**UNITED
      STATES SECURITIES AND EXCHANGE**


**COMMISSION**


**Washington,
      DC 20549**





**FORM 10-K**





**(Mark
      One)**





**x**
            
            **ANNUAL
                REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES
                EXCHANGE ACT OF 1934****For
                the fiscal year ended December 31, 2006****o**
            
            **TRANSITION
                REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE EXCHANGE ACT OF
                1934****For
                the transition period from
                               
                to**





**Commission
      file number 333-68532**





**SMALL
      WORLD KIDS, INC.**





**Nevada**
            
            **86-0678911**(State
                or other jurisdiction of
            
            (I.R.S.
                Employerincorporation
                or organization)
            
            Identification
                No.)





**5711
      Buckingham Parkway, Culver City, California 90230**


(Address
      of principal executive offices)





**(310)
      645-9680**


(Issuer’s
      telephone number:)





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


**None**





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


**None**





Indicate
      by check mark if the registrant is a well-known seasoned issuer, as defined
      in
      Rule 405 of the Securities Act. Yes o No  x





Indicate
      by check mark if the registrant is not required to file reports pursuant to
      Section 13 or Section 15(d) of the Exchange Act.
      Yes o No x




Indicate
      by check mark whether the registrant (1) has filed all reports required to
      be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934
      during the preceding 12 months (or for such shorter period as 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 o





Indicate
      by check mark if disclosure of delinquent filers in response to Item 405 of
      Regulation S-K is not contained herein, and no disclosure will 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.  x





Indicate
      by a check mark whether the registrant is a large accelerated filer, an
      accelerated filer, or a non-accelerated filer. See definition of “accelerated
      filer and large accelerated filer” in Rule 12b-2 of the Exchange
      Act.





Large
                accelerated filero
            
            Accelerated
                filero
            
            Non-accelerated
                filer   x





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





The
      aggregate market value of the voting and non-voting common equity (the only
      such
      common equity being Common Stock, $.001 par value) held by non-affiliates of
      the
      registrant as of the last business day of the registrants most recently
      completed second fiscal quarter was $1,049,000.





The
      number of shares outstanding of the registrant’s Common Stock, $.001 par value
      (being the only class of its common stock) is 5,410,575 (as of April 9,
      2007).





**Documents
      Incorporated by Reference**





None.











**Table
      of Contents**





PART I
            
            3ITEM
                1. Description of Business
            
            3ITEM
                1A. Risk Factors
            
            11ITEM
                1B. Unresolved Staff Comments
            
            16ITEM
                2. Description of Property
            
            16ITEM
                3. Legal Proceedings
            
            16ITEM
                4. Submission of Matters to a Vote of Security Holders
            
            16PART II
            
            16ITEM
                5. Market for Registrant’s Common Equity, Related Stockholder Matters and
                Issuer Purchases of Equity Securities
            
            16ITEM
                6. Consolidated Selected Financial Data
            
            18ITEM
                7. Management’s Discussion and Analysis of Financial Condition and Results
                of Operations
            
            18ITEM
                8. Financial Statements and Supplemental Data
            
            29ITEM
                8A. Quantitative and Qualitative Disclosures about Market
                Risk
            
            29ITEM
                9. Changes in and Disagreements with Accountants on Accounting and
                Financial Disclosure
            
            29ITEM
                9A. Controls and Procedures
            
            29ITEM
                9B. Other Information
            
            30PART III
            
            30ITEM
                10. Directors, Executive Officers, Promoters and Control
                Persons
            
            30ITEM
                11. Executive Compensation
            
            32ITEM
                12. Security Ownership of Certain Beneficial Owners and Management
                and
                Related Stockholder Matters
            
            39ITEM
                13. Certain Relationships and Related Transactions
            
            41ITEM
                14. Principal Accountant Fees and Services
            
            42ITEM
                15. Exhibits and Reports on Form 8-K
            
            43SIGNATURES
            
            46Index
                to Consolidated Financial Statements
            
            F-1


2





**Part I**





**Forward-Looking
      Statements**





The
      following discussion should be read in conjunction with the Company’s
      consolidated financial statements and the notes thereto appearing elsewhere
      in
      this prospectus. This annual report on Form 10-K, including the
“Management’s Discussion and Analysis” section in Part II, Item 7 of
      this report, and other materials accompanying this annual report on
      Form 10-K contain forward looking statements within the meaning of
      Section 27A of the Securities Act of 1933, as amended, and Section 21E
      of the Securities Act of 1934, as amended. For example, statements included
      in
      this prospectus regarding our financial position, business strategy and other
      plans and objectives for future operations, and assumptions and predictions
      about future product demand, supply, manufacturing, costs, marketing and pricing
      factors are all forward-looking statements. When we use words like “intend,”
“anticipate,” “believe,” “estimate,” “plan,” “will” or “expect,” we are making
      forward-looking statements. We believe that the assumptions and expectations
      reflected in such forward-looking statements are reasonable, based on
      information available to us on the date hereof, but we cannot assure you that
      these assumptions and expectations will prove to have been correct or that
      we
      will take any action that we may presently be planning. However, these
      forward-looking statements are inherently subject to known and unknown risks
      and
      uncertainties. Actual results or experience may differ materially from those
      expected or anticipated in the forward-looking statements. Factors that could
      cause or contribute to such differences include, but are not limited to,
      regulatory policies, competition from other similar businesses, and market
      and
      general economic factors.





**ITEM
      1. DESCRIPTION OF BUSINESS**





Small
      World Kids, Inc. was organized on July 28, 2001 under the name SavOn
      Team Sports, Inc. in the State of Utah to sell sporting goods over the
      Internet. On May 20, 2004, we acquired Fine Ventures, LLC, a Nevada limited
      liability company, and Small World Toys, a California corporation. As a result
      of these acquisitions, we had a change of our management, our controlling
      shareholders, our financial position and our business plan. Small World Kids
      is
      now a holding company and has no significant business operations or assets
      other
      than its interest in Small World Toys. Since the acquisition of Small World
      Toys, the Company has been engaged in the development, manufacturing, marketing
      and distribution of educational and developmental toys. To more accurately
      reflect our operations after the acquisitions, we changed our name from SavOn
      Team Sports, Inc. to Small World Kids, Inc. We also changed our place
      of incorporation from the state of Utah to the state of Nevada.





Small
      World Kids became a holding company as a result of the May 20, 2004
      transactions and has no significant business operations or assets other than
      its
      interest in Small World Toys, the accounting predecessor company. As such,
      accounting guidelines dictate that the results of operations for the predecessor
      and successor entities be clearly segregated for financial reporting purposes.
      However, for the purpose of describing and analyzing the results of operations
      in this section, both predecessor and successor entities have been
      combined.





As
      of
      December 31, 2006, Small World Kids is comprised solely of Small World Toys
      (which includes the Neurosmith brand) and as such the balances and results
      for
      each entity are one in the same.





**Overview
      of Small World Toys**





Small
      World Toys has been distributing toys for 45 years. Our Small World Toys’
proprietary product lines features toys for children ages zero to ten with
      a
      focus of promoting early learning, education, discovery and imagination. Small
      World Toys develops, manufactures, markets and distributes toys to promote
      healthy minds and bodies in infant, pre-school, early learning, imaginative
      play
      and active play categories. The company distributes products in specialty,
      mass,
      chain, education, catalog, online and international channels through sales
      representative firms as well as in-house sales executives. Proprietary brands
      include IQ Baby®, IQ Preschool®, Ryan’s Room®, Gertie Ball®, Small World Living,
      Puzzibilities®, All About Baby®, Neurosmith® and ImagiixTM. We also exclusively
      distribute product for several brands such as TOLO® to the specialty toy market
      in the United States through our “SW Express” distribution arm. Small World Toys
      has had acquired licenses for our developmental toy products including the
      works
      of Dr. Seuss, Eric Carle, including “The Very Hungry Caterpillar” and Karen
      Katz, including “Where is Baby’s Belly Button.”





**Recent
      Developments**





On
      February 28, 2006, the Company entered into a security agreement (the Laurus
      “Security Agreement”) with Laurus Master Fund, Ltd. (“Laurus”). Included in the
      Security Agreement is an asset-based Secured Non-Convertible Revolving Note
      (the
“Revolving Note”) that we may borrow up to $16.5 million and a $2.0 million, two
      year Secured Non-Convertible Term Note (the “Term Note “). On July 26, 2006 and
      amended on October 19, 2006, Laurus authorized $1.5 million in excess of the
      maximum allowed borrowings based on a formula amount of the secured assets
      (the
“Overadvance”) on the Revolving Note for a one year period. On January 26, 2007,
      the Company entered into an Omnibus Amendment No.1 with Laurus that (a) amended
      the Overadvance Side Letter by extending the maturity of the Overadvance of
      up
      to $1,500,000 from October 19, 2007 to February 28, 2008 and (b) increased
      the
      Concentration Limits for accounts on standard terms from 15% to 32.5%. In
      addition, the requirement for the listing of the Company’s shares on the NASDAQ,
      OTC Bulletin Board or other Principal Market and for the timely filing with
      the
      SEC of all reports required to be filed pursuant to the Exchange Act was
      deleted.




3





On
      January 26, 2007, the Company also entered into the Second Amendment to the
      Registration Rights Agreement with Laurus dated February 28, 2006, that deleted
      the requirement to file a Registration Statement without penalty In accordance
      with EITF 00-19, the value of the Warrant issued to Laurus on February 28,
      2006
      was subject to marked-to-market revaluation at each period end since this
      Warrant was subject to registration rights requiring the Company to register
      the
      underlying shares with the SEC within 60 days of the issuance of the warrant.
      Any change in fair value from the date of issuance to the date the underlying
      shares are registered was included in other (expense) income. With the Second
      Amendment to the Registration Rights Agreement that deleted the requirement
      to
      file a Registration Statement, the warrant liability is reclassified from a
      liability to equity. The change in fair value from December 31, 2006 to
      January 26, 2007 of $362,000 will be included in other income in January 2007.
      With the termination of the requirement to file a Registration Statement, the
      value of the warrant on the January 26, 2007 of $1,085,000 will be reclassified
      from a liability to equity (Note 5 of the accompanying financial
      statements).





On
      January 26, 2007, the Company issued a warrant to purchase an aggregate of
      685,185 shares at an exercise price of $.01 per share to Laurus. The warrant
      was
      issued in connection with the extension of the maturity of the Overadvance
      to
      February 28, 2008 and the increase of the Concentration Limits on standard
      terms
      from 15% to 32.5%. This warrant has a relative fair value of $711,000 calculated
      using the Black Scholes option pricing model with the following
      assumptions:





Expected
                life (in years)
            
            
            10Expected
                volatility
            
            
            1.18
            %Risk-free
                interest rate
            
            
            4.88
            %Expected
                dividend
            
            
            —




The
      Company has determined the issuance of the warrant in connection with Omnibus
      Amendment No.1 and the Second Amendment to the Registration Rights has resulted
      in a substantial modification resulting in the net present value between the
      original Revolving Note and the amended Revolving Note to be greater than 10%,
      and in accordance with EITF Issue 96-19, Debtor’s Accounting for a Modification
      or Exchange of Debt, the amendments were accounted for as an extinguishment
      of
      debt and the relative fair value of the warrant will be expensed.




**Strategic
      Plan**





Our
      strategic plan is market expansion through both growth of existing product
      lines, and the acquisition of licenses, product lines and companies that create
      synergies in operations, production and distribution or that can add value,
      sales and distribution into new retain accounts. We regard product line
      extensions, new customer relationships, and opportunities for increased cost
      reductions as particularly important in our analysis of a potential
      acquisition’s strategic value.




The
      anticipated benefits of this proposed strategy include:




·
            Enhanced
                channels of distribution for products through the combination of
                the
                potential target’s alternative distribution channels with our specialty
                retail distribution channels.




·
            Diversified
                product lines within high growth categories to create additional
                in-store
                placement in multiple sections of the store, which we believe will
                increase per store orders and a greater percentage of shelf
                space.




·
            Greater
                number of unit sales for products that will decrease manufacturing
                costs,
                therefore increasing margins and allowing us to benefit from price
                breaks
                that vendors offer for larger quantity
                orders.




·
            Fuller
                utilization of operations as a percentage of sales, which will increase
                operating margins, combined operating
                departments.




·
            Cost
                improvements in production and distribution coupled with expanded
                and
                improved product lines leading to increased profitability and
                growth.




4




·
            Expansion
                into international markets through multi-country
                distributors.




However,
      acquisitions involve uncertainties, and our attempts to identify appropriate
      acquisitions, and finance and complete any particular acquisition, may not
      be
      successful. In addition, growth by acquisition involves risks that could
      adversely affect our results of operations, including difficulties in
      integrating and assimilating the operations and personnel, the potential loss
      of
      key employees of acquired companies, failure of an acquired business to achieve
      targeted financial results and potential increase of indebtedness to finance
      the
      acquisition.





**Industry
      Overview**





Consumer
      spending on toys, dolls and games will reach $73.3 billion by 2011, according
      to
      the statisticians at Easy Analytic Software, a 42% increase from the $51.6
      billion spent in the United States on toys, dolls and games in 2006, a figure
      compiled by the U.S. Department of Commerce.





Management
      believes that the toy industry growth will be primarily driven by the following
      trends:





·
            According
                to Packaged Facts, the U.S. population of children under the age
                of 12 is
                at an all-time high at close to 38% of the population, or 64 million
                children.





·
            According
                to Packaged Facts, the U.S. birthrate is higher than it has been
                in 30
                years due to an increase in fertility and the trend of mothers giving
                birth later in life.




·
            The
                last census revealed that there are over 70 million people in the
                United
                States over the age of 55. That number is expected to grow 60% by
                2007,
                which is six times faster than the rest of the population. A vast
                majority
                of persons in this demographic are grandparents and according to
                Packaged
                Facts, grandparents currently spend more than $2 billion annually
                in toys
                for their grandchildren.





·
            Increase
                in dual income families.





**Product
      Overview**





While
      many of our products are evergreen brands or long life cycle products, we are
      continually developing new products and the refreshing of existing products.
      Our
      product offerings are a combination of proprietary products that we design,
      sourced product that we find in other countries, that we then purchase and
      package in our packaging for exclusive distribution in the United Sates
      specialty market, and finally a small amount of open market product that we
      put
      through our distribution chain for retailers. We have the capability to create
      and develop products from inception to completion as finished goods with our
      in
      house designers. Additionally, we use third-parties to provide a portion of
      the
      sculpting, sample making, illustration and package design required for our
      products. Typically, the development process takes from nine to eighteen months
      from concept to production and shipment to our customers. We have launched
      an
      electronic learning line through our 2004 acquisition of Neurosmith. We
      occasionally acquire other product concepts from unaffiliated third parties.
      If
      we accept and develop a third party’s concept for new toys, we generally pay a
      royalty on the toys developed from this concept that are sold, and may, on
      an
      individual basis, guarantee a minimum royalty. Royalties payable to inventors
      and developers generally range from 5% to 10% of the wholesale sales prices
      for
      each unit of a product sold by us. We believe that utilizing experienced
      third-party inventors gives us access to a wide range of development talent.
      We
      also have license agreements with third parties that permit us to utilize the
      trademark, characters or inventions of the licensor in products that we
      sell.










**Small
      World Toys Brands**





Small
      World Toys’ proprietary brands feature toys for children ages 0 - 10 years with
      a focus on early learning, discovery, imagination and active play. The
      company positioning reflects the Small World Kids “whole child” philosophy:
      Small World Toys provides products that nurture the whole child - mind, body
      and
      spirit - through vibrant, engaging toys that promote early learning, reward
      social interaction and encourage physical fitness.


5


***Learning
      Brands:***











**IQ
      Baby®** - Infant
      toys that invite exploration, encourage discovery and reward development in
      the
      critical years from birth through toddler hood. IQ
      baby
      products nurture the whole child-body, mind and spirit through vibrant, engaging
      toys designed to reward infant development and encourage social
      interaction Toys
      within this brand include Hickory Dickory Clock and Pillow Soft Activity
      Blocks.










**Neurosmith®** -
      Electronic learning toys that combine the latest child development research
      with
      fun, interactive play patterns. Research indicates that certain playtime
      actions, or “play patterns,” can positively affect the way a child’s brain
      develops. Neurosmith’s play patterns are designed with this research in mind,
      stimulating and developing important connections in a baby’s busy brain. These
      connections lay the groundwork for enhanced learning potential that lasts a
      lifetime. Toys within this brand include Music Block® and Touch ‘N Sing
      BlocksTM.











**Puzzibilities®** - Wooden
      puzzles designed in four progressive levels to stimulate “piece by piece” fun
      learning across a range of ages and developmental skills. Our puzzles foster
      primary learning skills such as fine motor skills, hand eye coordination,
      problem solving, concentration, and abstract thinking. Finely crafted puzzles
      have bright colors, imaginative themes and contemporary designs. Toys
      within this brand include Sounds
      On The Farm and Bilingual Counting puzzles.





***Imaginative
      Play Brands:***











**Ryan’s
      Room®** -
      Classic wooden play sets and accessories that allow children to imagine, create
      and bring to life their very own worlds. Constructed
      from solid sturdy wood, hand painted, and sized for little hands, every set
      of
      Ryan’s Room toys continues to encourage imaginative play. These open floor plan
      toys allow for easy access showcasing a number of unique architectural details.  Toys
      within this brand include Fairyland Forest treehouse, Sunshine Manor dollhouse, Pirate Ship and
      accessories.




6










**All
      About Baby®** - Sweet,
      huggable dolls to love and nurture complete with popular and imaginative
      accessories. These realistic baby dolls feature different sounds and interactive
      functions for hours of role playing fun. These dolls have interactive features
      that teach cause and effect, promotes social development, and develops manual
      dexterity. Toys within this brand include including Baby Sweet Sounds and Deluxe
      Baby Doll Set.











**Small
      World LivingTM** - The
      Role play toys and environments are designed to encourage your child to play
      out
      his dreams of “what I want to be when I grow up!” These toys stir up the
      imagination, while promoting a constructive lifestyle and empowering children
      through creative role play to create their dream world. Toys
      within this brand include Includes
      Stove, BBQ Grill, utensils, bakery and cookware sets.











**ImagiixTM** *-* Award
      winning toys for infant, toddler & pre-school. Toys
      within this brand include the
      Piano Stepper musical toy.





***Active
      Play Brands:***













**Gertie
      Ball®** - An
      award-winning line of balls for all ages, designed with a wide variety of unique
      textures, designs and features. Designed for preschoolers, these soft,
      lightweight, easy-to-catch balls will not bend back a finger or hurt when they
      hit. Gertie balls are gummy and soft enough for kids who may be scared of big
      heavy balls coming toward them. Toys within this brand include Glitter, Bumpie
      and Glow Gertie Balls.




7













**Active
      Edge®** - Sports
      and activity toys designed to give a child a sense of mastery, empowerment,
      and
      help build a foundation for an active, fit lifestyle. These toys encourages
      your
      child to get out and play. Toys
      within this brand include Bounce
      Around, Loop-To-Loop Parachute and Tube Travel toys.











**Active
      Edge®**  **Extreme** -
      Sports
      and activity toys designed with a twist thereby allowing your child’s play to
      reach the next level while building a foundation for an active, healthy and
      fit
      lifestyle. Toys
      within this brand include Aqua
      Hockey and Shoot ‘N’ Score Soccer Ball.





***Distribution***





Small
      World Toys has been distributing its products to a broad spectrum of retail
      and
      various other accounts for over 40 years. Some of these accounts include toy
      specialty, chain, gift, education, catalog and e-commerce. We have over 80
      sales
      representatives, within 11 representative firms that sell to these accounts
      by
      geographic locations. The representative firms are managed in house. In
      addition, a five member sales team handles in house accounts as well as develops
      new channels of distribution. We have utilized our distribution strength to
      represent other, high quality companies that did not have distribution into
      the
      specialty market in the United States, such as Tolo® for example. We receive
      samples of their products or catalogs that show their products; then either
      incorporate their product pictures and pricing into our catalog or use their
      own
      catalog. We buy their product, ship it into our warehouse, and sell it to our
      retail and on-line customers through our in house and outside sales
      representatives.











SW
      Express is our brand name of products that include both products that we buy
      from manufacturers to resell instead of developing ourselves, as well as,
      products that we distribute for other companies such as Tolo. It is not a
      separate company or branch of the company; it is a brand name in which to
      differentiate the products that we distribute rather than those we develop
      ourselves. Distribution allows us to increase category presence, expand market
      share, limit manufacturing (tooling) risk, and sell into new channels. SW
      Express has been distributing Tolo Toys exclusively in the United States for
      over 10 years. SW Express allows us to take advantage of the relationship we
      have with our customers and their 6,000 stores. Product categories that SW
      Express distributes include Nature and Science, Outdoor, Pool and high quality
      Infant and Toddler toys. Toys include Preschool Laptop, Tailgate Trio Car and
      Wigglin’ Water sprinkler. Small World Toys has agreements with these companies
      and either buys the products directly from the manufacturers to distribute
      into
      its channels or receives a distribution percentage upon selling the product.
      Currently, most of our distributed products are sourced and produced in
      China.




8











Infant
      and preschool toys made of quality, bright plastic and plush, which are produced
      in China by British founders with a strong European market presence. Small
      World
      has distributed Tolo products in the USA for over ten years. Toys include Sneezy
      The Activity Dragon and First Friends and accessories.





**International**




Outside
      of the United States, our primary markets are Canada, Western Europe, and Asia.
      Sales of our products abroad accounted for approximately $1,037,000 or 3.7%
      and
      $1,097,000 or 3.2 % of our net sales in 2006 and 2005, respectively. We believe
      that foreign markets present an attractive opportunity, and we plan to intensify
      our marketing efforts and further expand our distribution channels
      abroad.




**Marketing**




Generally,
      our products and brands are promoted through local market promotions,
      merchandising displays and advertising print, including cooperative advertising
      with retail accounts. Our product launches include in-store merchandising
      displays, trade advertising and newspaper ads that are co-oped with our retail
      customers. We participate in the New York Toy Fairs in October and February.
      We
      also attend gift and juvenile shows including JPMA (Juvenile Products
      Manufacturers Assoc.), NSSEA (National School Supply & Education Assoc.),
      ASTRA (American Specialty Toy Retailing Association), ABC (All Baby’s and
      Children Expo) and regional gift shows. Going forward, we will maintain our
      trade and local marketing efforts while expanding programs to reach the consumer
      on a more national level, including an increased focus on public relations
      outreach, strengthening partnerships with key influencers in the fields of
      early
      learning and child development, participation in relevant event marketing and
      sponsorships, utilization of direct-to-consumer media and the establishment
      of
      consumer loyalty programs.




**Manufacturing**




We
      outsource the manufacturing of our proprietary products to vendors in Asia.
      We
      believe our outsourcing strategy enhances the scalability of our manufacturing
      efforts. We use numerous manufacturers to source components and build finished
      products to our specifications. During the year ended December 31, 2006,
      our top ten suppliers accounted for 74.1 % of the total product purchases.
      The
      top two suppliers accounted for 20.9% and 10% of total purchases, respectively.
      Our tools and dies are located at the facilities of our third-party
      manufacturers. Manufacturers are selected based on their technical and
      production capabilities and are matched to particular products to achieve cost
      and quality efficiencies. Employees in the Culver City office create and design
      product in each product category. They then send the designs to the manufacturer
      to get a sample product and costing done or have samples made in the United
      States. Once the sample and costing is approved, these product developers will
      work with the factories to insure the integrity and safety of the products.
      Small World Toys designs approximately 90 toys per year and sources
      approximately 40 products from Asian or European manufacturers. We have long
      standing relationships with our manufacturers and have been manufacturing in
      Asia for more than 15 years. Small World Toys works with more than 40 factories
      both on a manufacturing basis and to source toys to distribute exclusively
      in
      the United States. Small World Toys has credit terms with most of its
      manufacturers and pays upon shipping of product from Hong Kong. Small World
      Toys
      has an office in Hong Kong with five people who are responsible for inspecting
      factories and setting up relationships with new manufacturers. The group also
      inspects product and sends product to a third party for safety certification.
      Small World Toys also has a staff in Quality and Control in its Culver City
      office that works with product development and all phases of production to
      assure that all safety requirements are met. Small World Toys owns all of its
      tools for product developed internally as well as trademarks and design patents.
      The majority of our products are shipped directly to our warehouse in Carson,
      California and are later shipped to meet the demands of our retailers and
      distributors.





**Customers
      and Customer Service**




Our
      three
      largest customers; Costco Wholesale Corporation, Target and TJX Companies
      collectively represented 36.4% and 32.5 % of 2006 and 2005 sales, respectively.
      No other customer represents greater than 5% of our sales in 2006 or 2005.
      Although we do not have long term contracts with any of our customers, we
      believe that our ability to establish and maintain long-term relationships
      is
      substantial as many of our accounts have been buying from Small World Toys
      for
      more than 15 years. Small World Toys has consistently been in the top five
      vendors with almost all of its 2,500 Specialty accounts. Small World Toys sells
      to high end Specialty stores as well as the educational channel, the book
      channel, high end department stores such as Nordstroms and other high end
      retailers such as Learning Express and Lakeshore Learning. Small World Toys
      has
      become a vendor with other high end chains such as Target and Costco. Small
      World is trying to differentiate its product for each channel in order to keep
      product fresh in each channel. Our success with our customers, which have
      approximately 6,000 stores (example - one customer, Target operates over 1,300
      stores), is based on providing programs and product that will help them stock
      and sell our product. Small World Toys has a staff of 5 customer service
      representatives who are supervised by a Customer Service Manager. We encourage
      and utilize frequent communication with and feedback from our customers and
      retailers to continually improve our products and service. We offer toll-free
      telephone support for customers who prefer to talk directly with a customer
      service representative. We also respond to e-mail inquiries received through
      our
      website.




9




**Product
      Development**




While
      many of our products are evergreen brands or long life cycle products, we are
      continually developing new products and refreshing existing products. We
      expensed approximately $1,743,000 and $1,972,000 in 2006 and 2005, respectively,
      on activities relating to the development and design of new products. Our
      product offerings are a combination of proprietary products that we design,
      sourced product that we find in other countries, purchased and packaged in
      our
      packaging for exclusive distribution in the United States specialty market
      and a
      small amount of open market product that we put through our distribution chain
      for retailers.




We
      have
      the capability to create and develop products from inception to completion
      of
      finished goods with our in house designers. Additionally, we use third-parties
      to provide a portion of the sculpting, sample making, illustration and package
      design required for our products. Typically, the development process takes
      from
      nine to eighteen months from concept to production and shipment to our
      customers.




Most
      of
      our products that we develop are sold under our trademarks and trade names,
      while the Neurosmith products incorporate patented devices or designs. Trade
      names and trademarks are significant assets in that they provide product
      recognition and acceptance. We customarily seek trademark and patent protection
      covering our products and own or have applications pending for US and
      foreign patents covering many of our Neurosmith products. A number of these
      trademarks relate to product lines that are significant to our business and
      operations. We believe our rights to these properties are adequately protected,
      but there can be no assurance that our rights can be successfully asserted
      in
      the future or will not be invalidated, circumvented or challenged.





We
      have
      launched an electronic learning line through our 2004 acquisition of Neurosmith.
      Small World Toys acquired the patents, designs, trademarks, copyrights and
      technology for over 20 Early Electronic Products in the Neurosmith brand. Small
      World Toys has more than 10 patent applications and patents and 100 copyrights
      and trademarks, including design patents in its portfolio. Small World Toys
      holds the licensing rights to design, manufacture, market and distribute many
      well known trademarks and copyrighted products based on the properties of Eric
      Carle, Dr. Seuss and Karen Katz.




We
      occasionally acquire other product concepts from unaffiliated third parties.
      If
      we accept and develop a third party’s concept for new toys, we generally pay a
      royalty on the toys developed from this concept that are sold, and may, on
      an
      individual basis, guarantee a minimum royalty. Royalties payable to inventors
      and developers generally range from 5% to 10% of the net sales prices for each
      unit of a product sold by us. We believe that utilizing experienced third-party
      inventors gives us access to a wide range of development talent.




We
      also
      have license agreements with third parties that permit us to utilize the
      trademark, characters or inventions of the licensor in products that we sell.
      Licensing fees paid to the licensor range from 8-10 percent of net
      sales.





**Competition**




Competition
      in the toy industry is intense. We compete with several medium and small toy
      companies in our product categories that distribute products into the specialty
      toy market such as Alex, International Playthings Inc., Melissa and Doug,
      Playmobil U.S.A., RC2 Corporation, and Toysmith Group. We also compete with
      several large toy companies such as Mattel, Hasbro and Jakks Pacific. These
      competitors have greater financial resources, larger sales and marketing and
      product development departments, stronger name recognition, longer operating
      histories and benefit from greater economies of scale. These factors, among
      others, may enable our competitors to market their products at lower prices
      or
      on terms more advantageous to customers than those we could offer for our
      competitive products. These competitors may have a greater ability to procure
      product licenses, as well as to market and distribute products and obtain shelf
      space. Competition may result in price reductions, reduced gross margins and
      loss of market share, any of which could have a material adverse effect on
      our
      business, financial condition and results of operations. We compete primarily
      in
      the infant and pre-school category and the educational toy category of the
      U.S.
      toy industry and, to some degree, in the International toy industry. Our
      platform company, Small World Toys, has been distributing our products into
      the
      specialty retail, catalog, education and chains for over 40 years and we believe
      that our relationships and quality of our product brand awareness have been
      critical to our penetration.




10




**Seasonality**




Our
      business is subject to seasonal fluctuations. In 2006 and 2005, approximately
      58% and 60%, respectively of net sales were generated in the third and fourth
      calendar quarters. We have traditionally introduced new product catalogs in
      January and in July. Generally, the first quarter is the period of lowest
      shipments and sales and therefore the least profitable due to fixed costs.
      Seasonality factors may cause our operating results to fluctuate from quarter
      to
      quarter. However, we employ customer programs for retailers or “early buy”
programs to lesson the seasonality. These programs provide an opportunity for
      our customers to purchase our products in the first and second quarters and
      stock through the year by offering dating programs, where they pay in their
      highest sales quarters, typically in the third and fourth quarters.





**Employees**




At
      December 31, 2006, we had 60 full time employees. None of our employees are
      covered by a collective bargaining agreement. We consider our relations with
      our
      employees to be good.




**ITEM
      1A. RISK FACTORS**





Our
      business faces many risks. The risks described below may not be the only risks
      we face. Additional risks that we do not yet know of, or that we currently
      think
      are material, may also impair our business operations or financial results.
      If
      any of the events or circumstances described in the following risks actually
      occurs, our business, financial conditions or results of operations could suffer
      and the trading price of our common stock could decline.





***We
      have limited cash available for operations. We may not have sufficient liquidity
      to continue to meet our debt obligations.***




As
      of
      December 31, 2006, we had approximately $1,169,000 of unrestricted cash and
      availability on our line of credit, which includes the $1,500,000 Overadvance
      with our senior lender, Laurus.





Cash
      has
      historically been generated from operations. Operations and liquidity needs
      are
      funded primarily through cash flows from operations, as well as, utilizing,
      when
      needed, borrowings under the Company’s secured credit facilities and short term
      notes. Working capital needs generally reach peak levels from August through
      November of each year. To gain shelf space and address the seasonality of the
      toy industry, we offer early buy programs that are volume related with extended
      payment terms. Our historical revenue pattern is one in which the second half
      of
      the year is more significant to our overall business than the first half and,
      within the second half of the year, the fourth quarter is the most prominent.
      The trend of retailers over the past few years has been to make a higher
      percentage of their purchases of toy and game products within or close to the
      fourth quarter holiday consumer buying season, which includes Christmas. We
      expect that this trend will continue. As such, historically, the majority of
      cash collections for Small World Toys occur late in the fourth quarter as the
      extended payment terms become due from our early buy programs. As receivables
      are collected, the proceeds are used to repay borrowings under the Revolving
      Note issued to Laurus Master Fund.




We
      have
      incurred significant losses since our purchase of Small World Toys in
      May 2004. As of December 31, 2006, our accumulated deficit was $22.6
      million. On June 9, 2006, the Company received approximately $2.4 million
      from the private placement of Class A-1 Preferred Stock at $1.10 per share
      and subsequently received an additional $.3 million by November 2006. In
      addition, on June 9, 2006, the Company converted $3.0 million of debt due in
      2006 and 2008 to Class A-1 Preferred Stock, and restructured a $2.5 million
      note due in 2006 to $250,000 due within 12 months and the balance to begin
      principal amortization in October 2008. On October 19, 2006, we have
      received an additional $200,000 from the private placement of Class A-1
      Preferred Stock at $1.10 per share. On October 19, 2006, we issued an aggregate
      of $330,000 in principal amount of 10% Convertible Debentures. On July 26,
      2006,
      Laurus authorized $750,000 in excess of the maximum allowed borrowings based
      on
      a formula amount of the secured assets (the “Overadvance”) on the Revolving
      Note. On October 19, 2006, Laurus increased to $1,500,000 the permitted
      Overadvance to the Company in excess of the maximum amounts available to be
      borrowed on our revolver loans.




11




As
      of
      December 31, 2006, we had $804,000 in principal payments due during the next
      twelve months to Laurus, Horizon, St. Cloud and the former shareholder of Small
      World Toys. Of the $804,000 in principal payments due in 2007, the Company
      is
      not permitted by Laurus to pay the $152,000 in principal payments due to St.
      Cloud in 2007 while any amounts are outstanding on the $1,500,000 overadvance.
      We may not be able to generate sufficient cash flow from operations to meet
      our
      debt and operational obligations. If we are unable to generate sufficient cash
      flow, we would be required to seek additional financing or restructure our
      debt
      obligations. There can be no assurance that we will be able to obtain additional
      financing or restructure our debt obligations or that, if we were to be
      successful in obtaining additional financing or restructure our debt
      obligations, it would be on favorable terms. Failure to obtain additional
      financing or restructuring our debt obligations may cause us to default on
      these
      debt obligations. In addition, under cross default provisions in the Laurus
      Security Agreement, defaults under our debt obligations may cause the
      acceleration of the repayment of the Revolving and Term Notes.




***We
      have a history of net losses.***




We
      have
      incurred significant losses since our purchase of Small World Toys in May 2004.
      As of December 31, 2006, our accumulated deficit was $22.6 million. These losses
      principally resulted from the cost of being public, research and development,
      general and administrative, sales and marketing expenses and significant
      interest expense associated with our capital structure. We may continue to
      experience net losses in the future.





***We
      have cross default provisions in our senior credit facility which may result
      in
      the acceleration the obligations due under the credit
      agreement***





Under
      cross default provisions in the Laurus Security Agreement, defaults under our
      debt obligations may cause the acceleration of the repayment of the Revolving
      and Term Notes. Under these provisions, a default or acceleration in one of
      debt
      agreement may result in the default and acceleration of our debt agreements
      with
      Laurus (regardless of whether we were in compliance with the terms of the Laurus
      Security Agreement), providing Laurus with the right to accelerate the
      obligations due under their debt agreement.





