** **

**UNITED STATES**

**SECURITIES AND EXCHANGE COMMISSION**

**Washington,D.C. 20549**

 

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# **FORM 10-Q**

 

**ýQUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACTOF 1934**

 

**For thequarterly period ended September 24, 2005**

** **

**or**

 

**oTRANSITION REPORT PURSUANT SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACTOF 1934**

 

**For thetransition period from                 to                 **

** **

**CommissionFile Number 0-25507**

 

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**iPARTY CORP.**

(Exactname of registrant as specified in its charter)

 

| **Delaware**                                                    | ** ** | **76-0547750**                        |
|-----------------------------------------------------------------|------------|---------------------------------------|
| (State  or other jurisdiction of incorporation or organization) |       | (I.R.S.  Employer Identification No.) |

 

| **270 Bridge Street, Suite 301, Dedham,  Massachusetts** | ** ** | **02026**   |
|----------------------------------------------------------|------------|-------------|
| (Address  of principal executive offices)                |       | (Zip  Code) |

 

**(781)329-3952**

(Registrant’s telephone number, including area code)

 

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

 

Indicate by check mark whether theregistrant is an accelerated filer (as defined in Rule 12b-2 of the ExchangeAct).  Yes  o  No  ý

 

Indicate by check mark whether theregistrant is a shell company (as defined in Rule 12b-2 of the ExchangeAct).  Yes  o  No  ý

 

As of November 2, 2005,there were 22,189,147 shares of common stock, $.001 par value, outstanding.

 

 

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**iPARTYCORP.**

**QUARTERLYREPORT ON FORM 10-Q**

**TABLEOF CONTENTS**

 

 
|           |                                                                                                                                  |   |
|----------------|---------------------------------------------------------------------------------------------------------------------------------------|--------|
|           |                                                                                                                                  |   |
| PART 1         | FINANCIAL  INFORMATION                                                                                                                |   |
|           |                                                                                                                                  |   |
| Item 1.        | Financial Statements (Unaudited)                                                                                                      |   |
|           | Consolidated  Balance Sheets — September 24, 2005 and December 25, 2004                                                          |   |
|           | Consolidated  Statements of Operations — Three months and nine months ended  September 24, 2005 and September 25, 2004 |   |
|           | Consolidated  Statements of Cash Flows — Nine months ended September 24, 2005 and September  25, 2004                            |   |
|           | Notes to Consolidated Financial Statements                                                                                            |   |
|           |                                                                                                                                  |   |
| Item 2.        | Management’s  Discussion and Analysis of Financial Condition and Results of Operations                                           |   |
|           |                                                                                                                                  |   |
| Item 3.        | Quantitative  and Qualitative Disclosures about Market Risk                                                                           |   |
|           |                                                                                                                                  |   |
| Item 4.        | Controls and  Procedures                                                                                                              |   |
|           |                                                                                                                                  |   |
| PART II        | OTHER INFORMATION                                                                                                                     |   |
|           |                                                                                                                                  |
| Item 1.        | Legal Proceedings                                                                                                                     |   |
|           |                                                                                                                                  |   |
| Item 2.        | Unregistered  Sales of Equity Securities and Use of Proceeds                                                                          |   |
|           |                                                                                                                                  |   |
| Item 3.        | Defaults upon  Senior Securities                                                                                                      |   |
|           |                                                                                                                                  |   |
| Item 4.        | Submission of  Matters to a Vote of Security Holders                                                                                  |   |
|           |                                                                                                                                  |   |
| Item 5.        | Other Information                                                                                                                     |   |
|           |                                                                                                                                  |
| Item  6.       | Exhibits                                                                                                                              |   |
|           |                                                                                                                                  |   |
| SIGNATURES     |                                                                                                                                  |
|           |                                                                                                                                  |   |
| EXHIBIT  INDEX |                                                                                                                                  |
|           |                                                                                                                                  |   |
| Ex. 31.1       | Certification of Chief Executive  Officer pursuant to Section 302 of the Sarbanes-Oxley Act                                           |   |
|           |                                                                                                                                  |   |
| Ex. 31.2       | Certification of Chief Financial  Officer pursuant to Section 302 of the Sarbanes-Oxley Act                                           |   |
|           |                                                                                                                                  |   |
| Ex. 32.1       | Certification of Chief Executive  Officer pursuant to 18 U.S.C. Section 1350                                                          |   |
|           |                                                                                                                                  |   |
| Ex. 32.2       | Certification of Chief Financial  Officer pursuant to 18 U.S.C. Section 1350                                                          |   |
|                |                                                                                                                                       |        |  |  |

 

1

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**PART I- FINANCIAL INFORMATION**

 

**Item1.    Financial Statements**

 

**iPARTYCORP.**

**CONSOLIDATEDBALANCE SHEETS**

 
| ** **                                                                                                                                                                                                                                       | ** ** | **Sep 24, 2005** | ** ** | **Dec 25, 2004** | ** ** |
|--------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|------------|------------------|------------|------------------|------------|
| ** **                                                                                                                                                                                                                                       | ** ** | **(Unaudited)**  | ** ** | ** **       | ** ** |
| **ASSETS**                                                                                                                                                                                                                                       |       |             |       |             |       |
| Current assets:                                                                                                                                                                                                                                  |       |             |       |             |       |
| Cash and cash equivalents                                                                                                                                                                                                                        |       | $                | 1,001,298  |             | $          | 1,757,157 |   |
| Restricted cash                                                                                                                                                                                                                                  |       | 451,798          |       | 561,407          |       |
| Accounts receivable                                                                                                                                                                                                                              |       | 945,417          |       | 700,961          |       |
| Inventory, net                                                                                                                                                                                                                                   |       | 17,399,118       |       | 11,400,971       |       |
| Prepaid expenses and other assets                                                                                                                                                                                                                |       | 809,662          |       | 476,046          |       |
| Total current assets                                                                                                                                                                                                                             |       | 20,607,293       |       | 14,896,542       |       |
| Property and equipment, net                                                                                                                                                                                                                      |       | 5,311,804        |       | 4,483,705        |       |
| Other assets                                                                                                                                                                                                                                     |       | 102,775          |       | 99,690           |       |
| Total assets                                                                                                                                                                                                                                     |       | $                | 26,021,872 |             | $          | 19,479,937 |   |
|                                                                                                                                                                                                                                             |       |             |       |             |       |
| **LIABILITIES AND STOCKHOLDERS’ EQUITY**                                                                                                                                                                                                    |       |             |       |             |       |
| Current liabilities:                                                                                                                                                                                                                             |       |             |       |             |       |
| Accounts payable                                                                                                                                                                                                                                 |       | $                | 9,459,521  |             | $          | 3,421,195 |   |
| Accrued expenses                                                                                                                                                                                                                                 |       | 3,036,100        |       | 2,615,835        |       |
| Current portion of capital lease obligations                                                                                                                                                                                                     |       | 425,847          |       | 365,674          |       |
| Borrowings under line of credit                                                                                                                                                                                                                  |       | 9,519,470        |       | 5,257,690        |       |
| Total current liabilities                                                                                                                                                                                                                        |       | 22,440,938       |       | 11,660,394       |       |
|                                                                                                                                                                                                                                             |       |             |       |             |       |
| Long-term liabilities:                                                                                                                                                                                                                           |       |             |       |             |       |
| Capital lease obligations, net of current portion                                                                                                                                                                                                |       | 555,150          |       | 796,693          |       |
| Other liabilities                                                                                                                                                                                                                                |       | 565,146          |       | 471,759          |       |
| Total long-term liabilities                                                                                                                                                                                                                      |       | 1,120,296        |       | 1,268,452        |       |
|                                                                                                                                                                                                                                             |       |             |       |             |       |
| Commitments and  contingencies                                                                                                                                                                                                                   |       |             |       |             |       |
|                                                                                                                                                                                                                                             |       |             |       |             |       |
| Stockholders’ equity:                                                                                                                                                                                                                       |       |             |       |             |       |
| Convertible preferred stock - $.001 par value; 10,000,000 shares  authorized,                                                                                                                                                                    |       |             |       |             |       |
| Series B convertible preferred stock - 1,150,000 shares authorized;  501,402 and 507,460 shares issued and outstanding at September 24, 2005 and  Dec 25, 2004, respectively (aggregate liquidation value of $10,028,039 at  September 24, 2005) |       | 7,460,861        |       | 7,551,002        |       |
| Series C convertible preferred stock - 100,000 shares authorized,  issued and outstanding (aggregate liquidation value of $2,000,000 at  September 24, 2005)                                                                                     |       | 1,492,000        |       | 1,492,000        |       |
| Series D convertible preferred stock - 250,000 shares authorized,  issued and outstanding (aggregate liquidation value of $5,000,000 at  September 24, 2005)                                                                                     |       | 3,652,500        |       | 3,652,500        |       |
| Series E convertible preferred stock - 296,667 shares authorized,  issued and outstanding (aggregate liquidation value of $1,112,500 at  September 24, 2005)                                                                                     |       | 1,112,500        |       | 1,112,500        |       |
| Series F convertible preferred stock - 114,286 shares authorized,  issued and outstanding (aggregate liquidation value of $500,000 at September  24, 2005)                                                                                       |       | 500,000          |       | 500,000          |       |
| Total convertible preferred stock                                                                                                                                                                                                                |       | 14,217,861       |       | 14,308,002       |       |
|                                                                                                                                                                                                                                             |       |             |       |             |       |
| Common stock - $.001 par value; 150,000,000 shares authorized;  22,189,147 and 22,092,717 shares issued and outstanding at September 24, 2005  and Dec 25, 2004, respectively                                                                    |       | 22,189           |       | 22,093           |       |
|                                                                                                                                                                                                                                             |       |             |       |             |       |
| Additional paid-in capital                                                                                                                                                                                                                       |       | 50,570,243       |       | 50,448,100       |       |
| Accumulated deficit                                                                                                                                                                                                                              |       | (62,349,655      | )          | (58,227,104      | )          |
| Total stockholders’ equity                                                                                                                                                                                                                  |       | 2,460,638        |       | 6,551,091        |       |
|                                                                                                                                                                                                                                             |       |             |       |             |       |
| Total liabilities and  stockholders’ equity                                                                                                                                                                                                 |       | $                | 26,021,872 |             | $          | 19,479,937 |   |

