**UNITEDSTATES**

**SECURITIESAND EXCHANGE COMMISSION**

**Washington, D. C. 20549**

 

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**FORM 10-QSB**

 

**(MarkOne)**

 

| **ý**                                              | **QUARTERLY REPORT UNDER SECTION 13  OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934** |
|---------------------------------------------------------|--------------------------------------------------------------------------------------------------|
| **For the quarterly period ended March 31,  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**

 

**GRAYMARKPRODUCTIONS, 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, Suite 920**      |
| **Oklahoma City, 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 sincelast report)

 

Checkwhether the issuer (1) filed all reports required to be filed by Section 13or 15(d) of the Exchange Act during the past 12 months (or for shorterperiod that the registrant was required to file such reports), and (2) hasbeen subject to such filing requirements for the past 90 days. Yes ý No o

 

Indicateby check mark whether the registrant is a shell company (as defined in Rule 12b-2of the Exchange Act). Yes o No ý

 

**APPLICABLE ONLY TO ISSUERS INVOLVED IN BANKRUPTCY**

**PROCEEDINGS DURING THE PRECEDING FIVE YEARS**

 

Checkwhether the registrant 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 undera plan confirmed by a court. Yes o No o

 

**APPLICABLE ONLY TO CORPORATE ISSUERS**

 

Statethe number of shares outstanding of each of issuer’s classes of common equity,as of the latest practicable date:  As ofMay 4, 2006, 8,353,283 shares of the issuer’s common stock, $0.0001 parvalue, were outstanding.

 

TransitionalSmall Business Disclosure Format (Check One): Yes o No ý

 

 

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**GRAYMARK PRODUCTIONS, INC.**

FORM 10-QSB

For the Quarter Ended March 31, 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    |                                                            |

 

Throughoutthis report the first personal plural pronoun in the nominative case form “we”and its objective case form “us”, its possessive and the intensive caseforms “our” and “ourselves” and its reflexive form “ourselves”  refer collectively to Graymark Productions, Inc.,its predecessor, Graymark Productions, L.L.C., and its executive officers anddirectors. The term “independent,” as used in this report, is used todistinguish us from the term “major studios” that is generally regarded in theentertainment industry to mean Universal Pictures, Warner Bros., TwentiethCentury Fox, Sony Pictures Entertainment, Paramount Pictures, The Walt DisneyCompany, Metro Goldwyn Mayer and their respective 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 $3million.

 

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**PART I. FINANCIAL INFORMATION**

 

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

 

Ourfinancial statements presented in this report were prepared and included inthis report in accordance with Regulation S-X and Regulation S-B and appear inthis report beginning on page F-1.

 

**Item 2.****          ****Management’s Discussion andAnalysis or Plan of Operation**

 

Youshould read the following discussion in conjunction with our financialstatements and notes thereto appearing elsewhere in this report.

 

**Overview**

 

Sincecommencement of our operations in August 2001, 2005 was the first yearthat we received significant revenue from our motion picture productions. In June 2005,we received a $450,000 non-refundable advance under licensing agreementscovering the foreign and domestic distribution and broadcast rights to ourfirst motion picture project, *Cloud 9*.During the three months ending March 31, 2006, we earned revenue ofapproximately $187,000 from the international distribution of *Cloud 9* and approximately $2,500 from theinternational distribution of *The Hunt*.We have competed the filming and production of *Cloud9,**The Hunt* and *Surveillance*. We are in post-production ofour fourth motion picture film project, *Soul’sMidnight* and we are currently filming our fifth motion pictureproject, *Fingerprints*.

 

Thefollowing discussion covers our plan of operations for the next 12 months. Aswith any plan, there is no assurance that our operations as described will goas planned or that we will be successful in achieving the anticipated results.

 

**Movie Development and Production**

 

The movie industry generally consists of twoprincipal activities, production and distribution. Production encompasses thedevelopment, financing and creation of feature-length movies. Distributionentails the promotion and marketing of movies in the various media markets,including theatrical, home video and television presentation. We typicallyacquire developed or “packaged” films from third parties, rather than retainand employ personnel to develop films for our production. Furthermore, ourmovies are typically distributed pursuant to licensing arrangements withunrelated third-parties that are independently engaged in the promotion anddistribution of movies. Our approach to acquisition, production, anddistribution is to balance our financial risks against the probability ofcommercial success of each movie project.

 

Weprimarily produce English language motion pictures intended for domesticancillary market release (home video and television, including pay-per-view,cable, satellite and network broadcast) that have production budgets of$250,000 to $3 million (“low-budget motion pictures,” “low budget movies” or “low-budgetfilms”). We initially anticipated producing motion pictures that had productionbudgets of $2 million to $5 million, but based on the production of our motionpictures to date, we believe that a range of $250,000 to $3 million isappropriate.

 

Thedevelopment and production costs of a low-budget film and each cost categoryvaries from movie-to-movie and this variation may be substantial. Eachmovie is unique and the storyline, special effects, production locations,creative personnel involved, etc. affect the budget amount of each costcategory. Accordingly, we believe the cost categories are somewhatindeterminable until the particular movie is identified and developed.

 

Ratherthan retain and employ personnel to develop screenplays and perform othermovie development activities, we typically acquire low-budget movie projectsfor production that are in the development phase, generally to the point thatthe initial screenplay has been written. In the pre-production and productionphases of a motion picture,

 

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wehire skilled creative and production personnel, including cinematographers,editors, costume designers, set designers, sound and lighting technicians andactors on an as needed basis.

 

Weenter into various production cost and revenue sharing arrangements, includingjoint ventures, partnerships and limited liability companies, on amovie-by-movie basis. These sharing arrangements are intended to complement orexpand our business to permit the production of a greater number of movies,while sharing the financial risks of the movie. We may not realize theanticipated financial benefits when we enter into these arrangements. Inaddition, the negotiation of these arrangements, whether successful or not, may requireus to incur significant costs and cause diversion of management’s time andresources. Accordingly, the costs of obtaining these sharing arrangementsincrease our invested cost in a movie without providing a correlating increasein the movie’s revenues and, consequently, adversely affect the financialperformance of the movie.

