**UNITED STATESSECURITIES AND EXCHANGE COMMISSION**

**Washington,D.C. 20549**

**FORM 10-K**

| **(MARK ONE)** |
|----------------|
| **x**          |   | **ANNUAL  REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934** |
|           |   |   |   |
|           |   | **For the fiscal year  ended June 30, 2005** |   |
|           |   |   |   |
|           |   | **OR** |   |
|           |   |   |   |
| **o**          | ** ** | **TRANSITION  REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934** |
|           |   |   |   |
|           |   | **For the transition  period from                 to                ** |   |

 

**Commissionfile number 1-07115**

**K-TEL INTERNATIONAL, INC.**

(Exact name ofregistrant as specified in its charter)

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

 

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

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

**None**

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

**Common Stock, par value $0.01**

(Title of class)

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

Yes o    No x

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

Yes o    No x

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

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

Indicate by checkmark whether the registrant is a large accelerated filer, an accelerated filer,or a non-accelerated filer.  Seedefinition of “accelerated filer and large accelerated filer”  in Rule 12b-2 of the Exchange Act.
| Large Accelerated Filer o |   | Accelerated Filer o |   | Non-Accelerated Filer x |
|---------------------------|--------|---------------------|--------|-------------------------|

 

Indicate by check markwhether the registrant is a shell company (as defined in Rule 12b-2 of theExchange Act).

Yes oNo x

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

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

DOCUMENTSINCORPORATED BY REFERENCE

None.

 

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

 

**SAFE HARBOR STATEMENT UNDER THE**

**PRIVATESECURITIES LITIGATION REFORM ACT OF 1995**

Certain statements of a non-historical nature underthe caption “Management’s Discussion and Analysis of Financial Condition andResults of Operations” and elsewhere in this Form 10-K constitute “forward-lookingstatements” within the meaning of the Private Securities Litigation Reform Actof 1995. Such forward-looking statements may be identified by the use ofterminology such as “may,” “will,” “expect,” “anticipate,” “estimate,” “should,”or “continue” or the negative thereof or other variations thereon or comparableterminology. Such forward-looking statements are subject to certain risks anduncertainties that could cause actual results to differ materially from historicalresults or from those results currently anticipated or projected. Such factorsinclude, among other things, the following: changes in consumer purchasing;demand for and market acceptance of new and existing products; the impact fromcompetition for recorded music; the outcome of legal proceedings; dependence onsuppliers and distributors; success of marketing and promotion efforts;technological changes and difficulties; availability of financing; foreigncurrency variations; general economic, political and business conditions; andother matters. See “Risk Factors” in Item 1A for additional information.  We undertake no obligation to releasepublicly the result of any revisions to these forward-looking statements,except as required by law.

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**PART I**

**ITEM1:  BUSINESS**

K-telInternational, Inc. (the “Company”, “K-tel” or the “registrant”) wasincorporated in 1968 and currently has its corporate offices located inPlymouth, Minnesota. Through its operating subsidiaries, K-tel licenses itsmusic catalog internationally and markets entertainment products mainly derivedfrom its catalog through retail and direct response marketing channels in theUnited States and Europe. The Company has a focused method of distribution thattargets the strengths of selected individual retailers and supplies productssuited to each retailer’s needs. These products are derived mainly from theCompany’s master recordings music catalog with the objective of realizing morecompetitive profit margins. K-tel seeks to license its trademarks to othercompanies in businesses unrelated to K-tel’s current operations. Licenses aregranted for a royalty or fee, with no cost to the Company.

Description ofBusinesses

Music Licensing and Sales

K-tel’s primary activity is marketing and distributing pre-recordedcompact discs utilizing the Company’s master recordings in its music catalog.Customers include retailers, wholesalers and rack service distributors. Theseproducts are also sold through subsidiaries and licensees in the United States,United Kingdom and elsewhere in Europe. The principal entertainment productsthat K-tel markets and sells consist primarily of pre-recorded thematic musicpackages in a compilation format featuring various artists. These thematicmusic selections, which cover nearly all music genres, are targeted at avariety of age groups. K-tel provides marketing support for its music salesthrough cooperative advertising with retailers, print media, radio andtelevision advertising, and in-store promotions and displays.

The Company also licenses music to other record companies and to othersegments of the entertainment industry. K-tel owns a proprietary master musiccatalog of approximately 6,000 titles consisting of original recordings andre-recordings of music from the 1950’s through today. The Company licenses therights to its master recordings to third parties worldwide for use in albums,which typically last three to five years, and is based on the number of unitssold. The Company also licenses its master recordings for films, televisionprograms, commercials and electronic downloads to various media formats, foreither a flat fee or a royalty based on the number of units sold. Licensing ofits proprietary music rights to third parties has historically been animportant revenue source for K-tel.

Three customers, Anderson Merchandising, Inc., Handleman Companyand  D.A.Tapes accounted forapproximately 18.4%, 15.3%, and 13.2%, respectively, of K-tel’s revenue for theyear ended June 30, 2005. The loss of, or a substantial reduction in, businessfrom any of these customers could have a material adverse effect on theCompany.

K-tel deliversmusic products (CDs) through traditional wholesale and retail distributionchannels. Prior to April 2001, the Company was distributing its music productsin the United States to most major music retailers (Transworld Entertainment,Musicland, Best Buy, Circuit City, Tower Records) and to major distributors(Handleman, Anderson Merchandising, Valley Media). The Company now has a customerbase that includes only a few selected retailers and distributors, and offersproducts that are of more interest to these individual customers. This focusedapproach is intended to improve product sell-through, minimize returns ofunsold inventory and allow the Company to realize more competitive profitmargins. This existing method of distributing music could be materially alteredby technologies that enable users and customers of pre-recorded music toelectronically download pre-recorded music at home to various personalcomputer media formats. The technology is developing and a number of competingcompanies are seeking to have the industry and the public embrace theirtechnologies. Participants in this technology competition include Microsoft Corporation,AOL, Apple Computer, Inc., YAHOO and others. Digital music distributionprovides both significant risks and opportunities for K-tel. The risks includeK-tel’s uncertain ability to compete with other music companies from amarketing and technological standpoint. The Company believes there areopportunities to enhance its current distribution methods as well as increaseopportunities to license its owned library of master recordings. K-tel’s musicsales and licensing subsidiaries are pursuing these alternative distributionchannels and have entered into licensing agreements with several companiesoffering   electronic downloads.

The Company’s ability tocontinue its present operations and implement future expansion planssuccessfully is contingent mainly upon its ability to maintain its line ofcredit arrangements with K-5 Leisure Products, Inc., the Company’s largestshareholder which is controlled by Philip Kives, the Chairman of the Board,President and Chief Executive Officer of K-tel (see Note 3 to the consolidatedfinancial statements), increase its revenues and profit margins, and ultimatelyattain and sustain profitable operations. Without increased revenues andsustained profitability, the cash generated from the Company’s currentoperations will likely be inadequate to fund operations and service the Company’sindebtedness on an ongoing basis. 

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Managementis focusing its efforts on music distribution and music licensing. However,there can be no assurance that the Company will achieve profitable operationsthrough these efforts or be able to continue operations. The financialstatements do not include any adjustments that might result from the outcome ofthese uncertainties.

Competition

The music businessis highly competitive and dominated by major companies. K-tel faces competitionfor discretionary consumer purchases of its products from other recordcompanies and other entertainment sources, such as film and video companies.Several major record companies in the United States, including Sony BMG Corp.,Time Warner, Inc. and EMI, dominate the market for pre-recorded music.K-tel does not have the financial resources, nor does it have the depth orbreadth of catalog, distribution capabilities or current repertoire of thesecompanies. Its ability to compete in this market depends upon:

·                  theskill and creativity of its employees to expand and utilize its music catalogto create compilation packages;

·                  itsability to distribute its products effectively and efficiently; and

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

The major pre-recordedmusic companies, either directly or through subsidiaries, now manufacture anddistribute pre-recorded music compilations in direct competition withK-tel’s music compilation products. With this competition, the Company relieson its own Dominion master music catalog for the production of musiccompilations.

IntellectualProperty

The Company believes that the K-tel® name and mark are well recognizedand are therefore valuable assets of the Company. The Company pursues theregistration of its trademarks and service marks in the U.S. andinternationally. Effective trademark, service mark and copyright protection maynot be available in every country in which its products and services are madeavailable. Federal and state trademark registrations continue indefinitely, solong as the trademarks are in use and periodic renewals and other requiredfilings are made.

The Company regards its copyrights, service marks, trademarks, tradedress, trade secrets and similar intellectual property as critical to itssuccess, and relies on trademark and copyright law, trade secret protection andconfidentiality and/or license agreements with its employees, customers,partners and others to protect its proprietary rights. K-tel believes stronglyin protecting its intellectual property and will seek protection for newproducts and marks whenever the Company believes it is advisable.****K-tel cannot assure you that any trademarks held by it willbe valid, enforceable or otherwise of value to the Company in relation to itscompetitors or the market in general, or that any trademark for which it hasapplied or may apply will be granted.

Inaddition to trademark protection, the Company generally obtains copyrights inmusic works, compilations and sound recordings.

Employees

On June 30, 2005,K-tel employed 17 full time people worldwide.

Financial andGeographic Information

For financialinformation about the Company’s business segment and geographic area operationsfor each of the three fiscal years ended June 30, 2005 (see Note 9 to theconsolidated financial statements).

**ITEM 1A:RISK FACTORS**

The following arecertain risk factors that could affect our business, financial condition,operation results and cash flows.  Theserisk factors should be considered in connection with evaluating theforward-looking statements contained in this Annual Report on Form 10-K becausethese risk factors could cause our actual results to differ materially fromthose expressed in any forward-looking statement.  The risks we have highlighted below are notthe only ones we face.  If any of thesesevents actually occur, our business, financial condition, operating results orcash flows could be negatively affected. 

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TheCompany cautions you to keep in mind these risk factors and to refrain fromattributing undue certainty to any forward-looking statements, which speak onlyas of the date of this report.

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

The Company incurred losses in recent fiscal years andexpects to continue incurring losses for the foreseeable future.  Continuation of the Company’s operations willrequire additional working capital and continued access to financing to meetworking capital requirements and develop new business opportunities which maynot be available on acceptable terms or at all.

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

The Company has primarily funded its recent operationsthrough internally generated capital and secured loans from K-5 LeisureProducts, Inc. (“K-5”), the Company’s largest shareholder which is controlledby Philip Kives, the Chairman of the Board, President and Chief ExecutiveOfficer of K-tel.  Although K-5 continuesto advance funds sufficient to meet the Company’s needs at this time, there canbe no assurance 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 or at all when required.

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

For the fiscal year ended June 30, 2005, net sales tothree customers, Handleman Company , Anderson Merchandising and D.A Tapes,accounted for approximately 18%, 15% and 12%, respectively, of our total netsales.  The Company believes that salesto a small group of customers will continue to represent a significantpercentage of our total net sales. Substantially all of the products theCompany distributes to these customers are supplied on a non-exclusive basisunder arrangements that may be cancelled without cause and upon short notice,and our retail customers generally are not required to make minimum purchases.If the Company is unable to continue to sell our products to all or any ofthese customers or are unable to maintain our sales to these customers atcurrent levels and cannot find other customers to replace these sales, therewould be an adverse impact on our net sales and profitability. There can be noassurance that the Company will continue to recognize a significant amount ofrevenue from sales to any specific customer.

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

The music business is highly competitive and dominatedby several major record companies that have greater financial resources thanthe Company and have a larger depth and breadth of catalog, distributioncapabilities and current repertoire than the Company, making it difficult tocompete in this market. The major pre-recorded music companies, eitherdirectly or through subsidiaries, now manufacture or distribute pre-recordedmusic compilations in direct competition with the Company’s music compilationproducts.

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

Home entertainment products have traditionally beenmarketed and delivered on a physical delivery basis. If, in the future, theseproducts are increasingly marketed and delivered through technology transfers,such as electronic downloading through the Internet or similar deliverymethods, then our retail and wholesale distribution business could benegatively impacted. As electronic downloading grows through Internetretailers, competition between suppliers to electronic retailers in traditionalways will intensify and likely negatively impact our net sales and margins. Ifthe Company is unable to develop the necessary vendor and customerrelationships to facilitate additional electronic downloading or if the termsof these arrangements differ from those related to our physical product salesour business may be materially harmed.

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

The recorded music industry has been adversely affectedby counterfeiting of  CDs and DVDs andalso by websites and technologies that allow consumers to illegally downloadand access music.  Increasedproliferation of these alternative access methods could impair our ability togenerate sales.

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

The Company regards its copyrights, service marks,trademarks, and similar intellectual property critical to its success, andrelies on trademark and copyright law to protect the intellectual property theCompany license.  Infringement on ourintellectual property may lead to litigation to protect our intellectualproperty rights which could result in substantial costs and diversion ofresources and could have a material effect on our business.

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

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

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potentialreturns.

**If the Company is unable to successfully remediatethe material weaknesses in its internal controls, the Company’s ability toreport its financial results on a timely and accurate basis may be adverselyaffected.**

The Company has reportedmaterial weaknesses and the actions taken to address them.  Such remediation may not proveeffective.  Further, should any materialweaknesses develop,  there are noassurances that the Company will be able to remediate them in a mannersatisfactory to outside parties.  Thiscould result in the Company not being able to report its financial results on atimely basis, harm our operating results, or result in material misstatementsin our financial statements.  Inaddition, the Company may be unable to have its internal controls overfinancial reporting attested to by our independent registered public accountingfirm when required.

