**UNITED STATES**

**SECURITIES AND EXCHANGE COMMISSION**

**Washington, D.C. 20549**

 

**FORM 10-K**

 

(MARK ONE)

**x**                              ANNUALREPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934

 

For the fiscal year ended **June 30,2006**

 

OR

 

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

 

For the transition period from                to                

 

Commission file number **1-07115**

 

**K-TEL INTERNATIONAL, INC.**

(Exact name of registrant as specified in its charter)

 

| **Minnesota**                                                                | ** ** | **41-0946588**                        |
|------------------------------------------------------------------------------|------------|---------------------------------------|
| (State or other  jurisdiction of                                             |       | (I.R.S. Employer  Identification No.) |
| incorporation or  organization)                                              |       |                                  |
|                                                                         |       |                                  |
| **2491  Xenium Lane North, Plymouth, Minnesota**                             | ** ** | **55441**                             |
| (Address of  principal executive offices)                                    |       | (Zip Code)                            |
|                                                                         |       |                                  |
| Registrant’s  telephone number, including area code: **(763) 559-5566** |
|                                                                         |
| Securities  registered pursuant to Section 12(b) of the Act:                 |
| **None**                                                                     |
|                                                                         |
| Securities  registered pursuant to Section 12(g) of the Act:                 |
| **Common  Stock, par value $0.01**                                           |
| (Title of class)                                                             |

 

Indicate by check mark if the registrant is awell-known seasoned issuer, as defined in Rule 405 of the Securities 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 check markwhether 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 check mark ifdisclosure of delinquent filers pursuant to Item 405 of Regulation S-K is notcontained 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 check mark whether the registrant is a large acceleratedfiler, an accelerated filer, or a non-accelerated filer. See definition of “acceleratedfiler and large accelerated filer”  inRule 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 o      No x

As of November 17, 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 $211,189.

As of November 17, 2006, the registrant had13,653,738 shares of Common Stock outstanding.

DOCUMENTSINCORPORATED BY REFERENCE

None.

 

----

 

**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                                 |   |                                                                                                               |   |
| Index to Consolidated Financial Statements |   |                                                                                                               |   |
| Exhibit  Index                             |   |                                                                                                               |   |

 

 

 

**SAFE HARBORSTATEMENT UNDER THEPRIVATE SECURITIES LITIGATION REFORM ACT OF 1995**

Certain statements of anon-historical nature under the caption “Management’s Discussion and Analysisof Financial Condition and Results of Operations” and elsewhere in this Form10-K constitute “forward-looking statements” within the meaning of the PrivateSecurities Litigation Reform Act of 1995. Such forward-looking statements maybe identified by the use of terminology such as “may,” “will,” “expect,” “anticipate,”“estimate,” “should,” or “continue” or the negative thereof or other variationsthereon or comparable terminology. Such forward-looking statements are subjectto certain risks and uncertainties that could cause actual results to differmaterially from historical results or from those results currently anticipatedor projected. Such factors include, among other things, the following: changesin consumer purchasing; demand for and market acceptance of new and existingproducts; the impact from competition for recorded music; the outcome of legalproceedings; dependence on suppliers and distributors; success of marketing andpromotion efforts; technological changes and difficulties; availability offinancing; foreign currency variations; general economic, political andbusiness conditions; and other matters. See “Risk Factors” in Item 1A foradditional information.  We undertake noobligation to release publicly the result of any revisions to theseforward-looking statements, except as required by law.

 

3

----

 

**PART I**

**ITEM 1:                BUSINESS**

K-tel International, Inc.(the “Company”, “K-tel” or the “registrant”) was incorporated in 1968 andcurrently has its corporate offices located in Plymouth, Minnesota. Through itsoperating subsidiaries, K-tel licenses its music catalog internationally andmarkets entertainment products mainly derived from its catalog through retailand direct response marketing channels in the United States and Europe. TheCompany has a focused method of distribution that targets the strengths of selectedindividual retailers and supplies products suited to each retailer’s needs.These products are derived mainly from the Company’s master recordings musiccatalog with the objective of realizing more competitive profit margins. K-telseeks to license its name and trademarks to other companies.  Licenses are granted for a royalty or fee,with no cost to the Company.

Description ofBusinesses

Music Licensing and Sales

K-tel’s primary activity is licensing music to other record companiesand to other segments of the entertainment industry. K-tel owns a proprietarymaster music catalog of approximately 6,000 titles consisting of originalrecordings and re-recordings of music from the 1950’s through today. TheCompany licenses the rights to its master recordings to third parties worldwidefor use in albums.  The Company alsolicenses its master recordings for films, television programs, commercials andelectronic downloads to various media formats, for either a flat fee or aroyalty based on the number of units sold. Licensing of its proprietary musicrights to third parties has historically been an important revenue source forK-tel.

The Company also markets and distributes pre-recorded compact discsutilizing the Company’s master recordings in its music catalog. Customersinclude retailers, wholesalers and rack service distributors. These productsare also sold through subsidiaries and licensees in the United States, UnitedKingdom and elsewhere in Europe. The principal entertainment products thatK-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.

One customer, I Tunes, accounted for approximately 15.2% of K-tel’srevenue for the year ended June 30, 2006. The loss of, or a substantialreduction in, business from this customer could have a material adverse effecton the Company.

K-tel delivers musicproducts through licensing its master music catalog to other music companies,through electronic downloads of the Company’s master music catalog and sales ofCDs through traditional wholesale and retail distribution channels. Digitalmusic distribution provides both significant risks and opportunities for K-tel.The risks include K-tel’s uncertain ability to compete with other musiccompanies from a marketing and technological standpoint. The Company believesthere are additional opportunities to license its owned library of masterrecordings and is pursuing alternative licensing and distribution opportunities.

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. Management is focusing its efforts on musiclicensing and music distribution. However, there can be no assurance that theCompany will achieve profitable operations through these efforts or be able tocontinue operations. The financial statements do not include any adjustmentsthat might result from the outcome of these uncertainties.

Competition

The music business ishighly competitive.  K-tels competitorsinclude national and regional companies; certain of these competitors (Sony BMGCorp., Time Warner, Inc. and EMI) dominate the market for licensing and pre-recordedmusic. K-tel does not have the financial resources, nor does it have the depthor breadth of catalog, distribution capabilities or current repertoire of thesecompanies. K-tel’s ability to compete in the future depends upon a number offactors, including its ability to:

4

----

·                  obtainlicenses with independent music labels and manufacturers;

·                  expandthe customer base for the Company’s master music catalog for digital downloads;and

·                  buildupon and maintain its reputation for licensing,  producing, marketingand distributing high quality music.

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

IntellectualProperty

TheCompany believes that the K-tel® name and mark are well recognized and aretherefore valuable assets of the Company. The Company pursues the registrationof its trademarks and service marks in the U.S. and internationally. Effectivetrademark, service mark and copyright protection may not be available in everycountry in which the Company’s products and services are made available.Federal and state trademark registrations continue indefinitely, so long as thetrademarks are in use and periodic renewals and other required filings aremade.

TheCompany regards its copyrights, service marks, trademarks, trade dress, tradesecrets and similar intellectual property as critical to its success, andrelies 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, 2006,K-tel employed 10 full time and 3 part time people worldwide.

# Financial and Geographic Information

For financialinformation about the Company’s business segment and geographic area operationsfor each of the three fiscal years ended June 30, 2006 (see Note 9 to theconsolidated financial statements).

**ITEM 1A:             RISK FACTORS**

The following arecertain risk factors that could affect the Company’s business, financialcondition, operation results and cash flows. These risk factors should be considered in connection with evaluatingthe forward-looking statements contained in this Annual Report on Form 10-K becausethese risk factors could cause actual results to differ materially from thoseexpressed in any forward-looking statement. The risks highlighted below are not the only ones the Company  faces. If any of these events actually occur, the Company’s business, financialcondition, operating results or cash flows could be negatively affected.  The Company cautions you to keep in mindthese risk factors and to refrain from attributing undue certainty to anyforward-looking statements, which speak only as of the date of this report.

**Continuinglosses could affect the Company’s ability to obtain additional working capital.**

The Company has incurred losses in recent fiscal yearsand expects to continue incurring losses for the foreseeable future.Continuation of the Company’s operations will require additional workingcapital and continued access to financing to meet working capital requirementsand develop new business opportunities which may not be available on acceptableterms or at all.

In addition, the report of the Company’s independentregistered public accounting firm for fiscal year 2006 includes an explanatoryparagraph expressing doubt about the Company’s ability to continue as a goingconcern.

5

----

**Thelevel of the Company’s indebtedness could adversely affect financial condition.**

The Company has primarily funded its recent operationsthrough secured loans from K-5 Leisure Products, Inc. (“K-5”), the Company’slargest shareholder which is controlled by Philip Kives, the Chairman of theBoard, President and Chief Executive Officer of K-tel.  Although K-5 continues to advance fundssufficient to meet the Company’s needs at this time, there can be no assurancethat K-5 will continue to advance funds sufficient to meet the Company’s needsor that the Company will be able to obtain additional financing upon favorableterms or at all when required.

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

The Companybelieves that sales to a small group of customers will continue to represent asignificant percentage of total net sales. Substantially all of the productsthe Company distributes to these customers are supplied on a non-exclusivebasis under arrangements that may be cancelled without cause and upon shortnotice, and retail customers generally are not required to make minimumpurchases. If the Company is unable to continue to sell products to this selectgroup of customers or is unable to maintain sales to these customers at currentlevels and cannot find other customers to replace these sales, there would bean adverse impact on net sales and profitability. There can be no assurancethat the Company will continue to recognize a significant amount of revenuefrom sales to any specific customer.

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

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

**Technologydevelopments may adversely affect net sales, margins and results of operations.**

Home entertainmentproducts have traditionally been marketed and delivered on a physical deliverybasis. If, in the future, these products are increasingly marketed anddelivered through technology transfers, such as electronic downloading throughthe Internet or similar delivery methods, then the Company’s retail andwholesale distribution business could be negatively impacted. As electronicdownloading grows through Internet retailers, competition between suppliers toelectronic retailers in traditional ways will intensify and likely negativelyimpact net sales and margins. If the Company is unable to develop the necessaryvendor and customer relationships to facilitate additional electronicdownloading or if the terms of these arrangements differ from those related tophysical product sales the Company’s business may be materially harmed.

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

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

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

The Companyregards its copyrights, service marks, trademarks, and similar intellectualproperty critical to its success, and relies on trademark and copyright law toprotect the intellectual property the Company licenses.  Infringement on the Company’s intellectualproperty may lead to litigation to protect the Company’s intellectual propertyrights which could result in substantial costs and diversion of resources andcould have a material effect on the Company’s business.

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

The Companymaintains a significant investment in product inventory. Like other companiesoperating in the music industry, product returns from retail customers aresignificant when expressed as a percentage of revenues.  Weakening market conditions could lead toincreased product returns, increasing the Company’s inventory and increasingthe need for higher obsolescence reserve. Adverse financial conditions could cause a significant decline in thevalue and marketability of products, possibly making it difficult to recoverinitial product acquisition costs. Under such circumstances, the Company’sbusiness, financial condition, operating results and cash flows, could beadversely affected. The Company maintains a sales return reserve based onhistorical product line experience rates. The Company can not assure thatreserves will be adequate to cover potential returns.

