UNITED
STATES SECURITIES AND EXCHANGE COMMISSION


Washington, D.C.
20549


Form 10-Q




(Mark One)þ
            
            QUARTERLY
      REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF
      1934For
      the Quarterly Period Ended September 30, 2009o
            
            TRANSITION
      REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF
      1934For
      the Transition Period
      from          to




Commission
File Number 000-51869




SouthPeak
Interactive Corporation


(Exact
Name of Registrant as Specified in Its Charter)




Delaware
                  (State
      or Other Jurisdiction of
                  Incorporation
      or Organization)
                20-3290391
                  (I.R.S.
      Employer
                  Identification
      No.)




2900
Polo Parkway


Midlothian,
Virginia 23113


(804) 378-5100


(Address
including zip code, and telephone number,


including
area code, of principal executive offices)




Not
applicable


(Former
name, former address and former fiscal year, if changed since last
report)




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




Yes þ     No  ̈




Indicate
by check mark whether the registrant has submitted electronically and posted on
its corporate Web site, if any, every Interactive Data File required to be
submitted and posted pursuant to Rule 405 of Regulation S-T (§232.405 of this
chapter) during the preceding 12 months (or for such shorter period that the
registrant was required to submit and post such files).




Yes  ̈     No  ̈




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




Large
      accelerated filer o
              Accelerated
      filer o
              Non-accelerated
      filer o
              Smaller
      reporting company þ


(Do not
check if a smaller reporting company)




Indicate
by check mark whether the registrant is a shell company (as defined
in Rule 12b-2 of the Exchange Act).




Yes o     No þ




As of
November 6, 2009, 44,998,600 shares of common stock, par value $0.0001 per
share, of the registrant were outstanding.





TABLE
OF CONTENTS




PagePART I —
      FINANCIAL INFORMATIONItem
      1.
                  Financial
      Statements
                  
                  
                  2Condensed
      Consolidated Financial Statements (unaudited)
                  
                  
                  2Condensed
      Consolidated Balance Sheets as of September 30, 2009 and June 30, 2009
      (unaudited)
                  
                  
                  2Condensed
      Consolidated Statements of Operations for the three months ended September
      30, 2009 and 2008 (unaudited)
                  
                  
                  3Condensed
      Consolidated Statements of Cash Flows for the three months ended September
      30, 2009 and 2008 (unaudited)
                  
                  
                  4Notes
      to Condensed Consolidated Financial Statements
                  
                  
                  5Item
      2.
                  Management’s
      Discussion and Analysis of Financial Condition and Results of
      Operations
                  
                  
                  23Item
      3.
                  Quantitative
      and Qualitative Disclosures about Market Risk
                  
                  
                  31Item
      4T.
                  Controls
      and Procedures
                  
                  
                  31PART II —
      OTHER INFORMATIONItem
      1.
                  Legal
      Proceedings
                  
                  
                  33Item
      1A.
                  Risk
      Factors
                  
                  
                  33Item
      6.
                  Exhibits
                  
                  
                  33SIGNATURES




1


PART I


Item 1.Condensed Consolidated
Financial Statements


SOUTHPEAK
INTERACTIVE CORPORATION AND SUBSIDIARIES


CONDENSED
CONSOLIDATED BALANCE SHEETS







September 30, 2009
                                
                                
                                June 30, 2009(Unaudited)AssetsCurrent
      assets:Cash
      and cash equivalents
                                
                                $
                                273,481
                                
                                
                                $
                                648,311Restricted
      cash
                                
                                
                                827,665
                                
                                
                                
                                1,245,582Accounts receivable, net of
      allowances of $8,135,879 and$7,214,984 at September 30, 2009
      and June 30, 2009, respectively
                                
                                
                                12,482,104
                                
                                
                                
                                4,872,767Inventories
                                
                                
                                7,996,651
                                
                                
                                
                                4,459,837Current
      portion of advances on royalties
                                
                                
                                5,823,254
                                
                                
                                
                                8,435,415Current
      portion of intellectual property licenses
                                
                                
                                387,475
                                
                                
                                
                                410,995Related
      party receivables
                                
                                
                                72,032
                                
                                
                                
                                33,207Prepaid
      expenses and other current assets
                                
                                
                                536,764
                                
                                
                                
                                672,795Total
      current assets
                                
                                
                                28,399,426
                                
                                
                                
                                20,788,909Property
      and equipment, net
                                
                                
                                2,728,130
                                
                                
                                
                                2,754,139Advances
      on royalties, net of current portion
                                
                                
                                1,556,798
                                
                                
                                
                                1,556,820Intellectual
      property licenses, net of current portion
                                
                                
                                1,821,964
                                
                                
                                
                                1,917,858Goodwill
                                
                                
                                8,031,276
                                
                                
                                
                                7,490,065Intangible
      assets, net
                                
                                
                                27,025
                                
                                
                                
                                43,810Other assets
                                
                                
                                11,762
                                
                                
                                
                                11,872Total
      assets
                                
                                $
                                42,576,381
                                
                                
                                $
                                34,553,473Liabilities
      and Shareholders’ EquityCurrent
      liabilities:Line
      of credit
                                
                                $
                                7,123,865
                                
                                
                                $
                                5,349,953Current
      maturities of long-term debt
                                
                                
                                51,697
                                
                                
                                
                                50,855Production
      advance payable
                                
                                
                                3,755,104
                                
                                
                                
                                -Accounts
      payable
                                
                                
                                18,942,329
                                
                                
                                
                                19,686,168Accrued
      royalties
                                
                                
                                1,321,128
                                
                                
                                
                                414,696Accrued
      expenses and other current liabilities
                                
                                
                                4,297,063
                                
                                
                                
                                2,419,100Deferred
      revenues
                                
                                
                                2,842,712
                                
                                
                                
                                2,842,640Due
      to shareholders
                                
                                
                                -
                                
                                
                                
                                232,440Due
      to related parties
                                
                                
                                2,200
                                
                                
                                
                                125,045Accrued
      expenses - related parties
                                
                                
                                79,491
                                
                                
                                
                                184,766Total
      current liabilities
                                
                                
                                38,415,589
                                
                                
                                
                                31,305,663Long-term
      debt, net of current maturities
                                
                                
                                1,526,261
                                
                                
                                
                                1,538,956Total
      liabilities
                                
                                
                                39,941,850
                                
                                
                                
                                32,844,619Commitments
      and contingencies
                                
                                
                                -
                                
                                
                                
                                -Shareholders’
      equity:Preferred
      stock, $0.0001 par value; 5,000,000 shares authorized; no shares issued
      and outstanding at September 30, 2009 and June 30, 2009
                                
                                
                                -
                                
                                
                                
                                -Series
      A convertible preferred stock, $0.0001 par value; 15,000,000 shares
      authorized; 5,653,833 and 5,953,833 shares issued and outstanding at
      September 30, 2009 and June 30, 2009, respectively; aggregate liquidation
      preference of $5,653,833 at September 30, 2009
                                
                                
                                565
                                
                                
                                
                                595Common
      stock, $0.0001 par value; 90,000,000 shares authorized; 44,921,600 and
      44,530,100 shares issued and outstanding at September 30, 2009 and June
      30, 2009, respectively
                                
                                
                                4,492
                                
                                
                                
                                4,453Additional
      paid-in capital
                                
                                
                                25,367,113
                                
                                
                                
                                25,210,926Accumulated
      deficit
                                
                                
                                (22,458,819
                                )
                                
                                
                                (23,145,800
                                )Accumulated
      other comprehensive loss
                                
                                
                                (278,820
                                )
                                
                                
                                (361,320
                                )Total
      shareholders’ equity
                                
                                
                                2,634,531
                                
                                
                                
                                1,708,854Total
      liabilities and shareholders’ equity
                                
                                $
                                42,576,381
                                
                                
                                $
                                34,553,473




See notes
to condensed consolidated financial statements.


2


SOUTHPEAK
INTERACTIVE CORPORATION AND SUBSIDIARIES


CONDENSED
CONSOLIDATED STATEMENTS OF OPERATIONS


(Unaudited)




For
      the three months ended
                              September
      30,2009
                            
                            
                            2008Net
      revenues
                            
                            $
                            16,709,649
                            
                            
                            $
                            8,387,703Cost
      of goods sold:Product
      costs
                            
                            
                            3,546,686
                            
                            
                            
                            5,425,553Royalties
                            
                            
                            5,000,671
                            
                            
                            
                            808,921Intellectual
      property licenses
                            
                            
                            119,660
                            
                            
                            
                            43,980Total
      cost of goods sold
                            
                            
                            8,667,017
                            
                            
                            
                            6,278,454Gross
      profit
                            
                            
                            8,042,632
                            
                            
                            
                            2,109,249Operating
      expenses:Warehousing
      and distribution
                            
                            
                            286,511
                            
                            
                            
                            207,583Sales
      and marketing
                            
                            
                            3,655,056
                            
                            
                            
                            1,995,736Transaction
      costs
                            
                            
                            -
                            
                            
                            
                            18,380General
      and administrative
                            
                            
                            3,114,768
                            
                            
                            
                            1,380,425Total
      operating expenses
                            
                            
                            7,056,335
                            
                            
                            
                            3,602,124Income
      (loss) from operations
                            
                            
                            986,297
                            
                            
                            
                            (1,492,875
                            )Interest
      expense, net
                            
                            
                            299,316
                            
                            
                            
                            58,879Net
      income (loss)
                            
                            
                            686,981
                            
                            
                            
                            (1,551,754
                            )Deemed
      dividend related to beneficial conversion feature on Series A convertible
      preferred stock
                            
                            
                            -
                            
                            
                            
                            1,142,439Net
      income (loss) attributable to common shareholders
                            
                            $
                            686,981
                            
                            
                            $
                            (2,694,193
                            )Basic
      income (loss) per share:
                            
                            $
                            0.02
                            
                            
                            $
                            (0.08
                            )Diluted
      income (loss) per share:
                            
                            $
                            0.01
                            
                            
                            $
                            (0.08
                            )Weighted
      average number of common shares outstanding - Basic
                            
                            
                            44,821,051
                            
                            
                            
                            35,920,100Weighted
      average number of common shares outstanding - Diluted
                            
                            
                            50,649,103
                            
                            
                            
                            35,920,100




See notes
to condensed consolidated financial statements.


3


SOUTHPEAK
INTERACTIVE CORPORATION AND SUBSIDIARIES


CONDENSED
CONSOLIDATED STATEMENTS OF CASH FLOWS


(Unaudited)




For
      the three months ended
                    September
      30,2009
                  
                  
                  2008Cash flows from
      operating activities:Net
      income (loss)
                  
                  $
                  686,981
                  
                  
                  $
                  (1,551,754
                  )Adjustments
      to reconcile net cash used in operating activities:Depreciation
      and amortization
                  
                  
                  64,877
                  
                  
                  
                  36,209Allowances
      for price protection, returns, and defective merchandise
                  
                  
                  958,427
                  
                  
                  
                  (48,374
                  )Bad
      debt expense
                  
                  
                  (37,531
                  )
                  
                  
                  -Stock-based
      compensation expense
                  
                  
                  156,196
                  
                  
                  
                  164,362Amortization
      of royalties and intellectual property licenses
                  
                  
                  4,215,050
                  
                  
                  
                  852,901Loss
      on disposal of fixed assets
                  
                  
                  4,839
                  
                  
                  
                  -Changes
      in operating assets and liabilities:Accounts
      receivable
                  
                  
                  (8,530,233
                  )
                  
                  
                  4,552,796Inventories
                  
                  
                  (3,536,814
                  )
                  
                  
                  2,149,302Advances
      on royalties
                  
                  
                  (1,449,716
                  )
                  
                  
                  (2,602,434
                  )Intellectual
      property licenses
                  
                  
                  -
                  
                  
                  
                  (440,000
                  )Related
      party receivables
                  
                  
                  (38,825
                  )
                  
                  
                  11,247Prepaid
      expenses and other current assets
                  
                  
                  136,031
                  
                  
                  
                  (2,094,164
                  )Accounts
      payable
                  
                  
                  (688,416
                  )
                  
                  
                  (1,965,641
                  )Production
      advance payable
                  
                  
                  3,755,104
                  
                  
                  
                  -Accrued
      royalties
                  
                  
                  906,432
                  
                  
                  
                  (273,013
                  )Accrued
      expenses - related parties
                  
                  
                  (105,275
                  )
                  
                  
                  41,521Accrued
      expenses and other current liabilities
                  
                  
                  1,281,329
                  
                  
                  
                  (659,048
                  )Total
      adjustments
                  
                  
                  (2,908,525
                  )
                  
                  
                  (274,336
                  )Net
      cash used in operating activities
                  
                  
                  (2,221,544
                  )
                  
                  
                  (1,826,090
                  )Cash
      flows from investing activities:Purchases
      of property and equipment
                  
                  
                  (26,734
                  )
                  
                  
                  (185,747
                  )Change
      in restricted cash
                  
                  
                  417,917
                  
                  
                  
                  65,314Net
      cash provided by (used in) investing activities
                  
                  
                  391,183
                  
                  
                  
                  (120,433
                  )Cash
      flows from financing activities:Proceeds
      from line of credit
                  
                  
                  8,117,146
                  
                  
                  
                  5,880,000Repayments
      of line of credit
                  
                  
                  (6,343,234
                  )
                  
                  
                  (8,044,191
                  )Repayments
      of long-term debt
                  
                  
                  (11,853
                  )
                  
                  
                  (6,163
                  )Net
      proceeds from (repayments of) amounts due to shareholders
                  
                  
                  (232,440
                  )
                  
                  
                  (228,998
                  )Net
      proceeds from (repayments of) amounts due to related
    parties
                  
                  
                  (122,845
                  )
                  
                  
                  41,599Proceeds
      from the issuance of Series A convertible preferred stock, net of cash
      offering costs
                  
                  
                  -
                  
                  
                  
                  1,361,281Net
      cash provided by (used in) financing activities
                  
                  
                  1,406,774
                  
                  
                  
                  (996,472
                  )Effect
      of exchange rate changes on cash and cash equivalents
                  
                  
                  48,757
                  
                  
                  
                  11,607Net
      decrease in cash and cash equivalents
                  
                  
                  (374,830
                  )
                  
                  
                  (2,931,388
                  )Cash
      and cash equivalents at beginning of the period
                  
                  
                  648,311
                  
                  
                  
                  4,095,036Cash
      and cash equivalents at end of the period
                  
                  $
                  273,481
                  
                  
                  $
                  1,163,648Supplemental
      cash flow information:Cash
      paid during the period for interest
                  
                  $
                  99,261
                  
                  
                  $
                  57,657Cash
      paid during the period for taxes
                  
                  $
                  -
                  
                  
                  $
                  2,457Supplemental
      disclosure of non-cash activities:Intellectual
      property licenses included in accrued expenses and other current
      liabilities
                  
                  $
                  -
                  
                  
                  $
                  110,000Contingent
      purchase price payment obligation related to Gamecock
      acquisition
                  
                  $
                  596,634
                  
                  
                  $
                  -




See notes
to condensed consolidated financial statements.


