**SECURITIES
        AND EXCHANGE COMMISSION**
 Washington,
        D.C. 20549
 
 **Form
        10-K**
 
 (Mark
        One)
 [X]
              ANNUAL
                  REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE
                  ACT OF
                  1934
 For
        the
        fiscal year ended December 31, 2005
 **OR**
 
 [ 
                   ]
              TRANSITION
                  REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE
                  ACT OF
                  1934 [NO FEE REQUIRED]
 For
        the
        transition period ________ to ________
 
 Commission
                  File Number 1-12368
 
 **Tandy
                  Leather Factory, Inc.**(exact
                  name of registrant as specified in its
                  charter)
 
 **Delaware**
              
              **75-2543540**(State
                  or other jurisdiction of incorporation)
              
              (IRS
                  Employer Identification Number)
 
 **3847
                  East Loop 820 South, Fort Worth, Texas**
              
              **76119**(Address
                  of principal executive offices)
              
              (Zip
                  Code)
 
 **Registrant’s
                  telephone number, including area code:**(817) 496-4414
 
 **Securities
        registered pursuant to Section 12(b) of the Act:**
 
 **Title
                  of Each Class**
              
              **Name
                  of Each Exchange on Which Registered**Common
                  Stock, par value $0.0024
              
              American
                  Stock Exchange
  **Securities
        registered pursuant to Section 12(g) of the Act:**
 NONE
 Indicate
          by check mark if the registrant is a well-known seasoned issuer, as defined
          in
          Rule 405 of the Securities Act Yes [  ] No [X]
 
 Indicate
          by check mark if the registrant is not required to file reports pursuant
          to
          Section 13 or Section 15(d) of the Act. Yes [  ] No [X]
 
 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 [X] No [  ]
 
 Indicate
          by check mark if disclosure of delinquent filers pursuant to Item 405 of
          Regulation S-K is not contained herein, and will not be contained, to the
          best
          of registrant's knowledge, in definitive proxy or information statements
          incorporated by reference in Part III of this Form 10-K or any amendment
          to this
          Form 10-K. Yes [X] No [  ]
 
 Indicate
          by check mark whether the registrant is a large accelerated filer, an
          accelerated filer, or a non-accelerated filer. See definition of “accelerated
          filer and large accelerated filer” in Rule 12b-2 of the Exchange Act. (Check
          one): Large accelerated filer [  ]   Accelerated filer [  ]
          Non-accelerated filer [X]
 
 Indicate
          by check mark whether the registrant is a shell company (as defined in
          Rule
          12b-2 of the Act). Yes [  ] No [X]
 
 The
          aggregate market value of the common stock held by non-affiliates of the
          registrant was approximately $17,570,892 at June 30, 2005 (the last business
          day
          of its most recently completed second fiscal quarter). At March 15, 2006,
          there
          were 10,735,976 shares of the registrant's common stock
          outstanding.
 
 Portions
          of the Registrant’s definitive Proxy Statement for the Annual Meeting of
          Stockholders to be held on May 24, 2006, are incorporated by reference
          in Part
          III of this report.


**PART
      I**





**ITEM
      1.
      BUSINESS**


**General**


We
        are a
        retailer and wholesale distributor of a broad line of leather and related
        products, including leather, leatherworking tools, buckles and adornments
        for
        belts, leather dyes and finishes, saddle and tack hardware, and do-it-yourself
        kits. We also manufacture leather lacing and kits. During 2005, our consolidated
        sales totaled $50.7 million of which approximately 10.3% were export sales.
        We
        maintain our principal offices at 3847 East Loop 820 South, Fort Worth, Texas
        76119. Our common stock trades on the American Stock Exchange under the symbol
        "TLF."
 
 Our
        company was founded in 1980 as Midas Leathercraft Tool Company, a Texas
        corporation. Midas' original business activity focused on the distribution
        of
        leathercraft tools. In addition, the founders of Midas entered into a consulting
        agreement with Brown Group, Inc., a major footwear retailer, as a result
        of
        their proposal to develop a multi-location chain of wholesale distribution
        centers known as "The Leather Factory." In 1985, Midas purchased the assets
        of
        The Leather Factory from Brown Shoe Group, which then consisted of six
        distribution centers.
 
 In
        1993,
        we changed our name to "The Leather Factory, Inc.", then reincorporated in
        the
        state of Delaware in 1994. In 2005, we changed our name to Tandy Leather
        Factory, Inc.
 
 **Our
        Development in Recent Years**
 
 Our
        expansion of the wholesale chain occurred via the opening of new centers
        as well
        as numerous acquisitions of small businesses in strategic geographic locations
        including the acquisition of our Canadian distributor, The Leather Factory
        of
        Canada, Ltd., in 1996. By 2000, we had grown to twenty-seven Leather Factory
        centers located in the United States and two Leather Factory centers in Canada.
        In November 2000, we acquired the operating assets of two subsidiaries of
        Tandycrafts, Inc. to form Tandy Leather Company. In 2002, we began opening
        retail stores under the "Tandy Leather" name. During that year, Tandy Leather
        purchased four independent leathercraft retail stores and opened another
        ten. We
        also opened our 30th Leather Factory center - our third in Canada. In 2003,
        we
        opened twelve Tandy Leather retail stores. In 2004, we purchased three
        independent leathercraft retail stores and opened an additional nine stores
        in
        the U.S. We also opened another store in Canada which is operating as a Tandy
        Leather retail store. In November 2004, we acquired all of the issued and
        outstanding shares of capital stock of Heritan Ltd. and its parent, our primary
        Canadian competitor, headquartered in Barrie, Ontario. The acquisition resulted
        in an additional three retail stores in Canada, bringing the total locations
        in
        Canada to seven - three Leather Factory centers and four Tandy Leather stores.
        In 2005, we opened eight Tandy Leather retail stores.
 
 At
        December 31, 2005, we operated thirty wholesale distribution centers operating
        under the Leather Factory name (27 in the U.S. and 3 in Canada) and 50 retail
        stores operating under the Tandy Leather name (46 in the U.S. and 4 in Canada).
        We also own and operate Roberts, Cushman and Company, Inc., a manufacturer
        of
        custom hat trims.
 
 Our
        growth, measured both by our net sales and net income, occurs as a result
        of the
        increase in the number of stores we have and the increase from year to year
        of
        the sales in our existing stores. The following tables provide summary
        information concerning the additions of facilities for our Leather Factory
        wholesale centers and Tandy Leather retail stores in each of our fiscal years
        from 1999 to 2005.




**STORE
      COUNT**


**YEARS
      ENDED DECEMBER 31, 1999 through 2005**





**Leather
                Factory wholesale centers**
            **Tandy
                Leather retail stores**Year
                Ended
            Opened
            Conversions(1)
            Total
            Opened
                (2)
            Closed
            TotalBalance
                Fwd
            
            
            22
            
            
            N/A1999
            4
            0
            26
            
            
            N/A2000
            2
            0
            28
            1*
            0
            12001
            2
            0
            30
            0
            0
            12002
            1
            (1)
            30
            14
            1*
            142003
            0
            0
            30
            12
            0
            262004
            0
            0
            30
            16
            0
            422005
            0
            0
            30
            8
            0
            50





(1)
      Leather Factory wholesale center converted to a Tandy Leather retail
      store.


(2)
      Includes conversions of Leather Factory wholesale centers to Tandy Leather
      retail stores.


(*)
      The
      Tandy Leather operation began as a central mail-order fulfillment center in
      2000
      that we closed in 2002.





No
        single
        customer’s purchases represent more than 10% of our total sales in 2005. Sales
        to our five largest customers represented 9.4%, 10.6% and 13.8%, respectively,
        of consolidated sales in 2005, 2004 and 2003. While management does not believe
        the loss of one of these customers would have a significant negative impact
        on
        our operations, it does believe the loss of several of these customers
        simultaneously or a substantial reduction in sales generated by them could
        temporarily affect our operating results.
 
 **Our
        Operating Divisions**
 
 We
        service our customers primarily through the operation of three divisions.
        We
        identify those divisions based on management responsibility and customer
        focus.
        The Wholesale Leathercraft division consists of 30 Leather Factory distribution
        centers of which 27 are located in the United States and three are located
        in
        Canada. As of March 1, 2006, the Retail Leathercraft division consists of
        54
        retail stores of which 50 are located in the United States and four are located
        in Canada. Both of these divisions sell leather and leathercraft-related
        products. Our third business segment, referred to as “Other,” consists of our
        hatband manufacturer, Roberts, Cushman & Company, Inc.
 
 **Wholesale
        Leathercraft**
 
 The
        Wholesale Leathercraft operation distributes its broad product line of leather
        and leathercraft-related products in the United States and internationally
        through Leather Factory distribution centers. This segment had net sales
        of
        $31.0 million, $30.6 million and $30.7 million for 2005, 2004 and 2003,
        respectively.
 
 **General** **** We
        operate Leather Factory wholesale centers in 20 states and three Canadian
        provinces. The centers range in size from 2,600 square feet to 19,800 square
        feet, with the average size of a center being approximately 6,000 square
        feet.
        The type of premises utilized for Leather Factory locations is generally
        light
        industrial office/warehouse space in proximity to a major freeway or with
        other
        similar access. This type of location typically offers lower rents compared
        to
        other more retail-oriented locations.
 
 **Business
        Strategy** **** The
        Leather Factory business concept centers around the wholesale distribution
        of
        leather and related accessories to retailers, manufacturers, and end users.
        Our
        strategy is that a customer can purchase the leather, related accessories
        and
        supplies necessary to complete his project from one place. The size and layout
        of the centers are planned to allow large quantities of product to be displayed
        in an easily accessible and visually appealing manner. Leather is displayed
        by
        the pallet where the customer can see and touch it, assessing first-hand
        the
        numerous sizes, styles, and grades offered. The location of the centers is
        selected based on the location of customers, so that delivery time to customers
        is minimized. A two-day maximum delivery time for phone, internet and mail
        orders is our goal.
 
 Leather
        Factory centers serve customers through various means including walk-in traffic,
        phone and mail order. We also employ a distinctive marketing tactic in that
        we
        maintain an internally-developed target customer mailing list for use in
        our
        aggressive direct mail advertising campaigns. We staff Leather Factory wholesale
        centers with experienced managers whose compensation is tied to the operating
        profit of the center they manage. Sales are generated by the selling efforts
        of
        the store personnel, our direct mail advertising, our website
        (www.leatherfactory.com), our participation at trade shows and, on a limited
        basis, the use of sales representative organizations. The sales representative
        organizations consist of companies located in specific geographic areas that
        represent numerous companies in a similar industry. These organizations call
        on
        customers and show multiple products from more than one vendor at a time.
 
 **Customers**  Leather
        Factory’s customer base consists of individuals, wholesale distributors, tack
        and saddle shops, institutions (prisons and prisoners, schools, hospitals),
        western stores, craft stores and craft store chains, other large volume
        purchasers, manufacturers, and retailers dispersed geographically throughout
        the
        world. Wholesale sales constitute the majority of our Leather Factory business,
        although retail customers may purchase products from Leather Factory centers.
        Leather Factory sales generally do not reflect significant seasonal patterns.
 
 Our
        Authorized Sales Center (“ASC”) program was developed to create a presence in
        geographical areas where we do not have a distribution center. An unrelated
        person operating an existing business who desires to become an ASC must apply
        with Leather Factory and upon approval, place a minimum initial order. There
        are
        also minimum annual purchase amounts to which the ASC must adhere in order
        to
        maintain ASC status. In exchange, the benefits to the ASC are free advertising
        in various sale flyers produced and distributed by us, price breaks on many
        products, advance notice of new products, and priority shipping and handling
        on
        all orders. Leather Factory centers service 174 ASC's: 102 located in the
        U.S.,
        54 located in Canada, and 18 located outside North America.
 
 **Merchandise**  Our
        products are generally organized into thirteen categories. We carry a wide
        assortment of products including leather, lace, hand tools, kits, and craft
        supplies. We operate a light manufacturing facility in Fort Worth whose
        processes generally involve cutting leather into various shapes and patterns
        using metal dies. The factory produces approximately 20% of our products
        and
        also assembles and repackages product as needed. Products manufactured in
        our
        factory are distributed through our stores under the Tejas TM brand
        name. We also distribute product under the Tandy Leather TM and Dr.
        Jackson's TM brands.
        We develop new products through the ideas and referrals of customers and
        store
        personnel as well as the tracking of fads and trends of interest in the market.
        Our personnel walk trade shows and various specialty stores with the purpose
        of
        obtaining product ideas that are then developed in-house.
 
 We
        offer
        an unconditional satisfaction guarantee to our customers. Simply stated,
        we will
        accept product returns for any reason. We believe this liberal policy promotes
        customer loyalty. We offer credit terms to our non-retail customers, upon
        receipt of a credit application and approval by our credit manager. Generally,
        our open accounts are net 30 days.


During
        2005 and 2004, Wholesale Leathercraft division sales by product category
        were as
        follows:





**Product
                Category**
            **2005**
              **Sales
                Mix**
            
            **2004**
              **Sales
                Mix**Belts
                strips and straps
            2%
            
            2%Books,
                patterns, videos
            1%
            
            2%Buckles
            4%
            
            4%Conchos^
            4%
            
            3%Craft
                supplies
            5%
            
            7%Tools
                and Hardware
            1%
            
            1%Dyes,
                finishes, glues
            5%
            
            5%Hand
                tools
            12%
            
            13%Hardware
            8%
            
            6%Kits
            8%
            
            8%Lace
            13%
            
            12%Leather
            34%
            
            34%Stamping
                tools
            3%
            
            3%**100%**
            
            **100%**





^A
      concho
      is a metal adornment attached to clothing, belts, saddles, etc., usually made
      into a pattern of some southwestern or geometric object.


In
        addition to meeting ordinary operational requirements, our working capital
        demands are a product of the need to maintain a level of inventory sufficient
        to
        fill customer orders as they are received with minimal backorders and the
        time
        required to collect our accounts receivable. Because availability of merchandise
        and prompt delivery time are important competitive factors for us, we maintain
        higher levels of inventory than our smaller competitors. For additional
        information regarding our cash, inventory and accounts receivable at the
        end of
        2005 and 2004, see "Item 7. Management's Discussion and Analysis of Financial
        Condition and Results of Operations."
 
 **Suppliers** **** We
        currently purchase merchandise and raw materials from approximately 200 vendors
        dispersed throughout the United States and in more than 20 foreign
        countries. **** In
        2005,
        our ten largest vendors accounted for approximately 75% of our inventory
        purchases.
 
 Because
        leather is sold internationally, market conditions abroad are likely to affect
        the price of leather in the United States. Outbreaks of mad cow and
        hoof-and-mouth disease (or foot-and-mouth disease) in any part of the world
        can
        influence the price of the leather we purchase. As such an occurrence is
        beyond
        our control, we cannot predict when and to what extent we could be affected
        in
        the future. Aside from increasing purchases when we anticipate price increases
        (or possibly delaying purchases if we foresee price declines), we do not
        attempt
        to hedge our inventory costs.
 
 Overall,  we
        believe that our relationships with suppliers are strong and do not anticipate
        any material changes in these supplier relationships. Due to the number of
        alternative sources of supply, the loss of any of these principal suppliers
        would not have a material impact on our operations.
 
 **Operations**  Hours
        of
        operations vary by location, but generally range from 8:00 am to 6:00 pm
        Monday
        through Friday, and from 9:00 am to 4:00 pm on Saturdays. The distribution
        centers maintain uniform prices, except where lower prices are necessary
        to meet
        local competition.
 
 **Competition** **** Most
        of
        our competition comes in the form of small, independently-owned retailers
        who in
        most cases are also our customers. We estimate that there are several hundred
        of
        these small independent stores in the United States and Canada. We compete
        on
        price, availability of merchandise, and delivery time. While there is
        competition in connection with a number of our products, to our knowledge
        there
        is no direct competition affecting our entire product line. Our large size
        relative to most competitors gives us the advantage of being able to purchase
        large volumes and stock a full range of products.
 
 **Distribution** **** The
        Leather Factory distribution centers receive the majority of their inventory
        from our central warehouse located in Fort Worth, Texas, although occasionally,
        merchandise is shipped directly from the vendor. Inventory is shipped to
        the
        distribution centers from our central warehouse once a week to meet customer
        demand without sacrificing inventory turns. Customer orders are filled as
        received, and we do not have backlogs.
 
 We
        attempt to maintain the optimum number of items in our product line to minimize
        out-of-stock situations against carrying costs involved with such an inventory
        level. We generally maintain higher inventories of imported items to ensure
        a
        continuous supply. The number of products offered changes every year due
        to the
        introduction of new items and the discontinuance of others. We carry approximately
        2,800 items in the current lines of leather and leather-related merchandise.
        All
        items are offered in both the Leather Factory distribution centers and the
        Tandy
        Leather retail stores.
 
 **Expansion** Leather
        Factory's expansion across the United States has been fairly consistent since
        we
        purchased the original six distribution centers in 1985. The newest center
        opened in August 2002, bringing the number of distribution centers to thirty.
        While we do not believe there is a significant and immediate opportunity
        for
        expansion of the Leather Factory distribution system in terms of opening
        additional locations, we do believe expansion could be achieved by acquiring
        companies in related areas/markets which offer collaborative advantages based
        on
        the local markets and/or the product lines of the businesses.
 