**ITEM 1B:UNRESOLVED STAFF COMMENTS**

None

**ITEM2:  PROPERTIES**

K-tel’s corporateoffices and U.S. operations are located in leased facilities in Plymouth, asuburb of Minneapolis, Minnesota, consisting of approximately 4,000 square feetof office space and approximately 6,000 square feet of warehouse. K-tel’sforeign subsidiaries lease a total of approximately 1,350 square feet of officespace. Effective October 2006, the Company’s U.S. operations is relocating to asmaller facility in Plymouth, Minnesota, which consists of 3,000 square feet ofoffice space and 4,500 square feet of warehouse space.  See Note 6 to the consolidated financial statementsfor a summary of the lease agreements.

**ITEM3:  LEGAL PROCEEDINGS**

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

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

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

On December 30, 2004, a Mutual General Release andSettlement Agreement was signed by K-tel and Tristar,  whereby both companies agreed to mutualreleases and Tristar agreed to pay K-tel $350,000.  The payment of $350,000 was received onFebruary 18, 2005.

Other Litigationand Disputes

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

Subsidiary’sLiquidation

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

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

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

No matters weresubmitted to a vote of K-tel’s security holders during the fourth quarter offiscal 2005.

**Executiveofficers of the registrant**

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

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

 

**PhilipKives**,****age 77, has held various offices and/or managerialpositions with K-tel for more than thirty-five years. Mr. Kives is currentlythe Company’s Chairman of the Board, Chief Executive Officer, President andDirector.

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

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**PART II**

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

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

The followingtable shows the range of high and low closing prices per share of K-tel’scommon stock for the fiscal year periods indicated. Such over-the-countermarket quotations reflect inter-dealer prices, without retail mark-up,mark-down or commission, and may not necessarily represent actual transactions.
|             | ** ** | **2005** | ** ** | **2004** | ** ** |
|-------------|------------|----------|------------|----------|------------|
| ** **  | ** ** | **High** | ** ** | **Low**  | ** ** | **High** | ** ** | **Low** | ** ** |
| 1st Quarter |       | $        | .15        |     | $          | .10 |   | $ | .13 |   | $ | .06 |   |
| 2nd Quarter |       | $        | .12        |     | $          | .10 |   | $ | .11 |   | $ | .06 |   |
| 3rd Quarter |       | $        | .13        |     | $          | .08 |   | $ | .29 |   | $ | .09 |   |
| 4th Quarter |       | $        | .10        |     | $          | .06 |   | $ | .24 |   | $ | .09 |   |

 

Nocash dividends were declared on K-tel’s common stock during fiscal year 2005 or2004 and K-tel does not expect to pay cash dividends in the foreseeable future.The declaration or payment by K-tel of dividends, if any, on its common stockin the future is subject to the discretion of the Board of Directors and willdepend on K-tel’s earnings, financial condition, capital requirements and otherrelevant factors. The declaration or payment by K-tel of dividends is alsosubject to the terms of its credit facility.

**Equity Compensation PlanInformation**

The following tableprovides information as of June 30, 2005 with respect to compensation plansunder which the Company’s equity securities are authorized for issuance.
| **Plan Category**                                      | ** ** | **Number of securities to be  issued upon exercise of  outstanding options,  warrants and rights  (a)** | ** ** | **Weighted-average  exercise price of  outstanding options,  warrants and rights  (b)** | ** ** | **Number of securities remaining  available for future issuance  under equity compensation plans  (excluding securities reflected in  column (a))  (c)** | ** ** |
|-------------------------------------------------------------|------------|-----------------------------------------------------------------------------------------------------------------------------------------------------------|------------|------------------------------------------------------------------------------------------------------------------|------------|---------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|------------|
| Equity  compensation plans approved by security holders     |       | 126,900                                                                                                                                                   | (1)        | $                                                                                                                | 5.86       |                                                                                                                                                                                                                      | 2,896,878  | (2) |
| Equity  compensation plans not approved by security holders |       | 2,437,939                                                                                                                                                 | (3)        | $                                                                                                                | 0.08       |                                                                                                                                                                                                                      | —     |   |
| Total                                                       |       | 2,564,839                                                                                                                                                 |       | $                                                                                                                | 0.36       |                                                                                                                                                                                                                      | 2,896,878  |   |

 

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(1)                                  Consistsof 125,900 shares issuable pursuant to options granted under the Company’s 1997Stock Option Plan and 1,000 shares of common stock issuable pursuant to optionsgranted under the Company’s 1987 Stock Incentive Plan.

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

(3)                                  Includesnon-qualified stock options to purchase 95,000 shares of  common stock issued outside  the Company’s 1997 Stock Option Plan to eachof Jay William Smalley, Richard R. Marklund and Wesley C. Hayne in connectionwith such non-employee directors’ appointment to the Company’s Compensation/Stock Option Committee and a non-qualified stock option to purchase 15,000shares of  common stock issued outsidethe Company’s 1997 Stock

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Option Plan to Jay William Smalley in consideration ofhis past and continued service on the Company’s board of directors. See “DirectorCompensation” in Item 11. Includes an aggregate of 2,137,939 shares of commonstock issuable pursuant to a stock option exchange program approved on March18, 2003 by a committee of the Company’s board of directors comprised solely ofindependent directors. Under the program, four optionees agreed to thecancellation of previously awarded options under the Company’s 1997 StockOption Plan and the Company agreed to issue options to purchase an equal numberof shares outside the Company’s stock option plan not earlier than six monthsand one day after the date of cancellation of the previously awarded options,such options to be issued at an exercise price per share equal to the thenfair  market value of the Company’scommon stock and to expire ten years after the new date of grant. On November18, 2003, the replacements options were issued at a price per share of $.08. Therewas no compensation expense recognized as a result of this exchange.

**ITEM 6: SELECTED FINANCIAL DATA**

The followingsummary of consolidated operations and certain balance sheet informationincludes the consolidated results of operations of K-tel and itssubsidiaries as of and for the five years ended June 30, 2005. This summaryshould be read in conjunction with the consolidated financial statements andnotes thereto appearing elsewhere in this report. All share and per shareamounts are based on the weighted average shares issued. All amounts are inthousands of dollars, except per share data.
|                                                 | ** ** | **2005**   | ** ** | **2004**   | ** ** | **2003**   | ** ** | **2002**   | ** ** | **2001**   | ** ** |
|-------------------------------------------------|------------|------------|------------|------------|------------|------------|------------|------------|------------|------------|------------|
| ** **                                      | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** |
| Net sales                                       |       | $          | 6,041      |       | $          | 6,679      |       | $          | 7,234      |       | $          | 6,891 |   | $ | 17,514 |   |
| Operating income  (loss)                        |       | $          | (90        | )          | $          | (33        | )          | $          | 149        |       | $          | (46 | ) | $ | (9,480 | ) |
| Income (loss)  from discontinued operations (1) |       | $          | 151        |       | $          | (52        | )          | $          | (581       | )          | $          | (180 | ) | $ | (4,315 | ) |
| Extraordinary  item (2)                         |       | $          | —     |       | $          | 347        |       | $          | —     |       | $          | 894 |   | $ | 16,185 |   |
| Net income  (loss)                              |       | $          | (457       | )          | $          | (87        | )          | $          | (892       | )          | $          | 300 |   | $ | 1,369 |   |
| Net loss per  share:                            |       |       |       |       |       |       |       |       |       |       |       |
| Continuing operations                           |       | $          | (.04       | )          | $          | (.03       | )          | $          | (.02       | )          | $          | (.03 | ) | $ | (.77 | ) |
| Total assets                                    |       | $          | 4,695      |       | $          | 4,496      |       | $          | 5,301      |       | $          | 4,610 |   | $ | 3,832 |   |
| Long-term debt                                  |       | $          | —     |       | $          | —     |       | $          | —     |       | $          | — |   | $ | 4,000 |   |

 

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(1)            The income (loss) fromdiscontinued operations reflects the operations of the Company’s consumerproducts business, net of any income taxes allocated to it.  The Company discontinued its consumerproducts operations in Germany in June 2000, in the United Kingdom in November2000, and in the United States in January 2001. The income in fiscal 2005 also includes the $350,000 lawsuit settlementreceived from Tristar that had originated in the discontinued consumer productsbusiness.

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

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

**General**

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

Through anothersubsidiary, K-tel Entertainment, Inc., K-tel has a focused method ofdistribution that targets the strengths of selected individual retailers andsupplies products suited to each retailer’s specific needs. These new productsare derived from the Company’s master recordings music catalog with theobjective of realizing more competitive profit margins. As well, the Companyseeks to license its name and marks to other businesses for a royalty or fee.

In fiscal 2005,the Company began licensing its master recording music catalog to several companiesthat sell electronic downloads to various media formats via their internetsites.

**A.  RESULTS OF OPERATIONS**

Thefollowing sections discuss the results of operations by business segment. SeeNote 9 to the consolidated financial statements for additional segmentinformation. General corporate expenses of $656,000 in the year ended June 30,2005, $869,000 in the year ended June 30, 2004 and $860,000 in the year endedJune 30, 2003 have been allocated to the segments.

**FISCAL2005 VERSUS FISCAL 2004**

Net sales for the year ended June 30, 2005 were $6,041,000, a decrease of10.0% from fiscal 2004 sales of $6,679,000. This sales decrease was attributedto reduced licensing activity.The net loss for fiscal 2005 was $457,000, or $.03 per share, compared to a netloss of $87,000, or $.01 per share, in fiscal 2004.

In fiscal 2005,the Company received $350,000 from the settlement of a lawsuit that involvedthe discontinued                     subsidiary, K-tel Consumer Products, Inc.

In fiscal 2004 the Company received approximately$214,000 from the liquidation of K-tel Marketing LTD., the Company’s consumerproducts subsidiary in the United Kingdom, which ceased operations in November2000, and approximately $333,000 from the sale of assets and account receivablecollections related to the March 2001 bankruptcy of K-tel International, (USA),Inc., the Company’s music distribution subsidiary in the United States (seeNote 1 to the consolidated financial statements).  The $547,000 of distributions have beenreflected as extraordinary items, net of income taxes.

Thefollowing sections discuss the results of continuing operations by businesssegment.

**BUSINESSSEGMENT RESULTS**

**Music**

Net sales in the music segment were $4,552,000 for the year ended June30, 2005 compared to $4,763,000 for the year ended June 30, 2004, a decrease of4.4%. The decrease was primarily related to the discontinued sales ofunprofitable budget music DVDs.

Cost of goods sold in the music segment decreased to 52.8% of net salesfor the year ended June 30, 2005 compared to 67.6% of net sales for the yearended June 30, 2004, due primarily to the higher cost as a percentage of salesof the budget music DVDs which were discontinued in fiscal 2005. Advertisingexpenses within the segment, which consist primarily of co-operativeadvertising payments, trade advertising and promotions, increased to $123,000for the year ended June 30, 2005 compared to $110,000 for the year ended June30, 2004 due primarily to increased promotional programs in fiscal 2005 comparedto fiscal 2004.

Selling,general and administrative expenses for the segment remained flat at $2,423,000for the year ended June 30, 2005 compared to $2,424,000 for the year ended June30, 2004.  The music segment incurred anoperating loss of $416,000 for the year ended June 30, 2005 compared to anoperating loss of $992,000 for the year ended June 30, 2004.

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**Licensing**

Licensingrevenues were $1,489,000 for the year ended June 30, 2005 compared to$1,916,000 for the year ended June 30, 2004, a decrease of 22.3%. Both domesticand European revenue decreased due primarily to the overall decrease in salesof the retail music business.  Operatingincome in the licensing segment was $326,000 for the year ended June 30, 2005and $959,000 for the year ended June 30, 2004, a decrease of 66.1%.

**FISCAL2004 VERSUS FISCAL 2003**

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

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

Thefollowing sections discuss the results of continuing operations by businesssegment.

**BUSINESSSEGMENT RESULTS**

**Music**

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

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

Selling, general and administrative expenses for the segment decreased$161,000, or 6.3%, to 2,424,000 for the year ended June 30, 2004 compared to$2,585,000 for the year ended June 30, 2003. The primary reason for thedecrease was the discontinuation of unprofitable product lines in England alongwith continued staff and cost reductions in the U.S. and England. The musicsegment incurred an operating loss of $992,000 for the year ended June 30, 2004compared to an operating loss of $1,010,000 for the year ended June 30, 2003.

**Licensing**

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

**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

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when payment isreceived from customers or when known amounts are receivable, as prior to thatdate collection is not considered probable. Most music sales are made with aright of return of unsold goods. Estimated reserves for returns are establishedby management based upon historical experience and product mix and are subjectto ongoing review and adjustment by the Company. These reserves are recorded atthe time of sale and are reflected as a reduction in revenues. The Company’sreserve for returns was $221,000 at June 30, 2005 and $133,000 at June 30,2004.