**If theCompany is unable to successfully remediate the material weaknesses in itsinternal controls, the Company’s ability to report its financial results on atimely and accurate basis may be adversely affected.**

The Company has reported material weaknesses and theactions taken to address them.  Suchremediation may not prove effective. Further, should any material weaknesses develop, there are no assurancesthat the Company will be able to remediate them in a manner satisfactory tooutside parties.  This could result inthe Company not being able to report its financial results on a timely basis,harm our operating results, or result in material misstatements in ourfinancial statements.  In addition, theCompany may be unable to have its internal controls over financial reportingattested to by our independent registered public accounting firm when required.

**ITEM 1B:             UNRESOLVED STAFF COMMENTS**

None

6

----

**ITEM 2:**                PROPERTIES

K-tel’s corporateoffices and U.S. operations are located in leased facilities in Plymouth, asuburb of Minneapolis, Minnesota, consisting of approximately 3,000 square feetof office space and approximately 4,500 square feet of warehouse. K-tel’sforeign subsidiaries lease a total of approximately 1,350 square feet of officespace.   See Note 6 to the consolidated financialstatements for a summary of the lease agreements.

**ITEM 3:                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 Litigation and Disputes

K-tel and its subsidiariesare also involved in other legal proceedings in the ordinary course of theirbusiness. With all litigation matters, management considers the likelihood ofloss based on the facts and circumstances. If management determines that a lossis probable and the amount of loss can be reasonably estimated, such amount isrecorded as a liability. Although the outcome of any such legal proceedingscannot be predicted, in the opinion of management there is currently no legalproceeding pending or asserted against or involving K-tel for which the outcomeis likely to have a material adverse effect on the consolidated financialposition or results of operations of K-tel.

Subsidiary’sLiquidation

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

In June 2004, theCompany received funds for the sale of assets and the collections of accountsreceivables related to the March 2001 bankruptcy of K-tel International (USA),Inc., the Company’s music 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.

**ITEM 4:**                   SUBMISSION OFMATTERS TO A VOTE OF SECURITY HOLDERS

No matters weresubmitted to a vote of K-tel’s security holders during the fourth quarter offiscal 2006.

**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.

7

----

The followingtable sets forth certain information with respect to the executive officers ofK-tel at November 22, 2006.
| **Name of  Officer** | ** ** | **Age** | ** ** | **Positions and Offices Held**                                            |
|----------------------|------------|---------|------------|---------------------------------------------------------------------------|
| Philip Kives         |       | 77      |       | Chairman of the Board, Chief Executive Officer,  President and Director   |
| Kimmy Lockwood       |       | 50      |       | Controller, Principal Financial Officer and  Principal Accounting 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.

**KimmyLockwood**, age 50, served as the Company’s Controller from1997 until July 2005, and from July 2006 until present.  From July 2005 toJuly 2006, Ms. Lockwood was Assistant Controller for Heritage Development,Inc., a land development company based in Little Canada, Minnesota.  Shewas appointed Principal Financial Officer and Principal Accounting Officer inSeptember 2006.

**PART II**
| **ITEM 5:** | ** ** | **MARKET FOR REGISTRANT’S COMMON STOCK, RELATED  STOCKHOLDER MATTERS  AND ISSUER PURCHASES OF EQUITY SECURITIES** |
|-------------|------------|------------------------------------------------------------------------------------------------------------------------|

** **

On November 13,2006, there were 1,388 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.

|             | ** ** | **2006** | ** ** | **2005** | ** ** |
|-------------|------------|----------|------------|----------|------------|
| ** **  | ** ** | **High** | ** ** | **Low**  | ** ** | **High** | ** ** | **Low** | ** ** |
| 1st Quarter |       | $        | .08        |     | $          | .04 |   | $ | .15 |   | $ | .10 |   |
| 2nd Quarter |       | $        | .04        |     | $          | .03 |   | $ | .12 |   | $ | .10 |   |
| 3rd Quarter |       | $        | .03        |     | $          | .02 |   | $ | .13 |   | $ | .08 |   |
| 4th Quarter |       | $        | .06        |     | $          | .02 |   | $ | .10 |   | $ | .06 |   |

 

No cash dividends weredeclared on K-tel’s common stock during fiscal year 2006 or 2005 and K-tel doesnot expect to pay cash dividends in the foreseeable future. The declaration orpayment by K-tel of dividends, if any, on its common stock in the future issubject to the discretion of the Board of Directors and will depend on K-tel’searnings, financial condition, capital requirements and other relevant factors.The declaration or payment by K-tel of dividends is also subject to the termsof its credit facility.

**EquityCompensation Plan Information**

Thefollowing table provides information as of June 30, 2006 with respect tocompensation plans under which the Company’s equity securities are authorizedfor issuance.

8

----

 
| **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     |       | 46,000                                                                                                                                                    | (1)        | $                                                                                                                | 5.51       |                                                                                                                                                                                                                      | 2,951,778  | (2) |
| Equity  compensation plans not approved by security holders |       | 2,182,939                                                                                                                                                 | (3)        | $                                                                                                                | 0.08       |                                                                                                                                                                                                                      | —     |   |
| Total                                                       |       | 2,228,939                                                                                                                                                 |       | $                                                                                                                | 0.19       |                                                                                                                                                                                                                      | 2,951,778  |   |

----

(1)             Consistsof 46,000 shares issuable pursuant to options granted under the Company’s 1997Stock Option Plan.

(2)             Representsshares of common stock remaining available for future issuance under the Company’s1997 Stock Option Plan, as amended.

(3)             Includesnon-qualified stock options to purchase 95,000 shares of  common stock issued outside the Company’s1997 Stock Option Plan to each of Jay William Smalley, Richard R. Marklund andWesley C. Hayne in connection with such non-employee directors’ appointment tothe Company’s Compensation/ Stock Option Committee and a non-qualified stockoption to purchase 15,000 shares of common stock issued outside the Company’s1997 Stock Option Plan to Jay William Smalley in consideration of his past andcontinued service on the Company’s board of directors. See “DirectorCompensation” in Item 11. Includes an aggregate of 1,882,939 shares of commonstock issued pursuant to a stock option exchange program approved on March 18,2003 by a committee of the Company’s board of directors comprised solely ofindependent directors. Under the program, three 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 then fairmarket value of the Company’s common stock and to expire ten years after thenew date of grant. On November 18, 2003, the replacements options were issuedat a price per share of $.08. There was no compensation expense recognized as aresult 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 its subsidiariesas of and for each of the five years in the period ended June 30, 2006. Thissummary should be read in conjunction with the consolidated financialstatements and notes thereto appearing elsewhere in this report. All share andper share amounts are based on the weighted average shares issued. All amountsare in thousands of dollars, except per share data.
| ** **                                     | ** ** | **2006** | ** ** | **2005** | ** ** | **2004** | ** ** | **2003** | ** ** | **2002** | ** ** |
|------------------------------------------------|------------|----------|------------|----------|------------|----------|------------|----------|------------|----------|------------|
| Net sales                                      |       | $        | 4,804      |     | $          | 6,041    |       | $        | 6,679      |     | $          | 7,234 |   | $ | 6,891 |   |
| Operating income  (loss)                       |       | $        | (425       | )        | $          | (90      | )          | $        | (33        | )        | $          | 149 |   | $ | (46 | ) |
| Income (loss)  from discontinued operations(1) |       | $        | (11        | )        | $          | 151      |       | $        | (52        | )        | $          | (581 | ) | $ | (180 | ) |
| Extraordinary  item(2)                         |       | $        | —     |     | $          | —   |       | $        | 347        |     | $          | — |   | $ | 894 |   |
| Net income  (loss)                             |       | $        | (1,211     | )        | $          | (457     | )          | $        | (87        | )        | $          | (892 | ) | $ | 300 |   |
| Net loss per  share:                           |       |     |       |     |       |     |       |     |       |     |       |
| Continuing operations                          |       | $        | (.09       | )        | $          | (.04     | )          | $        | (.03       | )        | $          | (.02 | ) | $ | (.03 | ) |
| Total assets                                   |       | $        | 3,272      |     | $          | 4,695    |       | $        | 4,496      |     | $          | 5,301 |   | $ | 4,610 |   |

----

(1)             Theincome (loss) from discontinued operations reflects the operations of theCompany’s consumer products business, net of any income taxes allocated to it.The Company discontinued its consumer products operations in Germany in June2000, in the United Kingdom in November 2000, and in the United States inJanuary 2001. The income in fiscal 2005 also includes the $350,000 lawsuitsettlement received from Tristar that had originated in the discontinuedconsumer products business.

(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 to distributionsreceived from the liquidation of K-tel Marketing, Ltd. in the United Kingdomand proceeds from the sale of assets and collections on accounts receivablerelated K-tel International, (USA), Inc. that had filed for bankruptcy in March2001. The extraordinary item in fiscal 2002 relates to the net liability thatexisted on K-tel Marketing, Ltd. when it filed for voluntary liquidation andwas subsequently removed when the Company received assurances that it would notbe held liable for any of K-tel Marketing, Ltd.’s debts.

9

----

** **
| **I****TEM 7:** | ** ** | **MANAGEMENT’S DISCUSSION AND ANALYSIS OF  FINANCIAL CONDITION AND RESULTS OF OPERATIONS** |
|-----------------|------------|-------------------------------------------------------------------------------------------------|

** **

**General**

Through its operatingsubsidiary, Dominion Entertainment, Inc. (“Dominion”), K-tel licenses its mastermusic catalog internationally and has entered into licensing agreements withseveral companies that offer electronic downloads via their internet sites ofmany of Dominion’s owned masters.  K-teland Dominion have also entered into agreements with BCI to market and sellentertainment products derived from Dominion’s master music catalog under theK-tel logo in the United States and Canada.

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 primarily derived from the Company’s master recordings music catalog withthe objective of realizing more competitive profit margins. The Company alsoseeks to license its name and marks to other businesses for a royalty or fee.

**A.**               RESULTS OFOPERATIONS

The following sectionsdiscuss the results of operations by business segment. See Note 9 to theconsolidated financial statements for additional segment information. Generalcorporate expenses of $510,000 in the year ended June 30, 2006, $656,000 in theyear ended June 30, 2005 and $869,000 in the year ended June 30, 2004 have beenallocated to the segments.

**FISCAL2006 VERSUS FISCAL 2005**

Netsales for the year ended June 30, 2006 were $4,804,000, a decrease of 20.5%from fiscal 2005 sales of $6,041,000. This sales decrease was attributed toreduced domestic music revenue. The netloss for fiscal 2006 was $1,211,000 or $.09 per share, compared to a net lossof $457,000, or $.03 per share in fiscal 2005.

In fiscal 2005, theCompany recorded and received $350,000 from the settlement of a lawsuit thatinvolved the discontinued subsidiary, K-tel Consumer Products, Inc.

Thefollowing sections discuss the results of continuing operations by businesssegment.

**BUSINESSSEGMENT RESULTS**

**Licensing**

Licensing revenues were$2,748,000 for the year ended June 30, 2006 compared to $1,489,000 for the yearended June 30, 2005, an increase of 84.6%. The increase was primarily due tothe increased domestic licensing revenue related to the Company’s licensingagreements with BCI and the agreements with companies that offer electronicdownloads of the Dominion master music catalog via their internet sites.

Operating income in thelicensing segment was $1,102,000 for the year ended June 30, 2006 and $326,000for the year ended June 30, 2005, an increase of $776,000.

 

10

----

 

**Music**

Netsales in the music segment were $2,056,000 for the year ended June 30, 2006compared to $4,552,000 for the year ended June 30, 2005, a decrease of 54.8%.The decrease was primarily due to decreased domestic music sales related to theCompany’s transition from primarily a distribution business to a licensingbusiness.

