**U.S.SECURITIES AND EXCHANGE COMMISSION**

**Washington, D.C. 20549**

 

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**FORM10-KSB**

 

**(Mark One)**

 

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

 

**For thefiscal year ended:****December 31, 2005**

 

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

 

**For the transition period from                to                **

 

**Commissionfile number:****000-29869**

 

**eACCELERATIONCORP.**

(Nameof small business issuer in its charter)

 

| **Delaware**                              | ** ** | **91-2006409**       |
|-------------------------------------------|------------|----------------------|
| (State  or other jurisdiction of          |       | (I.R.S.  Employer    |
| incorporation  or organization)           |       | Identification  No.) |
|                                      |       |                 |
| **1050 NE Hostmark St, Suite 100B**       | ** ** | **98370**            |
| **Poulsbo, Washington**                   |       | (Zip  Code)          |
| (Address  of principal executive offices) |       |                 |

 

Issuer’stelephone number:  **(360) 697-9260**

 

Securities registered underSection 12(b) of the Exchange Act:  **None**

 

Securities registered underSection 12(g) of the Exchange Act:  **Common stock, par value $0.0001**

 

Check whether the issuer isnot required to file reports pursuant to Section 13 or 15(d) of the ExchangeAct.
|   | Yes o | No ý |   |
|--------|-------|-----------|--------|

 

Check whether the issuer (1)filed all reports required to be filed by Section 13 or 15(d) of the ExchangeAct during the preceding 12 months (or for such shorter period that theregistrant was required to file such reports), and (2) has been subject to suchfiling requirements for the past 90 days.            Yesý  No o

 

Check if there is nodisclosure of delinquent filers in response to Item 405 of Regulation S-Bcontained in this form, and no disclosure will be contained, to the best ofregistrant’s knowledge, in definitive proxy or information statementsincorporated by reference in Part III of this Form 10-KSB or any amendment tothis Form 10-KSB. o

 

Indicate by check markwhether the registrant is a shell company (as defined in Rule 12b-2 of theExchange Act).
|   | Yes o | No ý |   |
|--------|-------|-----------|--------|

 

State issuer’s revenues forits most recent fiscal year:  $14,512,122

 

State the aggregate marketvalue of the voting and non-voting common equity held by non-affiliatescomputed by reference to the price at which the common equity was sold, or theaverage bid and asked price of such common equity, as of a specified datewithin the past 60 days. **Not Applicable**

 

As of March 1, 2006, therewas a total of 35,047,082 shares of the issuer’s common stock outstanding.

 

Traditional Small BusinessDisclosure Format (check one)          Yeso  No ý

 

**DOCUMENTSINCORPORATED BY REFERENCE. None.**

 

 

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**eACCELERATION CORP.**

 

**INDEX TO FORM 10-KSB**

 
| ** ** | **Page**                                                                                     |
|------------|----------------------------------------------------------------------------------------------|
| PART I     |
|       |                                                                                         |   |
| Item 1.    | Description of Business                                                                      | 1 |
|       |                                                                                         |   |
| Item 2.    | Description of Property                                                                      | 9 |
|       |                                                                                         |   |
| Item 3.    | Legal Proceedings                                                                            | 10 |
|       |                                                                                         |   |
| Item 4.    | Submission of Matters to a Vote of Security  Holders                                         | 10 |
|       |                                                                                         |   |
| PART II    |
|       |                                                                                         |   |
| Item 5.    | Market for Common Equity, Related Stockholder  Matters and Small Business Issuer             |   |
|       | Purchases of Equity Securities                                                               | 11 |
|       |                                                                                         |   |
| Item 6.    | Management’s Discussion and Analysis or Plan  of Operation                              | 11 |
|       |                                                                                         |   |
| Item 7.    | Financial Statements                                                                         | 15 |
|       |                                                                                         |   |
| Item 8.    | Changes in and Disagreements With Accountants  on Accounting and Financial Disclosure        | 15 |
|       |                                                                                         |   |
| Item 8A.   | Controls and Procedures                                                                      | 15 |
|       |                                                                                         |   |
| Item 8B.   | Other Information                                                                            | 15 |
|       |                                                                                         |   |
| PART  III  |
|       |                                                                                         |   |
| Item 9.    | Directors, Executive Officers, Promoters and  Control Persons; Compliance with Section 16(a) |   |
|       | of the Exchange Act of the Registrant                                                        | 16 |
|       |                                                                                         |   |
| Item 10.   | Executive Compensation                                                                       | 18 |
|       |                                                                                         |   |
| Item 11.   | Security Ownership of Certain Beneficial  Owners and Management and                          |   |
|       | Related Shareholder Matters                                                                  | 20 |
|       |                                                                                         |   |
| Item 12.   | Certain Relationships and Related  Transactions                                              | 21 |
|       |                                                                                         |   |
| Item 13.   | Exhibits                                                                                     | 22 |
|       |                                                                                         |   |
| Item 14.   | Principal  Accountant Fees and Services                                                      | 22 |
|       |                                                                                         |   |
| Signatures |                                                                                         | 39 |

 

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**PART I**

 

Throughout this annualreport on Form 10-KSB, the terms “we,” “us,” “our,” and “the Company” refer toeAcceleration Corp., and, unless the context indicates otherwise, our former wholly-ownedsubsidiary, Acceleration Software International Corporation (“ASIC”), on aconsolidated basis.

 

**IntroductoryComment - Forward-Looking Statements.**

 

Statements contained in thisannual report include “forward-looking statements” within the meaning ofSection 27A of the Securities Act of 1933, as amended (the “Securities Act”),and Section 21E of the Securities Exchange Act of 1934, as amended (the “ExchangeAct”). Forward-looking statements involve known and unknown risks,uncertainties and other factors which could cause our actual results,performance and achievements, whether expressed or implied by suchforward-looking statements, not to occur or be realized. Such forward-lookingstatements generally are based upon our best estimates of future results,performance or achievement, upon current conditions and upon the most recentresults of operations. Forward-looking statements may be identified by the useof forward-looking terminology such as “may,” “will,” “would,” “could,” “expect,”“believe,” “estimate,” “anticipate,” “continue,” or similar terms, variationsof those terms or the negative of those terms. Potential risks anduncertainties include, among other things, the matters described in the sectionentitled “Factors Affecting Future Operating Results” and elsewhere herein andin our other filings with the Securities and Exchange Commission.

 

Readers should carefullyconsider such risks, uncertainties and other information, disclosures anddiscussions which contain cautionary statements identifying important factorsthat could cause actual results to differ materially from those provided in theforward-looking statements. Except to the extent required by law, we undertakeno obligation to publicly update or revise any forward-looking statements,whether as a result of new information, future events or otherwise.

 

**Item 1. Description of Business.**

 

**Management’sOverview**

 

We are a provider and licensor of proprietary andopen-source software and related services that are distributed primarily throughthe Internet. Our primary focus is developing a subscriber base for oureAcceleration® online subscription service as the leading means ofdistributing some or all of our internally-produced software.

 

Our eAcceleration® online subscription service provides amyriad of computer applications, including our own software product line, toconsumers. All components are designed to make the user’s computing experience,both on and off the Internet, a fast, safe, easy, and fun experience. Ourflagship threat-remover and protection system, Stop-Sign®, was initially developed in 2002, and alertsusers to the presence of not only viruses, but also spyware, malware (*i.e*., malicious software designedspecifically to damage or disrupt a system, such as a worm), and keyloggers (*i.e*., surveillance software that recordsevery keystroke to an encrypted file, which can then e-mail such file to aremote recipient). We provide cures for the infected machines as well asongoing support and protection to safeguard our customers against futurethreats. Our online subscription service is not defined by any one application,and we expect that its nature and content will expand and evolve over time asthe needs of our customers change. We endeavor to constantly respond to the needsof the consumer market, and our online subscription service is designed to meetthose needs.

 

**History**

 

We were initiallyincorporated in Nevada in February 1987 as Apex Management, Inc. and, inOctober 1987, changed our name to Ballard Synergy Corporation. In June 1995, wemerged Ballard Synergy Corporation into a Washington corporation, and, in 1996,changed its name to Acceleration Software International Corporation (“ASIC”). InNovember 1999, we formed eAcceleration Corp., a Delaware corporation, and theshareholders of ASIC exchanged all of their stock in ASIC for all of the stockof eAcceleration Corp. As a result of this share exchange, ASIC became awholly-owned subsidiary of eAcceleration Corp. On May 14, 2004, we mergedASIC into its parent company, eAcceleration Corp. Subsequent to the merger,eAcceleration Corp. assumed all of the rights and obligations of ASIC.

 

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Although we initially began by providing crisisintervention computer software programming services, in 1996 we begandeveloping our Internet advertising and marketing business model, under whichwe provided our software and third-party products for free to users who agreedto utilize one of our websites, homepageware.com, as their Internet browser’sstarting page. Toward the end of 2000 this industry began its decline, and, in2000, we began developing a subscriber base for certain of our products on asmall scale. At first, this service was offered as an advertising-supportedservice, but over time we began to charge a nominal price for it, therebypartially offsetting our declining Internet advertising revenues. By 2002, thisservice developed into what is now our eAcceleration® onlinesubscription service.

 

We periodically change the product offerings of oureAcceleration service to meet the changing needs of an ever-increasing onlinepopulation in the United States and abroad. Throughout 2004 and 2005, wefocused the majority of our efforts on generating revenues from our eAccelerationservice. In 2005, we formed a subsidiary in the United Kingdom to give us thenecessary facilities to accept foreign currencies for our products in theUnited Kingdom as well as the European Union. However, we did not beginprocessing foreign currency transactions until February 2006.

 

**Productsand Services**

** **

Through our eAccelerationservice, we license various combinations of our software titles, together withthird-party software and open source software, to users for a subscription feethat varies depending on the level of services purchased. The eAccelerationservice currently features the following products, each of which is describedin further detail below:  Stop-Sign® Computer Protection Service, Veloz® Computer Speedup Service, kon-X® Internet Service, MegDat® Personal Media Service, eAcceleration SelectTM,OOdlz® Games, andtheir related incorporated products. The eAcceleration service operates on allcurrent versions of Windows for PC’s.

 

*Stop-Sign*®*Computer ProtectionService* is a threat-removaland protection system for the consumer market. It detects and removes threatsto a user’s computer such as viruses, spyware, malware, and keyloggers, inaddition to other undesirable items such as e-mail advertisements (spam) andpop-up advertisements. This system also helps to eliminate threats thatpropagate over non-traditional methods by means of its built-in firewall. Ifany undesirable software is detected, this system provides a cure for theinfected machine. In addition, this system offers outbreak alerts, ongoingsupport, and protection to safeguard the customer against future threats. Thissoftware became a component of our eAcceleration service in 2002. We currentlylicense a component of the virus definitions of our Stop-Sign ComputerProtection Service from a third party.

 

*Veloz*®*Computer Speedup Service* removes unnecessary files, disables speedstealing programs, optimizes hard disk space.

 

*kon-X*®*Internet Service*provides low cost internet access from over8,000 access numbers in the United States. It may be used either as a user’sprimary or back-up Internet service. kon-X also includes up to four mailboxesand sixteen megabytes of e-mail storage.

 

*MegDat*®*Personal Media Service*includes our *OnlineBackup*and*Zeus*TM**products which are available to customersat certain plan levels. Online Backup is designed to provide utility-typeprograms to help manage our customers’ data as well as an online backup thatautomatically copies our customers’ vital computer files to a secure onlinelocation. *Zeus* is an archive,compression and extraction tool that facilitates zipping and unzippingindividual or multiple files.

 

*eAcceleration Select*TM**isa powerful, highly customizable, open source application that provides wordprocessing, spreadsheet, presentation, drawing, web-browsing and emailcapabilities for home, work, and school use. It is the conduit of all theCompany’s integrated open source software. Its key features are:

 

*SonicOffice*TM is aproductivity suite that creates documents, spreadsheets, drawings, andpresentations. It provides file format choices that are compatible withMicrosoft Office.

 

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*WebVoyager*TM**is a web browserthat provides speedy viewing and navigation with tabbed browsing, pop-upblocking, privacy tools, and easy to customize interface.

 

*WindMail*TM**is**an email client that providesspellchecking, customizable security and privacy settings, and a powerful junkmail filter.

 

*OOdlz*®*Games*is an**advertising-freeonline game service that includes arcade, board, puzzle, word, and card games. Italso includes *The 4th Coming,*amultiplayer online role-playing game which features interactive play againstother online players in a virtual fantasy world.

 

**DistributionMethods**

** **

*Online subscription services*:  Wecurrently devote substantial resources to the continued development of oureAcceleration service which is sold directly to users over the Internet. Webegan offering this service in 2002 and, by the end of 2005, it accounted for99.98% of our operating revenues. We expect that the nature and content of thisservice will expand and evolve over time as the needs of our customers change. Theprimary component of this service is our Stop-Sign threat scanner for theconsumer market, which was added in 2002. In 2002, we also expanded oureAcceleration service offerings to include OOdlz Games. In 2003, we furtherexpanded our eAcceleration service offerings to include dial-up Internetservice under our brand kon-X, including e-mail and links to search engines,and to include Veloz. In 2004, we added MegDat which provides utility typeprograms to help manage customers’ data. In 2005, we added eAccelerationSelect, a productivity suite that creates documents, spreadsheets, drawings,and presentations. We continue to test additional products, but none are readyfor commercial deployment.

 

*Free downloads supported by online advertising*:  From1998 until 2001, we derived the majority of our revenues from selling onlineadvertising to other businesses. Most of our products described above, as wellas some third-party software programs, were offered as free homepageware, whichmeant that users were required to adopt our homepage as their Internet browser’sstarting page in exchange for using the software. Beginning in 2000, andthrough 2002, the online advertising industry showed a steady, significantdecline in terms of both volume and prices, and many online companies,including many of our clients at that time, did not survive that decline. As aresult, our revenue from this activity dropped considerably and we shifted ouremphasis away from an advertising-based platform to our presentsubscription-based platform. In 2005, Internet advertising accounted for only..02% of total revenue.

 

**MarketingStrategy**

 

Asthe Internet continues to expand, the size of our market also expands. Based onresearch published by ClickZ.com in February 2006, from data compiled byNielsen/NetRatings and the CIA’s World Factbook, we currently estimate that thepotential market for subscribers for our online subscription services isapproximately 341.8 million out of a total of 1,081 million people using theInternet worldwide. We believe that the 341.8 million represents people fromcountries with high enough income levels to afford our minimum introductorysubscription price in U.S. dollars.

 

We view the market for ourproducts and services as the sum of many smaller markets, rather than as asingle monolithic market. Since our eAcceleration service is composed ofmultiple products and services which, together, enhance the end user’sexperience, it may not be readily apparent to a non-technical end user whichspecific products and services best meet such user’s needs. We have identifiedtarget markets based on what we believe are the most powerful features of oureAcceleration service that would appeal to individual computer users, and havedirected ads in various media forms to those target markets.

 

Since 1996, we have been developing and refiningbetter and more efficient ways to utilize the Internet as an advertising anddirect marketing medium. Our marketing strategy for our eAcceleration serviceutilizes the extensive expertise we gained from our Internet advertisingefforts during this period. After we shifted our emphasis to our presentsubscription-based platform, we began actively utilizing Internet searchengines to market our products and services by bidding for top listings oncertain search terms. We also continue to advertise in more “traditional” mediasuch as radio and television.

 

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We believe that we have beeneffective in reaching an audience of consumers with our eAcceleration service. Thisaudience is composed not only of people in the U.S., but encompasses Internetusers all over the globe. We also believe that the users’ expectationsregarding the services available to them on the Internet are continuallyincreasing. We believe that we are well positioned for this future growth giventhe suite of products and services offered by us.

 

We seek to create a positive impression on ourcustomers that will make them want to continue using not only our existingproducts but also our future product offerings. The number and quality of ourproduct and service offerings is critical to our ability to attract and retainusers of our eAcceleration service, and thereby increase our revenues. Weexpect to expand the available components of our eAcceleration service througha combination of internal software development, licensing of components andsoftware from third parties, and possibly by offering goods and services fromthird parties.

 

**Competition**

 

We are in a highly competitive industry. As additionalcompanies such as Microsoft, Google, AOL, or other companies with large distributionchannels enter the same market as us, they create increased pricing pressure byeither giving away free software or selling it at extremely low prices to buildmarket share. To meet this challenge we must continually upgrade our existingproducts and services as well as develop new products and services.

