**UNITED STATESSECURITIES 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 January1, 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 OFAMERICA, INC.**

(Exact name of registrantas specified in its charter)

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

 

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

 

Securities registeredpursuant to Section 12(b) of the Act:  **None**

Securities registeredpursuant to Section 12(g) of the Act:  **Common Stock, without par value**
|   | (Title of class) |
|--------|------------------|

 

Indicate by check markwhether the registrant (1) has filed all reports required to be filed bySection 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding12 months (or for such shorter period that the registrant was required to filesuch reports) and (2) has been subject to such filing requirements for the past90 days.  Yes:  ý   No:  o

 

Indicate by check mark ifdisclosure of delinquent filers pursuant to Item 405 of Regulation S-K is notcontained herein, and will not be contained, to the best of registrant’sknowledge, in definitive proxy or information statements incorporated byreference in Part III of this Form 10-K or any amendment to this Form 10-K. o

 

Indicateby check mark whether the registrant is an accelerated filer (as defined inRule 12b-2 of the Act). Yes:  o  No:  ý

 

The aggregate marketvalue of the voting and non-voting common equity held by non-affiliates of theregistrant, based on the closing price of $2.65 per share, was $3,746,806 onJuly 3, 2004.

 

As of March 4, 2005,there were outstanding 4,161,277 shares of the registrant’s Common Stock,without par value.

 

**DOCUMENTS INCORPORATED BY REFERENCE**

 

Portions of theregistrant’s definitive proxy statement dated March 18, 2005, are incorporatedby reference into Part III hereof.

 

 

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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  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 2004, 2003 and 2002 |   |
| 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**

 

Weare a leading retailer and recycler of major appliances.  We generate revenues from:

 

1.     Retail sales of appliances at ourApplianceSmart factory outlets.

2.     Fees charged for collecting and recyclingappliances for utilities and other companies.

3.     Selling materials from the appliances that wecollect and recycle, including appliances from our ApplianceSmart factoryoutlets.

 

We were incorporated in Minnesota in 1983, althoughthrough our predecessors we commenced the appliance retail and recyclingbusiness in 1976.  Our principal officeis located at 7400 Excelsior Boulevard, Minneapolis, Minnesota 55426-4517.  References herein to our company include ouroperating subsidiaries.  (See Exhibit21.1.)

 

**Industry Background**

 

Inthe United States, more than 500 million major household appliances arecurrently in use.  These appliancesinclude:

 
| Refrigerators |   | Washers           |
|---------------|--------|-------------------|
| Freezers      |   | Dryers            |
| Ranges        |   | Water  heaters    |
| Ovens         |   | Air  conditioners |
| Dishwashers   |   | Dehumidifiers     |
| Microwaves    |   | Humidifiers       |

 

Disposingof these appliances can create several problems:

 

1.     Many areas have decreasing landfill capacityand bulky appliances take up valuable space.

2.     Many appliances contain materials that areharmful to the environment.  To preventair, water and ground pollution, these appliances must be processed to removethe hazardous materials before the remainder of the appliance can be disposedof.

3.     Alternatives to landfills that will acceptappliances for disposal, such as incinerators, may not have the capability toprocess the appliances to remove the hazardous substances.

 

Moststate and local governments have enacted laws affecting how their residentsdispose of unwanted appliances.  Forexample, some areas restrict landfills from accepting appliances, some requireprocessing to remove environmentally harmful materials before the appliance isdisposed of and some require advance disposal fees when a consumer purchases anew appliance.  As a result, oldappliances often cannot be discarded through ordinary solid waste systems.

 

Manytypes of major appliances contain components with substances that damage theenvironment.  These harmful materialsinclude PCBs, mercury and CFCs, which cause several problems:

 

1.     PCBs (polychlorinated biphenyls) aresuspected of causing cancer.  Althoughthe EPA banned the production of PCBs in 1979, it allowed manufacturers to usetheir remaining inventories of PCB-containing components.  Consequently, some old refrigerators,freezers and air 

 

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conditioners that are stillin use have capacitors that contain PCBs. If PCBs are released from the capacitors, groundwater contamination canoccur.

2.     Mercury is toxic to humans and can enter thebody when a person inhales it, absorbs it through the skin or ingests it.  At high temperatures, mercury vaporizes toform extremely poisonous fumes.  Freezersand washing machines may have mercury-containing switches in their lids.

3.     CFCs (chlorofluorocarbons) cause long-termdamage to the earth’s ozone layer and may contribute to global warming whenreleased into the atmosphere.  The federalgovernment requires the recovery of CFC refrigerants upon appliancedisposal.  Old refrigerators and freezerscommonly contain CFCs.

 

Appliancesmay also contain other materials, such as oil and sulfur dioxide, that areharmful to the environment.

 

Inaddition to these solid waste management and environmental issues, energyconservation is another motivating factor in appliance disposal.  Many electric utility companies sponsorprograms to encourage their residential customers to retire energy-inefficientappliances.

 

Refrigeratorsmanufactured in the 1960s and early 1970s use up to 1,750 kilowatt-hours ofelectricity each year.  By 2001, federalstandards enacted over the years have lowered the average annual energy use perunit to less than 500 kilowatt-hours. Utility companies often provide assistance and incentives for consumersto replace their old, inefficient appliances with newer, more efficient models.

 

Electricutilities also promote the removal of surplus appliances to customers whooperate more than one refrigerator, freezer or room air conditioner.  Additional appliances contributesignificantly to residential energy use and peak demand.

 

TheFederal Energy Policy Act of 1992 gave each state the option to deregulate itselectric utility industry.  Becauseelectric utilities were uncertain about the effect that potential deregulationwould have on their business, many scaled back their energy conservationefforts in the mid-1990s.  We believethat energy-efficiency programs will remain a long-term component of theelectric utility industry, and we have seen a resurgence of interest inutility-sponsored appliance recycling programs in the past few years.

 

**Company Background**

 

Westarted our business in 1976 as a used-appliance retailer.  We had contracts with national and regionalcompanies that sold new appliances, such as Sears and Montgomery Ward.  When their stores sold a new appliance in theMinneapolis/St. Paul, Miami or Atlanta market, we collected the old appliancefrom the customer’s residence.  In mostcases, our technicians reconditioned the appliance, which we then sold at ourown stores.  We sold the appliances thatwere not suitable for sale to scrap metal processors.

 

Inthe late 1980s, stricter environmental regulations began to affect the disposalof unwanted appliances.  When we were nolonger able to take appliances with hazardous components to the metalprocessor, we began to develop systems to process the appliances to remove theharmful materials.  This allowed us totake the remainder of the appliance to the metal processor for recycling.

 

Weoffered our services for disposing of appliances in an environmentally soundmanner to appliance manufacturers and retailers, waste hauling companies,rental property managers, local governments and the public.

 

4

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***Appliance Recycling for Utilities***

 

In1989, we added a new customer group when we opened an appliance processing andrecycling center in Milwaukee, Wisconsin, to serve a major utility.  The concept of appliance recycling as anenergy-efficiency measure was successful, and we began to focus our resourceson expanding our business with electric utilities. From 1989 to 1994 we openednine centers that served primarily seventeen utility companies.

 

Thepotential of industry deregulation negatively affected our business withelectric utilities in the middle to late 1990s. Utilities decreased their participation in energy-efficiency programssuch as the one we offered because of uncertainties about how potentialderegulation would affect them.

 

WhenCalifornia faced an energy crisis in the late 1990s, the California PublicUtilities Commission (CPUC) directed one of our customers, Southern CaliforniaEdison Company (Edison), to implement a statewide appliance recycling program(Summer Initiative).  The SummerInitiative, which began in September 2000, was available to utility customersin the service areas of Pacific Gas & Electric (PG&E), primarily theSan Francisco Bay area, and San Diego Gas & Electric (SDG&E).  We developed and managed the programadvertising, scheduled collection appointments when their customers called,picked up the appliances, and processed and recycled the units.  By the third quarter of 2001 when the SummerInitiative ended, we had recycled approximately 36,000 units for the program.

 

InJune 2001, we began providing services for the Appliance Early Retirement andRecycling Program in California.  Utilitycustomers in the San Diego area; a six-county region in California’s CentralValley, including the cities of Fresno and Stockton; and the seven-county BayArea, including San Francisco, were eligible to participate.  The program, which ended in August 2002,included refrigerators, freezers and room air conditioners.  We were responsible for advertising theprogram.

 

Duringfiscal year 2003, Edison was our only major electric utility customer.  They accounted for approximately 9% of ourtotal revenues or $3.8 million.  InSeptember 2003, we signed a contract with Edison to support the 2003 StatewideResidential Appliance Recycling Program in the service territories of Edisonand SDG&E.  We had been working underan extension of the 2002 contract since January 2003.  The 2003 program ran through December 31,2003.

 

InJanuary 2004, we signed a contract with Edison to handle appliance recyclingoperations in their service territory for 2004 and 2005.  In March 2004, we signed a contract withSDG&E to provide service in their territory for 2004.  Edison and SDG&E are each responsible foradvertising in their respective territories.

 

Severalother electric utilities awarded us contracts in 2004:

 

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 through 2005.  Both of these utilities are responsible foradvertising their programs.

2.     In December 2004, we reached an agreementwith Wisconsin Public Power (WPPI) to provide appliance recycling servicesduring 2005.  WPPI is a statewide powercompany owned by 37 municipalities that operate electric utilities.  They supply power to 145,000 homes andbusinesses throughout Wisconsin.  WPPI isresponsible 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. The City of Austin has granted Austin Energy the option to extend the programannually through 2008.

 

5

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Austin Energy is the nation’s tenth largestcommunity-owned electric utility.  Theyserve 360,000 customers within the City of Austin and surroundingcounties.  To support this program, weopened an appliance recycling facility in Austin.  Austin Energy is responsible for advertisingthis program.

 

Weare seeing renewed interest from utilities in appliance recyclingenergy-efficiency programs.  We willcontinue to aggressively pursue that segment of customers in 2005.  However, we still have a limited ability toproject revenues from utility programs in 2005.

 

***Retail Sales; ReverseLogistics Programs***

 

Whenelectric utilities began to scale back or discontinue their programs with us inthe mid-1990s, we increased our marketing to appliance manufacturers andretailers, waste haulers and property management companies.  We also focused on strengthening our sales ofused appliances.  In 1995, we beganoperating our own chain of stores, Encore Recycled Appliances®.  We changed the name of our retail stores toApplianceSmart® in 1998.

 

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

 

Allof these appliances are new, not used. Some are in the carton while others are out of the carton.  In the appliance industry, these “special-buy”appliances, units that require a different method of management, include:

 

•      Closeouts

•      Floor samples

•      Returned or exchanged items

•      Factory overruns

•      Scratch and dent

•      Open carton

 

Forexample, a manufacturer redesigns a current model to include a few updatedfeatures and then assigns a new model number. Because the manufacturer ships only the latest models to retailers, alarge quantity of the older model remains in the manufacturer’s inventory.

 

Formany years, manufacturers relied on small appliance dealers to buy this productto sell in their stores. However, today these small retailers are struggling tocompete with large appliance chains (the top 10 retailers control 80 percent ofthe appliance sales market).  At the sametime, the expansion of big-box retailers that sell appliances has created adramatic increase in the number of special-buy units, further straining thetraditional outlet system for distressed appliances.

 

However,because these special-buy appliances have value, manufacturers and retailersneed an efficient system to manage these appliances to recover their worth.

 

Inthe late 1990s, we began to design reverse logistics programs for majorappliance manufacturers.  In 1997, webegan providing reverse logistics services for Whirlpool Corporation, the nation’slargest manufacturer of major household appliances.  That pilot program led to a 1998 contractthat allowed us to purchase special-buy appliances from Whirlpool’sdistribution centers in the Midwest and some western states.

 

6

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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.

 

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

 

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

 

1.     There are no guarantees for the number ortype of appliances that we will be able to purchase.

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

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

 

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

 

1.     We have no minimum purchase requirements.

2.     The agreement may be terminated by eitherparty with 60 days’ written notice.

3.     The agreement may be terminated immediatelyif a default is not cured within ten (10) days after notification of thedefault.

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

 

InDecember 2001, we began carrying a full line of Frigidaire appliances at allApplianceSmart factory outlets.

 

InJanuary 2003, we entered into a contract with GE Consumer Products to purchaseand sell special-buy GE appliances.

 

Inaddition to our reverse logistics contracts, we are also an authorized dealerof new product for these four manufacturers.

 

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

 

Duringthe second quarter of 2003, we became a majority (60%) owner in North AmericaAppliance Company LLC (NAACO).  NAACObegan operations in June 2003 as a retailer of special-buy appliances inMcAllen, Texas.

 

***Growth Strategy***

 

Largerfactory outlet facilities offer consumers a wider selection of appliances thansmaller stores and are more efficient for us to operate.  For these reasons, we intend to continue tofocus our retail sales operations on these larger facilities.  We also expect to open new stores principallyin markets in which

 

7

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wecurrently have operations, for additional operational and marketingefficiencies of scale.  We presently planto open up to three additional stores in 2005 and four in 2006.

 

Weare also actively pursuing opportunities to support energy-efficiency programsrun by electric utility companies.  Wehave seen a renewed interest from these companies in these programs.  During 2004 we secured several contracts withutility companies to provide appliance recycling services for their customers.

 

**Customers and Source of Supply**

 

Weoffer reverse logistics services to manufacturers and retailers that need anefficient way to manage appliances that fall outside normal distribution andsales channels.  We also provide servicesfor electric utility companies that offer their customers appliance recyclingprograms as an energy conservation measure.

 

Overthe years, we have also recycled appliances for waste haulers, vending machinecompanies and residential property managers.

 

***Retailers of New Appliances******:*** We began our business by offering servicesto Sears, Montgomery Ward and other retailers of new appliances.  When a consumer purchased a new appliance, wecollected the replaced appliance from the customer’s home or the retailer’s facility.  These appliances were our source of supplyfor our used appliance business.  Becausewe no longer sell used appliances, we are phasing out this branch of ouroperations.

