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

**Washington, D.C. 20549**

 

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**FORM 10-KSB**

 

**(MarkOne)**

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

**For the fiscal year ended:****December 31, 2004**

 

**o****                                ****TRANSITION REPORT UNDER SECTION 13 OR 15(d) OF THE SECURITIESEXCHANGE ACT OF 1934**

**For the transition period from                     to                     **

 

**Commission file number: 000-29869**

 

**eACCELERATION CORP.**

(Name of small business issuer in itscharter)

 
| **Delaware**                                                    | ** ** | **91-2006409**                        |
|-----------------------------------------------------------------|------------|---------------------------------------|
| (State or other jurisdiction of  incorporation or organization) |       | (I.R.S. Employer  Identification No.) |
|                                                            |       |                                  |
| **1050 NE Hostmark St, Suite 100B  Poulsbo, Washington**        | ** ** | **98370**                             |
| (Address of principal executive offices)                        | ** ** | (Zip Code)                            |
| ** **                                                      | ** ** | ** **                            |
| Issuer’s telephone number:  **(360) 697-9260**        |

 

Securities registered under Section 12(b) of the ExchangeAct:  **None**

 

Securities registered under Section 12(g) of the ExchangeAct:  **Commonstock, par value $0.0001**

 

Checkwhether the issuer (1) filed all reports required to be filed by Section 13or 15(d) of the Exchange Act during the preceding 12 months (or for suchshorter period that the registrant was required to file such reports), and (2)has been subject to such filing requirements for the past 90 days.          Yes   ý   No   o

 

Checkif  no disclosure of delinquent filers inresponse to Item 405 of Regulation S-B is contained in this form, and nodisclosure will be contained, to the best of registrant’s knowledge, indefinitive proxy or information statements incorporated by reference in PartIII of this Form 10-KSB or any amendment to this Form 10-KSB.   ý

 

Stateissuer’s revenues for its most recent fiscal year: **$12,740,189**

 

Statethe aggregate market value of the voting and non-voting common equity held bynon-affiliates computed by reference to the price at which the common equitywas sold, or the average bid and asked price of such common equity, as of aspecified date within the past 60 days.  **Not Applicable**

 

Asof March 1, 2005, there was a total of 34,812,032 shares of the issuer’scommon stock outstanding.

 

TraditionalSmall Business Disclosure Format (check one)      Yes   o   No   ý

 

**DOCUMENTS INCORPORATED BY REFERENCE.  None.**

 

 

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**eACCELERATION CORP.**

 

**INDEX TO FORM 10-KSB**

 
| PART I     | Page                                                                                                             |
|------------|------------------------------------------------------------------------------------------------------------------|
|       |                                                                                                             |   |
| 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  and Executive Officers 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**

 

Throughoutthis annual report on Form 10-KSB, the terms “we,” “us,” “our,” and “ourcompany” refer to eAcceleration Corp., and, unless the context indicatesotherwise, our former wholly-owned subsidiary, Acceleration SoftwareInternational Corporation, on a consolidated basis, and the term “ASIC” refersto Acceleration Software International Corporation.

 

**Introductory Comment - Forward-Looking Statements.**

 

Statementscontained in this annual report include “forward-looking statements” within themeaning of Section 27A of the Securities Act of 1933, as amended (the “SecuritiesAct”), and Section 21E of the Securities Exchange Act of 1934, as amended(the “Exchange Act”).  Forward-lookingstatements involve known and unknown risks, uncertainties and other factorswhich could cause our actual results, performance and achievements, whetherexpressed or implied by such forward-looking statements, not to occur or berealized.  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-lookingstatements may be identified by the use of forward-looking terminology such as “may,”“will,” “would,” “could,” “expect,” “believe,” “estimate,” “anticipate,” “continue,”or similar terms, variations of those terms or the negative of thoseterms.  Potential risks and uncertaintiesinclude, among other things, the matters described in the section entitled“Factors Affecting Future Operating Results” and elsewhere herein and in ourother filings with the Securities and Exchange Commission.

 

Readersshould carefully consider such risks, uncertainties and other information,disclosures and discussions which contain cautionary statements identifyingimportant factors that could cause actual results to differ materially fromthose provided in the forward-looking statements.  Except to the extent required by law, weundertake no obligation to publicly update or revise any forward-looking statements,whether as a result of new information, future events or otherwise.

 

**Item 1.  Description ofBusiness.**

 

**Overview**

 

Weare a provider and licensor of proprietary and open-source software and relatedservices that are distributed primarily through the Internet. Our primary focusis developing a subscriber base for our eAccelerationTM onlinesubscription service as the leading means of distributing some or all of ourinternally-produced software.

 

Our eAccelerationTM online subscriptionservice provides a myriad of computer applications, including our own softwareproduct line, to consumers.  Allcomponents are designed to make the user’s computing experience, both on andoff the Internet, a fast, safe, easy, and fun experience.  Our flagship threat-remover and protectionsystem, Stop-SignTM,was initially developed in 2002, and alerts users to the presence of not onlyviruses but also spyware, malware (*i.e*.,malicious software designed specifically to damage or disrupt a system, such asa worm), and keyloggers (*i.e*.,surveillance software that records every keystroke to an encrypted file, whichcan then e-mail such file to a remote recipient).  We provide cures for the infected machines aswell as ongoing support and protection to safeguard our customers againstfuture threats.  Our online subscriptionservice is not defined by any one application, and we expect that its natureand content will expand and evolve over time as the needs of our customerschange.  We endeavor to constantlyrespond to the needs of the consumer market, and our online subscriptionservice is designed to meet those needs.

 

**History**

 

Wewere initially incorporated in Nevada in February 1987 as Apex Management,Inc. and, in October 1987, changed our name to Ballard SynergyCorporation.  In June 1995, wemerged Ballard Synergy Corporation into a Washington corporation, and, in 1996,changed its name to Acceleration Software International Corporation (“ASIC”).  In November 1999, we formedeAcceleration Corp., a Delaware corporation, and the shareholders of ASICexchanged all of their stock in ASIC for all of the stock of eAccelerationCorp.  As a result of this shareexchange, ASIC became a wholly-owned subsidiary of eAcceleration Corp.  On May 14, 2004, we merged ASICinto its parent company, eAccelerationCorp.  Subsequent to the merger, eAcceleration Corp. assumed all of therights and obligations of ASIC.

 

 

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Althoughwe initially began by providing crisis intervention computer softwareprogramming services, in 1996 we began developing our Internet advertising andmarketing business model, under which we provided our software and third-partyproducts for free to users who agreed to utilize one of our websites,homepageware.com, as their Internet browser’s starting page.  Toward the end of 2000 this industry beganits decline, and, in 2000, we began developing a subscriber base for certain ofour products on a small scale.  At first,this service was offered as an advertising-supported service, but over time webegan to charge a nominal price for it, thereby partially offsetting ourdeclining Internet advertising revenues. By 2002, this service developed into what is now our eAccelerationTMonline subscription service.  Weperiodically change the product offerings of our eAcceleration service to meetthe changing needs of an ever-increasing online population in the United Statesand abroad.  Throughout 2003 and 2004, wefocused most of our efforts on generating revenues from our eAccelerationservice, aimed primarily at consumers.

 

**Products and Services**

 

Throughour eAcceleration service, we license various combinations of our softwaretitles, together with third-party software and open source software, to usersfor a subscription fee that varies depending on the level of servicespurchased.  The eAcceleration servicecurrently features the following products, each which is described in furtherdetail below:  Stop-SignTMComputer Protection Service, VelozTM Computer Speedup Service, kon-X®Internet Service, MegDat® Personal Media Service, OOdlz®Games, and their related incorporated products. The eAcceleration service operates on all current versions of Windowsfor PC’s.

 

*Stop-Sign*TM*Computer Protection Service* is a threat-removal and protection system for the consumermarket.  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 alsohelps to eliminate threats that propagate over non-traditional methods by meansof its built-in firewall.  If anyundesirable software is detected, this system provides a cure for the infectedmachine.  In addition, this system offersoutbreak alerts, ongoing support, and protection to safeguard the customeragainst future threats.  This softwarebecame a component of our eAcceleration service in 2002.  We currently license a component of the virusdefinitions of our Stop-Sign Computer Protection Service from a third party.

 

*Veloz*TM*Computer Speedup Service* removes unnecessary files, disables speed stealing programs, optimizeshard disk space, and provides unlimited access to trained technicians.

 

*kon-X*®*Internet Service*provideslow cost internet access from over 8,000 access numbers in the UnitedStates.  It may be used either as a user’sprimary or back up Internet service. kon-X also includes up to four mailboxes and sixteen megabytes of e-mailstorage.

 

*MegDat*®*Personal Media Service*includes our *Online Backup*and*Zeus*products which are available tocustomers at certain plan levels.  OnlineBackup is designed to provide utility-type programs to help manage ourcustomers’ data as well as an online backup that automatically copies ourcustomers’ vital computer files to a secure online location.  *Zeus*is an archive, compression and extraction tool that facilitates zipping andunzipping individual or multiple files.

 

*OOdlz*®*Games* providesad-free online game services to our customers. Other game services available on the Internet offer games to the userfor free, but support themselves by selling Internet ads, which can be annoyingto the user if they appear while playing. Our games come as part of the eAcceleration service, and are completelyad-free.  Games available through oureAcceleration service include arcade games, board games, word games, and *The 4th Coming* (describedbelow).

 

*The 4th Coming*® is a multiplayer online role-playing game which features interactiveplay in a virtual fantasy world pitting the user against hordes of enemies.  Users may choose to play either alone, or in “guilds”formed by other players, as they follow instructions given in the form of “quests.”  We currently license this game from Vircom,Inc.

 

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**DistributionMethods**

** **

*Online subscription services*:  Wecurrently devote substantial resources to the continued development of oureAcceleration service which is sold directly to users over the Internet.  We began offering this service in 2002 and,by the end of 2004, it accounted for 99.8% of our revenues.  We expect that the nature and content of thisservice will expand and evolve over time as the needs of our customerschange.  The primary component of thisservice is our Stop-Sign threat scanner for the consumer market, which wasadded in 2002.  In 2002, we also expandedour eAcceleration service offerings to include OOdlz Games.  In 2003, we further expanded oureAcceleration service offerings to include dial-up Internet service under ourbrand kon-X, including e-mail and links to search engines, and to includeVeloz.  In 2004, we added MegDat whichprovides utility type programs to help manage customers’ data.  We continue to test additional products, butnone are ready for commercial deployment.

 

*Software licensing**to international distributors*:  Historically, we licensed software productsto a Japanese distributor, Sourcenext Corporation (“Sourcenext”).  Our distribution agreement with thisdistributor terminated on October 29, 2003.  Our contract with this distributor granted itthe exclusive right to reproduce, display, license and sub-license intellectualand proprietary rights in our software products to third parties in Japan, and wewere required to maintain, support and provide “bug fixes” for these productsand to develop specified upgraded versions of certain of these products.

 

*Free downloads supported by online advertising*:  From1998 until 2001, we derived the majority of our revenues from selling onlineadvertising to other businesses.  Most ofour products described above, as well as some third-party software programs,were offered as free homepageware, which meant that users were required toadopt our homepage as their Internet browser’s starting page in exchange forusing the software.  Beginning in 2000,and through 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, did not survive that decline.  As a result, our revenue from this activitydropped considerably and we shifted our emphasis away from an advertising-basedplatform to our present subscription-based platform.  In 2004, Internet advertising accounted foronly .2% of total revenue.

 

**Marketing Strategy**

 

Asthe Internet continues to expand, the size of our market also expands.  Based on research published by ClickZ.com in February 2005,from data compiled by Nielsen/NetRatings and the CIA’s World Factbook, wecurrently estimate that the potential market for subscribers for our onlinesubscription services is approximately 324 million out of a total of 934million people using the Internet worldwide. We believe that the 324 million represents people from countries withhigh enough income levels to afford our minimum introductory subscription pricein U.S. dollars.

 

Weview the eAcceleration market as the sum of many smaller markets, rather thanas a single monolithic market.  Since oureAcceleration service is composed of multiple products and services which,together, enhance the end user’s experience, it may not be readily apparent toa non-technical end user how to best utilize our eAcceleration service.  We have identified target markets based onwhat we believe are the most powerful features of our eAcceleration servicethat would appeal to individual computer users, and have directed ads invarious media forms to those target markets.

 

Since1996, we have been developing and refining better and more efficient ways toutilize the Internet as an advertising and direct marketing medium.  Our marketing strategy for our eAccelerationservice utilizes the extensive expertise we gained in the Internet advertisingindustry during this period.  After weshifted our emphasis to our present subscription-based platform, we beganactively utilizing Internet search engines to market our products and services bybidding for top listings on certain search terms.  The search engine keyword market is highlycompetitive, and prices can fluctuate widely. We also continue to experiment with advertising in more “traditional”media such as radio and television.

 

Webelieve that we have been effective in reaching an audience of consumers withour eAcceleration service.  This audienceis composed not only of people in the U.S., but encompasses Internet users allover the globe.  Based on data publishedby ClickZ.com, we believe that this market is continually expanding.  We also believe that the users’ expectationsregarding the services available to them on the Internet are continuallyincreasing as well.

 

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Weseek to create a positive impression on our customers that will make them wantto continue using not only existing, but also our future productofferings.  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.  We expect to expand the available componentsof our eAcceleration service through a combination of internal software development,licensing of components and software from third parties, and possibly byoffering goods and services from third parties.