 

Because eAcceleration is a “completeproduct line” service, we believe it would be inappropriate to classifysingle-function online subscription services in the same market segment as oureAcceleration service. We believe that, just as a component manufacturer (suchas an automobile transmission supplier) competes in a different market than themanufacturer of a complete system (such as an automobile manufacturer), thesesingle-function subscription services compete and will continue to compete in adifferent market segment than our eAcceleration service. We believe that thesynergy and savings afforded by all of our current and anticipated combinedcomponents will set us apart from the single-component producers. We have priced, and expect to continue to price, themultiple-component eAcceleration service in the same general price range astypical single-function component products.

 

We are seeing a confirmation of our business model via marketanalysis that indicates several of our competitors are beginning to bundlepreviously stand-alone products into an integrated security platform. We arealso seeing an increasing number of companies migrating to the subscriptionmodel. Thesechanges in the marketplace make it imperative that we use our technical expertise and technological adaptability to providea technologically comparable or superior product to ourcompetitors. What sets us apart is our commitment to quality customer service. We have and will continue to differentiate ourselves from thecompetition by providing free, live one-on-one customer service and technicalsupport to our customers.

 

**Customers**

 

During 2004 and 2005, 99.8% and 99.98% of our totaloperating revenue, respectively, was attributable to our eAccelerationsubscription service, which has a widely dispersed customer base, andapproximately .2% and .02% of our 2004 and 2005 total revenue, respectively,was attributable to Internet advertising. In prior years, we employed variouspay-for-performance Internet-based advertising methods. Although we are nolonger actively pursuing this line of business, we have not discontinued it. Internetadvertising continues to generate revenue from performance-based advertisingcreated in previous years, which continues to perform for certain clients. Wedid not incur any costs in 2004 or 2005 in connection with these advertisements.Internet advertising revenues are recognized in the period in which usersexecute pre-defined actions related to that advertising.

 

Our revenue from non-U.S.customers has historically been a small percentage of our total revenues. Revenuefrom foreign customers accounted for approximately 18% and 16% of our totalrevenue for the years ended December 31, 2005 and 2004, respectively.

 

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**Suppliers**

** **

We depend on severalsuppliers with respect to our eAcceleration service. Licensors of componentsthat we have included or intend to include as part of our eAcceleration servicerequire licensing fees for the use of their software. These licensing fees arenot a material portion of our costs of doing business. We employ outsidecontractors to test the software we produce for adequate performance. We alsopurchase advertising from third-party suppliers in order to advertise oureAcceleration service on the Internet, radio and television. We purchasebandwidth from several Internet connectivity providers to handle the largevolume of activity within our web pages. In each of 2004 and 2005, Google andLockard & Wechsler, Inc. were the only suppliers that individuallycomprised 10% or more of our total expenses. We purchase Internet advertisingfrom Google and advertising consulting services from Lockard & Wechsler,Inc.

 

**Technologyand Infrastructure**

 

We have developed anexpandable, reliable and secure technology infrastructure to support our onlineservices. Our software system architecture uses industry standard technologiesto maximize reliability. We use Secure Socket Layer for secure transactions,MySQL and PostgreSQL databases, the UNIX operating system and the Apache webserver within our infrastructure. All of these platforms have demonstrated ahigh degree of reliability. We back up our databases and other information on aregular basis.

 

We incorporate a variety ofencryption techniques designed to protect the privacy of consumer information. Wealso employ a variety of automated fraud detection procedures to identifypatterns of abuse and potential fraudulent use of our system. Our frauddetection systems can disable accounts in which fraud is suspected. Inaddition, the data center where our system is located provides physical andtechnical security management 24 hours per day, seven days per week.

 

When appropriate, we utilizeopen source projects and incorporate them into our eAcceleration service.Depending on the specific application, we might utilize just a portion of theopen source project or the complete project. We conform to the open sourcelicensing requirements and make the source code of projects we modify available.In the future, we may decide to release some currently proprietary internalprojects as open source.

 

We currently devotesubstantial resources to the continued development of our online subscriptionservice that is sold directly to users over the Internet. For the years ended December 31, 2005 and 2004, we spent$4,019,860 and $3,343,048, respectively, on software and web developmentexpenses. The costs of such activities were not borne directly by our customers.

 

**GovernmentRegulation**

 

United States federal andstate and foreign laws and regulations have been adopted and interpreted toregulate certain aspects of the Internet, including online content, userprivacy, taxation, liability for third-party activities, jurisdiction, Internettelephony and unsolicited electronic mail. Although we believe that we arefully compliant with all such laws, enforcement of these laws and regulationsand our compliance with these laws and regulations may have the effect ofraising the cost of doing business generally via the Internet. For example, wesoon may be required to collect value added tax on sales in the European Union,which will increase our cost of doing business there. Increased regulation ofbusiness conducted via the Internet may decrease growth, which may negativelyimpact the cost of doing business via the Internet or otherwise materiallyadversely affect our business, financial condition and results of operations.

 

Because our services areaccessible worldwide, and we facilitate the sale of our services and productsto users worldwide, other jurisdictions may claim that we are required tocomply with their laws. The failure by us to qualify as a foreign corporationin a jurisdiction where we are required to do so or fully comply with the lawsin that jurisdiction could subject us to additional taxes and penalties andcould result in our inability to enforce contracts in such jurisdictions. Anysuch new legislation or regulation, or the application of laws or regulationsfrom jurisdictions whose laws do not currently apply to our business, couldhave a material adverse effect on our business, financial condition and resultsof operations.

 

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**IntellectualProperty**

** **

We regard our patents, copyrights, service marks,trademarks, trade secrets, proprietary technology and similar intellectualproperty as critical to our success, and we rely on intellectual propertyprotection and confidentiality and license agreements with our employees,customers, independent contractors, partners and others to protect ourintellectual property rights. We own fourteen issued patents, including oneforeign patent, on our software products, and have several patent applicationspending on these products. We have registered several trademarks in the UnitedStates and may seek federal registration for additional trademarks and servicemarks in the future. Generally, we rely on common law intellectual propertyprotection in foreign jurisdictions and do not register our trademarks, servicemarks, copyrights, or similar intellectual property in those jurisdictions.

 

In December 2005, the Company sold six patents toMount Hamilton Partners, LLC for $560,000, as reported in the Forms 8-K filedby us on November 28, 2005 and January 10, 2006. None of these patents areassociated with or applicable to any of the Company’s current products,processes, or services. In December 2005, the Company also entered into anagreement with Acacia Patent Acquisition Corporation granting it a worldwide,exclusive right to license and enforce nine of the Company’s patents inexchange for which the Company is entitled to receive a certain percentage ofthe net profits, royalties, revenues, and other proceeds arising from suchlicensing and enforcement. None of these patents are associated with orapplicable to any of the Company’s current products, processes, or services.

 

The following tablediscloses the expiration schedule of our U.S. patents:

 
| **Number of Patents** | ** ** | **Year of Expiration** |
|---------------------------------|------------|----------------------------------|
|                            |       |                             |
| 1                               |       | 2009                             |
| 2                               |       | 2014                             |
| 4                               |       | 2016                             |
| 4                               |       | 2017                             |
| 1                               |       | 2018                             |
| 1                               |       | 2019                             |
| 1                               |       | 2023                             |

 

We have registered a numberof domain names, including eAcceleration.com, Stop-Sign.com, and Veloz.com. Domainnames generally are regulated by Internet regulatory bodies. The regulation ofdomain names in the United States and in foreign countries is evolving. Regulatorybodies could establish additional top-level domains, appoint additional domainname registrars or modify the requirements for holding domain names. The relationshipbetween domain names and trademarks, service marks, and other intellectualproperty is still being defined.

 

We may be required to obtainlicenses from others to refine, develop, market and deliver new services. Wemay be unable to obtain any such license on commercially reasonable terms, ifat all, or guarantee that the rights granted by any licenses will be valid andenforceable.

 

Although we have nothistorically emphasized our brand names, we expect that brand name strength maybecome increasingly important with respect to our eAcceleration service andespecially with respect to our Stop-Sign threat scanner. The reputation of ourbrand names is expected to depend on our ability to produce high-qualityinnovative software and services, and to provide a high-quality onlineexperience for users visiting our websites or using our products. Negativeexperiences of users with our services, websites or software might result inpublicity that could damage our reputation and diminish the strength of ourbrand names.

 

**EnvironmentalIssues**

 

We do not believe thatfederal, state or local environmental laws have had or are likely to have amaterial effect on our operations or costs of doing business.

 

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**Employees**

 

As of December 31, 2005, we had a total of 162employees, 19 of whom worked part-time. A total of 105 employees workedfull-time in our online services, including product development and customersupport, and 14 worked part-time; 30 employees worked full-time in sales and 5worked part-time; and 8 employees worked full-time in operations andadministration. None of our employees are represented by unions, and weconsider relations with our employees to be good. In addition, we contract witha number of independent contractors for product development and testingactivities.

 

**FactorsAffecting Future Operating Results**

** **

*Our current systems may not be capable of handlingunexpected, heavy customer traffic volumes and may be vulnerable to technicalfailures and security breaches.*

 

Ourtechnology is designed to support a large number of customers per month. Inaddition, we outsource a significant portion of our server capacity and areable to handle changing traffic volumes. Although we believe our current systemscan accommodate a heavy volume of customers, our websites could encounter avariety of systems problems, especially if the number of our customers expandssignificantly in a short period of time. These systems problems could includefailure of one or more of our current Internet service providers, failures inour outsourced servers, in-house hardware failures, or failure of softwareapplications. In addition, our computer servers may be vulnerable to computerviruses, physical or electronic break-ins and similar disruptions. We may needto expend significant additional capital and other resources to protect againsta security breach or to alleviate problems caused by any such breaches. We maybe unable to prevent or remedy all errors, failures, interruptions or delaysexperienced in connection with security breaches. If any of these failures orbreaches occur, we could temporarily lose the ability to effectively maintainour web sites and services. Any of these failures or breaches could negativelyimpact our relationship with users and adversely affect our brand and ourbusiness and could expose us to liabilities to third parties.

 

*If Microsoft (or asimilar company) bundles a fully-functional anti-virus product with the Windowsoperating system in the future, makes an anti-virus program available for freeto Windows customers, or begins to bundle anti-virus products with Windows onnew computers, our business would suffer.*

* *

If Microsoft Corporation (ora similar company) decides to incorporate a fully-functional anti-virus programinto its Windows home and business versions or makes such a product availablefor free to new or existing customers, this would be expected to have amaterial adverse effect on our sales, our business, our cash flows and our resultsof operations.

 

*We are subject to intense competition and we expect to faceincreased competition in the future.*

 

Thedomestic and international markets for our products and services are extremelycompetitive and we expect both product and pricing competition to increase. Someof our competitors have longer operating histories, more extensiveinternational and domestic operations, greater name recognition, largertechnical, sales, and marketing staffs, established relationships with hardwarevendors and/or greater financial resources. As a result, these competitors mayhave a greater ability to influence customers to purchase their productsinstead of ours. As competition increases, we may experience pricing pressuresfrom our competitors which may have a negative effect on our ability to sustainour revenue and market share growth both domestically and internationally. Ifwe are unable to anticipate or react to competition or if existing or newcompetitors gain market share, our sales may decline or be impaired, we mayexperience a decline in the prices we can charge for our products, and it mayadversely affect our ability to continue product development or provide currentlevels of customer support, any one of which could adversely affect our operatingresults.

 

*If the level of virus outbreaks drops significantly, demandfor our flagship program would decrease.*

 

If the writers of virusesworldwide were to stop or significantly reduce writing or disseminating theseprograms, demand for our flagship Stop-Sign service would plummet, and it wouldhave an adverse effect on our cash flows, financial position and results ofoperations.

 

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*If the prices of search engine advertising increasesignificantly, our costs of doing business could increase significantly.*

 

The search engine advertising market is highlycompetitive, and prices can fluctuate widely. Companies wishing to use thismedium for advertising must bid on the ranking they wish to obtain. If thecosts of purchasing advertising space on Internet search engine pages increasesignificantly, this could cause our advertising costs to correspondinglyincrease, and it could have a material adverse effect on our cash flows,financial position and results of operations.

 

*We are dependent on a limited number of suppliers ofInternet advertising.*

* *

A large percentage of ouronline revenues are derived from downloads of our products resulting from ouradvertising on the Internet. We are dependent on a small number of sources ofsuch advertising, and our loss of any significant source of this advertisingwould be expected to have a material adverse effect on our business. Forexample, during the second quarter of 2004, Google, one of our largestsuppliers of Internet advertising, suspended our advertising campaign,allegedly due to customer complaints. We did experience a decrease in revenue,but were not able to quantify whether all or just a portion of that decreasewas due to Google. We continued discussions with Google and, on October 22,2004, were successful in signing a new agreement.

 

*We may lose a significantportion of our revenues due to erroneous claims by some, including severalspyware-removal companies, that our software is spyware.*

* *

Our software has been erroneously labeled by somethird-party spyware-removal companies as spyware, which is a type of softwarethat secretly forwards information about a computer user’s online activities toothers without the user’s knowledge or consent. These spyware-removal companiesand their related products could remove our software from our customers’computers, which could cause us to lose a material portion of our revenues andthus could have a material adverse effect on our financial position, results ofoperations and cash flows. Although we are actively engaged and have beensuccessful in challenging this false allegation and taking all actions webelieve necessary to defend our reputation, we cannot provide any assurance wewill be successful in doing so in the future. Further, challenging these claimsmay result in litigation and its inherent risks and costs.

 

*If we grow very rapidly, we may be unable to find adequateoffice space or skilled employees in the county where we are currently located,and may be forced to relocate to another city, which would present a hardshipto us and our employees.*

 

The performance of our products and sales volumes willdictate the rate of growth, if any, we will undergo in the future. If the levelof sales of our products and services significantly increases from currentlevels, we may need to hire a significant number of additional employees tomeet the demand for online subscriptions. These additional employees will, inturn, create the need for additional office space. We are located in ruralKitsap County, and the availability of suitable office space and skilledemployees is limited. If we cannot find sufficient skilled employees in KitsapCounty to accommodate this growth, we may be forced to outsource certainaspects of our business or relocate to other parts of the Puget Sound areawhere skilled labor is more accessible. In addition, if we cannot findsufficient office space in Kitsap County to accommodate our growth, we may beforced to relocate to other parts of the Puget Sound area. Any relocation ofthis magnitude would cause a significant disruption of our operations, andcould have a material adverse effect on our cash flows, financial condition andresults of operations.

 

*The security measures we have in place to protect users’information may fail to operate properly and we may be subjected to lawsuitsfiled by users for the loss of their personal information.*

 

We collect personal information from users when theysubscribe to our eAcceleration service, including their credit card information.While we have security measures in place to protect such information when it istransmitted to us over the Internet, such as Secure-Socket-Layer and othermeasures, we cannot guarantee that these security measures will not fail,allowing experienced computer programmers, or “hackers”, access to suchpersonal information. Such a security breach would present a threat to ourusers, who may file lawsuits against us, claiming that we have failed toprotect their information adequately. We have no insurance protection againstsuch claims,

 

8

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and an unfavorableoutcome to such a lawsuit could have a material adverse impact on our financialposition and future sales.

 

*Our intellectual property rights are valuable, and theinability to protect them could reduce the value of our products and servicesand may harm our business.*

* *

Our patents, trademarks,trade secrets, copyrights and all of our other intellectual property rights areimportant to us. However, effective protection of our intellectual property maynot be available in every country in which our products and services aredistributed or made available through the Internet.

 

There can be no assurancethat the steps we have taken to protect our intellectual property rights willbe adequate to prevent third parties from infringing or misappropriating ourpatents, copyrights, trademarks, trade dress and similar intellectual propertyrights. The loss or impairment of our rights to the use of any suchintellectual property could harm our ability to compete and have a materialadverse effect on our business.

 

Additionally, noassurance can be given that the steps we have taken to protect our patents,copyrights, service marks, trademarks, trade dress, trade secrets and similarintellectual property have been sufficient for us to successfully defendagainst any future infringement claims that may arise, including patentinfringement claims, by any third party.

 

Protecting ourintellectual property rights is costly and time consuming and an increase inthe unauthorized use of our intellectual property could make it more expensiveto do business. Any such efforts, whether successful or not, may cause us toincur significant expenses.

 

*We may incur significant expenses with respect to thelocalization of our software to each local language or culture where we seek todistribute our software.*

 

We seek to distribute oureAcceleration service worldwide over the Internet. As we develop new softwareor distribute existing software to foreign regions, we could incur significantcosts associated with localization if the software in its present form does notgain acceptance among users, and this could adversely affect our cash flow,financial position and results of operations.

 

*We have incurred lossesin previous years, and there is no assurance that we will become profitable.*

* *

We were unprofitable in 2004 and experienced a netloss of ($1,820,142). We experienced a net loss of ($474,912) in 2005. Noassurance can be given that we will be profitable in the future.