 

The accompanying notesare an integral part of these Consolidated Financial Statements.

 

2

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**iPARTYCORP.**

**CONSOLIDATEDSTATEMENTS OF OPERATIONS**

**(Unaudited)**

 
| ** **                                | ** ** | **For the three months ended** | ** ** | **For the nine months ended** | ** ** |
|-------------------------------------------|------------|--------------------------------|------------|-------------------------------|------------|
| ** **                                | ** ** | **Sep 24, 2005**               | ** ** | **Sep 25, 2004**              | ** ** | **Sep 24, 2005** | ** ** | **Sep 25, 2004** | ** ** |
| Revenues                                  |       | $                              | 14,839,051 |                          | $          | 13,157,546 |   | $ | 44,516,336 |   | $ | 40,554,000 |   |
| Operating costs:                          |       |                           |       |                          |       |   |   |   |   |
| Cost of products sold and occupancy costs |       | 9,042,165                      |       | 7,897,580                     |       | 26,752,342 |   | 23,454,594 |   |
| Marketing and sales                       |       | 6,204,540                      |       | 5,276,532                     |       | 16,316,817 |   | 14,367,835 |   |
| General and administrative                |       | 1,852,047                      |       | 1,509,548                     |       | 5,187,189 |   | 4,674,898 |   |
|                                      |       |                           |       |                          |       |   |   |   |   |
| Operating loss                            |       | (2,259,701                     | )          | (1,526,114                    | )          | (3,740,012 | ) | (1,943,327 | ) |
|                                      |       |                           |       |                          |       |   |   |   |   |
| Other income                              |       | —                         |       | 28,000                        |       | — |   | 382,500 |   |
|                                      |       |                           |       |                          |       |   |   |   |   |
| Loss before interest                      |       | (2,259,701                     | )          | (1,498,114                    | )          | (3,740,012 | ) | (1,560,827 | ) |
|                                      |       |                           |       |                          |       |   |   |   |   |
| Interest income                           |       | 477                            |       | 271                           |       | 758 |   | 1,280 |   |
| Interest expense                          |       | (151,437                       | )          | (77,580                       | )          | (383,298 | ) | (148,900 | ) |
|                                      |       |                           |       |                          |       |   |   |   |   |
| Net loss                                  |       | $                              | (2,410,661 | )                             | $          | (1,575,423 | ) | $ | (4,122,552 | ) | $ | (1,708,447 | ) |
|                                      |       |                           |       |                          |       |   |   |   |   |
| Basic and diluted net loss per share      |       | $                              | (0.11      | )                             | $          | (0.07 | ) | $ | (0.19 | ) | $ | (0.08 | ) |
|                                      |       |                           |       |                          |       |   |   |   |   |
| Weighted-average shares outstanding:      |       |                           |       |                          |       |   |   |   |   |
| Basic and diluted                         |       | 22,147,063                     |       | 22,019,408                    |       | 22,123,289 |   | 21,123,511 |   |

 

The accompanying notesare an integral part of these Consolidated Financial Statements.

 

3

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**iPARTYCORP.**

**CONSOLIDATEDSTATEMENTS OF CASH FLOWS**

 
| ** **                                                                   | ** ** | **For the nine months ended** | ** ** |
|------------------------------------------------------------------------------|------------|-------------------------------|------------|
| ** **                                                                   | ** ** | **Sep 24, 2005**              | ** ** | **Sep 25, 2004** | ** ** |
| **Operating activities:**                                                    |       |                          |       |   |   |
|                                                                         |       |                          |       |   |   |
| Net loss                                                                     |       | $                             | (4,122,552 | ) | $ | (1,708,447 | ) |
| Adjustments to reconcile net loss to net cash used in operating  activities: |       |                          |       |   |   |
| Depreciation and amortization                                                |       | 785,693                       |       | 406,576 |   |
| Deferred rent                                                                |       | 93,387                        |       | 38,723 |   |
| Changes in operating assets and liabilities:                                 |       |                          |       |   |   |
| Accounts receivable                                                          |       | (244,456                      | )          | (350,294 | ) |
| Inventory                                                                    |       | (5,998,147                    | )          | (5,548,275 | ) |
| Prepaid expenses and other assets                                            |       | 56,431                        |       | 29,682 |   |
| Accounts payable                                                             |       | 6,038,326                     |       | 4,697,756 |   |
| Accrued expenses and other liabilities                                       |       | 45,830                        |       | 143,980 |   |
| Net cash used in operating activities                                        |       | (3,345,488                    | )          | (2,290,299 | ) |
|                                                                         |       |                          |       |   |   |
| **Investing activities:**                                                    |       |                          |       |   |   |
|                                                                         |       |                          |       |   |   |
| Purchase of property and equipment                                           |       | (1,480,824                    | )          | (1,648,300 | ) |
| Net cash used in investing activities                                        |       | (1,480,824                    | )          | (1,648,300 | ) |
|                                                                         |       |                          |       |   |   |
| **Financing activities:**                                                    |       |                          |       |   |   |
|                                                                         |       |                          |       |   |   |
| Net borrowings under line of credit                                          |       | 4,261,780                     |       | 2,499,908 |   |
| Increase (decrease) in restricted cash                                       |       | 109,609                       |       | (59,031 | ) |
| Principal payments on capital lease obligations                              |       | (314,338                      | )          | (72,995 | ) |
| Deferred financing costs                                                     |       | 9,804                         |       | (32,921 | ) |
| Proceeds from exercise of stock options                                      |       | 3,598                         |       | 4,529 |   |
| Net cash provided by financing activities                                    |       | 4,070,453                     |       | 2,339,490 |   |
|                                                                         |       |                          |       |   |   |
| **Net decrease in cash and cash equivalents**                                |       | (755,859                      | )          | (1,599,109 | ) |
|                                                                         |       |                          |       |   |   |
| **Cash and cash equivalents, beginning of period**                           |       | 1,757,157                     |       | 2,442,471 |   |
|                                                                         |       |                          |       |   |   |
| **Cash and cash equivalents, end of period**                                 |       | $                             | 1,001,298  |   | $ | 843,362 |   |
|                                                                         |       |                          |       |   |   |
| Supplemental disclosure of non-cash financing activities:                    |       |                          |       |   |   |
|                                                                         |       |                          |       |   |   |
| Conversion of Series A convertible preferred stock to common stock           |       | $                             | —     |   | $ | 1,000,000 |   |
| Conversion of Series B convertible preferred stock to common stock           |       | 90,141                        |       | 1,541,869 |   |
| Conversion of Series E convertible preferred stock to common stock           |       | —                        |       | 347,895 |   |
| Total conversion of convertible preferred stock to common stock              |       | $                             | 90,141     |   | $ | 2,889,764 |   |
|                                                                         |       |                          |       |   |   |
| Acquisition of assets under capital lease                                    |       | $                             | 132,968    |   | $ | 891,465 |   |