 

However,we continue to work with new-appliance retailers to manage units that customershave returned and other appliances that the retailer cannot sell as newin-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 nationalbuying cooperative enables us to purchase new in-the-carton appliances to fillout our mix of product.

 

Althoughwe believe that our current sources for appliances are adequate to supply ourretail stores and allow us to grow our sales, we face the risk that one or moreof these sources could be lost.

 

***Other Customers******:***  Wehave provided collection and recycling services for waste haulers, vendingmachine companies, property managers and the general public for specifiedfees.  However, we are phasing out thisaspect of our business to focus on reverse logistics, energy conservationprograms and retail sales.

 

***Electric Utility Companies:*** We contract with utility companies toprovide a 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.

 

Ourpricing is on a per-appliance basis and depends upon several factors,including:

 

1.     The total number of appliances processed.

2.     The length of the contract term.

3.     The specific services the utility selects usto provide.

 

8

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Ourcontracts with electric utility customers prohibit us from repairing andselling 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 utilities to handle recycling operationsin their service territories for 2005:

 

1.     Southern California Edison

2.     San Diego Gas & Electric

3.     United Illuminating

4.     Connecticut Light & Power

5.     Austin Energy

6.     Wisconsin Public Power

7.     Several small municipal utilities

 

**Company Operations**

 

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

 

Manyof the appliances that we receive from manufacturers are still in the factorycarton and are ready to sell.  Otherappliances may need repair or cosmetic work before we send them to ourApplianceSmart retail outlets.  Everyappliance we sell is under warranty and carries a 100 percent money-backguarantee. We also offer extended warranties, delivery, factory-trainedtechnician service and recycling of the customer’s old appliance.

 

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

 

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 received four new contracts with utilitiesin 2004 and enter 2005 serving six programs. We are aggressively pursuing utility customers, but still have a limitedability to project revenues from utility programs in 2005.

 

Since2003, we have focused on a carefully managed growth plan to strengthen ourretail operations.  We will continue toopen showroom 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 fromthree sources: retailing, recycling and byproduct.  The table below reflects the percentage oftotal revenues from each source.  Seealso “Management’s Discussion and Analysis of Financial Condition and Resultsof Operations.”

 
| ** ** | ** ** | **2004**   | ** ** | **2003** | ** ** | **2002** | ** ** |
|------------|------------|------------|------------|----------|------------|----------|------------|
| Revenues:  | ** ** | ** ** | ** ** |     |       |     |       |
| Retail     | ** ** | **79.2**   | **%**      | 79.8     | %          | 65.4     | %          |
| Recycling  | ** ** | **17.8**   | **%**      | 18.4     | %          | 32.0     | %          |
| Byproduct  | ** ** | **3.0**    | **%**      | 1.8      | %          | 2.6      | %          |
| ** ** |       | **100.0**  | **%**      | 100.0    | %          | 100.0    | %          |

 

Although we have two main sources of revenues, 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 are theresult of both retail revenues and 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**

 

Weuse a variety of methods to promote awareness of our products andservices.  We believe that we arerecognized as a leader in appliance retailing through reverse logistics andalso in the recycling industry.

 

OurApplianceSmart outlet store concept includes establishing large factoryshowrooms 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 through print media, including newspapers and yellowpages ads.  In addition, in some marketswe rely heavily upon television and radio spots.  Through www.ApplianceSmart.com, consumers canalso learn more about us on the Internet.

 

**Seasonality**

 

Weexperience some seasonality in retail revenues with revenues in the second andthird calendar quarters being slightly higher than revenues in the first andfourth calendar quarters.

 

Inmulti-year programs, electric utility companies that contract with us forservice typically roll out their programs towards the end of the first calendarquarter.  Promotional activities arestrong during the second and third calendar quarters, leading to highercustomer demand for services during that time period.  As a result, we experience a surge inbusiness during the second and third calendar quarters which declines throughthe fourth and first calendar quarters until advertising activities areresumed.

 

**Competition**

** **

Ourretail competition comes mainly from new-appliance and other special-buyretailers.  Each ApplianceSmart outletcompetes with local and national chains of new-appliance dealers.  Many of these retailers have been in businesslonger than we have and may have significantly greater assets.  We also compete with numerous independentlyowned retailers of new and special-buy appliances.

 

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Manyfactors, including existing and proposed governmental regulation, affectcompetition 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.

 

Weexpect our primary competition for appliance recycling contracts with existingor new customers to come from a variety of sources, including:

 

1.     Entrepreneurs entering the appliancerecycling business.

2.     Energy management consultants.

3.     Existing recycling companies.

4.     Major waste hauling companies.

5.     Scrap metal processors.

 

Inaddition, utility companies and other customers may operate appliance recyclingprograms internally rather than contracting with outside vendors.  We have no assurance that we will be able tocompete profitably in any of our chosen markets.

 

**Government Regulation**

 

Federal,state and local governments regulate appliance collection, recycling and salesactivities.  While some requirementsapply nationwide, others vary by market.

 

Themany laws and regulations that affect appliance recycling include landfilldisposal restrictions, hazardous waste management requirements and air qualitystandards.  Each of our recyclingfacilities maintains the appropriate registrations, permits and licenses forits location.

 

The1990 Amendments to the Clean Air Act prohibit the venting of CFC andCFC-substitute refrigerants while servicing or disposing of appliances.  At all our recycling centers, we use our owncompany-designed equipment to recover these refrigerants before recycling theunits.

 

Weregister our recycling centers as hazardous waste generators with the EPA.  We also obtain all appropriate regional andlocal licenses for managing hazardous wastes. Licensed hazardous waste companies transport and recycle or dispose ofthe hazardous materials we generate.

 

Ourretail stores obtain all required business licenses, sales tax licenses and anyother licenses for their locations.  Allour vehicles used for delivering appliances from our retail stores and forcollecting  appliances per a contract oragreement comply with all local DOT licensing requirements.

 

In1992, Congress adopted the Energy Policy Act of 1992 to encourage energyefficiency.  This act establishes, amongother things:

 

1.     Mandatory energy performance standards fornew major household appliances.

2.     The option for individual states toderegulate their energy providers, including electric utilities.

 

Weare unsure of the ultimate impact of potential deregulation on the electricutility industry.  Consequently, we areunable to assure you that all our current operations could continue in aderegulated environment.

 

Althoughwe believe that further governmental regulation of the appliance recyclingindustry could have a positive effect on us, we cannot foretell the directionof future legislation.  Under somecircumstances, for example, further regulation could materially increase ouroperational costs.  In addition, undersome circumstances we may be subject to contingent liabilities because wehandle hazardous materials.

 

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**Employees**

 

AtMarch 1, 2005, we had 300 full-time employees. The following is a breakdown of the approximate distribution of ouremployees:

 

1.     46% of our employees provide appliancecollection, transportation and processing services at our recycling centers.

2.     36% work in retail sales.

3.     18% are in administration and management.

 

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

 

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

 

Ourexecutive offices are located in Minneapolis, Minnesota, in a company-ownedfacility that includes approximately 11 acres of land.  The building contains approximately 122,000square feet, including 27,000 square feet of office space, 71,000 square feetof operations and processing space, and 24,000 square feet of retail space asidentified below (under “Minneapolis, MN, 1998”).  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”).

 

Wecurrently operate twelve 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             |       |                                                                       |

 

Weown the facilities in which the two stores that opened in 1998 (Minneapolis andLos Angeles) are located.  We alsooperate processing and recycling centers in these two facilities.  All of our other retail stores are located inleased facilities; we generally attempt to negotiate lease terms of two to fiveyears for our retail stores.

 

Weoperate four processing and recycling centers. Two are in the facilities that we own in Minneapolis and LosAngeles.  The other two are in leasedfacilities in Waterbury, Connecticut, and Austin, Texas.  Our recycling centers typically range in sizefrom 25,000 to 40,000 square feet.

 

Allof the facilities that we own currently secure loans that we have outstanding.

 

12

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**ITEM 3.****                  LEGALPROCEEDINGS**

 

InDecember 2004, we filed suit in the U.S. District Court for the CentralDistrict of California alleging that JACO Environmental, Inc. and a formerconsultant of ours fraudulently obtained a patent (U.S. Patent No. 6,732,416)in May 2004 covering appliance recycling methods and systems we originally developedbeginning in 1987 and have used in serving more than forty electric utilityappliance recycling programs since that time. We are seeking a declaratory judgment that the JACO patent is invalidand unenforceable, since it is almost entirely based on methods and processeswe developed and have used.  We are alsoasking the court for unspecified damages related to charges that JACO, in usinga fraudulently based patent, has engaged in unfair competition under federaland California statutes, false and misleading advertising under Californiastatutes, and interference with our prospective customer relationships.  The defendants have answered our complaintdenying liability.  We expect recyclingoperations to continue without interruption during the period of litigation,but if the court were to issue rulings in favor of the defendants, this couldchange.  Moreover, failure to win thislawsuit could have a long-term material adverse effect on our recyclingoperations.  In addition, we may incursubstantial costs in pursuing this litigation, which could have an adverseeffect on our results of operations.

 

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

 

We did not submit anymatters to a vote of security holders during the last quarter of the fiscalyear covered by this report.

 

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**PART II**

 

**ITEM 5.****                 MARKETFOR OUR COMMON EQUITY, RELATED SHAREHOLDER MATTERS AND ISSUER PURCHASES OFEQUITY SECURITIES**

 

**Market for Common Stock**

 

Our Common Stock, whichtrades under the symbol “ARCI,” began trading on the OTC Bulletin Board onSeptember 8, 1998.   Before that time,the Common Stock traded as follows: on the Nasdaq SmallCap Market from February26, 1997 to September 7, 1998; on the Nasdaq National Market from January 8,1993 to February 25, 1997; on the Nasdaq SmallCap Market from January 7, 1991to January 7, 1993; and on the local over-the-counter market before January 7,1991.  The following table sets forth,for the periods indicated, the high and low closing bid quotations for theCommon Stock, as reported by the OTC Bulletin Board.

 
| ** **     | ** ** | **High** | ** ** | **Low** | ** ** |
|----------------|------------|----------|------------|---------|------------|
| **2003**       |       |     |       |    |       |
|           |       |     |       |    |       |
| First Quarter  |       | $        | 2.08       |    | $          | 1.05 |   |
| Second Quarter |       | 1.80     |       | 1.02    |       |
| Third Quarter  |       | 2.10     |       | 1.11    |       |
| Fourth Quarter |       | 2.75     |       | 1.50    |       |
|           |       |     |       |    |       |
| **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    |       |

 

On March 4, 2005, thelast reported sale price of the Common Stock on the OTC Bulletin Board was$3.60 per share.  As of March 4, 2005,there were approximately 875 beneficial holders of our Common Stock.

 

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

 

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

 

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**ITEM 6.****                  SELECTEDFINANCIAL 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 2004, 2003 and 2002” and “Item 8. FinancialStatements and Supplementary Data.”

 
| **Fiscal Years Ended**                                        | ** ** | **2004**   | ** ** | **2003**   | ** ** | **2002**   | ** ** | **2001**   | ** ** | **2000**   | ** ** |
|---------------------------------------------------------------|------------|------------|------------|------------|------------|------------|------------|------------|------------|------------|------------|
| **(In  thousands, except**                                    | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** |
| **per-share  data)**                                          | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** |
|                                                          |       |       |       |       |       |       |       |       |       |       |       |
| **Statement  of Operations**                                  |       |       |       |       |       |       |       |       |       |       |       |
| Total revenues                                                |       | $          | 52,830     |       | $          | 43,609     |       | $          | 45,720     |       | $          | 43,810 |   | $ | 21,479 |   |
| Gross profit                                                  |       | $          | 15,543     |       | $          | 11,879     |       | $          | 15,774     |       | $          | 17,329 |   | $ | 8,921 |   |
| Operating income  (loss)                                      |       | $          | (1,103     | )          | $          | (1,776     | )          | $          | 1,742      |       | $          | 4,749 |   | $ | 1,963 |   |
| Net income  (loss)                                            |       | $          | (1,314     | )          | $          | (1,541     | )          | $          | 332        |       | $          | 2,646 |   | $ | 927 |   |
| Basic earnings  (loss) per common share                       |       | $          | (0.48      | )          | $          | (0.66      | )          | $          | 0.14       |       | $          | 1.15 |   | $ | 0.41 |   |
| Diluted earnings  (loss) per common share                     |       | $          | (0.48      | )          | $          | (0.66      | )          | $          | 0.11       |       | $          | 0.86 |   | $ | 0.32 |   |
| Basic weighted  average number of common shares outstanding   |       | 2,722      |       | 2,343      |       | 2,320      |       | 2,291      |       | 2,287      |       |
| Diluted weighted  average number of common shares outstanding |       | 2,722      |       | 2,343      |       | 3,025      |       | 3,068      |       | 2,889      |       |
|                                                          |       |       |       |       |       |       |       |       |       |       |       |
| **Balance  Sheet**                                            |       |       |       |       |       |       |       |       |       |       |       |
| Working capital                                               |       | $          | 4,600      |       | $          | 3,446      |       | $          | 5,003      |       | $          | 3,188 |   | $ | 1,183 |   |
| Total assets                                                  |       | $          | 24,340     |       | $          | 20,833     |       | $          | 20,239     |       | $          | 18,936 |   | $ | 12,651 |   |
| Long-term  liabilities                                        |       | $          | 5,521      |       | $          | 5,658      |       | $          | 5,797      |       | $          | 4,348 |   | $ | 4,431 |   |
| Shareholders’  equity                                    |       | $          | 6,063      |       | $          | 4,209      |       | $          | 5,737      |       | $          | 5,397 |   | $ | 2,751 |   |

 

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**QUARTERLYFINANCIAL DATA**

 

The following table setsforth certain unaudited quarterly financial data for the eight quarters endedJanuary 1, 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 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 |   |

 

 
| ** **                                                    | ** ** | **Fiscal 2003** | ** ** |
|---------------------------------------------------------------|------------|-----------------|------------|
| ** **                                                    | ** ** | **1st Quarter** | ** ** | **2nd Quarter** | ** ** | **3rd Quarter** | ** ** | **4th Quarter** | ** ** |
| Total revenues                                                |       | $               | 10,026     |   | $ | 10,722 |   | $ | 11,865 |   | $ | 10,996 |   |
| Net income  (loss)                                            |       | $               | (816       | ) | $ | (475 | ) | $ | 41 |   | $ | (291 | ) |
| Basic earnings  (loss) per common share                       |       | $               | (0.35      | ) | $ | (0.20 | ) | $ | 0.02 |   | $ | (0.12 | ) |
| Diluted earnings  (loss) per common share                     |       | $               | (0.35      | ) | $ | (0.20 | ) | $ | 0.01 |   | $ | (0.12 | ) |
| Basic weighted  average number of common shares outstanding   |       | 2,335           |       | 2,344 |   | 2,344 |   | 2,350 |   |
| Diluted weighted  average number of common shares outstanding |       | 2,335           |       | 2,344 |   | 2,897 |   | 2,350 |   |

 

**ITEM 7.****                 MANAGEMENT’SDISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS FORTHE FISCAL YEARS 2004, 2003 AND 2002**

 

**OVERVIEW**

 

Our 2004 fiscal year(2004) ended January 1, 2005, our 2003 fiscal year (2003) ended January 3, 2004and our 2002 fiscal year (2002) ended December 28, 2002.