***Our
      business and operating results***  ***will
      depend on our ability to redesign, restyle and extend our existing core products
      and product lines as consumer preferences evolve, and to develop, introduce
      and
      gain customer acceptance of new products and product
      lines.***





Our
      business and operating results depend largely upon the appeal of our products
      and on our ability to redesign, restyle and extend our existing core products
      and product lines as consumer preferences evolve, and to develop, introduce
      and
      gain customer acceptance of new products and product lines. Several trends
      in
      recent years have presented challenges for the toy industry,
      including:





·
            the
                phenomenon of children outgrowing toys at younger ages, particularly
                in
                favor of interactive and high technology products;·
            increasing
                use of technology;·
            higher
                consumer expectations for product quality, functionality and value;·
            Retailers
                buying direct from the manufacturers in Asia; and·
            Manufactureres
                in Asia selling direct to the
                retailers.





We
      cannot
      assure you that:





·
            our
                current products will continue to be popular with
                consumers;·
            the
                product lines or products that we introduce will achieve any significant
                degree of market acceptance;·
            We
                will be able to expand into new channels; or·
            the
                life cycles of our products will be sufficient to permit us to recover
                design, manufacturing, marketing and other costs associated with
                those
                products.





***Uncertainty
      and adverse changes in the general economic conditions of markets in which
      we
      participate may negatively affect our business.***




Current
      and future conditions in the economy have an inherent degree of uncertainty.
      As
      a result, it is difficult to estimate the level of growth or contraction for
      the
      economy as a whole. It is even more difficult to estimate growth or contraction
      in various parts, sectors and regions of the economy. These changes may
      negatively affect the sales of our products, increase exposure to losses from
      bad debts, or increase costs associated with manufacturing and distributing
      products.




12





***The
      toy industry is highly competitive.***





The
      toy
      industry is highly competitive. Some of our competitors have financial and
      strategic advantages over us, including:




·
            greater
                financial resources;·
            larger
                sales, marketing and product development departments;·
            stronger
                name recognition;·
            longer
                operating histories; and·
            greater
                economies of scale.





In
      addition, the toy industry has no significant barriers to entry. Competition
      is
      based primarily on the ability to design and develop new toys, to sell the
      products into retail and sell through to consumers through successful marketing.
      Many of our competitors offer similar products or alternatives to our products.
      We cannot assure you that we will be able to obtain adequate shelf space in
      retail stores to support our existing products or to expand our products and
      product lines or that we will be able to continue to compete effectively against
      current and future competitors.





***The
      toy industry is subject to high rates of seasonality.***





Our
      business and the toy industry in general experience the lowest sales rates
      in
      the first quarter and second quarters of the calendar year. In 2006 and 2005,
      approximately 58% and 60%, respectively of net sales were generated in the
      third
      and fourth calendar quarters. Seasonality factors may cause our operating
      results to fluctuate significantly from quarter to quarter. In addition, our
      results of operations may also fluctuate as a result of the timing of new
      product releases.





***Our
      growth strategy depends in part upon our ability to acquire companies, new
      product lines and licenses.***





Future
      acquisitions will succeed only if we can effectively assess characteristics
      of
      potential target companies and product lines, such as:





·
            salability
                of products;·
            suitability
                of distribution channels;·
            management
                ability;·
            financial
                condition and results of operations; and·
            the
                degree to which acquired operations can be integrated with our
                operations.





We
      cannot
      assure you that we can identify strategic acquisition candidates or negotiate
      acceptable acquisition terms, and a failure to do so may adversely affect our
      results of operations and our ability to sustain growth. Our acquisition
      strategy involves a number of risks, each of which could adversely affect our
      results, including:





·
            difficulties
                in integrating acquired businesses, product lines or
                licenses·
            assimilating
                new facilities and personnel·
            harmonizing
                diverse business strategies and methods of operation;·
            diversion
                of management attention from operation of the existing
                business;·
            loss
                of key personnel from acquired companies; and·
            failure
                of an acquired business to achieve targeted financial
                results.





***A
      substantial reduction in or termination of orders from any of our largest
      customers could adversely affect our financial condition and results of
      operations.***





Our
      three
      largest customers; Costco Wholesale Corporation, Target and TJX Companies
      collectively represented 36.4% and 32.5 % of 2006 and 2005 sales, respectively.
      No other customer represents greater than 5% of our sales in 2006 or 2005.
      Except for outstanding purchase orders for specific products, we do not have
      written contracts with or commitments from any of our customers. A substantial
      reduction in or termination of orders from any of our largest customers could
      adversely affect our business, financial condition and results of operations.
      In
      addition, pressure by large customers seeking price reductions, financial
      incentives, changes in other terms of sale or for us to bear the risks and
      the
      cost of carrying inventory also could adversely affect our business, financial
      condition and results of operations. If one or more of our major customers
      were
      to experience difficulties in fulfilling their obligations to us, cease doing
      business with us, significantly reduce the amount of their purchases from us,
      it
      could have a material adverse affect on our business, financial condition and
      results of operations.




13





***Liquidity
      problems or bankruptcy of our key customers could increase our exposure to
      losses from bad debts and could have a material adverse effect on our business,
      financial condition and results of operations.***




There
      is
      a risk that customers will not pay, or that payment may be delayed, because
      of
      bankruptcy or other factors beyond our control, which could increase our
      exposure to losses from bad debts. In addition, if these or other customers
      were
      to cease doing business as a result of bankruptcy, or significantly reduce
      the
      number of stores operated, it could have a material adverse effect on our
      business, financial condition and results of operations. In addition, the
      bankruptcy or financial difficulty of one or more of our significant retailers
      could negatively impact our revenues and bad debt expense.





***We
      depend on third-party manufacturers who develop, provide and use the tools
      and
      dies that we own to manufacture our products and we have limited control over
      the manufacturing processes.***





All
      of
      our products are manufactured by third-party manufacturers and any difficulties
      encountered by these third-party manufacturers that result in product defects,
      production delays, cost overruns or the inability to fulfill orders on a timely
      basis could adversely affect our business, financial condition and results
      of
      operations.





***We
      do not have long-term contracts with our third-party manufacturers and our
      operations would be impaired if we lost our current
      suppliers.***





Our
      operation would be impaired if we lost our current suppliers or if our current
      suppliers’ operations or sea or air transportation with our overseas
      manufacturers were disrupted or terminated even for a relatively short period
      of
      time. During the year ended December 31, 2006, our top ten suppliers
      accounted for 74.1 % of the total product purchases. The top two suppliers
      accounted for 20.9% and 10% of total purchases, respectively. Our tools and
      dies
      are located at the facilities of our third-party manufacturers. We are
      potentially subject to variations in the prices we pay third-party manufacturers
      for products, depending on what they pay for their raw materials since we do
      not
      have long-term contracts.





***We
      have manufacturing operations outside of the United States, subjecting us to
      risks associated with international operations.***





We
      utilize third-party manufacturers located principally in The People’s Republic
      of China, or the PRC and the Far East. Our third-party manufacturing operations
      are subject to the risks normally associated with international operations,
      including:





·
            currency
                conversion risks and currency fluctuations;·
            political
                instability;·
            civil
                unrest and economic instability;·
            complications
                in complying with laws in varying jurisdictions and changes in
                governmental policies;·
            rising
                cost of raw material;·
            rising
                energy prices;·
            blackouts
                due to energy shortages;·
            transportation
                delays, interruptions and strikes; and·
            the
                potential imposition of tariffs.





If
      we
      were prevented from obtaining our products due to medical, political, labor
      or
      other factors, our operations would be disrupted while alternative sources
      of
      products were secured. Also, the imposition of trade sanctions by the United
      States against a class of products imported by us from, or the loss of “normal
      trade relations” status by China, could significantly increase our cost of
      products imported from the PRC.





***Our
      products sold in the United States are subject to various laws, including the
      Federal Hazardous Substances Act, the Consumer Product Safety Act, the Federal
      Hazardous Substances Act, the Flammable Fabrics Act and the rules and
      regulations promulgated under these acts.***





These
      statutes are administered by the Consumer Product Safety Commission (“CPSC”),
      which has the authority to remove from the market products that are found to
      be
      defective and present a substantial hazard or risk of serious injury or death.
      The CPSC can require a manufacturer to recall, repair or replace these products
      under certain circumstances. Any such allegations or findings could result
      in:




14




·
            product
                liability claims;·
            loss
                of sales;·
            diversion
                of resources;·
            damage
                to our reputation;·
            increased
                warranty costs; and·
            removal
                of our products from the market.





***We
      could be the subject of future product liability suits, which could harm our
      business.***





Products
      that have been or may be developed by us may expose us to potential liability
      from personal injury or property damage claims by the users of such products.
      There can be no assurance that a claim will not be brought against us in the
      future. While we currently maintain product liability insurance coverage in
      amounts we believe sufficient for our business risks, we may not be able to
      maintain such coverage or such coverage may not be adequate to cover all
      potential claims. Moreover, even if we maintain sufficient insurance coverage,
      any successful claim could significantly harm our business, financial condition
      and results of operations.





***We
      have a material amount of goodwill which, if it becomes impaired, would result
      in a charge against our income***




Goodwill
      is the amount by which the cost of an acquisition accounted for using the
      purchase method exceeds the fair value of the net assets we acquire. Current
      accounting standards require that goodwill be periodically evaluated for
      impairment based on the fair value of the operations acquired. As of December
      31, 2006, approximately $2,767,000 or 13.3%, of our total assets represented
      goodwill. Reductions in our net income (loss) caused by the write-down of
      goodwill could harm our results of operations.




***The
      Company filed a registration statement with the SEC on June 15, 2006 and
      Amendment No. 1 on October 4, 2006 covering, among other things, shares of
      common stock issuable upon exercise of certain warrants, preferred stock and
      debentures. As of the date of this filing, the Company is in the process of
      reviewing and responding to the comments received from the SEC on Amendment
      No.1. The exercise or conversion of the warrants, convertible preferred Class
      A-1 Stock and convertible debenture if the registration is declared
      effective,  may cause significant dilution to our stockholders and the
      resale thereof may have an adverse impact on the market price of our common
      stock.***




As
      of
      December 31, 2006, there are 5,410,575 shares of our common stock outstanding.
      Being registered in the registration statement are 14,593,380 shares of our
      common stock that are issuable upon exercise or conversion of the following
      securities: (i) 3,899,995 warrants; (ii) 10,130,885 Class A-1 Convertible
      Preferred shares; and (iii) the conversion of the convertible debenture into
      562,500 shares. The exercise or conversion of these securities will increase
      the
      number of our publicly traded shares, which could depress the market price
      of
      our common stock.




The
      perceived risk of dilution may cause our stockholders to sell their shares,
      which would contribute to a downward movement in the stock price of our common
      stock. Moreover, the perceived risk of dilution and the resulting downward
      pressure on our stock price could encourage investors to engage in short sales
      of our common stock.





**Because
      of the limited trading and because of the possible price volatility, you may
      not
      be able to sell your shares of common stock when you desire to do
      so.**




The
      trading price of our common stock is not necessarily an indicator of what the
      trading price of our common stock might be in the future.





Because
      of the limited trading market for our common stock, and because of the possible
      price volatility, you may not be able to sell your shares of common stock when
      you desire to do so. The inability to sell your shares in a rapidly declining
      market may substantially increase your risk of loss because of such illiquidity
      and because the price for our common stock may suffer greater declines because
      of its price volatility.





Certain
      factors, some of which are beyond our control, that may cause our share price
      to
      fluctuate significantly include, but are not limited to, the
      following:





·
            announcement
                by us or our competitors of significant contracts, acquisitions,
                strategic
                partnerships, joint ventures or capital
                commitments;




15




·
            changes
                in market valuations of similar companies;·
            variations
                in our quarterly operating results;·
            inability
                to complete or integrate an acquisition;·
            additions
                or departures of key personnel; and·
            fluctuations
                in stock market price and volume.





Additionally,
      in recent years the stock market in general, and the Over-the-Counter Bulletin
      Board in particular, have experienced extreme price and volume fluctuations.
      In
      some cases, these fluctuations are unrelated or disproportionate to the
      operating performance of the underlying company. These market and industry
      factors may materially and adversely affect our stock price, regardless of
      our
      operating performance.





In
      the
      past, class action litigation has often been brought against companies following
      periods of volatility in the market price of those companies’ common stock. If
      we become involved in this type of litigation in the future, it could result
      in
      substantial costs and diversion of management attention and resources, which
      could have a further negative effect on your investment in our
      stock.





**ITEM 1B.
      UNRESOLVED STAFF COMMENTS**





The
      Company filed a registration statement with the SEC on June 15, 2006 and
      Amendment No. 1 on October 4, 2006. As of the date of this filing, the Company
      is in the process of reviewing and responding to the comments received from
      the
      SEC on Amendment No.1..





**ITEM
      2. DESCRIPTION OF PROPERTIES**





Our
      corporate headquarters are located at 5711 Buckingham Parkway, Culver City,
      California 90230, where we lease approximately 28,000 square feet and sublease
      approximately 17,000. This lease was amended to extend the term to February
      28,
      2009.  We also lease approximately 62,000 square feet of warehouse
      space in Carson, California. This lease was also amended to extend the term
      to
      January 31, 2008. We also leased 1,200 square feet of office space in China
      in
      the town of ChangAn, GuangDong Province but this lease expired November 1,
      2006
      and was not renewed.   We believe these facilities and additional or
      alternative space available to us will be adequate to meet our needs in the
      near
      term.




**ITEM
      3. LEGAL PROCEEDINGS**





On
      August 5, 2005, Gemini Partners, Inc. (“Gemini”) filed an action in
      the Superior Court of the State of California for the County of Los Angeles
      against Small World Toys, Debra Fine, and Fineline Services, LLC. On
      February 21, 2006, Gemini filed a second amended complaint that, among
      other things, named as a defendant Small World Kids, Inc. Gemini’s
      complaint arises out of a written consulting agreement dated as of
      November 10, 2003 entered into by and between Gemini and Fineline Services.
      On June 13, 2006, the Company and Gemini settled the suit out of court for
      $40,000.




On
      September 7, 2005, Small Play, Inc. (“Small Play”) filed an action in
      the United States District Court for the Southern District of New
      York against Small World Toys alleging $3 million in damages in
      connection with a supposed breach of an alleged oral licensing agreement.
      The suit was dismissed without prejudice by the Court on June 1, 2006 for
      failure of the plaintiffs to prosecute.




On
      April 12, 2006, Ryan Yanigihara ,
      the
      Company’s former Controller, filed a complaint with the Secretary of Labor
      alleging violation of Section 806 of the Sarbanes-Oxley Act protecting
      whistleblowers. The complaint is still pending investigation and a
      determintation before OSHA. The Board of Directors commissioned an independent
      investigation of the complaint which was unable to substantiate the
      allegations.





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





No
      matters were submitted to a vote of security holders during the fourth quarter
      of the fiscal year covered by this report.





**PART
      II**





**ITEM 5. 
       MARKET FOR REGISTRANT’S COMMON EQUITY, RELATED STOCKHOLDER MATTERS AND
      ISSUER PURCHASES OF EQUITY SECURITEIS**





Our
      common stock is quoted on the OTC Bulletin Board of the National Association
      of
      Securities Dealers, Inc. (the “NASD”) under the symbol “SMWK.OB”. The following
      table sets forth, for the periods indicated, the high and low bid prices for
      the
      periods from January 1, 2005 through December 31, 2006. These quotations reflect
      inter-dealer prices, without retail mark-up, mark-down or commission, and may
      not represent actual transactions.




16






**Fiscal Year Ending December 31, 2006**
            
            **Low**
            
            **High**First
                Quarter ended March 31, 2006
            
            $
            2.00
            
            $
            3.20Second
                Quarter ended June 30, 2006
            
            $
            1.05
            
            $
            2.00Third
                Quarter ended September 30, 2006
            
            $
            1.20
            
            $
            1.95Fourth
                Quarter ended December 31, 2006
            
            $
            .60
            
            $
            1.95





**Fiscal Year Ending December 31, 2005**
            
            **Low**
            
            **High**First
                Quarter ended March 31, 2005
            
            $
            4.20
            
            $
            7.00Second
                Quarter ended June 30, 2005
            
            $
            4.70
            
            $
            5.50Third
                Quarter ended September 30, 2005
            
            $
            4.70
            
            $
            5.20Fourth
                Quarter ended December 31, 2005
            
            $
            3.10
            
            $
            6.00




**Holders**





As
      of
      December 31, 2006, we currently have outstanding 5,410,575 shares of our common
      stock outstanding. As of December 31, 2006, our shares of common stock are
      held
      by approximately 64 stockholders of record. This does not include an
      indeterminate number of beneficial owners of securities whose shares are held
      in
      the names of various dealers and clearing agencies.





**Dividends**





We
      have
      never paid cash dividends on our common stock.




On
      June
      9, 2006, we issued Class A-1 Convertible Preferred Stock. The holders of the
      outstanding Class A-1 Preferred Stock will be entitled to receive, out of
      funds legally available therefore, cumulative dividends at the annual rate
      of 6% per annum payable quarterly in shares of the Company’s Class A-1
      Preferred Stock at a per share price of $1.10. As of December 31, 2006, the
      Company had accrued but not paid $375,000 in dividends on the Class A-1
      Preferred Stock. In addition, in conjunction with the issuance of the Class
      A-1
      Preferred Stock on June 9, 2006, a non-cash dividend of approximately $2.6
      million was recorded at the time of issuance in relation to the warrants and
      the
      in-the-money conversion feature that allows for the conversion at a price lower
      than fair market value on the day of issuance. In addition, the repriced and
      additional warrants issued to the $1.5 million Convertible Debenture holders
      was
      determined to have a fair market value of approximately $1.2 million and since
      the warrants have no mandatory registration rights, the value of the warrants
      is
      also deemed a non-cash dividend.





The
      10%
      Convertible Preferred Stock that we issued in August 2005 converted into the
      Class A-1 Convertible Preferred in June 2006 along with all accrued but unpaid
      dividends. Through June 9, 2006, when we converted such stock to the Class
      A-1
      Preferred Stock, we had not paid any dividends on the 10% Convertible Preferred
      in either cash or stock, but had accrued $399,000 in dividends which was
      converted into 362,703 Class A-1 shares.




In
      addition, in conjunction with the issuance of the 10% Convertible Preferred
      Stock in August 2005, a non-cash dividend of approximately $2.2 million was
      recorded at the time of issuance in relation to an in-the-money conversion
      feature that allows for the conversion at a price lower than fair market value
      on the day of issuance.




Our
      future dividend policy will be determined by our Board of Directors and will
      depend upon a number of factors, including our financial condition and
      performance, our cash needs and expansion plans, income tax consequences, and
      the restrictions that applicable laws and our credit arrangements then
      impose.





**Securities
      Authorized For Issuance under Equity Compensation Plans** .





The
      following table summarizes the securities authorized for issuance as of December
      31, 2006 under our 2004 Stock Compensation Plan, the number of shares of our
      common stock issuable upon the exercise of outstanding options, the weighted
      average exercise price of such options and the number of additional shares
      of
      our common stock still authorized for issuance under such plan.




17







**Plan category**
            
            **Number of securities to**
              **be issued upon exercise**
              **of outstanding options,**
              **warrants and rights**
            
            **Weighted-average**
              **exercise price of**
              **outstanding options,**
              **warrants and rights**
            
            **Number of securities**
              **remaining available for**
              **future issuance under**
              **equity compensation**
              **plans**Equity
                compensation plans approved by security holders
            
            
            722,000
            
            $
            2.43
            
            
            658,000Total
            
            
            722,000
            
            $
            2.43
            
            
            658,000





**ITEM 6.**
            **CONSOLIDATED
                SELECTED FINANCIAL DATA**





The
      following selected consolidated financial data is derived from our audited
      consolidated financial statements for the years ended December 31, 2006, 2005,
      2004 and 2003 and for the eleven months ended (short year, transition period)
      December 31, 2002. The selected financial data may not be indicative of our
      future performance.





**Eleven**
              **Months**
              **Ended****Years Ended December 31,**
            
            **(short year)****December 31,****(Amounts in thousands, except share and**
              **per share amounts)**
            
            **2006**
            
            **2005**
            
            **2004 (2)**
            
            **2003 (1)**
            
            **2002 (1)****Operating
                Data:**Net
                sales
            
            $
            28,331
            
            $
            33,756
            
            $
            29,493
            
            $
            25,970
            
            $
            24,344Gross
                profit
            
            10,770
            
            13,137
            
            12,102
            
            10,982
            
            10,055Operating
                expenses
            
            15,622
            
            17,218
            
            13,527
            
            10,242
            
            9,004Other
                income (expense)
            
            (5,164
            )
            (2,982
            )
            (416
            )
            396
            
            831Net
                income (loss)
            
            (10,016
            )
            (6,770
            )
            (1,218
            )
            740
            
            1,052Non-cash
                Preferred Stock dividend
            
            (2,544
            )
            (2,168
            )
            —
            
            —
            
            —Net
                loss attributable to Common Stock
            
            (12,560
            )
            (8,939
            )
            (1,218
            )
            740
            
            1,052Net
                income (loss) per share:Basic
                & diluted
            
            $
            (2.32
            )
            $
            (1.67
            )
            $
            (.23
            )
            $
            74.03
            
            $
            105.15Weighted
                average shares of Common Stock outstanding:Basic
                and diluted
            
            5,410,575
            
            5,363,961
            
            5,277,986
            
            10,000
            
            10,000





**December 31,****2006**
            
            **2005**
            
            **2004 (2)**
            
            **2003 (1)**
            
            **2002 (1)****Balance
                Sheet Data:**Current
                assets
            
            $
            12,290
            
            $
            13,253
            
            $
            12,888
            
            $
            10,078
            
            $
            8,778Working
                capital (deficit)
            
            
            4,197
            
            
            (5,246
            )
            
            6,704
            
            
            2,864
            
            
            4,203Total
                assets
            
            
            20,172
            
            
            19,510
            
            
            19,840
            
            
            10,798
            
            
            9,482Current
                liabilities
            
            
            8,092
            
            
            18,499
            
            
            6,184
            
            
            7,214
            
            
            4,575Long-term
                liabilities
            
            
            13,182
            
            
            249
            
            
            14,727
            
            
            171
            
            
            1,327Stockholders’
                equity (deficit)
            
            
            (1,102
            )
            
            762
            
            
            (1,071
            )
            
            3,413
            
            
            3,580







(1)
      Reflects the predecessor entity, Small World Toys prior to the May 20, 2004
      acquisition by Small World Kids, Inc.





(2)
      Reflects the financial position and results of operations for the predecessor
      entity, Small World Toys from January 1, 2004 through May 20, 2004 and the
      successor entity, Small World Kids, Inc. from May 21, 2004 through December
      31,
      2004.





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





Overview





Small
      World Kids was organized on July 28, 2001 in the state of Utah under the name
      Savon Team Sports, Inc. (“SavOn”) to sell sporting goods over the Internet. The
      business operations generated limited revenues and operated at a loss since
      inception. On August 1, 2004, as a result of the May 20, 2004 transactions
      discussed below, we changed our name from SavOn Team Sports, Inc. to Small
      World
      Kids, Inc. We also changed our domicile from Utah to Nevada.




May
      20,
      2004 Transactions




Pursuant
      to an Exchange Agreement dated as of May 20, 2004, by and among the Company
      and
      a group of investors (“the Investors'), we issued 4,531,375 shares of its common
      stock, par value $0.001 per share, in exchange for all of the equity interests
      of Fine Ventures, LLC (“FVL”). Prior to May 20, 2004, FVL had no operating
      activities. As a condition to the closing of this transaction, Michael Rubin,
      the then-majority shareholder of the Company, sold 553,000 shares of his 618,000
      shares of Small World Kids common stock for $10,000 to the
      Investors.




18




Simultaneously,
      pursuant to the terms of a Stock Purchase Agreement dated as of May 20, 2004,
      by
      and among Small World Kids, Debra Fine, Small World Toys, Eddy Goldwasser and
      Gail S. Goldwasser, Trustee of the Gail S. Goldwasser and Mark Chatinsky Family
      Trust (“Gail Goldwasser”; collectively with Eddy Goldwasser, (“Goldwassers”),
      Small World Kids acquired from the Goldwassers all of the issued and outstanding
      equity interests of Small World Toys (the “SWT Shares”). As consideration for
      the SWT Shares, Small World Kids paid an aggregate sum of $7,200,000, delivered
      as follows; (i) $5,000,000 in cash; and (ii) $2,200,000 in the form of a
      $500,000 six month promissory note, a $1,000,000 seven month promissory note,
      and a $700,000 two year promissory note payable in quarterly installments
      commencing April 2005.




As
      a
      result of the May 20, 2004 transactions, we have had a change of our management,
      our controlling shareholders, our financial position and our business plan.
      Since Small World Kids, our accounting successor, had no significant business
      operations or assets prior to the May 20, 2004 transactions described above,
      presenting comparative periods would not be meaningful. As such, the results
      of
      operations presented below for the predecessor are those of Small World
      Toys.




On
      October 14, 2005 we completed a ten for one (10:1) reverse stock split (“Reverse
      Split”), with rounding all fractional shares down to the next full share. After
      the Reverse Split, there are approximately 5,400,000 shares of common stock
      outstanding. The Reverse Split did not reduce the number of authorized shares
      of
      common stock, alter the par value or modify any voting rights or other terms
      thereof. As a result of the Reverse Split, the conversion price and/or the
      number of shares issuable upon the exercise of any outstanding options and
      warrants to purchase common stock was proportionally adjusted pursuant to the
      respective terms thereof. All references in this prospectus to units of
      securities (e.g. Common Stock shares) or per share amounts are reflective of
      the
      Reverse Split for all periods reported.





**2006
      Compared to 2005**





**Years Ended**
              **December 31,**
            
            **Years Ended**
              **December 31,****2006**
            
            **2005**
            
            **2006**
            
            **2005**Net
                sales
            
            $
            28,331,394
            
            $
            33,755,929
            
            
            100.0
            %
            
            100.0
            %Cost
                of sales
            
            
            17,561,159
            
            
            20,619,047
            
            
            62.0
            %
            
            61.1
            %Gross
                profit
            
            
            10,770,235
            
            
            13,136,882
            
            
            38.0
            %
            
            38.9
            %Operating
                expenses:Selling,
                general and administrative
            
            
            13,406,900
            
            
            14,793,258
            
            
            47.3
            %
            
            43.8
            %Research
                and development
            
            
            1,742,937
            
            
            1,972,343
            
            
            6.2
            %
            
            5.9
            %Intangibles
                amortization
            
            
            471,703
            
            
            452,252
            
            
            1.7
            %
            
            1.3
            %Total
                operating expenses
            
            
            15,621,540
            
            
            17,217,853
            
            
            55.1
            %
            
            51.0
            %Loss
                from operations
            
            
            (4,851,305
            )
            
            (4,080,971
            )
            
            (17.1
            )%
            
            (12.1
            )%Other
                income (expense):Interest
                expense
            
            
            (6,939,544
            )
            
            (3,521,012
            )
            
            (24.5
            )%
            
            (10.4
            )%Warrant
                valuation adjustment
            
            
            1,556,879
            
            
            291,113
            
            
            .7
            %
            
            .9
            %Other
            
            
            218,272
            
            
            247,870
            
            
            5.5
            %
            
            .7
            %Total
                other income (expense)
            
            
            (5,164,393
            )
            
            (2,982,029
            )
            
            (18.3
            )%
            
            (8.8
            )%Loss
                before income taxes
            
            
            (10,015,698
            )
            
            (7,063,000
            )
            
            (35.4
            )%
            
            (20.9
            )%Provision
                (benefit from) for income taxes
            
            
            —
            
            
            (292,419
            )
            
            —
            
            
            (.9
            )%Net
                loss
            
            $
            (10,015,698
            )
            $
            (6,770,581
            )
            
            (35.4
            )%
            
            (20.0
            )%





19




***Net
      sales***





Net
      sales
      for the year ended December 31, 2006 decreased $5,425,000 or 16.1% to
      $28,331,000 from $33,756,000 for the year ended December 31, 2005. The revenue
      decrease is mainly attributable to the decrease of $6,397,000 and $3,377,000
      in
      sales to the specialty toy and national chain channels, respectively, over
      the
      year ended December 31, 2005. Part of this decline is attributed to the lack
      of
      the right inventory to fill orders during the third and fourth quarters.
      Management initiated improved demand order forecasting to increase the fill
      rate
      and as a result inventory has increased by $.2 million during 2006. Partially
      offsetting the decline in revenue was an increase in sales to mass retailers
      of
      $4,072,000 for the year ended December 31, 2006 over the year ended December
      31,
      2005. Due to the increased sales to the mass channel, Ryan’s Room product line
      sales more than doubled during the year ended December 31, 2006 versus the
      comparable prior year period. The Eric Carle licensed products which were
      introduced in 2006 increased over the comparable prior year period along with
      the All About Baby brand. All other brands suffered declines over the comparable
      prior year period primarily due to the supply shortages.





***Gross
      Profit***





Gross
      profit for the year ended December 31, 2006 decreased $2,367,000 or 18.0% to
      $10,770,000 from $13,137,000 for the year ended December 31, 2005 due to the
      decline in sales in 2006 over 2005. Gross profit margin of 38.0% decreased
      for
      the year ended December 31, 2006 as compared to 38.9% for the year ended
      December 31, 2005. The decrease in gross margin primarily resulted from
      approximately $939,000 in increased demurrage penalty costs for goods held
      in
      port in 2006 over 2005, which is approximately 3 percentage points on sales.
      In
      addition, the sales to specialty stores declined to 56.8% of net sales for
      the
      year ended December 31, 2006, as compared to 66.1% of net sales for the for
      the
      year ended December 31, 2005. Sales to the national chains and mass retailers
      typically have lower gross margins than sales to the specialty channel but
      most
      sales to these channels do not incur freight out or warehousing expenses and
      have lower commissions.




***Operating
      Expenses***





Operating
      expenses for the year ended December 31, 2006 decreased $1,596,000 or 9.3%
      to
      $15,622,000 from $17,218,000 but as a percentage of sales increased to 55.1%
      from 51.0% for the year ended December 31, 2005. The increase as a percentage
      of
      sales resulted from the 16.1% decline in sales in 2006 from 2005. Selling,
      general and administrative expenses for the year ended December 31,
      2006 decreased $1,386,000 or 9.4% to $13,407,000 from $14,793,000 for the
      year ended December 31, 2005. Decreased selling, shipping and handling expenses
      for the year ended December 31, 2006 of $1,000,000 or 24.1% from the prior
      year
      period were driven by the higher mix of sales to the mass channel, which do
      not
      incur shipping and handling costs. Marketing and branding expenses decreased
      by
      $747,000 or 31.7% for the year ended December 31, 2006 as compared to the prior
      year period partly due to the write-off of $348,000 of barter credits in 2005.
      The non-cash consulting expenses for the year ended December 31, 2006
      attributable to the issuance of stock options granted to consultants for
      services valued by using the Black-Scholes option-pricing model decreased by
      $524,000 from the comparable period. The non-cash recognition of stock
      compensation expense in the year ended December 31, 2006 was $547,000 resulting
      from the adoption of SFAS 123(R) using the modified prospective transition
      method in January 2006. Prior to the adoption of SFAS 123R, the Company
      accounted for stock-based awards to employees and directors using the intrinsic
      value method in accordance with APB 25 as allowed under Statement of Financial
      Accounting Standards No. 123, *Accounting
      for Stock-Based Compensation* (“SFAS
      123”). Under the intrinsic value method, no stock-based compensation expense had
      been recognized in the Company’s statement of operations for the year ended
      December 31, 2005. As of December 31, 2006, $257,000 of unrecognized
      compensation costs related to non-vested stock options are expected to be
      recognized over the following 31 months. Partially offsetting the increase
      in
      operating expenses was the decrease in research and development costs of
      $229,000 or 11.6% to $1,743,000 for the year ended December 31, 2006 as compared
      to $1,972,000 for the year ended December 31, 2005. The Company also incurred
      a
      slight increase in amortization of intangible expenses of $19,000 for the year
      ended December 31, 2006 as compared to the same period of the prior
      year.




***Other
      Income and Expense***





Interest
      expense for the year ended December 31, 2006 increased $3, 419,000 or 97.1%
      to
      $6,940,000 from $3,521,000 for the year ended December 31, 2005. The increase
      is
      primarily due to: (i) the increase of $1,062,000 in non-cash interest expense
      resulting from the amortization of debt discounts that occurred for the year
      ended December 31, 2006 over the comparable prior year period; (ii) $1,077,000 in unamortized debt issuance costs related to the converted debt
      as a
      result of the conversion of $3 million of debt into Class A-1 Preferred Stock
      on
      June 9, 2006 and recorded as a non-cash expense in June 2006 (Note 5 of the
      accompanying financial statements); and (iii) $1,628,000 non-cash expense
      resulting from the repriced and additional warrants issued to the 10%
      Convertible Debenture holders on June 9, 2006 (Note 5 of the accompanying
      financial statements).




20





The
      agreement with Laurus and the $1.5 million 10% Convertible Debentures
      noteholders obligated us to file a registration statement to register the
      warrant shares and the common shares underlying the conversion prior to the
      Second Amendment to the Registration Rights Agreement dated January 26, 2007.
      Accordingly, pursuant to EITF 00-19, “Accounting for Derivative Financial
      Instruments Indexed to, and Potentially Settled in, a Company’s Own Stock”, the
      cumulative relative net value of the warrant at the date of issuance of
      $3,663,000 was recorded as a warrant liability on the balance sheet. Any change
      in fair value from the date of issuance to the date the underlying shares were
      to be registered was included in other (expense) income. The change in fair
      market value (“FMV”) of the warrant liability is a non-cash charge determined by
      the difference in FMV from period to period. The Company calculates the FMV
      of
      the warrants outstanding using the Black-Scholes model. The decrease in the
      fair
      value of the warrant liability associated with Laurus and the 10% Convertible
      Debentures for the year ended December 31, 2006 was $1,557,000 and is a result
      of the decrease in the trading value of our stock during the year ended December
      31, 2006. This compares to an increase of $291,000 for the year ended December
      31, 2005. Since the $1.5 million 10% Convertible Debentures were converted
      on
      June 9, 2006 into Class A-1 Convertible Preferred shares, the company no longer
      has an obligation to file a registration statement to register the warrant
      shares and the common shares underlying the conversion of the 10% Convertible
      Debentures and the warrant liability associated with the 10% Convertible
      Debentures was reclassified as Equity. As of December 31, 2006, the Company
      had
      an obligation to file a registration statement with Laurus and had filed the
      registration statement with the SEC on June 15, 2006 and the Amendment No.1
      on
      October 4, 2006. On January 26, 2007, the Company entered into the Second
      Amendment to the Registration Rights Agreement dated February 28, 2006 with
      Laurus that deleted the requirement to file a Registration Statement and no
      penalties were owed. Since the Company no longer has an obligation to file
      a
      registration statement to register the warrant shares, the warrant liability
      will be reclassified as Equity in January 2007 (Note 6 of the accompanying
      financial statements).





