** **

**UNITED STATESSECURITIES AND EXCHANGE COMMISSION**

**Washington, D.C. 20549**

 

**FORM 10-K**

 

**x AnnualReport Pursuant to Section 13 or 15(d)**

**of the Securities Exchange Actof 1934**

**For the fiscal year ended December 29, 2007**

** **

**or**

 

**o TransitionReport Pursuant to Section 13 or 15(d)**

**of the Securities Exchange Actof 1934**

** **

**Commission File No. 0-19621**

 

**APPLIANCE RECYCLING CENTERS OFAMERICA, INC.**

(Exact name of registrant as 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 telephone number, including area code:  **952-930-9000**

 

Securities registered pursuant to Section 12(b) of the Act:

 

| **Common Stock, without par value** | ** ** | **NASDAQ Capital Market**                 |
|-------------------------------------|------------|-------------------------------------------|
| Title of each class                 |       | Name of each exchange on which registered |

 

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

** **

Indicate by check mark ifthe registrant is a well-known seasoned issuer, as defined in Rule 405 ofthe Securities Act.

o Yes  x No

 

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

 

Indicate by check markwhether the registrant (1) has filed all reports required to be filed by Section 13or 15(d) of the Securities Exchange Act of 1934 during the preceding 12months (or for such shorter period that the registrant was required to filesuch reports) and (2) has been subject to such filing requirements for thepast 90 days.

x Yes  o No

 

Indicate by checkmark if disclosure of delinquent filers pursuant to Item 405 of Regulation S-Kis not contained 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

 

Indicate by check markwhether the registrant is a large accelerated filer, an accelerated filer, anon-accelerated filer, or a smaller reporting company. See definition of “largeaccelerated filer”, “accelerated filer” and “smaller reporting company” in Rule 12b-2of the Exchange Act. (Check one):

 
| Large accelerated  filer   o                                                                     | Accelerated  filer   o         |
|------------------------------------------------------------------------------------------------------------|------------------------------------------|
|                                                                                                       |                                     |
| Non-accelerated  filer   o    (Do not check  if a smaller reporting company) | Smaller reporting  company   x |

 

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

 

The aggregate marketvalue of the voting and non-voting common equity held by non-affiliates of theregistrant, based on the closing price of $4.20 per share, as of June 30,2007 (the last business day of the registrant’s most recently completed secondfiscal quarter) was $18,390,863.

 

As of March 14,2008, there were outstanding 4,509,277 shares of the registrant’s Common Stock,without par value.

 

**DOCUMENTS INCORPORATED BY REFERENCE**

 

Portionsof the registrant’s definitive Proxy Statement for its 2008 Annual Meeting ofShareholders to be held on May 15, 2008 are incorporated by reference intoPart III hereof.

 

 

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**TABLE OF CONTENTS**

 
| ** **            | ** ** | ** **                                                                                          | **Page**   |
|-----------------------|------------|-----------------------------------------------------------------------------------------------------|------------|
| ** **            | ** ** | ** **                                                                                          | ** ** |
|                  |       | **PART I**                                                                                     |       |
|                  |       |                                                                                                |       |
| Item  1.              |       | Business                                                                                            | 3          |
|                  |       | General                                                                                             | 3          |
|                  |       | Industry  Background                                                                                | 3          |
|                  |       | Company Background                                                                                  | 4          |
|                  |       | Customers and Source of Supply                                                                      | 8          |
|                  |       | Company Operations                                                                                  | 9          |
|                  |       | Principal  Products and Services                                                                    | 10         |
|                  |       | Sales  and Marketing                                                                                | 10         |
|                  |       | Seasonality                                                                                         | 11         |
|                  |       | Competition                                                                                         | 11         |
|                  |       | Government  Regulation                                                                              | 11         |
|                  |       | Employees                                                                                           | 12         |
| Item 1A.              |       | Risk  Factors                                                                                       | 12         |
| Item 1B.              |       | Unresolved  Staff Comments                                                                          | 17         |
| Item 2.               |       | Properties                                                                                          | 17         |
| Item 3.               |       | Legal Proceedings                                                                                   | 18         |
| Item 4.               |       | Submission  of Matters to a Vote of Security Holders                                                | 18         |
|                  |       |                                                                                                |       |
|                  |       | **PART II**                                                                                    |       |
|                  |       | ** **                                                                                          |       |
| Item 5.               |       | Market for  Our Common Equity, Related Shareholder Matters andIssuer Purchases of Equity Securities | 18         |
| Item 6.               |       | Selected Financial  Data                                                                            | 20         |
| Item 7.               |       | Management’s  Discussion and Analysis of Financial Condition and Results of Operations         | 21         |
| Item 7A.              |       | Quantitative and Qualitative Disclosures About Market  Risk                                         | 28         |
| Item 8.               |       | Financial  Statements and Supplementary Data                                                        | 29         |
| Item 9.               |       | Changes in  and Disagreements With Accountants on Accounting and Financial Disclosure               | 51         |
| Item 9A.              |       | Controls and  Procedures                                                                            | 51         |
| Item 9B.              |       | Other Information                                                                                   | 52         |
|                  |       |                                                                                                |       |
|                  |       | **PART III**                                                                                   |       |
|                  |       |                                                                                                |       |
| Item 10.              |       | Directors,  Executive Officers, and Corporate Governance                                            | 52         |
| Item 11.              |       | Executive Compensation                                                                              | 53         |
| Item 12.              |       | Security  Ownership of Certain Beneficial Owners and Management and Related Stockholder  Matters    | 53         |
| Item 13.              |       | Certain  Relationships and Related Transactions and Director Independence                           | 53         |
| Item 14.              |       | Principal  Accounting Fees and Services                                                             | 53         |
|                  |       |                                                                                                |       |
|                  |       | **PART IV**                                                                                    |       |
|                  |       |                                                                                                |       |
| Item 15.              |       | Exhibits and  Financial Statement Schedules                                                         | 54         |
|                  |       |                                                                                                |       |
| **SIGNATURES**        | 55         |
| **INDEX TO EXHIBITS** | 56         |

 

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**PART I**

 

**ITEM 1.**** ****               ****BUSINESS**

 

**General**

 

We are a leading retailer and recycler of major householdappliances.  We generate revenues from:

 

1.     Retailsales of appliances at our ApplianceSmart® factory outlets.

2.     Feescharged for collecting and recycling appliances for utilities and othercompanies.

3.     Sellingmaterials from the appliances that we collect and recycle, including appliancesfrom our ApplianceSmart factory outlets.

 

We were incorporated inMinnesota in 1983, although through our predecessors we began our applianceretail and recycling business in 1976. Our principal office is located at 7400 Excelsior Boulevard,Minneapolis, Minnesota 55426-4517. References herein to our company include our operatingsubsidiaries.  (See Exhibit 21.1.)

 

**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       |

 

Disposing of these appliances can create severalproblems:

 

1.     Manyareas have decreasing landfill capacity and bulky appliances take up valuablespace.

2.     Manyappliances contain materials that are harmful to the environment.  To prevent air, water and ground pollution,these appliances must be processed to remove the hazardous materials before theremainder of the appliance can be disposed of.

3.     Alternativesto landfills that will accept appliances for disposal, such as incinerators,may not have the capability to process the appliances to remove hazardoussubstances.

 

Many types of major appliances contain components withsubstances that damage the environment, including:

 

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

2.     Mercury,which is toxic to humans.  Mercury canenter the body through inhalation, absorption through the skin, oringestion.  At high temperatures, mercuryvaporizes to form extremely poisonous fumes. Freezers and washers may have mercury-containing switches in their lids.

3.     CFCs(chlorofluorocarbons), and hydrochlorofluorocarbons (HCFCs),which cause long-termdamage to the earth’s ozone layer and may contribute to global climatechange.Refrigeration appliances commonly contain CFC or HCFC refrigerants.

 

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4.     Othermaterials, such as oil and sulfur dioxide, that are harmful when released intothe environment.

 

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

 

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

 

Many electric utility companies sponsor programs toencourage their residential customers to retire working,  energy inefficient appliances.  Utility companies often provide assistanceand incentives for consumers to replace their old, inefficient appliances withnewer, more efficient models.  They alsopromote the removal of surplus appliances to customers who operate more thanone refrigerator, freezer or room air conditioner.  Additional appliances contributesignificantly to residential energy use and peak demand.

 

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

 

**Company Background**

 

We started our business in 1976 as a used-applianceretailer.  We had contracts with nationaland regional retailers of new appliances, such as Sears and MontgomeryWard.  When one of their stores sold anew appliance in the Minneapolis/St. Paul, Miami or Atlanta market, wecollected the old appliance from the customer’s residence.  Our technicians reconditioned most of thecollected appliances to sell at our own stores, and we sold the appliances thatwere not suitable for sale to scrap metal processors.

 

In the late 1980s, stricter environmental regulationsbegan to affect the disposal of unwanted appliances, and we were no longer ableto take appliances that contained hazardous components to a metal processor.  At that time, we began to develop systems andequipment to remove the harmful materials so that metal processors would acceptthe appliance shells for processing.

 

We then offered our services for disposing of appliancesin an environmentally sound manner to appliance manufacturers and retailers,waste hauling companies, rental property managers, local governments and thepublic.

 

***Appliance Recycling for Utilities***

 

In 1989, we added a new customer group when we opened anappliance processing and recycling center in Milwaukee, Wisconsin, to serve amajor electric utility company.  Theconcept of permanently removing operating, energy-inefficient appliances fromuse through a utility-sponsored energy efficiency program proved successful,and we began to focus our resources on expanding our business with electricutilities.  From 1989 to 1994, we openednine centers that served primarily seventeen utility companies.

 

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

 

However, when California faced an energy crisis in thelate 1990s, the California Public Utilities Commission (CPUC) directed one ofour customers, Southern California Edison Company (Edison), to implement astatewide appliance recycling program (Summer Initiative).  The Summer Initiative, which began in September 2000,was available to utility customers in the service areas of Pacific Gas &Electric (PG&E), primarily the San Francisco Bay area, and San Diego Gas &Electric (SDG&E).  We developed andmanaged the program advertising, scheduled collection appointments when theircustomers called, picked up the appliances, and processed and recycled theunits.

 

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

 

1.     TheAppliance Early Retirement and Recycling Program, which ran from June 2001until August 2002.  We providedservices, including advertising, for utility customers in the San Diego area, asix-county region in California’s Central Valley, and the seven-county BayArea.

2.     The 2003 StatewideResidential Appliance Recycling Program, which was available to qualifyingcustomers in the service territories of Edison and SDG&E through December 2003.  We had been working under an extension of the2002 contract until signing a new contract in September 2003.

3.     The 2004-2005 ResidentialAppliance Recycling Program sponsored by Edison for customers in their serviceterritory.

4.     The 2004 Appliance RecyclingProgram for customers of SDG&E, which was extended through 2005.

 

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

 

1.     A contract with Edison tohandle refrigerator and freezer recycling operations for Edison’s 2006-2008Appliance Recycling Program, covering substantially the same southern andcentral California territories that we handled under Edison’s 2004-2005program.  The contract runs through March 2009.Since the new contract was not finalized by year-end 2005, we had continued toprovide services for Edison under terms of the prior program.  Edison is responsible for advertising theprogram.

2.     A contract with SDG&E toprovide refrigerator, freezer and room air conditioner recycling servicesthrough December 2008 for their residential and small commercialcustomers.  Under terms of thisagreement, we are responsible for advertising the program.

3.     A contract for recycling theold, inefficient but working refrigerators and freezers of customers served bythe Sacramento Municipal Utility District (SMUD).  The initial term of the contract was from June 2006through December 2006, and was subsequently extended through June 2007.  We were responsible for advertising thisprogram.

 

InApril of 2007, we announced the expansion of our contract with theSouthern California Public Power Authority to include the Los AngelesDepartment of Water and Power for which sponsored a program to replace andrecycle 50,000 old, inefficient refrigerators owned by low income residents in thecity.  The contract is for 12 months.

 

Since2004, electric utilities in of the U.S. have also awarded us contracts:

 

1.     In December 2004, wereached an agreement with Wisconsin Public Power Inc. (WPPI) to provideappliance recycling services through December 2005.  The contract was initially extended through2006 and has been extended again through December 2007.  WPPI is a regional power company 

 

5

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owned by 40 municipalities that operate electric utilities.  They supply power to 154,000 homes andbusinesses throughout Wisconsin.  WPPI isresponsible for advertising this program.

2.     Also in December 2004,we entered into an agreement with Austin Energy in Texas to manage appliancerecycling operations in their service territory during 2005.  The contract was initially extended through2006 and has been extended again until December 2008.  The City of Austin has granted Austin Energythe option to renew the program annually through 2008.  In 2008, a refrigerator recycling program wasalso started with this utility.  AustinEnergy is the nation’s tenth largest community-owned electric utility, serving360,000 customers within the City of Austin and surrounding counties.  To support this program, we opened anappliance recycling facility in Austin. Austin Energy is responsible for advertising this program.

3.**    **In March 2006, weentered into an agreement with Wisconsin Energy Conservation Corporation (WECC)to provide appliance recycling services through June 2008.  WECC administers and implements theresidential components of the State of Wisconsin’s Focus on Energy, a public-privatepartnership offering energy information and services to customers throughoutthe state.  We are currently working withWECC to renew this contract.

4.     In June of 2007, we announced acontract with the Ontario Power Authority in Ontario, Canada to recyclerefrigerators, freezers, and room air conditioners.  This contract runs through the end of 2010.

 

Wehave seen a renewed interest from utilities in appliance recyclingenergy-efficiency programs. We will continue to aggressively pursue thatsegment of customers in 2008 and  weexpect that we will propose on various new public utility appliance recyclingprograms. However, we still have a limited ability to project revenues fromutility programs in 2008.

 

***Retail Sales; Reverse LogisticsPrograms***

 

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

 

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

 

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

 

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

 

·      Closeouts

·      Floor samples

·      Returned orexchanged items

·      Factoryoverruns

·      Scratch anddent

·      Open carton

 

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

 

Inthe late 1990s, we began to design reverse logistics programs for majorappliance manufacturers.  In 1997, webegan providing reverse logistics services for Whirlpool Corporation, the world’sleading 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.

 

We began selling these special-buy appliances in our network ofApplianceSmart factory outlets.  With anincreased supply of product, we started to focus on opening larger stores tooffer consumers a wider product selection. We also began to close our smaller stores and decided not to expand ourused appliance business.

 

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

 

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

 

1.     We have no guarantees forthe number or type of appliances that we will be able to purchase.

2.     The agreement may beterminated by either party with thirty days’ prior written notice.

3.     We have agreed to indemnifyWhirlpool for certain claims, allegations or losses concerning the Whirlpoolappliances we sell.

 

InOctober 2001, we entered into an agreement with Maytag Corporation topurchase special-buy appliances.  Underthe Maytag agreement:

 

1.     We have no minimum purchaserequirements.

2.     The agreement may beterminated by either party with 60 days’ written notice.

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

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

 

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

 

Wehave also entered into contracts with three other major manufacturers:

 

1.     In December 2001, webegan carrying a full line of Frigidaire appliances at all ApplianceSmartfactory outlets.

2.     In January 2003, weentered into a contract with GE Consumer Products to purchase and sellspecial-buy GE appliances.

3.     In March 2007, wesigned an agreement to carry appliances manufactured by Danby.

 

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

 

7

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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.

 

During the second quarter of 2003, we became amajority (60%) owner in North America Appliance Company, LLC (NAACO).  NAACO was formed and commenced operations in June 2003and is a retailer of special-buy appliances in Texas.  Because NAACO has a net shareholders’deficit, no minority interest has been recognized on our consolidated balancesheet, and 100% of NAACO’s operations are included in our consolidatedfinancial statements for the years of 2007 and 2006.

 

On September 1, 2006, we became a majority(60%) owner in Productos Duraderos de Norte America (PDN), a MexicanCorporation in exchange for $3,000 in cash. PDN refurbishes household window air conditioners for sale through ourNAACO operation in McAllen, Texas and through our ApplianceSmart outletstores.  Since PDN has operated at a losssince September 1, 2006, 100% of PDN’s operations are included in ourconsolidated financial statements.

 

In 2006 we established ARCA Canada Incorporatedas a wholly owned subsidiary.  ARCACanada’s results are included in our consolidated financial statements.

 

***Growth Strategy***

 

Larger factory outlet facilities offerconsumers a wider selection of appliances than smaller stores do and are moreefficient for us to operate.  For thesereasons, we intend to continue to focus our retail sales operations on largerfacilities.  We would consider openingnew stores primarily in markets in which we currently have operations, foradditional operational and marketing efficiencies of scale.  However, we will study other major consumermarkets throughout the United States with the possibility of expanding ourretail stores to new markets. We evaluate demographic, economic and financialinformation when considering a new store location as well as the facility andproposed lease terms.

 

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

 

**Customers and Source of Supply**

 

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

 

For many years, we provided collection and recyclingservices for waste haulers, vending machine companies, residential propertymanagers and the general public for specified fees.  We have phased out this aspect of ourbusiness to focus on reverse logistics, retail sales and energy conservationprograms.

 

***Retailers of New Appliances******:***  We began our business by offering services toSears and other retailers of new appliances. When a consumer purchased a new appliance, we collected the replacedappliance from the customer’s home or the retailer’s facility.  These appliances were our source of supplyfor our used appliance business, which we have since discontinued.

 

We continue to work with new-appliance retailers tomanage units that customers have returned and other appliances that theretailer cannot sell as new in-the-carton product.  We expect to continue to investigate thispotential revenue stream further for opportunities.

 

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***Appliance Manufacturers:***  We now work with appliancemanufacturers, including Whirlpool, Frigidaire, GE and Danby to acquire theproduct we sell at our ApplianceSmart retail stores.  We purchase special-buy appliances, such asdiscontinued models and factory overruns, and sell the product at a significantdiscount 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.