4


SOUTHPEAK
INTERACTIVE CORPORATION AND SUBSIDIARIES


Notes
to Condensed Consolidated Financial Statements


(Unaudited)




1. Summary of Significant
Accounting Policies




Business




SouthPeak
Interactive Corporation ( the “Company”) is an independent developer and
publisher of interactive entertainment software.  The Company
develops, markets and publishes videogames for all leading gaming and
entertainment hardware platforms, including home videogame consoles such as
Microsoft Corporation’s (“Microsoft”) Xbox 360 (“Xbox360”), Nintendo Co. Ltd.’s
(“Nintendo”) Wii (“Wii”), Sony Computer Entertainment’s (“Sony”) PlayStation 3
(“PS3”) and PlayStation 2 (“PS2”); handheld platforms such as Nintendo Dual
Screen (“DS”), Nintendo DSi, Sony PlayStation Portable (“PSP”), Sony PSPgo,
Apple Inc. (“Apple”) iPhone; and personal computers.  The Company’s
titles span a wide range of categories and target a variety of consumer
demographics, ranging from casual players to hardcore gaming
enthusiasts.




The
Company maintains its operations in the United States and the United Kingdom.
The Company sells its games to retailers and distributors in North America and
United Kingdom, and primarily to distributors in the rest of Europe, Australia
and Asia.




The
Company has one operating segment, a publisher and distributor of interactive
entertainment software for home video consoles, handheld platforms and personal
computers.  To date, management has not considered discrete
geographical or other information to be relevant for purposes of making
decisions about allocations of resources.




Gamecock
Acquisition




On
October 10, 2008, the Company acquired Gone Off Deep, LLC, doing business
as Gamecock Media Group (“Gamecock”), pursuant to a definitive purchase
agreement.  Gamecock’s operations were included in the Company’s
financial statements for all periods subsequent to the consummation of the
business combination only.




Liquidity
Risk




For the
fiscal year ended June 30, 2009, the Company incurred a significant
loss.  In order to meet its working capital needs during the past
fiscal year as well as currently, the Company has been, and is, dependent on its
line of credit with SunTrust Banks, Inc. (“SunTrust”).  This line of
credit is scheduled to expire on November 30, 2009.  The line of
credit has been in place since 2005 and has been extended every year thereafter.
Management is currently in discussions with SunTrust to renew the line of
credit.  While management believes the line of credit will be renewed,
there are no assurances that the line of credit will be renewed or renewed at
terms that are acceptable to the Company.  In the event the line of
credit is not renewed, management plans to pursue other financing sources which,
based upon the quality of the Company’s receivables, management believes will be
available to the Company.  The Company’s largest shareholder who
serves as the Company’s chairman, has committed to fund operating cash
shortfalls in the absence of another source of financing.   In
addition, independent of the risks associated with the non-renewal of the
SunTrust line of credit, the Company has engaged an investment bank for the
purpose of potentially raising capital to fund its growth most likely through
the sale of equity securities during its fiscal year ended June 30,
2010.  However, such capital, if needed and available, may not have
terms favorable to the Company or its current shareholders.




The
Company’s business model allows it to scale certain of its costs in reference to
its available capital and market conditions, including funding new game
development costs as well as certain operating expenses, such as sales and
marketing costs.  Irrespective of having a credit facility or other
funding in place, management closely monitors the retail/consumer landscape,
especially for upcoming holiday seasons, and reevaluates its sales and revenue
forecasts in order to scale its expenses and game development costs to the
Company’s performance and its available capital.  Based on the
Company’s projected operating plan, the Company believes that it has access to
adequate financial resources to fund its operations for at least the next twelve
months.




Basis
of Presentation




The
accompanying unaudited condensed consolidated financial statements as of
September 30, 2009 and for the three month periods ended September 30, 2009 and
2008 have been prepared pursuant to the rules and regulations of the Securities
and Exchange Commission (“SEC”) and in accordance with accounting principles
generally accepted in the United States of America (“U.S. GAAP”) for interim
financial reporting. Accordingly, they do not include all of the information and
footnotes required by U.S. GAAP. In the opinion of management, all adjustments
(all of which are of a normal, recurring nature) considered for a fair
presentation have been included. Operating results for the three months ended
September 30, 2009 are not necessarily indicative of the results that may be
expected for the year ending June 30, 2010.


5


SOUTHPEAK
INTERACTIVE CORPORATION AND SUBSIDIARIES


Notes
to Condensed Consolidated Financial Statements


(Unaudited)




1. Summary of Significant
Accounting Policies, continued




The
accounting policies followed by the Company with respect to unaudited interim
financial statements are consistent with those stated in the Company’s annual
report on Form 10-K. The accompanying June 30, 2009 financial statements were
derived from the Company’s audited financial statements. These unaudited
condensed consolidated financial statements should be read in conjunction with
the audited consolidated financial statements and the notes thereto included in
the Company’s annual report on Form 10-K for the year ended June 30, 2009 filed
with the SEC.




The
accompanying unaudited condensed consolidated financial statements include the
accounts of SouthPeak Interactive Corporation, and its wholly-owned subsidiaries
SouthPeak Interactive, L.L.C., SouthPeak Interactive, Ltd., Vid Sub, LLC, Gone
Off Deep, LLC, and Gamecock Media Europe Ltd. All intercompany accounts and
transactions have been eliminated in consolidation.




The
preparation of financial statements in conformity with U.S. GAAP requires
management to make estimates and assumptions that affect the reported amounts of
assets and liabilities and the disclosure of contingent assets and liabilities
at the dates of the financial statements and the reported amounts of net
revenues and expenses during the reporting periods. The most significant
estimates and assumptions relate to the recoverability of advances on royalties,
intellectual property licenses and intangibles, valuation of inventories,
realization of deferred income taxes, the adequacy of allowances for sales
returns, price protection and doubtful accounts, accrued liabilities, the
valuation of stock-based transactions and assumptions used in the
Company’s goodwill impairment test.  These estimates generally
involve complex issues and require the Company to make judgments, involve
analysis of historical and the prediction of future trends, and are subject to
change from period to period. Actual amounts could differ significantly from
these estimates.




Subsequent
events have been evaluated through the filing date (November 10, 2009) of these
unaudited condensed consolidated financial statements.




Concentrations
of Credit Risk, Major Customers and Major Vendors




The
financial instruments which potentially subject the Company to concentrations of
credit risk consist primarily of cash balances with financial institutions and
accounts receivable. The Company maintains cash in bank accounts that, at times,
may exceed federally insured limits.  The Company has not experienced
any losses in such accounts and believes it is not exposed to any significant
risks on its cash in bank accounts.




The
Company does not generally require collateral or other security to support
accounts receivable. Management must make estimates of the uncollectibility of
the accounts receivable. The Company considers accounts receivable past due
based on how recently payments have been received. The Company has established
an allowance for doubtful accounts based upon the facts surrounding the credit
risk of specific customers, past collections history and other
factors.




The
Company has three customers, Wal-Mart, GameStop, and Topware Entertainment,
which accounted for 20%, 15%, and 10%, respectively, of consolidated gross
revenues for the three months ended September 30, 2009.  Wal-Mart,
GameStop, Navarre Corporation, and PDQ Distribution Limited accounted for 18%,
17%, 10%, and 10%, respectively, of consolidated gross accounts receivable at
September 30, 2009.  For the three months ended September 30, 2008,
Wal-Mart, GameStop, and Circuit City accounted for 20%, 14%, and 10%,
respectively, of consolidated gross revenues.  Navarre Corporation,
GameStop, and Wal-Mart accounted for 20%, 17% and 15%, respectively, of
consolidated gross accounts receivable at June 30,
2009.




The
Company publishes videogames for the proprietary console and hand-held platforms
created by Microsoft, Sony and Nintendo, pursuant to the licenses they have
granted to the Company. Should the Company’s licenses with any of such three
platform developers not be renewed by the developer, it would cause a disruption
in the Company’s operations. The Company expects that such contracts will be
renewed in the normal course of business.


6


SOUTHPEAK
INTERACTIVE CORPORATION AND SUBSIDIARIES


Notes
to Condensed Consolidated Financial Statements


(Unaudited)




1. Summary of Significant
Accounting Policies, continued




Amounts
incurred related to these three vendors as of September 30, 2009 and June 30,
2009 and for the three month periods ended September 30, 2009 and 2008 are as
follows:




Cost
      of Goods Sold — Products
                  
                  
                  Accounts
      PayableFor the three months
                    ended September 30,
                    2009
                  
                  
                  For the three months
                    ended September 30,
                    2008
                  
                  
                  As of September 30,
                    2009
                  
                  
                  As of June 30,
                    2009Microsoft
                  
                  $
                  2,737,842
                  
                  
                  $
                  191,149
                  
                  
                  $
                  1,219,934
                  
                  
                  $
                  142,329Nintendo
                  
                  $
                  831,796
                  
                  
                  $
                  825,303
                  
                  
                  $
                  -
                  
                  
                  $
                  -Sony
                  
                  $
                  27,522
                  
                  
                  $
                  390,306
                  
                  
                  $
                  17,423
                  
                  
                  $
                  12,493




In
addition, the Company has purchased a significant amount of videogames for
resale for such platforms from a single supplier. Such purchases amounted to
$-0-and
$1,536,499in “cost of
goods sold - product costs” for the three months ended September 30, 2009 and
2008, respectively. Amounts included in accounts payable for this vendor at
September 30, 2009 and June 30, 2009 totaled $5,625,377and
$8,652,019, respectively.




Restricted
Cash




Restricted
cash relates to deposits held as cash collateral for the line of credit and
funds held in escrow pending resolution of an outstanding litigation
matter.




At
September 30, 2009 and June 30, 2009, restricted cash consisted of the
following:




September 30,
                        2009
                      
                      
                      June 30,
                        2009Cash
      collateral for the line of credit (See Note 5)
                      
                      $
                      -
                      
                      
                      $
                      742,199Funds
      held in escrow pending resolution of litigation (See Note 10), of which
      $22,134 and $265,919 is included as a liability at September 30,
      2009 and June 30, 2009, respectively
                      
                      
                      827,665
                      
                      
                      
                      503,383Total
                      
                      $
                      827,665
                      
                      
                      $
                      1,245,582







Allowances
for Returns, Price Protection, and Doubtful Accounts




Management
closely monitors and analyzes the historical performance of the Company’s
various games, the performance of games released by other publishers, and the
anticipated timing of other releases in order to assess future demands of
current and upcoming games. Initial volumes shipped upon title launch and
subsequent reorders are evaluated to ensure that quantities are sufficient
to meet the demands from the retail markets, but at the same time are
controlled to prevent excess inventory in the channel.




The
Company may permit product returns from, or grant price protection to, its
customers under certain conditions. Price protection refers to the circumstances
when the Company elects to decrease the wholesale price of a product based
on the number of products in the retail channel and, when granted
and taken, allows customers a credit against amounts owed by such customers to
the Company with respect to open and/or future invoices. The criteria the
Company’s customers must meet to be granted the right to return products or
price protection include, among other things, compliance with applicable payment
terms, and consistent delivery to the Company of inventory and sell-through
reports. In making the decision to grant price protection to customers, the
Company also considers other factors, including the facilitation of slow-moving
inventory and other market factors.


7


SOUTHPEAK
INTERACTIVE CORPORATION AND SUBSIDIARIES


Notes
to Condensed Consolidated Financial Statements


(Unaudited)




1. Summary of Significant
Accounting Policies, continued




Management
must estimate the amount of potential future product returns and price
protection related to current period revenues utilizing industry and historical
Company experience, information regarding inventory levels, and the demand and
acceptance of the Company’s games by end consumers. The following factors are
used to estimate the amount of future returns and price protection for a
particular game: historical performance of games in similar genres; historical
performance of the hardware platform; sales force and retail customer feedback;
industry pricing; weeks of on-hand retail channel inventory; absolute quantity
of on-hand retail channel inventory; the game’s recent sell-through history (if
available); marketing trade programs; and competing games. Significant
management judgments and estimates must be made and used in connection with
establishing the allowance for returns and price protection in any accounting
period. Based upon historical experience, management believes the estimates are
reasonable. However, actual returns and price protection could vary materially
from management’s allowance estimates due to a number of unpredictable reasons
including, among others, a lack of consumer acceptance of a game, the release in
the same period of a similarly themed game by a competitor, or technological
obsolescence due to the emergence of new hardware platforms. Material
differences may result in the amount and timing of the Company’s revenues for
any period if factors or market conditions change or if management makes
different judgments or utilizes different estimates in determining the
allowances for returns and price protection.




Similarly,
management must make estimates of the uncollectibility of the Company’s accounts
receivable. In estimating the allowance for doubtful accounts, the Company
analyzes the age of current outstanding account balances, historical bad debts,
customer concentrations, customer creditworthiness, current economic trends, and
changes in the Company’s customers’ payment terms and their economic condition.
Any significant changes in any of these criteria would affect management’s
estimates in establishing the allowance for doubtful accounts.




At
September 30, 2009 and June 30, 2009, accounts receivable allowances consisted
of the following:




September 30,
                      2009
                    
                    
                    June 30,
                      2009Sales
      returns
                    
                    $
                    1,726,231
                    
                    
                    $
                    1,294,082Price
      protection
                    
                    
                    5,489,113
                    
                    
                    
                    4,998,622Doubtful
      accounts
                    
                    
                    848,866
                    
                    
                    
                    874,645Defective
      items
                    
                    
                    71,669
                    
                    
                    
                    47,635Total
      allowances
                    
                    $
                    8,135,879
                    
                    
                    $
                    7,214,984




Inventories




Inventories
are stated at the lower of average cost or market. Management regularly reviews
inventory quantities on hand and in the retail channel and records a provision
for excess or obsolete inventory based on the future expected demand for the
Company’s games. Significant changes in demand for the Company’s games would
impact management’s estimates in establishing the inventory
provision.  Inventory costs include licensing fees paid toplatform proprietors.
These licensing fees include the cost to manufacture the game cartridges. These
licensing fees included in “cost of goods sold - product costs” amounted to
$3,597,160 and $1,406,758 for the three months ended September 30, 2009 and
2008, respectively. Licensing fees included in inventory at September 30, 2009
and June 30, 2009 totaled $1,352,806 and $920,747, respectively.




Advances on
Royalties




The
Company utilizes independent software developers to develop its
games in exchange for payments to the developers based upon
certain contract milestones. The Company enters into contracts with the
developers once the game design has been approved by the platform proprietors
and is technologically feasible.  Accordingly, the Company capitalizes
such payments to the developers during development of the games. These payments
are considered non-refundable royalty advances and are applied against the
royalty obligations owed to the developer from future sales of the game. Any
pre-release milestone payments that are not prepayments against future royalties
are expensed to “cost of goods sold - royalties” in the period when the game is
released. Capitalized royalty costs for those games that are cancelled or
abandoned are charged to “cost of goods sold - royalties” in the period of
cancellation.  Capitalized costs for games that are cancelled or
abandoned prior to product release are charged to “cost of goods sold -
royalties” in the period of cancellation. There were no costs for games
cancelled or abandoned during the three months ended September 30, 2009 and
2008, respectively.