 

Followingour production of a movie, we intend to arrange for distribution throughthird-parties primarily into the domestic (United States and Canada) andinternational ancillary market (home video or pay and free television). Dependingupon our ability to obtain favorable distribution arrangements, which dependsin many cases upon the distributor’s assessment of the movie’s revenuepotential, a particular movie may be distributed in the domestic andinternational theatrical markets as well as the ancillary markets. As of thedate of this report, we have not entered into any arrangements for thetheatrical release of our produced and in-production motion pictures. Asubstantial amount of time may elapse between our expenditure of funds inthe production of a motion picture and the receipt of revenue from the motionpicture we produce.

 

Ourproduced movies are distributed domestically pursuant to licensing arrangementswith unrelated third-parties that are independently engaged in the promotionand distribution of movies. Our foreign market distribution arrangements arepursuant to sale or license of the international distribution rights to anunrelated third-party distributor for either a single up-front payment (in U.S.currency) without any retained participation in international source revenuesor for the right to receive a percentage of gross receipts received by thedistributor. As of the date of this report, we have entered into domestic(United States and Canada) distribution arrangements covering all of our motionpicture projects and have entered into international distribution arrangementscovering *Cloud 9, The Hunt* and*Surveillance*.

 

Ourability to obtain international market distribution, whether in the ancillarymarket or the theatrical market, will be subject to:

 

•                                          changes in local regulatory requirements,including restrictions on content,

 

•                                          changes in the laws and policies affectingtrade, investment and taxes (including laws and policies relating to therepatriation of funds and withholding taxes),

 

•                                          differing degrees of protection forintellectual property,

 

•                                          instability of foreign economies andgovernments,

 

•                                          cultural barriers, and

 

•                                          wars and acts of terrorism.

 

Anyof these factors could have a material adverse effect on our ability to sellthe international distribution rights of any motion picture.

 

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**Recent Developments**

 

*Distribution of Cloud 9.*In conjunction with the production of *Cloud 9*, with the other producers of *Cloud 9*, we formed Out of the BlueProductions, LLC (the “Production Company”). The Production Company has enteredinto three agreements covering the domestic (United States and Canada) andinternational distribution of *Cloud 9*in the ancillary market (home video market) and the broadcast rights (pay andfree television, video on demand and pay-per-view) for *Cloud 9*. Pursuant to the agreementcovering domestic distribution (“Domestic Agreement”), the Production Companyreceived in June 2005 a non-refundable advance of $450,000 on our share ofthe net receipts from the domestic distribution of *Cloud 9* that was distributed to us. The Domestic Agreementallows the licensee to receive a distribution fee equal to 20% of grossdomestic receipts of *Cloud 9*afterits recoupment of all manufacturing, distribution and marketing costs fromthose receipts. *Cloud 9* wasreleased in the domestic video market during January 2006. The domesticdistributor for *Cloud 9* is notrequired to report revenue results to us for the first quarter of 2006 until 60days after the end of the quarter. We will record revenue from the domesticdistribution of *Cloud 9* on thedate that we receive detailed reporting of the sales results from the domesticdistributor and can accurately determine our revenues from this distribution.

 

DuringJune 2005, the Production Company entered in to an agreement for theinternational distribution of *Cloud 9*(“InternationalAgreement”). Under the International Agreement the licensee is entitled toreceive recoupment of its manufacturing, distribution and marketing costs andthereafter a distribution fee of equal to 15% of gross international receiptsup to $2,000,000 and 10% of gross international receipts above $2,000,000. Duringthe three months ended March 31, 2006, we earned approximately $187,000 ofrevenue under this agreement.

 

Furthermore,during June 2005, the Production Company entered in to a Sales AgencyAgreement for the marketing of the broadcast rights (pay and free television,video-on-demand and pay-per-view) of *Cloud 9*(“Broadcast Agreement”). Pursuant to the Broadcast Agreement, the licensee isentitled to a fee equal to 20% of the gross receipts from broadcast of *Cloud 9* on pay and free television,video-on-demand and pay-per-view after its recoupment of its distributionexpenses.

 

Asa result of the agreements with the director, casting company, actors andco-finance providers, our residual net profits interest in *Cloud 9* is 30.6% after recoupment andpayment of all distribution costs, expenses and fees. Furthermore, ourco-finance providers are entitled to receive the first $500,000 of proceeds wereceive from the licensing of the distribution rights of *Cloud 9* of which we have paid $500,000. Aftergiving effect to the recovery of the $500,000 contributions to the productioncosts of *Cloud 9* under theco-financing agreements and then the recovery of our production costs and otherinvested costs and interest, our net profits interest in *Cloud 9* will be 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*.

 

*Distribution of The Hunt*. During March 2005, we commenced andcompleted principal filming of our second motion picture project titled, *The Hunt*. *TheHunt* has been released in the international market and is expectedto be released domestically later in 2006. We have incurred total productioncosts for *The Hunt* ofapproximately $386,000 as of March 31, 2006.

 

InJuly 2005, we entered into an agreement for the domestic distribution of *The Hunt*. The agreement grants thelicensee a distribution fee equal to 22.5% of gross receipts and allows for therecoupment of all manufacturing, distribution and marketing costs. We have alsoentered into an agreement for the international distribution of *The Hunt*. The agreement grants thelicensee a distribution fee equal to 20% of gross receipts and allows for the recoupmentof all manufacturing, distribution and marketing costs. During the three monthsended March 31, 2006, we earned approximately $2,500 from theinternational distribution of *The Hunt*.

