**UNITED STATESSECURITIES AND EXCHANGE COMMISSION**

**Washington,D.C. 20549**

**FORM10-K/A**
| **(MARK ONE)**                                                                                                                                                                            |
|-------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|
| **x**                                                                                                                                                                                     | ** ** | **ANNUAL REPORT PURSUANT TO SECTION 13 OR 15(d) OF  THE SECURITIES EXCHANGE ACT OF 1934** |
| ** **                                                                                                                                                                                | ** ** | ** ** |
| **For the  fiscal year ended June 30, 2004**                                                                                                                                              |
| ** **                                                                                                                                                                                |
| **OR**                                                                                                                                                                                    |
| ** **                                                                                                                                                                                | ** ** | ** ** |
| **o**                                                                                                                                                                                     | ** ** | **TRANSITION REPORT PURSUANT TO SECTION 13 OR  15(d) OF THE SECURITIES EXCHANGE ACT OF 1934** |
| ** **                                                                                                                                                                                | ** ** | ** ** |
| **For the  transition period from               to             ** |

 

**Commissionfile number 1-07115**

**K-TEL INTERNATIONAL, INC.**

(Exact name ofregistrant as specified in its charter)

| **Minnesota**                                                 | ** ** | **41-0946588**                        |
|---------------------------------------------------------------|------------|---------------------------------------|
| (State or other  jurisdiction of                              |       | (I.R.S. Employer  Identification No.) |
| incorporation or  organization)                               |       |                                  |
|                                                          |       |                                  |
| **2655  Cheshire Lane North, Suite 100, Plymouth, Minnesota** | ** ** | **55447**                             |
| (Address of  principal executive offices)                     |       | (Zip Code)                            |

 

Registrant’stelephone number, including area code: **(763) 559-5566**

Securities registeredpursuant to Section 12(b) of the Act:

**None**

Securities registeredpursuant to Section 12(g) of the Act:

**Common Stock, par value $0.01**

(Title of class)

Indicate by checkmark if the registrant is a well-known seasoned issuer, as defined in Rule 405of the Securities Act.Yes  o   No  x

Indicate by checkmark if the registrant is not required to file reports pursuant to Section 13or 15(d) of the Act.Yes  o   No  x

Indicate by checkmark whether the registrant (1) has filed all reports required to be filed bySection 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding12 months (or for such shorter period that the registrant was required to filesuch reports), and (2) has been subject to such filing requirements for thepast 90 days.  Yes  o   No  x

Indicate by checkmark if disclosure of delinquent filers pursuant to Item 405 of Regulation S-Kis not contained herein, and will not be contained, to the best of registrant’sknowledge, in definitive proxy information statements incorporated by referencein Part III of this Form 10-K/A or any amendment to this Form 10-K/A.  x

Indicate by checkmark whether the registrant is a large accelerated filer, an accelerated filer,or a non-accelerated filer.  Seedefinition 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  x |
|--------------------------------------|--------|--------------------------------|--------|------------------------------------|

 

Indicate by checkmark whether the registrant is a shell company (as defined in Rule 12b-2 of theExchange Act).Yes  o   No  x

As of September 12, 2006 the aggregatemarket value of voting stock held by non-affiliates of the registrant based onthe last sale price as reported by the Over-the-Counter Bulletin Board on suchdate was $331,645.

As of September 12, 2006, the registrant had13,653,738 shares of Common Stock outstanding.

DOCUMENTSINCORPORATED BY REFERENCE

None.

 

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**PURPOSE OF AMENDMENT**

InSeptember 2004, the Company discovered that the former Chief Financial Officerof its UK subsidiary misappropriated funds from the Company’s UK subsidiary anda customer of such subsidiary. The Company terminated the employee, undertook afull-scale investigation of the matter, retained a forensic auditing firm anddismissed the accounting firm in the UK that audited the UK subsidiary’sfinancial books and records. Based upon the estimates of the Company’s forensicauditor, it was determined that the former employee misappropriatedapproximately $924,000 from the Company’s UK subsidiary and approximately$344,000 from a customer of such subsidiary beginning approximately in January2001 and continuing until September 2004. Further, the Company spentapproximately $150,000 investigating the misappropriation. Through negotiationswith the former employee, the Company’s UK subsidiary and its customer havereceived an aggregate of approximately $1,495,000 including interest and anadditional $100,000 is expected to be recovered. The Company’s UK subsidiaryhas received a deed of guarantee in connection with this remaining obligationand it expects to collect the remaining amount owed on or before February 15,2008.

Forthe fiscal year ended June 30, 2004, the misappropriation understated net salesby $4,000 in the quarter ended September 30, 2003.  Product costs were overstated by $13,000,$2,000, $63,000 and $72,000 and selling and general and administrative expenseswere overstated by $28,000, $43,000, $53,000 and $62,000 for the quarters endedSeptember 30, 2003, December 31, 2003, March 31, 2004 and June 30, 2004,respectively.

Forthe fiscal year ended June 30, 2003,  themisappropriation overstated product costs by $9,000, $21,000, $24,000 and$27,000 and overstated selling and general and administrative expenses by$14,000, $10,000, $32,000 and $13,000 for the quarters ended September 30,2002, December 31, 2002, March 31, 2003 and June 30, 2003, respectively.

Forthe fiscal year ending June 30, 2002, the misappropriation understated sales by$16,000 in the quarter ended September 30, 2001. Product costs were overstatedby $74,000, $10,000, $35,000 and $13,000 and selling and general andadministrative expenses were overstated by $102,000, $9,000, $16,000 and$11,000 for the quarters ended September 30, 2001, December 31, 2001, March 31,2002 and June 30, 2002, respectively.

TheCompany’s Form 10-K for its fiscal year ended June 30, 2004 as filed onSeptember 30, 2004 did not include financial statements and other informationas required by Items 6-8 and 14-15. These items are presented in this Form 10-K/A.  The effects of the foregoing, as well asother adjustments, on the Company’s fiscal 2004 unaudited quarterly financialinformation are disclosed in Note 11 to the audited financial statements,included herein.

TheCompany’s fiscal 2002 and 2003 financial statements were previously restated toinclude the effects of the foregoing, as well as certain other adjustments, asincluded in the Company’s Form 10-K/A for the fiscal year ended June 30, 2003,filed on January 5, 2006.  All financialinformation included herein for fiscal 2002 and 2003 includes the restatedamounts as previously reported.

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TABLE OF CONTENTS
| PART I        |                                                                                                                |   |
|---------------|---------------------------------------------------------------------------------------------------------------------|--------|
|          |                                                                                                                |   |
| Item 1.       | Business                                                                                                            | 4      |
| Item 1A.      | Risk Factors                                                                                                        | 6      |
| Item 1B.      | Unresolved Staff Comments                                                                                           | 7      |
| Item 2.       | Properties                                                                                                          | 7      |
| Item 3.       | Legal Proceedings                                                                                                   | 7      |
| Item 4.       | Submission of Matters to a  Vote of Security Holders                                                                | 8      |
|          |                                                                                                                |   |
| PART II       |                                                                                                                |   |
|          |                                                                                                                |   |
| Item 5.       | Market for  Registrant’s Common Equity, Related Stockholder Matters and Issuer Purchases  of Equity Securities | 10     |
| Item 6.       | Selected Financial  Data                                                                                            | 11     |
| Item 7.       | Management’s  Discussion and Analysis of Financial Condition and Results of Operations                         | 12     |
| Item 7A.      | Quantitative  and Qualitative Disclosures about Market Risk                                                         | 16     |
| Item 8.       | Financial  Statements and Supplementary Data                                                                        | 16     |
| Item 9.       | Changes in  and Disagreements with Accountants on Accounting and Financial Disclosure                               | 16     |
| Item 9A.      | Controls and  Procedures                                                                                            | 16     |
| Item 9B.      | Other Information                                                                                                   | 17     |
|          |                                                                                                                |   |
| PART III      |                                                                                                                |   |
|          |                                                                                                                |   |
| Item 10.      | Directors  and Executive Officers of the Registrant                                                                 | 18     |
| Item 11.      | Executive  Compensation                                                                                             | 19     |
| Item 12.      | Security  Ownership of Certain Beneficial Owners and Management and Related Stockholder  Matters                    | 20     |
| Item 13.      | Certain  Relationships and Related Transactions                                                                     | 21     |
| Item 14.      | Principal  Accountant Fees and Services                                                                             | 22     |
|          |                                                                                                                |   |
| PART IV       |                                                                                                                |   |
|          |                                                                                                                |   |
| Item 15.      | Exhibits  and Financial Statement Schedules                                                                         | 23     |
|          |                                                                                                                |   |
| Signatures    |                                                                                                                | 24     |
| Exhibit Index |                                                                                                                | 46     |

 

**SAFEHARBOR STATEMENT UNDER THE**

**PRIVATE SECURITIES LITIGATION REFORM ACT OF 1995**

Certain statements of a non-historical nature underthe caption “Management’s Discussion and Analysis of Financial Condition andResults of Operations” and elsewhere in this Form 10-K constitute “forward-lookingstatements” within the meaning of the Private Securities Litigation Reform Actof 1995. Such forward-looking statements may be identified by the use ofterminology such as “may,” “will,” “expect,” “anticipate,” “estimate,” “should,”or “continue” or the negative thereof or other variations thereon or comparableterminology. Such forward-looking statements are subject to certain risks anduncertainties that could cause actual results to differ materially fromhistorical results or from those results currently anticipated or projected.Such factors include, among other things, the following: changes in consumerpurchasing; demand for and market acceptance of new and existing products; theimpact from competition for recorded music; the outcome of legal proceedings;dependence on suppliers and distributors; success of marketing and promotionefforts; technological changes and difficulties; availability of financing;foreign currency variations; general economic, political and businessconditions; and other matters. See “Risk Factors” in Item 1A for additionalinformation.  We undertake no obligationto release publicly the result of any revisions to these forward-lookingstatements, except as required by law.

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**PART I**

**ITEM1:  BUSINESS**

K-telInternational, Inc. (the “Company”, “K-tel” or the “registrant”) wasincorporated in 1968 and currently has its corporate offices located inPlymouth, Minnesota. Through its operating subsidiaries, K-tel licenses itsmusic catalog internationally and markets entertainment products mainly derivedfrom its catalog through retail and direct response marketing channels in theUnited States and Europe. The Company has a focused method of distribution thattargets the strengths of selected individual retailers and supplies productssuited to each retailer’s needs. These products are derived mainly from theCompany’s master recordings music catalog with the objective of realizing morecompetitive profit margins. K-tel seeks to license its trademarks to othercompanies in businesses unrelated to K-tel’s current operations. Licenses aregranted for a royalty or fee, with no cost to the Company. The Company haslicensed certain marks to K-tel Drug Mart Ltd., a Canadian direct marketer ofprescription drugs beneficially owned by Philip Kives, the Chairman of theBoard, President and Chief Executive Officer of K-tel. K-tel is merely alicensor of its mark to K-tel Drug Mart. To date, K-tel Drug Mart’s operationshave not generated any significant licensing revenues for the Company.

Description ofCurrent Businesses

Music Licensingand Sales

Currently K-tel’sprimary activity is marketing and distributing pre-recorded compact discsutilizing the Company’s master recordings in its music catalog, and DVDs from itsdeveloping catalog of musical performances. Customers include retailers,wholesalers and rack service distributors. These products are also sold throughsubsidiaries and licensees in the United States, United Kingdom and elsewherein Europe. The principal entertainment products that K-tel markets and sellsconsist primarily of pre-recorded thematic music packages in a compilationformat featuring various artists. These thematic music selections, which covernearly all music genres, are targeted to a variety of age groups. K-telprovides marketing support for its music sales through cooperative advertisingwith retailers, print media, radio and television advertising, and in-storepromotions and displays.

The Company alsolicenses music to other record companies and to other segments of theentertainment industry. K-tel owns a proprietary master music catalog ofapproximately 6,000 titles consisting of original recordings and re-recordingsof music from the 1950’s through today. The Company licenses the rights to itsmaster recordings to third parties worldwide for use in albums, which typicallylast three to five years, and is based on the number of units sold. The Companyalso licenses its master recordings for films, television programs andcommercials for either a flat fee or on a perpetual basis. K-tel continuouslypursues opportunities to add to its music master catalog to ensure growth andproduct diversity. Licensing of its proprietary music rights to third partieshas historically been an important revenue source for K-tel.

Two customers,Handleman Company and Anderson Merchandising, Inc. accounted for approximately19.1% and 10.1% respectively of K-tel’s revenue for the year ended June 30,2004. The loss of, or a substantial reduction in, business from either of thesecustomers would have a material adverse effect on the Company.

K-telcurrently delivers music products (CDs and DVDs) through traditional wholesaleand retail distribution channels. Prior to April 2001, the Company wasdistributing its music products in the United States to most major musicretailers (Transworld Entertainment, Musicland, Best Buy, Circuit City, TowerRecords) and to major distributors (Handleman, Anderson Merchandising, ValleyMedia). The Company now has a customer base that includes only a few selectedretailers and distributors, and offers products that are of more interest tothese individual customers. This focused approach is intended to improveproduct sell-through, minimize returns of unsold inventory and allow the Companyto realize more competitive profit margins. This existing method ofdistributing music could be materially altered by technologies that enableusers and customers of pre-recorded music to electronically download pre-recordedmusic at home to various personal computer media formats. The technology isdeveloping and a number of competing companies are seeking to have the industryand the public embrace their technologies. Participants in this technologycompetition include Microsoft Corporation, Liquid Audio, Inc., Apple Computer,Inc., MP3.com, Inc. and others. Digital music distribution provides bothsignificant risks and opportunities for K-tel. The risks include K-tel’suncertain ability to compete with other music companies from a marketing and a technologicalstandpoint. The Company believes there are opportunities to enhance its currentdistribution methods as well as increase opportunities to license its ownedlibrary of master recordings. K-tel’s music sales and licensing subsidiariesare pursuing these alternative distribution channels.

The Company’s ability to continue its presentoperations and implement future expansion plans successfully is contingent

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mainly upon its ability to maintain its line of creditarrangements with K-5 Leisure Products, Inc., the Company’s largest shareholdercontrolled by Philip Kives, the Chairman of the Board, President and ChiefExecutive Officer of K-tel (see Note 3 to the consolidated financialstatements), increase its revenues and profit margins, and ultimately attainand sustain profitable operations. Without increased revenues and sustainedprofitability, the cash generated from the Company’s current operations willlikely be inadequate to fund operations and service its indebtedness on anongoing basis. Management is focusing its efforts on music distribution andmusic licensing. However, there can be no assurance that the Company willachieve profitable operations through these efforts or be able to continueoperations. The financial statements do not include any adjustments that mightresult from the outcome of these uncertainties.

# E-Commerce

K-tel ceasedoperating its K-tel.com website, which marketed its own and other suppliers’products to retail customers, in the fourth quarter of 2001 because this businesssegment was not cost effective. The web site has since been redeveloped tosupport the Company’s sale of proprietary brand-name compilations and newlydeveloped CD and DVD products to customers in the United States and UnitedKingdom.

Competition

Themusic business is highly competitive and dominated by major companies. K-telfaces competition for discretionary consumer purchases of its products fromother record companies and other entertainment sources, such as film and videocompanies. Several major record companies in the United States, includingBertelsmann AG, Sony Corp., Time Warner, Inc. and Universal Music Group,dominate the market for pre-recorded music. K-tel does not have thefinancial resources, nor does it have the depth or breadth of catalog,distribution capabilities or current repertoire of these companies. Its abilityto compete in this market depends upon:

·                  the skill andcreativity of its employees to expand and utilize its music catalog to createcompilation packages;

·                  itsability to distribute its products effectively and efficiently; and

·                  itsability to build upon and maintain its reputation for producing, licensing,marketing and distributing high quality music.

The major pre-recordedmusic companies, either directly or through subsidiaries, now manufacture ordistribute pre-recorded music compilations in direct competition with K-tel’smusic compilation products. With this competition, the Company relies on itsown Dominion master music catalog for the production of music compilations.

Another form ofcompetition for the Company is the increasing ability for users and customersof pre-recorded music to download pre-recorded music electronically at home tovarious personal computer media formats. Although the technology and the relatedlegal issues are still emerging, and although K-tel is pursuing opportunitiesoffered by this technology, the Company is uncertain how this new technologywill impact its current operations.

IntellectualProperty

The Company believes that the K-tel® name and markare well recognized and are therefore valuable assets of the Company. TheCompany pursues the registration of its trademarks and service marks in theU.S. and internationally. Effective trademark, service mark and copyrightprotection may not be available in every country in which its products andservices are made available on-line. The Company has registered the trademarksK-tel®, K-tel Drug Mart®, K-tel Meds® variations of the marks and other marksrelating to its products in the U.S. and internationally in various product andservice categories. K-tel also claims rights in trademarks licensed by theCompany in two pending U.S. trademark applications covering the marks “CANADABEST BUY MEDS, INC.” and “CANADA BEST BUY DRUGS, INC.”. Federal and statetrademark registrations continue indefinitely, so long as the trademarks are inuse and periodic renewals and other required filings are made.

The Company regards its copyrights, service marks,trademarks, trade dress, trade secrets and similar intellectual property ascritical to its success, and relies on trademark and copyright law, tradesecret protection and confidentiality and/or license agreements with itsemployees, customers, partners and others to protect its proprietary rights.K-tel believes

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strongly in protecting its intellectual property andwill seek protection for new products and marks whenever the Company believesit is advisable.****K-tel cannot assure you that anytrademarks held by it will be valid, enforceable or otherwise of value to theCompany in relation to its competitors or the market in general, or that anytrademark for which it has applied or may apply will be granted.

In addition to trademark protection, the Company generally obtainscopyrights in music works, compilations and sound recordings.

Employees

On June 30, 2004,K-tel employed 17 full time people worldwide.

# Financial andGeographic Information

Forfinancial information about the Company’s business segment and geographic areaoperations for each of the three fiscal years ended June 30, 2004 see Note 9 tothe consolidated financial statements.

**ITEM 1A: RISK FACTORS**

Thefollowing are certain risk factors that could affect our business, financialcondition, operation results and cash flows. These risk factors should be considered in connection with evaluatingthe forward-looking statements contained in this Annual Report on Form 10-Kbecause these risk factors could cause our actual results to differ materiallyfrom those expressed in any forward-looking statement.  The risks we have highlighted below are notthe only ones we face.  If any of thesesevents actually occur, our business, financial condition, operating results orcash flows could be negatively affected. The Company cautions you to keep in mind these risk factors and torefrain from attributing undue certainty to any forward-looking statements,which speak only as of the date of this report.

**Continuinglosses could affect our ability to obtain additional working capital.**

The Company incurredlosses in recent fiscal years and expects to continue incurring losses for theforeseeable future.  Continuation of theCompany’s operations will require additional working capital and continuedaccess to financing to meet working capital requirements and develop new businessopportunities which may not be available on acceptable terms or at all.

**Thelevel of our indebtedness could adversely affect our financial condition.**

The Company has primarilyfunded its recent operations through internally generated capital and securedloans from K-5 Leisure Products, Inc. (“K-5”), the Company’s largestshareholder which is controlled by Philip Kives, the Chairman of the Board,President and Chief Executive Officer of K-tel. Although K-5 continues to advance funds sufficient to meet the Company’sneeds at this time, there can be no assurance that K-5 will continue to advancefunds sufficient to meet the Company’s needs or that the Company will be ableto obtain additional financing upon favorable terms or at all when required.

**Asubstantial portion of our total net sales are from a small group of customers.A reduction in sales to any of these customers could have a material adverseeffect on our financial condition.**

For the fiscal year endedJune 30, 2004, net sales to two customers, Handleman Company and AndersonMerchandising accounted for approximately 19% and 10%, respectively, of ourtotal net sales.  The Company believesthat sales to a small group of customers will continue to represent asignificant percentage of our total net sales. Substantially all of theproducts the Company distributes to these customers are supplied on anon-exclusive basis under arrangements that may be cancelled without cause andupon short notice, and our retail customers generally are not required to makeminimum purchases. If the Company is unable to continue to sell our products toall or any of these customers or are unable to maintain our sales to thesecustomers at current levels and cannot find other customers to replace thesesales, there would be an adverse impact on our business, financial condition,operating results and cash flows. There can be no assurance that the Companywill continue to recognize a significant amount of revenue from sales to anyspecific customer.