 

We generate revenues fromthree sources:  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.

 

We expanded our ApplianceSmart operation to twelve stores in 2004 withthree additional facilities opening late in the fourth quarter.  ApplianceSmart retail outlets opened in St.Paul, Minnesota (the fifth serving the Minneapolis market), in San Antonio,Texas (a new market for ApplianceSmart), and in Atlanta (the secondApplianceSmart store in this market). Our Atlanta facility also serves as a regional

 

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distribution center that will supply appliances to our Columbus, SanAntonio and Atlanta retail operations.  Retailrevenues accounted for 79.2% of total revenues in 2004.

 

We are activelypursuing opportunities to support energy-efficiency programs run by electricutility companies.  During 2004, we beganhandling a joint appliance recycling program with The United IlluminatingCompany and The Connecticut Light & Power Company in their serviceterritories.  We also were contracted tobegin programs starting in January 2005 with Wisconsin Public Power Inc. andAustin Energy in Austin, Texas.

 

**Critical Accounting Policies andEstimates**

 

Oursignificant accounting policies are summarized in the footnotes to thefinancial statements.  Some of the mostcritical policies are also discussed below.

 

**Revenue****recognition:**  We recognize revenue from appliance sales inthe period the consumer purchases and pays for the appliance.  We recognize revenue from appliance recyclingwhen we collect and process a unit.  Werecognize byproduct revenue upon shipment.

 

Wedefer revenue under certain appliance extended warranty arrangements we serviceand recognize the revenue over the related terms of the warrantycontracts.  On extended warrantyarrangements that we sell but others service for a fixed portion of thewarranty sales price, we recognize revenue for the net amount retained at thetime we sell the extended warranty to the consumer.

 

Weinclude shipping and handling charges to customers in the revenues.  We include shipping and handling costs weincur in cost of revenues.

 

**Productwarranty: **We provide a warranty for the replacement orrepair of certain defective units.  Ourstandard warranty policy requires us to repair or replace certain defectiveunits at no cost to our customers.  Weestimate the costs that may be incurred under our warranty and record aliability reserve in the amount of such costs at the time we recognize productrevenue.  Factors that affect our warrantyliability reserve for covered units include the number of units sold,historical and anticipated rates of warranty claims on these units, and thecost of these claims.  We periodicallyassess the adequacy of our recorded warranty liability reserve and adjust theamount as necessary.  We believe thewarranty liability reserve of $35,000 is adequate.

 

**Trade receivables:**  Wecarry trade receivables atoriginal invoice amount less an estimate made for doubtful receivables based ona monthly review of all outstanding amounts. Our management determines the allowance for doubtful accounts byregularly evaluating individual customer receivables and considering a customer’sfinancial condition, credit history and current economic conditions.  We write off trade receivables when we deemthem uncollectible.  We record recoveriesof trade receivables previously written off when they are received.  We consider a trade receivable to be past dueif any portion of the receivable balance is outstanding for more than 90days.  We believe that our currentreserve for doubtful accounts of $102,000 is adequate for any exposure to lossin our January 1, 2005 accounts receivable.

 

**Inventories:**  Westate inventories, consisting principally of appliances, at the lower of cost,first-in, first-out (FIFO), or market. We provide estimated reserves for the realizability of our applianceinventories, including adjustments to market, based on various factorsincluding the age of the inventory and our assessment of the need for suchallowances.  We look at historicalinventory agings and margin analysis in determining our reserve estimate.  We believe the reserve of $385,000 isadequate.

 

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**Propertyand equipment:**  We compute depreciation using straight-lineand accelerated methods over the following estimated useful lives:

 
| ** **                  | ** ** | **Years** | ** ** |
|-----------------------------|------------|-----------|------------|
| Buildings and  improvements |       | 18 - 30   |       |
| Equipment                   |       | 3 - 8     |       |

 

Wedid not identify any items that were impaired as of January 1, 2005.

 

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

 

**Stock-basedcompensation:**  We regularly grant options to our employeesunder various plans as described in Note 8 to the financial statements.  As permitted under accounting principlesgenerally accepted in the United States of America, these grants are accountedfor following APB Opinion No. 25 and related interpretations.  Accordingly, compensation cost would berecognized for those grants where the exercise price is less than the fairmarket value of the stock on the date of grant. We recorded no compensation expense for employee grants for the fiscalyears 2004, 2003 and 2002 because the market price and exercise price of thegrants were the same on the day of grant.

 

Wealso grant options and warrants to non-employees for goods and services and inconjunction with certain agreements.  Weaccount for these grants under FASB (Financial Accounting Standards Board)Statement No. 123, *Accounting for Stock-BasedCompensation*, based on the grant date fair values, which requiresthese grants to be accounted for based on the fair value of the grant.

 

**Recently Issued Accounting Pronouncements**

** **

InNovember 2004, the FASB issued SFAS No. 151, *InventoryCosts*, an amendmentof ARB No. 43, Chapter 4.  The amendmentsmade by the SFAS No. 151 require that abnormal amounts of idle facilityexpense, freight, handling costs and wasted materials (spoilage) be recognizedas current-period charges and the allocation of fixed production overheads toinventory costs incurred during fiscal years beginning after June 15,2005.  We are currently evaluating theimpact that adoption of SFAS No. 151 will have on our financial position andresults of operations.

 

In December 2004, FASB publishedFASB Statement 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. 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,

 

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and to recognize the cost over theperiod the 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 FAS123(R) as of the beginning of our first interim period that begins after June15, 2005, which will be the third quarter of 2005.  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 transitionmethod, an entity would use the fair value based accounting method for allemployee awards 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 apply the Statement to all quarters in the fiscal yearof adoption.  Under the modifiedretrospective method of transition, an entity would revise its previouslyissued financial statements to recognize employee compensation cost for priorperiods presented in accordance with the original provisions of Statement No.123.

 

We have not yet completed our studyof the transition methods or made any decisions about how we will adopt FAS123(R).  However, the pro forma netincome effect of using the fair value method for the past three fiscal years ispresented in Note 1 to the financial statements.  The pro forma compensation costs presented inthe table in Note 1 and in our prior filings have been calculated using aBlack-Scholes option pricing model and may not be indicative of amounts thatshould be expected in future years.  Wehave not made any decisions about which option-pricing model is mostappropriate for us for future awards.

 

**REVENUES**

 

Our total revenues for2004 were $52,830,000 compared to $43,609,000 in 2003.

 

Retail revenues increased to $41,847,000 in 2004 from$34,805,000 in 2003, an increase of 20.2%. Same-store sales for 2004 (a sales comparison of seven stores open thefull year in both 2004 and 2003) increased 10%. The increase in retail revenues was due primarily to:

 

1.     Ournew-appliance purchases that resulted in an increase of approximately$6,000,000 in sales of new, in-the-box product.

2.     Operating oneadditional store the entire year of 2004 compared to 2003.

 

Our retail outlets carry awide range of new in-the-box and special-buy appliances, which includemanufacturer closeouts, factory overruns, floor samples, returned or exchangeditems, open carton items, and scratch and dent appliances.  All of these appliances are new, notused.  Some are in the carton whileothers are out of the carton.

 

Wecontinue to purchase both new in-the-box and special-buy appliances fromWhirlpool Corporation (Whirlpool), Maytag Corporation (Maytag), GE Corporation(GE) and Frigidaire.  We have no minimumpurchase requirements with any of these manufacturers.  We believe purchases from these fourmanufacturers will provide an adequate supply of high-quality appliances forour retail outlets; however there is a risk that one or more of these sourcescould be curtailed or lost.

 

We operated twelve retail stores at the end of 2004 and nine at the endof 2003.  In October 2004, we opened a36,000-square-foot store in the San Antonio, Texas market.  In November 2004, we opened an

 

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88,000 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 in2003.  The increase was primarily due tolarger total recycling volumes from all of our California contracts as well asfrom units recycled through our new recycling contract in Connecticut.  Southern California Edison Company (Edison)accounted for approximately 9% of our total revenues for 2004 and 2003.

 

During 2004, we managed recycling operations appliances under threecontracts with electric utility companies. We providedservices in the territories of:

 

1.     Edison,for their 2004-2005 program.

2.     SanDiego Gas & Electric Company (SDG&E) for their 2004 program.

3.     TheUnited Illuminating Company (UI) and The Connecticut Light & Power Company(CL&P), for a joint program for 2004.

 

Currently, each utility is responsible for advertising in its serviceterritory.

 

InFebruary 2005, we announced the extensions of the SDG&E contract and thejoint contract with UI and CL&P for 2005. In December 2004, we announced that we had entered into agreements withWisconsin Public Power, Inc. and Austin Energy in Austin, Texas, to beginprograms in January 2005.  As of March 1,2005, we operate processing and recycling centers in Minneapolis; Los Angeles;Waterbury, Connecticut; and Austin, Texas. We are also aggressively pursuing new appliance recycling programs inother states.

 

Duringthe first eight months of 2003, we recycled appliances in California under anextension of the 2002 Statewide Residential Appliance Recycling Program.  Edison administered the program and customersof Edison, Pacific Gas & Electric (PG&E) and SDG&E were eligible toparticipate.  We were responsible foradvertising in the PG&E and SDG&E service territories, while Edison wasresponsible for advertising in the Edison area. During the third quarter of 2003, Edison awarded us a contract for the2003 Statewide Residential Appliance Recycling Program in Edison’s andSDG&E’s territories.  This contractended December 31, 2003.

 

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

 

1.     An increase in scrap metal revenues ofapproximately $650,000.

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

 

Our total revenues for2003 were $43,609,000 compared to $45,720,000 in 2002.

 

Retail revenues increased to $34,805,000 in 2003 from$29,893,000 in 2002, an increase of 16.4%. Same-store sales for 2003 (a sales comparison of six stores open thefull year in both 2003 and 2002) increased 24%.

 

The increase in retail revenues was due primarily toan increase of approximately $5,000,000 in sales of new, in-the-box product dueto our additional purchases of new product from Maytag, GE and Frigidaire. Thisincrease was offset slightly by a decrease of approximately $500,000 inspecial-buy sales as a result of closing two stores and the ramping up of twonew stores.  We purchased special-buyappliances from Whirlpool, Maytag, GE and Frigidaire.

 

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We operated nine retail storesat the end of 2003 and 2002.  In March2002, we opened a 30,000-square-foot store in the Columbus, Ohio, market.  In December 2002, we closed an underperformingstore in the Dayton, Ohio, market.  InFebruary 2003, we closed a smaller store and opened a 33,000-square-foot storein the Minneapolis/St. Paul market.  InMarch 2003, we closed an underperforming store in the Dayton, Ohio,market.  In December 2003, we opened a30,000-square-foot store in the Atlanta, Georgia, market.

 

Recycling revenues decreased to$8,014,000 in 2003 from $14,625,000 in 2002. Approximately $6,500,000 of the decrease was due primarily to an overalldecrease in total recycling volumes from all of our California recyclingcontracts.  Edison accounted forapproximately 9% of our total revenues for 2003 and 13% for 2002.  We recycled appliances in California duringthe first eight months of 2003 under an extension of the 2002 StatewideResidential Appliance Recycling Program, which Edison administered.  Recycling services for this statewideenergy-efficiency program included customers of Edison, PG&E andSDG&E.  We were responsible foradvertising in the PG&E and SDG&E service territories, while Edison wasresponsible for advertising in the Edison area. During the third quarter of 2003, Edison awarded us a contract for the2003 Statewide Residential Appliance Recycling Program in the territoriesserved by Edison and SDG&E.  Thiscontract ended December 31, 2003.

 

In the first quarter of 2002,we recycled appliances for Edison under an extension of Edison’s 2001Residential Appliance Recycling Program. In July 2002, we signed a contract to provide services for California’sStatewide Residential Appliance Recycling Program for 2002, which Edisonadministered.  This contract becameeffective April 1, 2002 and ended December 31, 2002.  Recycling services for this statewide programincluded customers of Edison, PG&E and SDG&E.  We were responsible for advertising in thePG&E and SDG&E service territories while Edison was responsible foradvertising in the Edison area.

 

Byproduct revenues decreased to $790,000 in 2003 from $1,202,000 in2002.  The decrease was due primarily toa decrease in the volume and price of CFCs of approximately $360,000 and alower volume of scrap metal, offset slightly by an increase in the price ofscrap metal.