8


SOUTHPEAK
INTERACTIVE CORPORATION AND SUBSIDIARIES


Notes
to Condensed Consolidated Financial Statements


(Unaudited)




1. Summary of Significant
Accounting Policies, continued




Beginning
upon the related game’s release,
capitalized royalty costs are amortized to “cost of goods sold – royalties”
based on the ratio of current revenues to total projected revenues for the
specific game, generally resulting in an amortization period of twelve months or
less.




The
Company evaluates the future recoverability of capitalized royalty costs on a
quarterly basis. For games that have been released in prior periods, the primary
evaluation criterion is actual title performance. For games that are scheduled
to be released in future periods, recoverability is evaluated based on the
expected performance of the specific game to which the royalties relate.
Criteria used to evaluate expected game performance include: historical
performance of comparable games developed with comparable technology; orders for
the game prior to its release; and, for any game sequel, estimated performance
based on the performance of the game on which the sequel is based.




Significant
management judgments and estimates are utilized in the assessment of the
recoverability of capitalized royalty costs. In evaluating the recoverability of
capitalized royalty costs, the assessment of expected game performance utilizes
forecasted sales amounts and estimates of additional costs to be incurred. If
revised forecasted or actual game sales are less than, and/or revised forecasted
or actual costs are greater than, the original forecasted amounts utilized in
the initial recoverability analysis, the net realizable value may be lower than
originally estimated in any given quarter, which could result in an impairment
charge. Material differences may result in the amount and timing of charges for
any period if management makes different judgments or utilizes different
estimates in evaluating these qualitative factors.




Intellectual
Property Licenses




Intellectual
property license costs consist of fees paid by the Company to license the use of
trademarks, copyrights, and software used in the development of games. Depending
on the agreement, the Company may use acquired intellectual property in multiple
games over multiple years or for a single game.  When no significant
performance remains with the licensor upon execution of the license agreement,
the Company records an asset and a liability at the contractual amount. The
Company believes that the contractual amount represents the fair value of the
liability. When significant performance remains with the licensor, the Company
records the payments as an asset when paid and as a liability when incurred,
rather than upon execution of the agreement. The Company classifies these
obligations as current liabilities to the extent they are contractually due
within the next twelve months.  Capitalized intellectual property
license costs for those games that are cancelled or abandoned are charged to
“cost of goods sold - intellectual property licenses” in the period of
cancellation. There were no costs for games cancelled or abandoned during the
three months ended September 30, 2009 and 2008, respectively.




Beginning
upon the related game’s release, capitalized intellectual property license costs
are amortized to “cost of sales - intellectual property licenses” based on the
greater of (1) the ratio of current revenues for the specific game to total
projected revenues for all games in which the licensed property will be utilized
or (2) the straight-line amortization method over the estimated useful lives of
the licenses. As intellectual property license contracts may extend for multiple
years, the amortization of capitalized intellectual property license costs
relating to such contracts may extend beyond one year.




The
Company evaluates the future recoverability of capitalized intellectual property
license costs on a quarterly basis. For games that have been released in prior
periods, the primary evaluation criterion is actual title performance. For games
that are scheduled to be released in future periods, recoverability is evaluated
based on the expected performance of the specific games to which the costs
relate or in which the licensed trademark or copyright is to be used. Criteria
used to evaluate expected game performance include: historical performance of
comparable games developed with comparable technology; orders for the game prior
to its release; and, for any game sequel, estimated performance based on the
performance of the game on which the sequel is based.  Further, as
intellectual property licenses may extend for multiple games over multiple
years, the Company also assesses the recoverability of capitalized intellectual
property license costs based on certain qualitative factors, such as the
success of other products and/or entertainment vehicles utilizing the
intellectual property and the continued promotion and exploitation of the
intellectual property.


9


SOUTHPEAK
INTERACTIVE CORPORATION AND SUBSIDIARIES


Notes
to Condensed Consolidated Financial Statements


(Unaudited)




1. Summary of Significant
Accounting Policies, continued




Significant
management judgments and estimates are utilized in the assessment of the
recoverability of capitalized intellectual property license costs. In evaluating
the recoverability of capitalized intellectual property license costs, the
assessment of expected game performance utilizes forecasted sales amounts and
estimates of additional costs to be incurred. If revised forecasted or actual
game sales are less than, and/or revised forecasted or actual costs are greater
than, the original forecasted amounts utilized in the initial recoverability
analysis, the net realizable value may be lower than originally estimated in any
given quarter, which could result in an impairment charge. Material differences
may result in the amount and timing of charges for any period if management
makes different judgments or utilizes different estimates in evaluating these
qualitative factors.




Goodwill
and Intangible Assets




Goodwill
is the excess of purchase price paid over identified intangible and tangible net
assets of Gamecock. Intangible assets consist of acquired game sequel titles,
distribution and non-compete agreements. Certain intangible assets acquired in a
business combination are recognized as assets apart from goodwill. Identified
intangibles other than goodwill are generally amortized using the straight-line
method over the period of expected benefit ranging from one to three years,
except for acquired game sequel titles, which is a usage-based intangible asset
that is amortized using the shorter of the useful life or expected revenue
stream.




Assessment
of Impairment of Assets




Current
accounting standards require that the Company assess the recoverability of
purchased intangible assets and other long-lived assets whenever events or
changes in circumstances indicate the remaining value of the assets recorded on
its consolidated balance sheets is potentially impaired. In order to determine
if a potential impairment has occurred, management must make various assumptions
about the estimated fair value of the asset by evaluating future business
prospects and estimated cash flows. For some assets, the Company’s estimated
fair value is dependent upon predicting which of its products will be
successful. This success is dependent upon several factors, which are beyond the
Company’s control, such as which operating platforms will be successful in
the marketplace, market acceptance of the Company’s products and competing
products. Also, the Company’s revenues and earnings are dependent on the
Company’s ability to meet its product release schedules.




Income
Taxes




Income
taxes are accounted for under the asset and liability
method.  Deferred tax assets and liabilities are recognized for the
future tax consequences attributable to differences between the financial
statement carrying amounts of existing assets and liabilities and their
respective tax bases and operating loss and tax credit carryforwards. Deferred
tax assets and liabilities are measured using enacted tax rates expected to
apply to taxable income in the years in which those temporary differences are
expected to be recovered or settled. The effect on deferred tax assets and
liabilities of a change in tax rates is recognized in income in the period that
includes the enactment date. A valuation allowance is established to reduce
deferred tax assets to the amounts expected to be realized.




Revenue
Recognition




The
Company recognizes revenue from the sale of videogames upon the transfer of
title and risk of loss to the customer. Accordingly, the Company recognizes
revenue for software titles when (1) there is persuasive evidence that an
arrangement with the customer exists, which is generally a purchase order, (2)
the product is delivered, (3) the selling price is fixed or determinable and (4)
collection of the customer receivable is deemed probable.  The
Company’s payment arrangements with customers typically provides for net 30 and
60 day terms. Advances received for licensing and exclusivity arrangements are
reported on the consolidated balance sheets as deferred revenues until the
Company meets its performance obligations, at which point the
revenues are recognized. Revenue is recognized after deducting
estimated reserves for returns, price protection and other allowances. In
circumstances when the Company does not have a reliable basis to estimate
returns and price protection or is unable to determine that collection of a
receivable is probable, the Company defers the revenue until such time as it can
reliably estimate any related returns and allowances and determine that
collection of the receivable is probable.


10


SOUTHPEAK
INTERACTIVE CORPORATION AND SUBSIDIARIES


Notes
to Condensed Consolidated Financial Statements


(Unaudited)




1. Summary of Significant
Accounting Policies, continued




Some of
the Company’s videogames provide limited online features at no additional cost
to the consumer. Generally, the Company considers such features to be incidental
to the overall product offering and an inconsequential deliverable. Accordingly,
the Company recognizes revenue related to videogames containing these limited
online features upon the transfer of title and risk of loss to the
customer.  In instances where online features or additional
functionality are considered a substantive deliverable in addition to the
videogame, the Company takes this into account when applying its revenue
recognition policy.  This evaluation is performed for each videogame
together with any online transactions, such as electronic downloads or videogame
add-ons when it is released.  When the Company determines that a
videogame contains online functionality that constitutes a
more-than-inconsequential separate service deliverable in addition to the
videogame, principally because of its importance to game play, the Company
considers that its performance obligations for this game extend beyond the
delivery of the game. Fair value does not exist for the online
functionality, as the Company does not separately charge for this component of
the videogame. As a result, the Company recognizes all of the revenue from the
sale of the game upon the delivery of the remaining online
functionality.  In addition, the Company defers the costs of sales for
this game and recognizes the costs upon delivery of the remaining online
functionality.




With
respect to online transactions, such as electronic downloads of games or add-ons
that do not include a more-than-inconsequential separate service deliverable,
revenue is recognized when the fee is paid by the online customer to purchase
online content and the Company is notified by the online retailer that the
product has been downloaded. In addition, persuasive evidence of an arrangement
must exist, collection of the related receivable must be probable and the fee
must be fixed and determinable.




Third-party
licensees in Europe distribute Gamecock’s videogames under license agreements
with Gamecock. The licensees paid certain minimum, non-refundable, guaranteed
royalties when entering into the licensing agreements. Upon receipt of the
advances, the Company defers their recognition and recognizes the revenues in
subsequent periods as these advances are earned by the Company. As the
licensees pay additional royalties above and beyond those initially advanced,
the Company recognizes these additional royalties as revenues when
earned.




With
respect to license agreements that provide customers the right to make multiple
copies in exchange for guaranteed amounts, revenue is recognized upon delivery
of a master copy. Per copy royalties on sales that exceed the guarantee are
recognized as earned.  In addition, persuasive evidence of an
arrangement must exist, collection of the related receivable must be probable,
and the fee must be fixed and determinable.




Consideration
Given to Customers and Received from Vendors




The
Company offers sales incentives and other consideration to its
customers.  Sales incentives and other consideration that are
considered adjustments of the selling price of the Company’s games, such as
rebates and product placement fees, are reflected as reductions to
revenue.  Sales incentives and other consideration that represent
costs incurred by the Company for assets or services received, such as the
appearance of games in a customer’s national circular ad, are reflected as sales
and marketing expenses.




Cost
of Goods Sold




Cost of
goods sold includes: manufacturing costs, royalties, and amortization
of intellectual property licenses.




Stock-Based
Compensation




The
Company estimates the fair value of share-based payment awards on the
measurement date using the Black-Scholes option-pricing model. The value of the
portion of the award that is ultimately expected to vest is recognized as
expense over the requisite service periods in the consolidated statements of
operations.




Stock-based
compensation expense recognized in the consolidated statements of operations is
based on awards ultimately expected to vest and has been reduced for estimated
forfeitures. Stock compensation guidance requires forfeitures to be estimated at
the time of grant and revised, if necessary, in subsequent periods if actual
forfeitures differ from those estimates.


11


SOUTHPEAK
INTERACTIVE CORPORATION AND SUBSIDIARIES


Notes
to Condensed Consolidated Financial Statements


(Unaudited)




1. Summary of Significant
Accounting Policies, continued




The
Company estimates the value of employee stock options on the date of grant using
the Black-Scholes option pricing model. The Company’s determination of fair
value of share-based payment awards on the date of grant using an option-pricing
model is affected by the Company’s stock price as well as assumptions regarding
a number of highly complex and subjective variables. These variables include,
but are not limited to; the expected stock price volatility over the term of the
awards, and actual and projected employee stock option exercise
behaviors.




The
Company accounts for equity instruments issued to non-employees based on the
estimated fair value of the equity instrument that is recorded on the earlier of
the performance commitment date or the date the services required are
completed.  Until shares under the award are fully vested, the Company
marks-to-market the fair value of the options at the end of each accounting
period.




Fair
Value Measurements




Effective
July 1, 2009, the Company adopted the provisions of the fair value measurement
accounting and disclosure guidance related to non-financial assets and
liabilities recognized or disclosed at fair value on a nonrecurring basis. This
standard establishes a framework for measuring fair value and requires enhanced
disclosures about fair value measurements, and clarifies that fair value is an
exit price, representing the amount that would be received to sell an asset or
paid to transfer a liability in an orderly transaction between market
participants. The provisions also establish a fair value hierarchy that
prioritizes the inputs to valuation techniques used to measure fair value. The
guidance requires that assets and liabilities carried at fair value be
classified and disclosed in one of the following three categories:




·
            Level
      1: Quoted market prices in active markets for identical assets or
      liabilities.




·
            Level
      2: Quoted prices in active markets for similar assets and liabilities,
      quoted prices for identically similar assets or liabilities in markets
      that are not active and models for which all significant inputs are
      observable either directly or
indirectly.




·
            Level
      3: Unobservable inputs reflecting the reporting entity’s own assumptions
      or external inputs for inactive
markets.




The
determination of where assets and liabilities fall within this hierarchy is
based upon the lowest level of input that is significant to the fair value
measurement. While the Company has previously invested in certain assets that
would be classified as “level 1,” as of September, 2009, the Company does not
hold any “level 1” cash equivalents that are measured at fair value on a
recurring basis, nor does the Company have any assets or liabilities that are
based on “level 2” or “level 3” inputs.




Comprehensive
Income (Loss)





For the
three months ended September 30, 2009 and 2008, the Company's comprehensive
income (loss) was as follows:





Three
      months endedSeptember
      30,
                        2009
                      
                      
                      September
      30,
                        2008Net
      income (loss)
                      
                      $
                      686,981
                      
                      
                      $
                      (1,551,754
                      )Other
      comprehensive income (loss)Change
      in foreign currency translation adjustment
                      
                      
                      82,500
                      
                      
                      
                      (95,363
                      )Comprehensive
      income (loss)
                      
                      $
                      769,481
                      
                      
                      $
                      (1,647,117
                      )




12


SOUTHPEAK
INTERACTIVE CORPORATION AND SUBSIDIARIES


Notes
to Condensed Consolidated Financial Statements


(Unaudited)




1. Summary of Significant
Accounting Policies, continued




Earnings
(Loss) Per Common Share




Basic
earnings (loss) per share is computed by dividing net income (loss) attributable
to common shareholders by the weighted average number of common shares
outstanding for all periods.  Diluted earnings per share is computed
by dividing net income (loss) attributable to common shareholders by the
weighted average number of shares outstanding, increased by common stock
equivalents.  Common stock equivalents represent incremental shares
issuable upon exercise of outstanding options and warrants, the conversion of
preferred stock and the vesting of restricted stock. However, potential common
shares are not included in the denominator of the diluted earnings (loss) per
share calculation when inclusion of such shares would be anti-dilutive, such as
in a period in which a net loss is recorded.  Potentially dilutive
securities including outstanding options, warrants, restricted stock, and the
conversion of preferred stock amounted to 17,648,624 for the three months
ended September 30, 2008.