 

We continue to develop a customer base for oureAcceleration service. Our eAcceleration service provides the majority of ourrevenue and is the primary means of distributing our online subscriptionsoftware service. There is no assurance that we will be successful in marketingor distributing this service, nor that users’ acceptance of the service willrise to expected levels, nor that the revenue stream from such a service willgenerate enough positive cash flow to enable us to continue in business.

 

**Item 2. Description of Property.**

 

At December 31, 2005, the Companyleases office space under three operating lease agreements. The Companyterminated two month-to-month leases at its Viking Bank location, effective asof September 30, 2005. On August 30, 2005, the Company entered into a newfull-service office lease between Roben Family Limited Partnership, L.P. andthe Company at its headquarter location (the “Olympic Lease”). The OlympicLease consolidated two existing leases at this location in Suites 200 and 204,and added an additional 2,960 square feet of rentable space in Suite 210, for atotal of 6,048 square feet of rentable space. The expiration date of the termof the Olympic Lease is August 31, 2008. In addition, on August 30, 2005, theCompany extended the term of its lease in Suite 100 at this location to August31, 2008 (the “Suite 100 Lease”). The Suite 100 Lease was scheduled to expireon January 31, 2007. All other terms and conditions of the Suite 100 Lease wereunchanged. As a result of these transactions, all of the space currently leasedby the Company at the Company’s headquarter facility has a common leaseexpiration date of August 31, 2008. The combined total rentable square footageat this location under the Olympic Lease and Suite 100 Lease is 16,238. Thecombined total rental cost for the three-year term of the leases is

 

9

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$661,046.40.The third lease, Plaza 305, expires in March 2007 and has an average monthlypayment of $2,648 which is scheduled to increase to $2,574 in April 2006. Thetotal rentable square footage at this location is 2,472.

 

The Company entered into a Purchaseand Sale Agreement with the Bremerton School District No. 100-C for thepurchase of certain real property located in the City of Bremerton, Washington.After a thorough review of the project, we determined that it was not in theCompany’s best interests to complete the purchase. As disclosed in Item 5 ofPart II of the Company’s quarterly report on Form 10-QSB for the quarterlyperiod ended June 30, 2005, our obligations under the Purchase and SaleAgreement terminated effective August 10, 2005 upon our receipt of the earnestmoney paid by us to the Bremerton School District No. 100-C pursuant to theterms of that agreement.

 

Poulsbo, Washington, where our facilities arepresently located, is a rural area outside of Seattle, Washington. In the pastwe have experienced temporary outages in our telephone service and electricpower. While such outages have never materially affected systems that arecritical to our operations, there is no assurance that such outages will notoccur in the future more frequently or with greater magnitude or duration. Suchoutages could materially and adversely affect our business, financial conditionand results of operations.

 

**Item 3. Legal Proceedings.**

 

On September 8, 2005, theCompany filed a complaint for unfair competition entitled eAcceleration,Corporation, Plaintiff, vs. Trend Micro, Incorporated, Defendant in UnitedStates District Court, Western District of Washington. The complaint allegesthat Trend Micro, Incorporated has developed and is distributing a computersecurity software product called Trend Micro PC-cillin Anti-Virus thatinfringes on the Company’s intellectual property rights with respect to certainof its trademarks and trade dress. The packaging of Trend Micro’s productprominently features a graphical red octagonal stop-sign nearly identical tothe Company’s graphical stop-sign. Trend Micro’s web-site,http://www.trendmicro.com/en/home/us/enterprise.htm, also features anadvertisement for its products that prominently features a graphical redoctagonal stop-sign. We believe, and in the complaint have asserted that, TrendMicro’s adoption and use of a graphical red octagonal stop-sign inadvertisements and on its packaging for its computer software infringes uponthe Company’s trademarks and trade dress. We also have alleged that Trend Microdeliberately and knowingly adopted its infringing advertising and packaging inorder to take advantage of the Company’s television advertising campaign, whichprominently features a graphical red octagonal stop-sign. In the complaint weare seeking: (i) a permanent injunction enjoining and restraining TrendMicro from offering for sale, marketing, or selling any computer securitysoftware product or service in conjunction with a depiction of a red octagonalstop-sign or any other colorable imitation thereof; (ii) restitution of all profitsderived by Trend Micro attributable to Trend Micro’s trademark infringement andunfair competition; (iii) treble damages, pursuant to 15 U.S.C. Section 1117and RCW 19.86.090, sustained by the Company on account of Trend Micro’strademark infringement and unfair competition; (iv) the Company’s fees andcosts pursuant to 15 U.S.C. § 1117(a) and RCW 19.86.090; and (v) suchfurther relief as the Court may deem just and proper.

 

We are periodically subjectto various legal proceedings and claims arising in the ordinary course ofbusiness. We do not expect that the results in any of these legal proceedingswill have a material adverse effect on our financial condition, results ofoperations or cash flows.

 

**Item 4. Submission of Matters to a Vote of SecurityHolders.**

 

Nomatters were submitted to a vote of our security holders during the quarterlyperiod ended December 31, 2005.

 

10

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**PART II**

 

**Item 5. Market for Common Equity, Related StockholderMatters and Small Business Issuer Purchases of Equity Securities.**

 

### *MarketInformation*

### * *

As of March 1, 2006, we have35,047,082 outstanding shares of common stock owned of record by 321stockholders. There is no public market for our common stock.

 

### *RecentSales of Unregistered Securities*

### * *

During the past three years,we did not sell any of our securities without registration under the SecuritiesAct. In addition, we did not repurchase any of our common stock during thequarter ended December 31, 2005.

 

### *Dividends*

### * *

We currently do not pay anydividends and have not paid or declared any cash dividends on our common stockduring the last two fiscal years. There are no restrictions that currentlylimit our ability to pay dividends on our common stock or that are likely to doso in the future.

 

### *SecuritiesAuthorized for Issuance Under Equity Compensation Plans*

### * *

The following table setsforth certain information as of December 31, 2005.

 
| ** **                                                  | ** ** | **(a)**                                                                                                                                              | ** ** | **(b)**                                                                                                          | ** ** | **(c)**                                                                                                                                                                                                          | ** ** |
|-------------------------------------------------------------|------------|------------------------------------------------------------------------------------------------------------------------------------------------------|------------|------------------------------------------------------------------------------------------------------------------|------------|------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|------------|
| ** **                                                  | ** ** | **Number of securities  to be issued upon  exercise of outstanding  options, warrants and rights** | ** ** | **Weighted average  exercise price of  outstanding options,  warrants and rights** | ** ** | **Number of securities  remaining available for  future issuance under equity  compensation plans  (excluding securities  reflected in column (a))** | ** ** |
|                                                        |       |                                                                                                                                                 |       |                                                                                                             |       |                                                                                                                                                                                                             |       |
| Equity compensation plans approved by  security holders(1)  |       | 1,191,500                                                                                                                                            | (2)        | $                                                                                                                | 0.35       |                                                                                                                                                                                                             | 8,061,418  | (2) |
| Equity compensation plans not approved by  security holders |       | 0                                                                                                                                                    |       | 0                                                                                                                |       | 0                                                                                                                                                                                                                |       |
| **Total**                                                   |       | 1,191,500                                                                                                                                            | (2)        | $                                                                                                                | 0.35       |                                                                                                                                                                                                             | 8,061,418  | (2) |

 

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(1)        Includes our 2002 Equity Incentive Planand the 1999 Amended and Restated Stock Incentive Plan of ASIC.

(2)       Excludes 747,082 shares already issued as grants under our 2002 EquityIncentive Plan as of December 31, 2005.

 

**Item 6. Management’sDiscussion and Analysis or Plan of Operation.**

** **

**ManagementOverview**

 

We are a provider andlicensor of proprietary and open-source software and related services that aredistributed primarily through the Internet. Our primary focus is developing asubscriber base for our eAcceleration online subscription service as theleading means of distributing our internally-produced software.

 

11

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During 2005, we once again experienced problems withseveral third-party spyware-removal companies erroneously labeling our softwareas spyware as well as actively preventing our download process from being fullyfunctional. We contacted these companies and initiated discussions with themaimed at clearing any misconceptions they may have had regarding our software. Wehave been successful in our efforts with a majority of the companies andcontinue discussions with the others; however, we cannot provide any assurancethat we will be successful in all instances. With fewer downloads succeedingduring this timeframe our revenues were negatively impacted. However, by theend of the year our revenues were increasing as a result of adjustments to thedownload process and continued negotiations with these companies.

 

In 2005, we continued tofocus our efforts on increasing revenues from our eAcceleration services. Thisrequired large expenditures in advertising in order to increase sales volumes. Notonly did this increase our revenues, but also helped establish our Stop-Signproduct as one of the Top 50 most recognized TV direct response brandsaccording to Infomercial Monitoring Service, Inc.

 

We are in a highlycompetitive industry and, as more companies enter this space, it promises tobecome even more so. Pricing pressure will become more acute as these companiesvie to build market share. These changes in the market place make it imperativethat we use our technical expertise andtechnological adaptability to provide a technologically comparable or superiorproduct to our competitors. What sets us apart is ourcommitment to quality customer service. Wehave and will continue to differentiate ourselves from the competition byproviding free, live one-on-one customer service and technical support to ourcustomers.

 

While overall operatingrevenues have improved due to the increased sales of our eAcceleration service,there can be no assurance that these revenues will be sufficient to cover ourincreasing costs of advertising and payroll or to recover from previous losses,nor is there any assurance that we will not incur losses in the future.

 

**CriticalAccounting Policies**

** **

Management’s discussion andanalysis of our financial position and results of operations is based upon ouraudited consolidated financial statements, which have been prepared inaccordance with accounting principles generally accepted in the United Statesof America. The preparation of these audited financial statements requiresmanagement to make estimates and judgments that affect the reported amounts ofassets, liabilities, revenues and expenses and related disclosure of contingentassets and liabilities. Actual results could differ from those estimates. Managementbelieves that the critical accounting policies and areas that require the mostsignificant judgments and estimates to be used in the preparation of theseaudited financial statements relate to revenue recognition and returns andallowances relating to online subscriptions.

 

*RevenueRecognition and Returns and Allowances Relating to Online Subscriptions*

 

In 2005, our refund periodfor online subscriptions was a 30-day refund period in accordance with theindustry standard. We defer online subscription revenue and recognize suchrevenue on a straight-line basis monthly over the life of the customer’ssubscription, after the right of refund lapses, when persuasive evidence of anagreement exists, delivery of the product has occurred, the fee is fixed ordeterminable, collectibility is probable, and no significant Companyobligations with regard to implementation remain, in accordance with SOP 97-2.

 

Accounting standards requireus to estimate the amount of future returns and create a reserve for suchreturns at the time the sale is made. Accordingly, we have developed anestimate utilizing a weighted average ratio of returns based on our actualhistorical experience. Such a ratio is applied to current period sales todevelop the required reserve. All revenue not yet recognized from sales isdeferred until future periods. We believe our revenue recognition practices forsubscription revenues are in accordance with SFAS No. 48 and, as stated above,SOP 97-2.

 

12

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**Results ofOperations for the Fiscal Years Ended December 31, 2005 and 2004**

 

### *Revenues*

### * *

Our revenues increased $1,771,933, or 14%, from$12,740,189 in 2004 to $14,512,122 in 2005, primarily due to an increase inonline subscription services revenue of $1,796,617, or 14%, to $14,509,400 in2005 from $12,712,783 recognized in 2004. In accordance with SFAS No. 48, “RevenueRecognition When Right of Return Exists,” and SOP No. 97-2, “Software RevenueRecognition,” we recognized $10,959,584 of revenue, excluding returns, anddeferred $4,690,404 of subscription revenue on our eAcceleration servicesubscriptions for sales made during 2005. We recognized $4,746,703 ofsubscription revenue in 2005 from sales of subscriptions for our eAccelerationservice that had been deferred in 2004, 2003 and 2002. We also accrued anestimate of returns and allowances for 2005 sales of $1,196,887, which isnetted against revenue for presentation. The deferred revenue will berecognized in future periods, to the extent not refunded, after the right ofrefund expires, in accordance with the provisions of SFAS No. 48.

 

*Cost ofRevenues*

 

Our cost of subscription revenue from sales of subscriptionsfor our eAcceleration service increased $3,634, or less than 1%, from$8,775,768 in 2004 to $8,779,402 in 2005. The increase in costs correlates withthe increases in sales of subscriptions for our eAcceleration service. Althoughthe overall number of employees decreased slightly in 2005, salaries and theassociated taxes and benefits increased in 2005 as the Company addedadditional, more experienced personnel.

 

*Selling,General and Administrative Expenses*

 

Selling expenses in 2005increased $798,337, or 18%, from $4,399,228 in 2004 to $5,197,565 in 2005. Thisincrease is primarily due to additional advertising purchased to promote oureAcceleration service.

 

General and administrative expenses in 2005 decreased($121,621), or (8%), from $1,519,785 in 2004 to $1,398,164 in 2005. Thisdecrease is due to: (i) completion of a bonus payment to the Chief ExecutiveOfficer to reimburse him for certain tax liabilities incurred as a result ofhis ownership interest in the Company while the Company was an S-corporation;and (ii) a decrease in legal and accounting expenses.

 

**Liquidityand Capital Resources**

 

For the year ended December 31, 2005, we had a netloss of ($474,912), an accumulated deficit of ($6,324,788), and a workingcapital deficit of ($5,528,138). In December 2005, the Company sold six of itspatents to Mount Hamilton Partners, LLC for $560,000. Excluding this one timetransaction, our loss for the year would have been ($1,034,912). We believethat the size of the losses sustained in 2005 is attributable not only to themagnitude of expenses associated with growing our eAcceleration service, butalso to the method by which we are required to report the expenses. Accountingprinciples generally accepted in the United States require that the expenses berecognized currently while the associated revenues be deferred over the term ofthe subscription. We receive the cash, but must defer the associated revenue. Thedeferred revenue is classified and shown on the Consolidated Balance Sheet as acurrent liability. As a component of the net working capital calculation, itcontributes to the deficit in working capital. Deferred revenue decreased by($56,299), or approximately 1%, from a total of $5,387,913 as of December 31,2004 to a total of $5,331,614 as of December 31, 2005. Net cash provided byoperations decreased by ($1,366,555), or approximately (187%), from a total of$731,776 as of December 31, 2004 to a total of ($634,779) as of December 31,2005. Our cash balance for the year ended December 31, 2005 is $504,636.

 

We are considering seekingadditional financing through one or more debt or equity offerings. In the pastwe have also received additional funding from our principal stockholders tosupplement funds received from third parties. However, there is no assurancethat such additional funding through debt or security offerings or from ourstockholders will be available in the future.

 

13

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### *AdditionalEvents Affecting Liquidity*

### * *

The Company has borrowed funds from the Company’s ChiefExecutive Officer, who is one of the principal stockholders, under a promissorynote. This note bears interest at 10%, is payable on demand, and requiresmonthly interest-only payments. During the third quarter of 2005, the Companyborrowed an additional $32,154 from its Chief Executive Officer. Theoutstanding balance as of December 31, 2005 is $131,568.

 

The success of oureAcceleration service is highly dependent on our ability to sell the service tosubscribers via the Internet. Such sales are predominantly conducted byelectronic payment methods, the most popular of which utilizes the customer’scredit card information and processes the sale electronically. Our processorshold a combined total of $126,060 in cash reserves. The agreements we signedwith these processors provide that reserve funds are to be returned when theagreements with the processors are terminated. However, the processors retainthe right to withhold the reserves for a period of 12 to 18 months aftercontract termination to cover potential chargebacks. We have established anallowance against the cash reserves in the amount of $13,867, in the event someof the reserves should prove uncollectible. This estimate is based on ourhistorical return experience. We currently contract with several processors andalternate payment method providers to diversify our risk. We expect that theextent of the reserves required and/or amounts of processing limits by ourprocessors likely will have a direct effect on our financial position, resultsof operations and cash flow.

 

### *StockBonuses*

### * *

In 2005, we issued anaggregate of 235,050 shares of our common stock to employees, consultants anddirectors in the form of stock bonuses granted under our 2002 Equity Incentive Plan(the “2002 Plan”), all of which shares were registered under the Securities Act.The total number of shares available under the 2002 Plan is 5,000,000. Werecorded $42,309 of estimated compensation expense in connection with theseissuances.

 

### *IncomeTaxes*

### * *

We utilize the asset andliability method of accounting for income taxes. Under this method, deferredassets and liabilities are recognized based on anticipated future taxconsequences, which are based on differences occurring between GAAP financial andtax financial results.

 

At present, the State ofWashington does not impose income taxes on corporations, but it does impose abusiness and occupation tax on corporations conducting business in the State ofWashington.

 

**Inflation**

 

We believe that inflationhas generally not had a material impact on our operations.

