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UNITED STATES

SECURITIES AND EXCHANGE COMMISSION

WASHINGTON, DC 20549



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FORM 10-K/A

Amendment No. 1



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FOR ANNUAL AND TRANSITION REPORTS

PURSUANT TO SECTIONS 13 OR 15(d) OF THE

SECURITIES EXCHANGE ACT OF 1934



|x | ANNUAL REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934
|- | ------------------------------------------------------------------------------------



For the fiscal year ended December 31, 2004



| ̈ | TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934
|- | ----------------------------------------------------------------------------------------



For the transition period from              to



Commission file number 0-32613



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EXCELLIGENCE LEARNING CORPORATION

(Exact Name of Registrant as Specified in Its Charter)



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|                                                               |  |                                     
|-------------------------------------------------------------- |  | ------------------------------------
|Delaware                                                       |  | 77-0559897                          
|(State or Other Jurisdiction of Incorporation or Organization) |  | (I.R.S. Employer Identification No.)
|                                                               | 
|2 Lower Ragsdale Drive                                         |  |                                     
|Monterey, CA                                                   |  | 93940                               
|(Address of Principal Executive Offices)                       |  | (Zip Code)                          



Registrants
telephone number, including area code: (831) 333-2000



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

None



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

Common Stock, par value $.01 per share

(Title of Class)



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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. ̈



Indicate by check mark whether the registrant is an accelerated filer (as defined in Exchange Act Rule
12b-2).    Yes ̈No  x



The aggregate market value of the voting stock held by non-affiliates of the
registrant, based on the average high and low prices of the common stock on The Nasdaq SmallCap Market of $5.81 on June 30, 2004, the last business day of the registrants most recently completed second fiscal quarter, was approximately
$18,739,574. As of March 14, 2005, there were 8,935,124 shares of the registrants common stock outstanding.



Documents Incorporated by Reference



Certain portions of the registrants proxy statement to be filed with the Securities and Exchange Commission pursuant to Regulation 14A not later
than 120 days after the close of the registrants 2004 fiscal year are incorporated by reference in Part III hereof.



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EXPLANATORY NOTE



Due to the matters discussed below and as previously announced, Excelligence Learning Corporation (the Company)
is restating its previously issued financial statements for the fiscal year ended December 31, 2004. Accordingly, the Company is amending this annual report on Form 10-K to restate its consolidated financial statements for the fiscal year ended
December 31, 2004 and the related disclosures. Item 6 of this Form 10-K/A also includes the restatement of selected financial data as of and for the year ended December 31, 2004. Please also refer to Item 9.A Controls and
Procedures, and Note 3 to the consolidated financial statements included in Item 15  Exhibits and Financial Statement Schedules for a further discussion of the restatement.



On August 12, 2005, the Company announced a delay in the filing of its
Form 10-Q for the three and six months ended June 30, 2005 pending the completion of an internal investigation of allegations by current and former accounting personnel that the Company had failed to record and accrue for certain obligations
for the fiscal year ended December 31, 2004. The Companys Audit Committee retained independent legal counsel to lead the internal investigation and to direct forensic accounting consultants retained to assist in the investigation. On
September 7, 2005, after considering the results of the investigation, the Company determined that certain liabilities related to inventory, catalog costs, and certain operating expenses were understated at December 31, 2004. The Company
concluded that adjusting the effect of these items would be material to its previously reported results for fiscal year 2004 and the first quarter of 2005. Therefore, the Company is restating its previously issued financial statements for such year
as set forth in this Form 10-K/A and is restating its previously issued financial statements for such quarter in its Form 10-Q/A, hereafter to be filed with the Securities and Exchange Commission (the Commission). No other fiscal periods
prior to the fiscal year ended December 31, 2004 are affected by this restatement, as the issues identified do not have any significant impact on those periods. On November 14, 2005, the Company also announced a delay in filing its Form
10-Q for the three and nine months ended September 30, 2005 pending the completion of this restatement.



The Company determined that this restatement is attributable to a number of factors. The most significant factor was the Companys failure to timely
pay or accrue its obligations for certain invoices for inventory on hand as of year end. The Company determined, based upon the results of its internal investigation, that its accrual for accounts payable for inventory did not include certain
inventory items that had been received but had not been paid for by the Company prior to the end of fiscal 2004. As a result of the in-depth review procedures performed by the Company, the forensic accountants and its registered independent public
accountants, certain additional accounting errors were identified relating to 2004 which are also reflected in the restatement. Those additional errors included an understatement of costs capitalized into inventory, an understatement of the
provision for sales returns, an understatement of certain selling, general and administrative expenses, an understatement of expense for deferred compensation amounts relating to previously issued stock options, and an understatement of income taxes
related to stock option exercises.



The impact on previously
reported operating income as a result of corrections to the accounting for the aforementioned accruals, excluding the related tax effects, is a decrease to operating income of $975,000 for the fiscal year ended December 31, 2004. The
adjustments also increase previously reported total liabilities of $6.3 million at December 31, 2004 by approximately $1.5 million, and increase previously reported total assets of $48.7 million by approximately $1.3 million. The cumulative
effect of the identified items for the year ended December 31, 2004 results in a decrease to net income of $677,000, and a decrease in the Companys previously reported equity of $336,000. As a result of the restatement, the Companys
basic and diluted earnings per share for the fiscal year ended December 31, 2004 is reduced by $0.07 and $0.08 per share, respectively.



Certain elements of the adjustments consist of accruals relating to fiscal year 2004 that were not recorded until fiscal year 2005. Adjusting the timing
of when these accruals were recorded decreases the Companys previously reported operating (pre-tax) loss for the quarter ended March 31, 2005, as described in the Companys Form 10-Q/A for that fiscal quarter, hereafter to be filed
with the Commission.



The staff in the Division of Enforcement
in the San Francisco District Office of the Commission informed the Company in October 2005 that it was conducting an informal inquiry into the Companys restatement and related circumstances. At that time, the staff requested that the Company
preserve certain documents related to this inquiry and provide on a voluntary basis certain documents to the staff for its review. The Company has cooperated with the informal inquiry and provided documents and information in response to the
staffs requests. The staff obtained a non-public formal order of investigation from the Commission, in January 2006. The Company intends to continue to cooperate with the staff and Commission in connection with the formal investigation.



Except as discussed above, in this Form 10-K/A, the Company
has not modified or updated disclosures presented in its 2004 annual report on Form 10-K filed on March 16, 2005. Accordingly, this Form 10-K/A does not reflect events occurring after the filing of the Companys original Form 10-K or
modify or update those disclosures made at the time of the original filing of the Form 10-K on March 16, 2005. This Form 10-K/A should be read in conjunction with the Companys filings made with the



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Commission subsequent to the filing of the original Form 10-K, including any amendments to those filings. Only the
following items have been amended as a result of the restatement:



| |  | Part II  Item 6  Selected Financial Data;
|- |  | -------------------------------------------



| |  | Part II  Item 7  Managements Discussion and Analysis of Financial Condition and Results of Operations;
|- |  | ---------------------------------------------------------------------------------------------------------



| |  | Part II  Item 9A Controls and Procedures; and
|- |  | -----------------------------------------------



| |  | Part IV  Item 15  Exhibits and Financial Statements Schedules.
|- |  | ----------------------------------------------------------------



Please refer to Note 3 to the accompanying consolidated financial statements for additional information on the restatement.



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EXCELLIGENCE LEARNING CORPORATION



TABLE OF CONTENTS



|                                           |  |                                                                                                              |  |   
|------------------------------------------ |  | ------------------------------------------------------------------------------------------------------------ |  | --
|                                           |  | Forward Looking Statements                                                                                  |  | 1 
|                                           |  |                                                                                                             
|PART I:                                    |  |                                                                                                              |  | 2 
|                                           |  |                                                                                                             
|Item 1.                                    |  | Business                                                                                                     |  | 2 
|Item 2.                                    |  | Properties                                                                                                   |  | 13
|Item 3.                                    |  | Legal Proceedings                                                                                            |  | 13
|Item 4.                                    |  | Submission of Matters to a Vote of Security Holders                                                          |  | 13
|                                           |  |                                                                                                             
|PART II:                                   |  |                                                                                                              |  | 14
|                                           |  |                                                                                                             
|Item 5.                                    |  | Market for Registrants Common Equity, Related Stockholder Matters and Issuer Purchases of Equity Securities |  | 14
|Item 6.                                    |  | Selected Financial Data                                                                                      |  | 14
|Item 7.                                    |  | Managements Discussion and Analysis of Financial Condition and Results of Operations                        |  | 16
|Item 7A.                                   |  | Quantitative and Qualitative Disclosures About Market Risk                                                   |  | 22
|Item 8.                                    |  | Financial Statements and Supplementary Data                                                                  |  | 23
|Item 9.                                    |  | Changes in and Disagreements With Accountants on Accounting and Financial Disclosure                         |  | 23
|Item 9A.                                   |  | Controls and Procedures                                                                                      |  | 23
|Item 9B.                                   |  | Other Information                                                                                            |  | 25
|                                           |  |                                                                                                             
|PART III:                                  |  |                                                                                                              |  | 26
|                                           |  |                                                                                                             
|Item 10.                                   |  | Directors and Executive Officers of the Registrant                                                           |  | 26
|Item 11.                                   |  | Executive Compensation                                                                                       |  | 26
|Item 12.                                   |  | Security Ownership of Certain Beneficial Owners and Management and Related Stockholder Matters               |  | 26
|Item 13.                                   |  | Certain Relationships and Related Transactions                                                               |  | 26
|Item 14.                                   |  | Principal Accountant Fees and Services                                                                       |  | 26
|                                           |  |                                                                                                             
|PART IV:                                   |  |                                                                                                              |  | 27
|                                           |  |                                                                                                             
|Item 15.                                   |  | Exhibits and Financial Statement Schedules                                                                   |  | 27
|                                           | 
|SIGNATURES                                 |  | 30                                                                                                          
|                                           | 
|INDEX TO CONSOLIDATED FINANCIAL STATEMENTS |  | F-1                                                                                                         



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Forward-Looking Statements



Certain information included in this Annual Report on Form 10-K/A and other materials filed or to be filed by the Company with the Securities and Exchange Commission (as well as information in oral statements and other written statements
made or to be made by the Company) contains forward-looking statements within the meaning of Section 27A of the Securities Act of 1933, as amended, and Section 21E of the Securities Exchange Act of 1934, as amended. The Private Securities
Litigation Reform Act of 1995 provides a safe harbor for forward-looking statements so long as those statements are identified as forward-looking and are accompanied by meaningful cautionary language noting important factors that could
cause actual results to differ materially from those projected in such statements. Such forward-looking statements involve risks and uncertainties that could significantly affect anticipated results in the future and include information relating to:



| |  | projections of net revenues and operating income;
|- |  | -------------------------------------------------



| |  | plans for future expansion and other business development activities, as well as other capital spending;
|- |  | --------------------------------------------------------------------------------------------------------



| |  | financing sources and the effects of regulation;
|- |  | ------------------------------------------------



| |  | competition;
|- |  | ------------



| |  | integration of acquired businesses;
|- |  | -----------------------------------



| |  | the outcome of pending legal proceedings; and
|- |  | ---------------------------------------------



| |  | protection of the Companys intellectual property.
|- |  | --------------------------------------------------



As such, actual results may vary materially from those projected, anticipated or indicated in any forward-looking statements. The Company has based its forward-looking
statements on current expectations and projections about future events and assumes no obligation to update publicly any forward-looking information that may be made by or on behalf of the Company in this Annual Report on Form 10-K/A or otherwise,
whether as a result of new information, future events or otherwise, except to the extent the Company is required to do so.



When used in this Annual Report on Form 10-K/A and in other statements made by or on behalf of the Company, the words believes,
anticipates, expects, plans, intends, expects, estimates, projects, could and other similar words or expressions, which are predictions of or indicative
of future events, conditions and trends, identify forward-looking statements. Such forward-looking statements are subject to a number of important risks, uncertainties and assumptions that could significantly affect anticipated results in the
future. These risks, uncertainties and assumptions about the Company and its subsidiaries include, but are not limited to, the following:



| |  | the Companys ability to diversify product offerings or expand in new and existing markets;
|- |  | -------------------------------------------------------------------------------------------



| |  | changes in general economic and business conditions and in the educational products, catalog or e-retailing industry in particular;
|- |  | -----------------------------------------------------------------------------------------------------------------------------------



| |  | the impact of competition, specifically, if competitors were to either adopt a more aggressive pricing strategy than the Company or develop a competing line of proprietary products;
|- |  | -------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------



| |  | the level of demand for the Companys products;
|- |  | -----------------------------------------------



| |  | fluctuations in currency exchange rates, which could potentially result in a weaker U.S. dollar in overseas markets, increasing the Companys cost of inventory purchased; and
|- |  | ------------------------------------------------------------------------------------------------------------------------------------------------------------------------------



| |  | other factors discussed in Item 1 under Risk Factors.
|- |  | -------------------------------------------------------



In light of these risks, uncertainties and assumptions, the forward-looking events discussed in this Annual Report on Form 10-K/A might not occur.



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PART I.



Item 1. Business.



General



Excelligence Learning Corporation, a Delaware corporation
(Excelligence or the Company), was formed on November 6, 2000 for the purpose of effecting the combination (the Combination) of Earlychildhood LLC, a California limited liability company
(Earlychildhood), and SmarterKids.com, Inc., a Delaware corporation (SmarterKids.com), which was completed on April 30, 2001. As more fully described herein, the Companys Early Childhood segment is conducted
primarily through its direct wholly-owned subsidiaries Earlychildhood and Marketing Logistics, Inc., a Minnesota corporation dba Early Childhood Manufacturers Direct (ECMD), and its Elementary School segment is conducted through
Educational Products, Inc. (EPI), a Texas corporation and a wholly-owned subsidiary of Earlychildhood.



The following discussion relates to the businesses of Excelligence, which are comprised primarily of the businesses conducted by Earlychildhood, ECMD and
EPI. For convenience, the terms Company, Excelligence, we, our and us are used in this report to refer to Excelligence and its subsidiaries collectively after giving effect to the
acquisition of SmarterKids.com in April 2001, unless the context requires these terms to refer to Excelligence individually.



Corporate Website



The Company makes available its annual reports on Form 10-K, quarterly reports on Form 10-Q, current reports on Form 8-K and amendments to those reports
on its corporate website, free of charge, to individuals interested in acquiring such reports. The reports can be accessed at www.excelligencelearning.com as soon as reasonably practicable after they are electronically filed with the
Securities and Exchange Commission (the Commission or SEC).



Company Overview



The Company is a developer,
manufacturer and retailer of educational products, which are sold to child care programs, preschools, elementary schools and consumers. The Company serves early childhood professionals, educators and consumers by providing quality educational
products and programs for children from infancy to 12 years of age. With its proprietary product offerings, a multi-channel distribution strategy and extensive management expertise, the Company aims to foster childrens early childhood and
elementary education.



During fiscal year 2004, the Company
operated in two business segments, Early Childhood and Elementary School, each of which is described below. Financial information, including revenues from external customers, a measure of profit or loss and total assets, for each segment of the
Company for each of the last three fiscal years is contained in the Companys financial statements listed on the accompanying Index to Consolidated Financial Statements, set forth on page F-1, which are incorporated herein by reference.



Early Childhood Segment. The Companys
Early Childhood segment includes the brand names Discount School Supply (DSS), ECMD and Earlychildhood NEWS. Through its Early Childhood segment, the Company develops, markets and sells educational products through multiple
distribution channels primarily to early childhood professionals and, to a lesser extent, consumers. Through this segment, the Company also provides information to teachers and other education professionals regarding the development of children from
infancy through age eight.



Under the brand name Discount
School Supply, the Company manufactures, imports and sells Company-developed and third party products focused on the early childhood market. The Company sells a wide variety of early childhood products in the following categories: active play, arts
and crafts, carpets, dramatic play, furniture, infant and toddler, language, manipulatives, math, music, puzzles, sand and water, science and teacher resources.



The principal component of the Discount School Supply product line is its comprehensive arts and crafts product offerings. Anchored by its
Company-developed lines of art materials, BioColor®
and Colorations®, DSS provides a wide variety of
arts and crafts, art materials and accessories for use throughout the early childhood market. DSS also distributes third-party products, including brand names such as Crayola®, Lego®, and Elmers®.



The Discount School Supply catalog has been the Companys primary vehicle for customer acquisition and sales in its Early Childhood segment. The
Discount School Supply catalog is distributed twice annually to a growing customer base of



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education professionals, schools and consumers. Refresher versions of the catalogs are typically distributed 45 to 75
days after the initial distributions. In addition, the Company frequently sends targeted mailings to specific customer groups. The distribution of multiple catalogs enables the Company to adjust pricing and product strategies faster than competitors
that distribute catalogs less frequently, and allows the Company to develop more consistent customer contact than its competitors. Discount School Supply catalogs contain projects and curriculum ideas for using the Companys products that are
designed to assist customers in educating children and improving their learning process. This educational content enables the Company to position the Discount School Supply catalog not only as a sales tool, but also as a learning resource for
education professionals, teachers and consumers. It also supports an extended useful life for the catalog that competing catalogs that only sell products may not be able to attain. In the fiscal year ended December 31, 2004, the Company
distributed over 2.6 million Discount School Supply catalogs. In addition, the Company mailed four different specialty catalogs, each of which focused on a separate product category.



The Company has warehouses located across the United States in order to optimize shipping and delivery efficiencies and to
permit delivery of an order from the Discount School Supply catalog within two business days to over 90% of its customers. See Item 2. Properties. During fiscal year 2004, the Company achieved a greater than 98% success rate in shipping
orders that were placed by 2:00 p.m., customers local time, on the same day. The Company believes that its ability to ship and deliver its products in a timely manner has been a consistent competitive differentiator.



ECMD is the Companys primary vehicle for the sale of early childhood
furniture and equipment. When the Company acquired ECMD in February 2003, it was an internet-only business. However, because of the Companys focus on catalog sales, in addition to rebuilding ECMDs website, it created an ECMD catalog for
distribution to a customer base of early childhood professionals. The Company believes that the ECMD catalog, which groups like items from different vendors to facilitate comparison, offers the largest selection of furniture and equipment in one
catalog in the early childhood market. In fiscal year 2004, the first full year of its publication, the Company distributed an aggregate of approximately 900,000 ECMD catalogs in two mailings.



Earlychildhood NEWSis the Companys award-winning print and
web-based magazine focused on the growth and development of children from infancy through age eight. Earlychildhood NEWS offers information, curriculum and educational programs primarily to teachers and is published in print form six times
annually. The most recently published version was mailed to approximately 50,000 readers. Earlychildhood NEWS is also published continuously online at www.earlychildhoodnews.com and is available to early childhood professionals free of
charge. Readers of Earlychildhood NEWS online may participate in sharing boards, browse a reading room of selected articles and ask questions which are answered by early childhood experts, pediatricians and child psychologists. The objective
of Earlychildhood NEWS is to bring teachers together to share information, ideas and products.



Earlychildhood NEWS sponsors Newslink, a weekly opt-in e-mail program that brings its subscribers a collection of topical articles gathered from an
array of news media. In addition, Newslink includes seasonal crafts and product information linked to the Earlychildhood NEWS website. Earlychildhood NEWS also sponsors a Professional Development Program through the University of
Wisconsin-Stout, home of the nations second largest early childhood education program. Through the Professional Development Program, early childhood educators are able to improve their professionalism and to keep their credentials current.
Since the Professional Development Program started in 1995, over 13,000 teachers have participated in the program. The Professional Development Program reinforces the Companys position as a resource for educational information and products. In
addition, Earlychildhood NEWS sponsors Teacher QuickSource®, a web-based solution for educators in Head Start programs that relates activities and products to Head Starts assessment structure.



Elementary School Segment. The Companys Elementary School segment sells school supplies and other
products specifically targeted for use by children in kindergarten through sixth grade, to elementary schools, teachers and other education organizations. Those parties then resell the products either as a fundraising device for the benefit of a
particular school, student program or other community organization, or as a service project to the school.



Through its Elementary School segment, the Company offers products and programs to support several different fundraising alternatives, including
traditional sales programs of gift-wrap or candy and its Company-developed product called SchoolWrapPacs®. SchoolWrapPacs® are school supply sets individually packaged to the specifications of teachers in each grade and are designed to meet the needs of their classrooms. The Company primarily sells SchoolWrapPacs® to parent teacher organizations, or PTOs, which then
resell the product to parents as a fundraising activity or as a service to the school. This program can provide parents and teachers with a convenient and cost-effective way to purchase school supplies, while simultaneously supporting the
schools fundraising efforts. During the 2004 back-to-school season, the Company sold approximately 970,000 SchoolWrapPacs®, which generated approximately 87% of the Elementary School segments sales for the fiscal year ended December 31, 2004.



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Industry Overview



The Companys business is concentrated in the educational products industry. The educational products industry consists of the sale of educational
school supplies (excluding textbooks), furniture and equipment to school districts, individual schools, childcare programs and teachers who purchase products for school and classroom use.



The size of the preschool and elementary school-age population and levels of student enrollment fundamentally drive the
demand for educational products. Figures released by the U.S. Department of Education indicate that the preprimary school-age population (consisting of children ages three to five) is expected to be approximately 11.6 million by 2007. According
to a June 2003 report by the U.S. Department of Health and Human Services, 69% of children aged 0-5 years were in some type of non-parental care. According to the U.S. Department of Educations National Center for Education Statistics (NCES),
the primary federal entity for collecting and analyzing data related to education in the U.S., preprimary education (consisting of nursery and kindergarten schools) is growing substantially. An important feature of this growth is the number of
children attending full-day programs. For example, in 2001, about 52% of children attending preprimary schools attended all day, compared to only 38% in 1991. The U.S. Department of Education also estimates that enrollment in kindergarten through
eighth grade will be 37.3 million by 2007. The Company believes that, given the size of the preschool and elementary school-age populations and levels of student enrollment, as well as the increasing length of the preprimary school day, the
educational products industry will continue to experience significant demand in coming years.



One of the significant drivers of enrollment of children in early childhood care and education programs is the increasing number of parents in the workforce. In September 2002, the National Child Care Association, a
professional trade association focused exclusively on the needs of licensed, private childhood care and education programs, released the results of a study showing that 85% of fathers and over 50% of mothers with preschool-aged children (five years
or younger) were in the labor force. The Bureau of Labor Statistics (BLS) projects that women will represent 48% of the total workforce by 2007, compared to 46.5% in 2000. Further, the BLS projects that parents will comprise 85% of the total labor
force by 2010. The Company believes that this trend also indicates that the educational products industry will continue to experience significant demand in coming years.



The demand for educational products is also driven by expenditures on childcare services. In addition to private funding,
both federal and state funding support childcare and early childhood education initiatives. President George W. Bushs No Child Left Behind Act continues to emphasize spending on K-12 education, although the final fiscal year 2005
federal spending plan falls short of President Bushs requested expenditures on education. The omnibus measure combining nine education bills that was approved by the U.S. Senate in January 2004 provides $56.6 billion in discretionary spending
for the U.S. Department of Education in fiscal year 2005, an increase of $915 million, or 1.6%, over the 2004 budget. Although this increase was the lowest increase since fiscal year 1996, the 2005 spending package nevertheless builds on the
substantial federal investment in education over the past decade. In addition, the 2005 budget includes $12.7 billion for Title 1 grants, which provide assistance to improve the teaching and learning of children in high-poverty schools, representing
an increase of approximately $0.3 billion over the 2004 request.



State governments are becoming increasingly involved in early childhood programs. According to the second preschool yearbook published in November 2004 by the National Institute for Early Education Research, a nonpartisan,
research-based institute at Rutgers Universitys Graduate School of Education that supports early childhood education initiatives, enrollment in state-financed preschool programs continues to rise nationwide, although access to such services
varies greatly from state to state. For example, total state spending on preschool increased by more than $92 million from 2002 to 2003, but there are currently ten states that still do not fund preschool programs. However, that list of ten states
includes Florida, which has a voter mandate to begin offering preschool access to all four-year-olds by the summer of 2005. Only two states, Georgia and Oklahoma, currently offer universal access to preschool, regardless of family income; other
states target existing state-funded programs that benefit disadvantaged children. Fifteen states, including such populous states as California, Illinois, New Jersey and Pennsylvania, have increased their budgets for pre-kindergarten programs in
fiscal year 2005 over fiscal year 2004. The Company believes that these increases in state spending indicate a trend in the U.S. towards greater access to pre-kindergarten programs for more children, which could increase demand for the
Companys products.



The Company acknowledges that
budgeted spending by state and federal governments or agencies are only planned and may not ultimately become real expenditures, and that most states are currently reporting challenging economic climates and deficits. However, the Company believes
that increasing emphasis by state and federal governments on the importance of early childhood care and education and on education in general should result in planned expenditures being made.



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The educational products industry is also dependent on the number of schools and teachers. According to
the 2003 Family Child Care Licensing Study conducted by The Childrens Foundation, a private, national educational non-profit organization, there were 116,409 licensed childcare centers in the United States, an increase of about 2.7% over 2002.
In its Spring Quarterly 2003 Report, the NCES found that, in the 2000-2001 school year, 822,000 children were enrolled in 58,500 public elementary school pre-kindergarten classes nationwide. These classes were offered in 19,900 public elementary
schools. According to the National Child Care Association (NCCA), the only national association serving the private, licensed childhood care and education community, approximately 1.4 million educators worked at the elementary school level in
2000-2001. The NCCA found that 934,000 people were employed in the licensed childcare sector in 2002. The Company believes that these figures support a consistent marketplace for the products and services that it offers.



The 2002 Market Definition Study by the National School Supply and Equipment
Association (NSSEA) reviewed growth potential for the U.S. and Canadian market for consumable supplies, instructional materials, and equipment, furniture and fixtures, all of which are products the Company sells. The report found 4% growth in this
market in 2002 and estimated that, although the rate could be lower, this market would positively grow through 2005.



Academic research continues to highlight the importance of learning in early age groups (ages one through seven) and the medias increased focus on
the importance of parental involvement during this critical stage of growth and brain development. Increased emphasis by state and federal governments is evident in higher spending as well as future plans to create programs. More programs will
require more classrooms and more educators involved in early childhood education. With thousands of educational products to choose from and few reliable sources of information regarding those products, educators and administrators are faced with the
challenge of finding quality educational products and selecting the right products for their programs. Through the Company, education professionals have access to comprehensive and trusted educational content and product information to help them
make informed purchase decisions to better childrens learning.



Products and Services



The Company provides
educational products and offers a variety of services to teachers, other education professionals and consumers. The Company combines its expertise in childrens education with the sale of Company-developed products and a diverse selection of
third-party products to provide education professionals and consumers information, ideas and products. Through its various distribution channels, the Company has streamlined merchandising and distribution of its products and more efficiently offered
its services to ensure that customers can access the Companys products conveniently and effectively. To promote and sell its products, the Company relies on its wide-scale distribution of its Discount School Supply, ECMD and specialty
catalogs, its presence at industry trade shows, its national sales force and its Discount School Supply, ECMD and Earlychildhood websites.