 

**GROSS PROFIT**

 

Ouroverall gross profit increased to 29.4% in 2004 from 27.2% in 2003.  The increase was due primarily to:

 

1.               Improved efficiencies because of highervolumes from all our recycling contracts.

2.               An increase in gross profit in sales ofspecial-buy appliances.

 

Grossprofit as a percentage of total revenues for future periods can be affectedfavorably or unfavorably by numerous factors, including:

 

1.               The mix of retail products we sell.

2.               The prices at which we purchase product fromthe four manufacturers.

3.               The volume of appliances we receive throughour recycling contracts.

4.               The price and volume of byproduct revenues.

 

Weexpect gross profit percentages to remain about the same for future periods.

 

Our overall gross profit decreased to 27.2% in 2003 from 34.5% in2002.  The decrease was due primarily tolower recycling revenues and volumes related to the recycling programs, and adecrease in gross profit in sales of special-buy appliances.

 

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**SELLING, GENERAL AND ADMINISTRATIVE EXPENSES**

 

Selling, general and administrativeexpenses were 31.5% of total revenues in 2004 compared to 31.3% in 2003.  Selling, general and administrative expensesincreased to $16,646,000 in 2004 from $13,655,000 in 2003, a 21.9%increase.  Selling expenses increased to$10,795,000 in 2004 from $8,210,000 in 2003. The increase in selling expenses was due primarily to:

 

1.               The expense of operating one additional store overall during 2004.

2.               Expenses related to opening two new stores and a combination retailstore/warehouse distribution center in the fourth quarter of 2004.

3.               An increase in advertising expense of approximately $755,000, whichincludes two new markets compared to the same period in the previous year.

 

General and administrative expensesincreased to $5,851,000 in 2004 from $5,445,000 in 2003.  The increase was due primarily to an increasein administrative costs as a result of an overall increase in recycling volumesand an increase in the allowance for bad debt and one-time banking charges.

 

Selling, general and administrativeexpenses were 31.3% of total revenues in 2003 compared to 30.7% in 2002.  Selling, general and administrative expensesdecreased to $13,655,000 in 2003 from $14,032,000 in 2002, a 2.7%decrease.  Selling expenses increased to$8,210,000 in 2003 from $8,007,000 in 2002. The increase in selling expenses was due primarily to the expense ofopening and operating two new stores during 2003, offset by closing one smallerstore and one underperforming store in 2003 compared to 2002.  General and administrative expenses decreasedto $5,445,000 in 2003 from $6,025,000 in 2002. The decrease was due primarily to lower administration costs as a resultof an overall reduction in recycling volumes.

 

**INTEREST EXPENSE**

 

Interest expenseincreased to $777,000 in 2004 from $748,000 in 2003.

 

Interest expense decreased to $748,000 in 2003 from $1,236,000 in2002.  The decrease was due to a lowereffective rate on outstanding debt in 2003 as compared to 2002.  This was a result of refinancing the debt in2002 on the two company-owned buildings, offset by a minimum interest amount onthe line of credit.

 

**INCOME TAXES AND NET OPERATING LOSSES**

** **

We recorded a benefit for income taxes of $546,000 for 2004 compared to$976,000 in 2003.  The benefit for income taxes for 2004 is dueprimarily to a tax benefit of $600,000 that was a result of a federal incometax credit for a prior carryback claim and an income tax refund we receivedduring the second quarter that was greater than the estimated income taxreceivable that we had recorded offset by an increase in the deferred tax assetvaluation allowance.

 

We had net operating loss carryovers and credit carryforwards ofapproximately $8.6 million at January 1, 2005, which may be available to reducetaxable income and 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 maintaining 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

 

22

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generated prior to February 1999 may be limited to approximately$56,000 per year, or less than $1 million through 2018.

 

As of our 2004 and2003 year-ends, we had recorded cumulative valuation allowances of $4,445,000and $3,575,000 against our net deferred tax assets due to the uncertainty oftheir realization.  The 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.  In the future, when we believe we canreasonably estimate future operating results and these estimated resultsreflect taxable income, the amount of deferred tax assets considered reasonablecould be adjusted by a reduction in the valuation allowance.

 

**LIQUIDITY AND CAPITAL RESOURCES**

 

At January 1, 2005, we had working capital of$4,132,000 compared to $3,446,000 at January 3, 2004.  Cash and cash equivalents increased to$4,362,000 at January 1, 2005 from $1,196,000 at January 3, 2004. Net cashprovided by operating activities was $267,000 in 2004 compared to net cash usedin operating activities of $2,391,000 in 2003. The cash provided by operating activities was due primarily to an increasein accounts payable and accrued expenses, offset by the net loss.  During 2004, accounts payable and accruedexpenses increased by $1,691,000 principally due to more purchases of inventoryand the timing of accounts payable.

 

Net cash used in investing activities was $659,000 in 2004 compared to$558,000 in 2003.  The cash used ininvesting activities in 2004 was primarily related to continued softwaredevelopment of our enterprise-wide software and leasehold improvements relatedto opening four locations in 2004.  Thecash used in investing activities in 2003 was primarily related to continuedsoftware development and building improvements. We did not have any material purchase commitments for assets as ofJanuary 1, 2005.

 

Net cash provided by financing activities was $3,558,000 in 2004 comparedto $1,343,000 in 2003.  The cash providedby financing activities in 2004 was due primarily to a private placement wecompleted in late December 2004 which provided net proceeds of $3,134,000.  The cash provided by financing activities in2003 was due primarily to increased borrowing under the line of credit.

 

As of January 1, 2005, we had an $8 million line of credit with alender.  The interest rate as of January1, 2005 was 8.20%.  The amount ofborrowings available under the line of credit is based on a formula usingreceivables and inventories.  Our unusedborrowing capacity was $103,000 at January 1, 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 January 1, 2005, we were in violation ofthe covenant related to reaching a minimum annual level of net income.  On March 15, 2005, the lender waived this violation.

 

23

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A summary of our contractual cash obligations at January 1, 2005 is asfollows:

 
| ** **                         | ** ** | **Cash Payments Due by Period** | ** ** |
|------------------------------------|------------|---------------------------------|------------|
| **Contractual  Cash  Obligations** | ** ** | **Total**                       | ** ** | **2005** | ** ** | **2006** | ** ** | **2007** | ** ** | **2008** | ** ** | **2009** | ** ** | **2010 and  Thereafter** | ** ** |
| Long-term debt, including interest |       | $                               | 8,541,000  |   | $ | 859,000 |   | $ | 512,000 |   | $ | 499,000 |   | $ | 448,000 |   | $ | 448,000 |   | $ | 5,775,000 |   |
| Operating leases                   |       | $                               | 8,042,000  |   | $ | 2,596,000 |   | $ | 1,928,000 |   | $ | 1,561,000 |   | $ | 1,265,000 |   | $ | 692,000 |   | $ | — |   |
| Total contractual cash obligations |       | $                               | 16,583,000 |   | $ | 3,455,000 |   | $ | 2,440,000 |   | $ | 2,060,000 |   | $ | 1,713,000 |   | $ | 1,140,000 |   | $ | 5,775,000 |   |

 

We also have a commercial commitment as described below:

 
| **Other Commercial  Commitment** | ** ** | **Total Amount  Committed** | ** ** | **Outstanding at 01/01/05** | ** ** | **Date of Expiration** | ** ** |
|----------------------------------|------------|-----------------------------|------------|-----------------------------|------------|------------------------|------------|
| Line of credit                   |       | $                           | 8,000,000  |                        | $          | 5,415,000              |       | December 31, 2007 |   |
|                                  |            |                             |            |                             |            |                        |            |  |  |

 

We believe that our cash balance, availability under our line of creditand anticipated cash flows from operations will be adequate to fund cashrequirements for fiscal 2005.

 

We believe, based on theanticipated revenues from our recycling contracts, the anticipated sales perretail store 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 2005. Our total capital requirements for 2005 will depend upon, amongother things as discussed below, the recycling volumes generated from therecycling contracts in 2005 and the number and size of retail stores operatingduring the fiscal year.  Currently, wehave five centers and twelve stores in operation.  If revenues are lower than anticipated orexpenses are higher than anticipated, we may require additional capital tofinance operations.  Sources ofadditional financing, if needed in the future, may include further debtfinancing or the sale of equity (common or preferred stock) or othersecurities.  There can be no assurancethat such additional sources of financing will be available on termssatisfactory to us or permitted by our current lender.

 

**FORWARD-LOOKING STATEMENTS**

 

Statements contained in this annual report regarding our futureoperations, performance and results, and anticipated liquidity discussed hereinare forward-looking and therefore are subject to certain risks anduncertainties, including, but not limited to, those discussed herein.  Any forward-looking information regarding ouroperations will be affected primarily by our continued ability to purchaseproduct from Whirlpool, Maytag, Frigidaire and GE at acceptable prices and theability and timing of the utility companies to deliver units under therecycling contracts with us.  Inaddition, any forward-looking information will also be affected by the abilityof individual retail stores to meet planned revenue levels, the rate ofsustainable growth in the number of retail stores, the speed at whichindividual retail stores reach profitability, costs and expenses being realizedat higher than expected levels, our ability to secure an adequate supply ofspecial-buy appliances for resale, and the continued availability of ourcurrent line of credit.

 

24

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**ITEM 7A.****                                            QUANTITATIVEAND QUALITATIVE DISCLOSURE ABOUT MARKET RISK**

 

**MARKET RISK AND IMPACT OF INFLATION**

** **

We do not believe there is any significant risk related to interestrate fluctuations on the long-term fixed-rate debt.  However, there are interest rate risks on theline of credit, since our interest rate floats with prime, and on approximately$3,200,000 in long-term debt entered into in September 2002, since our interestrate is based on the 30-day LIBOR rate. Based on average floating rate borrowings of $8,500,000, a one-percentchange in the applicable rate would have caused our interest expense to changeby approximately $85,000.  Also, webelieve that inflation has not had a material impact on the results ofoperations for each of the fiscal years in the three-year period ended January1, 2005.  However, there can be noassurance that future inflation will not have an adverse impact on ouroperating results and financial condition.

 

25

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**ITEM 8.****                                                     FINANCIALSTATEMENTS AND SUPPLEMENTARY DATA**

 
| **Description**                                                                                | ** ** |
|------------------------------------------------------------------------------------------------|------------|
|                                                                                           |       |
| Report of Independent Registered Public  Accounting Firm                                       |       |
| Consolidated Balance Sheet as of January 1,  2005 and January 3, 2004                          |       |
| Consolidated Statement of Operations for  the three years ended January 1, 2005                |       |
| Consolidated Statement of Shareholders’  Equity for the three years ended January 1, 2005 |       |
| Consolidated Statement of Cash Flows for  the three years ended January 1, 2005                |       |
| Notes to Consolidated Financial Statements                                                     |       |

 

26

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REPORT OF INDEPENDENT REGISTERED PUBLIC ACCOUNTING FIRM

 

 

To the Board of DirectorsAppliance Recycling Centers of America, Inc. and SubsidiariesMinneapolis, Minnesota

 

Wehave audited the accompanying consolidated balance sheet of Appliance RecyclingCenters of America, Inc. and Subsidiaries as of January 1, 2005 and January 3,2004, and the related consolidated statement of operations, shareholders’equity and cash flows for each of the years in the three-year period endedJanuary 1, 2005.  These consolidatedfinancial statements are the responsibility of the Company’s management.  Our responsibility is to express an opinionon these consolidated financial statements based on our audits.

 

Weconducted our audits in accordance with the standards of the Public CompanyAccounting Oversight Board (United States). Those standards require that we plan and perform the audit to obtainreasonable assurance about whether the consolidated financial statements arefree of material misstatement.  An auditincludes examining, on a test basis, evidence supporting the amounts anddisclosures in the consolidated financial statements.  An audit also includes assessing theaccounting principles used and the significant estimates made by management, aswell as evaluating the overall financial statement presentation.  We believe that our audits provide areasonable basis for our opinion.

 

Inour opinion, the financial statements referred to above present fairly, in allmaterial respects, the financial position of Appliance Recycling Centers ofAmerica, Inc. and Subsidiaries as of January 1, 2005 and January 3, 2004, andthe results of their operations and their cash flows for each of the years inthe three-year period ended January 1, 2005, in conformity with accountingprinciples generally accepted in the United States of America.

 

 

McGLADREY & PULLEN, LLP

 

 

Minneapolis, Minnesota

February 18, 2005, except for Note 3 as towhich the date is March 15, 2005.