 

Inaddition, we sold 35% of the copyright interest in *The Hunt* to the licensee for an amount equal to 50% of thebudget of *The Hunt*. As of March 31,2006, we have received approximately $214,000 from the licensee (minorityinterest) under the terms of the agreement. The company that developed thestory concept for *The Hunt*retained a 25%

 

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interestin the net receipts of *The Hunt*. Netreceipts is defined as receipts after we recoup our production costs, interestand overhead. In addition, we entered in to net participation agreements withthe director, casting company and others equal to 7% of the net receipts of *The Hunt*.

 

*Distribution of Surveillance*. During August 2005, we commenced andcompleted principal filming of our third motion picture project titled, *Surveillance*. *Surveillance*has been released in the international marketand is expected to be released domestically later in 2006. We have incurredtotal production costs for *Surveillance*of approximately $592,000 as of March 31, 2006.

 

InJuly 2005, we entered into an agreement for the domestic distribution of *Surveillance*. The agreement grants thelicensee a distribution fee equal to 25% of gross receipts and allows for therecoupment of all manufacturing, distribution and marketing costs. We have alsoentered into an agreement for the international distribution of *Surveillance*. The agreement grants thelicensee a distribution fee equal to 20% of gross receipts and allows for therecoupment of all manufacturing, distribution and marketing costs.

 

Inaddition, we sold 50% of the copyright interest in *Surveillance* to the licensee for an amount equal to 50% ofthe budget of *Surveillance*. As ofMarch 31, 2006, we have received $314,000 from the licensee (minorityinterest) under the terms of the agreement. In addition, we entered in to netparticipation agreements with the director, casting company and others equal to8% of the net receipts of *Surveillance*.

 

*Post-Production of Soul’s Midnight*. During November 2005, we commenced andcompleted the filming of our fourth motion picture titled, *Soul’s Midnight*. We anticipate that ourtotal production costs for *Soul’s Midnight*will be approximately $650,000.

 

Wehave entered into an agreement for the domestic distribution of *Soul’s Midnight*. The agreement grants thelicensee a distribution fee equal to 25% of gross receipts and allows for therecoupment of all manufacturing, distribution and marketing costs. In addition,we sold 25% of the copyright interest in *Soul’sMidnight* 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 creators of the script for an amount equal to 50% of the budget. As of March 31,2006, we have received $504,500 from the minority interests under the terms ofthe agreement.

 

*Pre-Production and Filming of Fingerprints.*During March 2006, we commenced thepre-production phase of our fifth motion picture project titled, *Fingerprints*. We anticipate completing thefilming of this movie in April 2006. We anticipate that our totalproduction costs for *Fingerprints*will be approximately $650,000.

 

Wehave entered into an agreement for the domestic distribution of *Fingerprints*. The agreement grants thelicensee a distribution fee equal to 25% of gross receipts and allows for therecoupment of all manufacturing, distribution and marketing costs. In addition,we sold 42.5% of the copyright interest in *Fingerprints*to the licensee for an amount equal to 42.5% of the budget of *Fingerprints*. We also sold 20% of thecopyright interest in *Fingerprints*to the creators of the script for an amount equal to 20% of the budget. As of March 31,2006, we have received $504,500 from the minority interests under the terms ofthe agreement.

 

***Convertible Note Financing.***In August and October 2005, weissued two promissory notes (the “Notes”) in the aggregate principal amount of$1,500,000. The Notes are secured by all of our assets and the assets of ourcurrent 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 payable on the first to occur of:

 

•                                          July 27, 2007 for the first note and October 25,2007 for the second note (the “Maturity Dates”);

 

•                                          the consummation of a “Qualified Financing;”or

 

•                                          the continuation of and Event of Default, asdefined, for more than 30 days following notice of the occurrence of an Eventof Default.

 

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Uponconsummation of a Qualified Financing, the outstanding principal amount of theNotes and all accrued and unpaid interest (collectively the “Note Balance”)will automatically 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 equity securities sold in the Qualified Financing. Themaximum price or value of our common stock or other equity securities intowhich the Note Balance converts may not exceed the equivalent of $1.10 percommon stock share. Qualified Financing refers to any equity financing pursuantto which we receive aggregate gross cash proceeds of $2,000,000 or more on orbefore the Maturity Date.

 

Inconjunction with issuance of the Notes, we 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 25,2010 for the second note. Two agreements provide for the purchase of 250,000(500,000 total) common stock shares at $2.00 and the other two agreementsprovide for the purchase of 250,000 (500,000 total) common stock shares at$3.00.

 

Thefair value of each warrant issued was estimated on the date of issuance usingthe Black-Scholes option pricing model. 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 valueof the warrants was estimated to be $349,459 and was recorded as paid-incapital and as a discount to the value of the notes. The value of the warrantswill be amortized to interest expense over the respective terms of the Notes.

 

***Output Agreement.***In June 2005, we entered into anagreement providing Image Entertainment (“Image”) with the first-look right atthe movies we produce (the “Output Agreement”). Image has a “first look” on allprojects up to $2,000,000 that we undertake during the three-year periodbeginning on the date of delivery of *TheHunt* which was delivered in February 2006. If Image were tochoose not to become involved in a motion picture project, we have the right toproduce and distribute the motion picture with another person without anyfurther obligation to Image. Image agreed to fund up to 50% of each productionbudget for mutually agreed upon motion picture projects. This funding ispayable in three installments:  20% ofthe approved the production budget through pre-production, 60% of through thephysical shooting schedule, and 20% through the post production process.

 

Fora term of 20 years, Image will have domestic distribution rights of each motionpicture we co-produce with Image. Image is entitled to receive a 25%distribution fee from gross domestic sales and a back-end profit participationfrom all sales after payment of the distribution fee. In general, the back-endprofit participation interest and ownership interest in each co-produced motionpicture will be based upon Image’s funding of the budgeted share of productioncosts. 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. Our joint exploitation of the broadcastrights with Image have been left to future negotiation.

 

**Accounting Methods**

 

Theapplication of the following accounting policies, which are important inpresenting our financial position and results of operations, requiressignificant judgments and estimates on the part of management. For asummary of all of our accounting policies, including the accounting policiesdiscussed below, see note 2 to the unaudited consolidated financial statementsappearing elsewhere in this report.