Original Company-Developed Products. The principal component of the Companys product line is its comprehensive arts and crafts product
offerings. Anchored by its BioColor® and
Colorations® product lines, the Company provides a
wide variety of arts and crafts materials and accessories to children throughout the early childhood market. The Company also sells SchoolWrapPacs® to the elementary school market, which are in turn resold primarily through PTOs for service or fundraising programs.



Broad Selection of Third-Party Products. In addition to its
Company-developed products, the Company offers a broad assortment of carefully reviewed and selected third-party educational products, including brand names such as Crayola®, Lego®, and Elmers®. These products enhance the Companys product offerings, allowing the Company to reach teachers and other education professionals looking for a
diverse range of products to fulfill the educational needs of the children in their classrooms. The Company is continually updating its product line based on customer responses and sales feedback monitored by its product specialists.



Careful Selection and Review of Educational Products. The Company only
sells products that meet its quality standards. The Company consults with certified educators who assist the Company in selecting quality products that have educational or developmental value. Once selected, each product is put through a review
process to determine its suitability based on the skills taught, effectiveness in addressing each skill, and the appropriate grade level(s).



Workshops, Product Demonstrations and Activities. The services offered by the Company include a variety of workshops presented by its sales force
to educators, product demonstrations to PTOs and schools and archives of developmentally appropriate activities for children on each of its websites, in each case provided to enable teachers and other consumers to make easier and more effective use
of the Companys products.



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Marketing and Sales



The Company utilizes three primary channels to market and promote its products:



Catalogs. Catalogs represent the Companys primary outreach channel and are the most important component of the
Companys customer acquisition and branding efforts. Unlike its main competitors who send out only one principal catalog per year, the Company distributes several catalogs per year (with redistributions of selected catalogs in different covers
in between new catalogs) under its Discount School Supply and ECMD brand names. Distributing multiple catalogs per year provides the Company with flexibility to calibrate pricing to customer response rate, as well as to add to or delete from the
product selection. The Company distributed over 2.6 million Discount School Supply catalogs and approximately 900,000 ECMD catalogs during the fiscal year ended December 31, 2004.



Sales Representatives. As of December 31, 2004, the
Companys sales force consisted of 63 sales representatives. Of those representatives, 13 members acted as education consultants focused on catalog sales through the Companys Early Childhood segment, and 50 focused on sales through the
Companys Elementary School segment. The Early Childhood segments sales representatives promote Company-developed products, such as the BioColor® and Colorations® lines, and programs, such as Earlychildhood NEWS, to teachers and administrators through in-school demonstrations and workshops that are
designed to elicit higher customer response and better retention rates. Within the Elementary School segment, sales representatives educate PTOs and teachers about the benefits and convenience associated with SchoolWrapPacs® and the Companys other fundraising programs and
products.



Online Marketing. The Companys
Earlychildhood website at www.earlychildhood.com has been designed to be one of the principal vehicles used by the Company to reach customers and provide them with an array of information and services related to the Early Childhood
segments product lines. The Earlychildhood website offers content from Earlychildhood NEWS,including authoritative articles, professional advice and sharing boards. Earlychildhood NEWS sponsors Teacher QuickSource®, a web-based solution for educators in Head Start
programs that relates activities and products to Head Starts assessment structure, which is also linked to the Earlychildhood website. The Earlychildhood website also offers products online through its Discount School Supply website at
www.discountschoolsupply.com, which is linked towww.earlychildhood.com the Earlychildhood website, the more content-driven website. In addition, the ECMD website at www.ecmdstore.com allows early childhood professionals to
search a wide variety of furniture and equipment by individual vendor or by category to compare the offerings of various vendors. The Elementary School segment markets to its customers online with the EPI website at
www.educationalproducts.com, which offers information about the Companys back-to-school program, as well as its fundraising, apparel and science fair programs.



Seasonality



The Companys seasonal sales trends coincide with the start of each school year. For the fiscal year ended December 31, 2004, approximately 44%
of the Companys consolidated annual sales were generated in the third calendar quarter. The Companys working capital needs are greatest during the second calendar quarter as inventory levels are increased to meet seasonal demands. See
Risk FactorsOur business is highly seasonal.



Customers
and Suppliers



The Company sells its products in the
United States to institutions, such as public and private schools, school districts, early childhood learning centers, childcare programs and PTOs, as well as to education professionals and, to a lesser extent, consumers. The Company is not
dependent on any single customer or group of customers. For the fiscal year ended December 31, 2004, the Companys largest customer accounted for approximately one percent of the Companys consolidated revenues, compared to
approximately 1.5% for the fiscal year ended December 31, 2003.



The Company purchases services, products and materials from over 600 suppliers. As such, the Company does not have significant supplier concentration and experiences little or no supplier risks, as most of the product sources are standard
and obtainable from multiple vendors. The Company also sources a significant number of its products overseas. Products sourced overseas accounted for approximately 24% of the Companys sales for both the fiscal years ended December 31,
2004 and December 31, 2003.



Competition



Competition in the educational products industry is based on price, timely
service and product selection. The Companys major competitors in the educational products industry are School Specialty, Inc., Lakeshore Learning Materials, The Kaplan



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Early Learning Company, U.S. Toy Company and Oriental Trading Company. The Company also competes, to a much lesser
extent, with mass-market retail chains such as Target, Office Depot and Wal-Mart, with other custom-packers of school supplies such as Innisbrook, as well as with retail and online booksellers and toy stores, such as Barnes & Noble,
Amazon.com and Toys R Us. The Company believes that the primary advantage it has over its competitors is its combination of an aggressive pricing structure with an expansive range of proprietary products and superior customer service.



The Company believes that the following factors are essential
for it to remain competitive in its industry:



| |  | aggressive product pricing,
|- |  | ---------------------------



| |  | increased brand recognition and trust;
|- |  | --------------------------------------



| |  | enhanced ability to attract and retain customers; and
|- |  | -----------------------------------------------------



| |  | expanded breadth of product selection.
|- |  | --------------------------------------



Competitive Strengths



The Company has positioned itself as a key player in the educational products industry by focusing on its Company-developed products, competitive pricing,
excellent customer service, quick delivery through multiple distribution centers, the distribution of its Discount School Supply catalog multiple times per year, the distribution of its ECMD catalog and other specialty catalogs, and an aggressive
marketing strategy. The Company markets its art materials and consumables, for example, by featuring paints, craft materials and paint accessories foremost in its catalogs and on its websites and by utilizing these products in workshops for
teachers. While its competitors also feature products in this category and even offer out-sourced, private-labeled paints, the Company develops and manufactures paint formulations in-house. This allows the Company to exclusively offer products such
as BioColor® and Liquid WaterColorTM, to have greater control of product availability and to improve its margins. The Company seeks to enhance its product
offerings by providing its customers with information regarding activities in which such products can be used, allowing certain customers to participate in workshops and giving certain customers access to other services offered by the Company. For
example, the Companys print and online publication Earlychildhood NEWS, as well as its online sharing boards and product promotions, provide an opportunity for teachers to obtain and share information about product uses and learning
experiences critical to advancing the quality of early childhood education. As customers increasingly interact with and become aware of the Companys many distribution methods, including Discount School Supplys catalog, website and direct
sales force and EPIs fundraising programs and website, the Company seeks to become synonymous with convenience, quality and value.



The Company believes that its competitive strengths include, among other things, the following:



Company-Developed Products. The Company exclusively distributes its
Company-developed products in the United States, and, in very few cases, has assigned international distribution rights to third parties. Through the research, development and marketing of its own brands, the Company is able to monitor and control
the quality of many of its products, as well as offer high quality items at competitive prices while realizing favorable profit margins.



Workshops for Education Professionals. The Company aggressively markets its products by offering a menu of workshops to teachers and owners and
directors of child care centers. The workshops, which are conducted by members of the Companys national sales force, allow the Company to make hands-on demonstrations of its products. The workshops also qualify to earn teachers continuing
education credits toward maintenance of their professional credentials. These workshops have resulted in increased sales, better customer retention and more competitive margins, in large part because the products demonstrated in the workshops are
Company-developed and exclusively distributed by the Company. The programs also provide the Company with a useful channel for customer feedback, as well as personal interaction with the Companys representatives, that a catalog alone cannot
provide.



Contextual Merchandising. The Company
merchandises its products in an effort to maximize the educational benefit to its customers. For example, its sales force is trained to understand which products are relevant to pre-kindergarten children and which products are more educationally
appropriate for children in kindergarten or above. The Companys catalogs contain information about activities and suggestions about how to use the products offered. In addition, the Companys convenient and easy-to-use websites reinforce
the Companys contextual merchandising proposition. For example, the Earlychildhood website at



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www.earlychildhood.com links to the Discount School Supply website at www.discountschoolsupply.com for
products and also offers content from Earlychildhood NEWS,including authoritative articles, professional advice and sharing boards. Also, the Company developed and supports Teacher QuickSource®, a web-based solution for educators in Head Start programs that relates activities and
products to Head Starts assessment structure. This free resource enables teachers to quickly link specific Head Start assessment goals to daily activities and the products required to do them. In reverse, teachers can connect an activity to
the specific Head Start goal and appropriate developmental skill. Since the activities recommend products offered by the Company with a link to the Discount School Supply site to purchase those products, Teacher QuickSource® exemplifies the Companys contextual merchandising
strategy.



Compelling Educational Content and Educational
Expertise. The Company employs educators and product development professionals to work together to select products of educational value for its customers and to contribute other resources for the Companys customers, including educational
articles, product reviews and professional advice for parents and teachers. The Company works in conjunction with early childhood educators in various settings, including public and private preschools and universities, to test products in classroom
use. In addition, the Companys national sales force is comprised of education consultants who are familiar with the preschool and elementary school environment and the demands placed on early childhood educators time. The Companys
free services, including Teacher QuickSource®,
subscriptions to Earlychildhood NEWS, and the Newslink opt-in email program, provide information, curriculum and educational programs that supplement the Companys product offerings.



Fast Delivery. In the Early Childhood segment, the Company is able to
offer fast delivery because it has four distribution centers located strategically throughout the U.S. These distribution centers allow the Company consistently to deliver in-stock merchandise faster than competitors with fewer distribution centers.
During fiscal year 2004, the Company achieved a greater than 98% success rate in shipping orders that were placed by 2:00 p.m., customers local time, on the same day. The Company believes that its ability to ship and deliver its products in a
timely manner has been a competitive differentiator.



Intellectual Property



The Company regards the protection of its intellectual
property as critical to its future success and relies on a combination of copyright, trademark, service mark, trade secret laws, license agreements and contractual restrictions to establish and protect its proprietary rights, which include rights in
its names, products, website architecture and technology, content and services. The Company has entered into confidentiality and invention assignment agreements with certain employees and contractors in order to limit disclosure of its proprietary
information and to protect its ownership interest in its intellectual property. However, the Company cannot ensure that these contractual arrangements or the other steps taken by it to protect its intellectual property will prove sufficient to
prevent misappropriation of its intellectual property or deter independent third-party development of similar items.



The Company conducts business on the Internet and through other channels by utilizing a variety of trademarks and domain names. There are a number of
other trademarks and domain names similar to those of the Company. The owners of these trademarks and domain names could bring an infringement action against the Company at any time and there is a risk that such owners could overcome any defenses
available to the Company. If the owners of such trademarks and domain names were to prevail in such an action, the Company could lose the ability to use its trademarks and domain names and could be subject to substantial damages. Because certain of
the Companys trademarks are descriptive marks, there is also a risk that third parties might use trademarks that are similar to those of the Company. If third parties began using trademarks similar to the Companys trademarks, it could
adversely affect the Companys business by materially decreasing the value of its trademarks and harming its brands and reputation. If the Company is required to change any of its trademarks or domain names, it could lose customers and brand
equity, which would have a material adverse effect on the Companys business and financial condition. Although the Company may attempt to acquire or license the right to use potentially relevant third-party trademarks and domain names, it may
not be successful.



The following is a list of the
Companys registered trademarks and service marks: Basic Brights®, BioColor®,
BioPutty®, Child Care Central®, Colorations® , Colors Like Me® , Completing the Circle Between Teachers and Parents®, Dandi-Li-On®, Earlychildhood NEWS®, Econoboard®, EPI®, Excelligence®, First Art®,
Flexitemp®, The Imagination Playground®, LifeLong Learning Starts Here®, Little Bit O Paint®, Moo-Nay®, Proboard®, Rainbow®, SchoolWrapPac®, Smart Kids®,
SmarterKids®, SmarterKids.com®, Squeezeables®, TeacherQuickSource®, the design logo of a child reaching for a star and the design logo of ECMD. The
Company has the following registered patents: Foam Paint Set, BioColor (German patent registration), and Portable Cot Apparatus. In addition, the Company has pending patent applications relating to an expanding paint medium, a divided paint cup and
a bin with attachable label holder.



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Technology



The Company has implemented a broad array of scalable systems for catalog and website management, customer service, electronic transaction management and
data interchange, e-mail, order processing, payment processing, warehouse management, office administrative services and accounting. These systems use a combination of proprietary and commercially available technologies.



The Company develops or selects systems that are based on industry-standard
architectures that have been designed to minimize downtime in case of outages or catastrophic occurrences. The Companys transaction processing methods and databases are designed without arbitrary capacity constraints and are scalable to any
volume of demand that the Company expects to encounter. The Company utilizes load balancing systems and redundant equipment to provide for fault tolerance. In 2004, the Company completed the installation of the catalog creation and merchandising
support system. The software provides the Company with a centralized product information management system that supports product deployment within all of the Companys technologies. The Company implemented new drive technology from EMC to
improve performance and reliability, provide additional built-in redundancies, and increase the scalability of the systems. Due to prioritization and integration issues, the release of the forecasting system scheduled for implementation in 2004 was
delayed until early 2005. In the second quarter of 2004, the Company partnered with The Wheaton Group to implement a marketing database that supplies additional detailed information to the Companys marketing team on customer buying tendencies
improving the efficiencies of the email and catalog mailings. Several new features were added to the Discount School Supply website in 2004, including the ability to authorize credit cards in real-time and the ability to support corporate customer
discounting. To coincide with the release of its January catalog, the Discount School Supply website began featuring an interactive version of the catalog with links to the website for ordering products.



The Companys systems infrastructure is supported in-house at its
corporate headquarters in Monterey, California. Most of the systems are monitored 24 hours a day, seven days a week through applications and technology that contact systems personnel when problems are identified. Systems backups are done on a
regular cycle, and tapes are stored both in-house and offsite at a secure facility.



Governmental Regulation



The Company is
subject to the provisions of the federal Consumer Product Safety Act, which enables the Consumer Product Safety Commission to exclude from the market consumer products that fail to comply with applicable product safety regulations or otherwise
create a substantial risk of injury. The Consumer Product Safety Commission may also require the repurchase by the manufacturer of articles that are banned. Similar state laws exist in some states. In addition, the Companys manufacturing
operations are subject to numerous federal, state and local environmental and occupational health and safety laws and regulations, which include laws and regulations governing waste disposal, air and water emissions, workplace exposure and other
matters. All art materials produced by the Company are evaluated and certified as non-toxic by the Duke University Department of Occupational and Environmental Health. These products are packaged in accordance with federal labeling standards for art
materials.



The Companys catalog business, like the
catalog industry in general, is subject to regulation by a variety of state and federal laws relating to, among other things, advertising and sales taxes. The Federal Trade Commission regulates the Companys advertising and trade practices. The
Company believes that it collects sales taxes in states where it is required to do so.



The Company is also subject to various other federal, state and local laws and regulations applicable to its business. The Company believes that it is in substantial compliance with these laws and regulations.



Backlog



The Company has no firm backlog. The Companys customers typically purchase products on an as-needed basis. The Company
believes that, as of December 31, 2004, backlog was not a meaningful indicator of future business prospects due to the large volume of products delivered from shelf inventories.



Employees



As of December 31, 2004, the Company and its subsidiaries had 378 full-time employees, including 253 in its Early Childhood segment and 125 in its
Elementary School segment. From time to time, the Company also employs independent contractors to support its operations. The Company has not experienced any work stoppage and considers its relations with its employees to be good. None of the
Companys employees belongs to a collective bargaining unit.



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Risk Factors



Set forth below are certain risk factors related to the Companys business. The risk factors described below may not include all of the risk factors
that could affect future results. For example, the Company is subject to a wide array of risks that face all similarly situated companies, including its dependence on information systems, the continued service of its key employees, the impact of
environmental laws, and the potential for product liability claims. Actual results could differ materially from those anticipated as a result of these and various other factors, including the following risk factors, which the Company believes are
the most significant and specific risks associated with its businesses, and those set forth in the Companys other periodic and current reports filed with the Commission from time to time.



We are dependent upon the size of the preschool and elementary
school-age populations, levels of enrollment and expenditures per child in child care programs and elementary schools.



Our ability to grow our business depends in part on the size of the population in early childhood programs, preschools and elementary schools, the levels
of enrollment of such population in child care centers and elementary schools and the level of expenditures per child in child care programs and elementary schools. The level of enrollment in early childhood programs and preschools depends in part
on parents attitudes toward early childhood education, while the level of student enrollment in elementary schools is largely a function of demographics. Expenditures per child are a function of prevailing political and social attitudes toward
education, as well as government budgets. Any significant and sustained decline in the size of the preschool and elementary school-age populations, levels of enrollment and/or expenditures per student could have an adverse effect on our business,
financial condition and results of operations.



Our
business is highly seasonal and our annual results are highly dependent on the success of our third quarter results.



We are affected by seasonal shopping patterns. A significant portion of our sales occurs in the third quarter, coinciding with the start of the U.S.
school year. In the fiscal year ended December 31, 2004, we earned approximately 44% of our annual net revenues in the third quarter and operated at or near a net loss in the first, second and fourth quarters. As a result, the results of
operations for our entire fiscal year depend largely on third quarter results. Factors that could cause our sales and profitability to suffer due to this seasonality include:



| |  | the availability of and customer demand for particular products;
|- |  | ----------------------------------------------------------------



| |  | unfavorable economic conditions, which decrease consumer confidence and lower consumer discretionary spending;
|- |  | --------------------------------------------------------------------------------------------------------------



| |  | the inability to purchase or maintain appropriate inventory levels, which if too low, could cause fulfillment delays of high demand product and, if too high, could leave the Company
with excess inventory of unpopular products; and
|- |  | --------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------



| |  | the inability to hire adequate temporary personnel in the second and third quarters.
|- |  | ------------------------------------------------------------------------------------



This seasonality causes our operating results to vary significantly from quarter to quarter.



We are subject to intense competition which may impede or prevent us
from attaining greater market share and could impair the growth of our revenues.



Intense competition and increased consolidation, which could result in one companys dominance in the marketplace, may result in loss of our market share and ultimately reduce our revenues.



Our catalogs directly compete with catalogs of companies such as School
Specialty, Inc., Lakeshore Learning Materials, The Kaplan Early Learning Company, U.S. Toy Company and Oriental Trading Company. There has been consolidation among our competitors over the last several years. In addition, most of our competitors
have websites that compete with our websites.



We also compete,
to a lesser extent, with mass-market retailers such as Target, Office Depot and Wal-Mart, other packers of school supplies such as Innisbrook, as well as retail and online booksellers and toy stores, such as Barnes & Noble, Amazon.com and
Toys R Us,. These companies have greater brand recognition and greater resources than we do. We could be at a disadvantage in responding to these competitors freight policies or merchandising and pricing strategies.



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Our sales and profitability could suffer if, among other things:



| |  | new competitors enter markets in which we are currently operating;
|- |  | ------------------------------------------------------------------



| |  | our competitors recreate our operating strategies by pursuing an aggressive manufacturing and marketing program for a competing line of products similar to our Company-developed
products;
|- |  | -------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------



| |  | our competitors implement pricing strategies or freight policies that are more aggressive than ours;
|- |  | ----------------------------------------------------------------------------------------------------



| |  | our competitors expand their operations; or
|- |  | -------------------------------------------



| |  | our competitors adopt merchandising strategies similar to ours.
|- |  | ---------------------------------------------------------------



Restrictive loan covenants may limit our ability to draw on our credit facility, which could adversely affect our results of operations and our
financial condition.



Our business is capital
intensive and requires significant levels of inventory leading up to our peak business period, which we fund using our $19.4 million secured credit facility with Bank of America, N.A. (the Bank of America Facility). The Bank of America
Facility also includes up to $4.4 million through a reducing revolving term loan. The Bank of America Facility, which is secured by substantially all of our assets, including receivables, inventory, equipment and intellectual property, requires
adherence to certain financial covenants and limitations related to capital expenditures and acquisitions during the term of the Bank of America Facility. As of December 31, 2004, the Company was in compliance with all the financial covenants
as set forth in the Bank of America Facility.



As of
December 31, 2004 and March 14, 2005, the Company had $0 in outstanding borrowings under the Bank of America Facility. Available borrowing capacity as of December 31, 2004 and March 14, 2005 was $19.4 million. We cannot ensure
that amounts available under the Bank of America Facility will be sufficient to fund our liquidity needs. Our ability to fund our operations, make scheduled debt payments and planned capital expenditures and to remain in compliance with financial
covenants under the Bank of America Facility will depend on our future operating performance and cash flow, which in turn is subject to prevailing economic conditions and to financial, business and other factors, some of which are beyond our
control.



If a shipment of products that we import is
interrupted or delayed, our inventory levels and sales could decline.



We import some of our product offerings from foreign manufacturers. In 2004, products sourced overseas accounted for approximately 24% of the Companys sales. These foreign manufacturers are located primarily in
China, Taiwan, and Hong Kong, and, to a lesser extent, in a few European countries. We are subject to the following risks inherent in relying on foreign manufacturers:



| |  | the inability to return products which could result in excess inventory;
|- |  | ------------------------------------------------------------------------



| |  | fluctuations in currency exchange rates which could potentially result in a weaker U.S. dollar in overseas markets, increasing the cost of inventory purchased;
|- |  | ---------------------------------------------------------------------------------------------------------------------------------------------------------------



| |  | transportation delays and trade restrictive actions by foreign governments which could result in delays in shipping products to our customers;
|- |  | ----------------------------------------------------------------------------------------------------------------------------------------------



| |  | the laws and policies of the United States affecting importation of goods, including duties, quotas and taxes;
|- |  | --------------------------------------------------------------------------------------------------------------



| |  | trade infringement claims;
|- |  | --------------------------



| |  | increased risk of exposure from product liability claims due to uncollectibiilty from uninsured foreign manufacturers; and
|- |  | --------------------------------------------------------------------------------------------------------------------------



| |  | delays or cancellations in the manufacture or shipment of products caused by the continued threat of international terrorism, and increased security instituted in response thereto.
|- |  | ------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------



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Interruptions or delays in our imports could cause shortages in product inventory and a decline in our
sales unless we were able to secure alternative supply arrangements. Even if we could locate alternative sources, these alternative products may be of lesser quality or more expensive. Our sales could also suffer if our suppliers experience similar
problems with foreign manufacturers.



We may be unable to
protect our intellectual property, which could impair brand and reputation.



Our efforts to protect our proprietary rights may be inadequate. We regard our intellectual property as important to our marketing strategy. To protect our proprietary rights, we generally rely on copyright, trademark
and trade secret laws, confidentiality agreements with employees and third parties and license agreements with consultants and suppliers. However, a third party could, without authorization, copy or otherwise misappropriate information from us.
Furthermore, certain of our trademarks are descriptive marks that have not been and likely will not be registered with the United States Patent and Trademark Office, and third parties may use trademarks similar to ours, potentially diminishing our
brand name and reputation. Employees, consultants and others who participate in development activities could breach their confidentiality agreements, and we may not have adequate remedies for any such breach. If we fail or are unable to protect our
proprietary rights, it could materially decrease our value and our brand and reputation could be impaired. See Intellectual Property.



The cost of materials used to manufacture our products is subject to volatility, which could reduce our profitability.



The unavailability of raw materials or a substantial increase in their
prices could reduce our profitability and have a negative impact on our ability to produce proprietary products. We currently sell certain company-manufactured products, including non-toxic tempera paints, finger paints, glues and other water-based
art mediums. We may, from time to time, experience difficulty in obtaining adequate raw material requirements at competitive prices, and experience shortages of raw materials used in our manufacturing process, which could reduce our profitability.
In addition, the rising cost of petroleum impacts not only our inbound freight costs, but also increases our product development costs as we use various plastics in manufacturing our products. If these costs continue to rise, our manufacturing costs
will continue to rise and our profitability could be reduced.



Certain of our affiliates have significant influence over us, which could limit our other stockholders ability to influence corporate decisions.



As of March 14, 2005, our Chief Executive Officer and three of our other stockholders owned, as of record and in the
aggregate, approximately 45% of our common stock on a fully diluted basis. As a result, these stockholders, if they were to act together, would be able significantly to influence all matters requiring approval of a majority of our stockholders,
including any merger, sale of assets and other significant corporate transactions. This control could:



| |  | delay or prevent a change of control of the Company;
|- |  | ----------------------------------------------------



| |  | deprive our other stockholders of an opportunity to receive a premium for their common stock as a part of a sale of the Company or its assets; and
|- |  | --------------------------------------------------------------------------------------------------------------------------------------------------



| |  | negatively affect the market price of our common stock.
|- |  | -------------------------------------------------------



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Item 2. Properties.



The
Companys corporate headquarters are located at 2 Lower Ragsdale Drive in Monterey, California. The headquarters also house the administrative functions of the Companys Early Childhood segment. The property is leased under two
separate leases expiring in June 2007, one for approximately 17,000 square feet and one for approximately 9,000 square feet. The Company does not own any real property and leases the following other materially important facilities:



|                 |  |                           |  |                   |  |                 
|---------------- |  | ------------------------- |  | ----------------- |  | ----------------
|Locations        |  | ApproximateSquare Footage |  | Segment           |  | Lease Expiration
|Salinas, CA      |  | 122,000                   |  | Early Childhood   |  | June 2007       
|Salinas, CA      |  | 33,000                    |  | Early Childhood   |  | August 2005     
|Jacksonville, FL |  | 74,000                    |  | Early Childhood   |  | February 2009   
|Harrisburg, PA   |  | 120,000                   |  | Early Childhood   |  | January 2011    
|Dallas, TX       |  | 115,000                   |  | Elementary School |  | December 2007   
|Dallas, TX       |  | 50,000                    |  | Early Childhood   |  | December 2007   
|Houston, TX      |  | 96,000                    |  | Elementary School |  | December 2005   



Item 3. Legal Proceedings.



On
January 18, 2005, defendants in Excelligence Learning Corporation v. Oriental Trading Company and Teresa Martini (Case no. 03-04947-JF (RS) in the U.S. District Court for the Northern District of California) filed a bill of costs and
motion for attorneys fees from the Company. In its action, the Company had asserted claims that included theft of trade secrets, trade dress infringement and copyright infringement against a former employee (Martini) it alleged had taken trade
secrets and used them to the benefit of her new employer (Oriental Trading Company). On December 20, 2004, the District Court entered summary judgment in favor of defendants. In their bill of costs, defendants seek approximately $430,000 and,
in their attorneys fees motion, defendants seek approximately $1.8 million. Defendants bill and motion have not yet been heard, and the Company intends vigorously to appeal the adverse summary judgment decision. While the final outcome
of these proceedings cannot be determined at this time, based on information presently available, the Company believes that the final outcome of such proceedings will not have a material adverse effect upon its results of operations or financial
condition. However, the Companys belief regarding the likely outcome of such proceedings could change in the future and an unfavorable outcome could have a material adverse effect upon its liquidity, results of operations or financial
condition.