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

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

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

**RECENTACCOUNTING PRONOUNCEMENTS**

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

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

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

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**CONTRACTUALOBLIGATIONS**

The table belowdiscloses a summary of the Company’s specified contractual obligations at June30, 2005 (in thousands):
|                                       | ** ** | **Total** | ** ** | **Under 1 Year** | ** ** | **1-3 Years** | ** ** |
|---------------------------------------|------------|-----------|------------|----------------------------|------------|--------------------|------------|
| Notes payable to  Affiliate and Other |       | $         | 11,518     |                       | $          | 11,518             |       | $ | — |   |
| Operating Leases                      |       | 134       |       | 124                        |       | 10                 |       |
|                                  |       |      |       |                       |       |               |       |
| Total                                 |       | $         | 11,652     |                       | $          | 11,642             |       | $ | 10 |   |

 

**B.LIQUIDITY AND CAPITAL RESOURCES**

K-tel has a Lineof Credit Agreement with K-5 Leisure Products, Inc. (“K-5”), the Company’slargest shareholder controlled by Philip Kives, the Chairman of the Board,President and Chief Executive Officer of K-tel. Under the terms of theagreement (the “K-5 Facility”), K-5 has agreed to make available up to$8,000,000 to K-tel on a revolving basis. The loan bears interest at a variablerate based upon the “base rate” of a nationally recognized lending institution(6.0% at June 30, 2005), expires July 20, 2008, and is subordinated to theFoothill loan (see below). The K-5 Facility contains the same covenants as theFoothill loan agreement. K-tel has pledged the stock of its foreignsubsidiaries as collateral for the loan, and the loan carries a subordinatedposition to the Foothill loan on all other assets of the Company. K-tel hadoutstanding balances of $7,518,000 and $7,165,000 as of June 30, 2005 and 2004,respectively, under the K-5 Facility. At June 30, 2005, K-tel obtained a waiverfrom K-5 for its non-compliance under the covenants, limitations andrestrictions of the credit agreement.

Inaddition, K-tel has a second loan agreement with K-5, under which K-5 assumedrights and obligations under a loan from the Company’s former banker (FoothillCapital Corporation) pursuant to an Assignment and Acceptance Agreement datedFebruary 27, 2001. This Foothill loan, which has been extended through July 20,2008, provides for a $10,000,000 credit facility consisting of a $4,000,000term loan due upon expiration, and a $6,000,000 revolving facility under whichborrowings are limited to a percent of eligible receivables. Borrowings underthe facility bear interest at a variable rate based on a “base rate” of anationally recognized lending institution plus 1% (7.0% at June 30, 2005) andare collateralized by the assets of certain Company subsidiaries in the UnitedStates, including accounts receivable, inventories, equipment, music libraryand general intangibles. The loan agreement contains certain financial andother covenants or restrictions, including the maintenance of a minimumshareholders’ equity by K-tel, limitations on capital expenditures,restrictions on music library acquisitions, limitations on other indebtednessand restrictions on dividends paid by K-tel. As of June 30, 2005 and June 30,2004, $4,000,000 was outstanding under the term loan and there were noborrowings under the revolving facility. At June 30, 2005, K-tel obtained awaiver from K-5 for its non-compliance under the covenants, limitations andrestrictions of the credit agreement.

K-telhad an overdraft privilege borrowing facility of $45,000 with The Royal Bank ofScotland in the United Kingdom. This facility was secured by a standby letterof credit for $55,000 provided by K-tel International Ltd., a Canadian companycontrolled by Philip Kives and was payable on demand in accordance with normalbanking practices. Borrowings bore interest of 2.0% per annum over the baserate (a total of 6.0% at June 30, 2004) but were subject to a minimum of 6.0%per annum. This overdraft privilege borrowing facility was canceled at the endof calendar 2004.   K-tel had no outstandingbalance as of June 30, 2004.

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

The Company’s ability tocontinue its present operations 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, the cash generated fromthe Company’s current operations will likely be inadequate to fund operationsand service the Company’s indebtedness on an ongoing basis. Management isfocusing its efforts on music licensing and limited music distribution.However, there can be no assurance that the Company will achieve profitableoperations through these efforts. In the event the Company is unable to fundits operations and implement its current business plan properly, it may beunable to continue operations. The financial statements do not include anyadjustments that might result from the outcome of these uncertainties.

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

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

K-tel’sexposure to market risk for changes in interest rates relates to K-tel’sshort-term borrowings. K-tel’s short-term credit facilities carry a variableinterest rate that does have an impact on future earnings and cash flows. AtJune 30, 2005, K-tel had variable rate debt of $11,518,000. If the interestrate were to change 100 basis points, or 1%, while K-tel was borrowing underthe credit facilities, interest expense would change by $115,000.

Approximately43.3% of K-tel’s revenues during the year ended June 30, 2005 were derived fromoperations in Europe. The results of operations and financial position of K-tel’soperations in Europe were principally measured in their respective currenciesand translated into U.S. dollars. The effect of foreign currency fluctuationsin these European countries is somewhat mitigated by the fact that expenses aregenerally incurred in the same currencies in which the revenue is generated.The reported income of these subsidiaries will be higher or lower depending onthe weakening or strengthening of the U.S. dollar against the respectiveforeign currency. If the U.S. dollar foreign currency rate were to change by1%, the effect on income would have been $2,910 for the year ended June 30,2005. Additionally, approximately 53% of K-tel’s assets at June 30, 2005 werebased in its foreign operations and were translated into U.S. dollars atforeign currency exchange rates in effect as of the end of each accountingperiod, with the effect of such translation reflected as a separate componentof consolidated shareholders’ equity (deficit). Accordingly, K-tel’sconsolidated shareholders’ equity (deficit) will fluctuate depending on theweakening or strengthening of the U.S. dollar against the respective foreigncurrency.

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

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

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

There were no changes in or disagreements withaccountants during the years ended June 30, 2005 and June 30, 2004.

# **ITEM9A:  CONTROLS AND PROCEDURES**

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

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

In response to thematerial weakness above, the Company terminated the employee, undertook afull-scale investigation of the matter, retained a forensic auditing firm anddismissed the accounting firm in the UK that audited the UK subsidiary’sfinancial books and records. In addition the Company hired a new FinancialController 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 reestablish effective internal control overfinancial reporting.

In fiscal 2005 and 2004,it was determined that the segregation of duties in the U.S. office was limiteddue to the small number of employees. This segregation of duties became furtherlimited by vacancies that occurred in the Company’s finance department.   In particular, customer orders were recordedby the same person who initiated shipments, checks were

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deposited by theaccounts receivable clerk, and employee payroll and changes were entered by theOperations Manager, who also distributed the payroll checks.

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

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

**ITEM 9B.  OTHER INFORMATION**

Not applicable.

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**PART III**

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

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

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

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

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

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

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

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

**AuditCommittee**

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

**Code ofEthics**

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

**Section 16(a) Beneficial OwnershipReporting Compliance**

Section 16(a) of theSecurities Exchange Act of 1934, as amended, requires K-tel’s officers,directors and persons who own more than 10% of a registered class of K-tel’sequity securities to file reports of ownership on Form 3 and changes inownership on Form 4 or 5 with the Securities and Exchange Commission. Suchofficers, directors and 10% shareholders also are required by Securities andExchange Commission’s rules to furnish K-tel with copies of all Section 16(a)reports they file. Based solely on its review of the copies of such formsreceived by it, or written representations from certain reporting persons, theCompany believes that during fiscal year 2005, its officers, directors and 10%shareholders filed all reports on a timely basis.

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**ITEM 11: EXECUTIVE COMPENSATION**

Thefollowing table sets forth the aggregate cash compensation paid to or accruedfor each of K-tel’s executive officers for services rendered to K-tel duringthe fiscal years ended June 30, 2005, 2004 and 2003. K-tel has no writtenemployment agreements with its executive officers.

**SummaryCompensation Table**
| ** **                                     | ** ** | ** **                   | ** ** | ** **     | ** ** | ** **         | ** ** | **Long-Term**    | ** ** | ** **       | ** ** |
|------------------------------------------------|------------|------------------------------|------------|----------------|------------|--------------------|------------|------------------|------------|------------------|------------|
| ** **                                     | ** ** | ** **                   | ** ** | ** **     | ** ** | ** **         | ** ** | **Compensation** | ** ** | ** **       | ** ** |
| ** **                                     | ** ** | ** **                   | ** ** | ** **     | ** ** | ** **         | ** ** | **Awards**       | ** ** | ** **       | ** ** |
| ** **                                     | ** ** | ** **                   | ** ** | ** **     | ** ** | ** **         | ** ** | **Securities**   | ** ** | ** **       | ** ** |
| ** **                                     | ** ** | **Annual Compensation** | ** ** | **Underlying** | ** ** | **All Other** | ** ** |
| **Name and Principal Position** | ** ** | **Fiscal Year**         | ** ** | **Salary**     | ** ** | **Bonus**          | ** ** | **Options**      | ** ** | **Compensation** | ** ** |
| ** **                                     | ** ** | ** **                   | ** ** | ** **     | ** ** | ** **         | ** ** | ** **       | ** ** | ** **       | ** ** |
| Philip Kives                                   |       | 2005                         |       | $              | —     |               | $          | —           |       | —           |       | $ | — |   |
| Chief Executive Officer                        |       | 2004                         |       | $              | —     |               | $          | —           |       | —           |       | $ | — |   |
|                                           |       | 2003                         |       | $              | —     |               | $          | —           |       | —           |       | $ | — |   |

 

During the fiscalyears ended June 30, 2005, 2004 and 2003, the Company paid approximately$68,000 in annual management fees to K-5 for services provided to the K-telInternational, Inc. Companies.  Thesemanagement fees included payments for services provided by Mr. Kives to theCompany.

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

**OptionGrants in Last Fiscal Year**

No options were grantedto directors or executive officers in fiscal year 2005.

**Aggregated Option Exercises inLast Fiscal Year**

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

 

----

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

**Director Compensation**

Directors who areemployees of the Company receive no compensation for their services asdirector. Non-employee directors receive cash compensation of $10,000 per year(paid quarterly) and are entitled to receive non-qualified stock options forthe purchase of 5,000 shares of the Company’s common stock at an exercise priceequal to the fair market value of the common stock on the date of initialelection and upon each re-election by the shareholders at an annual orspecial meeting. In 

17

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connection with theirappointment to the Company’s Compensation/Stock Option Committee during thefiscal year ended June 30, 2003, Jay William Smalley, Richard R. Marklund andWesley C. Hayne each also received a non-qualified stock option to purchase95,000 shares of common stock issued outside the Company’s 1997 Stock OptionPlan. During the fiscal year ended June 30, 2003, Mr. Smalley also received anon-qualified stock option to purchase 15,000 shares of common stock outsidethe Company’s 1997 Stock Option Plan in consideration of his past and continuedservice on the Company’s board of directors. All stock options issued tonon-employee directors during the fiscal year ended June 30, 2003 areexercisable for a period of ten years from the date of grant and bear anexercise price of $.05 per share.  Nooptions were granted to directors during fiscal year 2004 or 2005.

**ITEM 12: SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT AND RELATED STOCKHOLDER MATTERS**

Thefollowing table contains certain information as of August 15, 2006, regardingthe beneficial ownership of our common stock by (i) each person known to K-telto own beneficially five percent or more of our common stock, (ii) eachdirector of K-tel, (iii) each named executive officer, and (iv) the directorsand executive officers as a group. The percentage of beneficial ownership isbased on 13,653,738 shares of common stock outstanding as of August 15, 2006.Any shares which are subject to an option or a warrant exercisable within 60days are reflected in the following table and are deemed to be outstanding forthe purpose of computing the percentage of common stock owned by the option orwarrant holder but are not deemed to be outstanding for the purpose ofcomputing the percentage of common stock owned by any other person. Unlessotherwise indicated, each person in the table has sole voting and investmentpower as to the shares shown. Unless otherwise indicated, the address for eachlisted shareholder is c/o K-tel International, Inc., 2655 Cheshire Lane North,Suite 100, Plymouth, Minnesota 55447.
| ** **                                                               | ** ** | **Amount and Nature  of Beneficial Ownership(1)** | ** ** | **Percent of  Outstanding Stock** | ** ** |
|--------------------------------------------------------------------------|------------|-----------------------------------------------------------------------|------------|---------------------------------------------|------------|
| Philip Kives  220 Saulteaux Crescent  Winnipeg, Manitoba R3J 3W3  Canada |       | 10,076,953                                                            | (2)        | 65.6                                        | %          |
|                                                                     |       |                                                                  |       |                                        |       |
| Jay William  Smalley                                                     |       | 120,000                                                               | (3)        | *                                           |       |
|                                                                     |       |                                                                  |       |                                        |       |
| Wesley C. Hayne                                                          |       | 100,000                                                               | (3)        | *                                           |       |
|                                                                     |       |                                                                  |       |                                        |       |
| Richard Marklund                                                         |       | 100,000                                                               | (3)        | *                                           |       |
|                                                                     |       |                                                                  |       |                                        |       |
| All current directors  and officers as a group  (4 persons)              |       | 10,396,953                                                            | (4)        | 66.3                                        | %          |

 

----

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

(1)                The securities “beneficiallyowned” by a person are determined in accordance with the definition of “beneficialownership” set forth in the regulations of the Securities and Exchange Commissionand accordingly, may include securities owned by or for, among others, thespouse, children or certain other relatives of such person as well as othersecurities as to which the person has or shares voting or investment power orhas the right to acquire within 60 days. More than one person may beneficiallyown the same shares.

(2)                Consists of8,048,678 shares held directly by K-5 Leisure Products Inc. (an affiliate ofthe Company controlled by Mr. Kives), 325,336 shares held by a wholly-ownedsubsidiary of K-5 and 1,702,939 shares purchasable upon the exercise ofoptions.

(3)                Represents sharespurchasable upon the exercise of options.

(4)                Includes 2,022,939shares purchasable upon the exercise of options.

