**UNITED STATESSECURITIES AND EXCHANGE COMMISSION**

**Washington,D.C. 20549**

 

**FORM 10-K/A**

 

**(MARK ONE)**

**ý****                                ****ANNUAL REPORT PURSUANT TO SECTION 13OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934**

 

**For thefiscal year ended June 30, 2003**

 

**OR**

 

**o****                                ****TRANSITION REPORT PURSUANT TO SECTION 13OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934**

 

**For thetransition period from           to           **

 

**Commissionfile number 1-07115**

 

**K-TEL INTERNATIONAL, INC.**

(Exact name of registrant asspecified 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’s telephone number,including area code: **(763) 559-5566**

 

Securities registered pursuantto Section 12(b) of the Act:

**None**

 

Securities registered pursuantto Section 12(g) of the Act:

**CommonStock, par value $0.01**

**(Title ofclass)**

 

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

Yes o  No ý

 

Indicate by check mark if the registrant is not required to filereports pursuant to Section 13 or 15(d) of the Act.

Yes o  No ý

 

Indicateby check mark whether the registrant (1) has filed all reports required tobe filed by Section 13 or 15(d) of the Securities Exchange Act of1934 during the preceding 12 months (or for such shorter period that theregistrant was required to file such reports), and (2) has been subject tosuch filing requirements for the past 90 days.  Yes o  No ý

 

Indicate by check mark if disclosure of delinquent filers pursuant toItem 405 of Regulation S-K is not contained herein, and will not be contained,to the best of registrant’s knowledge, in definitive proxy informationstatements incorporated by reference in Part III of this Form 10-K orany amendment to this Form 10-K. o

 

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

Yes o  No ý

 

Indicate by check mark whether the registrant is a shell company (asdefined in Rule 12b-2 of the Exchange Act)

Yes o  No ý

 

As of October 11, 2005, the aggregate market value of voting stockheld by non-affiliates of the registrant based on the last sale price asreported by the Over-the-Counter Bulletin Board on such date was $234,165.

 

As of October 11, 2005, the registrant had 13,653,738 shares ofCommon Stock outstanding.

 

DOCUMENTS INCORPORATED BYREFERENCE

 

None.

 

 

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**PURPOSEOF AMENDMENT**

 

In September 2004, the Company discovered that the former ChiefFinancial Officer of its UK subsidiary misappropriated funds from the Company’sUK subsidiary and a customer of such subsidiary. The Company terminated theemployee, undertook a full-scale investigation of the matter, retained aforensic auditing firm and dismissed the accounting firm in the UK that auditedthe UK subsidiary’s financial books and records. Based upon the estimates ofthe Company’s forensic auditor, it was determined that the former employeemisappropriated approximately $914,200 from the Company’s UK subsidiary andapproximately $343,588 from a customer of such subsidiary beginningapproximately in January 2001 and continuing until September 2004.Further, the Company spent approximately $150,862 investigating themisappropriation. Through negotiations with the former employee, the Company’sUK subsidiary and its customer have recovered an aggregate of approximately$1,493,076 and interest of approximately $1,919. Approximately $99,640 remainsoutstanding. The Company’s UK subsidiary has received a deed of guarantee inconnection with this remaining obligation and it expects to collect theremaining amount owed on or before February 15, 2008.

 

The effect of the misappropriation was to overstate product costs by$9,000, $21,000, $24,000 and $27,000 and selling and general and administrativeexpenses by $14,000, $10,000, $32,000 and $13,000 for the quarters ending September 30,2002, December 31, 2002, March 31, 2003 and June 30, 2003,respectively.

 

For the fiscal year ending June 30, 2002, the misappropriationunderstated sales by $16,000 in the quarter ending September 30, 2001.Product costs were overstated by $74,000, $10,000, $35,000 and $13,000 andselling and general and administrative expenses by $102,000, $9,000, $16,000and $11,000 for the quarters ending September 30, 2001, December 31,2001, March 31, 2002 and June 30, 2002, respectively.

 

Items 6-9 and 13-15 are amended in this Form 10K/A to reflect theforegoing.

 

**TABLE OFCONTENTS**

 
| PART II                               |   |                                                                                        |   |   |
|--------------------------------------------|--------|---------------------------------------------------------------------------------------------|--------|--------|
|                                       |   |                                                                                        |   |   |
| Item 6.                                    |   | Selected Financial Data                                                                     |   | 3      |
| Item 7.                                    |   | Management’s Discussion and Analysis of Financial Condition and  Results of Operations |   | 4      |
| Item 7a.                                   |   | Quantitative and Qualitative Disclosures about Market Risk                                  |   | 9      |
| Item 8.                                    |   | Financial Statements and Supplementary Data                                                 |   | 9      |
| Item 9a.                                   |   | Controls and Procedures                                                                     |   | 10     |
| Item  9b.                                  |   | Other  Information                                                                          |   | 10     |
|                                       |   |                                                                                        |   |   |
| PART III                              |   |                                                                                        |   |   |
|                                       |   |                                                                                        |   |   |
| Item 13.                                   |   | Certain Relationships and Related Transactions                                              |   | 11     |
| Item 14.                                   |   | Principal Accountant Fees and Services                                                      |   | 12     |
|                                       |   |                                                                                        |   |   |
| PART IV                               |   |                                                                                        |   |   |
|                                       |   |                                                                                        |   |   |
| Item 15.                                   |   | Exhibits and Financial Statement Schedules                                                  |   | 13     |
|                                       |   |                                                                                        |   |   |
| Signatures                                 |   | 14                                                                                          |
| Index to Consolidated Financial Statements |   | 15                                                                                          |
| Exhibit Index                         |   | 36                                                                                          |

 

**SAFEHARBOR STATEMENT UNDER THEPRIVATE SECURITIES LITIGATION REFORM ACT OF 1995**

 

Certain statements of a non-historical nature under the caption “Management’sDiscussion and Analysis of Financial Condition and Results of Operations” andelsewhere in this Form 10-K constitute “forward-looking statements” withinthe

 

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meaning of the Private Securities Litigation Reform Act of 1995. Suchforward-looking statements may be identified by the use of terminology such as “may,”“will,” “expect,” “anticipate,” “estimate,” “should,” or “continue” or thenegative thereof or other variations thereon or comparable terminology. Suchforward-looking statements are subject to certain risks and uncertainties thatcould cause actual results to differ materially from historical results or fromthose results currently anticipated or projected. Such factors include, amongother things, the following: changes in consumer purchasing; demand for andmarket acceptance of new and existing products; the impact from competition forrecorded music; the outcome of legal proceedings; dependence on suppliers anddistributors; the outcome of our subsidiaries’ bankruptcy and liquidation;success of marketing and promotion efforts; technological changes anddifficulties; availability of financing; foreign currency variations; generaleconomic, political and business conditions; and other matters. We undertake noobligation to release publicly the result of any revisions to theseforward-looking statements, except as required by law.

 

**ITEM 6:  SELECTED FINANCIAL DATA**

 

The following summary of consolidated operations and certain balancesheet information includes the consolidated results of operations of K-tel andits subsidiaries as of and for the five years ended June 30, 2003. Thissummary should be read in conjunction with the consolidated financialstatements and notes thereto appearing elsewhere in this filing. All share andper share amounts are based on the weighted average shares issued. All amountsare in thousands of dollars, except per share data.

 
| ** **                         | ** ** | **2003**       | ** ** | **2002**       | ** ** | **2001**   | ** ** | **2000**   | ** ** | **1999**   | ** ** |
|------------------------------------|------------|----------------|------------|----------------|------------|------------|------------|------------|------------|------------|------------|
| ** **                         | ** ** | **(RESTATED)** | ** ** | **(RESTATED)** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** |
|                               |       |           |       |           |       |       |       |       |       |       |       |
| Net sales                          |       | $              | 7,234      |           | $          | 6,891      |       | $          | 17,514     |       | $          | 29,092 |   | $ | 44,650 |   |
|                               |       |           |       |           |       |       |       |       |       |       |       |
| Operating  income (loss)           |       | $              | 149        |           | $          | (46        | )          | $          | (9,480     | )          | $          | (12,980 | ) | $ | (8,356 | ) |
|                               |       |           |       |           |       |       |       |       |       |       |       |
| Loss from discontinued  operations |       | $              | (581       | )              | $          | (180       | )          | $          | (4,315     | )          | $          | (5,541 | ) | $ | (2,260 | ) |
|                               |       |           |       |           |       |       |       |       |       |       |       |
| Extraordinary  item:               |       |           |       |           |       |       |       |       |       |       |       |
|                               |       |           |       |           |       |       |       |       |       |       |       |
| Gain on bankruptcies               |       | $              | —     |           | $          | 894        |       | $          | 16,185     |       | $          | — |   | $ | — |   |
|                               |       |           |       |           |       |       |       |       |       |       |       |
| Net income  (loss)                 |       | $              | (892       | )              | $          | 300        |       | $          | 1,369      |       | $          | (15,738 | ) | $ | (11,547 | ) |
|                               |       |           |       |           |       |       |       |       |       |       |       |
| Net loss per  share:               |       |           |       |           |       |       |       |       |       |       |       |
|                               |       |           |       |           |       |       |       |       |       |       |       |
| Continuing operations              |       | $              | (.02       | )              | $          | (.03       | )          | $          | (.77       | )          | $          | (1.02 | ) | $ | (1.01 | ) |
|                               |       |           |       |           |       |       |       |       |       |       |       |
| Total assets                       |       | $              | 5,301      |           | $          | 4,610      |       | $          | 3,832      |       | $          | 17,941 |   | $ | 32,249 |   |
|                               |       |           |       |           |       |       |       |       |       |       |       |
| Long-term  debt                    |       | $              | —     |           | $          | —     |       | $          | 4,000      |       | $          | 4,000 |   | $ | 4,000 |   |

 

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

 

**General**

 

Through its operating subsidiaries, K-tel licenses its music cataloginternationally and markets entertainment products mainly derived from itscatalog in the United States and Europe through retail and direct responsemarketing channels.

 

For this analysis, the following changes in the Company’s businessshould be considered: K-tel closed the operations of its German subsidiary,Dominion Vertriebs GmbH, in June 2000; one of its subsidiaries in theUnited Kingdom, K-tel Marketing Ltd., in November 2000; and a UnitedStates subsidiary, K-tel Consumer Products, Inc., in February 2001.These three closings represent the discontinuation of the Company’s consumerproducts division and accordingly have been presented in the accompanyingfinancial statements as discontinued operations. In addition, in March 2001,the Company’s music distribution subsidiary in the United States, K-tel (USA)ceased operations and filed for protection under Chapter 7 of the United StatesBankruptcy Code.

 

Through another subsidiary, K-tel Entertainment, Inc., K-tel has afocused method of distribution that targets the strengths of fewer individualretailers and supplies products suited to each retailer’s specific needs. Thesenew products are derived from the Company’s master recordings music catalogwith the objective of realizing more competitive profit margins. As well, theCompany seeks to license its name and marks to other businesses for a royaltyor fee.

 

**A. RESULTS OF OPERATIONS**

 

The following sections discuss the results of operations by businesssegment. See Note 8 to the consolidated financial statements for additionalsegment information. General corporate expenses of $860,000 in the year ended June 30,2003, $1,049,000 in the year ended June 30, 2002 and $2,689,000 in theyear ended June 30, 2001 have been allocated to the segments.

 

**FISCAL 2003 VERSUS FISCAL 2002**

 

Net sales for the year ended June 30, 2003 were$7,234,000, an increase of 5.0% from fiscal 2002 sales of $6,891,000. Thissales increase was attributed to increased domestic music sales partiallyoffset by a decrease in licensing revenue. The net loss for fiscal 2003 was$892,000, or $.06 per share, compared to a net income of $300,000, or $.02 pershare (after an extraordinary gain of $894,000 related to the K-tel Marketingliquidation), in fiscal 2002.

 

The following sections discuss the results ofcontinuing operations by business segment.

 

**BUSINESS SEGMENT RESULTS**

 

**Music**

 

Salesin the music segment were $4,454,000 for the year ended June 30, 2003compared 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 whobecame 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 to61.4% of sales for the year ended June 30, 2003 compared to 50.4% of salesfor the year ended June 30, 2002. Advertising expenses within the segment,which consists primarily of co-operative advertising payments, tradeadvertising and promotions, increased to $200,000 for the year ended June 30,2003 compared to $172,000 for the year ended June 30, 2002.

 

Selling, general and administrative expenses for thesegment 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 primaryreasons for the decrease were related the closing of the Company’s office inGermany in fiscal 2002 and efforts to reduce overhead costs in the Company’soffice in England. As a result, the music segment incurred an operating loss of$1,010,000 for the year ended June 30, 2003 compared to an operating lossof $1,439,000 for the year ended June 30, 2002.

 

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**Licensing**

 

Licensing revenues were $2,780,000 for fiscal 2003 compared to$3,118,000 for fiscal 2002, a decrease of 10.8%. While European revenuedecreased $405,000, domestic revenue from licensing activity increased $67,000.The decrease in Europe reflected a reduced level of licensing in the music industry.While domestic licensing experienced this as well, licensing revenue from theCompany’s main licensee increased significantly. In fiscal 2002, the Companyundertook a program to audit licensees of the music catalog in order to verifycompliance with the terms of license agreements. One of the audits undertakendetermined that a significant amount of revenue had not been reported to theCompany. During the year ended June 30, 2003 the licensee subject to thisaudit made the royalty payments required under the license, and the Company’srevenue increased accordingly. Operating income in the licensing segment was$1,159,000 for the year ended June 30, 2003 and $1,393,000 for the yearended June 30, 2002, a decrease of 16.8%.