Costof goods sold in the music segment decreased to $1,467,000 or 71.3% of netsales for the year ended June 30, 2006 compared to $2,422,000 or 53.2% of netsales for the year ended June 30, 2005, primarily due to the decrease indomestic music sales.  The segment’sadvertising expenses, which consist primarily of co-operative advertisingpayments, trade advertising and promotions, increased to $209,000 for the yearended June 30, 2006 compared to $123,000 for the year ended June 30, 2005 dueprimarily to increased promotional programs in fiscal 2006 compared to fiscal2005.

Selling,general and administrative expenses for the segment were $1,907,000 for theyear ended June 30, 2006 compared to $2,423,000 for the year ended June 30,2005.  The primary reason for thedecrease was the efforts to reduce the Company’s overhead costs at the Company’soffices in the United States and the United Kingdom. The music segment incurredan operating loss of $1,527,000 for the year ended June 30, 2006 compared to anoperating loss of $416,000 for the year ended June 30, 2005.

**FISCAL2005 VERSUS FISCAL 2004**

Netsales for the year ended June 30, 2005 were $6,041,000, a decrease of 9.6% fromfiscal 2004 sales of $6,679,000. This sales decrease was attributed toreduced licensing activity. The netloss for fiscal 2005 was $457,000, or $.03 per share, compared to a net loss of$87,000, or $.01 per share, in fiscal 2004.

In fiscal 2005, theCompany recorded and received $350,000 from the settlement of a lawsuit thatinvolved the discontinued subsidiary, K-tel Consumer Products, Inc.

In fiscal 2004 the Company received approximately $214,000 from theliquidation of K-tel Marketing LTD., the Company’s consumer products subsidiaryin the United Kingdom, which ceased operations in November 2000, andapproximately $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 were recordedas extraordinary items, net of income taxes.

Thefollowing sections discuss the results of continuing operations by businesssegment.

**BUSINESSSEGMENT RESULTS**

**Licensing**

Licensing revenues were$1,489,000 for the year ended June 30, 2005 compared to $1,916,000 for the yearended June 30, 2004, a decrease of 22.3%. Both domestic and European revenuedecreased due primarily to the overall decrease in sales of the retail musicbusiness.  Operating income in thelicensing segment was $326,000 for the year ended June 30, 2005 and $959,000for the year ended June 30, 2004, a decrease of 66.1%.

**Music**

Netsales in the music segment were $4,552,000 for the year ended June 30, 2005compared to $4,763,000 for the year ended June 30, 2004, a decrease of 4.4%.The decrease was primarily related to the discontinued sales of unprofitablebudget music DVDs.

Costof goods sold in the music segment decreased to 53.2% of net sales for the yearended June 30, 2005 compared to 67.6% of net sales for the year ended June 30,2004, due primarily to the higher cost as a percentage of sales of the budgetmusic DVDs which were discontinued in fiscal 2005. Advertising expenses withinthe segment, which consist primarily of co-operative advertising payments,trade advertising and promotions, increased to $123,000 for the year ended June30, 2005 compared to $110,000 for the year ended June 30, 2004 due primarily toincreased promotional programs in fiscal 2005 compared to fiscal 2004.

Selling,general and administrative expenses for the segment remained flat at $2,423,000for the year ended June 

11

----

30,2005 compared to $2,424,000 for the year ended June 30, 2004. The music segmentincurred an operating loss of $416,000 for the year ended June 30, 2005compared to an operating loss of $992,000 for the year ended June 30, 2004.

**CRITICAL ACCOUNTING POLICIES**

Revenue Recognition- The Company derives its revenue mainly from two sources: license revenue fromthe licensing of Company-owned masters and the sale of music compilations(predominately compact discs) produced by the Company. License revenue isrecognized when payment is received from customers or when known amounts arereceivable, as prior to that date collection is not considered probable.Revenue from music sales is recognized at the time of shipment to the customer.Most music sales are made with a right of return of unsold goods. Estimatedreserves for returns are established by management based upon historicalexperience and product mix and are subject to ongoing review and adjustment bythe Company. These reserves are recorded at the time of sale and are reflectedas a reduction in revenues. The Company’s reserve for returns was $126,000 atJune 30, 2006 and $221,000 at June 30, 2005.

Rights to Use MusicProduct - Certain of the Company’s compilation products aremaster recordings under license from record companies and publishers. In mostinstances, minimum guarantees or non-refundable advances are required to obtainthe licenses and are realized through future sales of the product. The amountspaid for minimum guarantees or non-refundable advances are capitalizedand charged to expense as sales are made. The unrealized portion of guaranteesand advances is included in royalty advances in the accompanying consolidatedbalance sheets. Licenses are subject to audit by licensors. When anticipatedsales appear to be insufficient to fully recover the minimum guarantees or non-refundableadvances, a provision against current operations is made for anticipatedlosses.

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.

Inventory -The Company  records lower of cost ormarket adjustments for  inventory basedupon estimated market prices to sell identified inventory items that are slowmoving. The Company reviews this estimate quarterly and the estimate isadjusted accordingly.

**RECENTACCOUNTING PRONOUNCEMENTS**

In June 2006, theFinancial Accounting Standards Board (“FASB”) issued Interpretation No. 48, “Accountingfor Uncertainty in Income Taxes” — an interpretation of FASB Statement No. 109,“Accounting for Income Taxes” (“FIN 48”), which clarifies the accounting foruncertainty in income taxes. FIN 48 prescribes a recognition threshold andmeasurement attribute for the financial statement recognition and measurementof a tax position taken or expected to be taken in a tax return. Theinterpretation requires that the Company recognize in the financial statementsthe impact of a tax position.  Recognition is allowed if the tax positionis more likely than not of being sustained on audit, based on the technicalmerits of the position. FIN 48 also provides guidance on derecognition,classification, interest and penalties, accounting in interim periods anddisclosure. The provisions of FIN 48 are effective for fiscal years beginning afterDecember 15, 2006 with the cumulative effect of the change in accountingprinciple recorded as an adjustment to opening retained earnings. The adoptionof this statement is not expected to have a material impact on the Company’sconsolidated financial position 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

12

----

havea material impact on our results of operations, regardless of the valuationmethod used.

**CONTRACTUALOBLIGATIONS**

The table belowdiscloses a summary of the Company’s specified contractual obligations at June30, 2006 (in thousands):

|                                       | ** ** | **Total** | ** ** | **Under 1 Year** | ** ** | **1-3 Years** | ** ** |
|---------------------------------------|------------|-----------|------------|----------------------------|------------|--------------------|------------|
| Notes payable to  affiliate and other |       | $         | 12,098     |                       | $          | 12,098             |       | $ | — |   |
| Operating leases                      |       | 161       |       | 46                         |       | 115                |       |
| Total                                 |       | $         | 12,259     |                       | $          | 12,144             |       | $ | 115 |   |

 

## **B.****               LIQUIDITY ANDCAPITAL RESOURCES**

K-tel has a Line ofCredit Agreement with K-5 Leisure Products, Inc. (“K-5”), the Company’s largestshareholder and an entity 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(8.25% at June 30, 2006), expiresJuly 20, 2008, and is subordinated to the Foothill loan (see below). The K-5Facility 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 $8,098,000 and$7,518,000 as of June 30, 2006 and 2005, respectively, under the K-5 Facility.At June 30, 2006, 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% (9.25% at June 30, 2006) 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, 2006 and June 30,2005, K-tel had $4,000,000 outstanding under the term loan and there were noborrowings under the revolving facility. At June 30, 2006, K-tel obtained awaiver from K-5 for its non-compliance under the covenants, limitations andrestrictions of the credit agreement.

K-tel has primarilyfunded its recent operations through secured loans from K-5. Assuming K-5continues to advance funds sufficient to meet the Company’s needs, managementcurrently believes that K-tel has sufficient cash and borrowing capacity toensure the Company will continue operations for the foreseeable future.Although K-5 continues to advance funds sufficient to meet the Company’s needsat this time, there can be no assurance that this will be adequate or continuein the future or that K-tel will be able to obtain additional financing uponfavorable terms when required.

The Company’s ability 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.

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

K-tel is exposedto various market risks, including changes in interest rates and foreigncurrency exchange rates. Market risk 

13

----

is the potentialloss arising from adverse changes in market rates and prices, such as interestrates and foreign currency exchange rates. K-tel does not enter intoderivatives or other financial instruments for trading or speculative purposes.

K-tel’s exposure tomarket risk for changes in interest rates relates to K-tel’s short-termborrowings. K-tel’s short-term credit facilities carry a variable interest ratethat does have an impact on future earnings and cash flows. At June 30, 2006,K-tel had variable rate debt of $12,098,000. If the interest rate were tochange 100 basis points, or 1%, while K-tel was borrowing at this level underthe credit facilities, annual interest expense would change by approximately$121,000.

Approximately 45.1% ofK-tel’s revenues during the year ended June 30, 2006 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 ofthese subsidiaries will be higher or lower depending on the weakening orstrengthening of the U.S. dollar against the respective foreign currency. Ifthe U.S. dollar foreign currency rate were to change by 1%, the effect onincome would have been approximately $5,000 for the year ended June 30, 2006.Additionally, approximately 68% of K-tel’s assets at June 30, 2006 were basedin its foreign operations and were translated into U.S. dollars at foreigncurrency exchange rates in effect as of the end of each accounting period, withthe effect of such translation reflected as a separate component ofconsolidated shareholders’ equity (deficit). Accordingly, K-tel’s consolidatedshareholders’ equity (deficit) will fluctuate depending on the weakening orstrengthening of the U.S. dollar against the respective foreign currency.

**ITEM 8:                FINANCIAL STATEMENTS ANDSUPPLEMENTARY DATA**

The consolidatedfinancial statements and related notes and schedules required by this Item areset forth in Part IV, Item 15, and identified in the Index to ConsolidatedFinancial Statements.

**ITEM 9:**                                                 CHANGESIN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND FINANCIAL DISCLOSURE

Therewere no changes in or disagreements with accountants during the years endedJune 30, 2006 and June 30, 2005.

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

Under the supervision andwith the participation of the Company’s management, including the Company’sChief Executive Officer and Chief Financial Officer, the Company evaluated theeffectiveness of the design and operation of its disclosure controls andprocedures (as defined in Rule 13a-15(e) and 15d-15(e) under the Exchange Act).Based on that evaluation, the Chief Executive Officer and Chief FinancialOfficer concluded that, as of the end of the period covered by this report, theCompany’s disclosure controls and procedures were not effective because of thecontinued inability of the Company to file its reporting on a timely basis.  The untimely filings have resulted in partfrom the follow up necessary to address the material weaknesses in internalcontrol over financial reporting that had been noted in fiscal year 2004.

The Company did notmaintain effective controls over cash disbursements and payroll transactions atits UK subsidiary. In September 2004, the Company discovered that the formerChief Financial Officer of its UK subsidiary misappropriated funds from thesubsidiary and one of its customers. Adjustments related to the reversal ofoverstated expenses and recovery of amounts misappropriated were included inthe restatement of the Company’s consolidated financial statements for periodsprior to June 30, 2004 and for the years ended June 30, 2005 and 2004 andresulted in  the Company reporting amaterial weakness in internal control over financial reporting.

In response to thismaterial weakness, the Company terminated the employee, undertook a full-scaleinvestigation of the matter, retained a forensic auditing firm and dismissedthe accounting firm in the UK that audited the UK subsidiary’s financial booksand records. In addition, the Company hired a new Financial Controller andstringent internal control procedures were created and implemented for theCompany’s purchasing, accounts payable, check signing, payroll, petty cash andfinancial reporting policies. Management believes that these procedures,implemented upon the discovery of the misappropriation of funds, have allowedthe Company to remediate this material weakness and to improve its internalcontrol over financial reporting.