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

K-tel has a Line ofCredit Agreement with K-5 Leisure Products, Inc. (“K-5”), the Company’s largestshareholder which is controlled by Philip Kives, the Chairman of the Board,President and Chief Executive Officer of K-tel. Under the terms of

18

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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 “baserate” of a nationally recognized lending institution (6.0% at June 30, 2005),expires July 20, 2008, and is subordinated to the Foothill loan (see below).The K-5 Facility contains the same covenants as the Foothill loan agreement.K-tel has pledged the stock of its foreign subsidiaries as collateral for theloan, and the loan carries a subordinated position to the Foothill loan on allother assets of the Company. K-tel had outstanding balances of $7,518,000 and$7,165,000 as of June 30, 2005 and 2004, respectively, under the K-5 Facility.At June 30, 2005, K-tel obtained a waiver from K-5 for its non-compliance underthe covenants, limitations and restrictions of the credit agreement.

In addition, K-telhas a second loan agreement with K-5, under which K-5 assumed rights andobligations under a loan from the Company’s former banker (Foothill CapitalCorporation) pursuant to an Assignment and Acceptance Agreement dated February27, 2001. This Foothill loan, which has been extended through July 20, 2008,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 nationallyrecognized lending institution plus 1% (7.0% at June 30, 2005) and arecollateralized by the assets of certain Company subsidiaries in the UnitedStates, including accounts receivable, inventories, equipment, music libraryand general intangibles. The loan agreement contains certain financial andother covenants or restrictions, including the maintenance of a minimumshareholders’ equity by K-tel, limitations on capital expenditures,restrictions on music library acquisitions, limitations on other indebtednessand restrictions on dividends paid by K-tel. As of June 30, 2005 and June 30,2004, $4,000,000 was outstanding under the term loan and there were noborrowings under the revolving facility. At June 30, 2005, K-tel obtained awaiver from K-5 for its non-compliance under the covenants, limitations andrestrictions of the credit agreement.

K-telhad an overdraft privilege borrowing facility of $45,000 with The Royal Bank ofScotland in the United Kingdom. This facility was secured by a standby letterof credit for $55,000 provided by K-tel International Ltd., a Canadian companywhich is controlled by Philip Kives, and was payable on demand in accordancewith normal banking practices. Borrowings bore interest of 2.0% per annum overthe base rate (a total of 6.0% at June 30, 2004) but were subject to a minimumof 6.0% per annum. This overdraft privilege borrowing facility was canceled atthe end of calendar 2004.   K-tel had nooutstanding balance as of June 30, 2004.

The Companypurchased approximately $400,000 in the year ended June 30, 2005, $502,000 inthe year ended June 30, 2004 and $463,000 in the year ended June 30, 2003 ofmusic entertainment and consumer convenience products from K-5, whichrepresented 16.0%, 17.1% and 14.6% of cost of goods sold, respectively. Therewere trade payables to K-5 of $398,000 at June 30, 2005, $390,000 at June 30,2004, and $371,000 at June 30, 2003, or 23.1%, 27.2% and 31.9% of total tradepayables, respectively.

During the fiscalyears ended June 30, 2005, 2004 and 2003, the Company paid approximately$68,000 in annual management fees to K-5 for services provided to the K-telInternational, Inc. Companies.  Thesemanagement fees included payment for services provided by Mr. Kives to theCompany.

The Company had nosales of products to K-5 during fiscal years 2005, 2004, and 2003. There was abalance receivable from K-5 at June 30, 2005 of $129,000, June 30, 2004 of$113,000, and June 30, 2003 of $73,000. No interest was charged on the related outstanding balances duringfiscal years 2005, 2004 and 2003.

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

19

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# **ITEM 14.  ****PRINCIPALACCOUNTANT FEES AND SERVICES**

Fees and Services

The followingtable shows the aggregate fees billed to the Company by Grant Thornton forservices rendered during fiscal years ended June 30, 2005 and June 30, 2004:

 
| **Description of Fees** | ** ** | **Fiscal 2005  Amount** | ** ** | **Fiscal 2004  Amount** | ** ** |
|-----------------------------------|------------|------------------------------|------------|------------------------------|------------|
|                              |       |                         |       |                         |       |
| Audit Fees                        |       | $                            | 95,000     | (1)                          | $          | 180,000 | (1) |
| Tax Fees                          |       | 37,000                       | (2)        | 60,000                       | (2)        |
| Other Fees                        |       | —                       | (3)        | 3,000                        | (3)        |
| Total                             |       | $                            | 132,000    |                         | $          | 243,000 |   |

 

----

| (1) | Audit fees consisted of fees for audit work of the  Company’s annual financial statements and review of the quarterly financial  statements included in the Company’s Quarterly Reports on Form 10-Q for the  fiscal years 2005 and 2004 and related audit committee meeting attendance. |
|-----|----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|
| (2) | Tax fees consisted of fees for federal, state and  international tax return preparation and tax planning and tax advice related  to various tax matters including state tax notices and other tax research  related matters.                                                                       |
| (3) | Other fees included fees related to statutory audit  work performed in Germany and other financial consulting assistance.                                                                                                                                                                          |

 

Pre-ApprovalPolicy and Procedures

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

The auditcommittee pre-approved 100% of the services described in the “Fees and Services”table pursuant to engagements that occurred in fiscal 2005 and 2004.

20

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**PART IV**

**ITEM15:  EXHIBITS AND FINANCIAL STATEMENTSCHEDULES**

(a)                                  FinancialStatements and Schedules

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

(b)                                 Exhibits

Reference is madeto the Exhibit Index.

(c)           ExcludedFinancial Statements

Not applicable.

21

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**SIGNATURES**

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

 

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

 

22

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

**INDEX TOCONSOLIDATED FINANCIAL STATEMENTS**
| Report of Independent  Registered Public Accounting Firm                                                         |   |
|------------------------------------------------------------------------------------------------------------------|--------|
|                                                                                                             |   |
| Consolidated  Balance Sheets as of June 30, 2005 and 2004                                                        |   |
|                                                                                                             |   |
| Consolidated  Statements of Operations for each of the three years ended June 30, 2005                           |   |
|                                                                                                             |   |
| Consolidated  Statements of Shareholders’ Equity (Deficit) for each of the three years  ended June 30, 2005 |   |
|                                                                                                             |   |
| Consolidated  Statements of Cash Flows for each of the three years ended June 30, 2005                           |   |
|                                                                                                             |   |
| Notes to Consolidated Financial Statements                                                                       |   |
|                                                                                                             |   |
| Supplemental Schedule to Consolidated Financial  Statements:                                                     |   |
|                                                                                                             |   |
| Schedule  II - Valuation and Qualifying Accounts for each of the three years ended June  30, 2005                |   |

 

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

23

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**REPORT OFINDEPENDENT REGISTERED PUBLIC ACCOUNTING FIRM**

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

We have auditedthe accompanying consolidated balance sheets of K-tel International, Inc. (aMinnesota corporation) and Subsidiaries as of June 30, 2005 and 2004 and therelated consolidated statements of operations, shareholders’ deficit, and cashflows for each of the three years in the period ended June 30, 2005. Thesefinancial statements are the responsibility of the Company’s management. Ourresponsibility is to express an opinion on these financial statements based onour audits.

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

In our opinion,the financial statements referred to above present fairly, in all materialrespects, the consolidated financial position of K-tel International, Inc. andSubsidiaries as of June 30, 2005 and 2004 and the consolidated results of theiroperations and their consolidated cash flows for the each of the three years inthe period ended June 30, 2005 in conformity with accounting principlesgenerally accepted in the United States of America.

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

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

 

24

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

## **CONSOLIDATED BALANCE SHEETS**

**JUNE 30,**

*(inthousands - except share and per share data)*
| ** **                                                                                                            | ** ** | **2005** | ** ** | **2004** | ** ** |
|-----------------------------------------------------------------------------------------------------------------------|------------|----------|------------|----------|------------|
|                                                                                                                  |       |     |       |     |       |
| ASSETS                                                                                                                |       |     |       |     |       |
|                                                                                                                  |       |     |       |     |       |
| Current Assets:                                                                                                       |       |     |       |     |       |
| Cash and cash equivalents                                                                                             |       | $        | 1,272      |     | $          | 147 |   |
| Accounts receivable, net of allowance for doubtful  accounts of $4 in 2005 and 2004                                   |       | 2,045    |       | 2,691    |       |
| Inventories                                                                                                           |       | 563      |       | 561      |       |
| Royalty advances                                                                                                      |       | 6        |       | 50       |       |
| Prepaid expenses and other                                                                                            |       | 227      |       | 308      |       |
| Total Current Assets                                                                                                  |       | 4,113    |       | 3,757    |       |
|                                                                                                                  |       |     |       |     |       |
| Property and  equipment, net of accumulated depreciation and amortization of $1,138 in 2005  and $1,506 in 2004       |       | 84       |       | 83       |       |
|                                                                                                                  |       |     |       |     |       |
| Owned catalog  masters, net of accumulated amortization of $3,115 in 2005 and $2,942 in 2004                          |       | 498      |       | 656      |       |
|                                                                                                                  |       |     |       |     |       |
|                                                                                                                  |       | $        | 4,695      |     | $          | 4,496 |   |
|                                                                                                                  |       |     |       |     |       |
| LIABILITIES AND  SHAREHOLDERS’ DEFICIT                                                                           |       |     |       |     |       |
| Current  Liabilities:                                                                                                 |       |     |       |     |       |
| Notes payable to affiliate and other                                                                                  |       | $        | 11,518     |     | $          | 11,165 |   |
| Accounts payable                                                                                                      |       | 1,727    |       | 1,432    |       |
| Accrued royalties                                                                                                     |       | 1,760    |       | 1,907    |       |
| Reserve for returns                                                                                                   |       | 221      |       | 133      |       |
| Net liabilities of discontinued operations                                                                            |       | 30       |       | 30       |       |
| Total Current Liabilities                                                                                             |       | 15,256   |       | 14,667   |       |
|                                                                                                                  |       |     |       |     |       |
| Shareholders’  Deficit:                                                                                          |       |     |       |     |       |
| Common Stock – 50,000,000 shares authorized, par value  $.01; 13,653,738 issued and outstanding in 2005 and 2004 |       | 136      |       | 136      |       |
| Additional paid-in capital                                                                                            |       | 21,292   |       | 21,292   |       |
| Accumulated deficit                                                                                                   |       | (31,923  | )          | (31,466  | )          |
| Accumulated other comprehensive loss                                                                                  |       | (66      | )          | (133     | )          |
| Total Shareholders’ Deficit                                                                                      |       | (10,561  | )          | (10,171  | )          |
|                                                                                                                  |       |     |       |     |       |
|                                                                                                                  |       | $        | 4,695      |     | $          | 4,496 |   |

 

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

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

**CONSOLIDATED STATEMENTS OF OPERATIONS**

## **YEARS ENDED JUNE 30,**

*(inthousands - except per share data)*
| ** **                                                                 | ** ** | **2005** | ** ** | **2004** | ** ** | **2003** | ** ** |
|----------------------------------------------------------------------------|------------|----------|------------|----------|------------|----------|------------|
| Net Sales                                                                  |       | $        | 6,041      |     | $          | 6,679    |       | $ | 7,234 |   |
| Costs and  Expenses:                                                       |       |     |       |     |       |     |       |
| Cost of goods sold                                                         |       | 2,439    |       | 2,934    |       | 3,100    |       |
| Advertising                                                                |       | 123      |       | 110      |       | 200      |       |
| Selling, general and administrative                                        |       | 3,569    |       | 3,668    |       | 3,785    |       |
| Total Costs and Expenses                                                   |       | 6,131    |       | 6,712    |       | 7,085    |       |
| Operating Income  (Loss)                                                   |       | (90      | )          | (33      | )          | 149      |       |
| Other Income  (Expense):                                                   |       |     |       |     |       |     |       |
| Interest expense                                                           |       | (630     | )          | (497     | )          | (534     | )          |
| Other income (expense), net                                                |       | 24       |       | (20      | )          | 74       |       |
| Total Other Expense                                                        |       | (606     | )          | (517     | )          | (460     | )          |
| Loss from  Continuing Operations Before Income Taxes                       |       | (696     | )          | (550     | )          | (311     | )          |
| Benefit for  Income Taxes                                                  |       | 88       |       | 168      |       | —   |       |
| Loss from  Continuing Operations                                           |       | (608     | )          | (382     | )          | (311     | )          |
| Discontinued  Operations:                                                  |       |     |       |     |       |     |       |
| Gain (loss) from discontinued operations, net of  taxes                    |       | 151      |       | (52      | )          | (581     | )          |
| Loss before  Extraordinary Item                                            |       | (457     | )          | (434     | )          | (892     | )          |
| Extraordinary  Item:                                                       |       |     |       |     |       |     |       |
| Gain on Subsidiary Liquidations, net of taxes                              |       | —   |       | 347      |       | —   |       |
| Net Loss                                                                   |       | $        | (457       | )        | $          | (87      | )          | $ | (892 | ) |
|                                                                       |       |     |       |     |       |     |       |
| Income (Loss)  per Share – Basic and Diluted:                         |       |     |       |     |       |     |       |
| Continuing Operations                                                      |       | $        | (.04       | )        | $          | (.03     | )          | $ | (.02 | ) |
| Discontinued Operations                                                    |       | .01      |       | (.01     | )          | (.04     | )          |
| Extraordinary Item                                                         |       | —   |       | .03      |       | —   |       |
| Net Loss                                                                   |       | $        | (.03       | )        | $          | (.01     | )          | $ | (.06 | ) |
|                                                                       |       |     |       |     |       |     |       |
| Shares used in  the calculation of loss per share– Basic and Diluted: |       | 13,654   |       | 13,654   |       | 13,654   |       |
|                                                                       |       |     |       |     |       |     |       |
| Comprehensive  Loss                                                        |       |     |       |     |       |     |       |
| Net loss                                                                   |       | $        | (457       | )        | $          | (87      | )          | $ | (892 | ) |
| Unrealized pension cost                                                    |       | —   |       | (74      | )          | —   |       |
| Translation adjustment                                                     |       | 67       |       | 96       |       | 131      |       |
| Comprehensive loss                                                         |       | $        | (390       | )        | $          | (65      | )          | $ | (761 | ) |