 

**Competition**

 

We are in a highly competitiveindustry.  As additional companies suchas Microsoft, AOL, or other companies with large distribution channels enterthe market, they create increased pricing pressure by giving away free softwareto build market share.  To meet thischallenge we must continually upgrade our existing products as well as developnew products and services.  Wedifferentiate ourselves from the competition by providing live one-on-onecustomer service and technical support to our customers.

 

BecauseeAcceleration is a “complete product line” service, we believe it would be inappropriateto classify single-function online subscription services in the same marketsegment as our eAcceleration service.  Webelieve that, just as a component manufacturer (such as an automobiletransmission supplier) competes in a different market than the manufacturer ofa complete system (such as an automobile manufacturer), these single-functionsubscription services compete and will continue to compete in a differentmarket segment than our eAcceleration service.

 

Currently,we know of no other company that offers an online software subscription servicesimilar in scope or substance to the services that we offer or plan to offerwith our eAcceleration service.  Whilethere may be dozens of products or companies in the marketplace that maycompete with each of the individual components of our eAcceleration service,including RealNetworks, Adobe, Symantec, and McAfee, to name a few, oureAcceleration service should be able to develop a significant marketingadvantage against these single-function products.  We believe that the synergy and savingsafforded by all of our current and anticipated combined components will set usapart 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.

 

In the event a competitorintroduces a comprehensive system of software offerings similar to ours in thefuture, we hope that by such time, we will have a competitive advantage becauseour eAccelerationservice will have an established brand and user base.  In addition, with our technical expertise andtechnological adaptability, we hope to provide a technologically comparable orsuperior product in each submarket addressed by a specific component of oureAcceleration service.

 

**Customers**

 

During 2004, 99.8% of our total revenue was attributable to oureAcceleration subscription service, which has a widely dispersed customer base,and approximately .2% of our 2004 total revenue was attributable to Internetadvertising.  In prior years, we employedvarious pay-for-performance web-based advertising methods.  Although we are no longer actively pursuingthis 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. We have not incurred any costs in 2004 in connection with theseadvertisements.  Internet advertisingrevenues are recognized in the period in which users execute pre-definedactions related to that advertising.

 

During2003, 89% of our revenue was attributable to our eAcceleration service.  Our Japanese distributor, Sourcenext,accounted for $800,000 or 10% of our total revenues.  This contract was terminated on October 29,2003.  No other customer accounted for10% or more of our revenues in 2003. Approximately 1% of our 2003 total revenues came from Internetadvertising.

 

Ourrevenue from non-U.S. customers, other than Sourcenext, has historically been asmall percentage of our total revenues. Revenue from foreign customers accounted for approximately 16% and 15%of our total revenue for the years ended December 31, 2004 and 2003,respectively.

 

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**Suppliers**

 

Wedepend on several suppliers with respect to our eAcceleration service.  Licensors of components that we have includedor intend to include as part of our eAcceleration service require licensingfees for the use of their software.  Weemploy outside contractors to test the software we produce for adequateperformance.  We also purchase Internetadvertising from third-party suppliers in order to advertise our eAccelerationservice on the Internet, radio and television. We purchase bandwidth from several Internet connectivity providers tohandle the large volume of activity within our web pages.  In 2003, none of these suppliers comprised10% or more of our total expenses.  In2004, Google and Lockard & Wechsler, Inc. were the only suppliers thatindividually comprised 10% or more of our total expenses.

 

**Technology and Infrastructure**

 

Wehave developed an expandable, reliable and secure technology infrastructure tosupport our online services.  Oursoftware system architecture uses industry standard technologies to maximizereliability.  We use Secure Socket Layerfor secure transactions, MySQL and PostgreSQL databases, the UNIX operatingsystem and the Apache web server within our infrastructure.  All of these platforms have demonstrated ahigh degree of reliability.  We back upour databases and other information on a regular basis.

 

Weincorporate a variety of encryption techniques meant to protect the privacy ofconsumer information.  We also employ avariety of automated fraud detection procedures to identify patterns of abuseand potential fraudulent use of our system. Our fraud detection systems can disable accounts in which fraud issuspected.  In addition, the data centerwhere our system is located provides physical and technical security management24 hours per day, seven days per week.

 

Whenappropriate, we utilize open source projects and incorporate them into oureAcceleration service. Depending on the specific application, we might utilizejust a portion of the open source project or the complete project.  We conform to the open source licensingrequirements and make the source code of projects we modify available.  In the future, we may decide to release somecurrently proprietary internal projects as open source.

 

Wecurrently devote substantial resources to the continued development of ouronline subscription service that is sold directly to users over theInternet.  Forthe years ended December 31, 2004 and 2003, we spent $3,343,048 and$3,392,282 respectively on software and web development expenses.  The costs of such activities were not bornedirectly by our customers.

 

**Government Regulation**

 

UnitedStates federal and state and foreign laws and regulations have been adopted andinterpreted to regulate certain aspects of the Internet, including onlinecontent, user privacy, taxation, liability for third-party activities,jurisdiction, Internet telephony and unsolicited electronic mail.  Although we believe that we are fullycompliant with all such laws, enforcement of these laws and regulations and ourcompliance with these laws and regulations may have the effect of raising thecost of doing business generally on the Internet.  For example, we soon may be required tocollect value added tax on sales in the European Union, which will increase ourcost of doing business there.  Increasedregulation of the Internet may decrease growth, which may negatively impact thecost of doing business via the Internet or otherwise materially adverselyaffect our business, financial condition and results of operations.

 

Becauseour services are accessible worldwide, and we facilitate the sale of ourservices and products to users worldwide, other jurisdictions may claim that weare required to comply with their laws. The failure by us to qualify as a foreign corporation in a jurisdictionwhere we are required to do so or fully comply with the laws in thatjurisdiction could subject us to additional taxes and penalties and couldresult in our inability to enforce contracts in such jurisdictions.  Any such new legislation or regulation, orthe application of laws or regulations from jurisdictions whose laws do notcurrently apply to our business, could have a material adverse effect on ourbusiness, financial condition and results of operations.

 

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**Intellectual Property**

 

Weregard our patents, copyrights, service marks, trademarks, trade secrets,proprietary technology and similar intellectual property as critical to oursuccess, and we rely on intellectual property protection and confidentialityand license agreements with our employees, customers, independent contractors,partners and others to protect our intellectual property rights.  We own twenty issued patents, including oneforeign patent, on our software products, and have several patent applicationspending on these products.  We haveregistered several trademarks in the United States and may apply for additionaltrademarks and service marks in the future. Generally, we rely on common law intellectual property protection inforeign jurisdictions and do not register our trademarks, service marks,copyrights, or similar intellectual property in those jurisdictions.

 

Thefollowing table discloses the expiration schedule of our U.S. patents:

 
| **Number  of Patents** | ** ** | **Year of Expiration** | ** ** |
|------------------------|------------|------------------------|------------|
|                   |       |                   |       |
| 1                      |       | 2009                   |       |
| 2                      |       | 2014                   |       |
| 4                      |       | 2016                   |       |
| 5                      |       | 2017                   |       |
| 4                      |       | 2018                   |       |
| 3                      |       | 2019                   |       |
| 1                      |       | 2023                   |       |

 

Wehave registered a number of domain names, including eAcceleration.com,Stop-Sign.com, and Veloz.com.  Domainnames generally are regulated by Internet regulatory bodies.  The regulation of domain names in the UnitedStates and in foreign countries is evolving. Regulatory bodies could establish additional top-level domains, appointadditional domain name registrars or modify the requirements for holding domainnames.  The relationship between domainnames and trademarks, service marks, and other intellectual property is stillbeing defined.

 

Wemay be required to obtain licenses from others to refine, develop, market anddeliver new services.  We may be unableto obtain any such license on commercially reasonable terms, if at all, orguarantee that the rights granted by any licenses will be valid andenforceable.

 

Althoughwe have not historically emphasized our brand names, we expect that brand namestrength may become increasingly important with respect to our eAccelerationservice and especially with respect to our Stop-Sign threat scanner.  The reputation of our brand names is expectedto depend on our ability to produce high-quality innovative software andservices, and to provide a high-quality online experience for users visitingour websites or using our products. Negative experiences of users with our services, websites or softwaremight result in publicity that could damage our reputation and diminish thestrength of our brand names.

 

**Environmental Issues**

 

Wedo not believe that federal, state or local environmental laws have had or arelikely to have a material effect on our operations or costs of doing business.

 

**Employees**

 

Asof December 31, 2004, we had a total of 169 employees, 25 of whom workedpart-time.  A total of 112 employeesworked full-time in our online services, including product development andcustomer support, and 22 worked part-time; 23 employees worked full-time in salesand 3 worked part-time; and 9 employees worked 

 

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full-timein operations and administration.  Noneof our employees are represented by unions, and we consider relations with ouremployees to be good.  In addition, wecontract with a number of independent contractors for product development andtesting activities.

 

**Factors Affecting Future Operating Results**

** **

*Our current systems may not be capable of handlingunexpected, heavy customer traffic volumes.*

 

Our technology is designed to support a largenumber 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 systems can accommodate a heavy volumeof customers, our websites could encounter a variety of systems problems,especially if the number of our customers expands significantly in a shortperiod of time.  These systems problemscould include failure of one or more of our current Internet service providers,failures in our outsourced servers, in-house hardware failures, or failure ofsoftware applications.  In addition, ourcomputer servers may be vulnerable to computer viruses, physical or electronicbreak-ins and similar disruptions.  Wemay need to expend significant additional capital and other resources toprotect against a security breach or to alleviate problems caused by any suchbreaches.  We may be unable to prevent orremedy all errors, failures, interruptions or delays experienced in connectionwith security breaches.  If any of these failuresor breaches occur, we could temporarily lose the ability to effectivelymaintain our web sites and services.  Anyof these failures or breaches could negatively impact our relationship withusers and adversely affect our brand and our business and could expose us toliabilities to third parties.

 

*IfMicrosoft (or a similar company) bundles a fully-functional anti-virus productwith the Windows operating system in the future, or makes an anti-virus programavailable for free to Windows customers, or begins to bundle anti-virusproducts with Windows on new computers, our business would suffer.*

* *

IfMicrosoft Corporation (or a similar company) decides to incorporate a fully-functionalanti-virus program into its Windows home and business versions or makes such aproduct available for free to new or existing customers, this would be expectedto have a material adverse effect on our sales, our business, our cash flowsand our results of operations.

 

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

 

Ifthe writers of viruses worldwide were to stop or significantly reduce writingor disseminating these programs, demand for our flagship Stop-Sign servicewould plummet, and it would have an adverse effect on our cash flows, financialposition and results of operations.

 

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

 

Thesearch engine advertising market is highly competitive, and companies wishingto use this medium for advertising must bid on the ranking they wish toobtain.  If the costs of purchasingadvertising space on Internet search engine pages increase significantly, thiscould cause our advertising costs to correspondingly increase, and it couldhave a material adverse effect on our cash flows, financial position andresults of operations.

 

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

* *

A large percentageof our online revenues are derived from downloads of our products resultingfrom our advertising on the Internet.  Weare dependent on a small number of sources of such advertising, and our loss ofany significant source of this advertising would be expected to have a materialadverse effect on our business.  Duringthe second quarter of 2004, Google, one of our largest suppliers of Internetadvertising, suspended our advertising campaign, allegedly due to customercomplaints.  We did experience a decreasein revenue, but were not able to quantify whether all or just a portion of thatdecrease was due to Google.  We continueddiscussions with Google and, on October 22, 2004, were successful insigning a new agreement.

 

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*We may lose a significant portion of our revenues due toerroneous claims by some, including several spyware-removal companies, that oursoftware is spyware.*

 

Oursoftware has been erroneously labeled by some third-party spyware-removalcompanies as spyware, which is a type of software that secretly forwardsinformation about a computer user’s online activities to others without theuser’s knowledge or consent.  Thesespyware-removal companies and their related products could remove our softwarefrom our customers’ computers, which could cause us to lose a material portionof our revenues and thus could have a material adverse effect on our financialposition, results of operations and cash flows. Although we are actively engaged and have been successful in challengingthis false allegation and taking all actions we believe necessary to defend ourreputation, we cannot provide any assurance we will be successful in doingso.  Further, challenging these claimsmay result in litigation and its inherent risks and costs.

 

*We are dependent on the processing of credit cardtransactions in connection with our eAcceleration service, and any significantinterruption in the processing of our credit card transactions would haveserious adverse effects on us.*

 

The success of oureAcceleration service, and our business as a whole, is dependent on our abilityto sell subscriptions over the Internet to consumers.  We utilize multiple merchant banks orprocessors to facilitate all of our credit card transactions.  Any failure on the part of these providers tosuccessfully process our credit card transactions in sufficient volume couldrestrict our ability to sell our services, which would have a material adverseeffect on our cash flows, financial position and results of operations.  In addition, we may experience difficultiesor increased costs associated with credit card transactions in foreigncurrencies.