Lower
      rent and commission income accounted for the $30,000 decrease in Other for
      the
      year ended December 31, 2006 over the comparative period in 2005.





***Provision
      for Income Tax***





Small
      World Kids recorded no provision for income taxes for the years ended December
      31, 2006 due to the net loss incurred during these periods. Income tax benefit
      for the year ended December 31, 2005 was $292,000, due to the benefit realized
      in recognizing for losses on which a valuation allowance has not been
      recorded.





***Dividends***





The
      10%
      Class A Convertible Preferred Stock requires that we accrue a quarterly
      dividend at a rate of 10% per annum. The dividend is payable in cash or a
      combination of 50% cash and 50% Common Stock at the Company’s option, but the
      Company has not yet declared or paid any of the accrued dividends since the
      conversion to Preferred Stock on August 11, 2005. On June 9, 2006, we
      issued Class A-1 Convertible Preferred Stock along with converting the 10%
      Class A Convertible Preferred Stock along with accrued but unpaid dividends
      of $399,000. The holders of the outstanding Class A-1 Preferred Stock will
      be entitled to receive, out of funds legally available therefore, cumulative
      dividends at the annual rate of 6% per annum payable quarterly in shares of
      the Company’s Class A-1 Preferred Stock at a per share price of $1.10. The
      Company has accrued $375,000 in dividends for the 6% Class A-1 Preferred Stock
      for the year ended December 31, 2006. The Company has not yet declared or paid
      any of the accrued dividends for the 6% Class A-1 since the issuance of these
      securities.




The
      Class
      A-1 Preferred Stock has a beneficial conversion feature which allows the holders
      to acquire Common Stock of the Company at an effective conversion price of
      approximately $.25 below fair value at the date of issuance on June 9,
      2006.  In accordance with EITF 98-5, *Accounting
      for Convertible Securities with Beneficial Conversion Features or Contingently
      Adjustable Conversion Ratios* ,
      the
      Company has determined the intrinsic value of this in-the-money conversion
      feature accounted for it as a discount to the Preferred Stock.  The fair
      market value of the intrinsic value of the beneficial conversion feature was
      determined to be approximately $2.5 million.  As the Preferred Stock is
      immediately convertible, the full value of the conversion feature is deemed
      a
      dividend upon issuance and as such has been recorded directly to retained
      earnings. (Note 5 of the accompanying financial statements).


21


**2005
      Compared to 2004**





The
      following table provides a summary of the Company’s consolidated results of
      operations and the percentage of total net sales represented by the line items
      reflected in the Company’s consolidated statements of operations:





**Years Ended**
              **December 31,**
            
            **Years Ended**
              **December 31,****2005**
            
            **2004(1)**
            
            **2005**
            
            **2004(1)**Net
                sales
            
            $
            33,755,929
            
            $
            29,492,888
            
            
            100.0
            %
            
            100.0
            %Cost
                of sales
            
            
            20,619,047
            
            
            17,391,282
            
            
            61.1
            %
            
            59.0
            %Gross
                profit
            
            
            13,136,882
            
            
            12,101,606
            
            
            38.9
            %
            
            41.0
            %Operating
                expenses:Selling,
                general and administrative
            
            
            14,793,258
            
            
            12,163,526
            
            
            43.8
            %
            
            41.2
            %Research
                and development
            
            
            1,972,343
            
            
            1,173,365
            
            
            5.9
            %
            
            4.0
            %Intangibles
                amortization
            
            
            452,252
            
            
            190,372
            
            
            1.3
            %
            
            0.6
            %Total
                operating expenses
            
            
            17,217,853
            
            
            13,527,263
            
            
            51.0
            %
            
            45.8
            %Loss
                from operations
            
            
            (4,080,971
            )
            
            (1,425,657
            )
            
            (12.1
            )%
            
            (4.8
            )%Other
                income (expense):Interest
                expense
            
            
            (3,521,012
            )
            
            (988,974
            )
            
            (10.4
            )%
            
            (3.3
            )%Warrant
                valuation adjustment
            
            
            291,113
            
            
            114,916
            
            
            .9
            %
            
            0.4
            %Other
            
            
            247,870
            
            
            458,173
            
            
            .7
            %
            
            1.5
            %Total
                other income (expense)
            
            
            (2,982,029
            )
            
            (415,885
            )
            
            (8.8
            )%
            
            (1.4
            )%Loss
                before income taxes
            
            
            (7,063,000
            )
            
            (1,841,542
            )
            
            (20.9
            )%
            
            (6.2
            )%Provision
                (benefit from) for income taxes
            
            
            (292,419
            )
            
            (623,695
            )
            
            (.9
            )%
            
            (2.1
            )%Net
                loss
            
            $
            (6,770,581
            )
            $
            (1,217,847
            )
            
            (20.0
            )%
            
            (4.1
            )%





(1)
        Reflects the financial position and results of operations for the predecessor
        entity, Small World Toys from January 1, 2004 through May 20, 2004 and the
        successor entity, Small World Kids, Inc. from May 21, 2004 through December
        31,
        2004.


***Net
      sales***





Net
      sales
      for the year ended December 31, 2005 increased $4,263,000 or 14.5 % to
      $33,756,000 from $29,493,000 for the year ended December 31, 2004. The revenue
      increase is mainly attributable to the expansion of the Company’s product lines
      including brands such as Active Edge®, Small World LivingTM, IQ Baby®, IQ
      Preschool®, Gertie Balls®, and the All about Baby products. The introduction of
      the Neurosmith product line in the second quarter resulted in 2005 sales of
      approximately $1,200,000. Sales to new 2005 mass retailers, Costco Wholesale
      Corporation and Target Corporation resulted in an increase of $4,200,000 in
      2005. Small World ExpressTM, the Company’s distribution arm experienced over a
      45% increase for the year ended December 31, 2005 over the comparable prior
      year
      period. Somewhat offsetting these increases were decreased shipments relating
      to
      the following core brands; Puzzibilities®, Ryan’s Room® and Tolo® products and
      the following item classes; Imaginative Play, Tub Tints, Preschool and
      Vehicles.





***Gross
      Profit***





Gross
      profit for the year ended December 31, 2005 increased $1,035,000 or 8.6% to
      $13,137,000 from $12,102,000 for the year ended December 31, 2004. Gross profit
      margin of 38.9% declined for the year ended December 31, 2005 as compared to
      41.0% for the year ended December 31, 2004. The decrease in gross margin
      primarily resulted from a greater mix of sales to national chains and mass
      retailers of 33.7% of net sales for the year ended December 31, 2005, as
      compared to 25.5% of net sales for the year ended December 31, 2004. Sales
      to
      national chains and mass retailers typically have lower gross margins than
      sales
      to the specialty stores, but do not incur freight out or warehousing expenses
      and have lower commissions. In addition, there was an increase in promotional
      rebates and royalties for the year ended December 31, 2005 as compared to the
      same period of the prior year.





***Operating
      Expenses***





Operating
      expenses for the year ended December 31, 2005 increased approximately $3,691,000
      or 27.3% and as a percentage of sales increased to 51.0% from 45.8% for the
      year
      ended December 31, 2004.





The
      increase in operating expenses was partly related to an increase in research
      and
      development costs of $799,000 or 68.1% incurred in the development of new
      products for the year ended December 31, 2005 as compared to the year ended
      December 31, 2004.




22





Selling,
      general and administrative expenses for the year ended December 31, 2005
      increased $2,630,000 or 21.6% to $14,793,000 from $12,163,000 for the year
      ended
      December 31, 2004. Increased selling, shipping and handling expenses for the
      year ended December 31, 2005 of $351,000 or 5.6% over the prior year was driven
      by the 14.5% increase in sales in 2005 over 2004. Also, legal, auditing,
      insurance and investor relations expenses, driven primarily by the costs of
      being a public company, increased by $686,000 for the year ended December 31,
      2005 as compared to the prior year. These costs were incurred for a full year
      in
      2005 as compared to only seven months during 2004 as we became a public entity
      in late May 2004. Also contributing to the increase was an increase in marketing
      and branding expenses by approximately $291,000 for the year ended December
      31,
      2005 as compared to the prior year as we have introduced the following new
      brands since the acquisition of Small World Toys in May 2004; Small World
      LivingTM, Active Edge®, Active Edge Extreme®, IQ Baby The Softer Side®,
      Neurosmith® and ImagiixTM. The write off of $348,000 of barter credits also
      contributed to the increase (Note 2 of the accompanying financial statements).
      Due to the amendments to our Credit Facility with PNC, our bank charges
      increased by $269,000 for the year ended December 31, 2005 as compared to the
      prior year. In addition, the Company incurred non-cash consulting expenses
      for
      the ended December 31, 2005 in the amount of $535,000 attributable to the
      issuance of 300,000 stock options granted to consultants for services valued
      by
      using the Black-Scholes option-pricing model. Only 16,000 of the options issued
      to the consultants were exercised, the balance expired or were terminated.
      The
      balance of the increase or $150,000 was attributable to increased travel and
      airfare expenses relating to the acquisition and fund raising activities in
      2005
      over prior year activities.





The
      Company also incurred additional costs of $262,000 for the year ended December
      31, 2005 related to the amortization of intangible assets acquired in the
      purchase of Small World Toys, the Neurosmith product line and Imagiix as opposed
      to the previous year.





***Other
      Income and Expense***





Interest
      expense for the year ended December 31, 2005 increased $2,532,000 or 256.0%
      to
      $3,521,000 from $989,000 for the year ended December 31, 2004. The increase
      is
      partly due to the increase of $1,310,000 in non-cash interest expense resulting
      from the amortization of debt discounts that occurred for the year ended
      December 31, 2005 over the prior year. The balance of the increase resulted
      from
      the increase in the outstanding balances of the Company’s notes payable and the
      revolving credit line. Cash interest paid for the year ended December 31, 2005
      increased by $999,000 over the prior fiscal year primarily due to the increased
      debt obligations.





The
      agreements with the $1.5 million 10% Convertible Debentures note holders
      obligated us to file a registration statement to register the warrant shares
      and
      the common shares underlying the conversion. Accordingly, pursuant to EITF
      00-19, “Accounting for Derivative Financial Instruments Indexed to, and
      Potentially Settled in, a Company’s Own Stock”, the relative net value of the
      warrants at the date of issuance of $1,077,000 was recorded as a warrant
      liability on the balance sheet. Any change in fair value from the date of
      issuance to the date the underlying shares are registered will be included
      in
      other (expense) income. The change in fair market value (“FMV”) of the warrant
      liability is a non-cash charge determined by the difference in FMV from period
      to period. The Company calculates the FMV of the warrants outstanding using
      the
      Black-Scholes model. The decrease in the fair value of the warrant liability
      associated with the 10% Convertible Debentures from the date of issuance to
      December 31, 2005 was $388,000.





Also
      due
      to fluctuations in the Company’s stock price, the Company also experienced a
      $97,000 increase in the FMV of the warrant liability associated with the St.
      Cloud Capital Partners LP Bridge Notes. As a result of the July 20, 2005
      amendment to the notes held by St Cloud Capital Partners LP, the FMV of the
      warrant liability has been reclassified to equity.





Lower
      commission income accounted for the $207,000 decrease in Other.





***Provision
      for Income Tax***





Income
      tax benefit for the year ended December 31, 2005 was $292,000, due to the
      benefit realized in recognizing for losses on which a valuation allowance has
      not been recorded.




**Liquidity
      and Capital Resources**





Operations
      and liquidity needs are funded primarily through cash flows from operations,
      as
      well as utilizing, when needed, borrowings under the Company’s secured credit
      facilities and short and long term notes. Working capital needs generally reach
      peak levels from August through November of each year. To gain shelf space
      and
      address the seasonality of the toy industry, the Company offers early buy
      programs that are volume related with extended payment terms. The Company’s
      historical revenue pattern is one in which the second half of the year is more
      significant to the Company’s overall business than the first half and, within
      the second half of the year, the fourth quarter is the most prominent. The
      trend
      of retailers over the past few years has been to make a higher percentage of
      their purchases of toy and game products within or close to the fourth quarter
      holiday consumer buying season, which includes Christmas. The Company expects
      that this trend will continue. As such, historically, the majority of cash
      collections for Small World Toys occur late in the fourth quarter as the
      extended payment terms become due from the Company’s early buy programs. As
      receivables are collected, the proceeds are used to repay borrowings under
      the
      Company’s Revolving Note.


23







On
      February 28, 2006, Small World Kids, Inc. issued a Secured Non-Convertible
      Revolving Note (the “Revolving Note”) with Laurus Master Fund, Ltd. (“Laurus”).
      The term of the Revolving Note is two years and provides that we may borrow
      up
      to $16,500,000 subject to certain conditions. Interest is payable monthly,
      in
      arrears at a rate per annum equal to the Prime Rate (as published in The
      Wall Street Journal ) plus
      two percent (2.0%). The Revolving Note has no financial covenants and is
      collateralized by a security interest in substantially all of the assets of
      the
      Company and its subsidiaries, including its operating subsidiary, Small World
      Toys.





On
      February 28, 2006, Small World Kids, Inc., also issued pursuant to a
      security agreement (the Laurus “Security Agreement”) a $2.0 million, two year
      Secured Non-Convertible Term Note (the “Term Note “) with Laurus. Commencing
      April 1, 2006 and each succeeding month after, the Company will make principal
      payments of $33,333 with all the balance of the unpaid principal amount due
      upon
      the maturity date of February 28, 2008. Interest is payable monthly, in arrears
      at a rate per annum equal to the Prime Rate (as published in The
      Wall Street Journal ) plus
      three percent (3.0%). The Term Note has no financial covenants and is
      collateralized by the Laurus Security Agreement.




Under
      cross default provisions in the Laurus Security Agreement, defaults under any
      of
      our debt obligations may cause the acceleration of the repayment of the
      Revolving and Term Notes. Under these provisions, a default or acceleration
      in
      any of our debt agreement may result in the default and acceleration of our
      debt
      agreements with Laurus (regardless of whether we were in compliance with the
      terms of the Laurus Security Agreement), providing Laurus with the right to
      accelerate the obligations due under their debt agreement.




On
      March 20, 2006, The Company entered into a Purchase Order Revolving Credit
      Line (“PO Credit Line”) of Five Million Dollars ($5,000,000) with Horizon
      Financial Services Group USA to provide financing for the acquisition of product
      from our overseas vendors. The term of the PO Credit Line is eighteen (18)
      months and provides that we may borrow up to $5,000,000 subject to certain
      conditions including Horizon’s approval of the applicable vendors. A financing
      fee equal to Four and One Half Percent (4.50%) of the gross amount or face
      value
      of each Horizon financing instrument will be charged for the first forty-five
      (45) day period or part thereof that the financing instrument remains
      outstanding. An additional fee of fifty basis points (.50%) for each additional
      period of 15 days, or part thereof, during which the Horizon financing
      instrument remains outstanding will be charged. The PO Credit Line has no
      financial covenants and is collateralized by a security interest, junior in
      position to that of our senior lender, Laurus Master Fund, Ltd, to the assets
      related to the PO Credit Line transactions. Horizon and St. Cloud Capital
      Partners executed an inter-creditor agreement on the collateralized security
      interest on June 1, 2006.




On
      June 9, 2006, the Company received approximately $2.4 million from the
      private placement of Class A-1 Preferred Stock at $1.10 per share and
      binding commitments for an additional $.3 million of which $150,000 was received
      in September and the balance was received in November 2006. As a condition
      of
      this transaction, we converted $3 million of debt into 2,763,636 shares of
      the
      Class A-1 Convertible Preferred as follows: (i) the 24% Notes Due 2006
      in principal amount of $1,000,000 with Hong Kong League Central Credit Union,
      PCCW Credit Union and HIT Credit Union; (ii) the $1.5 million in principal
      amount of the 10% Convertible Debentures due in 2008 along with accrued but
      unpaid interest and penalties; and (iii) the 10% Note Due 2006 - Related
      Party in principal amount of $500,000 in notes to various investors which
      included Debra Fine, the Company’s President and Chief Executive Officer who
      provided $175,000 of the total borrowing. We also converted the Series A
      Convertible Preferred Stock we issued on August 11, 2005, when we converted
      a $5,000,000 Bridge Note dated May 2004 held by SWT, LLC, along with
      accrued but unpaid dividends into 4,908,157 shares of the Class A-1
      Preferred Stock. Also, as a condition of this sale, the 10% Note Due 2006 to
      St
      Cloud Capital Partners LP in the principal amount of $2.5 million was
      restructured as follows: the Company prepaid $50,000 of the existing note and
      issued to St. Cloud two new notes to replace the exiting note. The first note
      in
      the principal amount of $200,000 will be for twelve months with monthly
      amortization payments at a 10% interest rate; the second note will be for
      $2,250,000 with interest at 10% per annum with interest only payable on
      June 30, 2006 and September 15, 2006 and commencing September 16,
      2006, payments will be interest only each month through September 15, 2008
      and commencing October 15, 2008, monthly amortization payments (based on a
      five-year amortization) with all interest plus unpaid principal due on
      September 15, 2011 and the second note will be convertible into shares of
      the common stock of the Company at $4.00 per share.




24





On
      July
      26, 2006, Laurus authorized $750,000 in excess of the maximum allowed borrowings
      based on a formula amount of the secured assets (the “Overadvance”) on the
      Revolving Note. On October 19, 2006, Laurus exercised the discretion granted
      to
      it pursuant to Section 2(a)(ii) of the Security Agreement dated February 28,
      2006 with the Company to make loans to the Company in excess of the maximum
      amounts available to be borrowed on our revolver loans. The aggregate principal
      amount of the Overadvance is $1,500,000, of which amount $1,500,000 was
      outstanding as of December 31, 2006. The Overadvance, subject to certain
      restrictions, is available to the Company for a one year period. The interest
      applicable to the Overadvance shall be the “prime rate” published in The
      Wall Street Journal from
      time to time plus two percent (2%).





Pursuant
      to a Securities Purchase Agreement (the “Purchase Agreement”) dated October 19,
      2006 between Small World Kids, Inc. and the following investors; Russell
      Fine and Debra Fine (our President and Chief Executive Officer) as trustees
      of
      the Fine Family Trust, and Vintage Filings, LLC, the Company sold in a private
      placement 181,818 shares of its Class A-1 Convertible Preferred Stock (the
“Preferred Shares”) for $200,000. The Purchase Agreement granted to the
      purchasers piggyback registration rights with respect to the shares of Company
      Common Stock issuable upon conversion of the Preferred Shares and certain
      participation rights in respect of future equity financings.




On
      October 19, 2006, the Company issued an aggregate of $330,000 in principal
      amount of 10% Convertible Debentures (the “Debenture”) to Hong Kong League
      Central Credit Union and Kershaw Mackie & Company with net proceeds of
      $300,000. Interest is payable monthly in arrears and the Debentures mature
      on March
      31,
      2008 . The
      Debentures are convertible into shares of the Registrant’s Common Stock at the
      option of the holder at a conversion price $1.10 (subject to normal
      adjustments). Since
      the
      convertible debenture has only standard adjustment features with no reset
      conversion price requirements nor registration rights requirements beyond
      piggy-back rights, the debt is considered conventional debt under FASB 133
      and
      EITF 00-19.




On
      November 6, 2006, the Company entered into an amendment with the former
      shareholder whereas the contingent earnout for 2006 was fixed at $670,000 and
      a
      three year note for $667,619 (the unpaid principal amount of the 5% Note) was
      issued with monthly amortization payments at a 10% interest rate.





On
      January 26, 2007, the Company entered into an Omnibus Amendment No.1 with Laurus
      that (a) amended the Overadvance Side Letter by extended the maturity of the
      Overadvance of up to $1,500,000 from October 19, 2007 to February 28, 2008
      and
      (b) increased the Concentration Limits for accounts on standard terms from
      15%
      to 32.5%. In addition, the requirement for the listing of the Company’s shares
      on the NASDAQ, OTC Bulletin Board or other Principal Market and for the timely
      filing with the SEC of all reports required to be filed pursuant to the Exchange
      Act was deleted along with the requirement to file a registration
      statement.





As
      of
      December 31, 2006, we had approximately $155,000 of cash and unrestricted cash
      which compares to $524,000 at December 31, 2005. Also, as of December 31, 2006,
      we had approximately $1,014,000 of availability on our line of credit which
      includes the $1,500,000 Overadvance. This compares to $612,000 of availability
      on our line of credit as of December 31, 2005.





For
      the
      year ended December 31, 2006, the Company used cash for operating activities
      of
      $6,012,000 as compared to $2,760,000 for the year ended December 31, 2005.
      Inclusive of this increase beyond the increase in net losses and non cash
      charges as previously explained were the following working capital changes:
      (i)
      an increase in inventory of $442,000 in the year ended December 31, 2006, (ii)
      a
      decrease in accounts receivable of $504,000 and (iii) a decrease in prepaid
      expenses and other current assets of $285,000; partially offset by (iv) an
      increase in accounts payable of $256,000 and (v) an decrease of accrued expenses
      of $839,000.





Since
      the
      Company outsources manufacturing of products to Asia, the Company has
      historically low requirements for additions to property and equipment. For
      the
      year ended December 31, 2006, the Company spent approximately $19,000 in
      additions to capital equipment as compared to $214,000 for the comparable period
      in 2005.




All
      securities issuances were made pursuant to an exemption from the registration
      requirements of the Securities Act of 1933, as amended, pursuant to Regulation
      D
      promulgated thereunder.





We
      have
      incurred significant losses since our purchase of Small World Toys in
      May 2004. As of December 31, 2006, our accumulated deficit was $22.6
      million. On June 9, 2006, the Company received approximately $2.4 million
      from the private placement of Class A-1 Preferred Stock at $1.10 per share
      and subsequently received an additional $.3 million by November 2006. In
      addition, on June 9, 2006, the Company converted $3.0 million of debt due in
      2006 and 2008 to Class A-1 Preferred Stock, and restructured a $2.5 million
      note due in 2006 to $250,000 due within 12 months and the balance to begin
      principal amortization in October 2008. On October 19, 2006, we have
      received an additional $200,000 from the private placement of Class A-1
      Preferred Stock at $1.10 per share. On October 19, 2006, we issued an aggregate
      of $330,000 in principal amount of 10% Convertible Debentures. On July 26,
      2006,
      Laurus authorized $750,000 in excess of the maximum allowed borrowings based
      on
      a formula amount of the secured assets (the “Overadvance”) on the Revolving
      Note. On October 19, 2006, Laurus increased to $1,500,000 the permitted
      Overadvance to the Company in excess of the maximum amounts available to be
      borrowed on our revolver loans.




25




As
      of
      December 31, 2006, we had $804,000 in principal payments due during the next
      twelve months to Laurus, Horizon, St. Cloud and the former shareholder of Small
      World Toys. Of the $804,000 in principal payments due in 2007, the Company
      is
      not permitted by Laurus to pay the $152,000 in principal payments due to St.
      Cloud in 2007 while any amounts are outstanding on the $1,500,000 overadvance.
      We may not be able to generate sufficient cash flow from operations to meet
      our
      debt and operational obligations. If we are unable to generate sufficient cash
      flow, we would be required to seek additional financing or restructure our
      debt
      obligations. There can be no assurance that we will be able to obtain additional
      financing or restructure our debt obligations or that if we were to be
      successful in obtaining additional financing or restructure our debt
      obligations, it would be on favorable terms. Failure to obtain additional
      financing or restructuring our debt obligations may cause us to default on
      these
      debt obligations. In addition, under cross default provisions in the Laurus
      Security Agreement, defaults under any of our debt obligations may cause the
      acceleration of the repayment of the Revolving and Term Notes. This raises
      substantial doubt about the Company’s ability to continue as a going concern for
      a reasonable period of time. Management has and will continue to pursue the
      following actions: (i) reducing operating expenses; (ii) seeking to obtain
      new
      equity; and (iii) restructuring the debt obligations.





Additionally,
      the Company may need additional financing to fund the Company’s acquisition
      strategy, the amount of which will depend on the price and structure of
      potential acquisitions.





**Contractual
      Obligations and Off-Balance Sheet Arrangements**





As
      part
      of the purchase for SWT Shares on May 20, 2004, the Company entered into a
      contingent earnout with the former shareholder of Small World Toys. The Company
      agreed to a two year promissory note, payable in quarterly installments
      commencing April 2005 with a minimum payment of $700,000 and a maximum payment
      of $1,500,000, if certain sales targets are achieved in 2005 and 2006. In 2005,
      the seller earned $673,000 based on the Company obtaining $33.7 million in
      net
      sales of which $350,000 was paid in quarterly installments in 2005 and the
      balance due in 2006 to be paid on a $60,000 per month payment schedule
      commencing on April 2006. The 2006 earnout is based on 2% of 2006 net sales
      up
      to a maximum of $800,000. On November 6, 2006, the Company entered into an
      amendment with the former shareholder whereas the contingent earnout for 2006
      was fixed at $670,000 and a three year note for $667,619 (the unpaid principal
      amount of the 5% Note) was issued with monthly amortization payments at a 10%
      interest rate.





On
      March 20, 2006, The Company entered into a Purchase Order Revolving Credit
      Line (“PO Credit Line”) of Five Million Dollars ($5,000,000) with Horizon
      Financial Services Group USA to provide financing for the acquisition of product
      from our overseas vendors. The term of the PO Credit Line is eighteen (18)
      months and provides that we may borrow up to $5,000,000 subject to certain
      conditions including Horizon’s approval of the applicable vendors. A financing
      fee equal to Four and One Half Percent (4.50%) of the gross amount or face
      value
      of each Horizon financing instrument will be charged for the first forty-five
      (45) day period or part thereof that the financing instrument remains
      outstanding. An additional fee of fifty basis points (.50%) for each additional
      period of 15 days, or part thereof, during which the Horizon financing
      instrument remains outstanding will be charged. The PO Credit Line has no
      financial covenants and is collateralized by a security interest, junior in
      position to that of our senior lender, Laurus Master Fund, Ltd, to the assets
      related to the PO Credit Line transactions. Horizon and St. Cloud Capital
      Partners executed an inter-creditor agreement on the collateralized security
      interest on June 1, 2006. As of December 31, 2006, there was $46,000
      outstanding under this PO Credit Line





The
      following tables summarize our total contractual cash obligations by
      year:





**Payments due by period (000’s)**
            
            **Total**
            
            **2007**
            
            **2008**
            
            **2009**
            
            **After 2009**Notes
                payables (1)
            
            $
            14,167,078
            
            $
            803,692
            
            $
            11,035,385
            
            $
            540,408
            
            $
            1,787,593Employment
                and consulting agreements
            
            
            231,161
            
            
            231,161
            
            
            —
            
            
            —
            
            
            —Operating
                leases
            
            
            1,220,848
            
            
            736,108
            
            
            391,824
            
            
            92,916
            
            
            —Total
                contractual cash obligations
            
            $
            15,619,087
            
            $
            1,770,961
            
            $
            11,427,209
            
            $
            633,324
            
            $
            1,787,593







(1)
      Prior
      to debt issuance costs, see Note 5 of the accompanying financial
      statements





26




The
      Company has no other off-balance sheet arrangements as defined by Regulation
      S-K
      that have or are reasonably likely to have a current or future effect on the
      Company’s financial condition, revenues or expense or liquidity.





**Critical
      Accounting Policies and Significant Estimates**





Management’s
      discussion and analysis of our financial condition and results of operations
      are
      based upon the consolidated financial statements, which have been prepared
      in
      accordance with accounting principles generally accepted in the United
      States.  The preparation of these financial statements requires management
      to make estimates and judgments that affect the reported amounts of assets,
      liabilities, revenues and expenses, and related disclosures of contingent assets
      and liabilities.  On an on-going basis, management evaluates estimates,
      including those related to the valuation of inventory and the allowance for
      uncollectible accounts receivable. We base our 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. A summary of the
      significant accounting policies can be found in Note 2 of the Notes to
      Consolidated Financial Statements. The significant accounting policies which
      management believes are the most critical to aid in fully understanding and
      evaluating our reported financial results include revenue recognition and sales
      allowances, inventory, accounts receivable and allowances for doubtful accounts
      and intangible assets.





***Revenue
      Recognition***




We
      recognize revenue when all four revenue recognition criteria have been met:
      persuasive evidence of an arrangement exists, the product has been delivered
      or
      the service has been rendered, the price is fixed or determinable and collection
      is probable. We recognize revenue from product sales upon when all of the
      foregoing conditions are met which in general is at the time of shipment where
      the risk of loss and title has passed to the customer. However, for certain
      shipments such as direct shipments from our vendors to our customers or where
      we
      use consolidators to deliver our products (usually export shipments) revenue
      is
      recognized in accordance with the sales terms specified by the respective sales
      agreements.




Sales
      allowances for customer promotions, discounts and returns are recorded as a
      reduction of revenue when the related revenue is recognized. We routinely commit
      to promotional sales allowance programs with our customers. These allowances
      primarily relate to fixed programs, which the customer earns based on purchases
      of our products during the year. Discounts are recorded as a reduction of
      related revenue at the time of sale. Sales to customers are generally not
      subject to any price protection or return rights.




We
      offer
      extended terms to some of its customers in the first three quarters of the
      year
      by way of sales promotions whereby payment will not become due until the fourth
      quarter if a specified purchase threshold has been met. This promotion allows
      us
      to capture additional shelf space and to encumber more of the annual budgets
      of
      our retail customers. The result of this promotion gives rise to a significant
      increase in accounts receivable through the fourth quarter until such time
      that
      substantially all accounts become due and are collected. Based upon historically
      low rates of return and collection of substantially all of these extended term
      accounts, we have determined that revenue is appropriately recognized in
      accordance with its normal procedures described above.




***Inventory***




Inventory
      is valued at the lower of average cost or market. Inventory costs consist of
      the
      purchases of finished goods from our vendors and the associated costs necessary
      to obtain those inventories. As necessary, we write down inventory to its
      estimated market value based on assumptions about future demand and market
      conditions. Failure to accurately predict and respond to consumer demand could
      result in the under production of popular items or overproduction of less
      popular items which may require additional inventory write-downs which could
      materially affect our future results of operations.




***Long-lived
      Assets***




We
      evaluate long-lived assets whenever events or changes in business circumstances
      or our planned use of assets indicate that their carrying amounts may not be
      fully recoverable or that their useful lives are no longer appropriate. 
Reviews are performed to determine whether the carrying values of assets are
      impaired based on comparison to either the discounted expected future cash
      flows
      (in the case of goodwill and intangible assets) or to the undiscounted expected
      future cash flows (for all other long-lived assets).  If the comparison
      indicates that impairment exists, the impaired asset is written down to its
      fair
      value.  Significant management judgment is required in the forecast of
      future operating results that are used in the preparation of expected discounted
      and undiscounted cash flows.




27


The
      total
      purchase price of our acquisitions are allocated to the fair value of the assets
      acquired and liabilities assumed in accordance with the provisions of Statements
      of Financial Accounting Standards (“SFAS”) No. 141, Business Combinations and
      No. 142, Goodwill and Other Intangible Assets. In accordance with Statement
      of
      Financial Accounting Standards No. 141, the estimated the fair value of the
      assets acquired for purpose of allocating the purchase price.





At
      December 31, 2006, we had a net amount of $5.4 million of goodwill and purchased
      intangible assets on our Consolidated Balance Sheet.  As no impairment
      indicators were present during fiscal 2006, we believe our purchased intangible
      assets remains recoverable based on the discounted estimated future cash flows
      of the associated products and technologies.





**Recent
      Accounting Pronouncements**




In
      February 2007, the Financial Accounting Standards Board (“FASB”) issued
      Statement No. 159, “The Fair Value Option for Financial Assets and
      Financial Liabilities” (“SFAS No. 159”), provides companies with an option
      to report selected financial assets and liabilities at fair value. This
      Statement is effective as of the beginning of an entity’s first fiscal year
      beginning after November 15, 2007. Early adoption is permitted as of the
      beginning of the previous fiscal year provided that the entity makes that choice
      in the first 120 days of that fiscal year and also elects to apply the
      provisions of Statement 157. We are currently evaluating the potential impact
      of
      the adoption of SFAS 159 on our future consolidated financial
      statements.




In
      September 2006, the FASB issued SFAS No. 158, “Employers’ Accounting
      for Defined Benefit Pension and Other Postretirement Plans—an amendment of FASB
      Statements No. 87, 88, 106 and 132(R)” (“SFAS 158”). SFAS 158
      requires an employer that sponsors one or more single-employer defined benefit
      plans to (a) recognize the overfunded or underfunded status of a benefit
      plan in its statement of financial position, (b) recognize as a component
      of other comprehensive income, net of tax, the gains or losses and prior service
      costs or credits that arise during the period but are not recognized as
      components of net periodic benefit cost pursuant to SFAS No. 87,
“Employers’ Accounting for Pensions,” or SFAS No. 106, “Employers’
Accounting for Postretirement Benefits Other Than Pensions,” (c) measure
      defined benefit plan assets and obligations as of the date of the employer’s
      fiscal year-end, and (d) disclose in the notes to financial statements
      additional information about certain effects on net periodic benefit cost for
      the next fiscal year that arise from delayed recognition of the gains or losses,
      prior service costs or credits, and transition asset or obligation. An
      employer with publicly traded equity securities is required to initially
      recognize the funded status of a defined benefit postretirement plan and to
      provide the required disclosures as of the end of the fiscal year ending
      after December 15, 2006. The requirement to measure plan assets and benefit
      obligations as of the date of the employers fiscal year-end statement of
      financial position is effective for fiscal years ending after December 15,
      2008. Since we do not have a Defined Benefit Plan, this did not have a
      material impact on the Company’s financial position, results of operations or
      cash flows.




In
      September 2006, the Financial Accounting Standards Board (“FASB”) issued
      Statement of Financial Accounting Standards (“SFAS”) No. 157, “Fair Value
      Measurements” (“SFAS 157”). SFAS 157 clarifies the principle that fair
      value should be based on the assumptions market participants would use when
      pricing an asset or liability and establishes a fair value hierarchy that
      prioritizes the information used to develop those assumptions. SFAS 157 is
      effective for our fiscal year beginning January 1, 2007. We are currently
      evaluating the potential impact of the adoption of SFAS 157 on our future
      consolidated financial statements.




In
      September 2006, the Securities and Exchange Commission (“SEC”) issued Staff
      Accounting Bulletin No. 108, “Considering the Effects of Prior Year
      Misstatements when Quantifying Misstatements in Current Year Financial
      Statements” (“SAB 108”). SAB 108 provides interpretive guidance on how the
      effects of the carryover or reversal of prior year misstatements should be
      considered in quantifying a current year misstatement. The SEC staff believes
      that registrants should quantify errors using both a balance sheet and an income
      statement approach and evaluate whether either approach results in quantifying
      a
      misstatement that, when all relevant quantitative and qualitative factors are
      considered, is material. SAB 108 is effective for our  fiscal year ending
      December 31, 2006. The adoption of  SAB 108 will only impact our
      consolidated financial statements if we have misstatements in the
      future.