 

**FISCAL 2002 VERSUS FISCAL 2001**

 

Net sales for the year ended June 30, 2002 were$6,891,000, a decrease of 61% from the year ended June 30, 2001 sales of$17,514,000. The sales decrease was primarily attributed to the cessation ofoperations of the Company’s domestic music distribution subsidiary, K-tel(USA), which had sales of $11,948,000 during fiscal 2001. For the fiscal yearended June 30, 2002, approximately 43% of the Company’s net sales werederived in Europe. Net income for the year ended June 30, 2002 was$300,000, or $.02 per share (after an extraordinary gain of $894,000 related tothe K-tel Marketing liquidation), compared to a net income of $1,369,000, or$.10 per share (after an extraordinary gain of $16,185,000 related to the K-tel(USA) bankruptcy filing) in the year ended June 30, 2001.

 

The following sections discuss the results ofcontinuing operations by business segment.

 

**BUSINESS SEGMENT RESULTS**

 

**Music**

 

Salesin the music segment were $3,773,000 for the year ended June 30, 2002compared to $14,202,000 for the year ended June 30, 2001, a decline of73.4%. European sales decreased $658,000 and domestic music sales decreased$9,965,000. The domestic business had been comprised primarily of sales ofmusic compilations produced by K-tel and the sales and distribution of otherrecord labels. Sales declined as K-tel (USA) ceased operations and filed forbankruptcy in March 2001. Sales during the year ended June 30, 2002were in another domestic subsidiary (K-tel Entertainment, Inc.) thatmarkets products derived from the Company’s proprietary master music catalog.

 

Cost of goods sold in the music segment decreased to50.4% of sales for the year ended June 30, 2002 compared to 106.9% ofsales for the year ended June 30, 2001. The cost of goods in excess of netsales for the year ended June 30, 2001 reflected the disposal ofslow-moving and obsolete inventory at prices less than cost during the period.Advertising expenses within the segment, which consist primarily ofco-operative advertising payments, trade advertising and promotions, decreasedto $172,000 for the year ended June 30, 2002 compared to $513,000 for theyear ended June 30, 2001. The decrease in advertising spending wasprimarily the result of reduced levels of advertising during the year ended June 30,2002.

 

Selling, general and administrative expenses for thesegment decreased $3,131,000, or 50.0%, to $3,130,000 for the year ended June 30,2002 compared to $6,261,000 for the year ended June 30, 2001. The primaryreasons for the decrease were related to general overall spending reductionsand nine months of operations of the domestic music distribution subsidiary inthe year ended June 30, 2001. As a result, the music segment incurred anoperating loss of $1,439,000 for the year ended June 30, 2002 compared toan operating loss of $7,749,000 for the year ended June 30, 2001.

 

In connection with the K-tel Marketing Ltd.creditors’ liquidation in the year ended June 30, 2002, the assets andliabilities of the subsidiary have been removed from the books of the Company andthe remaining net liability has been shown as a gain on liquidation. During thefiscal year ended June 30, 2002, this subsidiary was not operating. Duringthe fiscal year ended June 30, 2001, this subsidiary had net sales of$3,179,000 and sustained an operating loss of $3,220,000. Management believesthe Company will have no ongoing liability related to this subsidiary as aresult of the filing and the outcome of the liquidation proceeding.

 

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In connection with the K-tel (USA) bankruptcy filingin the year ended June 30, 2001, the assets and liabilities of thesubsidiary were removed from the books of the Company and the remaining netliability has been shown as a gain on liquidation. During the fiscal year endedJune 30, 2002, this subsidiary was not operating. During the fiscal yearended June 30, 2001, this subsidiary had net sales of $11,948,000 andsustained an operating loss $5,229,000. Management believes the Company willhave no ongoing liability related to this subsidiary as a result of the filingand the outcome of the bankruptcy proceeding.

 

**Licensing**

 

Licensing revenues were $3,118,000 for the year ended June 30,2002 compared to $3,710,000 for the year ended June 30, 2001, a decreaseof 15.9%. Included in the segment revenue in the year ended June 30, 2001was approximately $763,000 of inter-company revenue, which was eliminated onthe accompanying consolidated financial statements. Operating income in thelicensing segment was $1,393,000 for the year ended June 30, 2002 and$425,000 for the year ended June 30, 2001, an increase of 228%, which wasa result of operational productivity improvements.

 

**Other**

 

The “Other” segment of the business was comprised of the e-commercebusiness, which was closed in the fourth quarter of 2001. The Company hadneither revenue nor losses from this segment in the years ended June 30,2002 and 2003. Revenue from this segment was $365,000 in the year ended June 30,2001. Operating losses from this segment were $2,156,000 in the year ended June 30,2001.

 

**CriticalAccounting Policies**

 

Revenue Recognition– The Company derives its revenue mainly from two sources: the sale of musiccompilations (predominately compact discs) produced by the Company, and licenserevenue from the licensing of Company-owned masters. Revenue from music salesis recognized at the time of shipment to the customer, while license revenue isrecognized when payment is received from customers or when known amounts arereceivable, as prior to that date collection is not considered probable. Mostmusic sales are made with a right of return of unsold goods. Estimated reservesfor returns are established by management based upon historical experience andproduct mix and are subject to ongoing review and adjustment by the Company.These reserves are recorded at the time of sale and are reflected as areduction in revenues. The Company’s reserve for returns was $220,000 at June 30,2003 and $46,000 at June 30, 2002.

 

Rights to Use Music Product -Certain of the Company’s compilation products are master recordings underlicense from record companies and publishers. In most instances, minimumguarantees or non-refundable advances are required to obtain the licenses andare realized through future sales of the product. The amounts paid for minimumguarantees or non-refundable advances are capitalized and charged to expense assales are made. The unrealized portion of guarantees and advances is includedin royalty advances in the accompanying consolidated balance sheets. Licensesare 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.

 

Royalties - TheCompany has entered into license agreements with various record companies andpublishers 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.

 

**RecentAccounting Pronouncements**

 

In June 2002, the Financial Accounting Standards Board (FASB) issuedStatement of Financial Accounting Standards No. 146 (SFAS 146), *Accounting for Costs Associated with Exit or DisposalActivities*. SFAS 146 provides financial accounting and reportingguidance for costs associated with exit or disposal activities, includingone-time termination benefits, contract termination costs other than for acapital lease, and costs to consolidate facilities or relocate employees. Thisstatement is effective for exit or disposal activities that are initiated afterDecember 31, 2002. Management does not believe this pronouncement willhave a material effect on the Company’s consolidated financial position andresults of operations.

 

In November 2002, the FASB issued FASB Interpretation No. 45(FIN 45), *Guarantor’s Accounting and DisclosureRequirements for Guarantees, Including Indirect Guarantees of Indebtedness ofOthers.*FIN 45 addresses the disclosure

 

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requirements of a guarantor in its interim and annual financialstatements about its obligations under certain guarantees that is has issued.FIN 45 also requires a guarantor to recognize, at the inception of a guarantee,a liability for the fair value of the obligation undertaken in issuing theguarantee. The disclosure requirements of FIN 45 were effective for the Companyfor its quarter ended December 31, 2002. The liability recognitionrequirement is applicable prospectively to all guarantees issued or modifiedafter December 31, 2002. This pronouncement is not anticipated to have amaterial effect on the Company’s consolidated financial position or results ofoperations.

 

In December 2002, the FASB issued Statement 148 (FAS 148), *Accounting for Stock-Based Compensation Transitionand Disclosure.* FAS 148 amends the disclosure and certain transitionprovisions of Statement 123, *Accounting forStock-Based Compensation.* Its disclosure provisions, which apply toall entities with employee stock-based compensation, are effective for fiscalyears ending after December 15, 2002. New interim period disclosures wererequired in financial statements for interim periods beginning after December 15,2002. This pronouncement is not anticipated to have a material effect on theCompany’s consolidated financial position or results of operations.

 

In December 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 January 31, 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. Thispronouncement will have an effect on the Company’s consolidated financialposition and results of operations as the Company will consolidate a variableinterest entity in the quarter ending March 31, 2004.

 

# InMay 2003, the FASB issued Statement 150, *Accountingfor Certain Financial Instruments with Characteristics of both Liabilities andEquity*. Statement 150 changes the classifications in the statementof financial position of certain common financial instruments from eitherequity or mezzanine presentation to liabilities and requires an issuer of thosefinancial statements to recognize changes in fair value or redemption amount,as applicable, in earnings. SFAS 150 is effective for financial instrumentsentered into or modified after May 31, 2003, and otherwise is effective atthe beginning of the first interim period beginning after June 15, 2003.Adoption of Statement 150 is not anticipated to have an impact on the Company’sconsolidated financial position or results of operations.

 

InDecember 2004, the FASB issued SFAS No. 123R, *Share-Based Payment*, which replaced SFAS No. 123and superseded APB 25. SFAS No. 123R addresses the accounting forshare-based payment transactions in which a company receives employee servicesin exchange for either equity instruments of the company or liabilities thatare based on the fair value of the company’s equity instruments or that may besettled by the issuance of such equity instruments. Under SFAS No. 123R,companies will no longer be able to account for the share-based compensationtransactions using the intrinsic method in accordance with APB 25 but will berequired to account for such transactions using a fair-value method and recognizethe expense in the consolidated statement of operations. SFAS No. 123R iseffective beginning in the Company’s first quarter of fiscal year 2006. UnderSFAS 123R, the Company must determine the appropriate fair value model to beused for valuing share-based payments, the amortization method for compensationcost and the transition method to be used at date of adoption. The transitionmethods include prospective and retroactive adoption options. The Company hasbegun, but has not completed, evaluating the impact of the adoption of SFAS123R on its results of operations. In connection with evaluating the impact ofSFAS 123R, the Company is considering the potential implementation of differentvaluation methods to determine the fair value of share-based compensation. TheCompany believes the adoption of SFAS 123R will not have a material impact onour results of operations, regardless of the valuation method used.

 

## **B. LIQUIDITY AND CAPITALRESOURCES**

 

K-tel has a Line of Credit Agreement with K-5 Leisure Products, Inc.(“K-5”), the Company’s largest shareholder controlled by Philip Kives, theChairman of the Board, President and Chief Executive Officer of K-tel. Underthe terms of the agreement (the “K-5 Facility”), K-5 has agreed to makeavailable up to $8,000,000 to K-tel on a revolving basis. The loan bearsinterest at a variable rate based upon the “base rate” of a nationallyrecognized lending institution (4.0% at June 30, 2003), expired July 20, 2005,and is subordinated to the Foothill loan (see below). The Company is currentlyin negotiations to extend the Line of Credit Agreement until July 20, 2006.TheK-5 Facility contains the same covenants as the Foothill loan agreement. K-telhas pledged the stock of its foreign subsidiaries as collateral for the loan,and the loan carries a subordinated position to the Foothill loan on all otherassets of the Company. K-tel had outstanding balances of $7,282,000 and$6,026,000 as of June 30, 2003 and 2002 respectively under the K-5 Facility. AtJune 30, 2003, K-tel obtained a waiver from K-5 for its non-compliance underthe covenants, limitations and restrictions of the credit agreement.

 

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In addition, K-tel has a second loan agreement with K-5,under which K-5 assumed rights and obligations under a loan from the Company’sformer banker (Foothill Capital Corporation) pursuant to an Assignment andAcceptance Agreement dated February 27, 2001. This Foothill loan,which had been extended through July 20, 2005, (the Company iscurrently in negotiations to extend the loan agreement until July 20, 2006)provides for a $10,000,000 credit facility consisting of a $4,000,000 term loandue upon expiration, and a $6,000,000 revolving facility under which borrowingsare limited to a percent of eligible receivables. Borrowings under the facilitybear interest at a variable rate based on a “base rate” of a nationally recognized lending institutionplus 1% (5.0% at June 30, 2003) and are collateralized by the assets ofcertain Company subsidiaries in the United States, including accountsreceivable, inventories, equipment, music library and general intangibles. Theloan agreement contains certain financial and other covenants or restrictions,including the maintenance of a minimum shareholders’ equity by K-tel,limitations on capital expenditures, restrictions on music libraryacquisitions, limitations on other indebtedness and restrictions on dividendspaid by K-tel. As of June 30, 2003 and 2002, $4,000,000 was outstandingunder the term loan and there were no borrowings under the revolving facility.At June 30, 2003, K-tel obtained a waiver from K-5 for its non-complianceunder the covenants, limitations and restrictions of the credit agreement.

 

K-tel has an overdraft privilege borrowing facility with The Royal Bankof Scotland in the United Kingdom. This facility is secured by a standby letterof credit for $260,000 provided by K-tel International Ltd., a Canadian companycontrolled by Philip Kives and is payable on demand in accordance with normalbanking practices. Borrowings bear interest of 2.0% per annum over the baserate (a total of 5.75% at June 30, 2003) but are subject to a minimum of6% per annum. K-tel had outstanding balances of $233,000 and $227,000 as of June 30,2003 and 2002, respectively.

 

K-tel has primarily funded its operations to date through internallygenerated capital, proceeds from stock option exercises and secured loans fromK-5. Management currently believes that K-tel has sufficient cash and borrowingcapacity to ensure the Company will continue operations in the near term.Although K-5 continues to advance funds sufficient to meet the Company’s needsat this time, there can be no assurance that this will be adequate or continuein the future or that K-tel will be able to obtain additional financing uponfavorable terms when required.

