**UNITED STATES**

**SECURITIES AND EXCHANGE COMMISSION**

**Washington, D.C. 20549**

 

**FORM 10-K**

 
| **ý****Annual  Report Pursuant to Section 13 or 15(d)  of the Securities Exchange Act of 1934** |
|------------------------------------------------------------------------------------------------------|
| ** **                                                                                           |
| **For the fiscal year ended  December 31, 2005**                                                     |
|                                                                                                 |
| **or**                                                                                               |
| ** **                                                                                           |
| **o****Transition Report 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 itscharter)

** **

| **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 areacode:  **952-930-9000**

 

Securities registered pursuant to Section12(b) of the Act:  **None**

Securities registered pursuant to Section12(g) of the Act:  **CommonStock, without par value**

 

Indicate by check mark if theregistrant is a well-known seasoned issuer, as defined in Rule 405 of theSecurities Act.

o   Yes     ý   No

 
| Indicate by  check mark if the registrant is not required to file reports pursuant to  Section 13 or 15(d) of the Act. | o        |
|------------------------------------------------------------------------------------------------------------------------|---------------------------------------------|

 

Indicate by check mark whetherthe registrant (1) has filed all reports required to be filed by Section 13 or15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (orfor such shorter period that the registrant was required to file such reports)and (2) has been subject to such filing requirements for the past 90 days.

ý   Yes   o   No

 
| Indicate by  check mark if disclosure of delinquent filers pursuant to Item 405 of  Regulation S-K is not contained herein, and will not be contained, to the  best of registrant’s knowledge, in definitive proxy or information statements  incorporated by reference in Part III |
|------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|
| of this Form  10-K or any amendment to this Form 10-K.                                                                                                                                                                                                                                   | ý        |

 

Indicate by check mark whetherthe registrant is a large accelerated filer, an accelerated filer, or anon-accelerated filer.  See definition of“accelerated filer and large accelerated filer” in Rule 12b-2 of the ExchangeAct.  (Check one):

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

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

 

The aggregate market value ofthe voting and non-voting common equity held by non-affiliates of theregistrant, based on the closing price of $3.26 per share, as of July 2, 2005(the last business day of the registrant’s most recently completed secondfiscal quarter) was $5,881,167.

 

As of March 17, 2006, therewere outstanding 4,327,777 shares of the registrant’s Common Stock, without parvalue.

 

**DOCUMENTS INCORPORATED BYREFERENCE**

Portions of the registrant’s definitive proxystatement dated March 31, 2006, are incorporated by reference into Part IIIhereof.

 

 

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**TABLE OF CONTENTS**

 
| **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 2005, 2004 and 2003 |   |
| 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 and recycler of majorappliances.  We generate revenues from:

 

1.               Retail sales ofappliances at our ApplianceSmart® factory outlets.

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.

 

Wewere incorporated in Minnesota in 1983, although through our predecessors wecommenced the 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 millionmajor household appliances are currently in use.  These appliances include:

 
| 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.

 

Most state and local governments have enacted lawsaffecting how their residents dispose of unwanted appliances. For example, someareas restrict landfills from accepting appliances, some require processing toremove environmentally harmful materials before the appliance is disposed ofand some require advance disposal fees when a consumer purchases a newappliance.  As a result, old appliancesoften cannot be discarded through ordinary solid waste systems.

 

Many types of major appliances contain components withsubstances 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 that are still in usehave capacitors that contain PCBs.  IfPCBs are released from capacitors, groundwater contamination can occur.

 

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2.              Mercury, which is toxicto humans and can enter the body when a person inhales it, absorbs it throughthe skin or ingests it.  At hightemperatures, mercury vaporizes to form extremely poisonous fumes.  Freezers and washing machines may havemercury-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.  The federal government requires the recoveryof CFC refrigerants upon appliance disposal. Old refrigerators and freezers commonly contain CFCs.

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

 

In addition to these solid waste management andenvironmental issues, energy conservation is another motivating factor inappliance disposal.  Many electricutility companies sponsor programs to encourage their residential customers toretire energy-inefficient appliances.

 

Refrigerators manufactured in the 1960s and early 1970suse up to 1,750 kilowatt-hours of electricity each year.  By 2001, federal standards enacted over theyears lowered the average annual energy use per unit to less than 500kilowatt-hours.  Utility companies oftenprovide assistance and incentives for consumers to replace their old,inefficient appliances with newer, more efficient models.

 

Electric utilities 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 each state theoption 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 a used-applianceretailer.  We had contracts with nationaland regional companies that sold new appliances, such as Sears and MontgomeryWard.  When their stores sold a newappliance in the Minneapolis/St. Paul, Miami or Atlanta market, we collectedthe old appliance from the customer’s residence.  In most cases, our technicians reconditionedthe appliance, which we then sold at our own stores.  We sold the appliances that were not suitablefor sale to scrap metal processors.

 

In the late 1980s, stricter environmental regulationsbegan to affect the disposal of unwanted appliances.  When we were no longer able to takeappliances containing hazardous components to a metal processor, we began todevelop systems to process the appliances to remove the harmful materials.  This allowed us to take the remainder of the applianceto a metal processor for recycling.

 

We offered our services for disposing of appliances in anenvironmentally sound manner to appliance manufacturers and retailers, wastehauling companies, rental property managers, local governments and the public.

 

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***Appliance Recycling for Utilities***

 

In 1989, we added a new customer group when we opened anappliance processing and recycling center in Milwaukee, Wisconsin, to serve amajor utility.  The concept of appliancerecycling as an energy-efficiency measure was successful, and we began to focusour resources on expanding our business with electric utilities.  From 1989 to 1994, we opened nine centersthat served primarily seventeen utility companies.

 

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.

 

When California faced an energy crisis in the late 1990s,the California Public Utilities Commission (CPUC) directed one of ourcustomers, 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.  By thethird quarter of 2001 when the Summer Initiative ended, we had recycledapproximately 36,000 units for the program.

 

In June 2001, we began providing services for theAppliance Early Retirement and Recycling Program in California.  Utility customers in the San Diego area; asix-county region in California’s Central Valley, including the cities ofFresno and Stockton; and the seven-county Bay Area, including San Francisco,were eligible to participate.  Theprogram, which ended in August 2002, included refrigerators, freezers and roomair conditioners. We were responsible for advertising the program.

 

During fiscal year 2003, Edison was our onlymajor electric utility customer.  Theyaccounted for approximately 9% of our total revenues or $3.8 million.  In September 2003, we signed a contract withEdison to support the 2003 Statewide Residential Appliance Recycling Program inthe service territories of Edison and SDG&E.  We had been working under an extension of the2002 contract since January 2003.  The2003 program ran through December 31, 2003.

 

In January 2004, we signed a contract withEdison to handle appliance recycling operations in their service territory for2004 and 2005.  We have submitted aproposal for the continuation of the program with Edison to handle appliance recyclingoperations in their service territory for the years 2006-2008.  Edison would be responsible for advertisingin their territory.

 

In March 2004, we signed a contract withSDG&E to provide service in their territory for 2004, which was extendedthrough 2005.  We have also submitted aproposal for the continuation of the program with SDG&E to provide servicein their territory for the years 2006-2008. If we are awarded the contract, we will be responsible for advertisingthis program.

 

Since 2004, several other electric utilitieshave awarded contracts to us:

 

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 has been extended into 2006.  Both of these utilities are responsible foradvertising their programs.

2.               In December 2004, we reached an agreementwith Wisconsin Public Power Inc. (WPPI) to provide appliance recycling servicesduring 2005, which has been extended through 2006.  WPPI is a statewide power company owned by 40municipalities that operate electric utilities. They supply

 

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power to 154,000 homes and businesses throughout Wisconsin.  WPPI is responsible for advertising this program.

3.               Also in December 2004, we entered into anagreement with Austin Energy in Texas to manage appliance recycling operationsin their service territory during 2005, which has been extended through2006.  The City of Austin has grantedAustin Energy the option to renew the program annually through 2008.  Austin Energy is the nation’s tenth largestcommunity-owned electric utility, serving 360,000 customers within the City ofAustin and surrounding counties.  Tosupport this program, we opened an appliance recycling facility in Austin.  Austin Energy is responsible for advertisingthis 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 theresidential components of the State of Wisconsin’s Focus on Energy, a public-privatepartnership offering energy information and services to customers throughoutthe state.

 

Because of the renewed interest from utilitiesin appliance recycling energy-efficiency programs, we will continue toaggressively pursue that segment of customers in 2006.  However, we still have a limited ability toproject revenues from utility programs in 2006.

 

***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 on strengtheningour sales of used appliances.  In 1995,we began operating our own chain of stores, Encore Recycled Appliances®.  We changed the name of our retail stores toApplianceSmart in 1998.

 

One of the markets we have developed is inproviding reverse logistics services for appliance manufacturers andretailers.  Reverse logistics involvesmanaging appliances that fall outside a company’s normal channels ofdistribution.

 

All these appliances are new, not used.  Some are in the carton while others are outof the carton.  In the applianceindustry, these “special-buy” appliances, units that require a different methodof management, include:

 

•                  Closeouts

•                  Floor samples

•                  Returned or exchanged items

•                  Factory overruns

•                  Scratch and dent

•                  Open carton

 

For example, a manufacturerredesigns a current model to include a few updated features and then assigns anew model number.  Because themanufacturer ships only the latest models to retailers, a large quantity of theolder model remains in the manufacturer’s inventory.

 

For many years, manufacturers relied on smallappliance dealers to buy this product to sell in their stores. However, todaythese small retailers are struggling to compete with large appliance chains(the top 10 retailers control 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.

 

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In the late 1990s, we began to design reverselogistics programs for major appliance manufacturers.  In 1997, we began providing reverse logisticsservices for Whirlpool Corporation, the nation’s largest manufacturer of 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.

 

Webegan selling these special-buy appliances at our network of ApplianceSmartfactory outlets.  With an increasedsupply of product, we started to focus on opening larger stores to offerconsumers a wider product selection.  Wealso began to close our smaller stores and decided not to expand our usedappliance business.

 

In late 1998, we scaled back our agreementwith Whirlpool and reduced our purchases to be in line with our financialresources.  At that time, our purchaseswere mainly from Whirlpool’s Ohio distribution center.  As we have expanded our ApplianceSmartnetwork over the past few years, we have begun to purchase merchandise from allWhirlpool distribution centers.

 

Key components of our current agreement withWhirlpool, which became effective in 2004, 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.

 

In October 2001, we entered into an agreementwith Maytag Corporation to purchase special-buy appliances.  Under the Maytag agreement:

 

1.               We have no minimum purchase requirements.

2.               The agreement may be terminated by either partywith 60 days’ written notice.

3.               The agreement may be terminated immediately if adefault is not cured within ten (10) days after notification of the default.

4.               We have agreed to indemnify Maytag for allclaims, losses, liability and expenses with respect to Maytag appliances wesell.

 

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

 

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

 

In addition to our reverse logisticscontracts, we are also an authorized dealer of new product for these four manufacturers.

 

Although there are no guarantees on thenumber of units that any of the manufacturers will sell us, we believe thatpurchases from these four manufacturers will provide an adequate supply ofhigh-quality appliances for our ApplianceSmart outlets.

 

During the second quarter of 2003, we became a majority(60%) owner in North America Appliance Company LLC (NAACO).  NAACO began operations in June 2003 as aretailer of special-buy appliances in McAllen, Texas.

 

***Growth Strategy***

 

Larger factory outlet facilities offer consumers a wider selection of appliances thansmaller stores do and are more efficient for us to operate.  For these reasons, we intend to continue tofocus our retail sales operations on

 

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largerfacilities.  We would consider openingnew stores primarily in markets in which we currently have operations, foradditional operational and marketing efficiencies of scale.  We evaluate demographic, economic andfinancial information when considering a new store location.

 

We are also actively pursuing opportunitiesto support energy-efficiency programs run by electric utility companies.  We have seen a renewed interest from thesecompanies in these programs.

 

**Customers and Source of Supply**

 

We offer reverse logistics services to manufacturers andretailers that need an efficient way to manage appliances that fall outsidenormal distribution and sales channels. We also provide services for electric utility companies that offer theircustomers appliance recycling programs as an energy conservation measure.

 

Over the years, we have also recycled appliances forwaste haulers, vending machine companies and residential property managers.

 

***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.  Because we no longer sell used appliances, wehave phased out this branch of our operations.

 

However, we continue to work with new-appliance retailersto manage units that customers have returned and other appliances that the retailercannot sell as new in-the-carton product.

 

***Appliance Manufacturers:***  We now work with appliance manufacturers,including Whirlpool, Maytag, Frigidaire and GE, to acquire the product we sellat our ApplianceSmart retail stores.  Wepurchase special-buy appliances, such as discontinued models and factoryoverruns, and sell the product at a significant discount to full retail prices.In addition, our participation in a national buying cooperative enables us topurchase new in-the-carton appliances 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.

 

***Other Customers******:***  We formerly provided collectionand recycling services for waste haulers, vending machine companies, propertymanagers and the general public for specified fees.  We have phased out this aspect of ourbusiness to focus on reverse logistics, retail sales and energy conservationprograms.

 

***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 utility’s appliance recyclingprogram.  Under other contracts, weprovide only specified services, such as collection and recycling.

 

Our pricing is on a per-appliance basis and depends uponseveral factors, including:

 

1.               The total number ofappliances processed.

2.               The length of thecontract term.

3.               The specific servicesthe utility selects us to provide.

 

8

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Our contracts with electric utility customers prohibit usfrom repairing and selling appliances we receive through their programs.  Because the intent of the program is toconserve electricity, we need to assure that those appliances do not return touse.

 

Currently, we have contracts with the following utilitiesto handle recycling operations in their service territories for 2006:

 

1.               Southern CaliforniaEdison (proposal submitted)

2.               San Diego Gas &Electric (proposal submitted)

3.               United Illuminating

4.               Connecticut Light &Power

5.               Austin Energy

6.               Wisconsin Public Power

7.               Wisconsin EnergyConservation Corporation

8.               Several small municipalutilities

 

**Company Operations**

 

We provide a full range of reverse logistics,energy-efficiency and appliance recycling services.  We purchase major appliances primarily fromappliance manufacturers and retailers for our retail operations. We provideservices for electric utility companies to collect and recycle appliancesturned in through their energy-efficiency programs.

 

Many of the appliances that we receive frommanufacturers are still in the factory carton and are ready to sell.  Other appliances may need repair or cosmeticwork before we send them to our ApplianceSmart retail outlets.  Every appliance we sell is under warranty andcarries a 100 percent money-back guarantee. We also offer extended warranties,delivery, factory-trained technician service and recycling of the customer’sold appliance.

 

Some of the appliances we receive must berecycled.  These include appliances thatdo not meet our quality standards for sale at ApplianceSmart and appliancescollected through utility customers’ energy conservation programs.  We process and recycle these units usingenvironmentally sound systems and techniques.

 

In our recycling operation, ourcompany-trained technicians first inspect and categorize each appliance toidentify the types of hazardous materials it contains.  We then process the appliances to remove andmanage the environmentally hazardous substances according to all federal, stateand local regulations.  We deliver theprocessed appliances to local scrap processing facilities, where they shred andrecycle the metals.

 

Althoughthe potential of industry deregulation negatively affected our business withelectric utilities in the middle to late 1990s, we are seeing renewed interestin appliance recycling energy-efficiency programs.  We enter 2006 serving seven major utilityprograms.  We are aggressively pursuingadditional utility customers, but still have a limited ability to projectrevenues from utility programs in 2006.