 

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**APPLIANCE RECYCLING CENTERS OF AMERICA, INC.AND SUBSIDIARIESCONSOLIDATED BALANCE SHEET**

 
| ** **                                                                                                                      | ** ** | **January 1,** | ** **     | **January 3,** | ** ** |
|---------------------------------------------------------------------------------------------------------------------------------|------------|----------------|----------------|----------------|------------|
| ** **                                                                                                                      | ** ** | **2005**       | ** **     | **2004**       | ** ** |
| ** **                                                                                                                      |       |           |           |           |       |
| **ASSETS (Note 3)**                                                                                                             | ** ** | ** **     |           |           |       |
|                                                                                                                            |       |           |           |           |       |
| **Current Assets**                                                                                                              |       |           |           |           |       |
| Cash                                                                                                                            | ** ** | **$**          | **4,362,000**  |           | $          | 1,196,000 |   |
| Accounts receivable, net of allowance of $102,000  and $117,000, respectively (Note 9)                                          | ** ** | **2,034,000**  |           | 1,887,000      |       |
| Inventories, net of reserves of $385,000 and  $324,000, respectively                                                            | ** ** | **10,154,000** |           | 9,338,000      |       |
| Refundable income taxes                                                                                                         |       | —         |           | 904,000        |       |
| Deferred income taxes (Note 7)                                                                                                  | ** ** | **468,000**    |           | 566,000        |       |
| Other current assets                                                                                                            | ** ** | **338,000**    |           | 521,000        |       |
| Total current assets                                                                                                            | ** ** | **17,356,000** |           | 14,412,000     |       |
| **Property and Equipment,**  at cost (Notes 2 and 4)                                                                            |       |           |           |           |       |
| Land                                                                                                                            | ** ** | **2,050,000**  |           | 2,050,000      |       |
| Buildings and improvements                                                                                                      | ** ** | **4,338,000**  |           | 4,090,000      |       |
| Equipment                                                                                                                       | ** ** | **5,928,000**  |           | 5,359,000      |       |
| ** **                                                                                                                      |       | **12,316,000** |           | 11,499,000     |       |
| Less accumulated depreciation                                                                                                   | ** ** | **5,982,000**  |           | 5,321,000      |       |
| Net property and equipment                                                                                                      | ** ** | **6,334,000**  |           | 6,178,000      |       |
| **Other Assets**                                                                                                                | ** ** | **300,000**    |           | 243,000        |       |
| **Restricted Cash**                                                                                                             | ** ** | **350,000**    |           | —         |       |
| Total assets                                                                                                                    | ** ** | **$**          | **24,340,000** |           | $          | 20,833,000 |   |
|                                                                                                                            |       |           |           |           |       |
| **LIABILITIES AND SHAREHOLDERS’ EQUITY**                                                                                   |       |           |           |           |       |
|                                                                                                                            |       |           |           |           |       |
| **Current Liabilities**                                                                                                         |       |           |           |           |       |
| Line of credit (Note 3)                                                                                                         | ** ** | **$**          | **5,415,000**  |           | $          | 5,089,000 |   |
| Current maturities of long-term obligations                                                                                     | ** ** | **615,000**    |           | 240,000        |       |
| Accounts payable                                                                                                                | ** ** | **3,889,000**  |           | 2,958,000      |       |
| Accrued expenses (Note 5)                                                                                                       | ** ** | **2,779,000**  |           | 2,019,000      |       |
| Income taxes payable                                                                                                            | ** ** | **58,000**     |           | 660,000        |       |
| Total current liabilities                                                                                                       | ** ** | **12,756,000** |           | 10,966,000     |       |
| **Long-Term Obligations,**  less current maturities (Note 4)                                                                    | ** ** | **5,053,000**  |           | 5,209,000      |       |
| **Deferred Income Tax Liabilities**(Note  7)                                                                                    | ** ** | **468,000**    |           | 449,000        |       |
| Total liabilities                                                                                                               | ** ** | **18,277,000** |           | 16,624,000     |       |
| **Commitments and Contingencies**  (Note 6)                                                                                     |       |           |           |           |       |
| **Shareholders’ Equity**(Note  8)                                                                                          |       |           |           |           |       |
| Common Stock, no par value; authorized  10,000,000 shares; issued and outstanding 4,136,000 and 2,364,000 shares,  respectively | ** ** | **14,549,000** |           | 11,381,000     |       |
| Accumulated deficit                                                                                                             | ** ** | **(8,486,000** | **)**          | (7,172,000     | )          |
| Total shareholders’ equity                                                                                                 | ** ** | **6,063,000**  |           | 4,209,000      |       |
| Total liabilities and shareholders’ equity                                                                                 | ** ** | **$**          | **24,340,000** |           | $          | 20,833,000 |   |

 

See Notes to Consolidated FinancialStatements.

 

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**APPLIANCE RECYCLING CENTERS OF AMERICA, INC.AND SUBSIDIARIESCONSOLIDATED STATEMENT OF OPERATIONS**

 
| ** **                                                    | ** ** | **For the fiscal year ended** | ** **     |
|---------------------------------------------------------------|------------|-------------------------------|----------------|
| ** **                                                    | ** ** | **January 1,**                | ** **     | **January 3,** | ** ** | **December 28,** | ** ** |
| ** **                                                    | ** ** | **2005**                      | ** **     | **2004** | ** ** | **2002** | ** ** |
| **Revenues**(Note 9)                                          |       |                          | ** **     |   |   |   |   |
| Retail                                                        | ** ** | **$**                         | **41,847,000** | ** ** | $ | 34,805,000 |   | $ | 29,893,000 |   |
| Recycling                                                     | ** ** | **9,414,000**                 | ** **     | 8,014,000 |   | 14,625,000 |   |
| Byproduct                                                     | ** ** | **1,569,000**                 | ** **     | 790,000 |   | 1,202,000 |   |
|                                                          | ** ** | ** **                    | ** **     |   |   |   |   |
| Total revenues                                                | ** ** | **52,830,000**                | ** **     | 43,609,000 |   | 45,720,000 |   |
|                                                          |       |                          | ** **     |   |   |   |   |
| **Cost of Revenues**  (Note 9)                                | ** ** | **37,287,000**                | ** **     | 31,730,000 |   | 29,946,000 |   |
|                                                          |       |                          | ** **     |   |   |   |   |
| Gross profit                                                  | ** ** | **15,543,000**                | ** **     | 11,879,000 |   | 15,774,000 |   |
|                                                          |       |                          | ** **     |   |   |   |   |
| **Selling, General and Administrative  Expenses** (Note 2)    | ** ** | **16,646,000**                | ** **     | 13,655,000 |   | 14,032,000 |   |
|                                                          |       |                          | ** **     |   |   |   |   |
| Operating income (loss)                                       | ** ** | **(1,103,000**                | **)**          | (1,776,000 | ) | 1,742,000 |   |
|                                                          |       |                          | ** **     |   |   |   |   |
| **Other Income (Expense)**                                    |       |                          | ** **     |   |   |   |   |
| Other income (expense)                                        | ** ** | **20,000**                    | ** **     | (5,000 | ) | 47,000 |   |
| Interest income                                               | ** ** | **—**                    | ** **     | 12,000 | ** ** | **—** | ** ** |
| Interest expense                                              | ** ** | **(777,000**                  | **)**          | (748,000 | ) | (1,236,000 | ) |
|                                                          | ** ** | ** **                    | ** **     |   |   |   |   |
| Income (loss) before provision for (benefit  of) income taxes | ** ** | **(1,860,000**                | **)**          | (2,517,000 | ) | 553,000 |   |
|                                                          |       |                          | ** **     |   |   |   |   |
| **Provision for (Benefit of) Income Taxes**  (Note 7)         | ** ** | **(546,000**                  | **)**          | (976,000 | ) | 221,000 |   |
|                                                          |       |                          | ** **     |   |   |   |   |
| Net income (loss)                                             | ** ** | **$**                         | **(1,314,000** | **)** | $ | (1,541,000 | ) | $ | 332,000 |   |
|                                                          |       |                          | ** **     |   |   |   |   |
| **Basic Earnings (Loss) per Common Share**                    | ** ** | **$**                         | **(0.48**      | **)** | $ | (0.66 | ) | $ | 0.14 |   |
|                                                          |       |                          | ** **     |   |   |   |   |
| **Diluted Earnings (Loss) per Common Share**                  | ** ** | **$**                         | **(0.48**      | **)** | $ | (0.66 | ) | $ | 0.11 |   |
|                                                          |       |                          | ** **     |   |   |   |   |
| **Weighted Average Number of Common Shares  Outstanding:**    |       |                          | ** **     |   |   |   |   |
| Basic                                                         | ** ** | **2,722,000**                 | ** **     | 2,343,000 |   | 2,320,000 |   |
| Diluted                                                       | ** ** | **2,722,000**                 | ** **     | 2,343,000 |   | 3,025,000 |   |

 

See Notes to Consolidated FinancialStatements.

 

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**APPLIANCE RECYCLING CENTERS OF AMERICA, INC. AND SUBSIDIARIESCONSOLIDATED STATEMENT OF SHAREHOLDERS’ EQUITY**

 
| ** **                                                            | ** ** | ** **        | ** ** | **Accumulated** | ** ** | ** ** | ** ** |
|-----------------------------------------------------------------------|------------|-------------------|------------|-----------------|------------|------------|------------|
| ** **                                                            | ** ** | **Common  Stock** | ** ** | **Deficit**     | ** ** | **Total**  | ** ** |
|                                                                  |       |              |       |            |       |       |       |
| **Balance, December 29, 2001**                                        |       | $                 | 11,360,000 |            | $          | (5,963,000 | )          | $ | 5,397,000 |   |
| Exercise of stock options (Note 8)                                    |       | 8,000             |       | —          |       | 8,000      |       |
| Net income                                                            |       | —            |       | 332,000         |       | 332,000    |       |
|                                                                  |       |              |       |            |       |       |       |
| **Balance, December 28, 2002**                                        |       | 11,368,000        |       | (5,631,000      | )          | 5,737,000  |       |
| Exercise of warrants (Note 8)                                         |       | 13,000            |       | —          |       | 13,000     |       |
| Net loss                                                              |       | —            |       | (1,541,000      | )          | (1,541,000 | )          |
|                                                                  |       |              |       |            |       |       |       |
| **Balance, January 3, 2004**                                          |       | 11,381,000        |       | (7,172,000      | )          | 4,209,000  |       |
| Exercise of stock options (Note 8)                                    |       | 16,000            |       | —          |       | 16,000     |       |
| Exercise of warrants (Note 8)                                         |       | 18,000            |       | —          |       | 18,000     |       |
| Issuance of Common Stock, net of offering  costs of $316,000 (Note 8) |       | 3,134,000         |       | —          |       | 3,134,000  |       |
| Net loss                                                              |       | —            |       | (1,314,000      | )          | (1,314,000 | )          |
|                                                                  |       |              |       |            |       |       |       |
| **Balance, January 1, 2005**                                          |       | $                 | 14,549,000 |            | $          | (8,486,000 | )          | $ | 6,063,000 |   |

 

See Notes toConsolidated Financial Statements.

 

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**APPLIANCE RECYCLING CENTERS OF AMERICA, INC. AND SUBSIDIARIESCONSOLIDATED STATEMENT OF CASH FLOWS**

 
| ** **                                                                                          | ** ** | **For the fiscal year ended** | ** **     |
|-----------------------------------------------------------------------------------------------------|------------|-------------------------------|----------------|
| ** **                                                                                          | ** ** | **January 1,**                | ** **     | **January 3,** | ** ** | **December 28,** | ** ** |
| ** **                                                                                          | ** ** | **2005**                      | ** **     | **2004** | ** ** | **2002** | ** ** |
| **Cash Flows from Operating Activities**                                                            |       |                          | ** **     |   |   |   |   |
| Net income (loss)                                                                                   | ** ** | **$**                         | **(1,314,000** | **)** | $ | (1,541,000 | ) | $ | 332,000 |   |
| Adjustments to reconcile net income (loss)  to net cash provided by (used in) operating activities: |       |                          | ** **     |   |   |   |   |
| Depreciation and amortization                                                                       | ** ** | **658,000**                   | ** **     | 611,000 |   | 507,000 |   |
| Write-off of deferred financing fees and  debt discount                                             |       | —                        | ** **     | — |   | 258,000 |   |
| Loss on sale of property and equipment                                                              | ** ** | **—**                    | ** **     | 5,000 |   | 7,000 |   |
| Accretion of long-term debt discount                                                                |       | —                        | ** **     | **—** |   | 46,000 |   |
| Deferred income taxes                                                                               | ** ** | **117,000**                   | ** **     | **—** |   | 391,000 |   |
| Change in assets and liabilities:                                                                   |       |                          | ** **     |   |   |   |   |
| Receivables                                                                                         | ** ** | **(147,000**                  | **)**          | (758,000 | ) | 3,246,000 |   |
| Inventories                                                                                         | ** ** | **(816,000**                  | **)**          | (1,022,000 | ) | (1,568,000 | ) |
| Other assets                                                                                        | ** ** | **(224,000**                  | **)**          | (11,000 | ) | (238,000 | ) |
| Accounts payable and accrued expenses                                                               | ** ** | **1,691,000**                 | ** **     | 775,000 |   | 877,000 |   |
| Income taxes refundable or payable                                                                  | ** ** | **302,000**                   | ** **     | (450,000 | ) | (551,000 | ) |
| Net cash provided by (used in) operating  activities                                                | ** ** | **267,000**                   | ** **     | (2,391,000 | ) | 3,307,000 |   |
| ** **                                                                                          | ** ** | ** **                    | ** **     | ** ** | ** ** | ** ** | ** ** |
| **Cash Flows from Investing Activities**                                                            | ** ** | ** **                    | ** **     | ** ** | ** ** | ** ** | ** ** |
| Purchases of property and equipment                                                                 | ** ** | **(659,000**                  | **)**          | (558,000 | ) | (598,000 | ) |
| Proceeds from disposals of property and  equipment                                                  |       | —                        | ** **     | — |   | 100,000 |   |
| Net cash used in investing activities                                                               | ** ** | **(659,000**                  | **)**          | (558,000 | ) | (498,000 | ) |
|                                                                                                |       |                          | ** **     |   |   |   |   |
| **Cash Flows from Financing Activities**                                                            | ** ** | ** **                    | ** **     | ** ** | ** ** | ** ** | ** ** |
| Net borrowings (payments) under line of  credit                                                     | ** ** | **326,000**                   | ** **     | 1,574,000 |   | (1,193,000 | ) |
| Payments on long-term obligations                                                                   | ** ** | **(236,000**                  | **)**          | (244,000 | ) | (4,648,000 | ) |
| Proceeds from long-term obligations                                                                 |       | —                        | ** **     | — |   | 5,470,000 |   |
| Proceeds from short-term obligations                                                                | ** ** | **300,000**                   | ** **     | — |   | — |   |
| Payments of deferred financing fees                                                                 |       | —                        | ** **     | **—** |   | (150,000 | ) |
| Net proceeds from issuance of Common Stock                                                          | ** ** | **3,168,000**                 | ** **     | 13,000 |   | 8,000 |   |
| Net cash provided by (used in) financing  activities                                                | ** ** | **3,558,000**                 | ** **     | 1,343,000 |   | (513,000 | ) |
|                                                                                                | ** ** | ** **                    | ** **     |   |   |   |   |
| Increase (decrease) in cash and cash  equivalents                                                   | ** ** | **3,166,000**                 | ** **     | (1,606,000 | ) | 2,296,000 |   |
|                                                                                                |       |                          | ** **     |   |   |   |   |
| **Cash and Cash Equivalents**                                                                       |       |                          | ** **     |   |   |   |   |
| Beginning                                                                                           | ** ** | **1,196,000**                 | ** **     | 2,802,000 |   | 506,000 |   |
| Ending                                                                                              | ** ** | **$**                         | **4,362,000**  | ** ** | $ | 1,196,000 |   | $ | 2,802,000 |   |
|                                                                                                |       |                          | ** **     |   |   |   |   |
| **Supplemental Disclosures of Cash Flow  Information**                                              |       |                          | ** **     |   |   |   |   |
| Cash payments (receipts) relative to:                                                               |       |                          | ** **     |   |   |   |   |
| Interest                                                                                            | ** ** | **$**                         | **777,000**    | ** ** | $ | 748,000 |   | $ | 1,056,000 |   |
| Income taxes, net                                                                                   | ** ** | **(967,000**                  | **)**          | (527,000 | ) | 439,000 |   |
|                                                                                                | ** ** | ** **                    | ** **     |   |   |   |   |
| Equipment acquired under capital lease                                                              | ** ** | **$**                         | **155,000**    | ** ** | $ | 10,000 |   | $ | — |   |

 

SeeNotes to Consolidated Financial Statements.

