Stockholder Matters

41Item 13.

Certain Relationships and Related Transactions, and Director Independence

41Item 14.

Principal Accounting Fees and Services

41PART IVItem 15.

Exhibits and Financial Statement Schedules

42SIGNATURES

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Cautionary Note Regarding Forward-Looking Statements

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, our intellectual property may not restrict competing products that infringe on our patents from being sold, continued changes in fashion trends and consumer preferences
and general economic conditions, 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.

PART I

Item 1.    Business

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 operations in
Europe, the Middle East and Africa.

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

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furnished
pursuant to Section 13(a) or 15(d) of the Exchange Act, as soon as reasonably practicable 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 atwww.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 SEC 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 2009, approximately 98% of our net sales were derived from the sale of our HEELYS-wheeled footwear. The remainder of our net sales were derived from the sale of
non-wheeled footwear and branded accessories, such as replacement wheels.

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 and Modell's; department stores such as JCPenney; specialty apparel and
footwear retailers such as Skechers 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 and Amazon.com. In 2009, we distributed certain styles through Ross, a discount retailer, in order to sell excess inventory. In 2009, 34.6% 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 markets. During the first quarter of
2008, we 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 March 31, 2008 and April 30, 2008, respectively, we entered into agreements with
our former distributor in Germany and Austria (German market) and our former distributor in France, Monaco and Andorra (French market) whereby we terminated their rights to distribute our products in
their specified markets. We took over the distribution of our products in the German market effective April 1, 2008 and in the French market effective May 1, 2008.

In
2008, we opened a representative office in Qingdao, China. This office serves multiple sourcing functions including quality control, price negotiation, logistics and product
development.

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 our products appeal to a broad range of young, active consumers around the world who enjoy wheeled sports activities. The primary market for HEELYS-wheeled footwear is five to
fourteen year-old boys and girls.

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 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

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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:

Single-Wheel.Our single-wheel HEELYS-wheeled footwear has one detachable wheel and are available in various sizes for men,
women and children. We
offer wheels of various performance capabilities in order to appeal to beginners and advanced users. In addition to offering standard styles, we collaborate with certain of our retail customers to
develop HEELYS-wheeled footwear styles that these retail customers have the exclusive rights to sell. This special make-up program enables these customers to differentiate their
HEELYS-wheeled footwear product offering and allows us to broaden our product range.

Two-Wheel.Our two-wheel HEELYS-wheeled footwear includes two detachable wheels, are designed for novice users and are
offered only in children's sizes. The two-wheel HEELYS-wheeled footwear has been sold primarily to our distributor in Japan; however, we plan to launch this product in the domestic market
in 2010.

Grind-and-Roll.Grind-and-roll HEELYS-wheeled footwear represents our highest performance category
and are preferred by enthusiasts seeking a challenging and exciting action sports experience. This category features a single detachable wheel and a patented, hard nylon plate in the arch, enabling
the consumer to slide, or "grind," on hand railings and other similar surfaces. Consumers can use our grind-and-roll HEELYS-wheeled footwear to perform distinctive maneuvers,
similar to those performed by skateboarders and inline skaters.

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 and dialogue between our sales representatives and our retail customers.

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, we 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.

Currently,
we do not sell our products to traditional mass merchants or directly to consumers. We sold certain styles to select discount retailers in order to reduce our inventory levels
and dispose of excess inventory in 2008 and 2009. We expect sales to discount retailers will decline in 2010 due to our lower inventory levels. In 2010, we expect we will sell certain styles directly
to consumers via our website.

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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 we believe is consistent with our brand message and positioning. The Sports Authority, Academy, JCPenney, Big 5, Modell's, Skechers, Journeys, Famous
Footwear, Shoe Carnival, Zappos.com and Amazon.com are examples of our domestic retail customers. In 2008 and 2009, our domestic net sales were $37.1 million and $15.2 million
respectively, representing 52.4% and 34.6% 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. In 2008, we elected to reduce the number of stores
offering Heelys 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 sales representatives who are
employed by 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, 2009, we offered our products internationally through 31 independent distributors, each of which has
exclusive rights to a designated territory. In 2009, our largest international territory managed by an independent distributor was Japan, which accounted for 17.5% of our total net sales. 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, we 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
March 31, 2008 and April 30, 2008, respectively, we entered into agreements with our former distributor in Germany and Austria (German market) and our former distributor in France,
Monaco and Andorra (French market) whereby we terminated their rights to distribute our products in their specified markets. We took over the distribution of our products in the German market
effective April 1, 2008 and in the French market effective May 1, 2008. In 2009, our German and French markets accounted for 14.4% and 19.8% of our net sales, respectively.

In
2008 and 2009, our international net sales were $33.6 million and $28.6 million, respectively, representing 47.6% and 65.4% of our total net sales, respectively. We
believe 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 third party distributors in most countries and they have their own direct and independent sales representatives. In our direct international
markets, we utilize both employees and independent sales representatives.

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Principal Customers

In 2008, Journeys accounted for 9.9% of our net sales. In 2009, AG Corporation and Oxylane Group accounted for 17.5% and 10.9% of our
net sales, respectively. AG Corporation is the Company's independent distributor in Japan, and Oxylane Group is a French sporting goods retail chain operating under the name Decathlon. No other retail
customer or independent distributor accounted for 10% or more of our net sales in either of these periods.

Marketing

Our marketing strategy is to position our products and the HEELYS brand to represent a lifestyle that allows our consumers to have
Freedom and Fun with the sense that they are Fearless, providing them a sense of excitement and individuality. We utilize a multi-faceted strategy to promote awareness of and generate demand for the
HEELYS brand. This strategy includes a mix of mass advertising, point of purchase, or "POP," displays, product placement, targeted licensing agreements and partnerships, public relations,
celebrity/influential product trials and experiential 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 respective 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 allow 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

Kids, Tweens and Teens look to celebrities, musicians and other stars for inspiration and fashion cues. Therefore, we identify and
secure, through our agency relationships, "product-in-use" opportunities for our domestic and international markets ranging from feature films to television and celebrity
endorsement. We believe product placement activities enable us to build awareness of and demand for our products in a cost-effective manner.

Targeted Licensing Agreements and Partnerships

As our target demographic looks for inspiration from the celebrity world, our consumers are also fans of sporting teams and other
corporations that market their products to our same customer. Partnerships and licensing agreements allow us to communicate with consumers, along with other non-competing brands, in an
effort to establish a broader relationship with the consumer. It also allows us to get the most of our marketing funds by working with other brands that want to send the same or similar message.

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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

We are currently redesigning and upgrading thewww.heelys.comwebsite. The project's
goal is to provide a more interesting, informative and fun site for the online community of HEELYS users. The redesigned website will allow HEELYS to have an on-line store for select
products. In addition, the new site will allow us to advertise one main URL, to have a global look and feel and let our international offices modify language and specific product information while
keeping the same branded look and allow our consumers to choose their country and language.

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 alternate manufacturing or supply
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
2008, we opened a representative office in Qingdao, China. This office serves multiple sourcing functions including quality control, price negotiation, logistics and product
development. Prior to 2008, 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 the port in 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 2008, we also shipped products to a warehouse in San Pedro, California which was managed by a third party
logistics provider. In 2009, we no longer used this third party logistics provider. Upon receipt at our warehouse, merchandise is inspected and recorded in our management information systems and
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.

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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 we opened an office in Belgium we 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 current economic environment, our retail customers 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 90 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 95 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 internationally. 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 the holiday season. 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.

Employees

As of December 31, 2009, we employed a total of 51 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.

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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 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 current needs. However, we will continue to assess the need to expand and upgrade our information technology systems to support actual or expected future needs.

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 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, 2009, our backlog was approximately $2.0 million, compared to approximately $4.3 million at December 31, 2008. Although generally these orders are not subject
to cancellation prior to the date of shipment, cancellations have and may continue to occur. In the current economic environment, our retail customers are being cautious when placing orders and have
shifted towards shorter lead times and at-once inventory purchases. 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 2008 and 2009, 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 currently 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 our products will hold long-term consumer appeal.

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 we believe may
infringe upon our intellectual property rights. Knockoff products often are sold under a brand name that is the same

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as
or substantially similar to the HEELYS name. Knockoff and counterfeit products may continue to emerge, as others seek to trade on the goodwill of the HEELYS name and benefit from 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.

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

In the current economic environment, consumer confidence is low resulting in a reduction in discretionary consumer spending. When
discretionary consumer spending is reduced, purchases of our products may decline. We have noticed caution from our retail customers and this may continue to result in lower than expected orders by
some of our customers. Continued uncertainties regarding future economic prospects could have a material adverse effect on our results of operations. A 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

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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.

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, 2008, Journeys and Famous Footwear accounted for approximately
9.9% and 8.8% of our net sales, respectively. For the year ended December 31, 2009, AG Corporation and Oxylane Group accounted for approximately 17.5% and 10.9% of our net sales, respectively.
AG Corporation is the Company's independent distributor in Japan, and Oxylane Group is a French sporting goods retail chain operating under the name Decathlon. No other retail customer or independent
distributor accounted for 10% or more of our net sales in either 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,

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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 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 manner in which, or 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. 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. Additionally, in 2010 we contemplate selling certain of our products
directly to consumers via our website which may alienate certain of our retail customers and result in reduced sales to our retail customers. Reduced sales to our retail customers could have an
adverse impact on our financial condition and results of operations.

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 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.

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

During the first quarter of 2008, we 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 distribution model and the development of additional
distribution capabilities. This 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 distribution model may also adversely impact our relationship with our independent distributors.

Because our products are manufactured in Asia, because we operate offices in China, Belgium, Germany and France, and because a portion of our sales activities occur outside
of the United States, 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 47.6%
and 65.4% of our net sales in 2008 and 2009, respectively. We do not currently 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.

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 statement of operations and balance sheet of our Belgian subsidiary into U.S. dollars. For example, there is currently an intercompany loan due to our U.S. entity from
our Belgian subsidiary which must be repaid in U.S. dollars. Because this intercompany loan is U.S. dollar denominated (and not the Euro, which is the functional currency of our Belgian subsidiary),
our Belgian subsidiary recognizes a loss if the U.S. dollar strengthens compared to the Euro and recognizes a gain if the U.S. dollar weakens compared to the Euro. This impact is recorded in other
income and expense. We have not used foreign currency exchange contracts to hedge the profit and loss effects of any foreign currency exchange 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.

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

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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. In July of 2009, our Board of Directors elected Thomas C. Hansen to serve as our Chief Executive Officer.

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 independent sales representatives who are
employed by independent sales agencies. In our German and French markets we primarily rely on 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.