 

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

26

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

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

**YEARSENDED JUNE 30, 2005, 2004 AND 2003**

*(inthousands)*
| ** **                | ** ** | ** **            | ** ** | ** **  | ** ** | ** **      | ** ** | ** **        | ** ** | **Accumulated** | ** ** | ** ** | ** ** |
|---------------------------|------------|-----------------------|------------|-------------|------------|-----------------|------------|-------------------|------------|-----------------|------------|------------|------------|
| ** **                | ** ** | ** **            | ** ** | ** **  | ** ** | **Additional**  | ** ** | ** **        | ** ** | **Other**       | ** ** | ** ** | ** ** |
| ** **                | ** ** | **Common Stock** | ** ** | **Paid-In** | ** ** | **Accumulated** | ** ** | **Comprehensive** | ** ** | ** **      | ** ** |
| ** **                | ** ** | **Shares**            | ** ** | **Amount**  | ** ** | **Capital**     | ** ** | **Deficit**       | ** ** | **Loss**        | ** ** | **Total**  | ** ** |
| Balance at June  30, 2002 |       | 13,654                |       | $           | 136        |            | $          | 21,292            |       | $               | (30,485    | )          | $          | (286 | ) | $ | (9,343 | ) |
| Net loss                  |       | —                |       | —      |       | —          |       | (892              | )          | —          |       | (892       | )          |
| Translation  adjustment   |       | —                |       | —      |       | —          |       | —            |       | 131             |       | 131        |       |
| Balance at June  30, 2003 |       | 13,654                |       | 136         |       | 21,292          |       | (31,377           | )          | (155            | )          | (10,104    | )          |
| Net loss                  |       | —                |       | —      |       | —          |       | (87               | )          | —          |       | (87        | )          |
| Other                     |       | —                |       | —      |       | —          |       | (2                | )          | —          |       | (2         | )          |
| Unrealized  pension cost  |       |                  |       |        |       |            |       |              |       | (74             | )          | (74        | )          |
| Translation  adjustment   |       | —                |       | —      |       | —          |       | —            |       | 96              |       | 96         |       |
| Balance at June  30, 2004 |       | 13,654                |       | 136         |       | 21,292          |       | (31,466           | )          | (133            | )          | (10,171    | )          |
| Net loss                  |       | —                |       | —      |       | —          |       | (457              | )          | —          |       | (457       | )          |
| Translation  adjustment   |       | —                |       | —      |       | —          |       | —            |       | 67              |       | 67         |       |
| Balance at June 30,  2005 |       | 13,654                |       | $           | 136        |            | $          | 21,292            |       | $               | (31,923    | )          | $          | (66 | ) | $ | (10,561 | ) |

 

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

27

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

**CONSOLIDATEDSTATEMENTS OF CASH FLOWS**

**YEARSENDED JUNE 30,**

*(inthousands)*
| ** **                                                                            | ** ** | **2005** | ** ** | **2004** | ** ** | **2003** | ** ** |
|---------------------------------------------------------------------------------------|------------|----------|------------|----------|------------|----------|------------|
| Operating  Activities:                                                                |       |     |       |     |       |     |       |
| Net loss                                                                              |       | $        | (457       | )        | $          | (87      | )          | $ | (892 | ) |
| Adjustment to  reconcile net loss to cash Provided by (used in) operating activities: |       |     |       |     |       |     |       |
| Depreciation and amortization                                                         |       | 224      |       | 253      |       | 315      |       |
| (Gain) loss on disposal of property and equipment                                     |       | (11      | )          | 7        |       | 3        |       |
| Discontinued operations                                                               |       | —   |       | (93      | )          | 7        |       |
| Changes in  operating assets and liabilities:                                         |       |     |       |     |       |     |       |
| Accounts receivable, net                                                              |       | 657      |       | (118     | )          | (147     | )          |
| Inventories                                                                           |       | (4       | )          | (21      | )          | 135      |       |
| Royalty advances                                                                      |       | (6       | )          | 193      |       | 68       |       |
| Prepaid expenses                                                                      |       | 130      |       | 11       |       | 89       |       |
| Accounts payable                                                                      |       | 358      |       | (190     | )          | (10      | )          |
| Accrued royalties                                                                     |       | (98      | )          | (485     | )          | 87       |       |
| Reserve for returns                                                                   |       | 89       |       | (88      | )          | 173      |       |
| Cash provided by (used in) operating activities                                       |       | 882      |       | (618     | )          | (172     | )          |
|                                                                                  |       |     |       |     |       |     |       |
| Investing  Activities:                                                                |       |     |       |     |       |     |       |
| Purchases of property and equipment                                                   |       | (42      | )          | (66      | )          | (18      | )          |
| Music catalog additions                                                               |       | (15      | )          | (26      | )          | —   |       |
| Other                                                                                 |       | —   |       | 2        |       | 15       |       |
| Cash used in investing activities                                                     |       | (57      | )          | (90      | )          | (3       | )          |
| Financing  Activities:                                                                |       |     |       |     |       |     |       |
| Borrowings on notes payable                                                           |       | 4,773    |       | 2,569    |       | 2,278    |       |
| Payments on notes payable                                                             |       | (4,421   | )          | (2,944   | )          | (1,033   | )          |
| Cash provided by (used in) financing activities                                       |       | 352      |       | (375     | )          | 1,245    |       |
|                                                                                  |       |     |       |     |       |     |       |
| Effect of exchange rates on cash                                                      |       | (52      | )          | 11       |       | 74       |       |
|                                                                                  |       |     |       |     |       |     |       |
| Net increase (decrease) in cash equivalents                                           |       | 1,125    |       | (1,072   | )          | 1,144    |       |
|                                                                                  |       |     |       |     |       |     |       |
| Cash and cash equivalents at beginning of period                                      |       | 147      |       | 1,219    |       | 75       |       |
|                                                                                  |       |     |       |     |       |     |       |
| Cash and cash equivalents at end of period                                            |       | $        | 1,272      |     | $          | 147      |       | $ | 1,219 |   |
|                                                                                  |       |     |       |     |       |     |       |
| Supplemental Cash Flow  Information  Cash paid for interest                           |       | $        | 714        |     | $          | 539      |       | $ | 396 |   |

 

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

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

**NOTES TOCONSOLIDATED FINANCIAL STATEMENTS**

**JUNE 30,2005, 2004 AND 2003**

**1.             BUSINESS AND LIQUIDITY**

K-tel International, Inc. (the “Company” or “K-tel”)was incorporated in 1968 and currently has its corporate offices located inPlymouth, Minnesota. Through its operating subsidiaries, K-tel licenses itsmusic catalog internationally and markets entertainment products mainly derivedfrom its catalog through retail and direct response marketing channels in theUnited States and Europe. The Company has a focused method of distribution thattargets the strengths of selected individual retailers and supplies productssuited to each retailer’s needs. These products are derived mainly from theCompany’s master recordings music catalog with the objective of realizing morecompetitive profit margins. K-tel seeks to license its trademarks to othercompanies in businesses unrelated to K-tel’s current operations. Licenses aregranted for a royalty or fee, with no cost to the Company.

Subsidiary Liquidation

In November 2000, theCompany’s consumer products subsidiary in the United Kingdom, K-tel MarketingLtd., ceased operations and began voluntary liquidation proceedings. At theinitial meeting of the creditors on November 24, 2000, the creditors voted forthe liquidation to become a creditors’ liquidation under English law. TheCompany has not been informed by the liquidators or their counsel of any planto attempt to hold it or any of its subsidiaries liable for any of the commitmentsof K-tel Marketing Ltd. Management believes the Company will have no ongoingmaterial liability related to K-tel Marketing Ltd. as a result of theliquidation proceeding.  In fiscal 2002,the assets and liabilities of the subsidiary were removed from the books of theCompany and the remaining net liability was shown as a gain onliquidation.  As the only securedcreditor, the Company subsequently received distributions of approximately$138,000 on March 1, 2004 and $76,000 on May 14, 2004 and reflected these asadditional gain on liquidation, net of taxes. K-tel Marketing Ltd. had nooperations during the fiscal years ended June 30, 2005, 2004 and 2003.

In June 2004, the Companyreceived funds for the sale of assets and the collections of accounts receivablesrelated to the March 2001 bankruptcy of K-tel International, (USA), Inc., the Company ‘s music distribution subsidiary in the United States.  The Company received approximately $220,000for assets sold by a third party and received approximately $113,000 in accountreceivable collections.  These receiptswere reflected as a gain on liquidation, net of taxes.

DiscontinuedOperations

The Company’sconsumer products business, which was concentrated in Europe, consistedprimarily of housewares, consumer convenience items and exercise equipment. TheCompany discontinued its consumer products operations in Germany, the UnitedKingdom and the United States in June 2000, November 2000 and January 2001,respectively. Accordingly, these activities have been presented in theaccompanying financial statements as discontinued operations. The accompanyingcondensed consolidated financial statements have been prepared to reflect theconsumer products division as a discontinued operation. The net liabilities ofdiscontinued operations at June 30, 2005 and 2004 and losses from discontinuedoperations relate primarily to legal matters and completion of statutoryreporting requirements for the former operations in Germany (See Note 6).

In fiscal 2005 the Company received $350,000 from thesettlement of a lawsuit that involved the discontinued subsidiary, K-telConsumer Products, Inc.  Legal expensesrelating to the lawsuit offset this amount.

Liquidity

During the yearsended June 30, 2005, 2004 and 2003, the Company incurred  net losses from continuing operations of $608,000,$382,000 and $311,000, respectively, and provided $882,000 and used $618,000and $172,000 of cash in operating activities. Additionally, the Company had aworking capital deficit of $11,143,000 at June 30, 2005.

The Company’s ability tocontinue its present operations and implement future expansion planssuccessfully is contingent mainly upon its ability to maintain its line ofcredit arrangements with K-5 Leisure Products, Inc. (See Note 3), increase itsrevenues and profit margins, and ultimately attain and sustain profitableoperations. Without increased revenues and sustained profitability, the cashgenerated from the Company’s current operations will likely be inadequate tofund operations and service its indebtedness on an ongoing basis. Management isfocusing its efforts on music licensing and

29

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limitedmusic distribution. However, there can be no assurance that the Company willachieve profitable operations through these efforts. The financial statementsdo not include any adjustments that might result from the outcome of theseuncertainties.

**2.             SUMMARYOF SIGNIFICANT ACCOUNTING POLICIES**

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

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

RevenueRecognition – The Company derives its revenue mainly from twosources: the sale of music compilations (predominately compact discs) producedby the Company, and license revenue from the licensing of Company-ownedmasters. Revenue from music sales is recognized at the time of shipment to thecustomer, while license revenue is recognized when payment is received fromcustomers or when known amounts are receivable, as prior to that datecollection is not considered probable. Most music sales are made with a rightof return of unsold goods. Estimated reserves for returns are established bymanagement based upon historical experience and product mix and are subject toongoing review and adjustment by the Company. These reserves are recorded atthe time of sale and are reflected as a reduction in revenues. The Company’sreserve for returns was $221,000 at June 30, 2005 and $133,000 at June 30,2004.

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

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

Cash and CashEquivalents – Cash and cash equivalents consist principallyof cash and short-term, highly liquid investments with original maturities ofless than ninety days. At June 30, 2005 and 2004, $1,172,000 and $94,000,respectively, was held at various financial institutions in Europe.

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

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

Owned CatalogMasters – The Company capitalizes the costs to purchase ownedmaster recordings at the time of acquisition. These costs are amortized overthe estimated useful life of these master recordings, which is generally sevenyears and represents management’s best estimate of the average period of value.Amortization expense for the years ended June 30, 2005, 2004 and 2003 was $173,000,$190,000, and $238,000, respectively.

Estimatedamortization expense for the owned catalog masters is as follows for the yearsended June 30:
| 2006   |   | $       | 159,000 |   |
|--------|--------|---------|---------|--------|
| 2007   |   | 144,000 |    |
| 2008   |   | 118,000 |    |
| 2009   |   | 64,000  |    |
| 2010   |   | 13,000  |    |
|   |   | $       | 498,000 |   |

30

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

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

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

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

Advertising- The Company expenses the costs of advertising when the advertising takesplace, except for direct response advertising, which is capitalized andamortized over its expected period of future benefits (usually the periodremaining under a related contract, which is generally less than one year).Direct response advertising consists primarily of television advertisingwhereby customers respond specifically to the advertising and where the Companycan identify the advertising that elicited the response. Advertising expenseswere $123,000, $110,000, and  $200,000for the years ended June 30, 2005, 2004 and 2003, respectively.