14

----

In fiscal 2005 and 2004,it was also determined that the segregation of duties in the U.S. office waslimited due to the small number of employees. This segregation of duties becamefurther limited by vacancies that occurred in the Company’s finance department.In particular, customer orders were recorded by the same person who initiatedshipments, checks were deposited by the accounts receivable clerk, and employeepayroll and changes were entered by the Operations Manager, who alsodistributed the payroll checks.

In response to thismaterial weakness in the U.S. office, the former Controller was rehired in theperiod covered by this report and duties and responsibilities were revised toallow for improved segregation of duties and to increase the level of approvalsand reviews. The foregoing remedial steps have allowed the Company to remediateits material weakness and to improve its internal control over financialreporting.

# Other than as set forth above, during the fourthquarter ended June 30, 2006, there was no change in the Company’s internalcontrol over financial reporting (as defined in Rule 13a-15(f) or 15d-15(f)under the Exchange Act) that has materially affected, or is reasonably likelyto materially affect, the Company’s internal control over financial reporting.

**ITEM 9B.              OTHER INFORMATION**

Not applicable.

 

15

----

 

**PART III**

**ITEM 10:              DIRECTORS AND EXECUTIVE OFFICERSOF THE REGISTRANT**

The following describesthe business, the business experience and background of each current directorand executive officer of K-tel at November 22, 2006. No family relationshipsexist between K-tel’s directors and executive officers, except that Mr. Smalleyis the brother-in-law of 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.

**Wesley C.Hayne**, age 58, waselected a director in November 2002. Since 2000, Mr. Hayne has been ChiefExecutive Officer of Biorefining, Inc., a company that develops, commercializesand licenses patented technologies capable of converting residual plantmaterial into high-end, value-added products. From 1999 to 2000, Mr. Hayne wasPresident of Cybrix Corporation, Inc., a company that provides solutions andleases staffing for computer security and disaster planning. From 1997 to 2000,Mr. Hayne was Chief Executive Officer of International Concept Development,Inc., a company that develops fast food restaurants in Europe. Mr. Hayne, oneof our independent directors, serves as the “audit committee financial expert”as defined by Item 401(h) of Regulation S-K.

**PhilipKives**, age 77,founded K-tel in 1968 and has served as its Chairman of the Board since K-tel’sinception. In addition, Mr. Kives has been the Chief Executive Officer andPresident for more than five years.

**KimmyLockwood,**age 50, servedas the Company’s Controller from 1997 until July 2005, and from July 2006 untilpresent.  She was appointedPrincipal Financial Officer and Principal Accounting Officer in September 2006.From July 2005 to July 2006, Ms. Lockwood was Assistant Controller forHeritage Development, Inc., a land development company based in Little Canada,Minnesota.

**RichardMarklund**, age 61, was elected a director in November 2002.Since October 2006 Mr. Marklundhas been Executive Vice President and Director of ASI Communications, Inc., anintegrated marketing company. From 2002 until October 2006, he was Chairman andChief Executive Officer of Phoenix Newcastle Holdings, Inc., a managementconsulting company. From 2000 until 2002, Mr. Marklund served as Executive VicePresident of WAM!NET, Inc., a telecommunication company. From 1998 until 2000,Mr. Marklund served as Chief Executive Officer of Hyperport International,Inc., a real estate development company.

**JayWilliam Smalley**, age72, was elected a director in January 1999. From 1970 until 1998, Mr.Smalley served as Chief Executive Officer of JWS, Inc., a privately owned realestate development and sales company specializing in hotel, motel, industrialand residential properties. Since 1998, Mr. Smalley has been a broker andprivate contractor for Prudential California Realty.

**AuditCommittee**

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

**Code ofEthics**

K-telhas adopted a code of ethics that applies to its principal executive officer,principal financial officer and principal accounting officer.  This code of ethics is available on K-tel’swebsite at K-tel.com and in print upon written request to:  Code of Ethics, K-tel International, Inc.,2491 Xenium Lane North, Plymouth, Minnesota 55441.  Any amendment to, or waiver from, a provisionof the code of ethics will be posted to the above referenced website.

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

Section 16(a) 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 forms receivedby it, or written representations from certain reporting persons, the Companybelieves that during fiscal year 2006, its officers, directors and 10%shareholders filed all reports on a timely basis.

16

----

**ITEM 11:              EXECUTIVE COMPENSATION**

The following table setsforth the aggregate cash compensation paid to or accrued for each of K-tel’sexecutive officers for services rendered to K-tel during the fiscal years endedJune 30, 2006, 2005 and 2004. K-tel has no written employment agreements withits executive officers.

**Summary Compensation Table**
| ** **                                     | ** ** | **Annual Compensation** | ** ** | **Long-Term  Compensation  Awards** | ** ** | ** ** | ** ** |
|------------------------------------------------|------------|------------------------------|------------|-------------------------------------|------------|------------|------------|
| **Name and Principal Position** | ** ** | **Fiscal Year**         | ** ** | **Salary**                          | ** ** | **Bonus**  | ** ** | **Securities  Underlying  Options** | ** ** | **All Other  Compensation** | ** ** |
| Philip Kives                                   |       | 2006                         |       | $                                   | —     |       | $          | — |   | — |   | $ | — |   |
| Chief Executive Officer                        |       | 2005                         |       | $                                   | —     |       | $          | — | ** ** | **—** |   | $ | — |   |
|                                           |       | 2004                         |       | $                                   | —     |       | $          | — | ** ** | **—** |   | $ | — |   |

 

During the fiscalyears ended June 30, 2006, 2005 and 2004, 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 board of directors comprised solely of independentdirectors, approved a “Stock Option Exchange Program.” The Program provided fora small number of optionees who were previously awarded options to purchaseshares of common stock under the Company’s 1997 Stock Option Plan to exchangethem voluntarily for options to purchase an equal number of shares outside theCompany’s Stock Option Plan. Mr. Kives exchanged 1,702,939 options with aweighted average price per share of $5.95 under this Stock Option ExchangeProgram. Replacement options were proposed to be issued six months and one dayafter the date of cancellation of the existing options and were to be at anexercise price per share equal to the fair market value of the Company’s commonstock as quoted on the OTC Bulletin Board on the date of grant and expire tenyears after the date of grant. On November 18, 2003, the replacement optionswere issued at a price per share of $.08. There was no compensation expenserecognized as a result of this exchange.

**OptionGrants in Last Fiscal Year**

No options were grantedto directors or executive officers in fiscal year 2006.

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

----

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

**DirectorCompensation**

Directorswho are employees 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           

17

----

purchaseof 5,000 shares of the Company’s common stock at an exercise price equal to thefair market value of the common stock on the date of initial election and uponeach re-election by the shareholders at an annual or special meeting. Inconnection with their appointment to the Company’s Compensation/Stock OptionCommittee during the fiscal year ended June 30, 2003, Jay William Smalley,Richard R. Marklund and Wesley C. Hayne each also received a non-qualifiedstock option to purchase 95,000 shares of common stock issued outside theCompany’s 1997 Stock Option Plan. During the fiscal year ended June 30, 2003,Mr. Smalley also received a non-qualified stock option to purchase 15,000shares of common stock outside the Company’s 1997 Stock Option Plan inconsideration of his past and continued service on the Company’s board of directors.All stock options issued to non-employee directors during the fiscal year endedJune 30, 2003 are exercisable for a period of ten years from the date of grantand bear an exercise price of $.05 per share. No options were granted todirectors during fiscal year 2006 or 2005.
| **ITEM 12:** | ** ** | **SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS  AND MANAGEMENT AND  RELATED STOCKHOLDER MATTERS** |
|--------------|------------|------------------------------------------------------------------------------------------------------|

** **

The following tablecontains certain information as of November 22, 2006, regarding the beneficialownership of our common stock by (i) each person known to K-tel to ownbeneficially five percent or more of our common stock, (ii) each director ofK-tel, (iii) each named executive officer, and (iv) the directors and executiveofficers as a group. The percentage of beneficial ownership is based on13,653,738 shares of common stock outstanding as of November 22, 2006. Anyshares which are subject to an option or a warrant exercisable within 60 daysare reflected in the following table and are deemed to be outstanding for thepurpose 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., 2491 Xenium Lane NorthPlymouth, Minnesota 55441.

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

(2)             Consistsof 8,048,678 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)             Representsshares purchasable upon the exercise of options.

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

Informationregarding common stock that may be issued under our existing equitycompensation plans as of fiscal year end 2006 is set forth under Part II Item 5of this report.

18

----

**ITEM 13:              CERTAIN RELATIONSHIPS AND RELATEDTRANSACTIONS**

**LoanAgreements with K-5 Leisure Products, Inc.**

K-tel has a Line ofCredit Agreement with K-5 Leisure Products, Inc. (“K-5”), the Company’s largestshareholder and an entity 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(8.25% at June 30, 2006), expiresJuly 20, 2008, and is subordinated to the Foothill loan (see below). The K-5Facility 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 $8,098,000 and$7,518,000 as of June 30, 2006 and 2005, respectively, under the K-5 Facility.At June 30, 2006, 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% (9.25% at June 30, 2006) 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, 2006 and June 30,2005, K-tel had $4,000,000 outstanding under the term loan and there were noborrowings under the revolving facility. At June 30, 2006, K-tel obtained awaiver from K-5 for its non-compliance under the covenants, limitations andrestrictions of the credit agreement.

**OtherTransactions with K-5 Leisure Products, Inc.**

The Companypurchased approximately $61,000 in the year ended June 30, 2006, $400,000 inthe year ended June 30, 2005 and $502,000 in the year ended June 30, 2004 ofmusic entertainment and consumer convenience products from K-5, the Company’slargest shareholder and an entity controlled by Philip Kives, the Chairman ofthe board, President and Chief Executive Officer of K-tel, whichrepresented  3.0%, 16.0% and 17.1%  of cost of goods sold, respectively. Therewere trade payables to K-5 of $2,000 at June 30, 2006, $398,000 at June 30,2005, and $390,000 at June 30, 2004, or 0.2%, 23.1% and 27.2% of total tradepayables, respectively.

During the fiscalyears ended June 30, 2006, 2005 and 2004, 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 2006, 2005, and 2004. There was nobalance receivable from K-5 at June 30, 2006. There was a balance receivable of $129,000 at June 30, 2005 and $113,000at June 30, 2004.  No interest wascharged on the related outstanding balances during fiscal years 2006, 2005 and2004.

**General**

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.

**ITEM 14.             **PRINCIPALACCOUNTANT FEES AND SERVICES

Fees and Services

The followingtable shows the aggregate fees billed to the Company by Grant Thornton LLP forservices rendered during fiscal years ended June 30, 2006 and June 30, 2005:

19

----

 
| **Description of Fees** | ** ** | **Fiscal 2006  Amount** | ** ** | **Fiscal 2005  Amount** | ** ** |
|-----------------------------------|------------|------------------------------|------------|------------------------------|------------|
| Audit Fees                        |       | $                            | 80,000     | (1)                          | $          | 95,000 | (1) |
| Tax Fees                          |       | 39,500                       | (2)        | 37,000                       | (2)        |
|                              |       |                         |       |                         |       |
| Total                             |       | $                            | 119,500    |                         | $          | 132,000 |   |

----

(1)             Auditfees consisted of fees for audit work of the Company’s annual financialstatements and review of the quarterly financial statements included in theCompany’s Quarterly Reports on Form 10-Q for the fiscal years 2006 and 2005 andrelated audit committee meeting attendance.

