** **

**UNITED STATESSECURITIES AND EXCHANGE COMMISSION**

**Washington, D. C. 20549**

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**FORM 10-QSB**

** **

**(Mark One)**

**xQUARTERLY REPORT UNDER SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF1934**

For the quarterly period ended June 30, 2006

 

**o TRANSITION REPORT UNDER SECTION 13 OR 15(d)OF THE EXCHANGE ACT**

For the transition period from             to             

 

Commission File Number: 000-50638

** **

**GRAYMARK PRODUCTIONS, INC.**

(Exact name of small business issuer in its charter)

 

 

| **OKLAHOMA**                     |   | **20-0180812**       |
|----------------------------------|--------|----------------------|
| (State or other  jurisdiction of |   | (I.R.S. Employer     |
| incorporation or  organization)  |   | Identification  No.) |

 

**101 N. Robinson, Suite920**

**OklahomaCity, Oklahoma 73102**

(Address of principal executive offices)

**(405) 601-5300**

(Issuer’s telephone number)

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

 

Check whether the issuer(1) filed all reports required to be filed by Section 13 or 15(d) of theExchange Act during the past 12 months (or for shorter period that the registrantwas required to file such reports), and (2) has been subject to such filingrequirements for the past 90 days.  Yes xNo o

Indicate by check markwhether the registrant is a shell company (as defined in Rule 12b-2 of theExchange Act).    Yes oNo x

**APPLICABLE ONLY TOISSUERS INVOLVED IN BANKRUPTCY**

**PROCEEDINGS DURING THEPRECEDING FIVE YEARS**

** **

Check whether theregistrant filed all documents and reports required to be filed by Section 12,13 or 15(d) of the Exchange Act after the distribution of securities under aplan confirmed by a court.  Yes oNo o

**APPLICABLEONLY TO CORPORATE ISSUERS**

State the number ofshares outstanding of each of issuer’s classes of common equity, as of thelatest practicable date:  As of August 11, 2006,8,412,107 shares of the issuer’s common stock, $0.0001 par value, wereoutstanding.

Transitional SmallBusiness Disclosure Format (Check One): Yes oNo x

 

 

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**GRAYMARKPRODUCTIONS, INC**.FORM 10-QSBFor the Quarter Ended June 30, 2006

TABLE OF CONTENTS

 
| Part I.    |   | Financial  Information                                          |   |   |
|------------|--------|-----------------------------------------------------------------|--------|--------|
| Item  1.   |   | Financial  Statements                                           |   |   |
| Item 2.    |   | Management’s Discussion and Analysis or Plan of  Operation |   |   |
| Item 3.    |   | Controls and Procedures                                         |   |   |
|       |   |                                                            |   |   |
| Part  II.  |   | Other  Information                                              |   |   |
| Item  1.   |   | Legal  Proceedings                                              |   |   |
| Item 2.    |   | Unregistered Sale of Equity Securities and Use of  Proceeds     |   |   |
| Item 3.    |   | Defaults Upon Senior Securities                                 |   |   |
| Item 4.    |   | Submission of Matters to a Vote of Security Holders             |   |   |
| Item  5.   |   | Other  Information                                              |   |   |
| Item 6.    |   | Exhibits                                                        |   |   |
| SIGNATURES |   |                                                            |

 

Throughout thisreport the first personal plural pronoun in the nominative case form “we” andits objective case form “us”, its possessive and the intensive case forms “our”and “ourselves” and its reflexive form “ourselves”  refer collectively to Graymark Productions,Inc., its predecessor, Graymark Productions, L.L.C., and its executive officersand directors.  The term “independent,”as used in this report, is used to distinguish us from the term “major studios”that is generally regarded in the entertainment industry to mean UniversalPictures, Warner Bros., Twentieth Century Fox, Sony Pictures Entertainment,Paramount Pictures, The Walt Disney Company, Metro Goldwyn Mayer and theirrespective affiliates.  The terms “low-budgetmotion pictures,” “low-budget films” or “low-budget movie” within this report,refer to motion pictures that have a production budget of $250,000 to $3 million.

 

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**PARTI. FINANCIAL INFORMATION**

**Item 1.****           Financial Statements**

Our financialstatements presented in this report were prepared and included in this reportin accordance with Regulation S-X and Regulation S-B and appear in this reportbeginning on page F-1.

**Item2.****           Management’sDiscussion and Analysis or Plan of Operation**

You should readthe following discussion in conjunction with our financial statements and notesthereto appearing elsewhere in this report.

**Overview**

Since commencementof our operations in August 2001, 2005 was the first year that we receivedsignificant revenue from our motion picture productions.  In June 2005, we received a $450,000non-refundable advance under licensing agreements covering the foreign anddomestic distribution and broadcast rights to our first motion picture project,*Cloud 9*.  During the six months ending June 30, 2006,we earned revenue of approximately $204,000 from the international distributionof *Cloud 9* and approximately$12,000 and $21,000, respectively, from the international distribution of *The Hunt*and*Surveillance*.  Wehave completed the filming and production of *Soul’sMidnight* and we are in post-production of our motion picture filmproject, *Fingerprints*.

During the 2nd quarter of 2006, based on the actual domesticDVD sales to date, we adjusted our estimates of the ultimate revenues for *Cloud 9*which resulted in a write-down ofour investment in *Cloud 9*of$1,445,014.

The followingdiscussion covers our plan of operations for the next 12 months.  As with any plan, there is no assurance thatour operations as described will go as planned or that we will be successful inachieving the anticipated results.

**MovieDevelopment and Production**

The movie industry generallyconsists of two principal activities, production and distribution.  Production encompasses the development,financing and creation of feature-length movies.  Distribution entails the promotion andmarketing of movies in the various media markets, including theatrical, homevideo and television presentation.  Wetypically acquire developed or “packaged” films from third parties, rather thanretain and employ personnel to develop films for our production.  Furthermore, our movies are typicallydistributed pursuant to licensing arrangements with unrelated third-partiesthat are independently engaged in the promotion and distribution ofmovies.  Our approach to acquisition,production, and distribution is to balance our financial risks against theprobability of commercial success of each movie project.

We primarilyproduce English language motion pictures intended for domestic ancillary marketrelease (home video and television, including pay-per-view, cable, satelliteand network broadcast) that have production budgets of $250,000 to $3 million (“low-budgetmotion pictures,” “low budget movies” or “low-budget films”).  We initially anticipated producing motionpictures that had production budgets of $2 million to $5 million, but based onthe production of our motion pictures to date, we believe that a range of $250,000to $3 million is appropriate.

The developmentand production costs of a low-budget film and each cost category varies frommovie-to-movie and this variation may be substantial.  Each movie is unique and the storyline,special effects, production locations, creative personnel involved, etc. affectthe budget amount of each cost category. Accordingly, we believe the cost categories are somewhat indeterminableuntil the particular movie is identified and developed.

Rather than retainand employ personnel to develop screenplays and perform other movie developmentactivities, we typically acquire low-budget movie projects for production thatare in the development phase, generally to 

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the point that theinitial screenplay has been written.  Inthe pre-production and production phases of a motion picture, we hire skilledcreative and production personnel, including cinematographers, editors, costumedesigners, set designers, sound and lighting technicians and actors on an asneeded basis.

We enter into variousproduction cost and revenue sharing arrangements, including joint ventures,partnerships and limited liability companies, on a movie-by-movie basis.  These sharing arrangements are intended tocomplement or expand our business to permit the production of a greater numberof movies, while sharing the financial risks of the movie.  We may not realize the anticipated financialbenefits when we enter into these arrangements. In addition, the negotiation of these arrangements, whether successfulor not, may require us to incur significant costs and cause diversion ofmanagement’s time and resources. Accordingly, the costs of obtaining these sharing arrangements increaseour invested cost in a movie without providing a correlating increase in themovie’s revenues and, consequently, adversely affect the financial performanceof the movie.

Following ourproduction of a movie, we intend to arrange for distribution through thirdparties primarily into the domestic (United States and Canada) andinternational ancillary market (home video or pay and free television).  Depending upon our ability to obtainfavorable distribution arrangements, which depends in many cases upon thedistributor’s assessment of the movie’s revenue potential, a particular moviemay be distributed in the domestic and international theatrical markets as wellas the ancillary markets. As of the date of this report, we have not enteredinto any arrangements for the theatrical release of our produced andin-production motion pictures.  A substantialamount of time may elapse between our expenditure of funds in the production ofa motion picture and the receipt of revenue from the motion picture we produce.

Our producedmovies are distributed domestically pursuant to licensing arrangements with unrelatedthird parties that are independently engaged in the promotion and distributionof movies.  Our foreign marketdistribution arrangements are pursuant to sale or license of the internationaldistribution rights to an unrelated third-party distributor for either a singleup-front payment (in U.S. currency) without any retained participation ininternational source revenues or for the right to receive a percentage of grossreceipts received by the distributor.  Asof the date of this report, we have entered into domestic (United States andCanada) distribution arrangements covering all of our motion picture projectsand have entered into international distribution arrangements covering *Cloud 9, The Hunt* and*Surveillance*.

Our ability toobtain international market distribution, whether in the ancillary market orthe theatrical market, will be subject to:

·                                   changesin local regulatory requirements, including restrictions on content,

·                                   changesin the laws and policies affecting trade, investment and taxes (including lawsand policies relating to the repatriation of funds and withholding taxes),

·                                   differingdegrees of protection for intellectual property,

·                                   instabilityof foreign economies and governments,

·                                   culturalbarriers, and

·                                   warsand acts of terrorism.

Any of these factorscould have a material adverse effect on our ability to sell the internationaldistribution rights of any motion picture.

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**Recent Developments**

***Cloud 9.**** *Inconjunction with the production of *Cloud 9*,with the other producers of *Cloud 9*,we formed Out of the Blue Productions, LLC (the “Production Company”).  The Production Company has entered into threeagreements covering the domestic (United States and Canada) and internationaldistribution of *Cloud 9* in theancillary market (home video market) and the broadcast rights (pay and freetelevision, video on demand and pay-per-view) for *Cloud 9*.  Pursuant tothe agreement covering domestic distribution (“Domestic Agreement”), theProduction Company received in June 2005 a non-refundable advance of $450,000on our share of the net receipts from the domestic distribution of *Cloud 9* that was distributed to us.  This advance was recognized as revenue inJune 2005 upon delivery of the completed film. The Domestic Agreement allows the licensee to receive a distribution feeequal to 20% of gross domestic receipts of *Cloud9*after its recoupment of all manufacturing, distribution andmarketing costs from those receipts.  *Cloud 9* was released in the domestic videomarket during January 2006.  The domesticdistributor of *Cloud 9* is notrequired to report revenue results to us until 60 days after the end of eachcalendar quarter.  We will record revenuefrom the domestic distribution of *Cloud 9*on the date that we receive detailed reporting of the sales results from thedomestic distributor and can accurately determine our revenues from thisdistribution.  In July 2006, we receivedthe first reporting from the domestic distributor and based on the sales datarevised our ultimate revenue estimate. This resulted in an impairment charge to film costs of $1,445,014.