 

Since 2003, we havefocused on a carefully managed growth plan to strengthen our retailoperations.  We will continue to openshowroom outlet stores in heavily trafficked, conveniently located retailmalls.  In addition, we will continue toseek 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 newApplianceSmart outlets in our existing markets.

 

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**Principal Products and Services**

 

We generate revenues from threesources: retailing, recycling and byproduct. The table below reflects the percentage of total revenues from eachsource for the past three fiscal years. See also “Management’s Discussion and Analysis of Financial Conditionand Results of Operations.”

 
| ** ** | ** ** | **2005**  | ** ** | **2004** | ** ** | **2003** | ** ** |
|------------|------------|-----------|------------|----------|------------|----------|------------|
| Revenues:  |       |      |       |     |       |     |       |
| Retail     | ** ** | **83.3**  | **%**      | 79.2     | %          | 79.8     | %          |
| Recycling  | ** ** | **14.6**  | **%**      | 17.8     | %          | 18.4     | %          |
| Byproduct  | ** ** | **2.1**   | **%**      | 3.0      | %          | 1.8      | %          |
| ** ** |       | **100.0** | **%**      | 100.0    | %          | 100.0    | %          |

 

Althoughwe have three main sources of revenues, retail, recycling and byproduct, webelieve that we have only one operating segment.  That is, even though certain separatefinancial information by retail store or retail store and recycling center isavailable to us, we are managed as a single unit.  Specifically, we do not measure profit orloss or maintain asset information separately for our revenue sources.  Recycling and byproduct revenues result fromboth our retail operations and our recycling contracts.  Retail includes the free removal andrecycling of the customer’s existing appliance. Recycling includes the recycling of appliances through a contract oragreement.

 

**Sales and Marketing**

 

We use a variety of methods to promote awareness of ourproducts and services.  We believe thatwe are recognized as a leader in appliance retailing through reverse logisticsand also a leader in the recycling industry.

 

Our ApplianceSmart outlet store concept includesestablishing large factory showrooms in metropolitan locations.  We aim to offer consumers a selection ofhundreds, even thousands, of appliances at each of our stores.  Our visual branding consists of ample displayof manufacturers’ signage, along with custom-designed ApplianceSmart materialsin red, white and blue.  In every market, we advertise our stores throughprint media, including newspapers and yellow pages ads.  In addition, in some markets we rely heavilyupon television and radio spots.  Throughwww.ApplianceSmart.com, consumers can also learn more about us on the Internet.

 

**Seasonality**

 

We experience some seasonality in retail revenues withrevenues in the second and third calendar quarters being slightly higher thanrevenues 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.

 

**Competition**

 

Our retail competition comes mainly from new-applianceand other special-buy retailers.  EachApplianceSmart outlet competes with local and national chains of new-appliancedealers.  Many of these retailers havebeen in business longer than we have and may have significantly greaterassets.  We also compete with numerousindependently owned retailers of new and special-buy appliances.

 

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Many factors, including existing and proposed governmentalregulation, affect competition in the appliance recycling industry.  We generally compete for contracts with twoor three companies based in the program’s service territory.  Often, these companies are not able to offerthe full range of services that we provide.

 

We expect our primary competition for appliance recyclingcontracts with existing and new customers to come from a variety of sources,including:

 

1.               Entrepreneurs enteringthe appliance recycling business.

2.               Energy managementconsultants.

3.               Existing recyclingcompanies.

4.               Major waste haulingcompanies.

5.               Scrap metal processors.

 

In addition, utility companies and other customers mayoperate appliance recycling programs internally rather than contracting withoutside vendors.  We have no assurancethat we will be able to compete profitably in any of our chosen markets.

 

**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 affect appliancerecycling include landfill disposal restrictions, hazardous waste managementrequirements and air quality standards. Each of our recycling facilities maintains the appropriate registrations,permits and licenses for its location.

 

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

 

We register our recycling centers as hazardous wastegenerators with the EPA.  We also obtainall appropriate regional and local licenses for managing hazardous wastes.  Licensed hazardous waste companies transportand recycle or dispose of the hazardous materials we generate.

 

Our retail stores obtain all required business licenses,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 of 1992to encourage energy efficiency.  This actestablishes, among other things:

 

1.               Mandatory energyperformance standards for new major household appliances.

2.               The option forindividual states to deregulate their energy providers, including electricutilities.

 

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 governmental regulationof the appliance recycling industry could have a positive effect on us, wecannot 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.

 

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**Employees**

 

AtMarch 1, 2006, we had 294 full-time employees, distributed approximately asfollows:

 

1.               39% of our employeesprovide appliance collection, transportation and processing services at ourrecycling centers.

2.               46% work in retailsales.

3.               15% are inadministration and management.

 

Ouremployees have never caused our operations to be disrupted by a work stoppage,and we believe that our employee relations are good.

 

**ITEM1A.****                                           ****RISK FACTORS**

 

*An investment in our Common Stockinvolves a high degree of risk.  Youshould carefully consider the risks described below with respect to aninvestment in our shares.  If any of thefollowing risks actually occur, our business, financial condition, operatingresults or cash provided by operations could be materially harmed.  As a result, the trading price of our CommonStock could decline, and you might lose all or part of your investment.  When evaluating an investment in our CommonStock, you should also refer to the other information in this report, includingour financial statements and related notes.*

 

**Risks Related to ARCA**

 

***Our strategy of opening newretail stores has resulted in net losses in recent periods.***

 

Our primary growth strategy is to open newretail stores.  We evaluate demographic,economic and financial information in considering a new store location.  We primarily look in markets in which 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 $933,000 or $0.22per diluted share for fiscal year 2005 and a net loss of $1,314,000 or $0.48per diluted share for fiscal year 2004. Our full financial information is set out in the financial statementsand related notes and “Management’s Discussion and Analysis of FinancialCondition and Results of Operations.”

 

***Most of our revenues are derivedfrom retail sales.  We expect thisdependence on retail sales to continue in the future.***

 

Most of our revenues are derived from retailsales of appliances from our ApplianceSmart retail stores. We currently operatethirteen ApplianceSmart stores.  Retailrevenues have lower profit margins than recycling revenues.  We believe that our future economic resultswill be heavily dependent on our retail stores. In fiscal 2003, 2004 and 2005, approximately 80%, 79% and 83%,respectively, of our revenues were from retail sales.  We currently expect that retail revenues willaccount for approximately 87% of total revenues for 2006.  However, we cannot assure you that sales fromour stores will grow at the rates we currently anticipate.

 

***Our revenues from recyclingcontracts have declined, and future revenues from this source are verydifficult to project.***

 

In the past, our business was dependentlargely upon our ability to obtain new contracts and continue existingcontracts for appliance recycling services with utility companies.  Contracts with these entities generally haveinitial terms of one to four years, with renewal options and early terminationclauses.  The recycling and byproductsportion of our business has diminished from approximately 50% of total revenuesin fiscal 2001 to

 

12

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16.7% of total revenues in fiscal 2005,partially due to decreased sponsorship of energy conservation programs byutilities.  However, we are stilldependent on certain customers for a large portion of our revenues.  Generally, recycling revenues have a highergross profit than retail revenues.

 

Our major utility customer, SouthernCalifornia Edison Company (Edison), accounted for approximately 9% of revenuesfor 2003, 2004 and 2005.  The loss ormaterial reduction of business from Edison, or any major customer, couldadversely affect our net revenues and profitability.   We have submitted a proposal for thecontinuation of Edison’s refrigerator recycling program for the years2006-2008.  If awarded to us, thecontract would not provide for a minimum number of refrigerators to berecycled, and the timing and amount of revenues would be dependent on Edison’sadvertising.

 

We cannot assure you that our existingrecycling contracts will be continued or renewed, that existing customers,including Edison, will continue to use our services at current levels, or thatwe will be successful in obtaining new recycling contracts.

 

***Our revenues from recyclingcontracts are subject to seasonal fluctuations and are dependent on theutilities’ advertising and promotional activities, which are outside ourcontrol.***

 

In our business with utility companies, weexperience seasonal fluctuations that impact our operating results.  Our recycling revenues are generally higherduring the second and third calendar quarters and lower in the first and fourthcalendar quarters, due largely to advertising and promotional activityschedules managed by the utilities.  Weexpect that we will continue to experience such seasonal fluctuations in recyclingrevenues.  We experience less seasonalfluctuation in our retail business.

 

***We may need new capital to fullyexecute our growth strategy.***

 

Our business involves providingcomprehensive, integrated appliance recycling services and developing a chainof retail stores.  This commitment willrequire a significant continuing investment in capital equipment and leaseholdimprovements and could require additional investment in real estate.

 

Our total capital requirements will depend,among the other things discussed in this annual report, on the number ofrecycling centers and the number and size of retail stores operating during2006.  Currently, we have thirteen retailstores and four recycling centers in operation. If our revenues are lower than anticipated or our expenses are higherthan anticipated or our current line of credit cannot be maintained, we willrequire additional capital to finance our operations.  Even if we are able to maintain our currentline of credit, we may need additional equity or other capital in thefuture.  Sources of additional financing,if needed in the future, may include further debt financing or the sale ofequity (including the issuance of preferred stock) or other securities.  We cannot assure you that any additional sourcesof financing or new capital will be available to us, or available on acceptableterms, or permitted by the terms of our current debt.  In addition, if we sell additional equity toraise funds, all outstanding shares of Common Stock will be diluted.

 

***A decline in general economicconditions could lead to reduced consumer demand for our products and have anadverse effect on our liquidity and profitability.***

 

Since purchases of our merchandise aredependent upon discretionary spending by our retail customers, our financialperformance is sensitive to changes in overall economic conditions that affectconsumer spending.  Consumer spendinghabits are affected by, among other things, prevailing economic conditions, levelsof employment, salaries and wage rates, 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

 

13

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in excess inventories. This could, in turn,lead to increased merchandise markdowns and related costs associated withhigher levels of inventory that could adversely affect our liquidity andprofitability.

 

***Our market share may be adverselyimpacted at any time by a significant number of competitors.***

 

Competition for our retail stores comes fromretailers of new and used appliances. Each of our separate locations will compete not only with local andnational chains of new appliance retailers, many of whom have been in businesslonger than we have and who may have significantly greater assets, but willalso be required to compete with numerous independently owned retailers of usedappliances.  A number of our retailoperations have been opened within the past 24 months; therefore, we cannotassure you that we will be able to compete effectively in any such market.

 

While recycling revenues could become asmaller part of our business for the foreseeable future, many factors,including existing and proposed governmental regulation, may affect competitionin the industry.  We generally competewith two or three companies based in the geographic area to be served and theygenerally offer some of the services we provide.  We expect our primary competition forcontracts with existing or new customers to come from entrepreneurs enteringthe appliance recycling business, energy management consultants, currentrecycling companies, major waste hauling companies, scrap metal processors andused appliance dealers.  In addition,some of our customers, such as utility companies, may operate appliancerecycling programs internally rather than contracting with us or other thirdparties.  We cannot assure you that wewill be able to compete profitably in any of our chosen markets.

 

***Changes in governmentalregulations relating to our recycling business could increase our costs ofoperations and adversely affect our business.***

 

Our appliance recycling centers are subjectto various federal, state and local laws, regulations and licensingrequirements related to the collection, processing and recycling of householdappliances.  These requirements may varyby market location and include, for example laws, concerning the management ofhazardous materials and the 1990 Amendments to the Clean Air Act, which requireus to recapture CFC refrigerants from appliances to prevent the release of CFCsinto the atmosphere.

 

We have registered our centers with the EPAas hazardous waste generators and have obtained required licenses fromappropriate state and local authorities. We have agreements with approved and licensed hazardous waste companiesfor transportation and recycling or disposal of hazardous materials generatedthrough our recycling processes.  As isthe case with all companies handling hazardous materials, under somecircumstances we may be subject to contingent liability.

 

In 1992, Congress adopted the Federal EnergyPolicy Act of 1992 to encourage energy efficiency.  One component of this Act allows forderegulation of the nation’s energy providers, including the electric utilityindustry.  The immediate impact of thepotential of industry deregulation caused utility companies across the U.S. tosuspend their plans for implementing appliance recycling programs like ours.

 

***Our lender has the right todemand payment in full of the borrowings under our line of credit at anytime.  If it were to do so, we would notbe able to pursue our growth strategy and our operations would be severelylimited unless and until new financing was obtained.***

 

We have an $8.0 million line of credit with a stated maturity date of December 31, 2007.  The line of credit also provides that thelender may demand payment in full of the entire outstanding balance of the loanat any time.  We have pledgedsubstantially 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

 

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March 3, 2006, borrowings of $5,719,000 were outstanding under theline of credit, and we had unused borrowing capacity of $71,000.

 

***We may not be able to operatesuccessfully if we lose key personnel, are unable to hire qualified personnel,or experience turnover of our management team.***

 

We believe our operations are materiallydependent upon the continued services of our present management.  The loss of services of one or more membersof present management, including Edward R. (Jack) Cameron, our founder,Chairman of the Board and current CEO, could adversely affect ourbusiness.  We do not have employmentcontracts with present management.  Wemaintain key person insurance on the life of Mr. Cameron in the amount of$1,000,000.

 

***A competitor recently obtained apatent that covers appliance recycling methods and systems that we believe weredeveloped by us.  We are seeking apermanent injunction barring the use of the patent in marketing their recyclingservices.  We may incur substantial costsin pursuing this injunction, which could have an adverse effect on our resultsof operations.***

 

In December 2004, we filed suit in the U.S.District Court for the Central District of California alleging that JACO Environmental,Inc. and a former consultant of the company fraudulently obtained a patent(U.S. Patent No. 6,732,416) in May 2004 covering appliance recycling methodsand systems originally developed by us beginning in 1987 and used in servingmore than forty electric utility appliance recycling programs since thattime.  In September 2005, we received alegally binding document in which JACO states it will not sue us or any of ourcustomers for violating JACO’s recycling patent.  Therefore, our recycling operations willcontinue with our current contracts without interruption.  We are continuing to seek a permanentinjunction barring JACO from using the patent to market JACO’s recyclingservices, due to our belief 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 misleadingadvertising under federal and California statutes. Also, we may incur substantialcosts in pursuing this injunction, which could have an adverse effect on ourresults of operations.

 

**Risks Related to Our Common Stock**

 

***If an active trading market forour Common Stock does not develop, the value and liquidity of your investmentin our Common Stock could be adversely affected.***

 

On February 22, 2006, our Common Stock begantrading on the Nasdaq Capital Market. Previously, it was traded on the OTC Bulletin Board and the tradingvolumes were low.  There may be only alimited market for any shares of Common Stock that you purchase.

 

***The public sale of our CommonStock by the selling shareholders or by other shareholders could adverselyaffect the price of our Common Stock.***

 

The trading volumes in our Common Stock arelow compared to the number of shares that may be sold by the sellingshareholders.  Sales of substantialamounts of Common Stock into the public market by the selling shareholders orby our other shareholders could adversely affect the market price for ourCommon Stock.

 

***Our principal shareholders own alarge percentage of our voting stock, which will allow them to controlsubstantially all matters requiring shareholder approval.***

 

Currently, Edward R. (Jack) Cameron, Chairmanand CEO, owns approximately 8%of our outstanding shares of Common Stock. Our officers and directors together hold approximately 17%, including any options or

 

15

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warrants they may hold.  One of our principal lenders, MedallionCapital, Inc., owns approximately 13%of our outstanding shares.  Medallionalso has a non-voting right to attend and participate in all Boardmeetings.  Also, Perkins CapitalManagement, Inc. beneficially owns approximately 16% of our outstanding shares. Heartland Advisors, Inc. beneficially owns approximately 9% of ouroutstanding shares.  Because of suchownership, our management and principal shareholders may be able tosignificantly affect our corporate decisions, including the election of theBoard of Directors.