**TheCompany may not have the resources necessary to successfully compete in themusic industry.**

The music business ishighly competitive and dominated by several major record companies that havegreater financial resources than the Company and have a larger depth andbreadth of catalog, distribution capabilities and current repertoire than theCompany, making it difficult to compete in this market.  The major pre-recorded music companies,either directly or through subsidiaries, now manufacture or distribute pre-recordedmusic compilations in direct competition with the Company’s music compilationproducts.

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**Technologydevelopments, particularly electronic downloading, may adversely affect our netsales, margins and results of operations.**

Home entertainmentproducts have traditionally been marketed and delivered on a physical deliverybasis. If, in the future, these products are increasingly marketed anddelivered through technology transfers, such as electronic downloading throughthe Internet or similar delivery methods, then our retail and wholesaledistribution business could be negatively impacted. As electronic downloadinggrows through Internet retailers, competition between suppliers to electronicretailers in traditional ways will intensify and likely negatively impact ournet sales and margins. If the Company is unable to develop the necessary vendorand customer relationships to facilitate additional electronic downloading orif the terms of these arrangements differ from those related to our physicalproduct sales our business may be materially harmed.

**Increasedcounterfeiting or piracy may negatively affect the demand for our entertainmentproducts.**

The recorded musicindustry has been adversely affected by counterfeiting of CDs and DVDs and alsoby websites and technologies that allow consumers to illegally download andaccess music.  Increased proliferation ofthese alternative access methods could impair our ability to generate sales.

**TheCompany may not be able to successfully protect its intellectual propertyrights.**

The Company regards itscopyrights, service marks, trademarks, and similar intellectual propertycritical to its success, and relies on trademark and copyright law to protectthe intellectual property the Company license. Infringement on our intellectual property may lead to litigation toprotect our intellectual property rights which could result in substantialcosts and diversion of resources and could have a material effect on ourbusiness.

**Productreturns or inventory obsolescence could reduce our sales and profitability ornegatively impact our liquidity.**

The Company maintains asignificant investment in product inventory. Like other companies operating inour industry, product returns from our retail customers are significant whenexpressed as a percentage of revenues. Weakening market conditions could lead to increased product returns,increasing the Company’s inventory and obsolescence reserve.  Adverse financial conditions could cause asignificant decline in the value and marketability of our products, possiblymaking it difficult for us to recover our initial product acquisition costs.Under such circumstances, our business, financial condition, operating resultsand cash flows, could be adversely affected. The Company maintains a salesreturn reserve based on historical product line experience rates. The Companycan not assure you that our reserves will be adequate to cover potentialreturns.

**If the Company is unable tosuccessfully remediate the material weaknesses in its internal controls, theCompany’s ability to report its financial results on a timely and accuratebasis may be adversely affected.**

The Company has reportedmaterial weaknesses and the actions taken to address them.  Such remediation may not proveeffective.  Further, should any materialweaknesses develop, there are no assurances that the Company will be able toremediate them in a manner satisfactory to outside parties.  This could result in the Company not beingable to report its financial results on a timely basis, harm our operatingresults, or result in material misstatements in our financial statements. Inaddition, the Company may be unable to have its internal controls overfinancial reporting attested to by our independent registered public accountingfirm when required.

**ITEM 1B: UNRESOLVED STAFF COMMENTS**

None

**ITEM2:  PROPERTIES**

K-tel’s corporateoffices and U.S. operations are located in leased facilities in Plymouth, asuburb of Minneapolis, Minnesota, consisting of approximately 4,000 square feetof office space and approximately 6,000 square feet of warehouse. K-tel’sforeign subsidiaries lease a total of approximately 9,500 square feet of officeand warehouse facilities. See Note 6 to the consolidated financial statementsfor a summary of the lease agreements. The Company believes that thesefacilities are adequate for the foreseeable future.

**ITEM3:  LEGAL PROCEEDINGS**

RTL Shopping S. A.

The Company wasnamed in a lawsuit filed in France brought by RTL9, a French cable TV station.The action sought damages in the approximate amount of 20 million FrenchFrancs, or approximately $2.8 million. Initially, RTL9 was named as a defendantin a suit brought by a competitor of K-tel Marketing Ltd. alleging that RTL9ran a commercial for K-tel Marketing which presented a product under brandnames alleged to infringe on the competitor’s own trademarks and alsotranslated an English language script indicating that the product was “justlike” or “as good as” others into “better

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than” in French,contrary to French law. The suit alleged trademark infringement, unfaircompetition, illicit comparative advertising and passing off. RTL9 then suedK-tel Marketing on October 4, 2000, pursuant to an indemnification provisionthe parties had entered into. Subsequently, K-tel Marketing went intoliquidation and RTL9 filed a suit in March 2000 against K-tel International,Inc. under its agreement to guarantee payment for the commercial time. On May28, 2001, RTL9 presented documents in court identifying K-tel International(USA), Inc. as a target of its claim. On September 3, 2001, the Company fileddocuments disputing the claim and advising the court of K-tel International,(USA), Inc.’s Chapter 7 bankruptcy filing.

After the Companyadvised the Court that RTL9 had no basis for a complaint against the Company,RTL9 proposed to drop its lawsuit. On September 23, 2003, RTL9 and the Companysigned an agreement terminating the suit. The final disposition of the lawsuitwas confirmed by the Court at a trial hearing involving only the two remainingparties to the lawsuit.  There was nofinancial settlement with the termination of the lawsuit.

K-telInternational, Inc. vs. Tristar Products, Inc.

On March 14, 2000,K-tel and its subsidiary in Germany commenced an action in U.S. District Courtfor the District of Minnesota for breach of express and implied warrantiesagainst Tristar Products, Inc. This action arose out of Tristar’s sale to K-telof a defective home exercise product called the “BunBlaster” for resale inGermany, Austria and Switzerland. By written contract, Tristar agreed toindemnify K-tel for injuries and damages arising out of the resale of thosegoods.

On April 30, 2001,Tristar asserted a patent and trademark/ trade-dress counterclaim against K-telfor allegedly passing off a product called the “K-tel Hook and Hang” whileallegedly a distributor of the original patented Tristar Hook and Hang product.The Company denied the allegation because it never was a distributor of this orany similar product.

On December 30, 2004, aMutual General Release and Settlement Agreement was signed by K-tel andTristar,  whereby both companies agreedto mutual releases and Tristar agreed to pay K-tel $350,000.  The payment of $350,000 was received February18, 2005.

#### Other Litigation and Disputes

K-tel and itssubsidiaries are also involved in other legal proceedings in the ordinarycourse of their business. With all litigation matters, management considers thelikelihood of loss based on the facts and circumstances. If managementdetermines that a loss is probable and the amount of loss can be reasonablyestimated, such amount is recorded as a liability. Although the outcome of anysuch legal proceedings cannot be predicted, in the opinion of management thereis currently no legal proceeding pending or asserted against or involving K-telfor which the outcome is likely to have a material adverse effect on theconsolidated financial position or results of operations of K-tel.

Subsidiary’sLiquidation

In November 2000,the Company’s consumer products subsidiary in the United Kingdom, K-telMarketing Ltd., ceased operations and began voluntary liquidation proceedings.At the initial meeting of the creditors on November 24, 2000, the creditorsvoted for the liquidation to become a creditors’ liquidation under English law.The Company has not been informed by the liquidators or their counsel of anyplan to attempt to hold it or any of its subsidiaries liable for any of thecommitments of K-tel Marketing Ltd. Management believes the Company will haveno ongoing material liability related to K-tel Marketing Ltd. as a result ofthe liquidation proceeding. As the only secured creditor, the Company receiveddistributions of approximately $138,000 on March 1, 2004 and $76,000 on May 14,2004.

In June 2004, theCompany received funds for the sale of assets and the collections of accountsreceivables related to the March 2001 bankruptcy of K-tel International (USA),Inc.,  the Company ‘s music distributionsubsidiary in the United States.  TheCompany received approximately $220,000 for assets sold by a third party andreceived approximately $113,000 in account receivable collections.

**ITEM4:  SUBMISSION OF MATTERS TO A VOTE OFSECURITY HOLDERS**

No matters weresubmitted to a vote of K-tel’s security holders during the fourth quarter offiscal 2004.

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**Executiveofficers of the registrant**

Each of ourCompany’s executive officers is appointed to serve until his or her successoris duly appointed or his or her earlier removal or resignation from office.

The followingtable sets forth certain information with respect to the executive officers ofK-tel at September 18, 2006.
| **Name of  Officer** | ** ** | **Age** | ** ** | **Positions and Offices Held**                                          |
|----------------------|------------|---------|------------|-------------------------------------------------------------------------|
|                 |       |    |       |                                                                    |
| Philip Kives         |       | 77      |       | Chairman of the Board, Chief Executive Officer,  President and Director |
|                 |       |    |       |                                                                    |
| Larry Dunmall        |       | 56      |       | Chief Financial Officer                                                 |

 

**PhilipKives,**age 77,has held various offices and/or managerial positions with K-tel for more thanthirty-five years. Mr. Kives is currently the Company’s Chairman of the Board,Chief Executive Officer, President and Director.

**Larry Dunmall**, age 56, wasappointed the Chief Financial Officerof K-tel in April 2005.  From 2003 to2005, Mr. Dunmall was the Chief Financial Officer of Protegra Technology Group,a computer software development company. From 2002 to 2003, he was the Controller of the Agricultural ProductsDivision of Saskatchewan Wheat Pool and from 1995 to 2002 he was the ChiefFinancial Officer of ConAgra Grain, Canada.

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**PART II**

**ITEM5:  MARKET FOR REGISTRANT’S COMMON STOCK,RELATED STOCKHOLDER MATTERS AND ISSUER PURCHASES OF EQUITY SECURITIES**

On August 17,2006, there were 1,383 record holders of K-tel’s common stock and 13,653,738shares outstanding. The Company’s common stock is traded on theOver-the-Counter Bulletin Board under the symbol “KTEL”.

The followingtable shows the range of high and low closing prices per share of K-tel’scommon stock for the fiscal year periods indicated. Such over-the-countermarket quotations reflect inter-dealer prices, without retail mark-up,mark-down or commission, and may not necessarily represent actual transactions.
|             | ** ** | **2004** | ** ** | **2003** | ** ** |
|-------------|------------|----------|------------|----------|------------|
| ** **  | ** ** | **High** | ** ** | **Low**  | ** ** | **High** | ** ** | **Low** | ** ** |
| 1st Quarter |       | $        | .13        |     | $          | .06 |   | $ | .10 |   | $ | .05 |   |
| 2nd Quarter |       | $        | .11        |     | $          | .06 |   | $ | .10 |   | $ | .04 |   |
| 3rd Quarter |       | $        | .29        |     | $          | .09 |   | $ | .06 |   | $ | .04 |   |
| 4th Quarter |       | $        | .24        |     | $          | .09 |   | $ | .18 |   | $ | .04 |   |

 

Nocash dividends were declared on K-tel’s common stock during fiscal year 2004 or2003 and K-tel does not expect to pay cash dividends in the foreseeablefuture.  The declaration or payment byK-tel of dividends, if any, on its common stock in the future is subject to thediscretion of the Board of Directors and will depend on K-tel’s earnings,financial condition, capital requirements and other relevant factors. Thedeclaration or payment by K-tel of dividends is also subject to the terms ofits credit facility.

**Equity Compensation PlanInformation**

The following tableprovides information as of June 30, 2004 with respect to compensation plans underwhich the Company’s equity securities are authorized for issuance.
| **Plan Category**                                      | ** ** | **Number of securities to be   issued upon exercise of   outstanding options,   warrants and rights  (a)** | ** ** | **Weighted-average   exercise price of   outstanding options,   warrants and rights  (b)** | ** ** | **Number of securities remaining   available for future issuance   under equity compensation plans   (excluding securities reflected in   column (a))  (c)** | ** ** |
|-------------------------------------------------------------|------------|-----------------------------------------------------------------------------------------------------------------------------------------------------------------------------|------------|------------------------------------------------------------------------------------------------------------------------------------|------------|---------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|------------|
| Equity compensation  plans approved by security holders     |       | 136,900                                                                                                                                                                     | (1)        | $                                                                                                                                  | 5.95       |                                                                                                                                                                                                                                              | 2,896,878  | (2) |
| Equity compensation  plans not approved by security holders |       | 2,437,939                                                                                                                                                                   | (3)        | $                                                                                                                                  | 0.08       |                                                                                                                                                                                                                                              | —     |   |
| Total                                                       |       | 2,574,839                                                                                                                                                                   |       | $                                                                                                                                  | 0.39       |                                                                                                                                                                                                                                              | 2,896,878  |   |

 

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(1)                                  Consistsof 135,900 shares issuable pursuant to options granted under the Company’s 1997Stock Option Plan and 1,000 shares of common stock issuable pursuant to optionsgranted under the Company’s 1987 Stock Incentive Plan.

(2)                                  Representsshares of common stock remaining available for future issuance under theCompany’s 1997 Stock Option Plan, as amended.

(3)                                  Includesnon-qualified stock options to purchase 95,000 shares of our common stockissued outside the Company’s 1997 Stock Option Plan to each of Jay WilliamSmalley, Richard R. Marklund and Wesley C. Hayne in connection with suchnon-employee directors’ appointment to the Company’s Compensation/ Stock Option

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Committee and a non-qualified stock option to purchase15,000 shares of our common stock issued outside the Company’s 1997 StockOption Plan to Jay William Smalley in consideration of his past and continuedservice on the Company’s board of directors. See “Director Compensation” inItem 11. Includes an aggregate of 2,137,939 shares of common stock issuablepursuant to a stock option exchange program approved on March 18, 2003 by acommittee of the Company’s board of directors comprised solely of independentdirectors. Under the program, four optionees agreed to the cancellation ofpreviously awarded options under the Company’s 1997 Stock Option Plan and theCompany agreed to issue options to purchase an equal number of shares outsidethe Company’s stock option plan not earlier than six months and one day afterthe date of cancellation of the previously awarded options, such options to beissued at an exercise price per share equal to the then fair market value ofthe Company’s common stock and to expire ten years after the new date of grant.On November 18, 2003, the replacements options were issued at a price per shareof $.08. There was no compensation expense recognized as a result of thisexchange.

**ITEM 6: SELECTED FINANCIAL DATA**

The followingsummary of consolidated operations and certain balance sheet informationincludes the consolidated results of operations of K-tel and itssubsidiaries as of and for the five years ended June 30, 2004. This summaryshould be read in conjunction with the consolidated financial statements andnotes thereto appearing elsewhere in this report. All share and per shareamounts are based on the weighted average shares issued. All amounts are inthousands of dollars, except per share data.
|                                        | ** ** | **2004**   | ** ** | **2003**   | ** ** | **2002**   | ** ** | **2001**   | ** ** | **2000**   | ** ** |
|----------------------------------------|------------|------------|------------|------------|------------|------------|------------|------------|------------|------------|------------|
| ** **                             | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** |
| Net sales                              |       | $          | 6,679      |       | $          | 7,234      |       | $          | 6,891      |       | $          | 17,514 |   | $ | 29,092 |   |
| Operating income  (loss)               |       | $          | (33        | )          | $          | 149        |       | $          | (46        | )          | $          | (9,480 | ) | $ | (12,980 | ) |
| Loss from  discontinued operations (1) |       | $          | (52        | )          | $          | (581       | )          | $          | (180       | )          | $          | (4,315 | ) | $ | (5,541 | ) |
| Extraordinary  item (2)                |       | $          | 347        |       | $          | —     |       | $          | 894        |       | $          | 16,185 |   | $ | — |   |
| Net income  (loss)                     |       | $          | (87        | )          | $          | (892       | )          | $          | 300        |       | $          | 1,369 |   | $ | (15,738 | ) |
| Net loss per  share:                   |       |       |       |       |       |       |       |       |       |       |       |
| Continuing operations                  |       | $          | (.03       | )          | $          | (.02       | )          | $          | (.03       | )          | $          | (.77 | ) | $ | (1.02 | ) |
| Total assets                           |       | $          | 4,496      |       | $          | 5,301      |       | $          | 4,610      |       | $          | 3,832 |   | $ | 17,941 |   |
| Long-term debt                         |       | $          | —     |       | $          | —     |       | $          | —     |       | $          | 4,000 |   | $ | 4,000 |   |

 

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(1)            The loss fromdiscontinued operations reflects the operations of the Company’s consumerproducts business, net of any income taxes allocated to it.  The Company discontinued its consumerproducts operations in Germany in June 2000, in the United Kingdom in November2000, and in the United States in January 2001.

(2)            The extraordinaryitems reflect activity related to subsidiary liquidations and are shown net ofany income taxes allocated to them.  Theactivity in fiscal 2004 relates to distributions received from the liquidationof K-tel Marketing, Ltd. in the United Kingdom and proceeds from the sale ofassets and collections on accounts receivable related K-tel International,(USA), Inc. that had filed for bankruptcy in March 2001.  The extraordinary item in fiscal 2002 relatesto the net liability that existed on K-tel Marketing, Ltd. when it filed forvoluntary liquidation and was subsequently removed when the Company receivedassurances that it would not be held liable for any of K-tel Marketing, Ltd.’sdebts.  The extraordinary item in fiscal2001 relates to the net liability that existed on K-tel International (USA),Inc. when it filed for Chapter 7 bankruptcy and was removed as control of thesubsidiary was transferred to the bankruptcy trustee.

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**I****TEM 7:  MANAGEMENT’S DISCUSSIONAND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS**

**General**

Throughits operating subsidiaries, K-tel licenses its music catalog internationallyand markets entertainment products mainly derived from its catalog in theUnited States and Europe through retail and direct response marketing channels.

Forthis analysis, the Company has discontinued its United States subsidiary, K-telConsumer Products, Inc., in February 2001. This closing represents thediscontinuation of the Company’s consumer products division and accordingly hasbeen presented in the accompanying financial statements as discontinuedoperations. In addition, in March 2001, the Company’s music distributionsubsidiary in the United States, K-tel International (USA), Inc. ceasedoperations and filed for protection under Chapter 7 of the United StatesBankruptcy Code.

Through another subsidiary,K-tel Entertainment, Inc., K-tel has a focused method of distribution thattargets the strengths of fewer individual retailers and supplies productssuited to each retailer’s specific needs. These new products are derived fromthe Company’s master recordings music catalog with the objective of realizingmore competitive profit margins. As well, the Company seeks to license its nameand marks to other businesses for a royalty or fee.

**A.  RESULTS OF OPERATIONS**

Thefollowing sections discuss the results of operations by business segment. SeeNote 9 to the consolidated financial statements for additional segmentinformation. General corporate expenses of $869,000 in the year ended June 30,2004, $860,000 in the year ended June 30, 2003 and $1,049,000 in the year endedJune 30, 2002 have been allocated to the segments.

**FISCAL2004 VERSUS FISCAL 2003**

Net sales for the year ended June 30, 2004 were $6,679,000, a decrease of7.7% from fiscal 2003 sales of $7,234,000. This sales decrease was primarilydue to fiscal 2003 including additional licensing revenue that resulted from aone time licensing audit.  The net lossfor fiscal 2004 was $87,000, or $.01 per share, compared to a net loss of$892,000, or $.06 per share, in fiscal 2003.

In fiscal 2004 the Company received approximately$214,000 from the liquidation of K-tel Marketing LTD. the Company’s consumerproducts subsidiary in the United Kingdom which ceased operations in November2000 and approximately $333,000 from the sale of assets and account receivablecollections related to the March 2001 bankruptcy of K-tel International, (USA),Inc. the Company’s music distribution subsidiary in the United States (see Note1 to the consolidated financial statements). The $547,000 of distributions have been reflected as extraordinaryitems, net of income taxes.

Thefollowing sections discuss the results of continuing operations by businesssegment.

**BUSINESSSEGMENT RESULTS**

**Music**

Sales in the music segment were $4,763,000 for the year ended June 30,2004 compared to $4,454,000 for the year ended June 30, 2003, an increase of6.9%. The increase was primarily related to an increase in DVD sales as aresult of the Company’s introduction of new DVD product lines.

Cost of goods sold in the music segment increased to 67.6% of net salesfor the year ended June 30, 2004 compared to 61.4% of net sales for the yearended June 30, 2003, primarily relating to increasing the obsolescence reservefor karaoke related products. Advertising expenses within the segment, whichconsist primarily of co-operative advertising payments, trade advertising andpromotions, decreased to $110,000 for the year ended June 30, 2004 compared to$200,000 for the year ended June 30, 2003 due primarily to decreasedpromotional programs in fiscal 2004 compared to fiscal 2003.