 

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

 

***Electric Utility Companies:***  We contract with utilitycompanies to provide a full range of appliance recycling services to supporttheir energy conservation programs.  Thecontracts usually have terms of one to four years, with provisions for renewalat the option of the utility.  Under somecontracts, we manage all aspects of the utility’s appliance recyclingprogram.  Under other contracts, weprovide only specified services, such as collection and recycling.

 

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

 

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

 

1.     Totalnumber of appliances processed.

2.     Lengthof the contract term.

3.     Specificservices the utility selects us to provide.

4.     Marketfactors, including labor rates and transportation costs.

 

Currently, we have contracts for 2008 with the followingutilities to handle recycling operations in their service territories:

 

1.     SouthernCalifornia Edison

2.     SanDiego Gas & Electric

3.     WisconsinPublic Power

4.     AustinEnergy

5.     WisconsinEnergy Conservation Corporation

6.     SouthernCalifornia Public Power Authority

7.     OntarioPower Authority

8.     Severalother 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 forelectric utility companies to collect and recycle appliances turned in throughtheir energy-efficiency programs.

 

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

 

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

 

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

 

Althoughthe potential of industry deregulation negatively affected our business withelectric utilities in the middle to late 1990s, we are seeing renewed interestin appliance recycling energy-efficiency programs.  We enter 2008 serving seven major utilityprograms and several smaller ones.  Weare aggressively pursuing additional utility customers, but still have alimited ability to project revenues from utility programs in 2008.

 

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

 

**Principal Products and Services**

 

We generate revenues from three sources: retailing, recycling andbyproduct.  The table below reflects thepercentage of total revenues from each source for the past three fiscalyears.  See also “Management’s Discussionand Analysis of Financial Condition and Results of Operations.”

 
| **Revenues:** | ** ** | **2007**  | ** ** | **2006** | ** ** |
|---------------|------------|-----------|------------|----------|------------|
| Retail        | ** ** | **72.4**  | **%**      | 84.2     | %          |
| Recycling     | ** ** | **25.0**  | **%**      | 13.3     | %          |
| Byproduct     | ** ** | **2.6**   | **%**      | 2.5      | %          |
| ** **    |       | **100.0** | **%**      | 100.0    | %          |

 

During fiscal2007, we operated two reportable segments: Retail and Recycling.  The retail segment is comprised of salesgenerated through our ApplianceSmart factory outlet stores.  Our Recycling segment includes all feescharged for collecting, recycling, and installing appliances for utilities andother customers and includes byproduct revenue which is primarily generatedthrough the recycling of appliances. Financial information about our segments is included in Item 7,Management’s Discussion and Analysis of Financial Condition and Results ofOperations, and Note 9 to the Consolidated Financial Statements.

 

**Sales and Marketing**

 

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

 

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

 

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

 

**Seasonality**

 

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

 

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

 

**Competition**

** **

Our retail competition comes mainly from new-applianceand other special-buy retailers.  EachApplianceSmart outlet competes with local and national chains of new-appliancedealers, as well as with independently owned appliance retailers.  Many of these retailers have been in businesslonger than we have and may have significantly greater assets.

 

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

 

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

 

1.     Existing recycling companies.

2.     Entrepreneurs entering the appliance recyclingbusiness.

3.     Energy management consultants.

4.     Major waste hauling companies.

5.     Scrap metal processors.

 

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

 

**Government Regulation**

 

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

 

The many laws and regulations that affect appliancerecycling include landfill disposal restrictions, hazardous waste managementrequirements and air quality standards. Each of our recycling facilities maintains the appropriateregistrations, permits and licenses for operating at its location.

 

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

 

11

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

 

In 2004, the EPA awarded us, along with SouthernCalifornia Edison, the Stratospheric Ozone Protection Award for theenvironmentally responsible manner in which we collect and dispose ofappliances.

 

In 2007 we became a founding reporter of The ClimateRegistry, an organization that provides information regarding the measurementand reporting of green house gas emissions to various governmental and privateagencies and businesses.

 

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

 

In 1992, Congress adopted the Energy Policy Act of 1992to encourage energy efficiency.  This actestablishes, among other things:

 

1.     Mandatory energy performance standards for newmajor household appliances.

2.     The option for individual states to deregulatetheir energy providers, including electric utilities.

 

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

 

Although we believe that further governmental regulationof the appliance recycling industry could have a positive effect on us, wecannot foretell the direction of future legislation.  Under some circumstances, for example,further regulation could materially increase our operational costs.  In addition, under some circumstances we maybe subject to contingent liabilities because we handle hazardous materials.

 

**Employees**

 

AtMarch 1, 2008 we had 411 full-time employees, distributed approximately asfollows:

 

1.     29% of our employeesprovide appliance collection, transportation and processing services at ourrecycling centers.

2.     37% work in retail sales.

3.     34% 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 1A.****              ****RISK FACTORS**

 

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

 

12

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**RisksRelated to ARCA**

 

***Our strategy of opening new retail stores has resulted in net losses inrecent periods.***

 

Ourprimary growth strategy is to open new retail stores.  We evaluate demographic, economic andfinancial information in considering a new store location.  We look primarily in markets where wecurrently have operations, for additional operational and marketingefficiencies of scale.  New stores taketime to become profitable; we cannot assure you that any individual current orfuture store will attain or maintain projected profitability.  We earned net income of $2,539,000 or $0.58 and$0.57 per basic and diluted share respectively for fiscal year 2007 and a netloss of $1,409,000 or $0.33 per share for fiscal year 2006.  We have seen significant improvement in ourretail segment as our stores become established.  As illustrated in Note 9 to the financialstatements, operating income from the retail segment was $2,320,000 in 2007compared to a loss of $3,000,000 in 2006. Our full financial information is setout in the financial statements and related notes and “Management’s Discussionand Analysis of Financial Condition and Results of Operations.”

 

***Most of our revenues are derived from retail sales.  We expect this dependence on retail sales tocontinue in the future.***

 

Mostof our revenues are derived from retail sales of appliances from ourApplianceSmart retail stores. We currently operate fifteen ApplianceSmartstores.  Retail revenues have lowerprofit margins than recycling revenues. While we believe that our future economic results will be heavilydependent on our retail stores, we have seen a renewed interest in recyclingprograms.  In fiscal 2006 and 2007,approximately 84% and 72%, respectively, of our revenues were from retailsales.

 

***We currently purchase product for resale from a limited number ofsuppliers.***

 

Wepurchase inventory for resale from three main suppliers.  While we believe that our relationship withour vendors is strong, the loss of one of these suppliers could have a negativeimpact on the amount and mix of product that we would be able to offer forresale, which could adversely affect our net revenues and profitablility.

 

***Our revenues from recycling contracts increased in 2007, but futurerevenues from this source are very difficult to project.***

 

Inthe past, our business was dependent largely upon our ability to obtain newcontracts and continue existing contracts for appliance recycling services withutility companies.  Contracts with theseentities generally have initial terms of one to four years, with renewaloptions and early termination clauses. The recycling and byproducts portion of our business diminished fromapproximately 50% of total revenues in fiscal 2001 to 15.8% of total revenuesin fiscal 2006, but rebounded to 27.6% in 2007. This is partially due toincreased awareness of environmental and energy conservation issues.  However, we are still dependent on certaincustomers for a large portion of our revenues. Generally, recycling revenues have a higher gross profit than retailrevenues.

 

Ourthree major utility customers, Southern California Edison Company (Edison), theOntario Power Authority, and the Southern California Public Power Authority,accounted for approximately 21% of revenues for 2007.  In 2006, our major customer, Edison,accounted for approximately 11% of our revenues.  The loss or material reduction of businessfrom any of these major customers could adversely affect our net revenues andprofitability.

 

13

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Wecannot assure you that our existing recycling contracts will be continued or renewed,that existing customers, including Edison, will continue to use our services atcurrent levels, or that we will be successful in obtaining new recyclingcontracts.

 

***Our revenues from recycling contracts are subject to seasonalfluctuations and are dependent on the utilities’ advertising and promotionalactivities for contracts in which we do not provide advertising services.***

 

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

 

***We may need new capital to fully execute our growth strategy.***

 

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

 

Ourtotal capital requirements will depend, among the other things discussed inthis annual report, on the number of recycling centers and the number and sizeof retail stores operating during 2008. Currently, we have fifteen retail stores and four recycling centers inoperation.  If our revenues are lowerthan anticipated or our expenses are higher than anticipated or our currentline of credit cannot be maintained, we will require additional capital tofinance our operations.  Even if we areable to maintain our current line of credit, we may need additional equity orother capital in the future.  Sources ofadditional financing, if needed in the future, may include further debtfinancing or the sale of equity (including the issuance of preferred stock) orother securities.  We cannot assure youthat any additional sources of financing or new capital will be available tous, or available on acceptable terms, or permitted by the terms of our currentdebt.  In addition, if we sell additionalequity to raise funds, all outstanding shares of Common Stock will be diluted.

 

***A decline in general economic conditions could lead to reduced consumerdemand for our products and have an adverse effect on our liquidity andprofitability.***

 

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

 

***Our market share may be adversely impacted at any time by a significantnumber of competitors.***

 

Competitionfor our retail stores comes primarily from retailers of new and special-buyappliances.  Each of our locations willcompete not only with local and national chains of new appliance retailers,many of whom have been in business longer than we have and who may havesignificantly greater assets, but will also be required to compete withnumerous independently owned retailers of used appliances.  A number of our retail operations 

 

14

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havebeen opened within the past 24 months; therefore, we cannot assure you that wewill be able to compete effectively in any such market.

 

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

 

***Changes in governmental regulations relating to our recycling businesscould increase our costs of operations and adversely affect our business.***

 

Ourappliance recycling centers are subject to various federal, state and locallaws, regulations and licensing requirements related to the collection, processingand recycling of household appliances. These requirements may vary by market location and include, for example,laws concerning the management of hazardous materials and the 1990 Amendmentsto the Clean Air Act, which require us to recapture CFC refrigerants fromappliances to prevent their release into the atmosphere.

 

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

 

In1992, Congress adopted the Federal Energy Policy Act of 1992 to encourageenergy efficiency.  One component of thisAct allows for deregulation of the nation’s energy providers, including theelectric utility industry.  The immediateimpact of the potential of industry deregulation caused utility companiesacross the U.S. to suspend their plans for implementing appliance recyclingprograms like ours.

 

***Our lender has the right to demand payment in full of the borrowings underour line of credit at any time.  If itwere to do so, we would not be able to pursue our growth strategy and ouroperations would be severely limited unless and until new financing wasobtained.***

 

Wehave an $18.0 million line ofcredit, based on the loan amendment dated February 5, 2008, with a statedmaturity date of December 31,2010.  The line of credit alsoprovides that the lender may demand payment in full of the entire outstandingbalance of the loan at any time.  We havepledged substantially all our assets to secure payments under the line.  The line requires that we meet certainfinancial covenants, provides payment penalties for noncompliance andprepayment, limits the amount of other debt we can incur, limits the amount ofspending on fixed assets, and limits payments of dividends.  At March 13, 2008, borrowings of $8,892,000 were outstanding under theline of credit, and we had unused borrowing capacity of $2,890,000

 

***We may not be able to operate successfully if we lose key personnel,are unable to hire qualified personnel, or experience turnover of ourmanagement team.***

 

Webelieve our operations are materially dependent upon the continued services ofour present management.  The loss ofservices of one or more members of present management, including Edward R.(Jack) Cameron, our founder, Chairman of the Board and current CEO, couldadversely affect our business.  We do nothave 

 

15

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employmentcontracts with present management.  Wemaintain key person insurance on the life of Mr. Cameron in the amount of$1,000,000.

 

***We have initiated litigation surrounding intellectual property issuesand have successfully avoided  a claim ofinfringement in a second law suit.***

 

InDecember 2004, we filed suit in the U.S. District Court for the CentralDistrict of California alleging that JACO Environmental, Inc. and one ofour former consultants fraudulently obtained a patent (U.S. Patent No. 6,732,416)in May 2004 covering appliance recycling methods and systems originallydeveloped by us beginning in 1987 and used in serving more than forty-fiveelectric utility appliance recycling programs since that time.  We are seeking a permanent injunction barringJACO from using the patent to market JACO’s recycling services, due to ourbelief that the patent is invalid and unenforceable.  In addition, we are seeking a finding by theCourt that the patent obtained by JACO is unenforceable due to inequitableconduct before the United States Patent Office. We are also asking the court for unspecified damages related to chargesthat JACO, in using the patent to promote its services, has engaged in unfaircompetition and false and misleading advertising under federal and Californiastatutes.

 

Earlyin the litigation the JACO defendants offered to resolve one issue in the caseby promising never to assert the patent against ARCA or any of its customersfor recycling services. Moreover, the defendants in the JACO litigation havenot made a counterclaim against us. Accordingly, there is no risk of an adverseruling in this litigation that would negatively impact our recyclingoperations.

 

On October 24,2006, JACO and SEG Umwelt-Service/Basis of Mettlach, Germany (SEG) filed apatent infringement lawsuit in Federal Court in San Francisco against us.  The suit claimed that we have been usingrefrigerator recycling systems and processes covered by two U.S. patents issuedto SEG and exclusively licensed to JACO. JACO and SEG sought an undisclosed amount in damages, in addition to aninjunction barring us from continuing to use and market the systems andprocesses upon which we allegedly infringed. This suit has been subsequentlydismissed following a transfer of the case to Los Angeles upon the motion ofARCA.

 

**RisksRelated to Our Common Stock**

 

***If an active trading market for our Common Stock does not develop, thevalue and liquidity of your investment in our Common Stock could be adverselyaffected.***

 

Thetrading volumes in our Common Stock on the Nasdaq Capital Market are highly variable.  At any given time, there may be only alimited market for any shares of Common Stock that you purchase.  Sales of substantial amounts of Common Stockinto the public market at the same time could adversely affect the market priceof our Common Stock.

 

***Our principal shareholders own a large percentage of our voting stock,which will allow them to control substantially all matters requiringshareholder approval.***

 

Currently,Edward R. (Jack) Cameron, Chairman and CEO, owns approximately 7.2% of our outstanding shares of CommonStock.  Our officers and directorstogether hold approximately 8.1%,including any options or warrants they may hold.  One of our principal lenders, MedallionCapital, Inc., owns approximately 11%of our outstanding shares.  Medallionalso has a non-voting right to attend and participate in all meetings of ourBoard of Directors.  Perkins CapitalManagement, Inc. beneficially owns approximately 14% of our outstanding shares. Because of such ownership, ourmanagement and principal shareholders may be able to significantly affect ourcorporate decisions, including the election of the Board of Directors.

 

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

 

None.

 

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

 

Ourexecutive offices are located inMinneapolis, Minnesota, in a company-owned facility that includes approximately11 acres of land.  The building containsapproximately 122,000 square feet, consisting of 27,000 square feet of officespace, 71,000 square feet of operations and processing space, and 24,000 squarefeet of retail space as identified below (under “Minneapolis, MN, 1998”).  In March 2006, we entered into apurchase agreement for the sale of this property. This purchase agreement wascancelled in December 2006.  We alsoown and use a building in Compton, California, with 11,000 square feet ofoffice space and 35,000 square feet of warehouse and processing space.

 

We currently operate fifteen retail stores in thefollowing locations:

 
| ** **      | ** ** | ** **       | ** ** | **Retail Space** | ** ** | ** **                                                  | ** ** |     |
|-----------------|------------|------------------|------------|-----------------------|------------|-------------------------------------------------------------|------------|----------|
| **Market**      | ** ** | **Opening Date** | ** ** | **Size (Sq. Ft.)**    | ** ** | ** **                                                  | ** ** |     |
| Minneapolis, MN |       | Jan. 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.)*             | * *   | * * |
| Columbus, OH    |       | Jun. 1997   |       | 20,000                |       |                                                        |       |     |
|            |       | May 2001    |       | 32,000                |       |                                                        |       |     |
|            |       | Mar. 2002   |       | 30,000                |       |                                                        |       |     |
|            |       | Dec. 2007   |       | 30,000                |       |                                                        |       |     |
| Atlanta, GA     |       | Dec. 2003   |       | 30,000                |       |                                                        |       |     |
|            |       | Nov. 2004   | * *   | 30,000                | * *   | *(Also has 58,000 sq. ft. of production/warehouse  space.)* | * *   | * * |
|            |       | Oct. 2006   |       | 27,000                |       |                                                        |       |     |
|            |       | Dec. 2006   |       | 46,000                |       |                                                        |       |     |
| San Antonio, TX |       | Oct. 2004   |       | 36,000                |       |                                                        |       |     |
|            |       | Oct. 2005   |       | 37,000                |       |                                                        |       |     |

 

Weown the facility in which the store that opened in 1998 in Minneapolis islocated.  We also operate a processingand recycling center in this facility. All our other retail stores are located in leased facilities; wegenerally attempt to negotiate lease terms of fiveto ten years for our retail stores.

 

InMarch of 2008 we signed a lease for an additional retail outlet store inthe Minneapolis, MN market.

 

We operate four processing and recycling centers.  One is in the facilities that we own inMinneapolis.  The other three are inleased facilities in Los Angeles, California, Oakville, Ontario, and Austin, Texas. Our recycling centers typically range in size from 25,000 to 40,000 squarefeet.

 

All the facilities we own currently secure outstandingloans.  All of the facilities we occupycurrently are adequate for our future needs.

 

17

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**ITEM 3.****                 LEGAL PROCEEDINGS**

 

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

 

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

 

OnOctober 18, 2006, the U.S. District Court for the Central District ofCalifornia denied the motion for summary judgment filed by JACO to dismiss thesuit.

 

Thecase is scheduled for trial in November of 2008.

 

OnMay 21, 2007, the U.S. District Court for the Central District ofCalifornia dismissed a patent infringement suit brought against us in October 2006by JACO and SEB Umwelt-Service/Basis of Mettlach, Germany (SEG).  The suit claimed that we have been usingrefrigerator recycling systems and processes covered by two U.S. patents issuedto SEG and exclusively licensed to JACO. This suit was dismissed for lack of prosecution and may not bereinstated unless the Court sets aside the dismissal or a new action is filedafter the appropriate pretrial investigation of asserted claims.