 

**ITEM 1B.****                                           ****UNRESOLVEDSTAFF COMMENTS**

 

Not applicable.

 

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

 

Our executiveoffices are located in Minneapolis, Minnesota, in a company-owned facility thatincludes approximately 11 acres of land. The building contains approximately 122,000 square feet, consisting of27,000 square feet of office space, 71,000 square feet of operations andprocessing space, and 24,000 square feet of retail space as identified below(under “Minneapolis, MN, 1998”).  InMarch 2006, we entered into a purchase agreement for the sale of this property,and are evaluating alternative sites for this facility.  We also own and use a building in Compton,California, with 11,000 square feet of office space, 30,000 square feet ofwarehouse and processing space, and 5,000 square feet of retail space asidentified below (under “Los Angeles, CA”).

 

We currently operatethirteen retail stores in the following locations:

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

 

We own the facilities in which the two storesthat opened in 1998 (Minneapolis and Los Angeles) are located.  We also operate processing and recyclingcenters in these two facilities.  All ourother retail stores are located in leased facilities; we generally attempt tonegotiate lease terms of two to five yearsfor our retail stores.

 

We operate four processing and recycling centers.  Two are in the facilities that we own inMinneapolis and Los Angeles.  The othertwo are in leased facilities in Waterbury, Connecticut, and Austin, Texas.  Our recycling centers typically range in sizefrom 25,000 to 40,000 square feet.

 

All the facilities weown currently secure outstanding loans. Except as noted above in regards to the company-owned Minneapolisproperty, all of the facilities we occupy currently are adequate for our futureneeds.

 

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| **ITEM  3.** | **LEGAL  PROCEEDINGS** |
|--------------|------------------------|

 

In December 2004, we filed suit in the U.S.District Court for the Central District of California alleging that JACOEnvironmental, Inc. 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 electric utility appliance recycling programssince that time.  In September 2005, wereceived a legally binding document in which JACO states it will not sue us orany of our customers for violating JACO’s recycling patent.  Therefore, our recycling operations willcontinue with our current contracts without interruption.  We are continuing to seek a permanentinjunction barring JACO from using the patent to market JACO’s recyclingservices, due to our belief 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 misleadingadvertising under federal and California statutes. Also, we may incursubstantial costs in pursuing this injunction, which could have an adverseeffect on our results of operations.

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

 

We did not submit any matters toa vote of security holders during the last quarter of the fiscal year coveredby this report.

 

**PART II**

 
| **ITEM 5.** | **MARKET FOR OUR COMMON EQUITY,  RELATED SHAREHOLDER MATTERS AND ISSUER PURCHASES OF EQUITY SECURITIES** |
|-------------|----------------------------------------------------------------------------------------------------------|

 

**Market for Common Stock**

 

Our Common Stock, which tradesunder the symbol “ARCI,” began trading on the Nasdaq Capital Market on February22, 2006.  Before that time, the CommonStock was traded as follows:  on the OTCBulletin Board from September 8, 1998 to February 21, 2006; on the NasdaqSmallCap Market from February 26, 1997 to September 7, 1998; on the Nasdaq NationalMarket from January 8, 1993 to February 25, 1997; on the Nasdaq SmallCap Marketfrom January 7, 1991 to January 7, 1993; and on the local over-the-countermarket before January 7, 1991. The following table sets forth, for the periodsindicated, the high and low closing bid quotations for the Common Stock, asreported by the OTC Bulletin Board. These quotations reflect inter-dealer prices, without retail mark up,mark down or commissions, and may not represent actual transactions.

 
| ** **     | ** ** | **High** | ** ** | **Low** | ** ** |
|----------------|------------|----------|------------|---------|------------|
| **2004**       |       |     |       |    |       |
|           |       |     |       |    |       |
| First Quarter  |       | $        | 3.85       |    | $          | 2.05 |   |
| Second Quarter |       | 3.45     |       | 2.25    |       |
| Third Quarter  |       | 3.05     |       | 2.45    |       |
| Fourth Quarter |       | 4.65     |       | 2.55    |       |
|           |       |     |       |    |       |
| **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    |       |

 

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On March 3, 2006, the lastreported sale price of the Common Stock on the Nasdaq Capital Market was $4.95per share.  As of March 3, 2006, therewere approximately 830 beneficial holders of our Common Stock.

 

We have not paid dividends onour Common Stock and do not presently plan to pay dividends on our Common Stockfor the foreseeable future.  Our line ofcredit limits our ability to pay dividends.

 

Information concerningsecurities authorized for issuance under equity compensation plans is includedin Part III, Item 12 of this report.

 

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

 

The selected financialinformation set forth below should be read in conjunction with “Item 7.Management’s Discussion and Analysis of Financial Condition and Results ofOperations for the Fiscal Years of 2005, 2004 and 2003” and “Item 8. FinancialStatements and Supplementary Data.”

 
| **Fiscal Years Ended**                                        | ** ** | **2005**   | ** ** | **2004**   | ** ** | **2003**   | ** ** | **2002**   | ** ** | **2001**   | ** ** |
|---------------------------------------------------------------|------------|------------|------------|------------|------------|------------|------------|------------|------------|------------|------------|
| **(In thousands, except**                                     | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** |
| **per-share data)**                                           | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** |
|                                                          |       |       |       |       |       |       |       |       |       |       |       |
| **Statement  of Operations**                                  |       |       |       |       |       |       |       |       |       |       |       |
| Total revenues                                                |       | $          | 74,893     |       | $          | 52,830     |       | $          | 43,609     |       | $          | 45,720 |   | $ | 43,810 |   |
| Gross profit                                                  |       | $          | 22,487     |       | $          | 15,543     |       | $          | 11,879     |       | $          | 15,774 |   | $ | 17,329 |   |
| Operating income (loss)                                       |       | $          | (150       | )          | $          | (1,103     | )          | $          | (1,776     | )          | $          | 1,742 |   | $ | 4,749 |   |
| Net income (loss)                                             |       | $          | (933       | )          | $          | (1,314     | )          | $          | (1,541     | )          | $          | 332 |   | $ | 2,646 |   |
| Basic earnings (loss) per common share                        |       | $          | (0.22      | )          | $          | (0.48      | )          | $          | (0.66      | )          | $          | 0.14 |   | $ | 1.15 |   |
| Diluted earnings (loss) per common share                      |       | $          | (0.22      | )          | $          | (0.48      | )          | $          | (0.66      | )          | $          | 0.11 |   | $ | 0.86 |   |
| Basic weighted average number of common shares  outstanding   |       | 4,261      |       | 2,722      |       | 2,343      |       | 2,320      |       | 2,291      |       |
| Diluted weighted average number of common shares  outstanding |       | 4,261      |       | 2,722      |       | 2,343      |       | 3,025      |       | 3,068      |       |
|                                                          |       |       |       |       |       |       |       |       |       |       |       |
| **Balance Sheet**                                             |       |       |       |       |       |       |       |       |       |       |       |
| Working capital                                               |       | $          | 3,879      |       | $          | 4,600      |       | $          | 3,446      |       | $          | 5,003 |   | $ | 3,188 |   |
| Total assets                                                  |       | $          | 24,491     |       | $          | 24,340     |       | $          | 20,833     |       | $          | 20,239 |   | $ | 18,936 |   |
| Long-term liabilities                                         |       | $          | 5,216      |       | $          | 5,521      |       | $          | 5,658      |       | $          | 5,797 |   | $ | 4,348 |   |
| Shareholders’ equity                                     |       | $          | 5,421      |       | $          | 6,063      |       | $          | 4,209      |       | $          | 5,737 |   | $ | 5,397 |   |

 

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**QUARTERLY FINANCIAL DATA**

 

The following table sets forthcertain unaudited quarterly financial data for the eight quarters endedDecember 31, 2005.  In our opinion, theunaudited information set forth below has been prepared on the same basis asthe audited information and includes all adjustments necessary to presentfairly the information set forth herein. The operating results for any quarter are not indicative of results forany future period.  All data is inthousands except per-common share data.

 
| ** **                                                    | ** ** | **Fiscal 2005** | ** ** |
|---------------------------------------------------------------|------------|-----------------|------------|
| ** **                                                    | ** ** | **1st Quarter** | ** ** | **2nd Quarter** | ** ** | **3rd Quarter** | ** ** | **4th 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 |   |

 
| ** **                                                    | ** ** | **Fiscal 2004** | ** ** |
|---------------------------------------------------------------|------------|-----------------|------------|
| ** **                                                    | ** ** | **1st Quarter** | ** ** | **2nd Quarter** | ** ** | **3rd Quarter** | ** ** | **4th Quarter** | ** ** |
| Total revenues                                                |       | $               | 11,597     |   | $ | 12,995 |   | $ | 14,543 |   | $ | 13,695 |   |
| Net income (loss)                                             |       | $               | (732       | ) | $ | (42 | ) | $ | 260 |   | $ | (800 | ) |
| Basic earnings (loss) per common share                        |       | $               | (0.31      | ) | $ | (0.02 | ) | $ | 0.09 |   | $ | (0.27 | ) |
| Diluted earnings (loss) per common share                      |       | $               | (0.31      | ) | $ | (0.02 | ) | $ | 0.08 |   | $ | (0.27 | ) |
| Basic weighted average number of common  shares outstanding   |       | 2,398           |       | 2,506 |   | 2,986 |   | 2,999 |   |
| Diluted weighted average number of common  shares outstanding |       | 2,398           |       | 2,506 |   | 3,095 |   | 2,999 |   |

 

**ITEM 7.****           MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTSOF OPERATIONS FOR THE FISCAL YEARS 2005, 2004 AND 2003**

 

**OVERVIEW**

 

Our 2005 fiscal year (2005)ended December 31, 2005, our 2004 fiscal year (2004) ended January 1, 2005 andour 2003 fiscal year (2003) ended January 3, 2004.  The fiscal years of 2005 and 2004 contain 52weeks.  The fiscal year of 2003 contains53 weeks.

 

We generate revenues from threesources:  retail, recycling andbyproduct.  Retail revenues are sales ofappliances, 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 thirteen stores in 2005 with oneadditional facility opening in the fourth quarter.  An ApplianceSmart retail outlet opened in SanAntonio, Texas (the second ApplianceSmart store in this market).  Retail revenues accounted forapproximately 83% of total revenues in 2005.

 

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We are actively pursuingopportunities to support energy-efficiency programs run by electric utilitycompanies. During 2005, 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, andWisconsin Public Power.  We arecontracted to begin a program starting in April 2006 with Wisconsin EnergyConservation Corporation.

 

**CriticalAccounting Policies and Estimates**

 

Our significant accounting policies are summarized in the footnotes tothe financial statements.  Some of themost critical policies are also discussed below.

 

**Revenue****recognition:**  We recognize retail revenues when theconsumer pays for the appliance with cash, check or credit card and delivery ofthe appliance has been completed.  Werecognize recycling revenue when we collect and process a unit under ourrecycling contracts.  We recognize byproductrevenue when we receive payment from the scrap metal processor, and when weship CFCs to a recycler.

 

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:**  Currently, we use the Black-Scholes optionpricing model to determine the pro-forma compensation costs presented in Note 1of our financial statement.  This pricingmodel requires management to estimate if and when options granted will beexercised.  In determining this estimate,we review historical performance of our stock and stock option exercises.

 

**Recently Issued Accounting Pronouncements**

 

In November 2004, the FASB issued SFAS No.151, *Inventory Costs*, an amendment of ARB No. 43, Chapter4 “Inventory Pricing.”  The amendmentsmade by SFAS No. 151 require that abnormal amounts of idle facility expense,freight, handling costs and wasted materials (spoilage) be recognized as current-periodcharges and that fixed production overhead be allocated to inventory costsincurred during fiscal years beginning after June 15, 2005.  We do not expect the adoption of SFAS No. 151to have a material effect on our consolidated financial statements.

 

InDecember 2004, FASB published FASB Statement No. 123 (revised 2004), *Share-Based Payment* (“FAS 123(R)” or the “Statement”).  FAS 123(R) requires that the compensationcost relating to share-based payment transactions, including grants of employeestock options, be recognized in financial statements.  That cost will be measured based on the fairvalue 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.

 

Wewill be required to apply FAS 123(R) as of the beginning of our fiscal yearbeginning January 1, 2006.  FAS 123(R)allows two methods for determining the effects of the transition: the modifiedprospective transition method and the modified retrospective method oftransition.  Under the modified prospectivetransition method, an entity would use the fair value based accounting methodfor all employee awards granted, modified or settled after the effectivedate.  As of the effective date,compensation cost related to the nonvested portion of awards outstanding as ofthat date would be based on the grant-date fair value of those awards ascalculated under the original provisions of Statement No. 123; that is, anentity would not remeasure the grant-date fair value estimate of the unvestedportion of awards granted prior to the effective date of FAS 123(R).  An entity will have the

 

21

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furtheroption to either apply the Statement to only the quarters in the period ofadoption and subsequent periods, or apply the Statement to all quarters in thefiscal year of adoption.  Under themodified retrospective method of transition, an entity would revise itspreviously issued financial statements to recognize employee compensation costfor prior periods presented in accordance with the original provisions ofStatement No. 123.

 

Wehave evaluated the transition methods available and determined that we willadopt 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 three fiscal years is presented in Note 1 to the financialstatements.  The pro forma compensationcosts presented in the table in Note 1 and in our prior filings have beencalculated using a Black-Scholes option pricing model.  We will continue to use the Black-Scholesoption pricing model to determine the fair value of awards at grant date.  We estimate the expense for fiscal 2006 to beapproximately $68,000 based on the value of options outstanding at December 31,2005 that will vest during 2006. This estimate does not include any expense foroptions that may be granted and vest during 2006.

 

InJune 2005, FASB issued Statement of Financial Accounting Standards (SFAS) No.154, “Accounting Changes and Error Corrections,” a replacement of APB OpinionNo. 20 and FASB Statement No. 3.  SFAS154 applies to all voluntary changes in accounting principle, and changes therequirements for accounting for and reporting of a change in accountingprinciple.  SFAS No. 154 requiresretrospective application to prior periods’ financial statements of a voluntarychange in accounting principle unless it is impracticable.  SFAS No. 154 is effective for accountingchanges and corrections of errors made in fiscal years beginning after December15, 2005.  We do not expect the adoptionof SFAS No. 154 to have a material effect on our consolidated financialstatements.

 

**REVENUES**

 

Our total revenues for 2005were $74,893,000 compared to $52,830,000 in 2004.

 

Retailrevenues increased to $62,365,000 in 2005 from $41,847,000 in 2004, an increaseof 49% or $20,518,000.  The increase inretail revenues was due primarily to:

 

1.               Same-storesales increase of approximately 15.6% or $6,500,000 (a sales comparison of ninestores open the full years of 2005 and 2004).

2.               Three stores opened in the fourth quarter of2004 and operating during 2005 that had an increase in sales of approximately$13,386,000.

3.               One store opened in the fourth quarter of 2005with sales of approximately $632,000.

 

Our retail outlets carry a wide range ofnew in-the-box and special-buy appliances, which include manufacturercloseouts, factory overruns, floor samples, returned or exchanged items,open-carton items, and scratch and dent appliances.  All these appliances are new, not used.  Some are in the carton while others are outof the carton.

 

We continue to purchase both new in-the-boxand special-buy appliances from Whirlpool Corporation (Whirlpool), MaytagCorporation (Maytag), GE Corporation (GE) and Frigidaire.  We have no minimum purchase requirements withany of these manufacturers.  Webelieve purchases from these four manufacturers will provide an adequate supplyof high-quality appliances for our retail outlets; however, there is a riskthat one or more of these sources could be curtailed or lost.