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

Stock-basedCompensation – The Company accounts for stock-based awards toemployees using the intrinsic value method, whereby the options are granted atmarket price, and therefore no compensation costs are recognized. Ifcompensation expense for the Company’s various stock option plans had beendetermined based on the projected fair values at the grant dates for awardsunder those plans, the Company’s pro-forma net loss, basic and diluted loss percommon share would have been as follows:
|                           | ** ** | **Fiscal Year Ended** | ** ** |
|---------------------------|------------|---------------------------------|------------|
| ** **                | ** ** | **June 30,**               | ** ** |
| ** **                | ** ** | **2005**                        | ** ** | **2004** | ** ** | **2003** | ** ** |
| Net loss (in  thousands): |       |                            |       |   |   |   |   |
| As reported               |       | $                               | (457       | ) | $ | (87 | ) | $ | (892 | ) |
| Pro forma                 |       | $                               | (457       | ) | $ | (258 | ) | $ | (907 | ) |
|                      |       |                            |       |   |   |   |   |
| Basic and  Diluted EPS:   |       |                            |       |   |   |   |   |
| As reported               |       | $                               | (.03       | ) | $ | (.01 | ) | $ | (.06 | ) |
| Pro forma                 |       | $                               | (.03       | ) | $ | (.02 | ) | $ | (.06 | ) |

 

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 sharehave been computed by dividing net income (loss) by the weighted average numberof shares outstanding during the period. For all periods presented, commonstock equivalents were excluded from the per share calculation as the neteffect would be antidilutive. For the fiscal years

31

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ended June 30, 2005, 2004,and 2003, weighted averageoptions to purchase 2,564,839, 2,574,839, and 442,900 shares of common stock,with weighted average exercise prices of $.36, $.39, and $1.95, respectively,were excluded from the computation of common share equivalents for therespective periods as they were 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 financial statements and the reported amounts ofrevenues and expenses during the reporting period. Principal estimates includeallowances for bad debt, inventory valuation, return reserves, royaltyobligations, purchase commitments and product replacement costs. Actual resultscould differ from those estimates used by management.

**3.****                                      NOTES****PAYABLE TO AFFILIATE AND OTHER**

K-telhas a Line of Credit Agreement with K-5 Leisure Products, Inc. (“K-5”), theCompany’s largest shareholder controlled by Philip Kives, the Chairman of theBoard, President and Chief Executive Officer of K-tel. Under the terms of theagreement (the “K-5 Facility”), K-5 has agreed to make available up to$8,000,000 to K-tel on a revolving basis. The loan bears interest at a variablerate based upon the “base rate” of a nationally recognized lending institution(6.0% at June 30, 2005), expires July 20, 2008, and is subordinated to theFoothill loan (see below).   The K-5Facility contains the same covenants as the Foothill loan agreement. K-tel haspledged the stock of its foreign subsidiaries as collateral for the loan, andthe loan carries a subordinated position to the Foothill loan on all otherassets of the Company. K-tel had outstanding balances of $7,518,000 and$7,165,000 as of June 30, 2005 and 2004, respectively, under the K-5 Facility.At June 30, 2005, K-tel obtained a waiver from K-5 for its non-compliance underthe covenants, limitations and restrictions of the credit agreement.

Inaddition, K-tel has a second loan agreement with K-5, under which K-5 assumedrights and obligations under a loan from the Company’s former banker (FoothillCapital Corporation) pursuant to an Assignment and Acceptance Agreement datedFebruary 27, 2001. This Foothill loan, which has been extended through July 20,2008,  provides for a $10,000,000 creditfacility consisting of a $4,000,000 term loan due upon expiration, and a$6,000,000 revolving facility under which borrowings are limited to a percentof eligible receivables. Borrowings under the facility bear interest at avariable rate based on a “base rate” of a nationally recognized lendinginstitution plus 1% (7.0% at June 30, 2005) and are collateralized by theassets of certain 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 library acquisitions,limitations on other indebtedness and restrictions on dividends paid by K-tel.As of June 30, 2005 and 2004, $4,000,000 was outstanding under the term loanand there were no borrowings under the revolving facility. At June 30, 2005,K-tel obtained a waiver from K-5 for its non-compliance under the covenants,limitations and restrictions of the credit agreement.

K-telhad an overdraft privilege borrowing facility of $45,000 with The Royal Bank ofScotland in the United Kingdom. This facility was secured by a standby letterof credit for $55,000 provided by K-tel International Ltd., a Canadian companycontrolled by Philip Kives and was payable on demand in accordance with normalbanking practices. Borrowings bore interest of 2.0% per annum over the baserate (a total of  6.0% at June 30, 2004)but were subject to a minimum of 6.0% per annum. This overdraft privilegeborrowing facility was canceled at the end of calendar 2004.   K-tel had no outstanding balance as of June30, 2004.

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

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

32

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The provision  for income taxes consists of the followingfor the years ended June 30 (in thousands):
|                                                   | ** ** | **2005** | ** ** | **2004** | ** ** | **2003** | ** ** |
|---------------------------------------------------|------------|----------|------------|----------|------------|----------|------------|
| Income (loss)  before provision for income taxes: |       |     |       |     |       |     |       |
| United States                                     |       | $        | (163       | )        | $          | 277      |       | $ | 196 |   |
| Foreign                                           |       | (289     | )          | (364     | )          | (1,088   | )          |
| Total                                             |       | $        | (452       | )        | $          | (87      | )          | $ | (892 | ) |
|                                              |       |     |       |     |       |     |       |
| Provision for  income taxes:                      |       |     |       |     |       |     |       |
| Current                                           |       |     |       |     |       |     |       |
| United States                                     |       | $        | 5          |     | $          | —   |       | $ | — |   |
| Foreign                                           |       | —   |       | —   |       | —   |       |
|                                              |       |     |       |     |       |     |       |
| Total provision  for income taxes                 |       | $        | 5          |     | $          | —   |       | $ | — |   |

 

A reconciliationof the U.S. Federal statutory rate to the effective tax rate for the yearsended June 30 was as follows:

|                                      | ** ** | **2005** | ** ** | **2004** | ** ** | **2003** | ** ** |
|--------------------------------------|------------|----------|------------|----------|------------|----------|------------|
| Federal  statutory rate              |       | (34      | )%         | (34      | )%         | (34      | )%         |
| State Taxes, net  of Federal benefit |       | (2       | )          | (2       | )          | (2       | )          |
| Valuation  allowance                 |       | 36       |       | 36       |       | 36       |       |
|                                 |       | —   | %          | —   | %          | —   | %          |

 

Deferred incometaxes are provided for the temporary differences between the financialreporting basis and the tax basis of the Company’s assets and liabilities.Temporary differences, which are all deferred tax assets, were as follows (inthousands):
|                                  | ** ** | **June 30,  2005** | ** ** | **June 30,  2004** | ** ** |
|----------------------------------|------------|-------------------------|------------|-------------------------|------------|
| Net operating  loss carryfowards |       | $                       | 15,836     |                    | $          | 15,637 |   |
| Alternative  minimum tax credits |       | 439                     |       | 439                     |       |
| Foreign tax  credit              |       | 325                     |       | 325                     |       |
| Reserve for  returns             |       | 221                     |       | 221                     |       |
| Depreciation and  amortization   |       | (89                     | )          | (64                     | )          |
| Royalty reserves                 |       | 65                      |       | 96                      |       |
| Inventory  reserves              |       | 21                      |       | 40                      |       |
| Nondeductible  accruals          |       | 96                      |       | 83                      |       |
| Valuation  allowance             |       | (16,914                 | )          | (16,777                 | )          |
|                             |       | $                       | —     |                    | $          | — |   |

 

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

For U.S. taxreporting purposes, the Company has net operating loss (“NOL”) carryforwards ofapproximately $43,990,000. However, of the amount available through 2013 and2020, $20,100,000 of the NOL relates to deductions associated with the exerciseof stock options. The tax benefit of approximately $7,236,000 associated withthis stock option deduction will be recorded as additional paid-incapital if and when realized. The NOL carryforwards may be reduced in futureyears, without financial statement benefit, to the extent of intercompanydividends received from foreign subsidiaries. Also, the NOL carryforwards aresubject to review and possible adjustment by taxing authorities. In addition,the Company has approximately $439,000 in U.S. federal alternative minimum taxcredits and $325,000 in foreign tax credits, which may be utilized in thefuture to offset any regular corporate income tax liability.

33

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**5.****                                      CAPITALTRANSACTIONS**

Stock Option Plan

The Company has aStock Option Plan for officers, directors, and employees of the Company. Underthe terms of this plan the Board of Directors has the sole authority todetermine the employees to whom options and awards are granted, the type, sizeand terms of the awards, the timing of the grants, the duration of the exerciseperiod and any other matters arising under the plan. The common stockincentives may take the form of incentive stock options and nonqualified stockoptions. The Company’s 1987 plan, which has expired, covered a maximum of700,000 shares of common stock, of which options for the purchase of 1,000shares remain outstanding and exercisable. In February 1997, the Company’sBoard of Directors approved a new stock option plan covering a maximum of600,000 shares of common stock, which was subsequently amended to 5,000,000through shareholder amendments in February 1999, January 2000 and November2000. There were options for 2,037,605 net shares granted under this plan as ofJune 30, 2005, of which 1,011,111 have been exercised. Any options cancelledbecome available for future grants. No options granted have expired.

Stock Option Exchange

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

Restricted and Non-QualifiedStock Options

In addition tostock options granted under the terms of the Stock Option Plan, the Board ofDirectors has the sole authority to grant employees, officers and directorsincentive stock options and non-qualified stock options outside the StockOption Plan. The Board of Directors determines the type, size and terms of thegrants, timing of the grants, the duration of the exercise period and any othermatters pertaining to options or awards granted outside of the Stock OptionPlan. There were options for 2,482,939 net shares granted outside the StockOption Plan as of June 30, 2005. No options were granted outside the StockOption Plan during fiscal 2005.

34

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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, 2002 |       | 151,294                  |       | 2,122,545              |       | $                       | 5.89       |   |
|                       |       |                     |       |                   |       |                    |       |
| Granted                    |       | 10,000                   |       | 300,000                |       | .05                     |       |
| Cancelled                  |       | (73,394                  | )          | (2,067,545             | )          | 5.86                    |       |
| Outstanding June  30, 2003 |       | 87,900                   |       | 355,000                |       | $                       | 1.95       |   |
|                       |       |                     |       |                   |       |                    |       |
| Granted                    |       | —                   |       | 2,137,939              |       | .08                     |       |
| Cancelled                  |       | (6,000                   | )          | —                 |       | 5.30                    |       |
| Outstanding June  30, 2004 |       | 81,900                   |       | 2,492,939              |       | $                       | .39        |   |
|                       |       |                     |       |                   |       |                    |       |
| Cancelled                  |       | —                   |       | (10,000                | )          | 5.86                    |       |
| Outstanding June 30,  2005 |       | 81,900                   |       | 2,482,939              |       | $                       | .36        |   |

 

----

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

The followingtables summarize information concerning currently outstanding and exercisablestock options at June 30, 2005:
| Options Outstanding and Exercisable | ** **  |
|----------------------------------------------------|-------------|
| **Exercise Prices**                           | ** **  | ** ** | ** ** | **Weighted Average** | ** ** |
| ** **                                         | ** **  | **Weighted** | ** ** | **Number** | ** ** | **Remaining** | ** ** |
| **Range**                                          | ** **  | **Average** | ** ** | **of Shares** | ** ** | **Contractual Life** | ** ** |
| $                                                  | 0.05 - 0.08 |   | $ | 0.08 |   | 2,447,939 |   | 8.3 years |   |
| $                                                  | 1.75        |   | $ | 1.75 |   | 1,000 |   | 1.3 years |   |
| $                                                  | 3.06        |   | $ | 3.06 |   | 400 |   | 2.3 years |   |
| $                                                  | 5.51 - 5.66 |   | $ | 5.66 |   | 87,500 |   | 4.6 years |   |
| $                                                  | 8.73        |   | $ | 8.73 |   | 28,000 |   | 3.7 years |   |
|                                               |        |   |   | 2,564,839 |   |   |   |

 

The weightedaverage fair value of options granted in fiscal 2004 was $.08 and fiscal 2003was $.05. No options were granted in fiscal 2005. Because the fair valueprovisions have not been applied to options granted prior to June 30, 1995, theresulting pro forma compensation cost (See Note 1) may not be representative ofthat to be expected in future years.

The fair value ofeach option is estimated on the date of grant using the Black-Scholes optionpricing model. The following assumptions were used to estimate the fair valueof options:
|                          | ** ** | **2005** | ** ** | **2004** | ** ** | **2003** | ** ** |
|--------------------------|------------|----------|------------|----------|------------|----------|------------|
| Risk-free  interest rate |       | 4.00     | %          | 4.00     | %          | 4.00     | %          |
| Expected life            |       | 10 years |       | 10 years |       | 10 years |       |
| Expected  volatility     |       | 220      | %          | 220      | %          | 220      | %          |
| Expected dividend yield  |       | None     |       | None     |       | None     |       |

35

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

K-tel International,Inc. vs. Tristar Products, Inc. 

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

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

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

Other Litigationand Disputes

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

Leases

The Company hasentered into several office and warehouse leases which expire through 2006.Commitments under  these leases are$120,000 in 2006.  Rental expense was$222,000 in 2005, $228,000 in 2004, and $254,000 in 2003.  Effective October 2006, the Company isplanning to relocate its U.S. operations to a smaller facility in Plymouth,Minnesota, which consists of 3,000 square feet of office space and 4,500 squarefeet of warehouse space.