Aside from the above-referenced litigation, the
Company and its subsidiaries are, from time to time, party to legal proceedings arising in the normal course of business. In managements opinion, there are no other pending claims or litigation, the outcome of which would have a material
effect on the Companys consolidated results of operations, financial position or cash flows.



Item 4. Submission of Matters to a Vote of Security Holders.



No matters were submitted to a vote of the Companys security holders during the fourth quarter of 2004.



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##### Table of Contents

PART II.



Item 5. Market for Registrants Common Equity, Related Stockholder Matters and Issuer Purchases of Equity Securities.



The Companys common stock is currently traded on The Nasdaq SmallCap Market under the symbol LRNS. The following table sets forth the
high and low price per share of the Companys common stock during fiscal year 2004 and 2003:



|                             |  |      |      |     |   |     
|---------------------------- |  | ---- | ---- | --- | - | ----
|Year Ended December 31, 2004 |  | High |      | Low
|Fourth Quarter               |  | $    | 4.59 |     | $ | 3.74
|Third Quarter                |  |      | 6.00 |     |   | 3.65
|Second Quarter               |  |      | 6.29 |     |   | 4.50
|First Quarter                |  |      | 6.90 |     |   | 5.25
|Year Ended December 31,
2003 |  | High |      | Low
|Fourth Quarter               |  | $    | 7.40 |     | $ | 4.30
|Third Quarter                |  |      | 5.75 |     |   | 4.18
|Second Quarter               |  |      | 5.32 |     |   | 2.53
|First Quarter                |  |      | 3.90 |     |   | 1.99



On March 14,
2005, there were 8,935,124 outstanding shares of the Companys common stock held by 152 holders of record.



The Company has not paid and does not presently intend to declare cash dividends. The Company currently intends to retain future earnings to finance its
operations and fund the growth of its business. Any payment of future dividends will be at the sole discretion of the Companys Board of Directors and will depend upon, among other things, the Companys earnings, results of operations,
financial condition, capital requirements, level of indebtedness, contractual restrictions in respect of the payment of dividends, future prospects and other factors deemed relevant to such determination by the Board of Directors. See Item 7.
Managements Discussion and Analysis of Financial Condition and Results of OperationsLiquidity and Capital Resources.



The Company has not sold any securities that were not registered under the Securities Act within the past three years. Neither the Company nor any
affiliated purchaser purchased any of the Companys common stock during fiscal year 2004.



Item 6. Selected Financial Data.



SELECTED CONSOLIDATED FINANCIAL DATA

(in thousands, except share and per share data)



The following selected consolidated statements of operations and balance
sheet data have been derived from the audited consolidated financial statements of Excelligence Learning Corporation and its predecessor entities. The historical results presented herein are not necessarily indicative of future results and should be
read in conjunction with the audited consolidated financial statements and notes thereto beginning on page F-1 of this Annual Report on Form 10-K/A.



On September 7, 2005, the Company determined that certain liabilities related to inventory, prepaid catalog costs, and certain operating expenses
were understated at December 31, 2004. The Company concluded that adjusting the effect of these items would be material to its previously reported results for fiscal year 2004 and therefore is restating its previously issued financial
statements for such year as set forth in this Form 10-K/A. No other fiscal periods prior to the year ended December 31, 2004 are affected by this restatement, as the issues identified do not have any significant impact on those periods. Please
see the Explanatory Note that follows the cover page of this Form 10-K/A for references to additional discussion of the restatement.



The Company determined that this restatement is attributable to a number of factors. The most significant factor was the Companys failure to timely
pay or accrue its obligations for certain invoices for inventory on hand as of year end. The Company determined, based upon the results of its internal investigation, that its accrual for accounts payable for inventory did not include certain
inventory items that had been received but had not been paid for by the Company prior to the end of fiscal 2004. As a result of the in-depth review procedures performed by the Company, the forensic accountants and its registered independent public
accountants, certain additional accounting errors were identified relating to 2004 which are also reflected in the restatement. Those additional errors included an understatement of costs capitalized into inventory, an understatement of the
provision for sales returns, an understatement of certain selling, general and administrative expenses, an understatement of expense for deferred compensation amounts relating to previously issued stock options, and an understatement of income taxes
related to stock option exercises.



14



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##### Table of Contents

The impact on previously reported operating income as a result of corrections to the accounting for the
aforementioned accruals, excluding the related tax effects, is a decrease to operating income of $975,000 for the fiscal year ended December 31, 2004. The adjustments also increase previously reported total liabilities of $6.3 million at
December 31, 2004 by approximately $1.5 million, and increase previously reported total assets of $48.7 million by approximately $1.3 million. The cumulative effect of the identified items at December 31, 2004 results in a decrease in net
income of $677,000, and a decrease in the Companys previously reported equity of $336,000. As a result of the restatement, the Companys basic and diluted earnings per share for the fiscal year ended December 31, 2004 is reduced by
$0.07 and $0.08 per share, respectively.



Please refer to Note
3 of the accompanying consolidated financial statements for additional information on the restatement.



|                                                                 |  |                          |           |      |   |           |      |  |   |           |     |  |      |           |      |  |   |           |     
|---------------------------------------------------------------- |  | ------------------------ | --------- | ---- | - | --------- | ---- |  | - | --------- | --- |  | ---- | --------- | ---- |  | - | --------- | ----
|                                                                 |  | Years Ended December 31, |          
|                                                                 |  | 2004                     |           | 2003 |   |           | 2002 |  |   | 2001(2)   |     |  | 2000 |          
|                                                                 |  | (Restated)               |           |      |   |           |      |  |   |           |     |  |      |          
|Statement of Operations Data:                                    |  |                          |           |      |   |           |      |  |   |           |     |  |      |           |      |  |   |           |     
|Revenues                                                         |  | $                        | 120,988   |      | $ | 109,921   |      |  | $ | 100,760   |     |  | $    | 92,849    |      |  | $ | 80,400    |     
|Gross profit                                                     |  | $                        | 40,580    |      | $ | 39,494    |      |  | $ | 36,282    |     |  | $    | 33,102    |      |  | $ | 29,739    |     
|Selling, general and administrative expenses                     |  | $                        | 38,257    |      | $ | 34,578    |      |  | $ | 32,603    |     |  | $    | 39,208    |      |  | $ | 30,472    |     
|Impairment charges                                               |  | $                        |          |      | $ |          |      |  | $ |          |     |  | $    | 29,580    |      |  | $ |          |     
|Amortization of goodwill and other intangible assets             |  | $                        | 173       |      | $ | 279       |      |  | $ | 288       |     |  | $    | 5,485     |      |  | $ | 964       |     
|Income (loss) from operations                                    |  | $                        | 2,150     |      | $ | 4,637     |      |  | $ | 3,391     |     |  | $    | (41,171   | )    |  | $ | (1,697    | )   
|Net income (loss)                                                |  | $                        | 1,282     |      | $ | 7,811     |      |  | $ | 2,452     |     |  | $    | (35,610   | )(3) |  | $ | (2,310    | )(3)
|Net income per share:                                            |  |                          |           |      |   |           |      |  |   |           |     |  |      |          |      |  |   |          |     
|Basic                                                            |  | $                        | 0.15      |      | $ | 0.91      |      |  | $ | 0.29      |     |  |      |           |      |  |   |           |     
|Diluted                                                          |  | $                        | 0.14      |      | $ | 0.85      | (1)  |  | $ | 0.29      | (1) |  |      |           |      |  |   |           |     
|Shares used in per share calculation:                            |  |                          |           |      |   |           |      |  |   |           |     |  |      |          |      |  |   |          |     
|Basic                                                            |  |                          | 8,763,326 |      |   | 8,536,314 |      |  |   | 8,371,726 |     |  |      |           |      |  |   |           |     
|Diluted                                                          |  |                          | 9,277,719 |      |   | 9,171,814 | (1)  |  |   | 8,371,726 |     |  |      |           |      |  |   |           |     
|Pro forma net loss per sharebasic and diluted                   |  |                          |          |      |   |          |      |  |   |          |     |  |      | (4.79     | )(3) |  |   | (0.41     | )(3)
|Shares used in pro forma per share calculationbasic and diluted |  |                          |          |      |   |          |      |  |   |          |     |  |      | 7,433,503 | (3)  |  |   | 5,595,539 | (3) 



|                                       |  |                    |        |      |   |        |  |      |        |      |   |        |  |   |       
|-------------------------------------- |  | ------------------ | ------ | ---- | - | ------ |  | ---- | ------ | ---- | - | ------ |  | - | ------
|                                       |  | As of December 31,
|                                       |  | 2004               |        | 2003 |   | 2002   |  | 2001 |        | 2000
|                                       |  | (Restated)         |        |      |   |        |  |      |        |     
|Balance Sheet Data:                    |  |                    |        |      |   |        |  |      |        |      |   |        |  |   |       
|Cash and cash equivalents              |  | $                  | 2,657  |      | $ | 3,620  |  | $    | 2,713  |      | $ | 1,623  |  | $ | 181   
|Total assets                           |  | $                  | 49,951 |      | $ | 45,924 |  | $    | 39,054 |      | $ | 44,290 |  | $ | 38,087
|Working capital                        |  | $                  | 24,173 |      | $ | 21,991 |  | $    | 17,476 |      | $ | 12,484 |  | $ | 11,877
|Long-term debt, net of current portion |  | $                  |       |      | $ |       |  | $    |       |      | $ | 14     |  | $ | 7,250 
|Equity                                 |  | $                  | 42,026 |      | $ | 39,131 |  | $    | 30,610 |      | $ | 27,574 |  | $ | 18,436

---

|(1) | The Company has revised its calculation of treasury shares used in connection with its calculation of diluted earnings per share to eliminate the effect of compensation expense
ascribed to past services and to give effect to the amount of unrecognized compensation costs attributable to future services. This revision resulted in a decrease in the Companys diluted earnings per share of $0.02 and zero for the years
ended December 31, 2003 and 2002, respectively.
|--- | --------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

|(2) | On April 30, 2001, the combination of Earlychildhood LLC and SmarterKids.com, Inc. was completed. The financial information reflects the combined results of operations of
Excelligences predecessor, Earlychildhood, and SmarterKids.com subsequent to May 1, 2001.
|--- | ---------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

|(3) | Net loss for the years ended December 31, 2001 and 2000 reflect the pro forma income tax effect of Excelligence and its predecessor companies income being subject to
federal and state income taxes as a C corporation. The pro forma net loss basic and diluted per share information and shares used in pro forma per share calculation included in the statement of operations data for the year ended December 31,
2001 and 2000 reflect the impact of the exchange of all of the membership interests in Earlychildhood for shares of Excelligence common stock in the combination as of January 1, 2001 and 2000, respectively, or date of issuance, if later.
|--- | ----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------



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##### Table of Contents

Item 7. Managements Discussion and Analysis of Financial Condition and Results of Operations.



Restatement



On August 12, 2005, the Company announced a delay in the filing of its Form 10-Q for the three and six months ended June 30, 2005 pending the
completion of an internal investigation of allegations by current and former accounting personnel that the Company had failed to record and accrue for certain obligations for the fiscal year ended December 31, 2004. The Companys Audit
Committee retained independent counsel to lead the internal investigation and to direct forensic accounting consultants retained to assist in the investigation. On September 7, 2005, after considering the results of the investigation, the
Company determined that certain liabilities related to inventory, catalog costs and certain operating expenses were understated at December 31, 2004. The Company concluded that adjusting the effect of these items would be material to its
previously reported results for fiscal year 2004 and the first quarter of 2005. Therefore, the Company is restating its previously issued financial statements for such year as set forth in this Form 10-K/A and is restating its previously issued
financial statements for such quarter in its Form 10-Q/A, hereafter to be filed with the Commission. No other fiscal periods prior to the fiscal year ended December 31, 2004 are affected by this restatement, as the issues identified do not have
any significant impact on those periods. On November 14, 2005, the Company also announced a delay in filing its Form 10-Q for the three and nine months ended September 30, 2005 pending the completion of this restatement.



The Company determined that this restatement is attributable to a number of
factors. The most significant factor was the failure to timely pay or accrue its obligations for certain invoices relating to inventory on hand as of year end. The Company determined, based upon the results of its internal investigation, that its
accrual for accounts payable for inventory did not include certain inventory items that had been received but had not been paid for by the Company prior to the end of fiscal 2004. As a result of the in-depth review procedures performed by the
Company, its forensic accountants and its registered independent public accountants, certain additional accounting errors were identified relating to 2004 which are also reflected in the restatement. Those additional errors included an
understatement of costs capitalized into inventory, an understatement of the provision for sales returns, an understatement of certain selling, general and administrative expenses, and an understatement of income taxes related to stock options,
which were partially offset by an overstatement of compensation expense for deferred compensation amounts relating to previously issued stock option exercises.



The impact on previously reported operating income as a result of corrections to the accounting for the aforementioned accruals, excluding the related
tax effects, is a decrease to operating income of $975,000 for the fiscal year ended December 31, 2004. The adjustments also increase previously reported total liabilities of $6.3 million at December 31, 2004 by approximately $1.5 million,
and increase previously reported total assets of $48.7 million by approximately $1.3 million. The cumulative effect of the identified items for the year ended December 31, 2004 results in a decrease in net income of $677,000, and a decrease in
the Companys previously reported equity of $336,000. As a result of the restatement, the Companys basic and diluted earnings per share for the fiscal year ended December 31, 2004 is reduced by $0.07 and $0.08 per share,
respectively.



Certain elements of the adjustments consist of
accruals relating to fiscal year 2004 that were not recorded until fiscal year 2005. Adjusting the timing of when these accruals were recorded decreases the Companys previously reported operating (pre-tax) loss for the quarter ended
March 31, 2005, as described in the Companys Form 10-Q/A for that fiscal quarter, hereafter to be filed with the Commission.



Overview



The Company is a developer, manufacturer and retailer of educational products, which are sold to child care programs, preschools, elementary schools and
consumers. Through a predecessor entity, the Company began operations in 1985. The Company utilizes multiple sales, marketing and distribution channels, primarily including:



| |  | its Discount School Supply catalog, through which the Company develops, markets and sells educational products to early childhood professionals and consumers;
|- |  | --------------------------------------------------------------------------------------------------------------------------------------------------------------



| |  | EPIs fundraising programs, through which the Company sells school supplies and other products specifically targeted for use by children in kindergarten through sixth grade to
elementary schools, teachers and other education organizations;
|- |  | -----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------



| |  | its ECMD catalog, through which the Company markets and sells furniture and equipment to early childhood professionals; and
|- |  | ---------------------------------------------------------------------------------------------------------------------------



| |  | Earlychildhood NEWS, an award winning print and web-based magazine focused on the growth and development of children from infancy through age eight.
|- |  | ----------------------------------------------------------------------------------------------------------------------------------------------------



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##### Table of Contents

All of the foregoing is supported by a national sales force, which, as of December 31, 2004, numbered 63 people.



In fiscal year 2004, the Company operated in two business
segments: Early Childhood and Elementary School. The Early Childhood segment includes the brand names Discount School Supply, ECMD and Earlychildhood NEWS. The Early Childhood segment develops, manufactures and sells educational products
through multiple distribution channels to early childhood professionals and, to a lesser extent, consumers. The Early Childhood segment also provides information to teachers and other education professionals regarding the development of children
from infancy through age eight. The Elementary School segment sells school supplies and other products specifically targeted for use by children in kindergarten through sixth grade to elementary schools, teachers and other education organizations
for fundraising activities.



Critical Accounting Policies and Estimates



The Companys discussion and analysis of its
financial condition and results of operations are based upon the Companys consolidated financial statements, which have been prepared in accordance with accounting principles generally accepted in the United States of America. The preparation
of these financial statements requires the Company to make estimates and judgments that affect the reported amounts of assets, liabilities, revenues and expenses. On an on-going basis, Excelligence evaluates its estimates, including those related to
revenue recognition, bad debts, product returns, intangible assets, inventories and deferred income taxes. The Company bases its estimates on historical experience and on various other assumptions that are believed to be reasonable under the
circumstances, the results of which form the basis for making judgments about the carrying values of assets and liabilities that are not readily apparent from other sources. Actual results may differ from these estimates under different assumptions
or conditions.



The Company believes the following critical
accounting policies affect its more significant judgments and estimates used in the preparation of its consolidated financial statements.



Revenue Recognition and Accounts Receivable



The Company recognizes revenue from product sales upon the delivery of products to an unrelated third party customer when (a) the customer takes
title of the goods; (b) the price to the customer is fixed or determinable; (c) the customer is obligated to pay the Company and the obligation is not contingent on resale of the product; (d) the customers obligation to the
Company would not be changed in the event of theft or physical destruction or damage of the product; and (e) the Company does not have significant obligations for future performance to directly bring about resale of the product by the customer.
Provisions for estimated returns and allowances are recorded as a reduction to sales and cost of sales based on historical experience. The Company determines that collectibility of accounts receivable is reasonably assured through standardized
credit review to determine each customers credit worthiness. The Company maintains allowances for doubtful accounts for estimated losses resulting from the inability of its customers to make required payments. If the financial condition of the
Companys customers were to deteriorate, resulting in an impairment of their ability to make payments, additional allowances may be required.



Inventories



The Company uses the lower of cost or market under both the first-in, first-out and average cost methods to value inventories. In the Early Childhood
segment, the Company uses the first-in, first-out method for its finished goods inventory and the average cost method for its raw materials inventory related to paint manufacturing. The Elementary School segment uses the average cost method for all
inventories. Inventory cost is based on amounts paid to vendors plus the capitalization of certain labor and overhead costs necessary to prepare inventory to be saleable. The Company had previously disclosed that it values inventories at the lower
of cost or market, using only the first-in, first-out method. There is no impact or change to the Companys financial results as a result of adjusting this disclosure.



The Company writes down its inventory for estimated obsolescence, damaged or unmarketable inventory equal to the difference
between the cost of inventory and the estimated market value based upon assumptions about future demand and market conditions. If actual market conditions are less favorable than those projected by management, additional inventory write-downs may be
required.



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##### Table of Contents

Impairment of Long-Lived Assets



The Company assesses the need to record impairment losses on long-lived assets used in operations, including goodwill and
other intangibles, when indicators of impairment are present. On an on-going basis, management reviews the value and period of amortization or depreciation of its long-lived assets. Recoverability of long-lived assets to be held and used is measured
by comparing the carrying value of the asset group to the undiscounted future cash flow expected to be generated by the asset group. If such assets are considered to be impaired, the impairment to be recognized is measured by the amount by which the
carrying amount of the assets exceeds the fair value of the assets. Assets to be disposed of are reported at the lower of the carrying amount or fair value less cost to sell.



On January 1, 2002, the Company adopted SFAS No. 142, Goodwill and Other Intangible Assets. SFAS
No. 142 provides that goodwill should not be amortized but instead be tested for impairment annually at the reporting unit level. In accordance with SFAS No. 142, the Company conducted its annual impairment test as of December 31,
2004. The Companys goodwill impairment test is based on a comparison of carrying values and fair value of its Companys reporting units, its Early Childhood and Elementary School segments. As a result of the test, the Company determined
that no impairment had occurred. In addition, the Company recorded no impairment charges in 2003 or 2002.



Income Taxes



The
Company is taxed as a C corporation and files a consolidated tax return with its wholly-owned subsidiaries. The Companys consolidated statements of operations reflect the income tax expense based on the actual tax position of the Company and
its subsidiaries in effect for the respective periods.



The
Company has recorded a deferred tax asset in an amount that is more likely than not to be realized. While the Company has considered future taxable income and ongoing prudent and feasible tax planning strategies in assessing the value of the
deferred tax asset, in the event that the Company were to determine that it would be able to realize its deferred tax assets in the future in excess of its recorded amount, an adjustment to the deferred tax asset would increase income in the period
such determination was made. Likewise, should the Company determine that it would not be able to realize all or part of its deferred tax asset in the future, an adjustment to the deferred tax asset would be charged to income in the period such
determination was made.



Results of Operations



Revenues



Revenues were $121.0 million (as restated), $109.9 million and $100.8 million for 2004, 2003 and 2002, respectively. The
increase in revenue from 2003 to 2004 of 10.1% (as restated) was primarily due to growth of 15.8% (as restated), or $12.4 million (as restated), in the Early Childhood segment. Overall growth in the Early Childhood segment was achieved through new
product offerings, new customer solicitation and improved sales and marketing strategies. The Elementary School segments revenue decreased by 4.3% (as restated), or $1.4 million (as restated), from 2003 to 2004, primarily due to order
fulfillment challenges related to the consolidation of warehouses at the beginning of the year. The Company has taken steps to correct these fulfillment challenges and believes that the Elementary School segments processes will be operating
effectively in 2005. The increase in revenue from 2002 to 2003 of 9.1% was primarily due to growth of 11.8%, or $8.3 million, in the Early Childhood segment.



The Company will continue with its goal to achieve revenue growth in the Early Childhood and Elementary School segments by increasing circulation of its
catalogs, offering new proprietary products, soliciting new customers, implementing more aggressive sales and marketing strategies and enhancing the Companys websites. Certain factors that could cause actual results to differ materially from
the Companys expectations are discussed in Item 1. Risk Factors.



Gross Profit



Gross profit was $40.6 million
(as restated), $39.5 million and $36.3 million for 2004, 2003 and 2002, respectively. The increase in gross profit in 2004 of $1.1 million (as restated) was primarily due to an increase in gross profit of 7.6%, or $2.2 million, in the Early
Childhood segment. This increase in gross profit within the Early Childhood segment was achieved through effective sales and marketing strategies. The increase in gross profit in 2003 of $3.2 million was primarily due to revenue growth of 11.8%, or
$8.3 million, within the Early Childhood segment.



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##### Table of Contents

Gross profit as a percentage of sales was 33.5% (as restated), 35.9% and 36.0% for 2004, 2003 and 2002,
respectively. Gross profit as a percentage of sales decreased from 2003 to 2004 largely due to changes in product sales mix and initiatives to aggressively compete to gain market share in the Early Childhood segment and increased direct labor and
freight charges in the Elementary School segment. Gross profit as a percentage of sales remained relatively stable in 2003 when compared to 2002.



The Company accounts for shipping costs as cost of goods sold for shipments made directly from vendors to customers and also for shipments from the
Companys warehouses. The amount of shipping costs related to shipments from the Companys warehouses for the years ended December 31, 2004, 2003 and 2002 was $7.6 million, $6.5 million and $6.5 million, respectively, or 6.3%, 5.9%
and 6.4% as a percentage of sales, respectively. The amount of shipping costs related to shipments made directly from vendors to customers for the years ended December 31, 2004, 2003 and 2002 was $4.5 million, $3.2 million and $2.5 million,
respectively, or 3.7%, 2.8% and 2.5% as a percentage of sales, respectively.



Selling, General and Administrative Expenses



Selling, general and administrative expenses include wages and commissions, catalog costs, operating expenses (which include customer service and certain warehouse costs), administrative costs (which include information systems, accounting,
legal and human resources), e-business costs, equity-based wages and depreciation of property and equipment. Selling, general and administrative expenses were $38.3 million (as restated), $34.6 million and $32.6 million for 2004, 2003, and 2002,
respectively.



The $3.7 million (as restated) increase in
selling, general and administrative expenses in 2004 was attributable to an increase of $3.8 million (as restated) in the Early Childhood segment offset by savings of approximately $196,000 in the Elementary School segment. The greatest component of
the increase in the Early Childhood segment was legal fees for the Company pursuing a complaint against a competitor for, among other things, trade secret misappropriation, unfair competition and copyright infringement, in addition to costs
associated with increasing catalog circulation. The segment also had increases in wages of $506,000 related to increased headcount to strengthen its merchandising and marketing efforts. The increase in selling, general and administrative expenses in
2003 was attributable to the costs associated with introducing a new catalog initiative, as well as increased wages and insurance costs, in the Early Childhood segment, and an increase in wages as a result of an increase in the number of sales
representatives, an increase in temporary help hired for the back-to-school season and an increase in insurance costs in the Elementary School segment.



The Company does not anticipate significant personnel reductions in 2005. However, the Company will continue to focus on achieving selling, general and
administrative operating efficiencies.



Amortization of Other Intangible
Assets



Amortization of other intangible assets was
$173,000, $279,000 and $288,000 for 2004, 2003, and 2002, respectively. The decrease in amortization for 2004 over 2003 was due to intangible assets acquired in its 1998 acquisition of Colorations, Inc., an Ohio corporation and inactive indirect
wholly-owned subsidiary of the Company, becoming fully amortized in 2003.



Interest Expense



Interest expense was
$89,000, $261,000 and $428,000 for 2004, 2003 and 2002, respectively. The decrease in interest expense in 2002 through 2004 was primarily attributable to the Company carrying a lower average outstanding balance on its credit facility with Bank of
America, N.A. compared to its previous credit facility with GMAC Business Credit, LLC (the GMAC Facility). This was achieved by the Companys improved cash management.



Income Taxes



Income tax expense was $793,000 (as restated) in 2004, income tax benefit was $3.6 million in 2003 and income tax expense was $548,000 in 2002. In 2004,
the Companys tax rate was approximately in line with the statutory tax rate, while in 2003 the income tax benefit was lower than the statutory rate due to a reduction of the deferred tax valuation allowance of $2.8 million. The valuation
allowance was related to the deferred income tax assets acquired in the Combination. During fiscal year 2003, the Company determined that it would be able to realize a larger portion of its deferred tax assets related to net operating losses in
excess of the recorded amount and, accordingly, eliminated a portion of its deferred tax asset valuation allowance. During fiscal year 2003, the Company also recognized a current tax benefit of $2.4 million related to net operating losses generated
by the SmarterKids.com acquisition. The benefit came from additional net operating losses made available to the Company as a result of a 2003 Internal Revenue Service Notice pertaining to Section 382 limitations. Income tax expense in 2002 was
lower than the statutory tax rate primarily due to the reduction of the deferred tax valuation allowance.



19



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The Company has recorded a deferred tax asset in an amount that is more likely than not to be realized.
In the event the Company were to determine that it would be able to realize its deferred tax assets in the future in excess of its recorded amount, an adjustment to the deferred tax asset would increase income in the period such determination was
made. Likewise, should the Company determine that it would not be able to realize all or part of its deferred tax asset in the future, an adjustment to the deferred tax asset would be charged to income in the period such determination was made.



