**UNITED STATES**

**SECURITIES AND EXCHANGE COMMISSION**

**Washington,D.C. 20549**

**FORM 10-K**

**x Annual Report Pursuant to Section 13 or 15(d)of the Securities Exchange Act of 1934**

**For the fiscal year endedDecember 30, 2006**

**or**

**o TransitionReport Pursuant to Section 13 or 15(d) of the Securities Exchange Act of 1934**

Commission File No. **0-19621**

**APPLIANCE RECYCLING CENTERS OF AMERICA, INC.**

(Exact name of registrant as specified in its charter)

| **Minnesota**                                         |   | **41-1454591**       |
|-------------------------------------------------------|--------|----------------------|
| (State or other  jurisdiction of                      |   | (I.R.S. Employer     |
| incorporation or  organization)                       |   | Identification  No.) |
| ** **                                            |   | ** **           |
| **7400  Excelsior Boulevard, Minneapolis, Minnesota** |   | **55426-4517**       |
| (Address of  principal executive offices)             |   | (Zip Code)           |

 

Registrant’s telephone number, including area code:  **952-930-9000**

Securitiesregistered pursuant to Section 12(b) of the Act:  **None**

Securities registered pursuant to Section 12(g) of the Act:  **Common Stock, without parvalue**

Indicate by check mark if the registrant is a well-known seasonedissuer, as defined in Rule 405 of the Securities Act.

o  Yes   x  No

Indicateby check mark if the registrant is not required to file reports pursuant toSection 13 or 15(d) of the Act.    o

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 the past90 days.

x  Yes   o  No

Indicateby check mark if disclosure of delinquent filers pursuant to Item 405 ofRegulation S-K is not contained herein, and will not be contained, to the bestof registrant’s knowledge, in definitive proxy or information statements incorporatedby reference in Part III of this Form 10-K or any amendment to this Form 10-K.    o

Indicate by checkmark whether the registrant is a large accelerated filer, an accelerated filer,or a non-accelerated filer.  Seedefinition of “accelerated filer and large accelerated filer” in Rule 12b-2 ofthe Exchange Act.  (Check one):

| Large accelerated filer  o |   | Accelerated  filer  o |   | Non-accelerated  filer  x |
|---------------------------------|--------|----------------------------|--------|--------------------------------|

 

Indicate by checkmark whether the registrant is a shell company (as defined in Rule 12b-2 of theAct).    o  Yes   x  No

The aggregatemarket value of the voting and non-voting common equity held by non-affiliatesof the registrant, based on the closing price of $3.47 per share, as of July 1,2006 (the last business day of the registrant’s most recently completed secondfiscal quarter) was $6,660,430.

As of March 16, 2007,there were outstanding 4,341,277 shares of the registrant’s Common Stock,without par value.

**DOCUMENTS INCORPORATED BYREFERENCE**

Portions of the registrant’s definitive Proxy Statementfor its 2007 Annual Meeting of Shareholders to be held on May 10, 2007 areincorporated by reference into Part III hereof.

 

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**TABLE OFCONTENTS**
|                       | ** **                                                                                                                            | ** **                      | ** ** | ** ** |
|-----------------------|---------------------------------------------------------------------------------------------------------------------------------------|---------------------------------|------------|------------|
| **PART I**            |                                                                                                                                  |                            |
| ** **            |                                                                                                                                  |                            |
| Item 1.               | Business                                                                                                                              |                            |       |       |
|                  |                                                                                                                                  | General                         |       |       |
|                  |                                                                                                                                  | Industry Background             |       |       |
|                  |                                                                                                                                  | Company Background              |       |       |
|                  |                                                                                                                                  | Customers and Source of  Supply |       |       |
|                  |                                                                                                                                  | Company Operations              |       |       |
|                  |                                                                                                                                  | Principal Products and Services |       |       |
|                  |                                                                                                                                  | Sales and Marketing             |       |       |
|                  |                                                                                                                                  | Seasonality                     |       |       |
|                  |                                                                                                                                  | Competition                     |       |       |
|                  |                                                                                                                                  | Government Regulation           |       |       |
|                  |                                                                                                                                  | Employees                       |       |       |
| Item 1A.              | Risk Factors                                                                                                                          |                            |       |       |
| Item 1B.              | Unresolved Staff Comments                                                                                                             |                            |       |       |
| Item 2.               | Properties                                                                                                                            |                            |       |       |
| Item 3.               | Legal Proceedings                                                                                                                     |                            |       |       |
| Item 4.               | Submission of Matters to a Vote of Security  Holders                                                                                  |                            |       |
|                  |                                                                                                                                  |                            |       |
| **PART II**           |                                                                                                                                  |                            |
| ** **            |                                                                                                                                  |                            |
| Item 5.               | Market for Our Common Equity, Related  Shareholder Matters and Issuer Purchases of Equity Securities                                  |                            |       |
| Item 6.               | Selected Financial Data                                                                                                               |                            |       |
| Item 7.               | Management’s Discussion and Analysis of  Financial Condition and Results of Operations for the Fiscal Years 2006, 2005  and 2004 |                            |       |
| Item 7A.              | Quantitative and Qualitative Disclosure About  Market Risk                                                                            |                            |       |
| Item 8.               | Financial Statements and Supplementary Data                                                                                           |                            |       |       |
| Item 9.               | Changes in and Disagreements With Accountants  on Accounting and Financial Disclosure                                                 |                            |       |
| Item 9A.              | Controls and Procedures                                                                                                               |                            |       |
| Item 9B.              | Other Information                                                                                                                     |                            |       |       |
|                  |                                                                                                                                  |                            |       |       |
| **PART III**          |                                                                                                                                  |                            |
| ** **            |                                                                                                                                  |                            |
| Item 10.              | Directors and Executive Officers of the  Registrant                                                                                   |                            |       |
| Item 11.              | Executive Compensation                                                                                                                |                            |       |
| Item 12.              | Security Ownership of Certain Beneficial  Owners and Management and Related Stockholder Matters                                       |                            |       |
| Item 13.              | Certain Relationships and Related Transactions                                                                                        |                            |       |
| Item 14.              | Principal Accountant Fees and Services                                                                                                |                            |       |
|                  |                                                                                                                                  |                            |       |       |
| **PART IV**           |                                                                                                                                  |                            |
| ** **            |                                                                                                                                  |                            |
| Item 15.              | Exhibits and Financial Statement Schedules                                                                                            |                            |       |       |
|                  |                                                                                                                                  |                            |       |       |
| **SIGNATURES**        |                                                                                                                                  |                            |       |
| **INDEX TO EXHIBITS** |                                                                                                                                  |                            |       |
|                       |                                                                                                                                       |                                 |            |            |  |

 

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**PART I**

**ITEM 1.  BUSINESS**

**General**

We are a leading retailer andrecycler of major household appliances. We generate revenues from:

1.               Retail sales ofappliances at our ApplianceSmart® factoryoutlets.

2.              Fees charged forcollecting and recycling appliances for utilities and other companies.

3.               Selling materials fromthe appliances that we collect and recycle, including appliances from ourApplianceSmart factory outlets.

We wereincorporated in Minnesota in 1983, although, through our predecessors we beganour appliance retail and recycling business in 1976.  Our principal office is located at 7400Excelsior Boulevard, Minneapolis, Minnesota 55426-4517.  References herein to our company include ouroperating subsidiaries.  (See Exhibit21.1.)

**Industry Background**

In the United States, more than 500 million major household appliancesare currently in use.  These appliancesinclude:

Refrigerators                                                                                                                           Washers

Freezers                                                                                                                                                    Dryers

Ranges                                                                                                                                                        Water heaters

Ovens                                                                                                                                                             Air conditioners

Dishwashers                                                                                                                           Dehumidifiers

Microwaves                                                                                                                              Humidifiers

Disposing of these appliances can create severalproblems:

1.               Many areas havedecreasing landfill capacity and bulky appliances take up valuable space.

2.              Many appliances containmaterials that are harmful to the environment. To prevent air, water and ground pollution, these appliances must beprocessed to remove the hazardous materials before the remainder of theappliance can be disposed of.

3.              Alternatives tolandfills that will accept appliances for disposal, such as incinerators, maynot have the capability to process the appliances to remove hazardoussubstances.

Many types of major appliances contain componentswith substances that damage the environment, including:

1.              PCBs (polychlorinatedbiphenyls), which are suspected of causing cancer.  Although the EPA banned the production ofPCBs in 1979, it allowed manufacturers to use their remaining inventories ofPCB-containing components.  Consequently,some old refrigerators, freezers and air conditioners still in use havecapacitors that contain PCBs.  If PCBsare released from capacitors, groundwater contamination can occur.

2.              Mercury, which is toxicto humans.  Mercury can enter the bodythrough inhalation, absorption through the skin, or ingestion.  At high temperatures, mercury vaporizes toform extremely poisonous fumes.  Freezersand washers may have mercury-containing switches in their lids.

3.              CFCs(chlorofluorocarbons), which cause long-term damage to the earth’s ozone layerand may contribute to global warming when released into the atmosphere.  Old refrigerators and freezers commonlycontain CFC refrigerants.

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4.              Other materials, such asoil and sulfur dioxide, that are harmful when released into the environment.

The federal government requires the recovery ofCFC refrigerants upon appliance disposal, and also regulates the management ofhazardous materials found in appliances. Most state and local governments have also enacted laws affecting howtheir residents dispose of unwanted appliances. For example, some areas restrict landfills and scrap metal processorsfrom accepting appliances unless the units have been processed to removeenvironmentally harmful materials.  As aresult, old appliances usually cannot be discarded directly through ordinarysolid waste systems.

In addition to these solid waste management andenvironmental issues, energy conservation is another motivating factor inappliance disposal.  Refrigeratorsmanufactured in the 1960s and early 1970s use up to 1,750 kilowatt-hours ofelectricity each year.  By 2001, federalstandards enacted over the years lowered the average annual energy use per newunit to less than 500 kilowatt-hours.

Many electric utility companies sponsor programsto encourage their residential customers to retire energy-inefficientappliances.  Utility companies oftenprovide assistance and incentives for consumers to replace their old,inefficient appliances with newer, more efficient models.  They also promote the removal of surplusappliances to customers who operate more than one refrigerator, freezer or roomair conditioner.  Additional appliancescontribute significantly to residential energy use and peak demand.

The Federal Energy Policy Act of 1992 gave eachstate the option to deregulate its electric utility industry.  Because electric utilities were uncertainabout the effect that potential deregulation would have on their business, manyscaled back their energy conservation efforts in the mid-1990s.  We believe that energy-efficiency programswill remain a long-term component of the electric utility industry, and we haveseen a resurgence of interest in utility-sponsored appliance recycling programsin the past few years.

**Company Background**

We started our business in 1976 as aused-appliance retailer.  We hadcontracts with national and regional retailers of new appliances, such as Searsand Montgomery Ward.   When one of theirstores sold a new appliance in the Minneapolis/St. Paul, Miami or Atlantamarket, we collected the old appliance from the customer’s residence.  Our technicians reconditioned most of thecollected appliances to sell at our own stores, and we sold the appliances thatwere not suitable for sale to scrap metal processors.

In the late 1980s, stricter environmentalregulations began to affect the disposal of unwanted appliances, and we were nolonger able to take appliances that contained hazardous components to a metalprocessor.  At that time, we began todevelop systems and equipment to remove the harmful materials so that metalprocessors would accept the appliance shells for processing.

We then offered our services for disposing ofappliances in an environmentally sound manner to appliance manufacturers andretailers, waste hauling companies, rental property managers, local governmentsand the public.

***Appliance Recycling for Utilities***

In 1989, we added a new customer group when weopened an appliance processing and recycling center in Milwaukee, Wisconsin, toserve a major electric utility company. The concept of permanently removing operating, energy-inefficientappliances from use through a utility-sponsored energy-efficiency programproved successful, and we began to focus our resources on expanding ourbusiness with electric utilities.  From1989 to 1994, we opened nine centers that served primarily seventeen utilitycompanies.

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The potential of industry deregulation negativelyaffected our business with electric utilities in the middle to late 1990s.  Utilities decreased their participation inenergy-efficiency programs, such as the one we offered, because ofuncertainties about how potential deregulation would affect them.

However, when California faced an energy crisis inthe late 1990s, the California Public Utilities Commission (CPUC) directed oneof our customers, Southern California Edison Company (Edison), to implement astatewide appliance recycling program (Summer Initiative).  The Summer Initiative, which began inSeptember 2000, was available to utility customers in the service areas ofPacific Gas & Electric (PG&E), primarily the San Francisco Bay area,and San Diego Gas & Electric (SDG&E). We developed and managed the program advertising, scheduled collectionappointments when their customers called, picked up the appliances, andprocessed and recycled the units.

In the ensuing years, we provided services throughcontracts to support several additional utility-sponsored energy efficiencyprograms in California, including:

1.               The Appliance EarlyRetirement and Recycling Program, which ran from June 2001 until August2002.  We provided services, includingadvertising, for utility customers in the San Diego area, a six-county regionin California’s Central Valley, and the seven-county Bay Area.

2.               The 2003 Statewide Residential ApplianceRecycling Program, which was available to qualifying customers in the serviceterritories of Edison and SDG&E through December 2003.  We had been working under an extension of the2002 contract until signing a new contract in September 2003.

3.               The 2004-2005 Residential Appliance RecyclingProgram sponsored by Edison for customers in their service territory.

4.               The 2004 Appliance Recycling Program forcustomers of SDG&E, which was extended through 2005.

InJune 2006, we announced the signing of three new contracts in California:

1.               A contract with Edison to handle refrigeratorand freezer recycling operations for Edison’s 2006-2008 Appliance RecyclingProgram, covering substantially the same southern and central Californiaterritories that we handled under Edison’s 2004-2005 program.  The contract runs through March 2009. Sincethe new contract was not finalized by year-end 2005, we had continued toprovide services for Edison under terms of the prior program.  Edison is responsible for advertising theprogram.

2.               A contract with SDG&E to providerefrigerator, freezer and room air conditioner recycling services throughDecember 2008 for their residential and small commercial customers.  Under terms of this agreement, we areresponsible for advertising the program.

3.               A contract for recycling the old, inefficientbut working refrigerators and freezers of customers served by the SacramentoMunicipal Utility District (SMUD).  Theinitial term of the contract was from June 2006 through December 2006, and hassubsequently been extended through June 2007. We are responsible for advertising this program.

Since2004, electric utilities in other parts of the U.S. have also awarded us withcontracts:

1.              We were selected to handle a joint appliancerecycling program in Connecticut sponsored by The United Illuminating Companyand The Connecticut Light & Power Company. The program began in April 2004 and ended in December 2006.  Both of these utilities were responsible foradvertising their programs.

2.              In December 2004, we reached an agreementwith Wisconsin Public Power Inc. (WPPI) to provide appliance recycling servicesthrough December 2005.  The contract wasinitially extended through 2006 and has been extended again through December2007.  WPPI is a statewide power companyowned by 40 municipalities that operate electric utilities.  They supply power to 154,000 homes andbusinesses throughout Wisconsin.  WPPI isresponsible for advertising this program.

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3.              Also in December 2004, we entered into anagreement with Austin Energy in Texas to manage appliance recycling operationsin their service territory during 2005. The contract was initially extended through 2006 and has been extendedagain until December 2007.  The City ofAustin has granted Austin Energy the option to renew the program annuallythrough 2008.  Austin Energy is thenation’s tenth largest community-owned electric utility, serving 360,000customers within the City of Austin and surrounding counties.  To support this program, we opened anappliance recycling facility in Austin. Austin Energy is responsible for advertising this program.

4.**             **In March 2006, we entered into an agreementwith Wisconsin Energy Conservation Corporation (WECC) to provide appliancerecycling services through June 2007. WECC administers and implements the residential components of the Stateof Wisconsin’s Focus on Energy, a public-private partnership offeringenergy information and services to customers throughout the state.

Wehave seen a renewed interest from utilities in appliance recyclingenergy-efficiency programs, and we will continue to aggressively pursue that segmentof customers in 2007.  However, we stillhave a limited ability to project revenues from utility programs in 2007.

***Retail Sales; ReverseLogistics Programs***

When electric utilities began to scale back ordiscontinue their programs with us in the mid-1990s, we increased our marketingto appliance manufacturers and retailers, waste haulers and property managementcompanies.  We also focused onstrengthening our sales of used appliances. In 1995, we began operating our own chain of stores, Encore RecycledAppliances®.  In 1998, we changed the name of our retailstores to ApplianceSmart.

Oneof the markets we have developed is in providing reverse logistics services forappliance manufacturers and retailers. Reverse logistics involves managing appliances that fall outside acompany’s normal channels of distribution.

Allthese appliances are new, not used.  Someare in the carton while others are out of the carton.  One example of this type of product involvesmanufacturer redesign, in which a current model is updated to include a few newfeatures and is then assigned a new model number.  Because the manufacturer ships only thelatest models to retailers, a large quantity of the older model remains in themanufacturer’s inventory.

Inthe appliance industry, these appliances require a different method ofmanagement.  These “special-buy”appliances include:

·      Closeouts

·      Floorsamples

·      Returnedor exchanged items

·      Factoryoverruns

·      Scratchand dent

·      Opencarton

Formany years, manufacturers relied on small appliance dealers to buy this productto sell in their stores. However, today these small retailers are struggling tocompete with large appliance chains (the top 10 retailers are estimated tocontrol 80 percent of the appliance sales market).  At the same time, the expansion of big-boxretailers that sell appliances has created a dramatic increase in the number ofspecial-buy units, further straining the traditional outlet system for theseappliances.  Because these special-buyappliances have value, manufacturers and retailers need an efficient managementsystem to recover their worth.

Inthe late 1990s, we began to design reverse logistics programs for majorappliance manufacturers.  In 1997, webegan providing reverse logistics services for Whirlpool Corporation, thenation’s largest manufacturer of

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majorhousehold appliances.  That pilot programled to a 1998 contract that allowed us to purchase special-buy appliances fromWhirlpool’s distribution centers in the Midwest and some western states.

We began selling these special-buy appliances at ournetwork of ApplianceSmart factory outlets. With an increased supply of product, we started to focus on openinglarger stores to offer consumers a wider product selection.  We also began to close our smaller stores anddecided not to expand our used appliance business.

Inlate 1998, we scaled back our agreement with Whirlpool and reduced ourpurchases to be in line with our financial resources.  At that time, our purchases were mainly fromWhirlpool’s Ohio distribution center.  Aswe have expanded our ApplianceSmart network over the past few years, we havebegun to purchase merchandise from all Whirlpool distribution centers.

Keycomponents of our current agreement with Whirlpool, which became effective in2004, include:

1.               We have no guarantees for the number or typeof appliances that we will be able to purchase.

2.               The agreement may be terminated by eitherparty with thirty days’ prior written notice.

3.               We have agreed to indemnify Whirlpool forcertain claims, allegations or losses concerning the Whirlpool appliances wesell.

InOctober 2001, we entered into an agreement with Maytag Corporation to purchasespecial-buy appliances.  Under the Maytagagreement:

1.               We have nominimum purchase requirements.

2.               The agreementmay be terminated by either party with 60 days’ written notice.

3.               The agreement may beterminated immediately if a default is not cured within ten (10) days afternotification of the default.

4.               We have agreed to indemnifyMaytag for all claims, losses, liability and expenses with respect to Maytagappliances we sell.

Maytagwas acquired by Whirlpool in 2006; however, this has not affected our supply orthe terms of our agreement with Maytag.

Wehave also entered into contracts with three other major manufacturers:

1.               In December 2001, we began carrying a fullline of Frigidaire appliances at all ApplianceSmart factory outlets.

2.               In January 2003, we entered into a contractwith GE Consumer Products to purchase and sell special-buy GE appliances.

3.               In March 2007, we signed an agreement tocarry appliances manufactured by Danby.

Inaddition to our reverse logistics contracts, we are also an authorized dealerof new product for Whirlpool, Maytag, Frigidaire, GE and Danby.

Althoughthere are no guarantees on the number of units that any of the manufacturerswill sell us, we believe that purchases from these five manufacturers willprovide an adequate supply of high-quality appliances for our ApplianceSmartoutlets.

During the second quarter of 2003, we became amajority (60%) owner in North America Appliance Company, LLC (NAACO).  NAACO was formed and commenced operations inJune 2003 and is a retailer of special-buy appliances in Texas.  Because NAACO has a net shareholders’deficit, no minority interest has been recognized on

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our consolidated balance sheet, and 100% of NAACO’soperations are included in our consolidated financial statements for the yearsof 2006, 2005 and 2004.

On September 1, 2006, we became a majority (60%)owner in Productos Duraderos de Norte America (PDN), a Mexican Corporation inexchange for $3,000 in cash.  PDNrefurbishes household window air conditioners for sale through our NAACOoperation in McAllen, Texas and through our ApplianceSmart outlet stores.  Operating results of PDN from September 1,2006 through December 30, 2006 are included in our financial statements.  Since PDN has operated at a loss sinceSeptember 1, 2006, 100% of PDN’s operations are included in our consolidatedfinancial statements.

***Growth Strategy***

Larger factory outlet facilities offer consumers a widerselection of appliances than smaller stores do and are more efficient for us tooperate.  For these reasons, we intend tocontinue to focus our retail sales operations on larger facilities.  We would consider opening new storesprimarily in markets in which we currently have operations, for additionaloperational and marketing efficiencies of scale.  We evaluate demographic, economic andfinancial information when considering a new store location.

Weare also actively pursuing opportunities to support energy-efficiency programssponsored by electric utility companies. We have seen renewed interest from utility companies in these programs.