 

**ITEM 4.****                 SUBMISSION OF MATTERS TO A VOTE OF SECURITYHOLDERS**

 

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

 

**PART II**

 

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

 

**Market for Common Stock**

 

Our Common Stock, which trades under the symbol “ARCI,” began trading onthe Nasdaq Capital Market on February 22, 2006.  Before that time, the Common Stock was tradedon the OTC Bulletin Board from September 8, 1998 to February 21,2006.  The following table sets forth,for the periods indicated, the high and low prices for our Common Stock, asreported by the Nasdaq Capital Market and the OTC Bulletin Board.  These quotations reflect the daily closeprices.

 

18

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| ** ** | ** ** | ** **     | ** ** | **High** | ** ** | **Low** | ** ** |
|------------|------------|----------------|------------|----------|------------|---------|------------|
| **2007**   |       |           |       |     |       |    |       |
| ** ** |       | First Quarter  |       | $        | 2.76       |    | $          | 2.10 |   |
| ** ** |       | Second Quarter |       | 5.55     |       | 2.20    |       |
| ** ** |       | Third Quarter  |       | 9.40     |       | 4.05    |       |
| ** ** |       | Fourth Quarter |       | 11.00    |       | 6.29    |       |
| **2006**   |       |           |       |     |       |    |       |
| ** ** |       | First Quarter  |       | 6.50     |       | 4.25    |       |
| ** ** |       | Second Quarter |       | 6.50     |       | 2.66    |       |
| ** ** |       | Third Quarter  |       | 3.60     |       | 1.85    |       |
| ** ** |       | Fourth Quarter |       | 2.20     |       | 1.85    |       |
|            |            |                |            |          |            |         |            |  |  |

 

On March 14, 2008, the last reported sale price of the Common Stockon the Nasdaq Capital Market was $6.11 per share.  As of March 14, 2008, there wereapproximately 750 beneficial holders of our Common Stock.

 

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

 

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

 

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**ITEM 6.****                 SELECTEDFINANCIAL DATA**

 

The selected financialinformation set forth below has been derived from our consolidated financialstatements and should be read in conjunction with “Item 7. Management’sDiscussion and Analysis of Financial Condition and Results of Operations forthe Fiscal Years of 2007 and 2006” and “Item 8. Financial Statements andSupplementary Data.”

 
| **Fiscal Years Ended**                              | ** ** | **2007** | ** ** | **2006** | ** ** | **2005** | ** ** | **2004** | ** ** | **2003** | ** ** |
|---------------------------------------------------------------|------------|----------|------------|----------|------------|----------|------------|----------|------------|----------|------------|
| (In thousands,  except per-share data)                        |       |     |       |     |       |     |       |     |       |     |       |
| **Statement  of Operations**                                  |       |     |       |     |       |     |       |     |       |     |       |
| Total revenues                                                |       | $        | 100,765    |     | $          | 77,790   |       | $        | 74,893     |     | $          | 52,830 |   | $ | 43,609 |   |
| Gross profit                                                  |       | $        | 32,769     |     | $          | 23,745   |       | $        | 22,487     |     | $          | 15,543 |   | $ | 11,879 |   |
| Operating income  (loss)                                      |       | $        | 4,206      |     | $          | (1,111   | )          | $        | (150       | )        | $          | (1,103 | ) | $ | (1,776 | ) |
| Net income  (loss)                                            |       | $        | 2,539      |     | $          | (1,409   | )          | $        | (933       | )        | $          | (1,314 | ) | $ | (1,541 | ) |
| Basic income  (loss) per common share                         |       | $        | 0.58       |     | $          | (0.33    | )          | $        | (0.22      | )        | $          | (0.48 | ) | $ | (0.66 | ) |
| Diluted income  (loss) per common share                       |       | $        | 0.57       |     | $          | (0.33    | )          | $        | (0.22      | )        | $          | (0.48 | ) | $ | (0.66 | ) |
| Basic weighted  average number of common shares outstanding   |       | 4,400    |       | 4,335    |       | 4,261    |       | 2,722    |       | 2,343    |       |
| Diluted weighted  average number of common shares outstanding |       | 4,475    |       | 4,335    |       | 4,261    |       | 2,722    |       | 2,343    |       |
|                                                          |       |     |       |     |       |     |       |     |       |     |       |
| **Balance  Sheet**                                            |       |     |       |     |       |     |       |     |       |     |       |
| Working capital                                               |       | $        | 5,126      |     | $          | 3,026    |       | $        | 3,879      |     | $          | 4,600 |   | $ | 3,446 |   |
| Total assets                                                  |       | $        | 35,532     |     | $          | 23,913   |       | $        | 24,491     |     | $          | 24,340 |   | $ | 20,833 |   |
| Long-term  liabilities                                        |       | $        | 5,215      |     | $          | 5,377    |       | $        | 5,216      |     | $          | 5,521 |   | $ | 5,658 |   |
| Shareholders’  equity                                    |       | $        | 7,262      |     | $          | 4,142    |       | $        | 5,421      |     | $          | 6,063 |   | $ | 4,209 |   |

 

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###### QUARTERLY FINANCIAL DATA

 

The following table setsforth certain unaudited quarterly financial data for the eight quarters ended December 29,2007. In our opinion, the unaudited information set forth below has beenprepared on the same basis as the audited information and includes alladjustments necessary to present fairly the information set forth herein. Theoperating results for any quarter are not indicative of results for any futureperiod. All data is in thousands except per-common share data.

 

Fiscal 2007

 
| ** **                                                    | ** ** | **1st Quarter** | ** ** | **2nd Quarter** | ** ** | **3rd Quarter** | ** ** | **4th Quarter** | ** ** |
|---------------------------------------------------------------|------------|----------------------|------------|----------------------|------------|----------------------|------------|----------------------|------------|
| Total revenues                                                |       | $                    | 19,932     |                 | $          | 22,582               |       | $                    | 27,370     |   | $ | 30,881 |   |
| Gross profit                                                  |       | $                    | 6,566      |                 | $          | 7,975                |       | $                    | 9,292      |   | $ | 8,936 |   |
| Net income  (loss)                                            |       | $                    | (472       | )                    | $          | 836                  |       | $                    | 1,404      |   | $ | 771 |   |
| Basic earnings  (loss) per common share                       |       | $                    | (0.11      | )                    | $          | 0.19                 |       | $                    | 0.32       |   | $ | 0.17 |   |
| Diluted earnings  (loss) per common share                     |       | $                    | (0.11      | )                    | $          | 0.19                 |       | $                    | 0.31       |   | $ | 0.17 |   |
|                                                          |       |                 |       |                 |       |                 |       |                 |       |
| Basic weighted  average number of common shares outstanding   |       | 4,341                |       | 4,353                |       | 4,409                |       | 4,495                |       |
| Diluted weighted  average number of common shares outstanding |       | 4,341                |       | 4,426                |       | 4,511                |       | 4,582                |       |

 
| Fiscal 2006 |
|-------------|

 
| ** **                                                    | ** ** | **1st Quarter** | ** ** | **2nd Quarter** | ** ** | **3rd Quarter** | ** ** | **4th Quarter** | ** ** |
|---------------------------------------------------------------|------------|----------------------|------------|----------------------|------------|----------------------|------------|----------------------|------------|
| Total revenues                                                |       | $                    | 17,916     |                 | $          | 19,161               |       | $                    | 20,783     |   | $ | 19,930 |   |
| Gross profit                                                  |       | $                    | 5,224      |                 | $          | 5,678                |       | $                    | 6,715      |   | $ | 5,858 |   |
| Net income  (loss)                                            |       | $                    | (678       | )                    | $          | (461                 | )          | $                    | 21         |   | $ | (291 | ) |
| Basic earnings  (loss) per common share                       |       | $                    | (0.16      | )                    | $          | (0.11                | )          | $                    | 0.01       |   | $ | (0.07 | ) |
| Diluted earnings  (loss) per common share                     |       | $                    | (0.16      | )                    | $          | (0.11                | )          | $                    | 0.01       |   | $ | (0.07 | ) |
|                                                          |       |                 |       |                 |       |                 |       |                 |       |
| Basic weighted  average number of common shares outstanding   |       | 4,322                |       | 4,334                |       | 4,341                |       | 4,341                |       |
| Diluted weighted  average number of common shares outstanding |       | 4,322                |       | 4,334                |       | 4,388                |       | 4,341                |       |

 

**ITEM 7.****                 MANAGEMENT’SDISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS**

 

**OVERVIEW**

 

Our 2007 fiscal year(2007) ended December 29, 2007, and our 2006 fiscal year (2006) ended December 30,2006. The fiscal years of 2007 and 2006 contain 52 weeks.

 

21

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We generate revenues fromthree sources: retail, recycling and byproduct. Retail revenues are sales ofappliances, warranty and service revenue and delivery fees. Recycling revenuesare fees we charge for the disposal of appliances. Byproduct revenues are salesof scrap metal and reclaimed chlorofluorocarbons (CFCs) generated fromprocessed appliances.

 

In 2007 we closed our retail location in Los Angeles and opened afourth retail store in the Columbus, OH market. We currently operate 15 retailstores. Retailrevenues accounted for approximately 72% of total revenues in 2007.

 

We are activelypursuing opportunities to support energy-efficiency programs run by electricutility companies. During 2007, we handled appliance recycling programs for andin the service territories of Southern California Edison (Edison), San DiegoGas & Electric (SDG&E), Austin Energy in Austin, Texas, WisconsinPublic Power, Wisconsin Energy Conservation Corporation, the Ontario PowerAuthority, and the Southern California Public Power Authority.

 

**Critical Accounting Policies andEstimates**

 

Oursignificant accounting policies are summarized in the footnotes to thefinancial statements. Some of the most critical policies are also discussedbelow.

 

**Revenue****recognition:** Werecognize retail revenues when the consumer pays for the appliance with cash,check or credit card. We recognize recycling revenue when we collect andprocess a unit under our recycling contracts. We recognize byproduct revenuewhen we receive payment from the scrap metal processor, and when we ship CFCsto a recycler.

 

Wealso sell extended warranty agreements to consumers who purchase appliancesfrom ApplianceSmart. We retain the obligation to provide warranty service for asmall number of these agreements. In these cases, we collect funds at the timethe consumer purchases the extended warranty agreement and recognize revenueover the term of the warranty contract, which is usually 12 months. For theremaining extended warranty agreements we sell, we are not responsible forservice costs since the third-party service provider is responsible for them. Inthese cases, we recognize revenue at the time of sale, in an amount equal tothe sale price paid by the consumer, less a commission we pay to thethird-party service provider. Revenue from the sale of extended warrantyagreements is included in retail revenues.

 

Weinclude shipping and handling charges to customers in retail revenues, which isrecognized when the delivery has been completed. The shipping and handlingcosts we incur related to shipping and handling charges are included in cost ofrevenues.

 

Theapplication of our revenue recognition policy does not involve significantuncertainties and is not subject to accounting estimates or assumptions havingsignificant sensitivity to change.

 

**Productwarranty:**Our warranty policy states that we will repair or replace defective unitsduring the warranty period at no cost to our customers. We are an authorizedservice provider for Whirlpool, Maytag, Frigidaire and GE. After we provideservice to our customers who purchased an appliance from us, we submit aservice reimbursement claim to the appliance manufacturer to cover the costsincurred. There are a small number of warranties that we offer for which we areresponsible for the cost of the service call. We analyze this informationperiodically to determine what our potential future expense will be and thenrecord a liability. Our product warranty policy contains uncertainties becausemanagement must estimate the potential future expense for service calls notcovered under the authorized service provider agreements with appliancemanufacturers. However, we do not believe the uncertainties relating tomanagement’s estimates would have a material effect on our results ofoperations.

 

22

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

 

**Inventories:** We value our inventories of appliances atthe lower of cost, first-in, first-out (FIFO), or market and establish aninventory reserve, which represents management’s estimate as to therealizability of our appliance inventory. This inventory reserve containsuncertainties since we must make assumptions and apply judgments regardinginventory aging and adjustments to market. In making these assumptions andjudgments, we review historical aging information and margin analyses. Ourestimates and the adequacy of our inventory reserve could be affected bychanges in the market for appliances, including price changes by manufacturers,and such changes could have material effect on our results of operations.

 

**Incometaxes:** Deferred taxassets are reduced by a valuation allowance when, in the opinion of ourmanagement, it is more likely than not that some portion or all of the deferredtax assets will not be realized. In establishing a valuation allowance, we mustestimate whether and when we will have future taxable income that can bereduced by deferred tax assets.

 

**Stock-basedcompensation:** Weadopted FASB Statement No. 123 (revised 2004), Share Based Payment, infiscal 2006. Currently, we use the Black-Scholes option pricing model todetermine stock-based compensation costs. This pricing model requiresmanagement to estimate if and when options granted will be exercised. Indetermining this estimate, we review historical performance of our stock andstock option exercises.

 

**Recently Issued Accounting Pronouncements**

** **

DuringSeptember 2006, the Financial Accounting Standards Board (FASB) issuedStatement of Financial Accounting Standards (SFAS) No. 157, “Fair ValueMeasurements” (“SFAS 157”). This statement defines fair value, establishes aframework for measuring fair value under generally accepted accountingprinciples, and expands disclosures about fair value measurements. SFAS 157 iseffective for financial statements issued for fiscal years beginning after November 15,2007, however, during February 2008, the FASB issued FASB Staff Position SFAS157-2 which, deferred the effective date of certain provisions of SFAS 157until fiscal years beginning after November 15, 2008. We do not believethat the adoption of SFAS 157 will have a material effect on our results ofoperations or financial position.

 

DuringFebruary 2007, the Financial Accounting Standards Board issued Statementof Financial Accounting Standards (SFAS) No. 159, “The Fair Value Optionfor Financial Assets and Financial Liabilities” (“SFAS 159”). This statementpermits entities to choose to measure many financial instruments and certainother items at fair value. SFAS 159 is effective for fiscal years beginningafter November 15, 2007. We do not believe that the adoption or SFAS 159will have a material effect on our results of operations or financial position.

 

DuringDecember 2007, the Financial Accounting Standards Board issued Statementof Financial Accounting Standards (SFAS) No. 160, “NoncontrollingInterests in Consolidated Financial Statements and amendment of ARB No. 51”(“SFAS 160”). This statement establishes accounting and reporting standards fornoncontrolling interests in subsidiaries and for the deconsolidation ofsubsidiaries and clarifies that a noncontrolling interest in a subsidiary is anownership interest in the consolidated entity that should be reported as equityin the consolidated financial statements. This statement also requires expandeddisclosures that clearly identify and distinguish between the interests of theparent owners and the interests of the noncontrolling owners of a 

 

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subsidiary.SFAS 160 is effective for fiscal years beginning on or after December 15,2008. We do not believe the adoption of SFAS 160 will have a material effect onour results of operations or financial position.

 

DuringDecember 2007, the Financial Accounting Standards Board issued Statementof Financial Accounting Standards (SFAS) No. 141, (Revised 2007), “BusinessCombinations” (SFAS 141 (Revised 2007)”). While this statement retains thefundamental requirement of SFAS 141 that the acquisition method of accounting(which SFAS 141 called the *purchase method*)be used for all business combinations, SFAS 141 (Revised 2007) now establishesthe principles and requirements for how an acquirer in a business combination: recognizesand measures in its financial statements the identifiable assets acquired, theliabilities assumed, and any noncontrolling interests in the acquiree;recognizes and measures the goodwill acquired in the business combination orthe gain from a bargain purchase; and determines what information should bedisclosed in the financial statements to enable users of the financialstatements to evaluate the nature and financial effects of the businesscombination. SFAS 141 (Revised 2007) is effective for fiscal years beginning onor after December 15, 2008. We do not believe the adoption of SFAS 160will have a material effect on our results of operations or financial position.

 

DuringMarch 2008, the FASB issued SFAS No. 161, “Disclosures aboutDerivative Instruments and Hedging Activities” (SFAS No. 161). SFAS No. 161is intended to improve financial reporting about derivative instruments andhedging activities by requiring enhanced disclosures to enable investors to betterunderstand their effects on an entity’s financial position, financialperformance, and cash flows. SFAS No. 161 also improves transparency aboutthe location and amounts of derivative instruments in an entity’s financialstatements; how derivative instruments and related hedged items are accountedfor under Statement 133; and how derivative instruments and related hedgeditems affect its financial position, financial performance, and cash flows. SFASNo. 161 is effective for financial statements issued for fiscal years andinterim periods beginning after November 15, 2008, with early applicationencouraged. We do not believe the adoption of SFAS 161 will have a materialeffect on our results of operations or financial position.

 

**REVENUES**

 

Our total revenues for2007 were $100,765,000 compared to $77,790,000 in 2006.

 

Retail revenues increased to $72,915,000 in 2007 from$65,504,000 in 2006, an increase of 11% or $7,411,000. The increase in retailrevenues was due primarily to:

 

1.     Two stores opened in the Atlanta, GA market, one inSeptember, 2006 and one in December, 2006. Both were open the entire year in2007 resulting in an additional $4,074,000 in revenue.

2.     An increase in same storesales in the San Antonio, TX and Columbus, OH markets of 15.3% and 8.6%respectively, offset by a decrease of 1.5% in the Atlanta, GA market.

 

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 these appliancesare new, not used. Some are in the carton while others are out of the carton.

 

Wecontinue to purchase both new in-the-box and special-buy appliances fromWhirlpool Corporation (Whirlpool), GE Corporation (GE) and Frigidaire. We haveno minimum purchase requirements with any of these manufacturers. Webelieve purchases from these three manufacturers will provide an adequatesupply of high-quality appliances for our retail outlets; however, there is arisk that one or more of these sources could be curtailed or lost.