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

Three customers accounted for approximately 18.4%, 15.3% and 13.2% ofK-tel’s revenue for the year ended June 30, 2005 and had accounts receivablebalances of $503,000, $403,000, and $22,000 respectively, at June 30, 2005. Theloss of, or a substantial reduction in, business from any of these customerscould have a material adverse effect on the Company.

See Note 3 forinformation regarding debt transactions with related parties.

The Companypurchased approximately $400,000 in the year ended June 30, 2005, $502,000 inthe year ended June 30, 2004, and $463,000 in the year ended June 30, 2003 ofmusic entertainment and consumer convenience products from   K-5, the Company’s largest shareholdercontrolled by Philip Kives, Chairman of the Board, President and Chief ExecutiveOfficer of K-tel. There were trade payables to K-5 of $398,000 at June 30,2005, and $390,000 at June 30, 2004.

The Company had nosales of  products to K-5 during theyears ended June 30, 2005, 2004 and 2003. There was a balance receivable from K-5at June 30, 2005 of $129,000 and June 30, 2004 of $113,000. No interest wascharged on the related outstanding balances during fiscal years 2005, 2004 and2003.

All future transactions between the Company, its officers, directorsand principal shareholders and its affiliates will be approved by the auditcommittee of the Company’s board of directors.

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**8.             RETIREMENT PLANS**

Pension Plan

The Company has apension plan for its U.K. employees. Contributions to the Plan by the Companyon behalf of the eligible employees were terminated effective February 15, 2001and all benefit accruals under the Plan ceased. Summary plan information is asfollows:
|                                                 | ** ** | ** **                | ** ** | ** ** | ** ** |
|-------------------------------------------------|------------|---------------------------|------------|------------|------------|
| ** **                                      | ** ** | **Pension Benefits** | ** ** |
| ** **                                      | ** ** | **2005**                  | ** ** | **2004**   | ** ** |
| ** **                                      | ** ** | **(In Thousands)**   | ** ** |
| Net periodic  cost:                             |       |                      |       |       |       |
| Interest cost                                   |       | $                         | 58         |       | $          | 44 |   |
| Expected return  on assets                      |       | (37                       | )          | (42        | )          |
| Amortization of  transition amount              |       | (17                       | )          | (16        | )          |
| Actuarial loss                                  |       | 15                        |       | 9          |       |
| Net periodic  benefit cost                      |       | $                         | 19         |       | $          | (5 | ) |
|                                            |       |                      |       |       |       |
| Change in  benefit obligation:                  |       |                      |       |       |       |
| Benefit  obligation at beginning of year        |       | $                         | 957        |       | $          | 764 |   |
| Interest cost                                   |       | 58                        |       | 44         |       |
| Actuarial loss                                  |       | 197                       |       | 77         |       |
| Exchange rate  adjustment                       |       | (12                       | )          | 72         |       |
|                                            |       |                      |       |       |       |
| Benefit  obligation at end of year              |       | $                         | 1,200      |       | $          | 957 |   |
|                                            |       |                      |       |       |       |
| Change in plan  assets:                         |       |                      |       |       |       |
| Fair value of  plan assets at beginning of year |       | $                         | 823        |       | $          | 712 |   |
| Actual return on  plan assets                   |       | 43                        |       | 42         |       |
| Exchange rate  adjustment                       |       | (5                        | )          | 69         |       |
|                                            |       |                      |       |       |       |
| Fair value of plan at  end of year              |       | $                         | 861        |       | $          | 823 |   |

 

Theemployer is not expected to contribute to the plan in fiscal 2006.

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

 

37

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The Company’s investmentstrategy with respect to pension plan assets is to continue to hold the planasset in a deposit administration fund, which is similar to a bank account.Interest is added to the fund at a rate declared by Swiss Life.
| (In Thousands)               | ** ** | **2005** | ** ** | **2004** | ** ** |
|-----------------------------------|------------|----------|------------|----------|------------|
| Reconciliation  of funded status: |       |     |       |     |       |
| Funded status                     |       | $        | (339       | )        | $          | (134 | ) |
| Unrecognized  actuarial loss      |       | 435      |       | 265      |       |
| Unrecognized  transition amount   |       | (168     | )          | (185     | )          |
|                              |       |     |       |     |       |
| Unfunded accrued  pension cost    |       | $        | (72        | )        | $          | (54 | ) |

 
|                                         | ** ** | **2005** | ** ** | **2004** | ** ** |
|-----------------------------------------|------------|----------|------------|----------|------------|
| Statement of  financial position:       |       |     |       |     |       |
| Unfunded accrued  pension cost          |       | $        | (72        | )        | $          | (54 | ) |
| Additional  minimum liability           |       | —   |       | (74      | )          |
| Accumulated  other comprehensive income |       | —   |       | 74       |       |
|                                    |       |     |       |     |       |
| Recognized amount                       |       | $        | (72        | )        | $          | (54 | ) |

 

WEIGHTED-AVERAGEASSUMPTIONS USED TO DETERMINE NET PERIODIC COST FOR THE YEARS ENDED JUNE 30:
|                                 | ** ** | **2005** | ** ** | **2004** | ** ** |
|---------------------------------|------------|----------|------------|----------|------------|
| Discount rate                   |       | 5.75     | %          | 5        | %          |
| Expected return  on plan assets |       | 4.5      | %          | 4.25     | %          |
| Rate of compensation  increase  |       | 0        | %          | 0        | %          |

 

WEIGHTED-AVERAGE ASSUMPTION USED TO DETERMINEBENEFIT OBLIGATIONS AS OF JUNE 30:
|                                | ** ** | **2005** | ** ** | **2004** | ** ** |
|--------------------------------|------------|----------|------------|----------|------------|
| Discount rate                  |       | 5.00     | %          | 5.75     | %          |
| Rate of compensation  increase |       | N/A      |       | N/A      |       |

 

Money PurchasePlan

The Company’s U.K.subsidiaries contribute amounts for their employees to a money purchase definedcontribution plan. The Company has contributed $53,000, $77,000, and $51,000for the years ended June 30, 2005, 2004 and 2003, respectively.

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

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

The retail musicsegment consists primarily of the sales of pre-recorded music from theCompany’s master music catalog. The Company sells compact discs and DVD’sdirectly to retailers, wholesalers and rack service distributors which stockand manage inventory within music departments for retail stores.

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

Operating profitsor losses of these segments include an allocation of general corporateexpenses. Depreciation and 

38

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amortization andcapital additions are not significant and have therefore been excluded from thepresentation.

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

BUSINESS SEGMENTINFORMATION *(in thousands)*
| Fiscal Years Ended | ** ** | ** ** | ** ** | ** ** | ** ** | ** **    | ** ** | ** ** | ** ** | **Total**   | ** ** |
|------------------------------|------------|------------|------------|------------|------------|---------------|------------|------------|------------|-------------|------------|
| **June 30,**            | ** ** | ** ** | ** ** | **Music**  | ** ** | **Licensing** | ** ** | **Other**  | ** ** | **Company** | ** ** |
|                              |       |       |       |       |       |          |       |       |       |        |       |
| Net Sales                    |       | 2005       |       | $          | 4,552      |          | $          | 1,489      |       | $           | —     |   | $ | 6,041 |   |
|                              |       | 2004       |       | 4,763      |       | 1,916         |       | —     |       | 6,679       |       |
|                              |       | 2003       |       | 4,454      |       | 2,780         |       | —     |       | 7,234       |       |
|                         |       |       |       |       |       |          |       |       |       |        |       |
| Operating Income (Loss)      |       | 2005       |       | $          | (416       | )             | $          | 326        |       | $           | —     |   | $ | (90 | ) |
|                              |       | 2004       |       | (992       | )          | 959           |       | —     |       | (33         | )          |
|                              |       | 2003       |       | (1,010     | )          | 1,159         |       | —     |       | 149         |       |
|                         |       |       |       |       |       |          |       |       |       |        |       |
| Assets                       |       | 2005       |       | $          | 3,893      |          | $          | 548        |       | $           | 254        |   | $ | 4,695 |   |
|                              |       | 2004       |       | 3,519      |       | 664           |       | 313        |       | 4,496       |       |
|                              |       | 2003       |       | 2,900      |       | 2,128         |       | 273        |       | 5,301       |       |

 

GEOGRAPHICINFORMATION *(in thousands)*
| Fiscal Years Ended  June 30, | ** ** | **United States** | ** ** | **Europe** | ** ** | **Total** | ** ** |
|---------------------------------------------|------------|------------------------|------------|------------|------------|-----------|------------|
| * *                                    | * *   | * *               | * *   | * *   | * *   | * *  | * *   | * * | * * |
| Net Sales                                   |       | 2005                   |       | $          | 3,428      |      | $          | 2,613 |   | $ | 6,041 |   |
|                                             |       | 2004                   |       | 3,836      |       | 2,843     |       | 6,679 |   |
|                                             |       | 2003                   |       | 4,949      |       | 2,285     |       | 7,234 |   |
|                                        |       |                   |       |       |       |      |       |   |   |
| Assets                                      |       | 2005                   |       | $          | 2,240      |      | $          | 2,455 |   | $ | 4,695 |   |
|                                             |       | 2004                   |       | 2,148      |       | 2,348     |       | 4,496 |   |
|                                             |       | 2003                   |       | 3,889      |       | 1,412     |       | 5,301 |   |

 

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

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

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

InDecember 2004, the FASB issued SFAS No. 123R, *Share-BasedPayment*, which replaced SFAS No. 123 and superseded APB 25. SFAS No.123R addresses the accounting for share-based payment transactions in which acompany receives employee services in exchange for either equity instruments ofthe company or liabilities that are based on the fair value of the company’sequity instruments or that may be settled by the issuance of such equityinstruments. Under SFAS No. 123R, companies will no longer be able to accountfor the share-based compensation transactions using the intrinsic method inaccordance with APB 25 but will be required to account for such transactionsusing a fair-value

39

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methodand recognize the expense in the consolidated statement of operations. SFAS No.123R is effective beginning in the Company’s first quarter of fiscal year 2007.Under SFAS 123R, the Company must determine the appropriate fair value model tobe used for valuing share-based payments, the amortization method forcompensation cost and the transition method to be used at date of adoption. Thetransition methods include prospective and retroactive adoption options. TheCompany has begun, but has not completed, evaluating the impact of the adoptionof SFAS 123R on its results of operations. In connection with evaluating theimpact of SFAS 123R, the Company is considering the potential implementation ofdifferent valuation methods to determine the fair value of share-basedcompensation. The Company believes the adoption of SFAS 123R will not have amaterial impact on our results of operations, regardless of the valuationmethod used.

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

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

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

The Company  recorded account receivable amounts relating to the misappropriated funds ofapproximately $857,000 and   $545,000 atJune 30, 2004 and June 30, 2003, respectively, to the consolidated balancesheet.  At June 30, 2004 the consolidatedbalance sheet accounts receivable amount also includes approximately $324,000from a Lancaster receivable relating to the misappropriated funds (see Note12).

Fiscal 2005Interim Financial Data

Quarterly Financial Information (Unaudited)
|                                                                       | ** ** | **Three Months Ended,** | ** ** |
|-----------------------------------------------------------------------|------------|-----------------------------------|------------|
| ** **                                                            | ** ** | **September 30,  2004**      | ** ** | **December 31,  2004** | ** ** | **March 31,  2005** | ** ** | **June 30,  2005** | ** ** |
| Net sales                                                             |       | $                                 | 1,836      |   | $ | 1,695 |   | $ | 1,316 |   | $ | 1,194 |   |
| Gross profit                                                          |       | $                                 | 915        |   | $ | 923 |   | $ | 911 |   | $ | 853 |   |
| Advertising,  selling, general & administrative                   |       | $                                 | 944        |   | $ | 913 |   | $ | 953 |   | $ | 882 |   |
| Operating Income  (loss)                                              |       | $                                 | (29        | ) | $ | 10 |   | $ | (42 | ) | $ | (29 | ) |
| Net income  (loss)                                                    |       | $                                 | (153       | ) | $ | 190 |   | $ | (240 | ) | $ | (254 | ) |
| Basic and  diluted net loss per common share                          |       | $                                 | (.01       | ) | $ | .01 |   | $ | (.02 | ) | $ | (.02 | ) |
| Shares used in  computing basic and diluted net loss per common share |       | 13,654                            |       | 13,654 |   | 13,654 |   | 13,654 |   |

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Fiscal 2004Interim Financial Data

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

 

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

The Company sellscertain products to and buys from Lancaster, a company established in theU.K.  In accordance with FASBInterpretation 46 (Revised December 2003), *Consolidation of VariableInterest Entities* (FIN 46 (R)), the Company determined thatLancaster is a variable interest entity and that the Company is the primarybeneficiary of this entity.  The Companywas required to apply the guidance of FIN 46 (R) for periods ending after March15, 2004, and accordingly, during the quarter ended March 31, 2004, thefinancial statements of Lancaster were consolidated with those of the Company.

As of June 30,2005, the consolidated financial statements included approximately $399,000 ofcurrent assets and $243,000 of current liabilities related to Lancaster.  Lancaster’s current assets includeapproximately $322,000 of amounts receivable related to the misappropriation ofassets as described in Note 11.  Salesand purchases between Lancaster and the Company have been eliminated inconsolidation, and the additional effects of Lancaster on the Company’soperations were not material.