 

We operated thirteen retailstores at the end of 2005 and twelve at the end of 2004.  In October 2005, we opened a37,000-square-foot store in the San Antonio, Texas, market.

 

Recycling revenues increased to$10,937,000 in 2005 from $9,414,000 in 2004. The increase was primarily due to the Connecticut recycling program,which did not begin until the end of the second quarter of 2004 but

 

22

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was in operation during all of2005, and the recycling contracts with Austin Energy and Wisconsin Public Powerthat began in 2005.  Edison accounted forapproximately 9% of our total revenues for 2005 and 2004.

 

During 2005, 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(2004-2005 program)

2.               SDG&E(2005 program)

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

4.               Austin Energy (2005program)

5.               Wisconsin PublicPower Inc. (2005 program)

 

We have submitted proposals for thecontinuation of programs with Edison and SDG&E to recycle appliances intheir respective territories for the years 2006-2008.  In March 2006, we announced that we hadentered into an agreement with Wisconsin Energy Conservation Corporation tobegin a program in April 2006.  As of March 1, 2006, we operated processing andrecycling centers in Minneapolis; Los Angeles; Waterbury, Connecticut; and Austin,Texas.  We are also aggressively pursuingnew appliance recycling programs in these and other states.

 

Byproduct revenues increased to $1,591,000 in2005 from $1,569,000 in 2004.  Theincrease was due primarily to a slight increase of $64,000 in scrap metalrevenues, offset by a slight decrease of $42,000 in CFC revenues.

 

Our total revenues for 2004were $52,830,000 compared to $43,609,000 in 2003.

 

Retail revenues increased to $41,847,000 in2004 from $34,805,000 in 2003, an increase of 20.2% or $7,042,000.  The 2004 increase in retail revenues was dueprimarily to:

 

1.               Same-storesales increase of approximately 10% or $2,798,000 (a sales comparison of sevenstores open the full years of 2004 and 2003).

2.               Twostores opened during 2003 and operating for the full year 2004 had an increasein sales of approximately $3,666,000.

3.               Threestores opened during 2004, generating sales of approximately $578,000.

 

We purchased newin-the-box and special-buy appliances from Whirlpool, Maytag, GE and Frigidaire.

 

We operated twelve retailstores at the end of 2004 and nine at the end of 2003.  In October 2004, we opened a36,000-square-foot store in the San Antonio market.  In November 2004, we opened an88,000-square-foot facility in the Atlanta market.  This facility combines a retail store with aregional distribution facility for three of our markets.  On December 31, 2004, we opened a59,000-square-foot store in the Minneapolis/St. Paul market.

 

Recycling revenues increased to$9,414,000 in 2004 from $8,014,000 in 2003. The increase was due primarily to larger total recycling volumes fromall our California recycling contracts as well as from units recycled throughour recycling contract in Connecticut that began at the end of the secondquarter of 2004.  Edison accounted forapproximately 9% of our total annual revenues for 2004 and 2003.  During 2004, we managed appliance recyclingoperations under three contracts with electric utility companies, each of whichwas responsible for advertising in its service territory.  We provided services for:

 

1.               Edison (2004-2005program)

2.               SDG&E (2004program)

3.               UI and CL&P(joint 2004 program)

 

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During the first eight monthsof 2003, we recycled appliances under an extension of California’s 2002Statewide Residential Appliance Recycling Program.  Edison administered the program and customersof Edison, PG&E and SDG&E were eligible to participate.  We were responsible for advertising in thePG&E and SDG&E service territories, while Edison was responsible foradvertising in the Edison area.  Duringthe third quarter of 2003, Edison awarded us a contract for the 2003 StatewideResidential Appliance Recycling Program in Edison and SDG&E’sterritories.  This contract endedDecember 31, 2003.

 

Byproduct revenues increased to$1,569,000 in 2004 from $790,000 in 2003. The increase was due primarily to:

 

1.               An increase of approximately $650,000 inscrap metal revenues.

2.               An increase in the volume of CFCs,offset by a decrease in the price of CFCs.

 

**COSTOF REVENUE**

 

Cost of revenues includes allcosts related to the purchase of inventory, including freight, costs related toreceiving and distribution of inventory, and costs related to delivery andservice 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.

 

**GROSSPROFIT**

 

Our overall gross profit percentage increased to30.0% in 2005 from 29.4% in 2004.  Theincrease was due primarily to an increase of approximately 0.6% in overallgross profit in special-buy appliances.

 

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 ofappliances we 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 gross profitpercentage increased to 29.4% in 2004 from 27.2% in 2003.  The increase was due primarily to:

 

1.               Improved efficienciesof approximately 0.4% of recycling revenues because of higher volumes from allour recycling contracts.

2.               An increase in grossprofit in sales of special-buy appliances of approximately 1.8% of total retailrevenues.

 

**SELLING, GENERALAND ADMINISTRATIVE EXPENSES**

 

Selling, general and administrativeexpenses were 30.2% 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.  Selling expenses increased to$15,017,000 in 2005 from $10,795,000 in 2004. Theincrease in selling expenses was due primarily to:

 

1.               The expense ofapproximately $2,500,000 for operating three additional stores during all of2005.

 

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2.               An increase inadvertising expense of approximately $811,000, which includes a new marketcompared to the same period in the previous year.

 

General and administrative expensesincreased to $7,620,000 in 2005 from $5,851,000 in 2004.  The increase was due primarily to additionalpersonnel costs associated with operating additional retail stores andrecycling contracts and legal costs associated with the legal proceedingsdiscussed in Part I, Item 3, Legal Proceedings, and Note 6 of the Notes toConsolidated Financial Statements.

 

Selling, generaland administrative expenses were 31.5% of total revenues in 2004 compared to31.3% in 2003.  Selling, general andadministrative expenses increased to $16,646,000 in 2004 from $13,655,000 in2003, a 21.9% increase.  Selling expensesincreased to $10,795,000 in 2004 from $8,210,000 in 2003.  The increase in selling expenses was dueprimarily to:

 

1.               The expense of operatingone additional store overall during 2004.

2.               Expenses related toopening two new stores and a combination retail store/warehouse distributioncenter in the fourth quarter of 2004.

3.               An increase inadvertising expense of approximately $755,000, which includes two new marketscompared to the same period in the previous year.

 

General andadministrative expenses increased to $5,851,000 in 2004 from $5,445,000 in2003.  The increase was due primarily toan increase in administrative costs as a result of an overall increase inrecycling volumes and an increase in the allowance for bad debt and one-timebanking charges.

 

**INTERESTEXPENSE**

 

Interest expenseincreased to $883,000 in 2005 from $777,000 in 2004.  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 expense increased to$777,000 in 2004 from $748,000 in 2003. The increase was primarily due to an increase in the amount ofborrowings from the line of credit.

 

**INCOME TAXES AND NET OPERATING LOSSES**

 

We recorded a benefit forincome taxes of $546,000 for 2004, which is due primarily to:

 

1.               A tax benefit of$600,000 that was a result of a federal income tax credit for a prior carrybackclaim; and

2.               An income tax refund wereceived during the second quarter that was greater than the estimated incometax receivable we had recorded, offset by an increase in the deferred tax assetvaluation allowance.

 

We had netoperating loss carryovers and credit carryforwards of approximately $9.6million at December 31, 2005, which may be available to reduce taxable incomeand, therefore, income taxes payable in future years.  However, future utilization of these loss andcredit carryforwards is subject to certain significant limitations underprovisions of the Internal Revenue Code. These include limitations subject to Section 382, which relate to a 50percent change in control over a three-year period, and are further dependentupon our achieving profitable operations. We believe that the issuance of Common Stock during 1999 resulted in an “ownershipchange” under Section 382.  Accordingly,our ability to use net operating loss carryforwards generated prior to February1999 may be limited to approximately $56,000 per year, or less than $1 millionthrough 2018.

 

As of our 2005 and 2004year-ends, we had recorded cumulative valuation allowances of $4,914,000 and$4,445,000, respectively, against our net deferred tax assets due to theuncertainty of their realization.  The

 

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realization of deferredtax assets is dependent upon sufficient future taxable income during theperiods when deductible temporary differences and carryforwards are expected tobe available to reduce taxable income. In the future, when we believe we can reasonably estimate futureoperating results and these estimated results reflect taxable income, theamount of deferred tax assets considered reasonable could be adjusted by areduction in the valuation allowance.

 

**LIQUIDITYAND CAPITAL RESOURCES**

 

AtDecember 31, 2005, we had working capital of $3,879,000 compared to $4,600,000at January 1, 2005.  Cash and cashequivalents decreased to $2,095,000 at December 31, 2005 from $4,362,000 atJanuary 1, 2005.  Net cash used inoperating activities was $2,149,000 in 2005 compared to net cash provided byoperating activities of $267,000 in 2004. The cash used in operating activities was due primarily to an increasein inventories and accounts receivable, offset by a decrease in the netloss.  During 2005, inventories increasedby $1,746,000 due primarily to operating three additional stores during all of2005 as compared to the prior year. Accounts receivable increased by $862,000 due primarily to an increasein the volume of units recycled in December 2005.

 

Net cash used in investingactivities was $517,000 in 2005 compared to $659,000 in 2004.  The cash used in investing activities in 2005was primarily related to continued development of our enterprise-wide softwareand building improvements primarily related to the opening of a recyclingcenter in Austin, Texas, and a second retail store in the San Antonio, Texas,market during October 2005.  The cashused in investing activities in 2004 was primarily related to continueddevelopment of our enterprise-wide software and leasehold improvements relatedto opening four locations in 2004.  Wedid not have any material purchase commitments for assets as of December 31,2005.

 

Net cash provided by financingactivities was $399,000 in 2005 compared to $3,558,000 in 2004.  The cash provided by financing activities in2005 was due primarily to increased borrowing under the line of 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 31, 2005, we hadan $8 million line of credit with a lender. The interest rate on the line as of December 31, 2005 was prime plus2.95 percentage points (10.20%).  Theamount of borrowings available under the line of credit is based on a formulausing receivables and inventories.  Our unusedborrowing capacity was $932,000 at December 31, 2005.  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 secured 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 line requires that we meetcertain financial 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 December 31, 2005, we were in violation ofthe covenant related to reaching a minimum annual level of net income and thecovenant related to a minimum level of tangible net worth.  On March 17, 2006, the lender waived theseviolations.

 

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A summary of our contractualcash obligations at December 31, 2005 is as follows:

 
| **Contractual**                    | ** ** | **Cash Payments Due by Period** | ** ** |
|------------------------------------|------------|-----------------------------------------------------|------------|
| **Cash  Obligations**              | ** ** | **Total**                                           | ** ** | **2006** | ** ** | **2007** | ** ** | **2008** | ** ** | **2009** | ** ** | **2010** | ** ** | **2011 and  Thereafter** | ** ** |
| Long-term debt, including interest |       | $                                                   | 7,119,000  |   | $ | 558,000 |   | $ | 549,000 |   | $ | 494,000 |   | $ | 489,000 |   | $ | 489,000 |   | $ | 4,540,000 |   |
| Operating leases                   |       | $                                                   | 12,977,000 |   | $ | 2,493,000 |   | $ | 2,228,000 |   | $ | 1,979,000 |   | $ | 1,288,000 |   | $ | 862,000 |   | $ | 4,127,000 |   |
| Total contractual cash obligations |       | $                                                   | 20,096,000 |   | $ | 3,051,000 |   | $ | 2,777,000 |   | $ | 2,473,000 |   | $ | 1,777,000 |   | $ | 1,351,000 |   | $ | 8,667,000 |   |

 

We also have a commercialcommitment as described below:

 
| **Other Commercial  Commitment** | ** ** | **Total Amount  Committed** | ** ** | **Outstanding at 12/31/05** | ** ** | **Date of Expiration** | ** ** |
|---------------------------------------|------------|----------------------------------|------------|---------------------------------------|------------|----------------------------------|------------|
| Line of credit                        |       | $                                | 8,000,000  |                                  | $          | 6,125,000                        |       | December 31, 2007 |   |
|                                       |            |                                  |            |                                       |            |                                  |            |  |  |

 

In March 2006, we entered intoa purchase agreement for the sale of our headquarters facility in Minneapolis,MN for approximately $6.0 million.  Thepending transaction is expected to close in mid-May, after which time we willlease this facility for a limited period from the buyer until we move to a newlocation.  Approximately $3.0 million ofthe net proceeds from the pending sale will be used to pay off the mortgage onthe current headquarters facility with the remaining proceeds to be used forworking capital.

 

We believe, based onthe anticipated sales per retail store, the anticipated revenues from ourrecycling contracts and our anticipated gross profit, that our cash balance,anticipated funds generated from operations and our current line of credit willbe sufficient to finance our operations and capital expenditures throughDecember 2006.  Our total capitalrequirements for 2006 will depend upon, among other things as discussed below,the number and size of retail stores operating during the fiscal year and therecycling volumes generated from the recycling contracts in 2006.  Currently, we have thirteen stores and fourcenters in operation.  If revenues arelower than anticipated or expenses are higher than anticipated, we may requireadditional capital to finance operations. Sources of additional financing, if needed in the future, may includefurther debt financing or the sale of equity (common or preferred stock) orother securities.  There can be noassurance that such additional sources of financing will be available on termssatisfactory to us or permitted by our current lender.

 

**FORWARD-LOOKINGSTATEMENTS**

 

Statements contained in thisannual report regarding our future operations, performance and results, andanticipated liquidity discussed herein are forward-looking and therefore aresubject to certain risks and uncertainties, including, but not limited to,those discussed herein.  Anyforward-looking information regarding our operations will be affected primarilyby our continued ability to purchase product from Whirlpool, Maytag, Frigidaireand GE at acceptable prices and the ability and timing of utility companies todeliver units under their recycling contracts with us.  In addition, any forward-looking informationwill also be affected by the ability of individual retail stores to meetplanned revenue levels, the rate of growth in the number of retail stores, thespeed at which individual retail stores reach profitability, costs and expensesbeing realized at higher

 

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than expected levels, ourability to secure an adequate supply of special-buy appliances for resale, andthe continued availability of our current line of credit.

 

**ITEM 7A.****               QUANTITATIVE AND QUALITATIVE DISCLOSURE ABOUTMARKET RISK**

 

**MARKETRISK AND IMPACT OF INFLATION**

 

We do not believe there is anysignificant risk related to interest rate fluctuations on the long-termfixed-rate debt.  However, there isinterest rate risk on the line of credit, since our interest rate floats withprime, and on approximately $3,100,000 in long-term debt entered into inSeptember 2002, since our interest rate is based on the 30-day LIBOR rate.  Based on average floating rate borrowings of$9,243,000, a one-percent change in the applicable rate would have caused ourinterest expense to change by approximately $92,000.  Also, we believe that inflation has not had amaterial impact on the results of operations for each of the fiscal years inthe three-year period ended December 31, 2005. However, there can be no assurance that future inflation will not havean adverse impact on our operating results and financial condition.