 

The Company’s ability to continue its present operations and implementfuture expansion plans successfully is contingent mainly upon its ability tomaintain its line of credit arrangements with K-5, increase its revenues andprofit margins, and ultimately attain and sustain profitable operations.Without increased revenues and sustained profitability beyond the near term,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 through these efforts. In the event the Company is unableto fund its operations and implement its current business plan properly, it maybe unable to continue operations. The financial statements do not include anyadjustments that might result from the outcome of these uncertainties. Thereport of the Company’s independent registered public accounting firm as of June 30,2003 and 2002 and for the three years in the period ended June 30, 2003includes an explanatory paragraph expressing doubt about our ability tocontinue as a going concern.

 

**CAUTIONARY STATEMENT**

** **

Certain information of a non-historical naturecontained in this Form 10-K include forward-looking statements. Words suchas “anticipates”, “believes”, “expects”, “intends”, “future”, and similarexpressions identify forward-looking statements. Any such forward-lookingstatements reflect the Company’s current views with respect to future eventsand financial performance, and are subject to a variety of factors that couldcause the actual results or performance to differ materially from historicalresults or from the anticipated results or performance expressed or implied bysuch forward-looking statements. Because of such factors, the Company cannotassure you that the actual results or developments that it anticipates will berealized or, even if substantially realized, that they will have theanticipated results.

 

The risks and uncertainties that may affect theCompany’s business include, but are not limited to, those set forth below. Therisks and uncertainties set forth below incorporate both historical and “forward-lookingstatements” within the meaning of Section 27A of the Securities Act of1933, as amended, and Section 21E of the Securities Exchange Act of 1934,as amended. You should not place undue reliance on such forward-lookingstatements, which speak only as of the date hereof. You should also be awarethat, except as the law may otherwise require, the Company undertakes noobligation to publicly revise any such forward-looking statements to reflectevents or circumstances that may arise after the date of this report. Thefollowing information is not intended to limit in any way the characterizationof other statements or information under other captions as cautionary statementsfor such purpose. The order in which such factors appear below should not be

 

8

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construed to indicate their relative importance orpriority.

 

•                                          The Company incurred a loss in the fiscalyear ended June 30, 2003 and expects to continue incurring losses in thenear future.

 

•                                          Continuation and expansion of the Company’soperations will require additional working capital and continued access tofinancing to meet working capital requirements and develop new businessopportunities.

 

•                                          The Company has primarily funded itsoperations to date through internally generated capital, proceeds from stockoption exercises and secured loans from K-5 Leisure Products, Inc. (“K-5”),the Company’s largest shareholder controlled by Philip Kives, the Chairman ofthe Board, President and Chief Executive Officer of K-tel, and there can be noassurance that K-5 will continue to advance funds sufficient to meet theCompany’s needs or that the Company will be able to obtain additional financingupon favorable terms when required.

 

•                                          Approximately30.1% of the Company’s revenue for the year ended June 30, 2003, wasderived from two major customers, and the loss of any such customer could havea material adverse effect on the Company.

 

•                                          The music business is highly competitive anddominated by several major record companies that dominate the market for pre-recordedmusic, have greater financial resources than the Company and have a largerdepth and breadth of catalog, distribution capabilities and current repertoirethan the Company, 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.

 

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

 

K-tel is exposed to various market risks, includingchanges in interest rates and foreign currency exchange rates. Market risk isthe potential loss arising from adverse changes in market rates and prices,such as interest rates and foreign currency exchange rates. K-tel does notenter into derivatives or other financial instruments for trading orspeculative purposes.

 

K-tel’s exposure to market risk for changes in interest rates relatesto K-tel’s short-term borrowings. K-tel’s short-term credit facilities carry avariable interest rate that does have an impact on future earnings and cashflows. At June 30, 2003, K-tel had variable rate debt of $11,515,000. Ifthe interest rate were to change 100 basis points or 1% while K-tel wasborrowing under the credit facilities, interest expense would change by$115,000.

 

Approximately 32% of K-tel’s revenues during the year ended June 30,2003 were derived from operations in Europe. The results of operations andfinancial position of K-tel’s operations in Europe were principally measured intheir respective currencies and translated into U.S. dollars. The effect offoreign currency fluctuations in these European countries is somewhat mitigatedby the fact that expenses are generally incurred in the same currencies inwhich the revenue is generated. The reported income of these subsidiaries willbe higher or lower depending on the weakening or strengthening of the U.S.dollar against the respective foreign currency. If the U.S. dollar foreigncurrency rate were to change by 1%, the effect on income would be $4,000.Additionally, approximately 27% of K-tel’s assets at June 30, 2003 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**

 

The consolidated financial statements and related notes and schedulesrequired by this Item are set forth in Part IV, Item 15, and identified inthe Index to Consolidated Financial Statements and Schedules.

 

9

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# **ITEM 9A:****                   CONTROLS AND PROCEDURES**

#  

Underthe supervision and with the participation of the Company’s management,including the Company’s Chief Executive Officer and Chief Financial Officer,the Company evaluated the effectiveness of the design and operation of itsdisclosure controls and procedures (as defined in Rule 13a-15(e) and15d-15(e) under the Exchange Act). Based on that evaluation, the ChiefExecutive Officer and Chief Financial Officer concluded that, as of the end ofthe period covered by this report, the Company’s disclosure controls andprocedures were not effective because of the following material weakness ininternal control over financial reporting.

 

The Company did not maintain effective controls over cash disbursementsand payroll transactions at its UK subsidiary. In September 2004, theCompany discovered that the former Chief Financial Officer of its UK subsidiarymisappropriated funds from the subsidiary and one of its customers. Adjustmentsrelated to the reversal of overstated expenses and recovery of amountsmisappropriated were included in the restatement of the Company’s consolidatedfinancial statements for the years ended June 30, 2002 and 2003.

 

Inresponse to the material weakness above, the Company terminated the employee,undertook a full-scale investigation of the matter, retained a forensicauditing firm and dismissed the accounting firm in the UK that audited the UKsubsidiary’s financial books and records. In addition the Company hired a newFinancial Controller and stringent internal control procedures were created andimplemented for the Company’s purchasing, accounts payable, check signing,payroll, petty cash and financial reporting policies. Management believes thatthese procedures, implemented upon the discovery of the misappropriation offunds, will allow the Company to maintain internal control over financialreporting.

 

During the Company’s most recent fiscal quarter (September 30,2005), there has been no change in the Company’s internal control overfinancial reporting (as defined in Rule 13a-15(f) under the ExchangeAct) that has materially affected, or is reasonably likely to materiallyaffect, the Company’s internal control over financial reporting.

 

**ITEM 9B: OTHER INFORMATION**

 

Not applicable.

 

10

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

 

K-tel has a Line of CreditAgreement 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-5 Facility”), K-5 has agreed to make available up to $8,000,000 to K-tel ona revolving basis. The loan bears interest at a variable rate based upon the“base rate” of a nationally recognized lending institution (4.0% at June 30,2003), expired July 20, 2005, and is subordinated to the Foothill loan (seebelow). The Company is currently in negotiations to extend the Line of CreditAgreement until July 20, 2006.  The K-5 Facilitycontains the same covenants as the Foothill loan agreement. K-tel has pledgedthe stock of its foreign subsidiaries as collateral for the loan, and the loancarries a subordinated position to the Foothill loan on all other assets of theCompany. K-tel had outstanding balances of $7,282,000 and $6,026,000 as of June30, 2003 and 2002 respectively under the K-5 Facility. At June 30, 2003, K-telobtained a waiver from K-5 for its non-compliance under the covenants,limitations and restrictions of the credit agreement.

 

In addition, K-tel has a second loan agreement with K-5,under which K-5 assumed rights and obligations under a loan from the Company’sformer banker (Foothill Capital Corporation) pursuant to an Assignment andAcceptance Agreement dated February 27, 2001. This Foothill loan,which had been extended through July 20, 2005, (the Company iscurrently in negotiations to extend the loan agreement until July 20, 2006),provides for a $10,000,000 credit facility consisting of a $4,000,000 term loandue upon expiration, and a $6,000,000 revolving facility under which borrowingsare limited to a percent of eligible receivables. Borrowings under the facilitybear interest at a variable rate based on a “base rate” of a nationally recognized lending institutionplus 1% (5.0% at June 30, 2003) and are collateralized by the assets ofcertain Company subsidiaries in the United States, including accountsreceivable, inventories, equipment, music library and general intangibles. Theloan agreement contains certain financial and other covenants or restrictions,including the maintenance of a minimum shareholders’ equity by K-tel,limitations on capital expenditures, restrictions on music libraryacquisitions, limitations on other indebtedness and restrictions on dividendspaid by K-tel. As of June 30, 2003 and 2002, $4,000,000 was outstandingunder the term loan and there were no borrowings under the revolving facility.At June 30, 2003, K-tel obtained a waiver from K-5 for its non-complianceunder the covenants, limitations and restrictions of the credit agreement.

 

K-tel has an overdraft privilege borrowing facility with The Royal Bankof Scotland in the United Kingdom. This facility is secured by a standby letterof credit for $260,000 provided by K-tel International Ltd., a Canadian companycontrolled by Philip Kives and is payable on demand in accordance with normalbanking practices. Borrowings bear interest of 2.0% per annum over the baserate (a total of 5.75% at June 30, 2003) but are subject to a minimum of6.0% per annum. K-tel had outstanding balances of $233,000 and $227,000 as of June 30,2003 and 2002, respectively.

 

The Company purchased approximately $463,000 in the year ended June 30,2003, $366,000 in the year ended June 30, 2002 and $574,000 in the yearended June 30, 2001 of music entertainment and consumer convenienceproducts from K-5, which represented 14.6%, 14.7% and 3.7% of cost of goodssold, respectively. There were trade payables to K-5 of $371,000 at June 30,2003, $ 291,000 at June 30, 2002 and $285,000 at June 30, 2001, or31.9%, 23.0% and 22.2% of total trade payables, respectively.

 

The Company had no sales of consumer convenience products to K-5 duringfiscal years 2003 and 2002 and sales of $13,000 during fiscal 2001. There was abalance receivable from K-5 at June 30, 2003 of $73,000, June 30,2002 of $129,000 and June 30, 2001 of $109,000. No interest was charged onthe related outstanding balances during fiscal years 2003, 2002 and 2001.

 

During the fiscal year ended June 30, 2003, the Company licensedcertain marks to K-tel Drug Mart Ltd., a Canadian direct marketer ofprescription drugs owned by Philip Kives, the Chairman of the Board, Presidentand Chief Executive Officer of K-tel. The terms of the license agreementbetween the Company and K-tel Drug Mart have not been finalized, but willinvolve payment of a royalty to the Company by K-tel Drug Mart for use of thetrademark. The agreement is currently under consideration by the Company, andwill be subject to approval by the Company’s independent directors.

 

11

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# **ITEM14.  ****PRINCIPALACCOUNTANT FEES AND SERVICES**

#  

Audit fees

 

The following table shows the aggregate fees billed to the Company byGrant Thornton for services rendered during fiscal years ended June 30,2003 and June 30, 2002:

 
| **Description of Fees** | ** ** | **Fiscal 2003  Amount** | ** ** | **Fiscal 2002  Amount** | ** ** |
|-------------------------|------------|-------------------------|------------|-------------------------|------------|
|                    |       |                    |       |                    |       |
| Audit Fees              |       | $                       | 127,500    | (1)                     | $          | 97,500 | (1) |
| Audit  Related fees     |       | —                  |       | —                  |       |
| Tax Fees                |       | 54,600                  | (2)        | 40,150                  | (2)        |
| Other Fees              |       | 500                     | (3)        | 16,725                  | (3)        |
| Total                   |       | $                       | 182,600    |                    | $          | 154,375 |   |

 

----

(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 2003 and2002 and related 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, anaudit of an employee benefit plan in 2002, and other financial consultingassistance.

 

Auditor Independence

 

The audit committee requires that all audit and permissible non-auditservices provided by our independent auditors be pre-approved by the auditcommittee or a designated member of the audit committee. These services mayinclude audit services, audit-related services, tax services and otherservices. Any pre-approval is detailed as to the particular service or categoryof services. The audit committee reviews all non-audit services to be providedand assesses the impact of the services on the auditor’s independence.

 

The audit committee pre-approved 100% of the services described in the “PrincipalAccountant Fees and Services” table pursuant to engagements that occurred infiscal 2003.

 

12

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**PART IV**

 

**ITEM 15: EXHIBITS AND FINANCIAL STATEMENT SCHEDULES**

 

(a)                                  FinancialStatements and Schedules

 

The consolidated statements and scheduleslisted in the accompanying Index to Consolidated Financial Statements andSchedules hereof are filed as part of this report.

 

(b)                                 Exhibits

 

Reference is made to the Exhibit Index.

 

(c)                                  ExcludedFinancial Statements

 

Not applicable.