 

InJune 2000, the Accounting Standards Executive Committee of the AmericanInstitute of Certified Public Accountants issued Statement of Position 00-2,Accounting by Producers or Distributors of Films (“SoP 00-2”). SoP 00-2establishes accounting standards for producers or distributors of films,including changes in revenue recognition, capitalization and amortization ofcosts of acquiring films and television programs and accounting forexploitation costs, including advertising and marketing expenses. Theseaccounting standards are as follows:

 

•                                          advertising and marketing costs are expensedthe first time the advertising takes place; and

 

•                                          the capitalization of production costs forepisodic television series is limited to revenue that has been contractedfor on an episode-by-episode basis until the time that the criteria for recognizingsecondary market revenues

 

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aremet.

 

Wecapitalize the costs of production, including financing costs, to investment inmotion pictures. These costs are amortized to direct operating expenses inaccordance with SoP 00-2. These costs are stated at the lower of unamortizedmotion picture costs or fair value (net present 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 to regularly review and revise when necessarythe total revenue estimates of each motion picture produced. As a result, ifrevenue estimates change with respect to a motion picture, it may benecessary to write down all or a portion of the unamortized costs of the motionpicture. There is no assurance that revised revenue estimates will not occurthat result in significant write-downs affecting our results of operations andfinancial condition.

 

Revenuefrom the sale or licensing of motion pictures will be recognized upon meetingall recognition requirements of SoP 00-2. Revenue from the theatrical releaseof motion pictures will be recognized at the time of exhibition based on ourparticipation in box office receipts. If applicable, revenue from the sale ofDVDs in the retail market, net of an allowance for estimated returns, isrecognized on the later of shipment to the customer or “street date” (when itis available for sale by the customer). Furthermore, if applicable, underrevenue sharing arrangements, rental revenue is recognized when we becomeentitled to receipts. For contracts that provide for rights to exploit a motionpicture on multiple media (e.g. theatrical, video, television) with a fee for asingle motion picture where the contract specifies the permissible timing ofrelease to various media, the fee is allocated to the various media based on anassessment of the relative fair value of the rights to exploit each media andwill be recognized as the movie is released to each media. For multiple-titlecontracts with a fee, the fee is allocated on a title-by-title basis, based onan assessment of the relative fair value of each title. If applicable, revenuesfrom television licensing are recognized when the motion picture becomesavailable to the licensee for telecast. Cash payments received are recorded asdeferred revenue until all the conditions of revenue recognition have been met.If applicable, we accrue for video returns and provide for allowances in thefinancial statements based on previous returns and our allowances history on atitle-by-title basis in each of the video businesses. In this case, there may bedifferences between actual returns and allowances and our historical experiencethat we currently do not have. Revenues earned from the sale of DVDs throughdistribution agreements are recognized when sales from these distributors areknown or can be accurately estimated.

 

Wedepend on the distributors of any motion picture we produce to account for andaccurately report our share of exhibition revenue. While we expect to havecertain audit rights to verify exhibition revenues received by our NorthAmerican distributors,

 

•                                          distributors are often in a position toaccount for revenues in a manner that understates or fails accurately toaccount for revenues or

 

•                                          distributors may fail to maintainappropriate accounting records making it difficult to determine a producer’sactual share of revenues upon audit.

 

Althoughwe do not have any experience related to auditing distributors’ revenueaccounting, we anticipate that the costs associated with this type of audit may besubstantial and may vary significantly from distributor-to-distributor andeven picture-to-picture. Therefore, there is no assurance that, in all cases,we will be able to obtain an accurate accounting of exhibition revenues or thataudits will result in increases in the revenues that justify the associatedaudit costs.

 

**Recent Accounting Pronouncements**

 

*SFAS 123(R)* – In December 2004, the Financial Accounting Standards Board(FASB) issued Statement of Financial Accounting Standards (SFAS) No. 123(R),*Share-Based Payment*. SFAS 123(R)replaces SFAS No. 123, *Accounting forStock-Based Compensation*, and supersedes *Accounting Principles Board* (APB) Opinion No. 25, *Accounting for Stock Issued to Employees*. Weadopted SFAS 123(R) on January 1, 2006 using the modified prospectivemethod as described in the standard. Under the modified prospective method, weare required to record compensation

 

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costfor new and modified awards over the related vesting period of such awards prospectivelyand record compensation cost prospectively for the unvested portion at time ofadoption, of previously issued and outstanding awards over the remainingvesting period of such awards. As of January 1, 2006, we had no unvestedoutstanding awards and as a result, the adoption of SFAS123(R) had no impact onour consolidated financial statements or consolidated results of operations.

 

**Results of Operations**

 

Thefollowing table sets forth selected results of our operations for the threemonths ended March 31, 2006 and 2005. The following information wasderived and taken from our unaudited financial statements appearing elsewherein this report.

 
| ** **                   | ** ** | **For the Three Months Ended  March 31,** | ** ** |
|------------------------------|------------|------------------------------------------------|------------|
| ** **                   | ** ** | **2006**                                       | ** ** | **2005** | ** ** |
| Revenue                      |       | $                                              | 189,286    |   | $ | — |   |
|                         |       |                                           |       |   |   |
| Expenses:                    |       |                                           |       |   |   |
| Direct operating             |       | 160,011                                        |       | — |   |
| General and administrative   |       | 105,667                                        |       | 94,672 |   |
| Depreciation                 |       | 1,216                                          |       | 1,216 |   |
|                         |       |                                           |       |   |   |
| Total expenses               |       | 266,894                                        |       | 95,888 |   |
|                         |       |                                           |       |   |   |
| Operating loss               |       | (77,608                                        | )          | (95,888 | ) |
|                         |       |                                           |       |   |   |
| Other income (expense):      |       |                                           |       |   |   |
| Interest and other income    |       | 9,133                                          |       | 3,733 |   |
| Interest expense             |       | (91,577                                        | )          | — |   |
| Minority interests           |       | (382                                           | )          | — |   |
|                         |       |                                           |       |   |   |
| Net other income (expense)   |       | (82,826                                        | )          | 3,733 |   |
|                         |       |                                           |       |   |   |
| Net loss before income taxes |       | (160,434                                       | )          | (92,155 | ) |
| Provision for income taxes   |       | —                                         |       | — |   |
|                         |       |                                           |       |   |   |
| Net loss                     |       | $                                              | (160,434   | ) | $ | (92,155 | ) |