 

The accompanying notesare an integral part of these Consolidated Financial Statements.

 

4

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** **

**iPARTY CORP.**

**NOTES TO CONSOLIDATED FINANCIAL STATEMENTS**

**September 24, 2005**

**(Unaudited)**

 

 

**1.  BASIS OF PRESENTATION AND SIGNIFICANTACCOUNTING POLICIES**:

 

*Interim Financial Information*

 

**The interim consolidated financialstatements as of September 24, 2005 have been prepared by the Company pursuantto the rules and regulations of the Securities and Exchange Commission (the “SEC”)for interim financial reporting.  Theseconsolidated statements are unaudited and, in the opinion of management,include all adjustments (consisting of normal recurring adjustments andaccruals) necessary to present fairly the consolidated balance sheets,consolidated operating results, and consolidated cash flows for the periodspresented in accordance with generally accepted accounting principles.  The consolidated balance sheet at December25, 2004 has been derived from the audited consolidated financial statements atthat date.  Operating results for theCompany on a quarterly basis may not be indicative of the results for the entireyear due, in part, to the seasonality of the party goods industry.  Historically, higher revenues and operatingincome have been experienced in the second and fourth fiscal quarters.  Certain information and footnote disclosuresnormally included in financial statements prepared in accordance with generallyaccepted accounting principles have been omitted in accordance with the rulesand regulations of the SEC.  Theseconsolidated financial statements should be read in conjunction with theaudited consolidated financial statements, and accompanying notes, included inthe Company’s Annual Report on Form 10-K, as amended, for the year endedDecember 25, 2004.**

 

*Principles of Consolidation*

 

The consolidated financialstatements include the accounts of the Company and its wholly-ownedsubsidiaries after elimination of all significant intercompany transactions andbalances.

 

*Revenues**Recognition*

 

Revenues include the sellingprice of party goods sold, net of returns and discounts, and are recognized atthe point of sale.  The Company estimatesreturns based upon historical return rates and such amounts have not beensignificant.

 

*Concentrations*

 

The Company purchases its inventory from a diverse group ofvendors and is not overly dependent upon any single source for its merchandise,often using more than one vendor for similar kinds of products.

 

Accounts receivable primarily represent amounts duefrom credit card companies and vendors for inventory rebates.  Management does not provide for doubtfulaccounts as such amounts have not been significant to date; the Company does not requirecollateral.

 

*Use of Estimates*

 

The preparation of financialstatements in conformity with accounting principles generally accepted in theUnited States requires management to make estimates and assumptions that affectthe reported amounts of assets and liabilities and disclosure of contingentassets and liabilities at the date of the financial statements and the reportedamounts of revenues and expenses during the reporting period.  Actual results could differ from theseestimates.

 

5

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*Cash and Cash Equivalents and Restricted Cash*

 

The Company considers allhighly liquid investments with an original maturity date of three months or lessto be cash equivalents.  Cash equivalentsconsist primarily of money market accounts and are carried at cost plus accruedinterest, which approximates fair value.

 

TheCompany uses controlled disbursement banking arrangements as part of its cashmanagement program.  Outstanding checks, which were included in accountspayable, totaled $1,071,143 at September 24, 2005 and $950,156 at December 25,2004.  The Company had sufficient fundsavailable to fund the outstanding checks when they were presented for payment.

 

Restrictedcash represents money deposited in blocked accounts established for the benefitof and under the control of Wells Fargo Retail Finance II, LLC, the Company’slender under its line of credit, and constitutes collateral for amounts outstandingunder the Company’s line of credit.

 

*Fair**Value**of FinancialInstruments*

 

The carrying values of cash and cash equivalents,accounts receivable and accounts payable approximate fair value because of the short-term nature of theseinstruments.  The fair value ofborrowings under its line of credit approximates carrying value because thedebt bears interest at a variable market rate.

 

*Inventories*

 

Inventoriesconsist of party supplies and are valued at the lower of movingweighted-average cost or market.  Inventory has been reduced by an allowance forobsolete and excess inventory, which is based on management’s review ofinventories on hand compared to estimated future sales.  The activity in the allowance for obsoleteand excess inventory is as follows:

 

| ** **                 | ** ** | **Sep 24, 2005** | ** ** | **Dec 25, 2004** | ** ** |
|----------------------------|------------|------------------|------------|------------------|------------|
| Beginning balance          |       | $                | 1,296,855  |             | $          | 1,400,262 |   |
| Increases to reserve       |       | 196,477          |       | 200,000          |       |
| Write-offs against reserve |       | (368,375         | )          | (303,407         | )          |
| Ending balance             |       | $                | 1,124,975  |             | $          | 1,296,855 |   |

 

TheCompany records vendor rebates,discounts and certain other adjustments to inventory, including freight costs,and these amounts are recognized in the income statement as the related goodsare sold.

 

*Net**Income**(Loss) per Share*

 

Net income per basic shareis computed by dividing net income by the weighted-average number of commonshares outstanding plus the common share equivalents of all outstanding SeriesB, C, D, E and F convertible preferred stock. The common share equivalents of Series B, C, D, E and F convertiblepreferred stock are included in the calculation of net income per basic sharein accordance with EITF Topic D-95, Effect of Participating ConvertibleSecurities on the Computation of Basic Earnings Per Share, since theseconvertible preferred stockholders are entitled to participate in dividendswhen and if declared by the Board of Directors. For the periods with net losses, the Company excludes those common shareequivalents since their impact would be anti-dilutive.

 

Net income per diluted shareis computed by dividing net income by the weighted-average number of commonshares outstanding, plus the common share equivalents of all outstanding SeriesB, C, D, E and F convertible preferred stock, plus the common share equivalentsof the “in the money” stock options and warrants as computed by the treasurymethod.  For the periods with net losses,the Company excludes those common share equivalents since their impact would beanti-dilutive.

 

On August 26, 2005, a totalof 5,723,512 warrants issued in connection with the issuance of Series B andSeries C convertible preferred stock which were exercisable for 9,157,619shares of common stock expired.

 

6

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On September 10, 2005, atotal of 929,929 warrants issued in connection with the issuance of Series Econvertible preferred stock which were exercisable for 1,487,886 shares ofcommon stock expired.