Recent Accounting Pronouncements



In January 2003, the Financial Accounting Standards Board (FASB) issued FIN
46, Consolidation of Variable Interest Entities, an Interpretation of Accounting Research Bulletin 51, Consolidated Financial Statements. FIN 46 addresses the consolidation by business enterprises of variable interest
entities as defined in the interpretation. FIN 46 expands disclosure if an enterprise consolidates a variable interest entity, and the interpretation requires disclosure for those companies that hold significant variable interests in a variable
interest entity but are not required to consolidate that interest. In December 2003, the FASB issued FIN 46R, which made certain amendments to FIN 46. The revision clarified the definition of a business as a variable interest entity. The revision
also delayed the effective date of certain provisions of the interpretation from the first reporting period following December 15, 2003 to the first reporting period ending after March 15, 2004. The Company does not have any variable
interest entities, and, therefore, the adoption of FIN 46 has not had a material impact on its consolidated financial statements.



In November 2004, the FASB issued SFAS No. 151, Inventory Costs  an amendment of ARB No. 43, Chapter 4. SFAS No. 151 amends
the guidance in ARB No. 43, Chapter 4, Inventory Pricing, to clarify the accounting for abnormal amounts of idle facility expense, freight, handling costs, and wasted material (spoilage). SFAS No. 151 requires that those items
be recognized as current period charges. Additionally, SFAS No. 151 requires that allocation of fixed production overhead to the cost of conversion be based on the normal capacity of the production facility. SFAS No. 151 is effective for
fiscal years beginning after June 15, 2005. The Company does not expect the adoption of this provision to have a material effect on its consolidated financial statements.



In December 2004, the FASB issued SFAS No. 123 (revised 2004), Share-Based Payment, which is a revision of FASB
SFAS No. 123, Accounting for Stock-Based Compensation. SFAS No. 123(R) supersedes APB Opinion No. 25, Accounting for Stock Issued to Employees, and amends FASB SFAS No. 95, Statement of Cash Flows. The
approach in SFAS No. 123(R) is similar to the approach described in SFAS No. 123. However, SFAS No. 123(R) requires that all share-based payments to employees, including grants of employee stock options, be recognized in the income
statement based on their fair values. Pro forma disclosure is no longer an alternative. SFAS No. 123 (R) must be adopted no later than July 1, 2005. Early adoption is permitted in periods in which financial statements have not yet
been issued. The Company expects to adopt SFAS No. 123(R) on July 1, 2005. The impact of adoption of SFAS No. 123(R) cannot be predicted at this time because it will depend on levels of share-based payments granted in the future.
However, had the Company adopted SFAS No. 123(R) in prior periods using the Black-Scholes valuation model, the impact of that standard would have approximated the impact of SFAS No. 123 as described in the disclosure of pro forma net
income and earnings per share in Note 2 to the Companys consolidated financial statements. SFAS No. 123(R) also requires the benefits of tax deductions in excess of recognized compensation cost to be reported as a financing cash flow,
rather than as an operating cash flow as required under current literature. This requirement may reduce the Companys net operating cash flows and increase its net financing cash flows in periods after adoption.



Liquidity and Capital Resources



On September 29, 2003, the Company entered into a $20.0 million secured
credit facility with Bank of America, N.A. (the Bank of America Facility). The Bank of America Facility replaced the Companys GMAC Facility. Historically, the Companys primary cash needs have been for operations, capital
expenditures and acquisitions. The Companys primary source of liquidity through September 29, 2003 was the GMAC Facility. Since that time, the primary source of the Companys liquidity has been the Bank of America Facility. During
the last quarter of 2004, pursuant to the financing schedule contained in the Bank of America Facility, the amount available under the facility stepped down to $19.4 million. As of December 31, 2004, the Company had net working capital of $24.2
million (as restated).



During 2004, the Companys
operating activities provided $581,000 of cash, representing a decrease of $2.2 million from 2003, primarily due to the Companys decision to enhance market share by offering a bill-when-complete policy that allows customers to receive only one
invoice. The Company believes that the policy did improve sales in 2004. The cash provided from operating activities was primarily related to operating income offset by changes to working capital. The Company used $1.9 million in cash for investing
activities in 2004, with which the Company purchased property and equipment. The Company realized $320,000 in cash from financing activities as a result of certain employees exercising stock options.



20



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During 2003, the Companys operating activities provided $2.8 million of cash. The cash provided
from operating activities was primarily related to operating income offset by changes to working capital, including inventory liquidations. The Company used $2.1 million in cash for investing activities in 2003, with which the Company acquired
Marketing Logistics, Inc. and purchased property and equipment The Company realized $149,000 in cash from financing activities, primarily through issuances of equity.



During 2002, the Companys operating activities provided $7.7 million of cash. The cash provided from operating
activities was primarily related to operating income and changes in working capital. The Company used $1.1 million in cash for investing activities in 2002, with which the Company purchased property and equipment in the amount of $1.2 million and
received payment on a receivable from a related party. The Company used $5.6 million in cash for financing activities, primarily for principal payments made against the GMAC Facility.



The Bank of America Facility includes a $15.0 million revolving line of credit with a maturity date of October 1, 2005
and an interest rate of LIBOR plus 1.75% (4.525% at December 31, 2004). The Bank of America Facility also includes up to $4.4 million through a reducing revolving term loan with a maturity date of October 1, 2008 and an interest rate of
LIBOR plus 2.00% (4.775% at December 31, 2004). The Bank of America Facility is secured by substantially all of the Companys assets, including receivables, inventory, equipment and intellectual property. As of December 31, 2004, the
Company had no borrowings and available credit of $19.4 million under the Bank of America Facility.



The Bank of America Facility requires adherence to certain financial covenants and limitations related to capital expenditures and acquisitions during the
term of the Bank of America Facility. As of December 31, 2004, the Company was in compliance with the financial covenants and limitations as set forth in the Bank of America Facility.



The following table summarizes the Companys contractual obligations as
of December 31, 2004 and the effect such obligations are expected to have on the Companys liquidity and cash flow in future periods (in thousands):



|                                           |  |                        |       |                 |   |           |  |           |       |  |   |      
|------------------------------------------ |  | ---------------------- | ----- | --------------- | - | --------- |  | --------- | ----- |  | - | -----
|                                           |  | Payments due by period
|Contractual Obligations                    |  | Total                  |       | Less than1 year |   | 1-3 years |  | 3-5 years
|Non-cancelable Operating Lease Obligations |  | $                      | 9,307 |                 | $ | 3,180     |  | $         | 5,071 |  | $ | 1,056
|                                           |  |                        |       |                 |   |           |  |           |       |  |   |      



Management believes
that available cash on hand and availability under the Bank of America Facility will provide adequate funds for the Companys foreseeable working capital needs and planned capital expenditures. The Companys ability to fund its operations,
repay debt, make planned capital expenditures and to remain in compliance with its financial covenants under the Bank of America Facility depends on its future operating performance and cash flow, which in turn, are subject to prevailing economic
conditions and to financial, business and other factors, some of which are beyond its control.



As of December 31, 2004, the Company did not have any guarantees, including loan guarantees, standby letters of credit or indirect guarantees.



Business Outlook



As described more fully in the Explanatory Note that follows the cover page of this Form 10-K/A, the Company has not modified or updated disclosures
presented in its 2004 annual report on Form 10-K filed on March 16, 2005, except as required to reflect the effects of the restatement. Accordingly, the Company has not updated the following Business Outlook disclosure to reflect events
occurring after the filing of the Companys original Form 10-K.



The following forward-looking statements reflect the Companys expectations for the full year 2005. Actual results may differ materially from these expectations. Certain factors that could cause actual results to differ materially from
the Companys expectations are discussed in Item 1. Risk Factors. The Company does not undertake to update these expectations, except to the extent that the Company is required to do so.



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Managements goal is to continue revenue growth through increasing size of its catalogs, offering
new proprietary products, soliciting new customers for its Early Childhood and Elementary School segments, and implementing more aggressive pricing strategies in both segments.



For fiscal year 2005:



| |  | Net revenues are expected to be between $125.0 and $135.0 million; and
|- |  | ----------------------------------------------------------------------



| |  | Operating income is expected to be between $5.0 and $8.0 million.
|- |  | -----------------------------------------------------------------



While the Company has historically provided EBITDA guidance, and believes that it can be a useful measure for gauging its overall performance and results
of operations, it believes that operating income is a stronger indicator of the Companys financial health and growth going forward. The Company, therefore, no longer provides future guidance on EBITDA.



Off-Balance Sheet Arrangements



There are no off-balance sheet transactions, arrangements or obligations
(including contingent obligations) that have, or are reasonably likely to have a material effect on the Companys financial condition, changes in the financial condition, revenues or expenses, results of operations, liquidity, capital
expenditures or capital resources.



Seasonality



The Companys seasonal sales trends coincide with the start of each
school year. For the fiscal year ended December 31, 2004, 44% of the Companys consolidated 2004 annual sales were generated in the third calendar quarter. The Companys working capital needs are greatest during the second calendar
quarter as inventory levels are increased to meet seasonal demands. See Item 1. Risk FactorsOur business is highly seasonal.



Inflation



Inflation has and is expected to have only a minor effect on the Companys results of operations and sources of liquidity.



Item 7A. Quantitative and Qualitative Disclosures About Market Risk.



The following discussion of market risk includes forward-looking statements that involve risks and uncertainties that could significantly
offset anticipated results in the future. Actual results could differ materially from those projected in the forward-looking statements. The Company does not use derivative financial instruments for speculative or trading purposes.



Interest Rate Risk



The Companys financial instruments include cash and cash equivalents, accounts receivable, accounts payable and a
revolving line of credit. Market risks relating to operations result primarily from a change in interest rates. The Companys borrowings are primarily dependent upon LIBOR rates. As of December 31, 2004, the Company had no borrowings under
the Bank of America Facility and available borrowing capacity of $19.4 million. See Item 7. Managements Discussion and Analysis of Financial Condition and Results of OperationsLiquidity and Capital Resources. The estimated
fair value of borrowings under the Bank of America Facility is expected to approximate its carrying value.



Credit Risk



Financial
instruments, which potentially subject the Company to concentrations of credit risk, consist primarily of cash, cash equivalents, accounts receivable and its revolving line of credit. The Company has no customer comprising greater than 10% of its
revenues. However, receivables arising from the normal course of business are not collateralized and management continually monitors the payment of its accounts receivable and the financial condition of its customers to reduce the risk of loss. The
Company does not believe that its cash and cash equivalents are subject to any unusual credit risk beyond the normal credit risk associated with commercial banking relationships.



22



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Foreign Currency Risk



The Company purchases some of its products from foreign vendors. Accordingly, the Companys prices of imported products are subject to variability
based on foreign exchange rates. However, the Companys purchase orders are denominated in U.S. dollars and the Company does not enter into long-term purchase commitments.



Item 8. Financial Statements and Supplementary Data.



The financial statements listed on the accompanying Index to Consolidated Financial Statements, set forth on page F-1 and covered by the Independent Registered Public Accounting Firms Report, are incorporated
herein by reference and filed as a part of this Annual Report on Form 10-K/A.



Item 9. Changes in and Disagreements With Accountants on Accounting and Financial Disclosure.



During the Companys two most recent fiscal years or any subsequent interim period, there has been no resignation or dismissal of the independent
registered public accounting firm engaged as the principal accountant to audit the Companys financial statements.



Item 9A. Controls and Procedures.



Evaluation
of Disclosure Controls and Procedures



The Company has
established and currently maintains disclosure controls and procedures designed to ensure that material information required to be disclosed in its reports filed under the Securities Exchange Act of 1934 is recorded, processed, summarized and
reported within the time periods specified by the Securities and Exchange Commission and that any material information relating to the Company is recorded, processed, summarized and reported to its principal officers to allow timely decisions
regarding required disclosures. In designing and evaluating the disclosure controls and procedures, management recognizes that controls and procedures, no matter how well designed and operated, can provide only reasonable assurance of achieving
desired control objectives. In reaching a reasonable level of assurance, management necessarily is required to apply its judgment in evaluating the cost-benefit relationship of possible controls and procedures.



In conjunction with the close of the period covered by this report, the
Company conducted a review and evaluation, under the supervision and with the participation of the Companys management, including the Chief Executive Officer (who is also serving as the Companys Principal Financial Officer, of the
effectiveness of the design and operation of the Companys disclosure controls and procedures. As further discussed below, material weaknesses were identified in the Companys internal control over financial reporting. The Public Company
Accounting Oversight Boards Auditing Standard No. 2 defines a material weakness as a significant deficiency, or combination of significant deficiencies, that results in more than a remote likelihood that a material misstatement of the
annual or interim financial statements will not be prevented or detected.



Subsequent to the filing of the Companys Annual Report on Form 10-K for the fiscal year ended December 31, 2004, it came to the attention of management that certain current and former accounting personnel
alleged that the Company had failed to record and accrue for certain obligations for the fiscal year ended as of that date. In accordance with the Companys Complaint and Investigation Procedures for Accounting, Internal Accounting Controls,
Fraud and Auditing Matters, following a preliminary inquiry by the Companys General Counsel, the matter was reported to the Audit Committee of the Board of Directors. The Audit Committee engaged independent counsel to conduct an investigation
and to direct forensic accounting consultants to assist in the investigation. The results of that investigation were reported to the Audit Committee and the Board of Directors, and included findings which, upon the recommendation of management, the
Board determined would require a material adjustment to, and restatement of, the Companys previously reported financial statements for the year ended December 31, 2004 and the quarter ended March 31, 2005.



Please see the Explanatory Note that follows the cover page of
this Form 10-K/A for references to additional discussion of the restatement.



The Company determined that this restatement is attributable to a number of factors. The most significant factor was failure to timely record and accrue for certain invoices relating to inventory on hand as of year
end. The Company determined, based upon the results of the internal investigation, that its accrual of accounts payable for inventory did not include certain inventory items that had been received but had not been paid for by the Company prior to
the end of fiscal 2004. As a result of



23



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##### Table of Contents

the in-depth review procedures performed by the Company, the forensic accountants and the Companys registered
independent public accountants, certain additional accounting errors were identified relating to 2004 which are also reflected in the restatement. Those additional errors included an understatement of costs capitalized into inventory, an
understatement of the provision for sales returns, an understatement of certain selling, general and administrative expenses, an understatement of compensation expense for deferred compensation amounts relating to previously issued stock options,
and an understatement of income taxes related to stock option exercises.



The restatement of previously issued financial statements is a strong indicator that one or more material weaknesses in internal control over financial reporting may exist. As a result, the Companys Chief
Executive Officer and Board of Directors have concluded that, as of December 31, 2004, the end of the period covered by this amended annual report, the Companys disclosure controls and procedures were not effective to ensure that
information required to be disclosed under the Exchange Act is recorded, processed, summarized, and reported within the time periods specified in the Securities and Exchange Commissions rules and forms.



The material weaknesses that were found to exist are:



| |  |  | Inadequate staffing and training in the accounting functions over the Companys processing of certain financial information.
| | - |  | ----------------------------------------------------------------------------------------------------------------------------



| |  | Management identified this material weakness based on the internal investigation conducted at the direction of the Audit Committee, including review of the work product of the
forensic accountants retained to assist in the investigation. The Company believes that invoices for inventory on hand at year end, catalog costs and certain operating expenses were neither timely processed for payment nor adequately accrued. The
internal investigation revealed that certain invoices had been set aside pending completion of the year-end audit without definitively determining whether the invoices were properly accrued, and that some of the Companys accounting personnel
were aware of this treatment of invoices, but failed to bring the matter to the attention of appropriate senior management, the Audit Committee, or the independent auditors. The Company has determined that this material weakness contributed to the
failure to timely pay or properly accrue for certain invoices (relating primarily to inventory and catalog costs) as of December 31, 2004. These conditions also contributed to the other errors that were noted and corrected during the in-depth
review procedures performed by the Company, the forensic accountants and the Companys registered independent public accountants.
| |  | --------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------





| |  |  | Improper segregation of duties over the processing and review of journal entries.
| | - |  | ---------------------------------------------------------------------------------



| |  | Management identified this material weakness based on an incorrect journal entry directed by the former Chief Financial Officer, which was found during the course of the
investigation and reduced the accounts payable expense for inventory on hand at year end. The investigation revealed and management confirmed that the adjusting journal entry was not adequately justified and was out of line with the Companys
ordinary practices. Although the investigation revealed that other accounting employees, including the former Controller, were aware of and disagreed with the adjusting entry, they did not raise the matter with other senior management, the Audit
Committee, or the independent auditors.
| |  | --------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------



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##### Table of Contents

Changes in Internal Control Over Financial Reporting



There were no changes in the Companys internal control over financial
reporting during the quarter ended December 31, 2004 that materially affected, or were reasonably likely to affect, the Companys controls over financial reporting.



Subsequent to the discovery of the material weaknesses, the Company has taken and continues to take to remediate the
material weaknesses found to exist during its evaluation of disclosure controls and procedures are:



| |  |  | The first identified material weakness had already begun being remediated by the Company with its implementation of procedures in May 2005 to ensure that its accounts payable
invoices are processed promptly in accordance with standard procedures when received, and that accruals are maintained and reviewed by appropriate senior accounting and financial reporting management on a monthly basis. In addition, the
Companys Chief Financial Officer resigned effective as of September 13, 2005 and the Company is in the process of identifying a new Chief Financial Officer. The Companys former Controller had been terminated in June 2005. The
Company has significantly increased the number and skills and training of management and staff personnel in its accounting and finance departments, including training in the Companys whistleblower policies and procedures, implemented enhanced
segregation of duties, documented and implemented specific desk-level procedures in the accounting and financial reporting departments. The Company believes that the first identified material weakness has been substantially remediated, and
additional controls and safeguards are being evaluated; and
| | - |  | -------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------



| |  |  | To remediate the second identified material weakness, the Company has implemented and documented rigorous and detailed procedures for the closing of each fiscal period that include
specific protocols for the timely review by appropriate senior accounting and financial reporting management of all adjusting journal entries. In addition, the Company significantly increased the number and skills and training of management and
staff personnel in its accounting and finance departments, including training in the Companys whistleblower policies and procedures, and implemented enhanced segregation of duties. In addition, as noted, the Company is in the process of
identifying a new Chief Financial Officer and has replaced the former Controller. The Company believes that the second identified material weakness has been substantially remediated, and additional controls and safeguards are being evaluated.
| | - |  | ------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------



In addition to the remediation steps describe above, the Company
has:



| |  |  | Implemented new software enhancements to improve and/or integrate major systems and enhance the control environment in the areas of financial planning and analysis, internal
reporting, and integration of the sales order entry and inventory subsystems with the general ledger system;
| | - |  | ------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------



| |  |  | Initiated training and education of all relevant personnel involved in interactions with the Companys independent registered public accounting firm designed to ensure that
such personnel understand and comply with the provisions of the Securities Exchange Act of 1934, and the rules promulgated thereunder, regarding representations to the Companys independent registered public accountants;
| | - |  | ---------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------



| |  |  | Communicated with all Company employees reaffirming the Companys whistleblower protections; and
| | - |  | ------------------------------------------------------------------------------------------------



| |  |  | Accelerated the documentation and internal control evaluation processes contemplated by Section 404 of the Sarbanes-Oxley Act.
| | - |  | ------------------------------------------------------------------------------------------------------------------------------



Management believes the measures that have been implemented to remediate the
material weaknesses have had a significant and positive impact on the Companys internal control over financial reporting since December 31, 2004 and anticipates that these measures and other ongoing enhancements will continue to
strengthen the Companys internal control over financial reporting in future periods.



Although the Company has implemented and continues to implement remediation efforts, a material weakness indicates that there is more than a remote likelihood that a material misstatement of the Companys
financial statements will not be prevented or detected. In addition, the Company cannot ensure that it will not in the future identify further material weaknesses or significant deficiencies in its internal control over financial reporting that it
has not discovered to date. The Company has taken and is taking steps to improve its internal control over financial reporting to comply with Section 404 of the Sarbanes-Oxley Act as required by the end of 2007. The efforts it has taken and
continues to take are subject to continued management review supported by confirmation and testing by management, as well as Audit Committee oversight. As a result, additional changes are likely to be made to the Companys internal control over
financial reporting. Other than the foregoing initiatives since the date of the evaluation supervised by management, there have been no material changes in the Companys disclosure controls and procedures, or the Companys internal control
over financial reporting, that could have materially affected, or are reasonably likely to materially affect, the Companys disclosure controls and procedures or the Companys internal control over financial reporting.



The Company performed additional analyses and other post-closing
procedures to address the material weaknesses and to ensure that the consolidated financial statements contained in this report were prepared in accordance with generally accepted accounting principles. Accordingly, management believes that the
financial statements included in this report fairly present in all material respects the Companys financial position, results of operations and cash flows for the periods presented.



Item 9B. Other Information.



None.



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##### Table of Contents

PART III.



Item 10. Directors and Executive Officers of the Registrant.



The information required by this item will be set forth under Directors and Executive Officers and Compliance with Section 16(a)
Under the Securities Exchange Act of 1934 in the Companys definitive proxy statement to be filed with the Commission in connection with the Companys 2005 annual meeting of stockholders, and reference is expressly made thereto for
the specific information incorporated by reference herein.



The
Company has adopted a Code of Business Conduct and Ethics that applies to the Companys directors, officers (including the Chief Executive Officer, Chief Financial Officer, Controller and persons performing similar functions), employees, agents
and consultants. This Code satisfies the requirements of a code of business conduct and ethics under the Nasdaq Rules and a code of ethics within the meaning of Section 406 of the Sarbanes-Oxley Act of 2002 and
applicable SEC rules. This Code of Business Conduct and Ethics has been posted to the Companys website at www.excelligencelearning.com under Company Policies. Amendments to, or waivers from, a provision of this Code of Business Conduct and
Ethics that apply to the Companys directors or executive officers, including the Chief Executive Officer, Chief Financial Officer, Controller and persons performing similar functions, may be made only by the Board and will be promptly posted
on the Companys website.



Item 11. Executive Compensation.



The information required by this item will be set forth under Executive Compensation in the Companys definitive proxy statement to be filed with the Commission in connection with the Companys 2005 annual meeting of
stockholders, and reference is expressly made thereto for the specific information incorporated by reference herein.



Item 12. Security Ownership of Certain Beneficial Owners and Management and Related Stockholder Matters.



The information required by this item will be set forth under Security Ownership of Certain Beneficial Owners and Management and Related Stockholder
Matters in the Companys definitive proxy statement to be filed with the Commission in connection with the Companys 2005 annual meeting of stockholders, and reference is expressly made thereto for the specific information
incorporated by reference herein.



Item 13. Certain Relationships and Related Transactions.



The information required by this item will be set forth under Certain Relationships and Related Transactions in the Companys definitive proxy statement to be filed with the Commission in connection
with the Companys 2005 annual meeting of stockholders, and reference is expressly made thereto for the specific information incorporated by reference herein.



Item 14. Principal Accountant Fees and Services.



The information required by this item will be set forth under Audit Committee Report  Fees in the Companys definitive proxy statement to be filed with the Commission in connection with the
Companys 2005 annual meeting of stockholders, and reference is expressly made thereto for the specific information incorporated by reference herein.



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##### Table of Contents

PART IV.



Item 15. Exhibits and Financial Statement Schedules.



(a) Financial Statements



(1) The financial statements listed on the accompanying Index to Consolidated Financial Statements, set forth on page F-1 and covered by the Independent Registered Public Accounting Firms Report, are incorporated herein by
reference and filed as a part of this Annual Report on Form 10-K/A.



(2) The financial schedule appearing on page F-25 and covered by the Independent Registered Public Accounting Firms Report is incorporated herein by reference and filed as part of this Annual Report on Form 10-K/A.