 

13

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**SIGNATURES**

 

Pursuant to the requirements of Section 13 or 15(d) of theSecurities Exchange Act of 1934, the Company has duly caused this report to besigned on its behalf on January 5, 2006, by the undersigned, thereuntoduly authorized.

 
|   | K-TEL INTERNATIONAL, INC.              |
|--------|----------------------------------------|
|   |                                   |
|   | By                                     | /s/ Philip Kives |   |
|   | (Philip Kives - Chairman of the Board, |
|   | Chief Executive Officer and President) |

 

 

Pursuant to the requirements of the Securities and Exchange Act of1934, this report has been signed below by the following persons on behalf ofthe registrant and in the capacities indicated and on the dates indicated.

 
| **Signatures**           | ** ** | **Title**                      | ** **                          | **Date** |
|--------------------------|------------|--------------------------------|-------------------------------------|----------|
|                     |       |                           |                                |     |
| /s/ Philip  Kives        |       |                           | Chairman,  Chief Executive Officer, |     | January 5,  2006 |
| Philip Kives             |       | (Principal  Executive Officer) |                                |     |
|                     |       | President  and Director        |                                |     |
|                     |       |                           |                                |     |
| /s/ Larry  Dunmall       |       |                           | Chief  Financial Officer            |     | January 5,  2006 |
| Larry  Dunmall           |       | (Principal  Financial Officer) |                                |     |
|                     |       |                           |                                |     |
| /s/ Jay  William Smalley |       |                           | Director                            |     | January 5,  2006 |
| Jay William  Smalley     |       |                           |                                |     |
|                     |       |                           |                                |     |
| /s/ Wesley  C. Hayne     |       |                           | Director                            |     | January 5,  2006 |
| Wesley C.  Hayne         |       |                           |                                |     |
|                     |       |                           |                                |     |
| /s/ Richard  Marklund    |       |                           | Director                            |     | January 5,  2006 |
| Richard  Marklund        |       |                           |                                |     |

 

14

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

**INDEX TO CONSOLIDATED FINANCIAL STATEMENTS**

 
| Report of Independent Registered Public Accounting Firm                                                                            | 16     |
|------------------------------------------------------------------------------------------------------------------------------------|--------|
|                                                                                                                               |   |
| Consolidated Balance Sheets as of June 30, 2003 and 2002                                                                      | 17     |
|                                                                                                                               |   |
| Consolidated Statements of Operations for each of the three years in  the period ended June 30, 2003                          | 18     |
|                                                                                                                               |   |
| Consolidated Statements of Shareholders’ Equity (Deficit) for each of  the three years in the period ended June 30, 2003 | 19     |
|                                                                                                                               |   |
| Consolidated Statements of Cash Flows for each of the three years in  the period ended June 30, 2003                          | 20     |
|                                                                                                                               |   |
| Notes to Consolidated Financial Statements                                                                                         | 21     |
|                                                                                                                               |   |
| Supplemental Schedule to Consolidated  Financial Statements:                                                                  |   |
|                                                                                                                               |   |
| Schedule II  - Valuation and Qualifying Accounts for each of the three years in the period  ended June 30, 2003          | 35     |

 

All other schedules for which provision is made in the applicableaccounting regulations of the Securities and Exchange Commission have beenomitted as not required, not applicable or the information required has beenincluded elsewhere in the consolidated financial statements and notes thereto.

 

15

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**REPORT OF INDEPENDENT REGISTERED PUBLIC ACCOUNTING FIRM**

 

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

 

We have audited the accompanying consolidated balance sheets of K-telInternational, Inc. (a Minnesota corporation) and subsidiaries as of June 30,2003 and 2002 and the related consolidated statements of operations,shareholders’ equity (deficit), and cash flows for each of the three years inthe period ended June 30, 2003. These financial statements are theresponsibility of the Company’s management. Our responsibility is to express anopinion on these financial statements based on our audits.

 

We conducted our audits in accordance with auditing standards generallyaccepted in the United States of America. Those standards require that we planand perform the audit to obtain reasonable assurance about whether thefinancial statements are free of material misstatement. An audit includesexamining, on a test basis, evidence supporting the amounts and disclosures inthe financial statements. An audit also includes assessing the accountingprinciples used and significant estimates made by management, as well asevaluating the overall financial statement presentation. We believe that ouraudits provide a reasonable basis for our opinion.

 

In our opinion, the consolidated financial statements referred to abovepresent fairly, in all material respects, the financial position of K-telInternational, Inc. and subsidiaries as of June 30, 2003 and 2002 andthe results of their operations and their cash flows for the each of the threeyears in the period ended June 30, 2003 in conformity with accountingprinciples generally accepted in the United States of America.

 

As discussed in Note 11, the consolidated financials have beenrestated.

 

Theaccompanying financial statements have been prepared assuming that the Companywill continue as a going concern. As discussed in Note 1 to the financialstatements, the Company has incurred significant recurring losses fromoperations and has a net working capital deficit that raises substantial doubtabout the Company’s ability to continue as a going concern. Management’s plansin regard to these matters are also described in Note 1. The financialstatements do not include any adjustments that might result from the outcome ofthis uncertainty.

 

We have also audited Schedule II for each of the three years in theperiod ended June 30, 2003. In our opinion, this schedule, when consideredin relation to the basic financial statements taken as a whole, presentsfairly, in all material respects, the information therein.

 

 
|                    | /S/ GRANT THORNTON LLP |   |
|-------------------------|------------------------|--------|
|                    |                   |
| Minneapolis, Minnesota, |                   |
| December 15, 2005  |                   |

 

16

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

## **CONSOLIDATEDBALANCE SHEETS**

**JUNE 30,**

*(inthousands - except share data)*

 
| ** **                                                                                           | ** ** | **2003** | ** ** | **2002** | ** ** |
|------------------------------------------------------------------------------------------------------|------------|----------|------------|----------|------------|
|                                                                                                 |       |     |       |     |       |
| ASSETS                                                                                               |       |     |       |     |       |
|                                                                                                 |       |     |       |     |       |
| Current Assets:                                                                                      |       |     |       |     |       |
| Cash and cash equivalents                                                                            |       | $        | 1,219      |     | $          | 75 |   |
| Accounts receivable, net of allowance for  doubtful accounts of $25 and $68                          |       | 2,134    |       | 2,045    |       |
| Inventories                                                                                          |       | 522      |       | 637      |       |
| Royalty advances                                                                                     |       | 220      |       | 268      |       |
| Prepaid expenses and other                                                                           |       | 304      |       | 378      |       |
| Total Current Assets                                                                                 |       | 4,399    |       | 3,403    |       |
|                                                                                                 |       |     |       |     |       |
| Property and equipment, net of accumulated  depreciation and amortization of $1,506 and $1,418       |       | 83       |       | 147      |       |
|                                                                                                 |       |     |       |     |       |
| Owned catalog masters, net of accumulated  amortization of $2,755 and $2,829                         |       | 819      |       | 1,060    |       |
|                                                                                                 |       |     |       |     |       |
|                                                                                                 |       | $        | 5,301      |     | $          | 4,610 |   |
|                                                                                                 |       |     |       |     |       |
| LIABILITIES AND SHAREHOLDERS’ DEFICIT                                                           |       |     |       |     |       |
|                                                                                                 |       |     |       |     |       |
| Current Liabilities:                                                                                 |       |     |       |     |       |
| Notes payable to affiliate and other                                                                 |       | $        | 11,515     |     | $          | 10,253 |   |
| Accounts payable                                                                                     |       | 1,160    |       | 1,261    |       |
| Accrued royalties                                                                                    |       | 2,394    |       | 2,301    |       |
| Reserve for returns                                                                                  |       | 220      |       | 46       |       |
| Net liabilities of discontinued operations                                                           |       | 116      |       | 92       |       |
| Total Current Liabilities                                                                            |       | 15,405   |       | 13,953   |       |
|                                                                                                 |       |     |       |     |       |
| Shareholders’ Deficit:                                                                          |       |     |       |     |       |
| Common Stock – 50,000,000 shares  authorized, par value $.01; 13,653,738 issued and outstanding |       | 136      |       | 136      |       |
| Additional paid-in capital                                                                           |       | 21,292   |       | 21,292   |       |
| Accumulated deficit                                                                                  |       | (31,377  | )          | (30,485  | )          |
| Accumulated other comprehensive loss                                                                 |       | (155     | )          | (286     | )          |
| Total Shareholders’ Deficit                                                                     |       | (10,104  | )          | (9,343   | )          |
|                                                                                                 |       |     |       |     |       |
|                                                                                                 |       | $        | 5,301      |     | $          | 4,610 |   |

 

***The accompanying notes are an integral part ofthese financial statements.***

 

17

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

**CONSOLIDATEDSTATEMENTS OF OPERATIONS**

## **YEARS ENDED JUNE 30,**

*(inthousands - except per share data)*

 
| ** **                                                                  | ** ** | **2003** | ** ** | **2002** | ** ** | **2001** | ** ** |
|-----------------------------------------------------------------------------|------------|----------|------------|----------|------------|----------|------------|
|                                                                        |       |     |       |     |       |     |       |
| Net Sales                                                                   |       | $        | 7,234      |     | $          | 6,891    |       | $ | 17,514 |   |
|                                                                        |       |     |       |     |       |     |       |
| Costs and Expenses:                                                         |       |     |       |     |       |     |       |
| Cost of goods sold                                                          |       | 3,100    |       | 2,353    |       | 15,658   |       |
| Advertising                                                                 |       | 200      |       | 172      |       | 618      |       |
| Selling, general and administrative                                         |       | 3,785    |       | 4,412    |       | 10,718   |       |
| Total Costs and Expenses                                                    |       | 7,085    |       | 6,937    |       | 26,994   |       |
| Operating Income (Loss)                                                     |       | 149      |       | (46      | )          | (9,480   | )          |
|                                                                        |       |     |       |     |       |     |       |
| Other Income (Expense):                                                     |       |     |       |     |       |     |       |
| Interest income                                                             |       | —   |       | —   |       | 155      |       |
| Interest expense                                                            |       | (534     | )          | (472     | )          | (912     | )          |
| Foreign currency transaction loss                                           |       | —   |       | —   |       | (360     | )          |
| Other income (expense)                                                      |       | 74       |       | (37      | )          | —   |       |
| Total Other Income (Expense)                                                |       | (460     | )          | (509     | )          | (1,117   | )          |
|                                                                        |       |     |       |     |       |     |       |
| Income (Loss) from Continuing Operations                                    |       |     |       |     |       |     |       |
| Before Income Taxes                                                         |       | (311     | )          | (555     | )          | (10,597  | )          |
|                                                                        |       |     |       |     |       |     |       |
| Benefit for Income Taxes                                                    |       | —   |       | 141      |       | 96       |       |
| Income (Loss) from Continuing Operations                                    |       | (311     | )          | (414     | )          | (10,501  | )          |
|                                                                        |       |     |       |     |       |     |       |
| Discontinued Operations:                                                    |       |     |       |     |       |     |       |
| Loss from Discontinued Operations                                           |       | (581     | )          | (180     | )          | (4,315   | )          |
| Loss before Extraordinary Item                                              |       | (892     | )          | (594     | )          | (14,816  | )          |
|                                                                        |       |     |       |     |       |     |       |
| Extraordinary Item:                                                         |       |     |       |     |       |     |       |
| Gain on Subsidiary Liquidations                                             |       | —   |       | 894      |       | 16,185   |       |
| Net Income (Loss)                                                           |       | $        | (892       | )        | $          | 300      |       | $ | 1,369 |   |
|                                                                        |       |     |       |     |       |     |       |
| Income (Loss) per Share – Basic and  Diluted:                          |       |     |       |     |       |     |       |
| Continuing Operations                                                       |       | $        | (.02       | )        | $          | (.03     | )          | $ | (.77 | ) |
| Discontinued Operations                                                     |       | (.04     | )          | (.01     | )          | (.32     | )          |
| Extraordinary Item                                                          |       | —   |       | .06      |       | 1.19     |       |
| Net Income (Loss)                                                           |       | $        | (.06       | )        | $          | .02      |       | $ | .10 |   |
|                                                                        |       |     |       |     |       |     |       |
| Shares used in the calculation of loss per  share – Basic and Diluted: |       | 13,654   |       | 13,654   |       | 13,654   |       |
|                                                                        |       |     |       |     |       |     |       |
| Comprehensive Income (Loss)                                                 |       |     |       |     |       |     |       |
| Net income (loss)                                                           |       | $        | (892       | )        | $          | 300      |       | $ | 1,369 |   |
| Translation adjustment                                                      |       | 131      |       | (3       | )          | 476      |       |
| Comprehensive Income (Loss)                                                 |       | $        | (761       | )        | $          | 297      |       | $ | 1,845 |   |

 

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

 

18

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

**CONSOLIDATED STATEMENTS OF SHAREHOLDERS’ EQUITY (DEFICIT)**

**YEARSENDED JUNE 30, 2003, 2002 AND 2001**

*(inthousands)*

 
|                                    |   | **Common Stock** |   | **Additional** |   |                 |   | **Accumulated  Other**   |   |                      |    |
|-----------------------------------------|--------|------------------|--------|----------------|--------|----------------------|--------|--------------------------|--------|---------------------------|---------|
|                                    |   | **Shares**       |   | **Amount**     |   | **Paid-In  Capital** |   | **Accumulated  Deficit** |   | **Comprehensive  (Loss)** |    | **Total** |   |
|                                    |   |             |   |           |   |                 |   |                     |   |                      |    |   |   |
| Balance at June 30, 2000           |   | 10,321           |   | $              | 103    |                 | $      | 20,213                   |   | $                         | (32,154 | ) | $ | (759 | ) | $ | (12,597 | ) |
|                                    |   |             |   |           |   |                 |   |                     |   |                      |    |   |   |
| Net income                              |   | —           |   | —         |   | —               |   | 1,369                    |   | —                    |    | 1,369 |   |
| Conversion of debt to equity            |   | 3,333            |   | 33             |   | 467                  |   | —                   |   | —                    |    | 500 |   |
| Translation adjustment                  |   | —           |   | —         |   | —               |   | —                   |   | 476                       |    | 476 |   |
|                                    |   |             |   |           |   |                 |   |                     |   |                      |    |   |   |
| 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 income                              |   | —           |   | —         |   | —               |   | (892                     | )      | —                    |    | (892 | ) |
|                                    |   |             |   |           |   |                 |   |                     |   |                      |    |   |   |
| Translation adjustment                  |   | —           |   | —         |   | —               |   | —                   |   | 131                       |    | 131 |   |
|                                    |   |             |   |           |   |                 |   |                     |   |                      |    |   |   |
| Balance at June 30, 2003           |   | 13,654           |   | $              | 136    |                 | $      | 21,292                   |   | $                         | (31,377 | ) | $ | (155 | ) | $ | (10,104 | ) |