Reclassifications




Certain
prior period amounts have been reclassified to conform to current year
presentations. The reclassifications did not impact previously reported total
assets, liabilities, shareholders’ equity or net loss.




Recent
Accounting Pronouncements




The
Financial Accounting Standards Board (“FASB”) has codified a single source of
U.S. GAAP, the “Accounting Standards Codification.” Unless needed to clarify a
point to readers, the Company will refrain from citing specific section
references when discussing application of accounting principles or addressing
new or pending accounting rule changes.




During
September 2009, the Emerging Issues Task Force (“EITF”) issued EITF 08-1,
“Revenue Arrangements with Multiple Deliverables” and EITF 09-3, “Applicability
of Statement of Position 97-2 to Certain Arrangements that include Software
Elements.”  EITF 08-1 modifies the requirements for determining
whether deliverables meet the separate unit of accounting criteria and requires
allocation of arrangement consideration based on relative selling
price.  EITF 09-3 provides more guidance on whether transactions
should be accounted for under SOP 97-2, “Software Revenue Recognition.” The
Company must adopt EITF 08-1 and EITF 09-3 at the same time, no later than in
the first fiscal year beginning after June 15, 2010, but earlier adoption is
permitted.  Companies may adopt prospectively or
retrospectively.  The Company is currently evaluating the impact that
the adoption of EITF 08-1 and EITF 09-3 will have on the Company’s consolidated
financial position and results of operations.




2. Gamecock
Acquisition




On
October 10, 2008, the Company acquired Gamecock pursuant to a definitive
purchase agreement (the “Gamecock Agreement”) with Vid Agon, LLC (the “Seller”)
and Vid Sub, LLC (the “Member”). The Member is a wholly-owned subsidiary of the
Seller and Gamecock is a wholly-owned subsidiary of the
Member.  Pursuant to the terms of the Gamecock Agreement, the Company
acquired all of the outstanding membership interests of the Member in exchange
for aggregate consideration of 7% of the future revenues from sales of certain
Gamecock games, net of certain distribution fees and advances, and a warrant to
purchase 700,000 shares of the Company’s common stock.




The
amount of the contingent purchase price payment obligations (the “Gamecock
Earn-Out”) will be added to the purchase price (i.e., goodwill) when the
contingency is resolved.




The
purchase price of Gamecock consists of the following items:




Fair
      value of 700,000 warrants to purchase common stock with an exercise price
      of $1.50 per share based on the closing date of the transaction, October
      10, 2008
                    
                    $
                    1,033,164Transaction
      costs
                    
                    
                    750,000Total
      initial purchase consideration
                    
                    $
                    1,783,164




13


SOUTHPEAK
INTERACTIVE CORPORATION AND SUBSIDIARIES


Notes
to Condensed Consolidated Financial Statements


(Unaudited)




2. Gamecock Acquisition,
continued




The fair
value of the stock warrants was determined using the Black-Scholes option
pricing model and the following assumptions: (a) the fair value of the Company’s
common stock of $2.35 per share, which is the closing price as of October 10,
2008, (b) volatility of 57.68%, (c) a risk free interest rate of 2.77%, (d)
an expected term, also the contractual term, of 5.0 years, and (e) an
expected dividend yield of 0.0%.




The
allocation of the purchase price below was based upon a valuation and the
Company’s estimates and assumptions are subject to change. The primary areas of
those purchase price allocations that are not finalized relate to certain
intangible assets and residual goodwill. Any material adjustments to this
purchase price allocation in future periods will be disclosed.




The
valuation of acquired assets and liabilities performed in part by an unrelated
third-party valuation firm is as follows:




Working
      capital, excluding inventories
                  
                  $
                  827,287Inventories
                  
                  156,745Other
      current assets
                  
                  36,369Property
      and equipment
                  
                  209,441





Estimated useful
                      lifeIntangible
      assets:Royalty
      agreements (Advances on royalties)
                    1 –
      2 years
                    
                    3,424,000Game
      sequel titles
                    5 –
      12 years
                    
                    1,142,000Non-compete
      agreements
                    Less
      than 1 year
                    
                    200,000Distribution
      agreements
                    3
      years
                    
                    40,000Goodwill
                    Indefinite
                    
                    
                    6,539,700Liabilities
                    
                    
                    
                    (10,792,378
                    )Total
      initial purchase consideration
                    
                    
                    $
                    1,783,164




The
following table presents the gross and net balances, and accumulated
amortization of the components of the Company’s purchased amortizable intangible
assets included in the acquisition as of September 30, 2009:




AccumulatedGross
                      
                      
                      Amortization
                      
                      
                      NetRoyalty
      agreements (Advances on royalties)
                      
                      $
                      3,424,000
                      
                      
                      $
                      2,626,352
                      
                      
                      $
                      797,648Intangible
      assets, netGame
      sequel titles
                      
                      $
                      1,142,000
                      
                      
                      $
                      1,142,000
                      
                      
                      $
                      -Non-compete
      agreements
                      
                      
                      200,000
                      
                      
                      
                      200,000
                      
                      
                      
                      -Distribution
      agreements
                      
                      
                      40,000
                      
                      
                      
                      12,975
                      
                      
                      
                      27,025Total
      intangible assets, net
                      
                      $
                      1,382,000
                      
                      
                      $
                      1,354,975
                      
                      
                      $
                      27,025




Intangible
assets and goodwill are expected to be tax deductible.  During the
year ended June 30, 2009, the Company incurred an impairment charge of
$1,142,000 related to write-off of acquired game sequel titles due to the
underperformance of the acquired titles.


14





SOUTHPEAK
INTERACTIVE CORPORATION AND SUBSIDIARIES


Notes
to Condensed Consolidated Financial Statements


(Unaudited)




2. Gamecock Acquisition,
continued




The
estimated future decreases (increases) to net income (loss) from the
amortization of the finite-lived intangible assets are the following
amounts:




Year ending June
      30,2010
      (nine months ended June 30, 2010)
                      
                      $
                      10,0002011
                      
                      $
                      13,3332012
                      
                      $
                      3,692




The
weighted average estimated amortization period as of September 30, 2009 is 24
months.




As of
September 30, 2009, a total of $1,472,687, which may be netted contractually
against adjustments for excess payables, as defined pursuant to the Gamecock
Agreement, of the Gamecock Earn-Out has been achieved and was included to
goodwill in the consolidated balance sheets.





The
following table summarizes the unaudited pro forma information assuming the
business combination had occurred at the beginning of the periods
presented.  This pro forma financial information is for informational
purposes only and does not reflect any operating efficiencies or inefficiencies
which may result from the business combination and therefore is not necessarily
indicative of results that would have been achieved had the businesses been
combined during the periods presented.




For the three
      months ended
                                        September 30,2008Pro
      forma net revenues
                                      
                                      $
                                      9,033,730Pro
      forma net loss
                                      
                                      
                                      (36,805,975
                                      )Pro
      forma net loss per share—basic
                                      
                                      $
                                      (1.02
                                      )Pro
      forma net loss per share—diluted
                                      
                                      $
                                      (1.02
                                      )




On
December 4, 2008, the Company acquired the remaining 4% minority interest in
Gamecock in exchange for aggregate consideration of 50,000 warrants to purchase
shares of the Company’s common stock, with an exercise price of $1.50 per
share, exercisable subject to the achievement of certain revenue targets.
The transaction has been accounted for as a purchase and resulted in an increase
to goodwill of $18,889.  The fair value of the stock warrants was
determined using the Black-Scholes option pricing model and the following
assumptions: (a) the fair value of the Company’s common stock of $1.10 per
share, which is the closing price as of December 4, 2008, (b) volatility of
63.76%, (c) a risk free interest rate of 1.51%, (d) an expected term, also the
contractual term, of 3.0 years, and (e) an expected dividend yield of
0.0%.





3. Inventories




At
September 30, 2009 and June 30, 2009, inventories consist of the
following:




September 30,
                        2009
                      
                      
                      June 30,
                        2009Finished
      goods
                      
                      $
                      4,710,305
                      
                      
                      $
                      3,858,518Purchased
      parts and components
                      
                      
                      3,286,346
                      
                      
                      
                      601,319Total
                      
                      $
                      7,996,651
                      
                      
                      $
                      4,459,837




15


SOUTHPEAK
INTERACTIVE CORPORATION AND SUBSIDIARIES


Notes
to Condensed Consolidated Financial Statements


(Unaudited)




4. Property and Equipment,
net




At
September 30, 2009 and June 30, 2009, property and equipment, net was comprised
of the following:




September 30,
                      2009
                    
                    
                    June 30,
                      2009Land
                    
                    $
                    544,044
                    
                    
                    $
                    544,044Building
      and leasehold improvements
                    
                    
                    1,496,098
                    
                    
                    
                    1,496,147Computer
      equipment and software
                    
                    
                    736,774
                    
                    
                    
                    719,621Office
      furniture
      and other equipment
                    
                    
                    357,739
                    
                    
                    
                    353,4063,134,655
                    
                    
                    
                    3,113,218Less:
      accumulated depreciation and amortization
                    
                    
                    406,525
                    
                    
                    
                    359,079Property
      and equipment, net
                    
                    $
                    2,728,130
                    
                    
                    $
                    2,754,139




Depreciation
and amortization expense for the three months ended September 30, 2009 and 2008
was $47,982 and $36,209, respectively.




5. Line of
Credit




The
Company has a $7.5 million revolving line of credit facility with a financial
institution that expires on November 30, 2009. From time to time the financial
institution in its sole and absolute discretion may increase the Company’s line
of credit in the form of an overadvance agreement. As of September 30, 2009 and
June 30, 2009, the Company’s borrowing base may not exceed 65% of eligible
accounts receivable plus $500,000. The line of credit bears interest at prime
plus 1⁄2%, which was 3.75% at September 30, 2009 and June 30, 2009. The financial
institution processes payments received on such accounts receivable as payments
on the revolving line of credit. The line is collateralized by gross accounts
receivable of approximately $13,103,000 and $8,673,000 at September 30, 2009 and
June 30, 2009, respectively. The line of credit is further collateralized by
personal guarantees, and pledge of personal securities and assets by two Company
shareholders, one of whom is the Company’s chairman, and certain other
affiliates. The agreement contains certain financial and non-financial
covenants. At September 30, 2009, the Company was in compliance with these
covenants.




At
September 30, 2009 and June 30, 2009, the outstanding line of credit balance was
$7,123,865 and $5,349,953, respectively. At September 30, 2009 and June 30,
2009, the Company had $876,135 and $-0-, respectively, available under its
credit facility. For the three months ended September 30, 2009 and 2008,
interest expense relating to the line of credit was $51,759 and $31,132,
respectively.




6. Long-term
Debt




At
September 30, 2009 and June 30, 2009, long-term debt was comprised of the
following:




September 30,
                      2009
                    
                    
                    June 30,
                      2009Mortgages
      payableFirst
      National Bank
                    
                    $
                    1,033,150
                    
                    
                    $
                    1,039,078Southwest
      Securities, FSB
                    
                    
                    489,955
                    
                    
                    
                    493,437Vehicle
      note payable
                    
                    
                    54,853
                    
                    
                    
                    57,296Total
      debt
                    
                    
                    1,577,958
                    
                    
                    
                    1,589,811Less
      current portion
                    
                    
                    51,697
                    
                    
                    
                    50,855Total
      long-term debt
                    
                    $
                    1,526,261
                    
                    
                    $
                    1,538,956




16


SOUTHPEAK
INTERACTIVE CORPORATION AND SUBSIDIARIES


Notes
to Condensed Consolidated Financial Statements


(Unaudited)




6. Long-term Debt,
continued




In
connection with the purchase of an office building in Grapevine, Texas, the
Company entered into a five year mortgage with a financial institution in the
amount of $500,000.  The interest rate on the mortgage adjusts daily
to prime plus 1.0% (5.5% at September 30, 2009).  Principal and
interest are payable in monthly installments of $3,439 continuing until January
28, 2014 when the entire balance of principal and accrued interest is due and
payable.  The mortgage is secured by the land and building. The
Company’s chairman has personally guaranteed the mortgage
note.






In
connection with the purchase of an office building and land in Grapevine, Texas,
the Company entered into a 20 year mortgage with a financial institution in the
amount of $1,068,450. The interest rate on the mortgage adjusts every five years
to prime minus 1⁄4% (7.5% at September 30, 2009). The monthly principal and
interest payment is $8,611 with interest only payments for the first six months.
The mortgage is secured by the purchased land and building. Two shareholders of
the Company, one of whom is the Company’s chairman, have personally
guaranteed the mortgage note.






The
scheduled maturities of the long-term debt are as follows:




Year
      ending June 30,2010
      (nine months ended June 30, 2010)
                                  
                                  $
                                  39,0022011
                                  
                                  
                                  54,4782012
                                  
                                  
                                  58,3632013
                                  
                                  
                                  62,5302014
                                  
                                  
                                  478,008Thereafter
                                  
                                  
                                  885,577Total
                                  
                                  
                                  1,577,958Less:
      current maturities
                                  
                                  
                                  51,697Long-term
      debt, net of current portion
                                  
                                  $
                                  1,526,261





7. Related
Party Transactions




Related
Party Receivables




Related
party receivables consist of short-term advances to employees and an overpayment
of amounts owed to an affiliate of two shareholders of the Company, one of whom
is the Company’s chairman. No allowance has been provided due to the short-term
nature and recoverability of such advances.




Due
to Shareholders




During
the year ended June 30 2009, the Company’s chairman advanced the Company
$307,440. The advance was unsecured, payable on demand and non-interest
bearing.  Subsequent to June 30, 2009, the amount was
repaid.  At September 30, 2009 and June 30, 2009, the amount due was
$0 and $232,440, respectively.




Due
to Related Parties




During
the year ended June 30, 2009, the Company collected sales commissions totaling
$226,216 on behalf of an affiliate of two shareholders of the Company, one
of whom is the Company’s chairman.  At June 30,
2009,  $113,499 was payable to the affiliate and is included in due to
related parties in the accompanying consolidated balance sheets.  At
September 30, 2009, the Company was owed $38,390 from this affiliate, resulting
from an overpayment of amounts owed.  This amount is classified as
related party receivables at September 30, 2009 in the accompanying consolidated
balance sheets.


17


SOUTHPEAK
INTERACTIVE CORPORATION AND SUBSIDIARIES


Notes
to Condensed Consolidated Financial Statements


(Unaudited)




7. Related
Party Transactions,
continued




During
the three months ended September 30, 2009 and 2008, the Company expensed
$6,600 and $20,850, respectively, related to broadband usage from
an internet service provider partially owned by two shareholders of the
Company, one of whom is the Company’s chairman, of which $2,200 and $11,546
remained as a payable to the affiliate and is included in due to related parties
in the accompanying consolidated balance sheets at September 30, 2009 and June
30, 2009, respectively.  These amounts are included in general and
administrative expenses in the accompanying consolidated statements of
operations.