 

**Comparison of the Three-Month Periods Ended March 31,2006 and 2005**

 

Ourconsolidated revenues for the three months ended March 31, 2006 (the “20061st Quarter”) were $189,286 and were attributable to the internationaldistribution of *Cloud 9* and *The Hunt*. We did not generate any revenuein the prior year’s first quarter.

 

Directoperating expenses primarily include amortization of film costs andparticipation costs. Our direct operating expenses of $160,111 for the 2006 1stQuarter were 85% of revenues. We did not incur any direct operating expenses inthe prior year’s first quarter.

 

Generaland administration expenses of $105,667 for the 2006 1st Quarterincreased $10,995, or 12%, from $94,672 in the prior year’s quarter. Theincrease in general and administration expenses was primarily due to theaddition of a full-time production assistant and an increase in legal andprofessional fees associated with our reporting and filing requirements as apublic company.

 

Duringthe 2006 1st Quarter we realized interest income of $9,133, comparedto $3,733 in the prior year’s first quarter. This increase was attributable toa corresponding increase in the balance of cash and cash equivalents held ininterest bearing accounts.

 

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Weincurred interest expense of $91,577 during the 2006 1st Quarterthat was attributable to our convertible notes payable, amortization of prepaidloan fees and amortization of warrants issued with the convertible notespayable. We did not incur any interest expense in the prior year’s firstquarter.

 

Minorityinterests in our earnings for the 2006 1st Quarter were $382 andwere attributable to minority interests in our movie *The Hunt*.

 

**Liquidity and Capital Resources**

 

Ourliquidity and capital resources are provided principally through cash generatedfrom operations, issuance of convertible notes payable and equity offerings. Ourcash and cash equivalents at March 31, 2006 totaled approximately$1,091,000. As of March 31, 2006, we had working capital of approximately$1,016,000.

 

InApril 2004, we completed our private placement offering of our commonstock shares and redeemable warrants in units of one common stock share and oneredeemable warrant. During 2003 and 2004, we received net proceeds of$2,535,224 from this private placement offering.

 

During2005, we received $1,500,000 in proceeds from the issuance of convertiblepromissory notes.

 

Operatingactivities for the three months ended March 31, 2006, used net cash of$132,819 compared to operating activities for the three months ended March 31,2005 which used $320,201. The decrease in cash flows used by operatingactivities is attributable to revenue generated during the first quarter of2006 and a decrease in expenditures for film costs.

 

Investingactivities for the three months ended March 31, 2006, generated net cashof $119,500 as a result of contributions made by our minority interests oncertain film projects. We did not have any investing activities during thefirst quarter of 2005.

 

Financingactivities during the three months ended March 31, 2006, used cash of$50,000 for the repayment of film obligations. We did not have any financingactivities during the first quarter of 2005. During the 2006 1stQuarter, we issued 21,274 shares of common stock as payment of accrued interest(in the amount of $26,167) 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. Thisliability is only payable in the event Graymark Productions, L.L.C. or itsaffiliates obtain funding for film projects from outside investors. Messrs. Fredericksonand Stansberry have each represented that their intent was not to causeGraymark Productions, L.L.C. to be liable for this obligation and each hasagreed to indemnify us for any liability that may arise out of this agreement.In December 2003, we recorded a consulting expense and liability of$50,000 related to the agreement with FilmCapital. At the time that we pay thisrecorded liability, Messrs. Frederickson and Stansberry will be requiredimmediately to reimburse us for the payment.

 

***Registration Obligations.***We agreed, at our expense, to register thecommon stock shares and redeemable warrants offered for sale pursuant to ourprivate placement of 2,995,000 common stock shares and redeemable warrantsexercisable for the purchase of 2,995,000 common stock shares under the 1933Act and to maintain effectiveness of the registration for a seven-year periodending on April 14, 2010. Registration of the common stock shares andredeemable warrants became effective July 13, 2004.

 

Furthermore,we also similarly agreed to register (and maintain effective of theregistration under the 1933 Act for the seven-year period) the 443,250 commonstock shares underlying the placement agent warrants sold to the underwriter ofour private placement offering, Viewtrade Financial, and 383,425 common stockshares issued pursuant

 

8

----

 

tothe one-year Financial Advisor Agreement to Viewtrade Financial. In accordancewith this obligation, we initially included these common stock shares in theregistration statement that registered the private placement common stockshares and redeemable warrants; however, on February 27, 2004, ViewtradeFinancial, on its own behalf as well as the other holders of the placementagent warrants and the recipients and holders of the common stock sharesassigned to affiliates of Viewtrade Financial, elected to remove those sharesfrom the registration statement. Although we have been informed by our legalcounsel that the common stock shares, other than those underlying the placementagent warrants, may be sold without further restriction pursuant to Rule 144as promulgated by the Securities and Exchange Commission, we anticipate filinga registration statement in accordance with this registration obligation duringthe last half of 2006.