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

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 a designatedmember of the audit committee. These services may include audit services,audit-related services, tax services and other services. Any pre-approval isdetailed as to the particular service or category of services. The auditcommittee reviews all non-audit services to be provided and assesses the impactof the services on the auditor’s independence.

The auditcommittee pre-approved 100% of the services described in the “Fees and Services”table pursuant to engagements that occurred in fiscal years 2006 and 2005.

20

----

**PART IV**

**ITEM 15:              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

----

 

**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 November 22, 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 the requirements of the Securities andExchange Act of 1934, this report has been signed below by the followingpersons on behalf of the registrant and in the capacities indicated and on thedates indicated.

 
| Signatures               | ** ** | **Title**                                    | ** ** | **Date**          |
|--------------------------|------------|----------------------------------------------|------------|-------------------|
|                     |       |                                         |       |              |
| /s/ Philip Kives         |       | Chairman, Chief Executive Officer,           |       | November 22, 2006 |
| Philip Kives             |       | (Principal Executive Officer)                |       |              |
|                     |       | President and Director                       |       |              |
|                     |       |                                         |       |              |
| /s/Kimmy  Lockwood       |       | Controller                                   |       | November 22, 2006 |
| Kimmy Lockwood           |       | (Principal Financial and Accounting Officer) |       |              |
|                     |       |                                         |       |              |
| /s/ Jay William  Smalley |       | Director                                     |       | November 22, 2006 |
| Jay William  Smalley     |       |                                         |       |              |
|                     |       |                                         |       |              |
| /s/ Wesley C.  Hayne     |       | Director                                     |       | November 22, 2006 |
| Wesley C. Hayne          |       |                                         |       |              |
|                     |       |                                         |       |              |
| /s/ Richard  Marklund    |       | Director                                     |       | November 22, 2006 |
| Richard Marklund         |       |                                         |       |              |

 

22

----

** **

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

**INDEX TOCONSOLIDATED FINANCIAL STATEMENTS**
| Report of Independent  Registered Public Accounting Firm                                               |   |   |
|--------------------------------------------------------------------------------------------------------|--------|--------|
|                                                                                                   |   |   |
| Consolidated Balance Sheets as of June 30, 2006 and  2005                                              |   |   |
|                                                                                                   |   |   |
| Consolidated  Statements of Operations for each of the three years ended June 30, 2006                 |   |   |
|                                                                                                   |   |   |
| Consolidated Statements of Shareholders’ Deficit for  each of the three years ended June 30, 2006 |   |   |
|                                                                                                   |   |   |
| Consolidated Statements of Cash Flows for each of the  three years ended June 30, 2006                 |   |   |
|                                                                                                   |   |   |
| 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, 2006       |   |   |

 

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

----

** **

**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, 2006 and 2005 and therelated consolidated statements of operations, shareholders’ deficit, and cashflows for each of the three years in the period ended June 30, 2006. 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 material respects,the consolidated financial position of K-tel International, Inc. andSubsidiaries as of June 30, 2006 and 2005 and the consolidated results of theiroperations and their consolidated cash flows for the each of the three years inthe period ended June 30, 2006 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.

The accompanyingfinancial statements have been prepared assuming that the Company will continueas a going concern. As discussed in Note 1 to the financial statements, theCompany has incurred significant recurring losses from operations and has a networking capital deficit that raises substantial doubt about the Company’sability to continue as a going concern. Management’s plans in regard to these matters are also described in Note1.  The financial statements do notinclude any adjustments that might result from the outcome of this uncertainty.

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

/S/ GRANT THORNTONLLP

Minneapolis,Minnesota,

October 30, 2006

24

----

** **

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

## **CONSOLIDATED BALANCE SHEETS**

**JUNE 30,**

*(inthousands - except share and per share data)*
| ** **                                                                                                            | ** ** | **2006** | ** ** | **2005** | ** ** |
|-----------------------------------------------------------------------------------------------------------------------|------------|----------|------------|----------|------------|
| ASSETS                                                                                                                |       |     |       |     |       |
|                                                                                                                  |       |     |       |     |       |
| Current assets:                                                                                                       |       |     |       |     |       |
| Cash and cash  equivalents                                                                                            |       | $        | 1,689      |     | $          | 1,272 |   |
| Accounts receivable,  net of allowance for doubtful accounts of $2 in 2006 and $4 in 2005                             |       | 601      |       | 2,045    |       |
| Inventories                                                                                                           |       | 390      |       | 563      |       |
| Royalty advances                                                                                                      |       | 7        |       | 6        |       |
| Prepaid expenses and  other                                                                                           |       | 194      |       | 227      |       |
| Total current assets                                                                                                  |       | 2,881    |       | 4,113    |       |
|                                                                                                                  |       |     |       |     |       |
| Property and equipment, net of accumulated depreciation and  amortization of $306 in 2006 and $1,138 in 2005          |       | 55       |       | 84       |       |
|                                                                                                                  |       |     |       |     |       |
| Owned catalog masters, net of accumulated amortization of $3,277 in  2006 and $3,115 in 2005                          |       | 336      |       | 498      |       |
|                                                                                                                  |       |     |       |     |       |
|                                                                                                                  |       | $        | 3,272      |     | $          | 4,695 |   |
|                                                                                                                  |       |     |       |     |       |
| LIABILITIES AND SHAREHOLDERS’ DEFICIT                                                                            |       |     |       |     |       |
|                                                                                                                  |       |     |       |     |       |
| Current liabilities:                                                                                                  |       |     |       |     |       |
| Notes payable to  affiliate and other                                                                                 |       | $        | 12,098     |     | $          | 11,518 |   |
| Accounts payable                                                                                                      |       | 1,206    |       | 1,727    |       |
| Accrued royalties                                                                                                     |       | 1,793    |       | 1,760    |       |
| Reserve for returns                                                                                                   |       | 126      |       | 221      |       |
| Net liabilities of  discontinued operations                                                                           |       | 31       |       | 30       |       |
| Total current liabilities                                                                                             |       | 15,254   |       | 15,256   |       |
|                                                                                                                  |       |     |       |     |       |
| Shareholders’ deficit:                                                                                           |       |     |       |     |       |
| Common stock –  50,000,000 shares authorized, par value $.01;13,653,738 issued and  outstanding in 2006 and 2005 |       | 136      |       | 136      |       |
| Additional paid-in  capital                                                                                           |       | 21,292   |       | 21,292   |       |
| Accumulated deficit                                                                                                   |       | (33,134  | )          | (31,923  | )          |
| Accumulated other  comprehensive loss                                                                                 |       | (276     | )          | (66      | )          |
| Total shareholders’  deficit                                                                                     |       | (11,982  | )          | (10,561  | )          |
|                                                                                                                  |       |     |       |     |       |
|                                                                                                                  |       | $        | 3,272      |     | $          | 4,695 |   |

 

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

25

----

 

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

**CONSOLIDATED STATEMENTS OF OPERATIONS**

## **YEARS ENDED JUNE 30,**

*(inthousands - except per share data)*
| ** **                                                                 | ** ** | **2006** | ** ** | **2005** | ** ** | **2004** | ** ** |
|----------------------------------------------------------------------------|------------|----------|------------|----------|------------|----------|------------|
| Net Sales                                                                  |       | $        | 4,804      |     | $          | 6,041    |       | $ | 6,679 |   |
|                                                                       |       |     |       |     |       |     |       |
| Costs and expenses:                                                        |       |     |       |     |       |     |       |
| Cost of goods  sold                                                        |       | 2,012    |       | 2,439    |       | 2,934    |       |
| Advertising                                                                |       | 209      |       | 123      |       | 110      |       |
| Selling, general  and administrative                                       |       | 3,008    |       | 3,569    |       | 3,668    |       |
| Total costs and  expenses                                                  |       | 5,229    |       | 6,131    |       | 6,712    |       |
| Operating loss                                                             |       | (425     | )          | (90      | )          | (33      | )          |
|                                                                       |       |     |       |     |       |     |       |
| Other income (expense):                                                    |       |     |       |     |       |     |       |
| Interest expense                                                           |       | (800     | )          | (630     | )          | (497     | )          |
| Other income  (expense), net                                               |       | 25       |       | 24       |       | (20      | )          |
| Total other  expense                                                       |       | (775     | )          | (606     | )          | (517     | )          |
|                                                                       |       |     |       |     |       |     |       |
| Loss from continuing  operations                                           |       |     |       |     |       |     |       |
| Before income  taxes                                                       |       | (1,200   | )          | (696     | )          | (550     | )          |
|                                                                       |       |     |       |     |       |     |       |
| Benefit for income  taxes                                                  |       | —   |       | 88       |       | 168      |       |
|                                                                       |       |     |       |     |       |     |       |
| Loss from continuing  operations                                           |       | (1,200   | )          | (608     | )          | (382     | )          |
|                                                                       |       |     |       |     |       |     |       |
| Discontinued  operations:                                                  |       |     |       |     |       |     |       |
| Gain (loss) from  discontinued operations, net of taxes                    |       | (11      | )          | 151      |       | (52      | )          |
|                                                                       |       |     |       |     |       |     |       |
| Loss before  extraordinary item                                            |       | (1,211   | )          | (457     | )          | (434     | )          |
|                                                                       |       |     |       |     |       |     |       |
| Extraordinary item:                                                        |       |     |       |     |       |     |       |
| Gain on  subsidiary liquidations, net of taxes                             |       | —   |       | —   |       | 347      |       |
|                                                                       |       |     |       |     |       |     |       |
| Net loss                                                                   |       | $        | (1,211     | )        | $          | (457     | )          | $ | (87 | ) |
|                                                                       |       |     |       |     |       |     |       |
| Income (loss) per share  – basic and diluted:                         |       |     |       |     |       |     |       |
| Continuing  operations                                                     |       | $        | (.09       | )        | $          | (.04     | )          | $ | (.03 | ) |
| Discontinued  operations                                                   |       | —   |       | .01      |       | (.01     | )          |
| Extraordinary  item                                                        |       | —   |       | —   |       | .03      |       |
| Net loss                                                                   |       | $        | (.09       | )        | $          | (.03     | )          | $ | (.01 | ) |
|                                                                       |       |     |       |     |       |     |       |
| Shares used in the  calculation of loss per share – basic and diluted |       | 13,654   |       | 13,654   |       | 13,654   |       |
|                                                                       |       |     |       |     |       |     |       |
| Comprehensive loss                                                         |       |     |       |     |       |     |       |
| Net loss                                                                   |       | $        | (1,211     | )        | $          | (457     | )          | $ | (87 | ) |
| Unrealized  pension cost                                                   |       | (239     | )          | —   |       | (74      | )          |
| Translation  adjustment                                                    |       | 29       |       | 67       |       | 96       |       |
| Comprehensive loss                                                         |       | $        | (1,421     | )        | $          | (390     | )          | $ | (65 | ) |

 