 

**Off-BalanceSheet Arrangements**

** **

We do not have and are not reasonably likely to haveany off-balance sheet arrangements that would have a current or future effecton our financial condition, revenues or expenses, results of operations,liquidity, capital expenditures or capital resources that would be material toinvestors.

 

**Seasonality**

 

The computer software andInternet markets are characterized by significant seasonal swings in demand. Weexpect our net sales and operating results from our eAcceleration service tocontinue to be affected by these fluctuations in Internet usage. For ourproducts and services, usage is typically higher in the summer and lower atyear-end.

 

14

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**Item 7. Financial Statements.**

 

We set forth below a list ofour financial statements included in this annual report.

 
| ** **                                                                                                     | **Page***    |
|----------------------------------------------------------------------------------------------------------------|--------------|
|                                                                                                           |         |
| Report of Independent Registered Public Accounting Firm                                                        | F-3          |
|                                                                                                           |         |
| Consolidated Balance Sheet as of December 31, 2005                                                             | F-4          |
|                                                                                                           |         |
| Consolidated Statements of Operations for the years ended December  31, 2005 and 2004                          | F-5          |
|                                                                                                           |         |
| Consolidated Statements of Stockholders’ Equity (Deficit) for the years  ended December 31, 2005 and 2004 | F-6          |
|                                                                                                           |         |
| Consolidated Statements of Cash Flows for the years ended December  31, 2005 and 2004                          | F-7          |
|                                                                                                           |         |
| Notes to Consolidated Financial Statements                                                                     | F-8  to F-18 |

 

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* Page F-1 follows page22 to this annual report on Form 10-KSB.

 

**Item 8. Changes in andDisagreements With Accountants on Accounting and Financial Disclosure.**

** **

None.

 

**Item 8A. Controls andProcedures.**

** **

We carried out an evaluation under the supervision andwith the participation of our management, including our Chief Executive Officerand Chief Financial Officer, of the effectiveness of the design and operationof our disclosure controls and procedures as defined in Exchange Act Rules 13a-15(e)and 15d-15(e). Based upon that evaluation, the Chief Executive Officer andChief Financial Officer concluded that our disclosure controls and procedures,as of December 31, 2005, are effective in timely alerting them to materialcompany information required to be included in our periodic filings with theSecurities and Exchange Commission. The design of any system of controls isbased in part upon certain assumptions about the likelihood of future events,and there can be no assurance that any design will succeed in achieving itsstated goals under all potential future conditions. As of the date of thisevaluation, there were no changes in our internal control over financialreporting that have materially affected, or are reasonably likely to materiallyaffect, our internal control over financial reporting.

 

**Item 8B. OtherInformation.**

** **

None.

 

15

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**PART III**

 

**Item 9.****          ****Directors and ExecutiveOfficers of the Registrant.**

 

**Directorsand Executive Officers**

 

The following persons areour current executive officers and directors:

 
| **Name**             | ** ** | **Age** | ** ** | **Position**                                                  |
|----------------------|------------|---------|------------|---------------------------------------------------------------|
| Clinton L. Ballard   |       | 43      |       | President, Chief Executive  Officer and Chairman of the Board |
| E. Edward Ahrens     |       | 58      |       | Chief Financial Officer  and Secretary                        |
| Edward P. Swain, Jr. |       | 70      |       | Director                                                      |
| William E. Hoke      |       | 66      |       | Director                                                      |
| Chuck Blore          |       | 76      |       | Director                                                      |

 

Set forth below is a briefdescription of the background of our officers and directors based oninformation provided by them to us.

 

*Clinton L. Ballard*is our President, Chief Executive Officer and Chairman of the Board. Since1987, he has served as a Director and as Chief Executive Officer, President,and in other senior officer capacities. Mr. Ballard received a B.S. inmathematics from the California Institute of Technology in 1984.

 

*E. Edward Ahrens*has been our Chief Financial Officer since February 2000 and ourSecretary since July 11, 2005. Mr. Ahrens was self-employed as a CertifiedPublic Accountant from October 1993 through September 30, 2002, and in thatcapacity was our regular accountant, providing accounting and controllerfunctions to us since 1995. Mr. Ahrens sold his practice on September 30, 2002and became a full time employee as of November 1, 2002. Mr. Ahrens received aBachelor of Business Administration in banking and finance from the Universityof North Texas in 1971.

 

*Edward P. Swain, Jr.*has been a Director since August 2000 andserved as a consultant to us from September 1999 through August 2000. Mr. Swainis currently self-employed as a consultant. He served as President and ChiefExecutive Officer of P T Holdings Corporation from January 1992 to December1997. From January 1992 through December 1997, he also served as President,Chief Executive Officer and Director of Port Townsend Paper Corporation, aswell as Chairman of the Board of that company from December 1997 to December1998. Mr. Swain was a Director of FiberMark, Inc. from February 1998 throughDecember 2005 where he also served as chairman of the Audit Committee andsubsequently as chairman of the Nominating and Governance Committee. Mr. Swainis a Trustee Emeritus of the Museum of Flight in Seattle, Washington. Mr. Swainreceived a B.A. from Williams College in 1957 and a LLB from Harvard Law Schoolin 1964.

 

*William E. Hoke*has been a Director since August 2000. Mr. Hoke has been self-employedfrom January 1996 through the present, serving as president of Hoke Consulting.Prior to the time he became a director, Mr. Hoke’s firm provided us withadvertising and public relations services, immaterial in amount.

 

*Chuck Blore* has been a Director since July 11, 2005. Since 1970, Mr. Blore hasbeen self-employed as the CEO of The Chuck Blore Company, a creative andproduction company specializing in broadcast, advertising, imaging andcorporate films (“CBC”). CBC has provided consulting, marketing, andadvertising services to the Company, including the production of an infomercialwith respect to the Company’s products and services. Mr. Blore has taughtat UCLA, University of Southern California and California State University,Northridge, and has spoken to numerous advertising, broadcast and cable groups.

 

Our future success dependsto a significant extent on the efforts and abilities of our senior management,particularly Clinton L. Ballard, our President and Chief Executive Officer, andother key employees, including our technical personnel. The loss of theservices of any of these individuals could harm our business. We may be

 

16

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unable to attract, motivate and retain otherkey employees in the future. We are the beneficiary of a “key person” term lifeinsurance policy in the amount of $2,000,000 on the life of Mr. Ballard.

 

Our Board of Directors iselected annually by our stockholders. Edward P. Swain, Jr. and William E. Hokehave served as our non-employee directors since August 2000; Chuck Blore hasserved as a non-employee director since July 11, 2005. Our non-employeedirectors receive $600 per Audit Committee and per Board meeting attended, withthe exception of Mr. Swain, who, as chairman of our Audit Committee, receives$1,000 per Audit Committee meeting attended. Non-employee directors alsoreceive reimbursement of expenses related to their attendance at such meetingsand also are eligible to participate in the 2002 Plan.

 

Edward P. Swain, Jr. andWilliam E. Hoke serve as members of our Audit Committee; Mr. Swain is thechairman of our Audit Committee. The audit committee is responsible foroverseeing our management’s conduct in the financial reporting process,including reviews of our annual, quarterly and other financial reports and oursystems of internal accounting and financial controls. The audit committee isresponsible for pre-approving any non-audit services and special engagements tobe performed by the independent auditors and considering the effect of suchperformance on the auditors’ independence, in accordance with our related policiesand procedures. The audit committee is also responsible for engaging anddismissing our independent certified public accountants. In discharging itsoversight role, the audit committee is empowered to meet and discuss with ourmanagement and independent auditors the quality and accuracy of our accountingprinciples, the completeness and clarity of our financial disclosures and othersignificant decisions made by management in the preparation of our financialreports. Our Board of Directors has determined that (1) no members of the auditcommittee currently meet the definition of “audit committee financial expert,”as defined under Item 401(e) of Regulation S-B of the Exchange Act, and(2) our audit committee members are “independent directors,” as defined bythe NASDAQ Marketplace Rule 4200(a)(14) and the Sarbanes-Oxley Act of 2002.Although we continue to search for a financial expert to serve on our auditcommittee, we have not found a suitable candidate to date in our geographicarea. We believe that the current members of our audit committee provide anacceptable level of business and financial experience and expertise.

 

We currently have nocompensation committee or nominating committee, the functions of which areperformed by our Board of Directors.

 

**Section16(a) Beneficial Ownership Reporting Compliance**

 

In connection with Chuck Blore’s election to the Boardon July 11, 2005, a Form 3 was filed for Mr. Blore on July 21, 2005 within therequisite 10-day period after which he became a reporting person under Section16(a) of the Exchange Act. Simultaneous to Mr. Blore’s election to the Board,Mr. Blore, as a director of the Company, received 10,000 shares of the Company’scommon stock. A Form 4 was filed for Mr. Blore on July 21, 2005 to reportthis acquisition of stock. Since this Form 4 was filed ten days after Mr. Blore’sacquisition of the stock, it was not timely filed within the requisite two-dayperiod.

 

**Code ofEthics**

 

We have adopted a Code ofEthics within the meaning of Item 406(b) of Regulation S-B of the Exchange Act.This Code of Ethics applies to directors and senior officers, such as theprincipal executive officer, principal financial officer, controller, andpersons performing similar functions, of our company. Our Code of Ethics is publiclyavailable on our website at www.eacceleration.com/stockholders.php. Inaddition, our Code of Ethics is available in print, at no charge, to anysecurity holder who requests such information by contacting us at eAccelerationCorp., Attn: Investor Relations, 1050 NE Hostmark Street, Suite 100B, Poulsbo,WA 98370 USA.

 

17

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**Item 10. Executive Compensation.**

 

The following summary compensation table sets forth,for the three years ended December 31, 2005, the cash and other compensationpaid to Clinton L. Ballard, our President, Chief Executive Officer and Chairmanof the Board; Diana T. Ballard, our former Vice Chairman of the Board,Secretary and Treasurer; and E. Edward Ahrens, our Chief Financial Officer andSecretary. No other individual served as an executive officer of the Companyduring 2005 whose total compensation, for services rendered during 2005, was$100,000 or more. No individual received perquisites that in the aggregateexceeded the lesser of $50,000 or 10% of his or her salary and bonus.

 

**Summary CompensationTable**

 
| ** **                                     | ** ** | **Annual Compensation** | ** ** | ** **       | ** ** |
|------------------------------------------------|------------|------------------------------|------------|------------------|------------|
| **Name and principal position** | ** ** | **Fiscal  Year**             | ** ** | **Base  Salary** | ** ** | **Bonus** | ** ** | **Other Annual  Compensation** | ** ** | **Long-Term  Compensation** | ** ** | **All Other  Compensation** | ** ** |
|                                           |       |                         |       |             |       |   |   |   |   |   |   |   |   |
| Clinton L. Ballard                             |       | 2005                         |       | $                | 232,000    |   | $ | 145,874 | (3) | $ | 0 |   | $ | 0 |   | $ | 0 |   |
| President, CEO, and                            |       | 2004                         |       | 143,062          |       | 217,582 | (2) | 0 |   | 0 |   | 0 |   |
| Chairman of the Board                          |       | 2003                         |       | 108,000          | (1)        | 22,552 | (2) | 0 |   | 0 |   | 6,103 |   |
|                                           |       |                         |       |             |       |   |   |   |   |   |   |   |   |
| Diana T. Ballard(4)                            |       | 2005                         |       | $                | 28,000     |   | $ | 0 |   | $ | 0 |   | 0 |   | $ | 0 |   |
| Vice Chairman of the Board,                    |       | 2004                         |       | 75,064           |       | 16,110 | (2) | 0 |   | 0 |   | 0 |   |
| Secretary and Treasurer                        |       | 2003                         |       | 108,000          | (1)        | 22,421 | (2) | 0 |   | 0 |   | 5,123 |   |
|                                           |       |                         |       |             |       |   |   |   |   |   |   |   |   |
| E. Edward Ahrens                               |       | 2005                         |       | $                | 104,000    |   | $ | 447 | (3) | $ | 0 |   | 0 |   | $ | 0 |   |
| Chief Financial Officer                        |       | 2004                         |       | 102,474          |       | 2,004 | (2) | 0 |   | 0 |   | 0 |   |
|                                                |            |                              |            |                  |            |  |  |  |  |  |  |  |  |  |  |  |  |  |

 

----

(1) Each of Mr. Ballard and Mrs. Ballardreceived an additional $4,000 of salary in 2003 given our decision to payemployees on Wednesday, December 31, 2003 instead of Friday, January 2, 2004 inconnection with the holiday season.

 

(2) Each of Mrs. Ballard’sbonuses in 2004 and 2003 represented cash bonuses pursuant to her employmentagreement. Mr. Ballard’s bonus in 2003 represented a cash bonus pursuant to hisemployment agreement. Mr. Ballard’s bonus in 2004 was comprised of a$200,000 bonus to reimburse him for certain tax liabilities incurred by him asa result of his ownership interest in the Company while the Company was an S-corporation,and a $17,582 cash bonus pursuant to his employment agreement. Mr. Ahrens’bonus in 2004 was his share of Company bonuses based on cash flow increases.

 

(3) The bonus for Mr.Ballard in 2005 was the remainder of the bonus to reimburse him for certain taxliabilities incurred by him as a result of his ownership interest in theCompany while the Company was an S-corporation. The bonus to Mr. Ahrens was togross up his salary for the Social Security and Medicare taxes associated withthe issuance of his stock grants.

 

(4) Mrs. Ballard did not stand forre-election to the Board at the annual meeting of stockholders held onJuly 11, 2005, and, effective as of that date, resigned as theCompany’s Secretary and Treasurer. Mrs. Ballard’s annual compensation includesall amounts paid to her through July 11, 2005.

 

**StockOption Grants in 2005**

** **

The following table setsforth:

 

•                  the number of shares underlying optionsgranted during 2005 to the named executive officers;

•                  the percentage that the option grantrepresents of the total number of options granted to all of our employeesduring 2005;

•                  the per share exercise price of each suchoption; and

•                  the expiration date of each such option.  

 

18

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| **Name**           | ** ** | **Number of Shares  Underlying Options  Granted During 2005** | ** ** | **Percentage of Total  Options Granted to  Employees in 2005** | ** ** | **Exercise  Price** | ** ** | **Expiration  Date** | ** ** |
|--------------------|------------|----------------------------------------------------------------------------------------|------------|----------------------------------------------------------------------------------------------|------------|---------------------|------------|----------------------|------------|
| ** **         | ** ** | ** **                                                                             | ** ** | ** **                                                                                   | ** ** | ** **          | ** ** | ** **           | ** ** |
| Clinton L. Ballard |       | 0                                                                                      |       | —                                                                                       |       | —              |       | —               |       |
| Diana T. Ballard   |       | 0                                                                                      |       | —                                                                                       |       | —              |       | —               |       |
| E. Edward Ahrens   |       | 0                                                                                      |       | —                                                                                       |       | —              |       | —               |       |

** **

**AggregateOption Exercises in 2005 and Year-End Option Values**

 

Set forth in the table below is information withrespect to the named executive officers as to:

 

•                  the total number of unexercised options heldon December 31, 2005, separately identified between those exercisable and thosenot exercisable as of such date; and

•                  the aggregate value of in-the-money,unexercised options held on December 31, 2005, separately identified betweenthose exercisable and those not exercisable.

 
| ** **         | ** ** | **Number of  Unexercised Options  at December 31, 2005** | ** ** | **Value of Unexercised  In-the-Money Options  at December 31, 2005** | ** ** |
|--------------------|------------|-----------------------------------------------------------------------------------|------------|----------------------------------------------------------------------------------------------------|------------|
| **Name**           | ** ** | **Exercisable**                                                                   | ** ** | **Unexercisable**                                                                                  | ** ** | **Exercisable** | ** ** | **Unexercisable** | ** ** |
|               |       |                                                                              |       |                                                                                               |       |   |   |   |   |
| Clinton L. Ballard |       | 0                                                                                 |       | 0                                                                                                  |       | 0 |   | 0 |   |
| Diana T. Ballard   |       | 0                                                                                 |       | 0                                                                                                  |       | 0 |   | 0 |   |
| E. Edward Ahrens   |       | 16,000                                                                            |       | 64,000                                                                                             |       | 0 |   | 0 |   |

 

None of our named executiveofficers exercised any options during 2005. The value of unexercisedin-the-money options is calculated by subtracting the aggregate exercise priceof the options from the aggregate fair market value price of the shares ofcommon stock underlying the options as of December 31, 2005. The most recentdetermination of the Board of Directors as to the fair market value of theunderlying shares occurred in July 2005, at which time the Board of Directorsdetermined that the fair market value of the underlying shares was $0.18 pershare.