 

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**ITEM 8.****                  FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA**

 
| **Description**                                                                                  | ** ** | ** ** |
|--------------------------------------------------------------------------------------------------|------------|------------|
|                                                                                             |       |       |
| Reports of Independent Registered Public Accounting Firms                                        |       |       |
| Consolidated Balance Sheet as of December 31, 2005 and January 1, 2005                           |       |       |
| Consolidated Statement of Operations for the three years ended  December 31,  2005               |       |       |
| Consolidated Statement of Shareholders’ Equity for the three years ended  December 31, 2005 |       |       |
| Consolidated Statement of Cash Flows for the three years ended  December 31,  2005               |       |       |
| Notes to Consolidated Financial Statements                                                       |       |       |

 

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REPORTOF INDEPENDENT REGISTERED PUBLIC ACCOUNTING FIRM

 

To the Shareholders, Audit Committee andBoard of Directors

Appliance Recycling Centers of America, Inc.and Subsidiaries

Minneapolis, Minnesota

 

We have audited the accompanying consolidatedbalance sheet of Appliance Recycling Centers of America, Inc. and Subsidiariesas of December 31, 2005, and the related consolidated statements of operations,shareholders’ equity and cash flows for the year then ended.  These consolidated financial statements arethe responsibility of the Company’s management. Our responsibility is to express an opinion on these consolidatedfinancial statements based on our audit.

 

We conducted our audit in accordance with thestandards of the Public Company Accounting Oversight Board (UnitedStates).  Those standards require that weplan and perform the audit to obtain reasonable assurance about whether theconsolidated 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 statement presentation.  We believe that our audit provides areasonable basis for our opinion.

 

In our opinion, the consolidated financialstatements referred to above present fairly, in all material respects, thefinancial position of Appliance Recycling Centers of America, Inc. andSubsidiaries as of December 31, 2005 and the results of their operations andtheir cash flows for the year then ended, in conformity with U.S. generallyaccepted accounting principles.

 
| /s/ Virchow, Krause &  Company, LLP                                                     |   |
|---------------------------------------------------------------------------------------------|--------|
|                                                                                        |
| Minneapolis, Minnesota                                                                      |
| February 21, 2006, except  as to Note 3 and Note 10 as to which the date is March 17, 2006. |

 

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REPORT OF INDEPENDENT REGISTEREDPUBLIC ACCOUNTING FIRM

 

To the Board of Directors

Appliance Recycling Centers ofAmerica, Inc. and Subsidiaries

Minneapolis, Minnesota

 

We have audited the accompanyingconsolidated balance sheet of Appliance Recycling Centers of America, Inc. andSubsidiaries as of January 1, 2005, and the related consolidated statement ofoperations, shareholders’ equity and cash flows for each of the years in thetwo-year period ended January 1, 2005. Our audit also included the financial schedule listed in the index atItem 15.  These consolidated financialstatements and schedule are the responsibility of the Company’s management.  Our responsibility is to express an opinionon these consolidated financial statements and schedule based on our audits.

 

We conducted our audits in accordancewith the standards of the Public Company Accounting Oversight Board (UnitedStates).  Those standards require that weplan and perform the audit to obtain reasonable assurance about whether theconsolidated 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 the significant estimates made bymanagement, as well as evaluating the overall financial statementpresentation.  We believe that our auditsprovide a reasonable basis for our opinion.

 

In our opinion, the financial statementsreferred to above present fairly, in all material respects, the financialposition of Appliance Recycling Centers of America, Inc. and Subsidiaries as ofJanuary 1, 2005, and the results of their operations and their cash flows foreach of the years in the two-year period ended January 1, 2005, in conformitywith accounting principles generally accepted in the United States of America.  Also in our opinion, the related financialstatement schedule when considered in relation to the basic financialstatements, taken as a whole, presents fairly in all material respects theinformation set therein.

 
| /s/ 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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**APPLIANCE RECYCLING CENTERS OF AMERICA, INC. AND SUBSIDIARIES**

**CONSOLIDATED BALANCE SHEET**

 
| ** **                                                                                                                      | ** ** | **December 31,** | ** **     | **January 1,** | ** ** |
|---------------------------------------------------------------------------------------------------------------------------------|------------|-----------------------|----------------|---------------------|------------|
| ** **                                                                                                                      | ** ** | **2005**              | ** **     | **2005**            | ** ** |
|                                                                                                                            |       |                  |           |                |       |
| **ASSETS**(Note 3)                                                                                                              |       |                  |           |                |       |
|                                                                                                                            |       |                  |           |                |       |
| **Current Assets**                                                                                                              |       |                  |           |                |       |
| Cash                                                                                                                            | ** ** | **$**                 | **2,095,000**  |                | $          | 4,362,000 |   |
| Accounts receivable, net of allowance of $252,000  and $102,000, respectively (Note 9)                                          | ** ** | **2,896,000**         |           | 2,034,000           |       |
| Inventories, net of reserves of $379,000 and  $385,000, respectively                                                            | ** ** | **11,900,000**        |           | 10,154,000          |       |
| Deferred income taxes (Note 7)                                                                                                  | ** ** | **393,000**           |           | 468,000             |       |
| Other current assets                                                                                                            | ** ** | **449,000**           |           | 338,000             |       |
| Total current assets                                                                                                            | ** ** | **17,733,000**        |           | 17,356,000          |       |
| **Property and Equipment,**at  cost (Notes 2 and 4)                                                                             |       |                  |           |                |       |
| Land                                                                                                                            | ** ** | **2,050,000**         |           | 2,050,000           |       |
| Buildings and improvements                                                                                                      | ** ** | **4,501,000**         |           | 4,338,000           |       |
| Equipment                                                                                                                       | ** ** | **6,299,000**         |           | 5,928,000           |       |
| ** **                                                                                                                      |       | **12,850,000**        |           | 12,316,000          |       |
| Less accumulated depreciation                                                                                                   | ** ** | **6,798,000**         |           | 5,982,000           |       |
| Net property and equipment                                                                                                      | ** ** | **6,052,000**         |           | 6,334,000           |       |
| **Other Assets**                                                                                                                | ** ** | **356,000**           |           | 300,000             |       |
| **Restricted Cash**                                                                                                             | ** ** | **350,000**           |           | 350,000             |       |
| Total assets                                                                                                                    | ** ** | **$**                 | **24,491,000** |                | $          | 24,340,000 |   |
|                                                                                                                            |       |                  |           |                |       |
| **LIABILITIES AND SHAREHOLDERS’ EQUITY**                                                                                   |       |                  |           |                |       |
|                                                                                                                            |       |                  |           |                |       |
| **Current Liabilities**                                                                                                         |       |                  |           |                |       |
| Line of credit (Note 3)                                                                                                         | ** ** | **$**                 | **6,125,000**  |                | $          | 5,415,000 |   |
| Current maturities of long-term obligations                                                                                     | ** ** | **262,000**           |           | 615,000             |       |
| Accounts payable                                                                                                                | ** ** | **3,868,000**         |           | 3,889,000           |       |
| Accrued expenses (Note 5)                                                                                                       | ** ** | **3,541,000**         |           | 2,779,000           |       |
| Income taxes payable                                                                                                            | ** ** | **58,000**            |           | 58,000              |       |
| Total current liabilities                                                                                                       | ** ** | **13,854,000**        |           | 12,756,000          |       |
| **Long-Term Obligations,**less  current maturities (Note 4)                                                                     | ** ** | **4,823,000**         |           | 5,053,000           |       |
| **Deferred Income Tax Liabilities**(Note  7)                                                                                    | ** ** | **393,000**           |           | 468,000             |       |
| Total liabilities                                                                                                               | ** ** | **19,070,000**        |           | 18,277,000          |       |
| **Commitments and Contingencies**(Note  6)                                                                                      |       |                  |           |                |       |
| **Shareholders’ Equity**(Note  8)                                                                                          |       |                  |           |                |       |
| Common Stock, no par value; authorized  10,000,000 shares; issued and outstanding 4,320,000 and 4,136,000 shares,  respectively | ** ** | **14,840,000**        |           | 14,549,000          |       |
| Accumulated deficit                                                                                                             | ** ** | **(9,419,000**        | **)**          | (8,486,000          | )          |
| Total shareholders’ equity                                                                                                 | ** ** | **5,421,000**         |           | 6,063,000           |       |
| Total liabilities and shareholders’ equity                                                                                 | ** ** | **$**                 | **24,491,000** |                | $          | 24,340,000 |   |

 

See Notes to Consolidated FinancialStatements.

 

32

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

**CONSOLIDATED STATEMENT OF OPERATIONS**

 
| ** **                                                 | ** ** | **For the fiscal year ended** | ** **     |
|------------------------------------------------------------|------------|---------------------------------------------------|----------------|
| ** **                                                 | ** ** | **December 31,**                             | ** **     | **January 1,** | ** ** | **January 3,** | ** ** |
| ** **                                                 | ** ** | **2005**                                          | ** **     | **2005** | ** ** | **2004** | ** ** |
| **Revenues**(Note 9)                                       |       |                                              |           |   |   |   |   |
| Retail                                                     | ** ** | **$**                                             | **62,365,000** | ** ** | $ | 41,847,000 |   | $ | 34,805,000 |   |
| Recycling                                                  | ** ** | **10,937,000**                                    | ** **     | 9,414,000 |   | 8,014,000 |   |
| Byproduct                                                  | ** ** | **1,591,000**                                     | ** **     | 1,569,000 |   | 790,000 |   |
|                                                       |       |                                              | ** **     |   |   |   |   |
| Total revenues                                             | ** ** | **74,893,000**                                    | ** **     | 52,830,000 |   | 43,609,000 |   |
|                                                       |       |                                              | ** **     |   |   |   |   |
| **Cost of Revenues**(Note  9)                              | ** ** | **52,406,000**                                    | ** **     | 37,287,000 |   | 31,730,000 |   |
|                                                       |       |                                              | ** **     |   |   |   |   |
| Gross profit                                               | ** ** | **22,487,000**                                    | ** **     | 15,543,000 |   | 11,879,000 |   |
|                                                       |       |                                              | ** **     |   |   |   |   |
| **Selling, General and Administrative  Expenses**(Note 2)  | ** ** | **22,637,000**                                    | ** **     | 16,646,000 |   | 13,655,000 |   |
|                                                       |       |                                              | ** **     |   |   |   |   |
| Operating loss                                             | ** ** | **(150,000**                                      | **)**          | (1,103,000 | ) | (1,776,000 | ) |
|                                                       |       |                                              | ** **     |   |   |   |   |
| **Other Income (Expense)**                                 |       |                                              | ** **     |   |   |   |   |
| Other income (expense)                                     | ** ** | **68,000**                                        | ** **     | 20,000 |   | (5,000 | ) |
| Interest income                                            | ** ** | **32,000**                                        | ** **     | **—** |   | 12,000 |   |
| Interest expense                                           | ** ** | **(883,000**                                      | **)**          | (777,000 | ) | (748,000 | ) |
|                                                       |       |                                              | ** **     |   |   |   |   |
| Loss before benefit of income taxes                        | ** ** | **(933,000**                                      | **)**          | (1,860,000 | ) | (2,517,000 | ) |
|                                                       |       |                                              | ** **     |   |   |   |   |
| **Benefit of Income Taxes**(Note  7)                       |       | —                                            | ** **     | (546,000 | ) | (976,000 | ) |
|                                                       |       |                                              | ** **     |   |   |   |   |
| Net loss                                                   | ** ** | **$**                                             | **(933,000**   | **)** | $ | (1,314,000 | ) | $ | (1,541,000 | ) |
|                                                       |       |                                              | ** **     |   |   |   |   |
| **Basic Loss per Common Share**                            | ** ** | **$**                                             | **(0.22**      | **)** | $ | (0.48 | ) | $ | (0.66 | ) |
|                                                       |       |                                              | ** **     |   |   |   |   |
| **Diluted Loss per Common Share**                          | ** ** | **$**                                             | **(0.22**      | **)** | $ | (0.48 | ) | $ | (0.66 | ) |
| ** **                                                 | ** ** | ** **                                        | ** **     | ** ** | ** ** | ** ** | ** ** |
| **Weighted Average Number of Common Shares  Outstanding:** |       |                                              | ** **     |   |   |   |   |
| Basic                                                      | ** ** | **4,261,000**                                     | ** **     | 2,722,000 |   | 2,343,000 |   |
| Diluted                                                    | ** ** | **4,261,000**                                     | ** **     | 2,722,000 |   | 2,343,000 |   |

 

See Notes to Consolidated FinancialStatements.

 

33

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

**CONSOLIDATED STATEMENT OF SHAREHOLDERS’EQUITY**

 
| ** **                                                            | ** ** | **Common Stock** | ** ** | **Accumulated** | ** ** | ** **  | ** ** |
|-----------------------------------------------------------------------|------------|-----------------------|------------|-----------------|------------|-------------|------------|
| ** **                                                            | ** ** | **Shares**            | ** ** | **Amount**      | ** ** | **Deficit** | ** ** | **Total** | ** ** |
|                                                                  |       |                  |       |            |       |        |       |   |   |
| **Balance, December 28, 2002**                                        |       | 2,324,000             |       | $               | 11,368,000 |        | $          | (5,631,000 | ) | $ | 5,737,000 |   |
| Exercise of warrants (Note 8)                                         |       | 20,000                |       | 13,000          |       | —      |       | 13,000 |   |
| Cashless exercise of warrants (Note 8)                                |       | 20,000                |       | —          |       | —      |       | — |   |
| Net loss                                                              |       |                  |       | —          |       | (1,541,000  | )          | (1,541,000 | ) |
|                                                                  |       |                  |       |            |       |        |       |   |   |
| **Balance, January 3, 2004**                                          |       | 2,364,000             |       | 11,381,000      |       | (7,172,000  | )          | 4,209,000 |   |
| Exercise of stock options (Note 8)                                    |       | 16,000                |       | 16,000          |       | —      |       | 16,000 |   |
| Exercise of warrants (Note 8)                                         |       | 30,000                |       | 18,000          |       | —      |       | 18,000 |   |
| Cashless exercise of warrants (Note 8)                                |       | 576,000               |       | —          |       | —      |       | — |   |
| Issuance of Common Stock, net of offering  costs of $316,000 (Note 8) |       | 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 (Note 8)                                    |       | 179,000               |       | 365,000         |       | —      |       | 365,000 |   |
| Exercise of warrant (Note 8)                                          |       | 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 |   |

 

See Notes to Consolidated Financial Statements.