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 results 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," requires a 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 work with an accredited third party
testing service 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 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 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 we are infringing their intellectual property rights. While we do not believe 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 or

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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 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 brand image and results of operations.

We sell our products to sporting goods retailers, department stores, 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 2009, we sold certain styles of our product
to discount retailers in order to sell excess inventory. If we choose to distribute to mass merchants in the future, it 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 comparisons of our operating results between different quarters within a single year are not necessarily meaningful
and that these comparisons cannot be relied upon as indicators of our future performance. Any seasonal or quarterly

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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.

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. 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.

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



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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.

Existing stockholders significantly influence our corporate governance.

As of December 31, 2009, our executive officers, key employees, directors and their affiliates beneficially owned, in the
aggregate, approximately 36% 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 Chief Executive Officer of a company wholly-owned by CSC. The Chairman of our Audit
Committee 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

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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. 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, 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. 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.

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 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
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.

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

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Table of Contents

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 the Company's December 7, 2006 initial public offering (the "IPO")along with Capital
Southwest Corporation, Capital Southwest Venture Corporation and the underwriters for the IPOwere 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 alleged violations of Sections 11 and 15 of the Securities Act of 1933. The
plaintiff sought 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 were transferred to a single judge and were consolidated into a
single
action. Lead plaintiffs and lead counsel were appointed. An amended consolidated complaint was filed on March 11, 2008. The amended complaint alleged that the prospectus used in connection with
the Company's IPO contained misstatements of material fact or omitted to state material facts necessary in order to make the statements made not misleading relating to among other allegations, safety
concerns and injuries associated with the Company's products and their alleged impact on demand, visibility into the Company's sales channel and competition from knockoffs, in violation of
Sections 11, 12(a)(2) and 15 of the Securities Act of 1933 and requested 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 agreed to pay Plaintiffs and a proposed plaintiff settlement class a total of $7.5 million, including attorneys' fees and expenses. The Company also reached
an agreement with its insurers for the Company's insurance policies to fund the majority of this settlement amount. On November 17, 2009, the Court approved the settlement and signed a Final
Judgment and Order of Dismissal with Prejudice with respect to the lawsuit.

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 complaints
alleged 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 sought 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 was a nominal defendant, and the complaint did not seek any damages against the Company; however, the Company may have had indemnification
obligations to one or more of the defendants under the Company organizational documents. The derivative lawsuits were transferred to a single judge and 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

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Table of Contents

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
$1.0 million. The Company also reached an agreement with its insurers for the Company's insurance policies to fund the majority of this settlement amount. On November 17, 2009, the Court
approved the settlement and signed a Final Judgment and Order of Dismissal with Prejudice with respect to the lawsuit.

The
Company's insurance policies funded the majority of the settlement amounts related to the lawsuits described above and the Company paid approximately $800,000 of the settlement
amounts.

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 the Company's December 7, 2006 initial public offering (the "IPO")along with Capital Southwest Corporation, Capital Southwest Venture
Corporation and the underwriters for the IPOwere 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 asserted claims that were substantially similar to those asserted in the consolidated class action described above. Plaintiff alleged that he purchased
over 600,000 shares of Heelys for approximately $17.4 million. Plaintiff claimed to have sold his stock for a loss of approximately $11 million, which he sought to recover plus interest,
costs, and attorney fees. Plaintiff's second amended petition alleged violations of Sections 11 and 15 of the Securities Act of 1933, Sections 33(A), (C), and (F) of the Texas
Securities Act, and Section 27.01 of the Texas Business and Commerce Code. Defendants withdrew their previously-filed special exceptions to Plaintiff's petition seeking to have all claims
dismissed. On August 21, 2009, Plaintiff and Defendants settled this case for $5.25 million. The Company paid $2.5 million of this settlement amount on August 25, 2009, and
was subsequently reimbursed by the Company's insurance policies. The Company paid the remaining $2.75 million on December 1, 2009, and the Company's insurance policies subsequently
reimbursed the Company approximately $253,000 of this amount. Pursuant to the settlement agreement, the lawsuit was dismissed with prejudice on September 18, 2009.

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 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.    Reserved

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Table of Contents

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 Capital Market under the stock symbol "HLYS." As of March 8, 2010, there were
approximately 126 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, 2009 and
2008.

2009

High

LowFirst Quarter

$
2.49

$
1.10Second Quarter

$
2.80

$
1.42Third Quarter

$
2.91

$
1.67Fourth Quarter

$
2.64

$
2.01




2008

High

LowFirst Quarter

$
7.26

$
4.01Second Quarter

$
5.18

$
3.86Third Quarter

$
5.74

$
3.96Fourth Quarter

$
4.44

$
2.16


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. 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, 2009, we had used $8.5 million of these proceeds to repay amounts outstanding under our revolving credit facility and $27.7 million for working
capital purposes ($8.5 million in December 2006, $19.2 million in 2007), and $8.6 million in 2008 to expand our international operations.

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Table of Contents

No
proceeds were used in 2009. We intend to use the remaining proceeds to fund potential acquisitions, 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 825,835
shares remaining available at December 31, 2009 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 coldumn
(a)) (c)(a)

(b)

(c)Equity compensation plans approved by security holders


1,604,713

$
4.03


825,835Equity compensation plans not approved by security holders




$



Total


1,604,713

$
4.03


825,835


The
table above sets forth information regarding our 2006 Plan as of December 31, 2009.

Item 6.    Selected Financial Data

We are a Smaller Reporting Company as defined in Rule 12b-2 of the Securities Exchange Act of 1934 and are not
required to provide information under this Item.

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Table of Contents

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 discussion contains forward-looking statements that involve risks and uncertainties. Our actual results may
differ materially from those anticipated in these forward-looking statements due to known and unknown risks, uncertainties and other factors, including those described in Part I,
"Item 1A. Risk Factors" and elsewhere in this Annual Report on Form 10-K. Those risk factors expressly qualify all subsequent oral and written forward-looking statements
attributable to us or persons acting on our behalf. 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. In 2009,
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 the sale of non-wheeled footwear and branded
accessories, such as replacement wheels. 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, select
department stores, 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 markets. During the first quarter of 2008, we 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 March 31, 2008 and April 30, 2008, respectively, we entered into agreements with our former distributor in Germany and Austria (German market) and our former
distributor in France, Monaco and Andorra (French market) whereby we terminated their rights to distribute our products in their specified markets. Our Belgian subsidiary took over the distribution of
our products in the German market effective April 1, 2008 and in the French market effective May 1, 2008.

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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 new products and companies.

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. The remainder of our net sales was derived from the sale of non-wheeled footwear and branded
accessories, such as replacement wheels. Amounts billed to 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 2009, 34.6% of our net sales were derived from domestic retail customers.

Internationally,
our products are sold primarily to independent distributors with exclusive rights to specified markets. During the first quarter of 2008, we 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. We took over the distribution of our products in Germany and Austria (German market) effective April 1, 2008 and in France, Monaco and Andorra
(French market) effective May 1, 2008. In 2009, our German and French markets accounted for 14.4% and 19.8% of our net sales, respectively.

Additionally,
effective April 1, 2008, our subsidiary in Belgium became responsible for sales to our independent distributors in EMEA (Europe, the Middle East and Africa). Sales
to our customers in the German and French markets 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

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non-EMEA
markets 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.

In
2009, AG Corporation, the Company's independent distributor in Japan, accounted for 17.5% of our net sales; and Oxylane Group, a French sporting goods retail chain operating under the
name Decathlon, accounted for 10.9% of our net sales. No other retail customer or independent distributor accounted for 10% or more of our net sales during 2009.

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 freight, royalty expenses related to licensed intellectual property, an inventory reserve for shrinkage and write-downs and costs associated with operating our representative office
in China.

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 our sourcing model
allows us to minimize our capital investment, retain 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.

In
January 2008, we terminated our consulting agreement with our 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.

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 costs, our product mix and our ability to avoid excess inventory by accurately forecasting demand for our products. The unit prices we charge our
domestic and international retail customers are generally higher than 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 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, shipping and handling costs, 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.

General
accounting principles require 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

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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.

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 sales operations for Europe, the Middle East and Africa. 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 31,2008

2009Net sales


100.0
%

100.0
%Cost of sales


69.9
%

64.2
%Gross profit


30.1
%

35.8
%Selling, general and administrative expenseSales and marketing


16.0
%

14.9
%General and administrative


23.3
%

27.5
%Litigation settlements and related costs


2.6
%

9.4
%Severance


1.0
%

0.4
%Total selling, general and administrative expense


42.9
%

52.2
%Loss from operations


(12.8
)%

(16.4
)%Other expense (income)


(3.7
)%

(1.6
)%Loss before income taxes


(9.1
)%

(14.8
)%Income tax benefit


(0.7
)%

(3.1
)%Net loss


(8.4
)%

(11.7
)%


Highlights fiscal year ended December 31, 2009:



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Comparison of the Years Ended December 31, 2009 and 2008

Net Sales

Year Ended December 31,2008

2009Net Sales (in thousands)Domestic

$
37,094

$
15,157International


33,647


28,620Consolidated

$
70,741

$
43,777Net Sales (as % of Total Consolidated Net Sales)Domestic


52.4
%

34.6
%International


47.6
%

65.4
%Consolidated


100.0
%

100.0
%


Domestically,
our net sales decreased $21.9 million, or 59.1%, to $15.2 million in 2009, from $37.1 million in 2008. This decrease was primarily the result of lower
unit sales of our HEELYS-wheeled footwear which decreased by 849,000 pairs, or 55.4%, to 682,000 pairs in 2009, from 1.5 million pairs in 2008. We believe the decrease in unit sales may be
attributable to the higher inventory levels at certain of our domestic accounts as they experience decreased sales due to the overall depressed retail environment. As a result, retailers have been
reluctant to place significant orders until their current inventory levels are reduced to targeted levels. Additionally, our average sales price per unit decreased approximately 9.6%. This decrease in
average sales price per unit is attributable to the sale of certain of our older styles at lower prices to a discount retailer in 2009.

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Internationally,
our net sales decreased $5.0 million, or 14.9%, to $28.6 million in 2009, from $33.6 million in 2008. This decrease was the result of lower unit
sales of our HEELYS-wheeled footwear which decreased by 166,000 pairs, or 15.4%, to 910,000 pairs in 2009, from 1.1 million pairs in 2008. Unit sales in our German and French markets increased
101,000 pairs, or 44.4%, to 329,000 in 2009, from 228,000 in 2008. This increase in units sold was offset by a decrease in units sold to distributors. Unit sales to distributors decreased 267,000
pairs, or 31.5%, to 581,000 pairs in 2009, from 849,000 pairs in 2008.