Accrued
Expenses - Related Parties




Accrued
expenses - related parties as of and for the three months ended September 30,
2009 and the year ended June 30, 2009 are as follows:




Three months ended
                    September 30,
                    2009
                  
                  
                  Year ended
                    June 30,
                    2009Balance
      at beginning of period
                  
                  $
                  184,766
                  
                  
                  $
                  5,770Expenses
      incurred:Rent
                  
                  
                  27,500
                  
                  
                  
                  100,250Commissions
                  
                  
                  93,066
                  
                  
                  
                  705,032Less:
      amounts paid
                  
                  
                  (225,841
                  )
                  
                  
                  (626,286
                  )Balance
      at end of period
                  
                  $
                  79,491
                  
                  
                  $
                  184,766




The
Company incurred sales commissions for the marketing and sale of videogames with
two affiliates of the Company’s chairman.  Sales commissions for the
three months ended September 30, 2009 and 2008 were $93,066 and $147,599,
respectively.  These amounts are included in sales and marketing in
the accompanying consolidated statements of operations.




Lease
- Related Parties




The
Company leases certain office space from a company whose shareholders are also
shareholders of the Company, one of whom is the Company’s
chairman.  Related party lease expense was $27,500 and $22,625 for the
three months ended September 30, 2009 and  2008,
respectively.  These amounts are included in the general and
administrative expense in the accompanying consolidated statements of
operations. The lease expires on December 31, 2010.




The
Company leases certain office space to a company whose shareholders are also
shareholders of the Company, one of whom is the Company’s chairman. 
Related lease income was $-0- and $3,907 for the three months ended September
30, 2009 and 2008, respectively.  These amounts are included in general and
administrative expense in the accompanying consolidated statements of
operations.  The lease expires on December 31, 2010.




8. Commitments




Total
future minimum commitments are as follows:




Software
                                                      
                                                      
                                                      OfficeDevelopers
                                                      
                                                      
                                                      Lease
                                                      
                                                      
                                                      TotalFor
      the year ending June 30,2010
      (nine months ended June 30, 2010)
                                                      
                                                      $
                                                      8,928,364
                                                      
                                                      
                                                      $
                                                      119,544
                                                      
                                                      
                                                      $
                                                      9,047,9082011
                                                      
                                                      
                                                      788,000
                                                      
                                                      
                                                      
                                                      88,999
                                                      
                                                      
                                                      
                                                      876,9992012
                                                      
                                                      
                                                      -
                                                      
                                                      
                                                      
                                                      33,999
                                                      
                                                      
                                                      
                                                      33,9992013
                                                      
                                                      
                                                      -
                                                      
                                                      
                                                      
                                                      31,166
                                                      
                                                      
                                                      
                                                      31,166Total
                                                      
                                                      $
                                                      9,716,364
                                                      
                                                      
                                                      $
                                                      273,708
                                                      
                                                      
                                                      $
                                                      9,990,072


18


SOUTHPEAK
INTERACTIVE CORPORATION AND SUBSIDIARIES


Notes
to Condensed Consolidated Financial Statements


(Unaudited)




8. Commitments, continued




Developer
of Intellectual Property Contracts




The
Company regularly enters into contractual arrangements with third parties for
the development of games as well as the rights to license intellectual property.
Under these agreements, the Company commits to provide specified payments to a
developer or intellectual property holders, based upon contractual arrangements,
and conditioned upon the achievement of specified development milestones. These
payments to third-party developers and intellectual property
holders typically are deemed to be advances and are recouped against future
royalties earned by the developers based on the sale of the related game. On
October 26, 2007, the Company executed
an agreement with a third party game developer in connection with certain
development agreements. Pursuant to the agreement, the Company has committed to
spend specified amounts for marketing support of the related game which is to be
developed. “Cost of goods sold - royalties” related to this development
agreement amounted to $5,000,671 and $808,921 for the three months ended
September 30, 2009 and 2008, respectively.




Lease
Commitments




In
January 2008, the Company entered into a new four year lease for its United
Kingdom office, with a yearly rent of approximately $30,000 plus value added tax
(VAT).  Prior to this lease, the United Kingdom office had a one year
lease for office space beginning in December 2007, with a monthly rent of
approximately $5,200.  Office rent expense for the three months ended
September 30, 2009 and 2008 was $5,862 and $17,099, respectively.




The
Company entered into a non-cancelable operating lease with an affiliate, on
January 1, 2008, for offices located in Midlothian, Virginia. The lease provided
for monthly payments of $7,542 for the first 12 months and increased to $9,167
in January 2009 for the remaining 24 months. Office rent expense for the three
months ended September 30, 2009 and 2008 was $27,500 and $22,625,
respectively.




Employment
Agreements




The
Company has employment agreements with several members of senior management. The
agreements, with terms ranging from approximately two to three years, provide
for minimum salary levels, performance bonuses, and severance
payments.




9. Stock-based
Compensation




In May
2008, the Company’s board of directors and its shareholders approved the 2008
Equity Incentive Compensation Plan (the “2008 Plan”) for the grant of stock
awards, including restricted stock and stock options, to officers, directors,
employees and consultants.  The 2008 Plan expires in May 2018. Shares
available for future grant as of September 30, 2009 and June 30, 2009 were
2,610,867 and 2,924,200, respectively, under the 2008 Plan.




Stock
awards and shares are generally granted at prices which the Company’s board of
directors believes approximate the fair market value of the awards or shares at
the date of grant. Individual grants generally become exercisable ratably over a
period of three years from the date of grant. The contractual terms of the
options range from three to ten years from the date of grant.




The
Company uses the Black-Scholes option pricing model to determine the fair value
of stock-based compensation to employees and non-employees. The determination of
fair value is affected by the Company’s stock price and volatility, employee
exercise behavior, and the time for the shares to vest.


19


SOUTHPEAK
INTERACTIVE CORPORATION AND SUBSIDIARIES


Notes
to Condensed Consolidated Financial Statements


(Unaudited)




9. Stock-based
Compensation,
continued




The
assumptions used in the Black-Scholes option pricing model to value the
Company’s option grants  to employees and non-employees were as
follow:




For the three
                    months ended
                    September 30, 2009
                  
                  
                  For the three
                    months ended
                    September 30, 2008Risk-free
      interest rate
                  
                  
                  2.5
      – 3.5
                  %
                  
                  
                  4.01
                  %Weighted-average
      volatility
                  
                  
                  161
      – 165
                  %
                  
                  
                  57.56
                  %Expected
      term
                  
                  5.5
      – 9.7 years
                  
                  
                  6
      yearsExpected
      dividends
                  
                  
                  0.0
                  %
                  
                  
                  0.0
                  %




The
following table summarizes the stock-based compensation expense resulting from
stock options and restricted stock in the Company’s consolidated statements of
operations:




For the three
                      months ended
                      September 30, 2009
                    
                    
                    For the three
                      months ended
                      September 30, 2008Sales
      and marketing
                    
                    $
                    27,622
                    
                    
                    $
                    37,734General
      and administrative
                    
                    
                    128,574
                    
                    
                    
                    126,628Total
      stock-based compensation expense
                    
                    $
                    156,196
                    
                    
                    $
                    164,362




As of
September 30, 2009, the Company’s unrecognized stock-based compensation for
stock options issued to employees and non-employee directors was approximately
$794,000 and will be recognized over a weighted average of 1.8
years.  The Company estimated a 5% forfeiture rate related to the
stock-based compensation expense calculated for employees and non-employee
directors.




The
following table summarizes the Company’s stock option activity for employees,
non-employee directors, and non-employees for the three months ended
September 30, 2009:




Options
                    
                    
                    Weighted-
                      Average
                      Exercise
                      Price
                    
                    
                    Weighted-
                      Average
                      Remaining
                      Contractual
                      Term
                      (in years)
                    
                    
                    Aggregate
                      Intrinsic
                      ValueOutstanding
      as of June 30, 2009
                    
                    
                    1,960,300
                    
                    
                    $
                    1.69
                    
                    
                    
                    -
                    
                    
                    $
                    -Activity
      for the three months ended September 30, 2009Granted
                    
                    
                    328,000
                    
                    
                    
                    0.74
                    
                    
                    
                    -
                    
                    
                    
                    -Exercised
                    
                    
                    -
                    
                    
                    
                    -
                    
                    
                    
                    -
                    
                    
                    
                    -Forfeited,
      cancelled or expired
                    
                    
                    79,667
                    
                    
                    
                    1.83
                    
                    
                    
                    -
                    
                    
                    
                    -Outstanding
      as of September 30, 2009
                    
                    
                    2,208,633
                    
                    
                    $
                    1.54
                    
                    
                    
                    8.31
                    
                    
                    $
                    -Exercisable
      as of September 30, 2009
                    
                    
                    328,333
                    
                    
                    $
                    2.30
                    
                    
                    
                    8.75
                    
                    
                    $
                    -Exercisable
      and expected to be exercisable
                    
                    
                    2,032,773
                    
                    
                    $
                    1.56
                    
                    
                    
                    8.27
                    
                    
                    $
                    -




The
aggregate intrinsic value represents the total pre-tax intrinsic value based on
the Company’s closing stock price ($0.51 per share) as of September 30, 2009,
which would have been received by the option holders had all option holders
exercised their options as of that date.




The
weighted average fair value of stock options granted to employees and
non-employee directors during the three months ended September 30, 2009 was
$0.70 per share.


20


SOUTHPEAK
INTERACTIVE CORPORATION AND SUBSIDIARIES


Notes
to Condensed Consolidated Financial Statements


(Unaudited)




9. Stock-based
Compensation,
continued




The
following table summarizes the Company’s restricted stock activity for the three
months ended September 30, 2009:




Shares
                      
                      
                      Weighted-
                        Average
                        Grant Date
                        Fair ValueOutstanding
      as of June 30, 2009
                      
                      
                      115,500
                      
                      
                      $
                      2.14Activity
      for the three months ended September 30, 2009Granted
                      
                      
                      65,000
                      
                      
                      
                      0.75Vested
                      
                      
                      91,500
                      
                      
                      
                      2.30Forfeited,
      cancelled or expired
                      
                      
                      -
                      
                      
                      
                      -Outstanding
      as of September 30, 2009
                      
                      
                      89,000
                      
                      
                      $
                      0.96Vested
      as of September 30, 2009
                      
                      
                      91,500
                      
                      
                      $
                      2.30




10. Contingencies




The
Company was obligated to file a registration statement with the SEC covering the
resale of the shares of its common stock issued upon conversion of the Series A
convertible preferred stock and the exercise of Class Y warrants within 30 days
following the Company’s filing of its Form 10-K for the fiscal year in 2008 but
no later than January 15, 2009. The Company filed a registration statement on
Form S-1 with the SEC, however, the registration statement was not declared
effective by the SEC within the prescribed time period.




Since the
registration statement was not declared effective by the SEC within the
prescribed time period, the Company is obligated to make pro rata payments to
each holder of Series A convertible preferred stock in an amount equal to .5% of
the aggregate amount invested by such holder of Series A convertible preferred
stock for each 30 day period (or portion thereof) for which no registration
statement is effective. Accordingly, the Company has recognized a liability for
liquidating damages and interest totaling $196,511 for the year ended June 30,
2009.  The amount of the liability at September 30, 2009 and June 30,
2009 was $196,511.




The
Company is engaged in ordinary routine litigation incidental to the Company’s
business to which the Company is a party. While the Company cannot predict the
ultimate outcome of these various legal proceedings, it is management’s opinion
that the resolution of these matters should not have a material effect on the
consolidated financial position or results of operations of the
Company.




On March
12, 2009, the Company, Gamecock, SouthPeak Interactive, Ltd. and Gamecock Media
Europe, Ltd. were served with a complaint by a videogame distributor alleging a
breach of contract and other claims related to a publishing and distribution
agreement, or the Distribution Agreement, entered into between
Gamecock Media Europe, Ltd. and the videogame distributor in January 2008. The
videogame distributor is seeking the return of $4,590,000 in advances, an
injunction against the Company and its subsidiaries, approximately $650,000 in
specified damages, further damages to be assessed, and discretionary interest
and costs.  Gamecock Media Europe, Ltd. has filed a counterclaim
against the videogame distributor for $950,000 and discretionary interest and
costs, resulting from videogame sales and the achievement of a milestone under
the Distribution Agreement.  The case was heard in the United Kingdom
in July 2009 and closing submissions were made to the court on or about July 22,
2009.  The court has reserved judgment and the Company expects a
decision in the near future.  As part of the court proceedings between
the Company and the videogame distributor, the Company agreed (to avoid further
costly hearings) to pay 35% of certain European sales into an escrow account
pending the final resolution of the case.  As of September 30, 2009,
the amount held in escrow was approximately $827,665 and is included in
restricted cash.  Legal expenses associated with this complaint have
been expensed as incurred.  The Company’s management currently
believes that resolution of this matter will not have a material adverse effect
on the Company’s consolidated financial position or results of operations.
However, legal issues are subject to inherent uncertainties and there exists the
possibility that the ultimate resolution of this matter could have a material
adverse effect on the Company’s consolidated financial position and the results
of operations in the period in which any such effect is
recorded.


21


SOUTHPEAK
INTERACTIVE CORPORATION AND SUBSIDIARIES


Notes
to Condensed Consolidated Financial Statements


(Unaudited)




10. Contingencies, continued




On
October 27, 2008, Gamecock was served with a demand for arbitration by a
developer alleging various breaches of contract related to a publishing
agreement entered into between Gamecock and the developer on December 12, 2007.
The developer is seeking an award of $4,910,000, termination of the agreement,
exclusive control of the subject videogame, and discretionary interest and
costs. Gamecock has responded stating that the developer’s attempts to terminate
the publishing agreement constitute wrongful termination of the agreement and
breach of the agreement. Gamecock has also filed a counterclaim against the
developer seeking the return of approximately $5.9 million in advances on
royalties in the event the publishing agreement is terminated.  The
developer has filed a supplemental demand for arbitration concerning royalty
payments due under a separate publishing agreement and is seeking an award of
$41,084.  The arbitration hearing has been scheduled for January
2010.  As of September 30, 2009, no amounts have been accrued related
to this matter.  The Company’s management currently believes that
resolution of this matter will not have a material adverse effect on the
Company’s consolidated financial position or results of operations. However,
legal issues are subject to inherent uncertainties and there exists the
possibility that the ultimate resolution of this matter could have a material
adverse effect on the Company’s consolidated financial position and the results
of operations in the period in which any such effect is recorded.




On August
26, 2009, the Company was notified that the SEC was conducting a non-public,
fact-finding investigation regarding certain matters underlying the amendment of
its Form 10-Q, and the restatement of its financial statements, for the period
ended March 31, 2009, and the termination of its former chief financial
officer.  The Company has provided the SEC with the documents requested and
intends to cooperate in all respects with the SEC’s investigation.