**Customers and Source of Supply**

We offer reverse logistics services tomanufacturers and retailers that need an efficient way to manage appliancesthat fall outside their normal distribution and sales channels.  We also provide services for electric utilitycompanies that offer their customers appliance recycling programs as an energyconservation measure.

For many years, we provided collection andrecycling services for waste haulers, vending machine companies, residentialproperty managers and the general public for specified fees.  We have phased out this aspect of our businessto focus on reverse logistics, retail sales and energy conservation programs.

***Retailers of New Appliances******:***  We began our business byoffering services to Sears, Montgomery Ward and other retailers of newappliances.  When a consumer purchased anew appliance, we collected the replaced appliance from the customer’s home orthe retailer’s facility.  Theseappliances were our source of supply for our used appliance business, which wehave since discontinued.

However, we continue to work with new-applianceretailers to manage units that customers have returned and other appliancesthat the retailer cannot sell as new in-the-carton product.

***Appliance Manufacturers:***  We now work with appliance manufacturers,including Whirlpool, Maytag, Frigidaire, GE and Danby to acquire the product wesell at our ApplianceSmart retail stores. We purchase special-buy appliances, such as discontinued models andfactory overruns, and sell the product at a significant discount to full retailprices.  In addition, our participationin a national buying cooperative enables us to purchase new in-the-cartonappliances to fill out our mix of product.

Although we believe that our current sources forappliances are adequate to supply our retail stores and allow us to grow oursales, we face the risk that one or more of these sources could be lost.

***Electric Utility Companies:***  We contract with utility companies to providea full range of appliance recycling services to support their energyconservation programs.  The contractsusually have terms of one to four years, with provisions for renewal at theoption of the utility.  Under somecontracts, we manage all aspects of the

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utility’s appliance recycling program.  Under other contracts, we provide onlyspecified services, such as collection and recycling.

Our contracts with electric utility customersprohibit us from repairing and selling appliances we receive through theirprograms.  Because the intent of theprogram is to conserve electricity, we take steps to assure our customers thatthose appliances do not return to use.

Our pricing for energy efficiency programs is on aper-appliance basis and depends upon several factors, including:

1.     Totalnumber of appliances processed.

2.     Lengthof the contract term.

3.     Specificservices the utility selects us to provide.

4.     Marketfactors, including labor rates and transportation costs.

Currently, we have contracts for 2007 with thefollowing utilities to handle recycling operations in their serviceterritories:

1.               Southern CaliforniaEdison

2.               San Diego Gas &Electric

3.               Sacramento MunicipalUtility District

4.               Wisconsin Public Power

5.               Austin Energy

6.               Wisconsin EnergyConservation Corporation

7.               Several other municipalutilities

**Company Operations**

Weprovide a full range of reverse logistics, energy-efficiency and appliancerecycling services.  We purchase majorappliances primarily from appliance manufacturers and retailers for our retailoperations.  We provide services forelectric utility companies to collect and recycle appliances turned in throughtheir energy-efficiency programs.

Manyof the appliances that we receive from manufacturers are still in the factorycarton and are ready to sell.  Otherappliances need repair or cosmetic work before we send them to ourApplianceSmart retail outlets.  Allappliances we sell are under warranty and carry a 100 percent money-backguarantee.  We also offer extendedwarranties, delivery, factory-trained technician service and recycling ofcustomers’ old appliances.

Someof the appliances we receive must be recycled. These include appliances that do not meet our quality standards for saleat ApplianceSmart and appliances collected through utility customers’ energyconservation programs.  We process andrecycle these units using environmentally sound systems and techniques.

Inour recycling operation, our company-trained technicians first inspect andcategorize each appliance to identify the types of hazardous materials itcontains.  We then process the appliancesto remove and manage the environmentally hazardous substances according to allfederal, state and local regulations.  Wedeliver the processed appliances to local scrap processing facilities, wherethey shred and recycle the metals.

Although the potential of industry deregulation negatively affected ourbusiness with electric utilities in the middle to late 1990s, we are seeingrenewed interest in appliance recycling energy-efficiency programs.  We enter 2007 serving six major utilityprograms and several smaller ones.  Weare aggressively pursuing additional utility customers, but still have alimited ability to project revenues from utility programs in 2007.

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Since 2003, we have focused on a carefully managed growthplan to strengthen our retail operations. We will continue to open showroom outlet stores in convenient,high-traffic locations.  In addition, wewill continue to seek additional sources of product for our retail stores.  We believe that the growth of our retailbusiness in the near future will likely occur through opening new ApplianceSmartoutlets in our existing markets.

**Principal Products and Services**

We generate revenues from three sources: retailing, recycling andbyproduct.  The table below reflects thepercentage of total revenues from each source for the past three fiscal years.  See also “Management’s Discussion andAnalysis of Financial Condition and Results of Operations.”
| **Revenues:** | ** ** | **2006**  | ** ** | **2005** | ** ** | **2004** | ** ** |
|---------------|------------|-----------|------------|----------|------------|----------|------------|
| Retail        | ** ** | **84.2**  | **%**      | 83.3     | %          | 79.2     | %          |
| Recycling     | ** ** | **13.2**  | **%**      | 14.6     | %          | 17.8     | %          |
| Byproduct     | ** ** | **2.6**   | **%**      | 2.1      | %          | 3.0      | %          |
| ** **    |       | **100.0** | **%**      | 100.0    | %          | 100.0    | %          |

Although we havethree main sources of revenues—retail, recycling and byproduct—we believe thatwe have only one operating segment.  Thatis, even though certain separate financial information by retail store orretail store and recycling center is available to us, we are managed as asingle unit.  Specifically, we do notmeasure profit or loss or maintain asset information separately for our revenuesources.  Recycling and byproductrevenues result from both our retail operations and our recycling contracts.  Retail includes the free removal andrecycling of the customer’s replaced appliance. Recycling includes the recycling of appliances through a contract oragreement.

**Sales and Marketing**

We use a variety of methods to promote awarenessof our products and services.  We believethat we are recognized as a leader in the recycling industry and in applianceretailing through reverse logistics.

OurApplianceSmart outlet store concept includes establishing large factoryshowrooms in metropolitan locations.  Weaim to offer consumers a selection of hundreds, even thousands, of appliancesat each of our stores.  Our visualbranding consists of ample display of manufacturers’ signage, along withcustom-designed ApplianceSmart materials in red, white and blue.  In everymarket, we advertise our stores through print media, and in some markets, werely heavily upon television and radio spots. Through www.ApplianceSmart.com, consumers can also learn more about uson the Internet.

Wemarket our services to electric utility companies by contacting prospectiveclients directly, submitting proposals for services to interested parties, andresponding to utility-issued requests to bid. We also generate leads from inquiries received through our corporatewebsite, www.arcainc.com.

**Seasonality**

We experience some seasonality in retail revenues,with revenues in the second and third calendar quarters being slightly higherthan revenues in the first and fourth calendar quarters.

In multi-year programs, electric utility companiesthat contract with us for service typically roll out their programs towards theend of the first calendar quarter. Promotional activities are strong during the second and third calendarquarters, leading to higher customer demand for services during that timeperiod.  As a result, we experience asurge in business during the second and third calendar quarters, which declinesthrough the fourth and first calendar quarters until advertising activitiesresume.

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**Competition**

Our retail competition comes mainly fromnew-appliance and other special-buy retailers. Each ApplianceSmart outlet competes with local and national chains ofnew-appliance dealers, as well as with independently owned appliance retailers.  Many of these retailers have been in businesslonger than we have and may have significantly greater assets.

Many factors, including existing and proposedgovernmental regulation, affect competition in the appliance recyclingindustry.  We generally compete forcontracts with two or three companies based in the program’s serviceterritory.  Often, these companies arenot able to offer the full range of services that we provide.

We expect our primary competition for appliancerecycling contracts with existing and new customers to come from a variety ofsources, including:

1.     Existingrecycling companies.

2.     Entrepreneursentering the appliance recycling business.

3.     Energymanagement consultants.

4.     Majorwaste hauling companies.

5.     Scrap metalprocessors.

In addition, utility companies and other customersmay operate appliance recycling programs internally rather than contractingwith outside vendors.  We have noassurance that we will be able to compete profitably in any of our chosenmarkets.

**Government Regulation**

Federal, state and local governments regulate appliancecollection, recycling and sales activities. While some requirements apply nationwide, others vary by market.

The many laws and regulations that affectappliance recycling include landfill disposal restrictions, hazardous wastemanagement requirements and air quality standards.  Each of our recycling facilities maintainsthe appropriate registrations, permits and licenses for operating at itslocation.

The 1990 Amendments to the Clean Air Act prohibitthe venting of CFC and CFC-substitute refrigerants while servicing or disposingof appliances.  At all our recyclingcenters, we use our own company-designed equipment to recover theserefrigerants before recycling the units.

We register our recycling centers as hazardouswaste generators with the EPA.  We alsoobtain all appropriate regional and local licenses for managing hazardouswastes.  Licensed hazardous wastecompanies transport and recycle or dispose of the hazardous materials wegenerate.

Our retail stores obtain all required businesslicenses, sales tax licenses and any other licenses for their locations.  Our delivery and collection vehicles complywith all DOT licensing requirements.

In 1992, Congress adopted the Energy Policy Act of1992 to encourage energy efficiency. This act establishes, among other things:

1.     Mandatoryenergy performance standards for new major household appliances.

2.     The optionfor individual states to deregulate their energy providers, including electricutilities.

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We are unsure of the ultimate impact of potentialderegulation on the electric utility industry. Consequently, we are unable to assure you that all our currentoperations could continue in a deregulated environment.

Although we believe that further governmentalregulation of the appliance recycling industry could have a positive effect onus, we cannot foretell the direction of future legislation.  Under some circumstances, for example,further regulation could materially increase our operational costs.  In addition, under some circumstances we maybe subject to contingent liabilities because we handle hazardous materials.

**Employees**

At March 1, 2007 we had 301 full-time employees, distributedapproximately as follows:

1.               13% of our employeesprovide appliance collection, transportation and processing services at ourrecycling centers.

2.               62% work in retailsales.

3.               25% are inadministration and management.

Our employees have never caused our operations to be disrupted by awork stoppage, and we believe that our employee relations are good.

**ITEM 1A.               RISK FACTORS**

*Aninvestment in our Common Stock involves a high degree of risk.  You should carefully consider the risksdescribed below with respect to an investment in our shares.  If any of the following risks actually occur,our business, financial condition, operating results or cash provided byoperations could be materially harmed. As a result, the trading price of our Common Stock could decline, andyou might lose all or part of your investment. When evaluating an investment in our Common Stock, you should also referto the other information in this report, including our financial statements andrelated notes.*

**Risks Related to ARCA**

***Our strategy of opening new retail stores hasresulted in net losses in recent periods.***

Ourprimary growth strategy is to open new retail stores.  We evaluate demographic, economic andfinancial information in considering a new store location.  We look primarily in markets where wecurrently have operations, for additional operational and marketingefficiencies of scale.  New stores taketime to become profitable; we cannot assure you that any individual current orfuture store will attain or maintain projected profitability.  We incurred a net loss of $1,409,000 or $0.33per share for fiscal year 2006 and a net loss of $933,000 or $0.22 per sharefor fiscal year 2005.  Our full financialinformation is set out in the financial statements and related notes and “Management’sDiscussion and Analysis of Financial Condition and Results of Operations.”

***Most of our revenues are derived from retailsales.  We expect this dependence onretail sales to continue in the future.***

Mostof our revenues are derived from retail sales of appliances from ourApplianceSmart retail stores. We currently operate fifteen ApplianceSmartstores.  Retail revenues have lowerprofit margins than recycling revenues. We believe that our future economic results will be heavily dependent onour retail stores.  In fiscal 2004, 2005 and2006, approximately 79%, 83% and 84%, respectively, of our revenues were fromretail sales. We currently expect that retail revenues will account forapproximately 85% of total revenues for 2007. However, we cannot assure you that sales from our stores will grow atthe rates we currently anticipate.

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***Our revenues from recycling contracts havedeclined, and future revenues from this source are very difficult to project.***

Inthe past, our business was dependent largely upon our ability to obtain newcontracts and continue existing contracts for appliance recycling services withutility companies.  Contracts with theseentities generally have initial terms of one to four years, with renewaloptions and early termination clauses. The recycling and byproducts portion of our business has diminished fromapproximately 50% of total revenues in fiscal 2001 to 15.8% of total revenuesin fiscal 2006, partially due to decreased sponsorship of energy conservationprograms by utilities.  However, we arestill dependent on certain customers for a large portion of our revenues.  Generally, recycling revenues have a highergross profit than retail revenues.

Ourmajor utility customer, Southern California Edison Company (Edison), accountedfor approximately 9% of revenues for 2004 and 2005 and 11% for 2006.  The loss or material reduction of businessfrom Edison, or any major customer, could adversely affect our net revenues andprofitability.  We were awarded acontract to provide services for Edison’s refrigerator recycling program forthe years 2006-2008.  The contract doesnot provide for a minimum number of refrigerators to be recycled, and thetiming and amount of revenues is dependent on Edison’s advertising.

Wecannot assure you that our existing recycling contracts will be continued orrenewed, that existing customers, including Edison, will continue to use ourservices at current levels, or that we will be successful in obtaining newrecycling contracts.

***Our revenues from recycling contracts are subjectto seasonal fluctuations and are dependent on the utilities’ advertising andpromotional activities for contracts in which we do not provide advertisingservices.***

Inour business with utility companies, we experience seasonal fluctuations thatimpact our operating results.  Ourrecycling revenues are generally higher during the second and third calendarquarters and lower in the first and fourth calendar quarters, due largely tothe promotional activity schedules in advertising programs managed by theutilities.  We expect that we willcontinue to experience such seasonal fluctuations in recycling revenues. Weexperience less seasonal fluctuation in our retail business.

***We may need new capital to fully execute our growthstrategy.***

Ourbusiness involves providing comprehensive, integrated appliance recyclingservices and developing a chain of retail stores.  This commitment will require a significantcontinuing investment in capital equipment and leasehold improvements and couldrequire additional investment in real estate.

Ourtotal capital requirements will depend, among the other things discussed inthis annual report, on the number of recycling centers and the number and sizeof retail stores operating during 2006. Currently, we have fifteen retail stores and four recycling centers inoperation.  If our revenues are lowerthan anticipated or our expenses are higher than anticipated or our currentline of credit cannot be maintained, we will require additional capital tofinance our operations.  Even if we areable to maintain our current line of credit, we may need additional equity orother capital in the future.  Sources ofadditional financing, if needed in the future, may include further debtfinancing or the sale of equity (including the issuance of preferred stock) orother securities.  We cannot assure youthat any additional sources of financing or new capital will be available tous, or available on acceptable terms, or permitted by the terms of our currentdebt.  In addition, if we sell additionalequity to raise funds, all outstanding shares of Common Stock will be diluted.

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***A decline in generaleconomic conditions could lead to reduced consumer demand for our products andhave an adverse effect on our liquidity and profitability.***

Sincepurchases of our merchandise are dependent upon discretionary spending by ourretail customers, our financial performance is sensitive to changes in overalleconomic conditions that affect consumer spending.  Consumer spending habits are affected by,among other things, prevailing economic conditions, levels of employment,salaries and wage rates, gasoline prices, consumer confidence and consumerperception of economic conditions.  Ageneral or perceived slowdown in the United States economy or uncertainty as tothe economic outlook could reduce discretionary spending or cause a shift inconsumer discretionary spending to other products.  Any of these factors would likely cause us todelay or slow our expansion plans, reduce net sales and potentially result inexcess inventories. This could, in turn, lead to increased merchandisemarkdowns and related costs associated with higher levels of inventory thatcould adversely affect our liquidity and profitability.

***Our market share may be adversely impacted at anytime by a significant number of competitors.***

Competitionfor our retail stores comes primarily from retailers of new and special-buyappliances.  Each of our locations willcompete not only with local and national chains of new appliance retailers,many of whom have been in business longer than we have and who may havesignificantly greater assets, but will also be required to compete withnumerous independently owned retailers of used appliances.  A number of our retail operations have beenopened within the past 24 months; therefore, we cannot assure you that we willbe able to compete effectively in any such market.

Whilerecycling revenues could become a smaller part of our business for theforeseeable future, many factors, including existing and proposed governmentalregulation, may affect competition in the industry.  We generally compete with two or threecompanies based in the geographic area to be served, and they generally offersome of the services we provide.  Weexpect our primary competition for contracts with existing or new customers tocome from entrepreneurs entering the appliance recycling business, energymanagement consultants, current recycling companies, major waste haulingcompanies, scrap metal processors and used appliance dealers.  In addition, some of our customers, such asutility companies, may operate appliance recycling programs internally ratherthan contracting with us or other third parties.  We cannot assure you that we will be able tocompete profitably in any of our chosen markets.

***Changes in governmental regulations relating to ourrecycling business could increase our costs of operations and adversely affectour business.***

Ourappliance recycling centers are subject to various federal, state and locallaws, regulations and licensing requirements related to the collection,processing and recycling of household appliances.  These requirements may vary by marketlocation and include, for example laws, concerning the management of hazardousmaterials and the 1990 Amendments to the Clean Air Act, which require us torecapture CFC refrigerants from appliances to prevent their release into theatmosphere.

Wehave registered our centers with the EPA as hazardous waste generators and haveobtained required licenses from appropriate state and local authorities.  We have agreements with approved and licensedhazardous waste companies for transportation and recycling or disposal ofhazardous materials generated through our recycling processes.  As is the case with all companies handlinghazardous materials, under some circumstances we may be subject to contingentliability.

In1992, Congress adopted the Federal Energy Policy Act of 1992 to encourageenergy efficiency.  One component of thisAct allows for deregulation of the nation’s energy providers, including theelectric utility

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industry.  The immediate impact of the potential ofindustry deregulation caused utility companies across the U.S. to suspend theirplans for implementing appliance recycling programs like ours.

***Our lender has the right to demand payment in fullof the borrowings under our line of credit at any time.  If it were to do so, we would not be able topursue our growth strategy and our operations would be severely limited unlessand until new financing was obtained.***

Wehave an $8.0 million line ofcredit with a stated maturity date of December31, 2007.  The line of credit alsoprovides that the lender may demand payment in full of the entire outstandingbalance of the loan at any time.  We havepledged substantially all our assets to secure payments under the line.  The line requires that we meet certainfinancial covenants, provides payment penalties for noncompliance andprepayment, limits the amount of other debt we can incur, limits the amount ofspending on fixed assets, and limits payments of dividends.  At March 3, 2007, borrowings of $6,543,000 were outstanding under theline of credit, and we had a shortfall on our borrowing capacity of $454,000 which was paid back to the lender onMarch 3, 2007.

***We may not be able to operate successfully if welose key personnel, are unable to hire qualified personnel, or experienceturnover of our management team.***

Webelieve our operations are materially dependent upon the continued services ofour present management.  The loss ofservices of one or more members of present management, including Edward R.(Jack) Cameron, our founder, Chairman of the Board and current CEO, couldadversely affect our business.  We do nothave employment contracts with present management.  We maintain key person insurance on the lifeof Mr. Cameron in the amount of $1,000,000.

***We are involved in litigation surroundingintellectual property.  We may incursubstantial costs as a result of the litigation , which could have an adverseeffect on our results of operations.***

InDecember 2004, we filed suit in the U.S. District Court for the CentralDistrict of California alleging that JACO Environmental, Inc. and one of ourformer consultants fraudulently obtained a patent (U.S. Patent No. 6,732,416)in May 2004 covering appliance recycling methods and systems originallydeveloped by us beginning in 1987 and used in serving more than forty-fiveelectric utility appliance recycling programs since that time.  We are seeking a permanent injunction barringJACO from using the patent to market JACO’s recycling services, due to ourbelief that the patent is invalid and unenforceable.  We are also asking the court for unspecifieddamages related to charges that JACO, in using the patent to promote itsservices, has engaged in unfair competition and false and misleading advertisingunder federal and California statutes. We may incur substantial costs in pursuing this injunction, which couldhave an adverse effect on our results of operations.

OnOctober 24, 2006, JACO and SEG Umwelt-Service/Basis of Mettlach, Germany (SEG)filed a patent infringement lawsuit in Federal Court against us.  The suit claims that we have been usingrefrigerator recycling systems and processes covered by two U.S. patents issuedto SEG and exclusively licensed to JACO. JACO and SEG are seeking an undisclosed amount in damages, in additionto an injunction barring us from continuing to use and market the systems andprocesses upon which we allegedly infringe. We may incur substantial costs in defending this suit, which could havean adverse effect on our results of operations.

 

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**Risks Related to Our Common Stock**

***If an active trading market for our Common Stockdoes not develop, the value and liquidity of your investment in our CommonStock could be adversely affected.***

On February 22, 2006, our Common Stock began trading on the NasdaqCapital Market.  Previously, it wastraded on the OTC Bulletin Board and the trading volumes were low.  There may be only a limited market for anyshares of Common Stock that you purchase.

***The public sale of our Common Stock by the sellingshareholders or by other shareholders could adversely affect the price of ourCommon Stock.***

The trading volumes in our Common Stock are low compared to the numberof shares that may be sold by the selling shareholders.  Sales of substantial amounts of Common Stockinto the public market by the selling shareholders or by our other shareholderscould adversely affect the market price for our Common Stock.