During June 2005,the Production Company entered in to an agreement for the internationaldistribution of *Cloud 9*(“InternationalAgreement”).  Under the InternationalAgreement the licensee is entitled to receive recoupment  of its manufacturing, distribution andmarketing costs and thereafter a distribution fee of equal to 15% of grossinternational receipts up to $2,000,000 and 10% of gross international receiptsabove $2,000,000.  During the six monthsended June 30, 2006, we earned approximately $204,000 of revenue under thisagreement.

Furthermore,during June 2005, the Production Company entered in to a Sales Agency Agreementfor the marketing of the broadcast rights (pay and free television,video-on-demand and pay-per-view) of *Cloud 9*(“Broadcast Agreement”).  Pursuant to theBroadcast Agreement, the licensee is entitled to a fee equal to 20% of thegross receipts from broadcast of *Cloud 9*on pay and free television, video-on-demand and pay-per-view after itsrecoupment of its distribution expenses.

As a result of theagreements with the director, casting company, actors and co-finance providers,our residual net profits interest in *Cloud 9*is 30.6% after recoupment and payment of all distribution costs, expenses andfees.  Furthermore, our co-financeproviders were entitled to receive the first $500,000 of proceeds we receivefrom the licensing of the distribution rights of *Cloud 9* of which we have paid in whole.  After giving effect to the recovery of the$500,000 contributions to the production costs of *Cloud 9* under the co-financing agreements and then therecovery of our production costs and other invested costs and interest, our netprofits interest in *Cloud 9* willbe 30.6%.   Our entitlement todistributions from the Production Company and the profits interest granted toBert Reynolds provide for interest at a rate of 2% above the prime rate(limited to 5%) for purposes of determining recovery of the production andother costs of *Cloud 9*.

***The Hunt*.** During March 2005, we commenced and completedprincipal filming of our second motion picture project titled, *The Hunt*. *The Hunt* has been releasedin the international market and is expected to be released domestically laterin 2006.  We have incurred totalproduction costs for *The Hunt* ofapproximately $387,000 as of June 30, 2006.

In July 2005, weentered into an agreement for the domestic distribution of *The Hunt*. The agreement grants the licensee a distribution fee equal to 22.5% ofgross receipts and allows for the recoupment of all manufacturing, distributionand marketing costs.  We have alsoentered into an agreement for the international distribution of *The Hunt*. The agreement grants the licensee a distribution fee equal to 20% of grossreceipts and allows for the recoupment of all manufacturing, distribution andmarketing costs.  During the six monthsended June 30, 2006, we earned approximately $12,000 from the internationaldistribution of *The Hunt*.

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In addition, wesold 35% of the copyright interest in *TheHunt* to the licensee for an amount equal to 50% of the budget of *The Hunt*. As of June 30, 2006, we have received approximately $214,000 from thelicensee (minority interest) under the terms of the agreement.  The company that developed the story conceptfor *The Hunt* retained a 25%interest in the net receipts of *The Hunt*.  Net receipts is defined as receipts after werecoup our production costs, interest and overhead.  In addition, we entered in to netparticipation agreements with the director, casting company and others equal to7% of the net receipts of *The Hunt*.

***Surveillance*. **During August 2005, we commenced andcompleted principal filming of our third motion picture project titled, *Surveillance*.  *Surveillance*has been released in the international market and is expected to bereleased domestically later in 2006.  Wehave incurred total production costs for *Surveillance*of approximately $641,000 as of June 30, 2006.

In July 2005, weentered into an agreement for the domestic distribution of *Surveillance*.  The agreement grants the licensee adistribution fee equal to 25% of gross receipts and allows for the recoupmentof all manufacturing, distribution and marketing costs.  We have also entered into an agreement forthe international distribution of *Surveillance*.  The agreement grants the licensee adistribution fee equal to 20% of gross receipts and allows for the recoupmentof all manufacturing, distribution and marketing costs.

In addition, wesold 50% of the copyright interest in *Surveillance*to the licensee for an amount equal to 50% of the budget of *Surveillance*.  As of June 30, 2006, we have received$312,000 from the licensee (minority interest) under the terms of theagreement.  In addition, we entered in tonet participation agreements with the director, casting company and othersequal to 8% of the net receipts of *Surveillance*.

***Soul’s Midnight*. **During November 2005, we commenced andcompleted the filming of our fourth motion picture titled, *Soul’s Midnight*.  We have incurred total production costs for *Soul’s Midnight* of approximately $686,000as of June 30, 2006.

We have enteredinto an agreement for the domestic distribution of *Soul’s Midnight*.  Theagreement grants the licensee a distribution fee equal to 25% of gross receiptsand allows for the recoupment of all manufacturing, distribution and marketingcosts.  In addition, we sold 25% of thecopyright interest in *Soul’s Midnight*to the licensee for an amount equal to 25% of the budget of *Soul’s Midnight*.  We also sold 50% of the copyright interest in*Soul’s Midnight* to the creatorsof the script for an amount equal to 50% of the budget.  As of June 30, 2006, we have received $513,500from the minority interests under the terms of the agreement.

***Fingerprints.*** During April 2006, we commenced and completedthe filming of our fifth motion picture project titled, *Fingerprints*.  We anticipate completing the filming of thismovie in April 2006.  We have incurredtotal production costs for *Fingerprints*of approximately $586,000 as of June 30, 2006.

We have enteredinto an agreement for the domestic distribution of *Fingerprints*.  Theagreement grants the licensee a distribution fee equal to 25% of gross receiptsand allows for the recoupment of all manufacturing, distribution and marketingcosts.  In addition, we sold 42.5% of thecopyright interest in *Fingerprints*to the licensee for an amount equal to 42.5% of the budget of *Fingerprints*.  We also sold 20% of the copyright interest in*Fingerprints* to the creators ofthe script for an amount equal to 20% of the budget.  As of June 30, 2006, we have received $406,250from the minority interests under the terms of the agreement.

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***Summary Motion Picture Revenue Participation and Net Rightsin Distribution.***  The following summarizes the revenueparticipations before and after net profit participations in our films *The Hunt*, *Surveillance,Soul’s Midnight* and *Fingerprints*:
| ** **                   | ** ** | **Before Payout** | ** ** | **After Payout** | ** ** |
|------------------------------|------------|------------------------|------------|-----------------------|------------|
| ** **                   | ** ** | **Company**            | ** ** | **Other  Members**    | ** ** | **Company** | ** ** | **Other  Members** | ** ** | **Third-Party Interest** | ** ** |
|                         |       |                   |       |                  |       |   |   |   |   |   |   |
| The Hunt                     |       |                   |       |                  |       |   |   |   |   |   |   |
| Revenue allocation           |       | 65                     | %          | 35                    | %          | 44 | % | 24 | % | 34 | % |
| Production costs to be paid  |       | 50                     | %          | 50                    | %          |   |   |   |   |   |   |
|                         |       |                   |       |                  |       |   |   |   |   |   |   |
| Surveillance                 |       |                   |       |                  |       |   |   |   |   |   |   |
| Revenue allocation           |       | 50                     | %          | 50                    | %          | 46 | % | 46 | % | 8 | % |
| Production costs to be paid  |       | 50                     | %          | 50                    | %          |   |   |   |   |   |   |
|                         |       |                   |       |                  |       |   |   |   |   |   |   |
| Soul’s Midnight         |       |                   |       |                  |       |   |   |   |   |   |   |
| Revenue allocation           |       | 25                     | %          | 75                    | %          | 24 | % | 72 | % | 4 | % |
| Production costs to be paid  |       | 25                     | %          | 75                    | %          |   |   |   |   |   |   |
|                         |       |                   |       |                  |       |   |   |   |   |   |   |
| Fingerprints                 |       |                   |       |                  |       |   |   |   |   |   |   |
| Revenue allocation           |       | 35                     | %          | 65                    | %          | 34 | % | 62 | % | 4 | % |
| Production costs  to be paid |       | 35                     | %          | 65                    | %          |   |   |   |   |   |   |

 

The table belowsummarizes the distribution fees negotiated as of June 30, 2006 on a per moviebasis (markets that have no distribution agreements in place are identified as “n/a”):
| ****                 | ** ** | **Cloud 9** | ** ** | **The  Hunt** | ** ** | **Surv-  eillance** | ** ** | **Soul’s  Midnight** | ** ** | **Finger-  prints** | ** ** |
|----------------------|------------|------------------|------------|---------------|------------|---------------------|------------|---------------------------|------------|---------------------|------------|
|                 |       |             |       |          |       |                |       |                      |       |                |       |
| Domestic DVD  market |       | 20               | %          | 22.5          | %          | 25                  | %          | 25                        | %          | 25                  | %          |
| Broadcast            |       | 20               | %          | n/a           |       | n/a                 |       | n/a                       |       | n/a                 |       |
| International        |       | 15               | %          | 20            | %          | 20                  | %          | n/a                       |       | n/a                 |       |

 

***Convertible Note Financing.***  In August and October 2005, we issued twopromissory notes (the “Notes”) in the aggregate principal amount of$1,500,000.  The Notes are secured by allof our assets and the assets of our current and future subsidiaries.  The Notes bear interest at the rate of 8% perannum that is payable quarterly and can be paid in cash or shares of our commonstock.  The Notes become due and payableon the first to occur of:

·                                          July27, 2007 for the first note and October 25, 2007 for the second note (the “MaturityDates”);

·                                          theconsummation of a “Qualified Financing;” or

·                                          thecontinuation of and Event of Default, as defined, for more than 30 daysfollowing notice of the occurrence of an Event of Default.

Upon consummationof a Qualified Financing, the outstanding principal amount of the Notes and allaccrued and unpaid interest (collectively the “Note Balance”) willautomatically convert into shares of our common stock or other equitysecurities equal to 120% of the Note Balance divided by the price per share ofour common stock or other  equitysecurities sold in the Qualified Financing. The maximum price or value of our common stock or other equitysecurities into which the Note Balance converts may not exceed the equivalentof $1.10 per common stock share. Qualified Financing refers to any equity financing pursuant to which wereceive aggregate gross cash proceeds of $2,000,000 or more on or before theMaturity Date.

In conjunctionwith issuance of the Notes, we and the holder of the Notes entered into commonstock purchase warrant agreements, each evidencing warrants exercisable on orbefore August 5, 2010 for the first note and October 25, 

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2010 for the secondnote.  Two agreements provide for thepurchase of 250,000 (500,000 total) common stock shares at $2.00 and the othertwo agreements provide for the purchase of 250,000 (500,000 total) common stockshares at $3.00.