* *

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

 

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

**CONSOLIDATED STATEMENTS OF CASH FLOWS**

**YEARSENDED JUNE 30,**

*(inthousands)*

* *
| ** **                                                                                            | ** ** | **2003** | ** ** | **2002** | ** ** | **2001** | ** ** |
|-------------------------------------------------------------------------------------------------------|------------|----------|------------|----------|------------|----------|------------|
| Operating Activities:                                                                                 |       |     |       |     |       |     |       |
| Net income (loss)                                                                                     |       | $        | (892       | )        | $          | 300      |       | $ | 1,369 |   |
| Adjustment to reconcile net income (loss)  to cash used in operating activities:                      |       |     |       |     |       |     |       |
| Depreciation and amortization                                                                         |       | 315      |       | 380      |       | 408      |       |
| Loss on disposal of property and equipment                                                            |       | 3        |       | 18       |       | 349      |       |
| Gain on liquidation                                                                                   |       | —   |       | (894     | )          | (16,185  | )          |
| Discontinued operations                                                                               |       | 7        |       | (109     | )          | 3,630    |       |
| Write down of long lived asset                                                                        |       | —   |       | —   |       | 417      |       |
| Changes in operating assets and  liabilities:                                                         |       |     |       |     |       |     |       |
| Accounts receivable, net                                                                              |       | (147     | )          | (1,078   | )          | 3,217    |       |
| Inventories                                                                                           |       | 135      |       | (199     | )          | 2,378    |       |
| Royalty advances                                                                                      |       | 68       |       | (70      | )          | (82      | )          |
| Prepaid expenses and other current assets                                                             |       | 89       |       | 295      |       | (225     | )          |
| Accounts payable                                                                                      |       | (10      | )          | (695     | )          | 2,421    |       |
| Accrued royalties                                                                                     |       | 87       |       | 213      |       | 230      |       |
| Income taxes                                                                                          |       | —   |       | (130     | )          | —   |       |
| Reserve for returns                                                                                   |       | 173      |       | (18      | )          | (370     | )          |
| Cash used in operating activities                                                                     |       | (172     | )          | (1,987   | )          | (2,443   | )          |
|                                                                                                  |       |     |       |     |       |     |       |
| Investing Activities:                                                                                 |       |     |       |     |       |     |       |
| Purchases of property and equipment                                                                   |       | (18      | )          | (124     | )          | (62      | )          |
| Music catalog additions                                                                               |       | —   |       | —   |       | (63      | )          |
| Other                                                                                                 |       | 15       |       | 27       |       | 27       |       |
| Cash used in investing activities                                                                     |       | (3       | )          | (97      | )          | (98      | )          |
|                                                                                                  |       |     |       |     |       |     |       |
| Financing Activities:                                                                                 |       |     |       |     |       |     |       |
| Borrowings on notes payable                                                                           |       | 2,278    |       | 3,676    |       | 13,946   |       |
| Payments on notes payable                                                                             |       | (1,033   | )          | (1,629   | )          | (12,508  | )          |
| Cash provided by financing activities                                                                 |       | 1,245    |       | 2,047    |       | 1,438    |       |
|                                                                                                  |       |     |       |     |       |     |       |
| Effect of exchange rates on cash                                                                      |       | 74       |       | (61      | )          | 478      |       |
|                                                                                                  |       |     |       |     |       |     |       |
| Net increase (decrease) in cash equivalents                                                           |       | 1,144    |       | (98      | )          | (625     | )          |
|                                                                                                  |       |     |       |     |       |     |       |
| Cash and equivalents at beginning of period                                                           |       | 75       |       | 173      |       | 798      |       |
|                                                                                                  |       |     |       |     |       |     |       |
| Cash and equivalents at end of period                                                                 |       | $        | 1,219      |     | $          | 75       |       | $ | 173 |   |
|                                                                                                  |       |     |       |     |       |     |       |
| Supplemental Cash Flow Information                                                                    |       |     |       |     |       |     |       |
| Cash Paid For -                                                                                       |       |     |       |     |       |     |       |
| Interest                                                                                              |       | $        | 396        |     | $          | 598      |       | $ | 483 |   |
| Income Taxes                                                                                          |       | $        | —     |     | $          | —   |       | $ | 4 |   |
| 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      |       | $ | — |   |

 

*The accompanying notes are an integral part of these financialstatements.*

 

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

**NOTES TO CONSOLIDATED FINANCIAL STATEMENTS**

**JUNE 30,2003, 2002 AND 2001**

 

**1.             BUSINESSAND 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 fewer individual retailers and supplies productssuited to each retailer’s needs. These new 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 Drug Mart, offersprescription drugs from its pharmacy in Canada to persons in the United States.K-tel is merely a licensor of its mark to K-tel Drug Mart. To date, K-tel DrugMart’s operations have not generated any significant licensing revenues for theCompany.

 

Subsidiaries’ Bankruptcy and Liquidation

 

In March 2001, the Company’s music distribution subsidiary in theUnited States, K-tel International (USA), Inc. ceased operations and filedfor protection under Chapter 7 of the U. S. bankruptcy code. In connection withthis filing, the assets and liabilities of this subsidiary were removed fromthe books of the Company as control of the subsidiary was transferred to thebankruptcy trustee. The net liability at the time of this filing was shown as again on the Chapter 7 liquidation. Management believes the Company will have noongoing liability related to this subsidiary as a result of the filing and theoutcome of the bankruptcy proceeding. During the fiscal year ended June 30,2001, this subsidiary had net sales of $11,948,000 and an operating loss of$5,299,000.

 

In November 2000, the Company’s consumer products subsidiary inthe United Kingdom, K-tel Marketing Ltd., ceased operations and began voluntaryliquidation proceedings. At the initial meeting of the creditors on November 24,2000, the creditors voted for the liquidation to become a creditors’liquidation under English law. The Company has not been informed by theliquidators or their counsel of any plan to attempt to hold it or any of itssubsidiaries liable for any of the commitments of K-tel Marketing Ltd.Management believes the Company will have no ongoing material liability relatedto K-tel Marketing Ltd. as a result of the liquidation proceeding. K-telMarketing Ltd. had no operations during the fiscal years ended June 30,2003 and 2002. During fiscal 2001, this subsidiary had net sales of $3,179,000and an operating loss of $3,220,000. Losses in the year ended June 30,2003 of $581,000 and $180,000 in the year ended June 30, 2002 relatedmainly to legal fees incurred in the Tristar litigation (See Note 6.)

 

DiscontinuedOperations

 

The Company’s consumer products business, which was concentrated inEurope, consisted primarily of housewares, consumer convenience items and exerciseequipment. The Company discontinued its consumer products operations inGermany, the United Kingdom and the United States in June 2000, November 2000and January 2001, respectively. Accordingly, these activities have beenpresented in the accompanying financial statements as discontinued operations.Net sales for these operations were $3,818,000 for the fiscal year ended June 30,2001. The accompanying consolidated financial statements have been prepared toreflect the consumer products division as a discontinued operation. The netliabilities of discontinued operations at June 30, 2003 and 2002 consistof assets of $19,000 and $14,000 and liabilities of $135,000 and $106,000.

 

Going Concern

 

For the year ended June 30, 2003, 2002 and 2001, the Companyincurred net losses from continuing operations of $311,000, $414,000 and$10,501,000, respectively, and used $172,000, $1,987,000, and $2,443,000 ofcash in operating activities. Additionally, the Company had a working capitaldeficit of $11,006,000 at June 30, 2003.

 

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The Company’s ability to continue its present operations and implementfuture expansion plans successfully is contingent mainly upon its ability tomaintain its line of credit arrangements with K-5 Leisure Products, Inc.(See Note 3), 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 licensing andlimited music distribution. However, there can be no assurance that the Companywill achieve profitable operations through these efforts. The financialstatements do not include any adjustments that might result from the outcome ofthese uncertainties.

 

**2.             SUMMARYOF SIGNIFICANT ACCOUNTING POLICIES**

 

Principles of Consolidation- The accompanying consolidated financial statements include the accounts ofK-tel International, Inc. and its domestic and foreign subsidiaries, allof which are wholly owned. All significant intercompany accounts andtransactions have been eliminated.

 

Revenue Recognition– The Company derives its revenue mainly from two sources: the sale of musiccompilations (predominately compact discs) produced by the Company, and licenserevenue from the licensing of Company-owned masters. Revenue from music salesis recognized at the time of shipment to the customer, while license revenue isrecognized when payment is received from customers or when known amounts arereceivable, as prior to that date collection is not considered probable. Mostmusic sales are made with a right of return of unsold goods. Estimated reservesfor returns are established by management based upon historical experience andproduct mix and are subject to ongoing review and adjustment by the Company.These reserves are recorded at the time of sale and are reflected as a reductionin revenues. The Company’s reserve for returns was $220,000 at June 30,2003 and $46,000 at June 30, 2002.

 

Cost of Goods Sold –The Company expenses all product manufacturing, distribution and royalty costsassociated with music sales as cost of goods sold. The Company also expensesroyalties, commissions and amortization of its owned master recordingsassociated with its license revenue as costs of goods sold.

 

Shipping and Handling Costs– The Company expenses within cost of goods sold all shipping and handlingcosts incurred in the shipment of goods.

 

Cash and Equivalents– Cash and equivalents consist principally of cash and short-term, highlyliquid investments with original maturities of less than ninety days.

 

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 Catalog Masters– The Company capitalizes the costs to purchase owned master recordings at thetime of acquisition. These costs are amortized over the estimated useful lifeof these master recordings, which is generally seven years and representsmanagement’s best estimate of the average period of value.

 

Rights to Use Music Product -Certain of the Company’s compilation products are master recordings underlicense from record companies and publishers. In most instances, minimumguarantees or non-refundable advances are required to obtain the licenses andare realized through future sales of the product. The amounts paid for minimumguarantees or non-refundable advances are capitalized and charged to expense assales are made. The unrealized portion of guarantees and advances is includedin royalty advances in the accompanying consolidated balance sheets. Licensesare 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 and Equipment- Property and equipment are stated at cost. Depreciation and amortization isprovided using straight line or declining balance methods over the estimateduseful lives of the assets, which range from three 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. During the quarter ended March 31, 2001, the Companysuspended its online business to relocate these operations to the Company’s 

 

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offices in Minnesota and update the website to reflect the Company’scontinuing operations. The Company wrote down the assets of that business toits estimated fair value, resulting in a charge during the quarter ended March 31,2001 of approximately $240,000. In addition, during the quarter ended June 30,2001, the Company wrote down approximately $177,000 of trademarks related toits European operations, which were determined to have no remaining value asthe Company is no longer marketing the products benefited by those trademarks.These charges were included within general and administrative expense.

 

Royalties - TheCompany has entered into license agreements with various record companies andpublishers 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 - TheCompany expenses the costs of advertising when the advertising takes place,except for direct response advertising, which is capitalized and amortized overits expected period of future benefits (usually the period remaining under arelated contract, which is generally less than one year). Direct responseadvertising consists primarily of television advertising whereby customersrespond specifically to the advertising and where the Company can identify theadvertising that elicited the response. Advertising expenses were $200,000,$172,000, and $618,000 for the years ended June 30, 2003, 2002 and 2001,respectively.

 

Foreign Currency -The operations of foreign subsidiaries are measured in local currencies. Assetsand liabilities are translated into U.S. dollars at period-end exchange rates.Revenues and expenses are translated at the average exchange rates prevailingduring the period. Adjustments resulting from translating the financialstatements of foreign entities into U.S. dollars are recorded as a component ofaccumulated other comprehensive income or loss.

 

Stock-based Compensation– The Company accounts for stock-based awards to employees using the intrinsicvalue method prescribed in APB No. 25, “Accounting for Stock Issued toEmployees,” whereby the options are granted at market price, and therefore nocompensation costs are recognized. The Company has elected to retain itscurrent method of accounting as described above and has adopted the SFAS Nos.123 and 148 disclosure requirements. If compensation expense for the Company’svarious stock option plans had been determined based upon the projected fairvalues at the grant dates for awards under those plans in accordance with SFAS No. 123,the Company’s pro-forma net earnings, basic and diluted earnings per commonshare would have been as follows:

 
| ** **                         | ** ** | **Fiscal Year Ended  June 30,** | ** ** |
|------------------------------------|------------|--------------------------------------|------------|
| ** **                         | ** ** | **2003**                             | ** ** | **2002** | ** ** | **2001** | ** ** |
| Net income  (loss) (in thousands): |       |                                 |       |   |   |   |   |
| As reported                        |       | $                                    | (892       | ) | $ | 300 |   | $ | 1,369 |   |
| Pro forma                          |       | $                                    | (907       | ) | $ | (172 | ) | $ | (496 | ) |
|                               |       |                                 |       |   |   |   |   |
| Basic and  Diluted EPS:            |       |                                 |       |   |   |   |   |
| As reported                        |       | $                                    | (.06       | ) | $ | .02 |   | $ | .10 |   |
| Pro forma                          |       | $                                    | (.06       | ) | $ | (.01 | ) | $ | (.04 | ) |

 

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- Basic and diluted net income (loss) per share have been computed by dividingnet income (loss) by the weighted average number of shares outstanding duringthe period. For all periods presented, common stock equivalents were excludedfrom the per share calculation as the net effect would be antidilutive. For thefiscal years ended June 30, 2003, 2002 and 2001, weighted average optionsto purchase 442,900, 2,273,839, and 2,336,889 shares of common stock, withweighted average exercise prices of $1.95, $5.89, and $5.77 were excluded fromthe computation of common share equivalents for the respective periods as theywere antidilutive.