 

**Long-TermIncentive Plans - Awards in Last Fiscal Year**

 

Set forth in the table belowis information with respect to the named executive officers as to:

 

•                  the total number of options or shares grantedin 2005;

•                  the maturation or payout schedule of thoseoptions issued; and

•                  the exercise or target price for thoseoptions.

 
| **Name**           | ** ** | **Number of shares, units  or other rights** | ** ** | **Performance or other  period until maturation  or payout** | ** ** | **Target** |
|--------------------|------------|-----------------------------------------------------------------------|------------|---------------------------------------------------------------------------------------|------------|------------|
| Clinton L. Ballard |       | 0                                                                     |       | 0                                                                                     |       | 0          |
| Diana T. Ballard   |       | 0                                                                     |       | 0                                                                                     |       | 0          |
| E. Edward Ahrens   |       | 30,000  shares                                                        |       | n/a                                                                                   |       | n/a        |

 

In accordance with the 2002Plan, these stock bonuses were granted to the employee based on performance andare registered under our registration statement on Form S-8.

 

19

----

 

**EmploymentAgreements**

** **

We have entered into anemployment agreement with our President and CEO, Clinton L. Ballard, for afive-year term commencing January 1, 2003, which extends annually thereafterunless we or Mr. Ballard provide 60 days’ notice of termination. The employmentagreement with Mr. Ballard, as amended on July 11, 2005 and as further amendedon August 10, 2005, provides for him to serve as the President, Chief ExecutiveOfficer and Chairman of the Board, and provides for an annual base salary of$260,000, a bonus of up to $122,200 contingent upon completion of a financingagreement with Agility Capital, LLC, and a bonus of 4% of our annual cash flow,payable on a quarterly basis, with respect to fiscal years during the term ofthe agreement. A copy of Mr. Ballard’s Amended and Restated EmploymentAgreement was filed as Exhibit 10.1 to the Company’s quarterly report on Form10-QSB for the period ended June 30, 2005.

 

We have entered into an employment agreement with ourSecretary and CFO, E. Edward Ahrens, for a five-year term commencing August 15,2005, which extends annually thereafter unless we or Mr. Ahrens provide 60 days’notice of termination. The employment agreement with Mr. Ahrens provides forhim to serve as Chief Financial Officer and provides for an annual salary of$104,000 and a bonus of 1% of our annual cash flow, payable on a quarterlybasis, with respect to fiscal years during the term of the agreement. A copy ofMr. Ahrens’ Employment Agreement was filed as Exhibit 10.2 to the Company’squarterly report on Form 10-QSB for the period ended June 30, 2005.

 

Each of these employmentagreements contains restrictions on the employee engaging in competition withus for the term of the employment agreement and for one year after the term,and contains provisions protecting our proprietary rights and information. Eachagreement also provides for the payment to the employee of a lump sum equal tothree times the average of the employee’s annual compensation for the priorfive years, less $1.00, upon his termination in the event of a “change incontrol” of the Company, as that term is defined in the respective employmentagreements.

 

**IndemnificationAgreements**

 

We have entered intoindemnification agreements with each of our executive officers and directors. Theindemnification agreements provide for reimbursement for all direct andindirect costs of any type or nature whatsoever including attorneys’ fees andrelated disbursements, that are actually and reasonably incurred in connectionwith either the investigation, defense or appeal of a “proceeding”, as definedin the indemnification agreements, including amounts paid in settlement by oron behalf of an “indemnitee”, as defined in such agreements.

 

Insofar as indemnification for liabilities arisingunder the Securities Act may be permitted with respect to our directors,officers, and controlling persons pursuant to these indemnification agreements,or otherwise, we have been advised that in the opinion of the Securities andExchange Commission such indemnification is against public policy as expressedin the Securities Act and is, therefore, unenforceable.

 

**Item 11. SecurityOwnership of Certain Beneficial Owners and Management and Related StockholderMatters.**

** **

The following table sets forth the beneficialownership of our common stock as of March 1, 2006 of:

 

•                  each person known by us to beneficially own5% or more of the shares of outstanding common stock;

•                  each of our executive officers and directors;and

•                  all of our executive officers and directorsas a group.

 

Except as otherwise indicated in thefollowing table:

 

•                  all shares are beneficially owned, andinvestment and voting power is held, by the persons named as owners; and

•                  the address for each beneficial owner listedon the following table is eAcceleration Corp., 1050 NE Hostmark Street, Suite100B, Poulsbo, Washington 98370.

 

20

----

 
| **Name of  beneficial owner**            | ** ** | **Amount of  common stock  beneficially owned** | ** ** | **Percentage ownership  of common stock** | ** ** |
|----------------------------------------------------|------------|----------------------------------------------------------------|------------|----------------------------------------------------------|------------|
| Clinton L. Ballard                       |       | 34,300,000                                                     | (1)        | 97.87                                                    | %          |
| Diana T. Ballard                                   |       | 34,300,000                                                     | (1)        | 97.87                                                    | %          |
| Teresa D. Potasiak                                 |       | 7,500,000                                                      | (1)        | 21.40                                                    | %          |
| Teresa D. Potasiak                                 |       | 10,000                                                         |       |                                                     | *          |
| E. Edward Ahrens                                   |       | 40,250                                                         |       |                                                     | *          |
| Edward P. Swain, Jr.                               |       | 40,000                                                         |       |                                                     | *          |
| William E. Hoke                                    |       | 40,000                                                         |       |                                                     | *          |
| Chuck Blore                                        |       | 25,000                                                         |       |                                                     | *          |
| All officers and directors as a group (5  persons) |       | 34,445,250                                                     |       | 98.28                                                    | %          |

 

----

* Less than one percent

 

(1)           The shares beneficially owned by Mr.Ballard include the shares owned by his wife, Mrs. Ballard, and the sharesbeneficially owned by Mrs. Ballard include the shares owned by Mr. Ballard. Theshares beneficially owned by Mr. Ballard and Mrs. Ballard include an aggregateof 880,000 shares owned of record by the minor children of Mr. Ballard and Mrs.Ballard, as well as an aggregate of 23,500,000 shares held in the BallardFamily Trust, an irrevocable trust, for the benefit of their children. Pursuantto the trust agreement, Mr. Ballard, among other things, has agreed that solong as he is trustee of the trust, he will not vote any of the trust shares. TeresaD. Potasiak, as independent voting trustee for so long as, among other things,Mr. Ballard remains trustee, has the sole right to vote with respect to7,500,000 shares in the trust or such lesser number of shares that the trustmay hold.

 

**Item 12. Certain Relationships and RelatedTransactions.**

 

We have entered intoemployment agreements with our President and CEO, Clinton L. Ballard, and ourSecretary and CFO, E. Edward Ahrens. See “Executive Compensation - EmploymentAgreements.”  We also entered into anemployment agreement with Diana T. Ballard, dated November 1, 1999, as amended,to serve as our Secretary and Treasurer. Mrs. Ballard chose not to run forreelection as Vice-Chairman of the Board and terminated her employment with theCompany effective July 11, 2005.

 

During the fourth quarter of2001 and the first quarter of 2002, we borrowed an aggregate of $404,000 fromMr. Ballard, the Company’s President and CEO, under various notes payable. Duringthe third quarter of 2005, the Company borrowed an additional $32,154 from Mr.Ballard. As of December 31, 2005, there is one note payableremaining. This note bears interest at 10%, is payable ondemand, and requires monthly interest-only payments. The outstanding balance asof December 31, 2005 is $131,568.

 

In March 2004, we granted abonus of $17,582 to Mr. Ballard and a bonus of $16,110 to Mrs. Ballard. Each ofthese bonuses was granted in accordance with Mr. Ballard’s and Mrs. Ballard’s respectiveemployment agreements, as amended.

 

In March 2004, we issued1,250 shares of common stock to Mr. Ahrens. These shares had a value of $0.22per share at such time. In addition, in 2004 Mr. Ahrens received a cash bonusof $2,004 pursuant to the Company’s cash-flow bonus program.

 

In October 2004, we authorized the payment of $200,000in the form of a bonus to Mr. Ballard to reimburse Mr. Ballard for certaintax liabilities incurred by him as a result of his ownership interest in theCompany while the Company was an S-corporation.

 

Chuck Blore’s company, CBC, provided consulting,marketing, and advertising services to the Company, including the production ofan infomercial with respect to the Company’s products and services. For theseservices, the Company paid CBC a total of $26,500 in fiscal 2003, $70,783 infiscal 2004, and $96,000 through June 10, 2005. No services have been renderedby CBC to the Company, and no payments have been made by the Company to CBC,after Mr. Blore’s election to the Board on July 11, 2005.

 

21

----

 

During 2005, we granted and paid via the Companypayroll system a bonus of $145,874 to Mr. Ballard. The bonus was the remainderof the bonus to reimburse him for certain tax liabilities incurred by him as aresult of his ownership interest in the Company while the Company was an S-corporation.

 

On June 2, 2005, we issued30,000 shares of common stock to each of Mr. Ahrens, Mr. Hoke and Mr. Swain. Theseshares had a value of $0.18 per share at such time.

 

On July 11, 2005, we issued 10,000 shares of commonstock to Mr. Blore. These shares had a value of $0.18 per share at such time.

 

On July 15, 2005, we granteda bonus of $447 to Mr. Ahrens. This bonus was to gross up his salary for the SocialSecurity and Medicare taxes associated with the issuance of his stock grants.

 

All transactions between usand any of our officers, directors or five percent stockholders have been andwill be on terms no less favorable to us than would be available fromunaffiliated third parties.

 

**Item 13. Exhibits.**

 

The exhibits listed in theaccompanying index to exhibits are filed or incorporated by reference as partof this annual report.

 

**Item 14. Principal Accountant Fees and Services.**

 

*Audit Fees*

 

Peterson Sullivan PLLCprovided audit services to us for our annual report for the fiscal years endedDecember 31, 2005 and 2004. The fees per the engagement letter for the annualfinancial statements and review of quarterly financial statements for 2005 were$43,500. The fees billed by Peterson Sullivan PLLC for the 2004 audit of theannual financial statements and review of the quarterly financial statementswere $39,957.

 

*Audit-RelatedFees*

 

No fees were billed for theyears 2005 and 2004 for professional services that are reasonably related tothe audit or review of our financial statements that are not covered in the “AuditFees” disclosure above.

 

*Tax Fees*

 

Peterson Sullivan PLLCbilled fees of $1,664 and $17,321 for the years 2005 and 2004, respectively,for professional services rendered for tax compliance.

 

*All OtherFees*

 

No fees were billed for theyears of 2005 or 2004 for professional services rendered by Peterson SullivanPLLC for all other services not disclosed above.

 

*AuditCommittee Pre-Approval*

 

Our Audit Committeepre-approved our engagement of Peterson Sullivan PLLC to act as our independentauditor for our fiscal years ended December 31, 2004 and 2005. Our AuditCommittee also pre-approved Peterson Sullivan PLLC to provide the audit,audit-related, tax services and all other services described above. Ourindependent auditors performed all work only with their full time permanentemployees.

 

22

----

 

eACCELERATION CORP.

 

CONSOLIDATED FINANCIAL REPORT

 

DECEMBER 31, 2005

 

F-1

----

 

C  O  N T  E  N  T  S

 
| ** **                                                      | **Page**    |
|-----------------------------------------------------------------|-------------|
|                                                            |        |
| REPORT OF INDEPENDENT REGISTERED PUBLIC  ACCOUNTING FIRM        | F-3         |
|                                                            |        |
| Consolidated Balance Sheet                                      | F-4         |
| Consolidated Statements of  Operations                          | F-5         |
| Consolidated Statements of  Stockholders’ Equity (Deficit) | F-6         |
| Consolidated Statements of  Cash Flows                          | F-7         |
|                                                            |        |
| NOTES TO CONSOLIDATED  FINANCIAL STATEMENTS                     | F-8 to F-18 |

 

 

F-2

----

 

 

**REPORT OF INDEPENDENT REGISTERED PUBLIC ACCOUNTING FIRM**

 

To the Board of Directors

eAcceleration Corporation

Poulsbo, Washington

 

We have audited the accompanying consolidated balance sheet ofeAcceleration Corporation as of December 31, 2005, and the relatedconsolidated statements of operations, stockholders’ equity (deficit), and cashflows for the years ended December 31, 2005 and 2004. These consolidatedfinancial statements are the responsibility of management. Our responsibilityis to express an opinion on these consolidated financial statements based onour audits.

 

We conducted our audits in accordance with the standards of the PublicCompany Accounting Oversight Board (United States). Those standards requirethat we plan and perform the audit to obtain reasonable assurance about whetherthe consolidated financial statements are free of material misstatement. TheCompany has determined that it is not required to have, nor were we engaged toperform, an audit of its internal control over financial reporting. Our auditincluded consideration of internal control over financial reporting as a basisfor designing audit procedures that are appropriate in the circumstances, butnot for the purpose of expressing an opinion on the effectiveness of theCompany’s internal control over financial reporting. Accordingly, we express nosuch opinion. An audit includes examining, on a test basis, evidence supportingthe amounts and disclosures in the financial statements. An audit also includesassessing the accounting principles used and significant estimates made bymanagement, as well as evaluating the overall financial statement presentation.We believe that our audits provide a reasonable basis for our opinion.

 

In our opinion, the consolidated financial statements referred to abovepresent fairly, in all material respects, the financial position ofeAcceleration Corporation as of December 31, 2005, and the results oftheir operations, and their cash flows for the years ended December 31,2005 and 2004, in conformity with accounting principles generally accepted inthe United States.

 
| /s/ Peterson Sullivan PLLC |   |
|----------------------------|--------|
|                       |
| February 24, 2006          |
| Seattle, Washington        |

 

F-3

----

 

**eACCELERATION CORP.**

 

**CONSOLIDATED BALANCE SHEET**

**December 31, 2005**

 
| **ASSETS**                                                                                                |   |       |      |
|-----------------------------------------------------------------------------------------------------------|--------|------------|-----------|
| Current assets                                                                                            |   |       |      |
| Cash                                                                                                      |   | $          | 504,636   |   |
| Accounts receivable                                                                                       |   | 162,820    |      |
| Net deferred tax asset - current                                                                          |   | 160,696    |      |
| Prepaid expenses and other                                                                                |   | 36,561     |      |
|                                                                                                      |   |       |      |
| Total current assets                                                                                      |   | 864,713    |      |
|                                                                                                      |   |       |      |
| Property and  equipment, net                                                                              |   | 210,895    |      |
| Intangible  assets, net                                                                                   |   | 134,013    |      |
| Cash  reserves, net                                                                                       |   | 112,193    |      |
| Net deferred  tax asset - non-current                                                                     |   | 79,738     |      |
| Other assets                                                                                              |   | 15,326     |      |
| Total assets                                                                                              |   | $          | 1,416,878 |   |
|                                                                                                      |   |       |      |
| **LIABILITIES AND STOCKHOLDERS’ EQUITY  (DEFICIT)**                                                  |   |       |      |
|                                                                                                      |   |       |      |
| Current  liabilities                                                                                      |   |       |      |
| Accounts payable                                                                                          |   | $          | 886,911   |   |
| Accrued expenses                                                                                          |   | 356,505    |      |
| Deferred revenue, current portion                                                                         |   | 4,975,954  |      |
| Reserve for sales returns and allowances                                                                  |   | 41,912     |      |
| Note payable to stockholder                                                                               |   | 131,568    |      |
| Total current liabilities                                                                                 |   | 6,392,850  |      |
|                                                                                                      |   |       |      |
| Deferred  revenue, less current portion                                                                   |   | 355,660    |      |
|                                                                                                      |   |       |      |
| Total liabilities                                                                                         |   | 6,748,510  |      |
|                                                                                                      |   |       |      |
| Commitments  and contingencies                                                                            |   |       |      |
|                                                                                                      |   |       |      |
| Stockholders’  equity (deficit)                                                                      |   |       |      |
| Common stock, par value $0.0001;  100,000,000 shares authorized; 35,047,082 shares issued and outstanding |   | 3,505      |      |
| Additional paid-in capital                                                                                |   | 989,651    |      |
| Accumulated deficit                                                                                       |   | (6,324,788 | )         |
| Total stockholders’ equity (deficit)                                                                 |   | (5,331,632 | )         |
|                                                                                                      |   |       |      |
| Total liabilities and stockholders’ equity  (deficit)                                                |   | $          | 1,416,878 |   |

 

See Notes to Consolidated Financial Statements

 

F-4

----

 

**eACCELERATION CORP.**

 