The fair value ofeach warrant issued was estimated on the date of issuance using theBlack-Scholes option pricing model.  Thefair value of the options were based on the difference between the presentvalue of the exercise price of the option and the estimated fair value price ofthe common share.  The fair value of thewarrants was estimated to be $349,459 and was recorded as paid-in capital andas a discount to the value of the notes. The value of the warrants will be amortized to interest expense over therespective terms of the Notes.

***Output Agreement.***  In June 2005, we entered into an agreementproviding Image Entertainment (“Image”) with the first-look right at the movieswe produce (the “Output Agreement”). Image has a “first look” on all projects up to $2,000,000 that weundertake during the three-year period beginning on the date of delivery of *The Hunt* which was delivered in February2006.  If Image were to choose not tobecome involved in a motion picture project, we have the right to produce anddistribute the motion picture with another person without any furtherobligation to Image.  Image agreed tofund up to 50% of each production budget for mutually agreed upon motion pictureprojects.  This funding is payable inthree installments:  20% of the approved productionbudget through pre-production, 60% through the physical shooting schedule, and20% through the post-production process.

For a term of 20years, Image will have domestic distribution rights of each motion picture weco-produce with Image.  Image isentitled to receive a 25% distribution fee from gross domestic sales and aback-end profit participation from all sales after payment of the distributionfee.  In general, the back-end profitparticipation  interest and ownershipinterest in each co-produced motion picture will be based upon Image’s fundingof the budgeted share of production costs. The actual back-end profit participation percentage is equal to thepercentage Image funds of the motion picture project after recovery from salesof the mutually approved expenses.  Ourjoint exploitation of the broadcast rights with Image have been left to futurenegotiation.

**AccountingMethods**

The application ofthe following accounting policies, which are important in presenting ourfinancial position and results of operations, requires significant judgmentsand estimates on the part of management. For a summary of all of our accountingpolicies, including the accounting policies discussed below, see note 2 to theunaudited consolidated financial statements appearing elsewhere in this report.

In June 2000, theAccounting Standards Executive Committee of the American Institute of CertifiedPublic Accountants issued Statement of Position 00-2, Accounting byProducers or Distributors of Films (“SoP 00-2”).  SoP 00-2 establishes accountingstandards for producers or distributors of films, including changes in revenuerecognition, capitalization and amortization of costs of acquiring films andtelevision programs and accounting for exploitation costs, includingadvertising and marketing expenses. These accounting standards are as follows:

·                                          advertisingand marketing costs are expensed the first time the advertising takes place;and

·                                          thecapitalization of production costs for episodic television series is limited torevenue that has been contracted for on an episode-by-episode basisuntil the time that the criteria for recognizing secondary market revenues aremet.

We capitalize thecosts of production, including financing costs, to investment in motionpictures.  These costs are amortized todirect operating expenses in accordance with SoP 00-2. These costs arestated at the lower of unamortized motion picture costs or fair value (netpresent value).  Costs for an individualmotion picture are amortized in the proportion that current period actualrevenues bear to management’s estimates of the total revenue expected to bereceived from the motion picture over a period not to exceed 10 years from thedate of delivery.  We are required toregularly review and revise when necessary the total revenue estimates of eachmotion picture produced.  As a result, ifrevenue estimates change with respect to a motion picture, it may be necessaryto write down all or a portion of the 

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unamortized costs of themotion picture.  There is no assurancethat revised revenue estimates will not occur that result in significant write-downsaffecting our results of operations and financial condition.

Revenue from thesale or licensing of motion pictures will be recognized upon meeting allrecognition requirements of SoP 00-2. Revenue from the theatrical release of motion pictures will berecognized at the time of exhibition based on our participation in box officereceipts.  If applicable, revenue fromthe sale of DVDs in the retail market, net of an allowance for estimatedreturns, is recognized on the later of shipment to the customer or “street date”(when it is available for sale by the customer).  Furthermore, if applicable, under revenuesharing arrangements, rental revenue is recognized when we become entitled toreceipts.  For contracts that provide forrights to exploit a motion picture on multiple media (e.g. theatrical, video,television) with a fee for a single motion picture where the contract specifiesthe permissible timing of release to various media, the fee is allocated to thevarious media based on an assessment of the relative fair value of the rightsto exploit each media and will be recognized as the movie is released to eachmedia.  For multiple-titlecontracts with a fee, the fee is allocated on a title-by-titlebasis, based on an assessment of the relative fair value of each title.  If applicable, revenues from televisionlicensing are recognized when the motion picture becomes available to thelicensee for telecast.  Cash paymentsreceived are recorded as deferred revenue until all the conditions of revenuerecognition have been met.  If applicable,we accrue for video returns and provide for allowances in the financialstatements based on previous returns and our allowances history on a title-by-titlebasis in each of the video businesses. In this case, there may be differencesbetween actual returns and allowances and our historical experience that wecurrently do not have.  Revenues earnedfrom the sale of DVDs through distribution agreements are recognized when salesfrom these distributors are known or can be accurately estimated.

We depend on thedistributors of any motion picture we produce to account for and accuratelyreport our share of exhibition revenue. While we expect to have certain audit rights to verify exhibitionrevenues received by our North American distributors,

·                                          distributorsare often in a position to account for revenues in a manner that understates orfails accurately to account for revenues or

·                                          distributorsmay fail to maintain appropriate accounting records making it difficult todetermine a producer’s actual share of revenues upon audit.

Although we do nothave any experience related to auditing distributors’ revenue accounting, weanticipate that the costs associated with this type of audit may be substantialand may vary significantly from distributor-to-distributor and evenpicture-to-picture.  Therefore, there isno assurance that, in all cases, we will be able to obtain an accurateaccounting of exhibition revenues or that audits will result in increases inthe revenues that justify the associated audit costs.

**RecentAccounting Pronouncements**

*SFAS123(R)*B In December 2004, the FinancialAccounting Standards Board (FASB) issued Statement of Financial AccountingStandards (SFAS) No. 123(R), *Share-BasedPayment*.  SFAS 123(R) replacesSFAS No. 123, *Accounting for Stock-BasedCompensation*, and supersedes *AccountingPrinciples Board* (APB) Opinion No. 25, *Accounting for Stock Issued to Employees*.  We adopted SFAS 123(R) on January 1, 2006using the modified prospective method as described in the standard.  Under the modified prospective method, we arerequired to record compensation cost for new and modified awards over therelated vesting period of such awards prospectively and record compensationcost prospectively for the unvested portion at time of adoption, of previouslyissued and outstanding awards over the remaining vesting period of suchawards.  As of January 1, 2006, we had nounvested outstanding awards and as a result, the adoption of SFAS123(R) had noimpact on our consolidated financial statements or consolidated results ofoperations.

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**Results of Operations**

The following table setsforth selected results of our operations for the three and six months endedJune 30, 2006 and 2005.  The followinginformation was derived and taken from our unaudited financial statementsappearing elsewhere in this report.
| ** **                        | ** ** | **For the Three Months Ended  June 30,** | ** ** | **For the Six Months Ended  June 30,** | ** ** |
|-----------------------------------|------------|-------------------------------------------------------------------|------------|-----------------------------------------------------------------|------------|
| ** **                        | ** ** | **2006**                                                          | ** ** | **2005**                                                        | ** ** | **2006** | ** ** | **2005** | ** ** |
| Revenue                           |       | $                                                                 | 47,580     |                                                            | $          | 450,000 |   | $ | 236,866 |   | $ | 450,000 |   |
| Expenses:                         |       |                                                              |       |                                                            |       |   |   |   |   |
|  Direct  operating           |       | 31,440                                                            |       | 409,237                                                         |       | 191,451 |   | 409,237 |   |
|  Impairment of  film costs   |       | 1,445,014                                                         |       | —                                                          |       | 1,445,014 |   | — |   |
|  General and  administrative |       | 95,462                                                            |       | 107,027                                                         |       | 201,130 |   | 201,698 |   |
|  Depreciation                |       | 1,216                                                             |       | 1,216                                                           |       | 2,431 |   | 2,432 |   |
|                              |       |                                                              |       |                                                            |       |   |   |   |   |
| Total expenses                    |       | 1,573,132                                                         |       | 517,480                                                         |       | 1,840,026 |   | 613,367 |   |
|                              |       |                                                              |       |                                                            |       |   |   |   |   |
| Operating loss                    |       | (1,525,552                                                        | )          | (67,480                                                         | )          | (1,603,160 | ) | (163,367 | ) |
|                              |       |                                                              |       |                                                            |       |   |   |   |   |
| Other income  (expense):          |       |                                                              |       |                                                            |       |   |   |   |   |
|  Interest and  other income  |       | 7,514                                                             |       | 1,059                                                           |       | 16,646 |   | 4,791 |   |
|  Interest  expense           |       | (92,262                                                           | )          | —                                                          |       | (183,839 | ) | — |   |
|  Minority  interests         |       | (4,458                                                            | )          | —                                                          |       | (4,839 | ) | — |   |
|                              |       |                                                              |       |                                                            |       |   |   |   |   |
| Net other income (expense)        |       | (89,206                                                           | )          | 1,059                                                           |       | (172,032 | ) | 4,791 |   |
|                              |       |                                                              |       |                                                            |       |   |   |   |   |
| Net loss before  income taxes     |       | (1,614,758                                                        | )          | (66,421                                                         | )          | (1,775,192 | ) | (158,576 | ) |
| Provision for  income taxes       |       | —                                                            |       | —                                                          |       | — |   | — |   |
|                              |       |                                                              |       |                                                            |       |   |   |   |   |
| Net loss                          |       | $                                                                 | (1,614,758 | )                                                               | $          | (66,421 | ) | $ | (1,775,192 | ) | $ | (158,576 | ) |

 

**Comparisonof the Three-Month Periods Ended June 30, 2006 and 2005**

Our consolidatedrevenues for the three months ended June 30, 2006 (the “2006 2nd Quarter”) were$47,580 and were attributable to the international distribution of *Cloud 9,**TheHunt*and*Surveillance*.  We generated $450,000 of revenue in the prioryear’s second quarter from the non-refundable advance we received on thedomestic distribution of *Cloud 9*.

Direct operatingexpenses primarily include amortization of film costs and participationcosts.  Our direct operating expenses of$31,440 for the 2006 2nd Quarter were 66% of revenues.  Our direct operating expenses of $409,237 forthe 2005 2nd Quarter were 91% of revenues. The ratio of direct operating expenses to revenue is dependent on ourestimate of the ultimate revenue of each film.