11. Production Advance
Payable




On August
13, 2009, the Company entered into a unit production financing
agreement with a producer relating to the production of certain games, of
which the balance under this agreement was $3,755,104 at September 30,
2009.  Production fees relating to this production advance for the three
months ended September 30, 2009 totaled $199,946 and are included in
interest expense. As of September 30, 2009, accrued and unpaid production
fees totaled approximately $200,000 and are included in accrued expenses and
other current liabilities. The Company is obligated to pay approximately $103,000 of
production fees for every month the full production advance is outstanding past
its due date of November 14, 2009.  Pursuant to the agreement, the
Company has assigned to the producer a portion of the net
revenues related to the sale of certain games in
Europe.


22


Item 2.Management’s Discussion
and Analysis of Financial Condition and Results of
Operations


The
following discussion and analysis of our financial condition and results of
operations should be read in conjunction with our consolidated financial
statements and related notes that appear elsewhere in this report and in our
annual report on Form 10-K for the year ended June 30,
2009.


This
report includes forward-looking statements that are made pursuant to the safe
harbor provisions of the Private Securities Litigation Reform Act of 1995. These
forward-looking statements can be identified by the use of words such as
“anticipate,” “believe,” “estimate,” “may,” “intend,” “expect,” “will,”
“should,” “seeks” or other similar expressions. Forward-looking statements
reflect our plans, expectations and beliefs, and involve inherent risks and
uncertainties, many of which are beyond our control. You should not place undue
reliance on any forward-looking statement, which speaks only as of the date
made. Our actual results could differ materially from those discussed in the
forward-looking statements. Factors that could cause or contribute to these
differences include those discussed below and elsewhere in this report,
particularly in “Risk Factors” in Item 1A of Part II.


Overview




We are an
independent developer and publisher of interactive entertainment software. We
utilize our network of independent studios and developers to create
videogames for all popular videogame systems, including:




·
            home videogame consoles such as
      Microsoft Xbox 360, Nintendo Wii, Sony PlayStation 3 and
      Sony PlayStation 2;




·
            handheld platforms such as
      Nintendo DS, Nintendo DSi, Sony PSP, Sony PSPgo, and Apple iPhone;
      and




·
            personal
      computers.




Our
portfolio of games extends across a variety of consumer demographics, ranging
from adults to children and hard-core game enthusiasts to casual
gamers.




We are an
“indie” videogame developer and publisher working with independent software
developers and videogame studios to create our videogames. We have cultivated
relationships globally with independent developers and studios that provide us
with innovative and compelling videogame concepts.




Our
strategy is to establish a portfolio of successful proprietary content for the
major videogame systems, and to capitalize on the growth of the interactive
entertainment market. We currently work exclusively with independent software
developers and videogame studios to develop our videogames. This strategy
enables us to source and create highly innovative videogames while avoiding the
high fixed costs and risk of having a large internal development studio. Through
outsourcing, we are also able to access videogame concepts and content from
emerging studios globally, providing us with significant new product
opportunities with limited initial financial outlay.




Sources
of Revenue




Revenue
is primarily derived from the sale of software titles developed on our behalf by
independent software developers and videogame studios.  Our unique
business model of globally sourcing and developing creative product allows us to
better manage our fixed costs relative to our competition.  In North
America, we sell our videogames both to retailers and distributors, and in
Europe, Australia and Asia, we primarily sell our videogames to
distributors.




Our
operating margins are dependent in part upon our ability to continually release
new products that perform according to our budgets and forecasts, and manage our
product development costs. Our product development costs include license
acquisition, videogame development, and third-party royalties. Agreements with
third-party developers generally give us exclusive publishing and marketing
rights and require us to make advance royalty payments, pay royalties based on
product sales, and satisfy other conditions.


23


First
Quarter 2010 Releases




We
released the following videogames in the three months ended September 30,
2009:




Title
                
                Platform
                
                Date ReleasedEU
      Rome Gold
                
                PC
                
                7/7/2009East
      India Company
                
                PC
                
                7/9/2009Brave:
      A Warrior’s Tale
                
                X360,
      Wii
                
                8/1/2009Hearts
      of Iron 3
                
                PC
                
                8/3/2009Raven
      Squad: Hidden Dagger
                
                X360,
      PC
                
                8/21/2009Section
      8
                
                X360,
      PC
                
                8/26/2009Trine
                
                PC
                
                9/4/2009Majesty
      2: The Fantasy Kingdom
                
                PC
                
                9/16/2009Supreme
      Ruler 2020
                
                PC
                
                9/17/2009Fallen
      Earth
                
                PC
                
                9/28/2009




Cost
of Goods Sold and Operating Expenses




Cost of Goods Sold. Cost
of goods sold consists of royalty payments to third-party developers, license
fees to videogame manufacturers, intellectual property costs for items such as
trademarked characters and game engines, and manufacturing costs of videogame
discs, cartridges or similar media. Videogame system manufacturers approve and
manufacture each videogame for their videogame system.  The videogame
system manufacturers charge us a license fee for each videogame based on the
number of videogames manufactured.  Should some of the videogames
ultimately not be sold, or the sales price to the retailer be reduced by us
through price protection, no adjustment is made by the videogame system
manufacturer to the license fee originally charged.  Because of
the terms of these license fees, we may have an increase in the cost of goods
sold as a percent of net revenue should we fail to sell a number of copies of a
videogame for which a license has been paid, or if the price to the retailer is
reduced.




We
utilize third-parties to develop our videogames on a royalty payment basis. We
enter into contracts with independent software developers and videogame studios
once the videogame design has been approved by the videogame system manufacturer
and is technologically feasible.  Payments to independent software
developers and videogame studios are made when certain contract milestones are
reached, and these payments are capitalized. These payments are considered
non-refundable royalty advances and are applied against the royalty obligations
owing to the independent software developer or videogame studio from the sales
of the videogame. To the extent these prepaid royalties are sales performance
related, the royalties are expensed against projected sales revenue at the time
a videogame is released and charged to costs of goods sold. Any pre-release
milestone payments that are not prepayments against future royalties are
expensed when a videogame is released and then charged to costs of goods sold.
Capitalized costs for videogames that are cancelled or abandoned prior to
product release are charged to “cost of goods sold - royalties” in the period of
cancellation.




Warehousing and Distribution
Expenses. Our warehousing and distribution expenses primarily consist of
costs associated with warehousing, order fulfillment, and shipping. Because we
use third-party warehousing and order fulfillment companies in North America and
in Europe, the expansion of our product offerings and escalating sales will
increase our expenditures for warehousing and distribution in proportion to our
increased sales.




Sales and Marketing Expenses.
Sales and marketing expenses consist of salaries and related costs, advertising,
marketing and promotion expenses, and commissions to external sales
representatives. As we release more newly published videogames, advertising,
marketing and promotion expenses are expected to rise accordingly. We recognize
advertising, marketing and promotion expenses as incurred, except for production
costs associated with media advertising, which are deferred and charged to
expense when the related ad is run for the first time. We also engage in
cooperative marketing with some of our retail channel partners. We accrue
marketing and sales incentive costs when revenue is recognized and such amounts
are included in sales and marketing expense when an identifiable benefit to us
can be reasonably estimated; otherwise, the incentives are recognized as a
reduction to net revenues. Such marketing is offered to our retail channel
partners based on a single sales transaction, as a credit on their accounts
receivable balance, and would include items such as contributing to newspaper
circular ads and in-store banners and displays.




General and Administrative
Expenses. General and administrative expenses primarily represent
personnel-related costs, including corporate executive and support staff,
general office expenses, consulting and professional fees, and various other
expenses. Personnel-related costs represent the largest component of general and
administrative expenses. We expect that our personnel costs will increase as the
business continues to grow.  Depreciation expense also is included in
general and administrative expenses.


24


Interest and Financing Costs.
Interest and financing costs are attributable to our line of credit and
financing arrangements that are used to fund development of videogames with
independent software developers and videogame studios. Additionally, such costs
are used to finance accounts receivables prior to payment by
customers.




Critical
Accounting Policies and Estimates




Our
consolidated financial statements have been prepared in accordance with
accounting principles generally accepted in the United States. The preparation
of these consolidated financial statements requires estimates and judgments that
affect the reported amounts of assets, liabilities, revenues and expenses, and
related disclosure of contingent assets and liabilities. Estimates were based on
historical experience and on various other assumptions that we believe to be
reasonable under the circumstances, the results of which form the basis for
making judgments about the carrying values of assets and liabilities that are
not readily apparent from other sources. Actual results could differ materially
from these estimates under different assumptions or conditions.




Our
significant accounting policies are described in Note 1 to the accompanying
consolidated financial statements and in our annual report
on Form 10-K for the year ended June 30, 2009. The following
accounting policies involve a greater degree of judgment and complexity.
Accordingly, these are the policies we believe are the most critical to aid in
fully understanding and evaluating our consolidated financial condition and
results of operations.




Allowances for Returns, Price
Protection and Other Allowances.We accept returns from,
and grant price concessions to, our customers under certain conditions.
Following reductions in the price of our videogames, we grant price concessions
to permit customers to take credits against amounts they owe us with respect to
videogames unsold by them. Our customers must satisfy certain conditions to
entitle them to return videogames or receive price concessions, including
compliance with applicable payment terms and confirmation of field inventory
levels and sell-through rates.




We make
estimates of future videogame returns and price concessions related to current
period revenue. We estimate the amount of future returns and price concessions
for published titles based upon, among other factors, historical experience and
performance of the titles in similar genres, historical performance of the
videogame system, customer inventory levels, analysis of sell-through rates,
sales force and retail customer feedback, industry pricing, market conditions
and changes in demand and acceptance of our videogame by consumers.




Significant
management judgments and estimates must be made and used in connection with
establishing the allowance for returns and price concessions in any accounting
period. We believe we can make reliable estimates of returns and price
concessions. However, actual results may differ from initial estimates as a
result of changes in circumstances, market conditions and assumptions.
Adjustments to estimates are recorded in the period in which they become
known.




Inventories.Inventories are stated
at the lower of average cost or market. Management regularly reviews inventory
quantities on hand and in the retail channel and records a provision for excess
or obsolete inventory based on the future expected demand for our games.
Significant changes in demand for our games would impact management’s estimates
in establishing the inventory provision.




Advances on Royalties.We utilize independent
software developers to develop our videogames and make payments to the
developers based upon certain contract milestones. We enter into contracts with
the developers once the videogame design has been approved by the videogame
system manufacturers and is technologically feasible. Accordingly, we capitalize
such payments to the developers during development of the videogames. These
payments are considered non-refundable royalty advances and are applied against
the royalty obligations owed to the developer from future sales of the
videogame. Any pre-release milestone payments that are not prepayments against
future royalties are expensed to “cost of goods sold - royalties” in the period
when the game is released. Capitalized royalty costs for those videogames that
are cancelled or abandoned are charged to “cost of goods sold - royalties” in
the period of cancellation.




Beginning
upon the related videogame’s release, capitalized royalty costs are amortized to
“cost of goods sold – royalties,” based on the ratio of current revenues to
total projected revenues for the specific videogame, generally resulting in an
amortization period of twelve months or less.




We
evaluate the future recoverability of capitalized royalty costs on a quarterly
basis. For videogames that have been released in prior periods, the primary
evaluation criterion is actual title performance. For videogames that are
scheduled to be released in future periods, recoverability is evaluated based on
the expected performance of the specific videogame to which the royalties
relate. Criteria used to evaluate expected game performance include: historical
performance of comparable videogames developed with comparable technology;
orders for the videogame prior to its release; and, for any videogame sequel,
estimated performance based on the performance of the videogame on which the
sequel is based.


25


Significant
management judgments and estimates are utilized in the assessment of the
recoverability of capitalized royalty costs. In evaluating the recoverability of
capitalized royalty costs, the assessment of expected videogame performance
utilizes forecasted sales amounts and estimates of additional costs to be
incurred. If revised forecasted or actual videogame sales are less than, and/or
revised forecasted or actual costs are greater than, the original forecasted
amounts utilized in the initial recoverability analysis, the net realizable
value may be lower than originally estimated in any given quarter, which could
result in an impairment charge. Material differences may result in the amount
and timing of charges for any period if management makes different judgments or
utilizes different estimates in evaluating these qualitative
factors.




Intellectual Property
Licenses.Intellectual property
license costs consist of fees paid by us to license the use of trademarks,
copyrights, and software used in the development of videogames. Depending on the
agreement, we may use acquired intellectual property in multiple videogames over
multiple years or for a single videogame. When no significant performance
remains with the licensor upon execution of the license agreement, we record an
asset and a liability at the contractual amount. We believe that the contractual
amount represents the fair value of the liability. When significant performance
remains with the licensor, we record the payments as an asset when paid to the
licensee and as a liability upon achievement of certain contractual milestones
rather than upon execution of the agreement. We classify these obligations as
current liabilities to the extent they are contractually due within the next 12
months. Capitalized intellectual property license costs for those videogames
that are cancelled or abandoned are charged to “cost of goods sold -
intellectual property licenses” in the period of cancellation.




Beginning
upon the related videogame’s release, capitalized intellectual property
license costs are amortized to “cost of sales - intellectual property licenses”
based on the greater of: (1) the ratio of current revenues for the specific
videogame to total projected revenues for all videogames in which the licensed
property will be utilized or (2) the straight-line amortization based on
the useful lives of the asset. As intellectual property license contracts may
extend for multiple years, the amortization of capitalized intellectual property
license costs relating to such contracts may extend beyond one
year.




We
evaluate the future recoverability of capitalized intellectual property license
costs on a quarterly basis. For videogames that have been released in prior
periods, the primary evaluation criterion is actual title performance. For
videogames that are scheduled to be released in future periods, recoverability
is evaluated based on the expected performance of the specific videogames to
which the costs relate or in which the licensed trademark or copyright is to be
used. Criteria used to evaluate expected game performance include: historical
performance of comparable videogames developed with comparable technology;
orders for the game prior to its release; and, for any videogame sequel,
estimated performance based on the performance of the videogame on which the
sequel is based. Further, as intellectual property licenses may extend for
multiple videogames over multiple years, we also assess the recoverability of
capitalized intellectual property license costs based on certain qualitative
factors, such as the success of other products and/or entertainment vehicles
utilizing the intellectual property and the holder’s right to continued
promotion and exploitation of the intellectual property.




Significant
management judgments and estimates are utilized in the assessment of the
recoverability of capitalized intellectual property license costs. In evaluating
the recoverability of capitalized intellectual property license costs, the
assessment of expected game performance utilizes forecasted sales amounts and
estimates of additional costs to be incurred. If revised forecasted or actual
videogame sales are less than, and/or revised forecasted or actual costs are
greater than, the original forecasted amounts utilized in the initial
recoverability analysis, the net realizable value may be lower than originally
estimated in any given quarter, which could result in an impairment charge.
Material differences may result in the amount and timing of charges for any
period if management makes different judgments or utilizes different estimates
in evaluating these qualitative factors.