***Our principal shareholders own a large percentageof our voting stock, which will allow them to control substantially all mattersrequiring shareholder approval.***

Currently, Edward R. (Jack) Cameron, Chairman and CEO, ownsapproximately 8.6% of ouroutstanding shares of Common Stock.  Ourofficers and directors together hold approximately 16.4%, including any options or warrants they may hold.  One of our principal lenders, MedallionCapital, Inc., owns approximately 12%of our outstanding shares.  Medallionalso has a non-voting right to attend and participate in all meetings of ourBoard of Directors.  Perkins Capital Management,Inc. beneficially owns approximately 18%of our outstanding shares.  White PineCapital, LLC beneficially owns approximately 11% of our outstandingshares.  Because of such ownership, ourmanagement and principal shareholders may be able to significantly affect ourcorporate decisions, including the election of the Board of Directors.

**ITEM 1B.               UNRESOLVED STAFF COMMENTS**

Not applicable.

**ITEM 2.                 ****PROPERTIES**

Our executive offices are located inMinneapolis, Minnesota, in a company-owned facility that includes approximately11 acres of land.  The building containsapproximately 122,000 square feet, consisting of 27,000 square feet of officespace, 71,000 square feet of operations and processing space, and 24,000 squarefeet of retail space as identified below (under “Minneapolis, MN, 1998”).  In March 2006, we entered into a purchaseagreement for the sale of this property. This purchase agreement was cancelledin December 2006.  We also own and use abuilding in Compton, California, with 11,000 square feet of office space,30,000 square feet of warehouse and processing space, and 5,000 square feet ofretail space as identified below (under “Los Angeles, CA”).

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We currently operate fifteen retail stores in thefollowing locations:
| ** **      | ** ** | ** **                                       | ** ** | **Retail Space**                       | ** ** | ** **                                                  |
|-----------------|------------|--------------------------------------------------|------------|----------------------------------------|------------|-------------------------------------------------------------|
| **Market**      | ** ** | **Opening Date**                                 | ** ** | **Size (Sq. Ft.)**                     | ** ** | ** **                                                  |
| Minneapolis, MN |       | 1998  Jan. 2001  Oct. 2001  Feb. 2003  Dec. 2004 |       | 24,000  24,000  49,000  33,000  30,000 | * *   | *(Also has 29,000 sq. ft. of warehouse space.)*             |
| Los Angeles, CA |       | 1998                                             |       | 5,000                                  |       |                                                        |
| Columbus, OH    |       | 1997  May 2001  Mar. 2002                        |       | 20,000  32,000  30,000                 |       |                                                        |
| Atlanta, GA     |       | Dec. 2003  Nov. 2004  Oct. 2006  Dec. 2006       |       | 30,000  30,000  27,000  46,000         | * *   | *(Also has 58,000 sq. ft. of production/warehouse  space.)* |
| San Antonio, TX |       | Oct. 2004  Oct. 2005                             |       | 36,000  37,000                         |       |                                                        |

 

We own the facilities in which the two stores that opened in 1998(Minneapolis and Los Angeles) are located. We also operate processing and recycling centers in these twofacilities.  All our other retail storesare located in leased facilities; we generally attempt to negotiate lease termsof two to five years for our retail stores.

We operate four processing andrecycling centers.  Two are in thefacilities that we own in Minneapolis and Los Angeles.  The other two are in leased facilities inWaterbury, Connecticut, and Austin, Texas. Our recycling centers typically range in size from 25,000 to 40,000square feet.

All the facilities we own currently secureoutstanding loans.  All of the facilitieswe occupy currently are adequate for our future needs.

**ITEM 3.                 LEG****ALPROCEEDINGS**

In December 2004, we filed suit in the U.S. District Court for theCentral District of California alleging that JACO Environmental, Inc. (JACO)and one of our former consultants fraudulently obtained U.S. Patent No.6,732,416 in May 2004 covering appliance recycling methods and systemsoriginally developed by us beginning in 1987 and used in serving more thanforty-five electric utility appliance recycling programs since that time.  We are seeking an injunction to prevent JACOfrom claiming that it obtained a valid patent on appliance recycling processesthat we believe is based on methods and processes we invented.  We are also asking the court for unspecifieddamages related to charges that JACO, in using the patent to promote itsservices, has engaged in unfair competition and false and misleadingadvertising under federal and California statutes.  In addition, we may incur substantial costsin pursuing this injunction, which could have an adverse effect on our resultsof operations.

In September 2005, we received a legally binding document in which JACOstates it will not sue us or any of our customers for violating the JACOpatent. Therefore, our recycling operations will continue with our currentcontracts without interruption.

On October 18, 2006, the U.S. District Court for the Central Districtof California denied the motion for summary judgment filed by JACO to dismissthe suit.

The case is scheduled for trial in April 2007.

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On October 24, 2006, JACO and SEG Umwelt-Service/Basis ofMettlach, Germany (SEG) filed a patent infringement lawsuit in Federal Courtagainst us.  The suit claims that we havebeen using refrigerator recycling systems and processes covered by two U.S.patents issued to SEG and exclusively licensed to JACO.  JACO and SEG are seeking an undisclosedamount in damages, in addition to an injunction barring us from continuing touse and market the systems and processes upon which we allegedly infringe.  We believe this lawsuit is retaliatory in nature,given the Court’s denial of JACO’s request to have our litigationdismissed.  We intend to vigorouslydefend ARCA against this baseless suit.

**ITEM 4.                 SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS**

We did not submit any matters to a vote of security holders during thelast quarter of the fiscal year covered by this report.

**PART II**

**ITEM 5.****                                                    MARKET FOR OUR COMMON EQUITY, RELATED SHAREHOLDERMATTERS AND ISSUER PURCHASES OF EQUITY SECURITIES**

**Market for Common Stock**

Our Common Stock, which trades under the symbol “ARCI,” began trading onthe Nasdaq Capital Market on February 22, 2006. Before that time, the Common Stock was traded as follows:  on the OTC Bulletin Board from September 8,1998 to February 21, 2006; on the Nasdaq SmallCap Market from February 26, 1997to September 7, 1998; on the Nasdaq National Market from January 8, 1993 toFebruary 25, 1997; on the Nasdaq SmallCap Market from January 7, 1991 toJanuary 7, 1993; and on the local over-the-counter market before January 7,1991. The following table sets forth, for the periods indicated, the high andlow closing bid quotations for the Common Stock, as reported by the OTCBulletin Board.  These quotations reflectinter-dealer prices, without retail mark up, mark down or commissions, and maynot represent actual transactions.

|                | ** ** | **High**    | ** ** | **Low**     | ** ** |
|----------------|------------|-------------|------------|-------------|------------|
| **2005**       |       |        |       |        |       |
| First Quarter  |       | $ 4.60 |       | $ 2.75 |       |
| Second Quarter |       | 3.75        |       | 2.80        |       |
| Third Quarter  |       | 5.20        |       | 3.26        |       |
| Fourth Quarter |       | 6.00        |       | 4.05        |       |
| **2006**       |       |        |       |        |       |
| First Quarter  |       | $ 6.50 |       | $ 4.25 |       |
| Second Quarter |       | 6.50        |       | 2.66        |       |
| Third Quarter  |       | 3.60        |       | 1.85        |       |
| Fourth Quarter |       | 2.20        |       | 1.85        |       |

 

On March 16, 2007, the last reported sale price of the Common Stock onthe Nasdaq Capital Market was $2.20 per share. As of March 16, 2007, there were approximately 750 beneficial holders ofour Common Stock.

We have not paid dividends on our Common Stock and do not presently planto pay dividends on our Common Stock for the foreseeable future.  Our line of credit limits our ability to paydividends.

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Information concerning securities authorized for issuance under equitycompensation plans is included in Part III, Item 12 of this report.

**PerformanceGraph**

The followinggraph compares cumulative total shareholder returns on our common stock overthe last five fiscal years with the Nasdaq Stock Market (U.S. Companies) Indexand the Dow Jones Specialty Retailers Index, assuming an initial investment of$100 at the beginning of the period and the reinvestment of all dividends.
| ** **                                    | ** ** | **AT YEAR END** | ** ** |
|-----------------------------------------------|------------|---------------------------|------------|
| ** **                                    | ** ** | **12/01**                 | ** ** | **12/02** | ** ** | **12/03** | ** ** | **12/04** | ** ** | **12/05** | ** ** | **12/06** | ** ** |
| Appliance Recycling  Centers of America, Inc. |       | $ 100.00             |       | 49.75 |   | 68.41 |   | 114.43 |   | 121.89 |   | 53.48 |   |
| NASDAQ Stock  Market (U.S. Companies)         |       | $ 100.00             |       | 68.85 |   | 101.86 |   | 112.16 |   | 115.32 |   | 127.52 |   |
| Dow Jones Specialty  Retailers Index          |       | $ 100.00             |       | 66.25 |   | 100.02 |   | 111.66 |   | 119.30 |   | 131.06 |   |

 

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**ITEM 6.****                                                    SELECTED FINANCIAL DATA**

The selected financial information set forth below should be read inconjunction with “Item 7. Management’s Discussion and Analysis of FinancialCondition and Results of Operations for the Fiscal Years of 2006, 2005 and 2004”and “Item 8. Financial Statements and Supplementary Data.”
| **Fiscal Years Ended**                              | ** ** | **2006**                 | ** ** | **2005**                      | ** ** | **2004**                 | ** ** | **2003**                 | ** ** | **2002**                                 | ** ** |
|---------------------------------------------------------------|------------|--------------------------|------------|-------------------------------|------------|--------------------------|------------|--------------------------|------------|------------------------------------------|------------|
| **(In thousands, except per-share data)** | ** ** | ** **               | ** ** | ** **                    | ** ** | ** **               | ** ** | ** **               | ** ** | ** **                               | ** ** |
| ** **                                                    |       |                     |       |                          |       |                     |       |                     |       |                                     |       |
| **Statement  of Operations**                                  |       |                     |       |                          |       |                     |       |                     |       |                                     |       |
| Total revenues                                                |       | $ 77,790            |       | $ 74,893                 |       | $ 52,830            |       | $ 43,609            |       | $ 45,720                            |       |
| Gross profit                                                  |       | $ 23,745            |       | $ 22,487                 |       | $ 15,543            |       | $ 11,879            |       | $ 15,774                            |       |
| Operating income  (loss)                                      |       | $ (1,111            | )          | $    (150 | )          | $ (1,103            | )          | $ (1,776            | )          | $   1,742                 |       |
| Net income  (loss)                                            |       | $ (1,409            | )          | $    (933 | )          | $ (1,314            | )          | $ (1,541            | )          | $      332 |       |
| Basic earnings  (loss) per common share                       |       | $   (0.33 | )          | $   (0.22      | )          | $   (0.48 | )          | $   (0.66 | )          | $     0.14      |       |
| Diluted earnings  (loss) per common share                     |       | $   (0.33 | )          | $   (0.22      | )          | $   (0.48 | )          | $   (0.66 | )          | $     0.11      |       |
| Basic weighted  average number of common shares outstanding   |       | 4,335                    |       | 4,261                         |       | 2,722                    |       | 2,343                    |       | 2,320                                    |       |
| Diluted weighted  average number of common shares outstanding |       | 4,335                    |       | 4,261                         |       | 2,722                    |       | 2,343                    |       | 3,025                                    |       |
|                                                          |       |                     |       |                          |       |                     |       |                     |       |                                     |       |
| **Balance  Sheet**                                            |       |                     |       |                          |       |                     |       |                     |       |                                     |       |
| Working capital                                               |       | $   2,818 |       | $   3,879      |       | $   4,600 |       | $   3,446 |       | $   5,003                 |       |
| Total assets                                                  |       | $ 23,705            |       | $ 24,491                 |       | $ 24,340            |       | $ 20,833            |       | $ 20,239                            |       |
| Long-term  liabilities                                        |       | $   5,169 |       | $   5,216      |       | $   5,521 |       | $   5,658 |       | $   5,797                 |       |
| Shareholders’ equity                                     |       | $   4,142 |       | $   5,421      |       | $   6,063 |       | $   4,209 |       | $   5,737                 |       |

 

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**QUARTERLY FINANCIAL DATA**

The following table sets forth certain unaudited quarterly financialdata for the eight quarters ended December 30, 2006.  In our opinion, the unaudited information setforth below has been prepared on the same basis as the audited information andincludes all adjustments necessary to present fairly the information set forthherein.  The operating results for anyquarter are not indicative of results for any future period.  All data is in thousands except per-common sharedata.
| ** **                                                    | ** ** | **Fiscal 2006**                            | ** ** |
|---------------------------------------------------------------|------------|-------------------------------------------------|------------|
| ** **                                                    | ** ** | **1**st Quarter                            | ** ** | **2**nd Quarter | ** ** | **3**rd Quarter | ** ** | **4**th Quarter | ** ** |
| Total revenues                                                |       | $    17,916                 |       | $    19,161 |   | $    20,783 |   | $    19,930 |   |
| Net income  (loss)                                            |       | $       (678 | )          | $       (461 | ) | $           21 |   | $       (291 | ) |
| Basic earnings  (loss) per common share                       |       | $      (0.16      | )          | $      (0.11 | ) | $        0.01 |   | $      (0.07 | ) |
| Diluted earnings  (loss) per common share                     |       | $      (0.16      | )          | $      (0.11 | ) | $        0.01 |   | $      (0.07 | ) |
| Basic weighted  average number of common shares outstanding   |       | 4,322                                           |       | 4,334 |   | 4,341 |   | 4,341 |   |
| Diluted weighted  average number of common shares outstanding |       | 4,322                                           |       | 4,334 |   | 4,388 |   | 4,341 |   |

 
| ** **                                                    | ** ** | **Fiscal 2005**                            | ** ** |
|---------------------------------------------------------------|------------|-------------------------------------------------|------------|
| ** **                                                    | ** ** | **1**st Quarter                            | ** ** | **2**nd Quarter | ** ** | **3**rd Quarter | ** ** | **4**th Quarter | ** ** |
| Total revenues                                                |       | $    16,909                 |       | $    19,142 |   | $    20,706 |   | $    18,136 |   |
| Net income  (loss)                                            |       | $       (433 | )          | $         404 |   | $           47 |   | $       (951 | ) |
| Basic earnings  (loss) per common share                       |       | $      (0.10      | )          | $        0.09 |   | $        0.01 |   | $      (0.22 | ) |
| Diluted earnings  (loss) per common share                     |       | $      (0.10      | )          | $        0.09 |   | $        0.01 |   | $      (0.22 | ) |
| Basic weighted  average number of common shares outstanding   |       | 4,144                                           |       | 4,266 |   | 4,269 |   | 4,269 |   |
| Diluted weighted  average number of common shares outstanding |       | 4,144                                           |       | 4,341 |   | 4,388 |   | 4,269 |   |

 

**ITEM 7.****                                                     MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION ANDRESULTS OF OPERATIONS FOR THE FISCAL YEARS 2006, 2005 AND 2004**

**OVERVIEW**

Our 2006 fiscalyear (2006) ended December 30, 2006, our 2005 fiscal year (2005) ended December31, 2005 and our 2004 fiscal year (2004) ended January 1, 2005.  The fiscal years of 2006, 2005 and 2004contain 52 weeks.

We generaterevenues from three sources:  retail,recycling and byproduct.  Retail revenuesare sales of appliances, warranty and service revenue and delivery fees.  Recycling revenues are fees we charge for thedisposal of appliances.  Byproductrevenues are sales of scrap metal and reclaimed chlorofluorocarbons (CFCs)generated from processed appliances.  Weare managed as a unit and do not measure profit or loss separately for ourthree primary revenue sources. Therefore, we believe that we have one operating segment.

Weexpanded our ApplianceSmart operation to fifteen stores in 2006 with twoadditional facility openings in the Atlanta, Georgia market (the third andfourth stores in this market) in the fourth quarter.  Retail revenues accounted for approximately 84.2% oftotal revenues in 2006.

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We are actively pursuingopportunities to support energy-efficiency programs run by electric utilitycompanies. During 2006, we handled appliance recycling programs for and in theservice territories of Southern California Edison (Edison), San Diego Gas &Electric (SDG&E), The United Illuminating Company (UI), The ConnecticutLight & Power Company (CL&P), Austin Energy in Austin, Texas, WisconsinPublic Power, Wisconsin Energy Conservation Corporation, and the Ontario PowerAuthority.

**CriticalAccounting Policies and Estimates**

Our significant accountingpolicies are summarized in the footnotes to the financial statements.  Some of the most critical policies are alsodiscussed below.

**Revenue****recognition:**  We recognize retail revenues when theconsumer pays for the appliance with cash, check or credit card.  We recognize recycling revenue when wecollect and process a unit under our recycling contracts.  We recognize byproduct revenue when wereceive payment from the scrap metal processor, and when we ship CFCs to arecycler.

We also sell extended warranty agreements toconsumers who purchase appliances from ApplianceSmart.  We retain the obligation to provide warrantyservice for a small number of these agreements. In these cases, we collect funds at the time the consumer purchases theextended warranty agreement and recognize revenue over the term of the warrantycontract, which is usually 12 months. For the remaining extended warranty agreements we sell, we are notresponsible for service costs since the third-party service provider isresponsible for them.  In these cases, werecognize revenue at the time of sale, in an amount equal to the sale pricepaid by the consumer, less a commission we pay to the third-party serviceprovider.  Revenue from the sale ofextended warranty agreements is included in retail revenues.

We include shipping and handling charges tocustomers in retail revenues, which is recognized when the delivery has beencompleted.  The customer’s payment ofshipping and handling charges is deposited into our bank accounts within 48hours of receipt.  The shipping andhandling costs we incur related to shipping and handling charges are includedin cost of revenues.

The application of our revenue recognition policydoes not involve significant uncertainties and is not subject to accountingestimates or assumptions having significant sensitivity to change.

**Product warranty: **Our warranty policystates that we will repair or replace defective units during the warrantyperiod at no cost to our customers.  Weare an authorized service provider for Whirlpool, Maytag, Frigidaire andGE.  After we provide service to ourcustomers who purchased an appliance from us, we submit a service reimbursementclaim to the appliance manufacturer to cover the costs incurred.  There are a small number of warranties thatwe offer for which we are responsible for the cost of the service call.  We analyze this information periodically todetermine what our potential future expense will be and then record aliability.  Our product warranty policycontains uncertainties because management must estimate the potential futureexpense for service calls not covered under the authorized service provideragreements with appliance manufacturers. However, we do not believe the uncertainties relating to management’sestimates would have a material effect on our results of operations.

**Trade receivables:**  We invoice our recycling customers forservices with 30-day payment terms. Historically we have had very few write-offs of uncollectibleinvoices.  We also invoice the appliancemanufacturers for credits due to us as a result of appliances we receive thatdo not meet the requirements of our agreement with them.  Some of these receivables have beenwritten-off when credits have not been received from the manufacturer.  Management must apply judgment in determiningif any of these receivables will become uncollectible.  This estimate is used to calculate theallowance for doubtful accounts for these receivables.

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**Inventories:**  We value our inventories of appliances at thelower of cost, first-in, first-out (FIFO), or market and establish an inventoryreserve, which represents management’s estimate as to the realizability of ourappliance inventory.  This inventoryreserve contains uncertainties since we must make assumptions and applyjudgments regarding inventory aging and adjustments to market.  In making these assumptions and judgments, wereview historical aging information and margin analyses.  Our estimates and the adequacy of ourinventory reserve could be affected by changes in the market for appliances,including price changes by manufacturers, and such changes could have materialeffect on our results of operations.

**Property and equipment:**  We estimate the life of property andequipment based on the use of the item, and estimate the life of leaseholdsbased on the underlying lease and/or useful life.

**Income taxes:**  Deferred tax assets are reduced by avaluation allowance when, in the opinion of our management, it is more likelythan not that some portion or all of the deferred tax assets will not berealized.  In establishing a valuationallowance, we must estimate whether and when we will have future taxable incomethat can be reduced by deferred tax assets.

**Stock-based compensation:** We adopted FASBstatement No. 123 (revised 2004), Share Based Payment, in fiscal 2006; fiscal2005 and 2004 proforma compensation cost is presented in note 1. Currently, weuse the Black-Scholes option pricing model to determine stock-basedcompensation costs.  This pricing modelrequires management to estimate if and when options granted will be exercised.  In determining this estimate, we reviewhistorical performance of our stock and stock option exercises.

**Recently Issued Accounting Pronouncements**

In June 2006, the FASB haspublished FASB Interpretation (FIN) No. 48 (FIN No. 48), Accounting forUncertainty in Income Taxes, to address the noncomparability in reporting taxassets and liabilities resulting from a lack of specific guidance in FASB SFASNo. 109, Accounting for Income Taxes, on the uncertainty in income taxesrecognized in an enterprise’s financial statements.  Specifically, FIN No. 48 prescribes (a) aconsistent recognition threshold and (b) a measurement attribute for thefinancial statement recognition and measurement of a tax position taken orexpected to be taken in a tax return, and provides related guidance onderecognition, classification, interest and penalties, accounting in interimperiods, disclosure and transition.  The provisions of FIN No. 48 are effective for fiscal years beginningafter December 15, 2006.  We do notexpect FIN No. 48 will have a material effect on the consolidated financialstatements.