 **Retail
        Leathercraft**
 
 Our
        Retail Leathercraft division consists of a growing chain of retail stores
        operating under the name, Tandy Leather. Tandy Leather Company, established
        in
        1919 as Hinkley-Tandy Leather Company, is the oldest and best-known supplier
        of
        leather and related supplies used in the leathercraft industry. We offer
        a
        product line of quality tools, leather, accessories, kits and teaching
        materials. This segment had net sales of $18.0 million, $13.5 million and
        $9.2
        million for 2005, 2004 and 2003, respectively.
 
 **General** As of
        March 1, 2006, the Tandy Leather retail chain has 54 stores located in 30
        states
        and three Canadian provinces with plans to reach 100 stores as opportunities
        arise over the next several years. The stores range in size from 1,200 square
        feet to 3,800 square feet, with the average size of a store being approximately
        2,000 square feet. The type of premises utilized for a Tandy Leather store
        is
        generally an older strip shopping center located at well-known crossroads,
        making the store easy to find.
  **Business
        Strategy** **** Tandy
        Leather has long been known for its reputation in the leathercraft industry
        and
        its commitment to promoting and developing the craft through education and
        customer development. Our commitment to this strategy is evidenced by our
        re-establishment of the retail store chain throughout the United States
        following our acquisition of the assets of Tandy Leather in 2000. We continue
        to
        broaden our customer base by working with various youth organizations and
        institutions where people are introduced to leathercraft, as well as hosting
        classes in our stores.
 
 The
        retail stores serve walk-in, mail and phone order customers as well as orders
        generated from its website, www.tandyleather.com. Tandy Leather stores are
        staffed by knowledgeable sales people whose compensation is based, in part,
        upon
        the profitability of their store. Sales by Tandy Leather are driven by the
        efforts of the store staff, trade shows, and our direct mail and e-mail
        marketing program.
 
 **Customers** **** Individual
        retail customers are our largest customer group, representing more than 65%
        of
        Tandy Leather's 2005 sales. Youth groups, summer camps, schools, and a limited
        number of wholesale customers complete our customer base. Like Leather Factory,
        Tandy fills orders as they are received, and there is no order backlog. Tandy
        maintains reasonable amounts of inventory to fill these orders. Tandy Leather’s
        retail store operations historically generate slightly more sales in the
        4 th quarter
        of each year (30-35%) while the other three quarters remain fairly even at
        22-23% per quarter.
 
 **Merchandise**  Our
        products are generally organized into thirteen categories. We carry a wide
        assortment of products including leather, hand tools, kits, dyes & finishes,
        and stamping tools.





During
      2005 and 2004, Retail Leathercraft division sales by product category were
      as
      follows:





**Product
                Category**
            **2005**
              **Sales
                Mix**
            
            **2004**
              **Sales
                Mix**Belts
                strips and straps
            5%
            
            5%Books,
                patterns, videos
            3%
            
            3%Buckles
            4%
            
            3%Conchos
            4%
            
            3%Craft
                supplies
            3%
            
            4%Dyes,
                finishes, glues
            7%
            
            7%Hand
                tools
            16%
            
            18%Hardware
            6%
            
            4%Kits
            12%
            
            13%Lace
            4%
            
            5%Leather
            30%
            
            30%Stamping
                tools
            6%
            
            5%**100%**
            
            **100%**




As
          indicated above, the products sold in our Tandy Leather stores are also
          sold in
          our Leather Factory wholesale centers. Therefore, the discussion above
          regarding
          Leather Factory products, their sources and the working capital requirements
          for
          the Wholesale Leathercraft division also apply to the Tandy Leather stores.
          Sales at Tandy Leather stores are generally cash transactions or through
          national credit cards. We also sell on open account to selected wholesale
          customers including schools and other institutions and small retailers.
          Our
          terms are generally net 30 days. Like Leather Factory, Tandy Leather has
          an
          unconditional return policy.
 
 **Operations** **** Hours
          of
          operations vary by location, but generally range from 9:00 am to 6:00 pm
          Monday
          through Friday, and from 9:00 am to 4:00 pm on Saturdays. In addition,
          most of
          the stores stay open late one night a week for leathercrafting classes
          taught in
          the stores. Selling prices are uniform throughout the Tandy Leather store
          system.
 
 **Competition** **** Our
          competitors are generally small local craft stores that carry a limited
          line of
          leathercraft products. Several national retail chains that are customers
          in our
          Wholesale Leathercraft division also carry leathercraft products on a very
          small
          scale relative to their overall product line. To our knowledge, our retail
          store
          chain is the only one in existence solely specializing in
          leathercraft.
 
 **Distribution** **** The
          Tandy
          Leather stores receive their inventory from our central warehouse located
          in
          Fort Worth, Texas. The stores generally restock their inventory once a
          week with
          a shipment from the warehouse. Retail Leathercraft’s inventory turns are higher
          than Wholesale Leathercraft’s because the Wholesale Leathercraft calculation
          includes the central warehouse inventory whereas the Retail Leathercraft
          calculation includes only the inventory in the Tandy Leather retail stores.
 
 **Expansion** We
          intend to expand the Tandy Leather retail store chain to 100 stores throughout
          the United States at an average rate of approximately 12 stores per year.
          Fourteen stores were opened in 2002; twelve stores were opened in 2003;
          sixteen
          were opened in 2004 (including four in Canada); and eight were opened in
          2005.
          Ten of the 54 stores opened to date were independent leathercraft stores
          that we
          acquired. Separately, these acquisitions are not material. The other forty-four
          stores have been *de
          novo* stores
          opened by us. In 2006, we plan to open 12 retail stores in the United States.
          Four stores have been opened in the first two months of 2006, including
          the
          conversion of one Leather Factory wholesale center to a Tandy Leather retail
          store.
 
 **Other**
 
 Roberts,
          Cushman, founded in 1856, produces made-to-order trimmings for the headwear
          industry. This segment had net sales of $1.6 million, $2.0 million, and
          $1.8
          million for 2005, 2004 and 2003, respectively.
 
 **Business
          Strategy** Roberts,
          Cushman has long been considered one of the leaders in the field of headwear
          trimmings. It designs and manufactures exclusive trimmings for all types
          of
          hats. Trims are sold to hat manufacturers directly. We do not employ an
          outside
          sales force. Instead, customers visit our facilities in New York and, with
          an
          on-site designer, incorporate their ideas into a customized product. The
          customer is provided samples or photographs of each design before they
          leave the
          premises. These samples can then be used as a sales tool to obtain hat
          orders
          from their customers. This “design-on-site” process is unique in the industry.
 
 **Customers** **** We
          design
          and manufacture trims for over 75 of the headwear manufacturers worldwide,
          supplying customized trims, ribbons, buckle sets, name pins, feathers,
          and other
          items. Our success in developing and maintaining long-standing relationships
          with our customers is due primarily to our ability to deliver quality products
          in a timely manner. Our backlog of in-house orders from customers as of
          March
          10, 2006 was $140,000, which approximates thirty days of sales. Roberts,
          Cushman’s sales generally do not reflect significant seasonal
          patterns.
 
 The
          working capital requirements of this operation are dictated by the amounts
          needed to meet current obligations, purchase raw material and allow for
          collection of accounts receivable. Roberts, Cushman provides sufficient
          cash
          flow to satisfy these requirements.
 
 **Merchandise**  Our
          hat
          bands are generally produced from leather, ribbon, or woven fabrics, depending
          on the style of hat. They are created by cutting leather and/or other materials
          into strips, and then enhancing the trim by attaching conchos and/or three-piece
          buckle sets, braiding with other materials, and finishing the end or borders
          by
          stitching or by lacing with leather lace. We also supply custom-designed
          buckles
          and conchos, feathers for dress hats, and name pins, separate from hat
          bands.
          Roberts, Cushman purchases components from over 25 vendors, located
          predominately in the United States. In 2005, our top 10 vendors (in dollars
          purchased) represented approximately 47% of its total purchases. Products
          are
          sold on terms that generally range from net 30 to net 90 days. Because
          our
          products are custom-designed, we do not accept product returns, except
          in the
          case of defective merchandise.
 
 **Expansion** **** Cushman
          has been successful in providing a very specific product line directly
          to
          headwear manufacturers. Given the current industry conditions, we do not
          believe
          there is much potential for expansion, other than to capture additional
          market
          share.
  
 **Additional
          Information**
 
 **Compliance
          With Environmental Laws** **** Our
          compliance with federal, state and local environmental protection laws
          has not
          had, and is not expected to have, a material effect on our capital expenditures,
          earnings or competitive position.
 
 **Employees** **** As
          of
          December 31, 2005, we employed 359 people, 297 of whom were employed on
          a
          full-time basis. We are not a party to any collective bargaining agreements.
          Overall, we believe that relations with employees are good.
 
 **Intellectual
          Property** We own
          approximately 20 registered trademarks, including federal trade name
          registrations for "The Leather Factory" and "Tandy Leather Company." We
          also own
          approximately 20 registered foreign trademarks worldwide.
 
 We
          own
          approximately 500 registered copyrights in the United States covering more
          than
          600 individual works relating to various products. We also own several
          United
          States patents for specific belt buckles and leather-working equipment.
          These
          rights are valuable assets and we defend them as necessary.
 
 **International
          Operations** **** Information
          regarding our revenues from the United States and abroad and our long-lived
          assets are found in Note 13 to our Consolidated Financial Statements, *Segment
          Information* .
 
 **Our
          Website and Availability of SEC Reports** We file
          reports with the Securities and Exchange Commission ("SEC"). These reports
          include our Annual Report on Form 10-K, Quarterly Reports on Form 10-Q,
          Current
          Reports on Form 8-K and any amendments to these filings. The public may
          read any
          of these filings at the SEC's Public Reference Room at 450 Fifth Street,
          NW,
          Washington, DC 20549. In addition, the public may obtain information on
          the
          operation of the Public Reference Room by calling the SEC at 1/800-SEC-0330.
          Further, the SEC maintains an Internet site that contains reports, proxy
          and
          information statements and other information concerning us. You can connect
          to
          this site at http://www.sec.gov.
 
 Our
          corporate website is located at http://www.leatherfactory.com. We make
          copies of
          our Annual Report on Form 10-K, Quarterly Reports on Form 10-Q, Current
          Reports
          on Form 8-K, proxy statements and any amendments filed with or furnished
          to the
          SEC available to investors on or through our website free of charge as
          soon as
          reasonably practicable after we electronically file them with or furnish
          them to
          the SEC. Our SEC filings can be found on the Investor Relations page of
          our
          website through the "SEC Filings" link. In addition, certain other corporate
          governance documents are available on this website through the "Corporate
          Governance" link.


**Executive
      Officers of the Registrant**





The
      following table sets forth information concerning our executive
      officers.


**Name
                  and Age**
              **Position
                  and Business Experience****During
                  Past Five Years**
              **Served
                  as Officer Since**J.
                  Wray Thompson, 74
              Chief
                  Executive Officer since June 1993. President from June 1993 to
                  January
                  2001
              1993Shannon
                  L. Greene, 40
              Chief
                  Financial Officer since May 2000. Controller from January 1998
                  to May 2000
              2000Robin
                  L. Morgan, 55
              Vice
                  President of Administration since June 1993
              1993Ronald
                  C. Morgan, 58
              President
                  since January 2001. Chief Operating Officer since June 1993
              1993


**Wray
          Thompson** has
          served as our Chairman of the Board and Chief Executive Officer since June
          1993.
          He also served as President from June 1993 to January 2001. Mr. Thompson
          was a co-founder of the company.
 
 **Shannon
          L. Greene** has
          served as our Chief Financial Officer and Treasurer since May 2000. She
          was
          appointed to serve on the Board of Directors in January 2001. Ms. Greene
          is also
          our chief accounting officer. From September 1997 to May 2000, Ms. Greene
          served
          as our controller and assistant controller. Ms. Greene also is a member
          of our
          Employees’ Stock Ownership Plan (ESOP) Committee and is a certified public
          accountant. Her professional affiliations include the American Institute
          of
          Certified Public Accountants, the Texas Society of Certified Public Accountants
          and its Fort Worth chapter, the Fort Worth Association for Financial
          Professionals, the National Investor Relations Institute, and the Financial
          Executives International.
 
 **Robin
          L. Morgan** has
          served as our Vice President of Administration and Assistant Secretary
          since
          June 1993. Ms. Morgan is responsible for import, banking, and procurement
          for
          our import product lines and maintains all inventory costs. She administers
          our
          insurance programs and serves as chairman of our ESOP committee. Ms. Morgan
          is
          married to Ronald C. Morgan, our President.
 
 **Ronald
          C. Morgan** has
          served as our President since January 2001 and has served as Chief Operating
          Officer and director since June 1993. Mr. Morgan was also a co-founder of
          the company. Mr. Morgan is married to Robin L. Morgan, our Vice
          President.
 
 All
          officers are elected annually by the Board of Directors to serve for the
          ensuing
          year.
 
 Under
          our
          1995 Stock Option Plan, there were 8,000 unoptioned shares on January 1,
          2005
          and 20,000 unoptioned shares at December 31, 2005. Under our 1995 Director
          Non-qualified Stock Option plan, there were 32,000 unoptioned shares on
          January
          1, 2005 and 24,000 unoptioned shares at December 31, 2005. There were no
          changes
          to the exercise prices of the outstanding options under these two plans
          during
          2005.
 
 **ITEM
        2.
        PROPERTIES**





We
      lease
      all of our premises and believe that all of our properties are adequately
      covered by insurance. The properties leased by our Wholesale Leathercraft
      (Leather Factory centers) and Retail Leathercraft (Tandy Leather stores)
      divisions are described in Item 1 in the description of each segment. Our Fort
      Worth location, which includes the Fort Worth Leather Factory distribution
      center, our central warehouse and manufacturing facility, and the sales,
      advertising, administrative, and executive offices, consists of 115,000 square
      feet and leases for $424,000 per year. The lease expires in March 2008. We
      also
      lease a 284 square-foot showroom in the Denver Merchandise Mart for $5,908
      per
      year. This lease will expire in October 2008. Roberts, Cushman operates in
      a
      10,200 square foot manufacturing facility that is located in Long Island City,
      New York and leased for $91,000 per year. This lease will expire in June 2006.
      The following table summarizes the locations of our leased premises on a state
      and province basis as of December 31, 2005:




**State**
            **Wholesale
                Leathercraft**
            **Retail
                Leathercraft**
            **Other**Alabama
            -
            1
            -Arizona
            2
            2
            -California
            3
            5
            -Colorado
            1
            2
            -Connecticut
            -
            1
            -Florida
            1
            2
            -Georgia
            -
            1
            -Idaho
            -
            1
            -Illinois
            1
            1
            -Indiana
            -
            1
            -Iowa
            1
            -
            -Kansas
            1
            -
            -Kentucky
            -
            1
            -Louisiana
            1
            -
            -Maryland
            -
            1
            -Michigan
            1
            1
            -Minnesota
            -
            1
            -Missouri
            1
            2
            -Montana
            1
            -
            -Nebraska
            -
            1
            -Nevada
            -
            2
            -New
                Mexico
            1
            2
            -New
                York
            -
            1
            1North
                Carolina
            1
            -
            -Ohio
            1
            1
            -Oklahoma
            0
            2
            -Oregon
            1
            -
            -Pennsylvania
            1
            1
            -Tennessee
            1
            2
            -Texas
            5
            6
            -Utah
            1
            1
            -Virginia
            -
            1
            -Washington
            1
            2
            -Wisconsin
            -
            1
            -





**Canadian
                locations:**Alberta
            1
            1
            -British
                Columbia
            -
            1
            -Manitoba
            1
            -
            -Ontario
            1
            2
            -





**ITEM
      3. LEGAL
      PROCEEDINGS**





We
      are
      involved in litigation in the ordinary course of business but are not currently
      a party to any material pending legal proceedings.





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





There
      were no matters submitted to a vote of our security holders during the fourth
      quarter of our fiscal year ended December 31, 2005.








**PART
      II**


**ITEM
        5. MARKET FOR REGISTRANT’S COMMON
        EQUITY AND RELATED STOCKHOLDER MATTERS**
  Our
          common stock is traded on the American Stock Exchange using the symbol
          TLF.  The high and low prices for each calendar quarter during the last two
          fiscal years are as follows:
  **2005**
                **High**
                **Low**4thquarter
                $7.23
                $4.153rdquarter
                $5.65
                $4.302ndquarter
                $4.95
                $3.251stquarter
                $3.79
                $3.20
 
 **2004**
                **High**
                **Low**4thquarter
                $4.85
                $3.973rdquarter
                $4.58
                $3.252ndquarter
                $3.42
                $2.901stquarter
                $3.45
                $2.80
   There
          were approximately 520 stockholders of record on March 10, 2006.


We have
      never declared or paid any cash dividends on the shares of our common
      stock. Our Board of Directors has historically followed a policy of reinvesting
      our earnings in the expansion of our business. This policy is subject to change
      based on future industry and market conditions, as well as other
      factors.





The
      following table sets forth information regarding our equity compensation plans
      (including individual compensation arrangements) that authorize the issuance
      of
      shares of our common stock. The information is aggregated in two categories:
      plans previously approved by our stockholders and plans not approved by our
      stockholders. The table includes information for officers, directors, employees
      and non-employees. All information is as of December 31, 2005.