 

As of September 24, 2005,there were 28,273,403 potential additional common share equivalentsoutstanding, which were not included in the calculation of basic and dilutednet loss per share because their effect would be anti-dilutive.  These included 15,535,370 shares upon theconversion of immediately convertible preferred stock, 2,365,711 shares uponthe exercise of warrants with a weighted-average exercise price of $1.90 and10,372,322 shares upon the exercise of stock options with a weighted-averageexercise price of $0.95.

 

*StockOption Compensation Expense*

 

The Company accounts for itsstock option compensation agreements with employees under the provisions ofAccounting Principles Board (“APB”) Opinion No. 25, *Accountingfor Stock Issued to Employees*. The Company has adopted the disclosure-only provisions of Statement ofFinancial Accounting Standards (“SFAS”) No. 123, *Accounting forStock-Based Compensation*.

 

In response to FAS No. 123R,on September 21, 2005, our Board of Directors approved an acceleration of thevesting of certain unvested and “out-of-the-money” stock options previouslyawarded to employees and officers with exercise prices equal to or greater than$0.69 per share.  Options held bynon-employee directors were excluded from the vesting acceleration.  As a result, options to purchase approximately1.0 million shares of iParty stock became exercisable immediately.  Based upon our closing stock price of $0.46on September 21, 2005, none of these options had economic value on the date ofacceleration.

 

In making the decision toaccelerate these options, the Company’s Board of Directors considered theinterest of the stockholders as it will reduce the company’s reportedcompensation expense in future periods following the effectiveness of FAS No.123R. The future stock option expense that was eliminated was approximately$508,000 on a pre-tax basis and is reflected in the pro forma footnotedisclosure for the three and nine months ended September 24, 2005.

 

The Company has computed thevalue of options using the Black-Scholes option pricing model prescribed bySFAS No. 123.  The weighted-average fairvalue of the options granted was $0.36 per share during the third quarter offiscal 2005 and $0.59 per share during the third quarter of fiscal 2004, usingthe following assumptions:  no dividendyield, volatility of 109% in 2005 and 117% in 2004, a risk-free interest rateof 4.01% in the third quarter of fiscal 2005 and 3.26% in the third quarter offiscal 2004 and an expected life of five years from the date of the grant.  If compensation cost for the Company’s stockoption plan been determined based upon the fair value at the grant date forawards under the plan consistent with the methodology prescribed under SFAS123, the Company’s net loss and net loss per share would have been thefollowing pro forma amounts:

 
| ** **                        | ** ** | **For the three months ended** | ** ** | **For the nine months ended** | ** ** |
|-----------------------------------|------------|--------------------------------|------------|-------------------------------|------------|
| ** **                        | ** ** | **Sep 24, 2005**               | ** ** | **Sep 25, 2004**              | ** ** | **Sep 24, 2005** | ** ** | **Sep 25, 2004** | ** ** |
| Net income (loss):                |       |                           |       |                          |       |   |   |   |   |
| Reported                          |       | $                              | (2,410,661 | )                             | $          | (1,575,423 | ) | $ | (4,122,552 | ) | $ | (1,708,447 | ) |
| Stock option compensation expense |       | (717,743                       | )          | (117,460                      | )          | (927,744 | ) | (652,745 | ) |
| Pro forma                         |       | $                              | (3,128,404 | )                             | $          | (1,692,883 | ) | $ | (5,050,296 | ) | $ | (2,361,192 | ) |
|                              |       |                           |       |                          |       |   |   |   |   |
| Net income (loss) per  share:     |       |                           |       |                          |       |   |   |   |   |
| Reported                          |       |                           |       |                          |       |   |   |   |   |
| Basic and diluted:                |       | $                              | (0.11      | )                             | $          | (0.07 | ) | $ | (0.19 | ) | $ | (0.08 | ) |
| Pro forma                         |       |                           |       |                          |       |   |   |   |   |
| Basic and diluted:                |       | $                              | (0.14      | )                             | $          | (0.08 | ) | $ | (0.23 | ) | $ | (0.11 | ) |

 

7

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*Property and Equipment*

 

Propertyand equipment are stated at cost less accumulated depreciation and aredepreciated on the straight-line method over the estimated useful lives of theassets.  Expenditures for maintenance andrepairs are charged to operations as incurred. A listing of the estimated useful life of the various categories ofproperty and equipment is as follows:

 

| **Asset Classification**        | ** ** | **Estimated Useful Life**            |
|---------------------------------|------------|--------------------------------------|
| Leasehold  improvements         |       | Lesser of term  of lease or 10 years |
| Furniture and  fixtures         |       | 7 years                              |
| Computer  hardware and software |       | 3 years                              |
| Equipment                       |       | 5 years                              |

 

*Accounting for the Impairment of Long-Lived Assets*

 

In accordance with SFAS No.144, Accounting for the Impairment or Disposal of Long-Lived Assets, theCompany reviews each store for impairment indicators whenever events andchanges in circumstances suggest that the carrying amounts may not berecoverable from estimated future store cash flows.  Our review considersstore operating results, future sales growth and cash flows.

 

**Item2.    Management’s Discussion and Analysisof Financial Condition and Results of Operations**

 

This information should beread in conjunction with the unaudited consolidated financial statements andrelated notes included in Item 1 of this Quarterly Report on Form 10-Q and theaudited consolidated financial statements and related notes and Item 7,Management’s Discussion and Analysis of Financial Condition and Results ofOperations, contained in our Annual Report on Form 10-K, as amended, for thefiscal year ended December 25, 2004.

 

**ForwardLooking Statements**

 

This Quarterly Report onForm 10-Q, including this discussion and analysis by management, contains orincorporates forward-looking statements within the meaning of Section 27A ofthe Securities Act of 1933, as amended, and Section 21E of the SecuritiesExchange Act of 1934, as amended.  Theseforward-looking statements are based on current expectations, estimates,forecasts and projections about the industry and markets in which we operateand our management’s beliefs and assumptions. In addition, other written or oral statements that constituteforward-looking statements may be made by or on our behalf.  Words such as “expect”, “anticipate”, “intend”,“plan”, “believe”, “seek”, estimate”, variations of such words and similarexpressions are intended to identify such forward-looking statements.  These statements are not guarantees of futureperformance and involve certain risks, uncertainties and assumptions that aredifficult to predict.  We have includedimportant factors in the cautionary statements below under the heading “FactorsThat May Affect Future Results” that we believe could cause our actual resultsto differ materially from the forward-looking statements we make.  We do not intend to update publicly anyforward-looking statements, whether as a result of new information, futureevents or otherwise.

 

**Overview**

 

We believe we are a leadingbrand in the party industry in the markets we serve and a leading resource inthose markets for consumers seeking party goods, party planning advice andparty-related information.  We are aparty goods retailer operating stores throughout New England, where 45 of our50 retail stores are located.  Our otherfive stores are located in Florida.  Wealso license the name “iparty.com” (at www.iparty.com) to a third party inexchange for royalties from Internet sales, which to date have not beensignificant.