Gross Profit

Year Ended December 31,2008

2009Gross Profit (in thousands)Domestic

$
9,976

$
2,943International


11,336


12,723Consolidated

$
21,312

$
15,666Gross Profit (%)Domestic


26.9
%

19.4
%International


33.7
%

44.5
%Consolidated


30.1
%

35.8
%


Domestically,
gross profit decreased $7.0 million to $2.9 million in 2009, from $10.0 million in 2008. This decrease is attributable to the lower sales volume and
lower average sales price; offset by a decrease in material costs and a reduction in inventory markdowns ($1.1 million in 2009 versus $2.1 million in 2008). The domestic gross profit
percentage of 19.4% was negatively impacted by the sales of excess inventory to discount retailers. Excluding sales to discount retailers the domestic gross profit percentage would have been 22.4%.

Internationally,
gross profit increased $1.4 million to $12.7 million in 2009, from $11.3 million in 2008. The gross margin percentage improved from 33.7% in 2008,
to 44.5% in 2009 primarily due to an
increase in the proportion of sales to our direct customers in the German and French markets as well as lower material costs.

Sales and Marketing Expense

Year Ended December 31,2008

2009Selling & Marketing (in thousands)Domestic

$
9,328

$
3,062International


2,008


3,467Consolidated

$
11,336

$
6,529


Domestically,
selling and marketing expense, excluding commissions and payroll and payroll related expenses, decreased $5.1 million to $1.4 million in 2009, from
$6.5 million in 2008. These decreases were primarily a result of cost reduction efforts, which included a decrease in consumer advertising related costs which decreased $3.0 million to
$648,000 in 2009, from $3.7 million in 2008. Additionally, through cooperative advertising programs, we reimburse certain of our domestic retail customers for their costs of advertising our
products. Cooperative marketing related costs decreased $481,000 to $75,000 in 2009, from $556,000 in 2008. This decrease in cooperative marketing related costs is

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primarily
a result of the decrease in sales to those customers that participate in the cooperative marketing program.

Internationally,
selling and marketing expense, excluding commissions and payroll and payroll related expenses, increased approximately $849,000 to $1.7 million in 2009, from
$860,000 in 2008. This increase was mainly the result of increased consumer advertising and other marketing related expenses in our German and French markets.

Commissions
on domestic sales decreased $583,000, or 44.6%, to $725,000 in 2009, from $1.3 million in 2008. The decrease in commissions is mainly due to the decrease in domestic
sales. Internationally, commissions increased $337,000 to $577,000 in 2009, from $240,000 in 2008. This increase is a result of
increased direct sales in our German and French markets which began in April 1, 2008 and May 1, 2008, respectively; prior to that time sales in these markets were through independent
distributors.

Payroll
and payroll related costs for our domestic operations decreased $626,000 to $950,000 in 2009, from $1.5 million in 2008. The decrease in payroll and payroll related costs
for our domestic operations is mainly the result of reduction in headcount. Payroll and payroll related costs attributable to our international operations increased approximately $272,000 to
$1.2 million in 2009, from $909,000 in 2008. This increase in payroll and payroll related costs for our international operations is due to the opening of our office in Belgium (with branch
offices in Germany and France) in February 2008; offset by reduced headcount in 2009.

General and Administrative Expense

Year Ended December 31,2008

2009General & Administrative (in thousands)Domestic

$
9,228

$
6,013International


4,923


4,039Unallocated


2,357


1,982Consolidated

$
16,508

$
12,034


Consolidated
general and administrative expenses (excluding unallocated costs) decreased $4.1 million to $10.1 million in 2009, from $14.2 million in 2008. This
decrease is mainly attributable to a decrease in legal and other professional fees, a decrease in insurance costs, and management's overall cost reduction efforts. Legal and other professional fees
decreased $1.8 million to $1.4 million in 2009, from $3.2 million in 2008. This decrease is mainly attributable to a decrease in legal fees related to our intellectual property
and associated enforcement as well as management's overall cost reduction efforts. Insurance costs decreased $566,000 to $611,000 in 2009, from $1.2 million in 2008. The decrease in insurance
costs is attributable to a decrease in sales, lower negotiated insurance rates and changes in coverage.

Unallocated
costs are those costs that are directly attributable to operating as a public company. The decrease in these unallocated costs is mainly attributable to management's cost
reduction efforts.

Litigation Settlements and Related Costs

Year Ended December 31,2008

2009Litigation Settlements & Related Costs (in thousands)

$
1,823

$
4,117


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Litigation settlements and related costs are primarily related to the class action lawsuit (filed in August 2007), the shareholders' derivative lawsuit (filed in
October 2007) and the individual lawsuit (filed in May 2008). These lawsuits were settled during the third and fourth quarters of 2009.

Severance

Year Ended December 31,2008

2009Severance (in thousands)

$
693

$
154


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 received approximately $470,000 and was entitled to receive up to 14 months for reimbursements for health and life insurance. Additionally, the former CEO
agreed to perform certain consulting services for one year with no additional monetary compensation. During the term of the consulting relationship, options previously granted to the former CEO
continued to vest and as a result we recognized approximately $207,000 in stock-based compensation expense, which was 100% of the related stock-based compensation for those stock options that were
expected to vest during the term of the consulting arrangement.

In
May 2008, the Company named a replacement CEO. On February 10, 2009, the individual named as the Company's replacement CEO resigned. In connection with his resignation, he and
the Company entered into a Severance and General Release Agreement (the "SGR Agreement"). Under the SGR Agreement, the former CEO received approximately $150,000 and was entitled to receive up to six
months of reimbursements for health insurance.

Other Expense (Income)

Year Ended December 31,2008

2009Other (Income) Expense (in thousands)Interest (income) expense, net

$
(2,049
)
$
(171
)Other (income) expense, net


(1,151
)

(321
)Exchange (gain) loss, net


593


(198
)Other (Income) Expense (in thousands)

$
(2,607
)
$
(690
)


Interest
income (net of interest expense) decreased $1.9 million to $171,000 in 2009, from $2.0 million in 2008 primarily due to a decrease in interest income. The decrease
in interest income is due to a decrease in invested cash balances, mainly as a result of the $27.6 million dividend paid in December 2008, as well as a decrease in interest rates earned on
invested cash balances. Other income decreased $830,000 to $321,000 in 2009, from $1.2 million in 2008. Other income is primarily the result of the settlement of patent and trademark lawsuits.
We recognized a $198,000 net gain generated by foreign currency transactions in 2009; compared to a $593,000 net loss in 2008. Gains (losses) resulting from foreign currency transactions are mainly
attributable to an intercompany loan due to our U.S. entity from our Belgian entity which must be repaid in U.S. dollars.

Income Taxes

We recognized an income tax benefit of $1.4 million (effective tax rate of 20.9%) in 2009; compared to an income tax benefit of
$517,000 (effective tax rate of 8.0%) in 2008. Our effective tax

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rates
differ from the statutory federal rate of 35% for certain items, such as state and local taxes, non-deductible expenses, foreign operating losses for which tax benefits have been
recognized, foreign taxes at rates other than 35% and income tax liabilities on earnings generated outside of the U.S.

Liquidity and Capital Resources (in thousands)

Our primary cash need is for working capital, which we generally fund with cash flow from operating activities, and may be impacted by
fluctuations in demand for our products, investments in our infrastructure and expenditures on marketing and advertising. At December 31, 2009, we had a total of $39.4 million in cash
and cash equivalents, $20.6 million in current investments and $6.6 million in non-current investments. Our current investments will mature during the next 12 months
and include investments in certificates of deposit ($10.0 million) and debt securities ($10.6 million). Our non-current investments are in debt securities and will mature
within the next 18 months.

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 31,2008

2009Cash and cash equivalents at beginning of period

$
98,771

$
68,446Cash used in operating activities


(2,062
)

(1,058
)Cash used in investing activities


(2,397
)

(27,622
)Cash used in financing activities


(25,561
)

(567
)Effect of exchange rate changes on cash and cash equivalents


(305
)

171Cash and cash equivalents at end of period

$
68,446

$
39,370


For
the year ended December 31, 2009, cash used in operating activities was $1.1 million compared to $2.1 million of cash used in operating activities for the year
ended December 31, 2008. Cash used in 2009 was primarily the result of a net loss of $5.1 million adjusted for non-cash items including depreciation and amortization expense
of $818,000, stock-based compensation expense of $525,000, an inventory impairment charge of $1.1 million, $721,00 in deferred income taxes; partially offset by an unrealized gain of $243,000
due to the effect of changes in the foreign exchange rate related to an intercompany loan due to our U.S. entity from our Belgian entity which must be repaid in U.S. dollars and a $1.1 million
change in operating assets and liabilities.

The
change in operating assets and liabilities was due to:



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Cash
used in operating activities for the year ended December 31, 2008 was primarily the result of a net loss of $5.9 million adjusted for non-cash items
including depreciation and amortization expense of $643,000, 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), an inventory impairment charge of $2.1 million, an unrealized loss on foreign currency transactions of $609,000 due to the effect of changes in the foreign
exchange rate related to an intercompany loan due to our U.S. entity from our Belgian entity which must be repaid in U.S. dollars; partially offset by a $583,000 change in net deferred income tax
benefits and a $86,000 change in operating assets and liabilities.

Net
cash used in investing activities totaling $27.6 million for the year ended December 31, 2009 relates primarily to investment purchases ($10.0 million in
certificates of deposit and $17.1 million in debt securities). Net cash used of $2.4 million during the year ended December 31, 2008 was mainly for payments in connection with the
termination of agreements with our former independent distributors in the German and French markets. The balance of the cash used during 2008 was attributable to the opening of our offices in Belgium,
Germany and France as well as for upgrades to our information technology systems.

Cash
used in financing activities for the year ended December 31, 2009 was for payments of our previously acquired goodwill and intangible assets associated with the termination
of agreements with our former independent distributors in the German and French markets in 2008. Cash used in financing for the year ended December 31, 2008 was the result of dividends of
$27.6 million paid during the period, less proceeds from stock option exercises of $2.0 million.

We
believe our cash flow from operating activities, together with the cash on hand and investments, will be sufficient to meet our liquidity needs and capital expenditure requirements
for at least the next 12 months.

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 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,

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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.

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. Payments under this lease agreement are made in Euro.

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. Payments under this lease agreement are made in Euro.

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. Payments under this lease agreement are made in Euro.

Third-Party Distribution Arrangement

We use a third-party distribution facility in Belgium and pay this third-party distributor fees and charges for services including
storage, 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 $1,265,000 and $1,297,000 related to this third-party distribution facility in 2008 and 2009, respectively.

Purchase Commitments:

At December 31, 2009, we had open purchase commitments of $2.7 million related to inventories that were still being held
by the manufacturers.