 

*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 will dictate the rateof growth, if any, we will undergo in the future.  If our sales continue to increase at currentrates, we may need to hire a significant number of additional employees to meetthe demand for online subscriptions. These additional employees will, in turn, create the need for additionaloffice space.  We are located in ruralKitsap County, and the availability of suitable office space and skilledemployees is limited.  If we cannot findsufficient skilled employees in Kitsap County to accommodate this growth, wemay be forced to outsource certain aspects of our business or relocate to otherparts of the Puget Sound area where skilled labor is more accessible.  In addition, if we cannot find sufficientoffice space in Kitsap County to accommodate our growth, we may be forced torelocate to other parts of the Puget Sound area.  Any relocation of this magnitude would causea significant disruption of our operations, and could have a material adverseeffect on our cash flows, financial condition and results 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.*

 

Wecollect personal information from users when they subscribe to our eAccelerationservice, including their credit card information.  While we have security measures in place toprotect such information when it is transmitted to us over the Internet, suchas Secure-Socket-Layer and other measures, we cannot guarantee that these securitymeasures will not fail, allowing experienced computer programmers, or “hackers”,access to such personal information. Such a security breach would present a threat to our users, who may filelawsuits against us, claiming that we have failed to protect their informationadequately.  We have no insuranceprotection against such claims, and an unfavorable outcome to such a lawsuitcould have a material adverse impact on our financial position and futuresales.

 

*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 intellectualproperty rights are important to us. However, effective protection of our intellectual property may not beavailable in every country in which our products and services are distributedor made available through the Internet.

 

8

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There can be noassurance that the steps we have taken to protect our intellectual propertyrights will be adequate to prevent third parties from infringing ormisappropriating our patents, copyrights, trademarks, trade dress and similarintellectual property rights.  The lossor impairment of our rights to the use of any such intellectual property rightscould harm our ability to compete and have a material adverse effect on ourbusiness.

 

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 defense,whether successful or not, may cause us to incur 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.*

 

Weseek to distribute our eAcceleration service worldwide over the Internet.  As we develop new software or distributeexisting software to foreign regions, we could incur significant costsassociated with localization if the software in its present form does not gainacceptance among users, and this could adversely affect our cash flow,financial position and results of operations.

 

*We have incurred losses in previous years, and there is noassurance that we will become profitable again.*

 

We were unprofitable in 2004 and it is possible we may incur operatinglosses in the future, even though in 2003 we had net income of $13,553.  We experienced a net loss of ($1,820,142) in2004.  No assurance can be given that wewill be profitable again in the future.

 

Wecontinue to develop a customer base for our eAcceleration service.  Our eAcceleration service provides themajority of our revenue and is the primary means of distributing our onlinesubscription software service.  There isno assurance that we will be successful in marketing or distributing thisservice, nor that users' acceptance of the service will rise to expectedlevels, nor that the revenue stream from such a service will generate enoughpositive cash flow to enable us to continue in business.

 

**Item 2.  Description ofProperty.**

 

Wecurrently occupy three facilities totaling approximately 19,113 square feet inPoulsbo, Washington.  These threefacilities have five operating lease agreements and one sublease agreement.

 

The first facility has two leases and one sublease. Thetwo leases expire in January 2007. These leases together have an aggregate payment of $11,860 per month,with scheduled rent increases each year. In May 2004, we entered into a sublease with respect to additional spaceat this facility for a period of ten months with a monthly payment of$2,540.  On March 1, 2005, we enteredinto a new lease agreement for this additional space with a two year termexpiring on January 31, 2007.  Thesecond facility has two leases with monthly payments of $613 and $2,979.  The term of the first lease ended in March2005, however, we continue to lease this space on a month-to-month basis.  The term of the second lease ends in April 2005, and we expect to continueleasing this property on a month-to-month basis.  The third facility has one lease that expiresin March 2007 and has an average monthly payment of $2,563 with scheduledincreases in April 2005 and 2006. The Company records rent expense on a straight-line basis over the lifeof each lease.

 

Dueto anticipated increases in space requirements resulting from personnelincreases, we have entered into a Purchase and Sale Agreement with theBremerton School District No. 100-C for the purchase of certain real propertylocated in the City of Bremerton, Washington. The Purchase and Sale Agreement contains certain contingencies includingobtaining a special use permit from the City of Bremerton, which must besatisfied or waived, before the sale can be completed.

 

9

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Poulsbo,Washington, where our facilities are presently located, is a rural area outsideof Seattle and Tacoma, Washington.  Inthe past we have experienced temporary outages in our telephone service andelectric power.  While such outages havenever materially affected systems that are critical to our operations, there isno assurance that such outages will not occur in the future more frequently orwith greater magnitude or duration.  Suchoutages could materially and adversely affect our business, financial conditionand results of operations.

 

**Item3.  Legal Proceedings.**

 

OnDecember 15, 2003, a class action lawsuit entitled Consumer AdvocatesRights Enforcement Society (CARES), for itself and others similarly situated,and Patricia Cole, for herself and all others similarly situated v.eAcceleration Corp., a Delaware corporation, d/b/a Veloz.com, also d/b/aStopSign.com; Acceleration Software International Corporation, a Washingtoncorporation, Clint Ballard and Diana Ballard, Doubleclick, Inc., a Delawarecorporation and Does 1-50 inclusive, was commenced in the Superior Court ofthe State of California, County of San Joaquin-Stockton Branch.  The complaint alleged that through the use ofcertain advertising banners for our products on the Internet, we engaged indeceptive business practices and fraud and were liable for public and privatenuisance.  The complaint soughtinjunctive relief, disgorgement of profits, damages of $100,000, or such otheramount as the court deemed appropriate, as well as attorneys’ fees andcosts.  Subsequent to the close of theyear end on December 31, 2004, we settled this lawsuit for an immaterialamount.  We did not have to make anychanges to our business practices as a result of this settlement.

 

Weare periodically subject to various legal proceedings and claims arising in theordinary course of business.  We do notexpect that the results in any of these legal proceedings will have a materialadverse effect on our financial condition, results of operations or cash flows.

 

**Item 4.  Submission ofMatters to a Vote of Security Holders.**

 

No matters were submitted to a vote of our security holders during thefourth quarter of the year ended December 31, 2004.

 

10

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**PART II**

 

**Item 5.  Market forCommon Equity, Related Stockholder Matters and Small Business Issuer Purchasesof Equity Securities.**

 

### *Market Information*

### * *

Asof March 1, 2005, we have 34,812,032 outstanding shares of common stockowned of record by 257 stockholders. There is no public market for our common stock.

 

### *Recent Sales of Unregistered Securities*

### * *

Duringthe past three years, we did not sell any of our securities withoutregistration under the Securities Act. In addition, we did not repurchase any of our common stock during thequarter ended December 31, 2004.

 

### *Dividends*

### * *

Wecurrently do not pay any dividends and have not paid or declared any cashdividends on our common stock during 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.

 

### *Securities Authorized for Issuance Under Equity Compensation Plans*

### * *

Thefollowing table sets forth certain information as of December 31, 2004.

 
| ** **                                                  | ** ** | **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) |       | 1,304,500                                                                                          |  (2)  | $                                                                                  | 0.33       |                                                                                                                                                 | 8,183,468  |  (2) |
| Equity compensation plans not approved by  security holders |       | 0                                                                                                  |       | 0                                                                                  |       | 0                                                                                                                                                    |       |      |
| **Total**                                                   |       | 1,304,500                                                                                          |  (2)  | $                                                                                  | 0.33       |                                                                                                                                                 | 8,183,468  |  (2) |
|                                                             |            |                                                                                                    |            |                                                                                    |            |                                                                                                                                                      |            |           |  |  |  |  |  |

 

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

(2)                                  Excludes 512,032 shares already issued asgrants under our 2002 Equity Incentive Plan as of December 31, 2004.

 

**Item 6. Management’s Discussion and Analysis or Planof Operation.**

 

**Management Overview**

 

Weare a provider and licensor of proprietary and open-source software and relatedservices that are distributed primarily through the Internet.  Our primary focus is developing a subscriberbase for our eAccelerationTM online subscription service as theleading means of distributing our internally-produced software.

 

Oneof our more notable accomplishments during 2004 was the resolution of certaininaccurate claims about the nature of our products.  Our software had been erroneously labeled byseveral third-party spyware-removal 

 

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companiesas spyware.  We set about contacting theapplicable companies and initiating discussions with them aimed at clearing anymisconceptions they may have had regarding our software.  We have been successful in our efforts with amajority of the companies and continue discussions with the others; however, wecannot provide any assurance that we will be successful in all instances.

 

In2004, we focused our efforts on increasing revenues from our eAccelerationservices.  This required largeexpenditures in advertising in order to increase sales volumes, which in turnrequired increases in the number of customer service and technical supportpersonnel to handle the corresponding increase in customer requests that aredirectly proportional to the increase in sales.

 

Weare in a highly competitive industry and, with the entrance of Microsoft, itpromises to become even more so. Pricing pressure will become more acute ascompanies such as AOL and Microsoft give away their software for free in theirattempts to build market share.  Ourchallenge will be to differentiate ourselves from the competition by providingsuperior products and services.  Whileoverall cash flow has improved significantly due to the increased sales of oureAcceleration service, there can be no assurance that we will recognizesufficient revenues from this service to cover our increasing costs ofadvertising and payroll or to recover from previous losses, nor is there anyassurance that we will not incur losses in the future.

 

**Critical Accounting Policies**

 

Management’sdiscussion and analysis of our financial position and results of operations isbased upon our audited consolidated financial statements, which have beenprepared in accordance with accounting principles generally accepted in theUnited States of America.  Thepreparation of these audited financial statements requires management to makeestimates and judgments that affect the reported amounts of assets,liabilities, revenues and expenses and related disclosure of contingent assetsand liabilities.  Actual results coulddiffer 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, and revenue recognition relatingto the distribution of our software products in Japan.

 

*Revenue Recognition and Returns and Allowances Relating toOnline Subscriptions*

 

In2003, our refund period for online subscriptions was 7 days regardless ofsubscription length.  In May 2004,however, the refund policy was revised to offer a 30-day refund period inaccordance with the industry standard.  We defer online subscriptionrevenue and recognize such revenue on a straight-line basis monthly over thelife of the customer’s subscription, after the right of refund lapses, whenpersuasive evidence of an agreement exists, delivery of the product hasoccurred, the fee is fixed or determinable, collectibility is probable, and nosignificant Company obligations with regard to implementation remain, inaccordance with SOP 97-2.

 

Accountingstandards require us to estimate the amount of future returns and create areserve for such returns at the time the sale is made.  Accordingly, we have developed an estimateutilizing a weighted average ratio of returns based on our actual historicalexperience.  Such a ratio is applied tocurrent period sales to develop the required reserve.  All revenue not yet recognized from sales isdeferred until future periods.  Webelieve our revenue recognition practices for subscription revenues are inaccordance with SFAS No. 48 and, as stated above, SOP 97-2.

 

*Revenue Recognition Relating to the Distribution of ourSoftware Products in Japan*

 

Underour terminated distribution agreement with Sourcenext, we received monthlypayments of $150,000 for each of June, July and August 2002, andreceived $50,000 per month thereafter. The payments under the agreement were made net of a 10% Japanesewithholding tax.  SOP 97-2 requiredrevenue on this contract to be allocated to the post-contract customer support (“PCS”)and the upgrades based on the vendor-specific objective evidence of fair valueestimated by management.  Managementestimated the value of PCS services to be equal to the amount of the $50,000fixed monthly payments, which were recognized ratably over the life of thecontract.  The aggregate $300,000difference between the amount of fixed payments and the larger initial paymentswas deferred and was recognized when the contract terminated in the fourthquarter of fiscal 2003.

 

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**Results of Operations for the Fiscal Years Ended December 31,2004 and 2003**

 

*Revenues*

 

Ourrevenues increased $4,941,572 or 63%, from $7,798,617 in 2003 to $12,740,189 in2004, primarily due to an increase in online subscription services revenue of$5,752,434, or 83%, to $12,712,783 in 2004 from $6,960,349 recognized in2003.  In accordance with SFAS No. 48, “RevenueRecognition When Right of Return Exists,” and SOP No. 97-2, “Software RevenueRecognition,” we recognized $10,715,090 of revenue, excluding returns, anddeferred $5,018,709 of subscription revenue on our eAcceleration servicesubscriptions for sales made during 2004. We recognized $3,063,097 of subscription revenue in 2004 from sales ofsubscriptions for our eAcceleration service that had been deferred in 2003 and2002. We also accrued an estimate of returns and allowances for 2004 sales of$1,065,403, which is netted against revenue for presentation.  The deferred revenue will be recognized infuture periods, to the extent not refunded, after the right of refund expires,in accordance with the provisions of SFAS No. 48.

 

Revenuesfrom software licensing decreased by $800,000, or 100%, to $0 in 2004 ascompared to $800,000 in 2003.  Thelicensing contract with Sourcenext was terminated effective October 29,2003.

 

*Cost of Revenues*

 

Ourcost of subscription revenue from sales of subscriptions for our eAccelerationservice increased $4,760,149, or 119%, from $4,015,619 in 2003 to $8,775,768 in2004.  The increase in costs correlateswith the increases in sales of subscriptions for our eAccelerationservice.  Due to the higher volume ofsubscription sales in 2004, credit card processing costs have increased as wellas personnel costs due to the hiring of additional customer service employeesto handle a growing number of customer requests.

 

Ourcost of software licensing revenues decreased by $705,082, or 100%, from $705,082in 2003 to $0 in 2004, due to the termination of our contract with Sourcenexton October 29, 2003.