 

8

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The following table shows the number ofstores in operation:

 
| ** **          | ** ** | **For the three months ended** | ** ** | **For the nine months ended** | ** ** |
|---------------------|------------|--------------------------------|------------|-------------------------------|------------|
| ** **          | ** ** | **Sep 24, 2005**               | ** ** | **Sep 25, 2004**              | ** ** | **Sep 24, 2005** | ** ** | **Sep 25, 2004** | ** ** |
| Beginning of period |       | 45                             |       | 40                            |       | 44 |   | 38 |   |
| Openings            |       | 5                              |       | 2                             |       | 6 |   | 4 |   |
| Closings            |       | —                         |       | —                        |       | — |   | — |   |
| End of period       |       | 50                             |       | 42                            |       | 50 |   | 42 |   |

 

Our stores feature over20,000 products ranging from greeting cards and balloons to more uniquemerchandise such as piñatas, tiny toys, masquerade and Hawaiian Luauitems.  Our sales are driven by thefollowing events:  Halloween, Christmas,Easter, Valentine’s Day, New Year’s, Independence Day, St. Patrick’s Day,Thanksgiving and Chanukah.  We also focusour business closely on lifetime events such as anniversaries, graduations,birthdays, and bridal or baby showers. The following table shows a summary of our revenues and the increase inrevenues from the prior year periods:

 
| ** **           | ** ** | **For the three months ended** | ** ** | **For the nine months ended** | ** ** |
|----------------------|------------|--------------------------------|------------|-------------------------------|------------|
| ** **           | ** ** | **Sep 24, 2005**               | ** ** | **Sep 25, 2004**              | ** ** | **Sep 24, 2005** | ** ** | **Sep 25, 2004** | ** ** |
| Revenues             |       | $                              | 14,839,051 |                          | $          | 13,157,546 |   | $ | 44,516,336 |   | $ | 40,554,000 |   |
|                 |       |                           |       |                          |       |   |   |   |   |
| Increase in revenues |       | 12.8                           | %          | 10.8                          | %          | 9.8 | % | 12.7 | % |
|                      |            |                                |            |                               |            |  |  |  |  |  |  |  |  |

 

Our business has a seasonalpattern.  In the past three years we haverealized over one-third of our annual revenues in our fourth quarter, whichincludes Halloween and Christmas, and approximately 25% of our revenues in thesecond quarter, which includes school graduations.  Also, during the past three years, we havehad net income in our second and fourth quarters and generated losses in ourfirst and third quarters.

 

**Results of Operations**

 

Fiscal year 2005 has 53weeks and ends on December 31, 2005. Fiscal year 2004 had 52 weeks and ended on December 25, 2004.

 

The third quarter of fiscalyear 2005 had 13 weeks and ended on September 24, 2005.  The third quarter of fiscal year 2004 had 13weeks and ended on September 25, 2004.

 

**Three Months EndedSeptember 24, 2005 Compared to Three Months Ended September 25, 2004**

 

*Revenues*

 

Our consolidated revenuesfor the third quarter of fiscal 2005 were $14,839,051, an increase of$1,681,505, or 12.8% from the third quarter of the prior fiscal year.  Revenues include the selling price of partygoods sold, net of returns and discounts, and are recognized at the point ofsale.

 

Sales for the third quarterof fiscal 2005 included sales from eight new stores that opened subsequent tothe third quarter of 2004, as well as an increase of 2.5% in comparable storesales.  Comparable store sales are definedas sales from those stores open for at least one full year.  The increase in comparable store sales wasmostly driven by higher sales of Boston Red Sox related merchandise which wefeel was due to increased exposure for our brand through our Red Sox sponsorshipprogram as well as better inventory levels.

 

*Cost of goods sold and occupancy costs*

 

Our cost of goods sold andoccupancy costs for the third quarter of fiscal 2005 was $9,042,165, or 60.9%of revenues, an increase of $1,144,585 and an increase of 0.9 percentagepoints, as a percentage of revenues, from the third quarter of the prior fiscalyear.  Cost of goods sold and occupancycosts consists of the cost of merchandise

 

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sold to customers and the occupancy costs forour stores.  As a percentage of revenues,the increase was primarily attributable to our new stores, which operate at ahigher occupancy to sales ratio until they reach maturity.

 

*Marketing and sales expense*

 

Our consolidated marketingand sales expense for the third quarter of fiscal 2005 was $6,204,540, or 41.8%of revenues, an increase of $928,008 and an increase of 1.7 percentage points,as a percentage of revenues, from the third quarter of the prior fiscalyear.  Marketing and sales expenseconsists primarily of advertising and promotional expenditures, all storepayroll and related expenses for personnel engaged in marketing and sellingactivities and other non-payroll expenses associated with operating ourstores.  As a percentage of revenues, theincrease in marketing and sales expense was primarily due to increasedadvertising, including our sponsorship program with the Boston Red Sox, andhigher depreciation expenses related to the acquisition of fixed assets for newstores.

 

*General and administrative expense*

 

Our consolidated general andadministrative (“G&A”) expense for the third quarter of fiscal 2005 was$1,852,047, or 12.5% of revenues, an increase of $342,499 and 1.0 percentagepoints, as a percentage of revenues, from the third quarter of fiscal2004.  G&A expense consists ofpayroll and related expenses for executive, merchandising, finance andadministrative personnel, as well as information technology, professional feesand other general corporate expenses. The increase in G&A expense is largely attributable to consultantcosts associated with the selection of a new merchandise system that we arecurrently planning to install in 2006.

 

*Other income*

 

In the second quarter offiscal 2004 we reached a settlement with a third party in connection with thespecial charge pertaining to our preferred stock previously recorded in fiscalyear 2002.  We had recorded a netsettlement of $354,500 in the second quarter of 2004 and we recorded a finaladjustment of $28,000, relating to this previously recorded amount, in thethird quarter of 2004 as other income.

 

*Interest expense*

 

Our interest expense in thethird quarter of fiscal 2005 was $151,437, an increase of $73,857 from thethird quarter of fiscal 2004.  Theincrease in the third quarter of fiscal 2005 as compared to the prior fiscalyear was due to a higher average loan balance, increase in interest rates andadditional interest expense resulting from capital leases associated with ournew point-of-sale system that were executed in the third quarter of fiscal 2004. Our average loan balance wasapproximately $6,691,000 during the third quarter of fiscal 2005 compared to$4,531,000 in the third quarter of fiscal 2004, which increased interestexpense by approximately $40,500.  Theeffective interest rate on our borrowings under our line of credit increased to7.5% during the third quarter of fiscal 2005 compared to 5.4% in the thirdquarter of fiscal 2004, which increased interest expense by approximately$24,000.  The interest rate is based onthe bank’s base rate plus 50 basis points.

 

*Income taxes*

 

We have not provided forincome taxes for the third quarter of fiscal 2005 or fiscal 2004 due to theuncertainty of future taxable income.

 

At the end of fiscal 2004 wehad estimated net operating loss carryforwards of approximately $23.0 million,which begin to expire in 2018.  Inaccordance with Section 382 of the Internal Revenue Code, the use of thesecarryforwards will be subject to annual limitations based upon certainownership changes of our stock that have occurred or that may occur.

 

*Net Loss*

 

Our net loss in the thirdquarter of fiscal 2005 was $2,410,661, or $0.11 per basic and diluted share,compared to a net loss of $1,575,423, or $0.07 per basic and diluted share, inthe third quarter of fiscal 2004.

 

10

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**Ninemonths ended September 24, 2005 compared to nine months ended September 25,2004**

 

*Revenues*

 

Our consolidated revenuesfor the first nine months of fiscal 2005 were $44,516,336, an increase of$3,962,336, or 9.8% from the first nine months of the prior fiscal year.  Revenues include the selling price of partygoods sold, net of returns and discounts, and are recognized at the point ofsale.

 

Sales for the first ninemonths of fiscal 2005 included sales from eight new stores that opened sincethe end of the third quarter of 2004, as well as a slight increase of 0.4% incomparable store sales.  Comparable storesales are defined as sales from those stores open for at least one fullyear.  Comparable store sales for thefirst nine months of fiscal 2005 were affected by the severe weather thatimpacted our New England region stores during the first quarter of 2005.

 

*Cost of goods sold and occupancy costs*

 

Our cost of products soldand occupancy costs for the first nine months of fiscal 2005 was $26,752,342,or 60.1% of revenues, an increase of $3,297,748 and an increase of 2.3percentage points, as a percentage of revenues, from the first nine months ofthe prior fiscal year.  Cost of productssold and occupancy costs consists of the cost of merchandise sold to customersand the occupancy costs for our stores. As a percentage of revenues, the increase was attributable to our newstores, which operate at a higher occupancy to sales ratio until they reachmaturity, and increases in our product costs charged to us by certain keyvendors.