(3) Exhibits.



|               |  |                                                                                                                                                                                                                                                             
|-------------- |  | ------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
|Exhibit Number |  | Description                                                                                                                                                                                                                                                 
|2.1            |  | Contribution Agreement and Plan of Reorganization, dated as of November 14, 2000, by and among the Registrant, SmarterKids.com, Inc., Earlychildhood.com LLC and S-E Educational Merger
Corp. (1)                                                           
|               | 
|2.2            |  | Amendment No. 1 to the Contribution Agreement and Plan of Reorganization, dated as of March 14, 2001, by and among the Registrant, SmarterKids.com, Inc., Earlychildhood LLC and
S-E Educational Merger Corp. (2)                                           
|               | 
|3.1            |  | Restated Certificate of Incorporation of the Registrant. (6)                                                                                                                                                                                                
|               | 
|3.2            |  | Certificate of Amendment of Restated Certificate of Incorporation of the Registrant, dated May 3, 2002. (12)                                                                                                                                                
|               | 
|3.3            |  | Amended and Restated Bylaws of the Registrant, as currently in effect. (6)                                                                                                                                                                                  
|               | 
|4.1            |  | Business Loan Agreement, dated as of September 26, 2003, between Bank of America, N.A. and the Registrant, Earlychildhood LLC, Educational Products, Inc., SmarterKids.com, Inc., Marketing
Logistics, Inc. and Colorations, Inc. (15)                      
|               | 
|4.2            |  | Amendment Number One to Business Loan Agreement, dated as of October 28, 2003, between Bank of America, N.A. and the Registrant, Earlychildhood LLC, Educational Products, Inc.,
SmarterKids.com, Inc., Marketing Logistics, Inc. and Colorations, Inc. (16)
|               | 
|+10.1          |  | Amended and Restated 2001 Stock Option and Incentive Plan of the Registrant. (14)                                                                                                                                                                           
|               | 
|+10.2          |  | First Amendment to Amended and Restated 2001 Stock Option and Incentive Plan of the Registrant. (18)                                                                                                                                                        
|               | 
|+10.3          |  | 2001 Non-Employee Director Stock Option Plan of the Registrant. (7)                                                                                                                                                                                         
|               | 
|+10.4          |  | Second Amended and Restated 2001 Employee Stock Purchase Plan of the Registrant. (9)                                                                                                                                                                        
|               | 
|+10.5          |  | Amendment to Second Amended and Restated 2001 Employee Stock Purchase Plan of the Registrant. (14)                                                                                                                                                          
|               | 
|10.5           |  | Amended and Restated Registration Rights Agreement, dated June 30, 2001, by and among the Registrant and the stockholders listed on Schedule A thereto. (8)                                                                                                 
|               | 
|10.6           |  | Retention Agreement, dated as of April 30, 2001, by and between the Registrant and Al Noyes. (10)                                                                                                                                                           
|               | 
|10.7           |  | Release, dated as of July 31, 2001, by and between the Registrant and Al Noyes. (10)                                                                                                                                                                        
|               | 
|+10.8          |  | Employment Agreement, dated as of June 28, 2002, by and between the Registrant and Ronald Elliott. (12)                                                                                                                                                     



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|               |  |                                                                                                                                                                                                
|-------------- |  | -----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
|Exhibit Number |  | Description                                                                                                                                                                                    
|+10.9          |  | Employment Agreement, effective as of January 1, 2003, by and between the Registrant and Judith McGuinn. (13)                                                                                  
|               | 
|+10.10         |  | Employment Agreement, dated as of June 18, 2004, by and between the Registrant and Diane Kayser. (19)                                                                                          
|               | 
|10.11          |  | Lease Agreement, dated as of April 7, 2000, between SmarterKids.com, Inc. and Keep Your Day Job, LLC. (3)                                                                                      
|               | 
|10.12          |  | Lease Agreement, dated as of March 30, 2000, by and between Earlychildhood.com LLC and PTF For Operating Engineers, LLC. (4)                                                                   
|               | 
|10.13          |  | Lease Agreement, dated as of April 22, 1996, by and between QTL Corporation and Rubin Brothers, Inc., as amended. (4)                                                                          
|               | 
|10.14          |  | Addendum to Lease #3, dated as of December 15, 2003, by and between the Registrant and R.B.I. Holding Company, Inc. (17)                                                                       
|               | 
|10.15          |  | Lease Agreement, dated as of December 3, 1993, by and between Educational Products, Inc. and H B Industrial Properties, as amended. (4) (5)                                                    
|               | 
|10.16          |  | Lease Agreement, dated as of April 15, 1999, by and between Educational Products, Inc. and TIAA Realty, Inc., as amended. (10)                                                                 
|               | 
|10.17          |  | Lease Agreement, dated as of March 23, 1999, by and between QTL Corporation and Spieker Properties, L.P. (4)                                                                                   
|               | 
|10.18          |  | Amendment No. 1 to March 23, 1999 Lease Agreement, dated as of June 11, 1999, by and between Earlychildhood.com, LLC and Spieker Properties, L.P. (10)                                         
|               | 
|10.19          |  | Amendment No. 2 to March 23, 1999 Lease Agreement, dated as of March 14, 2000, by and between Earlychildhood.com LLC and Spieker Properties, L.P. (10)                                         
|               | 
|10.20          |  | Amendment No. 3 to March 23, 1999 Lease Agreement, dated as of August 20, 2001, by and between the Registrant and Ryan Oaks, LLC (as successor-in-interest to Spieker Properties,
L.P.). (10)  
|               | 
|10.21          |  | Amendment No. 4 to March 23, 1999 Lease Agreement, dated as of March 18, 2004, by and between the Registrant and Ryan Oaks, LLC (as successor-in-interest to Spieker Properties,
L.P.). (19)   
|               | 
|10.22          |  | Lease Agreement, dated as of November 22, 1999, by and between Earlychildhood.com LLC and Spieker Properties, L.P. (4)                                                                         
|               | 
|10.23          |  | Amendment No. 1 to November 22, 1999 Lease Agreement, dated as of April 6, 2001, by and between the Registrant and Ryan Oaks, LLC (as successor-in-interest to Spieker Properties,
L.P.). (10) 
|               | 
|10.24          |  | Amendment No. 2 to November 22, 1999 Lease Agreement, dated as of March 18, 2004, by and between the Registrant and Ryan Oaks, LLC (as successor-in-interest to Spieker Properties,
L.P.). (19)
|               | 
|10.25          |  | Lease Agreement, dated as of August 9, 2000, by and between Earlychildhood.com LLC and Elliott-Mair Salinas LLC. (3)                                                                           
|               | 
|10.26          |  | Lease Agreement, dated as of August 17, 2000, by and between Earlychildhood.com LLC and Mann Realty Associates, Inc. (4)                                                                       
|               | 
|10.27          |  | Sublease and Consent to Sublease, dated as of September 1, 2002, by and among Elliott-Mair Salinas LLC, Earlychildhood.com LLC and Ronald Elliott. (13)                                        



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|               |  |                                                                                                                                                                                                   
|-------------- |  | --------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
|Exhibit Number |  | Description                                                                                                                                                                                       
|14.1           |  | Code of Business Conduct and Ethics of the Registrant. (17)                                                                                                                                       
|               | 
|21.1           |  | Subsidiaries of the Registrant. (18)                                                                                                                                                              
|               | 
|*23.1          |  | Consent of Independent Registered Public Accounting Firm.                                                                                                                                         
|               | 
|*31.1          |  | Certification of Chief Executive Officer and Principal Financial Officer, pursuant to Rule 13a-14 promulgated under the Exchange Act, as created by Section 302 of the Sarbanes-Oxley Act of
2002.
|               | 
|*32.1          |  | Certification of Chief Executive Officer and Principal Financial Officer, pursuant to 18 U.S.C. Section 1350, as created by Section 906 of the Sarbanes-Oxley Act of 2002.                        

---

|* | Filed herewith.
|- | ---------------

|+ | Management contracts or compensatory plans or arrangements required to be filed as Exhibits by Item 601(b)(10)(iii) of Regulation S-K.
|- | --------------------------------------------------------------------------------------------------------------------------------------

|(1) | Incorporated by reference from Annex A to the Proxy-Statement Prospectus contained in Part I of Post-Effective Amendment No. 2 to the Registrants Registration Statement
on Form S-4 filed with the Commission on April 27, 2001 (File No. 333-53454).
|--- | -------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

|(2) | Incorporated by reference from Annex A-1 to the Proxy-Statement Prospectus contained in Part I of Post-Effective Amendment No. 2 to the Registrants Registration Statement
on Form S-4 filed with the Commission on April 27, 2001 (File No. 333-53454).
|--- | ---------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

|(3) | Incorporated by reference from the Registrants Registration Statement on Form S-4 filed with the Commission on January 9, 2001 (File No. 333-53454).
|--- | -----------------------------------------------------------------------------------------------------------------------------------------------------

|(4) | Incorporated by reference from Amendment No. 1 to the Registrants Registration Statement on Form S-4 filed with the Commission on February 21, 2001 (File
No. 333-53454).
|--- | --------------------------------------------------------------------------------------------------------------------------------------------------------------------------

|(5) | Incorporated by reference from Amendment No. 2 to the Registrants Registration Statement on Form S-4 filed with the Commission on March 7, 2001 (File
No. 333-53454).
|--- | ----------------------------------------------------------------------------------------------------------------------------------------------------------------------

|(6) | Incorporated by reference from the Registrants Registration Statement on Form S-8 filed with the Commission on July 9, 2001 (File No. 333-64762).
|--- | --------------------------------------------------------------------------------------------------------------------------------------------------

|(7) | Incorporated by reference from the Registrants Registration Statement on Form S-8 filed with the Commission on July 9, 2001 (File No. 333-64764).
|--- | --------------------------------------------------------------------------------------------------------------------------------------------------

|(8) | Incorporated by reference from the Registrants Quarterly Report on Form 10-Q/A for the Quarter Ended June 30, 2001, filed with the Commission on August 15, 2001
(File No. 000-32613).
|--- | ---------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

|(9) | Incorporated by reference from the Registrants Registration Statement on Form S-8 filed with the Commission on December 20, 2001 (File No. 333-75602).
|--- | -------------------------------------------------------------------------------------------------------------------------------------------------------

|(10) | Incorporated by reference from the Registrants Annual Report on Form 10-K for the Year Ended December 31, 2001, filed with the Commission on March 29, 2002 (File No.
000-32613).
|---- | ----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

|(11) | Incorporated by reference from the Registrants Quarterly Report on Form 10-Q for the Quarter Ended March 31, 2002, filed with the Commission on May 15, 2002 (File
No. 000-32613).
|---- | -----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

|(12) | Incorporated by reference from the Registrants Quarterly Report on Form 10-Q for the Quarter Ended June 30, 2002, filed with the Commission on August 14, 2002 (File
No. 000-32613).
|---- | -------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

|(13) | Incorporated by reference from the Registrants Annual Report on Form 10-K for the Fiscal Year Ended December 31, 2002, filed with the Commission on March 7, 2003
(File No. 000-32613).
|---- | ----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

|(14) | Incorporated by reference from the Registrants Quarterly Report on Form 10-Q for the Quarter Ended June 30, 2003, filed with the Commission on August 7, 2003 (File
No. 000-32613).
|---- | ------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

|(15) | Incorporated by reference from the Registrants Current Report on Form 8-K, filed with the Commission on September 29, 2003 (File No. 000-32613).
|---- | -------------------------------------------------------------------------------------------------------------------------------------------------

|(16) | Incorporated by reference from the Registrants Quarterly Report on Form 10-Q for the Quarter Ended September 30, 2003, filed with the Commission on November 7, 2003
(File No. 000-32613).
|---- | -------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

|(17) | Incorporated by reference from the Registrants Annual Report on Form 10-K for the Fiscal Year Ended December 31, 2003, filed with the Commission on March 11, 2004
(File No. 000-32613).
|---- | -----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

|(18) | Incorporated by reference from the Registrants Quarterly Report on Form 10-Q for the Quarter Ended March 31, 2004, filed with the Commission on May 11, 2004 (File
No. 000-32613).
|---- | -----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

|(19) | Incorporated by reference from the Registrants Quarterly Report on Form 10-Q for the Quarter Ended June 30, 2004, filed with the Commission on August 13, 2004 (File
No. 000-32613).
|---- | -------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------



(b) The exhibits required by
Item 601 of Regulation S-K are listed above.



(c)
Financial Statement Schedules.



The financial schedule
appearing on page F-25 and covered by the Independent Registered Public Accounting Firms Report is incorporated herein by reference and filed as part of this Annual Report on Form 10-K/A.



29



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##### Table of Contents

SIGNATURES



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



EXCELLIGENCE LEARNING CORPORATIONBy:

/s/ Ronald ElliottRonald ElliottChief Executive Officer




Dated: February 1, 2006



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



|                                     |  |                                                                                                                                                |  |                 
|------------------------------------ |  | ---------------------------------------------------------------------------------------------------------------------------------------------- |  | ----------------
|Signature                            |  | Title                                                                                                                                          |  | Date            
|                                     |  |                                                                                                                                               
|/s/ ROBERT MACDONALD                 |  | Chairman of the Board                                                                                                                          |  | February 1, 2006
|Robert MacDonald                     |  |                                                                                                                                               
|                                     |  |                                                                                                                                               
|/s/ RONALD ELLIOTTRonald Elliott     |  | Director and Chief Executive Officer (Principal Executive Officer, Acting Principal Financial Officer and Acting Principal Accounting Officer) |  | February 1, 2006
|                                     |  |                                                                                                                                               
|/s/ LOUIS CASAGRANDELouis Casagrande |  | Director                                                                                                                                       |  | February 1, 2006
|                                     |  |                                                                                                                                               
|/s/ DEAN DEBIASEDean DeBiase         |  | Director                                                                                                                                       |  | February 1, 2006
|                                     |  |                                                                                                                                               
|/s/ RICHARD DELANEYRichard Delaney   |  | Director                                                                                                                                       |  | February 1, 2006
|                                     |  |                                                                                                                                               
|/s/ COLIN GALLAGHERColin Gallagher   |  | Director                                                                                                                                       |  | February 1, 2006
|                                     |  |                                                                                                                                               
|/s/ SCOTT GRAVESScott Graves         |  | Director                                                                                                                                       |  | February 1, 2006



30



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##### Table of Contents

INDEX TO CONSOLIDATED FINANCIAL STATEMENTS



The following consolidated financial statements are filed as part of this Annual Report on Form 10-K/A:



|                                                                                                   |  |     
|-------------------------------------------------------------------------------------------------- |  | ----
|                                                                                                   |  | Page
|Consolidated Financial Statements:                                                                 |  |     
|Report of Independent Registered Public Accounting Firm                                            |  | F-2 
|Consolidated Balance Sheets at December 31, 2004 and 2003                                          |  | F-3 
|Consolidated Statements of Operations for the fiscal years ended December 31, 2004, 2003, and 2002 |  | F-4 
|Consolidated Statements of Equity for the fiscal years ended December 31, 2004, 2003 and 2002      |  | F-5 
|Consolidated Statements of Cash Flows for the fiscal years ended December 31, 2004, 2003 and 2002  |  | F-6 
|Notes to Consolidated Financial Statements                                                         |  | F-7 
|                                                                                                   | 
|Financial Statement Schedule:                                                                      |  |     
|Valuation and Qualifying Accounts                                                                  |  | F-25





F-1



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##### Table of Contents

Report of Independent Registered Public Accounting Firm



The Board of Directors and Stockholders

Excelligence Learning Corporation:



We have audited the consolidated balance sheets of Excelligence Learning Corporation and subsidiaries as of December 31, 2004 and 2003, and the related consolidated statements of operations, equity and cash flows for each of the years
in the three-year period ended December 31, 2004. In connection with our audits of the consolidated financial statements, we have also audited the financial statement schedule on valuation and qualifying accounts as listed in the preceding
index. These consolidated financial statements and financial statement schedule are the responsibility of the Companys management. Our responsibility is to express an opinion on these consolidated financial statements and financial statement
schedule based on our audits.



We conducted our audits in
accordance with the standards of the Public Company 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. An audit 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 consolidated financial statements referred to above present fairly, in all material respects, the financial position of Excelligence
Learning Corporation and subsidiaries as of December 31, 2004 and 2003, and the results of their operations and their cash flows for each of the years in the three-year period ended December 31, 2004, in conformity with U.S. generally
accepted accounting principles. Also in our opinion, the related financial statement schedule, when considered in relation to the basic consolidated financial statements taken as a whole, presents fairly, in all material respects, the information
set forth herein.



As discussed in Note 3, the consolidated
financial statements as of and for the year ended December 31, 2004 have been restated. In addition, the financial statement schedule on valuation and qualifying accounts has been restated.



/s/ KPMG LLP



San Francisco, California

March 11, 2005, except for Note 3,

which is as of December 30, 2005



F-2



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##### Table of Contents

EXCELLIGENCE LEARNING CORPORATION

CONSOLIDATED BALANCE SHEETS

(In thousands, except for par value and share amounts)



|                                                                                                                                                               |  |              |         |   |      |   |         |  
|-------------------------------------------------------------------------------------------------------------------------------------------------------------- |  | ------------ | ------- | - | ---- | - | ------- | -
|                                                                                                                                                               |  | December 31, |        
|                                                                                                                                                               |  | 2004         |         |   | 2003 |  
|                                                                                                                                                               |  | Restated (1) |         |   |      |  
|ASSETS                                                                                                                                                         |  |              |         |   |      |   |         |  
|Current assets:                                                                                                                                                |  |              |         |   |      |   |         |  
|Cash and cash equivalents                                                                                                                                      |  | $            | 2,657   |   |      | $ | 3,620   |  
|Accounts receivable, net of allowance for doubtful accounts of $412 and $481 at December 31, 2004 and December 31, 2003,
respectively                          |  |              | 8,286   |   |      |   | 5,480   |  
|Inventories                                                                                                                                                    |  |              | 16,478  |   |      |   | 15,133  |  
|Prepaid expenses and other current assets                                                                                                                      |  |              | 4,195   |   |      |   | 2,937   |  
|Deferred income taxes                                                                                                                                          |  |              | 700     |   |      |   | 1,214   |  
|                                                                                                                                                               |  |              |         |   |      |   |         |  
|Total current assets                                                                                                                                           |  |              | 32,316  |   |      |   | 28,384  |  
|Property and equipment, net                                                                                                                                    |  |              | 4,401   |   |      |   | 4,070   |  
|Deferred income taxes                                                                                                                                          |  |              | 6,373   |   |      |   | 6,367   |  
|Other assets                                                                                                                                                   |  |              | 238     |   |      |   | 307     |  
|Goodwill                                                                                                                                                       |  |              | 5,878   |   |      |   | 5,878   |  
|Other intangible assets, net                                                                                                                                   |  |              | 745     |   |      |   | 918     |  
|                                                                                                                                                               |  |              |         |   |      |   |         |  
|Total assets                                                                                                                                                   |  | $            | 49,951  |   |      | $ | 45,924  |  
|                                                                                                                                                               |  |              |         |   |      |   |         |  
|LIABILITIES AND EQUITY                                                                                                                                         |  |              |         |   |      |   |         |  
|Current liabilities:                                                                                                                                           |  |              |         |   |      |   |         |  
|Accounts payable                                                                                                                                               |  | $            | 4,125   |   |      | $ | 3,018   |  
|Accrued expenses                                                                                                                                               |  |              | 3,638   |   |      |   | 2,955   |  
|Income tax payable                                                                                                                                             |  |              |        |   |      |   | 234     |  
|Other current liabilities                                                                                                                                      |  |              | 162     |   |      |   | 186     |  
|                                                                                                                                                               |  |              |         |   |      |   |         |  
|Total current liabilities                                                                                                                                      |  |              | 7,925   |   |      |   | 6,393   |  
|                                                                                                                                                               |  |              |         |   |      |   |         |  
|Redeemable common shares, 0 and 100,000 shares authorized, issued, and outstanding at December 31, 2004 and 2003,
respectively                                 |  |              |        |   |      |   | 400     |  
|                                                                                                                                                               |  |              |         |   |      |   |         |  
|Equity:                                                                                                                                                        |  |              |         |   |      |   |         |  
|Common stock, $0.01 par value; 15,000,000 shares authorized; 8,840,354 and 8,549,423 shares issued and outstanding at December 31, 2004
and 2003, respectively |  |              | 88      |   |      |   | 85      |  
|Additional paid-in capital                                                                                                                                     |  |              | 63,257  |   |      |   | 62,353  |  
|Deferred stock compensation                                                                                                                                    |  |              | (214    | ) |      |   | (920    | )
|Accumulated deficit                                                                                                                                            |  |              | (21,105 | ) |      |   | (22,387 | )
|                                                                                                                                                               |  |              |         |   |      |   |         |  
|Total equity                                                                                                                                                   |  |              | 42,026  |   |      |   | 39,131  |  
|                                                                                                                                                               |  |              |         |   |      |   |         |  
|Total liabilities and equity                                                                                                                                   |  | $            | 49,951  |   |      | $ | 45,924  |  
|                                                                                                                                                               |  |              |         |   |      |   |         |  

---

|(1) | See Note 3, Restatement of Consolidated Financial Statements of the Notes to Consolidated Financial Statements.
|--- | -----------------------------------------------------------------------------------------------------------------



See accompanying notes to consolidated financial statements.



F-3



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##### Table of Contents

EXCELLIGENCE LEARNING CORPORATION

CONSOLIDATED STATEMENTS OF OPERATIONS

(In thousands, except for share and per share amounts)



|                                                                         |  |                                         |           |   |      |   |           |      |  |   |           |  
|------------------------------------------------------------------------ |  | --------------------------------------- | --------- | - | ---- | - | --------- | ---- |  | - | --------- | -
|                                                                         |  | For the Fiscal Years Ended December 31, |          
|                                                                         |  | 2004                                    |           |   | 2003 |   |           | 2002 | 
|                                                                         |  | Restated (1)                            |           |   |      |   |           |      | 
|Revenues                                                                 |  | $                                       | 120,988   |   |      | $ | 109,921   |      |  | $ | 100,760   |  
|Cost of goods sold                                                       |  |                                         | 80,408    |   |      |   | 70,427    |      |  |   | 64,478    |  
|                                                                         |  |                                         |           |   |      |   |           |      |  |   |           |  
|Gross profit                                                             |  |                                         | 40, 580   |   |      |   | 39,494    |      |  |   | 36,282    |  
|                                                                         |  |                                         |           |   |      |   |           |      |  |   |           |  
|Operating expenses:                                                      |  |                                         |           |   |      |   |           |      |  |   |           |  
|Selling, general and administrative                                      |  |                                         | 38,257    |   |      |   | 34,578    |      |  |   | 32,603    |  
|Amortization of intangible assets                                        |  |                                         | 173       |   |      |   | 279       |      |  |   | 288       |  
|                                                                         |  |                                         |           |   |      |   |           |      |  |   |           |  
|Operating income                                                         |  |                                         | 2, 150    |   |      |   | 4,637     |      |  |   | 3,391     |  
|                                                                         |  |                                         |           |   |      |   |           |      |  |   |           |  
|Other (income) expense:                                                  |  |                                         |           |   |      |   |           |      |  |   |           |  
|Interest expense                                                         |  |                                         | 89        |   |      |   | 261       |      |  |   | 428       |  
|Debt extinguishment                                                      |  |                                         |          |   |      |   | 216       |      |  |   |          |  
|Gain on sale of assets                                                   |  |                                         | (5        | ) |      |   |          |      |  |   |          |  
|Interest income                                                          |  |                                         | (9        | ) |      |   | (14       | )    |  |   | (37       | )
|                                                                         |  |                                         |           |   |      |   |           |      |  |   |           |  
|Income before income taxes                                               |  |                                         | 2,075     |   |      |   | 4,174     |      |  |   | 3,000     |  
|Income tax expense (benefit)                                             |  |                                         | 793       |   |      |   | (3,637    | )    |  |   | 548       |  
|                                                                         |  |                                         |           |   |      |   |           |      |  |   |           |  
|Net income                                                               |  | $                                       | 1,282     |   |      | $ | 7,811     |      |  | $ | 2,452     |  
|                                                                         |  |                                         |           |   |      |   |           |      |  |   |           |  
|Net Income Per Share Calculation:                                        |  |                                         |           |   |      |   |           |      |  |   |           |  
|Income per share: Basic                                                  |  | $                                       | 0.15      |   |      | $ | 0.91      |      |  | $ | 0.29      |  
|Diluted                                                                  |  | $                                       | 0.14      |   |      | $ | 0.85      |      |  | $ | 0.29      |  
|Weighted average shares used in basic and diluted per share calculation: |  |                                         |           |   |      |   |           |      |  |   |           |  
|Basic                                                                    |  |                                         | 8,763,326 |   |      |   | 8,536,314 |      |  |   | 8,371,726 |  
|Diluted                                                                  |  |                                         | 9,277,719 |   |      |   | 9,171,814 |      |  |   | 8,371,726 |  

---

|(1) | See Note 3, Restatement of Consolidated Financial Statements of the Notes to Consolidated Financial Statements.
|--- | -----------------------------------------------------------------------------------------------------------------



See accompanying notes to consolidated financial statements.



F-4



---

##### Table of Contents

EXCELLIGENCE LEARNING CORPORATION

CONSOLIDATED STATEMENTS OF EQUITY

(In thousands, except for share amounts)



|                                            |  |              |  |                           |    |  |                           |        |   |                    |   |        |       |  |   |         |   |  |   |       
|------------------------------------------- |  | ------------ |  | ------------------------- | -- |  | ------------------------- | ------ | - | ------------------ | - | ------ | ----- |  | - | ------- | - |  | - | ------
|                                            |  | Common Stock |  | AdditionalPaid-in Capital |    |  | DeferredStockCompensation |        |   | AccumulatedDeficit |   |        | Total
|                                            |  | Shares       |  | Amount                    |    |  |                           |       
|Balance at December 31, 2001                |  | 8,364,260    |  | $                         | 84 |  | $                         | 62,194 |   |                    | $ | (2,054 | )     |  | $ | (32,650 | ) |  | $ | 27,574
|Employee Stock Purchase Plan                |  | 7,710        |  |                           |   |  |                           | 8      |   |                    |   |       |       |  |   |        |   |  |   | 8     
|Exercise of stock options                   |  | 29,944       |  |                           |   |  |                           | 4      |   |                    |   |       |       |  |   |        |   |  |   | 4     
|Net income                                  |  |             |  |                           |   |  |                           |       |   |                    |   |       |       |  |   | 2,452   |   |  |   | 2,452 
|Deferred compensation amortization          |  |             |  |                           |   |  |                           |       |   |                    |   | 572    |       |  |   |        |   |  |   | 572   
|                                            |  |              |  |                           |    |  |                           |        |   |                    |   |        |       |  |   |         |   |  |   |       
|Balance at December 31, 2002                |  | 8,401,914    |  |                           | 84 |  |                           | 62,206 |   |                    |   | (1,482 | )     |  |   | (30,198 | ) |  |   | 30,610
|Employee Stock Purchase Plan                |  | 21,652       |  |                           |   |  |                           | 41     |   |                    |   |       |       |  |   |        |   |  |   | 41    
|Exercise of stock options                   |  | 125,857      |  |                           | 1  |  |                           | 106    |   |                    |   |       |       |  |   |        |   |  |   | 107   
|Net income                                  |  |             |  |                           |   |  |                           |       |   |                    |   |       |       |  |   | 7,811   |   |  |   | 7,811 
|Deferred compensation amortization          |  |             |  |                           |   |  |                           |       |   |                    |   | 562    |       |  |   |        |   |  |   | 562   
|                                            |  |              |  |                           |    |  |                           |        |   |                    |   |        |       |  |   |         |   |  |   |       
|Balance at December 31, 2003                |  | 8,549,423    |  |                           | 85 |  |                           | 62,353 |   |                    |   | (920   | )     |  |   | (22,387 | ) |  |   | 39,131
|Exercise of stock options                   |  | 190,931      |  |                           | 2  |  |                           | 318    |   |                    |   |       |       |  |   |        |   |  |   | 320   
|Tax benefit from employee stock option plan |  |             |  |                           |   |  |                           | 318    |   |                    |   |       |       |  |   |        |   |  |   | 318   
|Net income                                  |  |             |  |                           |   |  |                           |       |   |                    |   |       |       |  |   | 1,282   |   |  |   | 1,282 
|Conversion of redeemable common stock       |  | 100,000      |  |                           | 1  |  |                           | 399    |   |                    |   |       |       |  |   |        |   |  |   | 400   
|Deferred compensation amortization          |  |             |  |                           |   |  |                           | (131   | ) |                    |   | 706    |       |  |   |        |   |  |   | 575   
|                                            |  |              |  |                           |    |  |                           |        |   |                    |   |        |       |  |   |         |   |  |   |       
|Balance at December 31, 2004 Restated (1)   |  | 8,840,354    |  | $                         | 88 |  | $                         | 63,257 |   |                    | $ | (214   | )     |  | $ | (21,105 | ) |  | $ | 42,026
|                                            |  |              |  |                           |    |  |                           |        |   |                    |   |        |       |  |   |         |   |  |   |       

---

|(1) | See Note 3, Restatement of Consolidated Financial Statements of the Notes to Consolidated Financial Statements.
|--- | -----------------------------------------------------------------------------------------------------------------



See accompanying notes to consolidated financial statements.