As of June 30,2006, our domestic distributor had reported to us domestic DVD sales ofapproximately 100,000 units.  Based onthe actual results through June 30, 2006, we do not feel that we can bereasonably assured of receiving domestic revenue in excess of the $450,000non-refundable advance we received in 2005. As a result, we wrote down the carrying value of *Cloud 9* by $1,445,014 to $393,000 which isequal to the amount that management estimates will be collected throughcontinuing international distribution and broadcast distribution of *Cloud 9*.

General andadministration expenses of $95,462 for the 2006 2nd Quarter decreased $11,565,or 11%, from $107,027 in the prior year’s quarter.  The decrease in general and administrationexpenses was primarily due to a decrease in legal and professional feesassociated with our reporting and filing requirements as a public company and adecrease in employee benefits which were offset by a increase in our monthlylease expense.

8

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During the 20062nd Quarter, we realized interest income of $7,514, compared to $1,059 in theprior year’s first quarter.  Thisincrease was attributable to a corresponding increase in the balance of cashand cash equivalents held in interest bearing accounts and an increase in theyield earned on those accounts.

We incurredinterest expense of $92,262 during the 2006 2nd Quarter that was attributableto our convertible notes payable, amortization of prepaid loan fees andamortization of warrants issued with the convertible notes payable.  We did not incur any interest expense in theprior year’s quarter.

Minority interestsin our earnings for the 2006 2nd Quarter were $4,458 and were attributable tominority interests in our movies *The Hunt*and *Surveillance*.

**Comparisonof the Six-Month Periods Ended June 30, 2006 and 2005**

Our consolidatedrevenues for the six months ended June 30, 2006 were $236,866 and wereattributable to the international distribution of *Cloud 9,**The Hunt*and*Surveillance*.  We generated $450,000 of revenue in the prioryear’s first quarter from the non-refundable advance we received on thedomestic distribution of *Cloud 9*.

Direct operatingexpenses primarily include amortization of film costs and participationcosts.  Our direct operating expenses of$191,451 for the six months ended June 30, 2006 were 81% of revenues.  Our direct operating expenses of $409,237 forthe six months ended June 30, 2005 were 91% of revenues.  The ratio of direct operating expenses torevenue is dependent on our estimate of the ultimate revenue of each film.

As of June 302006, our domestic distributor had reported to us domestic DVD sales ofapproximately 100,000 units.  Based onthe actual results through June 30, 2006, we do not feel that we can bereasonably assured of receiving domestic revenue in excess of the $450,000non-refundable advance we received in 2005. As a result, we wrote down the carrying value of *Cloud 9* by $1,445,014 to $393,000 which isequal to the amount that management estimates will be collected throughcontinuing international distribution and broadcast distribution of *Cloud 9*.

General andadministration expenses of $201,130 for the six months ended decreased lessthan 1% from $201,698 in the prior year’s first six months.  The decrease in general and administrationexpenses was primarily due to a decrease in legal and professional feesassociated with our reporting and filing requirements as a public company and adecrease in employee benefits which were offset by a increase in our monthlylease expense.

During the firstsix months of 2006, we realized interest income of $16,646, compared to $4,791in the prior year’s first six months. This increase was attributable to a corresponding increase in thebalance of cash and cash equivalents held in interest bearing accounts and anincrease in the yield earned on those accounts.

We incurredinterest expense of $183,839 during the first six months of 2006 that wasattributable to our convertible notes payable, amortization of prepaid loanfees and amortization of warrants issued with the convertible notespayable.  We did not incur any interestexpense in the prior year’s first six months.

Minority interestsin our earnings for the six months ended June 30, 2006 were $4,839 and wereattributable to minority interests in our movies *The Hunt* and *Surveillance*.

 

9

----

 

**Liquidity and Capital Resources**

Our liquidity and capitalresources are provided principally through cash generated from operations,issuance of convertible notes payable and equity offerings.  Our cash and cash equivalents at June 30,2006 totaled approximately $889,000.  Asof June 30, 2006, we had working capital of approximately $837,000.

In April 2004, wecompleted our private placement offering of our common stock shares andredeemable warrants in units of one common stock share and one redeemable warrant.  During 2003 and 2004, we received netproceeds of $2,535,224 from this private placement offering.

During 2005, we received$1,500,000 in proceeds from the issuance of convertible promissory notes.

Operating activities forthe six months ended June 30, 2006, used net cash of $665,005 compared tooperating activities for the six months ended June 30, 2005 which used$205,038.  The decrease in cash flowsused by operating activities was attributable to a decrease of revenuegenerated during the first six months of 2006 and an increase in expendituresfor film costs.

Investingactivities for the six months ended June 30, 2006, generated net cash of$450,385 as a result of contributions made by our minority interests on certainfilm projects.  We did not have anyinvesting activities during the first six months of 2005.

Financingactivities during the six months ended June 30, 2006 and 2005, used cash of$50,000 and $450,000, respectively, for the repayment of film obligations.  During the first six months of 2006, we issued64,132 shares of common stock as payment of accrued interest (in the amount of$56,167) due on convertible notes payable.

***Financial Commitments***

***FilmCapital, Inc. Agreement.**** *In March 2002, Messrs. Fredericksonand Stansberry, members of Graymark Productions, L.L.C., entered into anagreement to pay FilmCapital, Inc. $50,000 for services performed.  This liability is only payable in the eventGraymark Productions, L.L.C. or its affiliates obtain funding for film projectsfrom outside investors.  Messrs.Frederickson and Stansberry have each represented that their intent was not tocause Graymark Productions, L.L.C. to be liable for this obligation and eachhas agreed to indemnify us for any liability that may arise out of thisagreement.  In December 2003, we recordeda consulting expense and liability of $50,000 related to the agreement withFilmCapital.  At the time that we paythis recorded liability, Messrs. Frederickson and Stansberry will be requiredimmediately to reimburse us for the payment.

***Registration Obligations.***** Weagreed, at our expense, to register the common stock shares and redeemablewarrants offered for sale pursuant to our private placement of 2,995,000 commonstock shares and redeemable warrants exercisable for the purchase of 2,995,000common stock shares under the 1933 Act and to maintain effectiveness of theregistration for a seven-year period ending on April 14, 2010.  Registration of the common stock shares andredeemable warrants became effective July 13, 2004.

Furthermore, wealso similarly agreed to register (and maintain effective of the registrationunder the 1933 Act for the seven-year period) the 443,250 common stock sharesunderlying the placement agent warrants sold to the underwriter of our privateplacement offering, Viewtrade Financial, and 383,425 common stock shares issuedpursuant to the  one-year FinancialAdvisor Agreement to Viewtrade Financial. In accordance with this obligation, we initially included these commonstock shares in the registration statement that registered the privateplacement common stock shares and redeemable warrants; however, on February 27,2004, Viewtrade Financial, on its own behalf as well as the other holders ofthe placement agent warrants and the recipients and holders of the common stockshares assigned to affiliates of Viewtrade Financial, elected to remove thoseshares from the registration statement. Although we have been informed by our legal counsel that the commonstock shares, other than those underlying the placement agent warrants, 

10

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may be sold withoutfurther restriction pursuant to Rule 144 as promulgated by the Securities andExchange Commission, we anticipate filing a registration statement inaccordance with this registration obligation during the last half of 2006.

***Office Space Arrangement*.** Our corporate headquarters and offices arelocated at 101 North Robinson, Suite 920, Oklahoma City, Oklahoma.  These office facilities consist approximatelyof 1,500 square feet and are occupied under an written month-to-month leasearrangement, requiring monthly rental payments of approximately $2,100.  The costs of building-out and improving ouroffices was approximately $15,000 which we paid rather than Corporate Tower,LLC, our landlord.  Roy T. Oliver, one ofour greater than 5% shareholders and affiliates, controls Corporate Tower,LLC.  Mr. Oliver on behalf of CorporateTower, LLC has orally indicated that as of the date of this report there is nointent to terminate our occupancy of the office facilities.  Under Oklahoma law, termination of ourmonth-to-month lease arrangement requires at least 30 days prior writtennotice.  In the event of thistermination, we believe there is adequate office space and facilities availablein the Oklahoma City area.

***12-Month Overhead Budget***

Our budgeted overheadexpenses for the next 12 months are as follows:

| Expenditure                        | ** ** | **Monthly** | ** ** | **12  Months** | ** ** |
|------------------------------------|------------|-------------|------------|----------------|------------|
| Administrative  expenditures:      |       |        |       |           |       |
| Executive officer compensation     |       | $           | 12,000     |           | $          | 144,000 |   |
| Administrative salaries            |       | 3,000       |       | 36,000         |       |
| Payroll taxes                      |       | 1,200       |       | 14,400         |       |
| Telephone                          |       | 600         |       | 7,200          |       |
| Rent                               |       | 2,100       |       | 25,200         |       |
| Legal                              |       | 3,000       |       | 36,000         |       |
| Accounting                         |       | 3,000       |       | 36,000         |       |
| Public relations                   |       | 500         |       | 6,000          |       |
| Insurance                          |       | 500         |       | 6,000          |       |
| Stock transfer                     |       | 800         |       | 9,600          |       |
| Miscellaneous                      |       | 1,000       |       | 12,000         |       |
| Total  Administrative Expenditures |       | $           | 27,700     |           | $          | 332,400 |   |

 

***Additional Financial Commitments***

Other than our commitments discussed above, we do nothave any capital  commitments.  Although we do not have any commitments, wemay enter into long-term lending arrangements during the next 12 months toprovide additional working capital and fund additional movie projects we desireto undertake.  In addition, we mayreceive additional funds from the exercise of outstanding warrants and stockoptions, the exercise of which is generally not within our control.

If our productionactivities are successful (of which there is no assurance) or movie productionbudgets increase, we may be required to increase overhead by hiring additionalemployees and increase our office facilities. We anticipate that during the next 12 months we will not be required toincrease the number of our employees or increase our office facilities.

We believe thatour operations as a result of our motion picture projects will achieveprofitability.  We provide no assurancethat

·                                          wewill be successful in implementing our business plan or

11

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·                                          unanticipatedexpenses or problems or technical difficulties will not occur which wouldresult in significant delays.

Either one of these willadversely affect our ability to become profitable or to maintain profitability.