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

26

----

** **

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

**CONSOLIDATEDSTATEMENTS OF SHAREHOLDERS’ DEFICIT**

**YEARSENDED JUNE 30, 2006, 2005 AND 2004**

*(inthousands)*
| ** **                | ** ** | **Common Stock** | ** ** | **Additional  Paid-In** | ** ** | **Accumulated** | ** ** | **Accumulated  Other  Comprehensive** | ** ** | ** ** | ** ** |
|---------------------------|------------|-----------------------|------------|-------------------------|------------|-----------------|------------|---------------------------------------|------------|------------|------------|
| ** **                | ** ** | **Shares**            | ** ** | **Amount**              | ** ** | **Capital**     | ** ** | **Deficit**                           | ** ** | **Loss**   | ** ** | **Total** | ** ** |
|                      |       |                  |       |                    |       |            |       |                                  |       |       |       |   |   |
| 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 | ) |
|                      |       |                  |       |                    |       |            |       |                                  |       |       |       |   |   |
| Net loss                  |       | —                |       | —                  |       | —          |       | (1,211                                | )          | —     |       | (1,211 | ) |
| Unrealized pension cost   |       | (239                  | )          | (239                    | )          |            |       |                                  |       |       |       |   |   |
| Translation adjustment    |       | —                |       | —                  |       | —          |       | —                                |       | 29         |       | 29 |   |
|                      |       |                  |       |                    |       |            |       |                                  |       |       |       |   |   |
| Balance at June 30, 2006  |       | 13,654                |       | $                       | 136        |            | $          | 21,292                                |       | $          | (33,134    | ) | $ | (276 | ) | $ | (11,982 | ) |

* *

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

27

----

** **

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

**CONSOLIDATEDSTATEMENTS OF CASH FLOWS**

**YEARSENDED JUNE 30,**

*(inthousands)*
| ** **                                         | ** ** | **2006** | ** ** | **2005** | ** ** | **2004** | ** ** |
|----------------------------------------------------|------------|----------|------------|----------|------------|----------|------------|
| Operating activities:                              |       |     |       |     |       |     |       |
| Net loss                                           |       | $        | (1,211     | )        | $          | (457     | )          | $ | (87 | ) |
| Adjustment to reconcile  net loss to cash          |       |     |       |     |       |     |       |
| Provided by (used in)  operating activities:       |       |     |       |     |       |     |       |
| Depreciation and  amortization                     |       | 200      |       | 224      |       | 253      |       |
| (Gain) loss on  disposal of property and equipment |       | —   |       | (11      | )          | 7        |       |
| Discontinued  operations                           |       | 1        |       | —   |       | (93      | )          |
| Changes in operating  assets and liabilities:      |       |     |       |     |       |     |       |
| Accounts  receivable, net                          |       | 1,441    |       | 657      |       | (118     | )          |
| Inventories                                        |       | 174      |       | (4       | )          | (21      | )          |
| Royalty advances                                   |       | 9        |       | (6       | )          | 193      |       |
| Prepaid expenses                                   |       | 24       |       | 130      |       | 11       |       |
| Accounts payable                                   |       | (758     | )          | 358      |       | (190     | )          |
| Accrued  royalties                                 |       | 26       |       | (98      | )          | (485     | )          |
| Reserve for  returns                               |       | (95      | )          | 89       |       | (88      | )          |
| Cash provided by  (used in) operating activities   |       | (189     | )          | 882      |       | (618     | )          |
|                                               |       |     |       |     |       |     |       |
| Investing activities:                              |       |     |       |     |       |     |       |
| Purchases of  property and equipment               |       | (8       | )          | (42      | )          | (66      | )          |
| Music catalog  additions                           |       | —   |       | (15      | )          | (26      | )          |
| Other                                              |       | —   |       | —   |       | 2        |       |
| Cash used in  investing activities                 |       | (8       | )          | (57      | )          | (90      | )          |
|                                               |       |     |       |     |       |     |       |
| Financing activities:                              |       |     |       |     |       |     |       |
| Borrowings on  notes payable                       |       | 3,968    |       | 4,773    |       | 2,569    |       |
| Payments on  notes payable                         |       | (3,388   | )          | (4,421   | )          | (2,944   | )          |
| Cash provided by  (used in) financing activities   |       | 580      |       | 352      |       | (375     | )          |
|                                               |       |     |       |     |       |     |       |
| Effect of  exchange rates on cash                  |       | 34       |       | (52      | )          | 11       |       |
|                                               |       |     |       |     |       |     |       |
| Net increase  (decrease) in cash equivalents       |       | 417      |       | 1,125    |       | (1,072   | )          |
|                                               |       |     |       |     |       |     |       |
| Cash and cash  equivalents at beginning of period  |       | 1,272    |       | 147      |       | 1,219    |       |
|                                               |       |     |       |     |       |     |       |
| Cash and cash  equivalents at end of period        |       | $        | 1,689      |     | $          | 1,272    |       | $ | 147 |   |
|                                               |       |     |       |     |       |     |       |
| Supplemental cash flow  information                |       |     |       |     |       |     |       |
| Cash paid for interest                             |       | $        | 868        |     | $          | 714      |       | $ | 539 |   |

* *

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

28

----

**K-TELINTERNATIONAL, INC. AND SUBSIDIARIES****NOTES TO CONSOLIDATED FINANCIAL STATEMENTS****JUNE 30, 2006, 2005 AND 2004**

**1.****                                      BUSINESSAND LIQUIDITY**

K-tel International, Inc. (the “Company” or “K-tel”)was incorporated in 1968 and currently has its corporate offices located inPlymouth, Minnesota. Through its operating subsidiaries, K-tel licenses itsmusic catalog internationally and markets entertainment products mainly derivedfrom its catalog through retail and direct response marketing channels in theUnited States and Europe. The Company has a focused method of distribution thattargets the strengths of 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. Licenses are granted for a royalty or fee, with no cost to theCompany.

Subsidiary Liquidations

In November 2000, theCompany’s consumer products subsidiary in the United Kingdom, K-tel MarketingLtd., ceased operations and began voluntary liquidation proceedings. At theinitial meeting of the creditors on November 24, 2000, the creditors voted forthe liquidation to become a creditors’ liquidation under English law. TheCompany has not been informed by the liquidators or their counsel of any planto attempt to hold it or any of its subsidiaries liable for any of thecommitments of K-tel Marketing Ltd. Management believes the Company will haveno ongoing material liability related to K-tel Marketing Ltd. as a result ofthe liquidation proceeding. In fiscal 2002, the assets and liabilities of thesubsidiary were removed from the books of the Company and the remaining netliability was shown as a gain on liquidation. As the only secured creditor, theCompany subsequently received distributions of approximately $138,000 on March1, 2004 and $76,000 on May 14, 2004 and reflected these as gain on subsidiaryliquidations, net of taxes. K-tel Marketing Ltd. had no operations during thefiscal years ended June 30, 2006, 2005 and 2004.

In June 2004, the Companyreceived funds for the sale of assets and the collections of accountsreceivables related to the March 2001 bankruptcy of K-tel International, (USA),Inc., the Company’s music distribution 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. Thesereceipts were reflected as gain on subsidiary liquidations, 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, 2006 and 2005 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 recorded and received$350,000 from the settlement of a lawsuit that involved the discontinuedsubsidiary, K-tel Consumer Products, Inc. Legal expenses relating to thelawsuit offset this amount.

Going Concern

During the yearsended June 30, 2006, 2005 and 2004, the Company incurred net losses fromcontinuing operations of $1,200,000, $608,000 and $382,000, respectively, andused $189,000, provided $882,000 and used $618,000 of cash in operatingactivities. Additionally, the Company had a working capital deficit of$12,373,000 at June 30, 2006.

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

29

----

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

**2.****                                      SUMMARYOF SIGNIFICANT ACCOUNTING POLICIES**

Principles ofConsolidation - The accompanying consolidated financialstatements include the accounts of K-tel International, Inc. and its domesticand foreign subsidiaries, all of which are wholly owned. All significantintercompany accounts and transactions have been eliminated. During the quarterended March 31, 2004, the company began to consolidate the financial statementsof Lancaster Trading Ltd., a variable interest entity of which the companydetermined it was the primary beneficiary (see Note 12).

RevenueRecognition - The Company derives its revenue mainly from twosources: license revenue from the licensing                ofCompany-owned masters and the sale of music compilations (predominately compactdiscs) produced by the Company. License revenue is recognized when payment isreceived from customers or when known amounts are receivable, as prior to thatdate collection is not considered probable and revenue from music sales isrecognized at the time of shipment to the customer. Most music sales are madewith a right of return of unsold goods. Estimated reserves for returns areestablished by management based upon historical experience and product mix andare subject to ongoing review and adjustment by the Company. These reserves arerecorded at the time of sale and are reflected as a reduction in revenues. TheCompany’s reserve for returns was $126,000 at June 30, 2006 and $221,000 atJune 30, 2005.

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, 2006 and 2005, $1,612,000 and $1,172,000,respectively, was held at various financial institutions in Europe.

Accounts Receivable- Accounts receivable balances are presented net of allowances. The Companydetermines its allowances by considering a number of factors, including thelength of time trade receivables are past due, the Company’s previous history,and the customer’s current ability to pay obligations to the Company. TheCompany writes off accounts receivables when they 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, 2006, 2005 and 2004 was$163,000, $173,000, and $190,000, respectively.

Estimatedamortization expense for the owned catalog masters is as follows for the yearsended June 30:

|        | ** ** | ** ** | ** ** |
|--------|------------|------------|------------|
| 2007   |       | $          | 145,000    |   |
| 2008   |       | 115,000    |       |
| 2009   |       | 63,000     |       |
| 2010   |       | 13,000     |       |
|   |       | $          | 336,000    |   |

 

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

30

----

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

Property 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 $209,000, $123,000, and $110,000, for the years ended June 30, 2006, 2005and 2004, 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,**               | ** ** |
| ** **                | ** ** | **2006**                        | ** ** | **2005** | ** ** | **2004** | ** ** |
| Net loss (in  thousands): |       |                            |       |   |   |   |   |
| As reported               |       | $                               | (1,211     | ) | $ | (457 | ) | $ | (87 | ) |
| Pro forma                 |       | $                               | (1,211     | ) | $ | (457 | ) | $ | (258 | ) |
|                      |       |                            |       |   |   |   |   |
| Basic and  Diluted EPS:   |       |                            |       |   |   |   |   |
| As reported               |       | $                               | (.09       | ) | $ | (.03 | ) | $ | (.01 | ) |
| Pro forma                 |       | $                               | (.09       | ) | $ | (.03 | ) | $ | (.02 | ) |
|                      |       |                            |       |   |   |   |   |

 

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

Net Income (Loss) Per Share - Basicand diluted net income (loss) per share have been computed by dividing netincome (loss) by the weighted average number of shares outstanding during theperiod. For all periods presented, common stock equivalents were excluded fromthe per share calculation as the net effect would be antidilutive. For thefiscal years ended June 30, 2006, 2005, and 2004, weighted average options topurchase 2,228,939, 2,564,839, and 2,574,839, shares of common stock, withweighted average exercise prices of $.19, $.36, and $.39, respectively, wereexcluded from the computation of common share equivalents for the respectiveperiods as they were antidilutive.

Use of Estimates- Preparing consolidated financial statements in conformity with accountingprinciples generally 

31

----

accepted in theUnited States of America (“US GAAP”) requires management to make estimates andassumptions that affect the reported amounts of assets, liabilities, anddisclosure of contingent assets and liabilities at the date of the financialstatements and the reported amounts of revenues and expenses during thereporting period. Principal estimates include allowances for bad debt,inventory valuation, return reserves, royalty obligations, purchase commitmentsand product replacement costs. Actual results could differ from those estimatesused by management.

**3.****                                      NOTESPAYABLE TO AFFILIATE AND OTHER**

K-tel has a Lineof Credit Agreement with K-5 Leisure Products, Inc. (“K-5”), the Company’slargest shareholder and an entity controlled by Philip Kives, the Chairman ofthe Board, President and Chief Executive Officer of K-tel. Under the terms ofthe agreement (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(8.25% at June 30, 2006), expiresJuly 20, 2008, and is subordinated to the Foothill loan (see below). The K-5Facility 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 $8,098,000 and$7,518,000 as of June 30, 2006 and 2005, respectively, under the K-5 Facility.At June 30, 2006, 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% (9.25% at June 30, 2006) 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, 2006 and June 30,2005, K-tel had $4,000,000 outstanding under the term loan and there were noborrowings under the revolving facility. At June 30, 2006, K-tel obtained awaiver from K-5 for its non-compliance under the covenants, limitations andrestrictions of the credit agreement.