Selling, general and administrative expenses for the segment decreased$161,000, or 6.3%, to 2,424,000 for the year ended June 30, 2004 compared to$2,585,000 for the year ended June 30, 2003. The primary reason for thedecrease was the 

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discontinuation of unprofitable product lines in England along withcontinued staff and cost reductions in the U.S. and England. The music segmentincurred an operating loss of $992,000 for the year ended June 30, 2004compared to an operating loss of $1,010,000 for the year ended June 30, 2003.

**Licensing**

Licensingrevenues were $1,916,000 for the year ended June 30, 2004 compared to$2,780,000 for the year ended June 30, 2003, a decrease of 31.1%. WhileEuropean revenue increased $342,000, domestic revenue from licensing activitydecreased $1,206,000. In mid-2002, the Company undertook a program to auditlicensees of the music catalog in order to verify compliance with the terms oflicense agreements. One of the audits undertaken determined that a significantamount of revenue had not been reported to the Company. During the year endedJune 30, 2003 the licensee that was subject to this audit made the catch uproyalty payments that were required under the license, and the Company’srevenue increased accordingly. Operating income in the licensing segment was$959,000 for the year ended June 30, 2004 and $1,159,000 for the year endedJune 30, 2003, a decrease of 17.2%. The decreased sales and income in fiscal2004 were due to fiscal 2003 reflecting the catch up collection of theroyalties from the audit.

**FISCAL2003 VERSUS FISCAL 2002**

Net sales for the year ended June 30, 2003 were $7,234,000, an increaseof 5.0% from fiscal 2002 sales of $6,891,000. This sales increase wasattributed to increased domestic music sales partially offset by a decrease inlicensing revenue. The net loss for fiscal 2003 was $892,000, or $.06 pershare, compared to a net income of $300,000, or $.02 per share (after anextraordinary gain of $894,000 related to the K-tel Marketing liquidation), infiscal 2002.

Thefollowing sections discuss the results of continuing operations by businesssegment.

**BUSINESSSEGMENT RESULTS**

**Music**

Sales in the music segment were $4,454,000 for the year ended June 30,2003 compared to $3,773,000 for the year ended June 30, 2002, an increase of18.1%. The increase was primarily related to increased sales to Handleman whichbecame a customer late in fiscal 2002 and to an increased number of productsavailable for sale during fiscal 2003.

Cost of goods sold in the music segment increased to 61.4% of sales forthe year ended June 30, 2003 compared to 50.4% of sales for the year ended June30, 2002. Advertising expenses within the segment, which consist primarily ofco-operative advertising payments, trade advertising and promotions, increasedto $200,000 for the year ended June 30, 2003 compared to $172,000 for the yearended June 30, 2002.

Selling, general and administrative expenses for the segment decreased$545,000, or 17.9%, to $2,585,000 for the year ended June 30, 2003 compared to$3,130,000 for the year ended June 30, 2002. The primary reasons for thedecrease were the closing of the Company’s office in Germany in fiscal 2002 andefforts to reduce overhead costs in the Company’s office in England.  The music segment incurred an operating lossof $1,010,000 for the year ended June 30, 2003 compared to an operating loss of$1,439,000 for the year ended June 30, 2002.

**Licensing**

Licensingrevenues were $2,780,000 for fiscal 2003 compared to $3,118,000 for fiscal2002, a decrease of 10.8%. While European revenue decreased $405,000, domesticrevenue from licensing activity increased $67,000. The decrease in Europereflected a reduced level of licensing in the music industry. While domesticlicensing experienced this as well, licensing revenue from the Company’s mainlicensee increased significantly. In fiscal 2002, the Company undertook aprogram to audit licensees of the music catalog in order to verify compliancewith the terms of license agreements. One of the audits undertaken determinedthat a significant amount of revenue had not been reported to the Company.During the year ended June 30, 2003 the licensee subject to this audit made thecatch up royalty payments required under the license, and the Company’s revenueincreased accordingly. Operating income in the licensing segment was $1,159,000for the year ended June 30, 2003 and $1,393,000 for the year ended June 30,2002, a decrease of 16.8%.

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**CRITICALACCOUNTING POLICIES**

RevenueRecognition – The Company derives its revenue mainly from twosources: the sale of music compilations (predominately compact discs) producedby the Company and license revenue from the licensing of Company-owned masters.Revenue from music sales is recognized at the time of shipment to the customer,while license revenue is recognized when payment is received from customers orwhen known amounts are receivable, as prior to that date collection is notconsidered probable. Most music sales are made with a right of return of unsoldgoods. Estimated reserves for returns are established by management based uponhistorical experience and product mix and are subject to ongoing review andadjustment by the Company. These reserves are recorded at the time of sale andare reflected as a reduction in revenues. The Company’s reserve for returns was$133,000 at June 30, 2004 and $220,000 at June 30, 2003.

Rights to UseMusic Product - Certain of the Company’s compilation productsare master recordings under license from record companies and publishers. Inmost instances, minimum guarantees or non-refundable advances are required toobtain the licenses and are realized through future sales of the product. Theamounts paid for minimum guarantees or non-refundable advances arecapitalized and charged to expense as sales are made. The unrealized portion ofguarantees and advances is included in royalty advances in the accompanyingconsolidated balance sheets. Licenses are subject to audit by licensors. Whenanticipated sales appear to be insufficient to fully recover the minimumguarantees or non-refundable advances, a provision against currentoperations is made for anticipated losses.

Royalties- The Company has entered into license agreements with various record companiesand publishers under which it pays royalties on units sold. The Company accruesroyalties using contractual rates and certain estimated rates on applicableunits sold. The contractual royalty liability is computed quarterly and theaccrued royalty balance is adjusted accordingly. The royalty agreements aresubject to audit by licensors.

InventoryObsolescence - The Company estimates and records inventorylosses for obsolete inventory based upon estimated market prices to sellidentified inventory items that are slow moving. The Company reviews thisestimate quarterly and the estimate is adjusted accordingly.

**RECENTACCOUNTING PRONOUNCEMENTS**

In December 2003,the FASB issued Interpretation (FIN 46R), *Consolidationof Variable Interest Entities.* FIN 46R is an interpretation ofAccounting Research Bulletin No. 51, *ConsolidatedFinancial Statements,* and addresses consolidation by businessenterprises of variable interest entities. FIN 46R applies to variable interestentities created or obtained after January 31, 2003 and it applies in the firstfiscal year or interim period beginning after March 15, 2004, to variableinterest entities in which an enterprise holds a variable interest that isacquired before February 1, 2003. The Company began consolidating a variableinterest entity during the quarter ending March 31, 2004 (see Note 12 to thefinancial statements).

# In May 2003, the FASB issuedStatement 150, *Accounting for Certain FinancialInstruments with Characteristics of both Liabilities and Equity*.Statement 150 changes the classifications in the statement of financialposition of certain common financial instruments from either equity ormezzanine presentation to liabilities and requires an issuer of those financialstatements to recognize changes in fair value or redemption amount, as applicable,in earnings. SFAS 150 is effective for financial instruments entered into ormodified after May 31, 2003, and otherwise is effective at the beginning of thefirst interim period beginning after June 15, 2003. Adoption of Statement 150did not have an impact on the Company’s consolidated financial position orresults of operations.

InDecember 2004, the FASB issued SFAS No. 123R, *Share-BasedPayment*, which replaced SFAS No. 123 and superseded APB 25. SFAS No.123R addresses the accounting for share-based payment transactions in which acompany receives employee services in exchange for either equity instruments ofthe company or liabilities that are based on the fair value of the company’sequity instruments or that may be settled by the issuance of such equityinstruments. Under SFAS No. 123R, companies will no longer be able to accountfor the share-based compensation transactions using the intrinsic method inaccordance with APB 25 but will be required to account for such transactionsusing a fair-value method and recognize the expense in the consolidatedstatement of operations. SFAS No. 123R is effective beginning in the Company’sfirst quarter of fiscal year 2007. Under SFAS 123R, the Company must determinethe appropriate fair value model to be used for valuing share-based payments,the amortization method for compensation cost and the transition method to beused at date of adoption. The transition methods include prospective andretroactive adoption options. The Company has begun, but has not completed,evaluating the impact of the adoption of SFAS 123R on its results ofoperations. In connection with evaluating the impact of SFAS 123R, the Companyis considering the potential implementation of different valuation

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methodsto determine the fair value of share-based compensation. The Company believesthe adoption of SFAS 123R will not have a material impact on our results ofoperations, regardless of the valuation method used.

**CONTRACTUALOBLIGATIONS**

The table belowdiscloses a summary of the Company’s specified contractual obligations at June30, 2004 (in thousands):
|                                       | ** ** | **Total** | ** ** | **Under 1 Year** | ** ** | **1-3 Years** | ** ** |
|---------------------------------------|------------|-----------|------------|----------------------------|------------|--------------------|------------|
| Notes payable to  affiliate and other |       | $         | 11,165     |                       | $          | 11,165             |       | $ | — |   |
| Operating leases                      |       | 146       |       | 133                        |       | 13                 |       |
|                                  |       |      |       |                       |       |               |       |
| Total                                 |       | $         | 11,311     |                       | $          | 11,298             |       | $ | 13 |   |

 

## **B.LIQUIDITY AND CAPITAL RESOURCES**

K-tel has a Lineof Credit Agreement with K-5 Leisure Products, Inc. (“K-5”), the Company’slargest shareholder controlled by Philip Kives, the Chairman of the Board,President and Chief Executive Officer of K-tel. Under the terms of theagreement (the “K-5 Facility”), K-5 has agreed to make available up to$8,000,000 to K-tel on a revolving basis. The loan bears interest at a variablerate based upon the “base rate” of a nationally recognized lending institution(4.0% at June 30, 2004), expires July 20, 2008, and is subordinated to theFoothill loan (see below). The K-5 Facility contains the same covenants as theFoothill loan agreement. K-tel has pledged the stock of its foreignsubsidiaries as collateral for the loan, and the loan carries a subordinatedposition to the Foothill loan on all other assets of the Company. K-tel hadoutstanding balances of $7,165,000 and $7,282,000 as of June 30, 2004 and 2003respectively under the K-5 Facility. At June 30, 2004, K-tel obtained a waiverfrom K-5 for its non-compliance under the covenants, limitations andrestrictions of the credit agreement.

In addition, K-tel has asecond loan agreement with K-5, under which K-5 assumed rights and obligationsunder a loan from the Company’s former banker (Foothill Capital Corporation)pursuant to an Assignment and Acceptance Agreement dated February 27, 2001.This Foothill loan, which has been extended through July 20, 2008, provides fora $10,000,000 credit facility consisting of a $4,000,000 term loan due uponexpiration, and a $6,000,000 revolving facility under which borrowings arelimited to a percent of eligible receivables. Borrowings under the facilitybear interest at a variable rate based on a “base rate” of a nationallyrecognized lending institution plus 1% (5.0% at June 30, 2004) and arecollateralized by the assets of certain Company subsidiaries in the UnitedStates, including accounts receivable, inventories, equipment, music libraryand general intangibles. The loan agreement contains certain financial andother covenants or restrictions, including the maintenance of a minimumshareholders’ equity by K-tel, limitations on capital expenditures,restrictions on music library acquisitions, limitations on other indebtednessand restrictions on dividends paid by K-tel. As of June 30, 2004 and June 30,2003, $4,000,000 was outstanding under the term loan and there were noborrowings under the revolving facility. At June 30, 2004, K-tel obtained awaiver from K-5 for its non-compliance under the covenants, limitations andrestrictions of the credit agreement.

K-telhad an overdraft privilege borrowing facility of $45,000 and $250,000 at June30, 2004 and 2003, respectively, with The Royal Bank of Scotland in the UnitedKingdom. This facility was secured by a standby letter of credit for $55,000and $260,000 at June 30, 2004 and 2003, respectively, provided by K-telInternational Ltd., a Canadian company controlled by Philip Kives and waspayable on demand in accordance with normal banking practices. Borrowings boreinterest of 2.0% per annum over the base rate (a total of 6.0% at June 30, 2004and 5.75% at June 30, 2003) but were subject to a minimum of 6.0% per annum.K-tel had an outstanding balance of $233,000 as of June 30, 2003 with nooutstanding balance as of June 30, 2004. This overdraft privilege borrowing facility was canceled at the end ofcalendar 2004.

K-tel hasprimarily funded its recent operations through internally generated capital andsecured loans from K-5. Assuming K-5 continues to advance funds sufficient tomeet the Company’s needs, management currently believes that K-tel hassufficient cash and borrowing capacity to ensure the Company will continueoperations for the foreseeable future. Although K-5 continues to advance fundssufficient to meet the Company’s needs at this time, there can be no assurancethat this will be adequate or continue in the future or that K-tel will be ableto obtain additional financing upon favorable terms when required.

TheCompany’s ability to continue its present operations is contingent mainly uponits ability to maintain its line of credit arrangements with K-5, increase itsrevenues and profit margins, and ultimately attain and sustain profitableoperations. 

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Withoutincreased revenues and sustained profitability, the cash generated from theCompany’s current operations will likely be inadequate to fund operations andservice its indebtedness on an ongoing basis. Management is focusing itsefforts on music licensing and limited music distribution. However, there canbe no assurance that the Company will achieve profitable operations throughthese efforts. In the event the Company is unable to fund its operations andimplement its current business plan properly, it may be unable to continueoperations. The financial statements do not include any adjustments that mightresult from the outcome of these uncertainties.

**ITEM 7A: QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK**

K-tel is exposed to various market risks, including changes in interestrates and foreign currency exchange rates. Market risk is the potential lossarising from adverse changes in market rates and prices, such as interest ratesand foreign currency exchange rates. K-tel does not enter into derivatives orother financial instruments for trading or speculative purposes.

K-tel’sexposure to market risk for changes in interest rates relates to K-tel’sshort-term borrowings. K-tel’s short-term credit facilities carry a variableinterest rate that does have an impact on future earnings and cash flows. AtJune 30, 2004, K-tel had variable rate debt of $11,165,000. If the interestrate were to change 100 basis points or 1% while K-tel was borrowing under thecredit facilities, interest expense would change by $112,000.

Approximately42.6% of K-tel’s revenues during the year ended June 30, 2004 were derived fromoperations in Europe. The results of operations and financial position of K-tel’soperations in Europe were principally measured in their respective currenciesand translated into U.S. dollars. The effect of foreign currency fluctuationsin these European countries is somewhat mitigated by the fact that expenses aregenerally incurred in the same currencies in which the revenue is generated.The reported income of these subsidiaries will be higher or lower depending onthe weakening or strengthening of the U.S. dollar against the respectiveforeign currency. If the U.S. dollar foreign currency rate were to change by1%, the effect on income would have been $3,820 for the year ended June 30,2004. Additionally, approximately 52% of K-tel’s assets at June 30, 2004 werebased in its foreign operations and were translated into U.S. dollars atforeign currency exchange rate in effect as of the end of each accountingperiod, with the effect of such translation reflected as a separate componentof consolidated shareholders’ equity (deficit). Accordingly, K-tel’sconsolidated shareholders’ equity (deficit) will fluctuate depending on theweakening or strengthening of the U.S. dollar against the respective foreigncurrency.

**ITEM 8:  FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA**

Theconsolidated financial statements and related notes and schedules required bythis Item are set forth in Part IV, Item 15, and identified in the Index toConsolidated Financial Statements.

**ITEM 9: CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING ANDFINANCIAL DISCLOSURE**

There were no changes in or disagreements withaccountants during the years ended June 30, 2004 and June 30, 2003.

# **ITEM9A:  CONTROLS AND PROCEDURES**

Under thesupervision and with the participation of the Company’s management, includingthe Company’s Chief Executive Officer and Chief Financial Officer, the Companyevaluated the effectiveness of the design and operation of its disclosurecontrols and procedures (as defined in Rule 13a-15(e) and 15d-15(e) under theExchange Act). Based on that evaluation, the Chief Executive Officer and ChiefFinancial Officer concluded that, as of the end of the period covered by thisreport, the Company’s disclosure controls and procedures were not effectivebecause of the following material weaknesses in internal control over financialreporting.

The Company didnot maintain effective controls over cash disbursements and payrolltransactions at its UK subsidiary. In September 2004, the Company discoveredthat the former Chief Financial Officer of its UK subsidiary misappropriatedfunds from the subsidiary and one of its customers. Adjustments related to thereversal of overstated expenses and recovery of amounts misappropriated wereincluded in the restatement of the Company’s consolidated financial statementsfor periods prior to June 30, 2004 and for the years ended June 30, 2005 and2004.

In response to thematerial weakness above, the Company terminated the employee, undertook afull-scale investigation of the matter, retained a forensic auditing firm anddismissed the accounting firm in the UK that audited the UK subsidiary’s 

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financial booksand records. In addition the Company hired a new Financial Controller andstringent internal control procedures were created and implemented for theCompany’s purchasing, accounts payable, check signing, payroll, petty cash andfinancial reporting policies. Management believes that these procedures,implemented upon the discovery of the misappropriation of funds, will allow theCompany to reestablish effective internal control over financial reporting.

In fiscal 2005 and2004, it was determined that the segregation of duties in the U.S. office waslimited due to the small number of employees. This segregation of duties becamefurther limited by vacancies that occurred in the Company’s financedepartment.   In particular, customerorders were recorded by the same person who initiated shipments, checks weredeposited by the accounts receivable clerk, and employee payroll and changeswere entered by the Operations Manager, who also distributed the payrollchecks.

In response to thematerial weakness in the U.S. office, the former Controller was recentlyrehired and duties and responsibilities were revised to allow for improvedsegregation of duties and to increase the level of approvals and reviews.

# Other than as set forthabove, during the fiscal year ended June 30, 2006, there was no change in theCompany’s internal control over financial reporting (as defined in Rule13a-15(f) or 15d-15(f) under the Exchange Act) that has materially affected, oris reasonably likely to materially affect, the Company’s internal control overfinancial reporting.

**ITEM 9B.  OTHER INFORMATION**

Not applicable.

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**PART III**

**ITEM 10: DIRECTORS AND EXECUTIVE OFFICERS OF THE REGISTRANT**

Thefollowing describes the business, the business experience and background ofeach current director and executive officer of K-tel at August 15, 2006.  No family relationships exist between K-tel’sdirectors and executive officers, except that Mr. Smalley is the brother-in-lawof Mr. Kives.

Each of our Company’sexecutive officers is appointed to serve until his or her successor is duly appointedor his or her earlier removal or resignation from office.

**LarryDunmall**, age 56, was appointed the Chief Financial Officer of K-tel in April 2005.  From 2003 to 2005, Mr. Dunmall was the ChiefFinancial Officer of Protegra Technology Group, a computer software developmentcompany.  From 2002 to 2003, he was theController of the Agricultural Products Division of Saskatchewan Wheat Pool andfrom 1995 to 2002 he was the Chief Financial Officer of ConAgra Grain, Canada.

**Wesley C. Hayne**, age 58, was elected a director in November2002. Since 2000, Mr. Hayne has been Chief Executive Officer of Biorefining,Inc., a company that develops, commercializes and licenses patentedtechnologies capable of converting residual plant material into high-end,value-added products. From 1999 to 2000, Mr. Hayne was President of CybrixCorporation, Inc., a company that provides solutions and leases staffing forcomputer security and disaster planning. From 1997 to 2000, Mr. Hayne was ChiefExecutive Officer of International Concept Development, Inc., a company thatdevelops fast food restaurants in Europe. Mr. Hayne serves as the “audit committee financial expert” as defined byItem 401(h) of Regulation S-K.

**Philip Kives**, age 77, founded K-tel in 1968 andhas served as its Chairman of the Board since K-tel’s inception. In addition,Mr. Kives has been the Chief Executive Officer and President for more than fiveyears.

**Richard Marklund**, age 61, was elected adirector in November 2002. Since 2002, Mr. Marklund has been Chairman and ChiefExecutive Officer of Phoenix Newcastle Holdings, Inc., a management consultingcompany. From 2000 until 2002, Mr. Marklund served as Executive Vice Presidentof WAM!NET, Inc., a telecommunication company. From 1998 until 2000, Mr.Marklund served as Chief Executive Officer of Hyperport International, Inc., areal estate development company.