In September 2006, the FASBhas published FASB SFAS No. 157, Fair Value Measurements, to eliminate thediversity in practice that exists due to the different definitions of fairvalue and the limited guidance for applying those definitions in GAAP that aredispersed among the many accounting pronouncements that require fair valuemeasurements.  SFAS No. 157 retains theexchange price notion in earlier definitions of fair value, but clarifies thatthe exchange price is the price in an orderly transaction between marketparticipants to sell an asset or liability in the principal or mostadvantageous market for the asset or liability. Moreover, the SFAS states that the transaction is hypothetical at themeasurement date, considered from the perspective of the market participant whoholds the asset or liability. Consequently, fair value is defined as the price that would be receivedto sell an asset or paid to transfer a liability in an orderly transactionbetween market participants at the measurement date (an exit price), as opposedto the price that would be paid to acquire the asset or received to assume theliability at the measurement date (an entry price).  SFAS No. 157 also stipulates that, as amarket-based measurement, fair value measurement should be determined based onthe assumptions that market participants would use in pricing the asset orliability, and establishes a fair value hierarchy that distinguishes between(a) market participant assumptions developed based on market data obtained fromsources independent of the reporting entity (observable inputs) and (b) thereporting entity’s own assumptions about market participant assumptionsdeveloped based on the best information available in the circumstances(unobservable inputs).  Finally, SFAS No.157 expands disclosures about the use of fair value to measure assets andliabilities 

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in interim and annualperiods subsequent to initial recognition. Entities are encouraged to combine the fair value information disclosedunder SFAS No. 157 with the fair value information disclosed under otheraccounting pronouncements, including SFAS No. 107, Disclosures about Fair Valueof Financial Instruments, where practicable. The guidance in this Statement applies for derivatives and otherfinancial instruments measured at fair value under SFAS No. 133, Accounting forDerivative Instruments and Hedging Activities, at initial recognition and inall subsequent periods.  The provisionsof SFAS No. 157 are effective for fiscal years beginning after November 15,2007.  We believe the impact of SFAS No.157 will not have a material effect on the consolidated financial statements.

In September 2006, the FASBhas published FASB SFAS No. 158, Employers’ Accounting for Defined BenefitPension and Other Postretirement Plans, to require an employer to fullyrecognize the obligations associated with single-employer defined benefitpension, retiree healthcare, and other postretirement plans in their financialstatements. Previous standards required an employer to disclose the completefunded status of its plan only in the notes to the financial statements.Moreover, because those standards allowed an employer to delay recognition ofcertain changes in plan assets and obligations that affected the costs of providingbenefits, employers reported an asset or liability that almost always differedfrom the plan’s funded status. Under SFAS No. 158, a defined benefitpostretirement plan sponsor that is a public or private company or anongovernmental not-for-profit organization must (a) recognize in its statementof financial position an asset for a plan’s overfunded status or a liabilityfor the plan’s underfunded status, (b) measure the plan’s assets and itsobligations that determine its funded status as of the end of the employer’sfiscal year (with limited exceptions), and (c) recognize, as a component ofother comprehensive income, the changes in the funded status of the plan thatarise during the year but are not recognized as components of net periodicbenefit cost pursuant to SFAS No. 87, Employers’ Accounting for Pensions, orSFAS No. 106, Employers’ Accounting for Postretirement Benefits Other ThanPensions. SFAS No. 158 also requires an employer to disclose in the notes tofinancial statements additional information on how delayed recognition ofcertain changes in the funded status of a defined benefit postretirement planaffects net periodic benefit cost for the next fiscal year.  We believethe impact of SFAS No. 158 will not have a material effect on the consolidatedfinancial statements.

**REVENUES**

Our total revenuesfor 2006 were $77,790,000 compared to $74,893,000 in 2005.

Retail revenuesincreased to $65,504,000 in 2006 from $62,365,000 in 2005, an increase of 4% or$3,139,000.  The increase in retail revenueswas due primarily to:

1.               Two stores opened in the Atlanta, GA market, one inSeptember, 2006 and one in December, 2006 resulting in additional revenue ofapproximately $1,178,000.  

2.               One store opened in thefourth quarter of 2005 was open for all of 2006 resulting in additional revenueof approximately $1,952,000.  

3.               An increase in same storesales in the Atlanta, GA and Columbus, OH markets of 16.7% and 7.0%respectively, offset by a decrease in same store sales in the MN market of7.2%.

Our retail outlets carry a wide range of new in-the-box and special-buyappliances, which include manufacturer closeouts, factory overruns, floorsamples, returned or exchanged items, open-carton items, and scratch and dentappliances.  All these appliances arenew, not used.  Some are in the cartonwhile others are out of the carton.

We continue to purchase both new in-the-box and special-buy appliancesfrom Whirlpool Corporation (Whirlpool), Maytag Corporation (Maytag), GECorporation (GE) and Frigidaire.  We haveno minimum purchase requirements with any of these manufacturers.  We believe purchases from these fourmanufacturers 

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will provide anadequate supply of high-quality appliances for our retail outlets; however,there is a risk that one or more of these sources could be curtailed or lost.

We operated fifteenretail stores at the end of 2006 and thirteen at the end of 2005.  In September, 2006, we opened a27,000-square-foot store in the Atlanta, GA, market and in December, 2006, weopened a 46,000 square foot store, also in the Atlanta, GA market.

Recycling revenuesdecreased to $10,314,000 in 2006 from $10,937,000 in 2005.  The decrease was primarily due to a decreasein units recycled for the recycling programs in Connecticut as the program cameto an end at the end of 2006. Southern California Edison accounted forapproximately 10% of our total revenues for 2006 and 9% of total revenues inboth 2005 and 2004.

During 2006, we managedrecycling operations under five contracts with electric utility companies, eachof which was responsible for advertising in its service territory.  We provided services for:

                           1.      Edison (2006-2008 program)

                           2.      SDG&E (2006-2008 program)

                           3.      UI and CL&P (joint 2006 program)

                           4.      Austin Energy (2006 program)

                           5.      Wisconsin Public Power Inc. (2006 program)

                           6.      Wisconsin Energy Conservation Corporation (2006 program)

In March 2006, we announced that we had entered into an agreement withWisconsin Energy Conservation Corporation to begin a program in April2006.  Asof March 1, 2006, we operated processing and recycling centers in Minneapolis,MN; Los Angeles, CA; Waterbury, CT; and Austin, TX.  We are also aggressively pursuing newappliance recycling programs in these and other states.

Byproduct revenues increased to $1,972,000 in 2006 from $1,591,000 in2005.  The increase was due primarily toan increase in scrap metal revenues resulting from in increase in the pricepaid for scrap metal by recyclers.  Ourtotal revenues for 2005 were $74,893,000 compared to $52,830,000 in 2004.

Retail revenues increased to $62,365,000 in 2005 from $41,847,000 in2004, an increase of 49% or $20,518,000. The 2005 increase in retail revenues was due primarily to:

1.               Same-store sales increase of approximately 15.6% or$6,500,000 (a sales comparison of nine stores open the full years of 2005 and2004).

2.               Three stores opened during the fourth quarter of 2004and operating for the full year 2005 had an increase in sales of approximately$13,386,000.

3.               One store opened during the fourth quarter of 2005, generatingsales of approximately $632,000.

We purchased new in-the-box and special-buy appliancesfrom Whirlpool, Maytag, GE and Frigidaire.

We operated thirteen retail stores at the end of 2005 and twelve at theend of 2004.  In October 2005, we openeda 37,000-square-foot store in the San Antonio market.

 

Recycling revenuesincreased to $10,937,000 in 2005 from $9,414,000 in 2004.  The increase was due primarily to theConnecticut recycling program, which did not begin until the end of the 2nd quarter of 2004, but was in operation duringall of 2005, and the recycling contracts with Austin Energy and WisconsinPublic Power that began in 2005. Edison accounted for approximately 9% of ourtotal annual revenues for 2005 and 2004. During 2005, we managed appliance recycling operations under threecontracts with electric utility companies, each of which was responsible foradvertising in its service territory.  Weprovided services for:

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                           1.      Edison (2004-2005 program)

                           2.      UI and CL&P (joint 2005 program)

                           3.      Austin Energy (2005 program)

                           4.      Wisconsin Public Power (2005program)

Byproduct revenuesincreased to $1,591,000 in 2005 from $1,569,000 in 2004.  The increase was due primarily to an increaseof approximately $64,000 in scrap metal prices offset by a $42,000 decrease inCFC revenues.

**COST OFREVENUE**

Cost of revenuesincludes all costs related to the purchase of inventory, including freight,costs related to receiving and distribution of inventory, and costs related todelivery and service of inventory after it is sold to the consumer.  Also, the costs related to the transportationand processing of units under the recycling programs are included in the costof revenues.

**GROSS PROFIT**

Our overall gross profit percentage remained at30.2% in 2006.

Gross profit as a percentage of total revenuesfor future periods can be affected favorably or unfavorably by numerousfactors, including:

1.               The mix of retailproducts we sell.

2.               The prices at which wepurchase product from the four manufacturers.

3.               The volume of applianceswe receive through our recycling contracts.

4.               The volume and price ofbyproducts.

We expect gross profit percentages to remainapproximately the same for future periods.

Our overall grossprofit percentage increased to 30.0% in 2005 from 29.4% in 2004.  The increase was due primarily to an increaseof approximately 0.6% in overall gross profit on Special Buy Appliances.

**SELLING, GENERAL ANDADMINISTRATIVE EXPENSES**

Selling, general and administrative expenses were 31.6% of totalrevenues in 2006 compared to 30.2% in 2005. Selling, general and administrative expenses increased to $24,562,000 in2006 from $22,637,000 in 2005, an 8.5% increase.  Selling expenses increased to $16,610,000 in2006 from $15,017,000 in 2005.  The increase inselling expenses was due primarily to:

1.               Theexpense of approximately $1,100,000 for operating two additional stores inAtlanta in the fourth quarter of 2006 and an additional store in the SanAntonio market open all of 2006.

2.               An increase in advertising expense of approximately $403,000.

General and administrative expenses increased to $7,951,000 in 2006from $7,620,000 in 2005.  The increasewas due primarily to additional personnel costs associated with operatingadditional retail stores and recycling contracts and legal costs associatedwith the legal proceedings discussed in Part I, Item 3, Legal Proceedings, andNote 6 of the Notes to Consolidated Financial Statements.

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Selling, general and administrative expenses were30.2% of total revenues in 2005 compared to 31.5% in 2004.  Selling, general and administrative expensesincreased to $22,637,000 in 2005 from $16,646,000 in 2004, a 36.0% increase.The increase in selling expenses was due primarily to:

1.               Theexpense of approximately $2,500,000 for operating three additional storesduring all of 2005.

2.               An increase in advertising expense of approximately $811,000, whichincludes a new market compared to the same period in the previous year.

**INTEREST EXPENSE**

Interest expenseincreased to $1,079,000 in 2006 from $883,000 in 2005.  The increase was primarily due to an increasein the interest rate over the prime rate on the line of credit at renewal, anincrease in the prime rate on the line of credit and an increase in the amountof borrowings from the line of credit.

Interest expenseincreased to $883,000 in 2005 from $777,000 in 2004.  The increase was primarily due to an increasein the amount of borrowings from the line of credit.

**INCOMETAXES AND NET OPERATING LOSSES**

We had net operating loss carryovers and credit carryforwards ofapproximately $11 million at December 30, 2006, which may be available toreduce taxable income and, therefore, income taxes payable in futureyears.  However, future utilization ofthese loss and credit carryforwards is subject to certain significantlimitations under provisions of the Internal Revenue Code.  These include limitations subject to Section382, which relate to a 50 percent change in control over a three-year period,and are further dependent upon our achieving profitable operations.  We believe that the issuance of Common Stockduring 1999 resulted in an “ownership change” under Section 382.  Accordingly, our ability to use net operatingloss carryforwards generated prior to February 1999 may be limited toapproximately $56,000 per year, or less than $1 million through 2018.

As of our 2006 and 2005year-ends, we had recorded cumulative valuation allowances of $2,150,000 and$1,598,000, respectively, against our net deferred tax assets due to theuncertainty of their realization.  Therealization of deferred tax assets is dependent upon sufficient future taxableincome during the periods when deductible temporary differences andcarryforwards are expected to be available to reduce taxable income.  In the future, when we believe we canreasonably estimate future operating results and these estimated resultsreflect taxable income, the amount of deferred tax assets considered reasonablecould be adjusted by a reduction in the valuation allowance.

**LIQUIDITY AND CAPITAL RESOURCES**

At December 30,2006, we had working capital of $2,818,000 compared to $3,879,000 at December31, 2005.  Cash and cash equivalentsincreased to $2,753,000 at December 30, 2006 from $2,095,000 at December 31,2005.  Net cash used in operatingactivities was $10,000 in 2006 compared to net cash used in operatingactivities of $2,149,000 in 2005. During 2006, inventories decreased by$902,000 due primarily to a decrease in inventory purchases in the fourthquarter of 2006.  Accounts receivabledecreased by $485,000 due primarily to a decrease in the volume of unitsrecycled in December 2006.

Net cash providedby investing activities was $179,000 in 2006 compared to cash used in investingactivities of $517,000 in 2005.  The cashprovided by investing activities in 2006 was primarily related to the receiptof a $730,000 non-refundable cash deposit on the sale of the St. Louis Park, MNfacility offset by the continued development of our enterprise-wide software,building improvements, and upgrades to our phone systems.  The cash used in investing activities in 2005was primarily related to continued development of our enterprise-wide softwareand leasehold improvements.  We did nothave any material purchase commitments for assets as of December 30, 2006.

Net cash providedby financing activities was $489,000 in 2006 compared to $399,000 in 2005.  The cash provided by financing activities in2006 and 2005 was due primarily to increased borrowing under the line of 

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credit and stockoption exercises, offset by payments on long-term obligations.  The cash provided by financing activities in2004 was due primarily to a private placement we completed in late December2004, which provided net proceeds of $3,134,000.

As of December 30,2006, we had an $8 million line of credit with a lender.  The interest rate on the line as of December30, 2006 was prime plus 2.95 percentage points (11.20%).  The amount of borrowings available under theline of credit is based on a formula using receivables and inventories.  Our unused borrowing capacity was $80,000 atDecember 30, 2006.  The line of credithas a stated maturity date of December 31, 2007, if not renewed, and providesthat the lender may demand payment in full of the entire outstanding balance ofthe loan at any time.  The line of creditis secured by substantially all our assets and requires minimum monthlyinterest payments of $37,500, regardless of the outstanding principalbalance.  The lender is also secured byan inventory repurchase agreement with Whirlpool Corporation for purchases fromWhirlpool only.  The line requires thatwe meet certain financial covenants, provides payment penalties fornoncompliance and prepayment, limits the amount of other debt we can incur,limits the amount of spending on fixed assets, and limits payments ofdividends.  At December 30, 2006, we werein violation of the covenant related to reaching a minimum annual level of netincome and the covenant related to a minimum level of tangible net worth.  On March 28, 2007, the lender waived theseviolations.

A summary of ourcontractual cash obligations at December 30, 2006 is as follows:
| ** **                          | ** ** | **Cash Payments Due by Period** | ** ** |
|-------------------------------------|------------|-----------------------------------------------------|------------|
| **Contractual  Cash  Obligations**  | ** ** | **Total**                                           | ** ** | **2007** | ** ** | **2008** | ** ** | **2009** | ** ** | **2010** | ** ** | **2011** | ** ** | **2012 and  Thereafter** | ** ** |
| Long-term debt,  including interest |       | $    7,082,000                  |       | $    648,000 |   | $    597,000 |   | $    591,000 |   | $    591,000 |   | $    554,000 |   | $ 4,101,000 |   |
| Operating leases                    |       | $  13,336,000                             |       | $ 2,898,000 |   | $ 2,318,000 |   | $ 1,477,000 |   | $ 1,045,000 |   | $ 1,070,000 |   | $ 4,528,000 |   |
| Total contractual cash  obligations |       | $  20,418,000                             |       | $ 3,546,000 |   | $ 2,915,000 |   | $ 2,068,000 |   | $ 1,636,000 |   | $ 1,624,000 |   | $ 8,629,000 |   |

 

We also have acommercial commitment as described below:
| **Other Commercial  Commitment** | ** ** | **Total Amount  Committed** | ** ** | **Outstanding at 12/30/06**                                                                                  | ** ** | **Date of Expiration** | ** ** |
|---------------------------------------|------------|----------------------------------|------------|------------------------------------------------------------------------------------------------------------------------|------------|----------------------------------|------------|
| Line of credit                        |       | $   8,000,000     |       | $                  6,872,000 |       | December 31, 2007                |       |

 

In March 2006, weentered into a purchase agreement for the sale of our headquarters facility inMinneapolis, MN for approximately $6.0 million. The transaction was cancelled as of December 30, 2006.  We retained the $730,000 deposit which isreflected in “other revenue” on the 2006 statement of operations.

We believe, based on the anticipated sales perretail store, the anticipated revenues from our recycling contracts and ouranticipated gross profit, that our cash balance, anticipated funds generatedfrom operations and our current line of credit will be sufficient to financeour operations and capital expenditures through December 2007.  Our total capital requirements for 2007 willdepend upon, among other things as discussed below, the number and size ofretail stores operating during the fiscal year and the recycling volumesgenerated from the recycling contracts in 2007. Currently, we have fifteen stores and four centers in operation.  If revenues are 

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lower than anticipated or expenses are higher thananticipated, we may require additional capital to finance operations.  Sources of additional financing, if needed inthe future, may include further debt financing or the sale of equity (common orpreferred stock) or other securities. There can be no assurance that such additional sources of financing willbe available on terms satisfactory to us or permitted by our current lender.

**FORWARD-LOOKING STATEMENTS**

Statementscontained in this annual report regarding our future operations, performanceand results, and anticipated liquidity discussed herein are forward-looking andtherefore are subject to certain risks and uncertainties, including, but notlimited to, those discussed herein.  Anyforward-looking information regarding our operations will be affected primarilyby the speed at which individual retail outlets reach profitability, the growthof appliance retail sales and the strength of energy conservation recyclingprograms.  Any forward-lookinginformation will also be affected by our continued ability to purchase productfrom Whirlpool, Maytag, Frigidaire and GE at acceptable prices and the abilityand timing of utility companies to deliver units under their recyclingcontracts with us, the ability of individual retail stores to meet plannedrevenue levels, the rate of growth in the number of retail stores, costs andexpenses being realized at higher than expected levels, our ability to securean adequate supply of special-buy appliances for resale, and the continuedavailability of our current line of credit.

**ITEM 7A.               QUANTITATIVE AND QUALITATIVE DISCLOSURE ABOUT MARKETRISK**

**MARKET RISK AND IMPACT OF INFLATION**

Wedo not believe there is any significant risk related to interest ratefluctuations on the long-term fixed-rate debt. However, there is interest rate risk on the line of credit, since ourinterest rate floats with prime, and on approximately $3,000,000 in long-termdebt entered into in September 2002, since our interest rate is based on the30-day LIBOR rate.  Based on averagefloating rate borrowings of $9,872,000, a one-percent change in the applicablerate would have caused our interest expense to change by approximately$99,000.  Also, we believe thatinflation, primarily in fuel costs, has adversely affected both the price wepay for inventory and the buying habits of our customers in 2006.

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**ITEM 8.                  FINANCIALSTATEMENTS AND SUPPLEMENTARY DATA**
| **Description**                                                          | ** ** | **Page** |
|--------------------------------------------------------------------------|------------|----------|
| Reports of  Independent Registered Public Accounting Firms               |       | 31       |
| Consolidated Balance  Sheet as of December 30, 2006                      |       |     |
| and December 31, 2005                                                    |       | 33       |
| Consolidated Statement  of Operations for the three years                |       |     |
| ended December 30, 2006                                                  |       | 34       |
| Consolidated Statement  of Shareholders’ Equity for the three years |       |     |
| ended December 30, 2006                                                  |       | 35       |
| Consolidated Statement  of Cash Flows for the three years                |       |     |
| ended December 30, 2006                                                  |       | 36       |
| Notes to Consolidated Financial Statements                               |       | 37       |

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REPORT OF INDEPENDENT REGISTERED PUBLIC ACCOUNTING FIRM

Tothe Shareholders, Audit Committee and Board of Directors

ApplianceRecycling Centers of America, Inc. and Subsidiaries

Minneapolis, Minnesota

We have audited theaccompanying consolidated balance sheets of Appliance Recycling Centers ofAmerica, Inc. and Subsidiaries as of December 30, 2006, and December 31, 2005,and the related consolidated statements of operations, shareholders’ equity andcash flows for the years then ended. These consolidated financial statements are the responsibility of theCompany’s management.  Our responsibilityis to express an opinion on these consolidated financial statements based onour audits.

We conducted our audits inaccordance with the standards of the Public Company Accounting Oversight Board(United States).  Those standards requirethat we plan and perform the audit to obtain reasonable assurance about whetherthe consolidated financial statements are free of material misstatement.  An audit includes examining, on a test basis,evidence supporting the amounts and disclosures in the consolidated financialstatements.  An audit also includesassessing the accounting principles used and significant estimates made bymanagement as well as evaluating the overall consolidated financial statementpresentation.  We believe that our auditsprovide a reasonable basis for our opinion.

In our opinion, theconsolidated financial statements referred to above present fairly, in allmaterial respects, the financial position of Appliance Recycling Centers ofAmerica, Inc. and Subsidiaries as of December 30, 2006 and December 31, 2005and the results of their operations and their cash flows for the years thenended, in conformity with U.S. generally accepted accounting principles.

/s/ Virchow, Krause &Company, LLP

Minneapolis,Minnesota

March 16, 2007

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REPORT OF INDEPENDENT REGISTERED PUBLIC ACCOUNTING FIRM

To the Board of Directors

Appliance Recycling Centers of America, Inc. and Subsidiaries

Minneapolis, Minnesota

Wehave audited the accompanying consolidated statement of operations,shareholders’ equity and cash flows of Appliance Recycling Centers of America,Inc. and Subsidiaries for the year ended January 1, 2005.  Our audit also included the financialstatement schedule for the year ended January 1, 2005 listed in the index atItem 15.  These consolidated financialstatements and schedule are the responsibility of the Company’smanagement.  Our responsibility is toexpress an opinion on these consolidated financial statements and schedulebased on our audit.