**Plan
                Category**
            **Column
                (a)**
              **Number
                of Securities to be issued upon exercise of outstanding options,
                warrants
                and rights**
            **Column
                (b)**
              **Weighted-average
                exercise price of outstanding options, warrants and
                rights**
            **Column
                (c)**
              **Number
                of securities remaining available for future issuance under equity
                compensation plans (excluding securities reflected in Column
                (a)**Equity
                compensation plans approved by stockholders
            421,000
            $1.93
            44,000Equity
                compensation plans not approved by stockholders
            140,000
            3.78
            -TOTAL
            561,000
            $2.39
            44,000





For
      additional information, see Note 11 to our Consolidated Financial Statements, *Stockholders'
      Equity* .








**ITEM
      6.
      SELECTED FINANCIAL DATA**


The
        selected financial data presented below are derived from and should be read
        in
        conjunction with our Consolidated Financial Statements and related notes. 
This information should also be read in conjunction with "Item 7 - Management’s
        Discussion and Analysis of Financial Condition and Results of Operations.” 
In particular, see the information there relating to the adoption of a new
        accounting pronouncement in 2002.  Data in prior years has not been
        restated to reflect acquisitions, if any, that occurred in subsequent
        years.
 
 **Income
                  Statement Data, Yea****rs
                  ended December 31,**
              **2005**
              
              **2004**
              
              **2003**
              
              **2002**
              
              **2001**Net
                  sales
              $50,719,574
              
              $46,146,284
              
              $41,712,191
              
              $39,728,615
              
              $37,279,262Cost
                  of sales
              21,964,530
              
              20,706,239
              
              19,020,292
              
              18,393,914
              
              17,934,935Gross
                  profit
              28,755,044
              
              25,440,045
              
              22,691,899
              
              21,334,701
              
              19,344,327Operating
                  expenses
              23,181,633
              
              21,181,599
              
              18,594,240
              
              17,202,927
              
              15,442,359Operating
                  income
              5,573,411
              
              4,258,446
              
              4,097,659
              
              4,131,774
              
              3,901,968Operating
                  income per share - basic
              $0.52
              
              $0.40
              
              $0.40
              
              $0.41
              
              $0.39Operating
                  income per shares - diluted
              $0.51
              
              $0.39
              
              $0.38
              
              $0.38
              
              $0.37Other
                  (income) expense
              (134,502)
              
              44,800
              
              125,169
              
              311,917
              
              533,482Income before
                  income taxes
              5,707,913
              
              4,213,646
              
              3,972,490
              
              3,819,857
              
              3,368,486Income
                  tax provision
              1,994,199
              
              1,559,605
              
              1,232,116
              
              1,224,868
              
              1,362,053Income before
                  cumulative effect of change in accounting principle
              3,713,714
              
              2,654,041
              
              2,740,374
              
              2,594,989
              
              2,006,433Cumulative
                  effect of change in accounting principle
              -
              
              -
              
              -
              
              (4,008,831)
              
              -Net
                  income (loss)
              $3,713,714
              
              $2,654,041
              
              $2,740,374
              
              $(1,413,842)
              
              $
                  2,006,433Earnings
                  (loss) per share
              $0.35
              
              $0.25
              
              $0.27
              
              $(0.14)
              
              $0.20Earnings
                  (loss) per share-*assuming
                  dilution*
              $0.34
              
              $0.24
              
              $0.25
              
              $(0.13)
              
              $0.19Weighted
                  average common shares outstanding for:Basic
                  EPS
              10,643,004
              
              10,543,994
              
              10,323,549
              
              10,063,581
              
              9,976,181Diluted
                  EPS
              10,976,240
              
              10,957,518
              
              10,861,305
              
              10,761,670
              
              10,449,306
   **Balance
                  Sheet Data, as of December 31,**
              **2005**
              
              **2004**
              
              **2003**
              
              **2002**
              
              **2001**Cash
                  and cash equivalents
              $3,215,727
              
              $2,560,202
              
              $1,728,344
              
              $101,557
              
              $409,040Total
                  assets
              25,680,473
              
              22,167,163
              
              19,058,406
              
              19,675,602
              
              19,548,323Capital
                  lease obligation, including current portion
              245,789
              
              379,857
              
              1,134
              
              7,691
              
              35,173Long-term
                  debt, including current portion
              -
              
              505,154
              
              1,792,984
              
              4,213,533
              
              4,500,422Total
                  Stockholders’ Equity
              $21,257,857
              
              $17,310,233
              
              $14,509,493
              
              $11,170,062
              
              $12,423,671
  
 **ITEM
          7. MANAGEMENT’S DISCUSSION AND ANALYSIS OF
          FINANCIAL CONDITION AND RESULTS OF
          OPERATIONS**


We
      intend
      for the following discussion to provide you with information that will assist
      you in understanding our financial statements, the changes in key items in
      those
      financial statements from year to year, and the primary factors that accounted
      for those changes, as well as how particular accounting principles affect our
      financial statements. This discussion also provides information about the
      financial results of the various segments of our business so you may better
      understand how those segments and their results affect our financial condition
      and results of operations as a whole. Finally, we have identified and discussed
      trends known to management that we believe are likely to have a material effect.


This
        discussion should be read in conjunction with our financial statements as
        of
        December 31, 2005 and 2004 and the two years then ended and the notes
        accompanying those financial statements. You are also urged to consider the
        information under the caption "Summary of Critical Accounting
        Policies."
 
 **Summary**
 
 We
        are
        the world's largest specialty retailer and wholesale distributor of leather
        and
        leathercraft-related items. Our operations are centered on operating retail
        stores and warehouse distribution centers. We have built our business by
        offering our customers quality products in one location at competitive prices.
        The key to our success is our ability to grow our base business. We grow
        that
        business by opening new locations and by increasing sales in our existing
        locations. We intend to continue to expand both domestically, in the short-term,
        and internationally, in the long-term.
 
 We
        operate in three segments. First, Wholesale Leathercraft, consisting of our
        Leather Factory warehouse distribution centers and our national account group,
        is the largest source of revenues ($31.0 million in 2005). This division
        has
        generally offered steady but modest increases in sales. Sales in 2005 grew
        1.4%,
        slightly under our target of annual sales growth of 2% to 4%. The decrease
        in
        sales to national accounts in 2005 accounted for the shortfall. Excluding
        national account sales, the distribution centers produced a sales gain of
        3.5%
        for 2005.
 
 Since
        acquiring its assets in 2000, we have focused on re-establishing Tandy Leather
        as the operator of retail leathercraft stores. These retail stores comprise
        our
        second segment, Retail Leathercraft. Because of growth here, this segment
        has
        experienced the greatest increases in sales ($18.0 million in 2005, up from
        $13.5 million in 2004). Our business plan calls for opening an average of
        12
        stores annually as we work toward a goal of 100 stores from 50 stores at
        the end
        of 2005.
 
 We
        refer
        to our third segment as “Other”. It consists of Roberts, Cushman, a manufacturer
        of trimmings for headwear. Its operations are not material to us. In 2002,
        we
        wrote off the goodwill related to our investment in Roberts, Cushman in
        connection with an accounting change.
 
 On
        a
        consolidated basis, a key indicator of costs, gross margin as a percent of
        total
        net sales, increased in 2004 and again in 2005, reflecting a number of factors
        including more retail sales with higher profit margins. Operating expenses
        as a
        percent of total net sales in 2005 decreased slightly (0.2%) from 2004.
        Operating expenses were up 1.3% as a percentage of total net sales in 2004
        when
        compared with 2003.
  We
        reported consolidated net income for 2005 of $3.7 million. Consolidated net
        income for 2004 was $2.7 million as was also the case in 2003. We have used
        our
        cash flow to fund our operations, to fund the opening of new Tandy Leather
        stores and to reduce our bank debt. In 2005, we eliminated our bank debt
        entirely, and, at the end of 2005, our stockholders’ equity had increased to
        $21.3 million from $17.3 million the previous year.
 
 Comparing
        the December 31, 2005 balance sheet with the prior year’s, we increased our
        investments in inventory ($15.7 million from $12.7 million) and accounts
        receivable ($2.2 million from $2.0 million), while total cash increased to
        $3.2
        million from $2.6 million. In addition to cash on hand, we have a $3 million
        bank line of credit, of which none was drawn on December 31, 2005.


**Net
      Sales**





Net
      sales
      for the three years ended December 31, 2005 were as follows:


**Year**
            **Wholesale
                Leathercraft**
            **Retail
                Leathercraft**
            **Other**
            **Total
                Company**
            **Total
                Company Increase**
              **from
                Prior Year****2005**
            **$31,046,268**
            **$18,023,214**
            **$1,650,092**
            **$50,719,574**
            **9.9%**2004
            $30,630,122
            $13,515,662
            $2,000,500
            $46,146,284
            10.6%2003
            $30,684,092
            $9,216,838
            $1,811,261
            $41,712,191
            5.0%





Our
      net
      sales grew by 9.9% in 2005 when compared with 2004 and 10.6% in 2004 when
      compared with 2003. These annual increases resulted primarily from our Retail
      Leathercraft expansion program.





**Costs
      and Expenses**





In
      general, our gross profit as a percentage of sales (our gross margin) fluctuates
      based on the mix of customers we serve, the mix of products we sell, and our
      ability to source products globally. Our negotiations with suppliers for lower
      pricing is an on-going process and we have varying degrees of success in those
      endeavors. Sales to retail customers tend to produce higher gross margins than
      sales to wholesale customers due to the difference in pricing levels. Therefore,
      as retail sales increase in the overall sales mix, higher gross margins tend
      to
      follow. Finally, there is significant fluctuation in gross margins between
      the
      various merchandise categories we offer. As a result, our gross margins can
      vary
      depending on the mix of products sold during any given time period.





For
      2005,
      our cost of sales decreased as a percentage of total net sales when compared
      to
      2004, resulting in an overall increase of 1.6% in our consolidated gross margin
      from 55.1% in 2004 to 56.7% in 2005. Similarly, our total cost of sales as
      a
      percentage of our total net sales had decreased for 2004 when compared to 2003
      resulting in an overall increase in consolidated gross margin of 0.7% from
      54.4%
      for 2003 to 55.1% in 2004. These increases in gross margin were primarily due
      to
      increased retail sales over the three years.





Our
      gross
      margins for the three years ended December 31, 2005 were as follows:





**Year**
            **Wholesale
                Leathercraft**
            **RetailLeathercraft**
            **Other**
            **Total
                Company****2005**
            **55.20%**
            **61.82%**
            **27.89%**
            **56.69%**2004
            53.82%
            61.77%
            30.31%
            55.13%2003
            53.23%
            62.98%
            30.62%
            54.40%





Our
        operating expenses decreased 0.2% as a percentage of total net sales to 45.7%
        in
        2005 when compared with 45.9% in 2004 which indicates that our sales grew
        slightly faster than our operating expenses. We achieved small decreases
        in
        various operating expenses in 2005 including employee benefits costs ($100,000),
        insurance ($150,000) and legal/professional fees ($80,000). We also spent
        more
        on advertising and marketing expenses ($650,000) in 2005, incurred costs
        associated with the eight retail stores opened in 2005 ($575,000), and increased
        the bonuses awarded to corporate and operational management ($200,000). Our
        store managers earned higher bonuses in 2005 as a result of increased operating
        profit at their respective stores ($250,000), and we incurred an increase
        in
        shipping costs to customers ($150,000). We believe that our advertising efforts
        generate sales. While we monitor our advertising costs with great scrutiny,
        we
        believe that the trend of increased advertising and marketing costs could
        continue for at least the near future.


Our
      operating expenses increased 1.3% as a percentage of total net sales to 45.9%
      in
      2004 when compared with 44.6% in 2003. This increase was primarily due to
      operating costs associated with the twelve Tandy stores opened in 2004 (an
      increase of $650,000), bonuses awarded to corporate and operational management
      ($400,000) the cost of employee health care (an increase of $500,000), an
      increase in advertising expenses ($200,000), and expenses associated with
      compliance with Section 404 of the Sarbanes-Oxley Act ($200,000).





We
      have
      completed the initial phase of design and documentation in our efforts to comply
      with Section 404 of the Sarbanes-Oxley Act with the assistance of outside
      consultants. Depending on the outcome of the SEC’s determination regarding the
      applicability of Section 404 to smaller public companies, we may or may not
      incur additional costs in order to comply.




**Other
      Income/Expense (net)**





Other
      Income/Expense consists primarily of interest expense, currency exchange gain
      or
      loss, and discounts taken or given. In 2005, we had income (net) of $135,000
      compared to an expense (net) of $45,000 in 2004, attributable to the reduction
      of $50,000 in interest paid, a currency exchange gain of $72,000 in 2005
      compared to a currency exchange loss of $5,000 in 2004, and net discounts taken
      in 2005 of $11,000 compared to net discounts given in 2004 of
      $63,000.





Other
      expenses (net) were $45,000 in 2004 compared to $125,000 in 2003, a decrease
      of
      approximately 64% attributable to the interest paid on our decreasing
      outstanding bank debt.





**Net
      Income**





During
      2005, we earned net income of $3.7 million, a 40% improvement over our net
      income of $2.65 million earned during 2004. As a result of the increase in
      our
      overall gross margin, slight improvement in operating efficiency, and reduction
      in interest and other expenses, our profits in 2005 grew at a rate faster than
      sales.





During
      2004, we earned net income of $2.65 million, a slight decrease from our net
      income of $2.74 million for 2003. The overall improvement in gross margin and
      a
      reduction in interest and other expenses contributed positively to our net
      income while increased operating expenses and income tax expense in 2004 offset
      that improvement.


**Wholesale Leathercraft**


**Year**
            **Net
                SalesIncr
                (Decr)**
              **from
                Prior Yr**
            **OperatingIncome**
            **Operating
                IncomeIncr
                (Decr)**
              **from
                Prior Year**
            **Operating
                Income as a Percentageof
                Sales****2005**
            **1.4%**
            **$3,721,891**
            **23.5%**
            **12.0%**2004
            (0.2)%
            $3,013,316
            (13.0)%
            9.8%2003
            1.2%
            $3,462,457
            (7.5)%
            11.3%





Wholesale
        Leathercraft, consisting of 30 warehouse distribution centers, accounted
        for
        61.2% of our consolidated net sales in 2005, which compares to 66.4% in 2004
        and
        73.5% in 2003. The decrease in this division's contribution to our total
        net
        sales is the result of the growth in Retail Leathercraft and we expect this
        trend to continue.
 
 The
        modest sales increase in 2005 resulted from gains to our institution and
        small
        manufacturing customer groups partially offset by a decrease in national
        account
        sales. Our sales mix by customer group was as follows:





**Customer
                Group**
            **2005**
            **2004**
            **2003**Retail
            23%
            23%
            23%Institution
            7%
            7%
            8%Wholesale
            45%
            47%
            42%National
                Accounts
            16%
            16%
            20%Manufacturers
            9%
            7%
            7%100%
            100%
            100%





The
      2005
      increase in operating income as a percentage of divisional sales resulted from
      an increase of 1.43% in gross margin (as a percentage of sales) compared with
      2004, and a decrease of 0.3% in operating expenses as a percent of sales.
      Significant operating expense decreases occurred in employee benefits
      ($245,000), various insurance costs ($195,000), legal and professional fees
      ($80,000) and outside services ($125,000). These reductions were partially
      offset by increases in manager bonuses ($320,000), advertising and marketing
      expenses ($285,000).





The
      2004
      decrease in operating income as a percentage of divisional sales resulted from
      an increase of 2.04% in operating expenses (as a percentage of sales) compared
      with 2003, partially offset by an increase in gross margin (as a percentage
      of
      sales) of 0.59%. The operating expense increase as a percent of sales in 2004
      was higher than 2003 due to bonuses awarded to corporate and operational
      management ($300,000) for 2004 and the cost of our employee health benefits
      (an
      increase of $300,000). In addition, we spent $170,000 with outside consultants
      on our Sarbanes-Oxley 404 project. Being the largest division, Wholesale
      Leathercraft bears the majority of the pro rata allocation of corporate
      expenses.





**Retail
      Leathercraft**





**Year**
            **Net
                Sales Increase**
              **from
                Prior Yr**
            **OperatingIncome**
            **Operating
                IncomeIncr
                (Decr)**
              **from
                Prior Year**
            **Operating
                Income as a Percentageof
                Sales****2005**
            **33.4%**
            **$1,766,960**
            **45.9%**
            **9.8%**2004
            46.6%
            $1,210,566
            100.3%
            8.9%2003
            24.7%
            $604,291
            62.7%
            6.6%





Reflecting
      the growth previously discussed, Retail Leathercraft accounted for 35.5% of
      our
      total net sales in 2005, up from 29.3% in 2004 and 22.1% in 2003.





Growth
      in
      net sales for Retail Leathercraft division in 2005 and 2004 resulted primarily
      from our expansion program. Expansion during 2005 and 2004 consisted of the
      opening of 8 and 16 new stores, respectively.





Our
      sales
      mix by customer group was as follows:





**Customer
                Group**
            **2005**
            **2004**
            **2003**Retail
            62%
            72%
            72%Institution
            11%
            6%
            6%Wholesale
            26%
            21%
            21%National
                Accounts
            0%
            0%
            0%Manufacturers
            1%
            1%
            1%100%
            100%
            100%





Operating
      income as a percentage of sales increased to 9.8% for 2005 compared to 8.9%
      for
      2004. Gross margin remained steady at 61.8% in 2004 and 2005. Operating expenses
      as a percent of sales in 2005 decreased by 0.8%, from 52.8% for 2004 to 52.0%
      for 2005 as sales and gross margin grew at a faster pace than that of operating
      expenses.