 

***Office Space Arrangement*****.**Our corporate headquarters and offices arelocated at 101 North Robinson, Suite 920, Oklahoma City, Oklahoma. Theseoffice facilities consist approximately of 1,500 square feet and are occupiedunder an unwritten month-to-month lease arrangement, requiring monthly rentalpayments of $600. The costs of building-out and improving our offices wasapproximately $15,000 which we paid rather than Corporate Tower, LLC, our landlord.Roy T. Oliver, one of our greater than 5% shareholders and affiliates, controlsCorporate Tower, LLC. Mr. Oliver on behalf of Corporate Tower, LLC hasorally indicated that as of the date of this report there is no intent toterminate our occupancy of the office facilities. Under Oklahoma law,termination of our month-to-month lease arrangement requires at least 30 daysprior written notice. In the event of this termination, we believe there isadequate office space and facilities available in the Oklahoma City area. Inthe event we are required to move from our current office facilities, the termsof occupancy, including the increased rental payments, will be substantiallydifferent than those under which our office space is currently occupied and theannual rental rate will probably be from $8 to $12 per square foot ($12,000 to$18,000 per year based upon 1,500 square feet of office facilities).

 

***12-Month Overhead Budget***

 

Ourbudgeted overhead expenses for the next 12 months are as follows:

 
| **Expenditure**                   | ** ** | **Monthly** | ** ** | **12  Months** | ** ** |
|-----------------------------------|------------|-------------|------------|----------------|------------|
| Administrative expenditures:      |       |        |       |           |       |
| Executive officer compensation    |       | $           | 18,333     |           | $          | 220,000 |   |
| Administrative salaries           |       | 1,517       |       | 18,200         |       |
| Payroll taxes                     |       | 2,527       |       | 30,330         |       |
| Film marketing                    |       | 2,000       |       | 24,000         |       |
| Telephone                         |       | 700         |       | 8,400          |       |
| Rent                              |       | 500         |       | 6,000          |       |
| Legal                             |       | 2,917       |       | 35,000         |       |
| Accounting                        |       | 2,917       |       | 35,000         |       |
| Public relations                  |       | 417         |       | 5,000          |       |
| Travel                            |       | 4,167       |       | 50,000         |       |
| Health insurance                  |       | 1,020       |       | 12,240         |       |
| Automobile                        |       | 500         |       | 6,000          |       |
| Miscellaneous                     |       | 485         |       | 5,820          |       |
| Total Administrative Expenditures |       | $           | 38,000     |           | $          | 455,990 |   |

 

***Additional Financial Commitments***

 

Otherthan our commitments discussed above, we do not have any capital commitments. Althoughwe do not have any commitments, we may enter into long-term lendingarrangements during the next 12 months to provide additional working capitaland fund additional movie projects we desire to undertake. In addition, we may receiveadditional funds from the exercise of outstanding warrants and stock options,the exercise of which is generally not within our control.

 

9

----

 

Ifour production activities are successful (of which there is no assurance) ormovie production budgets increase, we may be required to increase overheadby hiring additional employees and increase our office facilities. Weanticipate that during the next 12 months we will not be required to increasethe number of our employees or increase our office facilities.

 

Webelieve that our operations as a result of our motion picture projects willachieve profitability. We provide no assurance that

 

•                                          we will be successful in implementing ourbusiness plan or

 

•                                          unanticipated expenses or problems ortechnical difficulties will not occur which would result in significant delays.

 

Anyone of these will adversely affect our ability to become profitable or tomaintain profitability.

 

Futurecommitments under contractual obligations by expected maturity date at March 31,2006 are as follows:

 

 
| ** **                | ** ** | **< 1 year** | ** ** | **1-3 years** | ** ** | **3-5 years** | ** ** | **> 5 years** | ** ** | **Total** | ** ** |
|---------------------------|------------|-----------------|------------|---------------|------------|---------------|------------|------------------|------------|-----------|------------|
|                      |       |            |       |          |       |          |       |             |       |      |       |
| Convertible notes payable |       | $               | —     |          | $          | 1,500,000     |       | $                | —     |      | $          | — |   | $ | 1,500,000 |   |
| Operating leases          |       | 7,200           |       | —        |       | —        |       | —           |       | 7,200     |       |
| Employment contracts      |       | 60,000          |       | —        |       | —        |       | —           |       | 60,000    |       |
|                      |       |            |       |          |       |          |       |             |       |      |       |
|                      |       | $               | 67,200     |          | $          | 1,500,000     |       | $                | —     |      | $          | — |   | $ | 1,567,200 |   |

 

**Cautionary Statement Relating to Forward Looking Information**

 

Wehave included some forward-looking statements in this section and otherplaces in this report regarding our expectations. These forward-lookingstatements involve known and unknown risks, uncertainties and other factorswhich may cause our actual results, levels of activity, performance orachievements, or industry results, to be materially different from any futureresults, levels of activity, performance or achievements expressed or impliedby these forward-looking statements. Some of these forward-looking statementscan be identified by the use of forward-looking terminology including “believes,”“expects,” “may,” “will,” “should” or “anticipates” or the negative thereof orother variations thereon or comparable terminology, or by discussions ofstrategies that involve risks and uncertainties. You should read statementsthat contain these words carefully because they:

 

•                                          discuss our future expectations;

 

•                                          contain projections of our future operatingresults or of our future financial condition; or

 

•                                          state other “forward-looking” information.

 

Webelieve it is important to discuss our expectations; however, it must berecognized that events may occur in the future over which we have no controland which we are not accurately able to predict. Readers are cautioned toconsider the specific business risk factors described under the caption “AdditionalFactors that May Affect Our Future Results” appearing under “Item 1.Description of Business” of our Annual Report on Form 10-KSB filed withthe United States Securities and Exchange Commission on March 29, 2005,and not to place undue reliance on the forward-looking statements containedherein, which speak only as of the date of this report. We undertake noobligation to publicly revise forward-looking statements to reflect events orcircumstances that may arise after the date of this report.