 

*Selling, General and Administrative Expenses*

 

Sellingexpenses in 2004 increased $2,444,824, or 125%, from $1,954,404 in 2003 to$4,399,228 in 2004.  This increase isprimarily due to additional advertising purchased to promote our eAccelerationservice and the creation of a team of dedicated sales personnel late in thefourth quarter of 2003.

 

Generaland administrative expenses in 2004 increased $421,305, or 38%, from $1,098,480in 2003 to $1,519,785 in 2004.  Thisincrease is due primarily to the hiring of additional personnel and salaryincreases to existing personnel in 2004.

 

**Liquidity and Capital Resources**

 

Forthe year ended December 31, 2004, we had a net loss of ($1,820,142), anaccumulated deficit of ($5,849,876), and a working capital deficit of ($5,034,729).  We believe that the size of the lossessustained in 2004 is attributable not only to the magnitude of expensesassociated with growing our eAcceleration service, but also to the method bywhich we are required to report the expenses. Accounting principles generally accepted in the United States requirethat the expenses be recognized currently while the associated revenues bedeferred over the term of the subscription. We receive the cash, but must defer the associated revenue.  The deferred revenue is classified and shownon the Consolidated Balance Sheet as a current liability.  As a component of the net working capitalcalculation, it contributes to the deficit in working capital.  Deferred revenue increased by $1,995,612 from2003 to 2004 to a total of $5,387,912 as of December 31, 2004.  Net cash provided by operations increased by$149,588 from 2003 to 2004.  Our cashbalance for the year ended December 31, 2004 is $604,186.  The Company generated sufficient cash flowsto fund its operations as well as to purchase new equipment and pay down debt.

 

13

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Thisincrease in cash flow was accomplished despite the suspension of ouradvertising campaign with Google from May 2004 until October 2004.  This suspension was allegedly due to customercomplaints that we believe were caused by certain third-party spyware-removalcompanies erroneously listing our software as spyware.  Although we experienced a decrease in revenueduring this period, we have not been able to quantify the extent to which thedecrease was due to Google.  As a resultof our efforts to resolve these issues with Google, we have successfullyconcluded discussion with a number of the spyware-removal companies and havebeen removed from their lists of potential spyware.

 

Weare considering seeking additional financing through one or more debt or equityofferings.  In the past we have alsoreceived additional funding from our principal stockholders to supplement fundsreceived from third parties.  However,there is no assurance that such additional funding through debt or securityofferings or from our stockholders will be available in the future.

 

*Additional Events Affecting Liquidity*

 

The Company has borrowed an aggregate of $404,000 from the Company’schief executive officer, who is one of the principal stockholders, undervarious promissory notes.  These notesbear interest at 10%, are payable on demand, and require monthly interest-onlypayments.  A significant portion of thenotes was paid off during the second quarter of 2004, leaving an outstandingbalance at December 31, 2004 of $101,589.

 

The success of oureAcceleration service is highly dependent on our ability to sell the service tosubscribers via the Internet.  Such salesare predominantly conducted by electronic payment methods, the most popular ofwhich, utilizes the customer’s credit card information and processes the saleelectronically.  Our processors hold acombined total of $114,081 in cash reserves. The agreements we signed with these processors provide that reservefunds are to be returned when the agreements with the processors areterminated.  However, the processorsretain the right to withhold the reserves for a period of 12 to 18 months aftercontract termination to cover potential chargebacks.  We have established an allowance against thecash reserves in the amount of $27,200, in the event some of the reservesshould prove uncollectible.  Thisestimate is based on our historical return experience.  We currently contract with several processorsand alternate payment method providers to diversify our risk.  We expect that the extent of the reservesrequired and/or amounts of processing limits by our processors likely will havea direct effect on our financial position, results of operations and cash flow.

 

*Stock Bonuses*

 

In 2004, we issuedan aggregate of 66,232 shares of our common stock to employees in the form ofstock 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 underthe 2002 Plan is 5,000,000.  We recorded$13,796 of estimated compensation expense in connection with these issuances.

 

*Income Taxes*

 

We utilize theasset and liability method of accounting for income taxes.  Under this method, deferred assets andliabilities are recognized based on anticipated future tax consequences, whichare based on differences occurring between GAAP financial and tax financialresults.

 

Atpresent, the State of Washington does not impose income taxes on corporations,but it does impose a business and occupation tax on corporations conductingbusiness in the State of Washington.

 

**Inflation**

 

Webelieve that inflation has generally not had a material impact on our operations.

 

14

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**Off-Balance Sheet Arrangements**

 

Wedo not have and are not reasonably likely to have any off-balance sheetarrangements that would have a current or future effect on our financialcondition, revenues or expenses, results of operations, liquidity, capitalexpenditures or capital resources that would be material to investors.

 

**Seasonality**

 

Thecomputer software and Internet markets are characterized by significantseasonal swings in demand.  We expect ournet sales and operating results from our eAcceleration service to continue tobe affected by these fluctuations in Internet usage.  For our products and services, usage istypically higher in the summer and lower at year-end.

 

**Item7.  Financial Statements.**

 

Weset forth below a list of our financial statements included in this annualreport.

 
| ** **                                                                                                           | **Page**    |
|----------------------------------------------------------------------------------------------------------------------|-------------|
| Report  of Independent Registered Public Accounting Firm                                                             | F-3         |
|                                                                                                                 |        |
| Consolidated Balance Sheet  as of December 31, 2004                                                             | F-4         |
|                                                                                                                 |        |
| Consolidated  Statements of Operations for the years ended December 31, 2004 and 2003                           | F-5         |
|                                                                                                                 |        |
| Consolidated  Statements of Stockholders’ Equity (Deficit) for the years ended December 31,  2004 and 2003 | F-6         |
|                                                                                                                 |        |
| Consolidated  Statements of Cash Flows for the years ended December 31, 2004 and 2003                           | F-7         |
|                                                                                                                 |        |
| Notes to  Consolidated Financial Statements                                                                          | F-8 to F-16 |

 

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*Page F-1 follows page 22 to this annual report on Form 10-KSB.

 

**Item 8.  Changesin and Disagreements With Accountants on Accounting and Financial Disclosure.**

 

None.

 

**Item 8A. Controls and Procedures.**

 

Wecarried out an evaluation under the supervision and with the participation ofour management, including our Chief Executive Officer and Chief FinancialOfficer, of the effectiveness of the design and operation of our disclosurecontrols and procedures as defined in Exchange Act Rules 13a-15(e) and15d-15(e).  Based upon that evaluation,the Chief Executive Officer and Chief Financial Officer concluded that ourdisclosure controls and procedures, as of December 31, 2004, are effectivein timely alerting them to material company information required to be includedin our periodic filings with the Securities and Exchange Commission.  The design of any system of controls is basedin part upon certain assumptions about the likelihood of future events, andthere can be no assurance that any design will succeed in achieving its statedgoals under all potential future conditions. As of the date of this evaluation, there were no changes in our internalcontrol over financial reporting that have materially affected, or arereasonably likely to materially affect, our internal control over financialreporting.

 

**Item 8B.  OtherInformation.**

 

None.

 

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**PART III**

 

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

 

**Directors and Executive Officers**

 

Thefollowing persons are our current executive officers and directors:

 
| **Name**              | ** ** | **Age** | ** ** | **Position**                                                  |
|-----------------------|------------|---------|------------|---------------------------------------------------------------|
| Clinton  L. Ballard   |       | 42      |       | President,  Chief Executive Officer and Chairman of the Board |
| Diana  T. Ballard     |       | 47      |       | Vice  Chairman of the Board, Secretary and Treasurer          |
| E.Edward  Ahrens      |       | 57      |       | Chief  Financial Officer                                      |
| Edward  P. Swain, Jr. |       | 69      |       | Director                                                      |
| William  E. Hoke      |       | 65      |       | Director                                                      |

 

Setforth below is a brief description of the background of our officers anddirectors based on information provided by them to us.

 

*Clinton L. Ballard*is our President, Chief Executive Officer and Chairman of theBoard.  Since 1987, he has served asChief Executive Officer, President, and in other senior officercapacities.  Mr. Ballard received a B.S.in mathematics from the California Institute of Technology in 1984.

 

*Diana T. Ballard*is our Vice Chairman of the Board, Secretary and Treasurer.  In the past, she has served as Chairman ofthe Board as well as in other senior officer capacities, includingPresident.  Mrs. Ballard is the wife ofClinton L. Ballard.

 

*E. Edward Ahrens*has been our Chief Financial Officer since February 2000.  Mr. Ahrens was self-employed as a CertifiedPublic Accountant from October 1993 through September 30, 2002, andin that capacity was our regular accountant, providing accounting andcontroller functions to us since 1995. Mr. Ahrens sold his practice on September 30, 2002 and became afull time employee as of November 1, 2002. Mr. Ahrens received a Bachelor of Business Administration - banking andfinance, from the University of North Texas in 1971.

 

*Edward P. Swain, Jr.*has been a director since August 2000and served as a consultant to us from September 1999 through August 2000.  Mr. Swain is currently self-employed as aconsultant and as Asset Manager for Shawnee Investments, Inc., Shawnee-on-Delaware,PA.  He served as President and ChiefExecutive Officer of P T Holdings Corporation from January 1992 to February 2002.  From January 1992 through December 1997,he also served as President, Chief Executive Officer and Director of PortTownsend Paper Corporation, as well as Chairman of the Board of that companyfrom December 1997 to December 1998. Mr. Swain was appointed chairman of the nominating and governancecommittee of Fibermark, Inc., where he is also a Director.  Mr. Swain is a Trustee Emeritus of the Museumof Flight in Seattle, Washington.  Mr.Swain received a B.A. from Williams College in 1957 and a LLB from Harvard LawSchool in 1964.

 

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

 

Ourfuture success depends to a significant extent on the efforts and abilities ofour senior management, particularly Clinton L. Ballard, our President and ChiefExecutive Officer, and other key employees, including our technicalpersonnel.  The loss of the services ofany of these individuals could harm our business.  We may be unable to attract, motivate andretain other key employees in the future. We are the beneficiary of a “key person” term life insurance policy inthe amount of $2,000,000 on the life of Mr. Ballard.

 

OurBoard of Directors is elected annually by our stockholders.  Edward P. Swain, Jr. and William E. Hoke haveserved as our non-employee directors since August 2000.  Our non-employee directors receive paymentsof 

 

16

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$600per meeting, in addition to reimbursement of expenses related to meetingattendance.  Members of the Board ofDirectors are also eligible to participate in the 2002 Plan.

 

EdwardP. Swain, Jr. and William E. Hoke serve as members 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 is responsible forpre-approving any non-audit services and special engagements to be performed bythe independent auditors and considering the effect of such performance on theauditors’ independence, in accordance with our related policies andprocedures.  The audit committee is alsoresponsible for engaging and dismissing our independent certified publicaccountants.  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 hasdetermined that (1) no members of the audit committee currently meet thedefinition 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 “independentdirectors,” as defined by the NASDAQ Marketplace Rule 4200(a)(14) and theSarbanes-Oxley Act of 2002. Although we continue to search for a financialexpert to serve on our audit committee, we have not found a suitable candidateto date in our geographic area.  Webelieve that the current members of our audit committee provide an acceptablelevel of business and financial experience and expertise.

 

Wecurrently have no compensation committee or nominating committee, the functionsof which are performed by our Board of Directors.

 

**Code of Ethics**

 

Wehave adopted a Code of Ethics within the meaning of Item 406(b) of Regulation S-Bof the Exchange Act.  This Code of Ethicsapplies to directors and senior officers, such as the principal executiveofficer, principal financial officer, controller, and persons performingsimilar functions, of our company.  OurCode of Ethics is publicly available on our website at www.eacceleration.com/stockholders.php.  In addition, our Code of Ethics is availablein print, at no charge, to any security holder who requests such information bycontacting us at eAcceleration Corp., Attn: Investor Relations, 1050 NEHostmark Street, Suite 100B, Poulsbo, WA 98370 USA.

 

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**Item 10.  ExecutiveCompensation.**

 

Thefollowing summary compensation table sets forth, for the three years ended December 31,2004, the cash and other compensation paid to Clinton L. Ballard, ourPresident, Chief Executive Officer and Chairman of the Board; Diana T. Ballard,our Vice Chairman of the Board, Secretary and Treasurer; and E. Edward Ahrens,our Chief Financial Officer.  No otherindividual served as an executive officer of the Company during 2004 whosetotal compensation, for services rendered during 2004, was $100,000 ormore.  No individual received perquisitesthat in the aggregate exceeded the lesser of $50,000 or 10% of his or hersalary and bonus.