 

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 

 

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financial statements and the reported amounts of revenues and expensesduring the reporting period. Principal estimates include allowances for baddebt, inventory valuation, return reserves, royalty obligations, purchasecommitments and product replacement costs. Actual results could differ fromthose estimates used by management.

 

**3.            ****LOANS PAYABLE TO AFFILIATE**

 

K-tel has a Line of Credit Agreement with K-5 Leisure Products, Inc.(“K-5”), the Company’s largest shareholder controlled by Philip Kives, theChairman of the Board, President and Chief Executive Officer of K-tel. Underthe terms of the agreement (the “K-5 Facility”), K-5 has agreed to makeavailable up to $8,000,000 to K-tel on a revolving basis. The loan bearsinterest at a variable rate based upon the “base rate” of a nationallyrecognized lending institution (4.0% at June 30, 2003), expired July 20, 2005,and is subordinated to the Foothill loan (see below).  The Company is currently in negotiations toextend the Line of Credit Agreement until July 20, 2006. The K-5 Facilitycontains the same covenants as the Foothill loan agreement. K-tel has pledgedthe stock of its foreign subsidiaries as collateral for the loan, and the loancarries a subordinated position to the Foothill loan on all other assets of theCompany. K-tel had outstanding balances of $7,282,000 and $6,026,000 as of June30, 2003 and 2002, respectively, under the K-5 Facility. At June 30, 2003,K-tel obtained a waiver from K-5 for its non-compliance under the covenants,limitations and restrictions of the credit agreement.

 

In addition, K-tel has a second loan agreement with K-5, under whichK-5 assumed rights and obligations under a loan from the Company’s formerbanker (Foothill Capital Corporation) pursuant to an Assignment and AcceptanceAgreement dated February 27, 2001. This Foothill loan, which had been extendedthrough July 20, 2005, (the Company is currently in negotiations to extend theloan agreement until July 20, 2006), 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” of a nationally recognized lending institution plus 1%(5.0% at June 30, 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, 2003and 2002, $4,000,000 was outstanding under the term loan and there were noborrowings under the revolving facility. At June 30, 2003, K-tel obtained awaiver from K-5 for its non-compliance under the covenants, limitations andrestrictions of the credit agreement.

 

K-tel has an overdraft privilege borrowing facility with The Royal Bankof Scotland in the United Kingdom. This facility is secured by a standby letterof credit for $260,000 provided by K-tel International Ltd., a Canadian companycontrolled by Philip Kives and is payable on demand in accordance with normalbanking practices. Borrowings bear interest of 2.0% per annum over the baserate (a total of 5.75% at June 30, 2003) but are subject to a minimum of6.0% per annum. K-tel had outstanding balances of $233,000 and $227,000 as of June 30,2003 and 2002, respectively.

 

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**4.             INCOMETAXES**

 

The Company operates in several countries and is subject to various taxregulations and tax rates. The provisions for income taxes are computed basedon income reported for financial statement purposes in accordance with the tax rules andregulations of the taxing authorities where the income is earned.

 

The provision(benefit) for income taxes consists of the following for the years ended June 30(in thousands):

 
|                                                        |   | **2003** |   | **2002** |   | **2001** |   |
|-------------------------------------------------------------|--------|----------|--------|----------|--------|----------|--------|
| Income (loss) before provision (benefit)  for income taxes: |   |     |   |     |   |     |   |
| United States                                               |   | $        | 196    |     | $      | (295     | )      | $ | 2,871 |   |
| Foreign                                                     |   | (1,088   | )      | 454      |   | (1,598   | )      |
| Total                                                       |   | $        | (892   | )        | $      | 159      |   | $ | 1,273 |   |
|                                                        |   |     |   |     |   |     |   |
| Provision  (benefit) for income taxes:                      |   |     |   |     |   |     |   |
| Current                                                     |   |     |   |     |   |     |   |
| United States                                               |   | $        | — |     | $      | (141     | )      | $ | (100 | ) |
| Foreign                                                     |   | —   |   | —   |   | 4        |   |
|                                                        |   |     |   |     |   |     |   |
| Total  provision (benefit) for income taxes                 |   | $        | — |     | $      | (141     | )      | $ | (96 | ) |

 

Areconciliation of the U.S. Federal statutory rate to the effective tax rate forthe years ended June 30 was as follows:

 
| ** **                           | ** ** | **2003** | ** ** | **2002** | ** ** | **2001** | ** ** |
|--------------------------------------|------------|----------|------------|----------|------------|----------|------------|
| Federal statutory rate               |       | 34       | %          | 34       | %          | 34       | %          |
| State Taxes,  net of Federal benefit |       | 0        |       | 2        |       | 2        |       |
| Valuation  allowance                 |       | (34      | )          | (36      | )          | (36      | )          |
|                                 |       | —   |       | —   |       | —   |       |

 

Deferred income taxes are provided for the temporary differencesbetween the financial reporting basis and the tax basis of the Company’s assetsand liabilities. Temporary differences, which are all deferred tax assets, wereas follows (in thousands):

 
| ** **                       | ** ** | **June 30,  2003** | ** ** | **June 30,  2002** | ** ** |
|----------------------------------|------------|-------------------------|------------|-------------------------|------------|
| Net operating loss carryfowards  |       | $                       | 20,875     |                    | $          | 17,661 |   |
| Alternative  minimum tax credits |       | 432                     |       | 432                     |       |
| Foreign tax  credit              |       | 325                     |       | 325                     |       |
| Reserve for  returns             |       | 852                     |       | 761                     |       |
| Depreciation  and amortization   |       | 199                     |       | 238                     |       |
| Royalty  reserves                |       | 145                     |       | 105                     |       |
| Inventory  reserves              |       | 36                      |       | 40                      |       |
| Nondeductible  accruals          |       | 286                     |       | 310                     |       |
| Allowance  for bad debts         |       | 19                      |       | 29                      |       |
| Valuation  allowance             |       | (23,169                 | )          | (19,901                 | )          |
|                             |       | $                       | —     |                    | $          | — |   |

 

Avaluation allowance equal to the aggregate amount of deferred tax assets hasbeen established until such time as realizability is more likely than not.

 

For U.S. tax reporting purposes, the Company has net operating losscarryforwards (“NOL”) of approximately $58,000,000. However, of the amountavailable through 2013 and 2020, $20,100,000 of the NOL relates to deductionsassociated with the exercise of stock options. The tax benefit of approximately$7,236,000 associated with this stock option deduction will be recorded asadditional paid-in capital when realized. The NOL carryforwards may be reducedin future years, without financial statement benefit, to the extent ofintercompany dividends received from foreign subsidiaries. Also, the NOLcarryforwards are subject to review and possible adjustment by taxingauthorities. In 

 

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addition, the Company has approximately $432,000 in U.S. federalalternative minimum tax credits and $325,000 in foreign tax credits, which maybe utilized in the future to offset any regular corporate income tax liability.

 

**5.****                                      CAPITALTRANSACTIONS**

 

Stock Option Plan

 

The Company has a Stock Option Plan for officers, directors, andemployees of the Company. Under the terms of this plan the Board of Directorshas the sole authority to determine the employees to whom options and awardsare granted, the type, size and terms of the awards, the timing of the grants,the duration of the exercise period and any other matters arising under theplan. The common stock incentives may take the form of incentive stock optionsand nonqualified stock options. The Company’s 1987 plan, which has expired,covered a maximum of 700,000 shares of common stock, of which options for thepurchase of 2,000 shares remain outstanding and exercisable. In February 1997,the Company’s Board of Directors approved a new stock option plan covering amaximum of 600,000 shares of common stock, which was subsequently amended to5,000,000 through shareholder amendments in February 1999, January 2000and November 2000. There were options on 2,613,011 net shares grantedunder this plan as of June 30, 2003. Of these options granted, 2,472,111have been exercised. Any options cancelled are available for future grants. Nooptions granted have expired.

 

Stock Option Exchange

 

On March 18, 2003, a committee of the Company’s board of directorscomprised solely of independent directors, approved a “Stock Option ExchangeProgram.” The program provides for a small number of optionees who were previouslyawarded options to purchase shares of common stock under the Company’s 1997Stock Option Plan to exchange them for options to purchase an equal number ofshares outside the Company’s Stock Option Plan. The options to purchase anaggregate 2,137,939 shares of common stock have a weighted average price pershare of $5.95. Replacement options were issued six months and one day afterthe date of cancellation on November 18, 2003 of the existing options andwere issued at an exercise price per share equal to the fair market value ofthe Company’s common stock as quoted on the OTC Bulletin Board on the date ofgrant of $.08 per share and expire ten years after the date of grant. Nocompensation expense was recognized as a result of this exchange.

 

Restricted and Non-Qualified Stock Options

 

In addition to stock options granted under the terms of the StockOption Plan, the Board of Directors has the sole authority to grant employees,officers and directors incentive stock options and non-qualified stock optionsoutside the Stock Option Plan. The Board of Directors determines the type, sizeand terms of the grants, timing of the grants, the duration of the exerciseperiod and any other matters pertaining to options or awards granted outside ofthe Stock Option Plan. There were options on 355,000 net shares granted outsidethe Stock Option Plan as of June 30, 2003.

 

26

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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, 2000 |       | 2,210,556           |       | 497,000           |       | $                  | 6.72       |   |
|                           |       |                |       |              |       |               |       |
| Granted                        |       | 310,000             |       | 75,000            |       | 1.06               |       |
| Cancelled                      |       | (228,167            | )          | (527,500          | )          | 6.49               |       |
| 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       |   |

 

----

(1)           Adjustment reflects options disclosed previously asincentive that should have been recorded as non-qualified.

 

Thefollowing tables summarize information concerning currently outstanding andexercisable stock options at June 30, 2003:

 

| **Options Outstanding** | ** **  |
|-------------------------|-------------|
| **Exercise Prices**     | ** **  | ** ** | ** ** | **Weighted Average** | ** ** |
| ** **              | ** **  | **Weighted** | ** ** | **Number** | ** ** | **Remaining** | ** ** |
| **Range**               | ** **  | **Average** | ** ** | **of Shares** | ** ** | **Contractual Life** | ** ** |
| $                       | 0.05        |   | $ | 0.05 |   | 310,000 |   | 9.4 years |   |
| $                       | 1.75        |   | $ | 1.75 |   | 1,000 |   | 3.3 years |   |
| $                       | 3.06 - 3.38 |   | $ | 3.29 |   | 1,400 |   | 3.6 years |   |
| $                       | 5.51 - 6.00 |   | $ | 5.66 |   | 97,500 |   | 6.6 years |   |
| $                       | 8.73        |   | $ | 8.73 |   | 33,000 |   | 5.7 years |   |
|                    |        |   |   | 442,900 |   |   |   |

 

| **Options Exercisable** | ** **  | ** **   | ** ** |
|-------------------------|-------------|--------------|------------|
| **Exercise Prices**     | ** **  | ** **   | ** ** | ** ** | ** ** |
| ** **              | ** **  | **Weighted** | ** ** | **Number** | ** ** | ** ** | ** ** |
| **Range**               | ** **  | **Average**  | ** ** | **of Shares** | ** ** | ** ** | ** ** |
| $                       | 0.05        |         | $          | 0.05 |   | 310,000 |   |   |   |
| $                       | 1.75        |         | $          | 1.75 |   | 1,000 |   |   |   |
| $                       | 3.06 - 3.38 |         | $          | 3.29 |   | 1,400 |   |   |   |
| $                       | 5.51 - 6.00 |         | $          | 5.66 |   | 97,500 |   |   |   |
| $                       | 8.73        |         | $          | 8.73 |   | 33,000 |   |   |   |
|                    |        |         |       | 442,900 |   |   |   |

 

The weighted average fair value of options granted in fiscal 2003 was$.05 and fiscal 2001 was $1.06. No options were granted in fiscal 2002. Becausethe fair value provisions have not been applied to options granted prior to June 30,1995, the resulting pro forma compensation cost (See Note 1) may not be representativeof that to be expected in future years.

 

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Thefair value of each option is estimated on the date of grant using theBlack-Scholes option pricing model. The following assumptions were used to estimatethe fair value of options:

 
| ** **               | ** ** | **2003** | ** ** | **2002** | ** ** | **2001** | ** ** |
|--------------------------|------------|----------|------------|----------|------------|----------|------------|
|                     |       |     |       |     |       |     |       |
| Risk-free  interest rate |       | 4.00     | %          | 5.00     | %          | 5.00     | %          |
| Expected  life           |       | 10 years |       | 5 years  |       | 5 years  |       |
| Expected  volatility     |       | 220      | %          | 150      | %          | 150      | %          |
| Expected  dividend yield |       | None     |       | None     |       | None     |       |

 

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

 

RTL ShoppingS. A.

 

The Company has been named in a lawsuit filed in France brought byRTL9, a French cable TV station. The action seeks damages in the approximateamount of 20 million French Francs, or approximately $2.8 million. Initially,RTL9 was named as a defendant in a suit brought by a competitor of K-telMarketing Ltd. alleging that RTL9 ran a commercial for K-tel Marketing whichpresented a product under brand names alleged to infringe on the competitor’sown trademarks and also translated an English language script indicating thatthe product was “just like” or “as good as” others into “better than” inFrench, 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 indemnificationprovision the 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 May 28,2001, 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 (USA)’s Chapter 7bankruptcy filing.