**4.****                                      INCOMETAXES**

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

The provision forincome taxes consists of the following for the years ended June 30 (inthousands):

|                                                   | ** ** | **2006** | ** ** | **2005** | ** ** | **2004** | ** ** |
|---------------------------------------------------|------------|----------|------------|----------|------------|----------|------------|
| Income (loss)  before provision for income taxes: |       |     |       |     |       |     |       |
| United States                                     |       | $        | (793       | )        | $          | (163     | )          | $ | 277 |   |
| Foreign                                           |       | (418     | )          | (289     | )          | (364     | )          |
| Total                                             |       | $        | (1,211     | )        | $          | (452     | )          | $ | (87 | ) |
|                                              |       |     |       |     |       |     |       |
| Provision for  income taxes:                      |       |     |       |     |       |     |       |
| Current                                           |       |     |       |     |       |     |       |
| United States                                     |       | $        | —     |     | $          | 5        |       | $ | — |   |
| Foreign                                           |       | —   |       | —   |       | —   |       |
|                                              |       |     |       |     |       |     |       |
| Total provision  for income taxes                 |       | $        | —     |     | $          | 5        |       | $ | — |   |

 

32

----

 

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

|                                      | ** ** | **2006** | ** ** | **2005** | ** ** | **2004** | ** ** |
|--------------------------------------|------------|----------|------------|----------|------------|----------|------------|
| 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,  2006** | ** ** | **June 30,  2005** | ** ** |
|----------------------------------|------------|-------------------------|------------|-------------------------|------------|
| Net operating  loss carryfowards |       | $                       | 15,677     |                    | $          | 15,836 |   |
| Alternative  minimum tax credits |       | 439                     |       | 439                     |       |
| Foreign tax  credit              |       | 325                     |       | 325                     |       |
| Reserve for  returns             |       | 36                      |       | 221                     |       |
| Depreciation and  amortization   |       | (62                     | )          | (89                     | )          |
| Royalty reserves                 |       | 487                     |       | 65                      |       |
| Inventory  reserves              |       | 141                     |       | 21                      |       |
| Nondeductible  accruals          |       | 96                      |       | 96                      |       |
| Valuation  allowance             |       | (17,139                 | )          | (16,914                 | )          |
|                             |       | $                       | —     |                    | $          | — |   |

 

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 $43,200,000. 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.

**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. In February 1997, the Company’s Board of Directors approved a stockoption plan covering a maximum of 600,000 shares of common stock, which wassubsequently amended to 5,000,000 through shareholder amendments in February1999, January 2000 and November 2000. There were options for 2,037,605 netshares granted under this plan as of June 30, 2006, of which 1,011,111 havebeen exercised. Any options cancelled become available for future grants. Nooptions 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 

33

----

exchange them voluntarily for options to purchase anequal number of shares outside the Company’s Stock Option Plan. Mr. Kivesexchanged 1,702,939 options with a weighted average price per share of $5.95under this Stock Option Exchange Program. Replacement options were proposed tobe issued six months and one day after the date of cancellation of the existingoptions and were to be at an exercise price per share equal to the fair marketvalue of the Company’s common stock as quoted on the OTC Bulletin Board on thedate of grant and expire ten years after the date of grant. On November 18,2003, the replacement options were issued at a price per share of $.08. Therewas no compensation expense recognized as a result of this exchange.

Restricted and Non-QualifiedStock Options

In addition tostock options granted under the terms of the Stock Option Plan, the Board ofDirectors has the sole authority to grant employees, officers and directorsincentive stock options and non-qualified stock options outside the StockOption Plan. The Board of Directors determines the type, size and terms of thegrants, timing of the grants, the duration of the exercise period and any othermatters pertaining to options or awards granted outside of the Stock OptionPlan. There were options for 2,202,939 net shares granted outside the StockOption Plan as of June 30, 2006. No options were granted outside the StockOption Plan during fiscal 2006.

The shareinformation for all plans is summarized below:
| ** **                 | ** ** | ** **               | ** ** | ** **             | ** ** | **Weighted**            | ** ** |
|----------------------------|------------|--------------------------|------------|------------------------|------------|-------------------------|------------|
| ** **                 | ** ** | **Incentive Stock** | ** ** | **Non-Qualified**      | ** ** | **Average**             | ** ** |
| ** **                 | ** ** | **Options**              | ** ** | **Stock Options** | ** ** | **Exercise Price** | ** ** |
| 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                     |       |
|                       |       |                     |       |                   |       |                    |       |
| Cancelled                  |       | (55,900                  | )          | (280,000               | )          | .19                     |       |
| Outstanding June 30,  2006 |       | 26,000                   |       | 2,202,939              |       | $                       | .19        |   |

 

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

The followingtables summarize information concerning currently outstanding and exercisablestock options at June 30, 2006:

| Options Outstanding and Exercisable | ** **  |
|----------------------------------------------------|-------------|
| **Exercise Prices**                           | ** **  | ** ** | ** ** | **Weighted Average** | ** ** |
| ** **                                         | ** **  | **Weighted** | ** ** | **Number** | ** ** | **Remaining** | ** ** |
| **Range**                                          | ** **  | **Average** | ** ** | **of Shares** | ** ** | **Contractual Life** | ** ** |
| $                                                  | 0.05 - 0.08 |   | $ | 0.08 |   | 2,192,939 |   | 7.3 years |   |
| $                                                  | 5.51 - 6.00 |   | $ | 5.81 |   | 21,000 |   | 3.2 years |   |
| $                                                  | 8.73        |   | $ | 8.73 |   | 15,000 |   | 2.7 years |   |
|                                               |        |   |   | 2,228,939 |   |   |   |

 

The weightedaverage fair value of options granted in fiscal 2004 was $.08. No options weregranted in fiscal 2006 or 2005. Because the fair value provisions have not beenapplied to options granted prior to June 30, 1995, the resulting pro formacompensation cost (See Note 1) may not be representative of that to be expectedin future years.

34

----

 

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:
| Risk-free interest rate |   | 4.00%    |
|-------------------------|--------|----------|
| Expected life           |   | 10 years |
| Expected volatility     |   | 220%     |
| Expected dividend yield |   | None     |

** **

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

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

On March 14, 2000,K-tel and its subsidiary in Germany commenced an action for breach of expressand implied warranties against Tristar Products, Inc. This action arose out ofTristar’s sale to K-tel of a defective home exercise product called the “BunBlaster”for resale in Germany, Austria and Switzerland. By written contract,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 Company recordedthe  $350,000 in discontinued operationsand  payment was received February 18,2005.

#### Other Litigation and 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 calendar2009. Commitments under these leases are $38,000, $50,000, $50,000 and $13,000in fiscal 2007, 2008, 2009 and 2010, respectively.  Rental expense was $243,000 in 2006, $222,000in 2005, and $228,000 in 2004.

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

One customeraccounted for approximately 15.2% of K-tel’s revenue for the year ended June30, 2006 and had no accounts receivable balance at June 30, 2006. The loss of,or a substantial reduction in, business from this customer  could have a material adverse effect on theCompany.

In fiscal year2005, three customers accounted for approximately 18.4%, 15.3% and 13.2% ofK-tel’s revenue and had accounts receivable balances of $503,000, $403,000 and$22,000 respectively.

See Note 3 for informationregarding debt transactions with related parties.

The Companypurchased approximately $61,000 in the year ended June 30, 2006, $400,000 inthe year ended June 30, 2005, and $502,000 in the year ended June 30, 2004 ofmusic entertainment and consumer convenience products from  K-5, the Company’s largest shareholdercontrolled by Philip Kives, Chairman of the Board, President and ChiefExecutive Officer of K-tel. There were trade payables to K-5 of $2,000 at June30, 2006, $398,000 at June 30, 2005, and $390,000 at June 30, 2004.

35

----

The Company had nosales of products to K-5 during the years ended June 30, 2006, 2005 and 2004.There was no balance receivable from K-5 at June 30, 2006.  There was a balance receivable at June 30,2005 of $129,000 and June 30, 2004 of $113,000. No interest was charged on therelated outstanding balances during fiscal years 2006, 2005 or  2004.

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

**8.****                                     ****RETIREMENT PLANS**

Pension Plan

The Company has apension plan for its U.K. employees. Contributions to the Plan by the Companyon behalf of the eligible employees were terminated effective February 15, 2001and all benefit accruals under the Plan ceased. Summary plan information is asfollows:
| ** **                                      | ** ** | **(In Thousands)**   | ** ** | ** ** | ** ** |
|-------------------------------------------------|------------|---------------------------|------------|------------|------------|
| ** **                                      | ** ** | **Pension Benefits** | ** ** | ** ** | ** ** |
| ** **                                      | ** ** | **2006**                  | ** ** | **2005**   | ** ** |
|                                            |       |                      |       |       |       |
| Net periodic  cost:                             |       |                      |       |       |       |
| Interest cost                                   |       | $                         | 59         |       | $          | 58 |   |
| Expected return  on assets                      |       | (44                       | )          | (37        | )          |
| Amortization of  transition amount              |       | (16                       | )          | (17        | )          |
| Actuarial loss                                  |       | 26                        |       | 15         |       |
|                                            |       |                      |       |       |       |
| Net periodic  benefit cost                      |       | $                         | 25         |       | $          | 19 |   |
|                                            |       |                      |       |       |       |
| Change in  benefit obligation:                  |       |                      |       |       |       |
| Benefit  obligation at beginning of year        |       | $                         | 1,200      |       | $          | 957 |   |
| Interest cost                                   |       | 59                        |       | 58         |       |
| Actuarial loss                                  |       | (46                       | )          | 197        |       |
| Service costs                                   |       | (21                       | )          | —-    |       |
| Exchange rate  adjustment                       |       | 7                         |       | (12        | )          |
|                                            |       |                      |       |       |       |
| Benefit  obligation at end of year              |       | $1,199                    |       | $1,200     |       |
|                                            |       |                      |       |       |       |
|                                            |       |                      |       |       |       |
|                                            |       |                      |       |       |       |
| Change in plan  assets:                         |       |                      |       |       |       |
| Fair value of  plan assets at beginning of year |       | $                         | 861        |       | $          | 823 |   |
| Actual return on  plan assets                   |       | 41                        |       | 43         |       |
| Service costs                                   |       | (21                       | )          | —-    |       |
| Exchange rate  adjustment                       |       | 5                         |       | (5         | )          |
|                                            |       |                      |       |       |       |
| Fair value of  plan assets at end of year       |       | $886                      |       | $861       |       |
|                                            |       |                      |       |       |       |
|                                            |       |                      |       |       |       |
|                                            |       |                      |       |       |       |

Theemployer is not expected to contribute to the plan in fiscal 2007.