 

**SummaryCompensation Table**

 
| ** **                       | ** ** | **Annual Compensation** | ** ** | ** **       | ** ** | ** ** | ** ** |
|----------------------------------|------------|-------------------------|------------|------------------|------------|------------|------------|
| **Name  and principal position** | ** ** | **Fiscal  Year**        | ** ** | **Base  Salary** | ** ** | **Bonus**  | ** ** | **Other Annual  Compensation** | ** ** | **Long-Term  Compensation** | ** ** | **All Other  Compensation** | ** ** |
|                             |       |                    |       |             |       |       |       |   |   |   |   |   |   |
| Clinton L. Ballard               |       | 2004                    |       | $                | 143,062    |       | $          | 217,582 |  (2) | $ | 0 |   | $ | 0 |   | $ | 0 |   |
| President, CEO, and              |       | 2003                    |       | 108,000          |  (1)  | 22,552     |  (2)  | 0 |   | 0 |   | 6,103 |   |
| Chairman of the Board            |       | 2002                    |       | 104,000          |       | 100,000    |  (2)  | 6,138 |  (3) | 0 |   | 0 |   |
|                             |       |                    |       |             |       |       |       |   |   |   |   |   |   |
| Diana T. Ballard                 |       | 2004                    |       | $                | 75,064     |       | $          | 16,110 |  (2) | $ | 0 |   | 0 |   | $ | 0 |   |
| Vice Chairman of the Board,      |       | 2003                    |       | 108,000          |  (1)  | 22,421     |  (2)  | 0 |   | 0 |   | 5,123 |   |
| Secretary and Treasurer          |       | 2002                    |       | 104,000          |       | 0          |       | 6,138 |  (3) | 0 |   | 0 |   |
|                             |       |                    |       |             |       |       |       |   |   |   |   |   |   |
| E. Edward Ahrens                 |       | 2004                    |       | $                | 102,474    |       | $          | 2,004 |  (2) | $ | 0 |   | 0 |   | $ | 0 |   |
| Chief Financial Officer          |       |                    |       |             |       |       |       |   |   |   |   |   |   |
|                                  |            |                         |            |                  |            |            |            |  |  |  |  |  |  |  |  |  |  |  |

 

----

(1)Each of Mr. Ballard and Mrs. Ballard received an additional $4,000 of salary in2003 given our decision to pay employees on Wednesday, December 31, 2003instead of Friday, January 2, 2004 in connection with the holiday season.

 

(2)Each of Mrs. Ballard’s bonuses in 2004 and 2003 represented cash bonusespursuant to her employment agreement. Mr. Ballard’s bonus in 2003 represented a cash bonus pursuant to hisemployment agreement.  Mr. Ballard’sbonus in 2004 was comprised of a $200,000 bonus to reimburse him for certaintax liabilities incurred by him as a result of his ownership interest in theCompany while the Company was an S-corporation, and a $17,582 cash bonuspursuant to his employment agreement.  Mr.Ahrens’ bonus in 2004 was his share of Company bonuses based on cash flowincreases.  The bonus listed in 2002 forMr. Ballard represented a cash bonus approved by our Board of Directors.

 

(3)Other Annual Compensation for each period represented S-corporationdistributions.  The Company terminatedits S-corporation election on August 7, 2002.

 

**Stock Option Grants in 2004**

 

Thefollowing table sets forth:

 

•                  the number of shares underlying optionsgranted during 2004 to the named executive officers;

•                  the percentage that the option grantrepresents of the total number of options granted to all of our employeesduring 2004;

•                  the per share exercise price of each suchoption; and

•                  the expiration date of each such option.

 

18

----

 
| **Name**           | ** ** | **Number of Shares  Underlying Options  Granted During 2004** | ** ** | **Percentage of Total  Options Granted to  Employees in 2004** | ** ** | **Exercise  Price** | ** ** | **Expiration  Date** | ** **     |
|--------------------|------------|---------------------------------------------------------------|------------|----------------------------------------------------------------|------------|---------------------|------------|----------------------|----------------|
|               |       |                                                          |       |                                                           |       |                |       |                 |           |
| Clinton L. Ballard |       | 0                                                             |       | —                                                         |       | —              |       | —               |           |
| Diana T. Ballard   |       | 0                                                             |       | —                                                         |       | —              |       | —               |           |
| E. Edward Ahrens   |       | 40,000                                                        |       | 6                                                              | %          | $                   | 0.22       |                 | March 23, 2014 |   |
|                    |            |                                                               |            |                                                                |            |                     |            |                      |                |  |

 

**AggregateOption Exercises in 2004 and Year-End Option Values**

 

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

 

•                  the total number of unexercised options heldon December 31, 2004, 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, 2004, separately identified betweenthose exercisable and those not exercisable.

 
| ** **         | ** ** | **Number of  Unexercised Options  at December 31, 2004** | ** ** | **Value of Unexercised  In-the-Money Options  at December 31, 2004** | ** ** |
|--------------------|------------|----------------------------------------------------------|------------|----------------------------------------------------------------------|------------|
| **Name**           | ** ** | **Exercisable**                                          | ** ** | **Unexercisable**                                                    | ** ** | **Exercisable** | ** ** | **Unexercisable** | ** ** |
|               |       |                                                     |       |                                                                 |       |   |   |   |   |
| Clinton L. Ballard |       | 0                                                        |       | 0                                                                    |       | 0 |   | 0 |   |
| Diana T. Ballard   |       | 0                                                        |       | 0                                                                    |       | 0 |   | 0 |   |
| E. Edward Ahrens   |       | 8,000                                                    |       | 72,000                                                               |       | 0 |   | 0 |   |

 

None of our named executiveofficers exercised any options during 2004. The value of unexercised in-the-money options is calculated bysubtracting the aggregate exercise price of the options from the aggregate fairmarket value price of the shares underlying the options as of December 31,2004.  The most recent determination ofthe Board of Directors as to the fair market value of the underlying sharesoccurred in July 2004, at which time the Board of Directors determined that thefair market value of the underlying shares was $0.18 per share.

 

**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 2004;

•                  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    |       | 1,250 shares                                 |       | n/a                                                          |       | n/a        |       |

 
| **Name**           | ** ** | **Number of options, 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    |       | 40,000 shares                                 |       | 10 years                                                     |       | $          | 0.22       |   |
|                    |            |                                               |            |                                                              |            |            |            |  |

 

19

----

 

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

 

**EmploymentAgreements**

 

We have entered intoemployment agreements with Clinton L. Ballard and Diana T. Ballard, each for afive-year term commencing January 1, 2003, which extends annually thereafterunless we or such person provides 60 days’ notice of termination.  The employment agreement with Mr. Ballard, asamended on August 21, 2004, provides for him to serve as the President, ChiefExecutive Officer and Chairman of the Board, and provides for an annual basesalary of $208,000 and a bonus of 2.5% of our cash flow with respect to fiscalyears during the term of the agreement.  The employment agreement with Mrs. Ballard, as amended on August 21,2004, provides for her to serve as the Vice-Chairman of the Board, provides foran annual base salary of $52,000 and provides for a bonus of 2.5% of our cashflow with respect to fiscal years during the term of the agreement.

 

Each of these agreementscontains restrictions on the employee engaging in competition with us for theterm of the employment agreement and for one year after the term, and contains provisionsprotecting our proprietary rights and information.  Each agreement also provides for the paymentto the employee of a lump sum equal to three times the average of the employee’sannual compensation for the prior five years, less $1.00, upon his or hertermination in the event of a “change in control” of the Company.

 

**IndemnificationAgreements**

 

We have entered intoindemnification agreements with each of our executive officers anddirectors.  The indemnificationagreements provide for reimbursement for all direct and indirect costs of anytype or nature whatsoever including attorneys’ fees and related disbursements,that are actually and reasonably incurred in connection with either theinvestigation, defense or appeal of a “proceeding”, as defined in theindemnification agreements, including amounts paid in settlement by or onbehalf of an “indemnitee”, as defined in such agreements.

 

Insofar as indemnificationfor liabilities arising under the Securities Act may be permitted to ourdirectors, officers, and controlling persons pursuant to the above provisions,or otherwise, we have been advised that in the opinion of the Securities andExchange Commission such indemnification is against public policy as expressedin the Act and is, therefore, unenforceable.

 

**Item11.  Security Ownership of CertainBeneficial Owners and Management and Related Stockholder Matters.**

 

The following table sets forththe beneficial ownership of our common stock as of March 1, 2005 of:

 

•                  eachperson known by us to beneficially own 5% or more of the shares of outstandingcommon stock;

•                  eachof our executive officers and directors; and

•                  allof our executive officers and directors as a group.

 

Except as otherwise indicated:

 

•                  allshares are beneficially owned, and investment and voting power is held, by thepersons named as owners; and

•                  theaddress for each beneficial owner listed on the following table iseAcceleration Corp., 1050 NE Hostmark Street, Suite 100B, Poulsbo, Washington98370.

 

20

----

 
| **Name of  beneficial owner**                      | ** ** | **Amount of  common stock  beneficially owned** | ** **            | **Percentage ownership  of common stock** | ** ** |
|----------------------------------------------------|------------|-------------------------------------------------|-----------------------|-------------------------------------------|------------|
| Clinton L. Ballard                                 |       | 34,300,000                                      |    (1) | 98.53                                     | %          |
| Diana T. Ballard                                   |       | 34,300,000                                      |    (1)      | 98.53                                     | %          |
| Teresa D. Potasiak                                 |       | 7,500,000                                       |    (1) | 21.54                                     | %          |
| E. Edward Ahrens                                   |       | 10,250                                          |                  | *                                         |       |
| Edward P. Swain, Jr.                               |       | 10,000                                          |                  |  *                                   |       |
| William E. Hoke                                    |       | 10,000                                          |                  |  *                                   |       |
| All officers and directors as a group (5  persons) |       | 34,330,250                                      |                  | 98.62                                     | %          |

 

----

* Less than one percent

 

(1)                                  The shares beneficially owned by Mr. Ballardinclude the shares owned by his wife, Mrs. Ballard, and the shares beneficiallyowned by Mrs. Ballard include the shares owned by Mr. Ballard.  The shares beneficially owned by Mr. Ballardand Mrs. Ballard include an aggregate of 880,000 shares owned of record by theminor children of Mr. Ballard and Mrs. Ballard, as well as an aggregate of23,500,000 shares held in the Ballard Family Trust, an irrevocable trust, forthe 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 trustshares.  Teresa D. Potasiak, as independentvoting trustee for so long as, among other things, Mr. Ballard remains trustee,has the sole right to vote with respect to 7,500,000 shares in the trust orsuch lesser number of shares that the trust may hold.

 

**Item 12.  CertainRelationships and Related Transactions.**

 

We have entered intoemployment agreements with Clinton L. Ballard and Diana T. Ballard, each for afive-year term commencing January 1, 2003, which extends annually thereafterunless we or such person provides 60 days’ notice of termination.  On August 21, 2004, the employment agreementswere further amended to reflect revised salary compensations.  See “Executive Compensation - EmploymentAgreements”.

 

During the fourth quarter of2001 and the first quarter of 2002, we borrowed an aggregate of  $404,000 from Mr. Ballard under various notespayable.  These notes all are payable ondemand and interest is payable monthly on the outstanding balance at 10% perannum.  As of December 31, 2004, thebalance outstanding under these notes, net of repayments, was $101,589.

 

In April 2003, we issued2,000 shares of our common stock to E. Edward Ahrens, our Chief FinancialOfficer.  These shares had a value of$0.03 per share at such time.  In November2003, we issued 5,000 shares of our common stock to Mr. Ahrens.  These shares had a value of $0.04 per shareat such time.

 

In April 2003, we granted abonus of $8,890 to each of Mr. Ballard and to Mrs. Ballard, and, in November2003, we granted a bonus of $13,530 to each of Mr. Ballard and Mrs. Ballard.  Each of these bonuses was granted inaccordance with Mr. Ballard’s and Mrs. Ballard’s respective employmentagreement, as amended.

 

In March 2004, we granted abonus of $17,582 to Mr. Ballard and a bonus of $16,110 to Mrs. Ballard.  Each of these bonuses was granted inaccordance with Mr. Ballard’s and Mrs. Ballard’s respective employmentagreement, as amended.

 

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

 

In October 2004, weauthorized the payment of $200,000 in the form of the payment of a bonus to Mr.Ballard to reimburse Mr. Ballard for certain tax liabilities incurred by him asa result of his ownership interest in the Company while the Company was anS-corporation.

 

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.

 

21

----

 

**Item 13.****   ****Exhibits.**

 

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

 

**Item 14.  PrincipalAccountant Fees and Services.**

 

*Audit Fees*

 

Peterson Sullivan, P.L.L.C.provided audit services to us for our annual report for the fiscal years endedDecember 31, 2004 and 2003. The proposed fees per the engagement letter for theannual financial statements and review of quarterly financial statements for2004 were $44,044.  The fees billed byPeterson Sullivan, P.L.L.C. for the 2003 audit of the annual financialstatements and review of the quarterly financial statements were $34,814.

 

*Audit-RelatedFees*

 

No fees were billed for theyears 2004 and 2003 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 P.L.L.C.billed fees of $13,559 and $20,750 for the years 2004 and 2003, respectively,for professional services rendered for tax advice and planning.

 

*All OtherFees*

 

No fees were billed in eachof 2004 and 2003 for professional services rendered by Peterson SullivanP.L.L.C. for all other services not disclosed above.

 

*AuditCommittee Pre-Approval*

 

Our Audit Committeepre-approved our engagement of Peterson Sullivan, P.L.L.C. to act as ourindependent auditor for our fiscal years ended December 31, 2003 and 2004.  Our Audit Committee also pre-approvedPeterson Sullivan, P.L.L.C. to provide the audit, audit-related, tax servicesand all other services described above. Our independent auditors performed all work only with their full timepermanent employees.

 

22

----

 

eACCELERATIONCORP.

 

CONSOLIDATEDFINANCIAL REPORT

 

DECEMBER31, 2004

 

 

F-1

----

 

CONTENTS

 
|                                                            |   | **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-16 |

 

F-2

----

 

[letterhead]

 

 

 

**REPORTOF INDEPENDENT REGISTERED PUBLIC ACCOUNTING FIRM**

 

 

 

To the Board of Directors

eAcceleration Corp.