In
      July
      2006, the Financial Accounting Standards Board ("FASB") issued FASB
      Interpretation ("FIN") No. 48, *Accounting
      for Uncertainty in Income Taxes,* with
      respect to FASB Statement No. 109 ,*Accounting
      for Income Taxes,*regarding accounting for and disclosure of uncertain tax positions. FIN No.
      48
      is intended to reduce the diversity in practice associated with the recognition
      and measurement related to accounting for uncertainty in income taxes. This
      interpretation is effective for fiscal years beginning after December 15, 2006.
      We are currently evaluating the impact this interpretation will have on our
      financial statements.**




In
      March 2006, the FASB issued SFAS No. 156 “Accounting for Servicing of
      Financial Assets an amendment of FASB Statement No. 140”. FASB Statement
      No. 140, “Accounting for Transfers and servicing of Financial Assets and
      Extinguishments of Liabilities” establishing among other things, the accounting
      for all separately recognized servicing assets and servicing liabilities. This
      Statement amends Statement 140 to require that all separately recognized
      servicing assets and servicing liabilities be initially measured at fair value,
      if practicable. This Statement permits, but does not require, the subsequent
      measurement of separately recognized servicing assets and servicing liabilities
      at fair value. SFAS No. 156 is effective as of the beginning of the
      fiscal year that begins after September 15, 2006. The company will adopt
      SFAS 156 on January 1, 2007




28


In
      February 2006, the FASB issued SFAS No. 155, “Accounting for Certain
      Hybrid Financial Instruments” (“SFAS 155”), which amends SFAS No. 133,
“Accounting for Derivatives Instruments and Hedging Activities” (“SFAS 133”) and
      SFAS No. 140, “Accounting for Transfers and Servicing of Financial Assets
      and Extinguishment of Liabilities” (“SFAS 140”). SFAS 155 amends SFAS 133 to
      narrow the scope exception for interest-only and principal-only strips on debt
      instruments to include only such strips representing rights to receive a
      specified portion of the contractual interest or principle cash flows. SFAS
      155
      also amends SFAS 140 to allow qualifying special-purpose entities to hold a
      passive derivative financial instrument pertaining to beneficial interests
      that
      itself is a derivative instruments. The Company is currently evaluating the
      impact this new Standard, but believes that it will not have a material impact
      on the Company’s financial position, results of operations or cash flows. We
      will adopt SFAS 155 on January 1, 2007.




For
      the
      year ending December 31, 2007, under current rules, pursuant to
      Section 404 of the Sarbanes-Oxley Act, management will be required to
      deliver a report that assesses the effectiveness of our internal controls over
      financial reporting. The SEC issued a release in December 2006, however,
      announcing that the Commission has extended the date by which non-accelerated
      filers, which we currently are,must
      begin to comply with the Section 404(b) requirement to provide an auditor’s
      attestation report on internal controls over financial reporting. The deadline
      for the auditor’s attestation report has been moved to the first annual report
      for fiscal years ending on or after December 15, 2008. The SEC is
      considering further postponing this date.





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





Our
      audited Consolidated Financial Statements, including the notes thereto, appear
      beginning on page F-2 of this report.





**ITEM 8A.**
            **QUANTITATIVE
                AND QUALITATIVE DISCLOSURES ABOUT MARKET
                RISK**





Our
      principal financial instruments are our Secured Non-Convertible Revolving Note
      and Secured Non-Convertible Term Note with Laurus Master Funds, Ltd.
      (“Laurus”) which provides for an interest rate of Prime Rate (as published
      in The
      Wall Street Journal ) plus
      two percent (2.0%) for the Revolving Note and Prime Rate (as published in The
      Wall Street Journal ) plus
      three percent (3.0%) for the Term Note. We are affected by market risk exposure
      primarily through the effect of changes in the Prime Rate on our interest rates
      on our obligations under the Revolving and Term Notes. At December 31, 2006,
      an
      aggregate principal amount of $10.8 million was outstanding under the Revolving
      and Term Notes. If the principal amounts outstanding remained at this level
      for
      an entire year and the prime rate increased or decreased, respectively, by
      0.5%,
      we would pay or save, respectively, an additional $54,000 in interest in that
      year.





Our
      business outside the United States is conducted in United States Dollars.
      Although we purchase and sell products and services in United States Dollars
      and
      do not engage in exchange swaps, futures or options contracts or other hedging
      techniques, fluctuations in currency exchange rates could reduce demand for
      products sold in United States dollars. We cannot predict the effect that future
      exchange rate fluctuations will have on our operating results. We may in the
      future engage in currency hedging transactions, which could result in our
      incurring significant additional losses.





**ITEM 9.
      CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND FINANCIAL
      DISCOSURES**




None.





**ITEM
      9A. CONTROLS AND PROCEDURES**





As
      a
      result of the May 20, 2004 transactions, the internal control structure in
      place
      for Small World Toys, Inc. has succeeded to Small World Kids, Inc. Since the
      acquisition of Small World Toys, the Company’s system of internal controls has
      evolved consistent with the development of the business.





(a)
      Evaluation of disclosure controls and procedures: As of December 31, 2006,
      the
      end of the period covered by this report, the Company’s chief executive and the
      Company’s chief financial officer reviewed and evaluated the effectiveness of
      the Company’s disclosure controls and procedures (as defined in Exchange Act
      Rule 13a-15 and Rule 15d-15(e)), which are designed to ensure that material
      information the Company must disclose in the Company’s report filed or submitted
      under the Securities Exchange Act of 1934, as amended (the “Exchange Act”) is
      recorded, processed, summarized, and reported on a timely basis, and have
      concluded, based on that evaluation, that as of such date, the disclosure
      controls and procedures were effective to ensure that information required
      to be
      disclosed in reports filed or submitted under the Exchange Act is accumulated
      and communicated to the Company’s management, including its chief executive
      officer and chief financial officer, as appropriate to allow timely decisions
      regarding required disclosure. Although
      the evaluation did not detect any material weaknesses or significant
      deficiencies in the Company’s system of internal accounting controls over
      financial reporting, management identified certain potential ** deficiencies
      in its level of staffing. The Company is reviewing its staffing level to address
      this resource issue.





29


(b)
      Changes in internal control over financial reporting: There have been no changes
      in the Company’s internal control structure over that has materially affected,
      or is reasonably likely to materially affect, the Company’s internal control
      over financial reporting.





**ITEM
      9B. OTHER INFORMATION**





None





**PART
      III**





**ITEM 10.**
            **DIRECTORS,
                EXECUTIVE OFFICERS, PROMOTERS AND CONTROL
                PERSONS**





The
      following table and text set forth the names of all directors and executive
      officers of our Company as of December 31, 2006. The Board of Directors is
      comprised of only one class. All of the directors will serve until the next
      annual meeting of shareholders and until their successors are elected and
      qualified, or until their earlier death, retirement, resignation or removal.
      There are no family relationships between or among the directors, executive
      officers or persons nominated or charged by our Company to become directors
      or
      executive officers. Executive officers serve at the discretion of the Board
      of
      Directors, and are appointed to serve until the first Board of Directors meeting
      following the annual meeting of shareholders. Also provided herein are brief
      descriptions of the business experience of each director and executive officer
      and an indication of directorships held by each director in other companies
      subject to the reporting requirements under the Federal securities
      laws.





The
      directors and executive officers of the Company are as follows:





**Name**
            
            **Age**
            
            **Position Held with the Company**Debra
                Fine
            
            43
            
            Chairman,
                CEO, President and DirectorBob
                Rankin
            
            54
            
            Chief
                Financial Officer and SecretaryGary
                Adelson (b)
            
            51
            
            DirectorAlex
                Gerstenzang (a)
            
            52
            
            DirectorEric
                Manlunus (b)
            
            38
            
            DirectorLane
                Nemeth (a)
            
            57
            
            DirectorShelly
                Singhal (a)
            
            37
            
            DirectorDavid
                Swartz (b)
            
            62
            
            Director





(a)
            Member
                of the Compensation Committee


(b)
            Member
                of the Audit Committee





**Biographies
      of Directors and Executive Officers:**





*Debra
      Fine, Chief Executive Officer, Chairman and President*





Debra
      Fine has served as the Chief Executive Officer, Chairman and President since
      May 20, 2004. Fine served as a principal at EM Ventures (Venture Capital
      Fund) from 2002 to 2004. Prior to joining EM Ventures, she was the President
      and
      Chief Executive Officer of three consumer product companies, Fandom Media,
      a
“tween” products company from 2000 to 2002, President of New Media for Digital
      Domain, an academy award winning movie production company from 1998 to 2000
      and
      Cloud 9 Children’s products. With over 15 years of experience in consumer
      products, entertainment and media, Fine has developed expertise in operations,
      marketing, licensing and creating growth in start-up ventures. She holds a
      Bachelor of Arts in Journalism and Advertising from the University of Southern
      California and a MBA from the Anderson School, Executive Program at University
      of California, Los Angeles.





30


*Robert
      Rankin, Chief Financial Officer and Secretary*





Robert
      Rankin has served as the Chief Financial Officer and Secretary since May 24,
      2004. From 2002 until 2004, Mr. Rankin served as a consultant including
      serving as an interim CFO for a semiconductor start-up company from 2003 until
      joining the Company. From 1992 through 2002, Mr. Rankin held positions as
      Chief Financial Officer of public and private, mid-cap and start-up companies
      in
      the high technology and aerospace industries. In 2000, Rankin co-founded an
      application service provider software company. In 2000, while serving as the
      Chief Financial Officer of webcasts.com a private company, Rankin directed
      the
      sale of this software start-up for a valuation over $100 million. From 1992
      through 1998 under his leadership as CFO, DeCrane Aircraft Holdings, Inc. grew
      from a highly leveraged, VC funded, private aerospace company with sales of
      $13 million in 1991 to a multinational public company with sales of almost
      $200 million in 1998. Rankin's background also includes senior financial
      management positions with B.F. Goodrich and Coltec Industries. Mr. Rankin
      has a Bachelor of Science in Mechanical Engineering and a Master of Science
      in
      Business, both from Carnegie-Mellon University. On March 27, 2007, Mr. Rankin
      announced his resignation effective April 10, 2007.





*Gary
      Adelson, Director*





Gary
      Adelson has been a managing director of Houlihan Lokey Howard & Zukin and
      co-head of the firm’s Media & Entertainment Investment Banking Group since
      2003. Prior to joining the firm, he was a principal of Media Connect Partners,
      a
      provider of financial and operating advisory services to media, entertainment,
      sports and communications companies that he co-founded in 2003 and that was
      acquired by Houlihan. In 1996, Adelson co-founded EastWest Venture Group, which
      is a private venture capital, company managing a fund of over $250 million
      and
      served until 2002. From 1990 to 1995, He co-founded and served as Chairman
      and
      Chief Executive Officer of ICS, a telephony and cable company that was acquired
      by MCI in 1995. He earned a Bachelor of Arts degree in Economics from the
      University of California, Los Angeles and has served as the chairman of UCLA’s
      Venture Fund. Mr. Adelson serves on the board of the Pediatric Aids
      Foundation and was executive director of Israel’s 50th anniversary
      jubilee.




*Alex
      Gerstenzang, Director*




Alex
      Gerstenzang has been a senior executive with a big box retailer, having been
      with them for the last 29 years, overseeing a diverse product sales mix of
      approximately $12 billion since 1997. He has managed the East Coast region
      for
      Paris Boutique Corporation and subsequently founded a consulting business
      serving clients as diverse as prisons to the City of Portland and Georgia
      Pacific Corporation. He attended Dalton School, Columbia University, Pace
      University and New York University. He earned a Bachelor of Specialized Studies
      degree in finance and a Master of Business Administration.





*Eric
      Manlunus, Director*





Eric
      Manlunus is the Founder and Managing Director of Frontera Group, LLC, a boutique
      venture capital firm focused on investing in early to mid-stage emerging
      companies. Previously, he was also a principal of an LA-based value hedge fund
      from 2002 to mid-2006. Prior to Frontera, he was the founding Chairman and
      CEO
      of Sitestar; a publicly traded technology investment company focused on the
      consolidation of independent and privately owned Internet service providers
      in
      the rural markets of the mid-Atlantic region of the US. During his tenure,
      Sitestar completed seven acquisitions and became one of the largest independent
      ISPs in the region.  He started his career as an associate of Arthur
      Andersen’s retail management consulting division from 1991-1995. Eric earned an
      M.B.A from Pepperdine University and a B.S. in Communications from Florida
      International University. He is and was previously a member of the Board of
      Directors of Exist Global, Mobile Content Networks, Small World
      Kids, Brentwood Media Group, Sitestar, Sierra Madre
      Foods, Menu Directand Xcel Healthcare.




*Lane
      Nemeth, Director*




Lane
      Nemeth has been the founder and chief executive officer of Pet Lane, a direct
      sales enterprise since 2003. Prior to founding Pet Lane, she was an author,
      speaker and consultant from 1998 to 2003. She is the founder of Discovery Toys,
      an educational toy company based in Livermore, California, that was acquired
      by
      Avon (NYSE:AVP) in 1997 and was with Discovery from 1978 to 1998. She has
      received numerous entrepreneurial awards and is a regularly featured speaker
      at
      national child development, business leadership seminars, including the Stanford
      Leadership Academy and the National Association of Women Business Owners. She
      is
      a member of the Women’s Executive Leadership Council. Her recent book, *Discovering
      Another Way, Raising Brighter Children, While Having a Meaningful
      Career* , has
      received national recognition. She earned a Bachelor of Arts degree from the
      University of Pittsburgh and a Master of Arts degree in education from Seton
      Hall University.




*Shelly
      Singhal, Director*




Shelly
      Singhal currently serves as the Chairman and Chief Executive Officer of the
      SBI
      Group, a position he has held since 2001. Prior to joining SBI, Mr. Singhal
      was managing director of corporate finance at a brokerage firm in Orange County,
      California, joining the firm in 1995. He was responsible for several areas,
      including its E-Commerce Group from 1995 to 2000 and serving as manager of
      the
      Firm’s Bridge Fund. He earned a Bachelor of Science degree from Seaver College
      at Pepperdine University.




31




*David
      Swartz, Director*





David
      Swartz is the Managing Partner of Good Swartz Brown & Berns, which is a
      regional accounting and business advisory firm which he joined in 1990. Prior
      to
      joining Good Swartz Brown & Berns, he served as the chief financial officer
      of Westfield, Inc., a publicly held shopping center development company, from
      1988-1990. From 1968 to 1988, Swartz was a managing partner and on the national
      board of BDO Seidman, an international accounting firm. He is also a Director
      of
      Primedex Corporation, a public company. Mr. Swartz has more than
      thirty-five years of experience providing business advisory services to clients
      in several industries, including manufacturing, wholesale, retail,
      entertainment, real estate and professional services, and his professional
      experience also includes acquisitions, merger transactions, business valuations,
      and ESOPs. He has lectured extensively at several Southern California
      universities, and is a frequent speaker to trade and professional organizations.
      Swartz is past president of the Jewish Big Brothers of Los Angeles and serves
      on
      the boards of several other charitable foundations. Swartz earned his Bachelor
      of Science degree in Accounting from California State University, Northridge
      and
      is a member of the California Society of Certified Public Accountants and the
      American Institute of Certified Public Accountants. He also served as treasurer
      of the Los Angeles chapter of the California Society of Certified Public
      Accountants. He is now a Vice President on the California Board of Accountancy,
      a division of the California Department of Consumer Affairs.





**Family
      Relationships**





There
      are
      no family relationships between any of our directors or executive officers.





**Code
      Of Ethics And Conduct**





On
      October 15, 2004, the Board of Directors adopted a Code of Ethics and
      Conduct.





**Audit
      Committee**





The
      Company has an audit committee consisting of three independent directors David
      Swartz, Gary Adelson and Eric Manlunus. Our Board of Directors has determined
      that Mr. Swartz is an “audit committee financial expert” as that term is defined
      in Item 401(e) of Regulation S-B under the Exchange Act of 1934.





**ITEM
      11: EXECUTIVE COMPENSATION**





**Compensation
      Discussion and Analysis**




*Overview
      of Executive Compensation Program*





The
      following discussion and analysis describes the Company’s compensation
      objectives and policies as applied to the named executive officers appearing
      in
      the Summary Compensation Table.  This section is intended to provide a
      framework within which to understand the actual compensation awarded to, earned
      or held by each Executive Officer during 2006.





*Compensation
      Objectives*





The
      Compensation Committee of our Board of Directors has overall responsibility
      for
      the approval, evaluation and oversight of all of our compensation plans,
      policies and programs. The Compensation Committee believes that an effective
      executive compensation program should provide base annual compensation that
      is
      reasonable in relation to individual executive’s job responsibilities and reward
      the achievement of both annual and long-term strategic goals of our company.
      The
      Committee uses annual cash bonuses to reward an officer’s achievement of
      specific goals and stock options as a retention tool and as a means to align
      the
      executive’s long-term interests with those of our stockholders, with the
      ultimate objective of improving stockholder value. The Committee evaluates
      both
      performance and compensation to maintain our company’s ability to attract and
      retain excellent employees in key positions and to assure that compensation
      provided to key employees remains competitive relative to the compensation
      paid
      to similarly situated executives of comparable companies. To that end, the
      Committee believes executive compensation packages provided by us to our named
      executive officers should include both cash and share-based
      compensation.




Because
      of the size of our company, the small number of executive officers in our
      company, and our company’s financial priorities, the Committee has decided not
      to implement or offer any retirement plans, pension benefits or other similar
      plans for our executive officers. Accordingly, the components of the executive
      compensation consist of salary, year-end cash bonuses awarded based on the
      Company’s attainment of growth and profitability objectives and the Compensation
      Committee’s subjective assessment of each senior executive’s job performance
      during the past year, stock option grants to provide executives with longer-term
      incentives, and occasional special compensation awards (either cash or stock
      options) to reward extraordinary efforts or results.




32





The
      Compensation Committee also takes the company’s financial and working capital
      condition into account in its compensation decisions.





*Role
      of our Chief Executive Officer in Compensation Decisions*




The
      Compensation Committee on occasion meets with our Chief Executive Officer to
      obtain recommendations with respect to our compensation programs, practices
      and
      packages for executives, other employees and directors. Our Chief Executive
      Officer makes recommendations to the Compensation Committee on the executive
      compensation, but the Compensation Committee is not bound to and does not always
      accept the Chief Executive Officer’s recommendations.





The
      Compensation Committee makes all compensation decisions for the named executive
      officers and approves recommendations regarding equity awards to all of our
      employees. Decisions regarding the non-equity compensation of other executives
      are made by the Chief Executive Officer.





The
      Compensation Committee and the Chief Executive Officer annually review the
      performance of each named executive officer (other than the Chief Executive
      Officer, whose performance is reviewed only by the Committee). The conclusions
      reached and recommendations based on these reviews, including with respect
      to
      salary adjustments and annual award amounts, are presented to the Committee.
      The
      Committee can exercise its discretion in modifying any recommended adjustments
      or awards to executives.





*Setting
      Executive Compensation*





Based
      on
      the foregoing objectives, the Committee has structured the Company’s annual cash
      and incentive-based cash and non-cash executive compensation to motivate
      executives to achieve the business goals set by the Company, to reward the
      executives for achieving such goals, and to retain the executives. The Committee
      has not employed outside compensation consultants to assist it in executive
      compensation matters.





There
      is
      no pre-established policy or target for the allocation between either cash
      and
      non-cash incentive compensation.





*2006
      Executive Compensation Components*





For
      2006,
      the principal components of compensation for the named executive officers were:
      base salary; performance-based cash compensation; and long-term equity incentive
      compensation.





*Base
      Salary*




The
      Company provides named executive officers and other employees with base salary
      to compensate them for services rendered during the fiscal year. Base salary
      ranges for the named executive officers are determined for each executive based
      on his or her position and responsibility. During its review of base salaries
      for executives, the Committee primarily considers: the negotiated terms of
      each
      executive employment agreement; internal review of the executive’s compensation,
      both individually and relative to other executive officers; and individual
      performance of the executive. Salary levels are typically considered annually
      as
      part of the company’s performance review process, as well as upon a change in
      job responsibility. Merit-based increases to salaries are based on the
      Compensation Committee’s assessment of the individual’s performance and the
      financial condition of the Company. The contracts for both Ms. Fine and Mr.
      Rankin provide that on each and every anniversary of the employment agreement
      effective date, the executive’s annual base salary shall be increased by the
      increase in the consumer price index for the Los Angeles metropolitan
      statistical area over what it was during the preceding one-year period.




33





*Performance-Based
      Cash Compensation*




The
      Compensation Committee has not established an incentive cash compensation
      program with fixed performance targets except under our employment contract
      with
      Ms. Fine. Per Ms. Fine’s contract, she may receive an annual bonus, as
      determined and awarded by the Board of Directors from time to time in its sole
      discretion, but not less than an amount equal to 5% of earning before interest
      and taxes if such amount for any year is in excess of $1,000,000; 4% if such
      amount for any year is in excess of $2,000,000; and 3% if such amount is over
      $3,000,000.




Due
      to
      the losses incurred and financial condition of the Company, no performance
      compensation was awarded to the named Executives except for the Mr.
      Bennett who
      earned a special cash bonus of $60,000 in
      recognition of his role in increasing our penetration into the mass channel.





*Long-Term
      Equity Incentive Compensation*





As
      indicated above, the Committee also aims to encourage the company’s executive
      officers to focus on long-term company performance by allocating to them stock
      options that vest over a period of several years. In 2006, the Committee did
      not
      grant any stock options to the named executives.





*Retirement
      Plans, Perquisites And Other Personal Benefits*





We
      currently have no retirement plan for the named executive officers or other
      employees. Retirement benefits to employees are currently provided through
      our
      401(k) plan. In addition, we do not provide any of our executive officers with
      any perquisites or other personal benefits. We do not have in effect any change
      of control provisions for payment to any executive officer in the event of
      a
      change in control of Small World Kids except that our 2004 Stock Compensation
      Plan provides that all unvested options held by our employees, including the
      named executive officers, immediately vest upon a change of control.





*Ownership
      Guidelines*





The
      Committee has no requirement that each named executive officer maintain a
      minimum ownership interest in our company. Our long-term incentive compensation
      consists of the grant of stock options to our named executive officers. The
      stock option program assists the company to: establish the link between the
      creation of stockholder value and long-term executive incentive compensation;
      provide an opportunity for increased equity ownership by executives; function
      as
      a retention tool because of the vesting features included in all options granted
      by the Committee; and maintain competitive levels of total compensation.




We
      normally grant stock options to new executive officers when they join our
      company based upon their position with us and their relevant prior experience.
      The options granted by the Compensation Committee generally vest quarterly
      over
      the first three years of the ten-year option term. Vesting rights generally
      cease upon termination of employment and exercise rights cease three months
      after termination of employment. Prior to the exercise of an option, the holder
      has no rights as a stockholder with respect to the shares subject to such
      option, including voting rights and the right to receive dividends or dividend
      equivalents. In addition to the initial option grants, our compensation
      committee may grant additional options to retain our executives and reward,
      or
      provide incentive for, the achievement of corporate goals and strong individual
      performance. We expect that we will continue to provide new employees with
      initial option grants in the future to provide long-term compensation incentives
      and will continue to rely on performance-based and retention grants to provide
      additional incentives for current employees. Additionally, in the future, the
      Compensation Committee may consider awarding additional or alternative forms
      of
      equity incentives, such as grants of restricted stock, restricted stock units
      and other performance-based awards.




It
      is our
      policy to award stock options at an exercise price equal to the closing price
      of
      our common stock on the date of the grant. The Compensation Committee has never
      granted options with an exercise price that is less than the closing price
      of
      our common stock on the grant date, nor has it granted options which are priced
      on a date other than the grant date. For purposes of determining the exercise
      price of stock options, the grant date is deemed to be the date on which the
      Compensation Committee approves the stock option grant.





**Tax
      and Accounting Implications**





*Deductibility
      of Executive Compensation*





As
      part
      of its role, the Compensation Committee reviews and considers the deductibility
      of executive compensation under Section 162(m) of the Internal Revenue Code,
      which provides that corporations may not deduct compensation of more than
      $1,000,000 that is paid to certain individuals. We believe that compensation
      paid to our executive officers generally is fully deductible for federal income
      tax purposes.




34





*Accounting
      for Share-Based Compensation*





Beginning
      on January 1, 2006, the company began accounting for share-based compensation
      in
      accordance with the requirements of FASB Statement 123(R). This accounting
      treatment has not significantly affected our compensation decisions.





*Compensation
      Committee*





No
      member
      of our Compensation Committee participates in any of our employee compensation
      programs, and our Board has determined that none of our Compensation Committee
      members has any material business relationship with us. The members of the
      Compensation Committee are: Lane Nemeth; Alex Gerstenzang and Shelly Singhal
      and
      are considered independent.





**Summary
      Compensation Table**





The
      following table presents summary information concerning all compensation paid
      or
      accrued by us for services rendered in all capacities during 2006 by Debra
      Fine
      and Robert Rankin, who are the only individuals who served as our principal
      executive and financial officers, respectively during the year ended December
      31, 2006, and our two other most highly compensated executive officers who
      were
      serving as executive officers as of December 31, 2006. Also listed is our former
      Chief Operating Officer, Mr. Nelson who resigned on March 27, 2006 but continued
      to receive his monthly salary until the end of his employment contract on
      September 22, 2006. No other executive officer earned over $100,000 in
      2006.




**Annual Compensation**
            
            **All Other****Name and****Principal Position**
            
            **Year**
            
            **Salary**
            
            **Bonus**
            
            **Compensation**Debra
                Fine,Chairman,
                Chief Executive Officer and President (1)
            
            2006
            
            $
            275,424
            
            —
            
            18,000John
                Matise(2)Chief
                Operating Officer
            
            2006
            
            $
            146,392
            
            —
            
            41,330John
                Nelson(3)Formerly,
                Chief Operating Officer
            
            2006
            
            $
            124,231
            
            —
            
            —Robert
                Rankin(4)Chief
                Financial Officer and Secretary
            
            2006
            
            $
            196,329
            
            
            —
            
            —Howard
                Bennett,Executive
                Vice President, Sales
            
            2006
            
            $
            148,005
            
            $
            60,000
            
            
            —







(1)
      Ms.
      Fine was paid $250,000 in 2006 with the balance accrued that relates to the
      contractual CPI increase for 2005 and 2006 provided for in her contract. Per
      Ms.Fine’s employment contract she is entitled to car allowance however, this has
      not been paid since she her employment date, but was accrued in 2006 and
      included in Other Compensation.




(2) Mr.
      Matise was the Chief Operating Officer was from March 27, 2006 to December
      31,
      2006. Prior to joining the Company on March 27, 2006, Mr. Matise served as
      a
      Director and Consultant and whose 2006 Consulting and Director fees are included
      in Other Compensation.




(3)
      Mr.
      Nelson was the Chief Operating Officer prior to resigning on March 27, 2006.




(4)
      Mr.
      Rankin was paid $190,000 in 2006 with the balance accrued that relates to the
      contractual CPI increase for 2006 provided for in his contract. On
      March
      27, 2007, Mr. Rankin announced his resignation effective April 10,
      2007.





**2006
      Option Grants of Plan-Based Awards**





No
      options were granted during the fiscal year ended December 31, 2006 to any
      of
      the Named Executive Officers.




35





**2004
      Stock Compensation Plan**




The
      purpose of our 2004 Stock Compensation Plan (the “Plan”) is to promote our
      success and enhance our value by linking the personal interests of our
      employees, officers, consultants, advisors and directors to those of our
      stockholders, and by providing our employees, officers, consultants and
      directors with an incentive for outstanding performance. We adopted the Plan
      on
      September 22, 2004 under which 780,000 shares of common stock are available
      for
      issuance with respect to awards granted to our officers, directors, management
      and other employees. On January 25, 2005, the Board approved an amendment to
      the
      Plan to increase the number of shares of common stock reserved for issuance
      by
      an additional 600,000 shares of common stock bringing the total number of shares
      of common stock reserved for issuance under the Plan to 1,380,000. As of
      December 31, 2006, options to purchase 722,000 shares of common stock have
      been
      issued and are outstanding under the Plan.





The
      Plan
      authorizes the granting of awards to our employees, officers, consultants and
      directors and to employees, officers, consultants and directors of our
      subsidiaries. The following awards are available under the Plan:




·
            Incentive
                stock options to purchase shares of common stock;





·
            stock
                appreciation rights;





·
            restricted
                stock; and





·
            performance
                shares.





The
      aggregate Fair Market Value (determined at the time an ISO is granted) of the
      Common Stock covered by ISOs exercisable for the first time by an employee
      during any calendar year (under all plans of the Company) may not exceed
      $100,000.





*Administration*





The
      Plan
      is administered by the Compensation Committee of our Board of Directors. The
      Compensation Committee has the power, authority and discretion to make awards,
      to set administrative rules, guidelines and practices relating to the Plan
      as it
      shall deem advisable from time to time, and to interpret the provisions of
      the
      Plan. In determining the persons to whom awards shall be made, the number of
      shares to be covered by each award and the terms thereof (including the
      restriction, if any, which shall apply to the Common Stock subject to an award),
      the Committee shall take into account the duties of the respective persons,
      their present and potential contributions to the success of the Company and
      such
      other factors as the Committee, in its discretion, shall deem relevant in
      connection with accomplishing the purposes of the Plan.





**Awards**





*Stock
      Options* .
      The
      Compensation Committee is authorized to grant both incentive stock options.
      The
      terms of any incentive stock option must meet the requirements of Section 422
      of
      the Internal Revenue Code. The exercise price of an option is equal to the
      closing price of our common stock on the date of the grant, and no option may
      have a term of more than 10 years from the grant date.





*Stock
      Appreciation Rights* .
      The
      Compensation Committee may grant stock appreciation rights to participants.
      Upon
      the exercise of a stock appreciation right, the participant has the right to
      receive the excess, if any, of (1) the fair market value of one share of common
      stock on the date of exercise, over (2) the grant price of the stock
      appreciation right as determined by the Compensation Committee, which will
      not
      be less than the fair market value of one share of common stock on the date
      of
      grant.





*Restricted
      Stock* .
      The
      Compensation Committee may grant Restricted Stock Awards entitling recipients
      to
      acquire shares of Stock, subject to the right of the Company to repurchase
      all
      or part of such shares at their purchase price (or to require forfeiture of
      such
      shares if purchased at no cost) from the recipient in the event that conditions
      specified by the Board in the applicable award are not satisfied prior to the
      end of the applicable Restricted Period or Restricted Periods established by
      the
      Board for such award. Conditions for repurchase (or forfeiture) may be based
      on
      continuing employment or service or achievement of pre-established performance
      or other goals and objectives. Shares of Restricted Stock may not be sold,
      assigned, transferred, pledged or otherwise encumbered, except as permitted
      by
      the Board during the applicable Restricted Period.





*Performance
      Shares* .
      The
      Compensation Committee may grant performance shares entitling recipients to
      acquire shares of Stock upon the attainment of specified performance goals
      or on
      such terms and conditions as may be selected by the Compensation Committee.
      The
      Compensation Committee may make Performance Share Awards independent of or
      in
      connection with the granting of any other Award under the Plan. The Committee
      in
      its sole discretion shall determine the performance goals applicable under
      each
      such Award, the periods during which performance is to be measured, and all
      other limitations and conditions applicable to the awarded Performance
      Shares.




36





*Limitations
      on Transfer; Beneficiaries* .
      Awards
      under the Plan may not be sold, pledged, assigned or transferred in any manner
      other than by will or by the laws of intestate succession, and may be exercised
      during the lifetime of Optionee only by Optionee.





*Acceleration
      Upon Change in Control* .
      In the
      event that the Company or the division, subsidiary or other affiliated entity
      for which a Participant performs services is sold, merged, consolidated,
      reorganized or liquidated, all unvested options immediately vest.





*Other
      Adjustments.* In
      the
      event that the Company or the division, subsidiary or other affiliated entity
      for which a Participant performs services is sold, merged, consolidated,
      reorganized or liquidated, the Board may take any one or more of the following
      actions as to outstanding Awards: (i) provide that such Awards shall be assumed,
      or substantially equivalent Awards shall be substituted, by the acquiring or
      succeeding corporation (or an affiliate thereof) on such terms as the Board
      determines to be appropriate, (ii) upon written notice to Participants, provide
      that all unexercised Options or SARs shall terminate immediately prior to the
      consummation of such transaction unless exercised by the Participant within
      a
      specified period following the date of such notice, (iii) in the event of a
      sale
      or similar transaction under the terms of which holders of the Common Stock
      of
      the Company receive a payment for each share surrendered in the transaction
      (the
“Sales Price”), make or provide for a payment to each Option and/or SAR holder
      equal to the amount by which (A) the Sales Price times the number of shares
      of
      Common Stock subject to Participant’s outstanding, vested Options or SARs
      exceeds (B) the aggregate exercise price of all such outstanding, vested Options
      or SARs, in exchange for the termination of such Options or SARs, (iv) or make
      such other adjustments, if any, as the Board determines to be necessary or
      advisable to provide each Participant with a benefit substantially similar
      to
      that to which the Participant would have been entitled had such event not
      occurred.





*Termination
      and Amendment* .
      The
      Board may amend, modify or terminate any outstanding Award, including
      substituting therefor another Award of the same or a different type, changing
      the date of exercise or realization and converting an Incentive Stock Option
      to
      a Nonstatutory Stock Option, provided that the Participant’s consent to such
      action shall be required unless the Board determines that the action, taking
      into account any related action, would not materially and adversely affect
      the
      Participant.




**Holdings
      of Previously Awarded Equity**




Equity
      awards held as of December 31, 2006 by each of our named executive officers
      were
      issued under our 2004 Stock Incentive Plan. The following table sets forth
      outstanding equity awards held by our named executive officers as of December
      31, 2006:




**2006
      Outstanding Equity Awards at Fiscal Year-End**




**Option
      Awards**





**Name**
            
            **No. of Shares**
              **Underlying Options**
            
            **Option
                Exercise Price ($)**
            
            **Option
                Exercise Date****Exercisable**
            
            **Unexercisable**Debra
                Fine
            
            
            227,500
            
            
            32,500
            
            
            2.50
            
            
            May
                20, 2014John
                Matise(1)
            
            
            4,000
            
            
            0
            
            
            4.00
            
            
            January
                25, 2015John
                Nelson(2)
            
            
            0
            
            
            0
            
            
            —
            
            
            —Bob
                Rankin(3)
            
            
            52,000
            
            
            0
            
            
            3.80
            
            
            May
                24, 2014Howard
                Bennett
            
            
            42,500
            
            
            12,500
            
            
            4.80
            
            
            September
                22, 2014




(1) Mr.
      Matise was the Chief Operating Officer was from March 27, 2006 to December
      31,
      2006. Prior to joining the Company on March 27, 2006, Mr. Matise served as
      a
      Director and Consultant.