**Jay William Smalley**, age 72, was elected a director inJanuary 1999. From 1970 until 1998, Mr. Smalley served as Chief ExecutiveOfficer of JWS, Inc., a privately owned real estate development and salescompany specializing in hotel, motel, industrial and residential properties.Since 1998, Mr. Smalley has been a broker and private contractor for PrudentialCalifornia Realty.

**AuditCommittee**

K-tel has a separatedesignated audit committee made up of Wesley C. Hayne, Richard Marklund and JayWilliam Smalley.

**Code ofEthics**

K-telhas adopted a code of ethics that applies to its principal executive officer,principal financial officer and principal accounting officer.  This code of ethics is available on K-tel’swebsite at K-tel.com and in print upon written request to:  Code of Ethics, K-tel International, Inc.,2655 Cheshire Lane North, Suite 100, Plymouth, Minnesota 55447.  Any amendment to, or waiver from, a provisionof the code of ethics will be posted to the above referenced website.

**Section 16(a) BeneficialOwnership Reporting Compliance**

Section 16(a) ofthe Securities Exchange Act of 1934, as amended, requires K-tel’s officers,directors and persons who own more than 10% of a registered class of K-tel’sequity securities to file reports of ownership on Form 3 and changes inownership on Form 4 or 5 with the Securities and Exchange Commission. Suchofficers, directors and 10% shareholders also are required by Securities andExchange Commission’s rules to furnish K-tel with copies of all Section 16(a)reports they file. Based solely on its review of the copies of such formsreceived by it, or written representations from certain reporting persons, theCompany believes that during fiscal year 2004, its officers, directors and 10%shareholders filed all reports on a timely basis.

18

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**ITEM 11: EXECUTIVE COMPENSATION**

Thefollowing table sets forth the aggregate cash compensation paid to or accruedfor each of K-tel’s executive officers for services rendered to K-tel duringthe fiscal years ended June 30, 2004, 2003 and 2002. K-tel has no writtenemployment agreements with its executive officers.

**Summary Compensation Table**
|                                                | ** ** | ** **                   | ** ** | ** **     | ** ** | ** **         | ** ** | **Long-Term**    | ** ** | ** **       | ** ** |
|------------------------------------------------|------------|------------------------------|------------|----------------|------------|--------------------|------------|------------------|------------|------------------|------------|
| ** **                                     | ** ** | ** **                   | ** ** | ** **     | ** ** | ** **         | ** ** | **Compensation** | ** ** | ** **       | ** ** |
| ** **                                     | ** ** | ** **                   | ** ** | **Awards**     | ** ** | ** **         | ** ** |
| ** **                                     | ** ** | ** **                   | ** ** | ** **     | ** ** | ** **         | ** ** | **Securities**   | ** ** | ** **       | ** ** |
| ** **                                     | ** ** | **Annual Compensation** | ** ** | **Underlying** | ** ** | **All Other** | ** ** |
| **Name and Principal Position** | ** ** | **Fiscal Year**         | ** ** | **Salary**     | ** ** | **Bonus**          | ** ** | **Options**      | ** ** | **Compensation** | ** ** |
| ** **                                     | ** ** | ** **                   | ** ** | ** **     | ** ** | ** **         | ** ** | ** **       | ** ** | ** **       | ** ** |
| Philip Kives                                   |       | 2004                         |       | $              | —     |               | $          | —           |       | —           |       | $ | — |   |
| Chief Executive Officer                        |       | 2003                         |       | $              | —     |               | $          | —           |       | —           |       | $ | — |   |
|                                                |       | 2002                         |       | $              | —     |               | $          | —           |       | —           |       | $ | — |   |

 

During the fiscalyears ended June 30, 2004, 2003 and 2002, the Company paid approximately$68,000 in annual management fees to K-5 for services provided to the K-telInternational, Inc. Companies.  Thesemanagement fees include payments for services provided by Mr. Kives to theCompany.

On March 18, 2003, a committee of the Company’s boardof directors comprised solely of independent directors, approved a “StockOption Exchange Program.” The Program provided for a small number of optioneeswho were previously awarded options to purchase shares of common stock underthe Company’s 1997 Stock Option Plan to exchange them voluntarily for optionsto purchase an equal number of shares outside the Company’s Stock Option Plan.Mr. Kives exchanged 1,702,939 options with a weighted average price per shareof $5.95 under this Stock Option Exchange Program. Replacement options wereproposed to be issued six months and one day after the date of cancellation ofthe existing options and were to be at an exercise price per share equal to thefair market value of the Company’s common stock as quoted on the OTC BulletinBoard on the date of grant and expire ten years after the date of grant. OnNovember 18, 2003, the replacement options were issued at a price per share of$.08. There was no compensation expense recognized as a result of thisexchange.

**OptionGrants in Last Fiscal Year**

No options were granted todirectors or executive officers in fiscal year 2004.

**Aggregated Option Exercises in Last Fiscal Yearand FY-end Option Values**
| ** **   | ** ** | **Shares   Acquired** | ** ** | **Value**    | ** ** | **Number of Securities  Underlying Options at FY-End** | ** ** | **Value of In-the Money   Options at FY-End(1)** | ** ** |
|--------------|------------|----------------------------|------------|--------------|------------|---------------------------------------------------------------------------------|------------|--------------------------------------------------------------------------------|------------|
| **Name**     | ** ** | **On Exercise**       | ** ** | **Realized** | ** ** | **Exercisable**                                                                 | ** ** | **Unexercisable**                                                              | ** ** | **Exercisable** | ** ** | **Unexercisable** | ** ** |
| Philip Kives |       | 0                          |       | N/A          |       | 1,702,939                                                                       |       | —                                                                         |       | $ | 34,059 |   | N/A |   |
|              |            |                            |            |              |            |                                                                                 |            |                                                                                |            |  |  |  |  |  |

 

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(1)                                  Marketvalue of underlying securities at fiscal year end minus the exercise price.

**Director Compensation**

Directors who areemployees of the Company receive no compensation for their services asdirector. Non-employee directors receive cash compensation of $10,000 per year(paid quarterly) and are entitled to receive non-qualified stock

19

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options for thepurchase of 5,000 shares of the Company’s common stock at an exercise priceequal to the fair market value of the common stock on the date of initialelection and upon each re-election by the shareholders at an annual orspecial meeting. In connection with their appointment to the Company’sCompensation/Stock Option Committee during the fiscal year ended June 30, 2003,Jay William Smalley, Richard R. Marklund and Wesley C. Hayne each also receiveda non-qualified stock option to purchase 95,000 shares of our common stockissued outside the Company’s 1997 Stock Option Plan. During the fiscal yearended June 30, 2003, Mr. Smalley also received a non-qualified stock option topurchase 15,000 shares of common stock outside the Company’s 1997 Stock OptionPlan in consideration of his past and continued service on the Company’s boardof directors. All stock options issued to non-employee directors during thefiscal year ended June 30, 2003 are exercisable for a period of ten years fromthe date of grant and bear an exercise price equal to the last sale price ofour common stock as quoted by the OTC Bulletin Board for the five trading daysimmediately ending after the close of the market on November 27, 2002, the datethe board of directors resolved to grant such options.

**ITEM 12:  SECURITY OWNERSHIP OF CERTAIN BENEFICIALOWNERS AND MANAGEMENT AND RELATEDSTOCKHOLDER MATTERS**

The following table contains certain information as ofSeptember 15, 2006, regarding the beneficial ownership of the common stock by(i) each person known to K-tel to own beneficially five percent or more of thecommon stock, (ii) each director of K-tel, (iii) each named executive officer,and (iv) the directors and executive officers as a group. The percentage ofbeneficial ownership is based on 13,653,738 shares of common stock outstandingas of September 15, 2006. Any shares which are subject to an option or awarrant exercisable within 60 days are reflected in the following table and aredeemed to be outstanding for the purpose of computing the percentage of commonstock owned by the option or warrant holder but are not deemed to beoutstanding for the purpose of computing the percentage of common stock ownedby any other person. Unless otherwise indicated, each person in the table hassole voting and investment power as to the shares shown. Unless otherwiseindicated, the address for each listed shareholder is c/o K-tel International,Inc., 2655 Cheshire Lane North, Suite 100, Plymouth, Minnesota 55447.
| ** **                                                               | ** ** | **Amount and Nature  of Beneficial Ownership(1)** | ** ** | **Percent of  Outstanding Stock** | ** ** |
|--------------------------------------------------------------------------|------------|-----------------------------------------------------------------------|------------|---------------------------------------------|------------|
| Philip Kives  220 Saulteaux Crescent  Winnipeg, Manitoba R3J 3W3  Canada |       | 9,829,253                                                             | (2)        | 64.0                                        | %          |
|                                                                     |       |                                                                  |       |                                        |       |
| Jay William Smalley                                                      |       | 120,000                                                               | (3)        | *                                           |       |
|                                                                     |       |                                                                  |       |                                        |       |
| Wesley C. Hayne                                                          |       | 100,000                                                               | (3)        | *                                           |       |
|                                                                     |       |                                                                  |       |                                        |       |
| Richard Marklund                                                         |       | 100,000                                                               | (3)        | *                                           |       |
|                                                                     |       |                                                                  |       |                                        |       |
| All current directors  and officers as a group (4 persons)               |       | 10,149,253                                                            | (4)        | 64.7                                        | %          |

 

----

*        Indicatesownership of less than 1% of the outstanding shares of Common Stock.

(1)     Thesecurities “beneficially owned” by a person are determined in accordance withthe definition of “beneficial ownership” set forth in the regulations of theSecurities and Exchange Commission and accordingly, may include securitiesowned by or for, among others, the spouse, children or certain other relativesof such person as well as other securities as to which the person has or sharesvoting or investment power or has the right to acquire within 60 days. Morethan one person may beneficially own the same shares.

(2)     Consistsof 7,800,978 shares held directly by K-5 Leisure Products Inc. (an affiliate ofthe Company controlled by Mr. Kives), 325,336 shares held by a wholly-ownedsubsidiary of K-5 and 1,702,939 shares purchasable upon the exercise ofoptions.

(3)     Representsshares purchasable upon the exercise of options.

(4)     Includes2,022,939 shares purchasable upon the exercise of options.

20

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**ITEM 13: CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS**

K-telhas a Line of Credit Agreement with K-5 Leisure Products, Inc. (“K-5”), theCompany’s largest shareholder controlled by Philip Kives, the Chairman of theBoard, President and Chief Executive Officer of K-tel. Under the terms of theagreement (the “K-5 Facility”), K-5 has agreed to make available up to$8,000,000 to K-tel on a revolving basis. The loan bears interest at a variablerate based upon the “base rate” of a nationally recognized lending institution(4.0% at June 30, 2004), expires July 20, 2008, and is subordinated to theFoothill loan (see below). The K-5 Facility contains the same covenants as theFoothill loan agreement. K-tel has pledged the stock of its foreignsubsidiaries as collateral for the loan, and the loan carries a subordinatedposition to the Foothill loan on all other assets of the Company. K-tel hadoutstanding balances of $7,165,000 and $7,282,000 as of June 30, 2004 and 2003respectively under the K-5 Facility. At June 30, 2004, K-tel obtained a waiverfrom K-5 for its non-compliance under the covenants, limitations andrestrictions of the credit agreement.

In addition, K-tel has asecond loan agreement with K-5, under which K-5 assumed rights and obligationsunder a loan from the Company’s former banker (Foothill Capital Corporation)pursuant to an Assignment and Acceptance Agreement dated February 27, 2001.This Foothill loan, which has been extended through July 20, 2008, provides fora $10,000,000 credit facility consisting of a $4,000,000 term loan due uponexpiration, and a $6,000,000 revolving facility under which borrowings arelimited to a percent of eligible receivables. Borrowings under the facilitybear interest at a variable rate based on a “base rate” of a nationally recognized lendinginstitution plus 1% (5.0% at June 30, 2004) and are collateralized bythe assets of certain Company subsidiaries in the United States, includingaccounts receivable, inventories, equipment, music library and generalintangibles. The loan agreement contains certain financial and other covenantsor restrictions, including the maintenance of a minimum shareholders’ equity byK-tel, limitations on capital expenditures, restrictions on music libraryacquisitions, limitations on other indebtedness and restrictions on dividendspaid by K-tel. As of June 30, 2004 and June 30, 2003, $4,000,000 wasoutstanding under the term loan and there were no borrowings under therevolving facility. At June 30, 2004, K-tel obtained a waiver from K-5 for itsnon-compliance under the covenants, limitations and restrictions of the creditagreement.

K-tel had an overdraft privilege borrowing facility of$45,000 and $250,000 at June 30, 2004 and 2003, respectively, with The RoyalBank of Scotland in the United Kingdom. This facility was secured by a standbyletter of credit for $55,000 and $260,000 at June 30, 2004 and 2003,respectively, provided by K-tel International Ltd., a Canadian companycontrolled by Philip Kives and was payable on demand in accordance with normalbanking practices. Borrowings bore interest of 2.0% per annum over the baserate (a total of 6.0% at June 30, 2004 and 5.75% at June 30, 2003) but weresubject to a minimum of 6.0% per annum. K-tel had an outstanding balance of$233,000 as of June 30, 2003 with no outstanding balance as of June 30,2004.  This overdraft privilege borrowingfacility was canceled at the end of calendar 2004.

The Companypurchased approximately $502,000 in the year ended June 30, 2004, $463,000 inthe year ended June 30, 2003 and $366,000 in the year ended June 30, 2002 ofmusic entertainment and consumer convenience products from K-5, whichrepresented 17.1%, 14.6% and 14.7% of cost of goods sold, respectively. Therewere trade payables to K-5 of $390,000 at June 30, 2004, $371,000 at June 30,2003 and $291,000 at June 30, 2002, or 27.2%, 31.9% and 23.0% of total tradepayables, respectively.

During the fiscalyears ended June 30, 2004, 2003 and 2002, the Company paid approximately$68,000 in annual management fees to K-5 for services provided to the K-telInternational, Inc. Companies.  Thesemanagement fees included payments for services provided by Mr. Kives to theCompany.

The Company had nosales of products to K-5 during fiscal years 2004, 2003 and 2002. There was abalance receivable from K-5 at June 30, 2004 of $113,000, June 30, 2003 of$73,000 and June 30, 2002 of $129,000. No interest was charged on the relatedoutstanding balances during fiscal years 2004, 2003 and 2002.

During the fiscalyears ended June 30, 2004 and 2003, the Company licensed certain marks to K-telDrug Mart Ltd., a Canadian direct marketer of prescription drugs owned byPhilip Kives, the Chairman of the Board, President and Chief Executive Officerof K-tel. The terms of the license agreement between the Company and K-tel DrugMart have not been finalized, but will involve payment of a royalty to theCompany by K-tel Drug Mart for use of the trademark. The agreement is currentlyunder consideration by the Company, and will be subject to approval by theCompany’s independent directors.

All futuretransactions between the Company, its officers, directors and principalshareholders and its affiliates will be approved by the audit committee of theCompany’s board of directors.

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# **ITEM14.  ****PRINCIPAL ACCOUNTANT FEES AND SERVICES**

Fees and Services

The followingtable shows the aggregate fees billed to the Company by Grant Thornton forservices rendered during fiscal years ended June 30, 2004 and June 30, 2003:
| Description of Fees | ** ** | **Fiscal 2004  Amount** | ** ** | **Fiscal 2003  Amount** | ** ** |
|-------------------------------|------------|------------------------------|------------|------------------------------|------------|
|                          |       |                         |       |                         |       |
| Audit Fees                    |       | $                            | 180,000    | (1)                          | $          | 127,500 | (1) |
| Audit Related  fees           |       | —                       |       | —                       |       |
| Tax Fees                      |       | 60,000                       | (2)        | 54,600                       | (2)        |
| Other Fees                    |       | 3,000                        | (3)        | 500                          | (3)        |
| Total                         |       | $                            | 243,000    |                         | $          | 182,600 |   |

 

----

(1)   Auditfees consisted of fees for audit work of the Company’s annual financialstatements and review of the quarterly financial statements included in theCompany’s Quarterly Reports on Form 10-Q for the fiscal years 2004 and 2003 andrelated audit committee meeting attendance.

(2)   Taxfees consisted of fees for federal, state and international tax returnpreparation and tax planning and tax advice related to various tax mattersincluding state tax notices and other tax research related matters.

(3)   Otherfees included fees related to statutory audit work performed in Germany andother financial consulting assistance.

Pre-ApprovalPolicy and Procedures

The auditcommittee requires that all audit and permissible non-audit services providedby our independent auditors be pre-approved by the audit committee or adesignated member of the audit committee. These services may include auditservices, audit-related services, tax services and other services. Any pre-approvalis detailed as to the particular service or category of services. The auditcommittee reviews all non-audit services to be provided and assesses the impactof the services on the auditor’s independence.

The auditcommittee pre-approved 100% of the services described in the “Fees and Services”table pursuant to engagements that occurred in fiscal 2004 and 2003.

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**PART IV**

**ITEM15:  EXHIBITS AND FINANCIAL STATEMENTSCHEDULES**

(a)           FinancialStatements and Schedules

The consolidatedstatements and schedules listed in the accompanying Index to ConsolidatedFinancial Statements hereof are filed as part of this report.

(b)           Exhibits

Reference is madeto the Exhibit Index.

(c)           ExcludedFinancial Statements

Not applicable.

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**SIGNATURES**

Pursuant to therequirements of Section 13 or 15(d) of the Securities Exchange Act of 1934, theCompany has duly caused this report to be signed on its behalf on September 18,2006, by the undersigned, thereunto duly authorized.
|   | K-TEL INTERNATIONAL, INC.               |
|--------|-----------------------------------------|
|   |                                    |
|   | By                                      | /s/ Philip Kives |   |
|   | (Philip Kives -  Chairman of the Board, |
|   | Chief Executive  Officer and President) |

 

Pursuant to therequirements of the Securities and Exchange Act of 1934, this report has beensigned below by the following persons on behalf of the registrant and in thecapacities indicated and on the dates indicated.
| Signatures               | ** ** | **Title**                          | ** ** | **Date**           |
|--------------------------|------------|------------------------------------|------------|--------------------|
|                     |       |                               |       |               |
| /s/ Philip Kives         |       | Chairman, Chief Executive Officer, |       | September 18, 2006 |
| Philip Kives             |       | (Principal Executive Officer)      |       |               |
|                     |       | President and  Director            |       |               |
|                     |       |                               |       |               |
| /s/Larry Dunmall         |       | Chief Financial Officer            |       | September 18, 2006 |
| Larry Dunmall            |       | (Principal Financial and           |       |               |
|                     |       | Accounting  Officer)               |       |               |
|                     |       |                               |       |               |
| /s/ Jay William  Smalley |       | Director                           |       | September 18, 2006 |
| Jay William  Smalley     |       |                               |       |               |
|                     |       |                               |       |               |
| /s/ Wesley C.  Hayne     |       | Director                           |       | September 18, 2006 |
| Wesley C. Hayne          |       |                               |       |               |
|                     |       |                               |       |               |
| /s/ Richard  Marklund    |       | Director                           |       | September 18, 2006 |
| Richard Marklund         |       |                               |       |               |

 

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## **K-TEL INTERNATIONAL, INC. AND SUBSIDIARIES**

**INDEX TOCONSOLIDATED FINANCIAL STATEMENTS**
| Report of Independent  Registered Public Accounting Firm                                                         |   | 26     |
|------------------------------------------------------------------------------------------------------------------|--------|--------|
|                                                                                                             |   |   |
| Consolidated Balance Sheets as of  June 30, 2004 and 2003                                                        |   | 27     |
|                                                                                                             |   |   |
| Consolidated Statements of  Operations for each of the three years ended June 30, 2004                           |   | 28     |
|                                                                                                             |   |   |
| Consolidated Statements of  Shareholders’ Equity (Deficit) for each of the three years ended June 30,  2004 |   | 29     |
|                                                                                                             |   |   |
| Consolidated  Statements of Cash Flows for each of the three years ended June 30, 2004                           |   | 30     |
|                                                                                                             |   |   |
| Notes to  Consolidated Financial Statements                                                                      |   | 31     |
|                                                                                                             |   |   |
| Supplemental  Schedule to Consolidated Financial Statements:                                                     |   |   |
|                                                                                                             |   |   |
| Schedule II - Valuation and  Qualifying Accounts for each of the three years ended June 30, 2004                 |   | 45     |

 

 

All otherschedules for which provision is made in the applicable accounting regulationsof the Securities and Exchange Commission have been omitted as not required,not applicable or the information required has been included elsewhere in theconsolidated financial statements and notes thereto.