Operating
      income as a percentage of sales increased to 8.9% for 2004 compared to 6.6%
      for
      2003. Gross margin decreased from 63.0% in 2003 to 61.8% in 2004 due primarily
      to limitations in increasing selling prices to match cost increases. Selling
      prices are set at the time the product catalog is produced. As a result, it
      is
      difficult to implement price increases to customers until we distribute a new
      catalog. Historically, we distribute our new catalog at the beginning of each
      calendar year and did so in January 2004. However, due to the cost increases
      in
      metals, fuel, and other items this year and the need to pass on these increases
      to customers, we accelerated that schedule and distributed our 2005 catalog
      on
      November 1, 2004. Operating expenses as a percent of sales in 2004 decreased
      by
      3.61%, from 56.4% for 2003 to 52.8% for 2004 as sales and gross margin grew
      at a
      faster pace than that of operating expenses.





We
      intend
      to continue the expansion of Tandy Leather’s retail store chain in 2006 by
      opening approximately 12 new stores throughout the year. As of March 15, 2006,
      we have opened six new stores this year:




·
            Raleigh,
                NC


·
            Lubbock,
                TX


·
            Charlotte,
                NC*


·
            South
                Denver, CO


·
            Little
                Rock, AR


·
            Irving,
                TX




*
      converted from a Leather Factory wholesale distribution center





We
      remain
      committed to a conservative expansion plan for this division that minimizes
      risks to our profits and maintains financial stability.





**Other**





Roberts,
      Cushman accounted for 3.3% of our total sales in 2005 compared with 4.3% and
      4.4% in 2004 and 2003, respectively. Income from operations was $84,000 in
      2005
      compared to $35,000 in 2004 and $30,000 in 2003. Roberts, Cushman's sales and
      profits are immaterial to us as a whole, and the segment does not fit our
      business model for the future. We continue to assess strategic options for
      this
      segment.





**Financial
      Condition**




At
      December 31, 2004, our net total assets were $22.2 million. We held $12.7
      million of inventory and $1.9 million of property and equipment. Our cash
      totaled $2.5 million and our receivables were $2.0 million. Current liabilities
      were $3.8 million, while our long-term debt was $505,000. Total stockholders'
      equity at the end of 2004 had increased to $17.3 million, primarily as a result
      of the $2.7 million net income recorded in 2004.





At
      December 31, 2005, we held $3.2 million of cash, $15.6 million of inventory,
      accounts receivable of $2.2 million, and $1.7 million of property and equipment.
      Goodwill and other intangibles (net of amortization and depreciation) were
      $747,000 and $399,000, respectively. We also own a leather artwork collection,
      most of which was created by Al Stohlman, a legendary leathercrafter, valued
      on
      our balance sheet at $250,000. Net total assets were $25.7 million. Current
      liabilities were $4.1 million (including $134,000 of current maturities of
      long-term debt), while long-term debt was $111,000. Total stockholders’ equity
      at the end of 2005 was $21.2 million.





Specific
      ratios on a consolidated basis at the end of each year ended December 31 were
      as
      follows:





**2005**
            **2004**
            **2003****Solvency
                Ratios:**Quick
                Ratio
            Cash+Accts
                Rec/Total Current Liabilities
            1.31
            1.21
            1.40Current
                Ratio
            Total
                Current Assets/Total Current Liabilities
            5.30
            4.79
            6.16Current
                Liabilities to Net Worth
            Total
                Current Liabilities/Net Worth
            0.19
            0.22
            0.17Current
                Liabilities to Inventory
            Total
                Current Liabilities/Inventory
            0.26
            0.30
            0.23Total
                Liabilities to Net Worth
            Total
                Liabilities/Net Worth
            0.21
            0.28
            0.31Fixed
                Assets to Net Worth
            Fixed
                Assets/Net Worth
            0.08
            0.11
            0.13**Efficiency
                Ratios:**Collection
                Period (Days Outstanding)
            Accounts
                Receivable/Credit Sales x 365
            44.17
            43.57
            41.45Inventory
                Turnover
            Sales/Average
                Inventory
            3.57
            3.87
            3.51Assets
                to Sales
            Total
                Assets/Sales
            0.51
            0.48
            0.46Sales
                to Net Working Capital
            Sales/Current
                Assets - Current Liabilities
            2.38
            3.21
            3.18Accounts
                Payable to Sales
            Accounts
                Payable/Sales
            0.02
            0.04
            0.04**Profitability
                Ratios:**Return
                on Sales (Profit Margin)
            Net
                Profit After Taxes/Sales
            0.07
            0.06
            0.07Return
                on Assets
            Net
                Profit After Taxes/Total Assets
            0.14
            0.12
            0.14Return
                on Net Worth(Return on Equity)
            Net
                Profit After Taxes/Net Worth
            0.18
            0.15
            0.19





**Capital
        Resources and Liquidity**





On
      November 1, 2004, we entered into a Credit Agreement with JPMorgan Chase Bank,
      N.A. (formerly BankOne, N.A.), which replaced our line of credit with Wells
      Fargo Bank. The current facility matures in October 2008 and is secured by
      our
      accounts receivable and inventory. We opted to reduce the maximum amount that
      may be borrowed under this line of credit to $3.0 million in order to reduce
      the
      fees required on the un-borrowed portion of the line.





We
      are
      currently in compliance with all covenants and conditions contained in the
      JPMorgan Chase Credit Agreement and have no reason to believe that we will
      not
      continue to operate in compliance with the provisions of these financing
      arrangements. The principal terms and conditions of the Credit Agreement are
      described in further detail in Note 5 to the Consolidated Financial Statements, *Notes
      Payable and Long-Term Debt.*





We
      borrow
      and repay funds under revolving credit terms as needed. Principal balances
      at
      the end of each quarter are shown below:





**4****th****Qtr. ‘04**
            **1****st****Qtr. ‘05**
            **2****nd****Qtr. ‘05**
            **3****rd****Qtr. ‘05**
            **4****th****Qtr. ‘05**$505,154
            $-0-
            $-0-
            $-0-
            $-0-





Total
      bank indebtedness at the end of 2004 and 2005 are shown below:





**December
                31,****2004**
            
            **2005****Principal**
            
            **Accrued
                Interest**
            
            **Principal**
            
            **Accrued
                Interest**Revolving
                Line
            $505,154
            
            $6,219
            
            $-0-
            
            $-0-





Reflecting
      the reduction of bank indebtedness during the period, our financing activities
      for 2005, 2004 and 2003 had net cash requirements (deficits) of $447,000, $1.2
      million and $1.3 million, respectively.





The
      primary source of liquidity and capital resources during 2005 was cash flow
      provided by operating activities. Cash flow from operations for 2005 and 2004
      was $1.5 million and $2.9 million, respectively, the largest portion generated
      from net income partially offset by the increase in inventory. Cash flow from
      operations in 2003 was $3.3 million.





Consolidated
      accounts receivable increased to $2.2 million at December 31, 2005 compared
      to
      $2.0 million at December 31, 2004. Average days to collect accounts slowed
      slightly from 43.57 days in 2004 to 44.17 days in 2005 on a consolidated basis.





Inventory
      increased from $12.7 million at the end of 2004 to $15.7 million at December
      31,
      2005. We expect our inventory to slowly trend upward as we continue our
      expansion of the Tandy Leather store chain. We attempt to manage our inventory
      levels to avoid tying up excessive capital while maintaining sufficient
      inventory in order to service our current customer demand as well as plan for
      our expected store growth and expansion. While we are fairly pleased with our
      investment in inventory at the end of 2005, it was approximately 7% above our
      internal targets of optimum inventory levels.




Consolidated
      inventory turned 3.57 times during 2005, a slight slow down from the 3.87 times
      turned in 2004. We compute our inventory turnover rates as sales divided by
      average inventory.





By
      operating division, inventory turns are as follows:





**Segment**
            **2005**
            **2004**
            **2003**Wholesale
                Leathercraft
            2.68
            3.11
            2.97Retail
                Leathercraft
            8.23
            8.88
            8.69Other
            3.75
            4.12
            3.71Wholesale
                Leathercraft distribution centers only
            7.73
            8.69
            8.26





Retail
      Leathercraft inventory turns are significantly higher than that of the Wholesale
      Leathercraft because its inventory consists only of the inventory at the stores.
      The Tandy Leather stores have no warehouse (backstock) inventory to include
      in
      the turnover computation as the stores get their product from the central
      warehouse. Wholesale Leathercraft’s turns are expected to be slower because the
      central warehouse inventory supports the stores and distribution centers.





Accounts
      payable decreased to $1.2 million at the end of 2005 compared to $1.9 million
      at
      the end of 2004 due primarily to quicker payment of purchases.





As
      discussed above, the largest use of operating cash in 2005 was for inventory
      purchases and reduction of accounts payable. Capital expenditures totaled
      $273,000 and $370,000 for the years ended December 31, 2005 and 2004,
      respectively. The 2005 capital expenditures consisted of fixtures and equipment
      for the new Tandy Leather retail stores ($138,000), and miscellaneous computer
      and other office equipment ($135,000). Capital expenditures in 2004 occurred
      primarily due to the expansion of the Tandy Leather store chain ($155,000),
      the
      remodel of the accounting offices at our corporate complex ($77,000) and
      miscellaneous other equipment ($124,000). Also in 2004, we made expenditures
      of
      $557,000 to purchase our primary Canadian competitor as well as three U.S.-based
      independent leathercraft stores for conversion to Tandy Leather stores. Since
      we
      intend to continue opening or acquiring new Tandy Leather stores, expenditures
      related to this expansion should continue into 2006.





We
      believe that cash flow from operations will be adequate to fund our operations
      in 2006, while also funding expansion. At this time, we know of no trends or
      demands, commitments events or uncertainties that will or are likely to
      materially affect our liquidity, capital resources or results of operations.
      In
      addition, we anticipate that this cash flow will enable us to meet the
      contractual obligations and commercial commitments. However, if cash flows
      should decrease or uses of cash increase, we may increase our borrowings on
      our
      line of credit as needed. We believe that, if desired, our present financial
      condition would permit us to increase the maximum amount that could be borrowed
      from lenders. Further, we could defer expansion plans if required by
      unanticipated drops in cash flow. In particular, because of the relatively
      small
      investment required by each new Tandy Leather store, we have flexibility in
      when
      we make most expansion expenditures.





**Off-Balance
      Sheet Arrangements**





We
      did
      not have any off-balance sheet arrangements during 2005, 2004 and 2003, and
      we
      do not currently have any such arrangements.





**Contractual
      Obligations**





The
      following table summarizes by years our contractual obligations and commercial
      commitments as of December 31, 2005 (not including related interest
      expense):





**Payments
                Due by Periods****Contractual
                Obligations**
            **Total**
            **Less
                than****1
                Year**
            **1
                - 3****Years**
            **4
                -5 Years**
            **After
                5 Years**Long-Term
                Debt(1)
            --
            --
            --
            --
            --Capital
                Lease Obligations
            245,789
            $
                134,067
            111,722
            --
            --Operating
                Leases(2)
            6,222,988
            2,248,426
            3,710,456
            $264,106
            --Total
                Contractual Obligations
            $6,468,777
            $2,382,493
            $3,822,178
            $264,106
            $
                --


____________________


(1)
      Our
      loan from JPMorgan Chase matures in October 2008. The loan's maturity can be
      accelerated in the event of a material adverse change or upon other occurrences
      described in the related credit agreement.


(2)
      These
      are our leased facilities.





The
      interest rate on the capital lease is 0%. Any imputed interest over the term
      of
      the lease would be insignificant.





**Summary
      of Critical Accounting Policies**


We
        strive
        to report our financial results in a clear and understandable manner, although
        in some cases accounting and disclosure rules are complex and require us
        to use
        technical terminology. We follow generally accepted accounting principles
        in the
        U.S. in preparing our consolidated financial statements. These principles
        require us to make estimates and apply judgments that affect our financial
        position and results of operations. We continually review our accounting
        policies, how they are applied and how they are reported and disclosed in
        our
        financial statements. Following is a summary of our more significant accounting
        policies and how they are applied in preparation of the financial
        statements.
 
 **Basis
        of Consolidation.** We
        report our financial information on a consolidated basis. Therefore, unless
        there is an indication to the contrary, financial information is provided
        for
        the parent company, Tandy Leather Factory, Inc., and its subsidiaries as
        a
        whole. Transactions between the parent company and any subsidiaries are
        eliminated for this purpose. We own all of the capital stock of our
        subsidiaries, and we do not have any subsidiaries that are not consolidated.
        None of our subsidiaries are “off balance sheet.”
 
 **Revenue
        Recognition.** We
        recognize revenue for retail (over the counter) sales as transactions occur
        and
        other sales upon shipment of our products, provided that there are no
        significant post-delivery obligations to the customer and collection is
        reasonably assured, which generally occurs upon shipment. Net sales represent
        gross sales less negotiated price allowances, product returns, and allowances
        for defective merchandise.
 
 **Allowance
        for Accounts Receivable.** We
        reduce accounts receivable by an allowance for amounts that may become
        uncollectible in the future. This allowance is an estimate based primarily
        on
        our evaluation of the customer's financial condition, past collection history,
        and the aging of the account. If the financial condition of any of our customers
        deteriorates, resulting in an impairment or inability to make payments,
        additional allowances may be required.
 
 **Inventory.** Inventory is stated at the lower of cost or market and is accounted for on
        the
“first in, first out” method. This means that sales of inventory treat the
        oldest item of identical inventory as being the first sold. In addition,
        we
        regularly reduce the value of our inventory for slow-moving or obsolete
        inventory. This reduction is based on our review of items on hand compared
        to
        their estimated future demand. If actual future demand is less favorable
        than
        what we project, additional write-downs may be necessary. Goods shipped to
        us
        are recorded as inventory owned by us when the risk of loss shifts to us
        from
        the supplier.
 
 **Goodwill.** We have
        indicated previously that a change in the accounting rules necessitated a
        change
        in 2002 in how we report goodwill on our balance sheet. As a result, we incurred
        an impairment write-down in 2002 of our investment in Roberts, Cushman in
        the
        amount of $4.0 million. We periodically analyze the remaining goodwill on
        our
        balance sheet to determine the appropriateness of its carry value. As of
        December 31, 2005, we determined that the present value of the discounted
        estimated future cash flows of the stores associated with the goodwill is
        sufficient to support their respective goodwill balances. If actual results
        of
        these stores differ significantly from our projections, such difference could
        affect the present value calculation in the future resulting in an impairment
        of
        all or part of the goodwill currently carried on our balance sheet.
 
 **Forward-Looking
        Statements**
 
 “Item
        1.
        Business” and “Item 7. Management’s Discussion and Analysis of Financial
        Condition and Results of Operations” of this report contain forward-looking
        statements of management. In general, these are predictions or suggestions
        of
        future events and statements or expectations of future occurrences. There
        are
        important risks that could cause results to differ materially from those
        anticipated by some of the forward-looking statements. Some, but not all,
        of the
        important risks which could cause actual results to differ materially from
        those
        suggested by the forward-looking statements include, among other
        things:
 
 ·
            We
                might fail to realize the anticipated benefits of the opening of
                Tandy
                Leather retail stores or we might be unable to obtain sufficient
                new
                locations on acceptable terms to meet our growth plans. Further,
                we might
                fail to hire and train competent managers to oversee the stores
                opened.  ·
            Political
                considerations here and abroad could disrupt our sources of supplies
                from
                abroad or affect the prices we pay for
                goods. 
 ·
            Continued
                involvement by the United States in war and other military operations
                in
                the Middle East and other areas abroad could disrupt international
                trade
                and affect our inventory sources. 
 ·
            A
                slump in the economy in the United States, as well as abroad, may
                cause
                our sales to decrease or not to increase or adversely affect the
                prices
                charged for our products. Also, hostilities, terrorism or other events
                could worsen this condition.  ·
            As
                a result of the on-going threat of terrorist attacks on the United
                States,
                consumer buying habits could change and decrease our
                sales.  ·
            Livestock
                diseases such as mad cow could reduce the availability of hides and
                leathers or increase their cost. Also, the prices of hides and leathers
                fluctuate in normal times, and these fluctuations can affect
                us.  ·
            If,
                for whatever reason, the costs of our raw materials and inventory
                increase, we may not be able to pass those costs on to our
                customers.  ·
            Other
                factors could cause either fluctuations in buying patterns or possible
                negative trends in the craft and western retail markets. In addition,
                our
                customers may change their preferences to products other than ours,
                or
                they may not accept new products as we introduce them.  ·
            Tax
                or interest rates might increase. In particular, interest rates have
                been
                increasing. These increases will increase our costs of borrowing
                funds as
                needed in our business. 
 ·
            Any
                change in the commercial banking environment may affect us and our
                ability
                to borrow capital as needed. 
 ·
            Other
                uncertainties, which are difficult to predict and many of which are
                beyond
                our control, may occur as well. 
 We
        do not
        intend to update forward-looking statements .
 
 
 **ITEM
        7A. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET
        RISK**
 
 We
        face
        exposure to financial market risks, including adverse movement in foreign
        current exchange rates and changes in interest rates. These exposures may
        change
        over time and could have a material impact on our financial results. We do
        not
        use or invest in market risk sensitive instruments to hedge any of these
        risks
        or for any other purpose.
 