(2)
      Mr.
      Nelson was the Chief Operating Officer prior to resigning on March 27, 2006.


(3) On March
      27, 2007, Mr. Rankin announced his resignation as Chief Financial Officer
      effective April 10, 2007.





**2006
      Option Exercises**





None
      of
      our named executive officers exercised any stock options in 2006.




37





**Employment
      Agreements**




We
      entered into an employment agreement with Debra Fine, our Chairman, CEO and
      President on May 20, 2004 for a three-year term, which may continue upon the
      mutual agreement of the parties thereto except the employment relationship
      will
      be on an “at will” basis. The employment agreement provides compensation of a
      base salary of $250,000 per annum, an annual bonus, as determined and awarded
      by
      the Board from time to time in its sole discretion, but not less than an amount
      equal to 5% of EBIT, meaning earnings before interest and taxes, if such amount
      for any year is in excess of $1,000,000; 4% if such amount for any year is
      in
      excess of $2,000,000; and 3% if such amount is over $3,000,000, and 2,600,000
      stock options at the exercise price of $.25 per share of which 650,000 vested
      immediately and the balance vesting on a quarterly basis in equal amounts of
      162,500 shares each over the course of her agreement. The contract also provides
      that on each and every anniversary of the effective date of the employment
      agreement, the executive’s annual base salary shall be increased by the increase
      in the consumer price index for the Los Angeles metropolitan statistical area
      over what it was during the preceding one-year period. The employment agreement
      also provides that during each year of the Term, the Company shall, at its
      cost,
      furnish the executive with the full time use of a then-current year model Lexus
      automobile and automobile liability insurance coverage on such automobile.
      The
      employment agreement provides that in the event that Ms. Fine is terminated
      prior to the end of the initial three (3) year term, other than for cause,
      we
      will pay her salary for the remainder of the three (3) year term without any
      deduction or offset for any compensation earned or received from any other
      sources. In addition, we will pay any earned, but unpaid, bonus for the prior
      year, any unused vacation or other time-off benefits and any unpaid reimbursable
      business expenses incurred through the last day of her services. For an
      additional one (1) year after the termination, we shall continue benefits,
      at
      our expense. All unvested portion(s) of the options granted to her pursuant
      to
      her employment agreement shall vest and immediately become exercisable upon
      the
      effective date of such termination.




We
      entered into an employment agreement with John Matise, our Chief Operating
      Officer on March 27, 2006 for a two-year term, which may continue upon the
      mutual agreement of the parties thereto except the employment relationship
      will
      be on an “at will” basis. On October 19, 2006, Mr. Matise announced that he was
      reducing his involvement with the company to a part-time basis (approximately
      25%) through the end of the year and then will leave the Company.  His
      employment contract with the Company terminated on December 31, 2006.




We
      entered into an employment agreement with Robert Rankin, our Chief Financial
      Officer on May 24, 2004 for a two-year term, which may continue upon the mutual
      agreement of the parties thereto except the employment relationship will be
      on
      an “at will” basis. On April 6, 2006, the employment agreement was amended to
      extend the term to terminate on May 24, 2007. The employment agreement provides
      compensation of a base salary of $190,000 per annum, an annual bonus, as
      determined and awarded by the Board from time to time in its sole discretion
      and
      520,000 stock options at the exercise price of $.38 per share of which 130,000
      vested immediately and the balance vesting on a quarterly basis in equal amounts
      of 48,750 shares each over the course of his agreement. The contract also
      provides that on each and every anniversary of the effective date of the
      employment agreement, the executive’s annual base salary shall be increased by
      the increase in the consumer price index for the Los Angeles metropolitan
      statistical area over what it was during the preceding one-year period. The
      employment agreement provides that in the event that Mr. Rankin is terminated
      prior to the end of the term, other than for cause, we will pay his salary
      for
      an additional six months without any deduction or offset for any compensation
      earned or received from any other sources. In addition, we will pay any earned,
      but unpaid, bonus for the prior year, any unused vacation or other time-off
      benefits and any unpaid reimbursable business expenses incurred through the
      last
      day of his services. For an additional six months, we shall continue benefits,
      at our expense. All unvested portion(s) of the options granted to him pursuant
      to his employment agreement shall expire and be null and void upon the effective
      date of his termination.





**2006
      Director Compensation**





The
      following table sets forth certain information concerning the compensation
      earned in 2006 by our non-employee directors who served in 2006





**Name**
            
            **Fees
                Earned in Cash**
              **($)**
            
            **Option
                Awards (3)**
              **($)**
            
            **Total**
              **($)**Gary
                Adelson
            
            
            15,000
            
            
            39,557
            
            
            54,557Alex
                Gerstenzang
            
            
            13,500
            
            
            39,557
            
            
            53,057Eric
                Manlunus
            
            
            4,000
            
            
            39,557
            
            
            43,557Lane
                Nemeth
            
            
            7,500
            
            
            39,557
            
            
            47,057Shelly
                Singhal
            
            
            0
            
            
            39,557
            
            
            39,557David
                Swartz
            
            
            23,000
            
            
            39,557
            
            
            62,557Robert
                Lautz (1)
            
            
            10,500
            
            
            39,557
            
            
            50,057John
                Matise (2)
            
            
            5,500
            
            
            —
            
            
            5,500





(1)
      Mr.
      Lautz was a Director from January 1, 2006 to October 27, 2006 when he resigned.




(2)
      Mr.
      Matise was a Director from January 1, 2006 to July 18, 2006 when he resigned.




**(3)** We
      adopted the fair value recognition provisions of SFAS No. 123(R) effective
      January 1, 2006. Under the SFAS No. 123(R), we recorded compensation
      expense in our financial statements as of and for the year ended
      December 31, 2006 with respect to the awards included in this table. See
      Note 3 of the accompanying financial statements.




38


Prior
      to
      October 2006, the Directors who are not employees received $1,500 for each
      meeting attended, $1,000 for each committee meeting attended and 40,000 stock
      options per year. Further, the chairman of the audit committee receives an
      additional $5,000 annually. On October 19, 2006, the Board changed the
      compensation for attending meetings to


$1,500
      for each meeting attended in person or telephonically that lasts over one hour,
      $500 for each meeting attended telephonically that lasts less than one hour,
      $1,000 for each committee meeting attended in person or telephonically that
      lasts over one hour and $500 for each committee meeting attended telephonically
      that lasts less than one hour.




**Compensation
      Committee Interlocks and Insider Participation**





The
      compensation committee is composed entirely of directors who are not our current
      or former employees, each of who meets the applicable definition of
“independent” in the current rules of the under the listing standards of SEC
      rules and regulations. The compensation committee is responsible for
      establishing and administering our executive compensation policies. Our
      compensation committee does not have any interlocks with other companies.




**Compensation
      Committee Report**




The
      compensation committee has reviewed and discussed with the Company’s management
      the Compensation Discussion & Analysis contained in this annual report
      on Form 10-K. Based on these discussions, and the committee’s review of the
      Compensation Discussion & Analysis contained in this annual report, the
      compensation committee recommended to the Board of Directors the inclusion
      of
      the Compensation Discussion & Analysis in the Company’s annual report
      on Form 10-K for the year ended December 31, 2006.




**Compensation
      Committee**


Alex
      Gerstenzang


Lane
      Nemeth


Shelly
      Singhal





**ITEM 12.****SECURITY
      OWNERSHIP OF CERTAIN BENFICIAL OWNERS AND MANAGEMENT AND RELATED STOCKHOLDER
      MATTERS**




The
      following table sets forth, as of April 9, 2007 certain information regarding
      beneficial ownership of our common stock by (i) each person or entity who is
      known by us to own beneficially more than 5% of the outstanding shares of common
      stock, (ii) each of our directors, (iii) each of the Named Executive Officers,
      and (iv) all directors and executive officers as a group. As of April 9, 2007,
      there were 5,410,575 shares of our common stock issued and outstanding. In
      computing the number and percentage of shares beneficially owned by a person,
      shares of common stock that a person has a right to acquire within sixty (60)
      days of April 9, 2007, pursuant to options, warrants or other rights are counted
      as outstanding, while these shares are not counted as outstanding for computing
      the percentage ownership of any other person. Unless otherwise indicated, the
      address for each shareholder listed in the following table is c/o Small World
      Kids, Inc., 5711 Buckingham Parkway, Culver City, California 90230. This table
      is based upon information supplied by directors, officers and principal
      shareholders and reports filed with the Securities and Exchange
      Commission.




**Name
                and Address of**
              **Beneficial
                Owner**
            
            **Shares of Common Stock****Beneficially Owned**
            
            **Percentage
                of****Total Common Stock
                (1)****Directors
                and Officers**Debra
                L. Fine (2)
            
            
            2,429,379
            
            
            39.7
            %Robert
                Rankin (3)
            
            
            52,000
            
            
            *Gary
                Adelson (4)
            
            
            44,000
            
            
            *Alex
                Gerstenzang (5)
            
            
            44,000
            
            
            *Eric
                Manlunus (6)
            
            
            604,952
            
            
            10.2
            %Lane
                Nemeth (7)
            
            
            44,000
            
            
            *Shelly
                Singhal (8)
            
            
            1,922,660
            
            
            33.8
            %David
                Swartz (9)
            
            
            44,000
            
            
            *Total
                Directors and Officers as a Group
            
            
            5,184,991
            
            
            72.3
            %**5%
                Beneficial Owners**Bushido
                Capital Master Fund (10)
            
            
            1,758,243
            
            
            24.5
            %C.E.
                Unterberg, Towbin Capital Partners 1, L.P. (11)
            
            
            554,545
            
            
            9.3
            %David
                Marshall, Inc. (12)
            
            
            1,146,718
            
            
            21.2
            %Sid
                Marshall, Inc. (13)
            
            
            391,818
            
            
            7.0
            %Frontera
                Group, LLC (14)
            
            
            564,952
            
            
            9.6
            %Gamma
                Opportunity Capital Partners LP Class A (15)
            
            
            765,485
            
            
            12.4
            %Gamma
                Opportunity Capital Partners LP Class C (16)
            
            
            765,485
            
            
            12.4
            %HIT
                Credit Union (17)
            
            
            290,909
            
            
            5.1
            %Hong
                Kong Credit Union (18)
            
            
            788,636
            
            
            12.7
            %Laurus
                Master Fund, Ltd (19)
            
            
            1,036,000
            
            
            16.1
            %St.
                Cloud Capital Partners, LP (20)
            
            
            762,500
            
            
            12.5
            %SWT,
                LLC (21)
            
            
            5,112,239
            
            
            48.6
            %SWT
                Investments, LLC (22)
            
            
            1,297,673
            
            
            24.0
            %Trinad
                Capital Master Fund Ltd (23)
            
            
            454,545
            
            
            7.7
            %




39




*
      Less
      than 1%





(1)  Based
      on
      5,410,575 shares outstanding as of April 9,2007.




(2)  Debra
      Fine
      is the Chief Executive Officer, and President of the Company. Her shares are
      held indirectly by the Fine Family Trust of which she is the Co-Trustee which
      is
      the owner of 1,721,543 shares of our common stock, 3,063 shares underlying
      warrants, 227,500 shares underlying stock options that may be exercisable within
      60 days of April 9,2007 and 477,273 shares issuable upon conversion of the
      Series Class A-1 Preferred Stock. Does not include the shares issuable upon
      conversion of the Series Class A-1 Preferred Stock and underlying warrants
      owned by SWT, LLC of which The Fine Family Trust is a member.




(3)  Robert
      Rankin is the Chief Financial Officer and Secretary. Consists of 52,000 shares
      underlying stock options that may be exercisable within 60 days of the date
      of
      April 9,2007.




(4)  Gary
      Adelson is a director of the Company. Consists of 44,000 shares underlying
      stock
      options, which are exercisable within 60 days of April 9,2007.




**** (5)  Alex
      Gerstenzang is a director of the Company. Consists of 44,000 shares underlying
      stock options, which are exercisable within 60 days of April
      9,2007.





(6)  Eric
      Manlunus is a director of the Company and Managing Director of Frontera Group,
      LLC, which is the beneficial owner of 64,077 shares of our common stock, 875
      shares underlying warrants and 500,000 shares issuable upon conversion of the
      Series Class A-1 Preferred Stock. Does not include the shares issuable upon
      conversion of the Series Class A-1 Preferred Stock and underlying warrants
      owned by SWT, LLC of which Frontera Group is a member. Includes 40,000 shares
      underlying stock options, which are exercisable within 60 days of April
      9,2007.




(7)
      Lane
      Nemeth is a director of the Company. Consists of 44,000 shares underlying stock
      options, which are exercisable within 60 days of April 9,2007.




(8)  Shelly
      Singhal is a director of the Company. Of the shares beneficially owned by Mr.
      Singhal, 1,297,673 common shares are owned by SWT Investments, LLC, a Delaware
      limited liability company, of which Mr. Singhal owns 100%; 193,678 shares are
      owned by SBI Holdings of which he is a managing director and consists of 93,678
      common shares and 237,500 shares underlying warrants; 249,809 common shares
      are
      owned by Curried Clover LLC in which he has beneficial ownership; and 44,000
      shares underlying stock options which are exercisable within 60 days of April
      9,2007.The address for Mr. Singhal is 610 Newport Center Drive, Suite 1205
      Newport Beach, CA  92660. Does not include the shares issuable upon
      conversion of the Series A-1 Preferred Stock and underlying warrants owned
      by SWT, LLC of which SWT Investments, LLC is a member.




(9)  David
      Swartz is a director of the Company. Consists of 44,000 shares underlying stock
      options, which are exercisable within 60 days of April 9,2007.




(10)  Consists
      of 830,970 shares underlying warrants and 927,273 shares issuable upon
      conversion of the Series Class A-1 Preferred Stock. The address for Bushido
      Capital Partners, Ltd is 275 Seventh Ave., Suite 2000, New York, NY
      10001.




(11)  Consists
      of 454,545 shares issuable upon conversion of the Series Class A-1
      Preferred Stock and 100,000 shares underlying warrants. The address for C.E.
      Unterberg, Towbin Capital Partners 1, L.P. is 350 Madison Ave., New York, NY
      10017.




(12)  Consists
      of 1,146,718 shares of our common stock held by David Marshall, Inc. which
      is
      beneficially owned by David Marshall, an investor. The address for David
      Marshall, Inc. is 9229 Sunset Boulevard, Suite 505 Los Angeles, CA 90009. Does
      not include the shares issuable upon conversion of the Series Class A-1
      Preferred Stock and underlying warrants held by SWT, LLC of which David
      Marshall, Inc. is a member.




40




( 13)  Consists
      of 206,500 common shares and 3,500 shares issuable upon exercise of warrants
      and
      181,818 shares issuable upon conversion of the Series Class A-1 Preferred
      Stock and is beneficially owned by David Marshall’s father, Sid Marshall. The
      address for Sid Marshall is  9229
      Sunset Boulevard, Suite 505 Los Angeles, CA 90009.





(14)  Frontera
      Group, LLC which Eric Manlunus is the Managing Director and is a director of
      the
      Company. Consists of 64,077 shares of our common stock, 875 shares underlying
      warrants and 500,000 shares issuable upon conversion of the Series Class
      A-1 Preferred Stock. Does not include the shares issuable upon conversion of
      the
      Series Class A-1 Preferred Stock and underlying warrants owned by SWT, LLC
      of which Frontera Group is a member. The address for Frontera Group, LLC is
      15303 Ventura Boulevard, Suite 1510, Sherman Oaks, CA 91403.




(15)  Consists
      of 415,485 shares underlying warrants and 350,000 shares issuable upon
      conversion of the Series Class A-1 Preferred Stock. The address for Gamma
      Opportunity Capital Partners LP Class A is 1967 Longwood Lake Mary Road,
      Longwood, Fla 32750.




(16)  Consists
      of 415,485 shares underlying warrants and 350,000 shares issuable upon
      conversion of the Series Class A-1 Preferred Stock. The address for Gamma
      Opportunity Capital Partners LP Class C is 1967 Longwood Lake Mary Road,
      Longwood, Fla 32750.




(17)  Consists
      of 290,909 shares issuable upon conversion of the Series Class A-1
      Preferred Stock. The address for HIT Credit Union is 610 Newport Center Drive,
      Suite 1205, Newport Beach, CA 92660.




(18)  Consists
      of 513,636 shares issuable upon conversion of the Series Class A-1
      Preferred Stock and 275,000 shares issuable upon conversion of the $300,000
      convertible note. The address for Hong Kong League Credit Union is 610 Newport
      Center Drive, Suite 1205, Newport Beach, CA 92660.




(19)  Consists
      of 1,036,000 shares underlying warrant. The address for Laurus Master Fund,
      Ltd
      is 825 Third Ave., 14  th  Floor,
      New
      York, NY 10022.




(20)  Consists
      of 81,250 shares of our common stock, 118,750 shares underlying warrants and
      562,500 shares issuable upon conversion of the $2,225,000 convertible note..
      The
      address of St. Cloud is 10866 Wilshire Boulevard, Suite 1450, Los Angeles,
      CA
      90024.




(21)  Consists
      of 204,082 shares underlying warrants and 4,908,157 shares issuable upon
      conversion of the Series Class A-1 Preferred Stock. Members of SWT, LLC include
      Russell Fine and Debra Fine as trustees of the Fine Family Trust, SWT
      Investments, LLC, which is 100% owned by Shelly Singhal who is a director of
      the
      Company, and David Marshall; Inc.. Glenhaven Corporation manages SWT, LLC,
      and
      is owned by David Marshall. The address for SWT,LLC is 9229 Sunset Boulevard,
      Suite 505, Los Angeles, California 90069.





(22)  SWT
      Investments, LLC, which is 100% owned by Shelly Singhal who is a director of
      the
      Company. Consists of 1,297,673 shares of our common stock. Does not include
      the
      shares issuable upon conversion of the Series Class A-1 Preferred Stock and
      underlying warrants owned by SWT, LLC of which SWT Investments, LLC is a member.
      The address for SWT Investments, LLC is 610 Newport Center,Suite 1205,Newport
      Beach, CA 92660.





(23)  Consists
      of 454,545 shares issuable upon conversion of the Series Class A-1
      Preferred Stock. The address for Trinad Capital Master Fund Ltd is 2121 Avenue
      of the Stars, Suite 1650, Los Angeles, CA 90067.





**ITEM 13.****CERTAIN
      RELATIONSHIPS AND RELATED PARTY TRANSACTIONS**




This
      section describes the transactions since January 1, 2005 to which we
      or any of our subsidiaries were or are to be a party in which the amount exceeds
      $60,000 and in which any director, officer, or person known by us to be the
      beneficial owners of 5% or more of our common stock (or any family member
      of the foregoing).





On
      June
      9, 2006, the Note due 2006 in the principal amount of $2,500,000 to St. Cloud
      Capital Partners LP, of which Robert Lautz, who was a director of the Company
      at
      the time of the restructure, is a Managing Director, was restructured as a
      condition of the sale of Class A-1 Convertible Preferred Stock on June 9, 2006
      as follows: the Company prepaid $50,000 of the existing note and issued to
      St.
      Cloud two new notes to replace the exiting note: the first note in the principal
      amount of $200,000 will be for twelve months with monthly amortization payments
      at a 10% interest rate; the second note will be for $2,250,000 with interest
      at
      10% per annum with interest only payable on June 30, 2006 and September 15,
      2006, and, commencing September 16, 2006, payments will be interest only each
      month through September 15, 2008, and commencing October 15, 2008, monthly
      amortization payments (based on a five-year amortization) with all interest
      plus
      unpaid principal due on September 15, 2011. The second note will be convertible
      into shares of the common stock of the Company at $4.00 per share. The original
      loan of $2,000,000 to St. Cloud was made on September 15, 2004. On July 20,
      2005, St. Cloud agreed to advance an additional $500,000 for an aggregate loan
      of $2.5 million. On November 11, 2005, we entered into a second amendment
      with St. Cloud pursuant to which we issued to St. Cloud a new promissory note
      replacing the existing note to St. Cloud in the principal amount of $2,500,000
      and extended the maturity date of the loan to September 15, 2006. 
Pursuant to the terms of the note agreement with St. Cloud, during the period
      that notes are outstanding, Mr. Lautz will be appointed to the Company’s
      Board of Directors. On October 27, 2006, Mr. Lautz resigned as a Director from
      the Company’s Board. In addition, as long as St. Cloud owns in excess of 300,000
      shares, a designee of St. Cloud reasonably acceptable to us is entitled to
      an
      observer seat on the Board of Directors.




41





On
      June
      9, 2006, the 24% Notes issued to Hong Kong League Central Credit Union, PCCW
      Credit Union and HIT Credit Union (collectively the “Lenders”) and due 2006 in
      the principal amount of $1,000,000 were converted into 909,091 shares of Class
      A-1 Convertible Preferred Stock. The Notes were issued as follows: (i) On April
      28, 2005 we had entered into Term Credit Agreements (“Credit Agreements”) with
      Hong Kong League Central Credit Union and PCCW Credit Union for unsecured loans
      totaling $750,000 due on or before August 31, 2005; and (ii) On June 10, 2005
      we
      entered into additional Credit Agreements with Hong Kong League Central Credit
      Union and HIT Credit Union for unsecured loans totaling $250,000 due on or
      before September 30, 2005. Effective August 31, 2005, the maturity dates of
      all
      outstanding unsecured loans with the Lenders were extended to the earlier of
      the
      closing of a financing transaction with net proceeds of at least $20 million
      or
      March 1, 2006. In consideration for this extension, we issued a four-year
      warrant to purchase up to 100,000 shares of the common stock exercisable at
      $5.00 per share to SBI Advisors, LLC, of which Shelly Singhal, one of our
      directors, is Chairman and Chief Executive Officer. On February 28, 2006, the
      maturity dates of all outstanding unsecured loans with the Lenders were extended
      to the earlier of the closing of a financing transaction with net proceeds
      of at
      least $20 million or August 11, 2006.





On
      June
      9, 2006, the 10% Notes due 2006 in the principal amount of $500,000 were
      converted into 454,546 shares of Class A-1 Convertible Preferred Stock. On
      August 11, 2005, we had issued an aggregate of $500,000 in notes to various
      accredited investors including Russell Fine and Debra Fine **(** our
      President and Chief Executive Officer) **,** as
      trustees of the Fine Family Trust , who provided $175,000 of the total
      borrowing. The notes had a maturity of one year from the date of execution
      with
      interest payable monthly in arrears at a rate of 10% per annum and were secured
      by certain assets including receivables, inventory, equipment and other
      assets.





On
      June
      9, 2006, the 2,500,000 shares of Class A Convertible Preferred Stock owned
      by
      SWT, LLC in the amount of $5,000,000 along with $398,973 in accrued dividends
      were converted into 4,908,157 shares of Class A-1 Convertible Preferred Stock
      a
      s a condition of the sale of Class A-1 Convertible Preferred Stock on June
      9,
      2006. On August 11, 2005, we had converted the $5 million Bridge Note dated
      May
      21, 2004 issued to SWT, LLC, into 10% Class A Convertible Preferred Stock.
      The
      Class A Preferred stock was convertible at the option of the holder into the
      common stock at an initial fixed conversion price of $4.00 subject to adjustment
      based on the terms of future financings should they occur and accrued a
      quarterly dividend at a rate of 10% per annum and was payable in cash or a
      combination of 50% cash and 50% common stock at our option. In connection with
      the conversion of the $5 million Bridge Note, we issued on August 11, 2005,
      a
      three-year immediately exercisable warrant to purchase up to 204,082 shares
      of
      the common stock exercisable at $4.90 per share. Each of Russell Fine and Debra
      Fine (our President and Chief Executive Officer) as trustees of the Fine Family
      Trust, SWT Investments, LLC, which is wholly owned by Shelly Singhal, a director
      of the Company, and David Marshall; Inc. are members of SWT, LLC. Glenhaven
      Corporation manages SWT, LLC, and is owned by David Marshall who is the
      beneficially owner of more than 20% of our common stock.





On
      May
      20, 2004, the Company entered into a $72,000 per annum three-year
      consulting agreement with David Marshall, Inc., a related party. On each
      anniversary date, the fee shall be increased by the increase in the consumer
      index for the Los Angeles metropolitan statistical area. During the term, David
      Marshall, Inc. will provide consulting services relating to business plan
      development, strategic planning, public relations, investor relations,
      acquisitions and financing activities.




Since
      February 2006, Russell Fine, the spouse of Debra Fine (our President and Chief
      Executive Officer), has been providing operational and system consulting
      services on a month to month basis for $11,000 per month.




Since
      September 2006, the Company has retained Kershaw Mackie & Company to provide
      management consulting services to the Company at a weekly consulting charge
      of
      $4,000 per week. After 45 days, the weekly charge decreased to $3,000 for 90
      days and thereafter the weekly charge will be $2,000 until the consulting
      services are terminated. On October 19, 2006, the Company issued an aggregate
      of
      $27,500 in principal amount of 10% Convertible Debentures to Kershaw Mackie
      & Company. In consideration for the Convertible Debenture, the Company
      issued warrants to purchase an aggregate of 12,500 shares at an exercise price
      of $1.10 per share to Kershaw Mackie & Company.





Since
      July 2006, the Company has been using the services of Vintage Filings, LLC
      to
      provide EDGAR filing services for the filing for our SEC filing requirments.
      On
      October 19, 2006, the Company sold in a private placement 90,909 shares of
      its
      Class A-1 Convertible Preferred Stock for $100,000 to Vintage Filings,
      LLC.





All
      related party transactions have been and will continue to be approved by the
      majority of our directors who do not have an interest in the transactions being
      approved.




**ITEM
      14. PRINCIPAL ACCOUNTANT FEES AND SERVICES**





Audit
      Fees: The aggregate fees billed for the year ended December 31, 2006 for
      professional services rendered by the Stonefield Josephson, Inc. (“Stonefield”)
      for the audit of our annual financial statements and the quarterly review of
      financial statements for the Quarters ended March 31, 2006, June 30, 2006 and
      September 30, 2006 was $246,000 as compared to $113,000 for the aggregate fees
      billed for the year ended December 31, 2005 for professional services rendered
      by the Stonefield for the audit of our annual financial statements and the
      quarterly review of financial statements for the Quarters ended March 31, 2005,
      June 30, 2005 and September 30, 2005





42


Tax
      Fees:
      The aggregate fees billed for the years ended December 31, 2006 and 2005 for
      professional services rendered by the Grant Thornton LLP for tax compliance
      and
      tax planning was approximately $41,000 and $33,000, respectively.





All
      Other
      Fees: The aggregate fees billed for the years ended December 31, 2006 and 2005
      for products and services provided by Stonefield other than the services
      reported above was approximately $61,000 and $19,000, respectively. The Company
      also paid $16,000 to Grobstein Horwath and Company for a valuation of an
      embedded derivative.





**Audit
      Committee Pre-Approval Policies and Procedures**





Our
      Audit
      Committee’s policy is to pre-approve all audit and permissible non-audit
      services provided by our independent auditors. These services may include audit
      services, audit-related services, tax services and other services. Pre-approval
      is generally provided for up to one year and any pre-approval is detailed as
      to
      the particular service or category of services. The independent auditor and
      management are required to periodically report to the Audit Committee regarding
      the extent of services provided by the independent auditor in accordance with
      this pre-approval.





**ITEM
      15. EXHIBITS AND FINANCIAL STATEMENT SCHEDULES**





(a)
      Exhibits





***Exhibits
      are numbered in accordance with the Exhibit Table of Item 601 of Regulation
      S-K:***




Exhibit
                No.
            
            Exhibit
                Description3.1
            
            Articles
                of Incorporation incorporated by reference from the Form SB-2 filed
                with
                the SEC on August 28, 2001. File No. 333-68532.3.2
            
            Bylaws
                incorporated by reference from the Form SB-2 filed with the SEC on
                August
                28, 2001. File No. 333-68532.4.1
            
            Pledge
                Agreement, dated as of May 20, 2004 incorporated by reference from
                the
                Form 8-K filed with the SEC on June 4, 2004. File No.
                333-68532.4.2
            
            Stock
                Pledge Agreement, dated as of May 20, 2004 incorporated by reference
                from
                the Form 8-K filed with the SEC on June 4, 2004. File No.
                333-68532.4.3
            
            Registration
                Rights Agreement, dated as of May 20, 2004 incorporated by reference
                from
                the Form 8-K filed with the SEC on June 4, 2004. File No.
                333-68532.4.4
            
            Exchange
                Agreement, dated as of May 20, 2004 incorporated by reference from
                the
                Form 8-K filed with the SEC on June 4, 2004. File No.
                333-68532.4.5
            
            Stock
                Purchase Agreement, dated as of May 20, 2004 incorporated by reference
                from the Form 8-K filed with the SEC on June 4, 2004. File No.
                333-68532.4.6
            
            2004
                Stock Compensation Plan incorporated by reference from the Form S-8
                filed
                with the SEC on February 4, 2005. File No. 333-68532.4.7
            
            Common
                Stock Purchase Warrant incorporated by reference from the Form 8-K
                filed
                with the SEC on October 4, 2005. File No. 333-68532.4.8
            
            Common
                Stock Purchase Warrant incorporated by reference from the Form 8-K
                filed
                with the SEC on October 11, 2005. File No. 333-68532.4.9
            
            Certificate
                of Designation of Class A-1 Convertible Preferred Stock dated as
                of June
                9, 2006 incorporated by reference from the Form 8-K filed with the
                SEC on
                June 15, 2006. File No. 333-68532.5.1
            
            Legal
                Opinion of Troy & Gould and consent.10.1
            
            $700,000
                Promissory Note incorporated by reference from the Form 8-K filed
                with the
                SEC on June 4, 2004. File No. 333-68532.10.2
            
            Employment
                Agreement (Fine) incorporated by reference from the Form 10KSB filed
                with
                the SEC on March 28, 2005. File No. 333-68532.10.3
            
            Employment
                Agreement (Rankin) incorporated by reference from the Form 10KSB
                filed
                with the SEC on March 28, 2005. File No. 333-68532.10.4
            
            Lock-up
                Agreement incorporated by reference from the Form 8-K filed with
                the SEC
                on November 18, 2005. File No.
                333-68532.




43




10.5
            
            Secured
                Non-Convertible Revolving Note dated February 28, 2006 (Laurus Master
                Fund, LTD) incorporated by reference from the Form 8-K filed with
                the SEC
                on March 3, 2006. File No. 333-68532.10.6
            
            Secured
                Non-Convertible Term Note dated February 28, 2006 (Laurus Master
                Fund,
                LTD) incorporated by reference from the Form 8-K filed with the SEC
                on
                March 3, 2006. File No. 333-68532.10.7
            
            Security
                Agreement dated February 28, 2006 (Laurus Master Fund, LTD) incorporated
                by reference from the Form 8-K filed with the SEC on March 3, 2006.
                File
                No. 333-68532.10.8
            
            Common
                Stock Purchase Warrant dated February 28, 2006 (Laurus Master Fund,
                LTD)
                incorporated by reference from the Form 8-K filed with the SEC on
                March 3,
                2006. File No. 333-68532.10.9
            
            Financing
                Agreement, dated as of March 20, 2006 Horizon Financial Services
                Group
                USA) incorporated by reference from the Form 8-K filed with the SEC
                on
                March 23, 2006. File No. 333-68532.10.10
            
            Employment
                Agreement (Matise) dated March 27, 2006 incorporated by reference
                from the
                Form 8-K filed with the SEC on March 30, 2006. File No.
                333-68532.10.11
            
            Securities
                Purchase Agreement dated as of June 9, 2006 by and between Small
                World
                Kids, Inc. and Purchasers of the Company’s Class A-1 Convertible Preferred
                Stock incorporated by reference from the Form 8-K filed with the
                SEC on
                June 14, 2006. File No. 333-68532.10.12
            
            Registration
                Rights Agreement dated as of June 9, 2006 by and between Small World
                Kids,
                Inc. and Purchasers of the Company’s Class A-1 Convertible Preferred Stock
                incorporated by reference from the Form 8-K filed with the SEC on
                June 14,
                2006. File No. 333-68532.10.13
            
            Third
                Amendment to the Note Purchase Agreement dated June 9, 2006 by and
                between
                Small World Kids, Inc. and St. Cloud Capital Partners L.P. incorporated
                by
                reference from the Form 8-K filed with the SEC on June 14, 2006.
                File No.
                333-68532.10.14
            
            Conversion
                Agreement dated as of May 26, 2006 between the Company and HIT Credit
                Union incorporated by reference from the Form 8-K filed with the
                SEC on
                June 14, 2006. File No. 333-68532.10.15
            
            Conversion
                Agreement dated as of May 26, 2006 between the Company and PCCW
                Credit Union incorporated by reference from the Form 8-K filed with
                the
                SEC on June 14, 2006. File No. 333-68532.10.16
            
            Conversion
                Agreement dated as of May 26, 2006 between the Company and Hong Kong
                League Central Credit Union incorporated by reference from the Form
                8-K
                filed with the SEC on June 14, 2006. File No.
                333-68532.10.17
            
            Conversion
                Agreement dated as of May 26, 2006 between the Company and certain
                lenders ($500,000) incorporated by reference from the Form 8-K filed
                with
                the SEC on June 14, 2006. File No. 333-68532.10.18
            
            Conversion
                Agreement dated as of May 26, 2006 between the Company and SWT, LLC
                incorporated by reference from the Form 8-K filed with the SEC on
                June 14,
                2006. File No. 333-68532.10.19
            
            Conversion
                Agreement dated as of May 26, 2006 between the Company and certain
                lenders ($1,500,000) incorporated by reference from the Form 8-K
                filed
                with the SEC on June 14, 2006. File No. 333-68532.10.20
            
            Note
                Purchase Agreement dated as October 19, 2006 between the Company
                and
                certain lenders ($330,000) incorporated by reference from the Form
                8-K
                filed with the SEC on October 23, 2006. File No.
                333-68532.10.21
            
            Secured
                Convertible Note dated October 19, 2006 (Hong Kong League Central
                Credit
                Union) incorporated by reference from the Form 8-K filed with the
                SEC on
                October 23, 2006. File No. 333-68532.10.22
            
            Secured
                Convertible Note dated October 19, 2006 (Kershaw Mackie) incorporated
                by
                reference from the Form 8-K filed with the SEC on October 23, 2006.
                File
                No. 333-68532.10.23
            
            Common
                Stock Purchase Warrant dated October 19, 2006 (SBI Advisors) incorporated
                by reference from the Form 8-K filed with the SEC on October 23,
                2006.
                File No. 333-68532.10.24
            
            Registration
                Rights Agreement dated as of October 19, 2006 by and between Small
                World
                Kids, Inc. and Purchasers of the Secured Convertible Note incorporated
                by
                reference from the Form 8-K filed with the SEC on October 23, 2006.
                File
                No. 333-68532.10.25
            
            Overadvance
                Side Letter dated October 19, 2006 (Laurus Master Fund, LTD) incorporated
                by reference from the Form 8-K filed with the SEC on October 23,
                2006.
                File No. 333-68532.10.26
            
            Common
                Stock Purchase Warrant dated October 19, 2006 (Cambria LLC) incorporated
                by reference from the Form 8-K filed with the SEC on October 23,
                2006.
                File No. 333-68532.10.27
            
            Common
                Stock Purchase Warrant dated October 19, 2006 (David Fuchs) incorporated
                by reference from the Form 8-K filed with the SEC on October 23,
                2006.
                File No. 333-68532.10.28
            
            Amendment
                to Promissory Note to Former Shareholder dated November 6, 2006 by
                and
                between Small World Kids, Inc. and former shareholder of Small World
                Toys
                incorporated by reference from the Form 8-K filed with the SEC on
                November
                9, 2006. File No. 333-68532.10.29
            
            Omnibus
                Amendment No. 1, dated as of January 26, 2007 by and between Small
                World
                Kids, Inc. and Small World Toys, Inc. and Laurus Master Fund, Ltd.
                incorporated by reference from the Form 8-K filed with the SEC on
                January
                30, 2006. File No. 333-68532.10.30
            
            Second
                Amendment to Registration Rights Agreement, dated as of January 26,
                2007
                by and between Small World Kids, Inc. and Small World Toys, Inc.
                and
                Laurus Master Fund, Ltd. incorporated by reference from the Form
                8-K filed
                with the SEC on January 30, 2006. File No.
                333-68532.