Weconducted our audit in accordance with the standards of the Public CompanyAccounting Oversight Board (United States). Those standards require that we plan and perform the audit to obtainreasonable assurance about whether the consolidated financial statements arefree of material misstatement.  An auditincludes examining, on a test basis, evidence supporting the amounts and disclosuresin the consolidated financial statements. An audit also includes assessing the accounting principles used and thesignificant estimates made by management, as well as evaluating the overallfinancial statement presentation.  Webelieve that our audit provided a reasonable basis for our opinion.

Inour opinion, the financial statements referred to above present fairly, in allmaterial respects, the results of operations of Appliance Recycling Centers ofAmerica, Inc. and Subsidiaries and their cash flows for the year ended January1, 2005 in conformity with accounting principles generally accepted in theUnited States of America.  Also in ouropinion, the related financial statement schedule, when considered in relationto the basic financial statements for the year ended January 1, 2005, taken asa whole, presents fairly in all material respects the information set therein.

McGLADREY & PULLEN, LLP

Minneapolis, Minnesota

February 18, 2005, except for Note 3 of the January 1, 2005

consolidated financial statements as to which the date is March 15,2005.

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**APPLIANCERECYCLING CENTERS OF AMERICA, INC. AND SUBSIDIARIES**

**CONSOLIDATEDBALANCE SHEET**
| ** **                                                                                                                      | ** ** | **December 30,** | ** **     | **December 31,** | ** ** |
|---------------------------------------------------------------------------------------------------------------------------------|------------|-----------------------|----------------|-----------------------|------------|
| ** **                                                                                                                      | ** ** | **2006**              | ** **     | **2005**              | ** ** |
| ** **                                                                                                                      |       |                  |           |                  |       |
| **ASSETS**(Note  3)                                                                                                             |       |                  |           |                  |       |
| ** **                                                                                                                      |       |                  |           |                  |       |
| **Current Assets**                                                                                                              |       |                  |           |                  |       |
| Cash                                                                                                                            | ** ** | **$**                 | **2,753,000**  |                  | $          | 2,095,000 |   |
| Accounts receivable,  net of allowance of $152,000 and $252,000, respectively                                                   | ** ** | **2,411,000**         |           | 2,896,000             |       |
| Inventories, net of  reserves of $207,000 and $379,000, respectively                                                            | ** ** | **10,998,000**        |           | 11,900,000            |       |
| Deferred income taxes                                                                                                           | ** ** | **601,000**           |           | 393,000               |       |
| Other current assets                                                                                                            | ** ** | **657,000**           |           | 449,000               |       |
| Total current  assets                                                                                                           | ** ** | **17,420,000**        |           | 17,733,000            |       |
| **Property and Equipment,**  at cost                                                                                            |       |                  |           |                  |       |
| Land                                                                                                                            | ** ** | **2,050,000**         |           | 2,050,000             |       |
| Buildings and  improvements                                                                                                     | ** ** | **4,696,000**         |           | 4,501,000             |       |
| Equipment                                                                                                                       | ** ** | **6,889,000**         |           | 6,299,000             |       |
| ** **                                                                                                                      | ** ** | **13,635,000**        |           | 12,850,000            |       |
| Less accumulated  depreciation                                                                                                  | ** ** | **7,575,000**         |           | 6,798,000             |       |
| Net property and  equipment                                                                                                     | ** ** | **6,060,000**         |           | 6,052,000             |       |
| **Other Assets**                                                                                                                | ** ** | **433,000**           |           | 356,000               |       |
| **Restricted Cash**                                                                                                             |       | —                |           | 350,000               |       |
| Total assets                                                                                                                    | ** ** | **$**                 | **23,913,000** |                  | $          | 24,491,000 |   |
|                                                                                                                            | ** ** | ** **            |           |                  |       |
| **LIABILITIES AND SHAREHOLDERS’  EQUITY**                                                                                  |       |                  |           |                  |       |
| ** **                                                                                                                      |       |                  |           |                  |       |
| **Current Liabilities**                                                                                                         |       |                  |           |                  |       |
| Line of credit                                                                                                                  | ** ** | **$**                 | **6,872,000**  |                  | $          | 6,125,000 |   |
| Current maturities of  long-term obligations                                                                                    | ** ** | **309,000**           |           | 262,000               |       |
| Accounts payable                                                                                                                | ** ** | **3,198,000**         |           | 3,868,000             |       |
| Accrued expenses                                                                                                                | ** ** | **3,957,000**         |           | 3,541,000             |       |
| Income taxes payable                                                                                                            | ** ** | **58,000**            |           | 58,000                |       |
| Total current  liabilities                                                                                                      | ** ** | **14,394,000**        |           | 13,854,000            |       |
| **Long-Term Obligations,**less  current maturities                                                                              | ** ** | **4,776,000**         |           | 4,823,000             |       |
| **Deferred Income Tax Liabilities**                                                                                             | ** ** | **601,000**           |           | 393,000               |       |
| Total  liabilities                                                                                                              | ** ** | **19,771,000**        |           | 19,070,000            |       |
|                                                                                                                            | ** ** | ** **            |           |                  |       |
| **Shareholders’ Equity**                                                                                                   |       |                  |           |                  |       |
| Common Stock, no par  value; authorized 10,000,000 shares; issued and outstanding 4,341,000 and 4,320,000  shares, respectively | ** ** | **14,970,000**        |           | 14,840,000            |       |
| Accumulated deficit                                                                                                             | ** ** | **(10,828,000**       | **)**          | (9,419,000            | )          |
| Total  shareholders’ equity                                                                                                | ** ** | **4,142,000**         |           | 5,421,000             |       |
| Total liabilities and  shareholders’ equity                                                                                | ** ** | **$**                 | **23,913,000** |                  | $          | 24,491,000 |   |

 

See Notes toConsolidated Financial Statements.

33

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**APPLIANCERECYCLING CENTERS OF AMERICA, INC. AND SUBSIDIARIES**

**CONSOLIDATEDSTATEMENT OF OPERATIONS**
| ** **                                        | ** ** | **For the fiscal year ended** | ** **     |
|---------------------------------------------------|------------|---------------------------------------------------|----------------|
| ** **                                        | ** ** | **December 30,**                             | ** **     | **December 31,** | ** ** | **January 1,** | ** ** |
| ** **                                        | ** ** | **2006**                                          | ** **     | **2005** | ** ** | **2005** | ** ** |
| **Revenues**                                      |       |                                              |           |   |   |   |   |
| Retail                                            | ** ** | **$**                                             | **65,504,000** |   | $ | 62,365,000 |   | $ | 41,847,000 |   |
| Recycling                                         | ** ** | **10,314,000**                                    |           | 10,937,000 |   | 9,414,000 |   |
| Byproduct                                         | ** ** | **1,972,000**                                     |           | 1,591,000 |   | 1,569,000 |   |
|                                              | ** ** | ** **                                        |           |   |   |   |   |
| Total revenues                                    | ** ** | **77,790,000**                                    |           | 74,893,000 |   | 52,830,000 |   |
|                                              | ** ** | ** **                                        |           |   |   |   |   |
| **Cost of  Revenues**                             | ** ** | **54,315,000**                                    |           | 52,406,000 |   | 37,287,000 |   |
| ** **                                        | ** ** | ** **                                        |           |   |   |   |   |
| Gross profit                                      | ** ** | **23,475,000**                                    |           | 22,487,000 |   | 15,543,000 |   |
|                                              | ** ** | ** **                                        |           |   |   |   |   |
| **Selling,  General and Administrative Expenses** | ** ** | **24,586,000**                                    |           | 22,637,000 |   | 16,646,000 |   |
| ** **                                        | ** ** | ** **                                        |           |   |   |   |   |
| Operating loss                                    | ** ** | **(1,111,000**                                    | **)**          | (150,000 | ) | (1,103,000 | ) |
|                                              | ** ** | ** **                                        | ** **     |   |   |   |   |
| **Other  Income (Expense)**                       |       |                                              |           |   |   |   |   |
| Other income (expense)                            | ** ** | **758,000**                                       |           | 68,000 |   | 20,000 |   |
| Interest income                                   | ** ** | **23,000**                                        |           | 32,000 |   | — |   |
| Interest expense                                  | ** ** | **(1,079,000**                                    | **)**          | (883,000 | ) | (777,000 | ) |
|                                              | ** ** | ** **                                        | ** **     |   |   |   |   |
| Loss before  benefit of income taxes              | ** ** | **(1,409,000**                                    | **)**          | (933,000 | ) | (1,860,000 | ) |
|                                              | ** ** | ** **                                        | ** **     |   |   |   |   |
| **Benefit  From Income Taxes**                    |       | —                                            | ** **     | **—** |   | (546,000 | ) |
| ** **                                        |       |                                              | ** **     | ** ** |   |   |   |
| Net loss                                          | ** ** | **$**                                             | **(1,409,000** | **)** | $ | (933,000 | ) | $ | (1,314,000 | ) |
|                                              | ** ** | ** **                                        | ** **     |   |   |   |   |
| **Basic  Loss per Common Share**                  | ** ** | **$**                                             | **(0.33**      | **)** | $ | (0.22 | ) | $ | (0.48 | ) |
| ** **                                        | ** ** | ** **                                        | ** **     |   |   |   |   |
| **Diluted  Loss per Common Share**                | ** ** | **$**                                             | **(0.33**      | **)** | $ | (0.22 | ) | $ | (0.48 | ) |
| ** **                                        | ** ** | ** **                                        | ** **     |   |   |   |   |
| **Weighted  Average Number of Common**            |       |                                              |           |   |   |   |   |
| **Shares  Outstanding:**                          |       |                                              |           |   |   |   |   |
| Basic                                             | ** ** | **4,335,000**                                     |           | 4,261,000 |   | 2,722,000 |   |
| Diluted                                           | ** ** | **4,335,000**                                     |           | 4,261,000 |   | 2,722,000 |   |

 

See Notes toConsolidated Financial Statements.

34

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**APPLIANCERECYCLING CENTERS OF AMERICA, INC. AND SUBSIDIARIES**

**CONSOLIDATEDSTATEMENT OF SHAREHOLDERS’ EQUITY**

|                                                              | ** ** | **Common Stock** | ** ** | **Accumulated** | ** ** | ** **  | ** ** |
|--------------------------------------------------------------|------------|-----------------------|------------|-----------------|------------|-------------|------------|
| ** **                                                   | ** ** | **Shares**            | ** ** | **Amount**      | ** ** | **Deficit** | ** ** | **Total** | ** ** |
| **Balance,  January 3, 2004**                                |       | 2,364,000             |       | $               | 11,381,000 |        | $          | (7,172,000 | ) | $ | 4,209,000 |   |
| Exercise of stock options                                    |       | 16,000                |       | 16,000          |       | —      |       | 16,000 |   |
| Exercise of warrants                                         |       | 30,000                |       | 18,000          |       | —      |       | 18,000 |   |
| Cashless exercise of warrants                                |       | 576,000               |       | —          |       | —      |       | — |   |
| Issuance of Common Stock, net of offering costs of  $316,000 |       | 1,150,000             |       | 3,134,000       |       | —      |       | 3,134,000 |   |
| Net loss                                                     |       |                  |       | —          |       | (1,314,000  | )          | (1,314,000 | ) |
|                                                         |       |                  |       |            |       |        |       |   |   |
| **Balance,  January 1, 2005**                                |       | 4,136,000             |       | 14,549,000      |       | (8,486,000  | )          | 6,063,000 |   |
| Exercise of stock options                                    |       | 179,000               |       | 365,000         |       | —      |       | 365,000 |   |
| Exercise of warrant                                          |       | 5,000                 |       | 3,000           |       | —      |       | 3,000 |   |
| Stock issuance costs                                         |       |                  |       | (77,000         | )          | —      |       | (77,000 | ) |
| Net loss                                                     |       |                  |       | —          |       | (933,000    | )          | (933,000 | ) |
|                                                         |       |                  |       |            |       |        |       |   |   |
| **Balance,  December 31, 2005**                              |       | 4,320,000             |       | 14,840,000      |       | (9,419,000  | )          | 5,421,000 |   |
| Exercise of stock options                                    |       | 21,000                |       | 128,000         |       | —      |       | 128,000 |   |
| Exercise of warrant                                          |       | —                |       | 2,000           |       | —      |       | 2,000 |   |
| Net loss                                                     |       | —                |       | —          |       | (1,409,000  | )          | (1,409,000 | ) |
|                                                         |       |                  |       |            |       |        |       |   |   |
| **Balance, December 30, 2006**                               |       | 4,341,000             |       | $               | 14,970,000 |        | $          | (10,828,000 | ) | $ | 4,142,000 |   |

 

See Notes to Consolidated Financial Statements.

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**APPLIANCERECYCLING CENTERS OF AMERICA, INC. AND SUBSIDIARIES**

**CONSOLIDATEDSTATEMENT OF CASH FLOWS**
| ** **                                                                                 | ** ** | **For the fiscal year ended** | ** **     |
|--------------------------------------------------------------------------------------------|------------|---------------------------------------------------|----------------|
| ** **                                                                                 | ** ** | **December 30,**                             | ** **     | **December 31,** | ** ** | **January 1,** | ** ** |
| ** **                                                                                 | ** ** | **2006**                                          | ** **     | **2005** | ** ** | **2005** | ** ** |
| **Cash  Flows from Operating Activities**                                                  |       |                                              |           |   |   |   |   |
| Net loss                                                                                   | ** ** | **$**                                             | **(1,409,000** | **)** | $ | (933,000 | ) | $ | (1,314,000 | ) |
| Adjustments to reconcile net loss to net cash  provided by (used in) operating activities: |       |                                              |           |   |   |   |   |
| Depreciation and amortization                                                              | ** ** | **788,000**                                       |           | 818,000 |   | 658,000 |   |
| Stock-based compensation expense                                                           | ** ** | **128,000**                                       |           |   |   |   |   |
| Loss on sale of property and equipment                                                     | ** ** | **15,000**                                        | ** **     | **—** |   | — |   |
| Gain on building deposit forfeiture                                                        | ** ** | **(730,000**                                      | **)**          |   |   |   |   |
| Deferred income taxes                                                                      |       |                                              |           | — |   | 117,000 |   |
| Change in assets and liabilities:                                                          |       |                                              |           |   |   |   |   |
| Receivables                                                                                | ** ** | **485,000**                                       |           | (862,000 | ) | (147,000 | ) |
| Inventories                                                                                | ** ** | **902,000**                                       |           | (1,746,000 | ) | (816,000 | ) |
| Other current assets                                                                       | ** ** | **(208,000**                                      | **)**          | (111,000 | ) | (184,000 | ) |
| Other assets                                                                               | ** ** | **273,000**                                       |           | (56,000 | ) | (40,000 | ) |
| Accounts payable and accrued expenses                                                      | ** ** | **(254,000**                                      | **)**          | 741,000 |   | 1,691,000 |   |
| Income taxes refundable or payable                                                         |       | —                                            | ** **     | **—** |   | 302,000 |   |
| Net cash flows from operating activities                                                   | ** ** | **(10,000**                                       | **)**          | (2,149,000 | ) | 267,000 |   |
|                                                                                       | ** ** | ** **                                        | ** **     |   |   |   |   |
| **Cash  Flows from Investing Activities**                                                  |       |                                              |           |   |   |   |   |
| Purchases of property and equipment                                                        | ** ** | **(553,000**                                      | **)**          | (517,000 | ) | (659,000 | ) |
| Proceeds from disposal of equipment                                                        | ** ** | **2,000**                                         | ** **     | **—** | ** ** | **—** | ** ** |
| Deposit received from sale of building                                                     | ** ** | **730,000**                                       | ** **     | **—** | ** ** | **—** | ** ** |
| Net cash flows from investing activities                                                   | ** ** | **179,000**                                       |           | (517,000 | ) | (659,000 | ) |
|                                                                                       | ** ** | ** **                                        |           |   |   |   |   |
| **Cash  Flows from Financing Activities**                                                  |       |                                              |           |   |   |   |   |
| Net borrowings under line of credit                                                        | ** ** | **747,000**                                       |           | 710,000 |   | 326,000 |   |
| Payments on long-term obligations                                                          | ** ** | **(260,000**                                      | **)**          | (602,000 | ) | (236,000 | ) |
| Proceeds from short-term obligations                                                       |       | —                                            |           | — |   | 300,000 |   |
| Distribution to minority subsidiary owner                                                  | ** ** | **(25,000**                                       | **)**          | — |   | — |   |
| Proceeds from stock option exercises                                                       | ** ** | **29,000**                                        |           | 365,000 |   | 16,000 |   |
| Proceeds from warrant exercises                                                            |       | —                                            |           | 3,000 |   | 18,000 |   |
| Payments of stock placement costs                                                          | ** ** | **(2,000**                                        | **)**          | (77,000 | ) | **—** | ** ** |
| Net proceeds from issuance of Common Stock                                                 |       | —                                            | ** **     | **—** |   | 3,134,000 |   |
| Net cash flows from financing activities                                                   | ** ** | **489,000**                                       |           | 399,000 |   | 3,558,000 |   |
|                                                                                       | ** ** | ** **                                        |           |   |   |   |   |
| Increase (decrease) in cash and cash equivalents                                           | ** ** | **658,000**                                       |           | (2,267,000 | ) | 3,166,000 |   |
|                                                                                       | ** ** | ** **                                        |           |   |   |   |   |
| **Cash  and Cash Equivalents**                                                             |       |                                              |           |   |   |   |   |
| Beginning                                                                                  | ** ** | **2,095,000**                                     |           | 4,362,000 |   | 1,196,000 |   |
| Ending                                                                                     | ** ** | **$**                                             | **2,753,000**  |   | $ | 2,095,000 |   | $ | 4,362,000 |   |
|                                                                                       | ** ** | ** **                                        |           |   |   |   |   |
| **Supplemental  Disclosures of Cash Flow Information**                                     |       |                                              |           |   |   |   |   |
| Cash payments  (receipts) relative to:                                                     |       |                                              |           |   |   |   |   |
| Interest                                                                                   | ** ** | **$**                                             | **1,078,000**  |   | $ | 894,000 |   | $ | 777,000 |   |
| Income taxes, net                                                                          | ** ** | **9,000**                                         |           | 6,000 |   | (967,000 | ) |
|                                                                                       | ** ** | ** **                                        |           |   |   |   |   |
| Equipment acquired  under capital lease                                                    | ** ** | **$**                                             | **260,000**    |   | $ | 19,000 |   | $ | 155,000 |   |

 

SeeNotes to Consolidated Financial Statements.

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**APPLIANCE RECYCLING CENTERS OF AMERICA, INC. AND SUBSIDIARIES**

**NOTES TO CONSOLIDATED FINANCIAL STATEMENTS**

**Note 1.  Nature of Business andSignificant Accounting Policies**

**Nature of business: **Appliance Recycling Centers of America, Inc. and our subsidiaries arein the business of providing reverse logistics, energy conservation andrecycling services for major household appliances.  We sell appliances through a chain ofcompany-owned factory outlet stores under the name ApplianceSmart®.  We also provide recyclingservices on a credit basis to appliance retailers and electric utilities.

**A summary of our significantaccounting policies is as follows:**

**Principles of consolidation:**  The consolidated financial statements includethe accounts of Appliance Recycling Centers of America, Inc. and oursubsidiaries.  All significantintercompany accounts and transactions have been eliminated in consolidation.

During the second quarter of 2003, we became amajority (60%) owner in North America Appliance Company, LLC (NAACO).  NAACO was formed and commenced operations inJune 2003 and is a retailer of special-buy appliances in Texas.  Because NAACO has a net shareholders’deficit, no minority interest has been recognized on our consolidated balancesheet, and 100% of NAACO’s operations are included in our consolidatedfinancial statements for the years of 2006, 2005 and 2004.

On September 1, 2006, we became a majority (60%)owner in Productos Duraderos de Norte America (PDN), a Mexican Corporation inexchange for $3,000 in cash.  PDNrefurbishes household window air conditioners for sale through our NAACOoperation in McAllen, Texas and through our ApplianceSmart outlet stores.  Operating results of PDN from September 1,2006 through December 30, 2006 are included in our financial statements.  PDN has operated at a loss since September 1,2006 so 100% of PDN’s operations are included in our consolidated financialstatements.

During the third quarter of 2006, ARCA Canada,Incorporated was formed in Canada.  ARCACanada is a wholly owned (100%) subsidiary of ARCA Inc. and its operatingresults are included in our consolidated financial statements.

**Fair value of financialinstruments:** The followingmethods and assumptions are used to estimate the fair value of each class offinancial instrument:

**Cash, accounts receivable andaccounts payable:**  Due to theirnature and short-term maturities, the carrying amounts approximate fair value.

**Short- and long-term debt:**  The fair value of short- and long-term debthas been estimated based on discounted cash flows using interest rates beingoffered for similar debt having the same or similar remaining maturities andcollateral requirements.

No separate comparison of fair values versuscarrying values is presented for the aforementioned financial instruments sincetheir fair values are not significantly different than their balance sheetcarrying amounts.  In addition, theaggregate fair values of the financial instruments would not represent theunderlying value of our company.

37

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**Fiscal year:**  We use a 52-53 week fiscal year.  Our 2006 fiscal year (2006) ended December30, 2006.  Our 2005 fiscal year (2005)ended December 31, 2005, and our 2004 fiscal year (2004) ended January 1,2005.  All periods presented contain 52weeks.

**Revenue recognition:**  We recognize revenue from appliance sales inthe period the consumer purchases and pays for the appliances, net of allowancefor estimated returns.  We recognizerevenue from appliance recycling when we collect and process a unit.  We recognize byproduct revenue upon shipment.