 

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

 

**NOTESTO CONSOLIDATED FINANCIAL STATEMENTS**

 

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

 

**Natureof business: **Appliance Recycling Centers of America, Inc.and our subsidiaries are in the business of providing reverse logistics, energyconservation and recycling 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, electric utilities, waste managementcompanies and local governments.

 

**Asummary of our significant accounting policies is as follows:**

 

**Principlesof 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.

 

Duringthe second quarter of 2003, we became a majority (60%) owner in North AmericaAppliance Company, LLC (NAACO).  NAACO wasformed and commenced operations in June 2003 and is a retailer of special-buyappliances in Texas.  Because NAACO has anet shareholders’ deficit, no minority interest has been recognized on ourconsolidated balance sheet and 100% of NAACO’s operations are included in ourconsolidated financial statements as of January 1, 2005.

 

**Fairvalue of financial instruments:** The following methods andassumptions are used to estimate the fair value of each class of financialinstrument:

 

**Cash, accounts receivable and accounts payable:**  Dueto their nature and short-term maturities, the carrying amounts approximatefair value.

 

**Short- and long-term debt:**  The fair value of short- andlong-term debt has been estimated based on discounted cash flows using interestrates being offered for similar debt having the same or similar remainingmaturities and collateral requirements.

 

Noseparate comparison of fair values versus carrying values is presented for theaforementioned financial instruments since their fair values are notsignificantly different than their balance sheet carrying amounts.  In addition, the aggregate fair values of thefinancial instruments would not represent the underlying value of our company.

 

**Fiscalyear:**  We use a 52-53 week fiscal year.  Our 2004 fiscal year (2004) ended January 1,2005, our 2003 fiscal year (2003) ended January 3, 2004, and our 2002 fiscalyear (2002) ended December 28, 2002.  The2004 fiscal year contains 52 weeks.  The2003 fiscal year contains 53 weeks.  The2002 fiscal year contains 52 weeks.

 

**Revenuerecognition:**  We recognize revenue from appliance sales inthe period the consumer purchases and pays for the appliances.  We recognize revenue from appliance recyclingwhen we collect and process a unit.  Werecognize byproduct revenue upon shipment.

 

Wedefer revenue under certain appliance extended warranty arrangements we serviceand recognize the revenue over the related terms of the warrantycontracts.  On extended warrantyarrangements we sell but others service for

 

32

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afixed portion of the warranty sales price, we recognize revenue for the netamount retained at the time of sale of the extended warranty to the consumer.

 

Weinclude shipping and handling charges to customers in revenues.  Shipping and handling costs that we incur areincluded in cost of revenues.

 

**Product warranty:**  Weprovide a warranty for the replacement or repair of certain defectiveunits.  Our standard warranty policyrequires us to repair or replace certain defective units at no cost to ourcustomers.  We estimate the costs thatmay be incurred under our warranty and record a liability reserve in the amountof 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.

 

Changesin our warranty liability reserve are as follows:

 
| ** **                           | ** ** | **2004**    | ** ** | **2003**   | ** ** | **2002** | ** ** |
|--------------------------------------|------------|-------------|------------|------------|------------|----------|------------|
| Balance, beginning                   | ** ** | **$**       | **54,000** | ** ** | $          | 82,000   |       | $ | 187,000 |   |
| Standard accrual based on units sold | ** ** | **76,000**  | ** ** | 164,000    |       | 203,000  |       |
| Actual costs incurred                | ** ** | **(53,000** | **)**      | (133,000   | )          | (134,000 | )          |
| Periodic accrual adjustments         | ** ** | **(42,000** | **)**      | (59,000    | )          | (174,000 | )          |
| Balance, ending                      | ** ** | **$**       | **35,000** | ** ** | $          | 54,000   |       | $ | 82,000 |   |

 

**Tradereceivables: **We carry trade receivables at originalinvoice amount less an estimate made for doubtful receivables based on a reviewof all outstanding amounts on a monthly basis. Management determines the allowance for doubtful accounts by regularlyevaluating individual customer receivables and considering a customer’sfinancial condition, 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 pastdue if any portion of the receivable balance is outstanding for more than 90days.  Our management considers thereserve for doubtful accounts of $102,000 to be adequate to cover any exposureto loss in our January 1, 2005 accounts receivable.

 

**Cash:**  Wemaintain our cash in bank deposit and money-market accounts which, at times,exceed federally insured limits.  We havenot experienced any losses in such accounts.

 

**Restrictedcash:**  In connection with our consumer credit cardprocessing arrangements, we are required to maintain a cash balance that isrestricted.  At January 1, 2005, we wererequired to maintain a balance of $350,000, which is reflected in theconsolidated balance sheet as long-term restricted cash.

 

**Inventories:** Inventories, consisting principally of appliances, are stated at thelower of cost, first-in, first-out (FIFO), or market and consist of:

 
| ** **     | ** ** | **2004**     | ** **     | **2003**   | ** ** |
|----------------|------------|--------------|----------------|------------|------------|
| Finished goods | ** ** | **$**        | **10,539,000** | ** ** | $          | 9,662,000 |   |
| Less reserves  | ** ** | **(385,000** | **)**          | (324,000   | )          |
| ** **     |       | **$**        | **10,154,000** | ** ** | $          | 9,338,000 |   |

 

Weprovide estimated reserves for the realizability of our appliance inventories,including adjustments to market, based on various factors including the age ofsuch inventory and our management’s assessment of the need for

 

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suchallowances.  We look at historicalinventory agings and margin analysis in determining our reserve estimate.  We believe the reserve of $385,000 as ofJanuary 1, 2005 is adequate.

 

**Propertyand equipment:**  We compute depreciation using straight-lineand accelerated methods over the following estimated useful lives:

 
| ** **                 | ** ** | **Years**    | ** ** |
|----------------------------|------------|--------------|------------|
| Buildings and improvements |       | 18 – 30 |       |
| Equipment                  |       | 3 – 8   |       |

 

Weamortize leasehold improvements on a straight-line basis over the shorter oftheir estimated useful lives or the underlying lease term.

 

Wedid not identify any items that were impaired as of January 1, 2005.

 

**Softwaredevelopment 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 $220,000, $255,000 and $221,000 for the fiscalyears of 2004, 2003 and 2002, respectively. Amortization expense on software development costs was $212,000,$164,000 and $119,000 for the fiscal years 2004, 2003 and 2002,respectively.  Estimated amortizationexpenses are $216,000, $208,000, $226,000, $219,000 and $216,000 for the fiscalyears 2005, 2006, 2007, 2008 and 2009, respectively.

 

**Accountingfor long-lived assets: **We evaluate long-lived assets such as propertyand equipment for impairment whenever events or changes in circumstancesindicate the carrying value of an asset may not be recoverable.  We assess the fair value of the assets basedon the estimated future net undiscounted cash flows expected to result from theuse of the assets, including cash flows from disposition.  Should the sum of the expected future netcash flows be less than the carrying value, we recognize an impairment loss atthat time.  We measure an impairment lossby comparing the amount by which the carrying value exceeds the fair value(estimated discounted future cash flows or appraisal of assets) of thelong-lived assets.  Also see Note 2.

 

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

 

**Advertisingexpense: **Advertising is expensed as incurred and was$2,353,000, $1,545,000 and $1,823,000 for the 2004, 2003 and 2002 fiscal years,respectively.

 

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

 

**Basic and diluted net earningsper share:**  Basic per-share amounts are computed,generally, by dividing net income or 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.

 

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Inarriving at diluted weighted-average shares and per-share amounts, we includedoptions and warrants (see Note 8) with exercise prices below average marketprices, for the respective fiscal quarters in which they were dilutive, usingthe treasury stock method.  We calculatedthe number of additional shares by assuming the outstanding stock options andwarrants were exercised and that the proceeds from such exercises were used toacquire Common Stock at the average market price during the year.  The dilutive effect of these additionalshares for the fiscal year 2002 was to increase the weighted average sharesoutstanding by 705,000.  Because theeffect of options and warrants on 2004 and 2003 is antidilutive, they were notincluded in the computation of per-share amounts.

 

**Stock-basedcompensation:**  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 grantswhere the exercise price is less than the fair market value of the stock on thedate of grant.  We recorded nocompensation expense for employee grants for fiscal years 2004, 2003 and 2002because the market price and exercise price of the grants were the same on theday of grant.

 

Wealso grant options and warrants to non-employees for goods and services and inconjunction with certain agreements.  Weaccount for these grants under FASB (Financial Accounting Standards Board)Statement No. 123, *Accounting for Stock-BasedCompensation*, based on the grant date fair values, which requiresthese grants to be accounted for based on the fair value of the grant.

 

Hadcompensation cost for all of the employee stock-based compensation grants andwarrants issued been determined based on the fair values at the grant dateconsistent with the provisions of SFAS No. 123, our net income (loss) and netincome (loss) per basic and diluted common share would have been as indicatedbelow.

 
| ** **                                | ** ** | **2004**    | ** **     | **2003** | ** ** | **2002**   | ** ** |
|-------------------------------------------|------------|-------------|----------------|----------|------------|------------|------------|
| Net income (loss):                        |       |        | ** **     |     |       |       |       |
| As reported                               | ** ** | **$**       | **(1,314,000** | **)**    | $          | (1,541,000 | )          | $ | 332,000 |   |
| Deduct pro forma stock-based compensation | ** ** | **(46,000** | **)**          | (52,000  | )          | (80,000    | )     |
| Pro forma                                 | ** ** | **$**       | **(1,360,000** | **)**    | $          | (1,593,000 | )          | $ | 252,000 |   |
| Basic earnings (loss) per share:          |       |        | ** **     |     |       |       |       |
| As reported                               | ** ** | **$**       | **(0.48**      | **)**    | $          | (0.66      | )          | $ | 0.14 |   |
| Pro forma                                 |       | **$**       | **(0.50**      | **)**    | $          | (0.68      | )          | $ | 0.11 |   |
| Diluted earnings (loss) per share:        |       |        | ** **     |     |       |       |       |
| As reported                               | ** ** | **$**       | **(0.48**      | **)**    | $          | (0.66      | )          | $ | 0.11 |   |
| Pro forma                                 | ** ** | **$**       | **(0.50**      | **)**    | $          | (0.68      | )          | $ | 0.08 |   |

 

Theabove pro forma effects on net income (loss) and net income (loss) per basicand diluted common share are not likely to be representative of the effects onreported net income (loss) or net income (loss) per common share for futureyears because options vest over several years and additional awards generallyare made each year.

 

In December 2004, FASB publishedFASB Statement No. 123 (revised 2004), *Share-BasedPayment* (“FAS 123(R)” or the “Statement”). FAS 123(R) requires that thecompensation cost relating to share-based payment transactions, includinggrants of employee stock 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

 

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provide services for the award. FAS123(R) permits entities to use any option-pricing model that meets the fairvalue objective in the Statement.

 

We will be required to apply FAS123(R) as of the beginning of our first interim period that begins after June15, 2005, which will be the third quarter of 2005.  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 transitionmethod, an entity would use the fair value based accounting method for allemployee awards 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 apply the Statement to all quarters in the fiscal yearof adoption.  Under the modifiedretrospective method of transition, an entity would revise its previouslyissued financial statements to recognize employee compensation cost for priorperiods presented in accordance with the original provisions of Statement No.123.

 

We have not yet completed our studyof the transition methods or made any decisions about how we will adopt FAS123(R).  However, the pro forma netincome effect of using the fair value method for the past three fiscal years ispresented in the table above.  The proforma compensation costs presented in the table above and in our prior filingshave been calculated using a Black-Scholes option pricing model and may not beindicative of amounts that should be expected in future years.  We have not made any decisions about whichoption-pricing model is most appropriate for us for future awards.

 

**Comprehensiveincome: **Comprehensive income is equivalent to netincome in the statement of operations.

 

**Segmentinformation: **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, appliancerecycling including recycling services for utilities, and byproduct sales).

 

**Estimates:**  Thepreparation of financial statements in conformity with accounting principlesgenerally accepted in the United States of America requires our management tomake estimates and assumptions that affect the reported amounts of assets andliabilities and disclosure of contingent assets and liabilities at the date ofthe financial statements and the reported amounts of revenues and expensesduring the reporting period.  Significantitems subject to estimates and assumptions include the valuation allowances forinventories and deferred tax assets. Actual results could differ from those estimates.

 

**Recently issued accounting pronouncements: **The following items represent accounting standards that have beenrecently issued.