25

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**REPORT OFINDEPENDENT REGISTERED PUBLIC ACCOUNTING FIRM**

To the Board ofDirectors and Shareholders of K-tel International, Inc.

We have auditedthe accompanying consolidated balance sheets of K-tel International, Inc. (aMinnesota corporation) and Subsidiaries as of June 30, 2004 and 2003 and therelated consolidated statements of operations, shareholders’ deficit, and cashflows for each of the three years in the period ended June 30, 2004. Thesefinancial statements are the responsibility of the Company’s management. Ourresponsibility is to express an opinion on these financial statements based onour audits.

We conducted ouraudits in accordance with the standards of the Public Company AccountingOversight Board (United States). Those standards require that we plan andperform the audit to obtain reasonable assurance about whether the financialstatements are free of material misstatement. An audit includes considerationof internal control over financial reporting as a basis for designing auditprocedures that are appropriate in the circumstances, but not for the purposeof expressing an opinion on the effectiveness of the Company’s internal controlover financial reporting.  Accordingly,we express no such opinion.  An auditalso includes examining, on a test basis, evidence supporting the amounts anddisclosures in the financial statements, assessing the accounting principlesused and significant estimates made by management, as well as evaluating theoverall financial statement presentation. We believe that our audits provide areasonable basis for our opinion.

In our opinion,the financial statements referred to above present fairly, in all materialrespects, the consolidated financial position of K-tel International, Inc. andSubsidiaries as of June 30, 2004 and 2003 and the consolidated results of theiroperations and their consolidated cash flows for the each of the three years inthe period ended June 30, 2004 in conformity with accounting principlesgenerally accepted in the United States of America.

As discussed inNote 12 to the consolidated financial statements, the Company adopted FASBInterpretation 46 (Revised December 2003), *Consolidation of VariableInterest Entities*, during the quarter ended March 31, 2004.

Our audits wereconducted for the purpose of forming an opinion on the basic consolidatedfinancial statement taken as a whole. The accompanying Schedule II of K-tel International, Inc. andSubsidiaries is presented for the purposes of additional analysis and is not arequired part of the basic consolidated financial statements.  This schedule has been subjected to theauditing procedures applied in the audit of the basic consolidated financialstatements and, in our opinion, is fairly stated in all material respects inrelation to the basic consolidated financial statements taken as a whole.
|                          | /S/ GRANT  THORNTON LLP |   |
|--------------------------|-------------------------|--------|
|                     |
|                     |
| Minneapolis,  Minnesota, |
| August 15, 2006          |

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**K-TELINTERNATIONAL, INC. AND SUBSIDIARIES**

## **CONSOLIDATED BALANCE SHEETS**

**JUNE 30,**

*(inthousands - except share and per share data)*
| ** **                                                                                                             | ** ** | **2004** | ** ** | **2003** | ** ** |
|------------------------------------------------------------------------------------------------------------------------|------------|----------|------------|----------|------------|
|                                                                                                                   |       |     |       |     |       |
| ASSETS                                                                                                                 |       |     |       |     |       |
|                                                                                                                   |       |     |       |     |       |
| Current Assets:                                                                                                        |       |     |       |     |       |
| Cash and cash  equivalents                                                                                             |       | $        | 147        |     | $          | 1,219 |   |
| Accounts receivable,  net of allowance for doubtful accounts of $4 in 2004 and $25 in 2003                             |       | 2,691    |       | 2,134    |       |
| Inventories                                                                                                            |       | 561      |       | 522      |       |
| Royalty advances                                                                                                       |       | 50       |       | 220      |       |
| Prepaid expenses and  other                                                                                            |       | 308      |       | 304      |       |
| Total Current Assets                                                                                                   |       | 3,757    |       | 4,399    |       |
|                                                                                                                   |       |     |       |     |       |
| Property and equipment, net of accumulated depreciation and  amortization of $1,506 in 2004 and 2003                   |       | 83       |       | 83       |       |
|                                                                                                                   |       |     |       |     |       |
| Owned catalog masters, net of accumulated amortization of $2,942 in  2004 and $2,755 in 2003                           |       | 656      |       | 819      |       |
|                                                                                                                   |       |     |       |     |       |
|                                                                                                                   |       | $        | 4,496      |     | $          | 5,301 |   |
|                                                                                                                   |       |     |       |     |       |
| LIABILITIES AND SHAREHOLDERS’ DEFICIT                                                                             |       |     |       |     |       |
|                                                                                                                   |       |     |       |     |       |
| Current Liabilities:                                                                                                   |       |     |       |     |       |
| Notes payable to  affiliate and other                                                                                  |       | $        | 11,165     |     | $          | 11,515 |   |
| Accounts payable                                                                                                       |       | 1,432    |       | 1,160    |       |
| Accrued royalties                                                                                                      |       | 1,907    |       | 2,394    |       |
| Reserve for returns                                                                                                    |       | 133      |       | 220      |       |
| Net liabilities of  discontinued operations                                                                            |       | 30       |       | 116      |       |
| Total Current Liabilities                                                                                              |       | 14,667   |       | 15,405   |       |
|                                                                                                                   |       |     |       |     |       |
| Shareholders’ Deficit:                                                                                            |       |     |       |     |       |
| Common Stock –  50,000,000 shares authorized, par value $.01; 13,653,738 issued and  outstanding in 2004 and 2003 |       | 136      |       | 136      |       |
| Additional paid-in  capital                                                                                            |       | 21,292   |       | 21,292   |       |
| Accumulated deficit                                                                                                    |       | (31,466  | )          | (31,377  | )          |
| Accumulated other  comprehensive loss                                                                                  |       | (133     | )          | (155     | )          |
| Total Shareholders’  Deficit                                                                                      |       | (10,171  | )          | (10,104  | )          |
|                                                                                                                   |       |     |       |     |       |
|                                                                                                                   |       | $        | 4,496      |     | $          | 5,301 |   |

 

*Theaccompanying notes are an integral part of these financial statements.*

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**K-TEL INTERNATIONAL, INC. AND SUBSIDIARIES**

**CONSOLIDATEDSTATEMENTS OF OPERATIONS**

## **YEARS ENDED JUNE 30,**

*(inthousands - except per share data)*
| ** **                                                                 | ** ** | **2004** | ** ** | **2003** | ** ** | **2002** | ** ** |
|----------------------------------------------------------------------------|------------|----------|------------|----------|------------|----------|------------|
|                                                                       |       |     |       |     |       |     |       |
| Net Sales                                                                  |       | $        | 6,679      |     | $          | 7,234    |       | $ | 6,891 |   |
|                                                                       |       |     |       |     |       |     |       |
| Costs and  Expenses:                                                       |       |     |       |     |       |     |       |
| Cost of goods sold                                                         |       | 2,934    |       | 3,100    |       | 2,353    |       |
| Advertising                                                                |       | 110      |       | 200      |       | 172      |       |
| Selling, general and administrative                                        |       | 3,668    |       | 3,785    |       | 4,412    |       |
| Total Costs and Expenses                                                   |       | 6,712    |       | 7,085    |       | 6,937    |       |
| Operating Income  (Loss)                                                   |       | (33      | )          | 149      |       | (46      | )          |
|                                                                       |       |     |       |     |       |     |       |
| Other Income  (Expense):                                                   |       |     |       |     |       |     |       |
| Interest expense                                                           |       | (497     | )          | (534     | )          | (472     | )          |
| Other income (expense), net                                                |       | (20      | )          | 74       |       | (37      | )          |
| Total Other Expense                                                        |       | (517     | )          | (460     | )          | (509     | )          |
|                                                                       |       |     |       |     |       |     |       |
| Loss from  Continuing Operations Before Income Taxes                       |       | (550     | )          | (311     | )          | (555     | )          |
|                                                                       |       |     |       |     |       |     |       |
| Benefit for  Income Taxes                                                  |       | 168      |       | —   |       | 141      |       |
|                                                                       |       |     |       |     |       |     |       |
| Loss from  Continuing Operations                                           |       | (382     | )          | (311     | )          | (414     | )          |
|                                                                       |       |     |       |     |       |     |       |
| Discontinued  Operations:                                                  |       |     |       |     |       |     |       |
| Loss from discontinued operations, net of taxes                            |       | (52      | )          | (581     | )          | (180     | )          |
|                                                                       |       |     |       |     |       |     |       |
| Loss before  Extraordinary Item                                            |       | (434     | )          | (892     | )          | (594     | )          |
|                                                                       |       |     |       |     |       |     |       |
| Extraordinary  Item:                                                       |       |     |       |     |       |     |       |
| Gain on Subsidiary Liquidations, net of taxes                              |       | 347      |       | —   |       | 894      |       |
|                                                                       |       |     |       |     |       |     |       |
| Net Income  (Loss)                                                         |       | $        | (87        | )        | $          | (892     | )          | $ | 300 |   |
|                                                                       |       |     |       |     |       |     |       |
| Income (Loss)  per Share – Basic and Diluted:                         |       |     |       |     |       |     |       |
| Continuing Operations                                                      |       | $        | (.03       | )        | $          | (.02     | )          | $ | (.03 | ) |
| Discontinued Operations                                                    |       | (.01     | )          | (.04     | )          | (.01     | )          |
| Extraordinary Item                                                         |       | .03      |       | —   |       | .06      |       |
| Net Income (Loss)                                                          |       | $        | (.01       | )        | $          | (.06     | )          | $ | .02 |   |
|                                                                       |       |     |       |     |       |     |       |
| Shares used in  the calculation of loss per share– Basic and Diluted: |       | 13,654   |       | 13,654   |       | 13,654   |       |
|                                                                       |       |     |       |     |       |     |       |
| Comprehensive  Loss                                                        |       |     |       |     |       |     |       |
| Net income (loss)                                                          |       | $        | (87        | )        | $          | (892     | )          | $ | 300 |   |
| Unrealized pension cost                                                    |       | (74      | )          | —   |       | —   |       |
| Translation adjustment                                                     |       | 96       |       | 131      |       | (3       | )          |
| Comprehensive income  (loss)                                               |       | $        | (65        | )        | $          | (761     | )          | $ | 297 |   |

 

*Theaccompanying notes are an integral part of these financial statements.*

28

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**K-TELINTERNATIONAL, INC. AND SUBSIDIARIES**

**CONSOLIDATEDSTATEMENTS OF SHAREHOLDERS’ EQUITY (DEFICIT)**

**YEARSENDED JUNE 30, 2004, 2003 AND 2002**

*(inthousands)*
| ** **                               | ** ** | ** ** | ** ** | ** ** | ** ** | **Additional  Paid-In  Capital** | ** ** | **Accumulated  Deficit** | ** ** | **Accumulated  Other  Comprehensive  Loss** | ** ** | **Total** | ** ** |
|------------------------------------------|------------|------------|------------|------------|------------|----------------------------------|------------|--------------------------|------------|---------------------------------------------|------------|-----------|------------|
| ** **                               | ** ** | ** ** |
| **Common Stock**                    |
| **Shares**                               | ** ** | **Amount** |
|                                     |       |       |       |       |       |                             |       |                     |       |                                        |       |      |       |
| Balance at June  30, 2001                |       | 13,654     |       | $          | 136        |                             | $          | 20,680                   |       | $                                           | (30,785    | )         | $          | (283 | ) | $ | (10,252 | ) |
|                                     |       |       |       |       |       |                             |       |                     |       |                                        |       |      |       |
| Net income                               |       | —     |       | —     |       | —                           |       | 300                      |       | —                                      |       | 300       |       |
| Reduction of  notes payable to affiliate |       | —     |       | —     |       | 612                              |       | —                   |       | —                                      |       | 612       |       |
| Translation  adjustment                  |       | —     |       | —     |       | —                           |       | —                   |       | (3                                          | )          | (3        | )          |
|                                     |       |       |       |       |       |                             |       |                     |       |                                        |       |      |       |
| Balance at June  30, 2002                |       | 13,654     |       | 136        |       | 21,292                           |       | (30,485                  | )          | (286                                        | )          | (9,343    | )          |
|                                     |       |       |       |       |       |                             |       |                     |       |                                        |       |      |       |
| Net loss                                 |       | —     |       | —     |       | —                           |       | (892                     | )          | —                                      |       | (892      | )          |
| Translation  adjustment                  |       | —     |       | —     |       | —                           |       | —                   |       | 131                                         |       | 131       |       |
|                                     |       |       |       |       |       |                             |       |                     |       |                                        |       |      |       |
| Balance at June  30, 2003                |       | 13,654     |       | 136        |       | 21,292                           |       | (31,377                  | )          | (155                                        | )          | (10,104   | )          |
|                                     |       |       |       |       |       |                             |       |                     |       |                                        |       |      |       |
| Net loss                                 |       | —     |       | —     |       | —                           |       | (87                      | )          | —                                      |       | (87       | )          |
| Other                                    |       | —     |       | —     |       | —                           |       | (2                       | )          | —                                      |       | (2        | )          |
| Unrealized  pension cost                 |       |       |       |       |       |                             |       |                     |       | (74                                         | )          | (74       | )          |
| Translation  adjustment                  |       | —     |       | —     |       | —                           |       | —                   |       | 96                                          |       | 96        |       |
|                                     |       |       |       |       |       |                             |       |                     |       |                                        |       |      |       |
| Balance at June 30,  2004                |       | 13,654     |       | $          | 136        |                             | $          | 21,292                   |       | $                                           | (31,466    | )         | $          | (133 | ) | $ | (10,171 | ) |

 

*Theaccompanying notes are an integral part of these financial statements.*

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**K-TELINTERNATIONAL, INC. AND SUBSIDIARIES**

**CONSOLIDATEDSTATEMENTS OF CASH FLOWS**

**YEARSENDED JUNE 30,**

*(inthousands)*
| ** **                                                                                             | ** ** | **2004** | ** ** | **2003** | ** ** | **2002** | ** ** |
|--------------------------------------------------------------------------------------------------------|------------|----------|------------|----------|------------|----------|------------|
| Operating Activities:                                                                                  |       |     |       |     |       |     |       |
| Net income (loss)                                                                                      |       | $        | (87        | )        | $          | (892     | )          | $ | 300 |   |
| Adjustment to reconcile  net income (loss) to cash used in operating activities:                       |       |     |       |     |       |     |       |
| Depreciation and  amortization                                                                         |       | 253      |       | 315      |       | 380      |       |
| Loss on disposal  of property and equipment                                                            |       | 7        |       | 3        |       | 18       |       |
| Gain on  liquidation of subsidiaries                                                                   |       | —   |       | —   |       | (894     | )          |
| Discontinued  operations                                                                               |       | (93      | )          | 7        |       | (109     | )          |
| Changes in operating  assets and liabilities:                                                          |       |     |       |     |       |     |       |
| Accounts  receivable, net                                                                              |       | (118     | )          | (147     | )          | (1,078   | )          |
| Inventories                                                                                            |       | (21      | )          | 135      |       | (199     | )          |
| Royalty advances                                                                                       |       | 193      |       | 68       |       | (70      | )          |
| Prepaid expenses                                                                                       |       | 11       |       | 89       |       | 295      |       |
| Accounts payable                                                                                       |       | (190     | )          | (10      | )          | (695     | )          |
| Accrued  royalties                                                                                     |       | (485     | )          | 87       |       | 213      |       |
| Income taxes                                                                                           |       | —   |       | —   |       | (130     | )          |
| Reserve for  returns                                                                                   |       | (88      | )          | 173      |       | (18      | )          |
| Cash used in  operating activities                                                                     |       | (618     | )          | (172     | )          | (1,987   | )          |
|                                                                                                   |       |     |       |     |       |     |       |
| Investing Activities:                                                                                  |       |     |       |     |       |     |       |
| Purchases of  property and equipment                                                                   |       | (66      | )          | (18      | )          | (124     | )          |
| Music catalog  additions                                                                               |       | (26      | )          | —   |       | —   |       |
| Other                                                                                                  |       | 2        |       | 15       |       | 27       |       |
| Cash used in  investing activities                                                                     |       | (90      | )          | (3       | )          | (97      | )          |
|                                                                                                   |       |     |       |     |       |     |       |
| Financing Activities:                                                                                  |       |     |       |     |       |     |       |
| Borrowings on  notes payable                                                                           |       | 2,569    |       | 2,278    |       | 3,676    |       |
| Payments on  notes payable                                                                             |       | (2,944   | )          | (1,033   | )          | (1,629   | )          |
| Cash provided by  (used in) financing activities                                                       |       | (375     | )          | 1,245    |       | 2,047    |       |
|                                                                                                   |       |     |       |     |       |     |       |
| Effect of  exchange rates on cash                                                                      |       | 11       |       | 74       |       | (61      | )          |
|                                                                                                   |       |     |       |     |       |     |       |
| Net increase  (decrease) in cash equivalents                                                           |       | (1,072   | )          | 1,144    |       | (98      | )          |
|                                                                                                   |       |     |       |     |       |     |       |
| Cash and  equivalents at beginning of period                                                           |       | 1,219    |       | 75       |       | 173      |       |
|                                                                                                   |       |     |       |     |       |     |       |
| Cash and  equivalents at end of period                                                                 |       | $        | 147        |     | $          | 1,219    |       | $ | 75 |   |
|                                                                                                   |       |     |       |     |       |     |       |
| Supplemental Cash Flow  Information                                                                    |       |     |       |     |       |     |       |
| Cash Paid For -                                                                                        |       |     |       |     |       |     |       |
| Interest                                                                                               |       | $        | 539        |     | $          | 396      |       | $ | 598 |   |
| Non-cash Information                                                                                   |       |     |       |     |       |     |       |
| Reduction of  notes payable to affiliate through Debt forgiveness, recorded as a capital  contribution |       | $        | —     |     | $          | —   |       | $ | 612 |   |
| Music catalogs  reclassified to prepaid assets                                                         |       | $        | —     |     | $          | —   |       | $ | 173 |   |

 

*Theaccompanying notes are an integral part of these financial statements.*

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**K-TELINTERNATIONAL, INC. AND SUBSIDIARIES**

**NOTES TOCONSOLIDATED FINANCIAL STATEMENTS**

**JUNE 30,2004, 2003 AND 2002**

**1.             BUSINESS AND LIQUIDITY**

K-tel International, Inc. (the “Company” or “K-tel”)was incorporated in 1968 and currently has its corporate offices located inPlymouth, Minnesota. Through its operating subsidiaries, K-tel licenses itsmusic catalog internationally and markets entertainment products mainly derivedfrom its catalog through retail and direct response marketing channels in theUnited States and Europe. The Company has a focused method of distribution thattargets the strengths of selected individual retailers and supplies productssuited to each retailer’s needs. These products are derived mainly from theCompany’s master recordings music catalog with the objective of realizing morecompetitive profit margins. K-tel seeks to license its trademarks to othercompanies in businesses unrelated to K-tel’s current operations. Licenses aregranted for a royalty or fee, with no cost to the Company. The Company haslicensed certain marks to K-tel Drug Mart Ltd., a Canadian direct marketer ofprescription drugs beneficially owned by Philip Kives, the Chairman of theBoard, President and Chief Executive Officer of K-tel. K-tel is merely alicensor of its mark to K-tel Drug Mart. To date, K-tel Drug Mart’s operationshave not generated any significant licensing revenues for the Company.

SubsidiaryLiquidation

In November 2000, theCompany’s consumer products subsidiary in the United Kingdom, K-tel MarketingLtd., ceased operations and began voluntary liquidation proceedings. At theinitial meeting of the creditors on November 24, 2000, the creditors voted forthe liquidation to become a creditors’ liquidation under English law. TheCompany has not been informed by the liquidators or their counsel of any planto attempt to hold it or any of its subsidiaries liable for any of thecommitments of K-tel Marketing Ltd. Management believes the Company will haveno ongoing material liability related to K-tel Marketing Ltd. as a result ofthe liquidation proceeding.  In fiscal2002, the assets and liabilities of the subsidiary were removed from the booksof the Company and the remaining net liability was shown as a gain onliquidation.  As the only securedcreditor, the Company subsequently received distributions of approximately$138,000 on March 1, 2004 and $76,000 on May 14, 2004 and reflected these asadditional gain on liquidation, net of taxes. K-tel Marketing Ltd. had nooperations during the fiscal years ended June 30, 2004, 2003 and 2002.