We defer revenue under certain appliance extendedwarranty arrangements we sell and service and recognize the revenue over therelated terms of the warranty contracts. On extended warranty arrangements we sell but others service for a fixedportion of the warranty sales price, we recognize revenue for the net amountretained at the time of sale of the extended warranty to the consumer.

We include shipping and handling charges tocustomers in revenues, which are recognized when delivery has beencompleted.  Shipping and handling coststhat we incur are included in cost of revenues.

**Product warranty:**  We provide a warranty for the replacement orrepair of certain defective units.  Ourstandard warranty policy requires us to repair or replace certain defectiveunits at no cost to our customers.  Weestimate the costs that may be incurred under our warranty and record aliability reserve in the amount of such costs at the time we recognize productrevenue.  Factors that affect ourwarranty liability reserve for covered units include the number of units sold,historical and anticipated rates of warranty claims on these units, and thecost of such claims. We periodically assess the adequacy of our recordedwarranty liability reserve and adjust the amounts as necessary.

Changes in our warranty liability reserve are asfollows:
| ** **                           | ** ** | **2006**    | ** ** | **2005** | ** ** | **2004** | ** ** |
|--------------------------------------|------------|-------------|------------|----------|------------|----------|------------|
| Balance,  beginning                  | ** ** | **$**       | **27,000** |     | $          | 35,000   |       | $ | 54,000 |   |
| Standard accrual based on units sold | ** ** | **55,000**  |       | 58,000   |       | 76,000   |       |
| Actual costs incurred                | ** ** | **(4,000**  | **)**      | (3,000   | )          | (53,000  | )          |
| Periodic accrual adjustments         | ** ** | **(50,000** | **)**      | (63,000  | )          | (42,000  | )          |
| Balance, ending                      | ** ** | **$**       | **28,000** |     | $          | 27,000   |       | $ | 35,000 |   |

 

**Trade receivables: **We carry trade receivables at original invoiceamount less an estimate made for doubtful receivables based on a monthly reviewof all outstanding amounts.  Managementdetermines the allowance for doubtful accounts by regularly evaluatingindividual customer receivables and considering a customer’s financialcondition, credit history and current economic conditions.  We write off trade receivables when we deemthem uncollectible.  We record recoveriesof trade receivables previously written off when we receive them.  We consider a trade receivable to be past dueif any portion of the receivable balance is outstanding for more than 90days.  We do not charge interest on pastdue receivables.  Our managementconsiders the reserve for doubtful accounts of $152,000 and $252,000 to beadequate to cover any exposure to loss in our December 30, 2006 and December31, 2005 accounts receivable, respectively.

**Cash:**  We maintain our cash in bank deposit andmoney-market accounts which, at times, exceed federally insured limits.  We have not experienced any losses in suchaccounts.

**Restricted cash:**  In connection with our consumer credit cardprocessing arrangements, we are required to maintain a cash balance that isrestricted.  At December 31, 2005, wewere required to maintain a balance of $350,000, which is reflected in theconsolidated balance sheet as long-term restricted cash.  During October 2005, our credit cardprocessing was transferred to a different processor.  This new processor does not require us to 

38

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maintain a cash balance that is restricted.  The former processor required us to maintainthe restricted cash balance for 90 days after we ceased using the former creditcard processor.  In January 2006,$300,000 of the restricted cash balance was released and refunded to us.  The remaining $50,000 was released in thesecond quarter of 2006.

**Inventories:**  Inventories, consisting principally ofappliances, are stated at the lower of cost, first-in, first-out (FIFO), ormarket and consist of:
| ** **     | ** ** | **2006**     | ** **     | **2005** | ** ** |
|----------------|------------|--------------|----------------|----------|------------|
| Finished goods | ** ** | **$**        | **11,205,000** |     | $          | 12,279,000 |   |
| Less reserves  | ** ** | **(207,000** | **)**          | (379,000 | )          |
| ** **     |       | **$**        | **10,998,000** |     | $          | 11,900,000 |   |

 

We provide estimated reserves for therealizability of our appliance inventories, including adjustments to market,based on various factors including the age of such inventory and our management’sassessment of the need for such allowances. We look at historical inventory agings and margin analysis indetermining our reserve estimate.  Webelieve the reserve of $207,000 and $379,000 as of December 30, 2006 andDecember 31, 2005, respectively, is adequate.

**Property and equipment:**  We compute depreciation using straight-lineand accelerated methods over the following estimated useful lives:
| ** **                  | ** ** | **Years**    | ** ** |
|-----------------------------|------------|--------------|------------|
| Buildings and  improvements |       | 18 — 30 |       |
| Equipment                   |       | 3 — 8   |       |

 

We amortize leasehold improvements on astraight-line basis over the shorter of their estimated useful lives or theunderlying lease term.

We did not identify any items that were impairedas of December 30, 2006.

**Software development costs:**  We capitalize software developed for internaluse in accordance with Statement of Position 98-1 and are amortizing such costsover their estimated useful life of five years. Costs capitalized were $238,000, $230,000 and $220,000 for the fiscalyears of 2006, 2005 and 2004, respectively. Amortization expense on software development costs was $239,000,$246,000 and $212,000 for the fiscal years 2006, 2005 and 2004,respectively.  Estimated amortizationexpenses are $207,000, $157,000, $111,000, $81,000 and $44,000 for the fiscalyears 2007, 2008, 2009, 2010 and 2011, respectively.

**Accounting for long-livedassets: **We evaluate long-livedassets such as property and equipment for impairment whenever events or changesin circumstances indicate the carrying value of an asset may not berecoverable.  We assess the fair value ofthe assets based on the estimated future net undiscounted cash flows expectedto result from the use of the assets, including cash flows fromdisposition.  Should the sum of theexpected future net cash flows be less than the carrying value, we recognize animpairment loss at that time.  We measurean impairment loss by comparing the amount by which the carrying value exceedsthe fair value (estimated discounted future cash flows or appraisal of assets)of the long-lived assets.

**Deferred financing fees:** Deferred financing fees are presented in the consolidated balance sheetas a component of other assets and are reported net of accumulatedamortization.  We determine amortizationexpense on a straight-line basis over the term of the underlying debt.

**Advertising expense: **Advertising is expensed as incurred and was$3,593,000, $3,164,000 and $2,353,000 for the 2006, 2005 and 2004 fiscal years,respectively.

39

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**Income taxes:**  Deferred taxes are provided on an asset andliability method whereby deferred tax assets are recognized for deductibletemporary differences and operating loss and tax credit carryforwards, anddeferred tax liabilities are recognized for taxable temporary differences.  Temporary differences are the differencesbetween the reported amounts of assets and liabilities and their taxbasis.  Deferred tax assets are reducedby a valuation allowance when, in the opinion of our management, it is morelikely than not that some portion or all of the deferred tax assets will not berealized.  Deferred tax assets andliabilities are adjusted for the effects of changes in tax laws and rates onthe date of enactment.  Realization ofdeferred tax assets is dependent upon sufficient future taxable income duringthe periods when deductible temporary differences and carryforwards areexpected to be available to reduce taxable income.

**Basic and diluted net loss pershare:**  Basic per-share amounts arecomputed, generally, by dividing net loss by the weighted-average number ofcommon shares outstanding.  Dilutedper-share amounts assume the conversion, exercise or issuance of all potentialcommon stock instruments unless their effect is antidilutive, thereby reducingthe loss or increasing the income per common share.

In arriving at diluted weighted-average shares andper-share amounts, we included options and warrants (see Note 8) with exerciseprices below average market prices, for the respective fiscal quarters in whichthey were dilutive, using the treasury stock method.  We calculated the number of additional sharesby assuming the outstanding stock options and warrants were exercised and thatthe proceeds from such exercises were used to acquire Common Stock at theaverage market price during the year. Because the effect of options and warrants on 2006, 2005 and 2004 is antidilutive,they were not included in the computation of per-share amounts.

**Stock-based compensation:**   In December 2004, FASB published FASB Statement No.123 (revised 2004), *Share-Based Payment*(“FAS 123(R)” or the “Statement”).  FAS123(R) requires that the compensation cost relating to share-based paymenttransactions, including grants of employee stock options, be recognized infinancial statements.  That cost ismeasured based on the fair value of the equity or liability instruments issued.  FAS 123(R) covers a wide range of share-basedcompensation arrangements including stock options, restricted share plans,performance-based awards, share appreciation rights, and employee sharepurchase plans.  FAS 123(R) is areplacement of FASB Statement No. 123, *Accountingfor Stock-Based Compensation*, and supersedes APB Opinion No. 25, *Accounting for Stock Issued to Employees*,and its related interpretive guidance. The effect of the Statement will be to require entities to measure thecost of employee services received in exchange for stock options based on thegrant-date fair value of the award, and to recognize the cost over the periodthe employee is required to provide services for the award.  FAS 123(R) permits entities to use anyoption-pricing model that meets the fair value objective in the Statement.

We evaluated the transition methods available andadopted the modified prospective transition method in applying FAS 123(R) as ofour fiscal year beginning January 1, 2006. The pro forma net income effect of using the fair value method for thepast two fiscal years is presented in the table below.  The pro forma compensation costs presented inthe table and in our prior filings have been calculated using a Black-Scholesoption pricing model.  We continued touse the Black-Scholes option pricing model to determine the fair value ofawards at grant date.  We estimate theexpense for fiscal 2007 to be approximately $64,000, based on the value ofoptions issued in the first quarter of 2007 that will vest during 2007.  This estimate does not include any expensefor additional options that may be granted and vest during 2007.

As was permitted under accounting principlesgenerally accepted in the United States of America, 2005 and prior grants wereaccounted for following APB Opinion No. 25 and related interpretations.  Accordingly, compensation cost would berecognized for those grants where the exercise price is less than the fairmarket value of the stock on the date of grant. We recorded no compensation expense for employee grants for fiscal years2005 and 2004 because the market price and exercise price of the grants werethe same on the day of grant.

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Had compensation cost for all employee stock-basedcompensation grants and warrants issued been determined based on the fairvalues at the grant date consistent with the provisions of FAS No. 123(R), ournet loss and net loss per basic and diluted common share would have been asindicated below.
| ** **                                | ** ** | **2005**    | ** **     | **2004** | ** ** |
|-------------------------------------------|------------|-------------|----------------|----------|------------|
| Net income  (loss):                       |       |        |           |     |       |
| As reported                               | ** ** | **$**       | **(933,000**   | **)**    | $          | (1,314,000 | ) |
| Deduct pro forma stock-based compensation | ** ** | **(85,000** | **)**          | (46,000  | )          |
| Pro forma                                 | ** ** | **$**       | **(1,018,000** | **)**    | $          | (1,360,000 | ) |
| Basic earnings  (loss) per share:         |       |        |           |     |       |
| As reported                               | ** ** | **$**       | **(0.22**      | **)**    | $          | (0.48 | ) |
| Pro forma                                 | ** ** | **$**       | **(0.24**      | **)**    | $          | (0.50 | ) |
| Diluted earnings  (loss) per share:       |       |        |           |     |       |
| As reported                               | ** ** | **$**       | **(0.22**      | **)**    | $          | (0.48 | ) |
| Pro forma                                 | ** ** | **$**       | **(0.24**      | **)**    | $          | (0.50 | ) |

 

**Comprehensive income: **Comprehensive income is equivalent to net incomein the statement of operations.

**Segment information: **We have one operating segment.  Although certain separate financialinformation by retail store, or retail store and recycling center, is availableto management, we are managed as a unit. Specifically, we do not measure profit or loss or maintain assetsseparately for our products or revenue sources (retail appliance sales,appliance recycling including recycling services for utilities, and byproductsales).

**Estimates:**  The preparation of financial statements inconformity with accounting principles generally accepted in the United Statesof America requires our management to make estimates and assumptions thataffect the reported amounts of assets and liabilities and disclosure ofcontingent assets and liabilities at the date of the financial statements andthe reported amounts of revenues and expenses during the reporting period.  Significant items subject to estimates andassumptions include the valuation allowances for accounts receivable,inventories and deferred tax assets. Actual results could differ from those estimates.

**Recently issued accountingpronouncements: **The following itemsrepresent accounting standards that have recently been issued.

In June 2006, the FASB haspublished FASB Interpretation (FIN) No. 48 (FIN No. 48), Accounting forUncertainty in Income Taxes, to address the noncomparability in reporting taxassets and liabilities resulting from a lack of specific guidance in FASB SFASNo. 109, Accounting for Income Taxes, on the uncertainty in income taxesrecognized in an enterprise’s financial statements.  Specifically, FIN No. 48 prescribes (a) aconsistent recognition threshold and (b) a measurement attribute for thefinancial statement recognition and measurement of a tax position taken orexpected to be taken in a tax return, and provides related guidance onderecognition, classification, interest and penalties, accounting in interimperiods, disclosure and transition.  The provisions of FIN No. 48 are effective for fiscal years beginningafter December 15, 2006.  We do notexpect the adoption of FIN No. 48 will have a material impact on theconsolidated financial statements.

In September 2006, the FASBhas published FASB SFAS No. 157, Fair Value Measurements, to eliminate thediversity in practice that exists due to the different definitions of fairvalue and the limited guidance for applying those definitions in GAAP that are dispersedamong the many accounting pronouncements that require fair valuemeasurements.  SFAS No. 157 retains theexchange price notion in earlier definitions of fair value, but clarifies thatthe exchange price is the price in an orderly transaction between marketparticipants to sell an asset or liability in the principal or mostadvantageous market for the asset or liability. Moreover, the SFAS 

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states that the transactionis hypothetical at the measurement date, considered from the perspective of themarket participant who holds the asset or liability.  Consequently, fair value is defined as theprice that would be received to sell an asset or paid to transfer a liabilityin an orderly transaction between market participants at the measurement date(an exit price), as opposed to the price that would be paid to acquire theasset or received to assume the liability at the measurement date (an entryprice).  SFAS No. 157 also stipulatesthat, as a market-based measurement, fair value measurement should bedetermined based on the assumptions that market participants would use inpricing the asset or liability, and establishes a fair value hierarchy thatdistinguishes between (a) market participant assumptions developed based onmarket data obtained from sources independent of the reporting entity(observable inputs) and (b) the reporting entity’s own assumptions about marketparticipant assumptions developed based on the best information available inthe circumstances (unobservable inputs). Finally, SFAS No. 157 expands disclosures about the use of fair value tomeasure assets and liabilities in interim and annual periods subsequent toinitial recognition.  Entities areencouraged to combine the fair value information disclosed under SFAS No. 157with the fair value information disclosed under other accountingpronouncements, including SFAS No. 107, Disclosures about Fair Value ofFinancial Instruments, where practicable. The guidance in this Statement applies for derivatives and otherfinancial instruments measured at fair value under SFAS No. 133, Accounting forDerivative Instruments and Hedging Activities, at initial recognition and inall subsequent periods.  The provisionsof SFAS No. 157 are effective for fiscal years beginning after November 15,2007.  We believe the impact of SFAS No.157 will not have a material effect on the consolidated financial statements.

In September 2006, the FASBhas published FASB SFAS No. 158, Employers’ Accounting for Defined BenefitPension and Other Postretirement Plans, to require an employer to fullyrecognize the obligations associated with single-employer defined benefitpension, retiree healthcare, and other postretirement plans in their financialstatements. Previous standards required an employer to disclose the completefunded status of its plan only in the notes to the financial statements.Moreover, because those standards allowed an employer to delay recognition ofcertain changes in plan assets and obligations that affected the costs ofproviding benefits, employers reported an asset or liability that almost alwaysdiffered from the plan’s funded status. Under SFAS No. 158, a defined benefitpostretirement plan sponsor that is a public or private company or anongovernmental not-for-profit organization must (a) recognize in its statementof financial position an asset for a plan’s overfunded status or a liabilityfor the plan’s underfunded status, (b) measure the plan’s assets and itsobligations that determine its funded status as of the end of the employer’s fiscalyear (with limited exceptions), and (c) recognize, as a component of othercomprehensive income, the changes in the funded status of the plan that ariseduring the year but are not recognized as components of net periodic benefitcost pursuant to SFAS No. 87, Employers’ Accounting for Pensions, or SFAS No.106, Employers’ Accounting for Postretirement Benefits Other Than Pensions.SFAS No. 158 also requires an employer to disclose in the notes to financialstatements additional information on how delayed recognition of certain changesin the funded status of a defined benefit postretirement plan affects netperiodic benefit cost for the next fiscal year.  We believe the impact ofSFAS No. 158 will not have a material effect on the consolidated financialstatements.

**Note 2.  Line of Credit**

At December 30, 2006, we had an $8 million lineof credit with a lender.  The interestrate on the line as of December 30, 2006 was prime plus 2.95 percentage points(11.20%).  The amount of borrowingsavailable under the line of credit is based on a formula using receivables andinventories.  Our unused borrowingcapacity under this line was $80,000 at December 30, 2006.  The line of credit has a stated maturity dateof December 31, 2007, if not renewed, and provides that the lender may demandpayment in full of the entire outstanding balance of the loan at any time.  The line of credit is collateralized bysubstantially all our assets and requires minimum monthly interest payments of$37,500, regardless of the outstanding principal balance.  The lender is also secured by an inventoryrepurchase agreement with Whirlpool Corporation for purchases from Whirlpoolonly.  The loan requires that we meetcertain financial covenants, provides payment penalties for noncompliance andprepayment, 

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limits the amount of other debt we can incur,limits the amount of spending on fixed assets, and limits payments ofdividends.  At December 30, 2006, we werein violation of the covenant related to reaching a minimum annual level of netincome and a covenant related to a minimum level of tangible net worth.  On March 28, 2007, the lender waived theseviolations.

**Note 3.  Long-Term Obligations**

Long-term obligations consisted of the following:
| ** **                                                                                                                                                                                                                                                                       | ** ** | **2006**      | ** **    | **2005**  | ** ** |
|----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|------------|---------------|---------------|-----------|------------|
| Adjustable rate  mortgage based on the 30-day LIBOR rate adjusted annually each September  (5.32% as of December 30, 2006) plus 2.7%, monthly payments include interest  and principal, and are based on a 20-year amortization, due October 2012,  secured by land and building | ** ** | **$**         | **3,002,000** |      | $          | 3,118,000 |   |
| 6.85% mortgage,  due in monthly installments of $15,326, including interest, due January 2013,  secured by land and building                                                                                                                                                     | ** ** | **1,785,000** |          | 1,849,000 |       |
|                                                                                                                                                                                                                                                                             | ** ** | ** **    |          |      |       |
| Other, primarily  capital leases (see below)                                                                                                                                                                                                                                     | ** ** | **298,000**   |          | 118,000   |       |
| ** **                                                                                                                                                                                                                                                                       | ** ** | **5,085,000** |          | 5,085,000 |       |
| Less current  maturities                                                                                                                                                                                                                                                         | ** ** | **309,000**   |          | 262,000   |       |
| ** **                                                                                                                                                                                                                                                                       | ** ** | **$**         | **4,776,000** |      | $          | 4,823,000 |   |

 

The future annual maturities of long-termobligations are as follows:
| **Fiscal year** | ** ** | ** ** | ** ** |
|----------------------|------------|------------|------------|
| 2007                 |       | $          | 309,000    |   |
| 2008                 |       | 260,000    |       |
| 2009                 |       | 272,000    |       |
| 2010                 |       | 291,000    |       |
| 2011                 |       | 273,000    |       |
| 2012 and  thereafter |       | 3,680,000  |       |
|                 |       | $          | 5,085,000  |   |

 

**Capital leases:** We lease certain equipment under capital leases.  The cost of the equipment was approximately$441,000 and $314,000 at December 30, 2006 and December 31, 2005, respectively.  Accumulated amortization at December 30, 2006and December 31, 2005 was approximately $132,000 and $183,000, respectively.

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The following is a schedule by years of approximate remaining minimumpayments required under the leases, together with the present value at December30, 2006:
| **Fiscal Year**               | ** ** | ** ** | ** ** |
|------------------------------------|------------|------------|------------|
| 2007                               |       | $          | 128,000    |   |
| 2008                               |       | 76,000     |       |
| 2009                               |       | 70,000     |       |
| 2010                               |       | 70,000     |       |
| 2011                               |       | 34,000     |       |
| Total minimum  lease payments      |       | $          | 378,000    |   |
|                               |       |       |       |
| Less amount  representing interest |       | 79,000     |       |
| Less current  portion              |       | 96,000     |       |
| Long-term portion                  |       | $          | 203,000    |   |

 

**Note 4.  Accrued Expenses**

Accrued expenses were as follows:
| ** **                          | ** ** | **2006**      | ** **    | **2005**  | ** ** |
|-------------------------------------|------------|---------------|---------------|-----------|------------|
| Compensation and  benefits          | ** ** | **$**         | **1,427,000** |      | $          | 1,339,000 |   |
| Warranty expense                    | ** ** | **28,000**    |          | 27,000    |       |
| Accrued  recycling incentive checks | ** ** | **1,110,000** |          | 1,110,000 |       |
| Accrued Rent                        | ** ** | **356,000**   |          | 272,000   |       |
| Accrued Payables                    | ** ** | **570,000**   |          | 554,000   |       |
| Other                               | ** ** | **466,000**   |          | 239,000   |       |
| ** **                          | ** ** | **$**         | **3,957,000** |      | $          | 3,541,000 |   |

 

**Note 5.  Commitments and Contingencies**

**Operating leases: **We lease certain of our retail stores andrecycling center facilities and equipment under noncancelable operating leases.  The leases require the payment of taxes,maintenance, utilities and insurance.