Future commitmentsunder contractual obligations by expected maturity date at June 30, 2006 are asfollows:

 
| ** **                 | ** ** | **< 1 year** | ** ** | **1-3 years** | ** ** | **3-5 years** | ** ** | **> 5 years** | ** ** | **Total** | ** ** |
|----------------------------|------------|---------------------------|------------|--------------------|------------|--------------------|------------|----------------------------|------------|-----------|------------|
|                       |       |                      |       |               |       |               |       |                       |       |      |       |
| Convertible  notes payable |       | $                         | —     |               | $          | 1,500,000          |       | $                          | —     |      | $          | — |   | $ | 1,500,000 |   |
| Operating leases           |       | 25,608                    |       | —             |       | —             |       | —                     |       | 25,608    |       |
|                       |       |                      |       |               |       |               |       |                       |       |      |       |
|                       |       | $                         | 25,608     |               | $          | 1,500,000          |       | $                          | —     |      | $          | — |   | $ | 1,525,608 |   |

 

**CautionaryStatement Relating to Forward Looking Information**

We have includedsome forward-looking statements in this section and other places in this reportregarding our expectations.  Theseforward-looking statements involve known and unknown risks, uncertaintiesand other factors which may cause our actual results, levels of activity,performance or achievements, or industry results, to be materially differentfrom any future results, levels of activity, performance or achievementsexpressed or implied by these forward-looking statements.  Some of these forward-lookingstatements can be identified by the use of forward-looking terminologyincluding “believes,” “expects,” “may,” “will,” “should” or “anticipates” orthe negative thereof or other variations thereon or comparable terminology, orby discussions of strategies that involve risks and uncertainties.  You should read statements that contain thesewords carefully because they:

·                                          discussour future expectations;

·                                          containprojections of our future operating results or of our future financialcondition; or

·                                          stateother “forward-looking” information.

We believe it isimportant to discuss our expectations; however, it must be recognized thatevents may occur in the future over which we have no control and which we arenot accurately able to predict.  Readersare cautioned to consider the specific business risk factors described underthe caption “Additional Factors that May Affect Our Future Results” appearingunder “Item 1. Description of Business” of our Annual Report on Form 10-KSBfiled with the United States Securities and Exchange Commission on March 24,2006, and not to place undue reliance on the forward-looking statementscontained herein, which speak only as of the date of this report.  We undertake no obligation to publicly reviseforward-looking statements to reflect events or circumstances that may ariseafter the date of this report.

**Item3.  Controls and Procedures**

Our Chief Executive Officer and Chief FinancialOfficer are responsible primarily for establishing and maintaining disclosurecontrols and procedures designed to ensure that information required to bedisclosed in our reports filed or submitted under the Securities Exchange Actof 1934, as amended (the “Exchange Act”) is recorded, processed, summarized andreported within the time periods specified in the rules and forms of the U.S.Securities and Exchange Commission. These controls and procedures are designed to ensure that informationrequired to be disclosed in our reports filed or submitted under the ExchangeAct is accumulated and communicated to our management, including our principalexecutive and principal financial officers, or persons performing similarfunctions, as appropriate to allow timely decisions regarding requireddisclosure.

Furthermore, ourChief Executive Officer and Chief Financial Officer are responsible for thedesign and supervision of our internal controls over financial reporting  that are then effected by and through ourboard of directors, 

12

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management and otherpersonnel, to provide reasonable assurance regarding the reliability of ourfinancial reporting and the preparation of financial statements for externalpurposes in accordance with generally accepted accounting principles.  These policies and procedures (i) pertain tothe maintenance of records that, in reasonable detail, accurately and fairlyreflect the transactions and dispositions of our assets; (ii) providereasonable assurance that transactions are recorded as necessary to permitpreparation of financial statements in accordance with generally acceptedaccounting principles, and that our receipts and expenditures are being madeonly in accordance with authorizations of our management and directors; and(iii) provide reasonable assurance regarding prevention or timely detection ofunauthorized acquisition, use or disposition of our assets that could have amaterial effect on our financial statements.

Our ChiefExecutive Officer and Chief Financial Officer, based upon their evaluation ofthe effectiveness of our disclosure controls and procedures and the internalcontrols over financial reporting as of the last day of the period covered bythis report, concluded that our disclosure controls and procedures and internalcontrols over financial reporting were fully effective as of the last day ofthe period covered by this report and reported to our auditors and board ofdirectors that no change occurred in our disclosure controls and procedures andinternal control over financial reporting occurred during the period covered bythis report that would materially affect or is reasonably likely to materiallyaffect our disclosure controls and procedures or internal control overfinancial reporting.  In conducting theirevaluation of our disclosure controls and procedures and internal controls overfinancial reporting, these executive officers did not discover any fraud thatinvolved management or other employees who have a significant role in ourdisclosure controls and procedures and internal controls over financial reporting.  Furthermore, there were no significantchanges in our disclosure controls and procedures, internal controls overfinancial reporting, or other factors that could significantly affect ourdisclosure controls and procedures or internal controls over financialreporting subsequent to the date of their evaluation.  Because no significant deficiencies ormaterial weaknesses were discovered, no corrective actions were necessary ortaken to correct significant deficiencies and material weaknesses in our internalcontrols and disclosure controls and procedures.

**PART II OTHER INFORMATION**
| **Item 1.** | **Legal Proceedings**                                            |
|-------------|------------------------------------------------------------------|
|        |                                                             |
|        | None                                                             |
| ** **  | ** **                                                       |
| **Item 2.** | **Unregistered Sales of Equity Securities and Use  of Proceeds** |
|        |                                                             |
| (a)         | None                                                             |
|        |                                                             |
| (b)         | None                                                             |
|        |                                                             |
| (c)         | None                                                             |
| ** **  | ** **                                                       |
| **Item 3.** | **Defaults Upon Senior Securities**                              |
|        |                                                             |
|        | None                                                             |
| ** **  | ** **                                                       |
| **Item 4.** | **Submission of Matters to a Vote of Security  Holders**         |
| ** **  | ** **                                                       |
|        | None                                                             |
| ** **  | ** **                                                       |
| **Item 5.** | **Other Information**                                            |
|        |                                                             |
|        | None                                                             |

 

13

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**Item 6.**                          Exhibits

| Exhibit No. | ** ** | **Description**                                                                                                                                                                             |
|-------------|------------|---------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|
|        |       |                                                                                                                                                                                        |
| 3.1         |       | Registrant’s Certificate of Incorporation,  incorporated by reference to Registration Statement on Form SB-2 (No.  333-111819) filed with the Commission on January 9, 2004.           |
|        |       |                                                                                                                                                                                        |
| 3.2         |       | Registrant’s Bylaws, incorporated by reference to  Registration Statement on Form SB-2 (No. 333-111819) filed with the  Commission on January 9, 2004.                                 |
|        |       |                                                                                                                                                                                        |
| 31.1        |       | Certification of John Simonelli, Chief Executive  Officer of Registrant.                                                                                                                    |
|        |       |                                                                                                                                                                                        |
| 31.2        |       | Certification of Mark R. Kidd, Chief Financial  Officer and Controller of Registrant.                                                                                                       |
|        |       |                                                                                                                                                                                        |
| 32.1        |       | Certification Pursuant to 18 U.S.C. Section 1350, as  Adopted Pursuant to Section 906 of Sarbanes-Oxley Act of 2002 of John  Simonelli, Chief Executive Officer of Registrant.              |
|        |       |                                                                                                                                                                                        |
| 32.2        |       | Certification Pursuant to 18 U.S.C. Section 1350, as  Adopted Pursuant to Section 906 of Sarbanes-Oxley Act of 2002 of Mark R.  Kidd, Chief Financial Officer and Controller of Registrant. |

** **

**SIGNATURES**

In accordance withthe Exchange Act, the Registrant caused this report to be signed on its behalfby the undersigned, thereunto duly authorized.
|                  | GRAYMARK PRODUCTIONS, INC. |
|-----------------------|----------------------------|
|                  | (Registrant)               |
|                  |                       |
|                  | By:                        | /s/ JOHN SIMONELLI |
|                  |                       | John Simonelli |
|                  |                       | Chief Executive Officer |
| Date: August 11, 2006 |                       |   |
|                  |                       |   |
|                  | By:                        | /s/ MARK R. KIDD |
|                  |                       | Mark R. Kidd |
|                  |                       | Chief Financial Officer and Controller |
| Date: August 11, 2006 |                       |   |
|                  |                       |   |
|                  |                       |   |

 

 

 

14

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**GRAYMARKPRODUCTIONS, INC.**

**INDEXTO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS**

 
| Condensed Consolidated  Balance Sheets as of June 30, 2006 and December 31, 2005                       |   |   |
|--------------------------------------------------------------------------------------------------------|--------|--------|
|                                                                                                   |   |   |
| Condensed Consolidated Statements of Operations for  the Three Months Ended June 30, 2006 and 2005     |   |   |
|                                                                                                   |   |   |
| Condensed Consolidated Statements of Operations for  the Six Months Ended June 30, 2006 and 2005       |   |   |
|                                                                                                   |   |   |
| Condensed Consolidated Statements of Shareholders’  Equity for the Six Months Ended June 30, 2006 |   |   |
|                                                                                                   |   |   |
| Condensed Consolidated Statements of Cash Flows for  the Six Months Ended June 30, 2006 and 2005       |   |   |
|                                                                                                   |   |   |
| Notes to Condensed Consolidated Financial Statements                                                   |   |   |

 

F-1

----

 