 

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

**CONSOLIDATED STATEMENT OF CASH FLOWS**

 
| ** **                                                                                 | ** ** | **For the fiscal year ended** | ** **    |
|--------------------------------------------------------------------------------------------|------------|---------------------------------------------------|---------------|
| ** **                                                                                 | ** ** | **December 31,**                             | ** **    | **January 1,** | ** ** | **January 3,** | ** ** |
| ** **                                                                                 | ** ** | **2005**                                          | ** **    | **2005** | ** ** | **2004** | ** ** |
| **Cash Flows from Operating Activities**                                                   |       |                                              |          |   |   |   |   |
| Net loss                                                                                   | ** ** | **$**                                             | **(933,000**  | **)** | $ | (1,314,000 | ) | $ | (1,541,000 | ) |
| Adjustments to reconcile net loss to net cash  provided by (used in) operating activities: |       |                                              | ** **    |   |   |   |   |
| Depreciation and amortization                                                              | ** ** | **818,000**                                       | ** **    | 658,000 |   | 611,000 |   |
| Loss on sale of property and equipment                                                     |       | —                                            | ** **    | — |   | 5,000 |   |
| Deferred income taxes                                                                      |       | —                                            | ** **    | 117,000 |   | — |   |
| Change in assets and liabilities:                                                          |       |                                              | ** **    |   |   |   |   |
| Receivables                                                                                | ** ** | **(862,000**                                      | **)**         | (147,000 | ) | (758,000 | ) |
| Inventories                                                                                | ** ** | **(1,746,000**                                    | **)**         | (816,000 | ) | (1,022,000 | ) |
| Other current assets                                                                       | ** ** | **(111,000**                                      | **)**         | (184,000 | ) | (73,000 | ) |
| Other assets                                                                               | ** ** | **(56,000**                                       | **)**         | (40,000 | ) | 62,000 |   |
| Accounts payable and accrued expenses                                                      | ** ** | **741,000**                                       | ** **    | 1,691,000 |   | 775,000 |   |
| Income taxes refundable or payable                                                         |       | —                                            | ** **    | 302,000 |   | (450,000 | ) |
| Net cash provided by (used in) operating  activities                                       | ** ** | **(2,149,000**                                    | **)**         | 267,000 |   | (2,391,000 | ) |
|                                                                                       |       |                                              | ** **    |   |   |   |   |
| **Cash Flows from Investing Activities**                                                   | ** ** | ** **                                        | ** **    | ** ** | ** ** | ** ** | ** ** |
| Purchases of property and equipment                                                        | ** ** | **(517,000**                                      | **)**         | (659,000 | ) | (558,000 | ) |
| Net cash used in investing activities                                                      | ** ** | **(517,000**                                      | **)**         | (659,000 | ) | (558,000 | ) |
|                                                                                       |       |                                              | ** **    |   |   |   |   |
| **Cash Flows from Financing Activities**                                                   | ** ** | ** **                                        | ** **    | ** ** | ** ** | ** ** | ** ** |
| Net borrowings under line of credit                                                        | ** ** | **710,000**                                       | ** **    | 326,000 |   | 1,574,000 |   |
| Payments on long-term obligations                                                          | ** ** | **(602,000**                                      | **)**         | (236,000 | ) | (244,000 | ) |
| Proceeds from short-term obligations                                                       |       | —                                            | ** **    | 300,000 |   | — |   |
| Proceeds from stock option exercises                                                       | ** ** | **365,000**                                       | ** **    | 16,000 |   | — |   |
| Proceeds from warrant exercises                                                            | ** ** | **3,000**                                         | ** **    | 18,000 |   | 13,000 |   |
| Payments of stock placement costs                                                          | ** ** | **(77,000**                                       | **)**         | **—** |   | — |   |
| Net proceeds from issuance of Common Stock                                                 |       | —                                            | ** **    | 3,134,000 |   | — |   |
| Net cash provided by financing activities                                                  | ** ** | **399,000**                                       | ** **    | 3,558,000 |   | 1,343,000 |   |
|                                                                                       |       |                                              | ** **    |   |   |   |   |
| Increase (decrease) in cash and cash  equivalents                                          | ** ** | **(2,267,000**                                    | **)**         | 3,166,000 |   | (1,606,000 | ) |
|                                                                                       |       |                                              | ** **    |   |   |   |   |
| **Cash and Cash Equivalents**                                                              |       |                                              | ** **    |   |   |   |   |
| Beginning                                                                                  | ** ** | **4,362,000**                                     | ** **    | 1,196,000 |   | 2,802,000 |   |
| Ending                                                                                     | ** ** | **$**                                             | **2,095,000** | ** ** | $ | 4,362,000 |   | $ | 1,196,000 |   |
|                                                                                       |       |                                              | ** **    |   |   |   |   |
| **Supplemental Disclosures of Cash Flow  Information**                                     |       |                                              | ** **    |   |   |   |   |
| Cash payments (receipts) relative to:                                                      |       |                                              | ** **    |   |   |   |   |
| Interest                                                                                   | ** ** | **$**                                             | **894,000**   | ** ** | $ | 777,000 |   | $ | 748,000 |   |
| Income taxes, net                                                                          | ** ** | **6,000**                                         | ** **    | (967,000 | ) | (527,000 | ) |
|                                                                                       |       |                                              | ** **    |   |   |   |   |
| Equipment acquired under capital lease                                                     | ** ** | **$**                                             | **19,000**    | ** ** | $ | 155,000 |   | $ | 10,000 |   |

 

SeeNotes to Consolidated Financial Statements.

 

35

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

 

**NOTESTO 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 recycling services on acredit 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 2005, 2004 and 2003.

 

**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.

 

**Fiscal year:**  We use a 52-53 week fiscal year.  Our 2005 fiscal year (2005) ended December31, 2005, our 2004 fiscal year (2004) ended January 1, 2005, and our 2003fiscal year (2003) ended January 3, 2004. The 2005 fiscal year and the 2004 fiscal year contain 52 weeks.  The 2003 fiscal year contains 53 weeks.

 

**Revenue recognition:**  We recognize revenue from appliance sales inthe period the consumer purchases and pays for the appliances and delivery ofthe appliance has been completed, net of allowance for estimated returns.  We recognize revenue from appliance recyclingwhen we collect and process a unit.  Werecognize 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

 

36

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service for a fixed portion of the warranty salesprice, we recognize revenue for the net amount retained at the time of sale ofthe 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 defective unitsat no cost to our customers.  We estimatethe costs that may be incurred under our warranty and record a liabilityreserve in the amount of such costs at the time we recognize product revenue.  Factors that affect our warranty liabilityreserve for covered units include the number of units sold, historical andanticipated rates of warranty claims on these units, and the cost of suchclaims. We periodically assess the adequacy of our recorded warranty liabilityreserve and adjust the amounts as necessary.

 

Changes in our warranty liability reserve are asfollows:

 
| ** **                           | ** ** | **2005**    | ** ** | **2004**   | ** ** | **2003** | ** ** |
|--------------------------------------|------------|-------------|------------|------------|------------|----------|------------|
| Balance, beginning                   | ** ** | **$**       | **35,000** | ** ** | $          | 54,000   |       | $ | 82,000 |   |
| Standard accrual based on units sold | ** ** | **58,000**  | ** ** | 76,000     |       | 164,000  |       |
| Actual costs incurred                | ** ** | **(3,000**  | **)**      | (53,000    | )          | (133,000 | )          |
| Periodic accrual adjustments         | ** ** | **(63,000** | **)**      | (42,000    | )          | (59,000  | )          |
| Balance, ending                      | ** ** | **$**       | **27,000** | ** ** | $          | 35,000   |       | $ | 54,000 |   |

 

**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 $252,000 and $102,000 to beadequate to cover any exposure to loss in our December 31, 2005 and January 1,2005 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 tomaintain a cash balance that is restricted. The former processor required us to maintain the restricted cash balancefor 90 days after we ceased using the former credit card processor.  In January 2006, $300,000 of the restrictedcash balance was released and refunded to us. The remaining $50,000 will be released later in 2006.

 

37

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**Inventories:**  Inventories, consisting principally ofappliances, are stated at the lower of cost, first-in, first-out (FIFO), ormarket and consist of:

 
| ** **     | ** ** | **2005**     | ** **     | **2004** | ** ** |
|----------------|------------|--------------|----------------|----------|------------|
| Finished goods | ** ** | **$**        | **12,279,000** |     | $          | 10,539,000 |   |
| Less reserves  | ** ** | **(379,000** | **)**          | (385,000 | )          |
| ** **     |       | **$**        | **11,900,000** |     | $          | 10,154,000 |   |

 

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 $379,000 and $355,000 as of December 31, 2005 andJanuary 1, 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 31, 2005.

 

**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 $230,000, $220,000 and $255,000 for the fiscalyears of 2005, 2004 and 2003, respectively. Amortization expense on software development costs was $246,000,$212,000 and $164,000 for the fiscal years 2005, 2004 and 2003,respectively.  Estimated amortizationexpenses are $231,000, $163,000, $113,000, $67,000 and $37,000 for the fiscalyears 2006, 2007, 2008, 2009 and 2010, 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.  Also see Note2.

 

**Deferred financing fees:**  Deferredfinancing fees are presented in the consolidated balance sheet as a componentof other assets and are reported net of accumulated amortization.  We determine amortization expense on astraight-line basis over the term of the underlying debt.

 

**Advertising expense: **Advertising is expensed as incurred and was$3,164,000, $2,353,000 and $1,545,000 for the 2005, 2004 and 2003 fiscal years,respectively.

 

**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

 

38

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reported amounts of assets and liabilities andtheir tax basis.  Deferred tax assets arereduced by a valuation allowance when, in the opinion of our management, it ismore likely than not that some portion or all of the deferred tax assets willnot be realized.  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 the averagemarket price during the year.  Becausethe effect of options and warrants on 2005, 2004 and 2003 is antidilutive, theywere not included in the computation of per-share amounts.

 

**Stock-based compensation:**  We regularly grant options to our employeesunder various plans as described in Note 8. As permitted under accounting principles generally accepted in theUnited States of America, these grants are accounted for following APB OpinionNo. 25 and related interpretations. Accordingly, compensation cost would be recognized for those grants wherethe exercise price is less than the fair market value of the stock on the dateof grant.  We recorded no compensationexpense for employee grants for fiscal years 2005, 2004 and 2003 because themarket price and exercise price of the grants were the same on the day ofgrant.

 

In December 2002, the Financial AccountingStandards Board (FASB) issued Statement of Financial Accounting Standards(SFAS) No. 148, “Accounting for Stock-Based Compensation — Transition andDisclosure.”  SFAS No. 148 is an amendmentto SFAS No. 123, providing alternative methods of transition for a voluntarychange to the fair value based method of accounting for stock-based employeecompensation.  SFAS No. 148 also providesrequired additional disclosures about the method of accounting for stock-basedemployee compensation.  We adopted theannual disclosure provision of SFAS No. 148 during the year ended January 3,2004.  We chose not to adopt the voluntarychange to the fair value based method of accounting for stock-based employeecompensation, pursuant to SFAS No. 148.

 

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 SFAS No. 123 and148, our net loss and net loss per basic and diluted common share would havebeen as indicated below.

 
| ** **                                | ** ** | **2005**    | ** **     | **2004** | ** ** | **2003**   | ** ** |
|-------------------------------------------|------------|-------------|----------------|----------|------------|------------|------------|
| Net income (loss):                        |       |        |           |     |       |       |       |
| As reported                               | ** ** | **$**       | **(933,000**   | **)**    | $          | (1,314,000 | )          | $ | (1,541,000 | ) |
| Deduct pro forma stock-based compensation | ** ** | **(85,000** | **)**          | (46,000  | )          | (52,000    | )          |
| Pro forma                                 | ** ** | **$**       | **(1,018,000** | **)**    | $          | (1,360,000 | )          | $ | (1,593,000 | ) |
| Basic earnings (loss) per share:          |       |        | ** **     |     |       |       |       |
| As reported                               | ** ** | **$**       | **(0.22**      | **)**    | $          | (0.48      | )          | $ | (0.66 | ) |
| Pro forma                                 | ** ** | **$**       | **(0.24**      | **)**    | $          | (0.50      | )          | $ | (0.68 | ) |
| Diluted earnings (loss) per share:        |       |        | ** **     |     |       |       |       |
| As reported                               | ** ** | **$**       | **(0.22**      | **)**    | $          | (0.48      | )          | $ | (0.66 | ) |
| Pro forma                                 | ** ** | **$**       | **(0.24**      | **)**    | $          | (0.50      | )          | $ | (0.68 | ) |

 

39

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The above pro forma effects on net loss and netloss per basic and diluted common share are not likely to be representative ofthe effects on reported net income (loss) or net income (loss) per common sharefor future years because options vest over several years and additional awardsgenerally are made each year.

 

In December 2004, FASB published FASBStatement No. 123 (revised 2004), *Share-BasedPayment* (“FAS 123(R)” or the “Statement”).  FAS 123(R) requires that the compensationcost relating to share-based payment transactions, including grants of employeestock options, be recognized in financial statements.  That cost will be measured based on the fairvalue 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.  Theeffect of the Statement will be to require entities to measure the cost ofemployee 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 will be required to apply FAS 123(R)starting January 1, 2006, the beginning of our 2006 fiscal year.  FAS 123(R) allows two methods for determiningthe effects of the transition: the modified prospective transition method andthe modified retrospective method of transition.  Under the modified prospective transition method,an entity would use the fair value based accounting method for all employeeawards granted, modified or settled after the effective date.  As of the effective date, compensation costrelated to the nonvested portion of awards outstanding as of that date would bebased on the grant-date fair value of those awards as calculated under theoriginal provisions of Statement No. 123; that is, an entity would notremeasure the grant-date fair value estimate of the unvested portion of awardsgranted prior to the effective date of FAS 123(R).  An entity will have the further option toeither apply the Statement to only the quarters in the period of adoption andsubsequent periods, or to all quarters in the fiscal year of adoption.  Under the modified retrospective method oftransition, an entity would revise its previously issued financial statementsto recognize employee compensation cost for prior periods presented inaccordance with the original provisions of Statement No. 123.

 

We have evaluated the transition methodsavailable and determined that we will adopt the modified prospective transitionmethod in applying FAS 123(R) as of our fiscal year beginning January 1,2006.  The pro forma net income effect ofusing the fair value method for the past three fiscal years is presented in thetable above.  The pro forma compensationcosts presented in the table above and in our prior filings have beencalculated using a Black-Scholes option pricing model.  We will continue to use the Black-Scholesoption pricing model to determine the fair value of awards at grant date.  We estimate the expense for fiscal 2006 to beapproximately $68,000, based on the value of options outstanding at December31, 2005 that will vest during 2006.  Thisestimate does not include any expense for options that may be granted and vestduring 2006.

 

**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 that affectthe reported amounts of assets and liabilities and disclosure of contingentassets and liabilities at the date of the financial statements and the reportedamounts of revenues and expenses during the reporting period.  Significant items

 

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subject to estimates and assumptions include thevaluation allowances for accounts receivable, inventories and deferred taxassets.  Actual results could differ fromthose estimates.

 

**Recently issued accounting pronouncements: **The following items represent accounting standardsthat have recently been issued.

 

In November 2004, the FASB issued SFAS No.151, *Inventory Costs*, an amendment of ARB No. 43, Chapter4 “Inventory Pricing.”  The amendmentsmade by SFAS No. 151 require that abnormal amounts of idle facility expense,freight, handling costs and wasted materials (spoilage) be recognized ascurrent-period charges and that fixed production overhead be allocated toinventory costs incurred during fiscal years beginning after June 15,2005.  We do not expect the adoption ofSFAS No. 151 to have a material effect on our consolidated financialstatements.

 

In June 2005, FASB issued Statement ofFinancial Accounting Standards (SFAS) No. 154, “Accounting Changes and ErrorCorrections,” a replacement of APB Opinion No. 20 and FASB Statement No.3.  SFAS 154 applies to all voluntarychanges in accounting principle, and changes the requirements for accountingfor and reporting of a change in accounting principle.  SFAS No. 154 requires retrospectiveapplication to prior periods’ financial statements of a voluntary change inaccounting principle unless it is impracticable.  SFAS No. 154 is effective for accountingchanges and corrections of errors made in fiscal years beginning after December15, 2005.  We do not expect the adoptionof SFAS No. 154 to have a material effect on our consolidated financialstatements.

 

**Note 2.  Market Closings and Loss on Impaired Assets**

 

In February 2003, we closed a retail store in theMinneapolis market that resulted in no closing costs.

 

In March 2003, we closed a retail store in theDayton, Ohio, market and wrote off leasehold improvements of approximately$26,000.

 

**Note 3.  Line of Credit**

 

At December 31, 2005, we had an $8 million lineof credit with a lender.  The interestrate on the line as of December 31, 2005 was prime plus 2.95 percentage points(10.20%).  The amount of borrowingsavailable under the line of credit is based on a formula using receivables andinventories.  Our unused borrowingcapacity under this line was $932,000 at December 31, 2005.  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 secured 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, limits the amount of other debt we can incur, limits the amount ofspending on fixed assets, and limits payments of dividends.  At December 31, 2005, we were in violation ofthe covenant related to reaching a minimum annual level of net income and acovenant related to a minimum level of tangible net worth.  On March 17, 2006, the lender waived theseviolations.