Minimum future rental commitments undernoncancelable operating leases as of December 30, 2006 are as follows:
| **Fiscal Year** | ** ** | ** ** | ** ** |
|----------------------|------------|------------|------------|
| 2007                 |       | $          | 2,898,000  |   |
| 2008                 |       | 2,318,000  |       |
| 2009                 |       | 1,477,000  |       |
| 2010                 |       | 1,045,000  |       |
| 2011                 |       | 1,070,000  |       |
| 2012 and  thereafter |       | 4,528,000  |       |
|                 |       | $          | 13,336,000 |   |

 

Rent expense for fiscal years 2006, 2005 and 2004was $3,542,000, 2,995,000 and $1,957,000, respectively.

**Contracts:**  We have entered into contractswith four of our appliance vendors. Under the agreements there are no minimum purchase commitments; however,we have agreed to indemnify the vendors for certain claims, allegations orlosses with respect to appliances we sell.

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**Litigation: **In December 2004, we filed suit in the U.S.District Court for the Central District of California alleging that JACOEnvironmental, Inc. (JACO) and a former consultant of the company fraudulentlyobtained a patent (U.S. Patent No. 6,732,416) in May 2004 covering appliancerecycling methods and systems originally developed by us beginning in 1987 andused in serving more than forty-five electric utility appliance recyclingprograms since that time.  We are seekingan injunction to prevent JACO from claiming that it obtained a valid patent onappliance recycling processes that we believe is based on methods and processeswe invented.  We are also asking thecourt for unspecified damages related to charges that JACO, in using the patentto promote its services, has engaged in unfair competition and false andmisleading advertising under federal and California statutes.  In addition, we may incur substantial costsin pursuing this injunction, which could have an adverse effect on our resultsof operations.  In September 2005, wereceived a legally binding document in which JACO states it will not sue us orany of our customers for violating the JACO patent. Therefore, our recyclingoperations will continue with our current contracts without interruption.  On October 18, 2006, the U.S. District Courtfor the Central District of California denied the motion for summary judgmentfiled by JACO Environmental, Inc., (JACO) seeking to dismiss the suit.  The case is scheduled for trial in April2007.

On October 24, 2006, JACO and SEB Umwelt-Service/Basis of Mettlach,Germany (SEG) filed a patent infringement lawsuit in Federal Court againstus.  The suit claims that we have beenusing refrigerator recycling systems and processes covered by two U.S. patentsissued to SEG and exclusively licensed to JACO. JACO and SEG are seeking undisclosed amounts in damages, in addition toan injunction barring us from continuing to use and market the systems andprocesses upon which we allegedly infringe. We believe this lawsuit is retaliatory in nature, given the court’sdenial of JACO’s request to have our litigation dismissed.  We intend to vigorously defend ARCA againstthis suit.

**Note6.  Income Taxes**

The provision for (benefit of) income taxesconsisted of the following:
| ** ** | ** ** | **2006** | ** ** | **2005**   | ** ** | **2004**   | ** ** |
|------------|------------|----------|------------|------------|------------|------------|------------|
| Current:   |       |     |       |       |       |       |       |
| Federal    | ** ** | **$**    | **—** | ** ** | **—** |       | $          | (663,000 | ) |
| Deferred   |       | —   | ** ** | **—** |       | 117,000    |       |
| ** ** | ** ** | **$**    | **—** | ** ** | **$**      | **—** |       | $ | (546,000 | ) |
|            |            |          |            |            |            |            |            |  |  |  |

 

A reconciliation of our income tax expense withthe federal statutory tax rate is shown below:
| ** **                                                 | ** ** | **2006**       | ** **   | **2005**   | ** ** | **2004** | ** ** |
|------------------------------------------------------------|------------|----------------|--------------|------------|------------|----------|------------|
| Income tax  expense (benefit) at statutory rate            | ** ** | **$**          | **(479,000** | **)**      | $          | (343,000 | )          | $ | (639,000 | ) |
| State taxes net  of federal tax effect                     | ** ** | **(98,000**    | **)**        | (61,000    | )          | (117,000 | )          |
| Permanent  differences and other                           | ** ** | **25****,000** |         | (65,000    | )          | 13,000   |       |
| Federal income  tax credit attributable to carryback claim |       | —         | ** **   | **—** |       | (673,000 | )          |
| Change in valuation  allowance                             | ** ** | **552,000**    |         | 469,000    |       | 870,000  |       |
|                                                       |       | $              | —       |       | $          | —   |       | $ | (546,000 | ) |

 

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The components of net deferred tax assets are asfollows:
| ** **                       | ** ** | **2006**       | ** **    | **2005**   | ** ** |
|----------------------------------|------------|----------------|---------------|------------|------------|
| Deferred tax  assets:            |       |           |          |       |       |
| Net operating loss carryforwards | ** ** | **$**          | **1,981,000** |       | $          | 1,352,000 |   |
| Federal and state tax credits    | ** ** | **269,000**    |          | 269,000    |       |
| Reserves                         | ** ** | **235,000**    |          | 302,000    |       |
| Accrued expenses                 | ** ** | **171,000**    |          | 157,000    |       |
| Other                            | ** ** | **95****,000** |          | 12,000     |       |
| Net deferred tax assets          |       | **$**          | **2,751,000** |       | $          | 2,092,000 |   |
| Valuation  allowance             | ** ** | **(2,150,000** | **)**         | (1,598,000 | )          |
| ** **                       | ** ** | **$**          | **601,000**   |       | $          | 494,000 |   |
| Deferred tax  liabilities:       |       |           |          |       |       |
| Prepaid expenses                 |       | **$**          | **117,000**   |       | $          | 71,000 |   |
| Property and  equipment          |       | **484,000**    |          | 423,000    |       |
| Net deferred taxes               | ** ** | **$**          | **601,000**   |       | $          | 494,000 |   |

 

The deferred tax amounts mentioned above have beenclassified in the accompanying balance sheet as follows:
| ** **               | ** ** | **2006**     | ** **  | **2005** | ** ** |
|--------------------------|------------|--------------|-------------|----------|------------|
| Current assets           | ** ** | **$**        | **601,000** |     | $          | 393,000 |   |
| Non-current  liabilities | ** ** | **(601,000** | **)**       | (393,000 | )          |
| ** **               | ** ** | **$**        | **—**  |     | $          | — |   |

 

At December 30, 2006, we had a valuation allowanceagainst deferred tax assets to reduce the total to an amount our managementbelieves is appropriate.  Realization ofdeferred tax assets is dependent upon sufficient future taxable income duringthe periods when deductible temporary differences and carryforwards areexpected to be available to reduce taxable income.  The valuation allowance increased in thecurrent year primarily as a result of net operating losses generated during theyear in which we have provided a valuation allowance.  In the future when we believe we canreasonably estimate future operating results and those estimated resultsreflect taxable income, the amount of deferred tax assets considered reasonablecould be adjusted by a reduction of the valuation allowance.

At December 30, 2006, we had NOL carryforwardsexpiring as follows:
| **Expiration** | ** ** | **Amount** | ** ** |
|----------------|------------|------------|------------|
| 2013           |       | $          | 843,300    |   |
| 2023           |       | $          | 166,000    |   |
| 2024           |       | $          | 1,533,000  |   |
| 2025           |       | $          | 781,000    |   |
| 2026           |       | $          | 1,600,000  |   |

----

* These carryforward amounts may be limited under provisions of Section382 of the Internal Revenue Code.

Future utilization of NOL and tax credit carryforwards is subject tocertain limitations under provisions of Section 382 of the Internal RevenueCode.  This section relates to a 50percent change in control over a three-year period.  We believe that the issuance of Common Stockduring 1999 resulted in an “ownership change” under Section 382.  Accordingly, our ability to use NOL and taxcredit carryforwards generated prior to February 1999 may be limited toapproximately $56,000 per year.

 

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**Note 7.  Shareholders’ Equity**

**Stock options:**  Our2006 Stock Option Plan (the “2006 Plan”) permits the granting of “incentivestock options” meeting the requirements of Section 422 of the Internal RevenueCode of 1986, as amended, and nonqualified options that do not meet therequirements of Section 422.  The 2006Plan has 600,000 shares available for grant. Our Restated 1997 Stock Option Plan (the “1997 Plan” and collectivelywith the 2006 Plan, the “Plans”), has expired. As of March 16, 2007, options to purchase an aggregate of 94,500 shareshad been granted to employees and were outstanding under the 1997 Plan, andoptions to purchase an aggregate of 185,000 shares had been granted to theCompany’s non-employee directors.  Underthe 1997 Plan, 209,250 options have been exercised.  Options outstanding under the expired 1997Plan continue to be exercisable in accordance with their terms.

The fair value of each option grant is estimated on the date of grantusing the Black-Scholes option pricing model with the followingweighted-average assumptions:
| ** **                       | ** ** | **2006**   | ** ** | **2005** | ** ** | **2004** | ** ** |
|----------------------------------|------------|------------|------------|----------|------------|----------|------------|
| Expected dividend yield          |       | —     |       | —   |       | —   |       |
| Expected stock price  volatility | ** ** | **101.89** | **%**      | 77.7     | %          | 78.5     | %          |
| Risk-free interest rate          | ** ** | **4.91**   | **%**      | 3.2      | %          | 2.1      | %          |
| Expected life of options (years) | ** ** | **5.25**   |       | 6.75     |       | 2        |       |

 

Additional information relating to all outstanding options is asfollows:
| ** **                        | ** ** | ** ** | ** ** | **Weighted Average** | ** ** |
|-----------------------------------|------------|------------|------------|---------------------------|------------|
| ** **                        | ** ** | **Shares** | ** ** | **Exercise Price**   | ** ** |
| Outstanding at December  28, 2002 |       | 437,000    |       | $                    | 2.16       |   |
| Granted                           |       | 15,000     |       | $                         | 1.60       |   |
| Cancelled                         |       | (44,000    | )          | $                         | 3.06       |   |
| Outstanding at January  3, 2004   |       | 408,000    |       | $                    | 2.04       |   |
| Granted                           |       | 15,000     |       | $                         | 3.25       |   |
| Exercised                         |       | (16,000    | )          | $                         | 0.90       |   |
| Cancelled                         |       | (55,000    | )          | $                         | 1.92       |   |
| Outstanding at January  1, 2005   |       | 352,000    |       | $                    | 2.09       |   |
| Granted                           |       | 93,000     |       | $                         | 3.08       |   |
| Exercised                         |       | (179,000   | )          | $                         | 2.04       |   |
| Cancelled                         |       | (3,000     | )          | $                         | 3.93       |   |
| Outstanding at December  31, 2005 |       | 263,000    |       | $                    | 2.45       |   |
| Granted                           |       | 22,500     |       | $                         | 4.32       |   |
| Exercised                         |       | (21,500    | )          | $                         | 1.40       |   |
| Cancelled                         |       | (2,500     | )          | $                         | 0.59       |   |
| Outstanding at December 30, 2006  |       | 261,500    |       | $                    | 2.72       |   |

 

The weighted average fair value per option of options granted duringfiscal years 2006, 2005 and 2004 was $3.40, $2.06 and $1.41, respectively.

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The following tables summarize information about stock optionsoutstanding as of December 30, 2006:

OPTIONS OUTSTANDING
| **Range of Exercise Prices** | ** ** | **Number of Options  Outstanding** | ** ** | **Weighted Average  Remaining Contractual  Life in Years** | ** ** | **Weighted Average  Exercise Price** | ** ** |
|---------------------------------------------|------------|----------------------------------------------|------------|--------------------------------------------------------------------------------|------------|------------------------------------------------|------------|
| $4.05 to $4.32                              |       | 62,500                                       |       | 5.20                                                                           |       | $                                              | 4.18       |   |
| $2.43 to $3.25                              |       | 118,000                                      |       | 4.78                                                                           |       | $                                              | 2.91       |   |
| $1.38 to $2.00                              |       | 56,000                                       |       | 4.63                                                                           |       | $                                              | 1.62       |   |
| $0.59 to $0.75                              |       | 25,000                                       |       | 2.21                                                                           |       | $                                              | 0.65       |   |
|                                        |       | 261,500                                      |       |                                                                           |       | $                                              | 2.72       |   |

 

OPTIONS EXERCISABLE
| **Range of Exercise Prices** | ** ** | **Number of Options  Exercisable** | ** ** | **Weighted Average  Exercise Price** | ** ** |
|---------------------------------------------|------------|----------------------------------------------|------------|------------------------------------------------|------------|
| $4.05 to $4.30                              |       | 55,000                                       |       | $                                              | 4.19       |   |
| $2.43 to $3.25                              |       | 84,000                                       |       | $                                              | 2.88       |   |
| $1.38 to $2.00                              |       | 56,000                                       |       | $                                              | 1.62       |   |
| $0.59 to $0.75                              |       | 25,000                                       |       | $                                              | 0.65       |   |
|                                        |       | 220,000                                      |       | $                                              | 2.63       |   |

 

**Warrants: **We have adopted theprovisions of SFAS No. 123 in accounting for our warrants issued for financingor services.  Accordingly, the expense,if any, applicable to the value of such warrants is recognized as of the dateof grant.  Such warrants are generallyissued to non-employees.

In September 1998, we entered into a loan agreement with a lenderresulting in gross proceeds to us of $3.5 million.  In connection with this loan, we issued thelender a warrant to purchase 700,000 shares of Common Stock at an adjustableexercise price, which was at $0.60 per share. During 2004, the lender exercised the warrant to purchase 700,000options resulting in the issuance of 532,000 shares of Common Stock.

In February 1999, in connection with a private placement, we issuedwarrants to purchase 83,000 shares of Common Stock at $0.50 per share, subjectto adjustment.  During 2002, 4,000warrants were exercised, resulting in the issuance of 3,506 shares of CommonStock.  During 2003, 26,000 warrants wereexercised, resulting in the issuance of 20,326 shares of Common Stock.  During 2004, the remaining 53,000 warrantswere exercised, resulting in the issuance of 44,061 shares of Common Stock.

In March 1999, we issued to a board member at that time 5,000 warrantsto purchase our Common Stock at $0.625 per share, the market value of our stockat the date of grant.  During 2005, thiswarrant was exercised, resulting in the issuance of 5,000 shares of CommonStock.

In April 1999, we issued to a vendor 50,000 warrants to purchase CommonStock at $0.625 per share.  In February2003, 20,000 warrants were exercised, resulting in the issuance of 20,000shares of Common Stock.  In March 2004,the remaining 30,000 warrants were exercised, resulting in the issuance of30,000 shares of Common Stock.

**Preferred stock: **Our amended Articles of Incorporation authorizetwo million shares of Preferred Stock that may be issued from time to time inone or more series having such rights, powers, preferences and designations asthe Board of Directors may determine.  Todate no such preferred shares have been issued.

48

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**Private placement:**  In December 2004, we sold in aprivate placement 1,150,000 shares of Common Stock at a price of $3.00 pershare.  We incurred offering costs of$316,000 in 2004 and $77,000 in 2005. The net proceeds were used to repay certain indebtedness, to purchaseinventory and for future growth.

**Note 8.  Major Customers andSuppliers**

Revenues from our major recycling customers as a percentage of totalrevenues are as follows:
| ** **           | ** ** | **2006** | ** ** | **2005** | ** ** | **2004** | ** ** |
|----------------------|------------|----------|------------|----------|------------|----------|------------|
| Revenue  percentage: |       |     |       |     |       |     |       |
| Customer A           | ** ** | **11**   | **%**      | 9        | %          | 9        | %          |

 

We had a receivable from Customer A of $485,000 as of December 30, 2006and $1,307,000 as of December 31, 2005.

During the three-year period ended December 30, 2006, we purchased avast majority of appliances for resale from four suppliers.  We have and are continuing to secure othervendors from which to purchase appliances. However, the curtailment or loss of one of these suppliers or anyappliance supplier could adversely affect our operations.

**ITEM 9.****                            ****CHANGES IN AND DISAGREEMENTS WITHACCOUNTANTS ON ACCOUNTING AND FINANCIAL DISCLOSURE**

For the year ended December 31, 2005, we changed our accountants toVirchow Krause & Company, LLP, which was reported on Form 8-K filed April1, 2005.  During the two most recentfiscal years and through the effective date of the change of accountants, therewere no disagreements between us and our prior accountants on any matter ofaccounting principles or practices, financial statement disclosure, or auditingscope or procedure, which, if not resolved to the satisfaction of the prioraccountants, would have caused them to make reference thereto in their reporton the financial statements for such fiscal years.

**ITEM 9A.       CONTROLSAND PROCEDURES**

We maintain disclosure controls and procedures that are designed toensure that information required to be disclosed in the reports we file withthe Securities and Exchange Commission pursuant to the Securities Exchange Actof 1934 is recorded, processed, summarized and reported within the time periodsspecified in the rules and forms of the Commission and that such information isaccumulated and communicated to our management, including our Chief ExecutiveOfficer (CEO) and Chief Financial Officer (CFO), as appropriate, to allowtimely decisions regarding required disclosures.

We also maintain a system of internal accounting controls designed toprovide reasonable assurance that our books and records accurately reflect ourtransactions and that our policies and procedures are followed.  There have been no changes in our internalcontrol over financial reporting during the fiscal quarter ended December 30,2006, or thereafter, that have materially affected, or are reasonably likely tomaterially affect, our internal control over financial reporting.

Our management, under the supervision and with the participation of ourCEO and CFO, has evaluated the effectiveness of the design and operation of ourdisclosure controls and procedures as of the end of the period covered by thisannual report and have concluded that these controls and procedures wereeffective as of December 30, 2006, with the exception noted below.

49

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Our CEO and CFO became aware of a deficiency in our internal controlsin the area of retail sales revenue recognition.  This deficiency constituted a “significantdeficiency” but not a “material weakness” in our internal controls overfinancial reporting.  This deficiency didnot affect the accuracy of our consolidated financial statements included inthis report as the amounts were evaluated and determined not to be material.

We have discussed this deficiency with our Audit Committee and ourauditors.  Our management has begun toimplement the changes necessary to address this deficiency.

Any control system, no matter how well conceived and operated, canprovide only reasonable, not absolute, assurance that the objectives of thecontrol system are met.  The design of acontrol system inherently has limitations, and the benefits of controls must beweighed against their costs. Additionally, controls can be circumvented by the individual acts ofsome persons, by collusion of two or more people, or by management override ofthe control.  Therefore, no evaluation ofa cost-effective system of controls can provide absolute assurance that allcontrol issues and instances of fraud, if any, will be detected.

**ITEM 9B.               OTHERINFORMATION**— None

**PART III**

**ITEM 10.****                                             DIRECTORS,EXECUTIVE OFFICERS, AND CORPORATE GOVERNANCE**

Informationregarding directors and executive officers of the company is set forth underthe headings “Nominees” and “Information Concerning Officers and Key EmployeesWho Are Not Directors” and “Section 16 (a) Beneficial Ownership ReportingCompliance” in our Proxy Statement for our 2007 Annual Meeting of Shareholdersto be held May 10, 2007 and is incorporated herein by reference.

**Codeof Ethics**

Our AuditCommittee has adopted a code of ethics applicable to our directors, officers,including our chief executive officer, chief financial officer, principalfinancial officer and other of our senior financial officers, and employees, inaccordance with applicable rules and regulations of the SEC and The NASDAQStock Market.  A copy of the code ofethics may be obtained upon request, without charge, by addressing a request toInvestor Relations, ARCA, Inc., 7400 Excelsior Boulevard, Minneapolis, MN  55426.

**ITEM 11.****                                             EXECUTIVECOMPENSATION**

Informationregarding executive compensation is set forth under the headings “CompensationCommittee Report” and “Executive Compensation” in our Proxy Statement for our2007 Annual Meeting of Shareholders to be held May 10, 2007, and isincorporated herein by reference.

**ITEM 12.****                                             SECURITYOWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT AND RELATED STOCKHOLDERMATTERS**

Informationregarding security ownership of certain beneficial owners and management is setforth under the heading “Common Stock Ownership” in our Proxy Statement for our2007 Annual Meeting of Shareholders to be held May 10, 2007, and isincorporated herein by reference.

50

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The followingtable gives aggregate information under our equity compensation plans as ofDecember 30, 2006:
|                                                     | ** ** | (a)                                                                                                                                                  | ** ** | **(b)**                                                                                                     | ** ** | **(c)**                                                                                                                                                                                             | ** ** |
|-----------------------------------------------------|------------|------------------------------------------------------------------------------------------------------------------------------------------------------|------------|-------------------------------------------------------------------------------------------------------------|------------|-----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|------------|
| ** **                                          | ** ** | **Number of Securities to Be  Issued Upon Exercise of  Outstanding Options,  Warrants and Rights** | ** ** | **Weighted-Average Exercise  Price of Outstanding  Options, Warrants and  Rights** | ** ** | **Number of Securities Available for  Future Issuance Under Equity  Compensation Plans (Excluding  Securities Reflected in Column(a))** | ** ** |
| Equity compensation plans  approved by stockholders |       | 261,500                                                                                                                                              |       | $                                                                                                           | 2.72       |                                                                                                                                                                                                | 730,000    |   |
|                                                     |            |                                                                                                                                                      |            |                                                                                                             |            |                                                                                                                                                                                                     |            |  |

 

**ITEM 13.****                                             CERTAINRELATIONSHIPS AND RELATED TRANSACTIONS**

Informationregarding certain relationships and related transactions is set forth under theheadings “DirectorIndependence” and “Review,Approval or Ratification of Transactions with Related Persons” in ourProxy Statement for our 2007 Annual Meeting of Shareholders to be held May 10,2007, and is incorporated herein by reference.

**ITEM 14.               PRINCIPAL ACCOUNTANT FEES ANDSERVICES**

Informationregarding principal accountant fees and services is set forth under the heading“Independent Registered Public Accounting Firm” in our Proxy Statement for our2007 Annual Meeting of Shareholders to be held May 10, 2007, and isincorporated herein by reference.