**GRAYMARKPRODUCTIONS, INC.**

**CondensedConsolidated Balance Sheets(Unaudited)**
| ** **                                                                                                                                                                        | ** ** | **June 30,  2006** | ** ** | **December 31,  2005** | ** ** |
|-----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|------------|-------------------------|------------|-----------------------------|------------|
| ASSETS                                                                                                                                                                            |       |                    |       |                        |       |
|                                                                                                                                                                              |       |                    |       |                        |       |
| Cash and cash  equivalents                                                                                                                                                        |       | $                       | 889,220    |                        | $          | 1,153,840 |   |
| Film deposits                                                                                                                                                                     |       | 19,584                  |       | 32,500                      |       |
| Accounts receivable                                                                                                                                                               |       | 29,341                  |       | —                      |       |
|                                                                                                                                                                              |       |                    |       |                        |       |
| Total current  assets                                                                                                                                                             |       | 938,145                 |       | 1,186,340                   |       |
|                                                                                                                                                                              |       |                    |       |                        |       |
| Fixed assets, net                                                                                                                                                                 |       | 13,892                  |       | 16,325                      |       |
| Prepaid loan fees                                                                                                                                                                 |       | 89,794                  |       | 126,986                     |       |
| Investment in films                                                                                                                                                               |       | 2,523,967               |       | 3,458,417                   |       |
|                                                                                                                                                                              |       |                    |       |                        |       |
| Total assets                                                                                                                                                                      |       | $                       | 3,565,798  |                        | $          | 4,788,068 |   |
| ** **                                                                                                                                                                        | ** ** | ** **              | ** ** | ** **                  | ** ** |
| LIABILITIES AND  SHAREHOLDERS’ EQUITY                                                                                                                                        |       |                    |       |                        |       |
|                                                                                                                                                                              |       |                    |       |                        |       |
| Liabilities:                                                                                                                                                                      |       |                    |       |                        |       |
| Accounts payable  and accrued liabilities                                                                                                                                         |       | $                       | 101,113    |                        | $          | 101,659 |   |
|                                                                                                                                                                              |       |                    |       |                        |       |
| Total current  liabilities                                                                                                                                                        |       | 101,113                 |       | 101,659                     |       |
|                                                                                                                                                                              |       |                    |       |                        |       |
| Film obligations                                                                                                                                                                  |       | —                  |       | 50,000                      |       |
| Convertible note  payable, net of discounts of $200,560 and $287,207 at June 30, 2006 and  December 31, 2005, respectively                                                        |       | 1,299,440               |       | 1,212,793                   |       |
|                                                                                                                                                                              |       |                    |       |                        |       |
| Total  liabilities                                                                                                                                                                |       | 1,400,553               |       | 1,364,452                   |       |
|                                                                                                                                                                              |       |                    |       |                        |       |
| Minority interests                                                                                                                                                                |       | 1,449,321               |       | 994,097                     |       |
|                                                                                                                                                                              |       |                    |       |                        |       |
| Shareholders’ Equity:                                                                                                                                                        |       |                    |       |                        |       |
| Preferred stock  $0.0001 par value, 10,000,000 authorized; no shares issued and outstanding                                                                                       |       | —                  |       | —                      |       |
| Common stock  $0.0001 par value, 90,000,000 shares authorized; 8,353,283 issued and  outstanding at June 30, 2006 (8,289,151 shares issued and outstanding at  December 31, 2005) |       | 835                     |       | 829                         |       |
| Paid-in capital                                                                                                                                                                   |       | 4,283,443               |       | 4,221,852                   |       |
| Accumulated  deficit                                                                                                                                                              |       | (3,568,354              | )          | (1,793,162                  | )          |
|                                                                                                                                                                              |       |                    |       |                        |       |
| Total  shareholders’ equity                                                                                                                                                  |       | 715,924                 |       | 2,429,519                   |       |
|                                                                                                                                                                              |       |                    |       |                        |       |
| Total liabilities and  shareholders’ equity                                                                                                                                  |       | $                       | 3,565,798  |                        | $          | 4,788,068 |   |

 

See Accompanying Notes to Condensed ConsolidatedFinancial Statements

F-2

----

**GRAYMARKPRODUCTIONS, INC.**

**CondensedConsolidated Statements of Operations(Unaudited)**

 
| ** **                                                               | ** ** | **Three Months Ended  June 30,** | ** ** |
|--------------------------------------------------------------------------|------------|-------------------------------------------------|------------|
| ** **                                                               | ** ** | **2006**                                        | ** ** | **2005** | ** ** |
|                                                                     |       |                                            |       |   |   |
| Revenues                                                                 |       | $                                               | 47,580     |   | $ | 450,000 |   |
|                                                                     |       |                                            |       |   |   |
| Expenses:                                                                |       |                                            |       |   |   |
| Direct operating                                                         |       | 31,440                                          |       | 409,237 |   |
| Impairment of investment in films                                        |       | 1,445,014                                       |       | — |   |
| General and administrative                                               |       | 95,462                                          |       | 107,027 |   |
| Depreciation                                                             |       | 1,216                                           |       | 1,216 |   |
|                                                                     |       |                                            |       |   |   |
| Total expenses                                                           |       | 1,573,132                                       |       | 517,480 |   |
|                                                                     |       |                                            |       |   |   |
| Operating loss                                                           |       | (1,525,552                                      | )          | (67,480 | ) |
|                                                                     |       |                                            |       |   |   |
| Other Income  (Expense):                                                 |       |                                            |       |   |   |
| Interest and other income                                                |       | 7,514                                           |       | 1,059 |   |
| Interest expense                                                         |       | (92,262                                         | )          | — |   |
| Minority interests                                                       |       | (4,458                                          | )          | — |   |
|                                                                     |       |                                            |       |   |   |
| Net other income (expense)                                               |       | (89,206                                         | )          | 1,059 |   |
|                                                                     |       |                                            |       |   |   |
| Net loss before  provision for income taxes                              |       | (1,614,758                                      | )          | (66,421 | ) |
|                                                                     |       |                                            |       |   |   |
| Provision for income  taxes                                              |       | —                                          |       | — |   |
|                                                                     |       |                                            |       |   |   |
| Net loss                                                                 |       | $                                               | (1,614,758 | ) | $ | (66,421 | ) |
|                                                                     |       |                                            |       |   |   |
| Net loss per  share of common stock, basic and diluted                   |       | $                                               | (0.19      | ) | $ | (0.01 | ) |
|                                                                     |       |                                            |       |   |   |
| Weighted average number  of common shares outstanding, basic and diluted |       | 8,353,283                                       |       | 8,258,425 |   |

 

See Accompanying Notes to Condensed ConsolidatedFinancial Statements

 

F-3

----

 

**GRAYMARKPRODUCTIONS, INC.**

**CondensedConsolidated Statements of Operations(Unaudited)**

 
| ** **                                                               | ** ** | **Six Months Ended  June 30,** | ** ** |
|--------------------------------------------------------------------------|------------|-----------------------------------------------|------------|
| ** **                                                               | ** ** | **2006**                                      | ** ** | **2005** | ** ** |
|                                                                     |       |                                          |       |   |   |
| Revenues                                                                 |       | $                                             | 236,866    |   | $ | 450,000 |   |
|                                                                     |       |                                          |       |   |   |
| Expenses:                                                                |       |                                          |       |   |   |
| Direct operating                                                         |       | 191,451                                       |       | 409,237 |   |
| Impairment of  investment in films                                       |       | 1,445,014                                     |       | — |   |
| General and  administrative                                              |       | 201,130                                       |       | 201,698 |   |
| Depreciation                                                             |       | 2,431                                         |       | 2,432 |   |
|                                                                     |       |                                          |       |   |   |
| Total expenses                                                           |       | 1,840,026                                     |       | 613,367 |   |
|                                                                     |       |                                          |       |   |   |
| Operating loss                                                           |       | (1,603,160                                    | )          | (163,367 | ) |
|                                                                     |       |                                          |       |   |   |
| Other Income (Expense):                                                  |       |                                          |       |   |   |
| Interest and  other income                                               |       | 16,646                                        |       | 4,791 |   |
| Interest expense                                                         |       | (183,839                                      | )          | — |   |
| Minority  interests                                                      |       | (4,839                                        | )          | — |   |
|                                                                     |       |                                          |       |   |   |
| Net other income  (expense)                                              |       | (172,032                                      | )          | 4,791 |   |
|                                                                     |       |                                          |       |   |   |
| Net loss before  provision for income taxes                              |       | (1,775,192                                    | )          | (158,576 | ) |
|                                                                     |       |                                          |       |   |   |
| Provision for income  taxes                                              |       | —                                        |       | — |   |
|                                                                     |       |                                          |       |   |   |
| Net loss                                                                 |       | $                                             | (1,775,192 | ) | $ | (158,576 | ) |
|                                                                     |       |                                          |       |   |   |
| Net loss per share of  common stock, basic and diluted                   |       | $                                             | (0.21      | ) | (0.02 | ) |
|                                                                     |       |                                          |       |   |   |
| Weighted average number of common shares outstanding, basic and  diluted |       | 8,331,854                                     |       | 8,258,425 |   |

 

See Accompanying Notes to Condensed ConsolidatedFinancial Statements

F-4

----

 

**GRAYMARKPRODUCTIONS, INC.**

**CondensedConsolidated Statements of Shareholders’ Equity(Unaudited)**

 
| ** **                                | ** ** | **Common Stock** | ** ** | **Paid-in** | ** ** | **Accumulated** | ** ** |
|-------------------------------------------|------------|-----------------------|------------|-------------|------------|-----------------|------------|
| ** **                                | ** ** | **Shares**            | ** ** | **Amount**  | ** ** | **Capital**     | ** ** | **Deficit** | ** ** |
|                                      |       |                  |       |        |       |            |       |   |   |
| Balance,  December 31, 2004               |       | 8,258,425             |       | $           | 826        |            | $          | 3,837,689 |   | $ | (1,241,976 | ) |
|                                      |       |                  |       |        |       |            |       |   |   |
| Issuance of stock for consulting services |       | 10,000                |       | 1           |       | 14,499          |       | — |   |
| Issuance of stock for investor relations  |       | 10,000                |       | 1           |       | 9,374           |       | — |   |
| Issuance of stock for convertible notes   |       | 10,726                |       | 1           |       | 10,832          |       | — |   |
| Warrants issued with convertible notes    |       | —                |       | —      |       | 349,458         |       | — |   |
| Net loss                                  |       | —                |       | —      |       | —          |       | (551,186 | ) |
|                                      |       |                  |       |        |       |            |       |   |   |
| Balance,  December 31, 2005               |       | 8,289,151             |       | 829         |       | 4,221,852       |       | (1,793,162 | ) |
|                                      |       |                  |       |        |       |            |       |   |   |
| Issuance of stock for convertible notes   |       | 64,132                |       | 6           |       | 56,161          |       | — |   |
| Issuance of stock options                 |       | —                |       | —      |       | 5,430           |       | — |   |
| Net loss                                  |       | —                |       | —      |       | —          |       | (1,775,192 | ) |
|                                      |       |                  |       |        |       |            |       |   |   |
| Balance, June  30, 2006                   |       | 8,353,283             |       | $           | 835        |            | $          | 4,283,443 |   | $ | (3,568,354 | ) |
|                                      |       |                  |       |        |       |            |       |   |   |

 

See Accompanying Notes to Condensed ConsolidatedFinancial Statements

F-5

----

 