44




10.32
            
            Common
                Stock Purchase Warrant Agreement dated as of January 26, 2007 by
                and
                between Small World Kids, Inc. and Laurus Master Fund, Ltd. incorporated
                by reference from the Form 8-K filed with the SEC on January 30,
                2006.
                File No. 333-68532.16.1
            
            Letter
                regarding change of certifying accountant incorporated by reference
                from
                the Form 8-K filed with the SEC on July 23, 2004. File No.
                333-68532.31.1
            
            Certification
                of the Chief Executive pursuant to Section 302 of the Sarbanes-Oxley
                Act
                of 200231.2
            
            Certification
                of the Chief Financial pursuant to Section 302 of the Sarbanes-Oxley
                Act
                of 200232.1
            
            Certification
                of the Chief Executive under Section 906 of the Sarbanes-Oxley Act
                of
                200232.2
            
            Certification
                of the Chief Financial Officer under Section 906 of the Sarbanes-Oxley
                Act
                of 2002





Each
      person whose signature appears below, constitutes and appoints Debra Fine with
      full power to act without the other, such person’s true and lawful
      attorney-in-fact, with full power of substitution and resubstitution, for him
      and in his name, place and stead, in any and all capacities, to sign this Annual
      Report on Form 10-K and any and all amendments to such report and other
      documents in connection therewith, and to file the same, and all exhibits
      thereto and other documents in connection therewith, with the Securities and
      Exchange Commission, granting unto said attorneys-in-fact, and each of them,
      full power and authority to do and perform each and every act and thing
      necessary or desirable to be done in and about the premises, as fully to all
      intents and purposes as he or she might or could do in person, thereby ratifying
      and confirming all that said attorneys-in-fact, or any of them, or their or
      his
      or her substitute or substitutes, may lawfully do or cause to be done by virtue
      hereof.





45


**SIGNATURES**





In
      accordance with the requirements of the Securities Act of 1933, the Company
      certifies that it has reasonable grounds to believe that it meets all of the
      requirements for filing this Annual Report on Form 10-K and has authorized
      this
      registration statement to be signed on its behalf by the undersigned, thereunto
      duly authorized, in Culver City, State of California on April
      11, 2007.





SMALL
                WORLD KIDS, INC.By:
            /s/
                Debra FineName:
                Debra Fine
                Title:
                  Chief Executive Officer





Pursuant
      to the requirements of the Securities Act of 1933, this report has been signed
      by the following persons in the capacities and on the dates
      indicated.





**Signature**
            
            **Title**
            
            **Date**/s/ Debra
                Fine
            
            Chairman,
                Chief Executive Officer and
            
            April
                11, 2007**Debra
                Fine**
            
            Director
                (Principal Executive Officer)/s/ Robert
                Rankin
            
            Chief
                Financial Officer (Principal Financial
            
            April
                11, 2007**Robert
                Rankin**
            
            and
                Accounting Officer)/s/ Gary
                Adelson
            
            Director
            
            April
                11, 2007**Gary
                Adelson**/s/ Alex
                Gerstenzang
            
            Director
            
            April
                11, 2007**Alex
                Gerstenzang**/s/ Eric
                Manlunus
            
            Director
            
            April
                11, 2007**Eric
                Manlunus**/s/ Lane
                Nemeth
            
            Director
            
            April
                11, 2007**Lane
                Nemeth**/s/ Shelly
                Singhal
            
            Director
            
            April
                11, 2007**Shelly
                Singhal**/s/ David
                Swartz
            
            Director
            
            April
                11, 2007**David
                Swartz**


46


**SMALL
      WORLD KIDS, INC.**


**INDEX
      TO CONSOLIDATED FINANCIAL STATEMENTS**





Report
                of Independent Registered Public Accounting Firm
            
            
            F-2Consolidated
                Balance Sheets as of December 31, 2006 and December 31,
                2005
            
            
            F-3Consolidated
                Statements of Operations for the Years Ended December 31, 2006 and
                2005
                and the periods May 21, 2004 to December 31, 2004 and January 1,
                2004 to
                May 20, 2004
            
            
            F-4Consolidated
                Statements of Stockholders’ Equity (Deficit) for the Years Ended December
                31, 2006 and 2005 and the periods May 21, 2004 to December 31, 2004
                and
                January 1, 2004 to May 20, 2004
            
            
            F-5Consolidated
                Statements of Cash Flows for the Years Ended December 31, 2006 and
                2005
                and the periods May 21, 2004 to December 31, 2004 and January 1,
                2004 to
                May 20, 2004
            
            
            F-6Notes
                to Condensed Consolidated Financial Statements
            
            
            F-7


F-1





**SMALL
      WORLD KIDS, INC.**





**REPORT
      OF INDEPENDENT REGISTERED PUBLIC ACCOUNTING FIRM**






To:
        The
        Board of Directors and Stockholders of Small World Kids, Inc.
 Culver
        City, California
  We
        have
        audited the accompanying consolidated  balance
        sheets of Small World Kids, Inc. and subsidiaries as of December 31, 2006
        and
        2005, and the related consolidated statements of income, stockholders’ equity,
        and cash flows for each of the three years in the period ended December 31,
        2006. These financial statements are the responsibility of the Company’s
        management. Our responsibility is to express an opinion on these financial
        statements based on our audits.
  We
        conducted our audits in accordance with the standards of the Public 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. We were not engaged to perform
        an
        audit of the Company’s internal control over financial reporting. Our audit
        included consideration of internal control over financial reporting as a
        basis
        for designing audit procedures that are appropriate in the circumstances,
        but
        not for the purpose of expressing an opinion on the effectiveness of the
        Company’s internal control over financial reporting. Accordingly, we express no
        such opinion. An audit also includes examining, on a test basis, evidence
        supporting the amounts and disclosures in the financial statements, 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 Small World Kids, Inc.
        and
        subsidiaries as of December 31, 2006 and 2005, and the results of its operations
        and its cash flows for each of the three years in the period ended December
        31,
        2006 in conformity with accounting principles generally accepted in the United
        States of America.
  The
        accompanying financial statements have been prepared in conformity with
        accounting principles generally accepted in the United States of America,
        which
        contemplate continuation of the company as a going concern. As discussed
        in Note
        2, the Company has incurred significant net losses since its inception and
        has
        an accumulated deficit of $22,957,661, and used cash from operating activities
        of $6,011,955 during the year ended December 31, 2006. The company has $804,000
        in principal debt obligations due in 2007, of which $152,000 in principal
        payments are not permitted to be paid while any amounts are outstanding of
        the
        Company’s $1,500,000 over advance. Failure to obtain additional financing or
        restructure the Company’s debt obligations may cause a default on these
        obligations, cross default obligations may cause acceleration of payments
        on the
        Company’s debt obligations. The foregoing matters raise substantial doubt about
        the ability of the Company to continue as a going concern. Management's plans
        in
        regard to these matters are described in Note 2 of the accompanying financial
        statements. These financial statements do not include any adjustments that
        might
        result from the outcome of these uncertainties.
  As
        discussed in Note 3 to the consolidated financial statements, in 2006 the
        Company adopted Statement of Financial Accounting Standards No. 123 (Revised
        2004), Share-Based Payments
   /s/
        Stonefield Josephson, Inc.
 Los
        Angeles, California
 April
        10,
        2007  F-2


**SMALL
      WORLD KIDS, INC.**





**CONSOLIDATED
      BALANCE SHEETS**





**December 31,**
              **2006**
            
            **December 31,**
              **2005****ASSETS**Current
                assets:Cash
            
            $
            154,690
            
            $
            524,418Accounts
                receivable - net of allowances of $291,000 and $350,000,
                respectively
            
            
            6,638,147
            
            
            7,142,141Inventory
            
            
            4,971,776
            
            
            4,529,864Prepaid
                expenses and other current assets
            
            
            524,931
            
            
            1,056,459Total
                current assets
            
            
            12,289,544
            
            
            13,252,882Property
                and equipment, net
            
            
            333,276
            
            
            491,123Goodwill
            
            
            2,767,117
            
            
            2,477,117Other
                intangible assets, net
            
            
            2,633,301
            
            
            3,105,005Debt
                issuance costs
            
            
            2,095,101
            
            
            128,954Other
                assets
            
            
            53,759
            
            
            55,312Total
                assets
            
            $
            20,172,098
            
            $
            19,510,393**LIABILITIES
                AND STOCKHOLDERS’ EQUITY (DEFICIT)**Current
                Liabilities:Accounts
                payable
            
            $
            3,947,484
            
            $
            3,690,970Accrued
                liabilities
            
            
            1,894,190
            
            
            2,153,008Current
                portion of long-term debt
            
            
            597,844
            
            
            11,290,741Current
                portion of notes payable to related parties
            
            
            205,843
            
            
            675,119Warrant
                liability
            
            
            1,446,983
            
            
            688,698Total
                current liabilities
            
            
            8,092,344
            
            
            18,498,536Long-term
                debt
            
            
            13,182,486
            
            
            249,370Total
                liabilities
            
            
            21,274,830
            
            
            18,747,906Commitments
                and Contingencies (Note 8)Stockholders
                equity (deficit):Convertible
                Preferred Stock, no par, 15,000,000 Authorized:12,000,000
                shares of 6% Class A-1 Authorized and 10,312,703 Issued and Outstanding
                and 5,000,000 shares of 10% Class A Authorized and 2,500,000 Issued
                and
                Outstanding, respectively
            
            
            10,972,381
            
            
            4,992,080Common
                Stock, $.001 par value:Authorized
                - 100,000,000 shares
              Outstanding
                - 5,410,575 shares and 5,410,575 shares, respectively
            
            
            5,411
            
            
            5,411Additional
                paid-in capital
            
            
            10,500,475
            
            
            5,786,596(Accumulated
                deficit)
            
            
            (22,580,999
            )
            
            (10,021,600
            )Total
                stockholders’ equity (deficit)
            
            
            (1,102,732
            )
            
            762,487Total
                liabilities and stockholders’ equity (deficit)
            
            $
            20,172,098
            
            $
            19,510,393





*See
      Accompanying Notes to Consolidated Financial Statements.*


F-3


**SMALL
      WORLD KIDS, INC.**





**CONSOLIDATED
      STATEMENTS OF OPERATIONS**





**Successor**
            
            **Predecessor****Year Ended**
              **December 31,**
              **2006**
            
            **Year
                Ended**
              **December 31,**
              **2005**
            
            **May 21 -**
              **December 31,**
              **2004**
            
            **January 1 -**
              **May 20,**
              **2004**Net
                Sales
            
            $
            28,331,394
            
            $
            33,755,929
            
            $
            19,156,388
            
            $
            10,336,500Cost
                of sales
            
            
            17,561,159
            
            
            20,619,047
            
            
            11,610,502
            
            
            5,780,780Gross
                profit
            
            
            10,770,235
            
            
            13,136,882
            
            
            7,545,886
            
            
            4,555,720Operating
                expenses:Selling,
                general and administrative
            
            
            13,406,900
            
            
            14,793,258
            
            
            7,821,961
            
            
            4,341,565Research
                and development
            
            
            1,742,937
            
            
            1,972,343
            
            
            800,331
            
            
            373,034Amortization
                of intangibles
            
            
            471,703
            
            
            452,252
            
            
            190,372
            
            
            —Total
                operating expenses
            
            
            15,621,540
            
            
            17,217,853
            
            
            8,812,664
            
            
            4,714,599Loss
                from operations
            
            
            (4,851,305
            )
            
            (4,080,971
            )
            
            (1,266,778
            )
            
            (158,879
            )Other
                income (expense):Interest
                expense
            
            
            (4,234,070
            )
            
            (3,521,012
            )
            
            (927,499
            )
            
            (61,475
            )Debt
                discount upon conversion of notes
            
            
            (1,077,034
            )
            
            —
            
            
            —
            
            
            —Warrant
                repricing and adjustment
            
            
            (1,628,440
            )
            
            —
            
            
            —
            
            
            —Warrant
                valuation adjustment
            
            
            1,556,879
            
            
            291,113
            
            
            114,916
            
            
            —Other
            
            
            218,272
            
            
            247,870
            
            
            372,680
            
            
            81,850Total
                other income (expense)
            
            
            (5,164,393
            )
            
            (2,982,029
            )
            
            (439,903
            )
            
            20,375
            )Loss
                before income taxes
            
            
            (10,015,698
            )
            
            (7,063,000
            )
            
            (1,706,681
            )
            
            (138,504
            )Provision
                (benefit from) for income taxes
            
            
            **—**
            
            
            (292,419
            )
            
            (623,695
            )
            
            (3,643
            )Net
                loss
            
            
            (10,015,698
            )
            
            (6,770,581
            )
            
            (1,082,986
            )
            
            (134,861
            )Non-cash
                preferred stock dividend
            
            
            (2,543,701
            )
            
            (2,168,033
            )
            
            **—**
            
            
            **—**Net
                loss attributable to common shareholder
            
            $
            (12,559,399
            )
            $
            (8,938,614
            )
            $
            (1,082,986
            )
            $
            (134,861
            )Loss
                per share:Basic
                & diluted
            
            $
            (2.32
            )
            $
            (1.67
            )
            $
            (0.21
            )
            $
            (13.49
            )Weighted
                average number of shares:Basic
                & diluted
            
            
            5,410,575
            
            
            5,363,961
            
            
            5,277,986
            
            
            10,000





*See
      Accompanying Notes to Consolidated Financial Statements.*


F-4


**SMALL
      WORLD KIDS, INC.**





**CONSOLIDATED
      STATEMENTS OF STOCKHOLDERS EQUITY**




**Preferred**
            
            **Common Stock****Shares**
            
            **Amount**
            
            **Shares**
            
            **Amount**
            
            **Additional**
              **Paid-in**
              **Capital**
            
            **Retained**
              **Earnings**
            
            **Total****Balance
                at January 1, 2004 (Predecessor)**
            
            —
            
            —
            
            10,000
            
            10,000
            
            —
            
            3,403,127
            
            3,413,127Sale
                of predecessor company
            
            —
            
            —
            
            (10,000
            )
            (10,000
            )
            —
            
            (3,268,266
            )
            (3,278,266
            )Net
                income (loss)
            
            —
            
            —
            
            —
            
            —
            
            —
            
            (134,861
            )
            (134,861
            )**Balance
                at May 20, 2004**
            
            —
            
            —
            
            —
            
            —
            
            —
            
            —
            
            —Contributed
                capital
            
            —
            
            —
            
            —
            
            —
            
            11,821
            
            —
            
            11,821Issuance
                of common shares in recapitalization
            
            —
            
            —
            
            5,247,075
            
            5,247
            
            (5,247
            )
            —
            
            —Issuance
                of common shares in debt transaction
            
            —
            
            —
            
            65,000
            
            65
            
            —
            
            —
            
            65Net
                income (loss)
            
            —
            
            —
            
            —
            
            —
            
            —
            
            (1,082,986
            )
            (1,082,986
            )**Balance
                at December 31, 2004**
            
            —
            
            —
            
            5,312,075
            
            5,312
            
            6,574
            
            (1,082,986
            )
            (1,071,100
            )Issuance
                of Series A Convertible Preferred Stock
            
            250,000
            
            4,992,080
            
            —
            
            —
            
            —
            
            —
            
            4,992,080Net
                issuances under stock plans
            
            
            
            —
            
            16,000
            
            16
            
            79,984
            
            —
            
            80,000Stock
                compensation
            
            —
            
            —
            
            —
            
            —
            
            535,213
            
            —
            
            535,213Common
                stock issuance related to acquisitions
            
            —
            
            —
            
            50,000
            
            50
            
            244,950
            
            —
            
            245,000Common
                stock and warrants issued in connection with debt
                financing
            
            —
            
            —
            
            32,500
            
            33
            
            219,817
            
            —
            
            219,850Beneficial
                conversion feature related to issuance of Convertible
                Debentures
            
            —
            
            —
            
            —
            
            —
            
            1,335,025
            
            —
            
            1,335,025Warrants
                issued in connection with extension of notes payable
            
            —
            
            —
            
            —
            
            —
            
            556,958
            
            —
            
            556,958Non-cash
                dividend related to warrants issued and the beneficial conversion
                feature
                related to the issuance of convertible preferred stock
            
            
            
            
            
            
            
            
            
            2,168,033
            
            (2,168,033
            )
            —Reclassification
                of warrant liability
            
            —
            
            —
            
            —
            
            —
            
            509,185
            
            —
            
            509,185Reclassification
                of stock liability
            
            —
            
            —
            
            —
            
            —
            
            324,350
            
            —
            
            324,350Accrued
                dividends on convertible preferred stock
            
            —
            
            —
            
            —
            
            —
            
            (193,494
            )
            —
            
            —Net
                income (loss)
            
            —
            
            —
            
            —
            
            —
            
            —
            
            (6,770,581
            )
            (6,770,581
            )**Balance
                at December 31, 2005**
            
            250,000
            
            $
            4,992,080
            
            5,410,575
            
            $
            5,411
            
            $
            5,786,595
            
            $
            (10,021,600
            )
            $
            762,486Stock
                compensation
            
            
            
            
            
            
            
            
            
            
            
            
            547,107
            
            
            
            
            
            547,107Accrued
                dividends on Class A convertible preferred stock
            
            
            
            
            
            
            
            
            
            
            
            
            (205,480
            )
            
            
            
            
            (205,480
            )Accrued
                dividends on Class A-1 convertible preferred stock
            
            
            
            
            
            
            
            
            
            
            
            
            (374,602
            )
            
            
            
            
            (374,602
            )Non-cash
                dividend related to the beneficial conversion feature related to
                the
                issuance of convertible preferred stock
            
            
            
            
            
            
            
            
            
            
            
            
            2,543,701
            
            
            (2,543,701
            )Conversion
                of Class A convertible preferred
            
            (250,000
            )
            
            (4,992,080
            )
            
            
            
            
            
            
            
            
            
            
            
            
            (4,992,080
            )Issuance
                of Class A-1 convertible preferred
            
            2,640,909
            
            
            2,837,481
            
            
            
            
            
            
            
            
            
            
            
            
            
            2,837,481Conversion
                of debt and Class A into Class A-1 convertible
                preferred
            
            7,671,794
            
            
            8,438,973
            
            
            
            
            
            
            
            
            
            
            
            
            
            8,438,973Warrants
                issued in connection with issuance of Class A-1 preferred
            
            
            
            
            (304,073
            )
            
            
            
            
            
            
            304,073Reclassification
                of warrant liability
            
            
            
            
            
            
            
            
            
            
            
            
            270,641
            
            
            
            
            
            270,641Repriced
                and additional warrants issued related to convertible
                debenture
            
            
            
            
            
            
            
            
            
            
            
            
            1,628,440
            
            
            
            
            
            1,628,440Net
                loss
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            (10,015,698
            )
            
            (10,015,698
            )**Balance
                at December 31, 2006**
            
            10,312,703
            
            $
            10,972,381
            
            5,410,575
            
            $
            5,411
            
            $
            10,500,475
            
            $
            (22,580,999
            )
            $
            (1,102,732
            )





*See
      Accompanying Notes to Consolidated Financial Statements.*


F-5


**SMALL
      WORLD KIDS, INC.**





**CONDENSED
      CONSOLIDATED STATEMENTS OF CASH FLOWS**





**Successor**
            
            **Predecessor****Year
                Ended**
              **December 31,**
              **2006**
            
            **Year
                Ended**
              **December 31,**
              **2005**
            
            **May
                21 -**
              **December
                31, 2004**
            
            **January 1
                -**
              **May 20,
                2004****Cash
                flows from operating activities:**Net
                loss
            
            $
            (10,015,698
            )
            $
            (6,770,581
            )
            $
            (1,082,986
            )
            $
            (134,861
            )Adjustments
                to reconcile net loss to net cash used in operating
                activities:Depreciation
            
            
            176,706
            
            
            228,219
            
            
            111,685
            
            
            62,325Amortization
                of intangibles
            
            
            471,704
            
            
            452,252
            
            
            190,372
            
            
            —Non-cash
                compensation expense
            
            
            547,107
            
            
            535,213
            
            
            —
            
            
            —Non-cash
                interest expense
            
            
            2,585,880
            
            
            1,524,216
            
            
            214,397Non-cash
                debt discount upon conversion of notes
            
            
            1,077,034
            
            
            —
            
            
            —
            
            
            —Non-cash
                warrant repricing and adjustment
            
            
            1,628,440
            
            
            —
            
            
            —
            
            
            —Change
                in fair value of warrant liability
            
            
            (1,556,878
            )
            
            (291,112
            )
            
            (114,916
            )
            
            —Changes
                in operating assets and liabilities in:Receivables
            
            
            503,994
            
            
            (136,377
            )
            
            1,224,770
            
            
            (3,507,170
            )Inventories
            
            
            (441,912
            )
            
            (2,058,308
            )
            
            353,777
            
            
            1,445,781Prepaid
                expenses and other assets
            
            
            285,027
            
            
            676,605
            
            
            (651,144
            )
            
            182,695Accounts
                payable
            
            
            256,514
            
            
            1,882,333
            
            
            1,012,666
            
            
            (2,052,019
            )Accrued
                liabilities
            
            
            (838,900
            )
            
            1,145,314
            
            
            (22,530
            )
            
            (56,155
            )Other
            
            
            (690,973
            )
            
            51,813
            
            
            (759,832
            )
            
            66,584Net
                cash used in operating activities
            
            
            (6,011,955
            )
            
            (2,760,413
            )
            
            476,259
            
            
            (3,992,820
            )**Cash
                flows from investing activities:**Purchases
                of property and equipment
            
            
            (18,859
            )
            
            (214,283
            )
            
            (134,005
            )
            
            (81,372
            )Acquisitions
                of businesses, net of cash acquired
            
            
            —
            
            
            (133,429
            )
            
            (6,386,432
            )Net
                cash used in investing activities
            
            
            (18,859
            )
            
            (347,712
            )
            
            (6,520,437
            )
            
            (81,372
            )**Cash
                flows from financing activities:**Short-term
                debt borrowings (payments), net of expenses
            
            
            (11,704,543
            )
            
            625,379
            
            
            1,129,262
            
            
            4,200,000Long-term
                debt borrowings (payments), net of expenses
            
            
            11,427,092
            
            
            1,492,080
            
            
            8,200,000
            
            
            —Payments
                to former shareholder
            
            
            (345,837
            )
            
            (350,000
            )
            
            (1,500,000
            )
            
            (76,393
            )Proceeds
                from equity stock issuances
            
            
            2,837,481
            
            
            80,000
            
            
            —
            
            
            —Conversion
                of debt into Class A-1
            
            
            3,446,893
            
            
            —
            
            
            —
            
            
            —Net
                cash provided by financing (used for) activities
            
            
            5,661,086
            
            
            1,847,459
            
            
            7,829,262
            
            
            4,123,607Net
                increase (decrease) in cash
            
            
            (369,728
            )
            
            (1,260,666
            )
            
            1,785,084
            
            
            49,415Cash
                - beginning of period
            
            
            524,418
            
            
            1,785,084
            
            
            —
            
            
            24,202Cash
                - end of period
            
            $
            154,690
            
            $
            524,418
            
            $
            1,785,084
            
            $
            73,617**Supplemental
                cash flow information:**Cash
                payments for interest
            
            $
            1,404,768
            
            $
            1,557,753
            
            $
            488,323
            
            $
            70,462**Non-cash
                investing and financing activities:**Fair
                value of warrant issuances related to debt financing (Note
                6)
            
            $
            2,585,804
            
            
            —
            
            
            —
            
            
            —Non-cash
                dividend associated with the in-the-money conversion feature of
                convertible preferred stock issuance (Note 7)
            
            $
            2,554,682
            
            $
            2,168,033
            
            
            —
            
            
            —Fair
                value of stock granted for acquisition
            
            
            —
            
            $
            245,000
            
            
            —
            
            
            —





*See
      Accompanying Notes to Consolidated Financial Statements.*


F-6





**SMALL
      WORLD KIDS, INC.**





**NOTES
      TO CONSOLIDATED FINANCIAL STATEMENTS**





**NOTE
      1**  **BASIS
      OF CONSOLIDATION**





As
      a
      result of the May 20, 2004 transactions described in the following
      paragraph, the Company had a change in management, controlling shareholders,
      financial position and business plan.





On
      May 20, 2004, Small World Kids, Inc., formerly SavOn Team
      Sports, Inc. (“Small World”, “SWK” or the “Company”) executed an Exchange
      Agreement (the “Agreement”) whereby SWK issued common stock in exchange for all
      of the equity interests of Fine Ventures, LLC (“FVL”). Prior to the Agreement,
      SWK was considered a shell company as it had minimal net assets and operations.
      As the shareholders of FVL control the Company subsequent to the transaction,
      the Agreement was accounted for as a purchase by FVL of SWK and the financial
      statements presented for the Company are a continuation of FVL. Simultaneously
      SWK acquired all of the issued shares of Small World Toys, Inc. (“SWT”) in
      a transaction accounted for as a purchase resulting in a change in management,
      controlling shareholders, financial position and business plan of SWT. As such,
      SWT is considered to be the predecessor business and SWK the successor for
      accounting purposes. As SWK is considered a holding company because it currently
      has no significant business operations or assets other than SWT, the predecessor
      company’s results of operations are also presented for comparative
      purposes.





On
      October 14, 2005 the Company completed a ten for one (10:1) reverse stock
      split (“Reverse Split”). As of the date of the Reverse Split, there were
      54,105,750 shares of the Company’s Common Stock outstanding. Immediately after
      the split there were 5,410,575 Common shares outstanding. Accordingly, all
      references to units of securities (e.g. shares of Common Stock) or per share
      amounts are reflective of the Reverse Split for all periods
      reported.





**NOTE
      2**  **SUMMARY
      OF SIGNIFICANT ACCOUNTING POLICIES**





These
      financial statements have been prepared in accordance with U.S. GAAP, assuming
      that the Company will continue as a going concern. As such, the financial
      statements do not include any adjustments to reflect possible future effects
      of
      the recoverability and classification of assets or the amounts and
      classification of liabilities that may result from liquidity uncertainties
      or
      any future decisions made with respect to the Company’s strategic
      alternatives.





As
      of
      December 31, 2006, we had $804,000 in principal payments due during the next
      twelve months to Laurus, Horizon, St. Cloud and the former shareholder of Small
      World Toys. Of the $804,000 in principal payments due in 2007, the Company
      is
      not permitted by Laurus to pay the $152,000 in principal payments due to St.
      Cloud in 2007 while any amounts are outstanding on the $1,500,000 overadvance.
      We may not be able to generate sufficient cash flow from operations to meet
      our
      debt and operational obligations. If we are unable to generate sufficient cash
      flow, we would be required to seek additional financing or restructure our
      debt
      obligations. There can be no assurance that we will be able to obtain additional
      financing or restructuring our debt obligations or that, if we were to be
      successful in obtaining additional financing or restructure our debt
      obligations, it would be on favorable terms. Failure to obtain additional
      financing or restructuring our debt obligations may cause us to default on
      these
      debt obligations. In addition, under cross default provisions in the Laurus
      Security Agreement, defaults under our debt obligations may cause the
      acceleration of the repayment of the Revolving and Term Notes. This raises
      substantial doubt about the Company’s ability to continue as a going concern for
      a reasonable period of time. Management has and will continue to pursue the
      following actions: (i) reducing operating expenses; (ii) seeking to obtain
      new
      equity; and (iii) restructuring the debt obligations.





***Use
      of Estimates***





The
      preparation of financial statements in conformity with generally accepted
      accounting principles in the United States requires management to make estimates
      and assumptions that affect the amounts reported in the financial statements
      and
      the accompanying notes during the reporting period. Estimates in these financial
      statements may include but are not limited to inventory valuations, sales
      returns reserves, allowance for doubtful accounts receivable, income taxes
      and
      other contingent liabilities. Actual results could differ from those
      estimates.





***Segments
      of an Enterprise and Related Information***





The
      Company follows SFAS No. 131, “Disclosures about Segments of an Enterprise and
      Related Information.” SFAS No. 131 requires that a public business enterprise
      report financial and descriptive information about its reportable operating
      segments on the basis that is used internally for evaluating segment performance
      and deciding how to allocate resources to segments. We sell developmental toys
      including over 800 toy products for the baby to approximately 7 years old
      including blocks, balls, sorters, regular and bilingual puzzles, doll houses
      and
      castles with accessories, wooden appliances with bakery, utensil and realistic
      food replication, dolls and outdoor sports equipment and activities. We have
      one
      segment which meets the quantitative thresholds for reportable segments. Our
      international sales accounted for approximately $1,037,000 or 3.7% and
      $1,097,000 or 3.2 % of our net sales in 2006 and 2005, respectively




F-7





**Revenue
      Recognition**





We
      recognize revenue when all four revenue recognition criteria have been met:
      persuasive evidence of an arrangement exists, the product has been delivered
      or
      the service has been rendered, the price is fixed or determinable and collection
      is probable. We recognize revenue from product sales upon when all of the
      foregoing conditions are met which in general is at the time of shipment where
      the risk of loss and title has passed to the customer. However, for certain
      shipments such as direct shipments from our vendors to our customers or where
      we
      use consolidators to deliver our products (usually export shipments) revenue
      is
      recognized in accordance with the sales terms specified by the respective sales
      agreements.





Sales
      allowances for customer promotions, discounts and returns are recorded as a
      reduction of revenue when the related revenue is recognized. We routinely commit
      to promotional sales allowance programs with our customers. These allowances
      primarily relate to fixed programs, which the customer earns based on purchases
      of our products during the year. Discounts are recorded as a reduction of
      related revenue at the time of sale. Sales to customers are generally not
      subject to any price protection or return rights.





We
      offer
      extended terms to some of our customers in the first three quarters of the
      year
      by way of sales promotions whereby payment will not become due until the fourth
      quarter if a specified purchase threshold has been met. This promotion allows
      us
      to capture additional shelf space and to capture more of the annual budgets
      of
      our retail customers. The result of this promotion gives rise to a significant
      increase in accounts receivable through the fourth quarter until substantially
      all accounts become due and are collected. Based upon historically low rates
      of
      return and collection of substantially all of these extended term accounts,
      we
      have determined that revenue is appropriately recognized in accordance with
      its
      normal procedures described above.





***Advertising
      Costs***





All
      advertising costs are expensed as incurred and charged to operations within
      Selling, General and Administrative expenses. Such costs were $176,000, $137,000
      and $129,000 for the years ended December 31 2006, December 31, 2005 and
      December 31 2004, respectively.





***Shipping
      and Handling***





All
      shipping and handling costs related to sales to customers are expensed as
      incurred and charged to Selling, General and Administrative expenses. These
      expenses were $2.6 million and $3.1 million for the years ended December 31
      2006 and December 31 2005, respectively. We typically charge customers for
      freight out, except those vendors who qualify under the dating promotional
      programs, for orders over $1,000 or under fixed terms.




***Barter
      Transaction***





In
      fiscal
      year 2004, the Company exchanged $351,000 of excess inventory for advertising,
      travel and other barter credits valued by the barter provider at the cost of
      inventory. The Company recorded the barter credits as a prepaid expense at
      the
      $351,000 market value of the inventory exchanged. Additionally, in accordance
      with Emerging Issues Task Force No. 99-17, “Accounting for Advertising
      Barter Transactions,” the Company accounted for this transaction as a sale,
      recording revenue and cost of sales of $351,000 leaving no net impact to income.
      The Company did not use any credits in 2005 and only $3,000 of barter credits
      for travel in 2004. Since there were no assurances that the company would
      utilize these credits before they expired at the end of 2006, the Company
      determined that the realizability of the credits could not be assured and
      therefore wrote off the credits in 2005.





***Foreign
      Currency and International Operations***





The
      Company has no significant foreign assets. Almost all of our purchases are
      in US
      dollar denominations. Our nominal foreign currency transaction exposures include
      gains and losses realized on unhedged inventory purchases that are denominated
      in a currency other than the applicable functional currency.





***Cash
      and Cash Equivalents, Short and Long-Term Investments***





For
      purposes of cash flows, the Company considers all highly liquid investments
      purchased with a maturity of three months or less to be cash equivalents, those
      with original maturities not greater than three months and current maturities
      less than twelve months from the balance sheet date are considered short-term
      investments, and those with maturities greater than twelve months from the
      balance sheet date are considered long-term investments. The Company maintains
      bank accounts with balances which, at times, may exceed federally insured
      limits. The Company has not experienced any losses on such accounts. The Company
      believes it is not exposed to any significant risk on bank deposit accounts.
      As
      of December 31, 2006, the Company had cash balances of $155,000, of which
      individual bank accounts over $100,000 were not insured by the
      FDIC.




F-8





***Accounts
      Receivable***





The
      Company’s receivables are recorded when billed and represent claims against
      third parties that will be settled in cash. The carrying value of the Company’s
      receivables, net of the allowance for doubtful accounts, represents their
      estimated net realizable value. The Company evaluates the collectibility of
      accounts receivable on a customer-by-customer basis. The Company records a
      reserve for bad debts against amounts due to reduce the net recognized
      receivable to an amount the Company believes will be reasonably collected.
      The
      reserve is a discretionary amount determined from the analysis of the aging
      of
      the accounts receivables, historical experience and knowledge of specific
      customers.





**Year
                Ended**
              **December 31****2006**
            
            **2005**Trade
                Receivables
            
            $
            6,929,389
            
            $
            7,492,141Less:
                Allowances for doubtful accounts
            
            
            (291,242
            )
            
            (350,000
            )Accounts
                receivable, net
            
            $
            6,638,147
            
            $
            7,142,141





***Inventory***





Inventory
      is valued at the lower of average cost or market. Inventory costs consist of
      the
      purchases of finished goods from our vendors and the associated costs necessary
      to obtain those inventories. As necessary, we write down inventory to its
      estimated market value based on assumptions about future demand and market
      conditions. Failure to accurately predict and respond to consumer demand could
      result in the under production of popular items or overproduction of less
      popular items which may require additional inventory write-downs which could
      materially affect our future results of operations.