 **Foreign
        Currency Exchange Rate Risk**
 
 Our
        primary foreign currency exposure is related to our subsidiary in Canada.
        The
        Leather Factory of Canada, Ltd. has local currency (Canadian dollar) revenue
        and
        local currency operating expenses. Changes in the currency exchange rate
        impact
        the U.S. dollar amount of revenue and expenses. See Note 13 to the Consolidated
        Financial Statements, *Segment Information* ,
        for
        financial information concerning our foreign activities.
 
 **Interest
        Rate Risk**
 
 We
        are
        subject to market risk associated with interest rate movements on outstanding
        debt. Our current credit agreement with JPMorgan Chase accrues interest at
        a
        rate that changes with fluctuations in the prime rate. Because we currently
        have
        no outstanding borrowings, changes in the prime rate do not impact us in
        this
        area.





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





**Tandy
      Leather Factory, Inc.**


**Consolidated
      Balance Sheets**


**December
      31, 2005 and 2004**


**December
                  31,**
                **2005**
              
              **December
                  31,**
                **2004****ASSETS**CURRENT
                  ASSETS:Cash
              $3,215,727
              
              $2,560,202Accounts
                  receivable-trade, net of allowance for doubtful accounts of $138,000
                  and
                  $85,000 in 2005 and 2004, respectively
              2,178,848
              
              2,032,289Inventory
              15,669,182
              
              12,749,709Deferred
                  income taxes
              273,872
              
              199,308Other
                  current assets
              358,058
              
              629,723**Total
                  current assets**
              **21,695,687**
              ****
              **18,171,231**PROPERTY
                  AND EQUIPMENT, at cost
              6,424,091
              
              6,181,834Less
                  accumulated depreciation and amortization
              (4,664,614)
              
              (4,277,269)1,759,477
              
              1,904,565GOODWILL
              746,611
              
              742,860OTHER
                  INTANGIBLES, net of accumulated amortization of $223,000 and $185,000
                  in
                  2005 and 2004, respectively
              398,967
              
              437,758OTHER
                  assets
              1,079,731
              
              910,749**$25,680,473**
              
              **$22,167,163****LIABILITIES
                  AND STOCKHOLDERS' EQUITY**CURRENT
                  LIABILITIES:Accounts
                  payable-trade
              $1,220,420
              
              $1,954,146Accrued
                  expenses and other liabilities
              2,550,573
              
              1,682,003Income
                  taxes payable
              199,581
              
              22,764Current
                  maturities of capital lease obligation
              134,067
              
              134,067**Total
                  current liabilities**
              **4,104,641**
              ****
              **3,792,980**DEFERRED
                  INCOME TAXES
              206,253
              
              313,006LONG-TERM
                  DEBT, net of current maturities
              -
              
              505,154CAPITAL
                  LEASE OBLIGATION, net of current maturities
              111,722
              
              245,790COMMITMENTS
                  AND CONTINGENCIES
              -
              
              -STOCKHOLDERS'
                  EQUITY:Preferred
                  stock, $0.10 par value; 20,000,000 shares authorized, none issued
                  or
                  outstanding
              -
              
              -Common
                  stock, $0.0024 par value; 25,000,000 sharesauthorized,
                  10,741,835 and 10,560,661 shares issued at 2005 and 2004,10,735,976
                  and 10,554,711 outstanding at 2005 and 2004, respectively
              25,780
              
              25,345Paid-in
                  capital
              4,988,445
              
              4,796,999Retained
                  earnings
              16,172,475
              
              12,458,760Treasury
                  stock
              (25,487)
              
              (25,487)Accumulated
                  other comprehensive income
              96,644
              
              54,616Total
                  stockholders' equity
              21,257,857
              
              17,310,233**$25,680,473**
              
              **$22,167,163**










The
      accompanying notes are an integral part of these financial
      statements.





**Tandy
      Leather Factory, Inc.**


**Consolidated
      Statements of Income**


**For
      the Years Ended December 31, 2005, 2004 and 2003**




**2005**
            
            **2004**
            
            **2003**NET
                SALES
            $
                50,719,574
            
            $
                46,146,284
            
            $
                41,712,191COST
                OF SALES
            21,964,530
            
            20,706,239
            
            19,020,292Gross
                Profit
            28,755,044
            
            25,440,045
            
            22,691,899OPERATING
                EXPENSES
            23,181,633
            
            21,181,599
            
            18,594,240INCOME
                FROM OPERATIONS
            5,573,411
            
            4,258,446
            
            4,097,659OTHER
                (INCOME) EXPENSE:Interest
                expense
            3,188
            
            53,400
            
            206,942Other,
                net
            (137,690)
            
            (8,600)
            
            (81,773)Total
                other (income) expense
            (134,502)
            
            44,800
            
            125,169INCOME
                BEFORE INCOME TAXES
            5,707,913
            
            4,213,646
            
            3,972,490PROVISION
                FOR INCOME TAXES
            1,994,199
            
            1,559,605
            
            1,232,116NET
                INCOME
            $3,713,714
            
            $2,654,041
            
            $
                2,740,374NET
                INCOME PER COMMON SHARE - BASIC
            $0.35
            
            $0.25
            
            $
                0.27NET
                INCOME PER COMMON SHARE - DILUTED
            $0.34
            
            $0.24
            
            $
                0.25Weighted
                Average Number of Shares Outstanding:Basic
            10,643,004
            
            10,543,994
            
            10,323,549Diluted
            10,976,240
            
            10,957,518
            
            10,861,305




The
      accompanying notes are an integral part of these financial
      statements.





**Tandy
      Leather Factory, Inc.**


**Consolidated
      Statements of Cash Flows**


**For
      the Years Ended December 31, 2005, 2004 and 2003**





**2005**
            
            **2004**
            
            **2003**CASH
                FLOWS FROM OPERATING ACTIVITIES:Net
                income
            $
                3,713,714
            
            $
                2,654,041
            
            $
                2,740,374Adjustments
                to reconcile net income to net cash provided by operating activities
                -Depreciation
                and amortization
            456,706
            
            452,653
            
            529,262Gain
                on disposal of assets
            (9,145)
            
            (2,000)
            
            (9,103)Deferred
                income taxes
            (181,317)
            
            38,721
            
            47,991Other
            38,276
            
            20,123
            
            47,235Net
                changes in assets and liabilities, net of effect of business
                acquisitions:Accounts
                receivable-trade, net
            (146,559)
            
            (112,738)
            
            109,960Inventory
            (2,919,473)
            
            (1,303,762)
            
            1,615,451Income
                taxes
            176,817
            
            228,787
            
            (150,379)Other
                current assets
            271,664
            
            (102,163)
            
            (30,119)Accounts
                payable-trade
            (733,726)
            
            406,357
            
            (49,830)Accrued
                expenses and other liabilities
            868,570
            
            658,692
            
            (1,502,904)Total
                adjustments
            (2,178,187)
            
            284,670
            
            607,564**Net
                cash provided by operating activities**
            **1,535,527**
            
            **2,938,711**
            
            **3,347,938**CASH
                FLOWS FROM INVESTING ACTIVITIES:Purchase
                of property and equipment
            (272,826)
            
            (369,559)
            
            (360,202)Payments
                in connection with businesses acquired
            -
            
            (556,794)
            
            -Proceeds
                from sale of assets
            9,145
            
            2,000
            
            6,217Decrease
                (increase) in other assets
            (168,981)
            
            10,280
            
            (27,970)**Net
                cash used in investing activities**
            **(432,662)**
            
            **(914,073)**
            
            **(381,955)**CASH
                FLOWS FROM FINANCING ACTIVITIES:Net
                decrease in revolving credit loans
            (505,154)
            
            (1,287,830)
            
            (2,420,550)Payments
                on notes payable and long-term debt
            (134,067)
            
            (23,478)
            
            (6,556)Decrease
                (increase) in cash restricted for payment on revolver
            -
            
            -
            
            553,839Payments
                received on notes secured by common stock
            -
            
            20,000
            
            24,003Repurchase
                of common stock (treasury stock)
            -
            
            (25,487)
            
            -Proceeds
                from issuance of common stock and warrants
            191,881
            
            124,015
            
            510,068**Net
                cash used in financing activities**
            **(447,340)**
            
            **(1,192,780)**
            
            **(1,339,196)**NET
                INCREASE IN CASH
            655,525
            
            831,858
            
            1,626,787CASH,
                beginning of period
            2,560,202
            
            1,728,344
            
            101,557CASH,
                end of period
            $3,215,727
            
            $2,560,202
            
            $
                1,728,344SUPPLEMENTAL
                DISCLOSURES OF CASH FLOW INFORMATION:Interest
                paid during the period
            $
                3,188
            
            $
                59,773
            
            $
                216,275Income
                tax paid during the period, net of (refunds)
            1,954,364
            
            1,197,347
            
            1,138,799NON-CASH
                INVESTING ACTIVITIES:Equipment
                acquired under capital lease financing arrangements
            -
            
            $
                402,201
            
            -





The
      accompanying notes are an integral part of these financial
      statements.





**Tandy
      Leather Factory, Inc.**


**Consolidated
      Statements of Stockholders' Equity**


**For
      the Years Ended December 31, 2005, 2004 and 2003**





**Number
                of Shares**
            
            **Par
                Value**
            
            **Paid-in
                Capital**
            
            **Treasury**
              **Stock**
            
            **Retained
                Earnings**
            
            **Notes
                receivable - secured by common stock**
            
            **Accumulated
                Other Comprehensive Income (Loss)**
            
            **Total**
            
            **Comprehensive**
              **Income**BALANCE,
                December 31, 2002
            10,149,961
            
            $24,360
            
            $4,163,901
            
            -
            
            $7,064,345
            
            $(44,003)
            
            $(38,541)
            
            $11,170,062Payments
                on notes receivable
              secured
                by common stock
            -
            
            -
            
            -
            
            -
            
            -
            
            24,003
            
            -
            
            24,003Shares
                issued - stock options
              exercised
            338,000
            
            811
            
            442,016
            
            -
            
            -
            
            -
            
            -
            
            442,827Warrants
                to acquire 100,000 shares
              of
                common stock issued
            -
            
            -
            
            67,241
            
            -
            
            -
            
            -
            
            -
            
            67,241Net
                income
            -
            
            -
            
            -
            
            -
            
            2,740,374
            
            -
            
            -
            
            2,740,374
            
            $2,740,374Translation
                adjustment
            -
            
            -
            
            -
            
            -
            
            -
            
            -
            
            64,986
            
            64,986
            
            64,986BALANCE,
                December 31, 2003
            10,487,961
            
            $25,171
            
            $4,673,158
            
            -
            
            $9,804,719
            
            $(20,000)
            
            $26,445
            
            $14,509,493





Comprehensive
                income for the year ended December 31, 2003
            $2,805,360








Payments
                on notes receivable
              secured
                by common stock
            -
            
            -
            
            
            
            -
            
            -
            
            20,000
            
            -
            
            20,000Shares
                issued - stock options and
              warrants
                exercised
            72,700
            
            174
            
            74,896
            
            -
            
            -
            
            -
            
            -
            
            75,070Warrants
                to acquire 50,000 shares
              of
                common stock issued
            -
            
            -
            
            48,945
            
            -
            
            -
            
            -
            
            -
            
            48,945Purchase
                of treasury stock
            -
            
            -
            
            -
            
            (25,487)
            
            -
            
            -
            
            -
            
            (25,487)Net
                income
            -
            
            -
            
            -
            
            -
            
            2,654,041
            
            -
            
            -
            
            2,654,041
            
            $2,654,041Translation
                adjustment
            -
            
            -
            
            -
            
            -
            
            -
            
            -
            
            28,171
            
            28,171
            
            28,171BALANCE,
                December 31, 2004
            10,560,661
            
            $25,345
            
            $4,796,999
            
            $(25,487)
            
            $12,458,760
            
            -
            
            $54,616
            
            $17,310,233




Comprehensive
                income for the year ended December 31, 2004
            $2,682,212







Shares
                issued - stock options and
              warrants
                exercised
            181,174
            
            435
            
            191,446
            
            -
            
            -
            
            -
            
            -
            
            191,881Net
                income
            -
            
            -
            
            -
            
            -
            
            3,713,714
            
            -
            
            -
            
            3,713,714
            
            $3,713,714Translation
                adjustment
            -
            
            -
            
            -
            
            -
            
            -
            
            -
            
            42,029
            
            42,029
            
            42,029BALANCE,
                December 31, 2005
            10,741,835
            
            $25,780
            
            $4,988,445
            
            $(25,487)
            
            $16,172,474
            
            -
            
            $96,645
            
            $21,257,857




Comprehensive
                income for the year ended December 31, 2005
            $3,755,743









The
      accompanying notes are an integral part of these financial
      statements.





**TANDY
      LEATHER FACTORY, INC.**


**NOTES
      TO CONSOLIDATED FINANCIAL
      STATEMENTS**


**DECEMBER
      31, 2005, 2004, and 2003**





**1.
      DESCRIPTION OF BUSINESS**




Our
      primary line of business is the sale of leather, leather crafts and related
      supplies. We sell our products via company-owned stores throughout the United
      States and Canada. Numerous customers including retailers, wholesalers,
      assemblers, distributors and other manufacturers are geographically disbursed
      throughout the world. We also have light manufacturing facilities in Texas
      and
      New York.





On
      May
      23, 2005, our stockholders approved changing our name from The Leather
      Factory, Inc. to Tandy Leather Factory, Inc.





**2.
      SIGNIFICANT ACCOUNTING POLICIES**




*·*
            *Management
                estimates and reporting*





The
      preparation of financial statements in conformity with accounting principles
      generally accepted in the United States of America requires us to make estimates
      and assumptions that affect the reported amounts of assets and liabilities
      and
      disclosure of contingent assets and liabilities at the date of the financial
      statements and reported amounts of revenues and expenses during the periods
      presented. Actual results could differ from those estimates. Assets and
      liabilities with reported amounts based on significant estimates include trade
      accounts receivables, inventory (slow-moving), and deferred income
      taxes.





*·*
            *Principles
                of consolidation*





Our
      consolidated financial statements include the accounts of Tandy Leather Factory,
      Inc. and its wholly owned subsidiaries, The Leather Factory, L.P. (a Texas
      limited partnership) and its corporate partners, Tandy Leather Company, L.P.
      (a
      Texas limited partnership) and its corporate partners, Roberts, Cushman &
Company, Inc. (a New York corporation), and The Leather Factory of Canada,
      Ltd.
      (a Canadian corporation). All intercompany accounts and transactions have been
      eliminated in consolidation. Certain prior year amounts have been reclassified
      to conform to the current year presentation.





*·*
            *Foreign
                currency translation*





Foreign
      currency translation adjustments arise from activities of our Canadian
      operations. Results of operations are translated into U.S. dollars using the
      average exchange rates during the period, while assets and liabilities are
      translated using period-end exchange rates. Foreign currency translation
      adjustments of assets and liabilities are recorded in stockholders’ equity.
      Gains and (losses) resulting from foreign currency translations are reported
      in
      the statements of income under the caption “Other (Income) Expense”, net, for
      all periods presented.





*·*
            *Revenue
                recognition*





Our
      sales
      generally occur via two methods: (1) at the store counter, and (2) shipment
      by
      common carrier. Sales at the counter are recorded and title passes as
      transactions occur. Otherwise, sales are recorded and title passes when the
      merchandise is shipped to the customer. Shipping terms are normally FOB shipping
      point.





We
      offer
      an unconditional satisfaction guarantee to all customers and accept all product
      returns. Net sales represent gross sales less negotiated price allowances,
      product returns, and allowances for defective merchandise.





*·*
            *Discounts*





We
      maintain four price levels on a consistent basis: retail, wholesale, business,
      and distributor. Gross sales are reported after deduction of discounts. We
      do
      not pay slotting fees or make other payments to resellers. Several customers
      require us to participate in their cooperative advertising programs. These
      programs are a negotiated percentage of their purchases and are accounted for
      as
      a reduction of sales.





*·*
            *Expense
                categories*





Cost
      of
      goods sold include inbound freight and duty charges from vendors to our central
      warehouse, freight and handling charges to move merchandise from our central
      warehouse to our stores, and manufacturing overhead, as
      appropriate.





Operating
      expenses include all selling, general and administrative costs including wages
      and related employee expenses (payroll taxes, health benefits, ESOP
      contributions, etc.), advertising, outbound freight charges (to ship merchandise
      to customers), rent, and utilities.





*·*
            *Property
                and equipment, net of accumulated depreciation and amortization*





Property
      and equipment are stated at cost. Depreciation is computed using the
      straight-line method over the estimated useful lives of the assets, which are
      five to ten years for equipment, five to seven years for furniture and fixtures,
      and five years for vehicles. Leasehold improvements are amortized over the
      lesser of the life of the lease or the useful life of the asset. Repairs and
      maintenance costs are expensed as incurred.





*·*
            *Inventory*





Inventory
      is valued at the lower of first-in, first-out cost or market. In addition,
      the
      value of inventory is periodically reduced for slow-moving or obsolete inventory
      based on management's review of items on hand compared to their estimated future
      demand.





*·*
            *Impairment
                of long-lived assets*





Potential
      impairments of long-lived assets are reviewed annually or when events and
      circumstances warrant an earlier review. In accordance with SFAS No. 144,
      impairment is determined when estimated future undiscounted cash flows
      associated with an asset are less than the asset’s carrying
      value.