Poulsbo, Washington

 

 

 

We have audited theaccompanying consolidated balance sheet of eAcceleration Corp. as of December31, 2004, and the related consolidated statements of operations, stockholders’equity (deficit), and cash flows for the years ended December 31, 2004 and2003.  These consolidated financialstatements are the responsibility of the Company’s management.  Our responsibility is to express an opinionon these consolidated financial statements based on our audits.

 

We conducted our audits inaccordance with auditing standards of the Public Company Accounting OversightBoard (United States).  Those standardsrequire that we plan and perform the audit to obtain reasonable assurance aboutwhether the financial statements are free of material misstatement.  The Company has determined that it is notrequired to have, nor were we engaged to perform, an audit of its internalcontrol over financial reporting.  Ouraudit included consideration of internal control over financial reporting as abasis for designing audit procedures that are appropriate in the circumstances,but not for the purpose of expressing an opinion on the effectiveness of theCompany’s internal control over financial reporting.  Accordingly, we express no such opinion.  An audit includes examining, on a test basis,evidence supporting the amounts and disclosures in the financial statements.  An audit also includes assessing theaccounting principles used and significant estimates made by management, aswell as evaluating the overall financial statement presentation.  We believe that our audits provide areasonable basis for our opinion.

 

In our opinion, theconsolidated financial statements referred to above present fairly, in allmaterial respects, the financial position of eAcceleration Corp. as of December31, 2004, and the results of their operations, and their cash flows for the yearsended December 31, 2004 and 2003, in conformity with accounting principlesgenerally accepted in the United States.

 
| /s/ Peterson  Sullivan PLLC |
|-----------------------------|

 

March 1, 2005

Seattle, Washington

 

F-3

----

 

**eACCELERATION CORP.**

 

**CONSOLIDATED BALANCE SHEET**

**December 31, 2004**

 
| **ASSETS**                                                                                                |   |
|-----------------------------------------------------------------------------------------------------------|--------|
|                                                                                                      |   |   |   |
| Current assets                                                                                            |   |   |   |
| Cash                                                                                                      |   | $ | 604,186 |   |
| Accounts receivable                                                                                       |   | 3,385 |   |
| Net deferred tax asset - current                                                                          |   | 195,323 |   |
| Prepaid expenses and other                                                                                |   | 44,784 |   |
| Income tax receivable                                                                                     |   | 197,643 |   |
|                                                                                                      |   |   |   |
| Total current assets                                                                                      |   | 1,045,321 |   |
|                                                                                                      |   |   |   |
| Property and equipment, net                                                                               |   | 302,530 |   |
| Intangible assets, net                                                                                    |   | 142,762 |   |
| Cash reserves, net                                                                                        |   | 86,881 |   |
| Net deferred tax asset - non-current                                                                      |   | 197,424 |   |
| Other assets                                                                                              |   | 25,326 |   |
| Total assets                                                                                              |   | $ | 1,800,244 |   |
|                                                                                                      |   |   |   |
| **LIABILITIES AND STOCKHOLDERS’ EQUITY  (DEFICIT)**                                                  |   |
|                                                                                                      |   |   |   |
| Current liabilities                                                                                       |   |   |   |
| Accounts payable                                                                                          |   | $ | 763,514 |   |
| Accrued expenses                                                                                          |   | 292,992 |   |
| Deferred revenue, current portion                                                                         |   | 4,746,703 |   |
| Reserve for sales returns and allowances                                                                  |   | 175,252 |   |
| Notes payable to stockholder                                                                              |   | 101,589 |   |
| Total current liabilities                                                                                 |   | 6,080,050 |   |
|                                                                                                      |   |   |   |
| Deferred revenue, less current portion                                                                    |   | 641,209 |   |
|                                                                                                      |   |   |   |
| Total liabilities                                                                                         |   | 6,721,259 |   |
|                                                                                                      |   |   |   |
| Commitments and contingencies                                                                             |   | — |   |
|                                                                                                      |   |   |   |
| Stockholders’ equity (deficit)                                                                       |   |   |   |
| Common stock, par value $0.0001;  100,000,000 shares authorized; 34,812,032 shares issued and outstanding |   | 3,481 |   |
| Additional paid-in capital                                                                                |   | 925,380 |   |
| Accumulated deficit                                                                                       |   | (5,849,876 | ) |
| Total stockholders’ equity (deficit)                                                                 |   | (4,921,015 | ) |
|                                                                                                      |   |   |   |
| Total liabilities and stockholders’ equity  (deficit)                                                |   | $ | 1,800,244 |   |

 

SeeNotes to Consolidated Financial Statements

 

F-4

----

 

**eACCELERATION CORP.**

 

**CONSOLIDATED STATEMENTS OF OPERATIONS**

**For the Years Ended December 31, 2004 and 2003**

 
| ** **                              | ** ** | **2004**   | ** ** | **2003**   | ** ** |
|-----------------------------------------|------------|------------|------------|------------|------------|
|                                    |       |       |       |       |       |
| Revenue                                 |       |       |       |       |       |
| Online software subscriptions, net      |       | $          | 12,712,783 |       | $          | 6,960,349 |   |
| Software licensing                      |       |       |       | 800,000    |       |
| Internet advertising                    |       | 27,406     |       | 38,268     |       |
| Total revenue                           |       | 12,740,189 |       | 7,798,617  |       |
|                                    |       |       |       |       |       |
| Cost of revenue                         |       |       |       |       |       |
| Online software subscriptions service   |       | 8,775,768  |       | 4,015,619  |       |
| Software licensing                      |       |       |       | 705,082    |       |
| Internet advertising                    |       |       |       | 30,970     |       |
| Cost of revenue                         |       | 8,775,768  |       | 4,751,671  |       |
|                                    |       |       |       |       |       |
| Gross profit                            |       | 3,964,421  |       | 3,046,946  |       |
|                                    |       |       |       |       |       |
| Selling expenses                        |       | 4,399,228  |       | 1,954,404  |       |
| General and administrative expenses     |       | 1,519,785  |       | 1,098,480  |       |
|                                    |       |       |       |       |       |
| Loss from operations                    |       | (1,954,592 | )          | (5,938     | )          |
|                                    |       |       |       |       |       |
| Other income (expense)                  |       |       |       |       |       |
| Interest expense                        |       | (20,609    | )          | (57,602    | )          |
| Loss on settlement of litigation        |       | (10,000    | )          | (92,246    | )          |
| Other income                            |       |       |       | 8,919      |       |
| Total other income (expense)            |       | (30,609    | )          | (140,929   | )          |
|                                    |       |       |       |       |       |
| Loss before provision for income tax    |       | (1,985,201 | )          | (146,867   | )          |
|                                    |       |       |       |       |       |
| Foreign tax paid                        |       |       |       | (50,000    | )          |
| Income tax benefit - current            |       | 159,208    |       | 81,116     |       |
| Income tax benefit - deferred           |       | 5,851      |       | 129,304    |       |
|                                    |       |       |       |       |       |
| Total income tax (expense) benefit      |       | 165,059    |       | 160,420    |       |
|                                    |       |       |       |       |       |
| Net income (loss)                       |       | $          | (1,820,142 | )          | $          | 13,553 |   |
|                                    |       |       |       |       |       |
| Basic and diluted per-share information |       |       |       |       |       |
| Net income (loss)                       |       | $          | (0.05      | )          | $          | 0.00 |   |
|                                    |       |       |       |       |       |
| Weighted average shares outstanding     |       |       |       |       |       |
| Basic and diluted                       |       | 34,788,457 |       | 34,501,402 |       |

 

SeeNotes to Consolidated Financial Statements

 

F-5

----

 

**eACCELERATION CORP.**

 

**CONSOLIDATED STATEMENTS OF STOCKHOLDERS’ EQUITY (DEFICIT)****For the Years Ended December 31, 2004 and 2003**

 
| ** **                  | ** ** | **Common Stock  Shares** | ** ** | **Amount** | ** ** | **Additional  Paid-In  Capital** | ** ** | **Accumulated  Deficit** | ** ** | **Stockholders’  Equity  (Deficit)** | ** ** |
|-----------------------------|------------|--------------------------|------------|------------|------------|----------------------------------|------------|--------------------------|------------|-------------------------------------------|------------|
| ** **                  | ** ** | ** **               | ** ** | ** ** | ** ** | ** **                       | ** ** | ** **               | ** ** | ** **                                | ** ** |
| Balances, December 31, 2002 |       | 34,424,500               |       | $          | 3,443      |                             | $          | 789,805                  |       | $                                         | (4,043,287 | ) | $ | (3,250,039 | ) |
|                        |       |                     |       |       |       |                             |       |                     |       |                                      |       |
| Value of stock options      |       |                     |       |       |       | 64,320                           |       |                     |       | 64,320                                    |       |
|                        |       |                     |       |       |       |                             |       |                     |       |                                      |       |
| Value of stock issued       |       | 321,300                  |       | 32         |       | 12,190                           |       |                     |       | 12,222                                    |       |
|                        |       |                     |       |       |       |                             |       |                     |       |                                      |       |
| Net income                  |       |                     |       |       |       |                             |       | 13,553                   |       | 13,553                                    |       |
|                        |       |                     |       |       |       |                             |       |                     |       |                                      |       |
| 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 | ) |

 

SeeNotes to Consolidated Financial Statements

 

F-6

----

 

**eACCELERATION CORP.**

 

**CONSOLIDATED STATEMENTS OF CASH FLOWS****For the Years Ended December 31, 2004 and 2003**  

 
| ** **                                                                               | ** ** | **2004**  | ** ** | **2003** | ** ** |
|------------------------------------------------------------------------------------------|------------|-----------|------------|----------|------------|
| Cash flow from operating activities                                                      |       |      |       |     |       |
| Net Income (Loss)                                                                        |       | $         | (1,820,142 | )        | $          | 13,553 |   |
| Adjustments to reconcile net income (loss)  to net cash provided by operating activities |       |      |       |     |       |
| Depreciation and amortization                                                            |       | 131,761   |       | 95,866   |       |
| Bad debt expense                                                                         |       |      |       | (8,663   | )          |
| Value of stock options                                                                   |       | 45,275    |       | 64,320   |       |
| Issuance of common stock under equity  incentive plan                                    |       | 13,796    |       | 12,222   |       |
|                                                                                     |       |      |       |     |       |
| Changes in operating assets and liabilities                                              |       |      |       |     |       |
| Restricted cash                                                                          |       |      |       | 151,658  |       |
| Accounts receivable                                                                      |       | (3,205    | )          | 12,603   |       |
| Net deferred tax asset                                                                   |       | (18,704   | )          | (374,043 | )          |
| Prepaid expenses and other                                                               |       | 16,546    |       | (43,699  | )          |
| Income tax receivable                                                                    |       | (197,643  | )          |     |       |
| Cash reserves                                                                            |       | 270,304   |       | (296,988 | )          |
| Other assets                                                                             |       | (14,126   | )          | 2,650    |       |
| Accounts payable                                                                         |       | 430,419   |       | (23,101  | )          |
| Accrued expenses                                                                         |       | (130,983  | )          | 218,161  |       |
| Deferred revenue                                                                         |       | 1,955,612 |       | 635,263  |       |
| Reserve for sales returns and allowances                                                 |       | 52,866    |       | 122,386  |       |
| Net cash provided by operating activities                                                |       | 731,776   |       | 582,188  |       |
|                                                                                     |       |      |       |     |       |
| Cash flows from investing activities                                                     |       |      |       |     |       |
| Purchases of equipment                                                                   |       | (273,079  | )          | (86,459  | )          |
| Patent and trademark costs                                                               |       | (42,899   | )          | (39,708  | )          |
| Domain names acquired                                                                    |       | (15,621   | )          | (10,000  | )          |
| Net cash used in investing activities                                                    |       | (331,599  | )          | (136,167 | )          |
|                                                                                     |       |      |       |     |       |
| Cash flows from financing activities                                                     |       |      |       |     |       |
| Payments on notes payable                                                                |       | (292,427  | )          | (314,097 | )          |
| Net cash used in financing activities                                                    |       | (292,427  | )          | (314,097 | )          |
|                                                                                     |       |      |       |     |       |
| Net increase in cash                                                                     |       | 107,750   |       | 131,924  |       |
| Cash at beginning of period                                                              |       | 496,436   |       | 364,512  |       |
|                                                                                     |       |      |       |     |       |
| Cash at end of period                                                                    |       | $         | 604,186    |     | $          | 496,436 |   |
|                                                                                     |       |      |       |     |       |
| Supplemental disclosure of cash flow  information:                                       |       |      |       |     |       |
| Cash paid during the period for interest                                                 |       | $         | 21,017     |     | $          | 65,686 |   |
| Cash paid during the period for taxes                                                    |       | $         | 199,808    |     | $          | 65,103 |   |

 

SeeNotes to Consolidated Financial Statements

 

F-7

----

 

**eACCELERATION CORP.**

 

**NOTES TO CONSOLIDATED FINANCIAL STATEMENTS**

 

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

 

**Company**

 

eAcceleration Corp., aDelaware corporation (the “Company”), is a provider of proprietary software,including its eAcceleration online software subscription service, formerlynamed “eAnthology,” which is distributed directly by the Company via theInternet and, until October 2003, through a distributor in Japan thatexclusively distributed Japanese versions of certain of the Company’s software.The Company has also, in the past, provided Internet-based direct marketing andadvertising services, which the Company de-emphasized in 2002. Currently, theCompany is pursuing additional means of distributing its online softwaresubscription services in addition to its Internet sales.