 

*Marketing and sales expense*

 

Our consolidated marketingand sales expense for the first nine months of fiscal 2005 was $16,316,817, or36.7% of revenues, an increase of $1,948,982 and an increase of 1.3 percentagepoints, as a percentage of revenues, from the first nine months of the priorfiscal year.  Marketing and sales expenseconsists primarily of advertising and promotional expenditures, all storepayroll and related expenses for personnel engaged in marketing and sellingactivities and other non-payroll expenses associated with operating ourstores.  As a percentage of revenues, theincrease in marketing and sales expense was primarily due to increasedadvertising, including our sponsorship program with the Boston Red Sox, andhigher depreciation expenses related to the acquisition of fixed assets for newstores.

 

*General and administrative expense*

 

Our consolidated general andadministrative (“G&A”) expense for the first nine months of fiscal 2005 was$5,187,189, or 11.7% of revenues, an increase of $512,291 and an increase of0.2 percentage points, as a percentage of revenues, from the first nine monthsof the prior fiscal year.  G&A expenseconsists of payroll and related expenses for executive, merchandising, financeand administrative personnel, as well as information technology, professionalfees and other general corporate expenses. The increase in G&A expense is largely attributable to professionalfees related to our compliance work for Section 404 of Sarbanes-Oxley Act andconsultant costs associated with the selection of a new merchandise system thatwe are currently planning to install in 2006.

 

*Other income*

 

In fiscal 2004 we reached asettlement with a third party in connection with the special charge pertainingto our preferred stock previously recorded in fiscal year 2002.  We recorded the net settlement of $382,500 asother income.

 

*Interest expense*

 

Our interest expense in thefirst nine months of fiscal 2005 was $383,298, an increase of $234,398 from thefirst nine months of fiscal 2004.  Theincrease during the first nine months of fiscal 2005 was due to an increase ininterest rates, a higher average loan balance and additional interest expenseresulting from capital leases associated with our new point-of-salesystem.  Our average loan balance wasapproximately $5,919,000 during the first nine months of fiscal 2005 comparedto $3,021,000 in the first nine months of fiscal 2004, which increased interest

 

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expense by approximately $126,000.  The effective interest rate on our borrowingsunder our line of credit increased to 6.0% during the first nine months offiscal 2005 compared to 4.7% in the first nine months of fiscal 2004, whichincreased interest expense by approximately $45,000.  The interest rate is based on the bank’s baserate plus 50 basis points.

 

*Income taxes*

 

We have not provided abenefit for income taxes for the first nine months of fiscal 2005 or fiscal2004 due to the uncertainty of future taxable income.

 

At the end of fiscal 2004 wehad estimated net operating loss carryforwards of approximately $23.0 million,which begin to expire in 2018.  Inaccordance with Section 382 of the Internal Revenue Code, the use of thesecarryforwards will be subject to annual limitations based upon certainownership changes of our stock that have occurred or that may occur.

 

*Net Loss*

 

Our net loss in the firstnine months of fiscal 2005 was $4,122,552 or $0.19 per basic and diluted share,compared to a net loss of $1,708,447, or $0.08 per basic and diluted share, inthe first nine months of fiscal 2004.

 

 

**Liquidity and CapitalResources**

 

Our operating activities used $3,345,488 in the firstnine months of fiscal 2005 compared to using $2,290,299 in the first nine months of fiscal 2004, anincrease of $1,055,189.  The increase wasprimarily due to the $2,414,105 increase in our net loss in the first ninemonths of fiscal 2005 compared to the first nine months of fiscal2004. The increase innet loss was partially offset by the increases in depreciation expense and thetiming and terms of vendor payments related to our Halloween inventory.

 

We used $1,480,824 in investing activities in thefirst nine months of fiscal 2005 compared to $1,648,300 in the first nine months of 2004.  The cash invested in the first nine months of2005 was primarily for fixed assets associated with new stores, an existingstore expansion and point-of-sale system enhancements.  The cash invested in the first nine months offiscal 2004 was predominantly for fixed assets associated with new stores andthe new point-of-sale system.

 

We provided $4,070,453 by financing activities in thefirst nine months of 2005 compared to $2,339,490 in the first nine months of2004.  We increased our borrowings underour line of credit by $4,261,780 in the first nine months of 2005 compared to a$2,499,908 increase in the first nine months of 2004.  This increase was primarily used to fund thenet operating loss for the first nine months of fiscal 2005.

 

We have a line of credit(the “line”) with Wells Fargo Retail Finance II, LLC, which was amended onJanuary 2, 2004.  The amendment extendedthe maturity date of the line to January 2, 2007, eliminated the minimuminterest rate of 6.5%, established a new interest rate at the bank’s base rateplus 50 basis points and added the option to increase the line in increments of$2,500,000 beyond the previous limit of $7,500,000, to a limit of $12,500,000,upon 15 days written notice, as long as we are in compliance with all debtcovenants and the other provisions of the loan agreement.  Our inventory and accounts receivable secureour line of credit. We borrow against these assets at agreed upon advancerates, which may vary at different times of the year.

 

On September 12, 2005, weincreased our line of credit to $12,500,000 to help finance our presentoperations and current year new store expansion plans.

 

Our inventory consists ofparty supplies which are valued at the lower of weighted-average cost or marketand are reduced by an allowance for obsolete and excess inventory and otheradjustments, including vendor rebates, discounts and freight costs.  Our line of credit availability calculationallows us to borrow against “acceptable inventory at cost,” which takes ourinventory at cost and reflects adjustments that our lender has approved whichmay be different than adjustments we use for valuing our inventory in ourfinancial statements, such as the

 

12

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adjustment to reserve for inventoryshortage.  The amount of “acceptableinventory at cost” was approximately $18,731,000 at September 24, 2005.

 

Our accounts receivableconsists primarily of vendor rebates receivables and credit cardreceivables.  Our line of creditavailability calculation allows us to borrow against “eligible credit cardreceivables,” which are the credit card receivables for the previous three daysof business.  The amount of “eligiblecredit card receivables” was approximately $335,000 at September 24, 2005.

 

The total borrowing base isthen determined by adding the “acceptable inventory at cost” times an agreedupon advance rate plus the “eligible credit card receivables” times an agreedupon advance rate but not to exceed our established credit limit.  The total borrowing base at September 24,2005 was limited to our credit limit of $12,500,000.  Under the terms of our line of credit, thecredit limit amount of $12,500,000 was then further reduced by (1) a minimumavailability block, (2) customer deposits, (3) gift certificates, (4)merchandise credits and (5) outstanding letters of credit.  Therefore, our additional availability atSeptember 24, 2005 was approximately $1,881,000

 

The amounts outstandingunder our line were $9,519,470 as of September 24, 2005 and $5,257,690 as ofDecember 25, 2004.  The outstandingbalances under our line are classified as current liabilities in theaccompanying consolidated balance sheets since we are required to apply dailylock-box receipts to reduce the amount outstanding.

 

On April 27, 2005, weamended our agreement to allow for a “special subline” that would increase ourborrowing base by $500,000.  Uponactivation of the “special subline”, the interest rate on the line of creditwill be the bank’s base rate plus 75 basis points through the “special subline”termination date.  The “special subline”can be activated upon 5 days written notice and terminates as of November 1,2005 or earlier upon written notice.  Asof September 24, 2005, we had not activated the “special subline” and the “specialsubline” terminated on November 1, 2005.