**CONSOLIDATED STATEMENTS OF OPERATIONS**

**For the Years Ended December 31, 2005 and 2004**

 
| ** **                              | ** ** | **2005**   | ** ** | **2004**   | ** ** |
|-----------------------------------------|------------|------------|------------|------------|------------|
| Revenue                                 |       |       |       |       |       |
| Online software subscriptions, net      |       | $          | 14,509,400 |       | $          | 12,712,783 |   |
| Internet advertising                    |       | 2,722      |       | 27,406     |       |
| Total revenue                           |       | 14,512,122 |       | 12,740,189 |       |
|                                    |       |       |       |       |       |
| Cost of revenue                         |       |       |       |       |       |
| Online software subscriptions services  |       | 8,779,402  |       | 8,775,768  |       |
| Cost of revenue                         |       | 8,779,402  |       | 8,775,768  |       |
|                                    |       |       |       |       |       |
| Gross profit                            |       | 5,732,720  |       | 3,964,421  |       |
|                                    |       |       |       |       |       |
| Selling expenses                        |       | 5,197,565  |       | 4,399,228  |       |
| General and administrative expenses     |       | 1,398,164  |       | 1,519,785  |       |
|                                    |       |       |       |       |       |
| Loss from operations                    |       | (863,009   | )          | (1,954,592 | )          |
|                                    |       |       |       |       |       |
| Other income (expense)                  |       |       |       |       |       |
| Interest expense                        |       | (9,524     | )          | (20,609    | )          |
| Loss on settlement of litigation        |       | (17,500    | )          | (10,000    | )          |
| Loss on disposal of assets              |       | (3,881     | )          |       |       |
| Gain on sale of patents                 |       | 557,980    |       |       |       |
| Total other income (expense)            |       | 527,075    |       | (30,609    | )          |
|                                    |       |       |       |       |       |
| Loss before provision for income tax    |       | (335,934   | )          | (1,985,201 | )          |
|                                    |       |       |       |       |       |
| Income tax benefit - current            |       | 13,335     |       | 159,208    |       |
| Income tax (expense) benefit - deferred |       | (152,313   | )          | 5,851      |       |
| Total income tax (expense) benefit      |       | (138,978   | )          | 165,059    |       |
|                                    |       |       |       |       |       |
| Net income (loss)                       |       | $          | (474,912   | )          | $          | (1,820,142 | ) |
|                                    |       |       |       |       |       |
| Basic and diluted per-share information |       |       |       |       |       |
| Net income (loss)                       |       | $          | (0.01      | )          | $          | (0.05 | ) |
|                                    |       |       |       |       |       |
| Weighted average shares outstanding     |       |       |       |       |       |
| Basic and diluted                       |       | 34,597,171 |       | 34,788,457 |       |

 

See Notes to Consolidated Financial Statements

 

F-5

----

 

**eACCELERATION CORP.**

 

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

**For the Years Ended December 31, 2005 and 2004**

 
| ** **                   | ** ** | **Common Stock  Shares** | ** ** | **Amount** | ** ** | **Additional  Paid-In  Capital** | ** ** | **Accumulated  Deficit** | ** ** | **Stockholders’  Equity  (Deficit)** | ** ** |
|------------------------------|------------|--------------------------|------------|------------|------------|----------------------------------|------------|--------------------------|------------|-------------------------------------------|------------|
|                         |       |                     |       |       |       |                             |       |                     |       |                                      |       |
| Balances,  December 31, 2003 |       | 34,745,800               |       | $          | 3,475      |                             | $          | 866,315                  |       | $                                         | (4,029,734 | ) | $ | (3,159,944 | ) |
|                         |       |                     |       |       |       |                             |       |                     |       |                                      |       |
| Value of stock options       |       |                     |       |       |       | 45,275                           |       |                     |       | 45,275                                    |       |
|                         |       |                     |       |       |       |                             |       |                     |       |                                      |       |
| Value of stock issued        |       | 66,232                   |       | 6          |       | 13,790                           |       |                     |       | 13,796                                    |       |
|                         |       |                     |       |       |       |                             |       |                     |       |                                      |       |
| Net income (loss)            |       |                     |       |       |       |                             |       | (1,820,142               | )          | (1,820,142                                | )          |
|                         |       |                     |       |       |       |                             |       |                     |       |                                      |       |
| Balances,  December 31, 2004 |       | 34,812,032               |       | 3,481      |       | 925,380                          |       | (5,849,876               | )          | (4,921,015                                | )          |
|                         |       |                     |       |       |       |                             |       |                     |       |                                      |       |
| Value of stock options       |       |                     |       |       |       | 21,986                           |       |                     |       | 21,986                                    |       |
|                         |       |                     |       |       |       |                             |       |                     |       |                                      |       |
| Value of stock issued        |       | 235,050                  |       | 24         |       | 42,285                           |       |                     |       | 42,309                                    |       |
|                         |       |                     |       |       |       |                             |       |                     |       |                                      |       |
| Net income (loss)            |       |                     |       |       |       |                             |       | (474,912                 | )          | (474,912                                  | )          |
|                         |       |                     |       |       |       |                             |       |                     |       |                                      |       |
| Balances,  December 31, 2005 |       | 35,047,082               |       | $          | 3,505      |                             | $          | 989,651                  |       | $                                         | (6,324,788 | ) | $ | (5,331,632 | ) |

 

See Notes to Consolidated Financial Statements

 

F-6

----

 

**eACCELERATION CORP.**

 

**CONSOLIDATED STATEMENTS OF CASH FLOWS**

**For the Years Ended December 31, 2005 and 2004**

 
| ** **                                                                                  | ** ** | **2005** | ** ** | **2004**  | ** ** |
|---------------------------------------------------------------------------------------------|------------|----------|------------|-----------|------------|
| Cash flows from operating activities                                                        |       |     |       |      |       |
| Net (Loss)                                                                                  |       | $        | (474,912   | )         | $          | (1,820,142 | ) |
| Adjustments to reconcile net (loss) to net  cash provided by (used in) operating activities |       |     |       |      |       |
| Depreciation and amortization                                                               |       | 136,747  |       | 131,761   |       |
| Value of stock options                                                                      |       | 21,986   |       | 45,275    |       |
| Issuance of common stock under equity  incentive plan                                       |       | 42,309   |       | 13,796    |       |
| Loss on disposal of assets                                                                  |       | 3,881    |       | —    |       |
| Gain on sale of patents                                                                     |       | (557,980 | )          | —    |       |
| Other                                                                                       |       | 12,485   |       | —    |       |
|                                                                                        |       |     |       |      |       |
| Changes in operating assets and liabilities                                                 |       |     |       |      |       |
| Accounts receivable                                                                         |       | (159,435 | )          | (3,205    | )          |
| Net deferred tax asset                                                                      |       | 152,313  |       | (18,704   | )          |
| Prepaid expenses and other                                                                  |       | 8,223    |       | 16,546    |       |
| Income tax receivable                                                                       |       | 197,643  |       | (197,643  | )          |
| Cash reserves                                                                               |       | (25,312  | )          | 270,304   |       |
| Other assets                                                                                |       | 10,000   |       | (14,126   | )          |
| Accounts payable                                                                            |       | 123,398  |       | 430,419   |       |
| Accrued expenses                                                                            |       | 63,514   |       | (130,983  | )          |
| Deferred revenue                                                                            |       | (56,299  | )          | 1,955,612 |       |
| Reserve for sales returns and allowances                                                    |       | (133,340 | )          | 52,866    |       |
| Net cash provided by (used in) operating  activities                                        |       | (634,779 | )          | 731,776   |       |
|                                                                                        |       |     |       |      |       |
| Cash flows from investing activities                                                        |       |     |       |      |       |
| Purchases of equipment                                                                      |       | (43,737  | )          | (273,079  | )          |
| Patent and trademark costs                                                                  |       | (31,577  | )          | (42,899   | )          |
| Disposal of patents and trademarks                                                          |       | 20,564   |       | (15,621   | )          |
| Proceeds from sale of patents                                                               |       | 560,000  |       | —    |       |
| Net cash provided by (used in) investing  activities                                        |       | 505,250  |       | (331,599  | )          |
|                                                                                        |       |     |       |      |       |
| Cash flows from financing activities                                                        |       |     |       |      |       |
| Payments on notes payable                                                                   |       | (2,175   | )          | (292,427  | )          |
| Loan from stockholder                                                                       |       | 32,154   |       | -         |       |
| Net cash provided by (used in) financing  activities                                        |       | 29,979   |       | (292,427  | )          |
|                                                                                        |       |     |       |      |       |
| Net increase (decrease) in cash                                                             |       | (99,550  | )          | 107,750   |       |
| Cash at beginning of period                                                                 |       | 604,186  |       | 496,436   |       |
|                                                                                        |       |     |       |      |       |
| Cash at end of period                                                                       |       | $        | 504,636    |      | $          | 604,186 |   |
|                                                                                        |       |     |       |      |       |
| Supplemental disclosure of cash flow  information:                                          |       |     |       |      |       |
| Cash paid during the period for interest                                                    |       | $        | 7,953      |      | $          | 21,017 |   |
| Cash paid during the period for taxes                                                       |       | $        |       |      | $          | 199,808 |   |

 

See Notes to Consolidated Financial Statements

 

F-7

----

 

**eACCELERATION CORP.**

 

**NOTES TO CONSOLIDATED FINANCIAL STATEMENTS**

** **

**Note 1.  TheCompany and Basis of Presentation**

** **

**Company**

** **

eAcceleration Corp., a Delaware corporation (the “Company”),is a provider of proprietary software, including its eAcceleration onlinesoftware subscription service, formerly named “eAnthology,” which isdistributed directly by the Company via the Internet and, until October 2003,through a distributor in Japan that exclusively distributed Japanese versionsof certain of the Company’s software. The Company has also, in the past,provided Internet-based direct marketing and advertising services, which theCompany de-emphasized in 2002. Currently, the Company is pursuing additionalmeans of distributing its online software subscription services in addition toits Internet sales.

 

On May 14, 2004, the Company and the Company’swholly owned subsidiary, Acceleration Software International Corporation (“ASIC”),were merged.  Subsequent to the merger,the Company has assumed all of the rights and obligations of ASIC.

 

**Principles of Consolidation**

 

The accompanying consolidated financial statements include the accountsof the Company and ASIC.  Allintercompany accounts and transactions up to and including May 14, 2004, havebeen eliminated in consolidation.

 

**Liquidity**

 

The Company’s cash flow isdependent on its ability to generate and collect revenues from its subscriptionservices, and manage its advertising and payroll costs, which constitute thetwo largest variable expense categories. There can be no assurance, however, that the Company will recognizesufficient revenues to cover its increasing costs or to recover from itsprevious losses; nor is there any assurance that the Company will not incurlosses in the future.  As of December 31,2005, the Company has a working capital deficit of ($5,528,137).  However, $4,975,954 of the Company’s currentliabilities are deferred revenue, representing cash collections from customersin advance of the recognition of related sales of online softwaresubscriptions.  This amount will beearned over the subscription period and will not require settlement throughspecific cash payments.  The Company’sworking capital deficit, net of the current portion of deferred revenues is($552,183).  If the Company requiresadditional funds for operations, it believes that its principal stockholderswill provide additional funding, if it is unable to obtain financingindependently.  However, there is noassurance that such additional funding from its principal stockholders will beavailable when needed.  The Company isalso considering seeking additional financing through one or more debt orequity offerings.

 

**Revenue Recognition**

 

The Company’ssubscription-based revenue from online software subscription service isdeferred and recognized on a straight-line basis monthly, over the life of theuser’s subscription, after the right of refund lapses, when persuasive evidenceof an agreement exists, delivery of the product has occurred, the fee is fixedor determinable, collectibility is probable, and no significant Companyobligations with regard to implementation remain.  Management continuously reviews refundsgranted to customers during the 30-day refund period, and provides appropriateestimates of refunds at the time of sale based on this experience.

 

The Company hasemployed various pay-for-performance web-based advertising methods in thepast.  Although the Company is no longeractively pursuing this line of business, we have not discontinued it.  Internet advertising continues to generaterevenue from performance-based advertising created in previous years, whichcontinues to perform for certain clients. No costs have been incurred in 2005 or 2004 in connection with these

 

F-8

----

 

advertisements.  Internet advertising revenues are recognizedin the period in which users execute pre-defined actions related to thatadvertising.

 

**Cash**

 

Cash includes petty cash onhand, checking accounts at two local banks, a cash account with an onlinepayment processor, and a money market account with a local bank.  Cash balances exceed federally insured limitsfrom time to time.

##  

**AccountsReceivable**

 

AccountsReceivable consists primarily of an amount due from the sale of six patents ofthe Company and was received in January 2006.

 

## **Fair Value of Financial Instruments**

 

Thecarrying amounts reported for cash, accounts receivable, accounts payable, andthe note payable to stockholder approximate fair value because of theirimmediate or short-term maturity.  Thecarrying amount reported for notes payable approximates fair value because ofthe market rate of interest.

 

**Property and Equipment**

 

Propertyand equipment are recorded at cost and are depreciated using acceleratedmethods over the estimated useful lives of the related assets, ranging fromthree to seven years.  Maintenance andrepairs are charged to expense as incurred. Significant renewals and betterments are capitalized.

 

**Intangible Assets**

 

*Patents and Trademarks*

 

Patentsand trademarks are recorded at cost. Patents are amortized when registered using the straight-line methodover the estimated useful lives of the related assets ranging from three tofive years.  The costs of trademarks arenot amortized but are reviewed by management periodically, not less thanannually, for impairment based on expected future cash flows.

 

*Domain Names and Vanity Telephone Numbers*

 

Thecosts of domain names and vanity telephone numbers have indefinite lives andare treated as non-amortized intangible assets in accordance with theprovisions of Statement of Financial Accounting Standards (“SFAS”) 142.  The costs of these intangible assets arereviewed by management periodically, not less than annually, for impairmentbased on expected future cash flows.

 

**CashReserves**

 

The Company utilizes several credit card processors to process themajority of its subscription sales made over the Internet.  Several of these credit card processors havechosen to withhold cash reserves on the sales processed through them in thetotal amount of $126,060.  The companyhas established an allowance account of $13,867.  The allowance is calculated based on ourexperience with previous processors.

** **

**Earnings Per Share**

 

Basicnet income or loss per share is computed by dividing net income or lossavailable to common shareholders by the weighted average number of commonshares outstanding in the period. Diluted earnings per share takes into consideration common sharesoutstanding (computed under basic earnings per share) and potentially dilutivecommon shares.  Potentially dilutivecommon shares at December 31, 2005 and at December 31, 2004 consist of sharesissuable to holders of outstanding stock options (Note 9).  Stock options were not included in either the2005 or the 2004 computation of diluted earnings per share because they wereanti-dilutive.

** **

**F-9**

----

** **

**Stock-Based Compensation**

** **

AtDecember 31, 2005, the Company has a stock-based equity incentive plan, whichis described more fully in Note 9. Effective January 1, 2003, the Company adopted the fair valuerecognition provisions of SFAS 123, “Accounting for Stock-Based Compensation.”  Under the modified prospective method ofadoption selected by the Company under the provisions of SFAS 148, “Accountingfor Stock-Based Compensation - Transition and Disclosure,” compensation costsrecognized in 2005 and 2004 reflect the inclusion of stock-based compensation.

 

**Software and Web Development Costs**

 

SFASNo. 86, “Accounting for the Costs of Computer Software to be Sold, Leased orOtherwise Marketed,” states that all costs incurred in connection with thedevelopment of software subsequent to technological feasibility should becapitalized until such time that the software is essentially completed.  Management believes the Company’s software iscompleted concurrent with the establishment of technological feasibility.  When development of our software is complete,it is available to customers almost immediately at our websites on theInternet.  Therefore, no costs have beencapitalized in connection with software development.

 

Webdevelopment costs are accounted for in accordance with Emerging Issues TaskForce (“EITF”) 00-2, “Accounting for Web Site Development Costs,” withapplicable guidance from AICPA Statement of Position (“SOP”) 98-1, “Accountingfor the Costs of Computer Software Developed or Obtained for Internal Use.”  The Company’s internal website developmentprocesses are relatively short-term in nature, generally three months.  The costs incurred in the preliminary stagesof development are expensed as incurred. Once an application has reached the development stage, internal andexternal costs, if direct and incremental, will be capitalized and amortized ona straight-line basis if management believes such costs are significant.  All maintenance and enhancement costs areexpensed as incurred.

 

Software and web development expenses are included in costs of revenuesand for the years ended December 31, 2005 and 2004 were $4,019,860 and$3,343,048, respectively.  There were noamounts capitalized in 2005 or 2004.

 

**Advertising Expenses**

** **

**Advertising costs are included in selling expenses and areexpensed as incurred.  Advertisingexpenses for the years ended December 31, 2005 and 2004 were $4,493,600and $3,693,868, respectively.  In 2005,two vendors accounted for 69% of advertising expenses.  In 2004, two vendors accounted for 57% ofadvertising expenses.**

 

**Comprehensive Income**

 

TheCompany had no items of other comprehensive income in 2005 or 2004.