 

10

----

 

**Item 3. Controls and Procedures**

 

OurChief Executive Officer and Chief Financial Officer are responsible primarilyfor establishing and maintaining disclosure controls and procedures designed toensure that information required to be disclosed in our reports filed orsubmitted under the Securities Exchange Act of 1934, as amended (the “ExchangeAct”) is recorded, processed, summarized and reported within the time periodsspecified in the rules and forms of the U.S. Securities and ExchangeCommission. 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,our Chief Executive Officer and Chief Financial Officer are responsible for thedesign and supervision of our internal controls over financial reporting thatare then effected by and through our board of directors, 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. Thesepolicies and procedures (i) pertain to the maintenance of records that, inreasonable detail, accurately and fairly reflect the transactions anddispositions of our assets; (ii) provide reasonable assurance thattransactions are recorded as necessary to permit preparation of financialstatements in accordance with generally accepted accounting principles, andthat our receipts and expenditures are being made only in accordance withauthorizations of our management and directors; and (iii) providereasonable assurance regarding prevention or timely detection of unauthorizedacquisition, use or disposition of our assets that could have a material effecton our financial statements.

 

OurChief Executive Officer and Chief Financial Officer, based upon theirevaluation of the effectiveness of our disclosure controls and procedures andthe internal controls over financial reporting as of the last day of the periodcovered by this report, concluded that our disclosure controls and proceduresand internal controls over financial reporting were fully effective as of thelast day of the period covered by this report and reported to our auditors andboard of directors that no change occurred in our disclosure controls andprocedures and internal control over financial reporting occurred during theperiod covered by this report that would materially affect or is reasonablylikely to materially affect our disclosure controls and procedures or internalcontrol over financial reporting. In conducting their evaluation of ourdisclosure controls and procedures and internal controls over financialreporting, these executive officers did not discover any fraud that involvedmanagement or other employees who have a significant role in our disclosurecontrols and procedures and internal controls over financial reporting. Furthermore,there were no significant changes in our disclosure controls and procedures,internal controls over financial reporting, or other factors that couldsignificantly affect our disclosure controls and procedures or internalcontrols over financial reporting subsequent to the date of their evaluation. Becauseno significant deficiencies or material weaknesses were discovered, nocorrective actions were necessary or taken to correct significant deficienciesand material weaknesses in our internal controls and disclosure controls andprocedures.

 

**PART IIOTHER INFORMATION**

 

**Item 1.**** ****Legal Proceedings**

 

None

 

**Item 2.**** ****Unregistered Sales of Equity Securities and Use of Proceeds**

 

(a)           None

 

(b)           None

 

(c)           None

 

11

----

 

**Item 3.**** ****Defaults Upon Senior Securities**

 

None

 

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

 

None

 

**Item 5.**** ****Other Information**

 

None

 

**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**

 

Inaccordance with the Exchange Act, the Registrant caused this report to besigned on its behalf by the undersigned, thereunto duly authorized.

 
|                    | GRAYMARK  PRODUCTIONS, INC. |
|-------------------------|----------------------------------|
|                    | (Registrant)                     |
|                    |                             |
|                    |                             |
|                    | By:                              | /S/JOHN  SIMONELLI |   |
|                    |                             | John  Simonelli |
|                    |                             | Chief  Executive Officer |
| Date:  May 4, 2006 |                             |
|                    |                             |
|                    | By:                              | /S/MARK  R. KIDD |   |
|                    |                             | Mark  R. Kidd |
|                    |                             | Chief  Financial Officer and Controller |
| Date:  May 4, 2006 |                             |
|                         |                                  |  |  |  |

 

12

----

 

**GRAYMARK PRODUCTIONS, INC.**

 

**INDEX TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS**

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

 

F-1

----

 

**GRAYMARK PRODUCTIONS, INC.**

 

**CondensedConsolidated Balance Sheets**

**(Unaudited)**

 
| ** **                                                                                                                                                                                  | ** ** | **March 31,  2006** | ** ** | **December 31,  2005** | ** ** |
|---------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|------------|--------------------------|------------|-----------------------------|------------|
| ASSETS                                                                                                                                                                                      | ** ** | ** **               | ** ** | ** **                  | ** ** |
| ** **                                                                                                                                                                                  | ** ** | ** **               | ** ** | ** **                  | ** ** |
| Cash and cash equivalents                                                                                                                                                                   |       | $                        | 1,090,521  |                        | $          | 1,153,840 |   |
| Film deposits                                                                                                                                                                               |       | —                   |       | 32,500                      |       |
| Accounts receivable                                                                                                                                                                         |       | 58,612                   |       | —                      |       |
|                                                                                                                                                                                        |       |                     |       |                        |       |
| Total current assets                                                                                                                                                                        |       | 1,149,133                |       | 1,186,340                   |       |
|                                                                                                                                                                                        |       |                     |       |                        |       |
| Fixed assets, net                                                                                                                                                                           |       | 15,109                   |       | 16,325                      |       |
| Prepaid loan fees                                                                                                                                                                           |       | 108,493                  |       | 126,986                     |       |
| Investment in films                                                                                                                                                                         |       | 3,525,812                |       | 3,458,417                   |       |
|                                                                                                                                                                                        |       |                     |       |                        |       |
| Total assets                                                                                                                                                                                |       | $                        | 4,798,547  |                        | $          | 4,788,068 |   |
| ** **                                                                                                                                                                                  | ** ** | ** **               | ** ** | ** **                  | ** ** |
| LIABILITIES AND SHAREHOLDERS’ EQUITY                                                                                                                                                   |       |                     |       |                        |       |
|                                                                                                                                                                                        |       |                     |       |                        |       |
| Liabilities:                                                                                                                                                                                |       |                     |       |                        |       |
| Accounts payable and accrued liabilities                                                                                                                                                    |       | $                        | 133,439    |                        | $          | 101,659 |   |
|                                                                                                                                                                                        |       |                     |       |                        |       |
| Total current liabilities                                                                                                                                                                   |       | 133,439                  |       | 101,659                     |       |
|                                                                                                                                                                                        |       |                     |       |                        |       |
| Film obligations                                                                                                                                                                            |       | —                   |       | 50,000                      |       |
| Convertible note payable, net of discounts  of $244,123 and $287,207 at March 31, 2006 and December 31, 2005,  respectively                                                       |       | 1,255,877                |       | 1,212,793                   |       |
|                                                                                                                                                                                        |       |                     |       |                        |       |
| Total liabilities                                                                                                                                                                           |       | 1,389,316                |       | 1,364,452                   |       |
|                                                                                                                                                                                        |       |                     |       |                        |       |
| Minority interests                                                                                                                                                                          |       | 1,113,979                |       | 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; 8,310,425 issued and outstanding at March 31, 2006  (8,289,151 shares issued and outstanding at December 31, 2005) |       | 831                      |       | 829                         |       |
| Paid-in capital                                                                                                                                                                             |       | 4,248,017                |       | 4,221,852                   |       |
| Accumulated deficit                                                                                                                                                                         |       | (1,953,596               | )          | (1,793,162                  | )          |
|                                                                                                                                                                                        |       |                     |       |                        |       |
| Total shareholders’ equity                                                                                                                                                             |       | 2,295,252                |       | 2,429,519                   |       |
|                                                                                                                                                                                        |       |                     |       |                        |       |
| Total liabilities and shareholders’ equity                                                                                                                                             |       | $                        | 4,798,547  |                        | $          | 4,788,068 |   |