Consulting Agreement:

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.

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 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 Company and the Distributor was terminated, we

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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, and the Distributor and Lippoth agreed, until
March 31, 2010, not to compete with us relating to the Company's products anywhere in the world. In connection with the Termination Agreement we 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 we 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, we entered into a Consulting Agreement with TIL pursuant to which, among other things, TIL agreed to perform
certain consulting services and we 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, 2009, the Company paid $2.5 million (1.7 million Euro) for these acquired assets with the balance of $1.0 million (687,000 Euro) to be paid out over
time in accordance with the terms of the agreements; $456,000 is recorded as other long term liability and $547,000 is recorded as a current liability.

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

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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.

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, 2009, our backlog was approximately $2.0 million, compared to approximately $4.3 million at December 31, 2008. Although generally, these orders are not subject
to cancellation prior to the date of shipment, cancellations have and may continue to occur. In the current economic environment, our retail customers are being cautious when placing orders and have
shifted towards shorter lead times and at-once inventory purchases. 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 2008, Journeys accounted for 9.9% of our net sales. In 2009, AG Corporation and Oxylane Group accounted for 17.5% and 10.9%,
respectively, of our net sales. AG Corporation is the Company's independent distributor in Japan, and Oxylane Group is a French sporting goods retail chain operating under the name Decathlon.

We
took over the distribution of our products in Germany and Austria (German market) effective April 1, 2008 and in France, Monaco and Andorra (French market) effective
May 1, 2008. In 2009, our German and French markets accounted for 14.4% and 19.8% of our net sales, respectively.

No
other retail customer or independent distributor accounted for 10% or more of our net sales in either 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.

Off-Balance Sheet Arrangements

We do not have any off-balance sheet arrangements.

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

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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 discounts, marketing discretionary funds, estimated returns and other allowances, including permitted returns of damaged or defective
merchandise. We base our estimates and judgments on historical experience and other various factors, including customer communications and analysis of relevant market information.

Accounts Receivable.We continually make estimates relating to the collectability of our accounts receivable, as well as estimates for
customer
returns, defective merchandise and allowances for co-op advertising and marketing discretionary funds. In determining these allowances, we consider our historical experience, 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 determine that smaller or larger allowances are appropriate, these changes in estimates are recorded in the period in which such determination is made.

Inventories.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 the net realizable value of our inventory is less than the cost of the inventory,
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 as 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.

Goodwill.Goodwill is not amortized but is instead measured for impairment at least annually, or when events indicate that an impairment
might exist.
We compare the estimated fair value of goodwill to its carrying value. Our estimates of fair value utilized in impairment testing 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, 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 resulting impairment charge 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. The Company performs its annual impairment test during the fourth quarter.

Income Taxes.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. We follow guidance provided by Financial Accounting Standards Board Accounting Standards Codification 740, "Income
Taxes," ("ASC 740"). ASC 740 prescribes a comprehensive model for how a company should recognize, measure, present and disclose in its financial statements uncertain tax
positions that the company has taken or expects to take on a tax return. The impact of an uncertain tax position that is

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more
likely than not of being sustained upon examination by the relevant taxing authority is recognized at the largest amount that is more likely than not to be sustained. An uncertain tax position is
not recognized if the position has less than a 50% likelihood of being sustained. Also, under ASC 740, interest expense is recognized on the full amount of deferred benefits for uncertain tax
positions. We
adjust our reserves for uncertain tax positions in light of changing facts and circumstances; however, due to the complexity of some of these uncertainties, the ultimate resolution may result in a
payment that is materially different from our current estimate of the tax liabilities. If our estimate of tax liabilities proves to be less than the ultimate assessment, an additional charge would
result. If payment of these amounts ultimately proves to be less than the recorded amounts, the reversal of the liabilities would result in tax benefits being recognized in the period when we
determine the liabilities are no longer necessary. We recognize interest accrued related to recognized uncertain tax positions in interest expense and related penalties in general and administrative
expenses. Accrued interest and penalties are included within the related tax liability line in the consolidated balance sheet.

Recent Accounting Pronouncements

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 are a Smaller Reporting Company as defined in Rule 12b-2 of the Securities Exchange Act of 1934 and are not
required to provide information under this Item.

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(T).    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 our senior management and 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 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 Chief Executive Officer and Chief Financial Officer concluded that our disclosure controls and procedures are effective to provide reasonable assurance that information
required to be disclosed by us in the reports we file or submit under the Exchange Act is recorded, processed, summarized and reported within required time periods, and that it is made known to our
officers who certify our financial reports, as well as other members of our senior management and Board of Directors, to allow timely decisions regarding required disclosures.

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Inherent Limitations on Effectiveness of Controls

Our management, including our 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 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, 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 2009. We have completed our efforts regarding compliance with Section 404 of the Sarbanes-Oxley
Act of 2002 for the year ended December 31, 2009. 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, 2009, our internal control over financial reporting is effective.

This
Annual Report on Form 10-K does not include an attestation report of the Company's registered public accounting firm regarding internal control over financial
reporting. Management's report was not subject to attestation by our registered public accounting firm pursuant to temporary rules of the SEC that permit us to provide only management's report in this
Annual Report on Form 10-K.

Item 9B.    Other Information

None.

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PART III

Item 10.    Directors, Executive Officers and Corporate Governance

Incorporated by reference from the information in our proxy statement for the 2010 Annual Meeting of Stockholders, which we will file
with the SEC within 120 days of the end of the fiscal year to which this Annual Report on Form 10-K 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 2010 Annual Meeting of Stockholders, which we will file
with the SEC within 120 days of the end of the fiscal year to which this Annual Report on Form 10-K 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 2010 Annual Meeting of Stockholders, which we will file
with the SEC within 120 days of the
end of the fiscal year to which this Annual Report on Form 10-K relates.

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

Incorporated by reference from the information in our proxy statement for the 2010 Annual Meeting of Stockholders, which we will file
with the SEC within 120 days of the end of the fiscal year to which this Annual Report on Form 10-K relates.

Item 14.    Principal Accounting Fees and Services

Incorporated by reference from the information in our proxy statement for the 2010 Annual Meeting of Stockholders, which we will file
with the SEC within 120 days of the end of the fiscal year to which this Annual Report on Form 10-K relates.

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PART IV

Item 15.    Exhibits and Financial Statement Schedules

Exhibit No.

Description3.1

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

Amended and Restated By-Laws of the Registrant (incorporated by reference to Exhibit 3.1 of Registrant's Current Report on Form 8-K filed November 13, 2009).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

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).10.3

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).10.4

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).


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Exhibit No.

Description10.5

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).*10.6

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).*10.7

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).10.8

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).*10.9

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.)10.10

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.)10.11

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.)10.12

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.)


43

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Table of Contents

Exhibit No.

Description10.13

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.)10.14

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.)10.15

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).*10.16

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).*10.17

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).*10.18

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).*10.19

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).*10.20

Executive Employment Agreement, dated as of October 28, 2008, between Heeling Sports Limited and William D. Albers (incorporated by reference to Exhibit 10.1 of Registrant's Current Report on
Form 8-K filed on October 31, 2008).*10.21

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).*10.22

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).*10.23

Letter of 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).*10.24

Executive Employment Agreement, dated as of July 17, 2009, by and between Heeling Sports Limited and Thomas C. Hansen (incorporated by reference to Exhibit 10.1 of Registrant's Current Report on
Form 8-K filed on July 20, 2009).*


44

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Table of Contents

Exhibit No.

Description10.25

Compromise and Settlement Agreement, effective as of August 21, 2009 (incorporated by reference to Exhibit 10.1 of Registrant's Current Report on Form 8-K filed on September 1, 2009).10.26

First Amendment to Executive Employment Agreement dated February 18, 2010 (to be effective as of March 1, 2010) by and between John W. O Neil and Heeling Sports Limited (incorporated by reference to
Exhibit 10.1 of Registrant's Current Report on Form 8-K filed on February 18, 2010).*16.1

Letter, dated as of June 26, 2009, issued by Deloitte & Touche LLP to the SEC (incorporated by reference to Exhibit 16.1 of Registrant's Current Report on Form 8-K filed on June 26,
2009).18.1

Grant Thornton LLP Preferability Letter dated March 12, 2010 regarding change in accounting principle.21.1

List of subsidiaries of the Registrant.23.1

Consent of Grant Thornton LLP, independent registered public accounting firm.23.2

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 Thomas C. Hansen, 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 Chief Executive Officer and Chief Financial Officer pursuant to 18 U.S.C. Section 1350.


*Management
contract or a compensatory plan or arrangement required to be filed as an Exhibit pursuant to Item 15(b) of Form 10-K.Filed
herewith.


45

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Table of Contents

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/ THOMAS C. HANSEN Thomas C. Hansen Chief Executive Officer




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/ THOMAS C. HANSEN Thomas C. Hansen

Chief Executive Officer and Director
    (Principal Executive Officer)

March 12, 2010/s/ LISA K. PETERSON Lisa K. Peterson

Chief Financial Officer
    (Principal Financial Officer)

March 12, 2010Gary L. Martin

Chairman of the Board/s/ JERRY R. EDWARDS Jerry R. Edwards

Director

March 12, 2010/s/ PATRICK F. HAMNER Patrick F. Hamner

Director

March 12, 2010/s/ SAMUEL B. LIGON Samuel B. Ligon

Director

March 12, 2010/s/ N. RODERICK MCGEACHY, III N. Roderick McGeachy, III

Director

March 12, 2010Ralph T. Parks

Director/s/ JEFFREY G. PETERSON Jeffrey G. Peterson

Director

March 12, 2010


46

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Table of Contents

HEELYS, INC.    INDEX TO CONSOLIDATED FINANCIAL STATEMENTS



PageReports of Independent Registered Public Accounting Firms

F-2 - F-3Consolidated Balance Sheets as of December 31, 2008 and 2009

F-4Consolidated Statements of Operations for the Years Ended December 31, 2008 and
2009

F-5Consolidated Statements of Stockholders' Equity and Comprehensive Income (Loss) for
the Years Ended December 31, 2008 and 2009

F-6Consolidated Statements of Cash Flows for the Years Ended December 31, 2008 and
2009

F-7Notes to Consolidated Financial Statements

F-8 - F-31


F-1

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Table of Contents



REPORT OF INDEPENDENT REGISTERED PUBLIC ACCOUNTING FIRM

Board
of Directors and Shareholders
Heelys, Inc.

We
have audited the accompanying consolidated balance sheet of Heelys, Inc. and subsidiaries as of December 31, 2009, and the related consolidated statements of operations,
stockholders' equity and comprehensive income (loss), and cash flows for the year then ended. These financial statements are the responsibility of the Company's management. Our responsibility is to
express an opinion on these financial statements based on our audit.