 

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We operated fifteen retail stores at the end of 2007 and 2006. InOctober, 2007 we closed our retail outlet in Los Angeles. In December of2007 we opened a 30,000 square foot store in the Columbus, OH market.

 

Recycling revenues increased to $25,188,000 in 2007 from $10,314,000 in2006. The increase was primarily due to the addition of contracts with theOntario Power Authority and the Southern California Public Power Authority in2007.

 

During 2007, we managed recycling operations under seven contracts withelectric utility companies, each of which was responsible for advertising inits service territory. Weprovided services for:

 

1.     Edison(2006-2008 program)

2.     SDG&E(2006-2008 program)

3.     OntarioPower Authority

4.     AustinEnergy (2006 program)

5.     WisconsinPublic Power Inc. (2006 program)

6.     WisconsinEnergy Conservation Corporation (2006 program)

7.     SouthernCalifornia Public Power Authority

 

Asof March 1, 2008, we operated processing and recycling centers inMinneapolis, MN; Los Angeles, CA; Oakville, Ontario, Canada; and Austin, TX. Weare also aggressively pursuing new appliance recycling programs in these and otherstates.

 

Byproductrevenues increased to $2,662,000 in 2007 from $1,972,000 in 2006. The increasewas due primarily to an increase in scrap metal revenues resulting from inincrease in the price paid for scrap metal by recyclers and an increase in scrapmetal and CFC’s available for sale due to increased recycling volume.

 

**COST OFREVENUE**

 

Cost of revenues includesall costs related to the purchase of inventory, including freight, costsrelated to receiving and distribution of inventory, and costs related todelivery and service of inventory after it is sold to the consumer. Also, thecosts related to the transportation and processing of units, and the cost ofunits used in our refrigerator replacement programs, under the recyclingprograms are included in the cost of revenues.

 

**GROSS PROFIT**

 

Ouroverall gross profit percentage increased to 32.5% in 2007 from 30.2% in 2006primarily due to an increase in efficiencies in our retail operations and theavailability of early payment discounts and rebates with the appliancemanufacturers.

 

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 three manufacturers who supplied product to us.

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

4.     The volume and price of byproducts.

 

**SELLING, GENERAL ANDADMINISTRATIVE EXPENSES**

 

Selling, general and administrativeexpenses were 28.3% of total revenues in 2007 compared to 31.6% in 2006. Selling,general and administrative expenses increased to $28,563,000 in 2007 from$24,586,000 in 2006, a 16.2% 

 

25

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increase. Selling expensesincreased to $18,717,000 in 2007 from $16,610,000 in 2006. The increase inselling expenses was due primarily to the expense of approximately $1,713,000for operating two additional stores in Atlanta, GA for the entire year and anincrease in advertising expense of approximately $801,000.

 

General and administrative expensesincreased to $9,846,000 in 2007 from $7,951,000 in 2006. The increase was dueprimarily to additional personnel costs associated with operating additionalretail stores and recycling contracts and legal costs associated with the legalproceedings discussed in Part I, Item 3, Legal Proceedings, and Note 5 ofthe Notes to Consolidated Financial Statements.

 

In 2007 we incurred other expenseof $54,000 compared to other income of $758,000 in 2006. The change was dueprimarily to the $730,000 non-refundable deposit for the sale of the buildingthat included in other income in 2006 due to the cancellation of the buildingsale.

 

**INTEREST EXPENSE**

 

Interest expenseincreased to $1,471,000 in 2007 from $1,079,000 in 2006. The increase wasprimarily due an increase in the amount of borrowings from the line of creditto finance inventory purchases related to our refrigerator change out programs

 

**INCOME TAXES AND NET OPERATING LOSSES**

** **

We had net operating losscarryovers and credit carryforwards of approximately $8.4 million at December 29,2007, which may be available to reduce taxable income and, therefore, incometaxes payable in future years. However, future utilization of $6.7 million ofthese loss and credit carryforwards is subject to certain significantlimitations under provisions of the Internal Revenue Code. These includelimitations subject to Section 382, which relate to a 50 percent change incontrol over a three-year period, and are further dependent upon our achievingprofitable operations. We believe that the issuance of Common Stock during 1999resulted in an “ownership change” under Section 382. Accordingly, ourability to use net operating loss carryforwards generated prior to February 1999may be limited to approximately $56,000 per year, or less than $1 millionthrough 2018.

 

As of our 2007 and2006 year-ends, we had recorded cumulative valuation allowances of $2,324,000and $2,760,000, respectively, against our net deferred tax assets due to theuncertainty of their realization. The 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. In the future, when we believe we can reasonablyestimate future operating results and these estimated results reflect taxableincome, the amount of deferred tax assets considered reasonable could beadjusted by a reduction in the valuation allowance.

 

**LIQUIDITY AND CAPITAL RESOURCES**

 

At December 29, 2007, we had working capital of$5,126,000 compared to $3,026,000 at December 30, 2006. Cash and cashequivalents increased to $2,777,000 at December 29, 2007 from $2,753,000at December 30, 2006.

 

Net cash used in operating activities was $6,248,000in 2007 compared to net cash used in operating activities of $10,000 in 2006.During 2007, inventories increased by $3,066,000 due primarily to an increasein inventory purchases in the fourth quarter of 2007 and inventory purchasedfor the SCPPA replacement program. Accounts receivable increased by $7,675,000due primarily to an increase in billings for the new recycling programs.

 

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Net cash used in investingactivities was $932,000 in 2007 compared to cash provided by investingactivities of $179,000 in 2006. The cash used in investing activities in 2007was primarily related to the purchase of computer equipment, phone systems, andrecycling equipment to support the new recycling contracts. The cash providedby investing activities in 2006 was primarily related to the receipt of a$730,000 non-refundable cash deposit on the sale of the St. Louis Park, MNfacility offset by the continued development of our enterprise-wide software,building improvements, and upgrades to our phone systems. We did not have anymaterial purchase commitments for assets as of December 29, 2007.

 

Net cash provided byfinancing activities was $7,128,000 in 2007 compared to $489,000 in 2006. Thecash provided by financing activities in 2007 and 2006 was due primarily toincreased borrowing under the line of credit for inventory purchases and stockoption exercises, offset by payments on long-term obligations.

 

As of December 29, 2007,we had a $16 million line of credit with a lender. The interest rate on theline as of December 29, 2007 was prime plus 2.00 percentage points(9.25%). The amount of borrowings available under the line of credit is basedon a formula using receivables and inventories. Our unused borrowing capacitywas $769,000 at December 29, 2007. The line of credit has a statedmaturity date of December 31, 2010, if not renewed, and provides that thelender may demand payment in full of the entire outstanding balance of the loanat any time. The line of credit is secured by substantially all our assets andrequires minimum monthly interest payments of $58,000, regardless of theoutstanding principal balance. The lender is also secured by an inventoryrepurchase agreement with Whirlpool Corporation for purchases from Whirlpoolonly. The line requires that we meet certain financial covenants, providespayment penalties for noncompliance and prepayment, limits the amount of otherdebt we can incur, limits the amount of spending on fixed assets, and limitspayments of dividends. As of December 29, 2007 we were in compliance withour loan requirements.

 

Details of our line ofcredit are described below:

 
| **Other Commercial  Commitment** | ** ** | **Total Amount  Committed** | ** ** | **Outstanding at 12/29/07** | ** ** | **Date of Expiration** | ** ** |
|---------------------------------------|------------|----------------------------------|------------|---------------------------------------|------------|----------------------------------|------------|
| Line of credit                        |       | $                                | 16,000,000 |                                  | $          | 13,585,000                       |       | December 31, 2010 |   |
|                                       |            |                                  |            |                                       |            |                                  |            |  |  |

 

On February 5, 2008our lender increased our line of credit to $18 million. The maturity date andterms are unchanged.

 

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

 

We believe, based on theanticipated sales per retail store, the anticipated revenues from our recyclingcontracts and our anticipated gross profit, that our cash balance, anticipatedfunds generated from operations and our current line of credit will besufficient to finance our operations and capital expenditures through December 2008.Our total capital requirements for 2008 will depend upon, among other things asdiscussed below, the number and size of retail stores operating during thefiscal year and the recycling volumes generated from the recycling contracts in2008. Currently, we have fifteen stores and four centers in operation. Ifrevenues are lower than anticipated or expenses are higher than anticipated, wemay require additional capital to finance operations. Sources of additionalfinancing, if needed in the future, may include further debt financing or thesale of equity (common or preferred stock) or other securities. There can be noassurance that such additional sources of financing will be available on termssatisfactory to us or permitted by our current lender.

 

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**FORWARD-LOOKING STATEMENTS**

 

Statements contained inthis annual report regarding our future operations, performance and results,and anticipated liquidity discussed herein are forward-looking and thereforeare subject to certain risks and uncertainties, including, but not limited to,those discussed herein. Any forward-looking information regarding our operationswill be affected primarily by the speed at which individual retail outletsreach profitability, the growth of appliance retail sales and the strength ofenergy conservation recycling programs. Any forward-looking information willalso be affected by our continued ability to purchase product from oursuppliers at acceptable prices and the ability and timing of utility companiesto deliver units under their recycling contracts with us, the ability ofindividual retail stores to meet planned revenue levels, the rate of growth inthe number of retail stores, costs and expenses being realized at higher thanexpected levels, our ability to secure an adequate supply of special-buyappliances for resale, and the continued availability of our current line of credit.

 

**ITEM 7A.****               QUANTITATIVE ANDQUALITATIVE DISCLOSURE ABOUT MARKET RISK**

 

**Market Risk and Impact of Inflation**

** **

We do not believe thereis any significant risk related to interest rate fluctuations on the long-termfixed-rate debt. However, there is interest rate risk on the line of credit,since our interest rate floats with prime, and on approximately $3,000,000 inlong-term debt entered into in September 2002, since our interest rate isbased on the 30-day LIBOR rate. Based on average floating rate borrowings of$16,500,000, a one-percent change in the applicable rate would have caused ourinterest expense to change by approximately $165,000. Also, we believe thatinflation, primarily in fuel costs and the decline in the housing market, couldadversely affect both the price we pay for inventory and the buying habits ofour customers in 2008.

 

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

 
| ** ** | **Description**                                                                                                                                       | ** ** | **Page** | ** ** | ** ** |
|------------|-------------------------------------------------------------------------------------------------------------------------------------------------------|------------|----------|------------|------------|
|       |                                                                                                                                                  |       |     |       |       |
|       | Report of Independent  Registered Public Accounting Firm                                                                                              |       | 30       |       |       |
|       | Consolidated Balance Sheets as of  December 29, 2007   and December 30, 2006                                                                |       | 31       |       |       |
|       | Consolidated Statements of  Operations for the years  ended December 29, 2007 and December 30, 2006                                         |       | 32       |       |       |
|       | Consolidated Statements of  Shareholders’ Equity and Comprehensive Income for the years  ended December 29, 2007 and December 30, 2006 |       | 33       |       |       |
|       | Consolidated Statements of  Cash Flows for the years  ended December 29, 2007 and December 30, 2006                                         |       | 34       |       |       |
|       | Notes to Consolidated  Financial Statements                                                                                                           |       | 35       |       |       |
|       |                                                                                                                                                  |       |     |       |       |
|       | Schedule II, Valuation  and Qualifying Accounts is included in Part IV, Item 15 of this Annual  Report on Form 10-K,                        |       |

 

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**REPORT OF INDEPENDENT REGISTERED PUBLIC ACCOUNTINGFIRM**

 

To the Shareholders,Audit Committee and Board of Directors

Appliance RecyclingCenters of America, Inc. and Subsidiaries

Minneapolis, Minnesota

 

We have audited theaccompanying consolidated balance sheets of Appliance Recycling Centers ofAmerica, Inc. and Subsidiaries (the Company) as of December 29, 2007and December 30, 2006, and the related consolidated statements ofoperations, shareholders’ equity and comprehensive income and cash flows forthe years then ended. These consolidated financial statements are theresponsibility of the company’s management. Our responsibility is to express anopinion on these consolidated financial statements based on our audits.

 

We conducted our auditsin accordance with the standards of the Public Company Accounting OversightBoard (United States). Those standards require that we plan and perform theaudit to obtain reasonable assurance about whether the consolidated financialstatements are free of material misstatement. The Company is not required tohave, nor were we engaged to perform, an audit of its internal control overfinancial reporting. Our audits included consideration of internal control as abasis for designing procedures that are appropriate in the circumstances, butnot for the purpose of expressing an opinion on the effectiveness of theCompany’s internal control over financial reporting. Accordingly, we express nosuch opinion. An audit includes examining, on a test basis, evidence supportingthe amounts and disclosures in the consolidated financial statements. An auditalso includes assessing the accounting principles used and significantestimates made by management as well as evaluating the overall consolidatedfinancial statement presentation. We believe that our audits provide areasonable basis for our opinion.

 

In our opinion, theconsolidated financial statements referred to above present fairly, in allmaterial respects, the financial position of Appliance Recycling Centers ofAmerica, Inc. and Subsidiaries as of December 29, 2007 and December 30,2006 and the results of its operations and its cash flows for the years thenended, in conformity with U.S. generally accepted accounting principles.

 

As discussed in Note 9,the Company’s 2006 consolidated financial statements were restated to includedisclosures about the Company’s operating segments.

 

/s/ VIRCHOW, KRAUSE ANDCOMPANY, LLP

 

Minneapolis, Minnesota

March 26, 2008

 

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

**CONSOLIDATEDBALANCE SHEETS**

 
| ** **                                                                                                                      | ** ** | **December 29,  2007** | ** ** | **December 30,  2006** | ** ** |
|---------------------------------------------------------------------------------------------------------------------------------|------------|-----------------------------|------------|-----------------------------|------------|
| **ASSETS**                                                                                                                      |       |                        |       |                        |       |
| **Current  Assets:**                                                                                                            |       |                        |       |                        |       |
| Cash                                                                                                                            |       | $                           | 2,777,000  |                        | $          | 2,753,000 |   |
| Accounts  receivable, net of allowance of $152,000 and $152,000, respectively                                                   |       | 10,086,000                  |       | 2,411,000                   |       |
| Inventories, net  of reserves of $84,000 and $207,000, respectively                                                             |       | 14,064,000                  |       | 10,998,000                  |       |
| Deferred income  taxes                                                                                                          |       | 259,000                     |       | 601,000                     |       |
| Other current  assets                                                                                                           |       | 995,000                     |       | 657,000                     |       |
| Total current  assets                                                                                                           |       | 28,181,000                  |       | 17,420,000                  |       |
| **Property  and Equipment, at cost:**                                                                                           |       |                        |       |                        |       |
| Land                                                                                                                            |       | 2,050,000                   |       | 2,050,000                   |       |
| Buildings and  improvements                                                                                                     |       | 4,952,000                   |       | 4,696,000                   |       |
| Equipment                                                                                                                       |       | 8,152,000                   |       | 6,889,000                   |       |
|                                                                                                                            |       | 15,154,000                  |       | 13,635,000                  |       |
| Less accumulated  depreciation                                                                                                  |       | 8,392,000                   |       | 7,575,000                   |       |
| net property and  equipment                                                                                                     |       | 6,762,000                   |       | 6,060,000                   |       |
| **Other  Assets**                                                                                                               |       | 589,000                     |       | 433,000                     |       |
| Total assets                                                                                                                    |       | $                           | 35,532,000 |                        | $          | 23,913,000 |   |
|                                                                                                                            |       |                        |       |                        |       |
| **LIABILITIES  AND SHAREHOLDERS’ EQUITY**                                                                                  |       |                        |       |                        |       |
| **Current  Liabilities:**                                                                                                       |       |                        |       |                        |       |
| Checks issued in  excess of cash in bank                                                                                        |       | $                           | 310,000    |                        | $          | — |   |
| Line of credit                                                                                                                  |       | 13,585,000                  |       | 6,872,000                   |       |
| Current  maturities of long-term obligations                                                                                    |       | 479,000                     |       | 309,000                     |       |
| Accounts payable                                                                                                                |       | 4,350,000                   |       | 3,198,000                   |       |
| Accrued expenses                                                                                                                |       | 4,113,000                   |       | 3,957,000                   |       |
| Income taxes  payable                                                                                                           |       | 218,000                     |       | 58,000                      |       |
| Total current  liabilities                                                                                                      |       | 23,055,000                  |       | 14,394,000                  |       |
| **Long-Term  Obligations,******less current  maturities                                                                         |       | 4,956,000                   |       | 4,776,000                   |       |
| **Deferred  Income Tax Liabilities**                                                                                            |       | 259,000                     |       | 601,000                     |       |
| Total  liabilities                                                                                                              |       | 28,270,000                  |       | 19,771,000                  |       |
|                                                                                                                            |       |                        |       |                        |       |
| **Commitments  and Contingencies**                                                                                              |       | —                      |       | —                      |       |
| **Shareholders’  Equity:**                                                                                                 |       |                        |       |                        |       |
| Common Stock, no  par value; authorized 10,000,000 shares; issued and outstanding 4,509,000 and  4,341,000 shares, respectively |       | 15,475,000                  |       | 14,970,000                  |       |
| Accumulated  deficit                                                                                                            |       | (8,289,000                  | )          | (10,828,000                 | )          |
| Accumulated  Other Comprehensive Income                                                                                         |       |                        |       |                        |       |
| Foreign Currency  Translation Adjustments                                                                                       |       | 76,000                      |       | —                      |       |
| Total  shareholders’ equity                                                                                                |       | 7,262,000                   |       | 4,142,000                   |       |
| Total  liabilities and shareholders’ equity                                                                                |       | $                           | 35,532,000 |                        | $          | 23,913,000 |   |

 

See Notes toConsolidated Financial Statements.