 

InNovember 2004, the FASB issued SFAS No. 151, *InventoryCosts*, an amendmentof ARB No. 43, Chapter 4.  The amendmentsmade by the SFAS No. 151 require that abnormal amounts of idle facilityexpense, freight, handling costs and wasted materials (spoilage) be recognizedas current-period charges and the allocation of fixed production overheads toinventory costs incurred during fiscal years beginning after June 15, 2005.  We are currently evaluating the impact thatadoption of SFAS No. 151 will have on our financial position and results ofoperations.

 

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**Note 2.  Market Closings and Losson Impaired Assets**

 

InDecember 2002, we closed a retail store in the Dayton, Ohio, market andincurred expenses of $108,000 for the remaining lease payments and write-off ofleasehold improvements.

 

InFebruary 2003, we closed a retail store in the Minneapolis market that resultedin no closing costs.

 

InMarch 2003, we closed a retail store in the Dayton, Ohio, market and wrote offleasehold improvements of approximately $26,000.

 

**Note 3.  Line of Credit**

 

AtJanuary 1, 2005, we had an $8 million line of credit with a lender.  The interest rate as of January 1, 2005 was8.20%.  The amount of borrowingsavailable under the line of credit is based on a formula using receivables andinventories.  Our unused borrowingcapacity under this line was $103,000 at January 1, 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 January 1, 2005, we were in violation ofthe covenant related to reaching a minimum annual level of net income.  On March 15, 2005, the lender waived thisviolation.

 

**Note 4.  Long-Term Obligations**

 

Long-termobligations consisted of the following:

 
| ** **                                                                                                                                                                                                                                                    | ** ** | **2004**      | ** **    | **2003**  | ** ** |
|---------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|------------|---------------|---------------|-----------|------------|
| Adjustable rate mortgage based on the  30-day LIBOR rate (1.84% as of January 1, 2005) plus 2.7%, adjusted yearly, monthly  payments include interest and principal, and are based on a 20-year  amortization, due October 2012, secured by land and building | ** ** | **$**         | **3,216,000** |      | $          | 3,340,000 |   |
| 6.85% mortgage, due in monthly installments  of $15,326, including interest, due January 2013, secured by land and  building                                                                                                                                  | ** ** | **1,904,000** |          | 1,956,000 |       |
| 13.00% note payable, due in monthly  interest payments of $541 with balance due September 2005, secured by  equipment                                                                                                                                         | ** ** | **50,000**    |          | 50,000    |       |
| Other, primarily capital leases (see below)                                                                                                                                                                                                                   | ** ** | **498,000**   |          | 103,000   |       |
| ** **                                                                                                                                                                                                                                                    |       | **5,668,000** |          | 5,449,000 |       |
| Less current maturities                                                                                                                                                                                                                                       | ** ** | **615,000**   |          | 240,000   |       |
| ** **                                                                                                                                                                                                                                                    |       | **$**         | **5,053,000** |      | $          | 5,209,000 |   |

 

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Thefuture annual maturities of long-term obligations are as follows:

 
| **Fiscal year**     | ** ** | ** ** | ** ** |
|---------------------|------------|------------|------------|
| 2005                |       | $          | 615,000    |   |
| 2006                |       | 239,000    |       |
| 2007                |       | 243,000    |       |
| 2008                |       | 186,000    |       |
| 2009                |       | 241,000    |       |
| 2010 and thereafter |       | 4,144,000  |       |
|                |       | $          | 5,668,000  |   |

 

**Capital leases:** We lease certain equipment under capital leases.  The cost of the equipment was approximately$206,000 and $78,000 at January 1, 2005 and January 3, 2004, respectively.  Accumulated amortization at January 1, 2005and January 3, 2004, was approximately $166,000 and $124,000, respectively.

 

Thefollowing is a schedule by years of approximate remaining minimum paymentsrequired under the leases, together with the present value at January 1, 2005:

 
| **Fiscal Year**                   | ** ** | ** ** | ** ** |
|-----------------------------------|------------|------------|------------|
| 2005                              |       | $          | 106,000    |   |
| 2006                              |       | 64,000     |       |
| 2007                              |       | 52,000     |       |
| 2008                              |       | 4,000      |       |
| Total minimum lease payments      |       | $          | 226,000    |   |
|                              |       |       |       |
| Less amount representing interest |       | 25,000     |       |
| Less current portion              |       | 90,000     |       |
| Long-term portion                 |       | $          | 111,000    |   |

 

**Note 5.  Accrued Expenses**

 

Accruedexpenses were as follows:

 
| ** **                | ** ** | **2004**    | ** **    | **2003** | ** ** |
|---------------------------|------------|-------------|---------------|----------|------------|
| Compensation and benefits | ** ** | **$**       | **1,083,000** |     | $          | 930,000 |   |
| Warranty expense          | ** ** | **35,000**  |          | 54,000   |       |
| Accrued incentives        | ** ** | **909,000** |          | 686,000  |       |
| Other                     | ** ** | **752,000** |          | 349,000  |       |
| ** **                |       | **$**       | **2,779,000** |     | $          | 2,019,000 |   |

 

**Note 6.  Commitments andContingencies**

 

**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.

 

38

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Minimumfuture rental commitments under noncancelable operating leases as of January 1,2005 are as follows:

 
| **Fiscal Year** | ** ** | ** ** | ** ** |
|-----------------|------------|------------|------------|
| 2005            |       | $          | 2,596,000  |   |
| 2006            |       | 1,928,000  |       |
| 2007            |       | 1,561,000  |       |
| 2008            |       | 1,265,000  |       |
| 2009            |       | 692,000    |       |
|            |       | $          | 8,042,000  |   |

 

Rentexpense for fiscal years 2004, 2003 and 2002 was $1,957,000, $1,686,000 and $1,973,000,respectively.

 

**Contracts:**  We have entered into contractswith four of our appliance vendors. Under the agreements there are no minimum purchase commitments; however,we have agreed to indemnify the vendors for certain claims, allegations or losseswith respect to appliances we sell.  Alsosee 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. We are seeking adeclaratory judgment that the JACO patent is invalid and unenforceable, sinceit is almost entirely based on methods and processes we developed and haveused.  We are also asking the court forunspecified damages related to charges that JACO, in using a fraudulently basedpatent, has engaged in unfair competition under federal and Californiastatutes, false and misleading advertising under California statutes, andinterference with our prospective customer relationships.  The defendants have answered our complaintdenying liability.  We expect recyclingoperations to continue without interruption during the period of litigation,but if the court were to issue rulings in favor of the defendants, this couldchange.  Moreover, failure to win this lawsuitcould have a long-term material adverse effect on our recyclingoperations.  In addition, we may incursubstantial costs in pursuing this litigation, which could have an adverseeffect on our results of operations.

 

39

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**Note 7. Income Taxes**

 

Theprovision (benefit) for income taxes consisted of the following:

 
| ** ** | ** ** | **2004**    | ** **   | **2003**   | ** ** | **2002** | ** ** |
|------------|------------|-------------|--------------|------------|------------|----------|------------|
| Current:   |       |        | ** **   |       |       |     |       |
| Federal    | ** ** | **$**       | **(663,000** | **)**      | $          | (976,000 | )          | $ | (170,000 | ) |
| Deferred   | ** ** | **117,000** | ** **   | **—** |       | 391,000  |       |
| ** ** |       | **$**       | **(546,000** | **)**      | $          | (976,000 | )          | $ | 221,000 |   |

 

Areconciliation of our income tax expense with the federal statutory tax rate isshown below:

 
| ** **                                                 | ** ** | **2004**     | ** **   | **2003**   | ** ** | **2002** | ** ** |
|------------------------------------------------------------|------------|--------------|--------------|------------|------------|----------|------------|
| Income tax expense (benefit) at statutory  rate            | ** ** | **$**        | **(639,000** | **)**      | $          | (856,000 | )          | $ | 188,000 |   |
| State taxes net of federal tax effect                      | ** ** | **(117,000** | **)**        | (152,000   | )          | 25,000   |       |
| Permanent differences and other                            | ** ** | **13,000**   | ** **   | (42,000    | )          | 8,000    |       |
| Federal income tax credit attributable to  carryback claim | ** ** | **(673,000** | **)**        | **—** |       | —   |       |
| Change in valuation allowance                              | ** ** | **870,000**  | ** **   | 74,000     |       | —   |       |
| ** **                                                 |       | **$**        | **(546,000** | **)**      | $          | (976,000 | )          | $ | 221,000 |   |

 

Thechange in the valuation allowance includes a change in the conclusion regardingthe realizably of previously unreserved net deferred income taxes of $117,000.

 

Thecomponents of net deferred tax assets are as follows:

 
| ** **                       | ** ** | **2004**       | ** **    | **2003**   | ** ** |
|----------------------------------|------------|----------------|---------------|------------|------------|
| Deferred tax assets:             |       |           | ** **    |       |       |
| Net operating loss carryforwards | ** ** | **$**          | **4,228,000** | ** ** | $          | 3,505,000 |   |
| Federal and state tax credits    | ** ** | **269,000**    | ** **    | 269,000    |       |
| Reserves                         | ** ** | **355,000**    | ** **    | 322,000    |       |
| Accrued expenses                 | ** ** | **164,000**    | ** **    | 134,000    |       |
| Prepaid expenses                 | ** ** | **(56,000**    | **)**         | (106,000   | )          |
| Other                            | ** ** | **57,000**     | ** **    | 17,000     |       |
| Net deferred tax assets          | ** ** | **$**          | **5,017,000** | ** ** | $          | 4,141,000 |   |
| Valuation allowance              | ** ** | **(4,445,000** | **)**         | (3,575,000 | )          |
| ** **                       |       | **$**          | **572,000**   | ** ** | $          | 566,000 |   |
| Deferred tax liabilities:        |       |           | ** **    |       |       |
| Property and equipment           | ** ** | **$**          | **572,000**   | ** ** | $          | 449,000 |   |
| Net deferred taxes               | ** ** | **$**          | **—**    | ** ** | $          | 117,000 |   |

 

Thedeferred tax amounts mentioned above have been classified in the accompanyingbalance sheet as follows:

 
| ** **              | ** ** | **2004**     | ** **  | **2003**   | ** ** |
|-------------------------|------------|--------------|-------------|------------|------------|
| Current assets          | ** ** | **$**        | **468,000** | ** ** | $          | 566,000 |   |
| Non-current liabilities | ** ** | **(468,000** | **)**       | (449,000   | )          |
| ** **              |       | **$**        | **—**  | ** ** | $          | 117,000 |   |

 

40

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AtJanuary 1, 2005, we had a valuation allowance against deferred tax assetsto reduce the total to an amount our management believes is appropriate.  Realization of deferred tax assets isdependent upon sufficient future taxable income during the periods whendeductible temporary differences and carryforwards are expected to be availableto reduce taxable income.  The valuationallowance increased in the current year primarily as a result of net operatinglosses generated during the year in which we have provided a valuationallowance.  In the future when we believewe can reasonably 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.

 

AtJanuary 1, 2005, we had NOL carryforwards expiring as follows:

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

 

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

 

**Note 8.  Shareholders’ Equity**

 

**Stock options:**  We have two stock option plans (Plans) thatpermit the granting of “incentive stock options” meeting the requirements of Section 422of the Internal Revenue Code of 1986, as amended, and nonqualified options thatdo 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.

 

Thepro forma fair value of each option grant as presented in Note 1 to thefinancial statements is estimated on the date of grant using the Black-Scholesoption pricing model with the following weighted-average assumptions:

 
| ** **                        | ** ** | **2004** | ** ** | **2003** | ** ** | **2002** | ** ** |
|-----------------------------------|------------|----------|------------|----------|------------|----------|------------|
| Expected  dividend yield          |       | —   |       | —   |       | —   |       |
| Expected  stock price volatility  | ** ** | **78.5** | %          | 79.5     | %          | 79.7     | %          |
| Risk-free  interest rate          | ** ** | **2.1**  | %          | 0.9      | %          | 1.4      | %          |
| Expected  life of options (years) | ** ** | **2**    |       | 2        |       | 2        |       |

 

41

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Additionalinformation relating to all outstanding options is as follows:

 
| ** **              | ** ** | **Shares** | ** ** | **Weighted Average  Exercise Price** | ** ** |
|-------------------------|------------|------------|------------|--------------------------------------|------------|
| Outstanding  at         |       |       |       |                                 |       |
| December 29,  2001 |       | 408,000    |       | $                                    | 1.98       |   |
| Granted                 |       | 57,000     |       | $                                    | 3.77       |   |
| Exercised               |       | (8,000     | )          | $                                    | 0.96       |   |
| Cancelled               |       | (20,000    | )          | $                                    | 3.60       |   |
| 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       |   |

 

Theweighted average fair value per option of options granted during fiscal years2004, 2003 and 2002 was $1.41, $0.69 and $1.65, respectively.