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

In
our opinion, the consolidated financial statements referred to above present fairly, in all material respects, the financial position of Heelys, Inc. and subsidiaries as of
December 31, 2009, and the results of their operations and their cash flows for the year ended December 31, 2009 in conformity with accounting principles generally accepted in the United
States of America.

We
also have audited the adjustments to the 2008 financial statements to retrospectively apply the change in accounting for shipping and handling expenses, as described in Note 2
to the consolidated financial statements. In our opinion, such adjustments are appropriate and have been properly applied. We were not engaged to audit, review, or apply any procedures to the 2008
financial statements of the Company other than with respect to such adjustments and, accordingly, we do not express an opinion or any other form of assurance on the 2008 financial statements taken as
a whole.

/s/ Grant Thornton LLP

Dallas,
Texas
March 12, 2010

F-2

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Table of Contents

REPORT OF INDEPENDENT REGISTERED PUBLIC ACCOUNTING FIRM

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

We
have audited, before the effects of the adjustments to retrospectively apply the change in accounting discussed in Note 2 to the consolidated financial statements, the
consolidated balance sheet of Heelys, Inc. and subsidiaries (the "Company") as of December 31, 2008, and the related consolidated statements of operations and comprehensive income
(loss), stockholders' equity (deficit), and cash flows for the year ended December 31, 2008, (the 2008 consolidated financial statements before the effects of the adjustments discussed in
Note 2 to the consolidated financial statements are not presented herein).
These consolidated financial statements are the responsibility of the Company's management. Our responsibility is to express an opinion on these consolidated financial statements based on our audit.

We
conducted our audit in accordance with the standards of the Public Company Accounting Oversight Board (United States). Those standards require that we plan and perform the audit to
obtain reasonable assurance about whether the financial statements are free of material misstatement. 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 audit provides a reasonable basis for our opinion.

In
our opinion, such consolidated financial statements, before the effects of the adjustments to retrospectively apply the change in accounting discussed in Note 2 to the
consolidated financial statements, present fairly, in all material respects, the results of the Company's operations and its cash flows for the year ended December 31, 2008, in conformity with
accounting principles generally accepted in the United States of America.

We
were not engaged to audit, review, or apply any procedures to the adjustments to retrospectively apply the change in accounting discussed in Note 2 to the consolidated
financial statements and, accordingly, we do not express an opinion or any other form of assurance about whether such retrospective adjustments are appropriate and have been properly applied. Those
retrospective adjustments were audited by other auditors.

/s/
Deloitte & Touche LLP

Dallas,
Texas
March 31, 2009

F-3

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Table of Contents



HEELYS, INC.        CONSOLIDATED BALANCE SHEETS        (in thousands, except share and par value data)

December 31,2008

2009ASSETSCURRENT ASSETS:Cash and cash equivalents

$
68,446

$
39,370Investments





20,556Accounts receivable, net of allowances of $664 and $414, respectively


6,594


5,704Inventories


12,104


6,038Prepaid and other current assets


831


756Income tax receivable


268


3,106Deferred income tax assets


3,572


3,178Total current assets


91,815


78,708INVESTMENTS, NON-CURRENT





6,566PROPERTY AND EQUIPMENT, net of accumulated depreciation of $1,352 and $1,649, respectively


1,007


856PATENTS AND TRADEMARKS, net of accumulated amortization of $1,136 and $1,240, respectively


310


343INTANGIBLE ASSETS, net of accumulated amortization of $254 and $619, respectively


1,412


1,071GOODWILL


1,668


1,696DEFERRED INCOME TAX ASSETS


284


TOTAL ASSETS

$
96,496

$
89,240LIABILITIES AND STOCKHOLDERS' EQUITYCURRENT LIABILITIES:Accounts payable

$
1,910

$
1,634Accrued expenses


5,091


2,789Income taxes payable


1,347


2,108Total current liabilities


8,348


6,531LONG TERM LIABILITIES:Income taxes payable


442


439Deferred income tax liability





72Other long term liabilities


1,331


458TOTAL LIABILITIES


10,121


7,500COMMITMENTS AND CONTINGENCIES (Note 9)STOCKHOLDERS' EQUITY:Common stock, $0.001 par value, 75,000,000 shares authorized; 27,571,052 shares issued and outstanding as of December 31, 2008 and 2009


28


28Additional paid-in capital


64,809


65,305Retained earnings


21,657


16,532Accumulated other comprehensive loss


(119
)

(125
)Total stockholders' equity


86,375


81,740TOTAL LIABILITIES AND STOCKHOLDERS' EQUITY

$
96,496

$
89,240


See
notes to consolidated financial statements.

F-4

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Table of Contents



HEELYS, INC.        CONSOLIDATED STATEMENTS OF OPERATIONS        (in thousands, except per share data)

Year Ended December 31,2008

2009NET SALES

$
70,741

$
43,777COST OF SALES


49,429


28,111GROSS PROFIT


21,312


15,666SELLING, GENERAL AND ADMINISTRATIVE EXPENSESSelling and marketing


11,336


6,529General and administrative


16,508


12,034Litigation settlements and related costs


1,823


4,117Severance


693


154Total selling, general and administrative expenses


30,360


22,834LOSS FROM OPERATIONS


(9,048
)

(7,168
)OTHER (INCOME) EXPENSEInterest (income) expense, net


(2,049
)

(171
)Other (income) expense, net


(1,151
)

(321
)Exchange (gain) loss, net


593


(198
)Total other (income) expense, net


(2,607
)

(690
)LOSS BEFORE INCOME TAXES


(6,441
)

(6,478
)INCOME TAX BENEFIT


(517
)

(1,353
)NET LOSS

$
(5,924
)
$
(5,125
)LOSS PER SHARE:Basic and diluted

$
(0.22
)
$
(0.19
)WEIGHTED AVERAGE SHARES OUTSTANDING:Basic and diluted


27,321


27,571


See
notes to consolidated financial statements.

F-5

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Table of Contents



HEELYS, INC.        CONSOLIDATED STATEMENTS OF        STOCKHOLDERS' EQUITY AND COMPREHENSIVE INCOME (LOSS)        FOR THE YEARS ENDED DECEMBER 31,
2008 AND 2009        (in thousands)

Common Stock





Accumulated
Other
Comprehensive
LossAdditional
Paid-In
Capital

Retained
Earnings

Total
Stockholders'
EquityShares

AmountBALANCEDecember 31, 2007


27,075

$
27

$
61,783

$
55,152




$
116,962Comprehensive loss:Net loss











(5,924
)




(5,924
)Foreign currency translation adjustment














(119
)

(119
)Total comprehensive loss

















(6,043
)Stock option exercises


496


1


2,010








2,011Stock-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
)

86,375Comprehensive loss:Net loss











(5,125
)




(5,125
)Foreign currency translation adjustment














(6
)

(6
)Total comprehensive loss

















(5,131
)Stock-based compensation expense








525








525Income tax benefit on stock-based compensation awards








(29
)







(29
)BALANCEDecember 31, 2009


27,571

$
28

$
65,305

$
16,532

$
(125
)
$
81,740


(1)On
December 5, 2008, the Company's 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 the shareholders of record on December 15, 2008.


See
notes to consolidated financial statements.

F-6

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Table of Contents



HEELYS, INC.        CONSOLIDATED STATEMENTS OF CASH FLOWS        (in thousands)

Year Ended December 31,2008

2009OPERATING ACTIVITIES:Net Loss

$
(5,924
)
$
(5,125
)Adjustments to reconcile net loss to net cash used in operating activities:Depreciation and amortization


643


818Accretion (amortization) of premium (discount) on investments, net





15Accrued interest income





(96
)Deferred income taxes


(583
)

721Stock-based compensation


1,179


525Unrealized exchange (gain) loss, net


609


(243
)Loss on disposal of property and equipment


24


141Inventory impairment charges


2,076


1,099Changes in operating assets and liabilities:Accounts receivable


(1,122
)

941Inventories


598


4,990Prepaid and other current assets


596


176Accounts payable


1,671


(291
)Accrued expenses and other long term liabilities


(2,629
)

(2,634
)Income taxes payable/receivable


800


(2,095
)Net cash used in operating activities


(2,062
)

(1,058
)INVESTING ACTIVITIES:Purchase of investments





(27,137
)Purchases of equipment


(378
)

(337
)Increase in patents and trademarks


(74
)

(148
)Acquisition of goodwill and intangibles


(1,945
)

Net cash used in investing activities


(2,397
)

(27,622
)FINANCING ACTIVITIES:Proceeds from exercise of stock options


2,010


Dividend payment


(27,571
)

Payment for previously acquired goodwill and intangible assets





(567
)Net cash used in financing activities


(25,561
)

(567
)EFFECT OF EXCHANGE RATE CHANGES ON CASH AND CASH EQUIVALENTS


(305
)

171NET DECREASE IN CASH AND CASH EQUIVALENTS


(30,325
)

(29,076
)CASH AND CASH EQUIVALENTS, beginning of year


98,771


68,446CASH AND CASH EQUIVALENTS, end of year

$
68,446

$
39,370SUPPLEMENTAL DISCLOSURE OF CASH FLOW INFORMATION:Cash paid during the period for:Income taxes

$
1,079

$
260


See
notes to consolidated financial statements.

F-7

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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 through 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, and 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 and doubtful accounts; assessment of lower of cost or market on inventory; income taxes including deferred taxes and uncertain tax positions; and legal reserves for
current pending claims (if any) and estimated incurred-but-not-reported claims. Actual results could differ from these estimates and the differences could be
material. Differences are reported in the period in which they become known.

ReclassificationsThe Company reclassified $3,396,000 of shipping and handling costs from cost of sales to general and administrative expense for
the
year ended December 31, 2008 to conform to current-year presentation. The Company has changed its policy, regarding the classification of shipping and handling costs, because the
Company believes it allows for a better analysis of gross profit margin and will more consistently convey the relationship between sales and costs that are directly attributable to the procurement and
production of inventory sold from year to year.

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.

F-8

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Table of Contents

HEELYS, INC.

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued)

2. SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES (Continued)

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 $595,000 for 2008, compared to a net gain of $199,000 in
2009.

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. In 2008, the Company opened a representative office in Qingdao, China that serves multiple sourcing functions for the Company.
While the local currency for the office in China is the Chinese Yuan Renminbi, the functional currency is the U.S. dollar. 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. Net gain on foreign currency remeasurement was $2,000 for 2008, compared to a net loss of $1,000 in 2009.

Fair Value MeasurementsThe Company uses a hierarchy that prioritizes fair value measurements based on the types of inputs used for the various
valuation techniques (market approach, income approach, and cost approach).