In June 2004, the Companyreceived funds for the sale of assets and the collections of accountsreceivables related to the March 2001 bankruptcy of  K-tel International, (USA), Inc.,  the Company ‘s music distribution subsidiaryin the United States.  The Companyreceived approximately $220,000 for assets sold by a third party and receivedapproximately $113,000 in account receivable collections.  These receipts were reflected as a gain onliquidation, net of taxes.

DiscontinuedOperations

The Company’sconsumer products business, which was concentrated in Europe, consistedprimarily of housewares, consumer convenience items and exercise equipment. TheCompany discontinued its consumer products operations in Germany, the UnitedKingdom and the United States in June 2000, November 2000 and January 2001respectively. Accordingly, these activities have been presented in theaccompanying financial statements as discontinued operations. The accompanyingcondensed consolidated financial statements have been prepared to reflect the consumerproducts division as a discontinued operation. The net liabilities ofdiscontinued operations at June 30, 2004 and 2003 and losses from discontinuedoperations relate primarily to legal matters and completion of statutoryreporting requirements for the former operations in Germany (See Note 6).

Liquidity

During the yearsended June 30, 2004, 2003 and 2002, the Company incurred net losses fromcontinuing operations of $382,000, $311,000 and $414,000, respectively, andused $618,000, $172,000, and $1,987,000 of cash in operating activities.Additionally, the Company had a working capital deficit of $10,910,000 at June30, 2004.

TheCompany’s ability to continue its present operations and implement futureexpansion plans successfully is contingent mainly upon its ability to maintainits line of credit arrangements with K-5 Leisure Products, Inc. (See Note 3),increase its revenues and profit margins, and ultimately attain and sustainprofitable operations. Without increased revenues and sustained profitability,the cash generated from the Company’s current operations will likely beinadequate to fund operations and service its indebtedness on an ongoing basis.Management is focusing its efforts on music licensing and limited musicdistribution. However, there can be no assurance that the Company will achieveprofitable operations

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throughthese efforts. The financial statements do not include any adjustments thatmight result from the outcome of these uncertainties.

**2.             SUMMARYOF SIGNIFICANT ACCOUNTING POLICIES**

Principles ofConsolidation - The accompanying consolidated financialstatements include the accounts of K-tel International, Inc. and its domesticand foreign subsidiaries, all of which are wholly owned. All significantintercompany accounts and transactions have been eliminated.

During the quarterended March 31, 2004, the Company began to consolidate the financial statementsof Lancaster Trading Limited (Lancaster), a variable interest entity of whichthe Company determined it was the primary beneficiary (see Note 12).

RevenueRecognition – The Company derives its revenue mainly from twosources: the sale of music compilations (predominately compact discs) producedby the Company, and license revenue from the licensing of Company-ownedmasters. Revenue from music sales is recognized at the time of shipment to thecustomer, while license revenue is recognized when payment is received fromcustomers or when known amounts are receivable, as prior to that datecollection is not considered probable. Most music sales are made with a rightof return of unsold goods. Estimated reserves for returns are established bymanagement based upon historical experience and product mix and are subject toongoing review and adjustment by the Company. These reserves are recorded atthe time of sale and are reflected as a reduction in revenues. The Company’sreserve for returns was $133,000 at June 30, 2004 and $220,000 at June 30,2003.

Cost of Goods Sold– The Company expenses all product manufacturing, distribution and royaltycosts associated with music sales as cost of goods sold. The Company alsoexpenses royalties, commissions and amortization of its owned master recordingsassociated with its license revenue as costs of goods sold.

Shipping andHandling Costs – The Company expenses within cost of goodssold all shipping and handling costs incurred in the shipment of goods.

Cash and CashEquivalents – Cash and cash equivalents consist principallyof cash and short-term, highly liquid investments with original maturities ofless than ninety days. At June 30, 2004 and 2003 $94,000 and $25,000 was heldat various financial institutions in Europe.

AccountsReceivable - Accounts receivable balances are presented netof allowances. The Company determines its allowances by considering a number offactors, including the length of time trade receivables are past due, theCompany’s previous history, and the customer’s current ability to payobligations to the Company. The Company writes off accounts receivables whenthey become uncollectible.

Inventories– Inventories, which consists of finished goods that include all direct productcosts, are valued at the lower of cost, determined on a first-in, first-outbasis, or net realizable value.

Owned CatalogMasters – The Company capitalizes the costs to purchase ownedmaster recordings at the time of acquisition. These costs are amortized overthe estimated useful life of these master recordings, which is generally sevenyears and represents management’s best estimate of the average period of value.Amortization expense for the years ended June 30, 2004, 2003 and 2002 was$190,000, $238,000 and $238,000, respectively.

Estimatedamortization expense for the owned catalog masters is as follows for the yearsended June 30:
| 2005   |   | $       | 173,000 |   |
|--------|--------|---------|---------|--------|
| 2006   |   | 159,000 |    |
| 2007   |   | 142,000 |    |
| 2008   |   | 118,000 |    |
| 2009   |   | 64,000  |    |
|   |   | $       | 656,000 |   |

 

Rights to UseMusic Product - Certain of the Company’s compilation productsare master recordings under license from record companies and publishers. Inmost instances, minimum guarantees or non-refundable advances are required toobtain the licenses and are realized through future sales of the product. Theamounts paid for minimum guarantees or non-refundable advances arecapitalized and charged to expense as sales are made. The unrealized portion ofguarantees

32

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and advances isincluded in royalty advances in the accompanying consolidated balance sheets.Licenses are subject to audit by licensors. When anticipated sales appear to beinsufficient to fully recover the minimum guarantees or non-refundableadvances, a provision against current operations is made for anticipatedlosses.

Property andEquipment - Property and equipment are stated at cost.Depreciation and amortization is provided using straight line or decliningbalance methods over the estimated useful lives of the assets, which range fromthree to nine years.

Long Lived-Assets– The Company evaluates its long-lived assets quarterly, or earlier if atriggering event occurs, to determine potential impairment by comparing thecarrying value of those assets to the related undiscounted future cash flows ofthe assets. If an asset is determined to be impaired, it is written down to itsestimated fair value.

Royalties- The Company has entered into license agreements with various record companiesand publishers under which it pays royalties on units sold. The Company accruesroyalties using contractual rates and certain estimated rates on applicableunits sold. The contractual royalty liability is computed quarterly and theaccrued royalty balance is adjusted accordingly. The royalty agreements aresubject to audit by licensors.

Advertising- The Company expenses the costs of advertising when the advertising takesplace, except for direct response advertising, which is capitalized andamortized over its expected period of future benefits (usually the periodremaining under a related contract, which is generally less than one year).Direct response advertising consists primarily of television advertising wherebycustomers respond specifically to the advertising and where the Company canidentify the advertising that elicited the response. Advertising expenses were$110,000, $200,000, and $172,000 for the years ended June 30, 2004, 2003 and2002, respectively.

Foreign Currency- The operations of foreign subsidiaries are measured in local currencies.Assets and liabilities are translated into U.S. dollars at period-end exchangerates. Revenues and expenses are translated at the average exchange ratesprevailing during the period. Adjustments resulting from translating thefinancial statements of foreign entities into U.S. dollars are recorded as acomponent of accumulated other comprehensive income or loss.

Stock-basedCompensation – The Company accounts for stock-based awards toemployees using the intrinsic value method, whereby the options are granted atmarket price, and therefore no compensation costs are recognized. Ifcompensation expense for the Company’s various stock option plans had beendetermined based upon the projected fair values at the grant dates for awardsunder those plans, the Company’s pro-forma net loss, basic and diluted loss percommon share would have been as follows:
|                                    | ** ** | **Fiscal Year Ended  June 30,** | ** ** |
|------------------------------------|------------|------------------------------------------------|------------|
| ** **                         | ** ** | **2004**                                       | ** ** | **2003** | ** ** | **2002** | ** ** |
| Net income  (loss) (in thousands): |       |                                           |       |   |   |   |   |
| As reported                        |       | $                                              | (87        | ) | $ | (892 | ) | $ | 300 |   |
| Pro forma                          |       | $                                              | (258       | ) | $ | (907 | ) | $ | (172 | ) |
|                               |       |                                           |       |   |   |   |   |
| Basic and  Diluted EPS:            |       |                                           |       |   |   |   |   |
| As reported                        |       | $                                              | (.01       | ) | $ | (.06 | ) | $ | .02 |   |
| Pro forma                          |       | $                                              | (.02       | ) | $ | (.06 | ) | $ | (.01 | ) |

 

Income Taxes- Deferred income taxes are provided for temporary differences between thefinancial reporting basis and tax basis of the Company’s assets and liabilitiesat currently enacted tax rates. A valuation allowance equal to the aggregateamount of deferred tax assets is established when realization is not likely.

Net Income (Loss) Per Share - Basicand diluted net income (loss) per share have been computed by dividing netincome (loss) by the weighted average number of shares outstanding during theperiod. For all periods presented, common stock equivalents were excluded fromthe per share calculation as the net effect would be antidilutive. For thefiscal years ended June 30, 2004, 2003 and 2002, weighted average options topurchase 2,574,839, 442,900, and 2,273,839 shares of common stock, withweighted average exercise prices of $.39, $1.95, and $5.89 were excluded fromthe computation of common share equivalents for the respective periods as theywere antidilutive.

Reclassifications – Certainreclassifications have been made to the 2003 financial statements to conformwith the 2004 financial statement presentation. These reclassifications did notaffect earnings as previously reported.

33

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Use of Estimates- Preparing consolidated financial statements in conformity with accountingprinciples generally accepted in the United States of America (“US GAAP”)requires management to make estimates and assumptions that affect the reportedamounts of assets, liabilities, and disclosure of contingent assets andliabilities at the date of the financial statements and the reported amounts ofrevenues and expenses during the reporting period. Principal estimates includeallowances for bad debt, inventory valuation, return reserves, royaltyobligations, purchase commitments and product replacement costs. Actual resultscould differ from those estimates used by management.

**3.**             **NOTES****PAYABLE TO AFFILIATE ANDOTHER**

K-tel has a Line ofCredit Agreement with K-5 Leisure Products, Inc. (“K-5”), the Company’s largestshareholder controlled by Philip Kives, the Chairman of the Board, Presidentand Chief Executive Officer of K-tel. Under the terms of the agreement (the “K-5Facility”), K-5 has agreed to make available up to $8,000,000 to K-tel on arevolving basis. The loan bears interest at a variable rate based upon the “baserate” of a nationally recognized lending institution (4.0% at June 30, 2004 and2003), expires July 20, 2008, and is subordinated to the Foothill loan (seebelow).   The K-5 Facility contains thesame covenants as the Foothill loan agreement. K-tel has pledged the stock ofits foreign subsidiaries as collateral for the loan, and the loan carries asubordinated position to the Foothill loan on all other assets of the Company.K-tel had outstanding balances of $7,165,000 and $7,282,000 as of June 30, 2004and 2003 respectively under the K-5 Facility. At June 30, 2004, K-tel obtaineda waiver from K-5 for its non-compliance under the covenants, limitations andrestrictions of the credit agreement.

In addition, K-tel has a secondloan agreement with K-5, under which K-5 assumed rights and obligations under aloan from the Company’s former banker (Foothill Capital Corporation) pursuantto an Assignment and Acceptance Agreement dated February 27, 2001. ThisFoothill loan, which has been extended through July 20, 2008,  provides for a $10,000,000 credit facilityconsisting of a $4,000,000 term loan due upon expiration, and a $6,000,000revolving facility under which borrowings are limited to a percent of eligiblereceivables. Borrowings under the facility bear interest at a variable ratebased on a “base rate” ofa nationally recognized lending institution plus 1% (5.0% at June 30,2004 and 2003) and are collateralized by the assets of certain Companysubsidiaries in the United States, including accounts receivable, inventories,equipment, music library and general intangibles. The loan agreement containscertain financial and other covenants or restrictions, including themaintenance of a minimum shareholders’ equity by K-tel, limitations on capitalexpenditures, restrictions on music library acquisitions, limitations on otherindebtedness and restrictions on dividends paid by K-tel. As of June 30, 2004and 2003, $4,000,000 was outstanding under the term loan and there were no borrowingsunder the revolving facility. At June 30, 2004, K-tel obtained a waiver fromK-5 for its non-compliance under the covenants, limitations and restrictions ofthe credit agreement.

K-telhad an overdraft privilege borrowing facility of $45,000 and $250,000 at June30, 2004 and 2003, respectively, with The Royal Bank of Scotland in the UnitedKingdom. This facility was secured by a standby letter of credit for $55,000and $260,000 at June 30, 2004 and 2003, respectively, provided by K-telInternational Ltd., a Canadian company controlled by Philip Kives and waspayable on demand in accordance with normal banking practices. Borrowings boreinterest of 2.0% per annum over the base rate (a total of 6.0% at June 30, 2004and 5.75% at June 30, 2003) but were subject to a minimum of 6.0% per annum.K-tel had an outstanding balance of $233,000 as of June 30, 2003 with nobalance outstanding as of June 30, 2004. This overdraft privilege borrowing facility was canceled at the end ofcalendar 2004.

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**4.**             **INCOME TAXES**

The Companyoperates in several countries and is subject to various tax regulations and taxrates. The provisions for income taxes are computed based on income reportedfor financial statement purposes in accordance with the tax rules andregulations of the taxing authorities where the income is earned.

The provision  for income taxes consists of the followingfor the years ended June 30 (in thousands):
|                                                             | ** ** | **2004** | ** ** | **  2003   ** | ** ** | **2002** | ** ** |
|-------------------------------------------------------------|------------|----------|------------|----------------------------------------|------------|----------|------------|
|                                                        |       |     |       |                                   |       |     |       |
| Income (loss)  before provision (benefit) for income taxes: |       |     |       |                                   |       |     |       |
| United States                                               |       | $        | 277        |                                   | $          | 196      |       | $ | (295 | ) |
| Foreign                                                     |       | (364     | )          | (1,088                                 | )          | 595      |       |
| Total                                                       |       | $        | (87        | )                                      | $          | (892     | )          | $ | 300 |   |
|                                                        |       |     |       |                                   |       |     |       |
| Provision for  income taxes:                                |       |     |       |                                   |       |     |       |
| Current                                                     |       |     |       |                                   |       |     |       |
| United States                                               |       | $        | —     |                                   | $          | —   |       | $ | — |   |
| Foreign                                                     |       | —   |       | —                                 |       | —   |       |
|                                                        |       |     |       |                                   |       |     |       |
| Total provision  for income taxes                           |       | $        | —     |                                   | $          | —   |       | $ | — |   |

 

A reconciliationof the U.S. Federal statutory rate to the effective tax rate for the yearsended June 30 was as follows:
|                                      | ** ** | **2004** | ** ** | **2003** | ** ** | **2002** | ** ** |
|--------------------------------------|------------|----------|------------|----------|------------|----------|------------|
|                                 |       |     |       |     |       |     |       |
| Federal  statutory rate              |       | (34      | )%         | (34      | )%         | (34      | )%         |
| State Taxes, net  of Federal benefit |       | (2       | )          | (2       | )          | (2       | )          |
| Valuation  allowance                 |       | 36       |       | 36       |       | 36       |       |
|                                 |       | —   | %          | —   | %          | —   | %          |

 

Deferred incometaxes are provided for the temporary differences between the financialreporting basis and the tax basis of the Company’s assets and liabilities.Temporary differences, which are all deferred tax assets, were as follows (inthousands):
|                                  | ** ** | **June 30,  2004** | ** ** | **June 30,  2003** | ** ** |
|----------------------------------|------------|-------------------------|------------|-------------------------|------------|
|                             |       |                    |       |                    |       |
| Net operating  loss carryfowards |       | $                       | 15,637     |                    | $          | 20,875 |   |
| Alternative  minimum tax credits |       | 439                     |       | 432                     |       |
| Foreign tax  credit              |       | 325                     |       | 325                     |       |
| Reserve for  returns             |       | 221                     |       | 280                     |       |
| Depreciation and  amortization   |       | (64                     | )          | 267                     |       |
| Royalty reserves                 |       | 96                      |       | 145                     |       |
| Inventory  reserves              |       | 40                      |       | 36                      |       |
| Nondeductible  accruals          |       | 83                      |       | 55                      |       |
| Allowance for  bad debts         |       | —                  |       | —                  |       |
| Valuation allowance              |       | (16,777                 | )          | (22,415                 | )          |
|                             |       | $                       | —     |                    | $          | — |   |

 

A valuationallowance equal to the aggregate amount of deferred tax assets has beenestablished until such time as realizability of these assets is more likelythan not.

For U.S. taxreporting purposes, the Company has net operating loss carryforwards (“NOL”) ofapproximately $43,400,000. However, of the amount available through 2013 and2020, $20,100,000 of the NOL relates to deductions associated with the exerciseof stock options. The tax benefit of approximately $7,236,000 associated withthis stock option deduction will be recorded as additional paid-incapital if and when realized. The NOL carryforwards may be

35

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reduced in futureyears, without financial statement benefit, to the extent of intercompanydividends received from foreign subsidiaries. Also, the NOL carryforwards aresubject to review and possible adjustment by taxing authorities. In addition,the Company has approximately $432,000 in U.S. federal alternative minimum taxcredits and $325,000 in foreign tax credits, which may be utilized in thefuture to offset any regular corporate income tax liability.

**5.****                                      CAPITALTRANSACTIONS**

Stock Option Plan

The Company has aStock Option Plan for officers, directors, and employees of the Company. Underthe terms of this plan the Board of Directors has the sole authority todetermine the employees to whom options and awards are granted, the type, sizeand terms of the awards, the timing of the grants, the duration of the exerciseperiod and any other matters arising under the plan. The common stockincentives may take the form of incentive stock options and nonqualified stockoptions. The Company’s 1987 plan, which has expired, covered a maximum of700,000 shares of common stock, of which options for the purchase of 1,000shares remain outstanding and exercisable. In February 1997, the Company’sBoard of Directors approved a new stock option plan covering a maximum of600,000 shares of common stock, which was subsequently amended to 5,000,000through shareholder amendments in February 1999, January 2000 and November2000. There were options of 2,037,605 net shares granted under this plan as ofJune 30, 2004, of which 1,011,111 have been exercised. Any options cancelledare available for future grants. No options granted have expired.

Stock Option Exchange

On March 18, 2003, a committee of the Company’s boardof directors comprised solely of independent directors, approved a “StockOption Exchange Program.” The Program provided for a small number of optioneeswho were previously awarded options to purchase shares of common stock underthe Company’s 1997 Stock Option Plan to exchange them voluntarily for optionsto purchase an equal number of shares outside the Company’s Stock Option Plan.Options to purchase an aggregate of 2,137,939 shares of common stock, with aweighted average price per share of $5.95, were submitted for cancellation.Replacement options were issued six months and one day after the date ofcancellation on November 18, 2003 of the existing options and were issued at anexercise price per share equal to the fair market value of the Company’s commonstock as quoted on the OTC Bulletin Board on the date of grant of $.08 pershare and expire ten years after the date of grant. No compensation expense wasrecognized as a result of this exchange.

Restricted and Non-QualifiedStock Options

In addition tostock options granted under the terms of the Stock Option Plan, the Board ofDirectors has the sole authority to grant employees, officers and directorsincentive stock options and non-qualified stock options outside the StockOption Plan. The Board of Directors determines the type, size and terms of thegrants, timing of the grants, the duration of the exercise period and any othermatters pertaining to options or awards granted outside of the Stock OptionPlan. There were options on 2,492,939 net shares granted outside the StockOption Plan as of June 30, 2004.