 

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

**CONSOLIDATED STATEMENTS OF OPERATIONS**

 
| ** **                                                 | ** ** | **For the fiscal year ended** | ** ** |
|------------------------------------------------------------|------------|---------------------------------------------------|------------|
| ** **                                                 | ** ** | **December 29,  2007**                       | ** ** | **December 30,  2006** | ** ** |
| **Revenues**                                               |       |                                              |       |   |   |
| Retail                                                     |       | $                                                 | 72,915,000 |   | $ | 65,504,000 |   |
| Recycling                                                  |       | 25,188,000                                        |       | 10,314,000 |   |
| Byproduct                                                  |       | 2,662,000                                         |       | 1,972,000 |   |
|                                                       |       |                                              |       |   |   |
| Total revenues                                             |       | 100,765,000                                       |       | 77,790,000 |   |
|                                                       |       |                                              |       |   |   |
| **Cost of  Revenues**                                      |       | 67,996,000                                        |       | 54,315,000 |   |
|                                                       |       |                                              |       |   |   |
| Gross profit                                               |       | 32,769,000                                        |       | 23,475,000 |   |
|                                                       |       |                                              |       |   |   |
| **Selling,  General and Administrative Expenses**          |       | 28,563,000                                        |       | 24,586,000 |   |
|                                                       |       |                                              |       |   |   |
| Operating income  (loss)                                   |       | 4,206,000                                         |       | (1,111,000 | ) |
|                                                       |       |                                              |       |   |   |
| **Other  Income (Expense)**                                |       |                                              |       |   |   |
| Other income  (expense)                                    |       | (54,000                                           | )          | 758,000 |   |
| Interest income                                            |       | 21,000                                            |       | 23,000 |   |
| Interest expense                                           |       | (1,471,000                                        | )          | (1,079,000 | ) |
|                                                       |       |                                              |       |   |   |
| Income (loss)  before provision for income taxes           |       | 2,702,000                                         |       | (1,409,000 | ) |
|                                                       |       |                                              |       |   |   |
| **Provision  for Income Taxes**                            |       | 163,000                                           |       | — |   |
|                                                       |       |                                              |       |   |   |
| Net income  (loss)                                         |       | $                                                 | 2,539,000  |   | $ | (1,409,000 | ) |
|                                                       |       |                                              |       |   |   |
| **Basic  Income (Loss) per Common Share**                  |       | $                                                 | 0.58       |   | $ | (0.33 | ) |
|                                                       |       |                                              |       |   |   |
| **Diluted  Income (Loss) per Common Share**                |       | $                                                 | 0.57       |   | $ | (0.33 | ) |
|                                                       |       |                                              |       |   |   |
| **Weighted  Average Number of Common Shares Outstanding:** |       |                                              |       |   |   |
| Basic                                                      |       | 4,400,000                                         |       | 4,335,000 |   |
| Diluted                                                    |       | 4,475,000                                         |       | 4,335,000 |   |

 

See Notes toConsolidated Financial Statements.

 

32

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

**CONSOLIDATED STATEMENT OF SHAREHOLDERS’ EQUITY ANDCOMPREHENSIVE**

**INCOME**

 
| ** **                                           | ** ** | ** **            | ** ** | ** **        | ** ** | **Accumulated** | ** ** | ** **             | ** ** | ** ** | ** ** |
|------------------------------------------------------|------------|-----------------------|------------|-------------------|------------|-----------------|------------|------------------------|------------|------------|------------|
| ** **                                           | ** ** | ** **            | ** ** | ** **        | ** ** | **Other**       | ** ** | ** **             | ** ** | **Total**  | ** ** |
| ** **                                           | ** ** | **Common Stock** | ** ** | **Comprehensive** | ** ** | **Accumulated** | ** ** | **Shareholder’s** | ** ** |
| ** **                                           | ** ** | **Shares**            | ** ** | **Amount**        | ** ** | **Income**      | ** ** | **Deficit**            | ** ** | **Equity** | ** ** |
|                                                 |       |                  |       |              |       |            |       |                   |       |       |       |
| **Balance,  December 31, 2005**                 |       | 4,320,000             |       | $                 | 14,840,000 |            | $          | —                 |       | $          | (9,419,000 | ) | $ | 5,421,000 |   |
| Exercise of  stock options                           |       | 21,500                |       | 29,000            |       |            |       | —                 |       | 29,000     |       |
| Stock issuance  costs                                |       | —                |       | (2,000            | )          |            |       | —                 |       | (2,000     | )          |
| Stock based  compensation                            |       |                  |       | 128,000           |       |            |       |                   |       | 128,000    |       |
| Distribution to  minority subsidiary owner           |       |                  |       | (25,000           | )          |            |       |                   |       | (25,000    | )          |
| Net loss                                             |       | —                |       | —            |       |            |       | (1,409,000             | )          | (1,409,000 | )          |
|                                                 |       |                  |       |              |       |            |       |                   |       |       |       |
| **Balance,  December 30, 2006**                 |       | 4,341,000             |       | 14,970,000        |       |            |       | (10,828,000            | )          | 4,142,000  |       |
| Comprehensive  Income:                               |       |                  |       |              |       |            |       |                   |       |       |       |
| Net Income                                           |       |                  |       |              |       |            |       | 2,539,000              |       | 2,539,000  |       |
| Foreign Currency  Translation adjustment, net of tax |       |                  |       |              |       | 76,000          |       |                   |       | 76,000     |       |
| Total  Comprehensive Income                          |       |                  |       |              |       |            |       |                   |       | 2,615,000  |       |
| Exercise of  stock options                           |       | 168,000               |       | 398,000           |       |            |       |                   |       | 398,000    |       |
| Stock based  compensation                            |       |                  |       | 107,000           |       |            |       |                   |       | 107,000    |       |
|                                                 |       |                  |       |              |       |            |       |                   |       |       |       |
| **Balance,  December 29, 2007**                 |       | 4,509,000             |       | $                 | 15,475,000 |            | $          | 76,000                 |       | $          | (8,289,000 | ) | $ | 7,262,000 |   |

 

See Notes to Consolidated Financial Statements.

 

33

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

**CONSOLIDATED STATEMENTS OF CASH FLOWS**

 
| ** **                                                                                 | ** ** | **For the fiscal year ended** | ** ** |
|--------------------------------------------------------------------------------------------|------------|---------------------------------------------------|------------|
| ** **                                                                                 | ** ** | **December 29,  2007**                       | ** ** | **December 30,  2006** | ** ** |
| **Cash  Flows from Operating Activities**                                                  |       |                                              |       |   |   |
| Net Income  (loss)                                                                         |       | $                                                 | 2,539,000  |   | $ | (1,409,000 | ) |
| Adjustments to  reconcile net loss to net cash provided by (used in) operating activities: |       |                                              |       |   |   |
| Depreciation and  amortization                                                             |       | 873,000                                           |       | 788,000 |   |
| Stock-based  compensation expense                                                          |       | 107,000                                           |       | 128,000 |   |
| Loss on sale of  property and equipment                                                    |       | —                                            |       | 15,000 |   |
| Gain on building  deposit forfeiture                                                       |       | —                                            |       | (730,000 | ) |
| Change in assets  and liabilities:                                                         |       |                                              |       |   |   |
| Receivables                                                                                |       | (7,675,000                                        | )          | 485,000 |   |
| Inventories                                                                                |       | (3,066,000                                        | )          | 902,000 |   |
| Other current  assets                                                                      |       | (338,000                                          | )          | (208,000 | ) |
| Other assets                                                                               |       | (156,000                                          | )          | 273,000 |   |
| Accounts payable  and accrued expenses                                                     |       | 1,308,000                                         |       | (254,000 | ) |
| Income taxes  refundable or payable                                                        |       | 160,000                                           |       | — |   |
| Net cash flows  from operating activities                                                  |       | (6,248,000                                        | )          | (10,000 | ) |
|                                                                                       |       |                                              |       |   |   |
| **Cash  Flows from Investing Activities**                                                  |       |                                              |       |   |   |
| Purchases of  property and equipment                                                       |       | (932,000                                          | )          | (553,000 | ) |
| Proceeds from  disposal of equipment                                                       |       | —                                            |       | 2,000 |   |
| Deposit received  from sale of building                                                    |       | —                                            |       | 730,000 |   |
| Net cash flows from  investing activities                                                  |       | (932,000                                          | )          | 179,000 |   |
|                                                                                       |       |                                              |       |   |   |
| **Cash  Flows from Financing Activities**                                                  |       |                                              |       |   |   |
| Checks issued in  excess of cash in bank                                                   |       | 310,000                                           |       | — |   |
| Net borrowings  under line of credit                                                       |       | 6,713,000                                         |       | 747,000 |   |
| Payments on  long-term obligations                                                         |       | (293,000                                          | )          | (260,000 | ) |
| Distribution to  minority subsidiary owner                                                 |       | —                                            |       | (25,000 | ) |
| Proceeds from  stock option exercises                                                      |       | 398,000                                           |       | 29,000 |   |
| Payments of  stock placement costs                                                         |       | —                                            |       | (2,000 | ) |
| Net cash flows  from financing activities                                                  |       | 7,128,000                                         |       | 489,000 |   |
|                                                                                       |       |                                              |       |   |   |
| Effect of  exchange rate changes on cash                                                   |       | 76,000                                            |       | — |   |
| Increase in cash                                                                           |       | 24,000                                            |       | 658,000 |   |
|                                                                                       |       |                                              |       |   |   |
| **Cash**                                                                                   |       |                                              |       |   |   |
| Beginning                                                                                  |       | 2,753,000                                         |       | 2,095,000 |   |
| Ending                                                                                     |       | $                                                 | 2,777,000  |   | $ | 2,753,000 |   |
|                                                                                       |       |                                              |       |   |   |
| **Supplemental  Disclosures of Cash Flow Information**                                     |       |                                              |       |   |   |
| Cash payments  relative to:                                                                |       |                                              |       |   |   |
| Interest                                                                                   |       | $                                                 | 1,471,000  |   | $ | 1,078,000 |   |
| Income taxes,  net                                                                         |       | $                                                 | 3,000      |   | $ | 9,000 |   |
|                                                                                       |       |                                              |       |   |   |
| **Noncash  investing and financing activites:**                                            |       |                                              |       |   |   |
| Equipment  acquired under capital lease                                                    |       | $                                                 | 525,000    |   | $ | 260,000 |   |
| Equipment acquired  for long term debt                                                     |       | $                                                 | 118,000    |   | $ | — |   |

 

See Notes toConsolidated Financial Statements.

 

34

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

 

**NOTES TO CONSOLIDATED FINANCIAL STATEMENTS**

** **

**Note 1.Nature of Business and Significant Accounting Policies**

 

**Natureof business:**ApplianceRecycling Centers of America, Inc. and our subsidiaries are in thebusiness of providing reverse logistics, energy conservation and recyclingservices for major household appliances. We sell appliances through a chain ofcompany-owned factory outlet stores under the name ApplianceSmart®. Wealso provide recycling services on a credit basis to public electric utilities.

 

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

 

**Principlesof consolidation:** Theconsolidated financial statements include the accounts of Appliance RecyclingCenters of America, Inc. and our subsidiaries. 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 was formed and commenced operations in June 2003and is a retailer of special-buy appliances in Texas. Because NAACO has a netshareholders’ deficit, no minority interest has been recognized on ourconsolidated balance sheet, and 100% of NAACO’s operations are included in ourconsolidated financial statements for the years of 2007 and 2006.

 

OnSeptember 1, 2006, we became a majority (60%) owner in Productos Duraderosde Norte America (PDN), a Mexican Corporation in exchange for $3,000 in cash. PDNrefurbishes household window air conditioners for sale through our NAACOoperation in McAllen, Texas and through our ApplianceSmart outlet stores. PDNhas operated at a loss since September 1, 2006 and therefore 100% of PDN’soperations are included in our consolidated financial statements.

 

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

 

**Fairvalue of financial instruments:**The following methods and assumptions are used to estimate the fairvalue of each class of financial instrument:

 

**Cash,accounts receivable and accounts payable:** Due to their nature and short-termmaturities, the carrying amounts approximate fair value.

 

**Short-and long-term debt:** Thefair value of short- and long-term debt has been estimated based on discountedcash flows using interest rates being offered for similar debt having the sameor similar remaining maturities and collateral requirements.

 

No separate comparison offair values versus carrying values is presented for the aforementionedfinancial instruments since their fair values are not significantly differentthan their balance sheet carrying amounts. In addition, the aggregate fairvalues of the financial instruments would not represent the underlying value ofour company.

 

**Fiscalyear:** We use a 52-53week fiscal year. Our 2007 fiscal year (2007) ended December 29, 2007 andour 2006 fiscal year (2006) ended December 30, 2006. All periods presentedcontain 52 weeks.

 

35

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**Revenuerecognition:** Werecognize revenue from appliance sales in the period the consumer purchases andpays for the appliances, net of an allowance for estimated returns. Werecognize revenue from appliance recycling when we collect and process a unit. Werecognize byproduct revenue upon shipment.

 

Werecognize revenue on extended warranties with retained service obligations on astraight-line basis over the period of the warranty in accordance with FASBTechnical Bulletin 90-1, “Accounting for Separately Priced Extended Warrantyand Product Maintenance Contracts. On extended warranty arrangements we sell but others service for 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, which arerecognized in the period the consumer purchases and pays for the delivery.Shipping and handling costs that we incur are included in cost of revenues.

 

**Taxescollected from customers:**In June 2006, the FinancialAccounting Standards Board (FASB) ratified the consensus of Emerging IssuesTask Force Issue No. 06-3, “How Taxes Collected from Customers andRemitted to Governmental Authorities Should Be Presented in the IncomeStatement (That Is, Gross versus Net Presentation)” (EITF 06-3). EITF 06-3concluded that the presentation of taxes imposed on revenue-producingtransactions (sales, use, value added and excise taxes) on either a gross(included in revenues and costs) or a net (excluded from revenues) basis is anaccounting policy that should be disclosed. We adopted EITF 06-3 during theyear ended December 29, 2007, and it did not have any impact on ourresults of operations or financial condition. Our policy is to present taxesimposed on revenue-producing transactions on a net basis.

 

**Accountingfor Leases:** Weconduct the majority of our retail and recycling operations from leasedfacilities. The leases require payment of real estate taxes, insurance andcommon area maintenance, in addition to rent. The terms of our lease agreementstypically range from 5 to 10 years. Most of the leases contain renewal clausesand escalation clauses, and certain store leases require contingent rents basedon factors such as revenue.

 

Forleases that contain predetermined fixed escalations of the minimum rent, werecognize the related rent expense on a straight-line basis from the date wetake possession of the property to the end of the initial lease term. We recordany difference between straight-line rent amounts and amounts payable under theleases as part of deferred rent, in accrued liabilities.

 

Cashor lease incentives (“tenant allowances”) received upon entering into certainstore leases are recognized on a straight-line basis as a reduction to rentfrom the date we take possession of the property through the end of the initiallease term.

 

**Productwarranty:** We providea warranty for the replacement or repair of certain defective units. Ourstandard warranty policy requires us to repair or replace certain defectiveunits at no cost to our customers. We estimate the costs that may be incurredunder our warranty and record a liability reserve in the amount of such costsat the time we recognize product revenue. 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 such claims. We periodically assess the adequacy of our recordedwarranty liability reserve and adjust the amounts as necessary.

 

Changesin our warranty liability reserve are as follows:

 

36

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| ** **                            | ** ** | **2007** | ** ** | **2006** | ** ** |
|---------------------------------------|------------|----------|------------|----------|------------|
| Balance,  beginning                   |       | $        | 28,000     |     | $          | 27,000 |   |
| Standard accrual  based on units sold |       | 93,000   |       | 55,000   |       |
| Actual costs  incurred                |       | (4,000   | )          | (4,000   | )          |
| Periodic accrual  adjustments         |       | (37,000  | )          | (50,000  | )          |
| Balance, ending                       |       | $        | 80,000     |     | $          | 28,000 |   |

 

**Tradereceivables:**We carrytrade receivables at original invoice amount less an estimate made for doubtfulreceivables based on a monthly review of all outstanding amounts. Managementdetermines the allowance for doubtful accounts by regularly evaluatingindividual customer receivables and considering a customer’s financialcondition, credit history and current economic conditions. We write off tradereceivables when we deem them uncollectible. We record recoveries of tradereceivables previously written off when we receive them. We consider a tradereceivable to be past due if any portion of the receivable balance isoutstanding for more than 90 days. We do not charge interest on past duereceivables. Our management considers the reserve for doubtful accounts of$152,000 and $152,000 to be adequate to cover any exposure to loss as of December 29,2007 and December 30, 2006, respectively.

 

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

 

**Inventories:** Inventories, consisting principally of appliances,are stated at the lower of cost, first-in, first-out (FIFO), or market andconsist of:

 
| ** **     | ** ** | **2007** | ** ** | **2006** | ** ** |
|----------------|------------|----------|------------|----------|------------|
| Finished goods |       | $        | 14,148,000 |     | $          | 11,205,000 |   |
| Less reserves  |       | (84,000  | )          | (207,000 | )          |
|           |       | $        | 14,064,000 |     | $          | 10,998,000 |   |

 

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 such allowances.We look at historical inventory agings and margin analysis in determining ourreserve estimate. We believe the reserve of $84,000 and $207,000 is adequate asof December 29, 2007 and December 30, 2006, respectively..

 

**Propertyand equipment:** Wecompute depreciation using straight-line and accelerated methods over thefollowing 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 December 29, 2007.

 

37

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**Software development costs:** We capitalize software developed forinternal use in accordance with Statement of Position 98-1 and are amortizingsuch costs over their estimated useful life of three to five years. Costscapitalized were $231,000 and $238,000 for the fiscal years of 2007 and 2006,respectively. Amortization expense on software development costs was $260,000and $239,000 for the fiscal years 2007 and 2006 respectively. Estimatedamortization expenses are $228,000, $194,000, $114,000, and $44,000 for thefiscal years 2008, 2009, 2010 and 2011, respectively.