 

After the Company advised the Court that RTL9 had no basis for acomplaint against the Company, RTL9 proposed to drop its lawsuit. On September 23,2003, RTL9 and the Company signed an agreement terminating the suit. The finaldisposition of the lawsuit was confirmed by the Court at a trial hearinginvolving only the two remaining parties to the lawsuit.

 

K-tel International, Inc. vs. TristarProducts, Inc. 

 

On March 14, 2000, K-tel and its subsidiary in Germany commencedan action for breach of express and implied warranties against DefendantTristar Products, Inc. This action arose out of Tristar’s sale to K-tel ofa defective home exercise product called the “BunBlaster” for resale inGermany, Austria and Switzerland. By written contract, Tristar has agreed toindemnify K-tel for injuries and damages arising out of the resale of thosegoods.

 

On April 30, 2001, Tristar also asserted a patentand trademark/ trade-dress counterclaim against K-tel for allegedly passing offa product 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 Releaseand Settlement 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 February 18,2005.

 

#### Other Litigation and Disputes

 

K-tel and its subsidiaries are also involved in other legal actions inthe ordinary course of their business. With all litigation matters, managementconsiders the likelihood of loss based on the facts and circumstances. Ifmanagement determines that a loss is probable and the amount of loss can bereasonably estimated, such amount is recorded as a liability. Although theoutcome of any such legal actions cannot be predicted, in the opinion ofmanagement there is currently no legal proceeding pending or asserted againstor involving K-tel for which the outcome is likely to have a material adverseeffect upon the consolidated financial position or results of operations ofK-tel.

 

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Leases

 

The Company has entered into several office and warehouse leases whichexpire through 2005. Commitments under these leases are $210,576 in 2004, and$46,490 in 2005. Rental expense was $253,523 in 2003, $216,327 in 2002, and $654,000in 2001.

 

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

 

Three customers, Madacy Entertainment Group, Inc., AndersonMerchandisers and Handleman Company accounted for approximately 19.2%, 14.9%and 11.5% respectively, of K-tel’s revenue for the year ended June 30,2003. The loss of, or a substantial reduction in, business from any of thesecustomers would have a material adverse effect on the Company.

 

See Note 3 forinformation regarding debt transactions with related parties.

 

The Company purchased approximately $463,000 in the year ended June 30,2003, $366,000 in the year ended June 30, 2002 and $574,000 in the yearended June 30, 2001 of music entertainment and consumer convenienceproducts from K-5, the Company’s largest shareholder, which is controlled byPhilip Kives, Chairman of the Board, President and Chief Executive Officer ofK-tel. There were trade payables to K-5 of $371,000 at June 30, 2003,$291,000 at June 30, 2002 and $285,000 at June 30, 2001.

 

The Company had no sales of consumer convenience products to K-5 duringthe years ended June 30, 2003 and 2002, and sales of $13,000 during theyear ended June 30, 2001. There was a balance receivable from K-5 at June 30,2003 of  $73,000, June 30, 2002 of$129,000, and June 30, 2001 of $109,000. No interest was charged on therelated outstanding balances during fiscal years 2003, 2002 and 2001.

 

**8.             RETIREMENT PLANS**

 

Pension Plan

 

The Company has a pension plan for its U.K. employees. Companycontributions to the Plan on behalf of eligible employees were terminatedeffective February 15, 2001 and all benefit accruals under the Plan ceasedat that time. Summary plan information is as follows:

 
| ** **                                      | ** ** | **(In Thousands)  Pension Benefits** | ** ** |
|-------------------------------------------------|------------|--------------------------------------|------------|
| ** **                                      | ** ** | **2003**                             | ** ** | **2002** | ** ** |
| Net periodic  cost:                             |       |                                 |       |   |   |
| Interest  cost                                  |       | $                                    | 23         |   | $ | 19 |   |
| Expected  return on assets                      |       | (63                                  | )          | (10 | ) |
| Amortization  of transition amount              |       | (15                                  | )          | (13 | ) |
| Actuarial  loss                                 |       | —                               |       | — |   |
| Net periodic  benefit cost                      |       | $                                    | (55        | ) | $ |  (4 | ) |
|                                            |       |                                 |       |   |   |
| Change in  benefit obligation:                  |       |                                 |       |   |   |
| Benefit  obligation at beginning of year        |       | $                                    | 417        |   |   |   |
| Interest  cost                                  |       | 23                                   |       |   |   |
| Actuarial  loss                                 |       | 324                                  |       |   |   |
|                                            |       |                                 |       |   |   |
| Benefit  obligation at end of year              |       | $                                    | 764        |   |   |   |
|                                            |       |                                 |       |   |   |
| Change in  plan assets:                         |       |                                 |       |   |   |
| Fair value  of plan assets at beginning of year |       | $                                    | 601        |   |   |   |
| Actual  return on plan assets                   |       | $                                    | 111        |   |   |   |
|                                            |       |                                 |       |   |   |
| Fair value  of plan at end of year              |       | $                                    | 712        |   |   |   |

 

TheCompany is not expected to contribute to the plan in fiscal 2004.

 

TheCompany’s pension plan asset allocations are as follows at June 30:

 

29

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| ** **                    | ** ** | **Percentage of Plan Assets** | ** ** |
|-------------------------------|------------|-------------------------------|------------|
| ** **                    | ** ** | **2004**                      | ** ** | **2003** | ** ** |
| Asset  category:              |       |                          |       |   |   |
|                          |       |                          |       |   |   |
| Short-tem  liquid investments |       | 100                           | %          | 100 | % |

 

The Company’s investment strategy with respect topension plan assets is to continue to hold the plan assets in a depositadministration fund, which is similar to a bank account. Interest is added tothe fund at a rate declared by Swiss Life.

 
| **(In Thousands)**                   | ** ** | **2003** | ** ** |
|--------------------------------------|------------|----------|------------|
| Reconciliation  of funded status:    |       |     |       |
| Funded  status                       |       | $        | (51        | ) |
| Unrecognized  actuarial loss         |       | 180      |       |
| Unrecognized  transaction obligation |       | (183     | )          |
|                                 |       |     |       |
| Unfunded  accrued pension cost       |       | $        | (54        | ) |

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

 

At June 30, 2003, the projected benefit obligation, accumulatedbenefit obligation and fair value of plan assets for pension plans with aprojected benefit obligation in excess of plan assets, and pension plans withan accumulated benefit obligation in excess of plan assets, were are follows:

 
| ** **                      | ** ** | **(In thousands)**             | ** ** |
|---------------------------------|------------|--------------------------------|------------|
| ** **                      | ** ** | **Project Benefit Obligation** | ** ** | **Accumulated Benefit** | ** ** |
| ** **                      | ** ** | **Exceeds the Fair Value of**  | ** ** | **Obligation Exceeds the Fair** | ** ** |
| ** **                      | ** ** | **Plan’s Assets**         | ** ** | **Value of Plan’s Assets** | ** ** |
| ** **                      | ** ** | **June 30,**              | ** ** | **June 30,** | ** ** |
| ** **                      | ** ** | **2003**                       | ** ** | **2003** | ** ** |
| Projected  benefit obligation   |       | $                              | 764        |   | $ | 764 |   |
| Accumulated  benefit obligation |       | 764                            |       | 764 |   |
| Fair Value  of plan assets      |       | 712                            |       | 712 |   |
|                                 |            |                                |            |  |  |  |  |

 

The Company’s accumulatedbenefit obligation of $764,000 at June 30, 2003 exceeded the fair value ofthe plan’s assets at June 30, 2003. This amount has been accrued as of June 30, 2003; there was noadditional minimum liability in 2003. 

 

30

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WEIGHTED-AVERAGE ASSUMPTIONS USED TO DETERMINE NET PERIODIC COST FORTHE YEARS ENDED JUNE 30:

 
| ** **                      | ** ** | **2003** | ** ** | **2002** | ** ** |
|---------------------------------|------------|----------|------------|----------|------------|
| Discount  rate                  |       | 9        | %          | 5        | %          |
| Expected  return on plan assets |       | 5        | %          | 5        | %          |
| Rate of  compensation increase  |       | 0        | %          | 0        | %          |

 

WEIGHTED-AVERAGE ASSUMPTION USED TO DETERMINE BENEFITOBLIGATIONS AS OF JUNE 30:

 
| ** **                     | ** ** | **2003** | ** ** |   |   |
|--------------------------------|------------|----------|------------|--------|--------|
| Discount  rate                 |       | 5        | %          |   |   |
| Rate of compensation  increase |       | N/A      |       |   |   |

 

Money Purchase Plan

 

The Company’s U.K. subsidiaries contribute amounts for their employeesto a money purchase defined contribution plan. The Company contributed $51,000and $26,000 for the years ended June 30, 2003 and 2002.

 

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

 

The Company markets and distributes entertainmentproducts internationally and through its operating subsidiaries. K-tel’sbusinesses are organized, managed and internally reported as three segments:retail music sales, music licensing and other, which consists primarily ofe-commerce (which was closed in the fourth quarter of fiscal 2002). Thesesegments are based on differences in products, customer type and sales anddistribution methods. The Company’s consumer product operations have beendiscontinued and are presented in the accompanying financial statements asdiscontinued operations and are therefore not included in the segmentinformation.

 

The retail music segment consists primarily of the sales of pre-recordedmusic both from the Company’s music master catalog and under licenses obtainedfrom other record companies. The Company sells compact discs and DVD’s directlyto retailers, wholesalers and rack service distributors which stock and manageinventory within music departments for retail stores.

 

In the licensing segment, the Company licenses the rights to its mastermusic catalog, consisting of original recordings and re-recordings of musicfrom the 1950’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 profits or losses of these segments include an allocation ofgeneral corporate expenses. Depreciation and amortization and capital additionsare not significant and have therefore been excluded from presentation.

 

Certain financial information on the Company’s continuing operatingsegments is as follows:

 

BUSINESSSEGMENT INFORMATION

 
| **Fiscal Years Ended  June 30,** | ** ** | ** ** | ** ** | **Music**  | ** ** | **Licensing** | ** ** | **Other**  | ** ** | **Corporate  Eliminations** | ** ** | **Total  Company** | ** ** |
|---------------------------------------|------------|------------|------------|------------|------------|---------------|------------|------------|------------|-----------------------------|------------|--------------------|------------|
| **(in thousands)**                    | ** ** | ** ** | ** ** | ** ** | ** ** | ** **    | ** ** | ** ** | ** ** | ** **                  | ** ** | ** **         | ** ** |
|                                  |       |       |       |       |       |          |       |       |       |                        |       |               |       |
| Net Sales                             |       | 2003       |       | $          | 4,454      |          | $          | 2,780      |       | $                           | —     |               | —     |   | $ | 7,234 |   |
|                                  |       | 2002       |       | 3,773      |       | 3,118         |       | —     |       | —                      |       | 6,891              |       |
|                                  |       | 2001       |       | 14,202     |       | 3,710         |       | 365        |       | (763                        | )          | 17,514             |       |
|                                  |       |       |       |       |       |          |       |       |       |                        |       |               |       |
| Operating  Income (Loss)              |       | 2003       |       | $          | (1,010     | )             | $          | 1,159      |       | $                           | —     |               | —     |   | $ | 149 |   |
|                                  |       | 2002       |       | (1,439     | )          | 1,393         |       | —     |       |                        |       | (46                | )          |
|                                  |       | 2001       |       | (7,749     | )          | 425           |       | (2,156     | )          | —                      |       | (9,480             | )          |
|                                  |       |       |       |       |       |          |       |       |       |                        |       |               |       |
| Assets                                |       | 2003       |       | $          | 2,900      |          | $          | 2,128      |       | $                           | 273        |               | —     |   | $ | 5,301 |   |
|                                  |       | 2002       |       | 2,679      |       | 1,668         |       | 121        |       | 142                         |       | 4,610              |       |
|                                  |       | 2001       |       | 1,501      |       | 1,650         |       | 443        |       | 238                         |       | 3,832              |       |

 

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GEOGRAPHIC INFORMATION

 
| **Fiscal Years Ended  June 30,** | ** ** | ** ** | ** ** | **United States** | ** ** | **Europe** | ** ** | **Total**  | ** ** |
|---------------------------------------|------------|------------|------------|-------------------|------------|------------|------------|------------|------------|
| **(in thousands)**                    | ** ** | ** ** | ** ** | ** **        | ** ** | ** ** | ** ** | ** ** | ** ** |
| Net Sales                             |       | 2003       |       | $                 | 4,949      |       | $          | 2,285      |       | $ | 7,234 |   |
|                                  |       | 2002       |       | 3,949             |       | 2,942      |       | 6,891      |       |
|                                  |       | 2001       |       | 13,914            |       | 3,600      |       | 17,514     |       |
|                                  |       |       |       |              |       |       |       |       |       |
| Assets                                |       | 2003       |       | $                 | 3,889      |       | $          | 1,412      |       | $ | 5,301 |   |
|                                  |       | 2002       |       | 2,792             |       | 1,818      |       | 4,610      |       |
|                                  |       | 2001       |       | 2,042             |       | 1,790      |       | 3,832      |       |

 

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

 

In December 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 January 31,2003 and it applies in the first fiscal year or interim period beginning after March 15,2004, to variable interest entities in which an enterprise holds a variableinterest that is acquired before February 1, 2003. This pronouncement willhave an effect on the Company’s consolidated financial position and results ofoperations as the Company will consolidate a variable interest entity in thequarter ending March 31, 2004.