 

OnMay 14, 2004, the Company and the Company’s wholly owned subsidiary,Acceleration Software International Corporation (“ASIC”), were merged.  Subsequent to the merger, the Company hasassumed all of the rights and obligations of ASIC.

 

**Principlesof Consolidation**

 

The accompanying consolidatedfinancial statements include the accounts of the Company and its wholly-ownedsubsidiary, Acceleration Software International Corporation.  All intercompany accounts and transactions upto and including May 14, 2004, have been eliminated in consolidation.

 

**Liquidity**

** **

The Company’scash flow is dependent on its ability to generate and collect revenues from itssubscription services, and manage its advertising and payroll costs, whichconstitute the two largest variable expense categories.  There can be no assurance, however, that theCompany will recognize sufficient revenues to cover its increasing costs or torecover from its previous losses; nor is there any assurance that the Companywill not incur losses in the future.  Asof December 31, 2004, the Company has a working capital deficit of($5,034,729).  However, $4,746,703 of theCompany’s current liabilities are deferred revenue, representing cashcollections from customers in advance of the recognition of related sales ofonline software subscriptions.  Thisamount will be earned over the subscription period and will not requiresettlement through specific cash payments. The Company’s working capital deficit, net of the current portion ofdeferred revenues is ($288,026).  If theCompany requires additional funds for operations, it believes that itsprincipal stockholders will provide additional funding, if it is unable toobtain financing independently.  However,there is no assurance that such additional funding from its principalstockholders will be available when needed. The Company is also considering seeking additional financing through oneor more debt or equity offerings.

 

**Revenue Recognition**

** **

The Company’ssubscription-based revenue from online software subscription service is deferredand recognized on a straight-line basis monthly, over the life of the user’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.  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.

 

Revenuesrecognized in 2003 under the contract with the Company’s Japanese distributorwere accounted for in accordance with the provisions of SOPs 97-2 and98-9.  The contract contained multipleelements, including post-contract customer support (PCS) and specifiedupgrades.  This contract was terminatedon October 29, 2003.

 

F-8

----

 

The Companyhas employed 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 2004 in connection with theseadvertisements.  Internet advertisingrevenues are recognized in the period in which users execute pre-definedactions related to that advertising.

 

**Cash**

** **

Cash includespetty cash on hand, checking accounts at two local banks, a cash account withan online payment processor, and a money market account with a local bank.  Cash balances exceed federally insured limitsfrom time to time.

 

## **FairValue of Financial Instruments**

##  

The carrying amountsreported for cash, accounts receivable, and accounts payable approximate fairvalue because of their immediate or short-term maturity.  The carrying amount reported for notespayable approximates fair value because of the market rate of interest.

 

**Propertyand Equipment**

 

Property and equipment arerecorded at cost and are depreciated using accelerated methods over theestimated useful lives of the related assets, ranging from three to sevenyears.  Maintenance and repairs arecharged to expense as incurred. Significant renewals and betterments are capitalized.

 

**IntangibleAssets**

 

*Patentsand Trademarks*

 

Patents and trademarks arerecorded at cost.  Patents are amortizedwhen registered using the straight-line method over the estimated useful livesof the related assets ranging from three to five years.  The costs of trademarks are not amortized butare reviewed by management periodically, not less than annually, for impairmentbased on expected future cash flows.

 

*Domain Names and Vanity Telephone Numbers*

 

The costs ofdomain names and vanity telephone numbers have indefinite lives and are treatedas non-amortized intangible assets in accordance with the provisions of SFAS142.  The costs of these intangibleassets are reviewed by management periodically, not less than annually, forimpairment based on expected future cash flows.

 

**CashReserves**

** **

The Company utilizes several credit cardprocessors to process the majority of its subscription sales made over theInternet.  Several of these credit cardprocessors have chosen to withhold cash reserves on the sales processed throughthem in the total amount of $114,081. The company has established an allowance account of $27,200.  The allowance is calculated based on ourexperience with previous processors.

 

**EarningsPer Share**

** **

Basic netincome or loss per share is computed by dividing net income or loss availableto common shareholders by the weighted average number of common sharesoutstanding in the period.  Dilutedearnings per share takes into consideration common shares outstanding (computedunder basic earnings per share) and potentially dilutive common shares.  Potentially dilutive common shares atDecember 31, 2004, and at December 31, 2003 

 

F-9

----

 

consist of shares issuable toholders of outstanding stock options (Note 9). Stock options were not included in either the 2004 or the 2003computation of diluted earnings per share, because they were anti-dilutive.

 

**Stock-Based Compensation**

** **

At December31, 2004, the Company has a stock-based equity incentive plan, which isdescribed more fully in Note 9. Effective January 1, 2003, the Company adopted the fair valuerecognition provisions of FASB Statement 123, “Accounting for Stock-BasedCompensation.”  Under the modifiedprospective method of adoption selected by the Company under the provisions ofFASB Statement 148, “Accounting for Stock-Based Compensation - Transition andDisclosure,” compensation costs recognized in 2004 and 2003 reflect theinclusion of stock-based compensation.

 

**Softwareand 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.

 

Web development costs areaccounted for in accordance with EITF 00-2, “Accounting for Web SiteDevelopment Costs,” with applicable guidance from SOP 98-1, “Accounting for theCosts 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 developmentexpenses are included in costs of revenues and for the years ended December 31,2004 and 2003, were $3,343,048 and $3,392,282, respectively.  There were no amounts capitalized in 2004 of2003.

 

**Advertising Expenses**

** **

**Advertising costs are included in selling expenses and areexpensed as incurred.  Advertisingexpenses for the years ended December 31, 2004 and 2003, were $3,693,868and $1,904,875, respectively.  In 2004,two vendors accounted for 57% of advertising expenses.  In 2003, one vendor accounted for 35% ofadvertising expenses.**

** **

**ComprehensiveIncome**

 

The Company had no items ofother comprehensive income in 2004 or 2003.

 

**IncomeTaxes**

** **

The Company accounts forincome taxes in accordance with the asset and liability method per SFAS No.109. Under the asset and liability method, deferred assets and liabilities arerecognized for the future tax consequences attributable to differences betweenfinancial statement carrying amounts of existing assets and liabilities andtheir respective tax bases, tax credits, and loss carry-forwards.  The provision for income taxes is comprisedof the current tax liability and the change in deferred tax assets andliabilities.  The Company establishes avaluation allowance to the extent it is more likely than not that deferred taxassets will not be recoverable against future taxable income.

 

F-10

----

 

**Commitmentsand Contingencies**

 

*TechnologyRisks*

 

The Company’s operations aresubject to new innovations in product design and function.  Significant technological changes can have anadverse effect on product lives. Innovation, design and development of new products are importantelements to achieve competitive success and profitability in this industry.

 

*Purchase and Sale Agreement*

 

Due to anticipated increasesin space requirements resulting from personnel increases, we have entered intoa Purchase and Sale Agreement with the Bremerton School District No. 100-C forthe purchase of certain real property located in the City of Bremerton,Washington.  The registrant has contingenciesfor financing, appraisal, and obtaining a special use permit for the City ofBremerton that must be satisfied before the sale can be completed. 

 

*Litigation*

 

In October 2003, the Companyentered into a settlement agreement with certain parties who had filed aclass-action lawsuit against the Company in January 2003. The Company hasrecorded a liability, which is included in accrued expenses on the balancesheet, and a corresponding loss on settlement of litigation on the statement ofoperations, of  $92,246 for the estimatedaggregate amount of settlement payments.

 

The company was named asdefendant in a class-action lawsuit filed in December 2003.  Subsequent to December 31, 2004, this lawsuitwas settled for an immaterial amount.  Wedid not have to make any changes to our business practices as a result of thissettlement.

 

**RecentAccounting Pronouncements**

 

The following accountingstandards have been issued in recent months:

 

SFAS No. 151, InventoryCosts, is effective for fiscal years beginning after June 15, 2005.  This statement amends the guidance in APB No.43, Chapter 4, Inventory Pricing, to clarify the accounting for abnormalamounts of idle facility expenses, freight, handling costs, and wasted material(spoilage).  The adoption of SFAS 151 isexpected to have no impact on the Company’s consolidated financial statements.

 

SFASNo. 152, Accounting for Real Estate Time-Sharing Transactions, is effective forfiscal years beginning after June 15, 2005. This statement amends SFAS No. 66, Accounting for Sales of Real Estate,to reference the financial accounting and reporting guidance for real estatetime-sharing transactions that is provided in American Institute of CertifiedPublic Accountants Statement of Position 04-2, Accounting for Real EstateTime-Sharing Transactions.  The adoptionof SFAS No. 152 is expected to have no impact on the Company’s consolidatedfinancial statements.

 

SFAS No. 123(R), Share-BasedPayment, replaces SFAS No. 123, Accounting for Stock-Based Compensation, andsupersedes APB Opinion No. 25, Accounting for Stock Issued to Employees.  This statement requires that the compensationcost relating to share-based payment transactions be recognized in thefinancial statements.  The Company isrequired to apply this statement in the first interim period that begins afterDecember 15, 2005.  The adoption of SFASNo. 123 (R) is expected to have no impact on the Company’s consolidatedfinancial statements.

 

SFAS No. 153, Exchange ofNonmonetary Assets – an amendment of APB Opinion No. 29, is effective forfiscal years beginning after June 15, 2005. This statement addresses the measurement of exchange of nonmonetaryassets and eliminates the exception from fair-value measurement for nonmonetaryexchanges of similar productive assets in paragraph 21(b) of APB Opinion No.29, Accounting for Nonmonetary Transactions, and replaces it with 

 

F-11

----

 

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.

 

**Use ofEstimates**

 

Thepreparation of financial statements in conformity with accounting principlesgenerally accepted in the United States requires management to make estimatesand assumptions that affect the reported amounts of assets and liabilities andthe disclosure of contingent assets and liabilities at the date of thefinancial statements, and the reported amounts of revenue and expenses duringthe reporting period.  Actual resultscould materially differ from those estimates.

 

##### **Note 2. Property and Equipment**

##### ** **

Property and equipment consists of the following as of December 31,2004:

 
| Equipment and furniture     |   | $        | 604,465 |   |
|-----------------------------|--------|----------|---------|--------|
| Leasehold improvements      |   | 16,856   |    |
| Vehicles                    |   | 40,935   |    |
|                        |   | 662,256  |    |
| Accumulated depreciation    |   | (359,726 | )       |
| Property and equipment, net |   | $        | 302,530 |   |

 

During the years ended December31, 2004 and 2003, depreciation expense totaled $116,640 and $74,854respectively.

 

**Note3. Intangible Assets**

 

Intangible assets consist ofthe following at December 31, 2004:

 

 
| Amortizable intangible assets:            |   |     |    |
|-------------------------------------------|--------|----------|---------|
| Patents                                   |   | $        | 153,338 |   |
| Accumulated amortization                  |   | (131,760 | )       |
|                                      |   | 21,578   |    |
|                                      |   |     |    |
| Unamortizable intangible assets:          |   |     |    |
| Patents pending                           |   | 72,358   |    |
| Trademarks                                |   | 23,205   |    |
| Domain names and vanity telephone numbers |   | 25,621   |    |
|                                      |   | 121,184  |    |
|                                      |   |     |    |
| Intangible assets, net                    |   | $        | 142,762 |   |

 

During the years endedDecember 31, 2004 and 2003, amortization expense totaled $15,121 and $21,012,respectively.  Patents are amortizedgenerally over three years due to the rapid rate of obsolescence associatedwith computer and software technology. Patents included in unamortized intangible assets represent applicationsin progress.  The costs are capitalized,but not amortized until the patent is approved and issued.  Unsuccessful applications are expensed.  Since December 31, 2001, trademarks are nolonger amortized in accordance with the adoption of SFAS 142 because they areconsidered to have indefinite lives.

 

F-12

----

 

Amortization expense forcurrent patents will be as follows for the years ended December 31:

 
| 2005                                 |   | $      | 12,002 |   |
|--------------------------------------|--------|--------|--------|--------|
| 2006                                 |   | 6,615  |   |
| 2007                                 |   | 2,961  |   |
| Total amortization expense           |   | 21,578 |   |
| Patents pending                      |   | 72,358 |   |
|                                 |   |   |   |
| Total estimated amortization expense |   | $      | 93,936 |   |

 

Management tests trademarksfor impairment periodically, based on the expected cash flows.  No impairment was determined to have occurredin either 2004 or 2003.

 

Because the Companyconsiders purchased domain names and vanity telephone numbers to be intangibleassets in accordance with the definition of such assets contained in SFAS 142,the Company plans to re-assess the fair value of these assets based on expectedfuture cash flows on a periodic basis, not less than annually, and will recordan impairment if the book value of the assets exceed fair value.  No impairment was determined to have occurredwith respect to these assets during 2004.

 

**Note4.  Notes Payable To Stockholder**

** **

The Company has borrowed anaggregate of $404,000 from the Company’s chief executive officer who is one ofthe principal stockholders, under various promissory notes.  These notes bear interest at 10%, are payableon demand, and require monthly interest-only payments.

 

## **Note5.  Income Taxes**

##  

The Companyrecorded an income tax benefit of $165,059 for the year ended December 31,2004.