The
levels of hierarchy are described below:



The
Company's assessment of the significance of a particular input to the fair value measurement in its entirety requires judgment and considers factors specific to the asset or
liability. Financial assets and liabilities are classified in their entirety based on the most stringent level of input that is significant to the fair value measurement.

Refer
to Note 3 for discussion regarding fair value of investments as of December 31, 2009. All other financial instruments, including cash and cash equivalents, accounts
receivable, accounts payable and accrued expenses approximate fair value due to their liquid and short-term nature.

Cash EquivalentsCash equivalents consist of highly liquid investments with original maturity dates of three months or less when purchased. Cash
equivalents at December 31, 2009 include investments in the JPMorgan Prime Money Market Fund ($33,000) and in the Fidelity Money Market Fund ($20.1 million). Investments in the JPMorgan
Prime Money Market Fund and in the Fidelity Money Market Fund are valued using observable inputs (Level 1 fair value hierarchy).

Concentration of RiskThe Company maintains substantially all of its cash and cash equivalents, excluding investments in the JPMorgan Prime Money
Market Fund and in the Fidelity Money Market Fund, in financial institutions in amounts that exceed federally insured limits. Investments in the

F-9

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Table of Contents

HEELYS, INC.

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued)

2. SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES (Continued)

JPMorgan
Prime Money Market Fund and in the Fidelity Money Market Fund are not insured. The Company has not experienced any losses with regards to its cash and cash equivalents and believes it is not
exposed to significant credit risk.

The
Company invests a portion of its cash in fully insured certificates of deposit and in debt instruments of corporations and municipalities with strong credit ratings.

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 estimated allowances for uncollectible accounts, customer returns, defective merchandise,

co-op advertising and marketing discretionary funds. Accounts are not collateralized and do not bear interest. In determining the amount of the allowances for accounts receivable, the
Company considers, among other things, historical experience. If the Company determines a smaller or larger allowance was appropriate, these changes in estimates are recorded in the period in which
such determination is made. Accounts are written off when it is determined the receivable will not be collected.

InventoriesInventories are purchased as finished goods from independent manufacturers and 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. During 2008 and 2009, the Company charged cost of sales $2.1 million and $1.1 million,
respectively, in order to properly state inventories at lower of cost or market.

Goodwill and Intangible AssetsGoodwill is not amortized but is instead measured for impairment at least annually, or when events indicate that
impairment might exist. The Company compares the estimated fair value of the reporting unit 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. The Company performed its annual
impairment test during the fourth quarter. There were no impairments identified in the periods reported.

F-10

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Table of Contents

HEELYS, INC.

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued)

2. SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES (Continued)

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.

Long-Lived Assets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 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. 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 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. These liabilities (for uncertain tax positions) are included in income taxes payable in the
consolidated balance sheet. Related accrued interest is included in interest expense and related penalties are included in general and administrative expenses. Accrued interest and penalties are
included within the related income tax liability line in the consolidated balance sheet.

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 customer discounts, marketing discretionary funds, estimated returns and other allowances, including
permitted returns of damaged or defective merchandise. The Company recorded total reductions to revenue for these allowances of $1,138,000 and $958,000 during 2008 and 2009, 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 $6,948,000 and $2,649,000

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HEELYS, INC.

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued)

2. SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES (Continued)

during
2008 and 2009, respectively. Prepaid advertising and promotion expenses recorded in prepaid and other current assets totaled $49,000 and $125,000 at December 31, 2008 and 2009,
respectively.

Shipping and Handling CostsShipping and handling costs are expensed as incurred and are included in general and administrative expense. Shipping
and
handling costs included in general and administrative expense were $3,396,000 and $2,075,000 during 2008 and 2009, respectively. Shipping and handling costs billed to customers are included in net
sales, and were $73,000 and $57,000 during 2008 and 2009, respectively.

InsuranceThe Company's insurance retention for general liability claims is $50,000 per claim. An estimated liability is provided for current
pending
claims (if any) and estimated incurred-but-not-reported claims due to this retention risk. A liability is accrued by a charge to income if it is probable that a
liability had been incurred at the date of the financial statements, and the amount of loss can be reasonably estimated. A liability for estimated claims in the amount of $141,000 and $150,000 as of
December 31, 2008 and 2009, respectively, is reflected in the balance sheet as an accrued liability.

Income (Loss) per ShareBasic income (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 income (loss) per share reflects the effects of potentially dilutive securities that could share in the
income (loss) of the Company. A reconciliation of the numerator and denominator used in the calculation of basic and diluted income (loss) per share is as follows (in thousands):

Year Ended December 31,2008

2009Numeratornet loss available to common stockholders

$
(5,924
)
$
(5,125
)Denominator:Weighted average common stock outstanding for basic
loss per share


27,321


27,571Effect of dilutive securities:Stock options





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


27,321


27,571


Stock
options to purchase approximately 1.7 million and 1.6 million shares of common stock at December 31, 2008 and December 31, 2009, respectively, were not
included in the computation of diluted loss per share because the effect of their inclusion would be anti-dilutive.

Recent Accounting PronouncementsOn July 1, 2009, the Financial Accounting Standards Board ("FASB") issued a standard that established the
FASB
Accounting Standards Codification (the "Codification" or "ASC"). The Codification amended the hierarchy of generally accepted accounting principles ("GAAP") such that the ASC became the single source
of authoritative nongovernmental accounting principles generally accepted in the United States of America ("U.S. GAAP"). The ASC did not change current U.S. GAAP, but was intended to
simplify user access to all authoritative U.S. GAAP

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HEELYS, INC.

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued)

2. SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES (Continued)

by
providing all the authoritative literature related to a particular topic in one place. All previously existing accounting standard documents were superseded and all other accounting literature not
included in the ASC is considered non-authoritative. New accounting standards issued subsequent to June 30, 2009 are communicated by the FASB through Accounting Standards Updates
("ASUs"). The Codification was effective for interim and annual periods ending after September 15, 2009. The Company adopted the Codification for the quarter ending September 30, 2009.
There was no impact on the Company's financial position, cash flows or results of operations as a result of this adoption.

3. INVESTMENTS

Investments consist of the following:

As of December 31, 2009Net Carrying Amount

Gross Unrealized Gains

Gross Unrealized Losses

Aggregate Fair Value

Maturities(In thousands)Current held-to-maturity securitiesCertificates of deposit

$
10,000

$


$


$
10,000

May-2010Commercial paper


4,971








4,971

Aug thru Nov-2010Corporate bonds


2,562





(8
)

2,554

Oct-2010Municipal bonds


3,023





(24
)

2,999

Nov-2010Total current held-to-maturity securities

$
20,556

$


$
(32
)
$
20,524Non-current held-to-maturity securitiesCorporate bonds

$
3,466

$


$
(14
)
$
3,452

Apr-2011Municipal bonds


3,100





(32
)

3,068

Jun-2011Total non-current held-to-maturity securities

$
6,566

$


$
(46
)
$
6,520


All
investments as of December 31, 2009 are classified as held-to-maturity since the Company has the intent and ability to hold these investments to
maturity. Investments in debt securities (commercial paper, municipal bonds and corporate bonds) are reported at cost, adjusted for premiums and discounts that are recognized in interest income, using
a method that approximates the effective interest method, over the period to maturity. Unrealized gains and losses are excluded from earnings. The Company considers as current assets those investments
which will mature in the next 12 months. The remaining investments are considered non-current.

The
fair values of these investments are determined using inputs other than quoted prices that are observable for the investment (Level 2 fair value hierarchy).

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

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HEELYS, INC.

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued)

4. SIGNIFICANT CUSTOMERS (Continued)

common
ownership, which accounted for greater than 10% of accounts receivable at December 31, 2008 and 2009 or 10% of net sales during the periods reflected were as follows:

Net SalesAccounts Receivable

Years Ended December 31,December 31, 2008

December 31, 20092008

2009Oxylane Group


9
%

23
%

3
%

11
%AG Corporation


4
%

2
%

5
%

17
%Journeys


8
%

1
%

10
%

2
%Famous Footwear


9
%

15
%

9
%

6
%


Oxylane
Group is a French sporting goods retail chain operating under the name Decathlon. AG Corporation is the Company's independent distributor in Japan.

5. PROPERTY AND EQUIPMENT

Property and equipment included the following (in thousands):

December 31,Estimated useful lives2008

2009Leasehold improvements

1-10 years

$
497

$
498Furniture and fixtures

7 years


191


183Computer equipment (including software)

5 years


652


688Equipment

5 years


135


127Product molds and designs

2 years


884


1,009Total




2,359


2,505Less accumulated depreciation and amortization




(1,352
)

(1,649
)Property and equipmentnet



$
1,007

$
856


Property
and equipment 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. Gains and losses on disposal of property and
equipment are included in other (income) expense.

Depreciation
expense related to property and equipment was $258,000 and $344,000 in 2008 and 2009, respectively.

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HEELYS, INC.

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued)

6. PATENTS AND TRADEMARKS

Patents and trademarks included the following (in thousands):

December 31,2008

2009Patents

$
1,226

$
1,334Trademarks


195


224Other


25


25Total


1,446


1,583Less accumulated amortization


(1,136
)

(1,240
)Patents and trademarksnet

$
310

$
343


Patents
and trademarks are stated at cost less accumulated amortization. Amortization is provided using the straight-line method over the estimated useful lives of five
years. Losses on disposal of patents and trademarks are included in general and administrative expenses.

Amortization
expense related to patents and trademarks was $122,000 and $115,000 in 2008 and 2009, respectively. Amortization expense from 2010 through 2014 is expected to be $115,000,
$92,000, $66,000, $42,000 and $16,000, respectively.

7. INTANGIBLE ASSETS AND GOODWILL

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.

Intangible
assets included the following (in thousands):

December 31,2008

2009Non-compete agreements

$
233

$
233Customer lists


1,433


1,457Total


1,666


1,690Less accumulated amortization


(254
)

(619
)Intangible assetsnet

$
1,412

$
1,071


Non-compete
agreements are amortized over 2 to 5 years, and customer lists are amortized over 5 years. Amortization expense related to non-compete
agreements and customer lists was $263,000 in 2008, and $360,000 in 2009. Amortization expense from 2010 through 2013 is expected to be $332,000, $322,000, $322,000 and $95,000, respectively. These
assets will be fully amortized in 2013.

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Table of Contents

HEELYS, INC.