*·*
            *Earnings
                per share*





Basic
      earnings per share are computed based on the weighted average number of common
      shares outstanding during the period. Diluted earnings per share includes,
      to
      the extent inclusion of such shares would be dilutive, the effect of outstanding
      options and warrants using the treasury stock method. Unearned shares, if any,
      held by the Employees' Stock Ownership Plan (ESOP) are deemed not to be
      outstanding for earnings per shares calculations.





***BASIC***
            **2005**
            ****
            **2004**
            ****
            **2003**Net
                income
            $3,713,714
            
            $
                2,654,041
            
            $
                2,740,374Weighted
                average common shares outstanding
            10,643,004
            
            10,543,994
            
            10,323,549**Earnings
                per share - basic**
            **$
                0.35**
            
            **$
                0.25**
            
            **$
                0.27*****DILUTED***Net
                income
            $
                3,713,714
            
            $
                2,654,041
            
            $
                2,740,374Weighted
                average common shares outstanding
            10,643,004
            
            10,543,994
            
            10,323,549Effect
                of assumed exercise of stock options and warrants
            333,236
            
            413,524
            
            537,756Weighted
                average common shares outstanding,assuming
                dilution
            10,976,240
            
            10,957,518
            
            10,861,305**Earnings
                per share - diluted**
            **$
                0.34**
            
            **$
                0.24**
            
            **$
                0.25**Outstanding
                options and warrants excluded as anti-dilutive
            -
            
            136,000
            
            60,000





For
      additional disclosures regarding the employee stock options and the warrants,
      see Note 11. The net effect of converting stock options and warrants to purchase
      596,174 and 752,500 shares of common stock at option prices less than the
      average market prices has been included in the computations of diluted EPS
      for
      the years ended December 31, 2005 and 2004, respectively.





*·*
            *Goodwill
                and other intangibles*





Statement
      of Financial Accounting Standards ("SFAS") No. 142, "Goodwill and Other
      Intangible Assets," prescribes a two-phase process for impairment testing of
      goodwill, which is performed once annually, absent indicators of impairment.
      The
      first phase screens for impairment, while the second phase (if necessary)
      measures the impairment. As
      a
      result of SFAS 142, an impairment write-down occurred in the first quarter
      of
      2002 of the investment in subsidiary, Roberts, Cushman & Company, Inc., in
      the amount of $4.0 million. We periodically analyze goodwill remaining on the
      balance sheet to determine the appropriateness of its carrying value and have
      elected to perform
      the annual analysis during the fourth calendar quarter of each year. As
      of
      December 31, 2005, we determined that the present value of the discounted
      estimated future cash flows of the stores associated with the goodwill is
      sufficient to support their respective goodwill balances. Under
      SFAS 142, goodwill impairment is deemed to exist if the net book value of a
      reporting unit exceeds its estimated fair value. Our reporting units are
      generally the same as the operating segments identified in Note 13 - Segment
      Information.





A
      summary
      of changes in our goodwill for the years ended December 31, 2005 and 2004 is
      as
      follows:





**Wholesale
                Leathercraft**
            
            **Retail Leathercraft**
            
            **Total**Balance,
                December 31, 2003
            $351,406
            
            $352,829
            
            $704,235Acquisitions
                and adjustments
            -
            
            30,577
            
            30,577Foreign
                exchange gain/loss
            8,048
            
            -
            
            8,048Impairments
            -
            
            -
            
            -Balance,
                December 31, 2004
            $359,454
            
            $383,406
            
            $742,860Acquisitions
                and adjustments
            -
            
            -
            
            -Foreign
                exchange gain/loss
            3,751
            
            -
            
            3,751Impairments
            -
            
            -
            
            -Balance,
                December 31, 2005
            $363,205
            
            $383,406
            
            $746,611





As
      of
      December 31, 2005 and 2004, our intangible assets and related accumulated
      amortization consisted of the following:


**As
                of December 31, 2005****Gross**
            
            **Accumulated
                A****mortization**
            
            **Net**Trademarks,
                Copyrights
            $544,369
            
            $210,902
            
            $333,467Non-Compete
                Agreements
            78,000
            
            12,500
            
            65,500$622,369
            
            $223,402
            
            $398,967





**As
                of December 31, 2004****Gross**
            
            **Accumulated****Amortization**
            
            **Net**Trademarks,
                Copyrights
            $544,369
            
            $174,611
            
            $369,758Non-Compete
                Agreements
            78,000
            
            10,000
            
            68,000$622,369
            
            $184,611
            
            $437,758





Excluding
      goodwill, we have no intangible assets not subject to amortization under SFAS
      142. Amortization of intangible assets of $38,791 in 2005, $33,782 in 2004,
      and
      $52,215 in 2003 was recorded in operating expenses. Based on the current amount
      of intangible assets subject to amortization, the estimated amortization expense
      for each of the succeeding 5 years are as follows:





**Wholesale
                Leathercraft**
            **Retail
                Leathercraft**
            **Total**2006
            $5,954
            $32,837
            $38,2912007
            5,954
            31,837
            37,7912008
            5.954
            30,337
            36,2912009
            5,954
            30,337
            36,2912010
            5,954
            30,337
            36,291





During
      2005, we did not acquire any intangible assets.





*·*
            *Fair
                value of financial Instruments*





The
      principal financial instruments held consist of accounts receivable, accounts
      payable, notes payable and long-term debt. The carrying value of accounts
      receivable and accounts payable approximate their fair value due to the
      relatively short-term nature of the accounts. The interest rates on our notes
      payable and long-term debt fluctuate with changes in the prime rate and are
      the
      rates currently available to us; therefore, the carrying amount of those
      instruments approximates their fair value.





*·*
            *Deferred
                taxes*





Deferred
      income taxes result from temporary differences in the bases of our assets and
      liabilities reported for book and tax purposes.





*·*
            *Stock
                options*





We
      periodically grant stock options for a fixed number of shares to employees
      and
      non-employee directors with an exercise price equal to the fair market value
      of
      the shares at the date of grant. We account for stock option grants to employees
      and directors using the intrinsic value method. Under the intrinsic value
      method, compensation associated with stock awards to employees and directors
      is
      determined as the difference, if any, between the current fair value of the
      underlying common stock on the date compensation is measured and the price
      the
      employee or director must pay to exercise the award. The measurement date for
      employee awards is generally the date of grant.





At
      December 31, 2005, we had two stock-based compensation plans, which are
      described more fully in Note 11. No stock-based compensation cost is reflected
      in net income in 2005 and 2004, as all options granted under those plans had
      an
      exercise price equal to the market value of the underlying common stock on
      the
      date of grant. The following table illustrates the effect on net income and
      earnings per share if we had applied the fair value recognition provisions
      of
      FASB Statement No. 123, *Accounting
      for Stock-Based Compensation* ,
      to
      stock-based compensation.





**Years
                Ended December 31,****2005**
            
            **2004**
            
            **2003**Net
                income, as reported
            $3,713,714
            
            $2,654,041
            
            $2,740,374Plus:
                Stock -based employee compensation expense included in reported net
                income, net of tax
            -
            
            -
            
            -Less:
                Total stock-based compensation expense determined under fair value
                based
                method for all awards, net of related tax effects
            122,934
            
            117,443
            
            98,186Pro
                forma net income
            $3,590,780
            
            $2,536,598
            
            $2,642,188Earnings
                per share:Basic
                - as reported
            $0.35
            
            $0.25
            
            $0.27Basic
                - pro forma
            $0.34
            
            $0.24
            
            $0.26Diluted
                - as reported
            $0.34
            
            $0.24
            
            $0.25Diluted
                - pro forma
            $0.33
            
            $0.23
            
            $0.24





The
      fair
      value of options at the date of grant was estimated using the Black-Scholes
      option pricing model with the following weighted-average
      assumptions:




**2005**
            **2004**
            **2003**Volatility
            36.6%
            36.4%
            69.6%Expected
                option life
            3-5
            3-5
            5Interest
                rate (risk free)
            4.25%
            3.375%
            3.25%Dividends
            None
            None
            None





The
      effect on 2005, 2004 and 2003 pro forma net income (loss) and earnings (loss)
      per share of the estimated fair value of stock options and shares are not
      necessarily representative of the effects on the results of operations in the
      future. In addition, the estimates made utilize a pricing model developed for
      traded options with relatively short lives; our option grants typically have
      a
      life of up to ten years and are not transferable. Therefore, the actual fair
      value of a stock option grant may be different from our estimates. We believe
      that our estimates incorporate all relevant information and represent a
      reasonable approximation in light of the difficulties involved in valuing
      non-traded stock options.





In
      December 2004, SFAS No. 123 (revised 2004), "Share-Based Payment" (SFAS 123R)
      was issued. SFAS 123R replaces SFAS No. 123 and supercedes APB Opinion No.
      25.
      We are required to adopt SFAS 123R beginning January 1, 2006. SFAS 123R requires
      all share-based payments to employees, including grants of employee stock
      options, to be recognized in the financial statements based on their fair
      values. The pro forma disclosures previously permitted under SFAS no longer
      will
      be an alternative to financial statement recognition. See Note 14 - Recent
      Accounting Pronouncements for additional information.





*·*
            *Comprehensive
                income*





Comprehensive
      income represents all changes in stockholders’ equity, exclusive of transactions
      with stockholders. The accumulated balance of foreign currency translation
      adjustments is presented in the consolidated financial statements as
“accumulated other comprehensive income or loss”.





*·*
            *Shipping
                and handling costs*





All
      shipping and handling costs incurred by us are included in operating expenses
      on
      the statements of income. These costs totaled approximately $1,504,000,
      $1,360,000 and $1,206,000 for the years ended December 31, 2005, 2004 and 2003,
      respectively.





*·*
            *Advertising*





With
      the
      exception of catalog costs, advertising costs are expense as incurred. Catalog
      costs are capitalized and expensed over the estimated useful life of the
      particular catalog in question, which is typically twelve to eighteen months.
      Such capitalized costs are included in other current assets and totaled $211,000
      and $217,000 at December 31, 2005 and 2004, respectively. Total advertising
      expense was $3,074,991 in 2005; $2,571,124 in 2004; and $2,399,879 in
      2003.





We
      agree
      to list the names and addresses of our Authorized Sales Centers (ASCs) in
      certain mailing pieces produced. The inclusion of these names and addresses
      are
      at our sole discretion. The production and distribution of direct mailings
      is
      the primary method of advertising we use and normally consists of 50 to 75
      unique mailing pieces annually. Generally, the ASCs are listed in six to eight
      of those pieces. We believe that the inclusion of these ASC locations in the
      flyers has no impact on our financial statements.





*·*
            *Cash
                flows presentation*





For
      purposes of the statement of cash flows, we consider all highly liquid
      investments with initial maturities of three months or less from the date of
      purchase to be cash equivalents.





**3.
      VALUATION AND QUALIFYING ACCOUNTS**





·
            Allowance
                for uncollectible accounts





We
      maintain allowances for bad debts based on factors such as the composition
      of
      accounts receivable, the age of the accounts, historical bad debt experience,
      and our evaluation of the financial condition and past collection history of
      each customer. Accounts are written off as they are deemed uncollectible based
      on a periodic review of accounts. Our allowance for doubtful accounts was
      $137,587 and $85,132, respectively, at December 31, 2005 and 2004. The following
      is a roll forward of the allowance for doubtful accounts:




**Balance
                at beginning of year**
            **Reserve
                "purchased" during year**
            **Additions
                (reductions) charged to costs and expenses**
            **Foreign
                exchange gain/loss**
            **Write-offs**
            **Balance
                at**
              **end
                of****year**Year
                ended December 31, 2005
            $
                85,133
            -
            87,873
            527
            (35,946)
            $137,587Year
                ended December 31, 2004
            $
                31,469
            9,785
            104,587
            4,980
            (65,688)
            $85,133Year
                ended December 31, 2003
            $
                77,657
            -
            87,175
            967
            (134,330)
            $31,469





·
            Sales
                returns and defective merchandise





Product
      returns are generally recorded directly against sales as those returns occur.
      Historically, the amount of returns is immaterial and as a result, no reserve
      is
      recorded in the financial statements.





·
            Slow-moving
                and obsolete inventory





The
      majority of inventory items maintained by us have no restrictive shelf life.
      We
      review all inventory items annually to determine what items should be eliminated
      from the product line. Items are selected for several reasons: (1) the item
      is
      slow-moving; (2) the supplier is unable to provide an acceptable quality or
      quantity; or (3) to maintain a freshness in the product line. Once an item
      has
      been selected to discontinue, we devalue the cost of the item by 25% of its
      original value each quarter until its value has been reduced to zero. Reductions
      in inventory for slow-moving and obsolete inventory are recorded directly
      against inventory.





**4.
      BALANCE SHEET COMPONENTS as of December 31,**


**2005**
            
            **2004****INVENTORY**On
                hand:Finished
                goods held for sale
            
            $14,035,384
            
            $11,571,869Raw
                materials and work in process
            
            984,878
            
            1,177,840Inventory
                in transit
            
            648,920
            
            -TOTAL
            $15,669,182
            
            $12,749,709**PROPERTY
                AND EQUIPMENT**Leasehold
                improvements
            
            $1,199,996
            
            $1,181,828Equipment
            
            4,093,722
            
            3,837,654Furniture
                and fixtures
            
            1,064,081
            
            939,976Vehicles
            
            66,292
            
            46,0686,424,091
            
            6,005,526Less:
                accumulated depreciation
            
            (4,664,614)
            
            (4,100,961)TOTAL
            $1,759,477
            
            $1,904,565





Depreciation
      expense was $417,914, $444,878, and $477,047 for the years ended December 31,
      2005, 2004 and 2003, respectively.





**2005**
            
            **2004****OTHER
                CURRENT ASSETS**Accounts
                receivable - employees
            
            $12,158
            
            $40,401Accounts
                receivable - other
            
            2,037
            
            70,814Prepaid
                expenses
            
            313,344
            
            436,011Payments
                on merchandise not received
            
            30,519
            
            82,497TOTAL
            $358,058
            
            $629,723**OTHER
                ASSETS**Security
                deposits - utilities, locations, etc.
            
            $83,087
            
            $75,903Leather
                art collection
            
            250,000
            
            250,000Computer
                software not implemented yet
            
            746,644
            
            584,846TOTAL
            $1,079,731
            
            $910,749**ACCRUED
                EXPENSES AND OTHER LIABILITIES**Accrued
                bonuses
            
            $1,120,517
            
            $768,937Accrued
                payroll
            
            328,691
            
            212,298Accrued
                ESOP contribution
            
            -
            
            140,000Sales
                and payroll taxes payable
            
            208,396
            
            208,896Inventory
                in transit
            
            648,920
            
            -Other
            
            244,049
            
            351,872TOTAL
            $2,550,573
            
            $1,682,003







**5.
      NOTES PAYABLE AND LONG-TERM DEBT**





On
      November 1, 2004, we entered into a Credit Agreement with JPMorgan Chase
      (“Chase”), formerly known as Bank One, pursuant to which Chase agreed to provide
      a revolving credit facility of up to $3,000,000. The revolver bears interest
      at
      prime less .5% or LIBOR plus 1.35% and matures on October 6, 2008.





At
      December 31, 2005 and 2004, the amounts outstanding under the above agreements
      and other long-term debt consisted of the following:





**2005**
            **2004**Credit
                Agreement with Chase - collateralized by inventory and accounts
                receivable; payable as follows:Line
                of Credit Note dated October 6, 2004 in the maximum principal amount
                of
                $3,000,000 with revolving features as more fully described below
                -
                interest due quarterly at prime less .5% (7.25% at 12/31/2005) or
                LIBOR
                plus 1.35%; matures October 6, 2008
            $
                -
            $505,154-
            505,154Less
                - Current maturities
            -
            -$
                -
            $505,154





The
      terms
      of the Credit Facility contain various covenants which, among other things,
      require us to meet a specific debt service coverage ratio and limit capital
      expenditures. We are prohibited from incurring indebtedness except as permitted
      by the terms of the Credit Facility, from entering into any new business or
      making material changes in any of our business objectives, purposes or
      operations. We also have an affirmative duty to disclose any covenant violation
      to the lender.





**6.
      CAPITAL LEASE OBLIGATIONS**





We
      lease
      certain licensed software under a capital lease agreement. The asset subject
      to
      the agreement totaling $402,201 is included in other assets as of December
      31,
      2005. The asset will be reclassified into property and equipment once the
      conversion and implementation process is completed.





At
      December 31, 2005 and 2004, the amounts outstanding under capital lease
      obligations consisted of the following:





**2005**
            **2004**Capital
                Lease secured by certain licensed software - total monthly principal
                payments of $11,172, no interest, maturing October 2007
            $245,789
            $379,857Less
                - Current maturities
            134,067
            134,067$111,722
            $245,790





**7.
      EMPLOYEE BENEFIT PLAN**





We
      have
      an Employee Stock Ownership Plan (the "Plan") for employees with at least one
      year of service (as defined by the Plan) and who have reached their 21st
      birthday. Under the Plan, we make annual cash or stock contributions to a trust
      for the benefit of eligible employees. As of December 31, 2005, 223 employees
      and former employees were participants in or beneficiaries of the ESOP. The
      trust invests in shares of our common stock and those shares are included in
      our
      earnings per share calculations. The amount of our annual contribution is
      discretionary. Benefits under the Plan are 100% vested after three years of
      service and are payable upon death, disability or retirement. Vested benefits
      are payable upon termination of employment.