F-5



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##### Table of Contents

EXCELLIGENCE LEARNING CORPORATION

CONSOLIDATED STATEMENTS OF CASH FLOWS

(In thousands)



|                                                                                                                                |  |                                         |         |   |      |   |         |      |  |   |         |  
|------------------------------------------------------------------------------------------------------------------------------- |  | --------------------------------------- | ------- | - | ---- | - | ------- | ---- |  | - | ------- | -
|                                                                                                                                |  | For the Fiscal Years Ended December 31, |        
|                                                                                                                                |  | 2004                                    |         |   | 2003 |   |         | 2002 | 
|                                                                                                                                |  | Restated (1)                            |         |   |      |   |         |      | 
|Cash flows from operating activities:                                                                                           |  |                                         |         |   |      |   |         |      |  |   |         |  
|Net income                                                                                                                      |  | $                                       | 1,282   |   |      | $ | 7,811   |      |  | $ | 2,452   |  
|Adjustments to reconcile net income to net cash provided by operating activities:                                               |  |                                         |         |   |      |   |         |      |  |   |         |  
|Depreciation and amortization                                                                                                   |  |                                         | 1,711   |   |      |   | 1,697   |      |  |   | 1,554   |  
|Gain on sale of assets                                                                                                          |  |                                         | (5      | ) |      |   |        |      |  |   |        |  
|Provision for losses on accounts receivable                                                                                     |  |                                         | (69     | ) |      |   | 545     |      |  |   | 404     |  
|Stock-based compensation                                                                                                        |  |                                         | 575     |   |      |   | 562     |      |  |   | 572     |  
|Deferred income taxes                                                                                                           |  |                                         | 826     |   |      |   | (3,911  | )    |  |   | (258    | )
|Changes in operating assets and liabilities, net of assets acquired and liabilities assumed in the Combination and
acquisition: |  |                                         |         |   |      |   |         |      |  |   |         |  
|Accounts receivable                                                                                                             |  |                                         | (2,737  | ) |      |   | (1,007  | )    |  |   | (138    | )
|Inventories                                                                                                                     |  |                                         | (1,345  | ) |      |   | (1,195  | )    |  |   | 5,180   |  
|Prepaid expenses and other current assets                                                                                       |  |                                         | (1,258  | ) |      |   | (236    | )    |  |   | 460     |  
|Other assets                                                                                                                    |  |                                         | 69      |   |      |   | 719     |      |  |   | 66      |  
|Accounts payable                                                                                                                |  |                                         | 1,107   |   |      |   | (506    | )    |  |   | (1,718  | )
|Accrued expenses                                                                                                                |  |                                         | 683     |   |      |   | (1,342  | )    |  |   | (1,381  | )
|Income tax payable                                                                                                              |  |                                         | (234    | ) |      |   | 18      |      |  |   | 216     |  
|Other current liabilities                                                                                                       |  |                                         | (24     | ) |      |   | (343    | )    |  |   | 336     |  
|                                                                                                                                |  |                                         |         |   |      |   |         |      |  |   |         |  
|Net cash provided by operating activities                                                                                       |  |                                         | 581     |   |      |   | 2,812   |      |  |   | 7,745   |  
|                                                                                                                                |  |                                         |         |   |      |   |         |      |  |   |         |  
|Cash flows from investing activities:                                                                                           |  |                                         |         |   |      |   |         |      |  |   |         |  
|Purchase of property and equipment                                                                                              |  |                                         | (1,864  | ) |      |   | (1,183  | )    |  |   | (1,203  | )
|Acquisition of Marketing Logistics, Inc.                                                                                        |  |                                         |        |   |      |   | (871    | )    |  |   |        |  
|Proceeds received from payment of receivable from related party                                                                 |  |                                         |        |   |      |   |        |      |  |   | 139     |  
|                                                                                                                                |  |                                         |         |   |      |   |         |      |  |   |         |  
|Net cash used in investing activities                                                                                           |  |                                         | (1,864  | ) |      |   | (2,054  | )    |  |   | (1,064  | )
|                                                                                                                                |  |                                         |         |   |      |   |         |      |  |   |         |  
|Cash flows from financing activities:                                                                                           |  |                                         |         |   |      |   |         |      |  |   |         |  
|Borrowings on line of credit                                                                                                    |  |                                         | 13,750  |   |      |   | 72,671  |      |  |   | 78,229  |  
|Principal payments on line of credit                                                                                            |  |                                         | (13,750 | ) |      |   | (72,671 | )    |  |   | (83,818 | )
|Principal payments on notes payable                                                                                             |  |                                         |        |   |      |   |        |      |  |   | (14     | )
|Issuance of equity                                                                                                              |  |                                         | 320     |   |      |   | 149     |      |  |   | 12      |  
|                                                                                                                                |  |                                         |         |   |      |   |         |      |  |   |         |  
|Net cash provided by (used in) financing activities                                                                             |  |                                         | 320     |   |      |   | 149     |      |  |   | (5,591  | )
|                                                                                                                                |  |                                         |         |   |      |   |         |      |  |   |         |  
|Net (decrease) increase in cash and cash equivalents                                                                            |  |                                         | (963    | ) |      |   | 907     |      |  |   | 1,090   |  
|Cash and cash equivalents at beginning of year                                                                                  |  |                                         | 3,620   |   |      |   | 2,713   |      |  |   | 1,623   |  
|                                                                                                                                |  |                                         |         |   |      |   |         |      |  |   |         |  
|Cash and cash equivalents at end of year                                                                                        |  | $                                       | 2,657   |   |      | $ | 3,620   |      |  | $ | 2,713   |  
|                                                                                                                                |  |                                         |         |   |      |   |         |      |  |   |         |  
|Noncash investing and financing activities:                                                                                     |  |                                         |         |   |      |   |         |      |  |   |         |  
|Issuance of redeemable common shares in acquisition                                                                             |  | $                                       |        |   |      | $ | 400     |      |  | $ |        |  
|Supplemental disclosures of cash flow information:                                                                              |  |                                         |         |   |      |   |         |      |  |   |         |  
|Cash payments during the period for:                                                                                            |  |                                         |         |   |      |   |         |      |  |   |         |  
|Interest                                                                                                                        |  | $                                       | 89      |   |      | $ | 261     |      |  | $ | 365     |  
|Income taxes                                                                                                                    |  | $                                       | 471     |   |      | $ | 450     |      |  | $ | 695     |  

---

|(1) | See Note 3, Restatement of Consolidated Financial Statements of the Notes to Consolidated Financial Statements.
|--- | -----------------------------------------------------------------------------------------------------------------



See accompanying notes to consolidated financial statements.



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##### Table of Contents

EXCELLIGENCE LEARNING CORPORATION



NOTES TO CONSOLIDATED FINANCIAL STATEMENTS



|(1) | The Business
|--- | ------------



Excelligence Learning Corporation, a Delaware corporation (the Company), is a developer, manufacturer and retailer of educational products,
which are sold to child care programs, preschools, elementary schools and consumers. The Company was incorporated in the State of Delaware on November 6, 2000 for the purpose of effecting the combination (the Combination) of the
businesses of Earlychildhood LLC, a California limited liability company (Earlychildhood), and SmarterKids.com, Inc., a Delaware corporation. The Companys business is primarily conducted through its wholly-owned subsidiaries,
Earlychildhood, Educational Products, Inc., a Texas corporation (EPI), and Marketing Logistics, Inc., a Minnesota corporation dba Early Childhood Manufacturers Direct (ECMD).



|(2) | Summary of Significant Accounting Policies
|--- | ------------------------------------------



Critical Accounting Policies and Estimates



|(a) | Revenue Recognition and Accounts Receivable
|--- | -------------------------------------------



The Company recognizes revenue from product sales upon the delivery of products to an unrelated third party customer when (a) the customer takes
title of the goods; (b) the price to the customer is fixed or determinable; (c) the customer is obligated to pay the Company and the obligation is not contingent on resale of the product; (d) the customers obligation to the
Company would not be changed in the event of theft or physical destruction or damage of the product; and (e) the Company does not have significant obligations for future performance to directly bring about resale of the product by the customer.
Provisions for estimated returns and allowances are recorded as a reduction to sales and cost of sales based on historical experience. The Company determines that collectibility of accounts receivable is reasonably assured through standardized
credit review to determine each customers credit worthiness. The Company maintains allowances for doubtful accounts for estimated losses resulting from the inability of its customers to make required payments. If the financial condition of the
Companys customers were to deteriorate, resulting in an impairment of their ability to make payments, additional allowances may be required.



|(b) | Inventories
|--- | -----------



The Company uses the lower of cost or market under both the first-in, first-out and average cost methods to value inventories. In the Early Childhood
segment, the Company uses the first-in, first-out method for its finished goods inventory and the average cost method for its raw materials inventory related to paint manufacturing. The Elementary School segment uses the average cost method for all
inventories. Inventory cost is based on amounts paid to vendors plus the capitalization of certain labor and overhead costs necessary to prepare inventory to be saleable.



The Company writes down its inventory for estimated obsolescence, damaged or unmarketable inventory equal to the difference
between the cost of inventory and the estimated market value based upon assumptions about future demand and market conditions. If actual market conditions are less favorable than those projected by management, additional inventory write-downs may be
required.



|(c) | Accounting for Impairment of Long-Lived Assets
|--- | ----------------------------------------------



The Company assesses the need to record impairment losses on long-lived assets used in operations, including goodwill and other intangibles, when
indicators of impairment are present. On an on-going basis, management reviews the value and period of amortization or depreciation of its long-lived assets. Recoverability of long-lived assets to be held and used is measured by comparing the
carrying value of the asset group to the undiscounted future cash flow expected to be generated by the asset group. If such assets are considered to be impaired, the impairment to be recognized is measured by the amount by which the carrying amount
of the assets exceeds fair value. Assets to be disposed of are reported at the lower of the carrying amount or fair value less cost to sell.



On January 1, 2002, the Company adopted SFAS No. 142, Goodwill and Other Intangible Assets. SFAS No. 142 provides that goodwill
should not be amortized but instead be tested for impairment annually at the reporting unit level. In accordance with SFAS No. 142, the Company conducted its annual impairment test as of December 31, 2004. The Companys goodwill
impairment test is based on a comparison of carrying values and fair value of its Companys reporting units, its Early Childhood and Elementary School segments. As a result of the test, the Company determined that no impairment had occurred. In
addition, the Company recorded no impairment charges in 2003 or 2002.



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##### Table of Contents

|(d) | Income Taxes
|--- | ------------



The Company is taxed as a C corporation and files a consolidated tax return with its wholly-owned subsidiaries. The Companys consolidated statements
of operations reflect the income tax expense based on the actual tax position of the Company and its subsidiaries in effect for the respective periods.



The Company has recorded a deferred tax asset in an amount that is more likely than not to be realized. While the Company has considered future taxable
income and ongoing prudent and feasible tax planning strategies in assessing the value of the deferred tax asset, in the event that the Company were to determine that it would be able to realize its deferred tax assets in the future in excess of its
recorded amount, an adjustment to the deferred tax asset would increase income in the period such determination was made. Likewise, should the Company determine that it would not be able to realize all or part of its deferred tax asset in the
future, an adjustment to the deferred tax asset would be charged to income in the period such determination was made.



|(e) | Use of Estimates in Preparation of Financial Statements
|--- | -------------------------------------------------------



The preparation of financial statements in conformity with generally accepted accounting principles requires the Company to make estimates and judgments
that affect the reported amounts of assets, liabilities, revenues and expenses. On an on-going basis, the Company evaluates its estimates, including those related to revenue recognition, bad debts, product returns, intangible assets, inventories and
deferred income taxes. The Company bases its estimates on historical experience and on various other assumptions that are believed to be reasonable under the circumstances, the results of which form the basis for making judgments about the carrying
values of assets and liabilities that are not readily apparent from other sources. Actual results may differ from these estimates under different assumptions or conditions.



Other Accounting Policies



|(a) | Principles of Consolidation
|--- | ---------------------------



The consolidated financial statements include the accounts of the Company and wholly-owned subsidiaries. All material intercompany transactions have been
eliminated in consolidation.



|(b) | Fiscal Year
|--- | -----------



The Companys fiscal year end is December 31.



|(c) | Cash Equivalents
|--- | ----------------



The Company considers all highly liquid investments with an original maturity of three months or less at the date of the acquisition to be cash
equivalents. As of December 31, 2004 and 2003, cash equivalents consisted of an overnight investment account in the amount of $2.7 million and $3.6 million, respectively.



|(d) | Concentration of Credit Risk
|--- | ----------------------------



The Company has no customer comprising greater than 10% of its revenues. However, receivables arising from sales to customers are not collateralized and
management continually monitors the financial condition of its customers to reduce the risk of loss.



|(e) | Deferred Catalog Costs
|--- | ----------------------



Deferred catalog costs are considered direct response advertising and are capitalized and amortized in amounts proportionate to revenues over the lives of
each catalog, generally five months. Such costs are included in prepaid expenses and other current assets. Amortization expense related to deferred catalog costs is included in the statements of operations as a component of selling, general and
administrative expenses. Such amortization expense was $4.7 million, $3.3 million and $2.3 million for the years ended December 31, 2004, 2003 and 2002, respectively.



|(f) | Property and Equipment
|--- | ----------------------



Property and equipment are stated at cost less accumulated depreciation. Leasehold improvements are capitalized and amortized over the lesser of the
remaining life of the asset or the remaining term of the lease. Maintenance and repairs are expensed as incurred. Depreciation expense for property and equipment is calculated using the straight-line method over the estimated useful lives of the
respective assets. The estimated useful lives range from five to 10 years for leasehold improvements and three to seven years for furniture, fixtures, equipment, computer and software.



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##### Table of Contents

Depreciation of property and equipment amounted to $1.5 million, $1.4 million and $1.3 million for the
years ended December 31, 2004, 2003 and 2002, respectively.



|(g) | Intangible Assets
|--- | -----------------



Trademarks and definite live intangible assets are stated at cost, and are being amortized on the straight-line basis over their estimated useful lives,
which range from five to ten years.



|(h) | Shipping and Handling
|--- | ---------------------



Shipping and handling revenues are included in revenue. Shipping costs are included in cost of goods sold. Costs directly associated with warehouse
operations of $7.1 million, $7.0 million, and $6.4 million for the years ended December 31, 2004, 2003 and 2002, respectively, were included in selling, general and administrative expenses.



|(i) | Equity-Based Compensation
|--- | -------------------------



The Company accounts for its equity-based compensation plans in accordance with SFAS No. 123, Accounting for Stock-Based Compensation. As
permitted by SFAS No. 123, the Company measures compensation cost in accordance with Accounting Principles Board Opinion No. 25, Accounting for Stock Issued to Employees, and related interpretations. As a result, no accounting
recognition is given at the date of grant to stock options granted to employees with an exercise price equal to the fair market value of the underlying common stock. Upon exercise, net proceeds, including income tax benefits realized, are credited
to equity. Compensation cost for stock options granted with exercise prices below the fair market value of the underlying common stock is recognized over the vesting period. The pro forma impact on earnings has been disclosed in the notes to the
financial statements as allowed by SFAS No. 123.



The
following table illustrates the effect on net income and earnings per share if the Company had applied the fair value recognition provisions of SFAS No. 123, to stock-based employee compensation:



|                                                                                                                                      |  |                         |           |      |   |           |  |   |          
|------------------------------------------------------------------------------------------------------------------------------------- |  | ----------------------- | --------- | ---- | - | --------- |  | - | ---------
|                                                                                                                                      |  | Year Ended December 31,
|                                                                                                                                      |  | 2004                    |           | 2003 |   | 2002     
|                                                                                                                                      |  | Restated                |           |      |   |          
|Net income, as reported                                                                                                               |  | $                       | 1,282     |      | $ | 7,811     |  | $ | 2,452    
|Add: stock-based employee compensation expense included in reported net income, net of related tax effects                            |  |                         | 575       |      |   | 562       |  |   | 572      
|Deduct: stock-based employee compensation expense determined under fair value based method for all awards, net of related tax
effects |  |                         | 547       |      |   | 697       |  |   | 607      
|                                                                                                                                      |  |                         |           |      |   |           |  |   |          
|Pro forma net income                                                                                                                  |  | $                       | 1,310     |      | $ | 7,676     |  | $ | 2,417    
|                                                                                                                                      |  |                         |           |      |   |           |  |   |          
|Earnings per share:                                                                                                                   |  |                         |           |      |   |           |  |   |          
|Basic as restated in 2004 and reported in 2003 and 2002                                                                              |  | $                       | 0.15      |      | $ | 0.91      |  | $ | 0.29     
|                                                                                                                                      |  |                         |           |      |   |           |  |   |          
|Diluted as restated in 2004 and reported in 2003 and 2002                                                                            |  | $                       | 0.14      |      | $ | 0.85      |  | $ | 0.29     
|                                                                                                                                      |  |                         |           |      |   |           |  |   |          
|Basicpro forma                                                                                                                       |  | $                       | 0.15      |      | $ | 0.90      |  | $ | 0.29     
|                                                                                                                                      |  |                         |           |      |   |           |  |   |          
|Diluted pro forma                                                                                                                    |  | $                       | 0.14      |      | $ | 0.84      |  | $ | 0.29     
|                                                                                                                                      |  |                         |           |      |   |           |  |   |          
|Shares used for per share calculation:                                                                                                |  |                         |           |      |   |           |  |   |          
|Basic                                                                                                                                 |  |                         | 8,763,326 |      |   | 8,536,314 |  |   | 8,371,726
|Diluted                                                                                                                               |  |                         | 9,277,719 |      |   | 9,171,814 |  |   | 8,371,726



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##### Table of Contents

(i) The Company has revised its calculation of treasury shares used in connection with its
calculation of diluted earnings per share to eliminate the effect of compensation expense ascribed to past services and to give effect to the amount of unrecognized compensation costs attributable to future services. This revision resulted in a
decrease in the Companys diluted earnings per share of $0.02 and zero for the years ended December 31, 2003 and 2002, respectively.



|(j) | Comprehensive Income
|--- | --------------------



SFAS No. 130, Reporting Comprehensive Income, requires that the Company report comprehensive income, which includes net income as well as
other changes in assets and liabilities recorded directly to equity, in its financial statements. There were no components of comprehensive income other than net income for all periods presented.



|(k) | Basic and Diluted Net Income per Share
|--- | --------------------------------------



The basic and diluted net income per share information for the years ended December 31, 2004 and 2003 included in the accompanying statements of
operations is based on the weighted average number of shares outstanding during the period.



|(l) | Fair Value of Financial Instruments
|--- | -----------------------------------



The carrying value for cash and cash equivalents, accounts receivable, short-term debt, accounts payable and notes payable approximates fair value because
of the short term nature of these instruments.



|(m) | Recent Accounting Pronouncements
|--- | --------------------------------



In January 2003, the Financial Accounting Standards Board (FASB) issued FIN 46, Consolidation of Variable Interest Entities, an
Interpretation of Accounting Research Bulletin 51, Consolidated Financial Statements. FIN 46 addresses the consolidation by business enterprises of variable interest entities as defined in the interpretation. FIN 46 expands
disclosure if an enterprise consolidates a variable interest entity, and the interpretation requires disclosure for those companies that hold significant variable interests in a variable interest entity but are not required to consolidate that
interest. In December 2003, the FASB issued FIN 46R, which made certain amendments to FIN 46. The revision clarified the definition of a business as a variable interest entity. The revision also delayed the effective date of certain provisions of
the interpretation from the first reporting period following December 15, 2003 to the first reporting period ending after March 15, 2004. The Company does not have any variable interest entities as defined by this statement, and,
therefore, the adoption of FIN 46 has not had a material impact on its consolidated financial statements.



In November 2004, the FASB issued SFAS No. 151, Inventory Costs  an amendment of ARB No. 43, Chapter 4. SFAS No. 151 amends
the guidance in ARB No. 43, Chapter 4, Inventory Pricing, to clarify the accounting for abnormal amounts of idle facility expense, freight, handling costs, and wasted material (spoilage). SFAS No. 151 requires that those items
be recognized as current period charges. Additionally, SFAS No. 151 requires that allocation of fixed production overhead to the cost of conversion be based on the normal capacity of the production facility. SFAS No. 151 is effective for
fiscal years beginning after June 15, 2005. The Company does not expect the adoption of this provision to have a material effect on its consolidated financial statements.



In December 2004, the FASB issued SFAS No. 123 (revised 2004), Share-Based Payment, which is a revision of FASB
SFAS No. 123, Accounting for Stock-Based Compensation. SFAS No. 123(R) supersedes APB Opinion No. 25, Accounting for Stock Issued to Employees, and amends FASB SFAS No. 95, Statement of Cash Flows. The
approach in SFAS No. 123(R) is similar to the approach described in SFAS No. 123. However, SFAS No. 123(R) requires that all share-based payments to employees, including grants of employee stock options, be recognized in the income
statement based on their fair values. Pro forma disclosure is no longer an alternative. SFAS No. 123 (R) must be adopted no later than July 1, 2005. Early adoption is permitted in periods in which financial statements have not yet
been issued. The Company expects to adopt SFAS No. 123(R) on July 1, 2005. The impact of adoption of SFAS No. 123(R) cannot be predicted at this time because it will depend on levels of share-based payments granted in the future.
However, had the Company adopted SFAS No. 123(R) in prior periods using the Black-Scholes valuation model, the impact of that standard would have approximated the impact of SFAS No. 123 as described in the disclosure of pro forma net
income and earnings per share in Note 2 to the Companys consolidated financial statements. SFAS No. 123(R) also requires the benefits of tax deductions in excess of recognized compensation cost to be reported as a financing cash flow,
rather than as an operating cash flow as required under current literature. This requirement may reduce the Companys net operating cash flows and increase its net financing cash flows in periods after adoption.



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##### Table of Contents

|(3) | Restatement of Consolidated Financial Statements
|--- | ------------------------------------------------



On August 12, 2005, the Company announced a delay in the filing of its Form 10-Q for the three and six months ended June 30, 2005 pending the
completion of an internal investigation of allegations by current and former accounting personnel that the Company had failed to record and accrue for certain obligations for the fiscal year ended December 31, 2004. The Companys Audit
Committee retained independent counsel to lead the internal investigation and to direct forensic accounting consultants retained to assist in the investigation. On September 7, 2005, after considering the results of the investigation, the
Company determined that certain liabilities related to inventory, prepaid catalog costs, and certain operating expenses were understated at December 31, 2004. The Company concluded that adjusting the effect of these items would be material to
its previously reported results for fiscal year 2004 and the first quarter of 2005. Therefore, the Company is restating its previously issued financial statements for such year as set forth in this Form 10-K/A and is restating its previously issued
financial statements for such quarter in its Form 10-Q/A, hereafter to be filed with the Commission. No other fiscal periods prior to the fiscal quarter and year ended December 31, 2004 are affected by this restatement, as the issues identified
do not have any significant impact on those periods. On November 14, 2005, the Company also announced a delay in filing its Form 10-Q for the three and nine months ended September 30, 2005 pending the completion of this restatement.



The Company determined that this restatement is attributable
to a number of factors. The most significant factor was the failure to timely pay or accrue its obligations for certain invoices relating to inventory on hand as of year end. The Company determined, based upon the results of its internal
investigation, that its accrual for accounts payable for inventory did not include certain inventory items that had been received but had not been paid for by the Company prior to the end of fiscal 2004. As a result of the in-depth review procedures
performed by the Company, its forensic accountants and its registered independent public accountants, certain additional accounting errors were identified relating to 2004 are also reflected in the restatement. Those additional errors included an
understatement of costs capitalized into inventory, an understatement of the provision for sales returns, an understatement of certain selling, general and administrative expenses, an understatement of amortization expense for deferred compensation
amounts relating to previously issued stock options, and an understatement of income taxes related to stock option exercises.



The impact on previously reported December 31, 2004 operating income and net income as a result of corrections to the accounting for the aforementioned
errors, is as follows:



|                                                                                   |  |   |          |  
|---------------------------------------------------------------------------------- |  | - | -------- | -
|Understatement of the provision for sales returns and other sales accounts         |  | $ | 298,000  |  
|Understatement of costs capitalized into inventory                                 |  |   | (152,000 | )
|Understatement of other cost of goods sold accounts                                |  |   | 427,000  |  
|Understatement of deferred compensation related to previously issued stock options |  |   | 24,000   |  
|Understatement of certain selling, general and administrative expenses             |  |   | 378,000  |  
|                                                                                   |  |   |          |  
|Adjustment to operating income                                                     |  |   | 975,000  |  
|                                                                                   |  |   |          |  
|Understatement of income taxes related to stock options                            |  |   | 151,000  |  
|Tax benefit related to accounting errors                                           |  |   | (449,000 | )
|                                                                                   |  |   |          |  
|Adjustment to net income                                                           |  | $ | 677,000  |  
|                                                                                   |  |   |          |  



The adjustments also
increase previously reported total liabilities of $6.3 million at December 31, 2004 by approximately $1.5 million, and increase previously reported total assets of $48.7 million by approximately $1.3 million. The cumulative effect of the
identified items for the year ended December 31, 2004 results in a decrease in the Companys previously reported equity of $336,000. As a result of the restatement, the Companys basic and diluted earnings per share for the fiscal
year ended December 31, 2004 is reduced by $0.07 and $0.08 per share, respectively.



Certain elements of the adjustments consist of accruals relating to fiscal year 2004 that were not recorded until fiscal year 2005. Adjusting the timing of when these accruals were recorded decreases the
Companys previously reported operating (pre-tax) loss for the quarter ended March 31, 2005, as described in the Companys Form 10-Q/A for that fiscal quarter hereafter to be filed with the Commission.



Other changes resulting from the restatement are shown at Notes 2, 5, 6, 7,
10, 13, 14, 16 and 17.



The consolidated 2004 financial
statements include $59,000, net of income taxes, of expenses that relate to prior periods. The impact of these expenses on net income is 4%. The Company considers these expenses not to be material to 2004 operating results or the operating results
of any of the other periods presented. The quarterly impact of the out-of-period amount is discussed at Note 17.



Reconciliations of the Companys previously reported and as restated consolidated balance sheet, statement of operations and statement of cash flows
for the fiscal year ended December 31, 2004 are shown in the following tables.