**GRAYMARKPRODUCTIONS, INC.**

**CondensedConsolidated Statements of Cash Flows(Unaudited)**

 
| ** **                                                                   | ** ** | **Six Months Ended  June 30,** | ** ** |
|------------------------------------------------------------------------------|------------|-----------------------------------------------|------------|
| ** **                                                                   | ** ** | **2006**                                      | ** ** | **2005** | ** ** |
|                                                                         |       |                                          |       |   |   |
| Operating  activities:                                                       |       |                                          |       |   |   |
| Net loss                                                                     |       | $                                             | (1,775,192 | ) | $ | (158,576 | ) |
| Adjustments to reconcile net loss to net cash used  by operating activities: |       |                                          |       |   |   |
| Depreciation                                                                 |       | 2,431                                         |       | 2,432 |   |
| Amortization of film costs                                                   |       | 195,618                                       |       | 409,237 |   |
| Impairment of investment in films                                            |       | 1,445,014                                     |       | — |   |
| Issuance of common stock for convertible notes  interest                     |       | 56,167                                        |       | — |   |
| Interest expense allocated to warrants                                       |       | 86,647                                        |       | — |   |
| Non-cash stock option compensation                                           |       | 5,430                                         |       | — |   |
| Minority interests                                                           |       | 4,839                                         |       | — |   |
| Changes in assets and liabilities –                                     |       |                                          |       |   |   |
| Film deposits                                                                |       | 12,916                                        |       | 48,601 |   |
| Accounts receivable                                                          |       | (29,341                                       | )          | — |   |
| Prepaid loan fees                                                            |       | 37,192                                        |       | — |   |
| Investment in films                                                          |       | (706,181                                      | )          | (521,244 | ) |
| Accrued liabilities                                                          |       | (545                                          | )          | 14,512 |   |
|                                                                         |       |                                          |       |   |   |
| Net cash used by operating activities                                        |       | (665,005                                      | )          | (205,038 | ) |
|                                                                         |       |                                          |       |   |   |
| Investing  activities:                                                       |       |                                          |       |   |   |
| Minority interests - contributions                                           |       | 450,385                                       |       | — |   |
|                                                                         |       |                                          |       |   |   |
| Net cash provided by financing activities                                    |       | 450,385                                       |       | — |   |
|                                                                         |       |                                          |       |   |   |
| Financing  activities:                                                       |       |                                          |       |   |   |
| Repayment of film obligations                                                |       | (50,000                                       | )          | (450,000 | ) |
|                                                                         |       |                                          |       |   |   |
| Net cash used in financing activities                                        |       | (50,000                                       | )          | (450,000 | ) |
|                                                                         |       |                                          |       |   |   |
| Net change in  cash and cash equivalents                                     |       | (264,620                                      | )          | (655,038 | ) |
|                                                                         |       |                                          |       |   |   |
| Cash and cash  equivalents at beginning of period                            |       | 1,153,840                                     |       | 877,933 |   |
|                                                                         |       |                                          |       |   |   |
| Cash and cash  equivalents at end of period                                  |       | $                                             | 889,220    |   | $ | 222,895 |   |
|                                                                         |       |                                          |       |   |   |
| Noncash  Investing and Financing Activities:                                 |       |                                          |       |   |   |
| Issuance of stock for convertible notes interest                             |       | $                                             | 56,167     |   | $ | — |   |
|                                                                         |       |                                          |       |   |   |
| Cash Paid for  Interest and Income Taxes:                                    |       |                                          |       |   |   |
| Interest expense                                                             |       | $                                             | —     |   | $ | — |   |
| Income taxes                                                                 |       | $                                             | —     |   | $ | — |   |
|                                                                         |       |                                          |       |   |   |

 

See Accompanying Notes to Condensed ConsolidatedFinancial Statements

 

F-6

----

 

**GRAYMARKPRODUCTIONS, INC.**

**Notes toCondensed Consolidated Financial Statements(Unaudited)**

**Forthe Periods Ended June 30, 2006 and 2005**

Note 1 – Nature ofBusiness

GraymarkProductions, Inc. (the “Company”) is organized in Oklahoma and is anindependent producer and distributor of film entertainment content.  The Company began operations in 2001 asGraymark Productions, L.L.C. (“Graymark LLC”), all of the assets of which wereacquired by the Company through our incorporation-reorganization, effectiveAugust 18, 2003.

The Companyproduces and distributes films that are completed and marketed using smallerbudgets than those of major studios.  TheCompany has completed the production and released its motion picture projectstitled, *Cloud 9*, *The Hunt* and *Surveillance*.  TheCompany has completed, but not released its motion picture titled, *Soul’s Midnight*.  The Company has also completed the filmingand is in post-production on its motion pictures titled, *Fingerprints*.  The Company has negotiated agreements for thedomestic marketing and distribution of all five films and for the internationalmarketing and distribution of *Cloud 9*,*The Hunt* and *Surveillance*.  Management believes that producing anddistributing low- or modest-budget, commercially successful films affords theCompany access to Hollywood talent and scripts and third-party productionpackages for acquisition, without compromising management’s approach tomanaging financial risk.

Note 2 – Summaryof Significant Accounting Policies

*InterimFinancial Information* – The unaudited condensed consolidatedfinancial statements included herein have been prepared in accordance withgenerally accepted accounting principles for interim financial statements andwith Regulation S-X.  Accordingly, theydo not include all of the information and footnotes required by generallyaccepted accounting principles for complete financial statements.  In the opinion of management, all adjustments(consisting of normal recurring adjustments) considered necessary for a fairpresentation have been included. Operating results for the three and six months ended June 30, 2006 arenot necessarily indicative of results that may be expected for the year endedDecember 31, 2006.  The condensedconsolidated financial statements should be read in conjunction with theconsolidated financial statements and notes thereto included in the Company’sForm 10-KSB for the year ended December 31, 2005.  The December 31, 2005 condensed consolidatedbalance sheet was derived from audited financial statements.

*Consolidation*– The accompanying consolidated financial statements include the accounts ofGraymark Productions, Inc. and its majority owned and controlledsubsidiaries.  The Company controls asubsidiary company through a combination of existing voting interests and theability to exercise various rights under certain shareholder or operatingagreements.  The Company’s subsidiariesinclude Graymark Productions, L.L.C. (the “LLC”), Out of the Blue Productions,LLC (“Out of the Blue”), The Hunt, The Motion Picture LLC (“The Hunt”),Surveillance, The Motion Picture LLC (“Surveillance”), Soul’s Midnight LLC (“Soul’sMidnight”) and Fingerprints LLC (“Fingerprints”).  The LLC became a subsidiary of the Company inAugust 2003 as a result of the incorporation-reorganization of theCompany.  Out of the Blue was formed inDecember 2003 as the entity under which the Company’s first motion pictureproject, *Cloud 9*, wasproduced.  The Company has funded 100% ofthe acquisition and production costs of *Cloud9*.  The Company is entitled torecover its capital contributions to Out of the Blue plus interest at 2% abovethe prime rate (defined as “investment recoupment”) from cash distributionsbefore the other interest owners and thereafter 50% of cash distributions andis entitled to receive a majority of the proceeds from rights sales,distribution and any and all exploitation of the Picture.  Under the terms of the Out of the Blueoperating agreement, the Company has 100% voting control of Out of theBlue.  The Hunt, Surveillance and Soul’sMidnight are 100% owned by the Company.

F-7

----

 

*Useof estimates* – The preparation of financial statements inconformity with generally accepted accounting principles requires management ofthe Company to make estimates and assumptions that affect the amounts reportedin the financial statements and accompanying notes.  Actual results could differ from thoseestimates.

*Revenuerecognition* – Revenues from the sale of the rights to a filmare recognized when the feature film is available to the distributor forexploitation and no conditions for delivery exist, which under most salescontracts requires that full payment has been received from thedistributor.  Revenues from thetheatrical distribution of motion pictures are recognized when motion picturesare exhibited.  Revenues from video salesare recognized on the date that video units are made widely available for saleby retailers.  Revenues from the licensingof motion picture films are recorded when the material is available for telecastingby the licensee and when certain other conditions are met.  Revenues from consulting services arerecognized when earned.

*Investmentin Films* – Investment in films includes capitalized directnegative costs, production overhead, interest and development costs and arestated at the lower of cost, less accumulated amortization, or fair value.  Film production and participation costs areexpensed based on the ratio of the current period’s gross revenues to estimatedremaining total gross revenues from all sources on an individual productionbasis.

Investment infilms is stated at the lower of amortized cost or estimated fair value on anindividual film basis.  The valuation ofinvestment in films is reviewed on a title-by-title basis, when an event or changein circumstances indicate that the fair value of a film is less than itsunamortized cost.  The fair value of thefilm is determined using management’s future revenue and cost estimates and adiscounted cash flow approach. Additional amortization is recorded in the amount by which theunamortized costs exceed the estimated fair value of the film.  Estimates of future revenue involvemeasurement uncertainty and it is therefore possible that reductions in the carryingvalue of investment in films may be required as a consequence of changes inmanagement’s future revenue estimates.

*RecentlyIssued Accounting Standards* –

*SFAS123R* – In December 2004, the Financial Accounting StandardsBoard (FASB) issued Statement of Financial Accounting Standards (SFAS) No.123R, *Share-Based Payment*.  SFAS 123R replaces SFAS No. 123, *Accounting for Stock-Based Compensation*,and supersedes *Accounting Principles Board*(APB) Opinion No. 25, *Accounting for StockIssued to Employees*.  Weadopted SFAS 123R on January 1, 2006 using the modified prospective method asdescribed in the standard.  Under themodified prospective method, we are required to record compensation cost fornew and modified awards over the related vesting period of such awardsprospectively and record compensation cost prospectively for the unvestedportion at time of adoption, of previously issued and outstanding awards overthe remaining vesting period of such awards. As of January 1, 2006, we had no unvested outstanding awards and as aresult, the adoption of SFAS123R had no impact on our consolidated financialstatements or consolidated results of operations.

Note 3 –Investment in Films

|                                                           | ** ** | **June 30,  2006** | ** ** | **December 31,  2005** | ** ** |
|-----------------------------------------------------------|------------|-------------------------|------------|-----------------------------|------------|
|                                                      |       |                    |       |                        |       |
| Released, net of  accumulated amortization and impairment |       | $                       | 1,352,000  |                        | $          | 2,012,439 |   |
| Completed and  not released                               |       | 635,833                 |       | 375,790                     |       |
| In progress                                               |       | 536,134                 |       | 1,070,188                   |       |
| In development                                            |       | —                  |       | —                      |       |
|                                                      |       |                    |       |                        |       |
| Total                                                     |       | $                       | 2,523,967  |                        | $          | 3,458,417 |   |

 

F-8

----

 

The Companyestimates that 100% of the unamortized investment in films at June 30, 2006will be amortized within the next three years. Approximately $1,623,000 of film costs are expected to be amortizedduring the next twelve months.  No participationliabilities are expected to be paid during the next 12 months.

Based on therevenue generated to date for the domestic sales of *Cloud 9*, the Company made the determination that previousestimates of the ultimate revenue for *Cloud9* were overstated.  DuringJune 2006, the Company revised the estimates of ultimate revenue for *Cloud 9* which resulted in an impairmentcharge to investment in films of $1,445,014.

Note 4 –Convertible Note Payable

In August andOctober 2005, the Company issued promissory notes (the “Notes”) in theprincipal amount of $750,000, respectively; $1,500,000 in total.  The Notes are secured by all assets of theCompany including all purchase agreements and any options or rights to acquire,all intellectual and real property, all assets and properties of the Companyand all of its existing and future subsidiaries.  The Notes bear interest at the rate of 8% perannum.  Interest due on the Notes ispayable quarterly and can be paid in cash or shares of Company stock.