 

The Companyalso recorded deferred tax assets and has established a valuation allowance forthose assets for the year ended 2004 as follows:

 
| ** **                                | ** ** | **2004**   | ** ** |
|-------------------------------------------|------------|------------|------------|
|                                      |       |       |       |
| Deferred revenue                          |       | $          | 1,119,813  |   |
| Amortization                              |       | 60,449     |       |
| Reserve for sales returns and allowances  |       | 59,586     |       |
| Accrued vacation                          |       | 62,005     |       |
| Stock option compensation expense         |       | 34,641     |       |
| Depreciation                              |       | 19,204     |       |
| Foreign tax credit carryforwards          |       | 75,166     |       |
| Other                                     |       | 9,561      |       |
| Net operating loss carryforwards          |       | 510,120    |       |
|                                      |       |       |       |
| Total deferred tax assets                 |       | $          | 1,950,545  |   |
| Less: valuation allowance                 |       | (1,557,798 | )          |
| Net deferred taxes                        |       | $          | 392,747    |   |
|                                      |       |       |       |
| Net deferred tax asset - current          |       | $          | 195,323    |   |
| Net deferred tax asset – non-current |       | 197,424    |       |
| Total net deferred tax assets             |       | $          | 392,747    |   |

 

F-13

----

 

The change invaluation allowance from 2003 to 2004 was an increase of $503,170. Thedifference between the statutory federal rate of 34 % and the income taxbenefit of $142,232 for the year ended December 31, 2004 recorded by theCompany is summarized below:

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

 

The Company’s foreign tax creditcarry-forwards of $32,886 and $42,280 will expire in the years 2007 and 2008, respectively.  The company’s net operating loss carryforwardof approximately $1,500,000 will expire in 2024.

 

**Note6.  Business Segment Information**

 

Since all the Company’s operations are locatedin the United States of America, the Company’s geographic revenue informationis based on the country in which the sales originate.  The following table shows the origin ofrevenue for the years ended December 31, 2004 and 2003.  Certain reclassifications have been made tothe 2003 business segment information to conform to the current yearpresentation.  These reclassificationshad no effect on total revenue.

 
| **Year Ended  December 31,** | ** ** | **U.S.A.** | ** ** | **Asia** | ** ** | **All Other  Foreign** | ** ** | **Consolidated  Total** | ** ** |
|------------------------------|------------|------------|------------|----------|------------|------------------------|------------|-------------------------|------------|
|                         |       |       |       |     |       |                   |       |                    |       |
| 2004                         |       | $          | 10,749,987 |     | $          | 153,714                |       | $                       | 1,836,488  |   | $ | 12,740,189 |   |
| 2003                         |       | 5,796,480  |       | 908,651  |       | 1,093,486              |       | 7,798,617               |       |
|                              |            |            |            |          |            |                        |            |                         |            |  |  |  |  |

 

No geographic segment data isshown for long-lived assets, since the Company’s operations reside entirely inthe United States of America.

 

**Note7.  Operating Leases**

 

At December 31, 2004, theCompany leases office space and was committed to five operating leaseagreements and one sub-lease agreement.  Twoof these leases expire in January 2007 and require monthly payments of $9,260and $2,600, respectively, with scheduled increases each year.  In May 2004, the Company entered into asublease for a period of ten months with a payment of $2,540.  The Company expects to continue to lease thisadditional space and enter into a new lease agreement with a two year termexpiring in January 2007.  Two leases,with payments of $613 and $2,979, expire in March 2005 and April 2005,respectively.  The Company is reviewingoptions for renewal of this facility. The final lease expires in March 2007 and has an average monthly paymentof $2,563 with scheduled increases in April 2005 and 2006. The Company records rent expense on astraight-line basis over the life of each lease.

 

The Company’s future non-cancelable annualminimum lease payments at December 31, 2004, are as follows:

 
| 2005 |   | 216,067 |   |
|------|--------|---------|--------|
| 2006 |   | 207,972 |   |
| 2007 |   | 22,279  |   |

 

Total rent expense for the years endedDecember 31, 2004 and 2003, amounted to $216,646 and $110,317, respectively.

 

F-14

----

 

**Note8.  Employment Contracts**

 

The Company has employment agreements in effect with its two principalstockholders.  Each of these agreementsis for a period of five years commencing January 1, 2003, and is renewableannually thereafter unless either party provides 60 days’ notice.  Pursuant to an amendment dated August 2004,the Chairman of the Board’s annual salary was increased to $208,000.  The Vice-Chairman of the Board’s annualsalary was decreased to $52,000.  In2003, each employment agreement provided for an annual base salary of $104,000and a bonus based on the Company’s cash flow as defined in the agreement.

 

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

####  

In March 2004,the Company issued an aggregate of 46,882 shares; in May 2004, the Companyissued an aggregate of 5,800 shares; and in October 2004 the Company issued anaggregate of 13,550 shares of its common stock to employees in the form ofstock bonuses under its 2002 Equity Incentive Plan (the “2002 Plan”), all ofwhich 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 2003, theCompany issued an aggregate of 321,300 shares of its common stock to employeesand non-employees in the form of stock bonuses under the 2002 Plan, all ofwhich shares were registered under the Securities Act of 1933.  The total number of shares reserved andavailable for all types of grants under the 2002 Plan is 5,000,000.  Estimated compensation expense in connectionwith these issuances is an aggregate of $12,222.  The board of directors determined the fairvalue of its common stock, based on an independent appraisal, to be $0.03 and$0.04 per share at the times of issuances of these shares.

 

In March 2004,the Company granted time-based options to employees and directors to purchasean aggregate of 403,000 shares at $0.22; 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 underthe 2002 Plan.  Options granted in2004 to employees were 10-year incentive stock options to purchase shares ofthe Company’s common stock, which become exercisable at the rate of one-tenthof the amount granted on each of the first through tenth anniversaries of thedate of grant.  Options granted tonon-employees are recorded at fair value utilizing the Black-Scholes valuationmethod and are amortized over five years. Options granted to employees are recorded at fair value utilizing theBlack-Scholes valuation method, at the risk-free interest rate (10-yearTreasury note rate) in effect during the grant month, and are amortized over10 years.  Total compensationexpense recognized for the year ended December 31, 2004 was $17,415 foroptions granted to employees and $27,860 for options granted to non-employees.

 

In 2003, theCompany granted time-based options to purchase an aggregate of 392,500 sharesof the Company’s common stock at an exercise price of $0.12 per share under the2002 Plan.  All options granted in 2003were 10-year incentive stock options to purchase shares of the Company’s commonstock granted to employees.  The ten-yearoptions become exercisable at the rate of one-tenth of the amount granted oneach of the first through tenth anniversaries of the date of grant.  Options granted to non-employees in previousyears were recorded at fair value utilizing the Black-Scholes valuation methodand are amortized over five years. Options granted to employees were recorded at fair value utilizing theBlack-Scholes valuation method, at the risk-free interest rate (10-year Treasurynote rate) in effect during the grant month, and are amortized over 10years.  Total compensation expenserecognized in 2003 for options granted to employees was $11,884.  Compensation expense in 2003 for options heldby non-employees was $52,436.

 

F-15

----

 

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, 2002 |       | 824,300           |       | $                                     | 0.62       |   |
| Granted                          |       | 392,500           |       | 0.12                                  |       |
| Cancelled or forfeited           |       | (160,000          | )          | 0.12                                  |       |
|                             |       |              |       |                                  |       |
| 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                                  |       |
|                                  |            |                   |            |                                       |            |  |

 

The following table summarizes stock optionsoutstanding at December 31, 2004:

 
| ** **          | ** ** | **Options Outstanding**                        | ** ** | **Options Exercisable**                           | ** ** |
|---------------------|------------|------------------------------------------------|------------|---------------------------------------------------|------------|
| **Exercise  Price** | ** ** | **Number  Outstanding at  December 31,  2004** | ** ** | **Average  Remaining  Contractual Life  (Years)** | ** ** | **Weighted  Average  Exercise Price** | ** ** | **Number  Exercisable at  December 31,  2004** | ** ** | **Weighted  Average  Exercise Price** | ** ** |
| $                   | 0.12       |                                           | 692,500    |                                              | 9.16       |   | $ | 0.12 |   | 59,500 |   | $ | 0.12 |   |
| 0.18                |       | 228,000                                        |       | 10.00                                             |       | 0.18 |   | — |   | 0.18 |   |
| 0.22                |       | 319,000                                        |       | 9.80                                              |       | 0.22 |   | — |   | 0.22 |   |
| 0.70                |       | 25,000                                         |       | 0.61                                              |       | 0.70 |   | 25,000 |   | 0.70 |   |
| 5.31                |       | 61,800                                         |       | 5.00                                              |       | 5.31 |   | — |   | 5.31 |   |
| 6.25                |       | 12,500                                         |       | 6.00                                              |       | 6.25 |   | — |   | 6.25 |   |
|                |       | 1,338,800                                      |       |                                              |       |   |   | 84,500 |   |   |   |
|                     |            |                                                |            |                                                   |            |  |  |  |  |  |  |  |  |  |

 

The fair value of each option granted isestimated at the date of grant using the Black-Scholes option-pricingmodel.  The assumptions used in calculatingthe fair value of the options granted were as follows:

 
| ** **                    | ** ** | **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       |       | 3.8% to 4.7%                         |       | 4.0% to 4.5%                         |       | 6.00%                                |       | 6.00%                    |       |
|                          |       |                                 |       |                                 |       |                                 |       |                     |       |
| Stock price volatility factor |       | 99%                                  |       | 99%                                  |       | 99%                                  |       | 99%                      |       |
| Expected life of the options  |       | 5 and 10*                            |       | 5 and 10*                            |       | 5 and 10*                            |       | 5 and 10*                |       |
|                          |       | years                                |       | years                                |       | Years                                |       | Years                    |       |
| Dividend yield                |       | 0.00%                                |       | 0.00%                                |       | 0.00%                                |       | 0.00%                    |       |

 

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*                 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-16

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**SIGNATURES**

 

In accordance with Section13 or 15(d) of the Exchange Act, the registrant has duly caused this report tobe signed on its behalf by the undersigned, thereunto duly authorized.

 
| Dated: March 31, 2005 | eAcceleration Corp. |
|----------------------------|---------------------|
|                       |                |
|                       |                |
|                       | By:                 | /s/ Clinton L. Ballard |   |
|                       |                | Clinton L. Ballard |
|                       |                | President and Chief  Executive Officer |

 

**POWER OF ATTORNEY**

 

Pursuant to the requirementsof the Exchange Act, as amended, this annual report on Form 10-KSB has beensigned on March 31, 2005 by the following persons in the capacitiesindicated.  Each person whose signatureappears below constitutes and appoints Clinton L. Ballard, with full power ofsubstitution, his/her true and lawful attorney-in-fact and agent to do any andall acts and things in his/her name and on his/her behalf in his/her capacitiesindicated below which he may deem necessary or advisable to enableeAcceleration Corp. to comply with the Exchange Act, as amended, and any rules,regulations and requirements of the Securities and Exchange Commission, inconnection with this annual report on Form 10-KSB, including specifically, butnot limited to, power and authority to sign for him/her in his/her name in thecapacities stated below, any and all amendments thereto, granting unto saidattorney-in-fact and agent, full power and authority to do and perform each andevery act and thing requisite and necessary to be done in such connection, asfully to all intents and purposes as he/her might or could do in person, herebyratifying and confirming all that said attorney-in-fact and agent, or hissubstitute or substitutes, may lawfully do or cause to be done by virtuethereof.

 
|  /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/ Diana T. Ballard     |                            | Vice Chairman of the  Board, Secretary and Treasurer           |
| Diana T. Ballard               |                            |
|                           |                            |
|  /s/ Edward P. Swain, Jr. |                            | Director                                                       |
| Edward P. Swain, Jr.           |                            |
|                           |                            |
|  /s/ William E. Hoke      |                            | Director                                                       |
| William E. Hoke                |                            |

 

39

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**EXHIBIT INDEX**

 
| **Exhibit No.** | ** ** | **Description of Exhibit**                                                                                                                               |
|-----------------|------------|----------------------------------------------------------------------------------------------------------------------------------------------------------|
|            |       |                                                                                                                                                     |
| 3.2             |       | Amended and Restated  Bylaws of the Company.                                                                                                             |
|            |       |                                                                                                                                                     |
| 10.1            |       | Amendment No. 4 to  Employment Agreement between the Company and Clinton L. Ballard, dated as of  August 21, 2004.                                       |
|            |       |                                                                                                                                                     |
| 10.2            |       | Amendment No. 4 to  Employment Agreement between the Company and Diana T. Ballard, dated as of  August 21, 2004.                                         |
|            |       |                                                                                                                                                     |
| 10.3†      |       | Insertion Order between  the Company and Google Inc., dated as of October 22, 2004 (for purchase of up  to $3,000,000 in domestic advertising space).    |
|            |       |                                                                                                                                                     |
| 10.4†      |       | Insertion Order between  the Company and Google Inc., dated as of October 22, 2004 (for purchase of up  to $120,000 in international advertising space). |
|            |       |                                                                                                                                                     |
| 23.1            |       | Consent of Peterson  Sullivan, P.L.L.C.                                                                                                                  |
|            |       |                                                                                                                                                     |
| 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. |

 

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†              Confidential treatment sought byeAcceleration Corp. from the Securities and Exchange Commission.

 

40

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