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

K-tel International,Inc., through a wholly owned subsidiary, entered into a trademark licenseagreement with BCI Eclipse Company, LLC (“BCI”), a subsidiary of NavarreCorporation, effective October 10, 2005. K-tel, through a wholly owned subsidiary, also entered into a phonographrecord license agreement with BCI effective October 16, 2005.

Pursuant to the trademarklicense agreement, K-tel has granted to BCI a license to use its trademarks,K-TEL® and K-tel’s circular design logo. The agreement, which runs for an initial term of fourteen months, grantsBCI the exclusive license to use the marks in the United States in a field ofuse limited to the sale and distribution of compact discs and DVDs.  The marks may be used in connection withdistribution of K-tel’s music titles as well as products owned by third partiesand released by BCI.  The products whichmay be distributed using the marks exclude digital downloads, but includetangible products which may be marketed digitally.  The marks may not be used in connection withTV and/or radio-advertised and mail order packages.  The agreement provides for royalties of $0.30per compact disc on a minimum of 80% of the compact discs using the K-tel markand between $0.27 and $0.29 on the balance, with the payments due after BCIreceives payment from its customers.  BCIpaid K-tel a $100,000 advance against royalties upon execution of theagreement.  The advance is recoupable byBCI out of 50% of the royalties otherwise payable to K-tel.  After the initial term, BCI has the right toextend the term for one year if K-tel has earned royalties based on productsshipped including the advance totaling $350,000 or BCI has made make-uppayments in such amount, and for a second year extension if BCI has earnedroyalties based on products shipped of $450,000 in the first extension term.

Pursuant to the phonograph record license agreement, K-tel, through awholly owned subsidiary, licensed master recordings from K-tel’s masterrecording catalog for a period of two years commencing on the initial releasedate of each titled album from the catalog. The initial term of the agreement expires on December 31, 2006 and BCIhas the right to extend the term for one year if it has earned royalties basedon products shipped, including the advance, totaling $350,000, or has mademake-up payments in such amount, and for a second year extension if BCI hasearned royalties

41

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based on products shipped of $450,000 during the first extensionperiod.  The nonexclusive license allowsBCI to make reproductions of K-tel’s master recordings in audio compact discand DVD formats.  The agreement providesfor non-returnable advances of $150 per licensed master recoupable againstroyalties payable when BCI receives payment from their customers at the rate of$0.03 per pre-recorded licensed master and $0.04 per original licensed masterembodied in any album.  The territory ofthe license is the U.S. and Canada.  Thelicense allows BCI to compile master recordings and manufacture, distribute andsell albums in compact disc format through retail stores, online retail storesand record and video club sales channels under K-tel’s licensed marks.

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**SCHEDULEII**

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

**VALUATIONAND QUALIFYING ACCOUNTS**

Years ended June30,

(In thousands)
| ** **                       | ** ** | **Balance at  Beginning of  Period** | ** ** | **Charged to Costs  and Expenses or  Net Sales** | ** ** | **Charged to  Other  Accounts (1)** | ** ** | **Deductions** | ** ** | **Balance at  End of Period** | ** ** |
|----------------------------------|------------|------------------------------------------------|------------|---------------------------------------------------------------------------|------------|-----------------------------------------------|------------|----------------|------------|----------------------------------------------|------------|
| Allowance for Doubtful  Accounts |       |                                           |       |                                                                      |       |                                          |       |           |       |                                         |       |
|                             |       |                                           |       |                                                                      |       |                                          |       |           |       |                                         |       |
| 2005                             |       | $                                              | 4          |                                                                      | $          | —                                        |       | $              | —     |                                         | $          | — |   | $ | 4 |   |
| 2004                             |       | $                                              | 25         |                                                                      | $          | 24                                            |       | $              | 2          |                                         | $          | (47 | )(2) | $ | 4 |   |
| 2003                             |       | $                                              | 68         |                                                                      | $          | 62                                            |       | $              | 9          |                                         | $          | (114 | )(2) | $ | 25 |   |
|                             |       |                                           |       |                                                                      |       |                                          |       |           |       |                                         |       |
| Reserve for Returns              |       |                                           |       |                                                                      |       |                                          |       |           |       |                                         |       |
|                             |       |                                           |       |                                                                      |       |                                          |       |           |       |                                         |       |
| 2005                             |       | $                                              | 133        |                                                                      | $          | 646                                           |       | $              | —     |                                         | $          | (558 | ) | $ | 221 |   |
| 2004                             |       | $                                              | 220        |                                                                      | $          | 375                                           |       | $              | 1          |                                         | $          | (463 | ) | $ | 133 |   |
| 2003                             |       | $                                              | 46         |                                                                      | $          | 447                                           |       | $              | —     |                                         | $          | (273 | ) | $ | 220 |   |

 

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(1) Exchange ratechange

(2) Uncollectibleaccounts written off, net of recoveries

43

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**EXHIBITINDEX**
| Exhibit No. | ** ** | **Description of Exhibit**                                                                                                                                                                                                                                                                                                         |
|-------------|------------|------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|
|        |       |                                                                                                                                                                                                                                                                                                                               |
| 3.1         |       | Restated Articles of Incorporation, as amended  (incorporated by reference to the Company’s Annual Report on Form 10-K for  the fiscal year ended June 30, 2003 (File No. 1-07115)).                                                                                                                                          |
|        |       |                                                                                                                                                                                                                                                                                                                               |
| 3.2         |       | Restated By-Laws (incorporated by reference to the  Company’s Annual Report on Form 10-K for the fiscal year ended June 30, 1985  (File No. 1-07115)).                                                                                                                                                                        |
|        |       |                                                                                                                                                                                                                                                                                                                               |
| 4           |       | See Exhibits 3.1 and 3.2.                                                                                                                                                                                                                                                                                                          |
|        |       |                                                                                                                                                                                                                                                                                                                               |
| 10.1        |       | 1987 Stock Incentive Plan (incorporated by reference  to the Company’s Annual Report on Form 10-K for the fiscal year ended June  30, 1987 (File No. 1-07115)).                                                                                                                                                               |
|        |       |                                                                                                                                                                                                                                                                                                                               |
| 10.2        |       | 1997 Stock Option Plan (incorporated by reference to  the Company’s Annual Report on Form 10-K for the fiscal year ended June 30,  1997 (File No. 1-07115)).                                                                                                                                                                  |
|        |       |                                                                                                                                                                                                                                                                                                                               |
| 10.3        |       | Form of Incentive Stock Option Agreement under the  Company’s 1997 Stock Option Plan (incorporated by reference to the Company’s  Annual Report on Form 10-K for the fiscal year ended June 30, 2000 (File No.  1-07115)).                                                                                               |
|        |       |                                                                                                                                                                                                                                                                                                                               |
| 10.4        |       | Form of Non-Qualified Stock Option Agreement under  the Company’s 1997 Stock Option Plan (incorporated by reference to the  Company’s Annual Report on Form 10-K for the fiscal year ended June 30, 2000  (File No. 1-07115)).                                                                                           |
|        |       |                                                                                                                                                                                                                                                                                                                               |
| 10.5        |       | Form of Non-Qualified  Stock Option Agreement between the registrant and certain non-employee  directors of the registrant, authorized effective November 27, 2002  (incorporated by reference to the Company’s Quarterly Report on Form 10-Q for  the fiscal quarter ended March 31, 2003 (File No. 1-07115)).               |
|        |       |                                                                                                                                                                                                                                                                                                                               |
| 10.6        |       | Loan and Security Agreement between the Company and  Foothill Capital Corporation dated November 19, 1997 (incorporated by  reference to the Company’s Quarterly Report on Form 10-Q for the fiscal  quarter ended December 31, 1997 (File No. 1-07115)).                                                                     |
|        |       |                                                                                                                                                                                                                                                                                                                               |
| 10.7        |       | Amendment Number One to the Loan and Security  Agreement between the Company and Foothill Capital Corporation dated March  30, 1998 (incorporated by reference to the Company’s Annual Report on Form  10-K for the fiscal year ended June 30, 1998 (File No. 1-07115)).                                                      |
|        |       |                                                                                                                                                                                                                                                                                                                               |
| 10.8        |       | Amendment Number Two to the Loan and Security  Agreement between the Company and Foothill Capital Corporation dated  September 23, 1998 (incorporated by reference to the Company’s Annual Report  on Form 10-K for the fiscal year ended June 30, 1998 (File No. 1-07115)).                                                  |
|        |       |                                                                                                                                                                                                                                                                                                                               |
| 10.9        |       | Restated Amendment Number Two to the Loan and  Security Agreement between the Company and Foothill Capital Corporation dated  September 30, 1998 (incorporated by reference to the Company’s Annual Report  on Form 10-K for the fiscal year ended June 30, 1998 (File No. 1-07115)).                                         |
|        |       |                                                                                                                                                                                                                                                                                                                               |
| 10.10       |       | Amendment Number Three to the Loan and Security  Agreement between the Company and Foothill Capital Corporation dated  September 22, 1999 (incorporated by reference to the Company’s Annual Report  on Form 10-K for the fiscal year ended June 30, 2000 (File No. 1-07115)).                                                |
|        |       |                                                                                                                                                                                                                                                                                                                               |
| 10.11       |       | Amendment Number Four to the Loan and Security  Agreement between the Company and Foothill Capital Corporation dated May 15,  2000(incorporated by reference to the Company’s Annual Report on Form 10-K  for the fiscal year ended June 30, 2000 (File No. 1-07115)).                                                        |
|        |       |                                                                                                                                                                                                                                                                                                                               |
| 10.12       |       | Amendment to Loan Agreement and Security Agreement  between the Company and K-5 Leisure  Products, Inc., as assignee of Foothill Capital Corporation dated February  12, 2002 (incorporated by reference to the Company’s Quarterly Report  on Form 10-Q for the fiscal quarter ended December 31, 2001 (File No.  1-07115)). |

44

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| 10.13  |   | Credit Agreement between the Company and K-5 Leisure  Products, Inc. dated September 27, 1999 (incorporated by reference to the  Company’s Annual Report on Form 10-K for the fiscal year ended June 30, 2003  (File No. 1-07115)).                                                                                          |
|--------|--------|-----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|
|   |   |                                                                                                                                                                                                                                                                                                                              |
| 10.14  |   | $8,000,000 principal amount Note between the Company  and K-5 Leisure Products, Inc. dated  September 27, 1999 (incorporated by reference to the Company’s Annual  Report on Form 10-K for the fiscal year ended June 30, 2003 (File No.  1-07115)).                                                                         |
|   |   |                                                                                                                                                                                                                                                                                                                              |
| 10.15  |   | Amendment to Credit Agreement and Note between the  Company and K-5 Leisure Products,  Inc.dated February 12, 2002 (incorporated by reference to the  Company’s Quarterly Report on Form 10-Q for the fiscal quarter ended December  31, 2001 (File No. 1-07115)).                                                           |
|   |   |                                                                                                                                                                                                                                                                                                                              |
| 10.16  |   | Trademark license agreement dated effective October  10, 2005, between Dominion Entertainment, Inc. and BCI Eclipse Company, LLC  (incorporated by reference to the Company’s Report on Form 8-K filed on  August 29, 2006 (File No. 1-07115)).                                                                              |
|   |   |                                                                                                                                                                                                                                                                                                                              |
| 10.17  |   | Phonograph record license agreement between Dominion  Entertainment, Inc. and BCI Eclipse Company, LLC, effective October 16, 2005  (incorporated by reference to the Company’s Report on Form 8-K filed on August  29, 2006 (File No. 1-07115)).                                                                            |
|   |   |                                                                                                                                                                                                                                                                                                                              |
| 10.18  |   | Digital music download sales agreement dated October  10, 2003, between Dominion Entertainment, Inc. and Apple Computer, Inc.  (incorporated by reference to the Company’s Report on Form 8-K filed on  August 29, 2006 (File No. 1-07115)).                                                                                 |
|   |   |                                                                                                                                                                                                                                                                                                                              |
| 10.19  |   | Amendment Number Two to Loan Agreement and Security  Agreement between the Company and K-5  Leisure Products, Inc., as assignee of Foothill Capital Corporation dated  July 20, 2005 (incorporated by reference to the Company’s Annual  Report on Form 10-K/A for the fiscal year ended June 30, 2004 (File No.  1-07115)). |
|   |   |                                                                                                                                                                                                                                                                                                                              |
| 10.20  |   | Amendment Number Two to Credit Agreement and Note  between the Company and K-5 Leisure  Products, Inc. dated July 20, 2005 (incorporated by reference to the  Company’s Annual Report on Form 10-K/A for the fiscal year ended June 30,  2004 (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(a).                                                                                                                                                                                                                                                             |
|   |   |                                                                                                                                                                                                                                                                                                                              |
| 31.2   |   | Certification by Chief Financial Officer pursuant to  Rule 13a-14(a).                                                                                                                                                                                                                                                             |
|   |   |                                                                                                                                                                                                                                                                                                                              |
| 32.1   |   | Certification by Chief Executive Officer pursuant to  18 U.S.C. Section 1350, as adopted pursuant to Section 906 of the Sarbanes-Oxley  Act of 2002.                                                                                                                                                                              |
|   |   |                                                                                                                                                                                                                                                                                                                              |
| 32.2   |   | Certification by Chief Financial Officer pursuant to  18 U.S.C. Section 1350, as adopted pursuant to Section 906 of the  Sarbanes-Oxley Act of 2002.                                                                                                                                                                              |

 

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