***Property
      and Equipment***





Property
      and equipment are recorded at cost and are depreciated over the estimated useful
      lives of the assets using the straight-line method. Estimated useful lives
      for
      financial reporting purposes are as follows: furniture and fixtures, five to
      seven years; computer hardware and software, three years; leasehold
      improvements, over the shorter of five years or the lease term. The cost and
      related accumulated depreciation of all property and equipment retired or
      otherwise disposed of are removed from the accounts. Any gain or loss is
      recognized in the current period. Various accelerated methods are used for
      tax
      purposes.





Maintenance
      and repair costs are charged to expense as incurred, and renewals and
      improvements that extend the useful lives of the assets are capitalized and
      added to the property and equipment.





Property
      and equipment consist of the following:





**December 31,**
              **2006**
            
            **December 31,**
              **2005**Computer
                equipment
            
            $
            334,295
            
            $
            324,436Mold
                cost
            
            
            246,706
            
            
            246,706Warehouse
                equipment
            
            
            93,249
            
            
            93,249Furniture
                and fixtures
            
            
            78,930
            
            
            69,930Leasehold
                improvements
            
            
            67,207
            
            
            96,706820,387
            
            
            831,027Less:
                accumulated depreciation and amortization
            
            
            (487,111
            )
            
            (339,904
            )Property
                and equipment, net
            
            $
            333,276
            
            $
            491,123





Depreciation
      expense for the years ended December 31, 2006 and 2005 was approximately
      $177,000 and $228,000 respectively.





***Intangible
      Assets***





We
      evaluate long-lived assets whenever events or changes in business circumstances
      or our planned use of assets indicate that their carrying amounts may not be
      fully recoverable or that their useful lives are no longer appropriate. 
Reviews are performed to determine whether the carrying values of assets are
      impaired based on comparison to either the fair value in the case of goodwill
      or
      to the undiscounted expected future cash flows for all other long-lived
      assetsand amortizable intangible assets.  If the comparison indicates that
      impairment exists, the impaired asset is written down to its fair value. 
Significant management judgment is required in the forecast of future operating
      results that are used in the preparation of expected discounted and undiscounted
      cash flows.




F-9





In
      accordance with SFAS 142, goodwill shall be at a minimum, tested for impairment
      annually. The first of the impairment tests consists of a comparison of the
      total fair value of the Company based upon the closing stock price and the
      Company’s net assets on the date of the test. If the fair value is in excess of
      the net assets, there is no indication of impairment and no need to perform
      the
      second tier impairment test. The Company performed this test as of the end
      of
      the Second Quarter, the second year mark of the purchase of Small World Toys
      which resulted in the recording of the goodwill carried on the Company’s books.
      As the market value of the Company significantly exceeded the net assets of
      the
      Company, there is no indication of impairment and no adjustment was required
      to
      be made.




All
      other
      intangible assets are to be tested for impairment when a triggering event has
      occurred. In accordance with SFAS 142, the Company reviewed for impairment
      the
      fair value of the intangible assets acquired from Imagiix in June 2005. In
      2006,
      the Company shipped approximately $331,000 in Imagiix products and approximately
      met the projections used for the valuation of the assets acquired. As such,
      there is no indication of impairment and no adjustment was required to be
      made.





The
      Company also performed an impairment test as of September 2006 for the fair
      value of the assets acquired from Neurosmith LLC in September 2004. The
      Company sold $1.1 million and $1.2 million in Neurosmith products in 2006 and
      2005, respectively. These sales approximately meet the projections used for
      the
      valuation of the assets acquired. As such, there is no indication of impairment
      and no adjustment was required to be made.





Components
      of the Company’s identifiable amortizable intangible assets are as follows (in
      thousands):





**December 31,
                2006**
            
            **December 31,
                2005****Gross**
              **Carrying**
              **Amount**
            
            **Accumulated**
              **Amortization**
            
            **Net**
            
            **Gross**
              **Carrying**
              **Amount**
            
            **Accumulated**
              **Amortization**
            
            **Net**Trade
                names
            
            $
            2,092,839
            
            $
            520,270
            
            $
            1,572,569
            
            $
            2,092,839
            
            $
            314,025
            
            $
            1,778,814Customer
                lists
            
            
            1,155,685
            
            
            299,974
            
            
            855,711
            
            
            1,155,685
            
            
            152,854
            
            
            1,002,831Purchased
                technology
            
            
            320,971
            
            
            147,083
            
            
            173,888
            
            
            320,971
            
            
            82,912
            
            
            238,059Non-compete
                agreement
            
            
            162,549
            
            
            131,416
            
            
            31,133
            
            
            162,549
            
            
            77,248
            
            
            85,301Total
            
            $
            3,732,044
            
            $
            1,098,743
            
            $
            2,633,301
            
            $
            3,732,044
            
            $
            627,039
            
            $
            3,105,005





Amortization
      expense of intangible assets for the years ended December 31, 2006 and 2005
      was approximately $472,000 and $452,000 respectively. Estimated
      amortization expense for the next five succeeding fiscal years and all years
      thereafter are as follows:





****
            
            **Estimated**
              **Amortization**
              **Expense**2007
            
            $
            449,0002008
            
            
            418,0002009
            
            
            399,0002010
            
            
            353,0002011
            
            
            353,000Thereafter
            
            
            661,000Total
            
            $
            2,633,000





At
      December 31, 2006, the weighted average amoritization period remaining for
      the
      intangible assets was
      6.6
      years.





***Prepaid
      expenses and other current assets***





Prepaid
      expenses and other current assets include prepaid material, insurance, marketing
      and other prepaid expenses and miscellaneous items as follows:





**December 31,**
              **2006**
            
            **December 31,**
              **2005**Design
                and packaging expenses
            
            $
            —
            
            $
            395,709Prepaid
                material purchases
            
            
            92,937
            
            
            —Prepaid
                insurance
            
            
            106,537
            
            
            157,331Prepaid
                marketing fees
            
            
            218,050
            
            
            77,161Miscellaneous
                prepaid expenses and other current assets
            
            
            107,407
            
            
            426,258Total
            
            $
            524,931
            
            $
            1,056,459





F-10




***Major
      Vendors***





During
      the year ended December 31, 2006, our top ten suppliers accounted for 74.1
      % of the total product purchases. The top two suppliers accounted for 20.9%
      and
      10% of total purchases, respectively. Our tools and dies are located at the
      facilities of our third-party manufacturers.





During
      the year ended December 31, 2005, our top ten suppliers accounted for 64.7%
      of the total product purchases. The top two suppliers accounted for 11% and
      9%
      of total purchases, respectively.





***Recent
      Accounting Pronouncements***




In
      February 2007, the Financial Accounting Standards Board (“FASB”) issued
      Statement No. 159, “The Fair Value Option for Financial Assets and
      Financial Liabilities” (“SFAS No. 159”), provides companies with an option
      to report selected financial assets and liabilities at fair value. This
      Statement is effective as of the beginning of an entity’s first fiscal year
      beginning after November 15, 2007. Early adoption is permitted as of the
      beginning of the previous fiscal year provided that the entity makes that choice
      in the first 120 days of that fiscal year and also elects to apply the
      provisions of Statement 157. We are currently evaluating the potential impact
      of
      the adoption of SFAS 159 on our future consolidated financial
      statements.




In
      September 2006, the FASB issued SFAS No. 158, “Employers’ Accounting
      for Defined Benefit Pension and Other Postretirement Plans—an amendment of FASB
      Statements No. 87, 88, 106 and 132(R)” (“SFAS 158”). SFAS 158
      requires an employer that sponsors one or more single-employer defined benefit
      plans to (a) recognize the overfunded or underfunded status of a benefit
      plan in its statement of financial position, (b) recognize as a component
      of other comprehensive income, net of tax, the gains or losses and prior service
      costs or credits that arise during the period but are not recognized as
      components of net periodic benefit cost pursuant to SFAS No. 87,
“Employers’ Accounting for Pensions,” or SFAS No. 106, “Employers’
Accounting for Postretirement Benefits Other Than Pensions,” (c) measure
      defined benefit plan assets and obligations as of the date of the employer’s
      fiscal year-end, and (d) disclose in the notes to financial statements
      additional information about certain effects on net periodic benefit cost for
      the next fiscal year that arise from delayed recognition of the gains or losses,
      prior service costs or credits, and transition asset or obligation. An employer
      with publicly traded equity securities is required to initially recognize the
      funded status of a defined benefit postretirement plan and to provide the
      required disclosures as of the end of the fiscal year ending after December
      15,
      2006. The requirement to measure plan assets and benefit obligations as of
      the
      date of the employers fiscal year-end statement of financial position is
      effective for fiscal years ending after December 15, 2008. The Company is
      assessing the impact the adoption will have, but since we do not have a Defined
      Benefit Plan, we do not believe it will have a material impact on the Company’s
      financial position, results of operations or cash flows.




In
      September 2006, the Financial Accounting Standards Board (“FASB”) issued
      Statement of Financial Accounting Standards (“SFAS”) No. 157, “Fair Value
      Measurements” (“SFAS 157”). SFAS 157 clarifies the principle that fair
      value should be based on the assumptions market participants would use when
      pricing an asset or liability and establishes a fair value hierarchy that
      prioritizes the information used to develop those assumptions. SFAS 157 is
      effective for our fiscal year beginning January 1, 2007. We are currently
      evaluating the potential impact of the adoption of SFAS 157 on our future
      consolidated financial statements.




In
      September 2006, the Securities and Exchange Commission (“SEC”) issued Staff
      Accounting Bulletin No. 108, “Considering the Effects of Prior Year
      Misstatements when Quantifying Misstatements in Current Year Financial
      Statements” (“SAB 108”). SAB 108 provides interpretive guidance on how the
      effects of the carryover or reversal of prior year misstatements should be
      considered in quantifying a current year misstatement. The SEC staff believes
      that registrants should quantify errors using both a balance sheet and an income
      statement approach and evaluate whether either approach results in quantifying
      a
      misstatement that, when all relevant quantitative and qualitative factors are
      considered, is material. SAB 108 is effective for our  fiscal year ending
      December 31, 2006. The adoption of  SAB 108 will only impact our
      consolidated financial statements if we have misstatements in the
      future.




In
      July
      2006, the Financial Accounting Standards Board ("FASB") issued FASB
      Interpretation ("FIN") No. 48, *Accounting
      for Uncertainty in Income Taxes,* with
      respect to FASB Statement No. 109, *Accounting
      for Income Taxes,* regarding accounting for and disclosure of uncertain tax positions. FIN No.
      48
      is intended to reduce the diversity in practice associated with the recognition
      and measurement related to accounting for uncertainty in income taxes. This
      interpretation is effective for fiscal years beginning after December 15, 2006.
      We are currently evaluating the impact this interpretation will have on our
      financial statements. **




F-11


In
      March 2006, the FASB issued SFAS No. 156 “Accounting for Servicing of
      Financial Assets an amendment of FASB Statement No. 140”. FASB Statement
      No. 140, “Accounting for Transfers and servicing of Financial Assets and
      Extinguishments of Liabilities” establishing among other things, the accounting
      for all separately recognized servicing assets and servicing liabilities. This
      Statement amends Statement 140 to require that all separately recognized
      servicing assets and servicing liabilities be initially measured at fair value,
      if practicable. This Statement permits, but does not require, the subsequent
      measurement of separately recognized servicing assets and servicing liabilities
      at fair value. SFAS No. 156 is effective as of the beginning of the
      fiscal year that begins after September 15, 2006. The company will adopt
      SFAS 156 on January 1, 2007




In
      February 2006, the FASB issued SFAS No. 155, “Accounting for Certain
      Hybrid Financial Instruments” (“SFAS 155”), which amends SFAS No. 133,
“Accounting for Derivatives Instruments and Hedging Activities” (“SFAS 133”) and
      SFAS No. 140, “Accounting for Transfers and Servicing of Financial Assets
      and Extinguishment of Liabilities” (“SFAS 140”). SFAS 155 amends SFAS 133 to
      narrow the scope exception for interest-only and principal-only strips on debt
      instruments to include only such strips representing rights to receive a
      specified portion of the contractual interest or principle cash flows. SFAS
      155
      also amends SFAS 140 to allow qualifying special-purpose entities to hold a
      passive derivative financial instrument pertaining to beneficial interests
      that
      itself is a derivative instruments. The Company is currently evaluating the
      impact this new Standard, but believes that it will not have a material impact
      on the Company’s financial position, results of operations or cash flows. We
      will adopt SFAS 155 on January 1, 2007.




For
      the
      year ending December 31, 2007, under current rules, pursuant to
      Section 404 of the Sarbanes-Oxley Act, management will be required to
      deliver a report that assesses the effectiveness of our internal controls over
      financial reporting. The SEC issued a release in December 2006, however,
      announcing that the Commission has extended the date by which non-accelerated
      filers, which we currently are, must
      begin to comply with the Section 404(b) requirement to provide an auditor’s
      attestation report on internal controls over financial reporting. The deadline
      for the auditor’s attestation report has been moved to the first annual report
      for fiscal years ending on or after December 15, 2008. The SEC is
      considering further postponing this date.





**NOTE
      3****STOCK
      BASED COMPENSATION**





The
      Company’s 2004 Stock Compensation Plan (“Plan”) provides for grants of options
      up to 780,000 shares of common stock, and was amended on January 25, 2005 to
      provide grants of options up to 1,380,000. Pursuant to the Plan, the Company
      may
      grant options to any directors, officers, employees and independent contractors
      of the Company or of any subsidiary of the Company. Stock options are granted
      at, or above, the fair market value of our stock. As of December 31, 2006,
      there
      were 658,000 options available for grant.





The
      following table summarizes the activity of stock options under the
      Plan:




**2006**
            
            **2005**
            
            **2004****Number
                of**
              **Shares**
            
            **Weighted**
              **Average**
              **Exercise**
              **Price**
            
            **Number
                of**
              **Shares**
            
            **Weighted**
              **Average**
              **Exercise**
              **Price**
            
            **Number
                of**
              **Shares**
            
            **Weighted**
              **Average**
              **Exercise**
              **Price**Shares
                at beginning of the year
            
            
            654,166
            
            $
            3.84
            
            
            657,000
            
            
            3.81
            
            
            0
            
            
            0Granted
            
            
            350,000
            
            
            1.34
            
            
            398,000
            
            
            5.00
            
            
            657,000
            
            
            3.81Exercised
            
            
            0
            
            
            0
            
            
            (16,000
            )
            
            5.00
            
            
            0
            
            
            0Expired
            
            
            0
            
            
            0
            
            
            0
            
            
            0
            
            
            0
            
            
            0Canceled
            
            
            (282,166
            )
            
            4.34
            
            
            (384,834
            )
            
            4.66
            
            
            0
            
            
            0Shares
                outstanding at end of year
            
            
            722,000
            
            $
            2.43
            
            
            654,166
            
            
            3.84
            
            
            657,000
            
            
            3.81Exercisable
                shares at end of year
            
            
            609,915
            
            $
            2.42
            
            
            397,865
            
            
            3.72
            
            
            186,656
            
            
            3.35Unvested
                shares at end of year
            
            
            112,085
            
            $
            2.48
            
            
            256,301
            
            
            4.02
            
            
            470,344
            
            
            4.00





Effective
      January 1, 2006, the Company adopted Statement of Financial Accounting Standards
      No. 123 (revised 2004), *Share-Based
      Payment* , (“SFAS
      123R”) which requires the measurement and recognition of compensation expense
      for all share-based payment awards made to employees and directors, including
      employee stock options, based on estimated fair values. SFAS 123R supersedes
      the
      Company’s previous accounting under Accounting Principles Board Opinion No. 25, *Accounting
      for Stock Issued to Employees* (“APB
      25”) for periods beginning on or after January 1, 2006.




F-12





The
      Company adopted SFAS 123R using the modified prospective transition method,
      which requires the application of the accounting standard as of January 1,
      2006,
      the first day of the Company’s fiscal year 2006. The Company’s financial
      statements as of and for the year ended December 31, 2006 reflect the impact
      of
      SFAS 123R. In accordance with the modified prospective transition method, the
      Company’s financial statements for prior periods have not been restated to
      reflect, and do not include, the impact of SFAS 123R.





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





There
      were 350,000 options granted during the year ended December 31, 2006 of which
      280,000 were granted to the Directors and vested immediately. The fair value
      of
      the Company’s options granted during the year ended December 31, 2006 was
      estimated at the grant date using the Black-Scholes option pricing model with
      the following the weighted average assumptions:





**Year
                ended December**
              **31,
                2006**Expected
                life (in years)
            
            
            6.5Expected
                volatility
            
            
            91.9
            %Risk-free
                interest rate
            
            
            5.1
            %Expected
                dividend
            
            
            —




In
      accordance with SFAS 123R stock-based compensation expense recognized in the
      statements of operations for the year ended December 31, 2006 is based on awards
      ultimately expected to vest. Based on historical experiences, the Company
      expects 10% per year forfeitures of its prior option grants and therefore the
      compensation expense has been reduced for estimated forfeitures. SFAS 123R
      requires forfeitures to be estimated at the time of grant and revised, if
      necessary, in subsequent periods if actual forfeitures differ from those
      estimates. In the Company’s pro forma information required under SFAS 123 for
      the periods prior to fiscal 2006, the Company adjusted the expected forfeitures
      for actual as they occurred.




Stock-based
      compensation expense recognized under SFAS 123R for the year ended December
      31,
      2006, was approximately $547,000. There were 350,000 options granted during
      the
      year ended December 31, 2006. The weighted average fair value of options granted
      during the year ended December 31, 2006 was $1.34 with an aggregate total value
      of $469,000. As of December 31, 2006, $257,000 of unrecognized compensation
      costs related to non-vested stock options are expected to be recognized over
      the
      following 31 months. Since the Company adopted SFAS 123R as of January 1, 2006,
      there was no stock-based compensation expense related to employee stock options
      recognized during the year ended December 31, 2005.





Prior
      to
      the adoption of SFAS 123R, the Company accounted for stock-based awards to
      employees and directors using the intrinsic value method in accordance with
      APB
      25 as allowed under Statement of Financial Accounting Standards No. 123, *Accounting
      for Stock-Based Compensation* (“SFAS
      123”). Under the intrinsic value method, no stock-based compensation expense had
      been recognized in the Company’s statement of operations for the year ended
      December 31, 2005.





The
      following pro forma net loss and loss per share information is presented as
      if
      the Company accounted for stock-based compensation awarded using the fair value
      recognition provisions of SFAS 123 for the year ended December 31,
      2005:





**Year
                Ended**
              **December 31,**
              **2005**Net
                loss attributable to Common Shareholder as reported
            
            $
            (8,938,614
            )Deduct:
                Stock-based employee compensation expense determined under the fair
                value
                method for all awards, Net of related tax effects
            
            
            (264,441
            )Pro
                forma net loss
            
            $
            (9,203,055
            )Basic
                and diluted net loss per share:As
                reported
            
            $
            (1.67
            )Pro
                forma
            
            $
            (1.
              72
            )





F-13





During
      the year ended December 31, 2005, the Company granted 48,000 options,
      respectively at an exercise price equal to the fair market value of our stock
      at
      the time of the grant.





The
      Company also granted 50,000 stock options to a consultant in the first quarter
      of 2005. These options vest quarterly over a three year period beginning in
      the
      second quarter ended June 30, 2005. Any unexercised options expire three months
      after the completion or termination of the consulting agreement. The value
      of
      the options was determined using the Black-Scholes option-pricing model and
      was
      recorded as non-cash compensation expense during the service period of the
      consulting agreement. The consulting agreement was terminated June 30, 2006.
      No
      options were exercised and the options expired on September 30, 2006. The
      Company recorded compensation expense of $11,000 and $48,000 related to these
      options for the year ended December 31, 2006 and 2005, respectively.





**NOTE
      4**  **INCOME
      TAXES**





The
      Company accounts for its income taxes using the Financial Accounting Standards
      Board Statements of Financial Accounting Standards No. 109, “Accounting for
      Income Taxes,” which requires the establishment of a deferred tax asset or
      liability for the recognition of future deductible or taxable amounts and
      operating loss and tax credit carryforwards. Deferred tax expense or benefit
      is
      recognized as a result of timing differences between the recognition of assets
      and liabilities for book and tax purposes during the year.





Deferred
      tax assets and liabilities are measured using enacted tax rates expected to
      apply to taxable income in the years in which those temporary differences are
      expected to be recovered or settled. Deferred tax assets are recognized for
      deductible temporary differences and operating loss, and tax credit
      carryforwards. A valuation allowance is established to reduce that deferred
      tax
      asset if it is “more likely than not” that the related tax benefits will not be
      realized.





F-14





The
                provision (benefit) for income taxes for the years ended December
                31, 2006
                and 2005





**Year
                Ended**
              **December
                31,**
              **2006**
            
            **Year
                Ended**
              **December
                31,**
              **2005**CurrentState
            
            $
            1,600
            
            $
            459Federal
            
            
            0
            
            
            01,600
            
            
            459DeferredState
            
            
            (820,020
            )
            
            (600,573
            )Federal
            
            
            (2,531,121
            )
            
            (2,094,989
            )(3,351,141
            )
            
            (2,695,563
            )Change
                in Valuation Allowance
            
            
            3,351,141
            
            
            2,402,685Total
            
            $
            1,600
            
            $
            (623,695
            )





The
                reconciliation of income tax provision computed at federal statutory
                rates
                to income tax expense is as follows





Tax
                at federal statutory rates
            
            
            34.0
            %
            
            35.0
            %State
                taxes
            
            
            5.2
            %
            
            5.8
            %Goodwill
                amortization
            
            
            0.0
            %
            
            0.0
            %Meals
                and Entertainment
            
            
            -0.1
            %
            
            -0.1
            %Penalties
            
            
            0.0
            %
            
            0.0
            %Change
                in valuation allowance
            
            
            -32.2
            %
            
            -35.5
            %Other
            
            
            -7.1
            %
            
            -1.0
            %Total
            
            
            -0.02
            %
            
            4.3
            %





Net
      deferred tax assets at December 31, 2006 and 2005 are as
      follows:





CurrentAllowance
                for returns and doubtful accounts
            
            $
            125,455
            
            $
            150,096Accrued
                expenses
            
            
            314,894
            
            
            0Inventory
            
            
            216,320
            
            
            264,511Contributions
                Carryover
            
            
            3,568
            
            
            4,409State
                tax
            
            
            (47,569
            )
            
            183,841$
            612,669
            
            $
            602,857





NoncurrentBasis
                difference in fixed assets
            
            $
            3,776
            
            $
            (216Mark-to-market
                adjustment on warrants
            
            
            0
            
            
            (174,124
            )Intangibles
                assets
            
            
            (788,075
            )
            
            (933,251
            )Net
                operating loss carryforwards
            
            
            5,872,636
            
            
            3,043,823Stock-based
                compensation
            
            
            486,896
            
            
            0State
                tax
            
            
            (415,045
            )
            
            (136,404
            )$
            5,160,188
            
            
            1,799,828Gross
                deferred tax asset/(liability)
            
            $
            5,772,856
            
            $
            2,402,685Valuation
                allowance
            
            $
            (5,772,856
            )
            $
            (2,402,685
            )Net
                deferred tax asset/(liability)
            
            $
            0
            
            $
            0




F-15




The
      Company has loss carryforwards of approximately $13,498,000 and $6,220,765
      for
      the years ended December 31, 2006 and 2005, respectively, from continuing
      operations, which may be used to offset future United States federal taxes,
      which begin to expire in 2024 and state income taxes, which begin to expire
      in
      2014.





**NOTE
      5****LONG-TERM
      DEBT**





Components
      of long-term debt are as follows (net of discounts):





**December
                31,**
              **2006**
            
            **December
                31,**
              **2005**Secured
                Non-Convertible Revolving Note
            
            $
            9,069,947
            
            $
            8,115,641Secured
                Non-Convertible Term Note
            
            
            1,700,000
            
            
            —Purchase
                Order Revolving Credit Note
            
            
            45,936
            
            
            —10%
                Bridge Notes Due 2006 (less discounts of $762,576 on December 31,
                2005)
            
            
            —
            
            
            1,737,42410%
                Bridge Note Due 2011
            
            
            2,250,000
            
            
            —10%
                Bridge Note Due 2007
            
            
            151,908
            
            
            —10%
                Notes Due 2008 (less discounts of $180,900 on December 31,
                2006)
            
            
            149,100
            
            
            —10%
                Note Due 2009 - Former shareholder (related party)
            
            
            619,282
            
            
            675,11924%
                Notes Due 2006 (less discounts of $0 on December 31, 2005)
            
            
            —
            
            
            1,000,00010%
                Convertible Debentures Due 2008 (less discounts of $1,250,630 on
                December
                31, 2005)
            
            
            —
            
            
            249,37010%
                Note Due 2006 - Related party (less discounts of $62,324 on December
                31,
                2005)
            
            
            —
            
            
            437,67613,986,173
            
            
            12,215,230Less:
                current portion
            
            
            (803,687
            )
            
            (11,965,860
            )$
            13,182,486
            
            $
            249,370





***Laurus
      Security Agreement***





On
      February 28, 2006, the Company entered into a security agreement (the Laurus
      “Security Agreement”) with Laurus Master Fund, Ltd. (“Laurus”). Included in the
      Security Agreement is an asset-based Secured Non-Convertible Revolving Note
      (the
“Revolving Note”). The term of the Revolving Note is two years and provides that
      we may borrow up to $16,500,000 subject to certain conditions. Interest is
      payable monthly, in arrears at a rate per annum equal to the Prime Rate (as
      published in The
      Wall Street Journal ) plus
      two percent (2.0%). The Revolving Note has no financial covenants and is
      collateralized by a security interest in substantially all of the assets of
      the
      Company and its subsidiaries, including its operating subsidiary, Small World
      Toys. Proceeds from the Revolving Note were used to repay funds borrowed under
      the secured asset-based revolving credit facility with PNC Bank (“PNC”) and the
      PNC facility was terminated.





The
      Company also has a $2.0 million, two year Secured Non-Convertible Term Note
      (the
“Term Note “) with Laurus. Commencing April 1, 2006 and each succeeding month
      after, the Company will make principal payments of $33,333 with all the balance
      of the unpaid principal amount due upon the maturity date of February 28, 2008.
      Interest is payable monthly, in arrears at a rate per annum equal to the Prime
      Rate (as published in The
      Wall Street Journal ) plus
      three percent (3.0%). The Term Note has no financial covenants and is
      collateralized by the Laurus Security Agreement.





In
      consideration for the Revolving Note and the Term Note, the Company issued
      to
      Laurus a warrant (“Warrant”) to purchase 1,036,000 shares of common stock at a
      $0.001 per share exercise price. This Warrant has a fair value of $2,586,000
      calculated using the Black Scholes option pricing model with the following
      assumptions:





Expected
                life (in years)
            
            
            10Expected
                volatility
            
            
            107.1
            %Risk-free
                interest rate
            
            
            4.6
            %Expected
                dividend
            
            
            —





The
      value
      of the Warrant of $2,586,000 was recorded as an asset as debt issuance costs
      to
      be amortized over the life of the loan.





This
      Warrant is subject to registration rights requiring the Company to register
      the
      underlying shares with the SEC within 60 days of the issuance of the Warrant.
      The deadline to register the underlying shares has been subsequently amended
      to
      June 15, 2006. The Company filed the registration statement with the SEC on
      June
      15, 2006 and Amendment No. 1 on October 4, 2006. As of the date of this filing,
      the Company was in the process of reviewing and responding to the comments
      received from the SEC on Amendment No.1. The registration statement must be
      declared effective within 180 days of the issuance of the Warrant or Laurus
      may
      impose a default interest rate equal to two percent (2%) per month interest
      on
      the outstanding Revolving and Term Notes until the registration statement is
      declared effective.




F-16





It
      has
      been determined that the default interest rate is in effect liquidated damages,
      and therefore, in accordance with EITF 00-19, the Company determined that the
      maximum liquidated damages exceeds the difference
      between the fair value of a registered share of common stock and unregistered
      share of common stock on the date of the transaction and therefore the
      value
      of the Warrant has been recorded as a liability subject to marked-to-market
      revaluation at each period end. The decrease in the fair value of the warrant
      liability associated with Laurus from the date of issuance of February 28,
      2006
      to December 31, 2006 was $1,139,000 and is a result of the decrease in the
      trading value of our stock during this period.





In
      connection with the Security Agreement, the Company paid broker and management
      fees of $833,000 and was recorded as an asset as debt issuance costs to be
      amortized over the life of the loan.





On
      July
      26, 2006, Laurus authorized $750,000 in excess of the maximum allowed borrowings
      based on a formula amount of the secured assets (the “Overadvance”) on the
      Revolving Note. On October 19, 2006, Laurus exercised the discretion granted
      to
      it pursuant to Section 2(a)(ii) of the Security Agreement dated February 28,
      2006 with the Company to make loans to the Company in excess of the maximum
      amounts available to be borrowed on our revolver loans. The aggregate principal
      amount of the Overadvance is $1,500,000, of which amount $486,000 was
      outstanding as of December 31, 2006. The Overadvance, subject to certain
      restrictions, is available to the Company for a one year period. The interest
      applicable to the Overadvance shall be the “prime rate” published in The
      Wall Street Journal from
      time to time plus two percent (2%).





The
      Company had $1,014,000 of availability on the Revolving Note as of December
      31,
      2006 including $1,014,000 from the overadvance.





On
      January 26, 2007, the Company entered into an Omnibus Amendment No.1 with Laurus
      that (a) amended the Overadvance Side Letter by extended the maturity of the
      Overadvance of up to $1,500,000 from October 19, 2007 to February 28, 2008
      and
      (b) increased the Concentration Limits for accounts on standard terms from
      15%
      to 32.5%. In addition, the requirement for the listing of the Company’s shares
      on the NASDAQ, OTC Bulletin Board or other Principal Market and for the timely
      filing with the SEC of all reports required to be filed pursuant to the Exchange
      Act was deleted.





On
      January 26, 2007, the Company also entered into the Second Amendment with
      Laurus, to the Registration Rights Statement dated February 28, 2006, that
      deleted the requirement to file a Registration Statement and no penalties were
      owed. In accordance with EITF 00-19, the value of the Warrant issued to Laurus
      on February 28, 2006 was subject to marked-to-market revaluation at each period
      end since this Warrant was subject to registration rights requiring the Company
      to register the underlying shares with the SEC within 60 days of the issuance
      of
      the Warrant.. Any change in fair value from the date of issuance to the date
      the
      underlying shares are registered was included in other (expense) income. With
      the Second Amendment with Laurus, to the Registration Rights Statement dated
      February 28, 2006, that deleted the requirement to file a Registration
      Statement, the warrant liability is reclassified from a liability to equity.
      The
      change in fair value from December 31, 2006 to January 26, 2007 of $362,000
      will be included in other income in January 2007. With the termination of the
      requirement to file a Registration Statement, the value of the warrants on
      the
      January 26, 2007 of $1,085,000 will be reclassified from a liability to equity.





On
      January 26, 2007, the Company issued a warrant to purchase an aggregate of
      685,185 shares at an exercise price of $.01 per share to Laurus. The warrant
      was
      issued in connection with the extension of the maturity of the Overadvance
      to
      February 28, 2008 and the increase of the Concentration Limits on standard
      terms
      from 15% to 32.5%. This warrant has a relative fair value of $711,000 calculated
      using the Black Scholes option pricing model with the following
      assumptions:





Expected
                life (in years)
            
            
            10Expected
                volatility
            
            
            1.18
            %Risk-free
                interest rate
            
            
            4.88
            %Expected
                dividend
            
            
            —


The
        Company has determined the issuance of the warrant in connection with Omnibus
        Amendment No.1 and the Second Amendment to the Registration Rights has resulted
        in a substantial modification resulting in the net present value between
        the
        original Revolving Note and the amended Revolving Note to be greater than
        10%,
        and in accordance with EITF Issue 96-19, Debtor’s Accounting for a Modification
        or Exchange of Debt, the amendments were accounted for as an extinguishment
        of
        debt and the relative fair value of the warrant will be expensed.


***Purchase
      Order Financing Facility***





On
      March
      20, 2006, The Company entered into a Purchase Order Revolving Credit Line (“PO
      Credit Line”) of Five Million Dollars ($5,000,000) with Horizon Financial
      Services Group USA to provide financing for the acquisition of product from
      our
      overseas vendors. The term of the PO Credit Line is eighteen (18) months and
      provides that we may borrow up to $5,000,000 subject to certain conditions
      including Horizon’s approval of the applicable vendors. A financing fee equal to
      Four and One Half Percent (4.50%) of the gross amount or face value of each
      Horizon financing instrument will be charged for the first forty-five (45)
      day
      period or part thereof that the financing instrument remains outstanding. An
      additional fee of fifty basis points (.50%) for each additional period of 15
      days, or part thereof, during which the Horizon financing instrument remains
      outstanding will be charged. The PO Credit Line has no financial covenants
      and
      is collateralized by a security interest, junior in position to that of our
      senior lender, Laurus Master Fund, Ltd, to the assets related to the PO Credit
      Line transactions. As of December 31, 2006, $46,000 were due under this
      facility.




F-17





***10%
      Bridge Notes - St Cloud Capital Partners LP***





On
      September 15, 2004, we entered into a Note Purchase Agreement with St. Cloud
      Capital Partners L.P. (“St. Cloud”), pursuant to which we issued to St. Cloud a
      10% Convertible Promissory Note in the aggregate amount of $2,000,000, due
      September 15, 2005. The Company also was required to pay a closing fee of
      $80,000 and a management fee of $80,000 to St. Cloud. In connection with the
      issuance of the note, we issued St. Cloud 65,000 shares of common stock and
      warrants to purchase an additional 35,000 shares of common stock. The warrants
      are exercisable at an exercise price per share equal to $5.00 per share. The
      warrants expire in September 2008. The Company also granted certain registration
      rights whereby the Company agreed to include the common stock and warrants
      in a
      registration statement filed by the Company with the Securities and Exchange
      Commission (the “SEC”).




On
      July
      20, 2005 the Company amended the Agreement (the “Amendment”) pursuant to which
      St. Cloud agreed to advance to the Company an additional $500,000 for an
      aggregate loan of $2.5 million at an interest rate of 10% per annum payable
      monthly in arrears. The aggregate loan is secured by certain Company assets
      including Receivables, Inventory, Equipment and other assets. In consideration
      for the advance, the Company issued to St. Cloud an additional 16,250 shares
      of
      the Company’s Common Stock and four year immediately exercisable warrants for
      the right to acquire 8,750 shares (“Warrant Shares”) of the Company’s Common
      Stock. The aggregate Warrants underlying 43,750 shares of Common Stock are
      exercisable at an exercise price per share equal to the lowest of (a) $4.00
      per
      share or; (b) the per share price (or conversion price if a derivative security)
      of the next financing of the Company with gross proceeds of at least $5 million.
      The Amendment also provides piggyback registration rights with respect to the
      shares of Common Stock and Warrant Shares in the event the Company files a
      qualified Registration Statement with the SEC.