TheCompany’s pension plan asset target allocation for 2006 and actual assetallocations are as follows at June 30:
| ** **                   | ** ** | **Target** | ** ** | **Percentage of Plan Assets** | ** ** |
|------------------------------|------------|------------|------------|----------------------------------------------|------------|
| ** **                   | ** ** | **2006**   | ** ** | **2006**                                     | ** ** | **2005** | ** ** |
|                         |       |       |       |                                         |       |   |   |
| Asset category:              |       |       |       |                                         |       |   |   |
|                         |       |       |       |                                         |       |   |   |
| Short-tem liquid investments |       | 100        | %          | 100                                          | %          | 100 | % |

 

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

36

----

 
| (In Thousands)               | ** ** | **2006** | ** ** | **2005** | ** ** |
|-----------------------------------|------------|----------|------------|----------|------------|
| Reconciliation  of funded status: |       |     |       |     |       |
| Funded status                     |       | $        | (313       | )        | $          | (339 | ) |
| Unrecognized  actuarial loss      |       | 368      |       | 435      |       |
| Unrecognized  transition amount   |       | (153     | )          | (168     | )          |
|                              |       |     |       |     |       |
| Unfunded accrued  pension cost    |       | $        | (98        | )        | $          | (72 | ) |

 
|                                                    | ** ** | **2006** | ** ** | **2005** | ** ** |
|----------------------------------------------------|------------|----------|------------|----------|------------|
| Statement of  financial position:                  |       |     |       |     |       |
| Unfunded accrued  pension cost in accounts payable |       | $        | (98        | )        | $          | (72 | ) |
| Additional  minimum liability                      |       | (313     | )          | (74      | )          |
| Accumulated  other comprehensive income            |       | 313      |       | 74       |       |
|                                               |       |     |       |     |       |
| Recognized amount                                  |       | $        | (98        | )        | $          | (72 | ) |

 

WEIGHTED-AVERAGEASSUMPTIONS USED TO DETERMINE NET PERIODIC COST FOR THE YEARS ENDED JUNE 30:
|                                 | ** ** | **2006** | ** ** | **2005** | ** ** |
|---------------------------------|------------|----------|------------|----------|------------|
| Discount rate                   |       | 5        | %          | 5.75     | %          |
| Expected return  on plan assets |       | 5.25     | %          | 4.5      | %          |
| Rate of compensation  increase  |       | 0        | %          | 0        | %          |

 

WEIGHTED-AVERAGE ASSUMPTION USED TO DETERMINEBENEFIT OBLIGATIONS AS OF JUNE 30:

 
|                                | ** ** | **2006** | ** ** | **2005** | ** ** |
|--------------------------------|------------|----------|------------|----------|------------|
| Discount rate                  |       | 5.25     | %          | 5.00     | %          |
| 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 contributed $28,000, $53,000, and $77,000 forthe years ended June 30, 2006, 2005 and 2004, respectively.

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

K-tel’sbusinesses are organized, managed and internally reported as two segments:music licensing and retail music sales.

These segments arebased on differences in products, customer type and sales and distributionmethods.

The Companylicenses the rights to its master music catalog, consisting of originalrecordings and re-recordings of music from the 1950’s through today, tothird parties world-wide for use in albums, films, television programs,commercials and electronic downloads to various media formats, for either aflat fee or a royalty based on the number of units sold.

The music segmentof the Company markets and distributes entertainment products internationallyand through its operating subsidiaries. The retail music segment consistsprimarily of the sales of pre-recorded music from the Company’s mastermusic catalog. The Company sells compact discs and DVD’s directly to retailers,wholesalers and rack service distributors which stock and manage inventorywithin music departments for retail stores.

The Company’sconsumer product and e-commerce operations have been discontinued, arepresented in the accompanying financial statements as discontinued operationsand are therefore not included in the segment information.

Operating profits or losses of these segmentsinclude an allocation of general corporate expenses. Depreciation andamortization and capital additions are not significant and have therefore beenexcluded from the presentation.

37

----

 

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

BUSINESS SEGMENTINFORMATION *(in thousands)*

 
| **Fiscal Years Ended**

**June 30,** | ** ** | ** ** | ** ** | **Licensing** | ** ** | **Music**  | ** ** | **Other**  | ** ** | **Total**

**Company** | ** ** |
|-----------------------------------------------------|------------|------------|------------|---------------|------------|------------|------------|------------|------------|------------------------|------------|
| ** **                                          | ** ** | ** ** | ** ** | ** **    | ** ** | ** ** | ** ** | ** ** | ** ** | ** **             | ** ** |
| ** **                                          | ** ** | ** ** | ** ** | ** **    | ** ** | ** ** | ** ** | ** ** | ** ** | ** **             | ** ** |
|                                                     | * *   | * *   | * *   | * *      | * *   | * *   | * *   | * *   | * *   | * *               | * *   |
| Net sales                                           |       | 2006       |       | $             | 2,748      |       | $          | 2,056      |       | $                      | —     |   | $ | 4,804 |   |
|                                                |       | 2005       |       | 1,489         |       | 4,552      |       | —     |       | 6,041                  |       |
|                                                |       | 2004       |       | 1,916         |       | 4,763      |       | —     |       | 6,679                  |       |
|                                                |       |       |       |          |       |       |       |       |       |                   |       |
| Operating income (loss)                             |       | 2006       |       | $             | 1,102      |       | $          | (1,527     | )          | $                      | —     |   | $ | (425 | ) |
|                                                |       | 2005       |       | 326           |       | (416       | )          | —     |       | (90                    | )          |
|                                                |       | 2004       |       | 959           |       | (992       | )          | —     |       | (33                    | )          |
|                                                |       |       |       |          |       |       |       |       |       |                   |       |
| Assets                                              |       | 2006       |       | $             | 418        |       | $          | 2,827      |       | $                      | 27         |   | $ | 3,272 |   |
|                                                |       | 2005       |       | 548           |       | 3,893      |       | 254        |       | 4,695                  |       |
|                                                |       | 2004       |       | 664           |       | 3,519      |       | 313        |       | 4,496                  |       |

 

GEOGRAPHICINFORMATION *(in thousands)*

 
| Fiscal Years Ended

**June 30,** | ** ** | **United States** | ** ** | **Europe** | ** ** | **Total** | ** ** |
|-------------------------------------------------|------------|------------------------|------------|------------|------------|-----------|------------|
| * *                                        | * *   | * *               | * *   | * *   | * *   | * *  | * *   |
| Net sales                                       | 2006       |                   | $          | 2,642      |       | $         | 2,162      |   | $ | 4,804 |   |
|                                            | 2005       |                   | 3,428      |       | 2,613      |      | 6,041      |   |
|                                            | 2004       |                   | 3,836      |       | 2,843      |      | 6,679      |   |
|                                            |       |                   |       |       |       |      |       |   |
| Assets                                          | 2006       |                   | $          | 1,043      |       | $         | 2,229      |   | $ | 3,272 |   |
|                                            | 2005       |                   | 2,240      |       | 2,455      |      | 4,695      |   |
|                                            | 2004       |                   | 2,148      |       | 2,348      |      | 4,496      |   |

 

**10.****                                               RECENT ACCOUNTING PRONOUNCEMENTS**

In June 2006, theFinancial Accounting Standards Board (“FASB”) issued Interpretation No. 48, “Accountingfor Uncertainty in Income Taxes” — an interpretation of FASB Statement No. 109,“Accounting for Income Taxes” (“FIN 48”), which clarifies the accounting foruncertainty in income taxes. FIN 48 prescribes a recognition threshold andmeasurement attribute for the financial statement recognition and measurementof a tax position taken or expected to be taken in a tax return. Theinterpretation requires that the Company recognize in the financial statementsthe impact of a tax position.  Recognition is allowed if the tax positionis more likely than not of being sustained on audit, based on the technicalmerits of the position. FIN 48 also provides guidance on derecognition,classification, interest and penalties, accounting in interim periods anddisclosure. The provisions of FIN 48 are effective for fiscal years beginningafter December 15, 2006 with the cumulative effect of the change in accountingprinciple recorded as an adjustment to opening retained earnings. The adoptionof this statement is not expected to have a material impact on the Company’sconsolidated financial position 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

38

----

valuemodel to be 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 Companyrecorded account receivable amounts relating to the misappropriated funds ofapproximately $857,000 and $545,000 at June 30, 2004 and June 30, 2003,respectively, to the consolidated balance sheet.  At June 30, 2004 the consolidated balancesheet accounts receivable amount also includes approximately $324,000 from aLancaster receivable relating to the misappropriated funds (see Note 12).

Fiscal 2006Interim Financial Data

Quarterly Financial Information (Unaudited)
|                                                                         | ** ** | **Three Months Ended,** | ** ** |
|-------------------------------------------------------------------------|------------|-----------------------------------|------------|
| ** **                                                              | ** ** | **September 30,**

**2005**  | ** ** | **December 31,**

**2005** | ** ** | **March 31,**

**2006** | ** ** | **June 30,**

**2006** | ** ** |
| Net sales                                                               |       | $                                 | 1,196      |   | $ | 1,302 |   | $ | 1,144 |   | $ | 1,162 |   |
| Gross profit                                                            |       | $                                 | 691        |   | $ | 722 |   | $ | 712 |   | $ | 667 |   |
| Advertising,  selling, general and administrative                       |       | $                                 | 763        |   | $ | 656 |   | $ | 753 |   | $ | 1,045 |   |
| Operating income  (loss)                                                |       | $                                 | (72        | ) | $ | 66 |   | $ | (41 | ) | $ | (378 | ) |
| Net income  (loss)                                                      |       | $                                 | (264       | ) | $ | (165 | ) | $ | (276 | ) | $ | (506 | ) |
| Basic and  diluted net loss per common share                            |       | $                                 | (.02       | ) | $ | (.01 | ) | $ | (.02 | ) | $ | (.04 | ) |
| Shares used in  computing basic and diluted

net loss per  common share |       | 13,654                            |       | 13,654 |   | 13,654 |   | 13,654 |   |

 

39

----

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 and 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 |   |

 

**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 30,2006, the consolidated financial statements included approximately $2,000 ofcurrent assets and $95,000 of current liabilities related to Lancaster.   Sales and purchases between Lancaster andthe Company have been eliminated in consolidation, and the additional effectsof Lancaster on the Company’s operations were not material.

 

40

----

 

**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 | ** ** | ** **                                     | ** ** | ** **                                                                | ** ** | ** **                                    | ** ** | ** **     | ** ** | ** **                                   | ** ** |
| 2006                                       |       | $                                              | 4          |                                                                      | $          | 3                                             |       | $              | —     |                                         | $          | (5 | )(2) | $ | 2 |   |
| 2005                                       |       | $                                              | 4          |                                                                      | $          | —                                        |       | $              | —     |                                         | $          | — |   | $ | 4 |   |
| 2004                                       |       | $                                              | 25         |                                                                      | $          | 24                                            |       | $              | 2          |                                         | $          | (47 | )(2) | $ | 4 |   |
|                                       |       |                                           |       |                                                                      |       |                                          |       |           |       |                                         |       |
| Reserve for Returns                        |       |                                           |       |                                                                      |       |                                          |       |           |       |                                         |       |
| 2006                                       |       | $                                              | 221        |                                                                      | $          | 328                                           |       | $              | —     |                                         | $          | (423 | ) | $ | 126 |   |
| 2005                                       |       | $                                              | 133        |                                                                      | $          | 646                                           |       | $              | —     |                                         | $          | (558 | ) | $ | 221 |   |
| 2004                                       |       | $                                              | 220        |                                                                      | $          | 375                                           |       | $              | 1          |                                         | $          | (463 | ) | $ | 133 |   |

----

(1)            Exchange rate change

(2)            Uncollectible accountswritten off, net of recoveries

41

----

 

**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)).                                         |

 

42

----

 
| 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)). |
|--------|--------|------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|
|   |   |                                                                                                                                                                                                                                                                                                                               |
| 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.                                                                                                                                                                               |

 

43

----