 

**Accountingfor long-lived assets:**Weevaluate long-lived assets such as property and equipment for impairmentwhenever events or changes in circumstances indicate the carrying value of anasset may not be recoverable. We assess impairment based on the estimatedfuture net undiscounted cash flows expected to result from the use of theassets, including cash flows from disposition. Should the sum of the expectedfuture net cash flows be less than the carrying value, we recognize animpairment loss at that time. We measure an impairment loss by comparing theamount by which the carrying value exceeds the fair value (estimated discountedfuture cash flows or appraisal of assets) of the long-lived assets.

 

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

 

**Advertisingexpense:**Advertisingis expensed as incurred and was $4,447,000 and $3,593,000 for the 2007 and 2006fiscal years, respectively.

 

**Incometaxes:** Deferred taxesare provided on an asset and liability method whereby deferred tax assets arerecognized for deductible temporary differences and operating loss and taxcredit carryforwards, and deferred tax liabilities are recognized for taxabletemporary differences. Temporary differences are the differences between thereported amounts of assets and liabilities and their tax basis. Deferred taxassets are reduced by a valuation allowance when, in the opinion of ourmanagement, it is more likely than not that some portion or all of the deferredtax assets will not be realized. Deferred tax assets and liabilities areadjusted for the effects of changes in tax laws and rates on the date ofenactment. Realization of deferred tax assets is dependent upon sufficientfuture taxable income during the periods when deductible temporary differencesand carryforwards are expected to be available to reduce taxable income.

 

**Basicand diluted net income (loss) per share:** Basic per-share amounts are computed,generally, by dividing net income (loss) by the weighted-average number ofcommon shares outstanding. Diluted per-share amounts assume the conversion,exercise or issuance of all potential common stock instruments unless theireffect is antidilutive, thereby reducing the loss or increasing the income percommon share.

 

Inarriving at diluted weighted-average shares and per-share amounts, we includedoptions (see Note 7) with exercise prices below average market prices, for therespective fiscal years in which they were dilutive, using the treasury stockmethod. We calculated the number of additional shares by assuming theoutstanding stock options and warrants were exercised and that the proceedsfrom such exercises were used to acquire Common Stock at the average marketprice during the year. Because the effect of options on 2006 is antidilutive,they were not included in the computation of per-share amounts. The effect ofall options in 2007 is dilutive. A reconciliation of the denominator in thebasic and diluted income or loss per share is as follows:

 

38

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| ** **                                                                  | ** ** | **December 29** | ** ** | **December 30** | ** ** |
|-----------------------------------------------------------------------------|------------|----------------------|------------|----------------------|------------|
| **(In thousands, except per share data)**          | ** ** | **2007**             | ** ** | **2006**             | ** ** |
| Numerator:                                                                  |       |                 |       |                 |       |
| Net  Income (Loss)                                                          |       | 2,539                |       | (1,409               | )          |
| Denominator:                                                                |       |                 |       |                 |       |
| Denominator  for basic earnings (loss) per share, weighted average shares   |       | 4,400                |       | 4,335                |       |
| Dilutive  potential shares - employee stock options                         |       | 75                   |       | —               |       |
| Denominator  for diluted earnings (loss) per share, weighted average shares |       | 4,475                |       | 4,335                |       |
| Net  income (loss) per share - basic                                        |       | 0.58                 |       | (0.33                | )          |
| Net  income (loss) per share - diluted                                      |       | 0.57                 |       | (0.33                | )          |

 

**Stock-based compensation:**   We use the Black-Scholes optionpricing model to determine the fair value of awards at the grant date.  We calculate the expected volatility forstock options and awards using  historicalvolatility.  The company believes the expectedvolatility will approximate historical volatility. We estimate a 5% forfeiturerate for stock options but will continue to review this estimate in futureperiods.  The risk-free rates for theexpected terms of the stock options is based on the U.S. Treasury yield curvein effect at the time of grant.   Weestimate that the expense for fiscal 2008 will be approximately $476,000,$31,000 of which is the unrecognized portion of compensation expense as of December 29,2007, based on the value of options issued in the first quarter of 2008 thatwill vest during 2008.  This estimatedoes not include any expense for additional options that may be granted andvest during 2008.

 

**Comprehensiveincome: **The components of comprehensive incomeinclude net income and the effects of foreign currency translationadjustments.  The net of tax effect ofthe foreign currency translation adjustment for fiscal 2007 was $76,000, andwas not significant for the other years presented.

 

**Segmentinformation:  **A****business segmentis a distinguishable component of an enterprise that is engaged in providing anindividual product or service or a group of related products or services andthat is subject to risks and returns that are different for those of otherbusiness segments.** **We operate two reportable segments: Retail and Recycling.  The retailoperation is comprised of sales generated through our ApplianceSmart factoryoutlet stores.  The recycling operationis comprised of all fees charged for collecting, recycling and installingappliances for utilities and other customers.

 

**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 foraccounts receivable, inventories and deferred tax assets, accrued expenses, andthe assumptions we use to value stock-based compensation.  Actual results could differ from thoseestimates.

 

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

 

DuringSeptember 2006, the Financial Accounting Standards Board (FASB) issuedStatement of Financial Accounting Standards (SFAS) No. 157, “Fair ValueMeasurements” (“SFAS 157”).  Thisstatement defines fair value, establishes a framework for measuring fair valueunder generally accepted accounting principles, and expands disclosures aboutfair value measurements.  SFAS 157 iseffective for financial statements issued for fiscal years beginning after November 15,2007, however, during February 2008, the FASB issued FASB Staff PositionSFAS 157-2 which, deferred the effective date of certain provisions of SFAS 157until fiscal years

 

39

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beginningafter November 15, 2008.  We do notbelieve that the adoption of SFAS 157 will have a material effect on ourresults of operations or financial position.

 

DuringFebruary 2007, the Financial Accounting Standards Board issued Statementof Financial Accounting Standards (SFAS) No. 159, “The Fair Value Optionfor Financial Assets and Financial Liabilities” (“SFAS 159”).  This statement permits entities to choose tomeasure many financial instruments and certain other items at fair value.  SFAS 159 is effective for fiscal yearsbeginning after November 15, 2007. We do not believe that the adoption or SFAS 159 will have a materialeffect on our results of operations or financial position.

 

DuringDecember 2007, the Financial Accounting Standards Board issued Statementof Financial Accounting Standards (SFAS) No. 160, “NoncontrollingInterests in Consolidated Financial Statements and amendment of ARB No. 51”(“SFAS 160”).  This statement establishesaccounting and reporting standards for noncontrolling interests in subsidiariesand for the deconsolidation of subsidiaries and clarifies that a noncontrollinginterest in a subsidiary is an ownership interest in the consolidated entitythat should be reported as equity in the consolidated financialstatements.  This statement also requiresexpanded disclosures that clearly identify and distinguish between theinterests of the parent owners and the interests of the noncontrolling ownersof a subsidiary.  SFAS 160 is effectivefor fiscal years beginning on or after December 15, 2008.  We do not believe the adoption of SFAS 160will have a material effect on our results of operations or financial position.

 

DuringDecember 2007, the Financial Accounting Standards Board issued Statementof Financial Accounting Standards (SFAS) No. 141, (Revised 2007), “BusinessCombinations” (SFAS 141 (Revised 2007)”). While this statement retains the fundamental requirement of SFAS 141that the acquisition method of accounting (which SFAS 141 called the *purchase method*) be used for all business combinations, SFAS141 (Revised 2007) now establishes the principles and requirements for how anacquirer in a business combination: recognizes and measures in its financial statements the identifiableassets acquired, the liabilities assumed, and any noncontrolling interests inthe acquiree; recognizes and measures the goodwill acquired in the businesscombination or the gain from a bargain purchase; and determines whatinformation should be disclosed in the financial statements to enable users ofthe financial statements to evaluate the nature and financial effects of thebusiness combination.  SFAS 141 (Revised2007) is effective for fiscal years beginning on or after December 15,2008.  We do not believe the adoption ofSFAS 141 will have a material effect on our results of operations or financialposition.

 

DuringMarch 2008, the FASB issued SFAS No. 161, “Disclosures aboutDerivative Instruments and Hedging Activities” (SFAS No. 161).  SFAS No. 161 is intended to improvefinancial reporting about derivative instruments and hedging activities byrequiring enhanced disclosures to enable investors to better understand theireffects on an entity’s financial position, financial performance, and cashflows.  SFAS No. 161 also improvestransparency about the location and amounts of derivative instruments in anentity’s financial statements; how derivative instruments and related hedgeditems are accounted for under Statement 133; and how derivative instruments andrelated hedged items affect its financial position, financial performance, andcash flows.  SFAS No. 161 iseffective for financial statements issued for fiscal years and interim periodsbeginning after November 15, 2008, with early application encouraged.  We do not believe the adoption of SFAS 161will have a material effect on our results of operations or financial position

 

**Note2.  Line of Credit**

 

AtDecember 29, 2007, we had a $16 million line of credit with a lender.  The line was increased to $18 million on February 5,2008. The interest rate on the line as of December 29, 2007 was prime plus2.00 percentage points (9.25%) compared to 11.25% at December 30,2006.  The weighted average interest ratefor 2007 and 2006 was 10.58% and 10.90%, respectively. The amount of borrowingsavailable under the line of credit is based on a formula using receivables andinventories.  Our unused borrowingcapacity under this line was $769,000 at

 

40

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December 29,2007.  The line of credit has a statedmaturity date of December 31, 2010, if not renewed, and provides that thelender may demand payment in full of the entire outstanding balance of the loanat any time.  The line of credit iscollateralized by substantially all our assets and requires minimum monthlyinterest payments of $58,000, regardless of the outstanding principalbalance.  The lender is also secured byan inventory repurchase agreement with Whirlpool Corporation for purchases fromWhirlpool only.  The loan requires thatwe meet certain financial covenants, provides payment penalties fornoncompliance and prepayment, limits the amount of other debt we can incur,limits the amount of spending on fixed assets, and prohibits payments of dividends.  At December 29, 2007, we were incompliance with the terms of the loan agreement.

 

**Note3.  Long-Term Obligations**

 

Long-termdebt and capital lease obligations consisted of the following:

 
| ** **                                                                                                                                                                                                                               | ** ** | **2007**  | ** ** | **2006**  | ** ** |
|------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|------------|-----------|------------|-----------|------------|
| Adjustable rate  mortgage adjusted annually each September based on 30 day LIBOR plus 2.7  percentage points (7.62% as of December 29, 2007) on a 20-year amortization  due October 2012, collateralized by land and building. |       | $         | 2,902,000  |      | $          | 3,002,000 |   |
|                                                                                                                                                                                                                                     |       |      |       |      |       |
| 6.85% mortgage,  due in monthly installments of $15,326, including interest, due  January 2013, collateralized by land and building                                                                                                 |       | 1,721,000 |       | 1,785,000 |       |
|                                                                                                                                                                                                                                     |       |      |       |      |       |
| Other primarily  capital leases (see below)                                                                                                                                                                                              |       | 812,000   |       | 298,000   |       |
|                                                                                                                                                                                                                                     |       | 5,435,000 |       | 5,085,000 |       |
| Less current  maturities                                                                                                                                                                                                                 |       | 479,000   |       | 309,000   |       |
|                                                                                                                                                                                                                                     |       | $         | 4,956,000  |      | $          | 4,776,000 |   |

 

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

 
| **Fiscal Year** | ** ** | ** ** | ** ** |
|----------------------|------------|------------|------------|
| 2008                 |       | $          | 479,000    |   |
| 2009                 |       | 449,000    |       |
| 2010                 |       | 445,000    |       |
| 2011                 |       | 349,000    |       |
| 2012                 |       | 2,384,000  |       |
| 2013 and  thereafter |       | 1,329,000  |       |
|                 |       | $          | 5,435,000  |   |

 

**Capital leases:** We lease certain equipment under capitalleases. The cost of the equipment was approximately $966,000 and $441,000 at December 29,2007 and December 30, 2006, respectively. Accumulated amortization at December 29,2007 and December 30, 2006 was approximately $256,000 and $132,000,respectively. Amortization expense for 2006 and 2007 is included indepreciation expense.

 

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Thefollowing is a schedule by years of approximate remaining minimum paymentsrequired under the leases, together with the present value at December 29,2007:

** **
| **Fiscal Year**               | ** ** | ** ** | ** ** |
|------------------------------------|------------|------------|------------|
| 2008                               |       | $          | 265,000    |   |
| 2009                               |       | 258,000    |       |
| 2010                               |       | 226,000    |       |
| 2011                               |       | 92,000     |       |
| 2012                               |       | 25,000     |       |
| Total minimum  lease payments      |       | $          | 866,000    |   |
|                               |       |       |       |
| Less amount  representing interest |       | 166,000    |       |
| Less current  portion              |       | 198,000    |       |
| Long-term  portion                 |       | $          | 502,000    |   |

 

**Note 4.Accrued Expenses**

 

Accruedexpenses were as follows:

 
| ** **                          | ** ** | **2007**  | ** ** | **2006**  | ** ** |
|-------------------------------------|------------|-----------|------------|-----------|------------|
| Compensation and  benefits          |       | $         | 2,113,000  |      | $          | 1,427,000 |   |
| Warranty expense                    |       | 80,000    |       | 28,000    |       |
| Accrued  recycling incentive checks |       | 1,110,000 |       | 1,110,000 |       |
| Accrued Rent                        |       | 433,000   |       | 356,000   |       |
| Accrued Payables                    |       | 190,000   |       | 570,000   |       |
| Other                               |       | 187,000   |       | 466,000   |       |
|                                |       | $         | 4,113,000  |      | $          | 3,957,000 |   |

 

**Note 5.Commitments and Contingencies**

 

**Operatingleases:**We leasecertain of our retail stores and recycling center facilities and equipmentunder noncancelable operating leases. The leases require the payment of taxes,maintenance, utilities and insurance.

 

Minimumfuture rental commitments under noncancelable operating leases as of December 29,2007 are as follows:

 
| **Fiscal Year** | ** ** | ** ** | ** ** |
|----------------------|------------|------------|------------|
| 2008                 |       | $          | 3,450,000  |   |
| 2009                 |       | 2,805,000  |       |
| 2010                 |       | 2,246,000  |       |
| 2011                 |       | 1,732,000  |       |
| 2012                 |       | 1,755,000  |       |
| 2013 and  thereafter |       | 3,355,000  |       |
|                 |       | $          | 15,343,000 |   |

 

Rentexpense for fiscal years 2007 and 2006 was $4,069,000 and $3,542,000,respectively.

 

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** **

**Contracts:** We have entered into contracts with three of our appliance vendors. Underthe agreements there are no minimum purchase commitments; however, we haveagreed to indemnify the vendors for certain claims, allegations or losses withrespect to appliances we sell.

 

**Litigation:**In December 2004,we filed suit in the U.S. District Court for the Central District of Californiaalleging that JACO Environmental, Inc., (JACO) and one of our formerconsultants fraudulently obtained U.S. Patent No. 6,732,416 in May 2004covering appliance recycling methods and systems which were originallydeveloped by us beginning in 1987 and used in serving more than forty-fiveelectric utility appliance recycling programs since that time. We are seekingan injunction to prevent JACO from claiming that it obtained a valid patent onappliance recycling processes that we believe is based on methods and processeswe invented. In addition, we are seeking a finding by the Court that the patentobtained by JACO is unenforceable due to inequitable conduct before the UnitedStates Patent Office. We are also asking the court for unspecified damagesrelated to charges that JACO, in using the patent to promote its services, hasengaged in unfair competition and false and misleading advertising underfederal and California statutes.

 

InSeptember 2005, we received a legally binding document in which JACOstates it will not sue us or any of our customers for violating the JACOpatent. Further, the defendants in the case have not asserted any counterclaimsagainst ARCA. Therefore, our recycling operations will continue with ourcurrent contracts and future customers without interruption.

 

Thecase is scheduled for trial in November of 2008. The trial is expected tolast approximately two weeks.

 

On October 24,2006, JACO and SEG Umwelt-Service/Basis of Mettlach, Germany (SEG) filed apatent infringement lawsuit in Federal Court in San Francisco against us. Thesuit claimed that we have been using refrigerator recycling systems andprocesses covered by two U.S. patents issued to SEG and exclusively licensed toJACO. JACO and SEG sought an undisclosed amount in damages, in addition to aninjunction barring us from continuing to use and market the systems andprocesses upon which we allegedly infringed. This suit has been subsequentlydismissed following a transfer of the case to Los Angeles upon the motion ofARCA.