 

**IncomeTaxes**

 

The Company accounts forincome taxes in accordance with the asset and liability method per SFASNo. 109. Under the asset and liability method, deferred assets andliabilities are recognized for the future tax consequences attributable todifferences between financial statement carrying amounts of existing assets andliabilities and their respective tax bases, tax credits, and losscarry-forwards.  The provision for incometaxes is comprised of the current tax liability and the change in deferred taxassets and liabilities.  The Companyestablishes a valuation allowance to the extent it is more likely than not thatdeferred tax assets will not be recoverable against future taxable income.

 

F-10

----

 

**Commitments and Contingencies**

 

*Technology Risks*

 

TheCompany’s operations are subject to new innovations in product design andfunction.  Significant technologicalchanges can have an adverse effect on product lives.  Innovation, design and development of newproducts are important elements to achieve competitive success andprofitability in this industry.

 

*Purchase and Sale Agreement*

 

TheCompany entered into a Purchase and Sale Agreement with the Bremerton SchoolDistrict No. 100-C for the purchase of certain real property located in theCity of Bremerton, Washington.  TheCompany had contingencies for financing, appraisal, and obtaining a special usepermit for the City of Bremerton that must have been satisfied before the salecould be completed.  After a thoroughreview of the project, the Company determined that it was not in its bestinterests to complete the purchase.

 

*Litigation*

 

On September 8, 2005, theCompany filed a complaint for unfair competition entitled eAcceleration,Corporation, Plaintiff, vs. Trend Micro, Incorporated, Defendant in UnitedStates District Court, Western District of Washington.  The complaint alleges that Trend Micro,Incorporated has developed and is distributing a computer security softwareproduct called Trend Micro PC-cillin Anti-Virus that infringes on the Company’sintellectual property rights with respect to certain of its trademarks andtrade dress.  The packaging of TrendMicro’s product prominently features a graphical red octagonal stop-sign nearlyidentical to the Company’s graphical stop-sign. Trend Micro’s web-site, http://www.trendmicro.com/en/home/us/enterprise.htm,also features an advertisement for its products that prominently features agraphical red octagonal stop-sign. We believe, and in the complaint haveasserted that, Trend Micro’s adoption and use of a graphical red octagonalstop-sign in advertisements and on its packaging for its computer softwareinfringes upon the Company’s trademarks and trade dress.  We also have alleged that Trend Microdeliberately and knowingly adopted its infringing advertising and packaging inorder to take advantage of the Company’s television advertising campaign, whichprominently features a graphical red octagonal stop-sign.  In the complaint we are seeking: (i) apermanent injunction enjoining and restraining Trend Micro from offering forsale, marketing, or selling any computer security software product or servicein conjunction with a depiction of a red octagonal stop-sign or any othercolorable imitation thereof; (ii) restitution of all profits derived by TrendMicro attributable to Trend Micro’s trademark infringement and unfaircompetition; (iii) treble damages, pursuant to 15 U.S.C. § 1117 and RCW19.86.090, sustained by the Company on account of Trend Micro’s trademarkinfringement and unfair competition; (iv) the Company’s fees and costs pursuantto 15 U.S.C. § 1117(a) and RCW 19.86.090; and (v) such further relief as theCourt may deem just and proper.

 

**Recent Accounting Pronouncements**

 

Thefollowing accounting standards have been issued in recent months:

 

SFASNo. 151, “Inventory Costs,” is effective for fiscal years beginning after June15, 2005.  This statement amends theguidance in APB No. 43, Chapter 4, “Inventory Pricing,” to clarify theaccounting for abnormal amounts of idle facility expenses, freight, handlingcosts, and wasted material (spoilage). The adoption of SFAS No. 151 is expected to have no impact on theCompany’s consolidated financial statements.

 

SFAS No. 152, “Accounting for Real Estate Time-Sharing Transactions,”is effective for fiscal years beginning after June 15, 2005.  This statement amends SFAS No. 66, “Accountingfor Sales of Real Estate,” to reference the financial accounting and reportingguidance for real estate time-sharing transactions that is provided in SOP04-2, “Accounting for Real Estate Time-Sharing Transactions.”  The adoption of SFAS No. 152 is expected tohave no impact on the Company’s consolidated financial statements.

 

F-11

----

 

SFAS No. 123(R), “Share-Based Payment,” replaces SFAS No. 123, “Accountingfor Stock-Based Compensation,” and supersedes APB Opinion No. 25, “Accountingfor Stock Issued to Employees.”  Thisstatement requires that the compensation cost relating to share-based paymenttransactions be recognized in the financial statements.  The Company is required to apply thisstatement in the first interim period that begins after December 15, 2005.

 

SFAS No. 153, “Exchange of Nonmonetary Assets — an amendment of APBOpinion No. 29,” is effective for fiscal years beginning after June 15,2005.  This statement addresses themeasurement of exchange of nonmonetary assets and eliminates the exception fromfair-value measurement for nonmonetary exchanges of similar productive assetsin paragraph 21(b) of APB Opinion No. 29, “Accounting for NonmonetaryTransactions,” and replaces it with an exception for exchanges that do not havecommercial substance.  The adoption ofSFAS No. 153 is expected to have no impact on the Company’s consolidatedfinancial statements.

 

The EITF reached consensuson Issue No. 03-1, “The Meaning of Other-Than-Temporary Impairment and ItsApplication to Certain Investments,” which provides guidance on determiningwhen an investment is considered impaired, whether that impairment is otherthan temporary, and the measurement of an impairment loss.  The FASB issued FSP EITF 03-1-1, “EffectiveDate of Paragraphs 10-20 of EITF Issue No. 03-1,” “The Meaning ofOther-Than-Temporary Impairment and Its Application to Certain Investments,”which delays the effective date for the measurement and recognition criteriacontained in EITF 03-1 until final application guidance is issued.  The adoption of this consensus or FSP isexpected to have no impact on the Company’s consolidated financial statements.

 

Financial Accounting Standards Board Interpretation (“FIN”) No. 47, “Accountingfor Conditional Asset Retirement Obligations,” (“FIN 47”), was issued in March2005.  FIN 47 clarifies that an entitymust record a liability for a conditional asset retirement obligation if thefair value of the obligation can be reasonably estimated.  Asset retirement obligations covered by FIN47 are those for which an entity has a legal obligation to perform an assetretirement activity, even if the timing and method of settling the obligationare conditional on a future event that may or may not be within the control ofthe entity.  FIN 47 also clarifies whenan entity would have sufficient information to reasonably estimate the fairvalue of an asset retirement obligation. FIN 47 is effective no later than the end of fiscal years ending afterDecember 15, 2005.  The adoption ofFIN 47 is expected to have no impact on the Company’s consolidated financialsstatements

 

SFAS No. 154, “Accounting Changes and ErrorCorrections—a replacement of APB Opinion No. 20 and FASB Statement No. 3,” iseffective for accounting changes and corrections of errors made in fiscal yearsbeginning after December 15, 2005.  ThisStatement replaces APB Opinion No. 20, “Accounting Changes,” and FASB StatementNo. 3, “Reporting Accounting Changes in Interim Financial Statements,” andchanges the requirements for the accounting for and reporting of a change inaccounting principle. SFAS No. 154 applies to all voluntary changes inaccounting principle. It also applies to changes required by an accountingpronouncement in the unusual instance that the pronouncement does not includespecific transition provisions. When a pronouncement includes specifictransition provisions, those provisions should be followed.  The adoption of SFAS No. 154 is expected tohave no impact on the Company’s consolidated financial statements.

 

In September 2005, the EITFreached consensus on Issue No. 05-08, “Income Tax Consequences of IssuingConvertible Debt with a Beneficial Conversion Feature.”  EITF No. 05-08 is effective for financialstatements beginning in the first interim or annual reporting period beginningafter December 15, 2005.  Theadoption of EITF No. 05-08 is expected to have no impact on the Company’sconsolidated financial statements.

 

In September 2005, the EITFreached consensus on Issue No. 05-02, “The Meaning of ‘Conventional ConvertibleDebt Instrument’ in EITF Issue No. 00-19, ‘Accounting for Derivative FinancialInstruments Indexed to, and Potentially Settled in, a Company’s Own Stock.’”  EITF No. 05-02 is effective for newinstruments entered into and instruments modified in reporting periodsbeginning after June 29, 2005.  Theadoption of EITF No. 05-02 is expected to have no impact on the Company’sconsolidated financial statements.

 

F-12

----

 

In September 2005, theEITF reached consensus on Issue No. 05-07, “Accounting for Modifications toConversion Options Embedded in Debt Instruments and Related Issues.”  EITF No. 05-07 is effective for futuremodifications of debt instruments beginning in the first interim or annualreporting period beginning after December 15, 2005.  The adoption of EITF No. 05-07 is expected tohave no impact on the Company’s consolidated financial instruments.

 

**Use of Estimates**

 

The preparation of financial statements in conformity with accountingprinciples generally accepted in the United States requires management to makeestimates and assumptions that affect the reported amounts of assets andliabilities and the disclosure of contingent assets and liabilities at the dateof the financial statements, and the reported amounts of revenue and expensesduring the reporting period.  Actualresults could materially differ from those estimates.

 

##### **Note 2. Propertyand Equipment**

 

Propertyand equipment consists of the following as of December 31, 2005:

 
| Equipment and furniture     |   | $        | 624,371 |   |
|-----------------------------|--------|----------|---------|--------|
| Leasehold improvements      |   | 16,161   |    |
| Vehicles                    |   | 21,537   |    |
|                        |   | 662,069  |    |
| Accumulated depreciation    |   | (451,174 | )       |
| Property and equipment, net |   | $        | 210,895 |   |

 

During the years ended December 31, 2005 and2004, depreciation expense totaled $119,006 and $116,640, respectively.

 

**Note 3. Intangible Assets**

 

Intangible assetsconsist of the following at December 31, 2005:

 
| Amortizable intangible assets:            |   |    |    |
|-------------------------------------------|--------|---------|---------|
| Patents                                   |   | $       | 119,716 |   |
| Accumulated amortization                  |   | (95,274 | )       |
|                                      |   | 24,442  |    |
|                                      |   |    |    |
| Unamortizable  intangible assets:         |   |    |    |
| Patents pending                           |   | 51,203  |    |
| Trademarks                                |   | 32,747  |    |
| Domain names and vanity telephone numbers |   | 25,621  |    |
|                                      |   | 109,571 |    |
|                                      |   |    |    |
| Intangible assets, net                    |   | $       | 134,013 |   |

 

F-13

----

 

During the years ended December 31, 2005 and 2004, amortization expensetotaled $17,741 and $15,121, respectively. Patents are amortized generally over three years due to the rapid rate ofobsolescence associated with computer and software technology.  Patents included in unamortized intangibleassets represent applications in progress. The costs are capitalized, but not amortized until the patent isapproved and issued.  Unsuccessful applicationsare expensed.  Since December 31, 2001,trademarks are no longer amortized in accordance with the adoption of SFAS No.142 because they are considered to have indefinite lives.

 

Amortization expense for current patents will be as follows for theyears ended December 31:

 
| 2006                                 |   |   | $      | 13,944 |   |
|--------------------------------------|--------|--------|--------|--------|--------|
| 2007                                 |   |   | 10,290 |   |
| 2008                                 |   |   | 208    |   |
| Total amortization expense           |   |   | 24,442 |   |
| Patents pending                      |   |   | 51,203 |   |
|                                 |   |   |   |   |
| Total estimated amortization expense |   |   | $      | 75,645 |   |
|                                      |        |        |        |        |        |  |

 

Management teststrademarks for impairment periodically, based on the expected cash flows.  No impairment was determined to have occurredin either 2005 or 2004.

 

Because theCompany considers purchased domain names and vanity telephone numbers to beintangible assets in accordance with the definition of such assets contained inSFAS No. 142, the Company plans to re-assess the fair value of these assetsbased on expected future cash flows on a periodic basis, not less thanannually, and will record an impairment if the book value of the assets exceedfair value.  No impairment was determinedto have occurred with respect to these assets during 2005 or 2004.

 

**Note4.  Notes Payable To Stockholder**

 

The Company has borrowed funds from the Company’s ChiefExecutive Officer who is one of the principal stockholders, under a promissorynote.  This note bears interest at 10%,is payable on demand, and requires monthly interest-only payments.  During the third quarter of 2005, the Companyborrowed an additional $32,154 from its Chief Executive Officer.  The outstanding balance as of December 31,2005 is $131,568.

 

## **Note 5.  Income Taxes**

 

The Company recorded anincome tax (expense) benefit of ($138,978) and $165,059, respectively, for theyears ended December 31, 2005 and 2004.

 

The Company also recorded deferred tax assets and hasestablished a valuation allowance for those assets for the years ended December31, 2005 and 2004 as follows:

 

F-14

----

 
| ** **                                 | ** ** | **2005**   | ** ** | **2004**   | ** ** |
|--------------------------------------------|------------|------------|------------|------------|------------|
|                                       |       |       |       |       |       |
| Deferred  revenue                          |       | $          | 568,972    |       | $          | 1,119,813 |   |
| Difference  in gain on asset sale          |       | (189,714   | )          |       |       |
| Amortization                               |       | 57,850     |       | 60,449     |       |
| Allowance  for cash reserves               |       | 4,715      |       |       |       |
| Reserve for  sales returns and allowances  |       | 14,250     |       | 59,586     |       |
| Accrued  vacation                          |       | 72,431     |       | 62,005     |       |
| Stock option  compensation expense         |       | 35,785     |       | 34,641     |       |
| Depreciation                               |       | 10,585     |       | 19,204     |       |
| Foreign tax  credit carryforwards          |       | 85,000     |       | 75,166     |       |
| Other                                      |       |       |       | 9,561      |       |
| Net  operating loss carryforwards          |       | 1,498,090  |       | 510,120    |       |
|                                       |       |       |       |       |       |
| Total  deferred tax assets                 |       | $          | 2,157,964  |       | $          | 1,950,545 |   |
| Less:  valuation allowance                 |       | (1,917,530 | )          | (1,557,798 | )          |
| Net deferred  taxes                        |       | $          | 240,434    |       | $          | 392,747 |   |
|                                       |       |       |       |       |       |
| Net deferred  tax asset - current          |       | $          | 160,696    |       | $          | 195,323 |   |
| Net deferred  tax asset – non-current |       | 79,738     |       | 197,424    |       |
| Total net  deferred tax assets             |       | $          | 240,434    |       | $          | 392,747 |   |
|                                            |            |            |            |            |            |  |  |  |  |  |

 

The difference between thestatutory federal rate of 34% and the income tax (expense) benefit of($138,978) and $165,089, respectively, for the years ended December 31, 2005and 2004 recorded by the Company is summarized below:

 
| ** **                                        | ** ** | **2005** | ** ** | **2004** | ** ** |
|---------------------------------------------------|------------|----------|------------|----------|------------|
| Statutory  tax rate                               |       | (34      | )%         | (34      | )%         |
| Change in  deferred tax asset valuation allowance |       | 75       | %          | 26       | %          |
| U.S. Income  tax provision                        |       | 41       | %          | (8       | )%         |

 

The Company’s foreign taxcredit carry-forwards of $35,000 and $50,000 will expire in the years 2007 and2008, respectively.  The company’s netoperating loss carryforward of approximately $4,406,000 will expire in 2025.

 

**Note 6.  BusinessSegment Information**

** **

Since all the Company’s operations are located in the United States ofAmerica, the Company’s geographic revenue information is based on the countryin which the sales originate.  Thefollowing table shows the origin of revenue for the years endedDecember 31, 2005 and 2004:

 
| **Year Ended  December 31,** | ** ** | **U.S.A.** | ** ** | **Asia** | ** ** | **All Other  Foreign** | ** ** | **Consolidated  Total** | ** ** |
|----------------------------------------|------------|------------|------------|----------|------------|-----------------------------|------------|-------------------------|------------|
|                                   |       |       |       |     |       |                        |       |                    |       |
| 2005                                   |       | $          | 11,939,982 |     | $          | 180,086                     |       | $                       | 2,392,054  |   | $ | 14,512,122 |   |
| 2004                                   |       | 10,749,987 |       | 153,714  |       | 1,836,488                   |       | 12,740,189              |       |
|                                        |            |            |            |          |            |                             |            |                         |            |  |  |  |  |

 

No geographic segment data is shown for long-lived assets, since theCompany’s operations reside entirely in the United States of America.