 

Our prospective cash flowsare subject to certain trends, events and uncertainties, including demands forcapital to support growth, improve our infrastructure, respond to economicconditions, and meet contractual commitments. We expect our capital expenditures for 2005 to be primarily related tonew stores, store improvements and other technology advancements in support ofgrowth and operational enhancement.  Wecurrently believe that we have the ability to generate the cash needed fromoperations and available borrowings under the line to meet our short-termworking capital requirements for our operating activities.  However, webelieve that we will need to raise additional cash sometime in the next 12months through debt, equity, or a combination of both to continue to fundour investing activities with respect to our growth and infrastructureimprovement goals****.****

 
| ** **                                       | ** ** | ** ** | ** ** | **Within** | ** ** | **Within** | ** ** | ** **  | ** ** | ** ** | ** ** |
|--------------------------------------------------|------------|------------|------------|------------|------------|------------|------------|-------------|------------|------------|------------|
| ** **                                       | ** ** | **Within** | ** ** | **2 - 3**  | ** ** | **4 - 5**  | ** ** | **After**   | ** ** | ** ** | ** ** |
| ** **                                       | ** ** | **1 Year** | ** ** | **Years**  | ** ** | **Years**  | ** ** | **5 Years** | ** ** | **Total**  | ** ** |
| Line of credit                                   |       | $          | 9,519,470  |       | $          | —     |       | $           | —     |       | $          | — |   | $ | 9,519,470 |   |
| Capital lease obligations                        |       | 425,847    |       | 555,150    |       | —     |       | —      |       | 980,997    |       |
| Financed Insurance Premiums                      |       | 402,935    |       | —     |       | —     |       | —      |       | 402,935    |       |
| Operating leases (including retail space leases) |       | 8,165,799  |       | 13,204,624 |       | 10,569,133 |       | 14,735,766  |       | 46,675,322 |       |
| Total contractual obligations                    |       | $          | 18,514,051 |       | $          | 13,759,774 |       | $           | 10,569,133 |       | $          | 14,735,766 |   | $ | 57,578,724 |   |

 

 

**Seasonality**

 

Due to the seasonality of our business, sales andoperating income are typically higher in our second and fourth quarters. Our business is highly dependent upon salesof Easter, graduation and summer merchandise in the second quarter and sales ofHalloween and Christmas merchandise in the fourth quarter.

 

**GeographicConcentration**

** **

As of October 28, 2005 weoperated a total of 50 stores, 45 of which are located in New England.  As a result, a severe or prolonged regionalrecession or regional changes in demographics, employment levels, population, 

** **

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**weather patterns, real estatemarket conditions or other factors specific to the New England region mayadversely affect us more than a company that is more geographically diverse.**

 

**Effects of Inflation**

 

We do not view the effectsof inflation to have a material effect upon our business.

 

# **Factors That May Affect Future Results**

 

Various risks, uncertaintiesand contingencies could cause our actual results, performance or achievementsto differ materially from those expressed in, or implied by, statementscontained in this Quarterly Report on Form 10-Q, including, but not limited to,the following:

 

•                  the success orfailure of our efforts to implement our business strategy

•                  our inabilityto obtain additional financing, if required

•                  third-partysuppliers’ failure to fulfill their obligations to us

•                  unseasonableweather, particularly in the New England area

•                  intensecompetition from other party supply stores and stores that merchandise andmarket party supplies, including big discount retailers and dollar store chains

•                  theavailability of retail store space on reasonable lease terms

•                  the failure ofany of our systems, including, without limitation, our newly-installedpoint-of-sale system and our merchandise management system, the latter of whichwas developed by a vendor who is no longer in business

•                  generaleconomic and other developments affecting consumer confidence or spendingpatterns, particularly in the New England region and particularly during theHalloween season, which is our single most important season and

•                  compliance withevolving federal securities, accounting, and stock exchange rules andregulations applicable to publicly-traded companies listed on the American StockExchange.

 

**Critical Accounting Policies and Estimates**

 

Our financial statements arebased on the application of significant accounting policies, many of whichrequire management to make significant estimates and assumptions (see Note 1 tothe consolidated financial statements). We believe the following accounting policies to be those most importantto the portrayal of our financial condition and those that require the mostsubjective judgment.  If actual resultsdiffer significantly from management’s estimates and projections, there couldbe a material effect on our financial statements.

 

*Inventory**and Related Allowance forObsolete and Excess Inventory*

 

Our inventory consists ofparty supplies and is valued at the lower of moving weighted-average cost ormarket.  We record vendor rebates,discounts and certain other adjustments to inventory, including freight costs,and we recognize these amounts in the income statement as the related goods aresold.

 

*Revenue**Recognition*

 

Revenues include the sellingprice of party goods sold, net of returns and discounts, and are recognized atthe point of sale.  We estimate returnsbased upon historical return rates and such amounts have not been significant.

 

*Impairment**of Long-Lived Assets*

 

In accordance with SFAS No.144, *Accounting for the Impairment or Disposal ofLong-Lived Assets*, we perform a review of each store for impairmentindicators whenever events and changes in circumstances suggest that thecarrying amounts may not be recoverable from estimated future store cashflows.  Our review considers storeoperating results, future sales growth and cash flows.  The conclusion regarding impairment maydiffer from current estimates if underlying assumptions or business strategieschange.

 

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*Income**Taxes*

 

Historically, we have notrecognized an income tax benefit for our losses.  Accordingly we record a valuation allowanceagainst our deferred tax assets because of the uncertainty of future taxableincome and the realizability of the deferred tax assets.  In determining if a valuation allowanceagainst our deferred tax asset is appropriate, we consider both positive andnegative evidence.  The positive evidencethat we considered included (1) we were profitable for the last two years dueto the success of our Halloween seasons and (2) we have achieved positivecomparable store sales growth and improved merchandise margins during these twoyears of profitability.  The negativeevidence that we considered included (1) our merchandise margins decreasedduring the first nine months of 2005, (2) we have been profitable for only twoyears and we have been unprofitable for the first nine months of thoseyears,  (3) our future profitability isvulnerable to certain risks, including (a) the risk that we may not be able togenerate significant taxable income to fully utilize our net operating losscarryforwards of approximately $23.0 million, (b) the risk of unseasonableweather and other factors in a single geographic region, New England, where ourstores are concentrated, (c) the risk of being so dependent upon a singleseason, Halloween, for a significant amount of annual sales and profitabilityand (d) the risk of rising prices for petroleum products, which are a key rawmaterial for much of our merchandise and which affect our freight costs, (4)the costs that opening new stores will put pressure on our profit margins untilthese stores reach maturity (5) the investment in infrastructure required tosupport our store expansion plan will increase our costs and (6) the expectedcosts of increased regulatory compliance, including, without limitation, thoseassociated with Section 404 of the Sarbanes-Oxley Act , will likely have a negative impact on ourprofitability.

 

The negative evidence isstrong enough for us to conclude that the level of our future profitability isuncertain at this time. We believe that it is prudent for us to maintain avaluation allowance until we have a longer track record of profitability and wecan reduce our exposure to the risks described above.  Should we determine that we will be able torealize our deferred tax assets in the future, an adjustment to our deferredtax assets would increase income in the period we made such a determination.

 

*Stock**Option Compensation Expense*

 

We account for our stock option compensation agreements with employeesunder the provisions of Accounting Principles Board (“APB”) Opinion No. 25, *Accounting for Stock Issued to Employees*.  We have adopted the disclosure-only provisionsof SFAS No. 123, *Accounting for Stock-Based Compensation*,as amended by SFAS No. 148, *Accounting for Stock-BasedCompensation — Transition and Disclosure, an amendment of Financial AccountingStandards Board (“FASB”) Statement No. 123*.

 

*Property and Equipment*

 

Propertyand equipment are stated at cost less accumulated depreciation and aredepreciated on the straight-line method over the estimated useful lives of theassets.  Expenditures for maintenance andrepairs are charged to operations as incurred.