 

**Note 6. Income Taxes**

** **

Theprovision for income taxes consisted of the following:

 
| ** **    | ** ** | **2007** | ** ** | **2006**   | ** ** |
|---------------|------------|----------|------------|------------|------------|
| Current:      |       |     |       |       |       |
| Federal       |       | $        | 40,000     | ** ** | **—** | ** ** |
| State         |       | $        | 24,000     | ** ** | **—** | ** ** |
| International |       | $        | 99,000     | ** ** | **—** | ** ** |
| Deferred      |       | —   | ** ** | **—** | ** ** |
|          |       | $        | 163,000    | ** ** | **—** | ** ** |

 

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

 

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| ** **                                      | ** ** | **2007** | ** ** | **2006** | ** ** |
|-------------------------------------------------|------------|----------|------------|----------|------------|
| Income tax  expense (benefit) at statutory rate |       | $        | 918,000    |     | $          | (479,000 | ) |
| State taxes net  of federal tax effect          |       | 100,000  |       | (98,000  | )          |
| Permanent  differences and other                |       | (121,000 | )          | 25,000   |       |
| Change in  valuation allowance                  |       | (734,000 | )          | 552,000  |       |
|                                            |       | $        | 163,000    |     | —     |   |
|                                                 |            |          |            |          |            |  |  |

 

Thecomponents of net deferred tax assets are as follows:

 
| ** **                        | ** ** | **2007**   | ** ** | **2006**   | ** ** |
|-----------------------------------|------------|------------|------------|------------|------------|
| Deferred tax  assets:             |       |       |       |       |       |
| Net operating  loss carryforwards |       | $          | 1,986,000  |       | $          | 2,591,000 |   |
| Federal and  state tax credits    |       | 309,000    |       | 269,000    |       |
| Reserves                          |       | 205,000    |       | 235,000    |       |
| Accrued expenses                  |       | 168,000    |       | 171,000    |       |
| Stock -based  compensation        |       | 80,000     |       | 51,000     |       |
| Other                             |       | 26,000     |       | 44,000     |       |
| Net deferred tax  assets          |       | $          | 2,774,000  |       | $          | 3,361,000 |   |
| Valuation  allowance              |       | (2,324,000 | )          | (2,760,000 | )          |
|                              |       | $          | 450,000    |       | $          | 601,000 |   |
| Deferred tax  liabilities:        |       |       |       |       |       |
| Prepaid expenses                  |       | $          | 140,000    |       | $          | 117,000 |   |
| Property and  equipment           |       | 264,000    |       | 484,000    |       |
| Foreign Currency  translation     |       | 30,000     |       |       |       |
| Other                             |       | 16,000     |       |       |       |
| Net deferred  taxes               |       | $          | 450,000    |       | $          | 601,000 |   |

 

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

 
| ** **               | ** ** | **2007** | ** ** | **2006** | ** ** |
|--------------------------|------------|----------|------------|----------|------------|
| Current assets           |       | $        | 259,000    |     | $          | 601,000 |   |
| Non-current  liabilities |       | (259,000 | )          | (601,000 | )          |
|                     |       | $        | —     |     | $          | — |   |

 

AtDecember 29, 2007, we had a valuation allowance against deferred taxassets to reduce the total to an amount our management believes is appropriate.Realization of deferred tax assets is dependent upon sufficient future taxableincome during the periods when deductible temporary differences andcarryforwards are expected to be available to reduce taxable income. Thevaluation allowance decreased in the current year primarily as a result oftaxable income generated during the year, which was partly offset by anadjustment in the amount of $372,000 to increase net operating losscarryforwards and valuation allowance to their proper amounts. In the futurewhen we believe we can reasonably estimate future operating results and thoseestimated results reflect taxable income, the amount of deferred tax assetsconsidered reasonable could be adjusted by a reduction of the valuationallowance.

 

Wehave not recognized a deferred tax liability relating to cumulativeundistributed earnings of controlled foreign subsidiaries that are essentiallypermanent in duration. If some or all of the undistributed earnings of thecontrolled foreign subsidiaries are remitted to us in the future, income taxes,if any, after the application of foreign tax credits will be provided at thattime.

 

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Futureutilization of NOL and tax credit carryforwards is subject to certainlimitations under provisions of Section 382 of the Internal Revenue Code. Thissection relates to a 50 percent change in control over a three-year period. Webelieve that the issuance of Common Stock during 1999 resulted in an “ownershipchange” under Section 382. Accordingly, our ability to use NOL and taxcredit carryforwards generated prior to February 1999 is limited toapproximately $56,000 per year.

 

AtDecember 29, 2007, we had federal net operating loss (“NOL”) carryforwardsof approximately $8.4 million ($6.7 million of which is subject to IRC section382 limitation) and credits for general business credits of $13,000. Inaddition to general business credits we also had AMT credits carried forward ofapproximately $296,000. We also had state net operating loss carryforwards of$19.4 million ($3.3 million of which is subject to IRC section 382 limitation).The net operating loss carryforwards are available to offset future taxableincome or reduce taxes payable through 2027. These loss carryforwards willbegin expiring in 2016. The general business credits will expire in 2013. Wepreviously wrote off NOLs related to IRC section 382 limits against thevaluation allowance.

 

Part ofour net operating loss carryforwards (approximately $472,000 of tax deductions)resulted from the exercise of stock options. When these loss carryforwards arerealized, the corresponding change in valuation allowance will be recorded asadditional paid-in capital. We have adopted the “with and without” approach todetermine tax benefits under FAS 123R. Under this approach, windfall taxbenefits are used last to offset taxable income and a benefit is recorded inadditional paid-in capital only if an incremental benefit is provided afterconsidering all other tax attributes (including NOLs) presently available tous. This treatment results in a re-characterization of the NOL carryforward anda difference in the NOL asset between the financial statements and tax returns.The difference in the federal NOL deferred tax asset is $160,384.

 

Inaddition to the U.S. tax attributes discussed above, we had net operating losscarryforwards outside the U.S. totaling $270,000, which resulted in a deferredtax asset of $75,000. These international net operating loss carryforwardsexpire starting in 2015.

 

AtDecember 29, 2007, we had NOL carryforwards not subject to IRC section 382limitations, expiring as follows:

 
| **Expiration** | ** ** | **Amount** | ** ** |
|----------------|------------|------------|------------|
| 2025           |       | $          | 66,000     |   |
| 2026           |       | $          | 1,524,000  |   |

 

Weadopted the provisions of FASB Interpretation 48 (FIN 48), Accounting forUncertainty in Income Taxes, on December 31, 2006. Previously, we hadaccounted for tax contingencies in accordance with Statement of FinancialAccounting Standards 5, Accounting for Contingencies. As required by FIN 48,which clarifies Statement 109, Accounting for Income Taxes, we recognize thefinancial statement benefit of a tax position only after determining that therelevant tax authority would more likely than not sustain the position. For taxpositions meeting the more likely than not threshold, the amount recognized inthe financial statements is the largest benefit that has a greater than 50percent likelihood of being realized upon ultimate settlement with the relevanttax authority. At the adoption date, we applied FIN 48 to all tax positions forwhich the statute of limitations remained open. The adoption of FIN 48 had nomaterial impact on our financial position.

 

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Itis our practice to recognize interest related to income tax matters as acomponent of interest expense and penalties as a component of selling, generaland administrative expense. As of December 29, 2007, we had an immaterialamount of accrued interest and penalties.

 

Weare subject to income taxes in the U.S. federal jurisdiction, foreignjurisdictions and various states jurisdictions. Tax regulations from eachjurisdiction are subject to the interpretation of the related tax laws andregulations and require significant judgment to apply. With few exceptions, weare no longer subject to U.S. federal, foreign, state, or local income taxexaminations by tax authorities for the years before 2004. We are not currentlyunder examination by any taxing jurisdiction.

 

Wehad no significant unrecognized tax benefits as of December 29, 2007 thatwould reasonably be expected to affect our effective tax rate during the nexttwelve months.

 

**Note 7.Shareholders’ Equity**

 

**Stockoptions:** Our 2006Stock Option Plan (the “2006 Plan”) permits the granting of “incentive stockoptions” meeting the requirements of Section 422 of the Internal RevenueCode of 1986, as amended, and nonqualified options that do not meet therequirements of Section 422. The 2006 Plan has 600,000 shares availablefor grant. As of March 14, 2008, 222,000 options had been granted toemployees and non-employee directors under the 2006 Plan. Our Restated 1997Stock Option Plan (the “1997 Plan” and collectively with the 2006 Plan, the “Plans”),has expired. As of March 14, 2008, options to purchase an aggregate of28,500 shares had been granted to employees and were outstanding under the 1997Plan, and options to purchase an aggregate of 67,500 shares had been granted tothe Company’s non-employee directors. Under the 1997 Plan, 377,250 options havebeen exercised. Options outstanding under the expired 1997 Plan continue to beexercisable in accordance with their terms. Options granted to employeestypically vest over two years while grants to non-employee directors vest insix months.

 

Thefair value of each option grant is estimated on the date of grant using theBlack-Scholes option pricing model with the following weighted-averageassumptions:

 
| ** **                        | ** ** | **2007** | ** ** | **2006** | ** ** |
|-----------------------------------|------------|----------|------------|----------|------------|
| Expected  dividend yield          |       | —   |       | —   |       |
| Expected stock  price volatility  |       | 100.98   | %          | 101.89   | %          |
| Risk-free  interest rate          |       | 4.91     | %          | 4.91     | %          |
| Expected life of  options (years) |       | 6.05     |       | 5.25     |       |

 

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Additionalinformation relating to all outstanding options is as follows:

 
| ** **                             | ** ** | ** ** | ** ** | **Weighted Average** | ** ** |
|----------------------------------------|------------|------------|------------|---------------------------|------------|
| ** **                             | ** ** | **Shares** | ** ** | **Exercise Price**   | ** ** |
| Outstanding at December 31,  2005 |       | 265,500    |       | $                         | 2.45       |   |
| Granted                                |       | 22,500     |       | $                         | 4.32       |   |
| Exercised                              |       | (21,500    | )          | $                         | 1.40       |   |
| Cancelled                              |       | (2,500     | )          | $                         | 0.59       |   |
| Outstanding at December 30,  2006 |       | 264,000    |       | $                         | 2.72       |   |
| Granted                                |       | 47,500     |       | $                         | 3.06       |   |
| Exercised                              |       | (168,000   | )          | $                         | 2.37       |   |
| Cancelled                              |       | —     |       |                      |       |
| Outstanding at December 29,  2007 |       | 143,500    |       | 3.26                      |       |

 

 The weighted average fair value per option ofoptions granted during fiscal years 2007 and 2006 was $2.45 and $3.40,respectively.

 

Thefollowing tables summarize information about stock options outstanding as of December 29,2007:

 

OPTIONS OUTSTANDING

 
| **Range of Exercise Prices** | ** ** | **Number of Options  Outstanding** | ** ** | **Weighted Average  Remaining Contractual  Life in Years** | ** ** | **Weighted Average  Exercise Price** | ** ** | **Aggregate  Intrinsic  Value** | ** ** |
|------------------------------|------------|----------------------------------------------|------------|----------------------------------------------------------------------|------------|------------------------------------------------|------------|---------------------------------|------------|
| $3.81 to $4.32               |       | 79,000                                       |       | 4.20                                                                 |       | $                                              | 4.09       |                            |       |   |
| $2.38 to $2.80               |       | 47,000                                       |       | 5.05                                                                 |       | $                                              | 2.54       |                            |       |   |
| $1.38 to $1.51               |       | 17,500                                       |       | 2.88                                                                 |       | $                                              | 1.49       |                            |       |   |
|                         |       | 143,500                                      |       | 4.31                                                                 |       | $                                              | 3.26       |                            | $          | 757,242 |   |
|                              |            |                                              |            |                                                                      |            |                                                |            |                                 |            |  |  |

 

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OPTIONS EXERCISABLE

 
| ** **                                  | ** ** | ** **                      | ** ** | ** **                | ** ** | **Aggregate** | ** ** |
|---------------------------------------------|------------|---------------------------------|------------|---------------------------|------------|---------------|------------|
| ** **                                  | ** ** | **Number of Options** | ** ** | **Weighted Average** | ** ** | **Intrinsic** | ** ** |
| **Range of Exercise Prices** | ** ** | **Exercisable**                 | ** ** | **Exercise Price**   | ** ** | **Value**     | ** ** |
| $3.81 to $4.32                              |       | 74,000                          |       | $                         | 4.09       |          |       |   |
| $2.38 to $2.80                              |       | 22,000                          |       | $                         | 2.72       |          |       |   |
| $1.38 to $1.51                              |       | 17,500                          |       | $                         | 1.49       |          |       |   |
|                                        |       | 113,500                         |       | $                         | 3.40       |          | $          | 580,792 |   |
|                                             |            |                                 |            |                           |            |               |            |  |  |

 

Theaggregate intrinsic value in the preceding tables represent the total pretaxintrinsic value, based on our closing stock price of $8.54 on December 29,2007, which theoretically could have been received by the option holders hadall option holders exercised their options as of that date. The total number ofin-the-money options exercisable as of December 29, 2007 was 113,500. Theintrinsic value of stock options exercised during the years ended December 29,2007 and December 30, 2006 was $797,022 and $64,412 respectively.

 

**Preferredstock:**Our amended Articles ofIncorporation authorize two million shares of Preferred Stock that may beissued from time to time in one or more series having such rights, powers,preferences and designations as the Board of Directors may determine. To dateno such preferred shares have been issued.

 

**Note 8.Major Customers and Suppliers**

 

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

 
| ** **           | ** ** | **2007** | ** ** | **2006** | ** ** |
|----------------------|------------|----------|------------|----------|------------|
| Revenue  percentage: |       |     |       |     |       |
| Customer A           | ** ** | **4**    | **%**      | 11       | %          |
| Customer B           | ** ** | **12**   | **%**      | 0        | %          |
| Customer C           | ** ** | **5**    | **%**      | 0        | %          |

 

Wehad receivables of $610,000, $5,934,000 and $939,000 respectively for CustomersA, B, and C as of December 29, 2007. The balance for customer A at December 30,2006 was $485,000. We had no receivable balance at December 30, 2006 forcustomers B & C.

 

Duringthe two years ended December 29, 2007, we purchased a vast majority ofappliances for resale from four suppliers. We have and are continuing to secureother vendors from which to purchase appliances. However, the curtailment orloss of one of these suppliers or any appliance supplier could adversely affectour operations.

 

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**Note 9.Segment Information**

 

We operate two reportable segments: Retail andRecycling. The retail operation is comprised of sales generated through ourApplianceSmart factory outlet stores. The recycling operation is comprised ofall fees charged for collecting, recycling and installing appliances forutilities and other customers as well as all byproduct revenue. Our segmentsare evaluated on an operating income basis, and a stand-alone tax provision isnot calculated for each segment. Certain corporate items are not allocable tothe two segments as noted in the table below. The other accounting policies ofthe segments are the same as those described in Note 1, *Nature ofBusiness and Significant Accounting Policies.* The information for2006 has been labeled restated to reflect the inclusion of the comparableperiod, which was omitted from prior filings, in the current year report.

 

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The following tablespresent our business segment information for continuing operations in fiscal2007 and 2006:

 
| ** **                      | ** ** | **2007**    | ** ** | **2006**       | ** ** |
|---------------------------------|------------|-------------|------------|----------------|------------|
| ** **                      | ** ** | ** **  | ** ** | **(Restated)** | ** ** |
| **Revenue**                     |       |        |       |           |       |
| Retail                          |       | $           | 72,915,000 |           | $          | 65,504,000 |   |
| Recycling                       |       | 27,850,000  |       | 12,286,000     |       |
|                            |       |        |       |           |       |
| Total Revenue                   |       | 100,765,000 |       | 77,790,000     |       |
|                            |       |        |       |           |       |
| **Operating  Income**           |       |        |       |           |       |
| Retail                          |       | 2,320,000   |       | (3,000,000     | )          |
| Recycling                       |       | 2,317,000   |       | 2,075,000      |       |
| Unallocated  Corporate Costs    |       | (431,000    | )          | (186,000       | )          |
|                            |       |        |       |           |       |
| Total Operating  Income         |       | 4,206,000   |       | (1,111,000     | )          |
| **Assets**                      |       |        |       |           |       |
|                            |       |        |       |           |       |
| Retail                          |       | 19,160,000  |       | 16,003,000     |       |
| Recycling                       |       | 13,797,000  |       | 4,845,000      |       |
| Corporate assets  not allocable |       | 2,575,000   |       | 3,065,000      |       |
|                            |       |        |       |           |       |
| Total Assets                    |       | 35,532,000  |       | 23,913,000     |       |
|                            |       |        |       |           |       |
| **Capital  Expenditures**       |       |        |       |           |       |
|                            |       |        |       |           |       |
| Retail                          |       | 378,000     |       | 312,000        |       |
| Recycling                       |       | 323,000     |       | 3,000          |       |
| Corporate                       |       | 231,000     |       | 238,000        |       |
|                            |       |        |       |           |       |
| Total Capital  Expenditures     |       | 932,000     |       | 553,000        |       |
| **Depreciation**                |       |        |       |           |       |
|                            |       |        |       |           |       |
| Retail                          |       | 389,000     |       | 336,000        |       |
| Recycling                       |       | 105,000     |       | 94,000         |       |
| Corporate                       |       | 379,000     |       | 358,000        |       |
|                            |       |        |       |           |       |
| Total  Depreciation             |       | 873,000     |       | 788,000        |       |
|                            |       |        |       |           |       |
| **Interest  Expense**           |       |        |       |           |       |
| Retail                          |       | 944,000     |       | 706,000        |       |
| Recycling                       |       | 241,000     |       | 120,000        |       |
| Corporate                       |       | 286,000     |       | 253,000        |       |
|                            |       |        |       |           |       |
| Total Interest  Expense         |       | $           | 1,471,000  |           | $          | 1,079,000 |   |

 

50

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| **ITEM 9.** | ** ** | **CHANGES IN AND DISAGREEMENTS  WITH ACCOUNTANTS ON ACCOUNTING AND FINANCIAL DISCLOSURE** |
|-------------|------------|-------------------------------------------------------------------------------------------|

 

None.

 
| **ITEM 9A.** | **CONTROLS AND PROCEDURES** |
|--------------|-----------------------------|

 

**Evaluation of Disclosure Controlsand Procedures**

 

Wehave established disclosure controls and procedures to ensure that materialinformation relating to the Company is made known to the officers who certifythe financial statements and to other members of senior management and theAudit Committee of the Board.

 

Weconducted an evaluation, under the supervision and with the participation ofour chief executive officer, chief financial officer and principal accountingofficer of our disclosure controls and procedures (as defined in Rules 13a-15(e) and15d-15(e) under the Securities Exchange Act of 1934). Based on thisevaluation our chief executive officer, chief financial officer and principalaccounting officer have concluded that, as of December 29, 2007, ourdisclosure controls and procedures are effective.

 

**Changes in Internal Control OverFinancial Reporting**

 

Therehave been no changes in our internal controls over financial reporting for thethree-months ended December 29, 2007 that have materially affected, or arereasonably likely to materially affect, our internal control over financialreporting.

 

**Management’s Report on InternalControls over Financial Reporting**

 

Themanagement of the Company is responsible for establishing and maintainingadequate internal control over financial reporting. Our internal control systemwas designed to provide reasonable assurance to our management and Board ofDirectors regarding the preparation and fair presentation of publishedfinancial statements.