We
      apply
      Statement of Position 93-6 (SOP 93-6), "Employers’ Accounting for Employee Stock
      Ownership Plans," of the Accounting Standards Division of the American Institute
      of CPAs. During 2005, 2004, and 2003, respectively, we contributed $300,000;
      $250,000; and $221,400 in cash as current year contributions to the plan and
      recognized compensation expense related to these payments.





The
      following table summarizes the number of shares held by the Plan and the market
      value as of December 31, 2005, 2004, and 2003:





**Number
                of Shares**
            ****
            **Market
                Value******
            **2005**
            **2004**
            **2003**
            ****
            **2005**
            **2004**
            **2003**Allocated
            943,241
            948,147
            981,540
            
            $6,461,201
            $3,365,922
            $4,750,654Unearned
            -
            -
            -
            
            -
            -
            -Total
            943,241
            948,147
            981,540
            
            $6,461,201
            $3,365,922
            $4,750,654





We
      currently offer no postretirement or postemployment benefits to our
      employees.





**8.
      INCOME TAXES**





The
      provision for income taxes consists of the following:





**2005**
            
            **2004**
            
            **2003**Current
                provision:Federal
            $1,932,791
            
            $1,380,951
            
            $1,144,763State
            242,725
            
            139,933
            
            40,2672,175,516
            
            1,520,884
            
            1,185,030Deferred
                provision (benefit):Federal
            (166,850)
            
            33,483
            
            46,850State
            (14,467)
            
            5,238
            
            236(181,317)
            
            38,721
            
            47,086$1,994,199
            
            $1,559,605
            
            $1,232,116




Income
      before income taxes is earned in the following tax jurisdictions:





**2005**
            
            **2004**
            
            **2003**United
                States
            $5,220,991
            
            $
                4,078,434
            
            $
                3,744,550Canada
            486,922
            
            135,212
            
            227,940$5,707,913
            
            $
                4,213,646
            
            $
                3,972,490





The
      income tax effects of temporary differences that give rise to significant
      portions of deferred income tax assets and liabilities are as
      follows:





**2005**
            ****
            **2004**


**Deferred
      income tax assets:**


Allowance
                for doubtful accounts
            $
                45,665
            
            $
                26,546Capitalized
                inventory costs
            134,466
            
            115,022Warrants
            41,498
            
            42,989Accrued
                expenses, reserves, and other
            93,741
            
            57,740Total
                deferred income tax assets
            315,370
            
            242,297


**Deferred
      income tax liabilities:**


Property
                and equipment depreciation
            193,337
            
            249,892Goodwill
                and other intangible assets amortization
            54,414
            
            106,103Total
                deferred income tax liabilities
            247,751
            
            355,995Net
                deferred tax asset (liability)
            $67,619
            
            ($113,698)





The
      net
      deferred tax liability is classified on the balance sheets as
      follows:





**2005**
            
            **2004**Current
                deferred tax assets
            $273,872
            
            $
                199,308Long-term
                deferred tax liabilities
            (206,253)
            
            (313,006)Net
                deferred tax asset (liability)
            $
                67,619
            
            $
                (113,698)





The
      effective tax rate differs from the statutory rate as follows:


**2005**
            **2004**
            **2003**Statutory
                rate
            
            34%
            34%
            34%State
                and local taxes
            
            4%
            4%
            1%Other
            
            (3%)
            (1%)
            (4%)Effective
                rate
            
            35%
            37%
            31%








**9.
      COMMITMENTS AND CONTINGENCIES**





**Operating
      Leases**





Our
      primary office facility and warehouse are leased under a five-year lease
      agreement that expires in March 2008. Rental agreements for the stores and
      warehouse distribution units expire on dates ranging from March 2006 to February
      2011. The lease agreement for our manufacturing facility in Long Island City,
      New York, expires on June 30, 2006.





Rent
      expense on all operating leases for the years ended December 31, 2005, 2004,
      and
      2003, was $2,227,345, $1,994,030, and $1,814,457, respectively.





Future
      minimum lease payments under noncancelable operating leases at December 31,
      2005
      were as follows:





**Year
                ending December 31:**2006
            $2,248,4262007
            1,895,4772008
            1,172,7862009
            642,1932010
                and thereafter
            264,106Total
                minimum lease payments
            $6,222,988





**Litigation**





We
      are
      involved in various litigation that arise in the ordinary course of its business
      and operations. There are no such matters pending that we expect to have a
      material impact on our financial position and operating results.





**10.
      SIGNIFICANT BUSINESS CONCENTRATIONS AND RISK**





**Major
      Customers**





Our
      revenues are derived from a diverse group of customers primarily involved in
      the
      sale of leather crafts. While no single customer accounts for more than 10%
      of
      our consolidated revenues in 2005, 2004 and 2003, sales to our five largest
      customers represented 9.38%, 10.6% and 13.8%, respectively, of consolidated
      revenues in those years. While we do not believe the loss of one of these
      customers would have a significant negative impact on our operations, we do
      believe the loss of several of these customers simultaneously or a substantial
      reduction in sales generated by them could temporarily affect our operating
      results.





**Major
      Vendors**





We
      purchase a significant portion of our inventory through one supplier. Due to
      the
      number of alternative sources of supply, loss of this supplier would not have
      an
      adverse impact on our operations.





**Credit
      Risk**





Due
      to
      the large number of customers comprising our customer base, concentrations
      of
      credit risk with respect to customer receivables are limited. At December 31,
      2005 and 2004, 21.9% and 16.3%, respectively, of our consolidated accounts
      receivable were due from three nationally recognized retail chains. We do not
      generally require collateral for accounts receivable, but we do perform periodic
      credit evaluations of our customers and believe the allowance for doubtful
      accounts is adequate. It is our opinion that if any one or a group of customer
      receivable balances should be deemed uncollectable, it would not have a material
      adverse effect on our results of operations and financial
      condition.





We
      maintain our cash in bank deposit accounts that, at times, may exceed federally
      insured limits. We have not experienced any losses in such accounts. We believe
      we are not exposed to any significant credit risk on our cash and cash
      equivalents.





**11.
      STOCKHOLDERS' EQUITY**





**(a)**
            **Stock
                Option Plans**


***1995
                  Stock Option Plan***In
                  connection with the 1995 Stock Option Plan for officers and key
                  management
                  employees, we have outstanding options to purchase our common stock.
                  The
                  plan provides for the granting of either qualified incentive stock
                  options
                  or non-qualified options at the discretion of the Compensation
                  Committee
                  of the Board of Directors. Options are granted at the fair market
                  value of
                  the underlying common stock at the date of grant and vest over
                  a five-year
                  period. We have reserved 1,000,000 shares of common stock for issuance
                  under this plan.***1995
                  Director Non-Qualified Stock Option Plan***In
                  connection with the 1995 Director Non-qualified Stock Option Plan
                  for
                  non-employee directors, we have outstanding options to purchase
                  our common
                  stock. The plan provides for the granting of non-qualified options
                  at the
                  discretion of the Compensation Committee of the Board of Directors.
                  Options are granted at the fair market value of the underlying
                  common
                  stock at the date of grant and vest after six months. We have reserved
                  100,000 shares of common stock for issuance under this plan.***Stock
                  Option Summary***All
                  options expire ten years from the date of grant and are exercisable
                  at any
                  time after vesting. Of the combined 1,100,000 shares available
                  for
                  issuance under the two plans, at December 31, 2005, 2004 and 2003,
                  there
                  were 44,000, 40,000, and 58,000, respectively, in un-optioned shares
                  available for future grants.


A summary
      of stock option transactions for the years ended December 31, 2005, 2004, and
      2003, is as follows:





**2005**
            ****
            **2004**
            ****
            **2003**Weighted
            
            
            
            Weighted
            
            
            
            WeightedAverage
            
            
            
            Average
            
            
            
            AverageOption
            
            Exercise
            
            Option
            
            Exercise
            
            Option
            
            ExerciseShares
            
            Price
            
            Shares
            
            Price
            
            Shares
            
            PriceOutstanding
                at January 1
            
            602,500
            
            $1.630
            
            675,200
            
            $1.540
            
            747,200
            
            $1.196Granted
            
            8,000
            
            4.960
            
            18,000
            
            3.598
            
            68,000
            
            4.200Forfeited
                or expired
            
            (12,000)
            
            1.350
            
            (18,000)
            
            1.350
            
            (2,000)
            
            2.720Exchanged
            
            -
            
            -
            
            -
            
            -
            
            -
            
            -Exercised
            
            (177,500)
            
            1.081
            
            (72,700)
            
            1.053
            
            (138,000)
            
            0.972Outstanding
                at December 31
            
            421,000
            
            $1.930
            
            602,500
            
            $1.630
            
            675,200
            
            $1.540Exercisable
                at end of year
            
            295,000
            
            $1.670
            
            354,500
            
            $1.320
            
            308,200
            
            $1.158Weighted-average
                fair value ofoptions
                granted during year
            
            $1.48
            
            
            
            $1.20
            
            
            
            $2.31





The
      following table summarizes outstanding options into groups based upon exercise
      price ranges at December 31, 2005:





**Options
                Outstanding**
            ****
            **Options
                Exercisable**Weighted
            
            Weighted
            
            
            
            Weighted
            
            WeightedAverage
            
            Average
            
            
            
            Average
            
            AverageOption
            
            Exercise
            
            Maturity
            
            Option
            
            Exercise
            
            MaturityExercise
                Price Range
            
            Shares
            
            Price
            
            (Years)
            
            Shares
            
            Price
            
            (Years)$0.75
                or Less
            
            4,000
            
            $0.595
            
            3.24
            
            14,000
            
            $0.595
            
            3.24$0.76
                to $1.125
            
            52,000
            
            $0.942
            
            4.70
            
            52,000
            
            $0.942
            
            4.70$1.126
                to $1.69
            
            267,000
            
            $1.350
            
            5.40
            
            193,000
            
            $1.350
            
            5.40$1.70
                to $2.55
            
            2,000
            
            $1.900
            
            5.74
            
            2,000
            
            $1.900
            
            5.74$2.56
                to $3.84
            
            12,000
            
            $3.270
            
            8.31
            
            4,000
            
            $3.050
            
            7.68$3.85-$4.96
            
            84,000
            
            $4.241
            
            8.01
            
            40,000
            
            $4.098
            
            7.93421,000
            
            $1.930
            
            5.90
            
            295,000
            
            $1.670
            
            5.62








**(b)**
            **Warrants**





Warrants
      to acquire up to 100,000 shares of common stock at $3.10 per share were issued
      in conjunction with a consulting agreement to an unrelated entity in February
      2003. The warrants may be exercised at anytime until expiration on February
      12,
      2008.





Warrants
      to acquire up to 50,000 shares of common stock at $5.00 per share were issued
      in
      conjunction with a consulting agreement to an unrelated entity in February
      2004.
      The warrants may be exercised at anytime until expiration on February 24, 2009.





A
      summary
      of warrant transactions for the years ended December 31, 2005, 2004, and 2003,
      is as follows:





**2005**
            ****
            **2004**
            ****
            **2003**Weighted
            
            
            
            Weighted
            
            
            
            WeightedAverage
            
            
            
            Average
            
            
            
            AverageOption
            
            Exercise
            
            Option
            
            Exercise
            
            Option
            
            ExerciseShares
            
            Price
            
            Shares
            
            Price
            
            Shares
            
            PriceOutstanding
                at January 1
            
            150,000
            
            3.7333
            
            100,000
            
            3.1000
            
            200,000
            
            .4375Granted
            
            -
            
            -
            
            50,000
            
            5.0000
            
            100,000
            
            3.1000Forfeited
                or expired
            
            -
            
            -
            
            -
            
            -
            
            -
            
            -Exchanged
            
            -
            
            -
            
            -
            
            -
            
            -
            
            -Exercised
            
            (10,000)
            
            3.1000
            
            -
            
            -
            
            (200,000)
            
            .4375Outstanding
                at December 31
            
            140,000
            
            3.7786
            
            150,000
            
            3.7333
            
            100,000
            
            3.1000Exercisable
                at end of year
            
            140,000
            
            3.7786
            
            150,000
            
            3.7333
            
            100,000
            
            3.1000Weighted-average
                fair value ofwarrants
                granted during year
            
            -
            
            
            
            $
                0.98
            
            
            
            $
                0.67





The
      following table summarizes outstanding warrants into groups based upon exercise
      price ranges at December 31, 2005:


**Warrants
                  Outstanding**
              ****
              **Warrants
                  Exercisable**Weighted
              
              Weighted
              
              
              
              Weighted
              
              WeightedAverage
              
              Average
              
              
              
              Average
              
              AverageExercise
              
              Maturity
              
              
              
              Exercise
              
              MaturityExercise
                  Price Range
              
              Warrant
              
              Price
              
              (Years)
              
              Warrant
              
              Price
              
              (Years)$3.00
                  or Less
              
              -
              
              -
              
              -
              
              -
              
              -
              
              -More
                  than $3.00 andLess
                  Than $5.00
              
              90,000
              
              $3.1000
              
              2.12
              
              90,000
              
              $3.1000
              
              2.12$5.00
                  or More
              
              50,000
              
              $5.0000
              
              3.15
              
              50,000
              
              $5.0000
              
              3.15140,000
              
              $3.7786
              
              2.49
              
              140,000
              
              $3.7786
              
              2.49







**12.
      BUSINESS ACQUISITIONS**





During
      2004, we acquired certain assets of the following entities for a total purchase
      price of $156,452:





**Entity**
            **Location**
            **Date
                of acquisition**Robyn's
                LLC
            Syracuse,
                NY
            January
                2004Hawkins
                Handcrafted Leathers
            St.
                Louis, MO
            February
                2004Santa
                Fe Hides & Trappings
            Santa
                Fe, NM
            July
                2004





All
      of
      the acquired entities were formerly operated as independent retail leathercraft
      stores. The assets purchased in these acquisitions consisted primarily of
      inventory, store furniture and fixtures, and equipment. Goodwill recognized
      in
      these transactions amounted to $30,577, and is reported in the Retail
      Leathercraft segment. We also entered into non-compete agreements with the
      former owners totaling $26,000 for periods ranging from one to five
      years.





On
      November 30, 2004, we acquired all of the issued and outstanding shares of
      capital stock of 1124055 Ontario Inc., a Canadian corporation, and its
      wholly-owned subsidiary, Heritan Ltd. The total purchase price was approximately
      $400,000 which was funded with cash generated from operations. For financial
      reporting purposes, the transaction was accounted for under the purchase method,
      effective December 1, 2004.





**13.
      SEGMENT INFORMATION**





We
      identify our segments based on the activities of three distinct operations:





·
            **Wholesale
                Leathercraft**,
                which consists of a chain of warehouse distribution units operating
                under
                the name,*The
                Leather Factory*,
                located in the United States and Canada;


·
            **Retail
                Leathercraft,**which consists of a chain of retail stores operating under the name,*Tandy
                Leather Company*,
                located in the United States and Canada;
                and


·
            **Other**,
                which is a manufacturer of decorative hat trims sold directly to
                hat
                manufacturers.





Our
      reportable operating segments have been determined as separately identifiable
      business units. We measure segment earnings as operating earnings, defined
      as
      income before interest and income taxes.





**Wholesale
                Leathercraft**
            **RetailLeathercraft**
            **Other**
            **Total**For
                the year ended December 31, 2005Net
                Sales
            $31,046,268
            $18,023,214
            $1,650,092
            $50,719,574Gross
                Profit
            17,152,549
            11,142,350
            460,145
            28,755,044Operating
                earnings
            3,721,891
            1,766,960
            84,560
            5,573,411Interest
                expense
            (3,188)
            -
            -
            (3,188)Other,
                net
            126,040
            11,650
            -
            137,690Income
                before income taxes
            3,844,743
            1,778,610
            84,560
            5,707,913Depreciation
                and amortization
            323,881
            125,493
            7,332
            456,706Fixed
                asset additions
            131,603
            136,630
            4,593
            272,826Total
                assets
            $20,999,477
            $3,896,291
            $784,705
            $25,680,473For
                the year ended December 31, 2004Net
                Sales
            $30,630,122
            $13,515,662
            $2,000,500
            $46,146,284Gross
                Profit
            16,485,052
            8,348,616
            606,377
            25,440,045Operating
                earnings
            3,013,316
            1,210,566
            34,564
            4,258,446Interest
                expense
            53,400
            -
            -
            53,400Other,
                net
            (6,748)
            (1,852)
            -
            (8,600)Income
                before income taxes
            2,966,664
            1,212,418
            34,564
            4,213,646Depreciation
                and amortization
            363,878
            80,045
            8,730
            452,653Fixed
                asset additions
            226,095
            127,086
            16,378
            369,559Total
                assets
            $17,991,403
            $3,372,812
            $802,918
            $22,167,163For
                the year ended December 31, 2003Net
                Sales
            $30,684,092
            $9,216,838
            $1,811,261
            $41,712,191Gross
                Profit
            16,332,776
            5,804,504
            554,619
            22,691,899Operating
                earnings
            3,462,457
            604,291
            30,911
            4,097,659Interest
                expense
            206,942
            -
            -
            206,942Other,
                net
            (81,838)
            65
            -
            (81,773)Income
                before income taxes
            3,337,354
            604,225
            30,911
            3,972,490Depreciation
                and amortization
            443,623
            75,854
            9,785
            529,262Fixed
                asset additions
            214,256
            137,115
            8,831
            360,202Total
                assets
            $15,409,084
            $2,908,429
            $740,893
            $19,058,406





Net
      sales
      for geographic areas was as follows:


**2005**
            **2004**
            **2003**United
                States
            $45,492,215
            $42,485,339
            $38,934,923Canada
            3,643,133
            2,112,601
            1,611,093All
                other countries
            1,584,226
            1,548,344
            1,166,175$50,719,574
            $46,146,284
            $41,712,191





Geographic
      sales information is based on the location of the customer. Net sales from
      no
      single foreign country was material to our consolidated net sales for the years
      ended December 31, 2005, 2004, and 2003. We do not have any significant
      long-lived assets outside of the United States.