The Notes becomedue and payable on the first to occur of: (i) July 27, 2007 for the first noteand October 25, 2007 for the second note (the “Maturity Dates”); (ii) theconsummation of a Qualified Financing; or (iii) the continuation of an Event ofDefault, as defined, for more than 30 days following notice of the occurrenceof an event of default.  Uponconsummation of a Qualified Financing, the outstanding principal amount of theNotes and all accrued and unpaid interest (collectively the “Note Balances”)will automatically convert into shares of equity securities of the Companyequal to 120% of the Note Balances divided by the price per share of the equitysecurities sold in the Qualified Financing. The maximum price or value of the equity securities into which the NoteBalances convert may not exceed the equivalent of $1.10 per common stock share.  Qualified Financing refers to any equityfinancing pursuant to which the Company receives aggregate gross cash proceedsof $2,000,000 or more on or before the Maturity Dates.

In conjunctionwith issuance of the Notes, the Company and the holder of the Notes enteredinto common stock purchase warrant agreements, each evidencing warrantsexercisable on or before August 5, 2010 for the first note and October 25, 2010for the second note.  The two agreementsprovide for the purchase of 250,000 (500,000 total) common stock shares at$2.00 and the other two agreements provide for the purchase of 250,000 (500,000total) common stock shares at $3.00.

The fair value ofeach warrant issued was estimated on the date of issuance using theBlack-Scholes option pricing model.  Thefair value of the options were based on the difference between the presentvalue of the exercise price of the option and the estimated fair value price ofthe common share.  The fair value of thewarrants was estimated to be $349,459 and was recorded as paid-in capital.  The value of the warrants will increaseinterest expense over the life of the Notes.

In addition, theCompany’s financial advisor was paid fees of $150,000 for services rendered inconjunction with execution of the Notes.  The fees were recorded as  prepaid loan fees and will be amortized overthe life of the Notes.

Note 5 – FilmObligations

During May 2004,the Company obtained $500,000 of funding under co-finance agreements for itsmotion picture project, *Cloud 9*.  The terms of the co-financing provide for theinvestors to recoup their contribution from the first proceeds of *Cloud 9*. After all *Cloud 9* costsare recouped by the Company, the investors are entitled to a profitparticipation in the Company’s profit from *Cloud9*.  As a group, the investorsare entitled to 20% of the net profits paid to the Company, but the investorsdo not have any ownership rights in the film. The $500,000 received under the co-financing agreements represents 21%of the anticipated total cost of *Cloud 9*.  During June 2005 and January 2006, $450,000and $50,000, respectively, was repaid to 

F-9

----

investors from thefirst proceeds from *Cloud 9*.  The funding under the co-financing agreementscame from related parties to the Company as described below:

 

| Source of Funding                                        | ** ** | **Original  Amount** | ** ** | **Remaining  Balance** | ** ** |
|--------------------------------------------------------------------|------------|----------------------|------------|------------------------|------------|
|                                                               |       |                 |       |                   |       |
| Greater than 5%  shareholder                                       |       | $                    | 250,000    |                   | $          | — |   |
| Company’s  chairman and chief executive officer               |       | 100,000              |       | —                 |       |
| A company 50%  owned by the Company’s chief financial officer |       | 100,000              |       | —                 |       |
| Company  shareholder                                               |       | 50,000               |       | —                 |       |
|                                                               |       |                 |       |                   |       |
| Total                                                              |       | $                    | 500,000    |                   | $          | — |   |

 

Note 6 – FilmProfit Participation and Contingent Compensation

Pursuant to aninvestor agreement between the Company and the developers of the screenplay for*Cloud 9*(the “Picture”), theCompany shares the development and productions costs and revenue of *Cloud 9*. For its financial contribution to the costs of making *Cloud 9*, the Company is entitled toreceive the following:

·                                          100%of revenue and proceeds from the rights sales, distribution and/or any and allexploitation of *Cloud 9* until theCompany recovers its investment in the Picture, plus interest at the prime rateplus 2% per annum from the date of the contribution until the Company is repaidits investment in the Picture.

·                                          50%of “net profits” received from the rights sales, distribution and/or any andall exploitation of the Picture.  “NetProfits” is defined as the sum remaining after deduction of third partydistribution fees; cash deferments  tocast, equipment suppliers, rights holders or any other approved party.

The Company’ssubsidiary, Out of the Blue Productions, LLC (the “Production Company”),entered into contingent compensation agreements with the director and certaincast members of *Cloud 9* in theform of “net and gross  profitparticipations” that are customary in the film industry.  These participations are typically based onthe profit of a film after all production and distribution costs have beenrecouped (“gross participation”) or all production and distribution costs andoverhead have been recouped (“net participations”).  A percentage of these “gross and net profits”,as negotiated between the participants, are paid out as contingent compensationfor creative participants in a motion picture film.  The participations negotiated by theProduction Company for *Cloud 9*total 23.5% of which the Company’s interest in *Cloud9* is burdened by one-half of these net profit participations.  The Company’s residual profits interest in *Cloud 9* is 30.6% after giving effect tothe gross and net profits participations given pursuant to contingentcompensation arrangements and the co-finance agreements (see Note 5 – FilmObligations).

The ProductionCompany also agreed to pay additional contingent bonuses to certain castmembers when aggregate United States and Canada box office receipts as reportedin Daily Variety reach various levels between $8,500,000 and $20,000,000.  The total contingent amounts that would bepaid if box office receipts reach $20,000,000 is $300,000.

Pursuant to anoutput agreement between the Company and a third-party distribution company (“Distributor”),the Distributor has a first-look right at the movies produced by theCompany.  Pursuant to the agreement, theDistributor has agreed to fund up to 50% of each production budget on mutuallyagreed upon motion picture projects.  TheDistributor will be entitled to a respective percentage of all gross receiptson those projects.

F-10

----

The followingsummarizes the revenue participations before and after net profitparticipations on the Company’s films *TheHunt*, *Surveillance, Soul’sMidnight* and *Fingerprints*:

|                              | ** ** | **Before Payout** | ** ** | **After Payout** | ** ** |
|------------------------------|------------|------------------------|------------|-----------------------|------------|
| ****                         | ** ** | **Company**            | ** ** | **Other  Members**    | ** ** | **Company** | ** ** | **Other  Members** | ** ** | **Third-  Party  Interest** | ** ** |
|                         |       |                   |       |                  |       |   |   |   |   |   |   |
| The Hunt                     |       |                   |       |                  |       |   |   |   |   |   |   |
| Revenue allocation           |       | 65                     | %          | 35                    | %          | 44 | % | 24 | % | 32 | % |
| Production costs to be paid  |       | 50                     | %          | 50                    | %          |   |   |   |   |   |   |
|                         |       |                   |       |                  |       |   |   |   |   |   |   |
| Surveillance                 |       |                   |       |                  |       |   |   |   |   |   |   |
| Revenue allocation           |       | 50                     | %          | 50                    | %          | 46 | % | 46 | % | 8 | % |
| Production costs to be paid  |       | 50                     | %          | 50                    | %          |   |   |   |   |   |   |
|                         |       |                   |       |                  |       |   |   |   |   |   |   |
| Soul’s Midnight         |       |                   |       |                  |       |   |   |   |   |   |   |
| Revenue allocation           |       | 25                     | %          | 75                    | %          | 24 | % | 72 | % | 4 | % |
| Production costs to be paid  |       | 25                     | %          | 75                    | %          |   |   |   |   |   |   |
|                         |       |                   |       |                  |       |   |   |   |   |   |   |
| Fingerprints                 |       |                   |       |                  |       |   |   |   |   |   |   |
| Revenue allocation           |       | 35                     | %          | 65                    | %          | 34 | % | 62 | % | 4 | % |
| Production costs  to be paid |       | 35                     | %          | 65                    | %          |   |   |   |   |   |   |

 

Note 7 – DistributionAgreements

The Company hasentered into various distribution agreements for the marketing and distributionof it’s films in the domestic, broadcast and international markets.  These agreements provide for the distributorto earn a distribution fee from the gross proceeds generated by each picture inthe applicable market.  The table belowsummarizes the distribution fees negotiated as of June 30, 2006 (markets thathave no distribution agreements in place are identified as “n/a”):

 

|                      | ** ** | **Cloud 9** | ** ** | **The  Hunt** | ** ** | **Surv-  eillance** | ** ** | **Soul’s  Midnight** | ** ** | **Finger-  prints** | ** ** |
|----------------------|------------|------------------|------------|---------------|------------|---------------------|------------|---------------------------|------------|---------------------|------------|
|                 |       |             |       |          |       |                |       |                      |       |                |       |
| Domestic DVD  market |       | 20               | %          | 22.5          | %          | 25                  | %          | 25                        | %          | 25                  | %          |
| Broadcast            |       | 20               | %          | n/a           |       | n/a                 |       | n/a                       |       | n/a                 |       |
| International        |       | 15               | %          | 20            | %          | 20                  | %          | n/a                       |       | n/a                 |       |

 

Note 8 – CapitalStructure

In January 2006,the Company issued 21,274 shares of common stock to pay accrued interest due of$26,267, as of December 31, 2005, on the Company’s convertible notespayable.  In April 2006, the Company issued42,858 shares of common stock to pay accrued interest due of $30,000, as ofMarch 31, 2006, on the Company’s convertible notes payable.

Note 9 – StockOptions and Warrants

In June 2006, theCompany issued options to the Company’s officers and directors for the purchaseof 140,000 shares of the Company’s stock at an exercise price of $0.75.  The options were issued under the Company’s2003 Stock Option Plan and 2003 Non-Employee Stock Option Plan  The options expire on September 30, 2011.

To estimate thegrant-date fair value of its stock options, the Company uses the Black-Scholesoption pricing model with the following assumptions used for grants:  weighted average risk free interest rate of5.0%; no dividend yield; volatility of 46%; and expected life less than fiveyears.  The fair value of the options werebased on the difference between the present value of the exercise price of theoption and the estimated fair value price of the common share.  The fair value of the 140,000 options wasestimated to be $37,953 which will be recorded as compensation expense over therequisite service period of June 15, 2006 to October 1, 

F-11

----

2006.  The Company recorded compensation expense of$5,430 during the period ended June 30, 2006; the remaining $32,523 will beexpensed in the quarter ended September 30, 2006.

Note 10 – RelatedParty Transactions

The Company’scorporate offices are located in a building owned by an entity controlled byone of our greater than 5% shareholders. The office space is occupied under a month to month lease.  Rent expense applicable to the corporateoffices for the six months ended June 30, 2006 and 2005 was $8,168 and $2,943,respectively.

Note 11 –Subsequent Events

In July 2006, theCompany issued 58,824 shares of common stock to pay accrued interest of $30,000due, as of June 30, 2006, on the Company’s convertible notes payable.

 

F-12

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