 

Allinternal controls over financial reporting, no matter how well designed, haveinherent limitations, including the possibility of human error and thecircumvention or overriding of controls. Therefore, even effective internalcontrol over financial reporting can provide only reasonable assurance withrespect to financial statement preparation and presentation. Further, becauseof changes in conditions, the effectiveness of internal controls over financialreporting may vary over time.

 

Ourmanagement, including our chief executive officer and chief financial officer,assessed the effectiveness of our internal control over financial reporting asof December 29, 2007. In making its assessment of internal control overfinancial reporting, management used the criteria set forth by the Committee ofSponsoring Organizations of the Treadway Commission (COSO) in*Internal Control—Integrated Framework* .

 

UnderSEC rules, management may assess its internal control over financial reportingas effective if there are no identified material weaknesses at the reportingdate.  A material weakness is “adeficiency, or a combination of deficiencies (within the meaning of PCAOBAuditing Standard No. 5), in internal control over financial reporting,such that there is a reasonable possibility that a material misstatement of ourannual

 

51

----

 

orinterim financial statements will not be prevented or detected on a timelybasis.”  

 

Management’sassessment identified the following material weakness in internal controls overfinancial reporting as of December 29, 2007:

 

Controlssurrounding the process of reconciling a specific receivable related to creditsdue from inventory vendors and intercompany accounts were found to beinadequate as of December 29, 2007. These deficiencies in the design andimplementation of our internal control over financial reporting causedpost-closing adjustments to be recorded in the fourth quarter of 2007.  These adjustments were limited to 2007 andwere not material to previously reported interim periods or the fourth quarter,but could have grown to be material had they not been detected on audit.

 

Becauseof the material weakness described above, management believes that, as of December 29,2007, our internal controls over financial reporting were not effective.

 

Subsequentto December 29, 2007, we have undertaken and will continue to undertakework to remediate the material weakness described above, includingimplementing, documenting and testing new controls and procedures.

 

Thisannual report does not include an attestation report of the Company’sindependent registered public accounting firm regarding internal control overfinancial reporting.  Management’s reportwas not subject to attestation by the Company’s registered public accountingfirm pursuant to temporary rules of the Securities and Exchange Commissionthat permit the Company to provide only management’s report in this annualreport.

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

 

**PART III**

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

 

Information regarding directors and executive officers of the company isset 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 2008 AnnualMeeting of Shareholders to be held May 15, 2008 and is incorporated hereinby reference.

 

**Code of Ethics**

 

Our Audit Committee has adopted a code of ethics applicable to ourdirectors, officers, including our chief executive officer, chief financialofficer, principal financial officer and other of our senior financialofficers, and employees, in accordance with applicable rules andregulations of the SEC and The NASDAQ Stock Market.  A copy of the code of ethics may be obtainedupon request, without charge, by addressing a request to Investor Relations,ARCA, Inc., 7400 Excelsior Boulevard, Minneapolis, MN  55426.

 

52

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

 

Information regarding executive compensation is set forth under theheadings “Compensation Committee Report” and “Executive Compensation” in ourProxy Statement for our 2008 Annual Meeting of Shareholders to be held May 15,2008, and is incorporated herein by reference.

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

 

Information regarding security ownership of certain beneficial ownersand management is set forth under the heading “Common Stock Ownership” in ourProxy Statement for our 2008 Annual Meeting of Shareholders to be held May 15,2008, and is incorporated herein by reference.

 

The following table gives aggregate information under our equitycompensation plans as of December 29, 2007:

 
| ** **          | ** ** | **(a)**                     | ** ** | **(b)**                 | ** ** | **(c)**                   |
|---------------------|------------|-----------------------------|------------|-------------------------|------------|---------------------------|
| ** **          | ** ** | ** **                  | ** ** | ** **              | ** ** | **Number of Securities**  |
| ** **          | ** ** | ** **                  | ** ** | ** **              | ** ** | **Available for Future**  |
| ** **          | ** ** | **Number of Securities to** | ** ** | **Weighted-Average**    | ** ** | **Issuance Under Equity** |
| ** **          | ** ** | **Be Issued Upon Exercise** | ** ** | **Exercise Price of**   | ** ** | **Compensation Plans**    |
| ** **          | ** ** | **of Outstanding**          | ** ** | **Outstanding**         | ** ** | **(Excluding Securities** |
| ** **          | ** ** | **Options,**                | ** ** | **Options,**            | ** ** | **Reflected in**          |
| ** **          | ** ** | **Warrants and Rights**     | ** ** | **Warrants and Rights** | ** ** | **Column(a))**            |
| Equity compensation |       |                        |       |                    |       |                      |
| plans  approved by  |       |                        |       |                    |       |                      |
| stockholders        |       | 143,500                     |       | $                       | 3.26       |                      | 552,500 |
|                     |            |                             |            |                         |            |                           |  |

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

 

Information regarding certain relationships and related transactions isset forth under the headings “Director Independence” and “Review, Approval or Ratification ofTransactions with Related Persons”in our ProxyStatement for our 2008 Annual Meeting of Shareholders to be held May 15,2008, and is incorporated herein by reference.

 
| **ITEM 14.** | **PRINCIPAL ACCOUNTING FEES AND SERVICES** |
|--------------|--------------------------------------------|

 

Information regarding principal accountant fees and services is setforth under the heading “Independent Registered Public Accounting Firm” in ourProxy Statement for our 2008 Annual Meeting of Shareholders to be held May 15,2008, and is incorporated herein by reference.

 

53

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**PART IV**

 
| **ITEM 15.**                                     | **EXHIBITS AND FINANCIAL STATEMENT SCHEDULES**                        |
|--------------------------------------------------|-----------------------------------------------------------------------|
| ** **                                       | ** **                                                            | ** ** |
| **(a)**                                          | **Financial  Statements, Financial Statement Schedules and Exhibits** |
| ** **                                       | ** **                                                            | ** ** |
| ** **                                       | **1.**                                                                | **Financial  Statements** |
|                                             |                                                                  |   |
|                                             |                                                                  | See  Index to Financial Statements under Item 8 of this report. |
|                                             |                                                                  |   |
| ** **                                       | **2.**                                                                | **Financial  Statement Schedule** |
|                                             |                                                                  |   |
|                                             |                                                                  | To  the Board of Directors |
|                                             |                                                                  | Appliance  Recycling Centers of America, Inc. and Subsidiaries |
|                                             |                                                                  | Minneapolis,  Minnesota |
|                                             |                                                                  |   |
|                                             |                                                                  | Our audit was conducted in  accordance with the standards of the Public Company Accounting Oversight  Board (United States) and was made for the purpose of forming an opinion on  the basic consolidated financial statements of Appliance Recycling Centers of  America, Inc. and Subsidiaries taken as a whole.  The supplemental Schedule II is presented  for purposes of complying with the Securities and Exchange Commission’s  rules and is not a part of the basic consolidated financial  statements.  This schedule has been  subjected to the auditing procedures applied in our audit of the basic  consolidated financial statements and in our opinion, is fairly stated in all  material respects in relation to the basic consolidated financial statements  taken as a whole.

  |
|                                             |                                                                  |   |
|                                             |                                                                  | /s/  VIRCHOW, KRAUSE  AND COMPANY, LLP |
|                                             |                                                                  | Minneapolis,  Minnesota |
|                                             |                                                                  | March 26,  2008 |
|                                             |                                                                  |   |
| Schedule  II - Valuation and Qualifying Accounts |

 
| ** **                           | ** ** | **Accounts Receivable** | ** **  | **Inventory** | ** ** |
|--------------------------------------|------------|------------------------------|-------------|---------------|------------|
| ** **                           | ** ** | **Allowance**                | ** **  | **Allowance** | ** ** |
| Balance,  December 31, 2005     |       | $                            | 252,000     |          | $          | 379,000 |   |
| Additional  allowance                |       |                         |        | 220,000       |       |
| Write-offs/adjustments               |       | (100,000                     | )           | (392,000      | )          |
| Balance,  December 30, 2006     |       | $                            | 152,000     |          | $          | 207,000 |   |
| Additional  allowance                |       | 2573                         |        | 8,599         |       |
| Write-offs/adjustments               |       | (2573                        | )      | (131,599      | )          |
|                                 |       |                         |        |          |       |
| **Balance,  December 29, 2007** | ** ** | **$**                        | **152,000** | ** **    | **$**      | **84,000** | ** ** |

 
|   | **3.**     | **Exhibits**                                           |
|--------|------------|--------------------------------------------------------|
|   | ** ** | ** **                                             |
|   | ** ** | See  Index to Exhibits on page 56 of this report. |

 

54

----

 

**SIGNATURES**

 

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

 
| Dated:  March 28, 2008 | APPLIANCE  RECYCLING CENTERS OF |
|-----------------------------|---------------------------------|
|                        | AMERICA,  INC.                  |
|                        | (Registrant)                    |
|                        |                            |   |
|                        | By                              | /s/  Edward R. Cameron |
|                        |                            | Edward  R. Cameron |
|                        |                            | President  and Chief Executive Officer |
|                        |                            |   |
|                        | By                              | /s/  Peter Hausback |
|                        |                            | Peter  Hausback |
|                        |                            | EVP  and Chief Financial Officer |
|                        |                            |   |
|                        | By                              | /s/  Patrick J. Winters |
|                        |                            | Patrick  J. Winters |
|                        |                            | Principal  Accounting Officer |
|                             |                                 |  |  |

 

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

 
| **Signature**           | ** ** | **Title**                             | ** ** | **Date**            |
|-------------------------|------------|---------------------------------------|------------|---------------------|
| /s/  Edward R. Cameron  |       | Chairman  of the Board, President and |       | March 28, 2008 |
| Edward  R. Cameron      |       | Chief  Executive Officer              |       |                |
|                    |       |                                  |       |                |
| /s/  Peter Hausback     |       | Executive  Vice President and         |       | March 28, 2008 |
| Peter  Hausback         |       | Chief  Financial Officer              |       |                |
|                    |       |                                  |       |                |
| /s/  Patrick J. Winters |       | Principal  Accounting Officer         |       | March 28, 2008 |
| Patrick  J. Winters     |       |                                  |       |                |
|                    |       |                                  |       |                |
| /s/  Duane S. Carlson   |       | Director                              |       | March 28, 2008 |
| Duane  S. Carlson       |       |                                  |       |                |
|                    |       |                                  |       |                |
| /s/  Thomas Hunt Jr.    |       | Director                              |       | March 28, 2008 |
| Thomas  Hunt Jr.        |       |                                  |       |                |
|                    |       |                                  |       |                |
| /s/  Morgan Wolf        |       | Director                              |       | March 28, 2008 |
| Morgan  Wolf            |       |                                  |       |                |
|                    |       |                                  |       |                |
| /s/  Glynnis Jones      |       | Director                              |       | March 28, 2008 |
| Glynnis  Jones          |       |                                  |       |                |
|                    |       |                                  |       |                |
| /s/  Albin S. Dubiak    |       | Director                              |       | March 28, 2008 |
| Albin  S. Dubiak        |       |                                  |       |                |

 

55

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** **

**INDEX TOEXHIBITS**

 
| **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        |            | Bylaws  of Appliance Recycling Centers of America, Inc. as amended  December 26, 2007 [filed as Exhibit 3.2 to the Company’s  Form 8-K filed on January 2, 2008(File No. 0-19621) and  incorporated herein by reference]. |
|             |       |            |   |
|             | *10.1      |            | 2006 Stock Option Plan [filed as Appendix B to the  Company’s Schedule 14A filed on March 31, 2006 and incorporated herein  by reference]. |
|             |       |            |   |
|             | *10.2      |            | 1997  Stock Option Plan and Amendment [filed as Exhibits 28.1 and 28.2 to the  Company’s Registration Statement on Form S-8 (Registration  No. 333-28571) and incorporated herein by reference]. |
|             |       |            |   |
|             | *10.3      |            | Amendment  effective April 26, 2001 to 1997 Stock Option Plan [filed as  Exhibit 10.2 to the Company’s Form 10-Q for the quarter ended  March 31, 2001 (File No. 0-19621) and incorporated herein by  reference]. |
|             |       |            |   |
|             | *10.4      |            | Amendment  effective April 25, 2002 to 1997 Stock Option Plan [filed as  Exhibit 10.2 to the Company’s Form 10-Q for the quarter ended  March 30, 2002 (File No. 0-19621) and incorporated herein by  reference]. |
|             |       |            |   |
|             | 10.5       |            | Line  of credit dated August 30, 1996, between Appliance Recycling Centers of  America, Inc. and Spectrum Commercial Services, a division of Lyons  Financial Services, Inc. [filed as exhibit 10.15 to the Company’s  Form 10-Q for the quarter ended September 28, 1996 (File  No. 0-19621) and incorporated herein by reference]. |
|             |       |            |   |
|             | 10.6       |            | First  Amendment to General Credit and Security Agreement and Waiver dated  November 8, 1996, between Spectrum Commercial Services, a division of  Lyons Financial Services, Inc., and the Company, and related agreement  [filed as exhibit 10.16 to the Company’s Form 10-Q for the quarter ended  September 28, 1996 (File No. 0-19621) and incorporated herein by  reference]. |
|             |       |            |   |
|             | 10.7       |            | Second  Amendment to General Credit and Security Agreement and Waiver dated  February 12, 1998 between Spectrum Commercial Services, a division of  Lyons Financial Services, Inc., and the Company, and related agreements  [filed as Exhibit 10.10 to the Company’s Form 10-K for year ended  January 3, 1998 (File No. 0-19621) and incorporated herein by  reference]. |

 

56

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

 

57

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

 

58

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|   |   |   | 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].                                                                                                                                                                                                   |
|--------|--------|--------|---------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|
|   |   |   |                                                                                                                                                                                                                                                                                                                                                                                              |
|   | 10.30  |   | 2004-05  Statewide Residential Appliance Recycling Program Agreement dated  January 21, 2004 between Southern California Edison Company and ARCA  California, Inc., a wholly-owned subsidiary of the Company [filed as  Exhibit 10.34 to the Company’s Form 10-K for the year ended January 3,  2004 (File No. 0-19621) and incorporated herein by reference]. |
|   |   |   |                                                                                                                                                                                                                                                                                                                                                                                              |
|   | 10.31  |   | Agreements  dated September 24, 2002 between the Company and the Department of Water  and Power of the City of Los Angeles [filed as Exhibit 10.32 to the  Company’s Form 10-K for the year ended December 28, 2002 (File  No. 0-19621) and incorporated herein by reference].                                                                                      |
|   |   |   |                                                                                                                                                                                                                                                                                                                                                                                              |
|   | 10.32  |   | Agreement  dated March 1, 2004 between San Diego Gas & Electric and the  Company [filed as Exhibit 10.35 to the Company’s Form 10-K for the  year ended January 3, 2004 (File No. 0-19621) and incorporated  herein by reference].                                                                                                                         |
|   |   |   |                                                                                                                                                                                                                                                                                                                                                                                              |
|   | 10.33  |   | Agreement  dated May 24, 2006 between San Diego Gas & Electric and the  Company [filed as Exhibit No. 10.1 to the Company’s Form 8-K  dated July 5, 2006 (File No. 0-19621) and incorporated herein by  reference].                                                                                                                                   |
|   |   |   |                                                                                                                                                                                                                                                                                                                                                                                              |
|   | 10.34  |   | Agreement  dated June 14, 2006 between Southern California Edison Company (Edison)  and the Company [filed as Exhibit No. 10.1 to the Company’s  Form 8-K dated July 6, 2006 (File No. 0-19621) and  incorporated herein by reference].                                                                                                                        |
|   |   |   |                                                                                                                                                                                                                                                                                                                                                                                              |
|   | 10.35  |   | Form of Securities Purchase Agreement dated as of  December 31, 2004, between the Company and certain investors [filed as  Exhibit No. 99.2 to the Company’s Form 8-K dated  December 31, 2004 (File No. 0-19621) and incorporated herein by  reference].                                                                                                 |
|   |   |   |                                                                                                                                                                                                                                                                                                                                                                                              |
|   | 21.1   |   | Subsidiaries of  Appliance Recycling Centers of America, Inc.                                                                                                                                                                                                                                                                                                                                |
|   |   |   |                                                                                                                                                                                                                                                                                                                                                                                              |
|   | +23.1  |   | Consent  of Virchow Krause & Company, LLP, Independent Registered Public  Accounting Firm.                                                                                                                                                                                                                                                                                               |
|   |   |   |                                                                                                                                                                                                                                                                                                                                                                                              |
|   | +31.1  |   | Certification  by the Chief Executive Officer pursuant to Section 302 of the  Sarbanes-Oxley Act of 2002.                                                                                                                                                                                                                                                                                    |
|   |   |   |                                                                                                                                                                                                                                                                                                                                                                                              |
|   | +31.2  |   | Certification  by the Chief Financial Officer pursuant to Section 302 of the  Sarbanes-Oxley Act of 2002.                                                                                                                                                                                                                                                                                    |
|   |   |   |                                                                                                                                                                                                                                                                                                                                                                                              |
|   | +31.3  |   | Certification  by the Principal Accounting Officer pursuant to Section 302 of the  Sarbanes-Oxley Act of 2002                                                                                                                                                                                                                                                                                |
|   |   |   |                                                                                                                                                                                                                                                                                                                                                                                              |
|   | +32    |   | Certifications  pursuant to 18 U.S.C. Section 1350, as adopted pursuant to  Section 906 of the Sarbanes-Oxley Act of 2002.                                                                                                                                                                                                                                                              |

 

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| * | Items  that are management contracts or compensatory plans or arrangements required  to be filed as an exhibit pursuant to Item 14(a)3 of this Form 10-K. |
|---|----------------------------------------------------------------------------------------------------------------------------------------------------------------|
| + | Filed  herewith.                                                                                                                                               |

 

59

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