 

41

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**Note 4.  Long-Term Obligations**

 

Long-term obligations consisted of the following:

 
| ** **                                                                                                                                                                                                                                                                        | ** ** | **2005**      | ** **    | **2004**  | ** ** |
|-----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|------------|---------------|---------------|-----------|------------|
| Adjustable rate mortgage based on the  30-day LIBOR rate adjusted annually each September (3.86% as of September 30,  2005) 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 | ** ** | **$**         | **3,118,000** |      | $          | 3,216,000 |   |
| 6.85% mortgage, due in monthly installments  of $15,326, including interest, due January 2013, secured by land and  building                                                                                                                                                      | ** ** | **1,849,000** |          | 1,904,000 |       |
| 13.00% note payable, due in monthly  interest payments of $541 with balance due September 2005, secured by  equipment                                                                                                                                                             |       | **—**    |          | 50,000    |       |
| Other, primarily capital leases (see below)                                                                                                                                                                                                                                       | ** ** | **118,000**   |          | 498,000   |       |
| ** **                                                                                                                                                                                                                                                                        |       | **5,085,000** |          | 5,668,000 |       |
| Less current maturities                                                                                                                                                                                                                                                           | ** ** | **262,000**   |          | 615,000   |       |
| ** **                                                                                                                                                                                                                                                                        |       | **$**         | **4,823,000** |      | $          | 5,053,000 |   |

 

The future annual maturities of long-termobligations are as follows:

 
| **Fiscal year** | ** ** | ** ** | ** ** |
|----------------------|------------|------------|------------|
| 2006                 |       | $          | 262,000    |   |
| 2007                 |       | 249,000    |       |
| 2008                 |       | 211,000    |       |
| 2009                 |       | 217,000    |       |
| 2010                 |       | 229,000    |       |
| 2011 and thereafter  |       | 3,917,000  |       |
|                 |       | $          | 5,085,000  |   |
|                      |            |            |            |  |  |

 

**Capital leases:**  We leasecertain equipment under capital leases. The cost of the equipment was approximately $314,000 and $295,000 atDecember 31, 2005 and January 1, 2005, respectively.  Accumulated amortization at December 31, 2005and January 1, 2005 was approximately $183,000 and $166,000, respectively.

 

The following is a schedule by years of approximate remaining minimumpayments required under the leases, together with the present value at December31, 2005:

 
| **Fiscal Year**              | ** ** | ** ** | ** ** |
|-----------------------------------|------------|------------|------------|
| 2006                              |       | $          | 68,000     |   |
| 2007                              |       | 60,000     |       |
| 2008                              |       | 5,000      |       |
| Total minimum lease payments      |       | $          | 133,000    |   |
|                              |       |       |       |
| Less amount representing interest |       | 15,000     |       |
| Less current portion              |       | 60,000     |       |
| Long-term portion                 |       | $          | 58,000     |   |

 

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**Note 5.  Accrued Expenses**

 

Accrued expenses were as follows:

 
| ** **                         | ** ** | **2005**      | ** **    | **2004**   | ** ** |
|------------------------------------|------------|---------------|---------------|------------|------------|
| Compensation and benefits          |       | **$**         | **1,339,000** |       | $          | 1,083,000 |   |
| Warranty expense                   |       | **27,000**    |          | 35,000     |       |
| Accrued recycling incentive checks |       | **1,110,000** |          | 909,000    |       |
| Other                              |       | **1,065,000** |          | 752,000    |       |
| ** **                         | ** ** | **$**         | **3,541,000** | ** ** | $          | 2,779,000 |   |

 

**Note 6.  Commitments and Contingencies**

 

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

 

Minimum future rental commitments undernoncancelable operating leases as of December 31, 2005 are as follows:

 
| **Fiscal Year** | ** ** | ** ** | ** ** |
|----------------------|------------|------------|------------|
| 2006                 |       | $          | 2,493,000  |   |
| 2007                 |       | 2,228,000  |       |
| 2008                 |       | 1,979,000  |       |
| 2009                 |       | 1,288,000  |       |
| 2010                 |       | 862,000    |       |
| 2011 and thereafter  |       | 4,127,000  |       |
|                 |       | $          | 12,977,000 |   |
|                      |            |            |            |  |  |

 

Rent expense for fiscal years 2005, 2004 and 2003was $2,995,000, $1,957,000 and $1,686,000, respectively.

 

**Contracts:**  Wehave entered into contracts with four of our appliance vendors.  Under the agreements there are no minimumpurchase commitments; however, we have agreed to indemnify the vendors forcertain claims, allegations or losses with respect to appliances we sell.  Also see Note 9.

 

**Litigation: **In December 2004, we filed suit in the U.S. District Court for theCentral District of California alleging that JACO Environmental, Inc. and aformer consultant of ours fraudulently obtained a patent (U.S. Patent No.6,732,416) in May 2004 covering appliance recycling methods and systems weoriginally developed beginning in 1987 and have used in serving more than fortyelectric utility appliance recycling programs since that time.  In September 2005, we received a legallybinding document in which JACO states it will not sue us or any of ourcustomers for violating JACO’s recycling patent.  Therefore, our recycling operations willcontinue with our current contracts without interruption.  We are continuing to seek a permanentinjunction barring JACO from using the patent to market JACO’s recyclingservices, due to our belief 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 misleadingadvertising under federal and California statutes.  Also, we may incur substantial costs inpursuing this injunction, which could have an adverse effect on our results ofoperations.

 

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**Note 7. Income Taxes**

 

The provision for (benefit of) income taxesconsisted of the following:

 
| ** ** | ** ** | **2005**   | ** ** | **2004** | ** ** | **2003** | ** ** |
|------------|------------|------------|------------|----------|------------|----------|------------|
| Current:   |       |       |       |     |       |     |       |
| Federal    | ** ** | **$**      | **—** |     | $          | (663,000 | )          | $ | (976,000 | ) |
| Deferred   |       | **—** |       | 117,000  |       | —   |       |
| ** ** |       | **$**      | **—** |     | $          | (546,000 | )          | $ | (976,000 | ) |

 

A reconciliation of our income tax expense withthe federal statutory tax rate is shown below:

 
| ** **                                                 | ** ** | **2005**        | ** **   | **2004**   | ** ** | **2003** | ** ** |
|------------------------------------------------------------|------------|-----------------|--------------|------------|------------|----------|------------|
| Income tax expense (benefit) at statutory  rate            | ** ** | **$**           | **(343,000** | **)**      | $          | (639,000 | )          | $ | (856,000 | ) |
| State taxes net of federal tax effect                      | ** ** | **(61,000**     | **)**        | (117,000   | )          | (152,000 | )          |
| Permanent differences and other                            | ** ** | **(65,000**     | **)**        | 13,000     |       | (42,000  | )          |
| Federal income tax credit attributable to  carryback claim |       | **—**      | ** **   | (673,000   | )          | —   |       |
| Change in valuation allowance                              | ** ** | **469****,000** | ** **   | 870,000    |       | 74,000   |       |
| ** **                                                 |       | **$**           | **—**   | ** ** | $          | (546,000 | )          | $ | (976,000 | ) |

 

The components of net deferred tax assets are asfollows:

 
| ** **                       | ** ** | **2005**       | ** **    | **2004**   | ** ** |
|----------------------------------|------------|----------------|---------------|------------|------------|
| Deferred tax assets:             |       |           |          |       |       |
| Net operating loss carryforwards | ** ** | **$**          | **4,668,000** | ** ** | $          | 4,228,000 |   |
| Federal and state tax credits    | ** ** | **269,000**    | ** **    | 269,000    |       |
| Reserves                         | ** ** | **302,000**    | ** **    | 355,000    |       |
| Accrued expenses                 | ** ** | **157,000**    | ** **    | 164,000    |       |
| Other                            | ** ** | **12****,000** | ** **    | 57,000     |       |
| Net deferred tax assets          | ** ** | **$**          | **5,408,000** | ** ** | $          | 5,073,000 |   |
| Valuation allowance              | ** ** | **(4,914,000** | **)**         | (4,445,000 | )          |
| ** **                       |       | **$**          | **494,000**   | ** ** | $          | 628,000 |   |
| Deferred tax liabilities:        |       |           | ** **    |       |       |
| Prepaid expenses                 | ** ** | **$**          | **71,000**    | ** ** | $          | 56,000 |   |
| Property and equipment           | ** ** | **423,000**    | ** **    | 572,000    |       |
| Net deferred taxes               | ** ** | **$**          | **494,000**   | ** ** | $          | 628,000 |   |

 

The deferred tax amounts mentioned above have beenclassified in the accompanying balance sheet as follows:

 
| ** **              | ** ** | **2005**     | ** **  | **2004**   | ** ** |
|-------------------------|------------|--------------|-------------|------------|------------|
| Current assets          | ** ** | **$**        | **393,000** | ** ** | $          | 468,000 |   |
| Non-current liabilities | ** ** | **(393,000** | **)**       | (468,000   | )          |
| ** **              |       | **$**        | **—**  | ** ** | $          | — |   |

 

At December 31, 2005, 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 are expectedto be available to

 

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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 31, 2005, we had NOL carryforwardsexpiring as follows:

 
| **Expiration** | ** ** | **Amount** | ** ** |
|----------------|------------|------------|------------|
| 2011           |       | $          | 3,185,000  | * |
| 2012           |       | $          | 1,144,000  | * |
| 2013           |       | $          | 2,645,000  | * |
| 2018           |       | $          | 166,000    |   |
| 2019           |       | $          | 1,533,000  |   |

 

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* These carryforward amounts may be limitedunder provisions of Section 382 of the Internal Revenue Code.

 

Future utilization of NOL and tax creditcarryforwards is subject to certain limitations under provisions of Section 382of the Internal Revenue Code.  Thissection relates to a 50 percent change in control over a three-yearperiod.  We believe that the issuance ofCommon Stock during 1999 resulted in an “ownership change” under Section382.  Accordingly, our ability to use NOLand tax credit carryforwards generated prior to February 1999 may be limited toapproximately $56,000 per year.

 

**Note 8.  Shareholders’ Equity**

 

**Stock options:**  We have two stock option plans (Plans) thatpermit the granting of “incentive stock options” meeting the requirements ofSection 422 of the Internal Revenue Code of 1986, as amended, and nonqualifiedoptions that do not meet the requirements of Section 422.  The Plans have 150,000 and 600,000 shares,respectively, available for grant.  Theoptions that have been granted under the Plans are exercisable for a period offive to ten years from the date of grant and vest over a period of six monthsto five years from the date of grant.

 

The pro forma fair value of each option grant aspresented in Note 1 to the financial statements is estimated on the date ofgrant using the Black-Scholes option pricing model with the followingweighted-average assumptions:

 
| ** **                       | ** ** | **2005**   | ** ** | **2004** | ** ** | **2003** | ** ** |
|----------------------------------|------------|------------|------------|----------|------------|----------|------------|
| Expected dividend yield          |       | **—** | ** ** | —   |       | —   |       |
| Expected stock price volatility  | ** ** | **77.7**   | **%**      | 78.5     | %          | 79.5     | %          |
| Risk-free interest rate          | ** ** | **3.2**    | **%**      | 2.1      | %          | 0.9      | %          |
| Expected life of options (years) | ** ** | **6.75**   | ** ** | 2        |       | 2        |       |

 

45

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Additional information relating to all outstandingoptions is as follows:

 
| ** **                       | ** ** | ** ** | ** ** | **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       |   |

 

The weighted average fair value per option ofoptions granted during fiscal years 2005, 2004 and 2003 was $2.06, $1.41 and$0.69, respectively.

 

The following tables summarize information aboutstock options outstanding as of December 31, 2005:

 

OPTIONS OUTSTANDING

 
| **Range of Exercise Prices** | ** ** | **Number of  Options  Outstanding** | ** ** | **Weighted Average  Remaining Contractual  Life in Years** | ** ** | **Weighted  Average  Exercise Price** | ** ** |
|---------------------------------------------|------------|------------------------------------------|------------|--------------------------------------------------------------------------------|------------|--------------------------------------------|------------|
| $4.05 to $4.30                              |       | 40,000                                   |       | 6.60                                                                           |       | $                                          | 4.10       |   |
| $2.43 to $3.25                              |       | 118,000                                  |       | 5.78                                                                           |       | $                                          | 2.91       |   |
| $1.38 to $2.00                              |       | 70,000                                   |       | 4.93                                                                           |       | $                                          | 1.64       |   |
| $0.59 to $0.75                              |       | 35,000                                   |       | 2.37                                                                           |       | $                                          | 0.64       |   |
|                                        |       | 263,000                                  |       |                                                                           |       | $                                          | 2.45       |   |

 

OPTIONS EXERCISABLE

 
| **Range of Exercise Prices** | ** ** | **Number of Options  Exercisable** | ** ** | **Weighted Average  Exercise Price** | ** ** |
|------------------------------|------------|------------------------------------|------------|--------------------------------------|------------|
| $4.05 to $4.30               |       | 30,000                             |       | $                                    | 4.11       |   |
| $2.43 to $3.25               |       | 50,000                             |       | $                                    | 2.79       |   |
| $1.38 to $2.00               |       | 70,000                             |       | $                                    | 1.64       |   |
| $0.59 to $0.75               |       | 35,000                             |       | $                                    | 0.64       |   |
|                         |       | 185,000                            |       | $                                    | 2.16       |   |

 

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**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 loanagreement with a lender resulting 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 privateplacement, we issued warrants to purchase 83,000 shares of Common Stock at$0.50 per share, subject to adjustment. During 2002, 4,000 warrants were exercised, resulting in the issuance of3,506 shares of Common Stock.  During2003, 26,000 warrants were exercised, resulting in the issuance of 20,326shares of Common Stock.  During 2004, theremaining 53,000 warrants were exercised, resulting in the issuance of 44,061shares of Common Stock.

 

In March 1999, we issued to a board member at thattime 5,000 warrants to purchase our Common Stock at $0.625 per share, themarket value of our stock at the date of grant. During 2005, this warrant was exercised, resulting in the issuance of5,000 shares of Common Stock.

 

In April 1999, we issued to a vendor 50,000warrants to purchase Common Stock at $0.625 per share.  In February 2003, 20,000 warrants wereexercised, resulting in the issuance of 20,000 shares of Common Stock.  In March 2004, the remaining 30,000 warrantswere exercised, resulting in the issuance of 30,000 shares of Common Stock.

 

**Preferred stock: **Our amended Articles ofIncorporation authorize two million shares of Preferred Stock that may beissued from time to time in one or more series having such rights, powers,preferences and designations as the Board of Directors may determine.  To date no such preferred shares have beenissued.

 

**Private placement:**  In December 2004, we sold in a privateplacement 1,150,000 shares of Common Stock at a price of $3.00 per share.  We incurred offering costs of $316,000 in2004 and $77,000 in 2005.  The netproceeds were used to repay certain indebtedness, to purchase inventory and forfuture growth.

 

**Note 9.  Major Customers and Suppliers**

 

Revenues from our majorrecycling customers as a percentage of total revenues are as follows:

 
| ** **          | ** ** | **2005** | ** ** | **2004** | ** ** | **2003** | ** ** |
|---------------------|------------|----------|------------|----------|------------|----------|------------|
| Revenue percentage: |       |     |       |     |       |     |       |
| Customer A          | ** ** | **9**    | **%**      | 9        | %          | 9        | %          |

 

We had a receivable from Customer A of $1,307,000as of December 31, 2005 and $505,000 as of January 1, 2005.

 

During the three-year period ended December 31,2005, we purchased a vast majority of appliances for resale from foursuppliers.  We have and are continuing tosecure other vendors from which to purchase appliances.  However, the curtailment or loss of one ofthese suppliers or any appliance supplier could adversely affect ouroperations.