Revenue
Recognition.We recognize revenues from the sale of our
videogames upon the transfer of title and risk of loss to the
customer.   Accordingly, we recognize revenues for software titles
when (1) there is persuasive evidence that an arrangement with the customer
exists, which is generally a purchase order, (2) the product is delivered, (3)
the selling price is fixed or determinable, and (4) collection of the customer
receivable is deemed probable. Our payment arrangements with customers typically
provide for net 30 and 60 day terms. Advances received for licensing and
exclusivity arrangements are reported on the consolidated balance sheets as
deferred revenues until we meet our performance obligations, at which point the
revenues are recognized. Revenue is recognized after deducting estimated
reserves for returns, price protection and other allowances. In circumstances
when we do not have a reliable basis to estimate returns and price protection
or we are unable to determine that collection of a receivable is
probable, we defer the revenue until such time as we can reliably estimate any
related returns and allowances and determine that collection of the receivable
is probable.




Some of
our videogames provide limited online features at no additional cost to the
consumer. Generally, we consider such features to be incidental to the overall
product offering and an inconsequential deliverable. Accordingly, we recognize
revenue related to videogames containing these limited online features upon the
transfer of title and risk of loss to our customer. In instances where online
features or additional functionality are considered a substantive deliverable in
addition to the videogame, we take this into account when applying our revenue
recognition policy. This evaluation is performed for each videogame together
with any online transactions, such as electronic downloads or videogame add-ons
when it is released. When we determine that a videogame contains online
functionality that constitutes a more-than-inconsequential separate service
deliverable in addition to the videogame, principally because of its importance
to game play, we consider that our performance obligations for this game extend
beyond the delivery of the game. Fair value does not exist for the online
functionality, as we do not separately charge for this component of the
videogame. As a result, we recognize all of the revenue from the sale of the
game upon the delivery of the remaining online functionality. In addition, we
defer the costs of sales for this game and recognize the costs upon delivery of
the remaining online functionality.


26


With
respect to online transactions, such as electronic downloads of games or add-ons
that do not include a more-than-inconsequential separate service deliverable,
revenue is recognized when the fee is paid by the online customer to purchase
online content and we are notified by the online retailer that the product has
been downloaded. In addition, persuasive evidence of an arrangement must exist,
collection of the related receivable must be probable and the fee must be fixed
and determinable.




Third-party
licensees in Europe distribute Gamecock’s videogames under license agreements
with Gamecock. The licensees paid certain minimum, non-refundable, guaranteed
royalties when entering into the licensing agreements. Upon receipt of the
advances, we defer their recognition and recognize the revenues in subsequent
periods as these advances are earned by us. As the licensees pay additional
royalties above and beyond those initially advanced, we recognize these
additional royalties as revenues when earned.




With
respect to license agreements that provide customers the right to make multiple
copies in exchange for guaranteed amounts, revenue is recognized upon delivery
of a master copy. Per copy royalties on sales that exceed the guarantee are
recognized as earned. In addition, persuasive evidence of an arrangement must
exist, collection of the related receivable must be probable, and the fee must
be fixed and determinable.




Stock-Based
Compensation.We estimate the fair
value of stock-based payment awards on the measurement date using the
Black-Scholes option-pricing model. The value of the portion of the award
that is ultimately expected to vest is recognized as expense over the requisite
service periods in the consolidated statements of operations.




Stock-based
compensation expense recognized in the consolidated statements of operations is
based on awards ultimately expected to vest and has been reduced for estimated
forfeitures. Stock compensation guidance requires forfeitures to be estimated at
the time of grant and revised, if necessary, in subsequent periods if actual
forfeitures differ from those estimates.




We account
for equity instruments issued to non-employees in accordance with FASB guidance
surrounding stock compensation and equity-based payment for
non-employees.




We
estimate the value of employee, non-employee director and
non-employee stock options on the date of grant using the Black-Scholes
option pricing model. Our determination of fair value of stock-based payment
awards on the date of grant using an option-pricing model is affected by our
stock price as well as assumptions regarding a number of highly complex and
subjective variables. These variables include, but are not limited to the
expected stock price volatility over the term of the awards, and actual and
projected employee stock option exercise behaviors.




Business Combinations. We
estimate the fair value of assets acquired, and liabilities assumed in a
business combination. Our assessment of the estimated fair value of each of
these can have a material effect on our reported results as intangible assets
are amortized over various lives. Furthermore, a change in the estimated fair
value of an asset or liability often has a direct impact on the amount to
recognize as goodwill, an asset that is not amortized. Often determining the
fair value of these assets and liabilities assumed requires an assessment of
expected use of the asset, the expected future cash flows related to the asset,
and the expected cost to extinguish the liability. Such estimates are inherently
difficult and subjective and can have a material impact on our financial
statements.




Assessment of Impairment of
Goodwill.Current accounting
standards provide for a two-step approach to testing goodwill for impairment,
which must be performed at least annually by applying a fair-value-based test.
The first step measures for impairment by applying fair-value-based tests. The
second step (if necessary) measures the amount of impairment by applying
fair-value-based tests to the individual assets and liabilities.




To
determine the fair values of the reporting units used in the first step, we use
a combination of the market approach, which utilizes comparable companies’ data
and/or the income approach, or discounted cash flows. Each step requires us to
make judgments and involves the use of significant estimates and assumptions.
These estimates and assumptions include long-term growth rates and operating
margins used to calculate projected future cash flows, risk-adjusted discount
rates based on our weighted average cost of capital, future economic and market
conditions and determination of appropriate market comparables. These estimates
and assumptions have to be made for each reporting unit evaluated for
impairment. Our estimates for market growth, our market share and costs are
based on historical data, various internal estimates and certain external
sources, and are based on assumptions that are consistent with the plans and
estimates we are using to manage the underlying business. Our business consists
of publishing and distributing interactive entertainment software and content
using both established and emerging intellectual properties and our forecasts
for emerging intellectual properties are based upon internal estimates and
external sources rather than historical information and have an inherently
higher risk of accuracy. If future forecasts are revised, they may indicate or
require future impairment charges. We base our fair value estimates on
assumptions we believe to be reasonable but that are unpredictable and
inherently uncertain. Actual future results may differ from those
estimates.


27


Consolidated
Results of Operations




The
following table sets forth our results of operations expressed as a percentage
of net revenues for the three months ended September 30, 2009 and
2008:




Three Months Ended
                      September 30,2009
                    
                    
                    2008Net
      revenues
                    
                    
                    100.0
                    %
                    
                    
                    100.0
                    %Cost
      of goods sold:Product
      costs
                    
                    
                    21.2
                    %
                    
                    
                    64.7
                    %Royalties
                    
                    
                    29.9
                    %
                    
                    
                    9.6
                    %Intellectual
      property licenses
                    
                    
                    0.7
                    %
                    
                    
                    0.5
                    %Total
      cost of goods sold
                    
                    
                    51.9
                    %
                    
                    
                    74.9
                    %Gross
      profit
                    
                    
                    48.1
                    %
                    
                    
                    25.1
                    %Operating
      expenses:Warehousing
      and distribution
                    
                    
                    1.7
                    %
                    
                    
                    2.5
                    %Sales
      and marketing
                    
                    
                    21.9
                    %
                    
                    
                    23.8
                    %Transaction
      costs
                    
                    
                    -
                    
                    
                    
                    0.2
                    %General
      and administrative
                    
                    
                    18.6
                    %
                    
                    
                    16.5
                    %Total
      operating expenses
                    
                    
                    42.2
                    %
                    
                    
                    42.9
                    %Income
      (loss) from operations
                    
                    
                    5.9
                    %
                    
                    
                    (17.8
                    )%Interest
      expense, net
                    
                    
                    1.8
                    %
                    
                    
                    0.7
                    %Net
      income (loss)
                    
                    
                    4.1
                    %
                    
                    
                    (18.5
                    )%Deemed
      dividend related to beneficial conversion feature on Series A convertible
      preferred stock
                    
                    
                    -
                    
                    
                    
                    13.6
                    %Net
      income (loss) attributable to common shareholders
                    
                    
                    4.1
                    %
                    
                    
                    (32.1
                    )%




Three
Months Ended September 30, 2009 and 2008




Net Revenues. Net revenues
for the three months ended September 30, 2009 were $16,709,649, an increase of
$8,321,946, or 99%, from net revenues of $8,387,703 for the three months ended
September 30, 2008. The increase in net revenues was primarily driven by
releasing an increased number of titles.  For the three months ended
September 30, 2009, the number of videogame units sold increased to
approximately 737,000, an increase of 207,000 units from the units sold in the
prior period. Average net revenue per videogame unit sold increased 43%, from
$15.83 to $22.67 for the three months ended September 30, 2008 and 2009,
respectively. This average increase in price is mainly due to selling more units
for next generation platforms, which have a higher MSRP, in the three
months ended September 30, 2009 versus the prior period.




Cost of Goods Sold. Cost
of goods sold for the three months ended September 30, 2009 increased to
$8,667,017, up $2,388,563, or 38%, from $6,278,454 for the prior period. The
cost of royalty expense for the three months ended September 30, 2009 was
$5,000,671, an increase of 518%, from royalty expense of $808,921 for the three
months ended September 30, 2008.  This increase is attributable to an
increase in developer royalty agreements associated with the increased
number of titles released during the period.


28


Gross Profit. For the
three months ended September 30, 2009 and 2008, gross profit increased to
$8,042,632 from $2,109,249, or 281%, and gross profit margin increased to
approximately 48% from 25%. The increase in gross profit isattributed to selling
more units for next generation platforms, which have a higher MSRP, in the
three months ended September 30, 2009 versus the prior period.




Warehousing and Distribution
Expenses. For the three months ended September 30, 2009 and 2008,
warehousing and distribution expenses were $286,511 and $207,583, respectively,
resulting in an increase of 38%. This increase is due primarily to the increase
in the number of units shipped from 530,000 during the three months ended
September 30, 2008 to 737,000 during the three months ended September 30,
2009.




Sales and Marketing Expenses. For the three
months ended September 30, 2009, sales and marketing expenses increased 83% to
$3,655,056 from $1,995,736 for the three months ended September 30, 2008. This
increase is primarily due to increased marketing budgets relating to the launch
of two Xbox 360 titles released in the quarter, Section 8 and Raven Squad and
continued marketing for the My Baby brand.  Sales and marketing costs
vary on a videogame by videogame basis depending on market conditions and
consumer demand, and do not necessarily increase or decrease proportionate to
sales volumes. Included in sales and marketing expenses for the three months
ended September 30, 2009 and 2008 is a non-cash charge of $27,622 and $37,734,
respectively, for stock options granted to vendors and other
non-employees.




General and Administrative
Expenses.For the three months
ended September 30, 2009, general and administrative expenses increased 126% to
$3,114,768 from $1,380,425 for the prior period. The increase in general
and administrative expenses was primarily due to wages of $939,619, professional
fees of $1,277,847 and a non-cash charge of $128,574 related to employee stock
options and restricted stock. Travel and entertainment expenses were $87,120 for
the three months ended September 30, 2008, as compared to $53,323 for
the three months ended September 30, 2009. General and administrative expenses
as a percentage of net revenues increased, to approximately 19% for the three
months ended September 30, 2009 from 17% for the prior period.




Transaction Costs. For
the three months ended September 30, 2008, we incurred $18,380 in costs related
to the reverse acquisition. These costs included professional fees to accounting
firms, law firms and advisors.




Operating Income/Loss. For
the three months ended September 30, 2009, our operating income was $986,297, as
compared to an operating loss of $1,492,875 for the prior period.




Interest and Financing
Costs. For the three months ended September 30, 2009, interest and
financing costs increased to $299,316 from $58,879 for the prior period due to
an increase in average borrowings as a result of the increase in our accounts
receivable and a decrease in working capital resulting from the full deployment
of the proceeds we received from the sale of Series A convertible preferred
stock in fiscal years 2009 and 2008. The increase is also attributable to
expense related to the production advance payable.




Net Income/Loss. For the
three months ended September 30, 2009, our net income was $686,981, as
compared to a net loss of $1,551,754 for the prior period.




Quarterly
Operating Results Not Meaningful




Our
quarterly net revenues and operating results have varied widely in the past and
can be expected to vary in the future due to numerous factors, several of which
are not under our control. These factors include the timing of our release of
new titles, the popularity of both new titles and titles released in prior
periods, changes in the mix of titles with varying gross margins, the timing of
customer orders, and fluctuations in consumer demand for gaming platforms.
Accordingly, our management believes that quarter-to-quarter comparisons of our
operating results are not meaningful.




Liquidity
and Capital Resources




Our
primary cash requirements have been to fund (i) the development, manufacturing
and marketing of our videogames, (ii) working capital, and (iii) capital
expenditures. Historically, we have met our capital needs through our operating
activities, our line of credit, through the sale of our equity
securities, and, prior to the reverse acquisition, loans from related
parties and our shareholders. Our cash and cash equivalents were $273,481 at
September 30, 2009 and $648,311 at June 30, 2009.




Line of Credit. We
have a line of credit with a financial institution, which comes due on
November 30, 2009 and is currently in the process of being renewed. The line of
credit bears interest at prime plus 1⁄2%, which was 3.75% at September 30, 2009.
Availability under the line of credit is restricted to 65% of our eligible
accounts receivable plus $500,000. The line of credit is primarily secured by
our accounts receivable. The line of credit is further secured by the personal
guarantees and pledge of personal securities and assets, of two of our
shareholders and certain of their affiliates. At September 30, 2009, we
were in compliance with all of the line of credit’s covenants and
requirements.


29


At
September 30, 2009 and June 30, 2009, the outstanding line of credit balance was
$7,123,865 and $5,349,953, respectively, and the remaining available under the
line of credit amounted to $876,135 and  $-0-,
respectively.




Account Receivable.
Generally, we have been able to collect our accounts receivable in the ordinary
course of business. We do not hold any collateral to secure payment from
customers. We are subject to credit risks, particularly if any of our accounts
receivable represent a limited number of customers. If we are unable to collect
our accounts receivable as they become due, it could adversely affect our
liquidity and working capital position.




At
September 30, 2009 and June 30, 2009, amounts due from our three largest
customers comprised approximately 45% and 52% of our gross accounts receivable
balance, respectively. We believe that the receivable balances from these
largest customers do not represent a significant credit risk based on past
collection experience, although we actively monitor each customer’s credit
worthiness and economic conditions that may impact our customers’ business and
access to capital. We are monitoring the current turmoil in the economy, the
global contraction of current credit and other factors as they relate to
our customers in order to manage the risk of uncollectible accounts
receivable.




Preferred Stock. During the
fourth quarter of fiscal year 2008 and the first half of fiscal year 2009, we
sold 14,563,833 shares of preferred stock valued at $14,563,833, which provided
additional liquidity to fund our continued growth through investment in
videogame development.