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued)

7. INTANGIBLE ASSETS AND GOODWILL (Continued)

Goodwill
included the following (in thousands):

December 31,2008

2009Goodwill

$
1,668

$
1,696


Customer
lists and goodwill are intangible assets of the Company's Belgian subsidiary whose functional currency is the Euro. Assets and liabilities of foreign operations which are
denominated in a functional currency other than the U.S. dollar (the reporting currency) are translated at the rate of exchange during the applicable period. These intangibles are translated using the
exchange rate as of the balance sheet date. As a result, the U.S. dollar value of these intangibles is impacted by the fluctuation in the exchange rate.

8. ACCRUED EXPENSES

Accrued expenses consisted of the following (in thousands):

December 31,
2008

December 31,
2009Professional fees

$
579

$
129Litigation settlements and related costs (see Note 9)


1,046


Payments duetermination of distributorship agreements (see Note 9)


624


579Accrued taxes payable


283


449Customer credits and prepayments


745


439Payroll and payroll related costs


428


507Other


1,386


686Total accrued expenses

$
5,091

$
2,789


Customer
credits includes amounts due customers in excess of amounts owed, including estimated credits due customers for estimated returns and co-op advertising and marketing
allowances.

9. 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 two five year 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.

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, 2009.

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HEELYS, INC.

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued)

9. COMMITMENTS AND CONTINGENCIES (Continued)

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, included in the table below, have been estimated using the currency exchange rate as of December 31, 2009.

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 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, 2009.

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

Years Ending December 31,2010

$
2992011


2402012


2092013


2092014


209Thereafter


128$
1,294


Rent
expense for leased office space and warehouse space in Carrollton, Texas was $401,000 and $402,000 for 2008 and 2009, respectively. Rent expense for additional and temporary
warehouse space was $319,000 and $76,000 for 2008 and 2009, respectively. Rent expense for 2008 includes cost to lease floor space at a third-party distribution facility in California.

Third-Party Distribution Facility (Belgium)The Company uses a third-party distribution facility in Belgium. The Company pays this third-party
distributor fees and charges for services including storage, 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. The Company expensed $1,265,000 and $1,297,000 related to this third-party distribution
facility in 2008 and 2009, respectively. These costs are included in general and administrative expenses.

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

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HEELYS, INC.

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued)

9. COMMITMENTS AND CONTINGENCIES (Continued)

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 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 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
with the Termination Agreement, the Company entered into a Consulting Agreement with TIL pursuant to which, among other things, TIL agreed to perform certain consulting services and the Company 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 and the total amount paid for the acquired assets was $3.7 million (2.4 million Euro) 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

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HEELYS, INC.

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued)

9. COMMITMENTS AND CONTINGENCIES (Continued)

goodwill
of $1.9 million (1.2 million Euro) and intangibles (acquired customer relationships and non-compete) of $1.8 million (1.2 million Euro). As of
December 31, 2009, the Company paid $2.5 million (1.7 million Euro) for these acquired assets with the balance of $1.0 million (687,000 Euro) to be paid out over
time in accordance with the terms of the agreements. As of December 31, 2009, $456,000 is recorded as other long term liability and $547,000 is recorded as a current liability.

Consulting Agreement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. 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 recognized $75,000 and $129,000 in expense related to the Consulting Agreement in 2008 and 2009,
respectively. These charges are included in general and administrative expense in the statement of operations.

Purchase CommitmentsThe Company had open purchase commitments of $2.7 million related to inventories that were still being held by the
manufacturers at December 31, 2009.

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 the Company's December 7, 2006 initial public offering (the "IPO")along with Capital
Southwest Corporation, Capital Southwest Venture Corporation and the underwriters for the IPOwere 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 alleged violations of Sections 11 and 15 of the Securities Act of 1933. The
plaintiff sought 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 were transferred to a single judge and were consolidated into a
single action. Lead plaintiffs and lead counsel were appointed. An amended consolidated complaint was filed on March 11, 2008.

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HEELYS, INC.

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued)

9. COMMITMENTS AND CONTINGENCIES (Continued)

The
amended complaint alleged that the prospectus used in connection with the Company's IPO contained misstatements of material fact or omitted to state material facts necessary in order to make the
statements made not misleading relating to among other allegations, safety concerns and injuries associated with the Company's products and their alleged impact on demand, visibility into the
Company's sales channel and competition from knockoffs, in violation of Sections 11, 12(a)(2) and 15 of the Securities Act of 1933 and requested 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 agreed to pay Plaintiffs and a proposed plaintiff settlement class a total of $7.5 million,
including attorneys' fees and expenses. The Company also reached an agreement with its insurers for the Company's insurance policies to fund the majority of this settlement amount. On
November 17, 2009, the Court approved the settlement and signed a Final Judgment and Order of Dismissal with Prejudice with respect to the lawsuit.

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 complaints
alleged 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 sought 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 was a nominal defendant, and the complaint did not seek any damages against the Company; however, the Company may have had indemnification obligations to one or more of the defendants under
the Company organizational documents. The derivative lawsuits were transferred to a single judge and 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 $1.0 million. The Company also reached an agreement with its insurers for the
Company's insurance policies to fund the majority of this settlement amount. On November 17, 2009, the Court approved the settlement and signed a Final Judgment and Order of Dismissal with
Prejudice with respect to the lawsuit.

The
Company's insurance policies funded the majority of the settlement amounts related to the lawsuits described above and the Company paid approximately $800,000 of the settlement
amounts in August 2009.

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 the Company's December 7, 2006 initial public offering (the "IPO")along with Capital Southwest Corporation, Capital Southwest Venture
Corporation and the

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HEELYS, INC.

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued)

9. COMMITMENTS AND CONTINGENCIES (Continued)

underwriters
for the IPOwere 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 asserted claims that were substantially similar to those asserted in the consolidated class action described above. Plaintiff alleged that he purchased over 600,000 shares of
Heelys for approximately $17.4 million. Plaintiff claimed to have sold his stock for a loss of approximately $11 million, which he sought to recover plus interest, costs, and attorney
fees. Plaintiff's second amended petition alleged violations of Sections 11 and 15 of the Securities Act of 1933, Sections 33(A), (C), and (F) of the Texas Securities Act, and
Section 27.01 of the Texas Business and Commerce Code. Defendants withdrew their previously-filed special exceptions to Plaintiff's petition seeking to have all claims dismissed. On
August 21, 2009, Plaintiff and Defendants settled this case for $5.25 million. The Company paid $2.5 million of this settlement amount on August 25, 2009, and was
subsequently reimbursed by the Company's insurance policies. The Company paid the remaining $2.75 million on December 1, 2009, and the Company's insurance policies subsequently
reimbursed the Company approximately $253,000 of this amount. Pursuant to the settlement agreement, the lawsuit was dismissed with prejudice on September 18, 2009.

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.

10. INCOME TAXES

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

December 31,2008

2009Current expense (benefit):Federal

$
(5
)
$
(2,929
)State


3


61Foreign


68


794Total current expense (benefit)


66


(2,074
)Deferred expense (benefit):Federal


(809
)

734State


226


1Foreign





(14
)Total deferred expense (benefit)


(583
)

721Total income tax expense (benefit), net

$
(517
)
$
(1,353
)


F-21

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Table of Contents

HEELYS, INC.

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued)

10. INCOME TAXES (Continued)

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

December 31,2008

2009Tax at statutory rate

$
(2,225
)
$
(2,269
)Non-deductible incentive stock option expense


107


124Non-deductible penalties


19


5Non-deductible legal expenses





882State income taxes net of federal benefit


149


19Increase (decrease) in valuation allowance


1,371


(209
)Increase (decrease) in unrecognized tax benefits net of indirect benefits





21Reclassification of tax deductible/nondeductible awards


41


Other


21


74Total income tax expense (benefit), net

$
(517
)
$
(1,353
)


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. The tax effects of significant items included in the Company's net deferred tax benefits (expense) were as follows (in thousands):

December 31,2008

2009Current tax assets (liabilities):Allowance for bad debts

$
263


74Inventories


274


79Prepaid expenses


(139
)

(39
)Accrued expenses


403


96State income taxes


377


422Net operating loss carryovers


3,225


3,093Other


20


25Total current deferred tax assets


4,423


3,750Less: Valuation allowance


(851
)

(572
)Net current deferred tax assets


3,572


3,178Long-term tax assets (liabilities):Fixed assets and intangibles


105


205Tax method change





(61
)Net operating loss carryovers


353


5State income taxes


120


120Share-based compensation


432


462Total long-term deferred tax assets


1,010


731Less: Valuation allowance


(726
)

(803
)Net long-term deferred tax assets (liabilities)


284


(72
)Total deferred tax assets (net of deferred liabilities)

$
3,856

$
3,106


F-22

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Table of Contents

HEELYS, INC.

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued)

10. INCOME TAXES (Continued)

During
the year ended December 31, 2009, the valuation allowance decreased by approximately $200,000 as the Company believes that it is more likely than not that
certain U.S. deferred tax assets will not be realized as of December 31, 2009. Specifically, the U.S. net operating loss generated during 2009 is the only U.S. deferred tax asset that is likely
to be utilized going forward.

As
of December 31, 2009, a valuation allowance of $1.4 million had been recognized for deferred income taxes that may not be realized by the Company in future periods.

For
the year ended December 31, 2009, the Company generated approximately $8.8 million of federal net operating losses that are expected to be carried back and fully
recovered. This net operating loss carryback is currently reflected as a current deferred tax asset as of December 31, 2009. The Company filed a carryback claim for $8.3 million of
federal net operating loss related to 2008 which is expected to be fully recovered. This net operating loss is currently reflected as an income tax receivable as of December 31, 2009.

A
deferred tax liability has been set up for income taxes which may become payable upon distribution of earnings of the Company's Belgian subsidiary. The estimated amount of tax that
might be payable with regard to any distribution of foreign subsidiary earnings is reported net of foreign taxes paid which are creditable against domestic tax liability. The Company does not
permanently reinvest its foreign subsidiary's earnings. Prior to 2009, the Company's foreign subsidiary incurred losses and as such no
deferred taxes were recorded. As a result of 2009 earnings in its foreign subsidiary, the Company has recorded a deferred tax liability. The Company continually evaluates its assertion and will make a
change as business needs change.

A
reconciliation of the consolidated liability for gross unrecognized income tax benefits (excluding penalties and interest) from January 1, 2008 to December 31, 2009, is
as follows (in thousands):

2008

2009Balance at beginning of year

$
1,225

$
1,225Decreases in prior year tax positions





Increases in prior year tax positions





56Increases in current year tax positions





Settlements with taxing authorities





(24
)Lapse of statute of limitations





Balance at end of year

$
1,225

$
1,257


If
the Company were to prevail on all unrecognized tax benefits recorded, approximately $1.3 million of the unrecognized tax benefits (excluding accrued interest and penalties) at
December 31, 2009 would benefit the effective tax rate. Liabilities for unrecognized tax benefits are included in income taxes payable in the consolidated balance sheet.