F-11



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##### Table of Contents

The following is a summary of the restatements to the Consolidated Balance Sheet as of December 31, 2004:



|                                                                                                                          |  |             |         |   |                 |   |       |          |  |   |         |  
|------------------------------------------------------------------------------------------------------------------------- |  | ----------- | ------- | - | --------------- | - | ----- | -------- |  | - | ------- | -
|                                                                                                                          |  | As Reported |         |   | Adjustments (1) |   |       | Restated | 
|ASSETS                                                                                                                    |  |             |         |   |                 |   |       |          |  |   |         |  
|Current assets:                                                                                                           |  |             |         |   |                 |   |       |          |  |   |         |  
|Cash and cash equivalents                                                                                                 |  | $           | 2,657   |   |                 | $ |      |          |  | $ | 2,657   |  
|Accounts receivable, net of allowance for doubtful accounts of $412 at December 31, 2004                                  |  |             | 8,521   |   |                 |   | (235  | )        |  |   | 8,286   |  
|Inventories                                                                                                               |  |             | 16,434  |   |                 |   | 44    |          |  |   | 16,478  |  
|Prepaid expenses and other current assets                                                                                 |  |             | 3,282   |   |                 |   | 913   |          |  |   | 4,195   |  
|Deferred income taxes                                                                                                     |  |             | 444     |   |                 |   | 256   |          |  |   | 700     |  
|                                                                                                                          |  |             |         |   |                 |   |       |          |  |   |         |  
|Total current assets                                                                                                      |  |             | 31,338  |   |                 |   | 978   |          |  |   | 32,316  |  
|Property and equipment, net                                                                                               |  |             | 4,401   |   |                 |   |      |          |  |   | 4,401   |  
|Deferred income taxes                                                                                                     |  |             | 6,086   |   |                 |   | 287   |          |  |   | 6,373   |  
|Other assets                                                                                                              |  |             | 238     |   |                 |   |      |          |  |   | 238     |  
|Goodwill                                                                                                                  |  |             | 5,878   |   |                 |   |      |          |  |   | 5,878   |  
|Other intangible assets, net                                                                                              |  |             | 745     |   |                 |   |      |          |  |   | 745     |  
|                                                                                                                          |  |             |         |   |                 |   |       |          |  |   |         |  
|Total assets                                                                                                              |  | $           | 48,686  |   |                 | $ | 1,265 |          |  | $ | 49,951  |  
|                                                                                                                          |  |             |         |   |                 |   |       |          |  |   |         |  
|LIABILITIES AND EQUITY                                                                                                    |  |             |         |   |                 |   |       |          |  |   |         |  
|Current liabilities:                                                                                                      |  |             |         |   |                 |   |       |          |  |   |         |  
|Accounts payable                                                                                                          |  | $           | 3,686   |   |                 | $ | 439   |          |  | $ | 4,125   |  
|Accrued expenses                                                                                                          |  |             | 2,607   |   |                 |   | 1031  |          |  |   | 3,638   |  
|Other current liabilities                                                                                                 |  |             | 31      |   |                 |   | 131   |          |  |   | 162     |  
|                                                                                                                          |  |             |         |   |                 |   |       |          |  |   |         |  
|Total liabilities                                                                                                         |  |             | 6,324   |   |                 |   | 1,601 |          |  |   | 7,925   |  
|                                                                                                                          |  |             |         |   |                 |   |       |          |  |   |         |  
|Equity:                                                                                                                   |  |             |         |   |                 |   |       |          |  |   |         |  
|Common stock, $0.01 par value; 15,000,000 shares authorized; 8,840,354 shares issued and outstanding at December 31, 2004 |  |             | 88      |   |                 |   |      |          |  |   | 88      |  
|Additional paid-in capital                                                                                                |  |             | 63,070  |   |                 |   | 187   |          |  |   | 63,257  |  
|Deferred stock compensation                                                                                               |  |             | (368    | ) |                 |   | 154   |          |  |   | (214    | )
|Accumulated deficit                                                                                                       |  |             | (20,428 | ) |                 |   | (677  | )        |  |   | (21,105 | )
|                                                                                                                          |  |             |         |   |                 |   |       |          |  |   |         |  
|Total equity                                                                                                              |  |             | 42,362  |   |                 |   | (336  | )        |  |   | 42,026  |  
|                                                                                                                          |  |             |         |   |                 |   |       |          |  |   |         |  
|Total liabilities and equity                                                                                              |  | $           | 48,686  |   |                 | $ | 1,265 |          |  | $ | 49,951  |  
|                                                                                                                          |  |             |         |   |                 |   |       |          |  |   |         |  

---

|(1) | See the analysis of the components of the adjustments as previously disclosed herein.
|--- | -------------------------------------------------------------------------------------



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---

##### Table of Contents

The following is a summary of the restatements to the Consolidated Statement of Operations for the fiscal year ended
December 31, 2004:



|                                                       |  |             |           |   |                 |   |         |          |  |   |           |  
|------------------------------------------------------ |  | ----------- | --------- | - | --------------- | - | ------- | -------- |  | - | --------- | -
|                                                       |  | As Reported |           |   | Adjustments (1) |   |         | Restated | 
|Revenues                                               |  | $           | 121,286   |   |                 |   | (298    | )        |  | $ | 120,988   |  
|Cost of goods sold                                     |  |             | 80,133    |   |                 |   | 275     |          |  |   | 80,408    |  
|                                                       |  |             |           |   |                 |   |         |          |  |   |           |  
|Gross profit                                           |  |             | 41,153    |   |                 |   | (573    | )        |  |   | 40,580    |  
|                                                       |  |             |           |   |                 |   |         |          |  |   |           |  
|Operating expenses:                                    |  |             |           |   |                 |   |         |          |  |   |           |  
|Selling, general and administrative                    |  |             | 37,855    |   |                 |   | 402     |          |  |   | 38,257    |  
|Amortization of intangible assets                      |  |             | 173       |   |                 |   |        |          |  |   | 173       |  
|                                                       |  |             |           |   |                 |   |         |          |  |   |           |  
|Operating income                                       |  |             | 3,125     |   |                 |   | (975    | )        |  |   | 2, 150    |  
|                                                       |  |             |           |   |                 |   |         |          |  |   |           |  
|Other (income) expense:                                |  |             |           |   |                 |   |         |          |  |   |           |  
|Interest expense                                       |  |             | 89        |   |                 |   |        |          |  |   | 89        |  
|Debt extinguishment                                    |  |             |          |   |                 |   |        |          |  |   |          |  
|(Gain) on sale of assets                               |  |             | (5        | ) |                 |   |        |          |  |   | (5        | )
|Interest income                                        |  |             | (9        | ) |                 |   |        |          |  |   | (9        | )
|                                                       |  |             |           |   |                 |   |         |          |  |   |           |  
|Income before income taxes                             |  |             | 3,050     |   |                 |   | (975    | )        |  |   | 2,075     |  
|Income tax expense                                     |  |             | 1,091     |   |                 |   | (298    | )        |  |   | 793       |  
|                                                       |  |             |           |   |                 |   |         |          |  |   |           |  
|Net income                                             |  | $           | 1,959     |   |                 |   | (677    | )        |  |   | 1,282     |  
|                                                       |  |             |           |   |                 |   |         |          |  |   |           |  
|Net Income Per Share Calculation:                      |  |             |           |   |                 |   |         |          |  |   |           |  
|Income per share: Basic                                |  | $           | 0.22      |   |                 | $ | (0.07   | )        |  | $ | 0.15      |  
|Diluted                                                |  | $           | 0.22      |   |                 | $ | (0.08   | )        |  |   | 0.14      |  
|Weighted average shares used in per share calculation: |  |             |           |   |                 |   |         |          |  |   |           |  
|Basic                                                  |  |             | 8,776,987 |   |                 |   | 13,661  |          |  |   | 8,763,326 |  
|Diluted                                                |  |             | 8,776,987 |   |                 |   | 500,732 |          |  |   | 9,277,719 |  

---

|(1) | See the analysis of the components of the adjustments as previously disclosed herein.
|--- | -------------------------------------------------------------------------------------



F-13



---

##### Table of Contents

The following is a summary of the restatements to the Consolidated Statement of Cash Flows for the fiscal year ended
December 31, 2004:



|                                                                                                                                |  |             |         |   |                 |   |       |          |  |   |         |  
|------------------------------------------------------------------------------------------------------------------------------- |  | ----------- | ------- | - | --------------- | - | ----- | -------- |  | - | ------- | -
|                                                                                                                                |  | As Reported |         |   | Adjustments (1) |   |       | Restated | 
|Cash flows from operating activities:                                                                                           |  |             |         |   |                 |   |       |          |  |   |         |  
|Net income                                                                                                                      |  | $           | 1,959   |   |                 | $ | (677  | )        |  | $ | 1, 282  |  
|Adjustments to reconcile net income to net cash provided by operating activities:                                               |  |             |         |   |                 |   |       |          |  |   |         |  
|Depreciation and amortization                                                                                                   |  |             | 1,710   |   |                 |   | 1     |          |  |   | 1,711   |  
|Gain on sale of assets                                                                                                          |  |             | (5      | ) |                 |   |      |          |  |   | (5      | )
|Provision for losses on accounts receivable                                                                                     |  |             | 275     |   |                 |   | (344  | )        |  |   | (69     | )
|Stock-based compensation                                                                                                        |  |             | 552     |   |                 |   | 23    |          |  |   | 575     |  
|Deferred income taxes                                                                                                           |  |             | 1,051   |   |                 |   | (225  | )        |  |   | 826     |  
|Changes in operating assets and liabilities, net of assets acquired and liabilities assumed in the Combination and
acquisition: |  |             |         |   |                 |   |       |          |  |   |         |  
|Accounts receivable                                                                                                             |  |             | (3,316  | ) |                 |   | 579   |          |  |   | (2,737  | )
|Inventories                                                                                                                     |  |             | (1,301  | ) |                 |   | (44   | )        |  |   | (1,345  | )
|Prepaid expenses and other current assets                                                                                       |  |             | (344    | ) |                 |   | (914  | )        |  |   | (1,258  | )
|Other assets                                                                                                                    |  |             | 69      |   |                 |   |      |          |  |   | 69      |  
|Accounts payable                                                                                                                |  |             | 668     |   |                 |   | 439   |          |  |   | 1,107   |  
|Accrued expenses                                                                                                                |  |             | (348    | ) |                 |   | 1,031 |          |  |   | 683     |  
|Income tax payable                                                                                                              |  |             | (366    | ) |                 |   | 132   |          |  |   | (234    | )
|Other current liabilities                                                                                                       |  |             | (23     | ) |                 |   | (1    | )        |  |   | (24     | )
|                                                                                                                                |  |             |         |   |                 |   |       |          |  |   |         |  
|Net cash provided by operating activities                                                                                       |  |             | 581     |   |                 |   |      |          |  |   | 581     |  
|                                                                                                                                |  |             |         |   |                 |   |       |          |  |   |         |  
|Cash flows from investing activities:                                                                                           |  |             |         |   |                 |   |       |          |  |   |         |  
|Purchase of property and equipment                                                                                              |  |             | (1,864  | ) |                 |   |      |          |  |   | (1,864  | )
|                                                                                                                                |  |             |         |   |                 |   |       |          |  |   |         |  
|Net cash used in investing activities                                                                                           |  |             | (1,864  | ) |                 |   |      |          |  |   | (1,864  | )
|                                                                                                                                |  |             |         |   |                 |   |       |          |  |   |         |  
|Cash flows from financing activities:                                                                                           |  |             |         |   |                 |   |       |          |  |   |         |  
|Borrowings on line of credit                                                                                                    |  |             | 13,750  |   |                 |   |      |          |  |   | 13,750  |  
|Principal payments on line of credit                                                                                            |  |             | (13,750 | ) |                 |   |      |          |  |   | (13,750 | )
|Issuance of equity                                                                                                              |  |             | 320     |   |                 |   |      |          |  |   | 320     |  
|                                                                                                                                |  |             |         |   |                 |   |       |          |  |   |         |  
|Net cash provided by financing activities                                                                                       |  |             | 320     |   |                 |   |      |          |  |   | 320     |  
|                                                                                                                                |  |             |         |   |                 |   |       |          |  |   |         |  
|Net decrease in cash and cash equivalents                                                                                       |  |             | (963    | ) |                 |   |      |          |  |   | (963    | )
|Cash and cash equivalents at beginning of year                                                                                  |  |             | 3,620   |   |                 |   |      |          |  |   | 3,620   |  
|                                                                                                                                |  |             |         |   |                 |   |       |          |  |   |         |  
|Cash and cash equivalents at end of year                                                                                        |  | $           | 2,657   |   |                 | $ |      |          |  | $ | 2,657   |  
|                                                                                                                                |  |             |         |   |                 |   |       |          |  |   |         |  
|Supplemental disclosures of cash flow information:                                                                              |  |             |         |   |                 |   |       |          |  |   |         |  
|Cash payments during the period for:                                                                                            |  |             |         |   |                 |   |       |          |  |   |         |  
|Interest                                                                                                                        |  | $           | 89      |   |                 | $ |      |          |  | $ | 89      |  
|Income taxes                                                                                                                    |  | $           | 471     |   |                 | $ |      |          |  | $ | 471     |  

---

|(1) | See an analysis of the components of the adjustments as previously disclosed herein.
|--- | ------------------------------------------------------------------------------------



F-14



---

##### Table of Contents

|(4) | Business Combination
|--- | --------------------



On February 19, 2003, the Company consummated its acquisition of Marketing Logistics, Inc., an online retailer of early childhood furniture and
equipment now doing business as ECMD. Consideration for the acquisition included $800,000 in cash and 100,000 redeemable shares of the Companys common stock. The seller had a one-time opportunity, exercisable during the thirty-day period prior
to February 19, 2004, to exchange the shares received by him in the acquisition for $400,000 in cash. The exercise period has expired and the shares were not redeemed; therefore, the redeemable common shares listed on the balance sheet as of
December 31, 2003 were reclassified to equity in 2004.



The allocation of the purchase price of $1.2 million plus transaction costs of $71,000 is summarized as follows (in thousands):



|                     |  |   |      
|-------------------- |  | - | -----
|Goodwill             |  | $ | 1,177
|Trademarks           |  |   | 94   
|                     |  |   |      
|Total purchase price |  | $ | 1,271
|                     |  |   |      



|(5) | Accounts Receivable
|--- | -------------------



Accounts receivable consists of the following amounts (in thousands):



|                                     |  |              |       |   |      |   |       |  
|------------------------------------ |  | ------------ | ----- | - | ---- | - | ----- | -
|                                     |  | December 31, |      
|                                     |  | 2004         |       |   | 2003 |  
|                                     |  | Restated     |       |   |      |  
|Accounts receivable                  |  | $            | 8,698 |   |      | $ | 5,961 |  
|Less allowance for doubtful accounts |  |              | (412  | ) |      |   | (481  | )
|                                     |  |              |       |   |      |   |       |  
|                                     |  | $            | 8,286 |   |      | $ | 5,480 |  
|                                     |  |              |       |   |      |   |       |  



|(6) | Inventories
|--- | -----------



Inventories, stated at lower of cost or market, consist of the following amounts (in thousands):



|                                   |  |              |        |      |   |       
|---------------------------------- |  | ------------ | ------ | ---- | - | ------
|                                   |  | December 31,
|                                   |  | 2004         |        | 2003
|                                   |  | Restated     |        |     
|Raw materials and work in progress |  | $            | 940    |      | $ | 961   
|Finished goods                     |  |              | 15,538 |      |   | 14,172
|                                   |  |              |        |      |   |       
|                                   |  | $            | 16,478 |      | $ | 15,133
|                                   |  |              |        |      |   |       



F-15



---

##### Table of Contents

|(7) | Prepaid Expenses and Other Current Assets
|--- | -----------------------------------------



Prepaid expenses and other current assets consist of the following amounts (in thousands):



|                       |  |              |       |      |   |      
|---------------------- |  | ------------ | ----- | ---- | - | -----
|                       |  | December 31,
|                       |  | 2004         |       | 2003
|                       |  | Restated     |       |     
|Prepaid catalog costs  |  | $            | 1,137 |      | $ | 869  
|Prepaid inventory      |  |              | 1,282 |      |   | 105  
|Non trade receivables  |  |              | 395   |      |   | 321  
|Prepaid rent           |  |              | 193   |      |   | 190  
|Prepaid insurance      |  |              | 418   |      |   | 557  
|Deposits               |  |              | 10    |      |   | 553  
|Other prepaid expenses |  |              | 760   |      |   | 342  
|                       |  |              |       |      |   |      
|                       |  | $            | 4,195 |      | $ | 2,937
|                       |  |              |       |      |   |      



|(8) | Property and Equipment
|--- | ----------------------



A summary of property and equipment is as follows (in thousands):



|                              |  |              |        |   |      |   |        |  
|----------------------------- |  | ------------ | ------ | - | ---- | - | ------ | -
|                              |  | December 31, |       
|                              |  | 2004         |        |   | 2003 |  
|Machinery and equipment       |  | $            | 6,096  |   |      | $ | 5,158  |  
|Computer and software         |  |              | 3,297  |   |      |   | 2,439  |  
|Leasehold improvements        |  |              | 1,681  |   |      |   | 1,670  |  
|Furniture and fixtures        |  |              | 812    |   |      |   | 775    |  
|                              |  |              |        |   |      |   |        |  
|                              |  |              | 11,886 |   |      |   | 10,042 |  
|Less accumulated depreciation |  |              | (7,485 | ) |      |   | (5,972 | )
|                              |  |              |        |   |      |   |        |  
|                              |  | $            | 4,401  |   |      | $ | 4,070  |  
|                              |  |              |        |   |      |   |        |  



|(9) | Other Intangible Assets
|--- | -----------------------



As of December 31, 2004 and 2003, the major classes of intangible assets were as follows (in thousands):



|                                     |  |                     |       |                         |                   |        |                     |  |                         |       |  |   |        |  
|------------------------------------ |  | ------------------- | ----- | ----------------------- | ----------------- | ------ | ------------------- |  | ----------------------- | ----- |  | - | ------ | -
|                                     |  | December 31, 2004   |       |                         | December 31, 2003 |       
|                                     |  | GrossCarryingAmount |       | AccumulatedAmortization |                   |        | GrossCarryingAmount |  | AccumulatedAmortization |      
|Trademarks, trade names and formulas |  | $                   | 953   |                         | $                 | (819   | )                   |  | $                       | 953   |  | $ | (787   | )
|Customer lists                       |  |                     | 1,410 |                         |                   | (799   | )                   |  |                         | 1,410 |  |   | (658   | )
|                                     |  |                     |       |                         |                   |        |                     |  |                         |       |  |   |        |  
|                                     |  | $                   | 2,363 |                         | $                 | (1,618 | )                   |  | $                       | 2,363 |  | $ | (1,445 | )
|                                     |  |                     |       |                         |                   |        |                     |  |                         |       |  |   |        |  



Total amortization
expense on intangible assets for the years ended December 31, 2004, 2003 and 2002 was $173,000, $279,000, and $288,000, respectively. The carrying amount of goodwill was $5.9 million at December 31, 2004 and 2003.



F-16



---

##### Table of Contents

Estimated amortization expense (in thousands) for the years ended December 31,



|           |  |   |    
|---------- |  | - | ---
|2005       |  | $ | 173
|2006       |  |   | 173
|2007       |  |   | 173
|2008       |  |   | 173
|2009       |  |   | 51 
|Thereafter |  |   | 2  



The following table
identifies the weighted average remaining life of the Companys intangible assets (dollars in thousands):



|                       |  |                                 |     |                      |   |                                 |  |     
|---------------------- |  | ------------------------------- | --- | -------------------- | - | ------------------------------- |  | ----
|Intangible Assets      |  | Net Balance atDecember 31, 2004 |     | Monthly Amortization |   | Remaining Life of Asset (years)
|Formulas               |  | $                               | 74  |                      | $ | 1                               |  | 5.41
|Patents and trademarks |  |                                 | 60  |                      |   | 2                               |  | 3.19
|EPI customer list      |  |                                 | 611 |                      |   | 12                              |  | 4.33
|                       |  |                                 |     |                      |   | Weighted Average                |  | 4.35



|(10) | Accrued Expenses and Merger Integration Charges
|---- | -----------------------------------------------



Accrued expenses consist of the following amounts (in thousands):



|                            |  |              |       |      |   |      
|--------------------------- |  | ------------ | ----- | ---- | - | -----
|                            |  | December 31,
|                            |  | 2004         |       | 2003
|                            |  | Restated     |       |     
|Payroll and commissions     |  | $            | 896   |      | $ | 644  
|Vacation                    |  |              | 781   |      |   | 757  
|Accrued freight             |  |              | 125   |      |   |     
|Accrued catalog costs       |  |              | 754   |      |   |     
|Professional services       |  |              | 263   |      |   | 336  
|Sales tax                   |  |              | 148   |      |   | 119  
|Needham facility exit costs |  |              |      |      |   | 632  
|Other                       |  |              | 671   |      |   | 467  
|                            |  |              |       |      |   |      
|                            |  | $            | 3,638 |      | $ | 2,955
|                            |  |              |       |      |   |      



In conjunction with
the Combination, the Company terminated certain SmarterKids.com employees and determined that the acquired lease for its Needham facility was an unfavorable lease. As a result, liabilities of $1.5 million and $1.1 million were recorded for severance
and unfavorable leases in 2001, respectively.



In the fourth
quarter of 2001, the Company approved a restructuring plan to aid in the reduction of operating costs. Specifically, the Company closed its Needham, Massachusetts facility in January 2002. The closure of the Needham facility was designed to
consolidate information systems and marketing functions in Monterey, California and reduce the administrative costs associated with operating an additional facility.



Restructuring and related charges of $1.8 million were expensed in 2001. Of this amount, $1.3 million related to exit costs
associated with the Needham lease and various equipment leases that were no longer going to be utilized in the Companys operations. The remaining $469,000 was related to other merger and integration costs. No additional accrual for severance
was made at the end of the year; however, approximately 22 employee positions were reduced in early 2002 as a result of the closure of the Needham facility. During the year ended December 31, 2002, the Company paid $401,000 and $1.3 million
relating to severance and Needham facility costs, respectively. Of these costs, $226,000 related to severance for termination announced in the first quarter of 2002 and therefore was recorded as an expense in the first quarter of 2002. During the
third quarter of 2002, the Company determined that based on current real estate market conditions in Needham, Massachusetts, its assumptions for sublease income should be reduced and an additional lease abandonment charge of $653,000 was recorded in
selling, general and administrative expenses. In 2003, no other additional charges related to the Needham lease were determined to be necessary and the Company paid $938,000 related to Needham facility costs.



F-17



---

##### Table of Contents

A rollforward of activity in merger integration related liabilities follows (in thousands):



|                             |  |           |      |   |                 |   |        |       |  |   |        |  
|---------------------------- |  | --------- | ---- | - | --------------- | - | ------ | ----- |  | - | ------ | -
|                             |  | Severance |      |   | NeedhamFacility |   |        | Total | 
|Balance at December 31, 2001 |  | $         | 175  |   |                 | $ | 2,257  |       |  | $ | 2,432  |  
|Additional 2002 charges      |  |           | 226  |   |                 |   | 653    |       |  |   | 879    |  
|Amounts paid                 |  |           | (401 | ) |                 |   | (1,340 | )     |  |   | (1,741 | )
|                             |  |           |      |   |                 |   |        |       |  |   |        |  
|Balance at December 31, 2002 |  |           |     |   |                 |   | 1,570  |       |  |   | 1,570  |  
|Amounts paid                 |  |           |     |   |                 |   | (938   | )     |  |   | (938   | )
|                             |  |           |      |   |                 |   |        |       |  |   |        |  
|Balance at December 31, 2003 |  |           |     |   |                 |   | 632    |       |  |   | 632    |  
|                             |  |           |      |   |                 |   |        |       |  |   |        |  
|Amounts paid                 |  |           |     |   |                 |   | (632   | )     |  |   | (632   | )
|                             |  |           |      |   |                 |   |        |       |  |   |        |  
|Balance at December 31, 2004 |  | $         |     |   |                 | $ |       |       |  | $ |       |  
|                             |  |           |      |   |                 |   |        |       |  |   |        |  



|(11) | Credit Facility
|---- | ---------------



On September 29, 2003, the Company entered into a $20.0 million secured credit facility with Bank of America, N.A. (the Bank of America
Facility). The Bank of America Facility replaced the Companys credit facility with GMAC Business Credit, LLC (the GMAC Facility). During the last quarter of 2004, pursuant to the financing schedule contained in the Bank of
America Facility, the amount available under the facility stepped down to $19.4 million.



The Bank of America Facility includes a $15.0 million revolving line of credit with a maturity date of October 1, 2005 and an interest rate of LIBOR plus 1.75% (4.525% at December 31, 2004). The Bank of
America Facility also includes up to $4.4 million through a reducing revolving term loan with a maturity date of October 1, 2008 and an interest rate of LIBOR plus 2.00% (4.775% at December 31, 2004). The Bank of America Facility is
secured by substantially all of the Companys assets, including receivables, inventory, equipment and intellectual property. As of December 31, 2004, the Company had no borrowings and available credit of $19.4 million under the Bank of
America Facility.



The Bank of America Facility requires
adherence to certain financial covenants and limitations related to capital expenditures and acquisitions during the term of the facility. As of December 31, 2004, the Company was in compliance with the financial covenants and capital
expenditure and acquisition limitations as set forth in the Bank of America Facility.



|(12) | Related Party Transactions
|---- | --------------------------



The Company leases its Salinas paint manufacturing facility center from an entity comprised of its Chief Executive Officer and another significant
stockholder. The lease expires on August 5, 2005 and calls for monthly rent payments of $24,885.



The Company purchases product for sale from an entity of which one of its directors is the Managing Director and majority shareholder. During the fiscal
year ended December 31, 2004, the Company paid the entity an aggregate of $66,985.