 

**Note 10.  Subsequent Event**

 

In March 2006, we entered into a purchaseagreement for the sale of our headquarters facility in Minneapolis, MN, forapproximately $6.0 million.  The pendingtransaction is expected to close in mid-May, after which time we will

 

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lease this facility for a limited period from thebuyer until we move to a new location. Approximately $3.0 million of the net proceeds from the pending salewill be used to pay off the mortgage on the current headquarters facility.

 

**ITEM 9.                ********CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTSON ACCOUNTING AND FINANCIAL DISCLOSURE**

 

For the year ended December 31, 2005, we changedour accountants to Virchow Krause & Company, LLP, which was reported onForm 8-K filed April 1, 2005.  During thetwo most recent fiscal years and through the effective date of the change ofaccountants, there were no disagreements between us and our prior accountantson any matter of accounting principles or practices, financial statementdisclosure, or auditing scope or procedure, which, if not resolved to thesatisfaction of the prior accountants, would have caused them to make referencethereto in their report on the financial statements for such fiscal years.

 

**ITEM 9A.****             ****CONTROLS ANDPROCEDURES**

 

We maintain disclosure controls andprocedures that are designed to ensure that information required to bedisclosed in the reports we file with the Securities and Exchange Commissionpursuant to the Securities Exchange Act of 1934 is recorded, processed,summarized and reported within the time periods specified in the rules andforms of the Commission and that such information is accumulated andcommunicated to our management, including our Chief Executive Officer (CEO) andChief Financial Officer (CFO), as appropriate, to allow timely decisionsregarding required disclosures.

 

We also maintain a system of internalaccounting controls designed to provide reasonable assurance that our books andrecords accurately reflect our transactions and that our policies andprocedures are followed.  There have beenno changes in our internal control over financial reporting during the fiscalquarter ended December 31, 2005, or thereafter, that have materially affected,or are reasonably likely to materially affect, our internal control overfinancial reporting.

 

Our management, under the supervision andwith the participation of our CEO and CFO, has evaluated the effectiveness ofthe design and operation of our disclosure controls and procedures as of theend of the period covered by this annual report and have concluded that thesecontrols and procedures were effective as of December 31, 2005, with theexception noted below.

 

Our CEO and CFO became aware of a deficiencyin our internal controls in the area of retail sales revenue recognition.  This deficiency constituted a “reportablecondition” 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 ourAudit Committee and our auditors.  Ourmanagement has begun to implement the changes necessary to address thisdeficiency.

 

Any control system, no matter how wellconceived and operated, can provide only reasonable, not absolute, assurancethat the objectives of the control system are met.  The design of a control system inherently haslimitations, and the benefits of controls must be weighed against theircosts.  Additionally, controls can becircumvented by the individual acts of some persons, by collusion of two ormore people, or by management override of the control.  Therefore, no evaluation of a cost-effectivesystem of controls can provide absolute assurance that all control issues andinstances of fraud, if any, will be detected.

 

48

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| **ITEM 9B.** | **OTHER INFORMATION**– None |
|--------------|----------------------------------|

 

**PART III**

 
| **ITEM 10.** | **DIRECTORS AND EXECUTIVE OFFICERS OF THE REGISTRANT** |
|--------------|--------------------------------------------------------|

 

Information regarding directorsand executive officers of the company is set forth under the headings “Nominees”and “Information Concerning Officers and Key Employees Who Are Not Directors”and “Section 16 (a) Beneficial Ownership Reporting Compliance” in our ProxyStatement for our 2006 Annual Meeting of Shareholders to be held May 4, 2006,and is incorporated herein by reference.

 
| **ITEM 11.** | **EXECUTIVE COMPENSATION** |
|--------------|----------------------------|

 

Information regarding executivecompensation is set forth under the headings “Executive Compensation” and “StockOptions Granted and Exercised in Last Fiscal Year” in our Proxy Statement forour 2006 Annual Meeting of Shareholders to be held May 4, 2006, and isincorporated herein by reference.

 
| **ITEM 12.** | **SECURITY OWNERSHIP OF CERTAIN BENEFICIAL  OWNERS AND MANAGEMENT AND RELATED STOCKHOLDER MATTERS** |
|--------------|-----------------------------------------------------------------------------------------------------|

 

Information regarding securityownership of certain beneficial owners and management is set forth under theheading “Common Stock Ownership” in our Proxy Statement for our 2006 AnnualMeeting of Shareholders to be held May 4, 2006, and is incorporated herein byreference.

 

The following table givesaggregate information under our equity compensation plans as of December 31,2005:

 
| ** **                                          | ** ** | **(a)**                                                                                                                                          | ** ** | **(b)**                                                                                                 | ** ** | **(c)**                                                                                                                                                                                 | ** ** |
|-----------------------------------------------------|------------|--------------------------------------------------------------------------------------------------------------------------------------------------|------------|---------------------------------------------------------------------------------------------------------|------------|-----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|------------|
| ** **                                          | ** ** | **Number of Securities to  Be Issued Upon Exercise  of Outstanding  Options,  Warrants and Rights** | ** ** | **Weighted-Average  Exercise Price of  Outstanding  Options,  Warrants and Rights** | ** ** | **Number of Securities  Available for Future  Issuance Under Equity  Compensation Plans  (Excluding Securities  Reflected in  Column(a))** | ** ** |
| Equity compensation plans approved by  stockholders |       | 263,000                                                                                                                                          |       | $                                                                                                       | 2.45       |                                                                                                                                                                                    | 150,000    |   |
|                                                     |            |                                                                                                                                                  |            |                                                                                                         |            |                                                                                                                                                                                         |            |  |

 
| **ITEM 13.** | **CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS** |
|--------------|----------------------------------------------------|

 

Information regarding certainrelationships and related transactions is set forth under the headings “Nominees”and “Information Concerning Officers and Key Employees Who Are Not Directors”and “Certain Relationships and Transactions” in our Proxy Statement for our2006 Annual Meeting of Shareholders to be held May 4, 2006, and is incorporatedherein by reference.

 

49

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**ITEM 14.****               PRINCIPAL ACCOUNTANT FEES AND SERVICES**

 

Information regarding principalaccountant fees and services is set forth under the heading “Fees Paid toAuditors by the Company During Most Recent Fiscal Years” in our Proxy Statementfor our 2006 Annual Meeting of Shareholders to be held May 4, 2006, and isincorporated herein by reference.

 

**PART IV**

 

**ITEM 15.****               EXHIBITS AND FINANCIAL STATEMENT SCHEDULES**

 

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

 

**1.****                                     Financial Statements**

 

See Index to FinancialStatements under Item 8 of this report.

 

**2.****                                     Financial Statement Schedule**

 

To the Board of Directors

Appliance Recycling Centers ofAmerica, Inc. and Subsidiaries

Minneapolis, Minnesota

 

Our audit was conductedin accordance with the standards of the Public Company Accounting OversightBoard (United States) and was made for the purpose of forming an opinion on thebasic consolidated financial statements of Appliance Recycling Centers ofAmerica, 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

February 21, 2006

 

Schedule II - Valuation andQualifying Accounts

 
| ** **                     | ** ** | **Accounts Receivable** | ** **  | **Inventory** | ** ** |
|--------------------------------|------------|------------------------------|-------------|---------------|------------|
| ** **                     | ** ** | **Allowance**                | ** **  | **Allowance** | ** ** |
| Balance, January 1, 2005       |       | $                            | 102,000     |          | $          | 385,000 |   |
| Additional allowance           |       | 150,000                      |        | 312,000       |       |
| Writeoffs/adjustments          |       | —                       |        | (318,000      | )          |
| **Balance, December 31, 2005** | ** ** | **$**                        | **252,000** | ** **    | **$**      | **379,000** | ** ** |

 

50

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Schedule II - Valuation andQualifying Accounts – See report from McGladrey & Pullen, LLP on page 31.

 
| ** **                   | ** ** | **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       |       |
| Writeoffs/adjustments        |       | (243,000                     | )           | (197,000      | )          |
| **Balance, January 1, 2005** | ** ** | **$**                        | **102,000** | ** **    | **$**      | **385,000** | ** ** |

 

**3.****             Exhibits**

 

See Index to Exhibits on page 53of this report.

 

51

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**SIGNATURES**

 

Pursuant to the requirements ofSection 13 or Section 15(d) of the Securities Exchange Act of 1934, theRegistrant has duly caused this Report to be signed on our behalf by theundersigned, thereunto duly authorized.

 
| Dated: March 24, 2006 |   |   |   |   | APPLIANCE RECYCLING CENTERS OF |
|-----------------------|--------|--------|--------|--------|--------------------------------|
|                  |   |   |   |   |                           |   | AMERICA, INC. |
|                  |   |   |   |   |                           |   | (Registrant) |
|                  |   |   |   |   |                           |   |   |   |   |
|                  |   |   |   |   |                           |   | By | /s/ Edward R. Cameron |   |
|                  |   |   |   |   |                           |   |   | Edward R. Cameron |   |
|                  |   |   |   |   |                           |   |   | President and Chief Executive Officer |   |
|                  |   |   |   |   |                           |   |   |   |   |
|                  |   |   |   |   |                           |   | By | /s/ Linda A. Koenig |   |
|                  |   |   |   |   |                           |   |   | Linda A. Koenig |   |
|                  |   |   |   |   |                           |   |   | Chief Financial Officer |   |

 

Pursuant to the requirements ofthe Securities Exchange Act of 1934, this Report has been signed by thefollowing persons on behalf of the Registrant and in the capacities and on thedates indicated.

 
| **Signature**            | ** ** | **Title** | ** **                           | **Date**       |           |
|--------------------------|------------|-----------|--------------------------------------|----------------|----------------|
|                     |       |      |                                 |           |           |
| /s/ Edward R. Cameron    |       |      | Chairman of the Board, President and |           | March 24, 2006 |   |
| Edward R. Cameron        |       |      | Chief Executive Officer              |           |           |   |
|                     |       |      |                                 |           |           |   |
| /s/ Linda A. Koenig      |       |      | Chief Financial Officer              |           | March 24, 2006 |   |
| Linda A. Koenig          |       |      |                                 |           |           |   |
|                     |       |      |                                 |           |           |   |
| /s/ Duane S. Carlson     |       |      | Director                             |           | March 24, 2006 |   |
| Duane S. Carlson         |       |      |                                 |           |           |   |
|                     |       |      |                                 |           |           |   |
| /s/ Harry W. Spell       |       |      | Director                             |           | March 24, 2006 |   |
| Harry W. Spell           |       |      |                                 |           |           |   |
|                     |       |      | Director                             |           |           |   |
| s/ W. William Bednarczyk |       |      |                                 | March 24, 2006 |           |
| W. William Bednarczyk    |       |      |                                 |           |           |   |
|                     |       |      |                                 |           |           |   |
| s/ Albin S. Dubiak       |       |      | Director                             |           | March 24, 2006 |   |
| Albin S. Dubiak          |       |      |                                 |           |           |   |

 

52

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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       |       | Amended Appliance Recycling Centers of America, Inc. Restated 1989  Stock Option Plan [filed as Exhibit 19.3 to the Company’s Form 10-Q for the  quarter ended June 30, 1993 (File No. 0-19621) and incorporated herein by  reference].                                                                                                                                          |
|        |       |                                                                                                                                                                                                                                                                                                                                                                                  |
| *10.2       |       | Amendment, effective April 24, 1997, to 1989 Stock Option Plan [filed  as Exhibit 28.2 to the Company’s Post-Effective Amendment No. 1 (June 5,  1997) to Registration Statement on Form S-8 (Registration No. 33-68890) and  incorporated herein by reference].                                                                                                                 |
|        |       |                                                                                                                                                                                                                                                                                                                                                                                  |
| *10.3       |       | 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].                                                                                                                                                                                  |
|        |       |                                                                                                                                                                                                                                                                                                                                                                                  |
| *10.4       |       | 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].                                                                                                                                                                  |
|        |       |                                                                                                                                                                                                                                                                                                                                                                                  |
| *10.5       |       | 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].                                                                                                                                                                  |
|        |       |                                                                                                                                                                                                                                                                                                                                                                                  |
| 10.6        |       | 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].                                              |
|        |       |                                                                                                                                                                                                                                                                                                                                                                                  |
| 10.7        |       | 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]. |
|        |       |                                                                                                                                                                                                                                                                                                                                                                                  |
| 10.8        |       | 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].         |

 

53

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| 10.9   |   | 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].   |
|--------|--------|--------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|
|   |   |                                                                                                                                                                                                                                                                                                                                                                     |
| 10.10  |   | 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].   |
|   |   |                                                                                                                                                                                                                                                                                                                                                                     |
| 10.11  |   | 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]. |
|   |   |                                                                                                                                                                                                                                                                                                                                                                     |
| 10.12  |   | 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].                                               |
|   |   |                                                                                                                                                                                                                                                                                                                                                                     |
| 10.13  |   | 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].                                               |
|   |   |                                                                                                                                                                                                                                                                                                                                                                     |
| 10.14  |   | 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].                                              |
|   |   |                                                                                                                                                                                                                                                                                                                                                                     |
| 10.15  |   | 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].                                            |
|   |   |                                                                                                                                                                                                                                                                                                                                                                     |
| 10.16  |   | 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].                                     |
|   |   |                                                                                                                                                                                                                                                                                                                                                                     |
| 10.17  |   | 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].                                                                    |
|   |   |                                                                                                                                                                                                                                                                                                                                                                     |
| 10.18  |   | 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].                                                      |

 

54

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| 10.19  |   | 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].                                                         |
|--------|--------|-----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|
|   |   |                                                                                                                                                                                                                                                                                                                  |
| 10.20  |   | 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].                                        |
|   |   |                                                                                                                                                                                                                                                                                                                  |
| 10.21  |   | 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].                                                                     |
|   |   |                                                                                                                                                                                                                                                                                                                  |
| 10.22  |   | 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].                                                                            |
|   |   |                                                                                                                                                                                                                                                                                                                  |
| 10.23  |   | 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].                                                                 |
|   |   |                                                                                                                                                                                                                                                                                                                  |
| 10.24  |   | 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].                 |
|   |   |                                                                                                                                                                                                                                                                                                                  |
| 10.25  |   | 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].   |
|   |   |                                                                                                                                                                                                                                                                                                                  |
| 10.26  |   | 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]. |
|   |   |                                                                                                                                                                                                                                                                                                                  |
| 10.27  |   | 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].     |
|   |   |                                                                                                                                                                                                                                                                                                                  |
| 10.28  |   | 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].                                                                         |
|   |   |                                                                                                                                                                                                                                                                                                                  |
| 10.29  |   | 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].                                                          |

 

55

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| 10.30  |   | 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]. |
|--------|--------|-----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|
|   |   |                                                                                                                                                                                                                                                                                                                                                                  |
| 10.31  |   | 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].    |
|   |   |                                                                                                                                                                                                                                                                                                                                                                  |
| 10.32  |   | 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].                                                                                    |
|   |   |                                                                                                                                                                                                                                                                                                                                                                  |
| 10.33  |   | 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].                                                                                                                            |
|   |   |                                                                                                                                                                                                                                                                                                                                                                  |
| 10.34  |   | 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  |   | Certifications pursuant to 18 U.S.C. Section 1350, as adopted  pursuant to Section 302 of the Sarbanes-Oxley Act of 2002.                                                                                                                                                                                                                                             |
|   |   |                                                                                                                                                                                                                                                                                                                                                                  |
| +31.2  |   | Certifications pursuant to 18 U.S.C. Section 1350, as adopted  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.

 

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