 

*Use of Estimates*

 

The preparation of financial statements in conformity with accountingprinciples generally accepted in the United States requires us to makeestimates and assumptions that affect the reported amounts of assets andliabilities and disclosure of contingent assets and liabilities at the date ofthe financial statements and the reported amounts of revenues and expensesduring the reporting period.  Our actualresults could differ from our estimates.

 

 

**New Accounting Pronouncements**

 

On December 16, 2004, the Financial AccountingStandards Board (“FASB”) issued FASB Statement No. 123 (revised 2004), *Share-Based Payment*, which is a revisionof FASB Statement No. 123, *Accounting forStock-Based Compensation*. Statement 123(R) supersedes APB Opinion No. 25, *Accounting for Stock Issued to Employees*,and amends FASB Statement No. 95, *Statementof Cash Flows*.  Generally, theapproach in Statement 123(R) is similar to the approach described in Statement123.  However, Statement 123(R) requiresall share-based

 

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paymentsto employees, including grants of employee stock options, to be recognized inthe income statement based on their fair values.  Pro forma disclosure is no longer analternative.

 

On April 14, 2005, the SEC announced that it wouldprovide for a phased-in implementation process for Statement 123(R) for publiccompanies.  As a result, we will not berequired to adopt Statement 123(R) until January 1, 2006 (a delay of sixmonths).  Early adoption will bepermitted in periods in which financial statements have not yet beenissued.  We expect to adopt Statement123(R) on January 1, 2006.

 

Statement 123(R) permits public companies to adoptits requirements using one of two methods:

 

•      A “modified prospective” method in whichcompensation cost is recognized beginning with the effective date (a) based onthe requirements of Statement 123(R) for all share-based payments granted afterthe effective date and (b) based on the requirements of Statement 123 for allawards granted to employees prior to the effective date of Statement 123(R)that remain unvested on the effective date.

 

•      A “modified retrospective” method which includesthe requirements of the modified prospective method described above, but alsopermits entities to restate based on the amounts previously recognized underStatement 123 for purposes of pro forma disclosures either (a) all priorperiods presented or (b) prior interim periods of the year of adoption.

 

We have not yet determined which method we willuse.

 

As permitted by Statement 123, we currently accountfor share-based payments to employees using Opinion 25’s intrinsic value methodand, as such, generally recognize no compensation cost for employee stockoptions.  Accordingly, the adoption ofStatement 123(R)’s fair value method will have a significant impact on ourresults of operations, although it will have no impact on our overall financialposition.  The impact of adoption ofStatement 123(R) cannot be predicted at this time because it will depend onlevels of share-based payments granted in the future.  However, had we adopted Statement 123(R) inprior periods, the impact of that standard would have approximated the impactof Statement 123 as described in the disclosure of pro forma net loss and netloss per share discussed above.

 

In February 2005, the Chief Accountant of the SECissued a letter clarifying his staff’s interpretation of certain accountingissues and their application under generally accepted accounting principles (“GAAP”)relating to operating leases.  Insummary, their interpretation is that (1) leasehold improvements should beamortized by the lessee over the shorter of their economic lives or the leaseterm, which could include lease renewal terms when the renewals are “reasonablyassured,” (2) free or reduced rents should be recognized by the lessee on astraight-line basis over the lease term (including any free or reduced rentperiod) and (3) the statement of cash flows should reflect cash received from thelessor that is accounted for as a lease incentive within operating activitiesand the acquisition of leasehold improvements for cash within investingactivities.  These positions are basedupon existing accounting literature.  Webelieve that our present accounting policies are consistent with the positionsdescribed by the Chief Accountant and his staff in this letter.  Our policy is to amortize leaseholdimprovements for 10 years or the life of the lease, whichever period isshorter.  Our policy is to amortize freeor reduced rent on a straight-line basis over the lease term (including anyfree or reduced rent periods).  Wegenerally do not enter into agreements that involve receiving cash fromlessors/landlords.

 

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**Item 3.    Quantitativeand Qualitative Disclosures about Market Risk**

 

Therehas been no material change in our market risk exposure since the filing of ourAnnual Report on Form 10-K, as amended.

 

**Item 4.    Controls andProcedures**

 

(a) *Evaluation of Disclosure Controls and Procedures.** *Our management, with theparticipation of our Chief Executive Officer, or CEO, and Chief FinancialOfficer, or CFO, evaluated the effectiveness of our disclosure controls andprocedures (as defined in Rules 13a-15(e) and 15d-15(e) under the SecuritiesExchange Act) as of September 24, 2005. In designing and evaluating our disclosure controls and procedures, ourmanagement recognized that any controls and procedures, no matter how welldesigned and operated, can provide only reasonable assurance of achieving theirobjectives, and our management necessarily applied its judgment in evaluatingthe cost-benefit relationship of possible controls and procedures.  Based on this evaluation, our CEO and CFOconcluded that, as of September 24, 2005, our disclosure controls andprocedures were (1) designed to ensure that material information relating tous, including our consolidated subsidiaries, is made known to our CEO and CFOby others within those entities, particularly during the period in which thisreport was being prepared and (2) effective, in that they provide reasonableassurance that information required to be disclosed by us in the reports thatwe file or submit under the Securities Exchange Act is recorded, processed,summarized and reported within the time periods specified in the Securities andExchange Commission’s rules and forms.

 

(b) *Changes in Internal Controls. *No change in our internal controlsover financial reporting (as defined in Rules 13a-15(f) and 15d-15(f) under theSecurities Exchange Act) occurred during the fiscal quarter ended September 24,2005 that has materially affected, or is reasonably likely to materiallyaffect, our internal controls over financial reporting.

 

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**PART II - OTHERINFORMATION**

 

 

**Item 1.****         LegalProceedings**

 

Not applicable.

 

**Item 2.****         UnregisteredSales of Equity and Securities and Use of Proceeds**

 

Not applicable.

 

**Item 3.****         Defaultsupon Senior Securities**

 

Not applicable.

 

**Item 4.****         Submissionof Matters to a Vote of Security Holders**

 

Not applicable.

 

**Item 5.****         OtherInformation**

 

Not applicable.

 

**Item 6.****        ****Exhibits**

 

Theexhibits listed in the Exhibit Index immediately preceding the exhibits arefiled as part of this Quarterly Report on Form 10-Q.

 

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**SIGNATURES**

 

Pursuant to the requirementsof the Securities Exchange Act of 1934, the registrant has duly caused thisreport to be signed on its behalf by the undersigned, thereunto dulyauthorized.

 
|   | iPARTY CORP. |
|--------|--------------|
|   |         |   |   |
|   |         |   |   |
|   | By:          |   | /s/  SAL PERISANO |   |   |
|   |         | Sal  Perisano |   |
|   |         | Chairman  of the Board and Chief Executive Officer |   |
|   |         | (Principal  Executive Officer) |   |
|   |         |   |   |
|   | By:          |   | /s/  PATRICK FARRELL |   |   |
|   |         | Patrick  Farrell |   |
|   |         | President  and Chief Financial Officer |   |
|   |         | (Principal  Financial and Accounting Officer) |   |

 

Dated: November 7, 2005

 

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**EXHIBIT INDEX**

 

 
| **EXHIBIT  NUMBER** | ** ** | **DESCRIPTION**                                                                             |
|---------------------|------------|---------------------------------------------------------------------------------------------|
| Ex. 31.1            |       | Certification of Chief  Executive Officer pursuant to Section 302 of the Sarbanes-Oxley Act |
| Ex. 31.2            |       | Certification of Chief  Financial Officer pursuant to Section 302 of the Sarbanes-Oxley Act |
| Ex. 32.1            |       | Certification of Chief  Executive Officer pursuant to 18 U.S.C. Section 1350                |
| Ex. 32.2            |       | Certification of Chief  Financial Officer pursuant to 18 U.S.C. Section 1350                |

 

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