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The shareinformation for all plans is summarized below:
| ** **                 | ** ** | ** **               | ** ** | ** **             | ** ** | **Weighted**            | ** ** |
|----------------------------|------------|--------------------------|------------|------------------------|------------|-------------------------|------------|
| ** **                 | ** ** | **Incentive Stock** | ** ** | **Non-Qualified**      | ** ** | **Average**             | ** ** |
| ** **                 | ** ** | **Options**              | ** ** | **Stock Options** | ** ** | **Exercise Price** | ** ** |
| Outstanding June  30, 2001 |       | 2,292,389                |       | 44,500                 |       | $                       | 5.77       |   |
|                       |       |                     |       |                   |       |                    |       |
| Adjustment (1)             |       | (2,105,045               | )          | 2,105,045              |       |                    |       |
| Cancelled                  |       | (36,050                  | )          | (27,000                | )          | 5.86                    |       |
| Outstanding June  30, 2002 |       | 151,294                  |       | 2,122,545              |       | $                       | 5.89       |   |
|                       |       |                     |       |                   |       |                    |       |
| Granted                    |       | 10,000                   |       | 300,000                |       | .05                     |       |
| Cancelled                  |       | (73,394                  | )          | (2,067,545             | )          | 5.86                    |       |
| Outstanding June  30, 2003 |       | 87,900                   |       | 355,000                |       | $                       | 1.95       |   |
|                       |       |                     |       |                   |       |                    |       |
|  Granted              |       | —                   |       | 2,137,939              |       | .08                     |       |
| Cancelled                  |       | (6,000                   | )          | —                 |       | 5.30                    |       |
| Outstanding June 30,  2004 |       | 81,900                   |       | 2,492,939              |       | $                       | .39        |   |

 

----

(1)                            Adjustmentreflects options disclosed previously as incentive that should have beenrecorded as non-qualified.

The followingtables summarize information concerning currently outstanding and exercisablestock options at June 30, 2004:
| Options Outstanding and Exercisable | ** **  |
|----------------------------------------------------|-------------|
| **Exercise Prices**                           | ** **  | ** ** | ** ** | **Weighted Average** | ** ** |
| ** **                                         | ** **  | **Weighted** | ** ** | **Number** | ** ** | **Remaining** | ** ** |
| **Range**                                          | ** **  | **Average** | ** ** | **of Shares** | ** ** | **Contractual Life** | ** ** |
| $                                                  | 0.05 - 0.08 |   | $ | 0.08 |   | 2,447,939 |   | 9.3 years |   |
| $                                                  | 1.75        |   | $ | 1.75 |   | 1,000 |   | 2.3 years |   |
| $                                                  | 3.06        |   | $ | 3.06 |   | 400 |   | 3.3 years |   |
| $                                                  | 5.51 - 6.00 |   | $ | 5.66 |   | 92,500 |   | 5.6 years |   |
| $                                                  | 8.73        |   | $ | 8.73 |   | 33,000 |   | 5.7 years |   |
|                                               |        |   |   | 2,574,839 |   |   |   |

 

The weightedaverage fair value of options granted in fiscal 2004 was $.08 and fiscal 2003was $.05. No options were granted in fiscal 2002. Because the fair valueprovisions have not been applied to options granted prior to June 30, 1995, theresulting pro forma compensation cost (See Note 1) may not be representative ofthat to be expected in future years.

The fair value ofeach option is estimated on the date of grant using the Black-Scholes optionpricing model. The following assumptions were used to estimate the fair valueof options:
|                          | ** ** | **2004** | ** ** | **2003** | ** ** | **2002** | ** ** |
|--------------------------|------------|----------|------------|----------|------------|----------|------------|
| Risk-free  interest rate |       | 4.00     | %          | 4.00     | %          | 5.00     | %          |
| Expected life            |       | 10 years |       | 10 years |       | 5 years  |       |
| Expected  volatility     |       | 220      | %          | 220      | %          | 150      | %          |
| Expected dividend yield  |       | None     |       | None     |       | None     |       |

 

37

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**6.****                                      COMMITMENTSAND CONTINGENCIES**

RTL Shopping S. A.

The Company wasnamed in a lawsuit filed in France brought by RTL9, a French cable TV station.The action sought damages in the approximate amount of 20 million FrenchFrancs, or approximately $2.8 million. Initially, RTL9 was named as a defendantin a suit brought by a competitor of K-tel Marketing Ltd. alleging that RTL9ran a commercial for K-tel Marketing which presented a product under brandnames alleged to infringe on the competitor’s own trademarks and alsotranslated an English language script indicating that the product was “justlike” or “as good as” others into “better than” in French, contrary to Frenchlaw. The suit alleged trademark infringement, unfair competition, illicitcomparative advertising and passing off. RTL9 then sued K-tel Marketing onOctober 4, 2000, pursuant to an indemnification provision the parties hadentered into. Subsequently, K-tel Marketing went into liquidation and RTL9filed a suit in March 2000 against K-tel International, Inc. under itsagreement to guarantee payment for the commercial time. On May 28, 2001, RTL9presented documents in court identifying K-tel International (USA), Inc. as atarget of its claim. On September 3, 2001, the Company filed documentsdisputing the claim and advising the court of K-tel International (USA), Inc.’sChapter 7 bankruptcy filing.

After the Companyadvised the Court that RTL9 had no basis for a complaint against the Company,RTL9 proposed to drop its lawsuit. On September 23, 2003, RTL9 and the Companysigned an agreement terminating the suit. The final disposition of the lawsuitwas confirmed by the Court at a trial hearing involving only the two remainingparties to the lawsuit.  There was nofinancial settlement with the termination of the lawsuit.

K-telInternational, Inc. vs. Tristar Products, Inc. 

On March 14, 2000,K-tel and its subsidiary in Germany commenced an action for breach of expressand implied warranties against Tristar Products, Inc. This action arose out ofTristar’s sale to K-tel of a defective home exercise product called the “BunBlaster”for resale in Germany, Austria and Switzerland. By written contract, Tristaragreed to indemnify K-tel for injuries and damages arising out of the resale ofthose goods.

On April 30, 2001, Tristar asserted a patent andtrademark/ trade-dress counterclaim against K-tel for allegedly passing off aproduct called the “K-tel Hook and Hang” while allegedly a distributor of theoriginal patented Tristar Hook and Hang product. The Company denies theallegation because it never was a distributor of this or any similar product.

On December 30, 2004, a Mutual General Release andSettlement Agreement was signed by K-tel and Tristar,  whereby both companies agreed to mutualreleases and Tristar agreed to pay K-tel $350,000.  The payment of $350,000 was received February18, 2005.

#### Other Litigation and Disputes

K-tel and itssubsidiaries are also involved in other legal actions in the ordinary course oftheir business. With all litigation matters, management considers thelikelihood of loss based on the facts and circumstances. If managementdetermines that a loss is probable and the amount of loss can be reasonablyestimated, such amount is recorded as a liability. Although the outcome of anysuch legal actions cannot be predicted, in the opinion of management there iscurrently no legal proceeding pending or asserted against or involving K-telfor which the outcome is likely to have a material adverse effect on theconsolidated financial position or results of operations of K-tel.

Leases

The Company hasentered into several office and warehouse leases which expire through 2005.Commitments under these leases are $221,000 in 2005, and $31,000 in 2006.Replacement space is anticipated to be obtained at similar rates. Rentalexpense was $228,000 in 2004, $254,000 in 2003, and $216,000 in 2002.

**7.****                                      SIGNIFICANTCUSTOMERS AND RELATED PARTY TRANSACTIONS**

Two customers accounted for approximately 19.1% and 10.1% respectively,of K-tel’s revenue for the year ended June 30, 2004 and had accounts receivablebalances of $321,000 and $320,000, respectively at June 30, 2004. The loss of,or a substantial reduction in, business from any of these customers would havea material adverse effect on the Company.

See Note 3 forinformation regarding debt transactions with related parties.

38

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The Companypurchased approximately $502,000 in the year ended June 30, 2004, $463,000 inthe year ended June 30, 2003 and $366,000 in the year ended June 30, 2002 ofmusic entertainment and consumer convenience products from   K-5, the Company’s largest shareholdercontrolled by Philip Kives, Chairman of the Board, President and ChiefExecutive Officer of K-tel. There were trade payables to K-5 of $390,000 atJune 30, 2004 and $371,000 at June 30, 2003.

The Company had nosales of products to K-5 during the years ended June 30, 2004, 2003 and 2002.There was a balance receivable from K-5 at June 30, 2004 of $113,000 and June30, 2003 of $73,000. No interest was charged on the related outstandingbalances during fiscal years 2004, 2003 and 2002.

All future transactionsbetween the Company, its officers, directors and principal shareholders and itsaffiliates will be approved by the audit committee of its board of directors.

**8.             RETIREMENT PLANS**

Pension Plan

The Company has apension plan for its U.K. employees. Contributions to the Plan by the Companyon behalf of the eligible employees were terminated effective February 15, 2001and all benefit accruals under the Plan ceased. Summary plan information is asfollows:
|                                                 | ** ** | **(In Thousands)**   | ** ** | ** ** | ** ** |
|-------------------------------------------------|------------|---------------------------|------------|------------|------------|
| ** **                                      | ** ** | **Pension Benefits** | ** ** | ** ** | ** ** |
| ** **                                      | ** ** | **2004**                  | ** ** | **2003**   | ** ** |
|                                            |       |                      |       |       |       |
| Net periodic  cost:                             |       |                      |       |       |       |
|                                            |       |                      |       |       |       |
| Interest cost                                   |       | $                         | 44         |       | $          | 23 |   |
| Expected return  on assets                      |       | (42                       | )          | (63        | )          |
| Amortization of  transition amount              |       | (16                       | )          | (15        | )          |
| Actuarial loss                                  |       | 9                         |       | —     |       |
|                                            |       |                      |       |       |       |
| Net periodic benefit  cost                      |       | $                         | (5         | )          | $          | (55 | ) |
|                                            |       |                      |       |       |       |
| Change in  benefit obligation:                  |       |                      |       |       |       |
| Benefit  obligation at beginning of year        |       | $                         | 764        |       | $          | 417 |   |
| Interest cost                                   |       | 44                        |       | 23         |       |
| Actuarial loss                                  |       | 77                        |       | 284        |       |
| Exchange rate  adjustment                       |       | 72                        |       | 40         |       |
|                                            |       |                      |       |       |       |
| Benefit  obligation at end of year              |       | $                         | 957        |       | $          | 764 |   |
|                                            |       |                      |       |       |       |
| Change in plan  assets:                         |       |                      |       |       |       |
| Fair value of  plan assets at beginning of year |       | $                         | 712        |       | $          | 601 |   |
| Actual return on  plan assets                   |       | 42                        |       | 63         |       |
| Exchange rate  adjustment                       |       | 69                        |       | 48         |       |
|                                            |       |                      |       |       |       |
| Fair value of plan at  end of year              |       | $                         | 823        |       | $          | 712 |   |

 

Theemployer is not expected to contribute to the plan in fiscal 2005.

TheCompany’s pension plan asset target allocation for 2005 and actual assetallocations are as follows at June 30:
|                               | ** ** | **Target** | ** ** | **Percentage of Plan Assets** | ** ** |
|-------------------------------|------------|------------|------------|----------------------------------------------|------------|
| ** **                    | ** ** | **2005**   | ** ** | **2004**                                     | ** ** | **2003** | ** ** |
| Asset category:               |       |       |       |                                         |       |   |   |
| Short-tem liquid  investments |       | 100        | %          | 100                                          | %          | 100 | % |

 

The Company’s investmentstrategy with respect to pension plan assets is to continue to hold the planasset in a deposit administration fund, which is similar to a bank account. Interestis added to the fund at a rate declared by Swiss Life.

39

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| (In Thousands)               | ** ** | **2004** | ** ** | **2003** | ** ** |
|-----------------------------------|------------|----------|------------|----------|------------|
| Reconciliation of  funded status: |       |     |       |     |       |
| Funded status                     |       | $        | (134       | )        | $          | (51 | ) |
| Unrecognized actuarial  loss      |       | 265      |       | 180      |       |
| Unrecognized transition  amount   |       | (185     | )          | (183     | )          |
|                              |       |     |       |     |       |
| Unfunded accrued  pension cost    |       | $        | (54        | )        | $          | (54 | ) |

 
|                                         | ** ** | **2004** | ** ** | **2003** | ** ** |
|-----------------------------------------|------------|----------|------------|----------|------------|
| Statement of financial  position:       |       |     |       |     |       |
| Unfunded accrued  pension cost          |       | $        | (54        | )        | $          | (54 | ) |
| Additional minimum  liability           |       | (74      | )          | —   |       |
| Accumulated other  comprehensive income |       | 74       |       | —   |       |
|                                    |       |     |       |     |       |
| Recognized amount                       |       | $        | (54        | )        | $          | (54 | ) |

 

WEIGHTED-AVERAGEASSUMPTIONS USED TO DETERMINE NET PERIODIC COST FOR THE YEARS ENDED JUNE 30:
| ** **                      | ** ** | **2004** | ** ** | **2003** | ** ** | **2002** | ** ** |
|---------------------------------|------------|----------|------------|----------|------------|----------|------------|
| Discount rate                   |       | 5        | %          | 9        | %          | 5        | %          |
| Expected return on plan  assets |       | 4.25     | %          | 5        | %          | 5        | %          |
| Rate of compensation  increase  |       | 0        | %          | 0        | %          | 0        | %          |

 

WEIGHTED-AVERAGE ASSUMPTION USED TO DETERMINEBENEFIT OBLIGATIONS AS OF JUNE 30:
|                               | ** ** | **2004** | ** ** | **2003** | ** ** |
|-------------------------------|------------|----------|------------|----------|------------|
| Discount rate                 |       | 5.75     | %          | 5        | %          |
| Rate of compensation increase |       | N/A      |       | N/A      |       |

r

Money PurchasePlan

The Company’s U.K.subsidiaries contribute amounts for their employees to a money purchase definedcontribution plan. The Company has contributed $77,000, $51,000 and $26,000 forthe years ended June 30, 2004, 2003 and 2002.

**9.****                                      BUSINESSSEGMENT AND GEOGRAPHIC AREA DATA**

The Company marketsand distributes entertainment products internationally and through itsoperating subsidiaries. K-tel’s businesses are organized, managed andinternally reported as two segments: retail music sales and music licensing.These segments are based on differences in products, customer type and salesand distribution methods. The Company’s consumer product and e-commerceoperations have been discontinued, are presented in the accompanying financialstatements as discontinued operations and are therefore not included in thesegment information.

The retail musicsegment consists primarily of the sales of pre-recorded music both fromthe Company’s master music catalog and under licenses obtained from otherrecord companies. The Company sells compact discs and DVD’s directly toretailers, wholesalers and rack service distributors which stock and manageinventory within music departments for retail stores.

In the licensingsegment, the Company licenses the rights to its master music catalog,consisting of original recordings and re-recordings of music from the1950’s through today, to third parties world-wide for use in albums,films, television programs, and commercials for either a flat fee or a royaltybased on the number of units sold.

Operating profitsor losses of these segments include an allocation of general corporateexpenses. Depreciation and amortization and capital additions are notsignificant and have therefore been excluded from the presentation.

Certain financialinformation on the Company’s continuing operating segments is as follows:

40

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BUSINESS SEGMENTINFORMATION *(in thousands)*
| Fiscal Years Ended  June 30, | ** ** | **Music** | ** ** | **Licensing** | ** ** | **Other** | ** ** | **Total  Company** | ** ** |
|---------------------------------------------|------------|-----------|------------|---------------|------------|-----------|------------|--------------------|------------|
| * *                                    | * *   | * *  | * *   | * *      | * *   | * *  | * *   | * *           | * *   |
| Net  Sales                                  | 2004       |      | $          | 4,763         |       | $         | 1,916      |               | $          | — |   | $ | 6,679 |   |
|                                        | 2003       |      | 4,454      |          | 2,780      |      | —     |               | 7,234      |   |
|                                        | 2002       |      | 3,773      |          | 3,118      |      | —     |               | 6,891      |   |
|                                        |       |      |       |          |       |      |       |               |       |   |
| Operating  Income (Loss)                    | 2004       |      | $          | (992          | )          | $         | 959        |               | $          | — |   | $ | (33 | ) |
|                                        | 2003       |      | (1,010     | )             | 1,159      |      | —     |               | 149        |   |
|                                        | 2002       |      | (1,439     | )             | 1,393      |      | —     |               | (46        | ) |
|                                        |       |      |       |          |       |      |       |               |       |   |
| Assets                                      | 2004       |      | $          | 3,519         |       | $         | 664        |               | $          | 313 |   | $ | 4,496 |   |
|                                        | 2003       |      | 2,900      |          | 2,128      |      | 273        |               | 5,301      |   |
|                                        | 2002       |      | 2,679      |          | 1,668      |      | 263        |               | 4,610      |   |

 

GEOGRAPHICINFORMATION *(in thousands)*
| Fiscal Years Ended  June 30, | ** ** | **United States** | ** ** | **Europe** | ** ** | **Total** | ** ** |
|---------------------------------------------|------------|------------------------|------------|------------|------------|-----------|------------|
| * *                                    | * *   | * *               | * *   | * *   | * *   | * *  | * *   |
| Net  Sales                                  | 2004       |                   | $          | 3,836      |       | $         | 2,843      |   | $ | 6,679 |   |
|                                        | 2003       |                   | 4,949      |       | 2,285      |      | 7,234      |   |
|                                        | 2002       |                   | 3,949      |       | 2,942      |      | 6,891      |   |
|                                        |       |                   |       |       |       |      |       |   |
| Assets                                      | 2004       |                   | $          | 2,148      |       | $         | 2,348      |   | $ | 4,496 |   |
|                                        | 2003       |                   | 3,889      |       | 1,412      |      | 5,301      |   |
|                                        | 2002       |                   | 2,792      |       | 1,818      |      | 4,610      |   |

 

**10.****                              RECENTACCOUNTING PRONOUNCEMENTS**

InDecember 2003, the FASB issued Interpretation (FIN 46R), *Consolidation of Variable Interest Entities.*FIN 46R is an interpretation of Accounting Research Bulletin No. 51, *Consolidated Financial Statements,* andaddresses consolidation by business enterprises of variable interest entities.FIN 46R applies to variable interest entities created or obtained after January31, 2003 and it applies in the first fiscal year or interim period beginningafter March 15, 2004, to variable interest entities in which an enterpriseholds a variable interest that is acquired before February 1, 2003. The Companybegan consolidating a variable interest entity during the quarter ending March31, 2004 (see Note 12).

# In May 2003, the FASB issued Statement 150, *Accountingfor Certain Financial Instruments with Characteristics of both Liabilities andEquity*. Statement 150 changes the classifications in thestatement of financial position of certain common financial instruments fromeither equity or mezzanine presentation to liabilities and requires an issuerof those financial statements to recognize changes in fair value or redemptionamount, as applicable, in earnings. SFAS 150 is effective for financialinstruments entered into or modified after May 31, 2003, and otherwise iseffective at the beginning of the first interim period beginning after June 15,2003. Adoption of Statement 150 did not have an impact on the Company’sconsolidated financial position or results of operations.

In December 2004, theFASB issued SFAS No. 123R, *Share-BasedPayment*, which replaced SFAS No. 123 and superseded APB 25. SFAS No.123R addresses the accounting for share-based payment transactions in which acompany receives employee services in exchange for either equity instruments ofthe company or liabilities that are based on the fair value of the company’sequity instruments or that may be settled by the issuance of such equityinstruments. Under SFAS No. 123R, companies will no longer be able to accountfor the share-based compensation transactions using the intrinsic method inaccordance with APB 25 but will be required to account for such transactionsusing a fair-value method and recognize the expense in the consolidatedstatement of operations. SFAS No. 123R is effective beginning in the Company’sfirst quarter of fiscal year 2007. Under SFAS 123R, the Company must determinethe appropriate fair value model to be used for valuing share-based payments,the amortization method for compensation cost and the transition method to beused at date of adoption. The transition methods include prospective andretroactive adoption options. The Company has begun, but has not completed,evaluating the impact of the adoption of SFAS 123R on its results ofoperations. In connection with evaluating the impact of SFAS 123R, the Companyis considering the potential

41

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implementation ofdifferent valuation methods to determine the fair value of share-basedcompensation. The Company believes the adoption of SFAS 123R will not have amaterial impact on our results of operations, regardless of the valuationmethod used.

**11.****                              ****INTERIM FINANCIAL DATA (UNAUDITED)**

Restatementof Fiscal 2004 Interim Financial Data

InSeptember 2004, the Company discovered that the former Chief Financial Officerof its UK subsidiary misappropriated funds from the Company’s UK subsidiary anda customer of such subsidiary. The Company terminated the employee, undertook afull-scale investigation of the matter, retained a forensic auditing firm anddismissed the accounting firm in the UK that audited the UK subsidiary’sfinancial books and records. Based upon the estimates of the Company’s forensicauditor, it was determined that the former employee misappropriatedapproximately $924,000 from the Company’s UK subsidiary and approximately$344,000 from a customer of such subsidiary beginning approximately in January2001 and continuing until September 2004. Further, the Company spentapproximately $150,000 investigating the misappropriation. Through negotiationswith the former employee, the Company’s UK subsidiary and its customer havereceived an aggregate of approximately $1,495,000 including interest and anadditional $100,000 is expected to be recovered. The Company’s UK subsidiaryhas received a deed of guarantee in connection with this remaining obligationand it expects to collect the remaining amount owed on or before February 15,2008.