 

F-15

----

 

**Note 7. Operating Leases**

 

AtDecember 31, 2005, the Company leases office space under three operating leaseagreements. The Company terminated two month-to-month leases at its Viking Banklocation, effective as of September 30, 2005. On August 30, 2005, the Company entered into a new full-service officelease between Roben Family Limited Partnership, L.P. and the Company at itsheadquarter location (the “Olympic Lease”). The Olympic Lease consolidated two existing leases at this location inSuites 200 and 204, and added an additional 2,960 square feet of rentable spacein Suite 210, for a total of 6,048 square feet of rentable space.  The expiration date of the term of theOlympic Lease is August 31, 2008.  Inaddition, on August 30, 2005, the Company extended the term of its lease inSuite 100 at this location to August 31, 2008 (the “Suite 100 Lease”).  The Suite 100 Lease was scheduled to expireon January 31, 2007.  All other terms andconditions of the Suite 100 Lease were unchanged.  As a result of these transactions, all of thespace currently leased by the Company at the Company’s headquarter facility hasa common lease expiration date of August 31, 2008.  The combined total rentable square footage atthis location under the Olympic Lease and Suite 100 Lease is 16,238.  The combined total rental cost for thethree-year term of the leases is $661,046.40. The third lease, Plaza 305, expires in March 2007 and has an averagemonthly payment of $2,648 with a scheduled increase in April 2006. The totalrentable square footage at this location is 2,472.

 

The Company’s future non-cancelable annual minimum lease payments atDecember 31, 2005, are as follows:

 
| 2006 |   | 250,274 |   |
|------|--------|---------|--------|
| 2007 |   | 230,051 |   |
| 2008 |   | 149,818 |   |

 

 

Total rent expense for the years ended December 31, 2005 and 2004amounted to $259,479 and $216,646, respectively.

 

**Note 8. Employment Contracts**

 

The Company has anemployment agreement with its principal stockholder, Clinton L. Ballard, for afive-year term commencing January 1, 2003, which extends annually thereafterunless we or Mr. Ballard provide 60 days’ notice of termination.  The employment agreement with Mr. Ballard, asamended on July 11, 2005 and August 10, 2005, provides for him to serve as thePresident, Chief Executive Officer and Chairman of the Board, and provides foran annual base salary of $260,000, a bonus of up to $122,200 contingent uponcompletion of a financing agreement with Agility Capital, LLC, and a bonus of4% of our cash flow with respect to fiscal years during the term of theagreement.  The Vice-Chairman of theBoard, Diana Ballard, chose not to run for re-election and her employmentagreement was terminated effective July 11, 2005.

 

The Company has anemployment agreement with E. Edward Ahrens for a five-year term commencingAugust 15, 2005, which extends annually thereafter unless the Company or Mr.Ahrens provide 60 days’ notice of termination. The employment agreement with Mr. Ahrens provides for him to serve asChief Financial Officer and provides for an annual salary of $104,000 and abonus of 1% of our cash flows with respect to fiscal years during the term ofthe agreement.

 

Each of these agreements contains restrictions on the employee engagingin competition with the Company for the term of the employment agreement andfor one year after the term, and contains provisions protecting our proprietaryrights and information.  Each agreementalso provides for the payment to the employee of a lump sum equal to three timesthe average of the employee’s annual compensation for the prior five years,less $1.00, upon his termination in the event of a “change in control” of theCompany, as that term is defined in the respective employment agreements.

 

#### **Note9.  Stock-Based Compensation**

 

In March 2005, the Company issued an aggregate of 950shares; in May 2005, the Company issued an aggregate of 12,000 shares; in June2005, the Company issued an aggregate of 209,600 shares; in July 2005, the Companyissued an aggregate of 10,000 shares; in August 2005, the Company issued anaggregate of 1,300 shares; and, in November 2005, the Company issued anaggregate of 1,200 shares of its common stock to employees,

 

F-16

----

 

consultants anddirectors in the form of stock bonuses and awards under its 2002 EquityIncentive Plan (the “2002 Plan”), all of which shares were registered under theSecurities Act of 1933.  The total numberof shares reserved under the 2002 Plan is 5,000,000.  Estimated compensation expense in connectionwith these issuances is $171; $2,160; $37,728; $1,800; $234 and $216,respectively.  The Board of Directorsdetermined the fair value of the stock issued in March, May, June, July, andAugust and November 2005 to be $0.18 per share.

 

In March 2004, the Company issued an aggregate of46,882 shares; in May 2004, the Company issued an aggregate of 5,800 shares;and, in October 2004, the Company issued an aggregate of 13,550 shares of itscommon stock to employees in the form of stock bonuses under the 2002 Plan, allof which shares were registered under the Securities Act of 1933.  The total number of shares reserved under the2002 Plan is 5,000,000.  Estimatedcompensation expense in connection with these issuances is $10,313; $1,044; and$2,439, respectively.  The Board ofDirectors determined the fair value of the stock issued in March 2004 to be$0.22 per share.  The Board of Directorsdetermined the fair value of its common stock issued in May 2004 and October2004, based on an independent appraisal, to be $0.18 per share.

 

In March 2005, the Company granted time-based optionsto employees to purchase an aggregate of 27,500 shares of the Company’s commonstock at $0.18 per share; in May 2005, the Company granted time-based optionsto employees to purchase an aggregate of 27,500 shares of the Company’s commonstock at $0.18 per share; in June 2005, the Company granted time-based optionsto employees and a non-employee to purchase an aggregate of 83,000 shares ofthe Company’s common stock at $0.18 per share under the 2002 Plan; inAugust 2005, the Company granted time-based options to employees to purchase anaggregate of 70,000 shares of the Company’s common stock at $0.18 per share;and, in November 2005, the Company granted time-based options to employees topurchase an aggregate of 30,000 shares of Company’s common stock at $0.18 pershare.  Options granted in 2005 toemployees were 10-year incentive stock options to purchase shares of theCompany’s common stock, which become exercisable at the rate of one-tenth ofthe amount granted on each of the first through tenth anniversaries of the dateof grant. Options granted in 2005 to non-employees were 5-year non-qualifiedstock options to purchase shares of the Company’s common stock, which becomeexercisable at the rate of one-fifth of the amount granted on each of the firstthrough fifth anniversaries of the date of grant.  Options granted to non-employees are recordedat fair value utilizing the Black-Scholes valuation method and are amortizedover five years.  Options granted toemployees are recorded at fair value utilizing the Black-Scholes valuationmethod, at the risk-free interest rate (10-year Treasury note rate) in effectduring the grant month, and are amortized over 10 years.  Total compensation expense recognized for thetwelve months ended December 31, 2005 was $18,620 for options granted toemployees and $3,366 for options granted to non-employees.

 

In March 2004, the Companygranted time-based options to employees and directors to purchase an aggregateof 403,000 shares at $0.22 per share; in May 2004, the Company grantedtime-based options to employees to purchase an aggregate of 123,250 sharesof the Company’s common stock at $0.18 per share; and in October 2004 theCompany granted time-based options to employees to purchase an aggregate of146,750 shares of the Company’s common stock at $0.18 per share, allof which grants were made under the 2002 Plan.  Options granted in 2004 to employees were10-year incentive stock options to purchase shares of the Company’s commonstock, which become exercisable at the rate of one-tenth of the amount grantedon each of the first through tenth anniversaries of the date of grant.  Options granted to non-employees are recordedat fair value utilizing the Black-Scholes valuation method and are amortizedover five years.  Options granted toemployees are recorded at fair value utilizing the Black-Scholes valuationmethod, at the risk-free interest rate (10-year Treasury note rate) in effectduring the grant month, and are amortized over 10 years.  Total compensation expense recognized for theyear ended December 31, 2004 was $17,415 for options granted to employeesand $27,860 for options granted to non-employees.

 

F-17

----

 

Previously,the Company had issued options under its 1995 and 1999 stock option plans.  None of the options vested under the1999 Plan are exercisable.  Optionsissued under the 1995 and 2002 Plans are exercisable to the extent they arevested.

** **
| ** **                       | ** ** | **Stock Options** | ** ** | **Weighted  Average  Exercise Price** | ** ** |
|----------------------------------|------------|------------------------|------------|--------------------------------------------|------------|
|                             |       |                   |       |                                       |       |
| Outstanding at December 31, 2003 |       | 1,056,800              |       | 0.51                                       |       |
| Granted                          |       | 673,000                |       | 0.20                                       |       |
| Cancelled or forfeited           |       | (391,000               | )          | 0.15                                       |       |
|                             |       |                   |       |                                       |       |
| Outstanding at December 31, 2004 |       | 1,338,800              |       | 0.46                                       |       |
| Granted                          |       | 240,500                |       | 0.18                                       |       |
| Cancelled or forfeited           |       | (353,500               | )          | 0.17                                       |       |
| Outstanding at December 31, 2005 |       | 1,225,800              |       | 0.49                                       |       |

 

The following table summarizes stock options outstanding at December31, 2005:

 
| ** **                     | ** ** | **Options Outstanding**                             | ** ** | **Options Exercisable**                           | ** ** |
|--------------------------------|------------|----------------------------------------------------------|------------|--------------------------------------------------------|------------|
| **Exercise Price  Range** | ** ** | **Number  Outstanding at  December 31,  2005** | ** ** | **Average  Remaining  Contractual Life  (Years)** | ** ** | **Weighted  Average  Exercise Price** | ** ** | **Number  Exercisable at  December 31,  2005** | ** ** | **Weighted  Average  Exercise Price** | ** ** |
| 0.12                           |       | 562,500                                                  |       | 7.08                                                   |       | 0.12 |   | 178,000 |   | 0.12 |   |
| 0.18                           |       | 319,000                                                  |       | 9.66                                                   |       | 0.18 |   | 12,650 |   | 0.18 |   |
| 0.22                           |       | 245,000                                                  |       | 8.71                                                   |       | 0.22 |   | 30,500 |   | 0.22 |   |
| 0.70                           |       | 25,000                                                   |       | —                                                 |       | 0.70 |   | 25,000 |   | 0.70 |   |
| 5.31                           |       | 61,800                                                   |       | 5.00                                                   |       | 5.31 |   | — |   | 5.31 |   |
| 6.25                           |       | 12,500                                                   |       | 4.00                                                   |       | 6.25 |   | — |   | 6.25 |   |
|                           |       | 1,225,800                                                |       |                                                   |       |   |   | 246,150 |   |   |   |

 

The fair value of each option granted is estimated at the date of grantusing the Black-Scholes option-pricing model. The assumptions used in calculating the fair value of the optionsgranted were as follows:

** **
| ** **                    | ** ** | **Grants in  2005 under  2002 Plan** | ** ** | **Grants in  2004 under  2002 Plan** | ** ** | **Grants in  2003 under  2002 Plan** | ** ** | **Grants in  2002 under  2002 Plan** | ** ** | **1995 and  1999  Plans** | ** ** |
|-------------------------------|------------|-----------------------------------------------------|------------|-----------------------------------------------------|------------|-----------------------------------------------------|------------|-----------------------------------------------------|------------|--------------------------------|------------|
| Risk-free-interest rate       |       | 4.0% to 4.5%                                        |       | 3.8% to 4.7%                                        |       | 4.0% to 4.5%                                        |       | 6.00%                                               |       | 6.00%                          |       |
|                          |       |                                                |       |                                                |       |                                                |       |                                                |       |                           |       |
| Stock price volatility factor |       | 99%                                                 |       | 99%                                                 |       | 99%                                                 |       | 99%                                                 |       | 99%                            |       |
| Expected life of the options  |       | 5 and 10*                                           |       | 5 and 10*                                           |       | 5 and 10*                                           |       | 5 and 10*                                           |       | 5 and 10*                      |       |
|                          |       | years                                               |       | years                                               |       | years                                               |       | years                                               |       | years                          |       |
| Dividend yield                |       | 0.00%                                               |       | 0.00%                                               |       | 0.00%                                               |       | 0.00%                                               |       | 0.00%                          |       |

 

----

*      Non-qualified options issued to non-employeeshave an estimated average life of 5 years; incentive stock options grantedto employees are estimated to have an average life of 10 years.

 

 

F-18

----

** **

**SIGNATURES**

 

In accordance with Section 13 or 15(d) of the Exchange Act, theregistrant has duly caused this report to be signed on its behalf by theundersigned, thereunto duly authorized.

 
| Dated: March 22, 2006 | eACCELERATION CORP. |
|----------------------------|---------------------|
|                       |                |
|                       |                |
|                       | By:                 | /s/ Clinton L. Ballard |   |
|                       |                | Clinton L. Ballard |
|                       |                | President and Chief Executive  Officer |

 

**POWER OF ATTORNEY**

 

Pursuant to the requirements of the Exchange Act, as amended, thisannual report on Form 10-KSB has been signed on March 22, 2006 by the followingpersons in the capacities indicated. Each person whose signature appears below constitutes and appointsClinton L. Ballard, with full power of substitution, his/her true and lawfulattorney-in-fact and agent to do any and all acts and things in his/her nameand on his/her behalf in his/her capacities indicated below which he may deemnecessary or advisable to enable eAcceleration Corp. to comply with theExchange Act, as amended, and any rules, regulations and requirements of theSecurities and Exchange Commission, in connection with this annual report onForm 10-KSB, including specifically, but not limited to, power and authority tosign for him/her in his/her name in the capacities stated below, any and allamendments thereto, granting unto said attorney-in-fact and agent, full powerand authority to do and perform each and every act and thing requisite andnecessary to be done in such connection, as fully to all intents and purposesas he/her might or could do in person, hereby ratifying and confirming all thatsaid attorney-in-fact and agent, or his substitute or substitutes, may lawfullydo or cause to be done by virtue thereof.

 

 
| /s/  Clinton L. Ballard   |   | Chairman of the Board,  President, and Chief Executive Officer |
|---------------------------|--------|----------------------------------------------------------------|
| Clinton  L. Ballard       |   | (Principal Executive  Officer)                                 |
|                      |   |                                                           |
| /s/  E. Edward Ahrens     |   | Chief Financial Officer                                        |
| E.  Edward Ahrens         |   | (Principal Accounting  Officer)                                |
|                      |   |                                                           |
| /s/  Edward P. Swain, Jr. |   | Director                                                       |
| Edward  P. Swain, Jr.     |   |                                                           |
|                      |   |                                                           |
| /s/  William E. Hoke      |   | Director                                                       |
| William  E. Hoke          |   |                                                           |
|                      |   |                                                           |
| /s/  Chuck Blore          |   | Director                                                       |
| Chuck  Blore              |   |                                                           |

 

39

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**EXHIBIT INDEX**

 
| **Exhibit No.** | ** ** | **Description of Exhibit**                                                                                                                                                                                                                                                                              |
|-----------------|------------|---------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|
|            |       |                                                                                                                                                                                                                                                                                                    |
| 3.1             |       | Articles  of Incorporation of the Company, as filed with the Delaware Secretary of  State on November 1, 1999. (Incorporated by reference to Exhibit 3.1 to the  Company’s Registration Statement on Form SB-2 (Registration Number:  333-90867), filed with the Commission on November 12, 1999.) |
|            |       |                                                                                                                                                                                                                                                                                                    |
| 3.2             |       | Amended  and Restated Bylaws of the Company, as amended through August 11, 2004.  (Incorporated by reference to Exhibit 3.2 to the Company’s annual report on  Form 10-KSB for the year ended December 31, 2004.)                                                                                  |
|            |       |                                                                                                                                                                                                                                                                                                    |
| 10.1            |       | Patent  Purchase Agreement, dated November 21, 2005, between the Company and Mount  Hamilton Partners, LLC.                                                                                                                                                                                             |
|            |       |                                                                                                                                                                                                                                                                                                    |
| 10.2            |       | Amendment  to the Patent Purchase Agreement between eAcceleration Corp. and Mount  Hamilton Partners, LLC, dated January 31, 2006.                                                                                                                                                                      |
|            |       |                                                                                                                                                                                                                                                                                                    |
| 23.1            |       | Consent  of Peterson Sullivan PLLC                                                                                                                                                                                                                                                                      |
|            |       |                                                                                                                                                                                                                                                                                                    |
| 24.1            |       | Power  of Attorney (see signature page herein).                                                                                                                                                                                                                                                         |
|            |       |                                                                                                                                                                                                                                                                                                    |
| 31.1            |       | Certification  of Chief Financial Officer of eAcceleration Corp. pursuant to Section 302(a)  of the Sarbanes-Oxley Act of 2002.                                                                                                                                                                         |
|            |       |                                                                                                                                                                                                                                                                                                    |
| 31.2            |       | Certification  of Chief Executive Officer of eAcceleration Corp. pursuant to Section 302(a)  of the Sarbanes-Oxley Act of 2002.                                                                                                                                                                         |
|            |       |                                                                                                                                                                                                                                                                                                    |
| 32.1            |       | Certification  of Chief Executive Officer and Chief Financial Officer of eAcceleration Corp.  pursuant to Section 906 of the Sarbanes-Oxley Act of 2002.                                                                                                                                                |

 

40

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