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, 2008 and 2009, the Company recognized approximately $153,000 and $106,000 in interest and penalties, respectively. The Company has accrued $528,000 and $631,000 for
interest and penalties at December 31, 2008 and 2009, respectively. Accrued interest and penalties are included within the related income tax liability line in the consolidated balance sheet.

F-23

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Table of Contents

HEELYS, INC.

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued)

10. INCOME TAXES (Continued)

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 $976,000 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, 2009. All other unrecognized tax benefits have been classified as noncurrent liabilities.

The
statute of limitation remains open for the Company's consolidated federal income tax returns for the tax years ended December 31, 2006 forward. During 2009, the Company
settled a 2006 federal audit which resulted in a net tax refund. There are no other income tax examinations currently in process. State and foreign statutes are open for various years, depending on
the jurisdiction.

11. 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.

The
Company has reserved 2,972,725 shares of common stock subject to the 2006 Plan and as of December 31, 2009 had 825,835 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 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, or are not expected to, render the requisite service.

The
following summarizes stock option grants made by the Company during 2008 and 2009:

Date of Grant

Number of
Shares Granted

Exercise
PriceMarch 2008


120,000

$
4.26May 2008


48,500

$
4.39August 2008


365,000

$
5.07September 2008


30,000

$
5.14September 2009


350,000

$
2.39November 2009


20,000

$
2.15


The
exercise price per share was the fair value of the underlying stock at the grant date. All options granted vest and become exercisable in four equal cumulative
installments on each successive anniversary date of the grant and have a contractual term of ten years.

F-24

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Table of Contents

HEELYS, INC.

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued)

11. STOCK-BASED COMPENSATION (Continued)

The
Company computed the fair value of the options granted using the Black-Scholes option pricing model and the following assumptions:

March
2008

May
2008

August
2008

September
2008

September
2009

November
2009Expected volatility


35.75
%

45.77
%

46.34
%

46.34
%

50.39
%

50.26
%Dividend yield

















Risk-free interest rate


3.00
%

3.68
%

3.45
%

3.21
%

3.03
%

2.87
%Expected life (years)


6.25


6.25


6.25


6.25


6.25


6.25


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 a simplified method as allowed by ASC 718, "Stock Compensation." This decision was based on the lack of
relevant historical data.

The
following summarizes stock option transactions for the year ended December 31, 2009:

Options

Shares

Weighted
Average
Exercise
Price

Weighted
Average
Remaining
Contractual
Life
(Years)

Aggregate
Intrinsic
ValueOutstanding at December 31, 2008


1,666,423

$
4.54


8.2

$
Granted


370,000


2.38Exercised





Forfeited


431,710


4.59Outstanding at December 31, 2009


1,604,713

$
4.03


7.7

$
600Exercisable at December 31, 2009


858,647

$
4.37


6.7

$
Vested at December 31, 2009


858,647

$
4.37


6.7

$
Unvested at December 31, 2009


746,066

$
3.64


8.8

$
600


Intrinsic
value is the amount by which the fair value of the underlying stock exceeds the exercise price of an option. If the fair value of the underlying stock is less
than the exercise price of an option, there is no intrinsic value.

The
aggregate intrinsic value of options exercised during 2008 was $406,000. No options were exercised during 2009.

The
weighted average fair value of options granted during the years ended December 31, 2008 and 2009 was $2.32 and $1.23, respectively.

The
total fair value of shares that vested during 2008 and 2009 was $827,000 and $606,000, respectively.

F-25

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Table of Contents

HEELYS, INC.

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued)

11. STOCK-BASED COMPENSATION (Continued)

Stock-based
compensation cost was $1,179,000 and $525,000 for the years ended December 31, 2008 and 2009, respectively.

The
portion of stock-based compensation included in cost of sales, selling and marketing, and general and administrative expenses during 2008 was $181,000, $90,000 and $701,000,
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.

The
portion of stock-based compensation included in cost of sales, selling and marketing, and general and administrative expenses during 2009 was $96,000, $43,000 and $386,000,
respectively.

The
remaining unrecognized compensation cost related to unvested awards at December 31, 2009 is $1.5 million and the weighted-average period of time over which this cost
will be recognized is 1.5 years.

The
Company has not capitalized any stock-based compensation costs at December 31, 2008 or 2009. There have been no significant modifications to stock option awards during 2008 or
2009.

All
unvested options at December 31, 2009 are expected to vest, except for approximately 37,500 options. The weighted average exercise price of the options that are not expected
to vest is $5.07; weighted average remaining contractual term of 8.7 years; aggregate intrinsic value of $0; and unrecognized compensation cost of approximately $430,000.

12. OTHER EMPLOYEE BENEFIT PLANS

The Company sponsors a 401(k) Retirement Plan (the "401(k) Plan"). All employees of Heeling Sports Limited who are 21 years of age or older are eligible to enroll in the 401(k)
Plan. The Company expensed contributions of $109,000 and $46,000 during 2008 and 2009, respectively.

13. RELATED-PARTY TRANSACTIONS

The Company's patent attorney is also a stockholder of the Company. The Company capitalized (patents and trademarks) $87,000 and $101,000 of costs incurred in 2008 and 2009,
respectively; and expensed (general and administrative) $1.0 million and $728,000 in 2008 and 2009, respectively. Additionally, this patent attorney's law firm provides general corporate legal
counsel to the Company. The Company expensed $436,000 and $196,000 for these services during 2008 and 2009, respectively. This expense is included in general and administrative expense. The Company
owed $216,000 and $136,000 to this law firm as of December 31, 2008 and 2009, respectively.

F-26

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Table of Contents

HEELYS, INC.

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued)

13. RELATED-PARTY TRANSACTIONS (Continued)

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. 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. The Company recognized $75,000 and
$129,000 in expense related to the Consulting Agreement in 2008 and 2009, respectively. These charges are included in general and administrative expenses. As of December 31, 2008 and 2009, no
payable existed related to the Consulting Agreement.

14. 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 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

F-27

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Table of Contents

HEELYS, INC.

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued)

14. LITIGATION SETTLEMENT (Continued)

settling
the Lawsuit, and such payments are to be made, as follows: $750,000 upon execution of the Settlement Agreement, $250,000 in June of 2008; $250,000 in February of 2009; and $150,000 in
February of 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 and $250,000 of income related to the Settlement Agreement during 2008 and 2009, respectively. This income is reported in other income. As of
December 31, 2009, the Company has not recognized any royalties in connection with the Technology License Agreement.

15. 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, 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

F-28

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Table of Contents

HEELYS, INC.

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued)

15. SEGMENT REPORTING (Continued)

segments
for financial statement purposes. Each segment derives revenue primarily from the sale of HEELYS-wheeled footwear.

Year Ended December 31, 2008Domestic

International

Unallocated

Consolidated(in thousands)Net Sales

$
37,094

$
33,647

$


$
70,741Cost of Sales


27,118


22,311





49,429Gross Profit


9,976


11,336





21,312Selling, General and Administrative Expenses


19,249


6,931


4,180


30,360Income (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
)


The
Company reclassified $2.1 million (domestic) and $1.3 million (international) of shipping and handling costs from cost of sales to general and administrative expense to
conform to current-year presentation. Refer to Note 2 for additional information regarding these reclassifications.

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

Year Ended December 31, 2009Domestic

International

Unallocated

Consolidated(in thousands)Net Sales

$
15,157

$
28,620

$


$
43,777Cost of Sales


12,214


15,897





28,111Gross Profit


2,943


12,723





15,666Selling, General and Administrative Expenses


9,229


7,506


6,099


22,834Income (Loss) from Operations


(6,286
)

5,217


(6,099
)

(7,168
)Other (Income) Expense, net


(294
)

(188
)

(208
)

(690
)Income (Loss) before Income Taxes

$
(5,992
)
$
5,405

$
(5,891
)
$
(6,478
)


F-29

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Table of Contents

HEELYS, INC.

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued)

15. SEGMENT REPORTING (Continued)

In
2009, sales to the Company's independent distributor in Japan accounted for 17.5% of net sales. Sales in the German and French markets accounted for 14.4% and 19.8% of net sales,
respectively. No other country, other than the United States, accounted for 10% of net sales in 2009.

As of December 31, 2008Domestic

International

Eliminations

Consolidated(in thousands)Total Assets

$
83,241

$
13,255

$


$
96,496Goodwill

$


$
1,668

$


$
1,668




As of December 31, 2009Domestic

International

Eliminations

Consolidated(in thousands)Total Assets

$
77,770

$
11,470

$


$
89,240Goodwill

$


$
1,696

$


$
1,696


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; directors' and officers' 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 these costs have not been allocated to the international operations.

F-30

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Table of Contents

HEELYS, INC.

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued)

16. 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 ended3/31/08

6/30/08

9/30/08

12/31/08

3/31/09

6/30/09

9/30/09

12/31/09(in thousands, except per share data)Consolidated Statements of Operations Data:Net Sales

$
13,107

$
18,211

$
23,825

$
15,598

$
9,249

$
12,402

$
10,751

$
11,375Gross Profit

$
3,442

$
5,115

$
8,981

$
3,774

$
3,398

$
4,078

$
3,667

$
4,523Net Income (Loss)

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

$
(5,238
)
$
(1,310
)
$
(1,590
)
$
(1,102
)
$
(1,123
)Earnings (Loss) per shareBasic

$
(0.04
)
$
(0.01
)
$
0.03

$
(0.19
)
$
(0.05
)
$
(0.06
)
$
(0.04
)
$
(0.04
)Diluted

$
(0.04
)
$
(0.01
)
$
0.03

$
(0.19
)
$
(0.05
)
$
(0.06
)
$
(0.04
)
$
(0.04
)Weighted average shares outstanding:Basic


27,076


27,193


27,439


27,571


27,571


27,571


27,571


27,571Diluted


27,076


27,193


27,549


27,571


27,571


27,571


27,571


27,571


The Company reclassified shipping and handling costs from cost of sales to general and administrative expense to conform to
current-year presentation. The impact of these reclassifications on gross profit is presented below. There was no effect on Net Income (Loss). Refer to Note 2 for additional
information regarding these reclassifications.

Gross Profit, as originally reported

$
2,824

$
4,195

$
7,945

$
2,952

$
2,851

$
3,585

$
3,179

$
4,523Reclassification

$
618

$
920

$
1,036

$
822

$
547

$
493

$
488

$
Gross Profit, as adjusted

$
3,442

$
5,115

$
8,981

$
3,774

$
3,398

$
4,078

$
3,667

$
4,523


F-31

---