Forthe fiscal year ending June 30, 2004, the misappropriation understated sales by$4,000 in the quarter ending September 30, 2003. Product costs were overstatedby $13,000, $2,000, $63,000 and $72,000 and selling and general andadministrative expenses by $28,000, $43,000, $53,000 and $62,000 for thequarters ending September 30, 2003, December 31, 2003, March 31, 2004 and June30, 2004, respectively.

TheCompany recorded account receivable amounts relating to the misappropriatedfunds of approximately $857,000 and $545,000 at June 30, 2004 and June 30, 2003respectively, to the consolidated balance sheet. At June 30, 2004 theconsolidated balance sheet accounts receivable amount also includesapproximately $324,000 from a Lancaster receivable relating to themisappropriated funds (see Note 12).

Statementsof operations previously reported for each of the quarters of fiscal year 2004have been restated as follows:

Fiscal 2004 Interim Financial Data

Quarterly FinancialInformation (Unaudited)
|                                                                       | ** ** | **Three Months Ended,** | ** ** |
|-----------------------------------------------------------------------|------------|-----------------------------------|------------|
| ** **                                                            | ** ** | **September 30,  2003**      | ** ** | **December 31,  2003** | ** ** | **March 31,  2004** | ** ** |
| ** **                                                            | ** ** | **AS FILED**                 | ** ** | **AS FILED** | ** ** | **AS FILED** | ** ** |
| Net sales                                                             |       | $                                 | 1,618      |   | $ | 1,759 |   | $ | 1,647 |   |
| Gross profit                                                          |       | $                                 | 949        |   | $ | 899 |   | $ | 849 |   |
| Advertising,  selling, general & administrative                   |       | $                                 | 909        |   | $ | 986 |   | $ | 1,040 |   |
| Operating income  (loss)                                              |       | $                                 | 40         |   | $ | (87 | ) | $ | (191 | ) |
| Net loss                                                              |       | $                                 | (129       | ) | $ | (227 | ) | $ | (196 | ) |
| Basic and  diluted net loss per common share                          |       | $                                 | (.01       | ) | $ | (.02 | ) | $ | (.01 | ) |
| Shares used in  computing basic and diluted net loss per common share |       | 13,654                            |       | 13,654 |   | 13,654 |   |

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|                                                                       | ** ** | **Three Months Ended,** | ** ** |
|-----------------------------------------------------------------------|------------|-----------------------------------|------------|
| ** **                                                            | ** ** | **September 30,  2003**           | ** ** | **December 31,  2003** | ** ** | **March 31,  2004** | ** ** | **June 30,  2004** | ** ** |
| ** **                                                            | ** ** | **AS  RESTATED**                  | ** ** | **AS  RESTATED** | ** ** | **AS  RESTATED** | ** ** | ** ** | ** ** |
| Net sales                                                             |       | $                                 | 1,622      |   | $ | 1,759 |   | $ | 1,647 |   | $ | 1,651 |   |
| Gross profit                                                          |       | $                                 | 966        |   | $ | 902 |   | $ | 912 |   | $ | 965 |   |
| Advertising,  selling, general & administrative                   |       | $                                 | 881        |   | $ | 943 |   | $ | 987 |   | $ | 967 |   |
| Operating income  (loss)                                              |       | $                                 | 85         |   | $ | (40 | ) | $ | (71 | ) | $ | (7 | ) |
| Net income  (loss)                                                    |       | $                                 | (84        | ) | $ | (180 | ) | $ | (76 | ) | $ | 253 |   |
| Basic and  diluted net loss per common share                          |       | $                                 | (.01       | ) | $ | (.01 | ) | $ | (.01 | ) | $ | .02 |   |
| Shares used in  computing basic and diluted net loss per common share |       | 13,654                            |       | 13,654 |   | 13,654 |   | 13,654 |   |

 

Fiscal 2003 Interim Financial Data

Quarterly FinancialInformation (Unaudited)
|                                                                       | ** ** | **Three Months Ended,** | ** ** |
|-----------------------------------------------------------------------|------------|-----------------------------------|------------|
| ****                                                                  | ** ** | **September 30,  2002**      | ** ** | **December 31,  2002** | ** ** | **March 31,  2003** | ** ** | **June 30,  2003** | ** ** |
|                                                                  |       |                              |       |   |   |   |   |   |   |
| Net sales                                                             |       | $                                 | 1,498      |   | $ | 1,874 |   | $ | 1,923 |   | $ | 1,939 |   |
| Gross profit                                                          |       | $                                 | 908        |   | $ | 998 |   | $ | 957 |   | $ | 1,271 |   |
| Advertising,  selling, general & administrative                   |       | $                                 | 983        |   | $ | 968 |   | $ | 1,075 |   | $ | 959 |   |
| Operating income  (loss)                                              |       | $                                 | (75        | ) | $ | 30 |   | $ | (118 | ) | $ | 312 |   |
| Net income  (loss)                                                    |       | $                                 | (485       | ) | $ | (358 | ) | $ | (383 | ) | $ | 334 |   |
| Basic and  diluted net income (loss) per common share                 |       | $                                 | (.04       | ) | $ | (.03 | ) | $ | (.03 | ) | $ | .02 |   |
| Shares used in  computing basic and diluted net loss per common share |       | 13,654                            |       | 13,654 |   | 13,654 |   | 13,654 |   |

 

**12.****                              ****CONSOLIDATION OF VARIABLEINTEREST ENITITY**

Thecompany sells certain products to and buys from Lancaster, a companyestablished in the U.K. In accordance with FASB Interpretation 46 (Revised December2003), *Consolidation of Variable Interest Entities*(FIN 46 (R)), the Company determined that Lancaster is a variable interestentity and that the Company is the primary beneficiary of this entity.  The Company was required to apply theguidance of FIN 46 (R) for periods ending after March 15, 2004, andaccordingly, during the quarter ended March 31, 2004, the financial statementsof Lancaster were consolidated with those of the Company.

As ofJune 30, 2004, the consolidated financial statements included approximately$347,000 of current assets and $241,000 of current liabilities related toLancaster.  Lancaster’s current assetsinclude approximately $324,000 of amounts receivable related to themisappropriation of assets as described in Note 11.  Sales and purchases between Lancaster and theCompany have been eliminated in consolidation, and the additional effects ofLancaster on the Company’s operations were not material.

**13.****                              ****SUBSEQUENT EVENT**

K-telInternational, Inc., through a wholly owned subsidiary, entered into atrademark license agreement with BCI Eclipse Company, LLC (“BCI”), a subsidiaryof Navarre Corporation, effective October 10, 2005.  K-tel, through a wholly owned subsidiary,also entered into a phonograph record license agreement with BCI effectiveOctober 16, 2005.

Pursuant to thetrademark license agreement, K-tel has granted to BCI a license to use itstrademarks, K-TEL® and K-tel’s circular design logo.  The agreement, which runs for an initial termof fourteen months, grants BCI the exclusive license to use the marks in theUnited States in a field of use limited to the sale and distribution of compactdiscs and DVDs.  The marks may be used inconnection with distribution of K-tel’s music titles as well as products ownedby third parties and released by BCI. The products which may be distributed using the marks exclude digitaldownloads, but include tangible products which may be marketed digitally.  The marks may not be used in connection withTV and/or

43

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radio-advertisedand mail order packages.  The agreementprovides for royalties of $0.30 per compact disc on a minimum of 80% of thecompact discs using the K-tel mark and between $0.27 and $0.29 on the balance,with the payments due after BCI receives payment from its customers.  BCI paid K-tel a $100,000 advance againstroyalties upon execution of the agreement. The advance is recoupable by BCI out of 50% of the royalties otherwisepayable to K-tel.  After the initialterm, BCI has the right to extend the term for one year if K-tel has earnedroyalties based on products shipped including the advance totaling $350,000 orBCI has made make-up payments in such amount, and for a second year extensionif BCI has earned royalties based on products shipped of $450,000 in the firstextension term.

Pursuant to thephonograph record license agreement, K-tel, through a wholly owned subsidiary,licensed master recordings from K-tel’s master recording catalog for a periodof two years commencing on the initial release date of each titled album fromthe catalog.  The initial term of theagreement expires on December 31, 2006 and BCI has the right to extend the termfor one year if it has earned royalties based on products shipped, includingthe advance, totaling $350,000, or has made make-up payments in such amount,and for a second year extension if BCI has earned royalties based on productsshipped of $450,000 during the first extension period.  The nonexclusive license allows BCI to makereproductions of K-tel’s master recordings in audio compact disc and DVDformats.  The agreement provides fornon-returnable advances of $150 per licensed master recoupable againstroyalties payable when BCI receives payment from their customers at the rate of$0.03 per pre-recorded licensed master and $0.04 per original licensed masterembodied in any album.  The territory ofthe license is the U.S. and Canada.  Thelicense allows BCI to compile master recordings and manufacture, distribute andsell albums in compact disc format through retail stores, online retail storesand record and video club sales channels under K-tel’s licensed marks.

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**SCHEDULEII**

**K-TELINTERNATIONAL, INC. AND SUBSIDIARIES**

**VALUATIONAND QUALIFYING ACCOUNTS**

Years ended June30,

(In thousands)
| ** **                       | ** ** | **Balance at  Beginning of  Period** | ** ** | **Charged to Costs  and Expenses or  Net Sales** | ** ** | **Charged to  Other  Accounts (1)** | ** ** | **Deductions** | ** ** | **Balance at  End of Period** | ** ** |
|----------------------------------|------------|------------------------------------------------|------------|---------------------------------------------------------------------------|------------|-----------------------------------------------|------------|----------------|------------|----------------------------------------------|------------|
| Allowance for Doubtful  Accounts |       |                                           |       |                                                                      |       |                                          |       |           |       |                                         |       |
|                             |       |                                           |       |                                                                      |       |                                          |       |           |       |                                         |       |
| 2004                             |       | $                                              | 25         |                                                                      | $          | 24                                            |       | $              | 2          |                                         | $          | (47 | )(2) | $ | 4 |   |
| 2003                             |       | $                                              | 68         |                                                                      | $          | 62                                            |       | $              | 9          |                                         | $          | (114 | )(2) | $ | 25 |   |
| 2002                             |       | $                                              | 33         |                                                                      | $          | 50                                            |       | $              | 5          |                                         | $          | (20 | )(2) | $ | 68 |   |
|                             |       |                                           |       |                                                                      |       |                                          |       |           |       |                                         |       |
| Reserve for Returns              |       |                                           |       |                                                                      |       |                                          |       |           |       |                                         |       |
|                             |       |                                           |       |                                                                      |       |                                          |       |           |       |                                         |       |
| 2004                             |       | $                                              | 220        |                                                                      | $          | 375                                           |       | $              | 1          |                                         | $          | (463 | ) | $ | 133 |   |
| 2003                             |       | $                                              | 46         |                                                                      | $          | 447                                           |       | $              | —     |                                         | $          | (273 | ) | $ | 220 |   |
| 2002                             |       | $                                              | 50         |                                                                      | $          | 55                                            |       | $              | 6          |                                         | $          | (65 | ) | $ | 46 |   |

 

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(1) Exchange ratechange

(2) Uncollectibleaccounts written off, net of recoveries

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**EXHIBITINDEX**
| Exhibit No. | ** ** | **Description of Exhibit**                                                                                                                                                                                                                                                                                           |
|-------------|------------|----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|
|        |       |                                                                                                                                                                                                                                                                                                                 |
| 3.1         |       | Restated Articles of Incorporation, as amended  (incorporated by reference to the Company’s Annual Report on Form 10-K for  the fiscal year ended June 30, 2003 (File No. 1-07115)).                                                                                                                            |
|        |       |                                                                                                                                                                                                                                                                                                                 |
| 3.2         |       | Restated By-Laws (incorporated by reference to the  Company’s Annual Report on Form 10-K for the fiscal year ended June 30, 1985  (File No. 1-07115)).                                                                                                                                                          |
|        |       |                                                                                                                                                                                                                                                                                                                 |
| 4           |       | See Exhibits 3.1 and 3.2.                                                                                                                                                                                                                                                                                            |
|        |       |                                                                                                                                                                                                                                                                                                                 |
| 10.1        |       | 1987 Stock Incentive Plan (incorporated by reference  to the Company’s Annual Report on Form 10-K for the fiscal year ended June  30, 1987 (File No. 1-07115)).                                                                                                                                                 |
|        |       |                                                                                                                                                                                                                                                                                                                 |
| 10.2        |       | 1997 Stock Option Plan (incorporated by reference to  the Company’s Annual Report on Form 10-K for the fiscal year ended June 30,  1997 (File No. 1-07115)).                                                                                                                                                    |
|        |       |                                                                                                                                                                                                                                                                                                                 |
| 10.3        |       | Form of Incentive Stock Option Agreement under the  Company’s 1997 Stock Option Plan (incorporated by reference to the Company’s  Annual Report on Form 10-K for the fiscal year ended June 30, 2000 (File No.  1-07115)).                                                                                 |
|        |       |                                                                                                                                                                                                                                                                                                                 |
| 10.4        |       | Form of Non-Qualified Stock Option Agreement under  the Company’s 1997 Stock Option Plan (incorporated by reference to the  Company’s Annual Report on Form 10-K for the fiscal year ended June 30, 2000  (File No. 1-07115)).                                                                             |
|        |       |                                                                                                                                                                                                                                                                                                                 |
| 10.5        |       | Form of Non-Qualified  Stock Option Agreement between the registrant and certain non-employee  directors of the registrant, authorized effective November 27, 2002  (incorporated by reference to the Company’s Quarterly Report on Form 10-Q for  the fiscal quarter ended March 31, 2003 (File No. 1-07115)). |
|        |       |                                                                                                                                                                                                                                                                                                                 |
| 10.6        |       | Loan and Security Agreement between the Company and  Foothill Capital Corporation dated November 19, 1997 (incorporated by  reference to the Company’s Quarterly Report on Form 10-Q for the fiscal  quarter ended December 31, 1997 (File No. 1-07115)).                                                       |
|        |       |                                                                                                                                                                                                                                                                                                                 |
| 10.7        |       | Amendment Number One to the Loan and Security  Agreement between the Company and Foothill Capital Corporation dated March  30, 1998 (incorporated by reference to the Company’s Annual Report on Form  10-K for the fiscal year ended June 30, 1998 (File No. 1-07115)).                                        |
|        |       |                                                                                                                                                                                                                                                                                                                 |
| 10.8        |       | Amendment Number Two to the Loan and Security  Agreement between the Company and Foothill Capital Corporation dated  September 23, 1998 (incorporated by reference to the Company’s Annual Report  on Form 10-K for the fiscal year ended June 30, 1998 (File No. 1-07115)).                                    |
|        |       |                                                                                                                                                                                                                                                                                                                 |
| 10.9        |       | Restated Amendment Number Two to the Loan and  Security Agreement between the Company and Foothill Capital Corporation dated  September 30, 1998 (incorporated by reference to the Company’s Annual Report  on Form 10-K for the fiscal year ended June 30, 1998 (File No. 1-07115)).                           |
|        |       |                                                                                                                                                                                                                                                                                                                 |
| 10.10       |       | Amendment Number Three to the Loan and Security  Agreement between the Company and Foothill Capital Corporation dated September  22, 1999 (incorporated by reference to the Company’s Annual Report on Form  10-K for the fiscal year ended June 30, 2000 (File No. 1-07115)).                                  |
|        |       |                                                                                                                                                                                                                                                                                                                 |
| 10.11       |       | Amendment Number Four to the Loan and Security  Agreement between the Company and Foothill Capital Corporation dated May 15,  2000(incorporated by reference to the Company’s Annual Report on Form 10-K  for the fiscal year ended June 30, 2000 (File No. 1-07115)).                                          |
|        |       |                                                                                                                                                                                                                                                                                                                 |
| 10.12       |       | Amendment to Loan Agreement and Security Agreement  between the Company and K-5 Leisure  Products, Inc., as assignee of Foothill Capital Corporation dated February  12, 2002 (incorporated by                                                                                                                       |

46

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|        |   | reference to the Company’s Quarterly Report on Form  10-Q for the fiscal quarter ended December 31, 2001 (File No. 1-07115)).                                                                                                                                       |
|--------|--------|--------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|
|   |   |                                                                                                                                                                                                                                                                     |
| 10.13  |   | Credit Agreement between the Company and K-5 Leisure  Products, Inc. dated September 27, 1999 (incorporated by reference to the  Company’s Annual Report on Form 10-K for the fiscal year ended June 30, 2003  (File No. 1-07115)).                                 |
|   |   |                                                                                                                                                                                                                                                                     |
| 10.14  |   | $8,000,000 principal amount Note between the Company  and K-5 Leisure Products, Inc. dated  September 27, 1999 (incorporated by reference to the Company’s Annual  Report on Form 10-K for the fiscal year ended June 30, 2003 (File No.  1-07115)).                |
|   |   |                                                                                                                                                                                                                                                                     |
| 10.15  |   | Amendment to Credit Agreement and Note between the  Company and K-5 Leisure Products, Inc.  dated February 12, 2002 (incorporated by reference to the Company’s  Quarterly Report on Form 10-Q for the fiscal quarter ended December 31, 2001  (File No. 1-07115)). |
|   |   |                                                                                                                                                                                                                                                                     |
| 10.16  |   | Trademark license agreement dated effective October  10, 2005, between Dominion Entertainment, Inc. and BCI Eclipse Company, LLC  (incorporated by reference to the Company’s Report on Form 8-K filed on  August 29, 2006 (File No. 1-07115)).                     |
|   |   |                                                                                                                                                                                                                                                                     |
| 10.17  |   | Phonograph record license agreement between Dominion  Entertainment, Inc. and BCI Eclipse Company, LLC, effective October 16, 2005  (incorporated by reference to the Company’s Report on Form 8-K filed on  August 29, 2006 (File No. 1-07115)).                   |
|   |   |                                                                                                                                                                                                                                                                     |
| 10.18  |   | Digital music download sales agreement dated October  10, 2003, between Dominion Entertainment, Inc. and Apple Computer, Inc.  (incorporated by reference to the Company’s Report on Form 8-K filed on  August 29, 2006 (File No. 1-07115)).                        |
|   |   |                                                                                                                                                                                                                                                                     |
| 10.19  |   | Amendment Number Two to Loan Agreement and Security  Agreement between the Company and K-5 Leisure Products, Inc., as assignee of  Foothill Capital Corporation dated July 20, 2005.                                                                                     |
|   |   |                                                                                                                                                                                                                                                                     |
| 10.20  |   | Amendment Number Two to Credit Agreement and Note  between the Company and K-5 Leisure  Products, Inc. dated July 20, 2005.                                                                                                                                              |
|   |   |                                                                                                                                                                                                                                                                     |
| 21     |   | Subsidiaries of the Registrant                                                                                                                                                                                                                                           |
|   |   |                                                                                                                                                                                                                                                                     |
| 23     |   | Consent of Independent Registered Public Accounting  Firm                                                                                                                                                                                                                |
|   |   |                                                                                                                                                                                                                                                                     |
| 31.1   |   | Certification by Chief Executive Officer pursuant to  Rule 13a-14(a).                                                                                                                                                                                                    |
|   |   |                                                                                                                                                                                                                                                                     |
| 31.2   |   | Certification by Chief Financial Officer pursuant to  Rule 13a-14(a).                                                                                                                                                                                                    |
|   |   |                                                                                                                                                                                                                                                                     |
| 32.1   |   | Certification by Chief Executive Officer pursuant to  18 U.S.C. Section 1350, as adopted pursuant to Section 906 of the  Sarbanes-Oxley Act of 2002.                                                                                                                     |
|   |   |                                                                                                                                                                                                                                                                     |
| 32.2   |   | Certification by Chief Financial Officer pursuant to  18 U.S.C. Section 1350, as adopted pursuant to Section 906 of the  Sarbanes-Oxley Act of 2002.                                                                                                                     |

 

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