F-18



---

##### Table of Contents

|(13) | Income Taxes
|---- | ------------



The Companys consolidated statements of operations reflect income tax expense based on the actual tax position of the company and its subsidiaries
in effect for the respective periods. The following table reflects the components of the provision for income taxes of the Company and its subsidiaries for the respective periods (in thousands):



|                                    |  |                                        |     |      |   |        |      |  |   |      |  
|----------------------------------- |  | -------------------------------------- | --- | ---- | - | ------ | ---- |  | - | ---- | -
|                                    |  | For the Fiscal Years EndedDecember 31, |    
|                                    |  | 2004                                   |     | 2003 |   |        | 2002 | 
|                                    |  | Restated                               |     |      |   |        |      | 
|Federal:                            |  |                                        |     |      |   |        |      |  |   |      |  
|                                    |  |                                        |    
|Current                             |  | $                                      | 213 |      | $ | (13    | )    |  | $ | 237  |  
|Deferred                            |  |                                        | 350 |      |   | (3,882 | )    |  |   | (369 | )
|                                    |  |                                        |     |      |   |        |      |  |   |      |  
|Total                               |  | $                                      | 563 |      | $ | (3,895 | )    |  | $ | (132 | )
|                                    |  |                                        |     |      |   |        |      |  |   |      |  
|State:                              |  |                                        |     |      |   |        |      |  |   |      |  
|                                    |  |                                        |    
|Current                             |  | $                                      | 73  |      | $ | 287    |      |  | $ | 569  |  
|Deferred                            |  |                                        | 157 |      |   | (29    | )    |  |   | 111  |  
|                                    |  |                                        |     |      |   |        |      |  |   |      |  
|Total                               |  | $                                      | 230 |      | $ | 258    |      |  | $ | 680  |  
|                                    |  |                                        |     |      |   |        |      |  |   |      |  
|Total income tax expense (benefit): |  |                                        |     |      |   |        |      |  |   |      |  
|                                    |  |                                        |    
|Current                             |  | $                                      | 286 |      | $ | 274    |      |  | $ | 806  |  
|Deferred                            |  |                                        | 507 |      |   | (3,911 | )    |  |   | (258 | )
|                                    |  |                                        |     |      |   |        |      |  |   |      |  
|Total                               |  | $                                      | 793 |      | $ | (3,637 | )    |  | $ | 548  |  
|                                    |  |                                        |     |      |   |        |      |  |   |      |  



The Companys tax
expense (benefit) differs from the statutory federal income tax rate of 35% for the years ended December 31, 2004, 2003 and 2002, as shown in the following schedule (in thousands):



|                                     |  |                                        |      |   |      |   |        |      |  |   |       |  
|------------------------------------ |  | -------------------------------------- | ---- | - | ---- | - | ------ | ---- |  | - | ----- | -
|                                     |  | For the Fiscal Years EndedDecember 31, |     
|                                     |  | 2004                                   |      |   | 2003 |   |        | 2002 | 
|                                     |  | Restated                               |      |   |      |   |        |      | 
|Income tax expense at statutory rate |  | $                                      | 726  |   |      | $ | 1,461  |      |  | $ | 1,050 |  
|State income taxes                   |  |                                        | 566  |   |      |   | 270    |      |  |   | 216   |  
|Change in tax law                    |  |                                        |     |   |      |   | (2,401 | )    |  |   |      |  
|Change in valuation allowance        |  |                                        | (574 | ) |      |   | (2,792 | )    |  |   | (576  | )
|Other                                |  |                                        | 75   |   |      |   | (175   | )    |  |   | (142  | )
|                                     |  |                                        |      |   |      |   |        |      |  |   |       |  
|Actual tax expense (benefit)         |  | $                                      | 793  |   |      | $ | (3,637 | )    |  | $ | 548   |  
|                                     |  |                                        |      |   |      |   |        |      |  |   |       |  



F-19



---

##### Table of Contents

The following table displays the tax effects of temporary differences (in thousands):



|                                                |  |                                        |        |   |      |   |        |      |  |   |        |  
|----------------------------------------------- |  | -------------------------------------- | ------ | - | ---- | - | ------ | ---- |  | - | ------ | -
|                                                |  | For the Fiscal Years EndedDecember 31, |       
|                                                |  | 2004                                   |        |   | 2003 |   |        | 2002 | 
|                                                |  | Restated                               |        |   |      |   |        |      | 
|Deferred tax assets:                            |  |                                        |        |   |      |   |        |      |  |   |        |  
|Allowance for bad debts                         |  | $                                      | 171    |   |      | $ | 189    |      |  | $ | 182    |  
|Accrued expenses                                |  |                                        | 198    |   |      |   | 489    |      |  |   | 850    |  
|State taxes                                     |  |                                        | 21     |   |      |   | 105    |      |  |   | 88     |  
|Net operating loss and tax credit carry forward |  |                                        | 7,708  |   |      |   | 8,530  |      |  |   | 6,934  |  
|Stock option expense                            |  |                                        | 170    |   |      |   |       |      |  |   |       |  
|Inventories                                     |  |                                        | 315    |   |      |   | 431    |      |  |   | 374    |  
|Property, equipment and intangible assets       |  |                                        | 101    |   |      |   | 22     |      |  |   | 219    |  
|                                                |  |                                        |        |   |      |   |        |      |  |   |        |  
|                                                |  |                                        | 8,684  |   |      |   | 9,766  |      |  |   | 8,647  |  
|Less valuation allowance                        |  |                                        | (1,611 | ) |      |   | (2,185 | )    |  |   | (4,977 | )
|Other                                           |  |                                        |       |   |      |   |       |      |  |   |       |  
|                                                |  |                                        |        |   |      |   |        |      |  |   |        |  
|Net deferred tax assets                         |  | $                                      | 7,073  |   |      | $ | 7,581  |      |  | $ | 3,670  |  
|                                                |  |                                        |        |   |      |   |        |      |  |   |        |  



The valuation
allowance is related to deferred income tax assets acquired in the Combination. The Company has recorded a deferred tax asset in an amount that is more likely than not to be realized. A valuation allowance has been established for the net operating
losses, which, if not utilized, will expire between 2006 and 2020. The Company has considered future taxable income and ongoing prudent and feasible tax planning strategies in assessing the need for a valuation allowance. In the event the Company
were to determine that it would not be able to realize all or part of its net deferred tax asset in the future, an adjustment to the deferred tax asset would be charged to income in the period such determination was made. Although the valuation
allowance was related to the assets acquired in the Combination, the 2003 and 2002 reduction in the valuation allowance has been reflected as a reduction to income tax expense because goodwill and any other non-current intangibles acquired in the
Combination were fully impaired as of December 31, 2001.



As of December 31, 2004, the Company had Federal and state net operating loss carry forwards of approximately $20.7 million and $4.9 million, respectively. If not utilized, net operating loss carry forwards will expire in years 2005 through
2024. The utilization of net operating loss carry forwards is limited by current tax regulations. These net operating loss carry forwards will be utilized in future periods if sufficient income is generated. The Companys ability to utilize
certain loss carry forwards is subject to limitations pursuant to the ownership change rules of Internal Revenue Code Section 382.



During fiscal year 2003, the Company recognized a current tax benefit of $2.4 million related to net operating losses generated by the SmarterKids.com
acquisition. The benefit came from additional net operating losses made available to the Company as a result of a 2003 Internal Revenue Service Notice pertaining to Section 382 limitations. Also, during fiscal year 2003, the Company determined
that it would be able to realize a larger portion of its deferred tax assets related to net operating losses in excess of the recorded amount and, accordingly, eliminated a portion of its deferred tax asset valuation allowance. This valuation
allowance reduction resulted in a tax benefit of approximately $2.8 million for fiscal year 2003.



|(14) | Employee Benefits
|---- | -----------------



Retirement Savings Plan



Employees of the Company are eligible to participate in the Excelligence Learning Corporation 401(k) Plan (the Plan). The Plan is a defined contribution plan operating under Section 401(k) of the Internal Revenue Code of
1986, as amended. Employees are eligible to participate in the Plan after completing 90 days of service. Participants may defer up to 15% of their compensation, up to a maximum of $13,000 in 2004, as a contribution to the Plan. Participants who are
50 years or older had the option to defer an additional $3,000 in 2004. The Company matches 15% of employee contributions to the Plan up to a maximum of 6% of their compensation. The Company suspended matching participants contributions to the
Plan from February through September 2002.



F-20



---

##### Table of Contents

Participant contributions are 100% vested immediately. Employer contributions are subject to the
following vesting schedule:



|                  |  |     |  
|----------------- |  | --- | -
|Year 2 of service |  | 20  | %
|Year 3 of service |  | 40  | %
|Year 4 of service |  | 60  | %
|Year 5 of service |  | 100 | %



The Companys
expense related to matching participants contributions to the Plan was $44,000, $60,000, and $30,000 for the years ended December 31, 2004, 2003 and 2002, respectively.



Stock Options



In March 2001, the Company adopted its 2001 Stock Option and Incentive Plan, pursuant to which the Companys Board of Directors may grant stock
options to key employees, directors and certain consultants of the Company. The 2001 Stock Option and Incentive Plan, which was amended and restated in its entirety in May 2003 upon receipt of stockholder approval, authorizes grants of options to
purchase up to 1.8 million shares of common stock.



In
March 2001, the Company also adopted its 2001 Non-Employee Director Stock Option Plan, pursuant to which the Companys Board of Directors may grant stock options as an inducement to obtain and retain the services of qualified persons who are
not employees or officers of the Company to serve as members of its Board of Directors. The 2001 Non-Employee Director Stock Option Plan authorizes grants of options to purchase up to 300,000 shares of common stock.



The following table summarizes stock option activity for the three years
ended December 31, 2004:



|                                       |  |                    |   |  |                         |              |                                         |      
|-------------------------------------- |  | ------------------ | - |  | ----------------------- | ------------ | --------------------------------------- | -----
|                                       |  | Shares InThousands |   |  | Exercise PricePer Share |              | WeightedAverageExercise Price Per Share
|Options outstanding, December 31, 2001 |  | 1,145              |   |  |                         |              |                                         | $2.79
|Options granted                        |  | 296                |   |  |                         | $  1.383.60 |                                         | $2.00
|Options lapsed or cancelled            |  | (170               | ) |  |                         | $0.1512.00  |                                         | $7.05
|Options exercised                      |  | (30                | ) |  |                         | $  0.150.15 |                                         | $0.15
|                                       |  |                    |   |  |                         |              |                                         |      
|Options outstanding, December 31, 2002 |  | 1,241              |   |  |                         |              |                                         | $2.04
|Options granted                        |  | 66                 |   |  |                         | $  2.986.31 |                                         | $4.81
|Options lapsed or cancelled            |  | (35                | ) |  |                         | $0.1512.00  |                                         | $2.13
|Options exercised                      |  | (125               | ) |  |                         | $  0.151.43 |                                         | $0.87
|                                       |  |                    |   |  |                         |              |                                         |      
|Options outstanding, December 31, 2003 |  | 1,147              |   |  |                         |              |                                         | $2.47
|Options granted                        |  | 124                |   |  |                         | $  4.085.95 |                                         | $5.08
|Options lapsed or cancelled            |  | (85                | ) |  |                         | $0.1512.00  |                                         | $6.02
|Options exercised                      |  | (191               | ) |  |                         | $  1.386.31 |                                         | $1.66
|                                       |  |                    |   |  |                         |              |                                         |      
|Options outstanding, December 31, 2004 |  | 995                |   |  |                         |              |                                         | $3.29



F-21



---

##### Table of Contents

The following table summarizes significant ranges of outstanding and exercisable options at
December 31, 2004:



|                          |  |                     |  |                                        |  |                              |       |                    |     |                              |   |      
|------------------------- |  | ------------------- |  | -------------------------------------- |  | ---------------------------- | ----- | ------------------ | --- | ---------------------------- | - | -----
|                          |  | Options Outstanding |  |                                        |  | Options Exercisable         
|Ranges of Exercise Prices |  | Shares InThousands  |  | WeightedAverageRemaining Life in Years |  | WeightedAverageExercisePrice |       | Shares InThousands |     | WeightedAverageExercisePrice
|Under $1.00               |  | 60                  |  | 5.7                                    |  | $                            | 0.15  |                    | 59  |                              | $ | 0.15 
|1.01 to 2.00              |  | 552                 |  | 6.9                                    |  |                              | 1.42  |                    | 520 |                              |   | 1.42 
|2.01 to 4.00              |  | 218                 |  | 6.2                                    |  |                              | 3.32  |                    | 206 |                              |   | 3.50 
|4.01 to 11.00             |  | 162                 |  | 4.5                                    |  |                              | 10.67 |                    | 17  |                              |   | 7.14 
|over $11.00               |  | 3                   |  | 0.2                                    |  |                              | 12.00 |                    | 3   |                              | $ | 12.00
|                          |  |                     |  |                                        |  |                              |       |                    |     |                              |   |      
|                          |  | 995                 |  | 6.2                                    |  | $                            | 3.29  |                    | 805 |                              | $ | 8.80 
|                          |  |                     |  |                                        |  |                              |       |                    |     |                              |   |      



The weighted average
fair value per share of options granted during 2004, 2003 and 2002 was $3.40, $5.58 and $2.47, respectively. The fair value of these options was estimated using the Black-Scholes model with the following weighted average assumptions:



|                         |  |               |   |  |      |   |  |      |  
|------------------------ |  | ------------- | - |  | ---- | - |  | ---- | -
|                         |  | Stock Options |  
|Year Ended December 31,  |  | 2004          |   |  | 2003 |   |  | 2002 |  
|Expected life (in years) |  | 7.3           |   |  | 7.5  |   |  | 8.6  |  
|Risk-free interest rate  |  | 3.9           | % |  | 3.5  | % |  | 4.3  | %
|Volatility               |  | 91            | % |  | 104  | % |  | 120  | %
|Dividend yield           |  | 0.0           | % |  | 0.0  | % |  | 0.0  | %



The Company has
revised its weighted average assumptions for the fair value of its pro forma disclosures from those previously reported.



The Company has revised its calculation of treasury shares used in connection with its calculation of diluted earnings per share to eliminate the effect
of compensation expense ascribed to past services and to give effect to the amount of unrecognized compensation costs attributable to future services. This revision resulted in a decrease in the Companys diluted earnings per share of $0.02 and
zero for the years ended December 31, 2003 and 2002, respectively.



In March 2001, the Company adopted the Excelligence Learning Corporation 2001 Employee Stock Purchase Plan that covers substantially all employees, which was amended and restated in its entirety for the second time in May 2002 upon receipt
of stockholder approval. By contributing a percentage of their compensation, participants in the plan may elect to purchase the Companys common stock at a 15% discount of the lower of the closing price at the beginning or end of any six-month
payment period. The first six-month payment period began in March 2002. The number of shares purchased through the plan for fiscal year 2003 was 21,652, with an average price of $1.91. For fiscal year 2002, 7,710 shares were purchased through the
plan, with an average price of $1.05. The Company suspended the 2001 Employee Stock Purchase Plan in August 2003.



|(15) | Lease Commitments
|---- | -----------------



The Company leases its facilities and certain equipment under non-cancelable lease agreements, which expire at various dates. Future minimum lease
payments as of December 31, 2004 under operating leases are as follows (in thousands):



|           |  |                 |      
|---------- |  | --------------- | -----
|           |  | OperatingLeases
|2005       |  | $               | 3,180
|2006       |  |                 | 2,407
|2007       |  |                 | 1,870
|2008       |  |                 | 794  
|2009       |  |                 | 534  
|Thereafter |  |                 | 522  
|           |  |                 |      
|           |  | $               | 9,307
|           |  |                 |      



As provided in SFAS
No. 13, Accounting for Leases, rental expenses for certain operating lease agreements with step rent increases are recognized on a straight-line basis over the term of the lease. Total rental expense under operating leases was $3.7
million, $3.9 million and $4.0 million for December 31, 2004, 2003, and 2002, respectively.



As stated in Note 11, the Company leases one of its warehouse facilities from a company owned by its Chief Executive Officer and one of its other
significant stockholders.



F-22



---

##### Table of Contents

|(16) | Segment Information
|---- | -------------------



The Company operates in two business segments, the Early Childhood segment and the Elementary School segment. The Early Childhood segment includes the
brand names Discount School Supply, SmarterKids.com, ECMD and Earlychildhood NEWS. The Early Childhood segment develops, manufactures and sells educational products through multiple distribution channels to early childhood professionals and
parents. The Early Childhood segment also provides information to teachers and other education professional regarding development of children from infancy through age eight. The Elementary School segment sells school supplies and other products
specifically targeted for use by children in kindergarten through sixth grade to elementary schools, teachers and other education organizations for fundraising activities.



The accounting policies of the reportable segments are the same as those described in the summary of significant accounting
policies in the Companys annual report filed on Form 10-K. The Companys supplemental profit measure is EBITDA. EBITDA, a non-GAAP financial measure which the Company believes is a meaningful supplemental measure of its operating
performance, is calculated by adding back to net income (loss): net interest, income taxes, depreciation and amortization. EBITDA is presented because the Company believes that EBITDA, when combined with other measures, can be a useful measure of
its overall performance and results of operations. In addition, the Company uses the measure and believes that it is also used by lenders, analysts, investors and others as an indication of the Companys ability to service debt and fund future
capital expenditure requirements. EBITDA information should not be considered an alternative to any measure of performance as promulgated under generally accepted accounting principles (such as operating income or net income) nor should it be
considered as an indicator of the Companys overall financial performance. The Companys calculations of EBITDA may be different from the calculations used by other companies and therefore comparability may be limited. Revenues by segment
and reconciliation of net income (loss) to EBITDA follows (in thousands):



|                              |  |                              |        |      |                                |        |      |                           |   |          |   |  |      |        |      |  |   |          |  |      |        |   |      |   |         |  |   |         |   |  |   |        
|----------------------------- |  | ---------------------------- | ------ | ---- | ------------------------------ | ------ | ---- | ------------------------- | - | -------- | - |  | ---- | ------ | ---- |  | - | -------- |  | ---- | ------ | - | ---- | - | ------- |  | - | ------- | - |  | - | -------
|                              |  | Early Childhood December 31, |        |      | Elementary School December 31, |        |      | Consolidated December 31,
|                              |  | 2004                         |        | 2003 |                                |        | 2002 |                           |   | 2004     |   |  | 2003 |        | 2002 |  |   | 2004     |  | 2003 |        |   | 2002
|                              |  | Restated                     |        |      |                                |        |      |                           |   | Restated |   |  |      |        |      |  |   | Restated |  |      |        |   |     
|Net revenues                  |  | $                            | 90,908 |      | $                              | 78,490 |      |                           | $ | 70,190   |   |  | $    | 30,080 |      |  | $ | 31,431   |  | $    | 30,570 |   |      | $ | 120,988 |  | $ | 109,921 |   |  | $ | 100,760
|                              |  |                              |        |      |                                |        |      |                           |   |          |   |  |      |        |      |  |   |          |  |      |        |   |      |   |         |  |   |         |   |  |   |        
|Net income (loss)             |  | $                            | 1,464  |      | $                              | 7,237  |      |                           | $ | (217     | ) |  | $    | (182   | )    |  | $ | 574      |  | $    | 2,669  |   |      | $ | 1,282   |  | $ | 7,811   |   |  | $ | 2,452  
|Interest  net                |  |                              | 80     |      |                                | 247    |      |                           |   | 409      |   |  |      |       |      |  |   |         |  |      | (18    | ) |      |   | 80      |  |   | 247     |   |  |   | 391    
|Income tax (benefit) expense  |  |                              | 793    |      |                                | (4,100 | )    |                           |   | 548      |   |  |      |       |      |  |   | 463      |  |      |       |   |      |   | 793     |  |   | (3,637  | ) |  |   | 548    
|Depreciation and amortization |  |                              | 1,024  |      |                                | 1,146  |      |                           |   | 1,168    |   |  |      | 686    |      |  |   | 551      |  |      | 386    |   |      |   | 1,710   |  |   | 1,697   |   |  |   | 1,554  
|                              |  |                              |        |      |                                |        |      |                           |   |          |   |  |      |        |      |  |   |          |  |      |        |   |      |   |         |  |   |         |   |  |   |        
|EBITDA                        |  | $                            | 3,361  |      | $                              | 4,530  |      |                           | $ | 1,908    |   |  | $    | 504    |      |  | $ | 1,588    |  | $    | 3,037  |   |      | $ | 3,865   |  | $ | 6,118   |   |  | $ | 4,945  
|                              |  |                              |        |      |                                |        |      |                           |   |          |   |  |      |        |      |  |   |          |  |      |        |   |      |   |         |  |   |         |   |  |   |        



The Early Childhood
segment performs limited administrative activities, including certain accounting and information system functions, on behalf of the Elementary School segment. Such inter-segment charges are based on estimates of its actual costs for such activities.
Inter-segment charges amounted to $407,000, $580,000, and $577,000 for the years ended December 31, 2004, 2003, and 2002, respectively. The Company allocates income tax expense for the current year based on a percentage of each segments
pre-tax income. The non-recurring adjustments in 2003 related to the change in tax law and adjustment to the deferred tax valuation allowance directly related to the Early Childhood segment and therefore the benefit of the adjustments is reflected
entirely in that segment. Prior to fiscal year 2003, no allocation of income tax was made to the Elementary School segment.



SFAS No. 131, Disclosures about Segments of an Enterprise and Related Information, establishes standards for the reporting by Public business
enterprises of information about operating segments, products and services, geographic areas, and major customers. The methodology for determining the information reported is based on the organization of operating segments and the related
information that the Chief Operating Decision Maker (CODM) uses for operational decisions and assessing financial performance. The Companys Chief Executive Officer (CEO) is considered the Companys CODM. For purposes of making operating
decisions and assessing financial performance, the Companys CEO reviews financial information for the Early Childhood segment and the Elementary School segment.



The Company had no customer comprising greater than 10% of its revenue or accounts receivable as of and for the years ended
December 31, 2004, 2003 or 2002.



F-23



---

##### Table of Contents

The segment asset information available is as follows:



|                  |  |              |         |   |      |   |         |  
|----------------- |  | ------------ | ------- | - | ---- | - | ------- | -
|                  |  | December 31, |        
|                  |  | 2004         |         |   | 2003 |  
|                  |  | Restated     |         |   |      |  
|Assets            |  |              |         |   |      |   |         |  
|Early Childhood   |  | $            | 41,922  |   |      | $ | 38,098  |  
|Elementary School |  |              | 19,339  |   |      |   | 19,136  |  
|Eliminations      |  |              | (11,310 | ) |      |   | (11,310 | )
|                  |  |              |         |   |      |   |         |  
|Total             |  | $            | 49,951  |   |      | $ | 45,924  |  
|                  |  |              |         |   |      |   |         |  



|(17) | Quarterly Information (Unaudited)
|---- | ---------------------------------



|                                                  |  |          |        |   |         |   |              |  |             |        |  |   |        |  
|------------------------------------------------- |  | -------- | ------ | - | ------- | - | ------------ |  | ----------- | ------ |  | - | ------ | -
|                                                  |  | March 31 |        |   | June 30 |   | September 30 |  | December 31 |       
|                                                  |  |          |        |   |         |   |              |  | Restated(2) |       
|2004:                                             |  |          |        |   |         |   |              |  |             |        |  |   |        |  
|Revenues                                          |  | $        | 19,836 |   |         | $ | 26,549       |  | $           | 53,404 |  | $ | 21,199 |  
|Gross margin                                      |  | $        | 6,908  |   |         | $ | 9,284        |  | $           | 18,142 |  | $ | 6,246  |  
|Operating income (loss)                           |  | $        | (1,641 | ) |         | $ | 270          |  | $           | 7,279  |  | $ | (3,758 | )
|Net income (loss)                                 |  | $        | (943   | ) |         | $ | 136          |  | $           | 4,054  |  | $ | (1,965 | )
|Net income (loss) per share:                      |  |          |        |   |         |   |              |  |             |        |  |   |        |  
|Basic                                             |  | $        | (0.11  | ) |         | $ | 0.02         |  | $           | 0.46   |  | $ | (0.22  | )
|Diluted                                           |  | $        | (0.11  | ) |         | $ | 0.01         |  | $           | 0.44   |  | $ | (0.20  | )
|                                                  |  |          |        |  
|2003:                                             |  |          |        |   |         |   |              |  |             |        |  |   |        |  
|Revenues                                          |  | $        | 17,418 |   |         | $ | 23,645       |  | $           | 50,951 |  | $ | 17,907 |  
|Gross margin                                      |  | $        | 6,128  |   |         | $ | 8,732        |  | $           | 18,654 |  | $ | 5,980  |  
|Operating income (loss)                           |  | $        | (1,974 | ) |         | $ | 665          |  | $           | 8,872  |  | $ | (2,926 | )
|Net income (loss)                                 |  | $        | (1,148 | ) |         | $ | 320          |  | $           | 7,848  |  | $ | 791    |  
|Basic and diluted net income (loss) per share (1) |  | $        | (0.14  | ) |         | $ | 0.04         |  | $           | 0.92   |  | $ | 0.09   |  
|                                                  |  |          |        |  
|2002:                                             |  |          |        |   |         |   |              |  |             |        |  |   |        |  
|Revenues                                          |  | $        | 15,574 |   |         | $ | 22,091       |  | $           | 46,264 |  | $ | 16,831 |  
|Gross margin                                      |  | $        | 5,621  |   |         | $ | 8,255        |  | $           | 17,216 |  | $ | 5,190  |  
|Operating income (loss)                           |  | $        | (2,822 | ) |         | $ | 588          |  | $           | 8,450  |  | $ | (2,825 | )
|Net income (loss)                                 |  | $        | (2,912 | ) |         | $ | 433          |  | $           | 5,926  |  | $ | (995   | )
|Basic and diluted net income (loss) per share (1) |  | $        | (0.35  | ) |         | $ | 0.05         |  | $           | 0.71   |  | $ | (0.12  | )

---

|(1) | The Company has revised its calculation of treasury shares used in connection with its calculation of diluted earnings per share to eliminate the effect of compensation expense
ascribed to past services and to give effect to the amount of unrecognized compensation costs attributable to future services. This revision resulted in a decrease in the Companys diluted earnings per share of $0.02 and zero for the years
ended December 31, 2003 and 2002, respectively.
|--- | --------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------



|(2) | The restatement adjustments described at Note 3 have been recorded by the Company in the quarter ended December 31, 2004. Certain of those adjustments totaling $61,000 related to
the first, second and third quarters of the 2004 fiscal year. The Company has determined that the impact of those adjustments on the fourth quarter of 2004 and the prior 2004 quarters is not material to reported operating results. The restatement
adjustments described in Note 3 also include $59,000, net of taxes, of out-of-period expenses that were recorded in the fourth quarter of 2004. The Company has also determined that the impact of those adjustments is not material to its 2004 fourth
quarter operating results.
|--- | ----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------



F-24



---

##### Table of Contents

Excelligence Learning Corporation

Schedule II

Valuation and Qualifying Accounts



|                                  |  |             |        |   |             |      |   |                                         |        |   |      |        |   |  |        |  
|--------------------------------- |  | ----------- | ------ | - | ----------- | ---- | - | --------------------------------------- | ------ | - | ---- | ------ | - |  | ------ | -
|                                  |  |             |        |   |             |      |   | For the Fiscal Years Ended December 31, |       
|                                  |  |             |        |   | 2004        |      |   | 2003                                    |        |   | 2002 |       
|                                  |  |             |        |   |             |      |   | (in thousands)                          |       
|                                  |  | As Reported |        |   | Adjustments |      |   | Restated                                |        |   |      |        |   |  |       
|Allowance for Doubtful Accounts:  |  |             |        |   |             |      |   |                                         |        |   |      |        |   |  |        |  
|Balance at beginning of period    |  | $           | 481    |   |             |     |   |                                         | 481    |   |      | 479    |   |  | 583    |  
|Additions charged to expense      |  |             | 275    |   |             | 425  |   |                                         | 700    |   |      | 545    |   |  | 404    |  
|Deductions (write-offs)           |  |             | (371   | ) |             | (398 | ) |                                         | (769   | ) |      | (543   | ) |  | (508   | )
|                                  |  |             |        |   |             |      |   |                                         |        |   |      |        |   |  |        |  
|Balance at end of period          |  | $           | 385    |   |             | 27   |   |                                         | 412    |   |      | 481    |   |  | 479    |  
|                                  |  |             |        |   |             |      |   |                                         |        |   |      |        |   |  |        |  
|Allowance for Sales Returns:      |  |             |        |   |             |      |   |                                         |        |   |      |        |   |  |        |  
|Balance at beginning of period    |  | $           | 350    |   |             |     |   |                                         | 350    |   |      | 138    |   |  | 186    |  
|Additions charged to expense      |  |             | 2,700  |   |             | 233  |   |                                         | 2,933  |   |      | 3,002  |   |  | 2,688  |  
|Deductions (write-offs)           |  |             | (2,954 | ) |             |     |   |                                         | (2,954 | ) |      | (2,790 | ) |  | (2,736 | )
|                                  |  |             |        |   |             |      |   |                                         |        |   |      |        |   |  |        |  
|Balance at end of period          |  | $           | 96     |   |             | 233  |   |                                         | 329    |   |      | 350    |   |  | 138    |  
|                                  |  |             |        |   |             |      |   |                                         |        |   |      |        |   |  |        |  
|Deferred Tax Valuation Allowance: |  |             |        |   |             |      |   |                                         |        |   |      |        |   |  |        |  
|Balance at beginning of period    |  | $           | 2,185  |   |             |     |   |                                         | 2,185  |   |      | 4,977  |   |  | 5,553  |  
|Additions charged to expense      |  |             |       |   |             |     |   |                                         |       |   |      |       |   |  |       |  
|Deductions (write-offs)           |  |             | (729)  |   |             |     |   |                                         | (729   | ) |      | (2,792 | ) |  | (576   | )
|                                  |  |             |        |   |             |      |   |                                         |        |   |      |        |   |  |        |  
|Balance at end of period          |  | $           | 1,456  |   |             |     |   |                                         | 1,456  |   |      | 2,185  |   |  | 4,977  |  
|                                  |  |             |        |   |             |      |   |                                         |        |   |      |        |   |  |        |  



F-25