 

In December 2002, the FASB issued Statement 148 (FAS 148), *Accounting for Stock-Based Compensation Transitionand Disclosure.* FAS 148 amends the disclosure and certain transitionprovisions of Statement 123, *Accounting forStock-Based Compensation.* Its disclosure provisions, which apply toall entities with employee stock-based compensation, are effective for fiscalyears ending after December 15, 2002. New interim period disclosures arerequired in financial statements for interim periods beginning after December 15,2002. This pronouncement is not anticipated to have a material effect on theCompany’s consolidated financial position or results of operations.

 

In November 2002, the FASB issued FASB Interpretation No. 45(FIN 45), *Guarantor’s Accounting andDisclosure Requirements for Guarantees, Including Indirect Guarantees ofIndebtedness of Others.*FIN 45 addresses the disclosure requirementsof a guarantor in its interim and annual financial statements about itsobligations under certain guarantees that is has issued. FIN 45 also requires aguarantor to recognize, at the inception of a guarantee, a liability for thefair value of the obligation undertaken in issuing the guarantee. Thedisclosure requirements of FIN 45 are effective for the Company for its quarterended December 31, 2002. The liability recognition requirement isapplicable prospectively to all guarantees issued or modified after December 31,2002. This pronouncement is not anticipated to have a material effect on theCompany’s consolidated financial position or results of operations.

 

In June 2002, the Financial Accounting Standards Board (FASB)issued Statement of Financial Accounting Standards No. 146 (SFAS 146), *Accounting for Costs Associated with Exit or DisposalActivities*. SFAS 146 provides financial accounting and reportingguidance for costs associated with exit or disposal activities, includingone-time termination benefits, contract termination costs other than for acapital lease, and costs to consolidate facilities or relocate employees. Thisstatement is effective for exit or disposal activities that are initiated afterDecember 31, 2002. Management does not believe this pronouncement willhave a material effect on the Company’s consolidated financial position andresults of operations.

 

In May 2003, the FASB issued Statement 150, Accounting for CertainFinancial Instruments 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 150is not anticipated to have an impact on the Company’s consolidated financialposition or results of operations.

 

InDecember 2004, the FASB issued SFAS No. 123R, *Share-Based Payment*, which replaced SFAS No. 123and superseded APB 25. SFAS No. 123R addresses the accounting forshare-based payment transactions in which a company 

 

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receivesemployee services in exchange for either equity instruments of the company orliabilities that are based on the fair value of the company’s equityinstruments or that may be settled by the issuance of such equity instruments.Under SFAS No. 123R, companies will no longer be able to account for theshare-based compensation transactions using the intrinsic method in accordancewith APB 25 but will be required to account for such transactions using afair-value method and recognize the expense in the consolidated statement ofoperations. SFAS No. 123R is effective beginning in the Company’s firstquarter of fiscal year 2006. Under SFAS 123R, the Company must determine theappropriate fair value model to be used for valuing share-based payments, theamortization method for compensation cost and the transition method to be usedat date of adoption. The transition methods include prospective and retroactiveadoption options. The Company has begun, but has not completed, evaluating theimpact of the adoption of SFAS 123R on its results of operations. In connectionwith evaluating the impact of SFAS 123R, the Company is considering thepotential implementation of different valuation methods to determine the fairvalue of share-based compensation. The Company believes the adoption of SFAS123R will not have a material impact on our results of operations, regardlessof the valuation method used.

 

**11.          RESTATEMENTS**

 

In September 2004, the Company discovered that the former ChiefFinancial Officer of its UK subsidiary misappropriated funds from the Company’sUK subsidiary and a customer of such subsidiary. The Company terminated theemployee, undertook a full-scale investigation of the matter, retained aforensic auditing firm and dismissed the accounting firm in the UK that auditedthe UK subsidiary’s financial books and records. Based upon the estimates ofthe Company’s forensic auditor, it was determined that the former employeemisappropriated approximately $914,200 from the Company’s UK subsidiary andapproximately $343,588 from a customer of such subsidiary beginningapproximately in January 2001 and continuing until September 2004.Further, the Company spent approximately $150,862 investigating themisappropriation. Through negotiations with the former employee, the Company’sUK subsidiary and its customer have recovered an aggregate of approximately$1,493,076 and interest of approximately $1,919. Approximately $99,640 remainsoutstanding. The Company’s UK subsidiary has received a deed of guarantee inconnection with this remaining obligation and it expects to collect theremaining amount owed on or before February 15, 2008.

 

The effect of the misappropriation was to overstate product costs by$9,000, $21,000, $24,000 and $27,000 and selling and general and administrativeexpenses by $14,000, $10,000, $32,000 and $13,000 for the quarters ending September 30,2002, December 31, 2002, March 31, 2003 and June 30, 2003,respectively.

 

For the fiscal year ending June 30, 2002, the misappropriationunderstated sales by $16,000 in the quarter ending September 30, 2001.Product costs were overstated by $74,000, $10,000, $35,000 and $13,000 andselling and general and administrative expenses by $102,000, $9,000, $16,000and $11,000 for the quarters ending September 30, 2001, December 31,2001, March 31, 2002 and June 30, 2002, respectively.

 

Statementsof operations previously reported for each of the quarters of fiscal year 2003and 2002 in the Company’s Form 10-Qs are restated as follows:

 

 

Quarterly Financial Information (Unaudited)

 
| ** **                                                           | ** ** | **Three Months Ended,**      | ** ** |
|----------------------------------------------------------------------|------------|------------------------------|------------|
| **AS FILED**                                                         | ** ** | **September 30,  2002** | ** ** | **December 31,  2002** | ** ** | **March 31,  2003** | ** ** | **June 30,  2003** | ** ** |
| Total revenues                                                       |       | $                            | 1,498      |   | $ | 1,874 |   | $ | 1,923 |   | $ | 1,939 |   |
| Gross profit                                                         |       | $                            | 899        |   | $ | 977 |   | $ | 933 |   | $ | 1,244 |   |
| Total cost and expenses                                              |       | $                            | 997        |   | $ | 978 |   | $ | 1,109 |   | $ | 918 |   |
| Income (loss) from operations                                        |       | $                            | (98        | ) | $ | (1 | ) | $ | (174 | ) | $ | 326 |   |
| Net income (loss)                                                    |       | $                            | (508       | ) | $ | (389 | ) | $ | (439 | ) | $ | 348 |   |
| Basic and diluted net income (loss) per  common share                |       | $                            | (.04       | ) | $ | (.03 | ) | $ | (.03 | ) | $ | .03 |   |
| Shares used in computing basic and  dilutednet loss per common share |       | 13,654                       |       | 13,654 |   | 13,654 |   | 13,654 |   |

 

33

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| ** **                                                           | ** ** | **Three Months Ended,**      | ** ** |
|----------------------------------------------------------------------|------------|------------------------------|------------|
| **AS RESTATED**                                                      | ** ** | **September 30,  2002** | ** ** | **December 31,  2002** | ** ** | **March 31,  2003** | ** ** | **June 30,  2003** | ** ** |
| Total revenues                                                       |       | $                            | 1,498      |   | $ | 1,874 |   | $ | 1,923 |   | $ | 1,939 |   |
| Gross profit                                                         |       | $                            | 908        |   | $ | 998 |   | $ | 957 |   | $ | 1,271 |   |
| Total cost and expenses                                              |       | $                            | 983        |   | $ | 968 |   | $ | 1,077 |   | $ | 957 |   |
| Income (loss) from operations                                        |       | $                            | (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  dilutednet loss per common share |       | 13,654                       |       | 13,654 |   | 13,654 |   | 13,654 |   |

 

Quarterly Financial Information(Unaudited)

 
| ** **                                                           | ** ** | **Three Months Ended,**      | ** ** |
|----------------------------------------------------------------------|------------|------------------------------|------------|
| **AS FILED**                                                         | ** ** | **September 30,  2001** | ** ** | **December 31,  2001** | ** ** | **March 31,  2002** | ** ** | **June 30,  2002** | ** ** |
| Total revenues                                                       |       | $                            | 1,381      |   | $ | 2,104 |   | $ | 1,766 |   | $ | 1,624 |   |
| Gross profit                                                         |       | $                            | 859        |   | $ | 1,210 |   | $ | 1,047 |   | $ | 1,274 |   |
| Total cost and expenses                                              |       | $                            | 1,257      |   | $ | 1,062 |   | $ | 1,175 |   | $ | 1,228 |   |
| Income (loss) from operations                                        |       | $                            | (398       | ) | $ | 148 |   | $ | (128 | ) | $ | 46 |   |
| Net income (loss)                                                    |       | $                            | (504       | ) | $ | (107 | ) | $ | (307 | ) | $ | 932 |   |
| Basic and diluted net income (loss) per  common share                |       | $                            | (.04       | ) | $ | (.01 | ) | $ | (.02 | ) | $ | .07 |   |
| Shares used in computing basic and  dilutednet loss per common share |       | 13,654                       |       | 13,654 |   | 13,654 |   | 13,654 |   |

 
| ** **                                                           | ** ** | **Three Months Ended,**      | ** ** |
|----------------------------------------------------------------------|------------|------------------------------|------------|
| **AS RESTATED**                                                      | ** ** | **September 30,  2001** | ** ** | **December 31,  2001** | ** ** | **March 31,  2002** | ** ** | **June 30,  2002** | ** ** |
| Total revenues                                                       |       | $                            | 1,397      |   | $ | 2,104 |   | $ | 1,766 |   | $ | 1,624 |   |
| Gross profit                                                         |       | $                            | 949        |   | $ | 1,220 |   | $ | 1,082 |   | $ | 1,287 |   |
| Total cost and expenses                                              |       | $                            | 1,155      |   | $ | 1,053 |   | $ | 1,159 |   | $ | 1,217 |   |
| Income (loss) from operations                                        |       | $                            | (206       | ) | $ | 167 |   | $ | (77 | ) | $ | 70 |   |
| Net income (loss)                                                    |       | $                            | (312       | ) | $ | (88 | ) | $ | (256 | ) | $ | 956 |   |
| Basic and diluted net income (loss) per  common share                |       | $                            | (.02       | ) | $ | (.01 | ) | $ | (.02 | ) | $ | .07 |   |
| Shares used in computing basic and  dilutednet loss per common share |       | 13,654                       |       | 13,654 |   | 13,654 |   | 13,654 |   |

 

34

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**SCHEDULE II**

 

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

 

**VALUATION AND QUALIFYING ACCOUNTS**

 

Years ended June 30,

(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 |       |                                 |       |                                             |       |                                |       |           |       |                          |       |
|                            |       |                                 |       |                                             |       |                                |       |           |       |                          |       |
| 2003                            |       | $                                    | 68         |                                             | $          | 62                                  |       | $              | 9          |                          | $          | (114 | )(2) | $ | 25 |   |
| 2002                            |       | $                                    | 33         |                                             | $          | 50                                  |       | $              | 5          |                          | $          | (20 | )(2) | $ | 68 |   |
| 2001                            |       | $                                    | 1,416      |                                             | $          | (41                                 | )          | $              | (4         | )                             | $          | (1,338 | )(2) | $ | 33 |   |
|                            |       |                                 |       |                                             |       |                                |       |           |       |                          |       |
| Reserve for Returns             |       |                                 |       |                                             |       |                                |       |           |       |                          |       |
|                            |       |                                 |       |                                             |       |                                |       |           |       |                          |       |
| 2003                            |       | $                                    | 46         |                                             | $          | 447                                 |       | $              | —     |                          | $          | (273 | ) | $ | 220 |   |
| 2002                            |       | $                                    | 50         |                                             | $          | 55                                  |       | $              | 6          |                          | $          | (65 | ) | $ | 46 |   |
| 2001                            |       | $                                    | 4,623      |                                             | $          | 45                                  |       | $              | (3         | )                             | $          | (4,615 | ) | $ | 50 |   |

 

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(1) Exchange rate change

(2) Uncollectible accounts written off,net of recoveries

 

35

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**EXHIBIT INDEX**

 
| **Exhibit No.** | ** ** | **Description of Exhibit**                                                                                                                                                                                                                                                                                                                     |
|----------------------|------------|------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|
|                 |       |                                                                                                                                                                                                                                                                                                                                           |
| 3.1                  |       | Restated Articles of Incorporation, as  amended.*                                                                                                                                                                                                                                                                                              |
|                 |       |                                                                                                                                                                                                                                                                                                                                           |
| 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 reference to the Company’s Quarterly Report on  Form 10-Q for the fiscal quarter ended December 31,                    |

 

36

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|   |   | 2001 (File No. 1-07115)).                                                                                                                                                                                                                                                                     |
|--------|--------|----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|
|   |   |                                                                                                                                                                                                                                                                                               |
| 10.13  |   | Credit Agreement between the Company and  K-5 Leisure Products, Inc. dated September 27, 1999.*                                                                                                                                                                                          |
|   |   |                                                                                                                                                                                                                                                                                               |
| 10.14  |   | $8,000,000 principal amount Note between  the Company and K-5 Leisure Products, Inc. dated September 27,  1999.*                                                                                                                                                                         |
| 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)).* |
|   |   |                                                                                                                                                                                                                                                                                               |
| 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.                                                                                                                                                                                                                            |
|   |   |                                                                                                                                                                                                                                                                                               |
| 31.2   |   | Certification by Chief Financial Officer  pursuant to Rule 13a-14.                                                                                                                                                                                                                            |
|   |   |                                                                                                                                                                                                                                                                                               |
| 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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* Previously filed.

 

37

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