Although
there can be no assurance, we believe our current cash and cash equivalents and
projected cash flow from operations, along with availability under our line of
credit, will provide us with sufficient liquidity to satisfy our cash
requirements for working capital, capital expenditures and commitments through
at least the next 12 months. In addition, if we were to become unable to
fully fund our cash requirements through current cash and cash equivalents and
projected cash flow from operations, we would need to obtain additional
financing through a combination of equity and debt financings. If any such
activities become necessary, there can be no assurance that we would be
successful in obtaining additional financing, particularly in light of the
general economic downturn.




Cash Flows. We expect
that we will make significant expenditures relating to advances on royalties to
third-party developers to fund our continued growth. Cash flows from operations
are affected by our ability to release successful titles. Though many of these
titles have substantial royalty advances and marketing expenditures, once a
title recovers these costs, incremental net revenues typically will directly and
positively impact cash flows.




For the
three months ended September 30, 2009 and 2008, we had net cash used in
operating activities of $2,221,544 and $1,826,090, respectively.




During
the three months ended September 30, 2009, investing activities resulted in net
cash provided of $391,183 and during the three months ended September 30, 2008,
investing activities resulted in net cash used of $120,433. The cash provided
was a result of the increase in restricted cash during the three months ended
September 30, 2009.




During
the three months ended September 30, 2009, financing activities resulted in net
cash provided of $1,406,774 and during the three months ended September 30,
2008, financing activities resulted in net cash used of $996,472.




As our
gross profit margins increase, our operating cash flows are expected to
contribute more towards our capital needs in the future. The Gamecock
Acquisition caused a short-term strain on our cash flows, as we needed to
fund the payment of certain liabilities Gamecock incurred prior to the Gamecock
Acquisition. This short-term strain on cash flows limited our ability to fund
additional production of a successful videogame. As a result, our Chairman,
Terry Phillips, advanced $307,440 to us in order to fund the production of
additional cartridges for a particular videogame. The advance was
unsecured, payable on demand and non-interest bearing.  At June 30,
2009, the amount due was $232,440.  Subsequent to June 30, 2009, the
amount was repaid.




International
Operations.Net revenue earned
outside of North America is principally generated by our operations in Europe,
Australia and Asia. For the three months ended September 30, 2009 and 2008,
approximately 28% and 11%, respectively, of our net revenue was earned outside
of the U.S. We are subject to risks inherent in foreign trade, including
increased credit risks, tariffs and duties, fluctuations in foreign currency
exchange rates, shipping delays and international political, regulatory and
economic developments, all of which can have a significant impact on our
operating results.


30


Item 3.Quantitative and
Qualitative Disclosures about Market Risk




For
quantitative and qualitative disclosures about market risk, see Item 7A,
“Quantitative and Qualitative Disclosures About Market Risk,” of our annual
report on Form 10-K for the year ended June 30, 2009. Our exposures to
market risk have not changed materially since June 30, 2009.




Item
4T. Controls and
Procedures




Restatement
of Previously Issued Financial Statements




In
connection with the filing of our Form 10-Q/A with the SEC on September 11,
2009, during the first fiscal quarter of 2010, management reevaluated the
effectiveness of our disclosure controls and procedures (as defined in Rules
13a-15(e) and 15d-15(e) under the Securities Exchange Act of 1934, as amended
(the “Exchange Act”)). Based on that reevaluation, the Chief Executive Officer,
who is also serving as our interim Chief Financial Officer, and in consultation
with our Chairman, concluded that the our disclosure controls and procedures
were not effective as of March 31, 2009 as a result of the following material
weaknesses in our internal control over financial reporting.




·
            There
      were material operational deficiencies related to the preparation and
      review of financial information during our quarter end closing
      process.  These items resulted in more than a remote likelihood
      that a material misstatement or lack of disclosure within our interim
      financial statements would not be prevented or detected.  Our
      senior financial management lacked the necessary experience and we did not
      maintain a sufficient number of qualified personnel to support our
      financial reporting and close process. This reduced the likelihood that
      such individuals could detect a material adjustment to our books and
      records or anticipate, identify, and resolve accounting issues in the
      normal course of performing their assigned functions.  This
      material weakness resulted in adjustments to inventories, accounts
      payable, accrued royalties, accrued expenses and other current
      liabilities, due to shareholders, additional paid-in capital, product
      costs, royalties, sales and marketing and general and administrative
      expenses in our condensed consolidated financial statements for the three
      and nine month periods ended March 31,
2009.




·
            There
      were material operational deficiencies in our controls over related party
      transactions which resulted in a more than remote likelihood that a
      material misstatement or lack of disclosure in our interim financial
      statements would not be prevented or detected.  Management
      determined that established controls over related party transactions were
      not consistently applied to all related party transactions. This
      inconsistent application led to breakdowns in communication between
      management and our accounting department and resulted in an increased
      likelihood that the accounting department would not detect a significant
      transaction affecting us, which would lead to a material adjustment to our
      books and records or a material change to the disclosure in the footnotes
      to our interim financial statements. This material weakness resulted in
      adjustments to inventories, due to shareholders, and product costs in our
      condensed consolidated financial statements for the three and nine month
      periods ended March 31, 2009.




·
            There
      were material internal control and operational deficiencies related to the
      maintenance of our accruals and related expense accounts.  These
      items resulted in more than a remote likelihood that a material
      misstatement or lack of disclosure within our interim financial statements
      would not be prevented or detected.  Specifically, effective
      controls were not designed and in place to ensure the completeness,
      accuracy and timeliness of the recording of accruals for services provided
      and not billed at period end. This increased the likelihood that our
      accruals would be materially understated.  This material
      weakness resulted in adjustments to accounts payable, accrued royalties,
      accrued expenses and other current liabilities, product costs, royalties,
      sales and marketing and general and administrative expenses in our
      condensed consolidated financial statements for the three and nine month
      periods ended March 31, 2009.




·
            There
      were material internal control and operational deficiencies related to our
      reconciliation of inventory liability clearing accounts.  This
      item resulted in more than a remote likelihood that a material
      misstatement or lack of disclosure within our interim financial statements
      would not be prevented or detected.  Specifically, our account
      reconciliations, analyses and review procedures were ineffective as they
      lacked independent and timely review and separate review and approval of
      journal entries related to these accounts.  This material
      weakness resulted in adjustments to inventories in our condensed
      consolidated financial statements for the three and nine month periods
      ended March 31, 2009.




Evaluation
of Disclosure Controls and Procedures




An
evaluation was carried out under the supervision and with the participation of
our management, including our Chief Executive Officer, who is also serving as
our interim Chief Financial Officer, and in consultation with our Chairman and
our interim Chief Accounting Officer, of the effectiveness of the design and
operation of our disclosure controls and procedures, to ensure that the
information required to be disclosed by us in this quarterly report was
recorded, processed, summarized and reported within the time periods specified
in the SEC’s rules and Form 10-Q and that such information required to be
disclosed was accumulated and communicated to management, including our Chief
Executive Officer and our Chief Financial Officer, to allow timely decisions
regarding required disclosure.  Based upon this reevaluation, our
Chief Executive Officer, who is also serving as our interim Chief Financial
Officer, concluded that our disclosure controls and procedures were not
effective as of September 30, 2009 as a result of the previously identified
material weaknesses in our internal control over financial
reporting.


31


In
connection with the preparation of our annual report on Form 10-K for the year
ended June 30, 2009, under the supervision and with the participation of
management, including our Chief Executive Officer, who is also serving as our
interim Chief Financial Officer, and in consultation with our Chairman and our
interim Chief Accounting Officer, we conducted an evaluation of the
effectiveness of our internal control over financial reporting based on the
framework in “Internal
Control — Integrated Framework”issued by the Committee of
Sponsoring Organizations of the Treadway Commission. Based on our evaluation
under the framework in “Internal Control — Integrated
Framework”, our management concluded that our internal control over
financial reporting was not effective as of June 30, 2009 as a result of the
previously identified material weaknesses.




Changes
in Internal Control over Financial Reporting




As
discussed above, as of June 30, 2009, we had material weaknesses in our internal
control over financial reporting.




In
addition to the remediation measures described below under the heading
“Remediation Steps to Address Material Weakness,” we have made the following
changes to address the previously reported material weaknesses in internal
control over financial reporting and disclosure controls and
procedures:




·
            we
      implemented a closing calendar and consolidation process that includes
      accrual based financial statements being reviewed by qualified personnel
      in a timely manner;




·
            we
      review consolidating financial statements with senior management and the
      audit committee of the board of directors;
and




·
            we
      complete disclosure checklists for both GAAP and SEC required disclosures
      to ensure disclosures are complete.




Remediation
Steps to Address Material Weakness




Beginning
in the first fiscal quarter of 2010, we began the process of remediating the
material weaknesses described above and enhancing our internal control over
financial reporting.  In connection with our remediation process, we
have taken the following remediation measures:




·
            we
      have hired an interim Chief Accounting Officer with the
      requisite experience in internal accounting in the videogame industry and
      made other related personnel
changes;




·
            we
      have provided training to our management and accounting personnel
      regarding established controls and procedures for related party
      transactions; and




·
            we
      have enhanced our computer software and internal procedures related to
      information technology in order to migrate from spreadsheet applications
      into automated functions within the accounting
  system.




Additionally,
in connection with our remediation process we are implementing the following
remediation measures:




·
            we
      are developing additional training for our accounting personnel and
      reallocating duties of certain accounting
  personnel;




·
            we
      are implementing access controls into our financial accounting
      software;




·
            we
      are enhancing procedures and documentation supporting our
      accruals;




·
            we
      are beginning an internal communication program with our employees
      regarding ethics and the availability of our internal fraud hotline;
      and




·
            we
      are incorporating more robust management review of our general and
      administrative expense accruals.




Management
anticipates that the actions described above and the resulting improvements in
controls will strengthen its internal control over financial reporting relating
to the preparation of the condensed consolidated financial statements and will
remediate the material weakness identified by the end of our fiscal year
2010.  As we improve our internal control over financial reporting and
implement remediation measures, we may supplement or modify the remediation
measures described above.  Management is committed to implementing
effective control policies and procedures and will continually update our Audit
Committee as to the progress and status of our remediation efforts to ensure
that they are adequately implemented.


32


PART II




Item 1.Legal
Proceedings




On March
12, 2009, we, along with Gamecock, SouthPeak Interactive, Ltd. and
Gamecock Media Europe, Ltd., were served with a complaint by CDV Software
Entertainment A.G., or CDV, alleging various breach of contract and other claims
related to a publishing and distribution agreement, or the Distribution
Agreement, entered into between Gamecock Media Europe, Ltd. and CDV in January
2008. CDV is seeking the return of $4,590,000 in videogame development advances,
an injunction against us and our subsidiaries, approximately $650,000 in
specified damages, further damages to be assessed, and discretionary interest
and costs. Gamecock Media Europe, Ltd. filed a counterclaim against CDV for
$950,000 and discretionary interest and costs, resulting from videogame sales
and the achievement of a milestone under the Distribution Agreement. The hearing
for both CDV’s claims and Gamecock Media Europe’s counterclaim concluded on
July 22, 2009, and the court is expected to issue its ruling in the near
future.




On
October 27, 2008, Gamecock was served with a demand for arbitration by a
developer alleging various breaches of contract related to a publishing
agreement entered into between Gamecock and the developer on December 12, 2007.
The developer is seeking an award of $4,910,000, termination of the agreement,
exclusive control of the subject videogame, and discretionary interest and
costs. Gamecock has responded stating that the developer’s attempts to terminate
the publishing Agreement constitute wrongful termination of the agreement and
breach of the agreement. Gamecock has also filed a counterclaim against the
developer seeking the return of approximately $5.9 million in advances on
royalties in the event the publishing agreement is terminated.  The
developer has filed a supplemental demand for arbitration concerning royalty
payments due under a separate publishing agreement and is seeking an award of
$41,084.  The arbitration hearing has been scheduled for January
2010.  As of September 30, 2009, no amounts have been accrued related
to this matter.




Other
than the foregoing, we are not currently subject to any material legal
proceedings. From time to time, however, we are named as a defendant in legal
actions arising from our normal business activities. Although we cannot
accurately predict the amount of our liability, if any, that could arise with
respect to legal actions currently pending against us, we do not expect that any
such liability will have a material adverse effect on our consolidated financial
position, operating results or cash flows. We believe that we have obtained
adequate insurance coverage, rights to indemnification, or where appropriate,
have established reserves in connection with these legal
proceedings.




Item 1A.Risk
Factors




“Item 1A.
Risk Factors” of our annual report on Form 10-K for the year ended June 30,
2009 includes a discussion of our risk factors.  There have been no
material changes to risk factors as previously disclosed in our annual report on
Form 10-K filed with the Securities and Exchange Commission on October 13,
2009.




Item 6.Exhibits




ExhibitNumber
              
              Exhibit3.1(1)
              
              Amended
      and Restated Certificate of Incorporation.3.2(1)
              
              Amended
      and Restated Bylaws.31.1*
              
              Certification
      of Chief Executive Officer pursuant to Rule 13a-14(a) and
      Rule 15d-14(a), promulgated under the Securities Exchange Act of
      1934, as amended.31.2*
              
              Certification
      of Chief Financial Officer pursuant to Rule 13a-14(a) and
      Rule 15d-14(a), promulgated under the Securities Act of 1934, as
      amended.32.1*
              
              Certification
      of Chief Executive Officer and Chief Financial Officer pursuant to
      18 U.S.C. Section 1350, as adopted pursuant to Section 906
      of the Sarbanes-Oxley Act of
2002.





*
            Filed
    herewith





(1)
            Incorporated by reference to an
      exhibit to the Current Report on Form 8-K of the Registrant filed with the
      Securities and Exchange Commission on May 15,
  2008.


33


SIGNATURES




Pursuant
to the requirements of the Securities Exchange Act of 1934, the registrant has
duly caused this report to be signed on its behalf by the undersigned thereunto
duly authorized.




SOUTHPEAK
      INTERACTIVE CORPORATIONBy:
              /s/ Melanie MrozMelanie
      Mroz
                President,
      Chief Executive Officer and Interim Chief Financial
  OfficerDate: November
      11, 2009





INDEX
TO EXHIBITS




ExhibitNumber
              
              Exhibit3.1(1)
              
              Amended
      and Restated Certificate of Incorporation.3.2(1)
              
              Amended
      and Restated Bylaws.31.1*
              
              Certification
      of Chief Executive Officer pursuant to Rule 13a-14(a) and
      Rule 15d-14(a), promulgated under the Securities Exchange Act of
      1934, as amended.31.2*
              
              Certification
      of Chief Financial Officer pursuant to Rule 13a-14(a) and
      Rule 15d-14(a), promulgated under the Securities Act of 1934, as
      amended.32.1*
              
              Certification
      of Chief Executive Officer and Chief Financial Officer pursuant to
      18 U.S.C. Section 1350, as adopted pursuant to Section 906
      of the Sarbanes-Oxley Act of
2002.







*
            Filed
    herewith





(1)
            Incorporated by reference to an
      exhibit to the Current Report on Form 8-K of the Registrant filed with the
      Securities and Exchange Commission on May 15,
  2008.