**14.
      RECENT ACCOUNTING PRONOUNCEMENTS**





In
      December 2004, the Financial Accounting Standards Board ("FASB") issued
      Statement of Financial Accounting Standards ("SFAS") No. 123R, "Share-Based
      Payment," a revision of SFAS 123, Accounting for Stock Based Compensation."
      Among other items, SFAS No. 123R eliminates the use of APB 25 and the intrinsic
      value method of accounting, and requires companies to recognize the cost of
      employee services received in exchange for awards of equity instruments, based
      on the grant date fair value of those awards, in the financial statements.
      We
      adopted SFAAS No. 123R on January 1, 2006 using the modified prospective method.
      Under this method, compensation cost is recognized in the financial statements
      beginning with the effective date, based on the requirements of SFAS No. 123R
      for all share-based payments granted after that date, and based on the
      requirements of SFAS No. 123 for all unvested awards granted prior to the
      effective date of SFAS No. 123R. We expect that the adoption of SFAS No. 123R
      will reduce our fiscal 2006 operating income by approximately $105,000 based
      on
      the number of unvested options at the beginning of the year, excluding any
      that
      might be granted in 2006.





SFAS
      123R
      also requires that the benefits associated with the tax deductions in excess
      of
      recognized compensation cost be reported as a financing cash flow, rather than
      as an operating cash flow as required under current literature. This requirement
      will reduce net operating cash flows and increase net financial cash flows
      in
      periods after the effective date. These future amounts cannot be estimated,
      because they depend on, among other things, when employees exercise stock
      options.





In
      November 2004, the FASB issued SFAS 151, “Inventory Costs, an amendment of ARB
      No. 43, Chapter 4.” SFAS 151 clarifies that abnormal inventory costs such as
      costs of idle facilities, excess freight and handling costs, and wasted
      materials (spoilage) are required to be recognized as current period charges.
      The provisions of SFAS 151 become effective for annual periods beginning after
      June 15, 2005. We do not expect the adoption of SFAS 151 to have any impact
      on
      our consolidated financial statements.





**15.
      QUARTERLY FINANCIAL DATA (UNAUDITED)**





**First**
            **Second**
            **Third**
            **Fourth****2005**
            ****
            **Quarter**
            **Quarter**
            **Quarter**
            **Quarter**Net
                sales
            
            $12,707,516
            $12,181,699
            $11,777,133
            $14,053,226Gross
                profit
            
            7,157,283
            6,899,872
            6,763,802
            7,934,087Net
                income
            
            1,049,222
            787,669
            696,090
            1,180,733Net
                income per common share:Basic
            
            0,10
            0.07
            0.07
            0.11Diluted
            
            0.10
            0.07
            0.06
            0.11Weighted
                average number of common shares outstanding:Basic
            
            10,584,244
            10,615,802
            10,679,389
            10,735,702Diluted
            
            10,911,103
            10,955,282
            11,029,840
            11,047,426





**First**
            **Second**
            **Third**
            **Fourth****2004**
            ****
            **Quarter**
            **Quarter**
            **Quarter**
            **Quarter**Net
                sales
            
            $12,180,877
            $10,959,813
            $10,580,074
            $12,425,520Gross
                profit
            
            6,724,913
            5,981,059
            5,939,433
            6,794,640Net
                income
            
            970,966
            516,213
            427,385
            739,477Net
                income per common share:Basic
            
            0.09
            0.05
            0.04
            0.07Diluted
            
            0.09
            0.05
            0.04
            0.07Weighted
                average number of common shares outstanding:Basic
            
            10,506,995
            10,553,243
            10,560,661
            10,554,776Diluted
            
            11,011,122
            11,006,638
            10,931,940
            10,888,883














**REPORT
      OF INDEPENDENT
      REGISTERED**


**PUBLIC
      ACCOUNTING FIRM**











To
      the
      Board of Directors and Stockholders


Tandy
      Leather Factory, Inc. and Subsidiaries








We
      have
      audited the accompanying consolidated balance sheets of Tandy Leather Factory,
      Inc. and Subsidiaries (the Company) as of December 31, 2005 and 2004, and the
      related consolidated statements of income, stockholders’ equity and cash flows
      for each of the years in the three-year period ended December 31, 2005. These
      financial statements are the responsibility of the Company’s management. Our
      responsibility is to express an opinion on these financial statements based
      on
      our audits.




We
      conducted our audits in accordance with the standards of the Public Accounting
      Oversight Board (United States). Those standards require that we plan and
      perform the audit to obtain reasonable assurance about whether the financial
      statements are free of material misstatement. The Company is not required to
      have, nor were we engaged to perform, an audit of its internal control over
      financial reporting. Our audit included consideration of internal control over
      financial reporting as a basis for designing audit procedures that are
      appropriate in the circumstances, but not for the purpose of expressing an
      opinion on the effectiveness of the Company’s internal control over financial
      reporting. Accordingly, we express no such opinion. An audit also includes
      examining, on a test basis, evidence supporting the amounts and disclosures
      in
      the financial statements. An audit also includes assessing the accounting
      principles used and significant estimates made by management, as well as
      evaluating the overall financial statement presentation. We believe that our
      audits provide a reasonable basis for our opinion.





In
      our
      opinion, the financial statements referred to above present fairly, in all
      material respects, the consolidated financial position of the Company as of
      December 31, 2005, 2004 and 2003 and the consolidated results of its operations
      and its cash flows for each of the years in the three-year period ended December
      31, 2005, in conformity with accounting principles generally accepted in the
      United States of America.











WEAVER
      AND TIDWELL, L.L.P.





Fort
      Worth, Texas


February
      24, 2006





**ITEM
      9. CHANGE IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND FINANCIAL
      DISCLOSURE**





None





**ITEM
      9A. CONTROLS AND PROCEDURES**


At
        the
        end of 2005, our President, Chief Executive Officer and Chief Financial Officer
        evaluated the effectiveness of the design and operation of our disclosure
        controls and procedures pursuant to Rule 13a-15(b) under the Securities Exchange
        Act of 1934, as amended. Based upon this evaluation, they concluded that,
        subject to the limitations described below, our disclosure controls and
        procedures offer reasonable assurance that the information required to be
        disclosed by us in the reports we file under the Exchange Act is recorded,
        processed, summarized, and reported within the time periods specified in
        the
        rules and forms adopted by the Securities and Exchange Commission.
 
 During
        the period covered by this report, there has been no change in our internal
        controls over financial reporting that materially affected, or is reasonably
        likely to materially affect, these controls.
 
 *Limitations
        on the Effectiveness of Controls.* Our
        management, including the President, Chief Executive Officer and Chief Financial
        Officer, does not expect that our disclosure controls and procedures will
        prevent all error and all fraud. A well conceived and operated control system
        is
        based in part upon assumptions about the likelihood of future events and
        can
        provide only reasonable, not absolute, assurance that the objectives of the
        control system are met. Further, the design of a control system must reflect
        the
        fact that there are resource constraints, and the benefits of controls must
        be
        considered relative to their costs.
 
 **ITEM
        9B. OTHER INFORMATION**
 
 None
 
 **PART
        III**
 
 Certain
        information required by Part III is omitted from this annual report as we
        will
        file a proxy statement for our 2006 Annual Meeting of Stockholders, pursuant
        to
        Regulation 14A of the Securities Exchange Act of 1934, as amended, not later
        than 120 days after the end of our fiscal year covered by this Report, and
        certain information included in that proxy statement is incorporated herein
        by
        reference.
 
 **ITEM
        10. DIRECTORS AND EXECUTIVE OFFICERS OF THE REGISTRANT**
 
 The
        information required by this item is contained under the heading "Executive
        Officers of the Registrant" in Part I of this Annual Report on Form 10-K,
        and
        the remainder is contained in our proxy statement for our 2006 Annual Meeting
        of
        Stockholders under the heading "Election of Directors," and is incorporated
        herein by reference. Information relating to filings on Forms 3, 4 and 5
        will be
        contained in our 2006 proxy statement under the heading "Section 16(a)
        Beneficial Ownership Reporting Compliance," and is incorporated herein by
        reference. Information required by this item pursuant to Items 401(h), 401(i)
        and 401(j) of Regulation S-K relating to an audit committee financial expert,
        the identification of the audit committee of our board of directors and
        procedures of security holders to recommend nominees to our board of directors
        will be contained in our 2006 proxy statement under the heading "Corporate
        Governance" and is incorporated herein by reference.
 
 We
        have
        adopted a written code of ethics that applies to our employees, including
        our
        principal executive officer, principal financial officer, principal accounting
        officer, controller, or persons performing similar functions.  It is
        available on our website (http://www.leatherfactory.com).
 
 **ITEM
        11. EXECUTIVE COMPENSATION**
 
 The
        information required by this item is contained in our proxy statement for
        our
        2006 Annual Meeting of Stockholders under the heading "Report of the
        Compensation Committee,” which is incorporated herein by reference.
 
 **ITEM
        12. SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT AND RELATED
        STOCKHOLDER MATTERS**
 
 The
        information required by this item is contained in our proxy statement for
        our
        2006 Annual Meeting of Stockholders under the headings "Stock Ownership by
        Directors and Executive Officers” and “Principal Holders of Stock,” which is
        incorporated herein by reference.
 
 **ITEM
        13. CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS**
  The
          information required by this item is contained in our proxy statement for
          our
          2006 Annual Meeting of Stockholders under the heading " Other
          Relationships Involving Directors, Executive Officers, or their Associates” and is
          incorporated herein by reference.
  **ITEM
        14. PRINCIPAL ACCOUNTANT FEES AND SERVICES**
 
 The
        information required by this item is contained in our proxy statement for
        our
        2006 Annual Meeting of Stockholders under the headings "Audit Committee” and
“Report of the Audit Committee” and is incorporated herein by
        reference.
 
 **PART
        IV**
 
 **ITEM
        15. EXHIBITS AND FINANCIAL STATEMENT SCHEDULES**




The
      following are filed as part of this Annual Report on Form 10-K:





*1.
      Financial Statements*





The
      following consolidated financial statements are included in Item 8:





·
            Consolidated
                Balance Sheets at December 31, 2005 and
                2004


·
            Consolidated
                Statements of Income for the years ended December 31, 2005, 2004
                and
                2003


·
            Consolidated
                Statements of Cash Flows for the years ended December 31, 2005, 2004
                and
                2003


·
            Consolidated
                Statements of Stockholders' Equity for the years ended December 31,
                2005,
                2004 and 2003





*2.
      Financial Statement Schedules*





All
      financial statement schedules are omitted because the required information
      is
      not present or not present in sufficient amounts to require submission of the
      schedule or because the information is reflected in the consolidated financial
      statements or notes thereto.





*3.
      Exhibits*





The
      exhibits listed in the Exhibit Index immediately preceding such exhibits are
      filed as part of this Annual Report on Form 10-K.





**SIGNATURES**





Pursuant
      to the requirements of Section 13 or 15(d) of the Securities Exchange Act of
      1934, the Registrant has duly caused this Annual Report on Form 10-K to be
      signed on its behalf by the undersigned, thereunto duly authorized.





**TANDY
      LEATHER FACTORY, INC.**


By: /s/
      Wray Thompson


**Wray
      Thompson**


**Chairman
      of the Board
      and Chief Executive Officer**





By: /s/
      Shannon L. Greene


**Shannon
      L.
      Greene**


**Chief
      Financial
      Officer, Chief Accounting Officer and Treasurer**


Dated:
      March 27, 2006





In
      accordance with the Securities Exchange Act of 1934, this Report has been signed
      below by the following persons on behalf of Tandy Leather Factory, Inc. and
      in the capacities and on the dates indicated.





**Signature**
            **Title**
            **Date**/s/
                Wray Thompson
            Chairman
                of the Board, Chief Executive Officer and Director
            March
                27, 2006**Wray
                Thompson**/s/
                Shannon L. Greene
            Chief
                Financial Officer, Chief Accounting Officer, Treasurer and
                Director
            March
                27, 2006**Shannon
                L. Greene**/s/
                T. Field Lange
            Director
            March
                27, 2006**T.
                Field Lange**/s/
                Joseph R. Mannes
            Director
            March
                27, 2006**Joseph
                R. Mannes**/s/
                H.W. Markwardt
            Director
            March
                27, 2006**H.W.
                Markwardt**/s/
                Michael A. Markwardt
            Director
            March
                27, 2006**Michael
                A. Markwardt**/s/
                Ronald C. Morgan
            President
                and Director
            March
                27, 2006**Ronald
                C. Morgan**/s/
                Robin L. Morgan
            Vice
                President and Assistant Secretary
            March
                27, 2006**Robin
                L. Morgan**/s/
                Michael A. Nery
            Director
            March
                27, 2006**Michael
                A. Nery**/s/
                William M. Warren
            Secretary
            March
                27, 2006**William
                M. Warren**








**TANDY
                  LEATHER FACTORY, INC. AND SUBSIDIARIES**
                **EXHIBIT
                  INDEX****Exhibit**
                **Number**
              ******Description**3.1
              Certificate
                  of Incorporation of The Leather Factory, Inc., and Certificate
                  of
                  Amendment to Certificate of Incorporation of The Leather Factory,
                  Inc.
                  filed as Exhibit 3.1 to Form 10-Q filed by Tandy Leather Factory,
                  Inc.
                  with the Securities and Exchange Commission on August 12, 2005
                  and
                  incorporated by reference herein.3.2
              Bylaws
                  of The Leather Factory, Inc., filed as Exhibit 3.2 to the Registration
                  Statement on Form SB-2 of The Leather Factory, Inc. (Commission
                  File No.
                  33-81132) filed with the Securities and Exchange Commission on
                  July 5,
                  1994 and incorporated by reference herein.4.1
              Financial
                  Advisor's Warrant Agreement, dated February 12, 2003, between The
                  Leather
                  Factory, Inc. and Westminster Securities Corporation filed as Exhibit
                  4.1
                  to Form 10-Q filed by The Leather Factory, Inc. with the Securities
                  and
                  Exchange Commission on May 14, 2003 and incorporated by reference
                  herein.4.2
              Financial
                  Advisor’s Warrant Agreement, dated February 24, 2004, between The Leather
                  Factory, Inc. and Westminster Securities Corporation filed as Exhibit
                  4.1
                  to Form 10-Q filed by The Leather Factory, Inc. with the Securities
                  and
                  Exchange Commission on May 14, 2004 and incorporated by reference
                  herein.4.3
              Capital
                  Markets Services Engagement Agreement, dated February 24, 2004,
                  between
                  The Leather Factory, Inc. and Westminster Securities Corporation
                  filed as
                  Exhibit 4.2 to Form 10-Q filed by The Leather Factory, Inc. with
                  the
                  Securities and Exchange Commission on May 14, 2004 and incorporated
                  by
                  reference herein.10.1
              Credit
                  Agreement, dated as of October 6, 2004, made by The Leather Factory,
                  Inc.,
                  a Delaware corporation, and Bank One, National Association, filed
                  as
                  Exhibit 10.1 to the Current Report on Form 8-K of The Leather Factory,
                  Inc. (Commission File No. 1-12368) filed with the Securities and
                  Exchange
                  Commission on November 5, 2004 and incorporated by reference
                  herein.10.2
              Line
                  of Credit Note, dated October 6, 2004, in the principal amount
                  of up to
                  $3,000,000 given by The Leather Factory, Inc., a Delaware corporation
                  as
                  borrower, payable to the order of Bank One, National Association,
                  filed as
                  Exhibit 10.2 to the Current Report on Form 8-K of The Leather Factory,
                  Inc. (Commission File No. 1-12368) filed with the Securities and
                  Exchange
                  Commission on November 5, 2004 and incorporated by reference
                  herein.14.1
              Code
                  of Business Conduct and Ethics of The Leather Factory, Inc., adopted
                  by
                  the Board of Directors on February 26, 2004, filed as Exhibit 14.1
                  to the
                  Annual Report on Form 10-K of The Leather Factory, Inc. (Commission
                  File
                  No. 1-12368) filed with the Securities and Exchange Commission
                  on March
                  29, 2004 and incorporated by reference herein.21.1
              Subsidiaries
                  of Tandy Leather Factory, Inc. filed as Exhibit 21.1 to the Annual
                  Report
                  on Form 10-K of The Leather Factory, Inc. for the year ended December
                  31,
                  2002 filed with the Securities and Exchange Commission on March
                  28, 2003,
                  and incorporated by reference herein.*23.1
              Consent
                  of Weaver & Tidwell LLP dated March 27, 2006*31.1
              13a-14(a)
                  Certification by Wray Thompson, Chairman of the Board and Chief
                  Executive
                  Officer*31.2
              13a-14(a)
                  Certification by Shannon Greene, Chief Financial Officer and
                  Treasurer*32.1
              Certification
                  Pursuant to 18 U.S.C. Section 1350, as Adopted Pursuant to Section
                  906 of
                  the Sarbanes-Oxley Act of 2002______________*Filed
                  herewith.