 

Thefollowing tables summarize information about stock options outstanding as of January 1,2005:

 

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              |       | 33,000                              |       | 6.3                                                        |       | $                                     | 4.13       |   |
| $2.38 to  $3.50              |       | 35,000                              |       | 7.0                                                        |       | $                                     | 2.79       |   |
| $0.75 to  $2.20              |       | 244,000                             |       | 2.0                                                        |       | $                                     | 1.96       |   |
| $0.59 to  $0.65              |       | 40,000                              |       | 2.8                                                        |       | $                                     | 0.62       |   |
|                         |       | 352,000                             |       |                                                       |       | $                                     | 2.09       |   |

 

OPTIONS EXERCISABLE

 
| **Range of Exercise Prices** | ** ** | **Number of Options  Exercisable** | ** ** | **Weighted Average  Exercise Price** | ** ** |
|------------------------------|------------|------------------------------------|------------|--------------------------------------|------------|
| $4.05 to  $4.30              |       | 33,000                             |       | $                                    | 4.13       |   |
| $2.38 to  $3.50              |       | 35,000                             |       | $                                    | 2.79       |   |
| $0.75 to  $2.20              |       | 212,000                            |       | $                                    | 1.92       |   |
| $0.59 to  $0.65              |       | 40,000                             |       | $                                    | 0.62       |   |
|                         |       | 320,000                            |       | $2.08                                |       |

 

42

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Thefollowing table summarizes options exercisable for stock options outstanding asof January 3, 2004 and December 28, 2002:

 
| ** **                       | ** ** | **January 3,  2004** | ** ** | **December 28,  2002** | ** ** |
|----------------------------------|------------|---------------------------|------------|-----------------------------|------------|
| Number of  options exercisable   |       | 336,000                   |       | 325,000                     |       |
| Weighted  average exercise price |       | $                         | 1.88       |                        | $          | 2.01 |   |
|                                  |            |                           |            |                             |            |  |  |

 

**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.

 

InSeptember 1998, we entered into a loan agreement with a lender resultingin gross proceeds to us of $3.5 million. In connection with this loan, we issued the lender a warrant to purchase700,000 shares of Common Stock at an adjustable exercise price, which was at$0.60 per share.  During 2004, the lenderexercised the warrant to purchase 700,000 options resulting in the issuance of532,000 shares of Common Stock.  We alsoissued to an investment banker associated with this transaction a warrant topurchase 125,000 shares of Common Stock at $2.50 per share.  The portion of the gross loan proceedsascribed to the aforementioned warrants issued in conjunction with this debt financingwas $307,000 as determined using the Black-Scholes method.  During 2002, 32,136 warrants were exercisedresulting in the issuance of 14,872 shares of Common Stock.  The remaining unexercised warrants expired in2003.

 

InFebruary 1999, in connection with a private placement, we issued warrantsto purchase 83,000 shares of Common Stock at $0.50 per share, subject toadjustment.  During 2002, 4,000 warrantswere exercised resulting in the issuance of 3,506 shares of Common Stock.  During 2003, 26,000 warrants were exercisedresulting in the issuance of 20,326 shares of Common Stock.  During 2004, the remaining 53,000 warrantswere exercised resulting in the issuance of 44,061 shares of Common Stock.

 

InMarch 1999, we issued to a board member at that time 5,000 warrants topurchase our Common Stock at $0.625 per share, the market value of our stock atthe date of grant.  These warrants expirein 2009.

 

InApril 1999, we issued to a vendor 50,000 warrants to purchase Common Stockat $0.625 per share.  In February 2003,20,000 warrants were exercised resulting in the issuance of 20,000 shares ofCommon Stock.  In March 2004, theremaining 30,000 warrants were exercised resulting in the issuance of 30,000shares of Common Stock.

 

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

 

**Private placement:**  In December 2004, we soldin a private placement, 1,150,000 shares of Common Stock at a price of $3.00per share.  We incurred offering costs of$316,000.  The net proceeds were used torepay certain indebtedness, to purchase inventory and for future growth.

 

43

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**Note 9.  Major Customers andSuppliers**

 

Revenuesfrom our major recycling customers as a percentage of total revenues are asfollows:

 
| ** **           | ** ** | **2004** | ** ** | **2003**   | ** ** | **2002** | ** ** |
|----------------------|------------|----------|------------|------------|------------|----------|------------|
| Revenue  percentage: |       |     |       |       |       |     |       |
| Customer A           | ** ** | **9**    | %          | 9          | %          | 13       | %          |
| Customer B           |       | —   | ** ** | **—** |       | 12       | %          |

 

Asof January 1, 2005, we had a receivable from Customer A of $505,000.

 

Duringthe three-year period ended January 1, 2005, we purchased a vast majorityof appliances for resale from four suppliers. We have and are continuing to secure other vendors from which topurchase appliances.  However, thecurtailment or loss of one of these suppliers or any appliance supplier couldadversely affect our operations.

 

**ITEM 9****.**** ****CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING ANDFINANCIAL DISCLOSURE**

 

Nochanges in or disagreements with accountants have occurred within the two-yearperiod ended January 1, 2005 that required reporting on Form 8-K.

 

**ITEM9A.****              ****CONTROLS AND PROCEDURES**

 

Wemaintain disclosure controls and procedures that are designed to ensure thatinformation required to be disclosed in the reports we file with the Securitiesand Exchange Commission pursuant to the Securities Exchange Act of 1934 isrecorded, processed, summarized and reported within the time periods specifiedin the rules and forms of the Commission and that such information isaccumulated and communicated to our management, including our Chief ExecutiveOfficer (CEO) and Chief Financial Officer (CFO), as appropriate, to allow timelydecisions regarding required disclosures.

 

Wealso maintain a system of internal accounting controls designed to providereasonable assurance that our books and records accurately reflect ourtransactions and that our policies and procedures are followed.  Except as described below, there have been nochanges in our internal control over financial reporting during the fiscalquarter ended January 1, 2005, or thereafter, that have materiallyaffected, or are reasonably likely to materially affect, our internal controlover financial reporting.

 

44

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Ourmanagement, under the supervision and with the participation of our CEO andCFO, has evaluated the effectiveness of the design and operation of ourdisclosure controls and procedures as of the end of the period covered by thisannual report.  Based on that evaluation,our CEO and CFO have concluded that, because of the material weakness describedbelow, these controls and procedures were not effective as of January 1,2005.

 

Inconnection with our review of our consolidated financial statements for theyear ended January 1, 2005 and the audit of those statements by ourindependent registered public accounting firm, we determined that our year-endfinancial statement closing process did not ensure that all significantelements of our financial statements were adequately reviewed.  In our post-closing and audit processes,certain issues were discovered by us and our independent registered publicaccounting firm that resulted in adjustments to our financial statements,specifically with respect to our reserve for doubtful accounts and therecording of certain lease expenses.  Wediscovered these matters before our financial statements were completed, andthey are properly accounted for in our financial statements.  However, we have concluded that the failureto discover these items in our regular closing process is the result of asignificant deficiency that constitutes a material weakness in the design oroperation of our internal controls over financial reporting.

 

•      A significant deficiency is defined as acontrol deficiency, or combination of deficiencies, that adversely affects acompany’s ability to initiate, authorize, record, process or report externalfinancial data reliably in accordance with generally accepted accountingprinciples such that there is more than a remote likelihood that a misstatementof the company’s financial statements that is more than inconsequential willnot be prevented or detected.

 

•      A material weakness is a significantdeficiency, or combination of significant deficiencies, that results in morethan a remote likelihood that a material misstatement of the financialstatements will not be prevented or detected.

 

Althoughthe items described above were properly accounted for before completing ourconsolidated financial statements, we have concluded that the failure todiscover these items in our regular closing process was a material weaknessbecause the elements of our financial statements that were not adequatelyreviewed are material to our consolidated financial statements and there ismore than a remote likelihood that a material misstatement of our consolidatedfinancial statements would not be prevented or detected.

 

Wehave discussed the material weakness described above with our AuditCommittee.  Our management is workingwith our Audit Committee to identify and implement corrective actions whererequired to improve the effectiveness of our internal controls, including theenhancement of our systems and procedures. Specifically, we are enhancing and formalizing our period-end closingprocesses to ensure that all significant elements of our financial statementsare adequately reviewed.

 

Anycontrol system, no matter how well conceived and operated, can provide onlyreasonable, not absolute, assurance that the objectives of the control systemare met.  The design of a control systeminherently has limitations, and the benefits of controls must be weighedagainst their costs.  Additionally,controls can be circumvented by the individual acts of some persons, bycollusion of two or more 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.

 

**ITEM 9B.****               OTHERINFORMATION – None**

 

45

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**PART III**

 

**ITEM 10.****               DIRECTORSAND EXECUTIVE OFFICERS OF THE REGISTRANT**

 

Information regarding directors and executive officers of the Companyis set forth under the headings “Nominees” and “Information Concerning Officersand Key Employees Who Are Not Directors” and “Section 16 (a) BeneficialOwnership Reporting Compliance” in our Proxy Statement for our 2005 AnnualMeeting of Shareholders to be held May 5, 2005, and is incorporated herein byreference.

 

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

 

Information regarding executive compensation is set forth under theheadings “Executive Compensation” and “Stock Options Granted and Exercised inLast Fiscal Year” in our Proxy Statement for our 2005 Annual Meeting ofShareholders to be held May 5, 2005, and is incorporated herein by reference.

 

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

 

Information regarding security ownership of certain beneficial ownersand management is set forth under the heading “Common Stock Ownership” in ourProxy Statement for our 2005 Annual Meeting of Shareholders to be held May 5,2005, and is incorporated herein by reference.

 

The following table gives aggregate information under our equitycompensation plans as of January 1, 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         |       | 352,000                                                                                             |       | $                                                                                   | 2.09       |                                                                                                                                       | 257,000    |   |
| Equity  compensation plans not approved by stockholders (1) |       | 5,000                                                                                               |       | $                                                                                   | 0.63       |                                                                                                                                       | N/A        |   |
| Total                                                       |       | 357,000                                                                                             |       | $                                                                                   | 2.07       |                                                                                                                                       | 257,000    |   |

 

----

(1)    SeeNote 8 regarding warrants issued for financing or services.

 

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

 

Information regarding certain relationships and related transactions isset forth under the headings “Nominees” and “Information Concerning Officersand Key Employees Who Are Not Directors” and “Certain Relationships and Transactions”in our Proxy Statement for our 2005 Annual Meeting of Shareholders to be heldMay 5, 2005, and is incorporated herein by reference.

 

46

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**ITEM 14.****               PRINCIPALACCOUNTANT FEES AND SERVICES**

 

Information regarding principal accountant fees and services is setforth under the heading “Fees Paid to Auditors by the Company During MostRecent Fiscal Years” in our Proxy Statement for our 2005 Annual Meeting ofShareholders to be held May 5, 2005, and is incorporated herein by reference.

 

**PART IV**

 

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

 

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

 

**1.****             FinancialStatements**

 

See Index to Financial Statements under Item8 of this report.

 

**2.****             FinancialStatement Schedule**

 

To the Board of Directors

Appliance Recycling Centers of America, Inc.

Minneapolis, Minnesota

 

Our audits were conducted in accordance with the standardsof the Public Company Accounting Oversight Board (United States) and were madefor the purpose of forming an opinion on the basic consolidated financialstatements of Appliance Recycling Centers of America, Inc. and Subsidiariestaken as a whole.  The supplemental Schedule IIis presented for purposes of complying with the Securities and ExchangeCommission’s rules and is not a part of the basic consolidated financialstatements.  This schedule has beensubjected to the auditing procedures applied in our audits of the basicconsolidated financial statements and in our opinion, is fairly stated in allmaterial respects in relation to the basic consolidated financial statementstaken as a whole.

 
|   |   | McGLADREY & PULLEN, LLP |
|--------|--------|-----------------------------|

 

 

Minneapolis, Minnesota

February 18, 2005, except for Note 3 asto which the date is March 15, 2005.

 

47

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Schedule II- Valuation and Qualifying Accounts

 
| ** **                         | ** ** | **Accounts Receivable  Allowance** | ** **  | **Inventory  Allowance** | ** ** |
|------------------------------------|------------|------------------------------------|-------------|--------------------------|------------|
| Balance, December 29,  2001   |       | $                                  | 100,000     |                     | $          | 464,000 |   |
| Additional  allowance/adjustments  |       | (35,000                            | )           | 265,000                  |       |
| Write-offs                         |       | (39,000                            | )           | (181,000                 | )          |
| Balance, December 28,  2002   |       | $                                  | 26,000      |                     | $          | 548,000 |   |
| Additional  allowance/adjustments  |       | 100,000                            |        | 148,000                  |       |
| Write-offs                         |       | (9,000                             | )           | (372,000                 | )          |
| Balance, January 3,  2004     |       | $                                  | 117,000     |                     | $          | 324,000 |   |
| Additional  allowance/adjustments  |       | $                                  | 228,000     |                     | $          | 258,000 |   |
| Writeoffs                          |       | (243,000                           | )           | (197,000                 | )          |
| **Balance,  January 1, 2005** | ** ** | **$**                              | **102,000** | ** **               | **$**      | **385,000** | ** ** |

 

**3.****             Exhibits**

 

See Index toExhibits on page 47 of this report.

 

48

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**SIGNATURES**

 

Pursuant to the requirements of Section 13 or Section 15(d)of the Securities Exchange Act of 1934, the Registrant has duly caused thisReport to be signed on our behalf by the undersigned, thereunto dulyauthorized.

 
| Dated: March 21, 2005 |   | 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 of the Securities Exchange Act of 1934,this Report has been signed by the following persons on behalf of theRegistrant and in the capacities and on the dates indicated.

 
| **Signature**         | ** ** | **Title**               | ** **                           | **Date** |
|-----------------------|------------|-------------------------|--------------------------------------|----------|
|                  |       |                    |                                 |     |
| /s/ Edward R. Cameron |       |                    | Chairman of the Board, President and |     | March 21, 2005 |
| Edward R. Cameron     |       | Chief Executive Officer |                                 |     |
|                  |       |                    |                                 |     |
| /s/ Linda A. Koenig   |       |                    | Chief Financial Officer              |     | March 21, 2005 |
| Linda A. Koenig       |       |                    |                                 |     |
|                  |       |                    |                                 |     |
| /s/ Duane S. Carlson  |       |                    | Director                             |     | March 21, 2005 |
| Duane S. Carlson      |       |                    |                                 |     |
|                  |       |                    |                                 |     |
| /s/ Harry W. Spell    |       |                    | Director                             |     | March 21, 2005 |
| Harry W. Spell        |       |                    |                                 |     |

 

49

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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].         |

 

50

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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].                                                             |

 

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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].                                                          |

 

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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 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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*      Itemsthat are management contracts or compensatory plans or arrangements required tobe filed as an exhibit pursuant to Item 14(a)3 of this Form 10-K.

+      Filedherewith.

 

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