51

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**PART IV**

**ITEM 15.****                                             EXHIBITSAND FINANCIAL STATEMENT SCHEDULES**

**(a)           Financial Statements, FinancialStatement Schedules and Exhibits**

**1.            Financial Statements**

See Index toFinancial Statements under Item 8 of this report.

**2.            Financial Statement Schedule**

To the Board ofDirectors

ApplianceRecycling Centers of America, Inc. and Subsidiaries

Minneapolis,Minnesota

Ouraudit was conducted in accordance with the standards of the Public CompanyAccounting Oversight Board (United States) and was made for the purpose offorming an opinion on the basic consolidated financial statements of ApplianceRecycling Centers of America, Inc. and Subsidiaries taken as a whole.  The supplemental Schedule II is presented forpurposes of complying with the Securities and Exchange Commission’s rules andis not a part of the basic consolidated financial statements.  This schedule has been subjected to theauditing procedures applied in our audit of the basic consolidated financialstatements and in our opinion, is fairly stated in all material respects inrelation to the basic consolidated financial statements taken as a whole.

VIRCHOW KRAUSE& COMPANY

Minneapolis,Minnesota

March 16, 2007

Schedule II -Valuation and Qualifying Accounts
| ** **                     | ** ** | **Accounts Receivable** | ** **  | **Inventory** | ** ** |
|--------------------------------|------------|------------------------------|-------------|---------------|------------|
| ** **                     | ** ** | **Allowance**                | ** **  | **Allowance** | ** ** |
| Balance,  December 31, 2005    |       | $                            | 252,000     |          | $          | 379,000 |   |
| Additional allowance           |       |                         |        | 220,000       |       |
| Write-offs/adjustments         |       | (100,000                     | )           | (392,000      | )          |
| **Balance, December 30, 2006** | ** ** | **$**                        | **152,000** | ** **    | **$**      | **207,000** | ** ** |

 

52

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Schedule II -Valuation and Qualifying Accounts — See report from McGladrey & Pullen, LLPon page 32.
| ** **                   | ** ** | **Accounts Receivable** | ** **  | **Inventory** | ** ** |
|------------------------------|------------|------------------------------|-------------|---------------|------------|
| ** **                   | ** ** | **Allowance**                | ** **  | **Allowance** | ** ** |
| Balance,  December 28, 2002  |       | $                            | 26,000      |          | $          | 548,000 |   |
| Additional allowance         |       | 100,000                      |        | 148,000       |       |
| Write-offs/adjustments       |       | (9,000                       | )           | (372,000      | )          |
| Balance, January  3, 2004    |       | $                            | 117,000     |          | $          | 324,000 |   |
| Additional allowance         |       | 228,000                      |        | 258,000       |       |
| Write-offs/adjustments       |       | (243,000                     | )           | (197,000      | )          |
| **Balance, January 1, 2005** | ** ** | **$**                        | **102,000** | ** **    | **$**      | **385,000** | ** ** |

 

**3.             Exhibits**

See Index to Exhibits onpage 55 of this report.

53

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**SIGNATURES**

Pursuant to the requirements of Section 13 or Section 15(d) of theSecurities Exchange Act of 1934, the Registrant has duly caused this Report tobe signed on our behalf by the undersigned, thereunto duly authorized.
| Dated: March 29, 2007 | APPLIANCE RECYCLING CENTERS OF |
|-----------------------|--------------------------------|
|                  | AMERICA, INC.                  |
|                  | (Registrant)                   |   |
|                  |                           |   |

 
|        | By     | /s/ Edward R. Cameron                 |
|--------|--------|---------------------------------------|
|   |   | Edward R. Cameron                     |
|   |   | President and Chief Executive Officer |
|   |   |                                  |
|   | By     | /s/ Patrick J. Winters                |
|   |   | Patrick J. Winters                    |
|   |   | Principal Accounting Officer          |

 

Pursuant to the requirements of the Securities Exchange Act of 1934,this Report has been signed by the following persons on behalf of theRegistrant and in the capacities and on the dates indicated.

| Signature                 | ** ** | **Title**               | ** **                           | **Date**   |
|---------------------------|------------|-------------------------|--------------------------------------|------------|
| ** **                | ** ** | ** **              | ** **                           | ** ** |
| /s/ Edward R. Cameron     |       |                    | Chairman of the Board, President and |       | March 29, 2007 |
| Edward R. Cameron         |       | Chief Executive Officer |                                 |       |
|                      |       |                    |                                 |       |
| /s/ Patrick J. Winters    |       |                    | Principal Accounting Officer         |       | March 29, 2007 |
| Patrick J. Winters        |       |                    |                                 |       |
|                      |       |                    |                                 |       |
| /s/ Duane S. Carlson      |       |                    | Director                             |       | March 29, 2007 |
| Duane S. Carlson          |       |                    |                                 |       |
|                      |       |                    |                                 |       |
| /s/ W. William Bednarczyk |       |                    | Director                             |       | March 29, 2007 |
| W. William Bednarczyk     |       |                    |                                 |       |
|                      |       |                    |                                 |       |
| /s/ Albin S. Dubiak       |       |                    | Director                             |       | March 29, 2007 |
| Albin S. Dubiak           |       |                    |                                 |       |

 

54

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**INDEX TO EXHIBITS**
| Exhibit  No. | ** ** | **Description**                                                                                                                                                                                                                                                                                                                                                                        | ** ** |
|--------------|------------|----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|------------|
|         |       |                                                                                                                                                                                                                                                                                                                                                                                   |       |
| 3.1          |       | Restated Articles of  Incorporation of Appliance Recycling Centers of America, Inc. [filed as  Exhibit 3.1 to the Company’s Form 10-K for the year ended January 2, 1999  (File No. 0-19621) and incorporated herein by reference].                                                                                                                                               |       |
|         |       |                                                                                                                                                                                                                                                                                                                                                                                   |       |
| 3.2          |       | Amended and Restated  Bylaws of Appliance Recycling Centers of America, Inc. [filed as Exhibit 3.2  to the Company’s Form 10-K for the year ended January 2, 1999 (File No.  0-19621) and incorporated herein by reference].                                                                                                                                                      |       |
|         |       |                                                                                                                                                                                                                                                                                                                                                                                   |       |
| *10.1        |       | 2006 Stock Option Plan  [filed as Appendix B to the Company’s Schedule 14A filed on March 31, 2006  and incorporated herein by reference].                                                                                                                                                                                                                                        |       |
|         |       |                                                                                                                                                                                                                                                                                                                                                                                   |       |
| *10.2        |       | 1997 Stock Option Plan  and Amendment [filed as Exhibits 28.1 and 28.2 to the Company’s Registration  Statement on Form S-8 (Registration No. 333-28571) and incorporated herein by  reference].                                                                                                                                                                                  |       |
|         |       |                                                                                                                                                                                                                                                                                                                                                                                   |       |
| *10.3        |       | Amendment effective  April 26, 2001 to 1997 Stock Option Plan [filed as Exhibit 10.2 to the  Company’s Form 10-Q for the quarter ended March 31, 2001 (File No. 0-19621)  and incorporated herein by reference].                                                                                                                                                                  |       |
|         |       |                                                                                                                                                                                                                                                                                                                                                                                   |       |
| *10.4        |       | Amendment effective  April 25, 2002 to 1997 Stock Option Plan [filed as Exhibit 10.2 to the  Company’s Form 10-Q for the quarter ended March 30, 2002 (File No. 0-19621)  and incorporated herein by reference].                                                                                                                                                                  |       |
|         |       |                                                                                                                                                                                                                                                                                                                                                                                   |       |
| 10.5         |       | Line of credit dated  August 30, 1996, between Appliance Recycling Centers of America, Inc. and  Spectrum Commercial Services, a division of Lyons Financial Services, Inc.  [filed as exhibit 10.15 to the Company’s Form 10-Q for the quarter ended  September 28, 1996 (File No. 0-19621) and incorporated herein by reference].                                               |       |
|         |       |                                                                                                                                                                                                                                                                                                                                                                                   |       |
| 10.6         |       | First Amendment to  General Credit and Security Agreement and Waiver dated November 8, 1996,  between Spectrum Commercial Services, a division of Lyons Financial Services,  Inc., and the Company, and related agreement [filed as exhibit 10.16 to the  Company’s Form 10-Q for the quarter ended September 28, 1996 (File No.  0-19621) and incorporated herein by reference]. |       |
|         |       |                                                                                                                                                                                                                                                                                                                                                                                   |       |
| 10.7         |       | Second Amendment to  General Credit and Security Agreement and Waiver dated February 12, 1998  between Spectrum Commercial Services, a division of Lyons Financial Services,  Inc., and the Company, and related agreements [filed as Exhibit 10.10 to the  Company’s Form 10-K for year ended January 3, 1998 (File No. 0-19621) and  incorporated herein by reference].         |       |
|         |       |                                                                                                                                                                                                                                                                                                                                                                                   |       |

55

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| 10.8   |   | Fourth Amendment to  General Credit and Security Agreement dated September 10, 1998 between  Spectrum Commercial Services, a division of Lyons Financial Services, Inc.,  and the Company, and related agreement [filed as Exhibit 10.15 to the  Company’s Form 10-K for the year ended January 2, 1999 (File No. 0-19621) and  incorporated herein by reference].   |   |
|--------|--------|---------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|--------|
|   |   |                                                                                                                                                                                                                                                                                                                                                                      |   |
| 10.9   |   | Fifth Amendment to  General Credit and Security Agreement dated September 17, 1998 between  Spectrum Commercial Services, a division of Lyons Financial Services, Inc.,  and the Company, and related agreements [filed as Exhibit 10.16 to the  Company’s Form 10-K for the year ended January 2, 1999 (File No. 0-19621) and  incorporated herein by reference].   |   |
|   |   |                                                                                                                                                                                                                                                                                                                                                                      |   |
| 10.10  |   | Eight Amendment to  General Credit and Security Agreement dated August 30, 2000 between Spectrum  Commercial Services, a division of Lyons Financial Services, Inc., and the  Company, and related agreements [filed as Exhibit 10.1 to the Company’s Form  10-Q for the quarter ended September 30, 2000 (File No. 0-19621) and  incorporated herein by reference]. |   |
|   |   |                                                                                                                                                                                                                                                                                                                                                                      |   |
| 10.11  |   | Ninth Amendment to  General Credit and Security Agreement dated June 18, 2001 between Spectrum  Commercial Services Company and the Company, and related agreements [filed as  Exhibit 10.2 to the Company’s Form 10-Q for the quarter ended June 30, 2001  (File No. 0-19621) and incorporated herein by reference].                                                |   |
|   |   |                                                                                                                                                                                                                                                                                                                                                                      |   |
| 10.12  |   | Tenth Amendment to  General Credit and Security Agreement dated July 26, 2001 between Spectrum  Commercial Services Company and the Company, and related agreements [filed as  Exhibit 10.3 to the Company’s Form 10-Q for the quarter ended June 30, 2001  (File No. 0-19621) and incorporated herein by reference].                                                |   |
|   |   |                                                                                                                                                                                                                                                                                                                                                                      |   |
| 10.13  |   | Eleventh Amendment to  General Credit and Security Agreement dated August 24, 2001 between Spectrum  Commercial Services and the Company, and related agreements[filed as Exhibit  10.1 to the Company’s Form 10-Q for the quarter ended September 29, 2001  (File No. 0-19621) and incorporated herein by reference].                                               |   |
|   |   |                                                                                                                                                                                                                                                                                                                                                                      |   |
| 10.14  |   | Twelfth Amendment to  General Credit and Security Agreement dated April 11, 2002 between Spectrum  Commercial Services Company and the Company and related agreements [filed as  Exhibit 10.1 to the Company’s Form 10-Q for the quarter ended March 30, 2002  (File No. 0-19621) and incorporated herein by reference].                                             |   |
|   |   |                                                                                                                                                                                                                                                                                                                                                                      |   |
| 10.15  |   | Thirteenth Amendment to  General Credit and Security Agreement dated January 23, 2003 between Spectrum  Commercial Services Company and the Company, and related agreements [filed as  Exhibit 10.34 to the Company’s Form 10-K for the year ended December 28, 2002  (File No. 0-19621) and incorporated herein by reference].                                      |   |
|   |   |                                                                                                                                                                                                                                                                                                                                                                      |   |
| 10.16  |   | Fourteenth Amendment to  General Credit and Security Agreement dated July 1, 2004 between Spectrum  Commercial Services Company and the Company [filed as Exhibit 10.1 to the  Company’s Form 10-Q for the quarter ended July 3, 2004 (File No. 0-19621) and  incorporated herein by reference].                                                                     |   |
|   |   |                                                                                                                                                                                                                                                                                                                                                                      |   |
| 10.17  |   | Sixteenth Amendment to  General Credit and Security Agreement dated December 23, 2004 between  Spectrum Commercial Services Company and the Company, and related Guarantor  Acknowledgment [filed as Exhibit 10.18 to the Company’s Registration  Statement on Form S-2 and incorporated herein by reference].                                                       |   |
|   |   |                                                                                                                                                                                                                                                                                                                                                                      |   |

56

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| 10.18  |   | Tenth Amended and  Restated Revolving Note dated December 23, 2004 of the Company in favor of  Spectrum Commercial Services Company [filed as Exhibit 10.19 to the Company’s  Registration Statement on Form S-2 and incorporated herein by reference].                                                                                                           |   |
|--------|--------|------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|--------|
|   |   |                                                                                                                                                                                                                                                                                                                                                                   |   |
| 10.19  |   | Seventeenth Amendment  to General Credit and Security Agreement dated January 12, 2005 between  Spectrum Commercial Services Company and the Company [filed as Exhibit 10.20  to the Company’s Registration Statement on Form S-2 and incorporated herein  by reference].                                                                                         |   |
|   |   |                                                                                                                                                                                                                                                                                                                                                                   |   |
| 10.20  |   | Loan Agreement dated  September 10, 1998 between Medallion Capital, Inc. and the Company [filed as  Exhibit 10.1 to the Company’s Form 10-Q for the quarter ended October 3, 1998  (File No. 0-19621) and incorporated herein by reference].                                                                                                                      |   |
|   |   |                                                                                                                                                                                                                                                                                                                                                                   |   |
| 10.21  |   | Note dated September  10, 1998 of the Company in favor of Medallion Capital, Inc. [filed as Exhibit  10.2 to the Company’s Form 10-Q for the quarter ended October 3, 1998 (File  No. 0-19621) and incorporated herein by reference].                                                                                                                             |   |
|   |   |                                                                                                                                                                                                                                                                                                                                                                   |   |
| 10.22  |   | Security Agreement  dated September 10, 1998 between Medallion Capital, Inc. and the Company  [filed as Exhibit 10.3 to the Company’s Form 10-Q for the quarter ended  October 3, 1998 (File No. 0-19621) and incorporated herein by reference].                                                                                                                  |   |
|   |   |                                                                                                                                                                                                                                                                                                                                                                   |   |
| 10.23  |   | Stock Purchase Warrant  of the Company for the Purchase of 700,000 shares of Common Stock in favor of  Medallion Capital, Inc. [corrected copy] [filed as Exhibit 10.14 to the  Company’s Form 10-K for the year ended January 2, 1999 (File No. 0-19621) and  incorporated herein by reference].                                                                 |   |
|   |   |                                                                                                                                                                                                                                                                                                                                                                   |   |
| 10.24  |   | Amendment No. 1 to Loan  Agreement and Security Agreement dated December 23, 2004 between Medallion  Capital, Inc. and the Company, and related Consent and Amendment and  Promissory Note [filed as Exhibit 10.25 to the Company’s Registration  Statement on Form S-2 and incorporated herein by reference].                                                    |   |
|   |   |                                                                                                                                                                                                                                                                                                                                                                   |   |
| 10.25  |   | Balloon Promissory Note  dated September 19, 2002 of the Company in favor of General Electric Capital  Business Asset Funding Corp. and related agreement [filed as Exhibit 10.1 to  the Company’s Form 10-Q for the quarter ended September 28, 2002 (File No.  0-19621) and incorporated herein by reference].                                                  |   |
|   |   |                                                                                                                                                                                                                                                                                                                                                                   |   |
| 10.26  |   | Balloon Promissory Note  dated December 27, 2002 of the Company in favor of General Electric Capital  Business Asset Funding Corp. and related agreement [filed as Exhibit 10.33 to  the Company’s Form 10-K for the year ended December 28, 2002 (File No.  0-19621) and incorporated herein by reference].                                                      |   |
|   |   |                                                                                                                                                                                                                                                                                                                                                                   |   |
| 10.27  |   | Reverse Logistics  Master Service Agreement between Whirlpool Corporation and the Company [filed  as Exhibit 10 to the Company’s Form 10-Q for the quarter ended July 4, 1998  (File No. 0-19621) and incorporated herein by reference].                                                                                                                          |   |
|   |   |                                                                                                                                                                                                                                                                                                                                                                   |   |
| 10.28  |   | Retail Dealer Sales  Agreement dated October 12, 2001 between Maytag Corporation and the Company  [filed as Exhibit 10.2 to the Company’s Form 10-Q for the quarter ended  September 29, 2001 (File No. 0-19621) and incorporated herein by reference].                                                                                                           |   |
|   |   |                                                                                                                                                                                                                                                                                                                                                                   |   |
| 10.29  |   | 2003 Statewide  Residential Appliance Recycling Program Agreement dated September 2, 2003  between Southern California Edison Company and ARCA California, Inc., a  wholly-owned subsidiary of the Company [filed as Exhibit 10.1 to the  Company’s Form 10-Q for the quarter ended September 27, 2003 (File No.  0-19621) and incorporated herein by reference]. |   |
|   |   |                                                                                                                                                                                                                                                                                                                                                                   |   |

57

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| 10.30  |   | 2004-05 Statewide  Residential Appliance Recycling Program Agreement dated January 21, 2004  between Southern California Edison Company and ARCA California, Inc., a  wholly-owned subsidiary of the Company [filed as Exhibit 10.34 to the  Company’s Form 10-K for the year ended January 3, 2004 (File No. 0-19621) and  incorporated herein by reference]. |   |
|--------|--------|---------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|--------|
|   |   |                                                                                                                                                                                                                                                                                                                                                                |   |
| 10.31  |   | Agreements dated  September 24, 2002 between the Company and the Department of Water and Power  of the City of Los Angeles [filed as Exhibit 10.32 to the Company’s Form 10-K  for the year ended December 28, 2002 (File No. 0-19621) and incorporated  herein by reference].                                                                                 |   |
|   |   |                                                                                                                                                                                                                                                                                                                                                                |   |
| 10.32  |   | Agreement dated March  1, 2004 between San Diego Gas & Electric and the Company [filed as  Exhibit 10.35 to the Company’s Form 10-K for the year ended January 3, 2004  (File No. 0-19621) and incorporated herein by reference].                                                                                                                          |   |
|   |   |                                                                                                                                                                                                                                                                                                                                                                |   |
| 10.33  |   | Agreement dated May 24,  2006 between San Diego Gas & Electric and the Company [filed as Exhibit  No. 10.1 to the Company’s Form 8-K dated July 5, 2006 (File No. 0-19621) and  incorporated herein by reference].                                                                                                                                         |   |
|   |   |                                                                                                                                                                                                                                                                                                                                                                |   |
| 10.34  |   | Agreement dated June  14, 2006 between Southern California Edison Company (Edison) and the Company  [filed as Exhibit No. 10.1 to the Company’s Form 8-K dated July 6, 2006 (File  No. 0-19621) and incorporated herein by reference].                                                                                                                         |   |
|   |   |                                                                                                                                                                                                                                                                                                                                                                |   |
| 10.35  |   | Form of Securities  Purchase Agreement dated as of December 31, 2004, between the Company and  certain investors [filed as Exhibit No. 99.2 to the Company’s Form 8-K dated  December 31, 2004 (File No. 0-19621) and incorporated herein by reference].                                                                                                       |   |
|   |   |                                                                                                                                                                                                                                                                                                                                                                |   |
| +21.1  |   | Subsidiaries of  Appliance Recycling Centers of America, Inc.                                                                                                                                                                                                                                                                                                       |   |
|   |   |                                                                                                                                                                                                                                                                                                                                                                |   |
| +23.1  |   | Consent of Virchow  Krause & Company, LLP, Independent Registered Public Accounting Firm.                                                                                                                                                                                                                                                                       |   |
|   |   |                                                                                                                                                                                                                                                                                                                                                                |   |
| +23.2  |   | Consent of McGladrey  & Pullen, LLP, Independent Registered Public Accounting Firm.                                                                                                                                                                                                                                                                             |   |
|   |   |                                                                                                                                                                                                                                                                                                                                                                |   |
| +31.1  |   | Certification by the  Chief Executive Officer pursuant to Section 302 of the Sarbanes-Oxley Act of  2002.                                                                                                                                                                                                                                                           |   |
|   |   |                                                                                                                                                                                                                                                                                                                                                                |   |
| +31.2  |   | Certification by the  Principal Accounting Officer pursuant to Section 302 of the Sarbanes-Oxley  Act of 2002.                                                                                                                                                                                                                                                      |   |
|   |   |                                                                                                                                                                                                                                                                                                                                                                |   |
| +32    |   | Certifications pursuant  to 18 U.S.C. Section 1350, as adopted pursuant to Section 906 of the  Sarbanes-Oxley Act of 2002.                                                                                                                                                                                                                                          |   |

 

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*                  Items that are management contracts orcompensatory plans or arrangements required to be filed as an exhibit pursuantto Item 14(a)3 of this Form 10-K.

+                  Filed herewith.

58

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