On
      November 11, 2005, the Company entered into a Second Amendment to the
      Agreement with St. Cloud pursuant to which the Company issued to St. Cloud
      a new
      promissory note (the “Replacement Note”) replacing the existing note to St.
      Cloud in the principal amount of $2,500,000 (the “Loan Amount”). Under the
      Replacement Note, the maturity date of the Loan Amount was extended to
      September 15, 2006. The Replacement Note is convertible into shares of the
      Common Stock of the Company at $4.00 per share (subject to adjustment) or,
      as to
      up to 50% of the Loan Amount, into securities issued by the Company in a
      financing with gross proceeds of at least $12,500,000. As the Replacement Note
      is convertible at a price below the fair market value on the date of issuance,
      it is deemed to have a beneficial conversion feature with an intrinsic value
      of
      $912,000. In consideration of the agreement of St. Cloud to accept the
      Replacement Note, the Company issued to St. Cloud two warrants to purchase
      an
      aggregate of 75,000 shares of Common Stock (the “New Warrant Shares”) as
      follows: a First Warrant for 50,000 shares at $6.00 per share exercisable for
      a
      number of New Warrant Shares (each, a “Tranche”) in accordance with the
      following: 12,500 shares to be vested at Closing and 12,500 shares (or the
      prorated portion thereof as provided in the Warrant) to be vested on
      January 1, 2006, April 1, 2006 and July 1, 2006 (a “Vesting
      Date”); and a Second Warrant for 25,000 shares at $7.50 per share, 6,250 shares
      to be is vested at Closing and 6,250 shares (or the prorated portion thereof
      as
      provided in the Warrant) to be vested on each Vesting Date, provided that the
      applicable Warrant may not be exercised for a specific Tranche if the
      Replacement Note is not outstanding on the applicable Vesting Date. The number
      of New Warrant Shares is proportionally reduced, as of a Vesting Date, if the
      principal amount of the Note is less than the Loan Amount. The Company
      determined the Replacement Note resulted in a substantial modification due
      to
      the new maturity date and the conversion feature, and in accordance with EITF
      Issue 96-19, Debtor’s Accounting for a Modification or Exchange of Debt, the
      exchange transaction was accounted for as an extinguishment of debt. As such,
      the relative fair market value was deemed to be fees paid associated with the
      extinguishment of the old debt instrument and included as debt extinguishment
      loss to be recognized in the current period.





On
      June 9, 2006, the Company received approximately $2.4 million from the
      private placement of Class A-1 Preferred Stock at $1.10 per share and
      binding commitments for an additional $.3 million of which $150,000 was received
      in September and the balance was received in November 2006. As a condition
      of
      this sale, the Company entered into a Third Amendment to the Agreement with
      St.
      Cloud whereas the 10% Note Due 2006 to St Cloud in the principal amount of
      $2.5
      million was restructured as follows: the Company prepaid $50,000 of the existing
      note and issued to St. Cloud two new notes to replace the exiting note. The
      first note in the principal amount of $200,000 will be for twelve months with
      monthly amortization payments at a 10% interest rate; the second note (the
      first
      and second notes in aggregate “Notes”) will be for $2,250,000 with interest at
      10% per annum with interest only payable on June 30, 2006 and
      September 15, 2006 and commencing September 16, 2006, payments will be
      interest only each month through September 15, 2008 and commencing
      October 15, 2008, monthly amortization payments (based on a five-year
      amortization) with all interest plus unpaid principal due on September 15,
      2011 and the second note will be convertible into shares of the common stock
      of
      the Company at $4.00 per share. **** The
      Company determined the Notes resulted in a substantial modification since the
      effective interest rate of the Replacement Note included warrants issued while
      there were no warrants issued with the Notes resulting in the net present value
      between the two notes to be greater than 10%, and in accordance with EITF Issue
      96-19, Debtor’s Accounting for a Modification or Exchange of Debt, the exchange
      transaction was accounted for as an extinguishment of debt. The relative fair
      market value of the Replacement Note and the Notes were deemed to be equal
      since
      the principal and interest of the two notes are equal and therefore there was
      no
      gain or loss associated with the extinguishment of the old debt instrument
      to be
      recognized in the current period.




F-18





Per
      the
      subordination agreement signed between St Cloud and Laurus on February 28,
      2006,
      principal payments on either of the two notes with St Cloud are not allowed
      to
      be made while any amounts are open under the Overadvance. The aggregate
      principal amount of the Overadvance is $1,500,000, of which $486,000 was
      outstanding as of December 31, 2006.





***10%
      Notes Due 2008***





On
      October 19, 2006, the Company issued an aggregate of $330,000 in principal
      amount of 10% Convertible Debentures (the “Debenture”) to Hong Kong League
      Central Credit Union and Kershaw Mackie & Company, who are also providing
      management consulting services to the Company, with net proceeds of $300,000.
      Interest is payable monthly in arrears and the Debentures mature on March 31,
      2008. Per the Intercreditor and Subordination Agreement dated March 2007 between
      St. Cloud and Hong Kong League Central Credit Union and Kershaw Mackie &
Company, no principal payments can be made on the Debenture until all notes
      between the Company and St. Cloud have been paid in full. The Debenture
      is convertible into shares of the Registrant’s Common Stock at the option
      of the holder at a conversion price $1.10 (subject to normal adjustments).
      Since
      the Debenture has only standard adjustment features with no reset conversion
      price requirements nor registration rights requirements beyond piggy-back
      rights, the debt is considered conventional debt under FASB 133 and EITF 00-19.
      As the Debenture is convertible at a price below the fair market value on the
      date of issuance, it is deemed to have a beneficial conversion feature with
      an
      intrinsic value of $29,000 and recorded as adebt issuance expense to be
      amortized over the remaining life of the loan.




In
      consideration for the Debenture, the Company issued Warrants (“SBI Warrants”) to
      purchase an aggregate of 137,500 and 12,500 shares, respectively, at an exercise
      price of $1.10 per share, to SBI Advisors LLC, a placement agent and which
      is
      beneficially owned by Shelly Singhal, a director of the Small World Kids ,
      and
      Kershaw Mackie & Company. These warrants have a relative fair value of
      $150,000 calculated using the Black Scholes option pricing model with the
      following assumptions:





Expected
                life (in years)
            
            
            5Expected
                volatility
            
            
            91.5
            %Risk-free
                interest rate
            
            
            4.79
            %Expected
                dividend
            
            
            —




The
      relative fair value of the warrants will be recorded as a discount to the debt
      issuance to be amortized over the life of the Convertible Debenture. The Company
      also entered into a Registration Rights Agreement in connection with the
      Debentures and Warrants on October 19, 2006 to provide piggy-back registration
      rights for the common shares issuable upon conversion of the Debentures or
      exercise of the Warrants.




***10%
      Note Due 2009 - Former shareholder***





As
      part
      of the purchase for SWT Shares on May 20, 2004, the Company entered into a
      contingent earnout with the former shareholder of Small World Toys. The Company
      agreed to a two year promissory note, payable in quarterly installments
      commencing April 2005 with a minimum payment of $700,000 and a maximum payment
      of $1,500,000, if certain sales targets are achieved in 2005 and 2006. In 2005,
      the seller earned $673,000 based on the Company obtaining $33.7 million in
      net
      sales of which $350,000 was paid in quarterly installments in 2005 and the
      balance and interest due in 2006 to be paid on a $60,000 per month payment
      schedule commencing on April 2006 at 10% interest on the unpaid balance. The
      2006 earnout is based on 2% of 2006 net sales up to a maximum of $800,000.
      If
      the certain sales targets are achieved, as allowed by SFAS 141, “ *Business
      Combinations* ”,
      and in
      accordance with paragraph 28, the contingent payout of up to a maximum of
      $800,000 will be considered additional cost of acquiring Small World Toys and
      recorded as goodwill. Of the 2006 earnout, a minimum quarterly payment of
      $87,500 will be paid with the balance earned due January 2007.




F-19





On
      November 6, 2006, the Company entered into an amendment with the former
      shareholder whereas the contingent earnout for 2006 was fixed at $670,000 and
      a
      three year note for $667,619 (the unpaid principal amount of the 5% Note) was
      issued with monthly amortization payments at a 10% interest rate. A default
      interest rate of 15% will be incurred on the unpaid scheduled interest and
      principal payments if not cured within 5 days. The Company has determined the
      amendment has resulted in a substantial modification resulting in the net
      present value between the two notes to be greater than 10%, and in accordance
      with EITF Issue 96-19, Debtor’s Accounting for a Modification or Exchange of
      Debt, the amendment was accounted for as an extinguishment of debt.





***24%
      Notes Due 2006***





On
      April
      28, 2005 the Company entered into Term Credit Agreements (“Credit Agreements”)
      with Hong Kong League Central Credit Union and PCCW Credit Union (collectively
      the “Lenders”) for unsecured loans totaling $750,000 due on or before August 31,
      2005. Interest is charged at a rate of 2% per month and is payable monthly
      in
      arrears. On June 10, 2005 the Company entered into additional Credit Agreements
      with Hong Kong League Central Credit Union and HIT Credit Union for unsecured
      loans totaling $250,000 due on or before September 30, 2005. Effective August
      31, 2005 the maturity dates of all outstanding unsecured loans with the Lenders
      were extended to the earlier of the closing of a financing transaction with
      net
      proceeds of at least $20 million or March 1, 2006. In consideration of the
      extension, the Company agreed to issue four year immediately exercisable
      warrants to purchase 100,000 shares of the Company’s Common Stock exercisable at
      $5.00 per share to SBI Advisors, a related party, as a placement fee. At
      inception the fair value was determined to be $325,000 using the Black-Scholes
      option pricing model and applied to the principal as a discount to be accreted
      over the expected life of the unsecured loans. In connection with the Security
      Agreement with Laurus, the maturity date of all outstanding unsecured loans
      with
      the Lenders were extended to the earlier to occur of (a) the closing of a
      financing with net proceeds of at least $20,000,000 or (b) August 11,
      2006.




On
      June 9, 2006, the Company received approximately $2.4 million from the
      private placement of Class A-1 Preferred Stock at $1.10 per share and
      binding commitments for an additional $.3 million of which $150,000 was received
      in September and the balance was received in November 2006. As a condition
      of
      this sale, the 24% Notes Due 2006 in the aggregate principal amount of
      $1,000,000 with Hong Kong League Central Credit Union, PCCW Credit Union and
      HIT
      Credit Union were converted into 909,091 shares of the Class A-1 Preferred
      Stock.





***10%
      Convertible Debentures Due 2008***





On
      September 30, 2005 the Company completed the issuance of an aggregate of $1.5
      million in principal amount of 10% Convertible Debentures (the “Debentures”) and
      entered into a Securities Purchase Agreement (“Stock Purchase Agreement”) with
      Gamma Opportunity Capital Partners LP and Bushido Capital Master Fund LP. The
      Debentures will mature on September 30, 2008 and bear an interest rate of 10%
      per annum payable quarterly in arrears. The Company may make interest payments
      in cash or shares of its Common Stock, subject, in the case of payment in
      shares, to satisfaction of certain conditions. The Debentures are immediately
      convertible to the Company’s Common Stock at the option of the holder. The
      conversion price is $4.00, subject to adjustments for stock splits, stock
      dividends or rights offerings combinations, recapitalization, reclassifications,
      extraordinary distributions and similar events and certain subsequent equity
      sales. As the Debentures are convertible at a price below the fair market value
      on the date of issuance, they are deemed to have a beneficial conversion feature
      with an intrinsic value of $425,000.





In
      consideration for the issuance of the Debentures, the Company issued five year
      immediately exercisable warrants to purchase an aggregate of 281,250 shares
      of
      the Company’s Common Stock. Of the shares underlying the warrants, 93,750 have
      an exercise price of $7.50 per share (subject to adjustment) and 187,550 have
      an
      exercise price of $6.00 per share. These warrants have a fair value of $1.1
      million calculated using the Black Scholes option pricing model. These warrants
      are subject to registration rights requiring the Company to register the
      underlying shares with the SEC within 120 days of the issuance of the
      Debentures. In connection with the Security Agreement with Laurus, the
      registration rights were amended to require the Company to register the
      underlying shares with the SEC when the Company registers the underlying shares
      of the Warrant issued with the Security Agreement with Laurus. In accordance
      with EITF 00-19, the value of the warrants has been recorded as a liability
      subject to marked-to-market revaluation at each period end. The decrease in
      the
      fair value of the warrant liability associated with the 10% Convertible
      Debentures from December 31, 2005 to June 9, 2006 was $418,000 and is a result
      of the decrease in the trading value of our stock during this
      period.




F-20





On
      June 9, 2006, the Company received approximately $2.4 million from the
      private placement of Class A-1 Preferred Stock at $1.10 per share and
      binding commitments for an additional $.3 million of which $150,000 was received
      in September and the balance was received in November 2006. As a condition
      of
      this sale, the $1.5 million in principal amount of the 10% Convertible
      Debentures due in 2008 along with accrued but unpaid interest and penalties
      were
      converted into 1,400,000 shares of the Class A-1 Preferred Stock. As a result
      of
      this transaction, the Company no longer has an obligation to register the
      underlying shares with the SEC and as such the warrant liability of $271,000
      was
      reclassified to equity. Also, as a result of this conversion, $1,062,000 of
      unamortized debt discount was charged to interest expense. Per the warrant
      agreement, because the price per share of the Class A-1 Preferred Stock $1.10
      was less than the exercise price of the 93,750 warrants with an exercise price
      of $7.50 per share and 187,550 warrants with an exercise price of $6.00 per
      share, the 93,750 and 187,500 warrants were repriced to $1.10 and an additional
      1,380,688 warrants were issued at $1.10. Statement of Financial Accounting
      Standards No. 123 (revised 2004), *Share-Based
      Payment* ,
      (“SFAS
      123R”) addresses modifications to equity instruments. In accordance with SFAS
      123R, the modification of the exercise price resulted in an expense of
      $80,000.





The
      fair
      market value of the additional 1,380,688 warrants was $1,549,000 and calculated
      using the Black Scholes option pricing model with the following
      assumptions:




Expected
                life (in years)
            
            
            4.25Expected
                volatility
            
            
            121.7
            %Risk-free
                interest rate
            
            
            5.0
            %Expected
                dividend
            
            
            —





***10%
      Note Due 2006 - Related Party***





Effective
      August 11, 2005, the Company completed the issuance of an aggregate of $500,000
      in Notes to various investors which included Debra Fine, the Company’s President
      and Chief Executive Officer who provided $175,000 of the total borrowing. The
      Notes mature one year from the date of execution with interest payable monthly
      in arrears at a rate of 10% per annum. The Notes are secured by certain Company
      assets including Receivables, Inventory, Equipment and other assets. The Notes
      also provide piggyback registration rights in the event the Company files a
      qualified Registration Statement with the SEC. In consideration for the loans,
      the Company agreed to issue an aggregate of 16,250 shares of the Company’s
      Common Stock and four year immediately exercisable warrants to purchase an
      aggregate of 8,750 shares of the Company’s Common Stock. The Warrants are
      exercisable at an exercise price per share equal to the lowest of (a) $4.00
      per
      share, or (b) the per share price (or conversion price if a derivative security)
      of the next financing of the Company with gross proceeds of at least $5 million.
      At inception the fair value of these warrants was determined to be $100,000
      using the Black-Scholes option pricing model and applied to the principal as
      a
      discount to be accreted as a non-cash interest cost over the life of the
      loan.





On
      June 9, 2006, the Company received approximately $2.4 million from the
      private placement of Class A-1 Preferred Stock at $1.10 per share and
      binding commitments for an additional $.3 million of which $150,000 was received
      in September and the balance was received in November 2006. As a condition
      of
      this sale, the $500,000 in principal amount of the 10% Note due 2006 was
      converted into 455,000 shares of the Class A-1 Preferred Stock. As a result
      of
      this conversion, $15,000 of unamortized debt discount was charged to interest
      expense.





***Accretion
      of Debt Discounts***





For
      the
      years ended December 31, 2006 and 2005, aggregate accretion of debt discounts
      were $2,586,000 and $1,524,216, respectively and included in interest expense.
      In addition, as a result of the conversion of $3 million of debt into Class
      A-1
      Preferred Stock on June 9, 2006, $1,077,000 in unamortized debt issuance costs
      related to the converted debt were recorded as a non-cash expense in June
      2006.





**NOTE
      6: WARRANT LIABILITY**





In
      consideration for the Revolving Note and the Term Note, the Company issued
      to
      Laurus a warrant (“Warrant”) to purchase 1,036,000 shares of common stock at a
      $0.001 per share exercise price. These warrants are subject to registration
      rights requiring the Company to register the underlying shares with the SEC
      within 60 days of the issuance of the warrant. The deadline to register the
      underlying shares has been subsequently amended to June 15, 2006. The Company
      filed the registration statement with the SEC on June 15, 2006 and Amendment
      No.
      1 on October 4, 2006. As of the date of this filing, the Company was in the
      process of reviewing and responding to the comments received from the SEC on
      Amendment No.1. Per the Registration Rights Statement dated February 28, 2006,
      the registration statement must be declared effective within 180 days of the
      issuance of the warrant or Laurus may impose a default interest rate equal
      to
      two percent (2%) per month interest on the outstanding Revolving and Term Notes
      until the registration statement is declared effective. In accordance with
      EITF
      00-19, the value of the warrants of $2,586,000 has been recorded as a liability
      subject to marked-to-market revaluation at each period end. Any change in fair
      value from the date of issuance to the date the underlying shares are registered
      will be included in other (expense) income. The change in fair value from the
      date of issuance to December 31, 2006 of $1,139,000 has been included in
      other income.




F-21





On
      June 9, 2006, the Company received approximately $2.4 million from the
      private placement of Class A-1 Preferred Stock at $1.10 per share and
      binding commitments for an additional $.3 million of which $150,000 was received
      in September and the balance was received in November 2006. As a condition
      of
      this sale, the $1.5 million in principal amount of the 10% Convertible
      Debentures due in 2008 along with accrued but unpaid interest and penalties
      were
      converted into 1,400,000 shares of the Class A-1 Preferred Stock. As a result
      of
      this transaction, the Company no longer has an obligation to register the
      underlying shares with the SEC and as such the warrant liability of $271,000
      associated with the 10% Convertible Debentures due in 2008 was reclassified
      to
      equity.





On
      January 26, 2007, the Company entered into the Second Amendment with Laurus,
      to
      the Registration Rights Statement, that deleted the requirement to file a
      Registration Statement and no penalties were owed. The change in fair value
      from
      December 31, 2006 to January 26, 2007 of $362,000 will be included in other
      income in January 2007. With the termination of the requirement to file a
      Registration Statement, the value of the warrants on the January 26, 2007 of
      $1,085,000 will be reclassified from a liability to equity.





**NOTE
      7**  **ISSUANCE
      OF CLASS A-1 PREFERRED STOCK**




On
      June 9, 2006, the Company received approximately $2.4 million from the
      private placement of Class A-1 Preferred Stock at $1.10 per share and
      binding commitments for an additional $.3 million of which $150,000 was received
      in September and the balance was received in November 2006. **** As a
      condition of this transaction, we converted an aggregate of $3 million of debt
      (plus a portion accrued interest) into 2,763,636 shares of the Class A-1
      Convertible Preferred as follows: (i) the 24% Notes Due 2006 in principal
      amount of $1,000,000 with Hong Kong League Central Credit Union, PCCW Credit
      Union and HIT Credit Union; (ii) the $1.5 million in principal amount of
      the 10% Convertible Debentures due in 2008 along with accrued but unpaid
      interest and penalties; and (iii) the 10% Note Due 2006 - Related Party in
      principal amount of $500,000 in notes to various investors which included Debra
      Fine, the Company’s President and Chief Executive Officer who provided $175,000
      of the total borrowing. We also converted the shares of Series A
      Convertible Preferred Stock we issued to SWT, LLC on August 11, 2005, when
      we converted a $5,000,000 Bridge Note dated May 2004 held by SWT, LLC,
      along with accrued but unpaid dividends, into 4,908,157 shares of the
      Class A-1 Preferred Stock.





Pursuant
      to a Securities Purchase Agreement (the “Purchase Agreement”) dated October 19,
      2006 between Small World Kids, Inc. and the following investors; Russell
      Fine and Debra Fine (our President and Chief Executive Officer) as trustees
      of
      the Fine Family Trust, and Vintage Filings, LLC, the Company sold in a private
      placement 181,818 shares of its Class A-1 Convertible Preferred Stock (the
“Preferred Shares”) for $200,000. The Purchase Agreement granted to the
      purchasers piggyback registration rights with respect to the shares of Company
      Common Stock issuable upon conversion of the Preferred Shares and certain
      participation rights in respect of future equity financings.




The
      Company issued 100,000 warrants on June 9, 2006 with an exercise price of $2.00
      to C.E.Unterberg, Towbin Capital Partners1, L.P. in connection with the private
      placement of Class A-1 Preferred Stock. The warrants have a fair value of
      $11,000 calculated using the Black Scholes option pricing model with the
      following assumptions:





Expected
                life (in years)
            
            
            5Expected
                volatility
            
            
            121.7
            %Risk-free
                interest rate
            
            
            5.0
            %Expected
                dividend
            
            
            —





The
      fair
      value of the warrants was recorded as a reduction to the net proceeds from
      the
      private placement of Class A-1 Preferred Stock.





The
      Class
      A-1 Preferred has an adjustment of the conversion price upon issuance of
      additional equity at a price lower than the conversion which causes the Class
      A-1 Preferred to be treated as an unconventional preferred instrument. Upon
      evaluation under FASB Statement No. 133, “Accounting for Derivative Instruments
      and Hedging Activities” and EITF 00-19, “Accounting for Derivative Financial
      Instruments Indexed to, and Potentially Settled in, a Company’s Own Stock”, it
      was determined that the embedded derivative would be classified as equity and
      as
      such, the Company did not bifurcate the conversion feature. The Class A-1
      Preferred Stock has a beneficial conversion feature which allows the holders
      to
      acquire Common Stock of the Company at an effective conversion price of $.25
      below fair value at the date of issuance.  In accordance with EITF 98-5, *Accounting
      for Convertible Securities with Beneficial Conversion Features or Contingently
      Adjustable Conversion Ratios* , the
      Company has determined the intrinsic value of this in-the-money conversion
      feature be accounted for it as a discount to the Preferred Stock.  The
      intrinsic value of the beneficial conversion feature was determined to be
      approximately $2.5 million.  As the Preferred Stock is immediately
      convertible, the full value of the conversion feature is deemed a dividend
      upon
      issuance and as such have been recorded directly to accumulated deficit.




F-22




On October
      19, 2006, the Company issued warrants to purchase 91,477 and 67,614 shares
      at an
      exercise price of $1.10 per share to Cambria Capital LLC and David Fuchs,
      respectively. The warrants were issued in connection with the conversion of
      the
      $1.5 million debentures and the sale on June 9, 2006 in a private placement
      of 227,727 shares of its Class A-1 Convertible Preferred Stock for $250,000
      as referenced in the Company’s Form 8-K filed June 14, 2006 and have
      piggy-back registration rights for the common shares issuable upon the exercise
      of the warrants. The warrants have a fair value of $293,000 calculated using
      the
      Black Scholes option pricing model with the following assumptions:





Expected
                life (in years)
            
            
            5Expected
                volatility
            
            
            91.5
            %Risk-free
                interest rate
            
            
            4.79
            %Expected
                dividend
            
            
            —





The
      fair
      value of the warrants was recorded as a reduction to the net proceeds from
      the
      private placement of Class A-1 Preferred Stock.




**NOTE
      8: COMMITMENTS AND CONTINGENCIES**





As
      part
      of the purchase for SWT Shares on May 20, 2004, the Company entered into a
      contingent earnout with the former shareholder of Small World Toys. The Company
      agreed to a two year promissory note, payable in quarterly installments
      commencing April 2005 with a minimum payment of $700,000 and a maximum
      payment of $1,500,000, if certain sales targets are achieved in 2005 and 2006.
      In 2005, the seller earned $673,000 based on the Company obtaining $33.7 million
      in net sales of which $350,000 was paid in quarterly installments in 2005 and
      the balance due in 2006. The 2006 earnout is based on 2% of 2006 net sales
      up to
      a maximum of $800,000. Of the 2006 earnout, a minimum quarterly payment of
      $87,500 will be paid with the balance earned due January 2007. On November
      6, 2006, the Company entered into an amendment with the former shareholder
      whereas the contingent earnout for 2006 was fixed at $670,000 and a three year
      note for $667,619 (the unpaid principal amount of the 5% Note) was issued with
      monthly amortization payments at a 10% interest rate (Note 5).





On
      May 20, 2004, the Company entered into a $72,000 per annum three-year
      consulting agreement with David Marshall, Inc., a related party. On each
      anniversary date, the fee shall be increased by the increase in the consumer
      index for the Los Angeles metropolitan statistical area. During the term, David
      Marshall, Inc. will provide consulting services relating to business plan
      development, strategic planning, public relations, investor relations,
      acquisitions and financing activities.





On
      August 5, 2005, Gemini Partners, Inc. (“Gemini”) filed an action in
      the Superior Court of the State of California for the County of Los Angeles
      against Small World Toys, Debra Fine, and Fineline Services, LLC. On
      February 21, 2006, Gemini filed a second amended complaint that, among
      other things, named as a defendant Small World Kids, Inc. Gemini’s
      complaint arises out of a written consulting agreement dated as of
      November 10, 2003 entered into by and between Gemini and Fineline Services.
      On June 13, 2006, the Company and Gemini settled the suit out of court for
      $40,000.




On
      September 7, 2005, Small Play, Inc. (“Small Play”) filed an action in
      the United States District Court for the Southern District of New
      York against Small World Toys alleging $3 million in damages in
      connection with a supposed breach of an alleged oral licensing agreement.
      The suit was dismissed without prejudice by the Court on June 1, 2006 for
      failure of the plaintiffs to prosecute.




On
      April 12, 2006, Ryan Yanigihara,the
      Company’s former Controller, filed a complaint with the Secretary of Laboralleging
      violation of Section 806 of the Sarbanes-Oxley Act protecting
      whistleblowers. The complaint is still pending investigation and a
      determintation before OSHA.The Board of Directors commissioned an independent
      investigation of the complaint which was unable to substantiate the allegations.





Additionally,
      the Company is subject to legal proceedings and claims which arise in the
      ordinary course of business. In the opinion of management, such matters are
      without merit and are of such kind that if disposed of unfavorably, would not
      have a material adverse effect on the Company’s consolidated financial position
      or results of operations or liquidity.




F-23





Our
      corporate headquarters are located at 5711 Buckingham Parkway, Culver City,
      California 90230, where we lease approximately 28,000 square feet and sublease
      approximately 17,000. This lease was amended to extend the term to February
      28,
      2009.  We also lease approximately 62,000 square feet of warehouse
      space in Carson, California. This lease was also amended to extend the term
      to
      January 31, 2008. We also leased 1,200 square feet of office space in China
      in
      the town of ChangAn, GuangDong Province but this one year lease expired in
      November 1, 2006 and was not renewed.   We believe these facilities and
      additional or alternative space available to us will be adequate to meet our
      needs in the near term. The aggregate future rental rates are:





Year
                Ending December 31, 2007
            
            $
            736,000Year
                Ending December 31, 2008
            
            
            392,000Year
                Ending December 31, 2009
            
            
            93,000





The
      Company is party to several license agreements for the acquisition and
      development of certain toys and related manufacturing, licensing and
      distribution rights. Royalties range from 3% to 10% of various categories of
      sales. The agreements remain in effect for as long as the Company manufactures
      and sells the toys.





**NOTE
      9: EARNINGS (LOSS) PER SHARE**





Basic
      earnings per share are computed by dividing income or loss available to common
      shareholders by the weighted average number of common shares outstanding during
      the reporting period. Diluted earnings per share is computed based on the
      weighted average number of shares outstanding during the period increased by
      the
      effect of the potential dilution that could occur if securities or other
      contracts, such as stock options and stock purchase contracts, were exercised
      or
      converted into common stock using the treasury stock method.





For
      the
      years ended December 31, 2006, 2005 and 2004, there were a total of 15,468,000,
      3,521,000 and 360,000, respectively, potentially dilutive securities based
      on outstanding stock options, warrants, convertible preferred stock and
      convertible debentures during the period reported considered to be anti-dilutive
      which due to the net loss from operations were not included in the calculations
      of earnings per share. For the year ended December 31, 2003, the
      predecessor had no dilutive securities since there were no outstanding options
      or warrants.





**NOTE
      10: PROFIT SHARING PLAN**





The
      Company has a qualified 401(k) profit sharing plan in effect for eligible
      employees. The plan provides for pre-tax employee contributions. A portion
      of
      the pre-tax employee contributions will be matched by the Company on a
      discretionary basis. The plan also provides for annual contributions at the
      discretion of the Company. Total contributions are not to exceed annual amounts
      deductible under Internal Revenue Service regulations. No contributions were
      made for the years ended December 31, 2006 and December 31,
      2005.





**NOTE
      11: SELECTED QUARTERLY FINANCIAL DATA (Unaudited)**





**Quarters
                Ended****Mar. 31, 2006**
            
            **Jun. 30, 2006**
            
            **Sep. 30, 2006**
            
            **Dec. 31, 2006****(In
                thousands, except per share data)**Net
                sales
            
            $
            6,448
            
            $
            5,462
            
            $
            8,306
            
            $
            8,116Gross
                profit
            
            $
            2,148
            
            $
            2,330
            
            $
            2,989
            
            $
            3,304Net
                loss
            
            $
            (1,974
            )
            $
            (4,946
            )
            $
            (2,636
            )
            $
            (459
            )Net
                loss attributed to common stock
            
            $
            (1,974
            )
            $
            (7,490
            )
            $
            (2,636
            )
            $
            (459
            )Loss
                per share (basic and diluted)(1)
            
            $
            (0.36
            )
            $
            (1.38
            )
            $
            (0.49
            )
            $
            (0.09
            )





**Quarters
                Ended****Mar. 31, 2005**
            
            **Jun. 30, 2005**
            
            **Sep. 30, 2005**
            
            **Dec. 31, 2005****(In
                thousands, except per share data)**Net
                sales
            
            $
            7,152
            
            $
            6,164
            
            $
            9,532
            
            $
            10,907Gross
                profit
            
            $
            3,248
            
            $
            2,310
            
            $
            3,358
            
            $
            4,221Net
                loss
            
            $
            (1,992
            )
            $
            (1,805
            )
            $
            (1,206
            )
            $
            (1,768
            )Net
                loss attributed to common stock
            
            $
            (1,992
            )
            $
            (1,805
            )
            $
            (3,374
            )
            $
            (1,768
            )Loss
                per share (basic and diluted)(1)
            
            $
            (0.38
            )
            $
            (0.34
            )
            $
            (0.62
            )
            $
            (0.33
            )







(1)
      Per
      share amounts are reflective of the Reverse Split for all periods
      reported.




F-24





**NOTE
      12: VALUATION**





**Description**
            
            **Balance
                at**
              **Beginning
                of**
              **Period**
            
            **Charged
                to**
              **Costs
                and**
              **Expenses**
            
            **Write-offs**
            
            **Balance**
              **at
                end of**
              **Period**Allowance
                for doubtful accounts:Year
                ended December 31, 2003
            
            $
            434,164
            
            $
            152,904
            
            $
            (412,068
            )
            $
            175,000Year
                ended December 31, 2004
            
            $
            128,180
            
            $
            271,154
            
            $
            (147,122
            )
            $
            252,212Year
                ended December 31, 2005(1)
            
            $
            252,212
            
            $
            3,055
            
            $
            94,733
            
            $
            350,000Year
                ended December 31, 2006
            
            $
            350,000
            
            $
            145,324
            
            $
            (204,082
            )
            $
            291,242Reserve
                for shrinkage, obsolescence, and scrapYear
                ended December 31, 2003
            
            $
            0
            
            $
            0
            
            $
            (0
            )
            $
            0Year
                ended December 31, 2004
            
            $
            0
            
            $
            0
            
            $
            (0
            )
            $
            0Year
                ended December 31, 2005
            
            $
            0
            
            $
            315,000
            
            $
            (0
            )
            $
            315,000Year
                ended December 31, 2006
            
            $
            315,000
            
            $
            119,000
            
            $
            (334,000
            )
            $
            100,000







(1) Includes
      recovery of $141,000 that was written off in 2003.





**NOTE
      13: SUBSEQUENT EVENTS**





On
      January 26, 2007, the Company entered into an Omnibus Amendment No.1 with Laurus
      that (a) amended the Overadvance Side Letter by extended the maturity of the
      Overadvance of up to $1,500,000 from October 19, 2007 to February 28, 2008
      and
      increased the Concentration Limits for accounts on standard terms from 15%
      to
      32.5%. In addition, the requirement for the listing of the Company’s shares on
      the NASDAQ, OTC Bulletin Board or other Principal Market and for the timely
      filing with the SEC of all reports required to be filed pursuant to the Exchange
      Act was deleted.





On
      January 26, 2007, the Company also entered into the Second Amendment with
      Laurus, to the Registration Rights Statement dated February 28, 2006, that
      deleted the requirement to file a Registration Statement and no penalties were
      owed. In accordance with EITF 00-19, the value of the Warrant issued to Laurus
      on February 28, 2006 were subject to marked-to-market revaluation at each period
      end since this Warrant was subject to registration rights requiring the Company
      to register the underlying shares with the SEC within 60 days of the issuance
      of
      the Warrant.. Any change in fair value from the date of issuance to the date
      the
      underlying shares are registered was included in other (expense) income. With
      the Second Amendment with Laurus, to the Registration Rights Statement dated
      February 28, 2006, that deleted the requirement to file a Registration
      Statement, the warrant liability is reclassified from a liability to equity.
      The
      change in fair value from December 31, 2006 to January 26, 2007 of $362,000
      will be included in other income in January 2007. With the termination of the
      requirement to file a Registration Statement, the value of the Warrant on the
      January 26, 2007 of $1,085,000 will be reclassified from a liability to equity
      (Note 5).





On
      January 26, 2007, the Company issued a warrant to purchase an aggregate of
      685,185 shares at an exercise price of $.01 per share to Laurus. The warrant
      was
      issued in connection with the extension of the maturity of the Overadvance
      to
      February 28, 2008 and the increase of the Concentration Limits on standard
      terms
      from 15% to 32.5%. This warrant has a relative fair value of $711,000 calculated
      using the Black Scholes option pricing model with the following
      assumptions:





Expected
                life (in years)
            
            
            10Expected
                volatility
            
            
            1.18
            %Risk-free
                interest rate
            
            
            4.88
            %Expected
                dividend
            
            
            —




The
      relative fair value of the warrant will be recorded as a discount to the debt
      issuance to be amortized over the remaining life of the credit facility with
      Laurus.




F-25