 

See Accompanying Notes to Condensed Consolidated Financial Statements

 

F-2

----

 

**GRAYMARK PRODUCTIONS, INC.**

 

**CondensedConsolidated Statements of Operations**

**(Unaudited)**

 
| ** **                                            | ** ** | **Three Months Ended  March 31,** | ** ** |
|-------------------------------------------------------|------------|----------------------------------------|------------|
| ** **                                            | ** ** | **2006**                               | ** ** | **2005** | ** ** |
|                                                  |       |                                   |       |   |   |
| Revenues                                              |       | $                                      | 189,286    |   | $ | — |   |
|                                                  |       |                                   |       |   |   |
| Expenses:                                             |       |                                   |       |   |   |
| Direct operating                                      |       | 160,011                                |       | — |   |
| General and administrative                            |       | 105,667                                |       | 94,672 |   |
| Depreciation                                          |       | 1,216                                  |       | 1,216 |   |
|                                                  |       |                                   |       |   |   |
| Total expenses                                        |       | 266,894                                |       | 95,888 |   |
|                                                  |       |                                   |       |   |   |
| Operating loss                                        |       | (77,608                                | )          | (95,888 | ) |
|                                                  |       |                                   |       |   |   |
| Other Income (Expense):                               |       |                                   |       |   |   |
| Interest and other income                             |       | 9,133                                  |       | 3,733 |   |
| Interest expense                                      |       | (91,577                                | )          | — |   |
| Minority interests                                    |       | (382                                   | )          | — |   |
|                                                  |       |                                   |       |   |   |
| Net other income (expense)                            |       | (82,826                                | )          | 3,733 |   |
|                                                  |       |                                   |       |   |   |
| Net loss before provision for income taxes            |       | (160,434                               | )          | (92,155 | ) |
|                                                  |       |                                   |       |   |   |
| Provision for income taxes                            |       | —                                 |       | — |   |
|                                                  |       |                                   |       |   |   |
| Net loss                                              |       | $                                      | (160,434   | ) | $ | (92,155 | ) |
|                                                  |       |                                   |       |   |   |
| Net loss per share of common stock, basic and diluted |       | $                                      | (0.02      | ) | $ | (0.01 | )  |
|                                                  |       |                                   |       |   |   |
| Weighted average number of common shares outstanding  |       | 8,310,425                              |       | 8,258,425 |   |

 

See Accompanying Notes to Condensed Consolidated Financial Statements

 

F-3

----

 

**GRAYMARK PRODUCTIONS, INC.**

 

**CondensedConsolidated Statements of Shareholders’ Equity**

**(Unaudited)**

 
| ** **                                         | ** ** | **Common Stock** | ** ** | **Paid-in  Capital** | ** ** | **Accumulated  Deficit** | ** ** |
|----------------------------------------------------|------------|------------------|------------|----------------------|------------|--------------------------|------------|
| **Shares**                                         | ** ** | **Amount**       |
|                                               |       |             |       |                 |       |                     |       |   |   |
| 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  services |       | 10,000           |       | 1                    |       | 9,374                    |       | — |   |
| Issuance of stock for convertible notes  interest  |       | 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  interest  |       | 21,274           |       | 2                    |       | 26,165                   |       | — |   |
| Net loss                                           |       | —           |       | —               |       | —                   |       | (160,434 | ) |
|                                               |       |             |       |                 |       |                     |       |   |   |
| Balance, March 31, 2006                       |       | 8,310,425        |       | $                    | 831        |                     | $          | 4,248,017 |   | $ | (1,953,596 | ) |

 

See Accompanying Notes to Condensed Consolidated Financial Statements

 

F-4

----

 

**GRAYMARK PRODUCTIONS, INC.**

 

**CondensedConsolidated Statements of Cash Flows**

**(Unaudited)**

 
| ** **                                                                   | ** ** | **Three Months Ended  March 31,** | ** ** |
|------------------------------------------------------------------------------|------------|----------------------------------------|------------|
| ** **                                                                   | ** ** | **2006**                               | ** ** | **2005** | ** ** |
|                                                                         |       |                                   |       |   |   |
| Operating activities:                                                        |       |                                   |       |   |   |
| Net loss                                                                     |       | $                                      | (160,434   | ) | $ | (92,155 | ) |
| Adjustments to reconcile net loss to net  cash used by operating activities: |       |                                   |       |   |   |
| Depreciation                                                                 |       | 1,216                                  |       | 1,216 |   |
| Amortization of film costs                                                   |       | 159,581                                |       | — |   |
| Issuance of common stock for convertible  notes interest                     |       | 26,167                                 |       | — |   |
| Interest expense allocated to warrants                                       |       | 43,084                                 |       | — |   |
| Minority interests                                                           |       | 382                                    |       | — |   |
| Changes in assets and liabilities –                                     |       |                                   |       |   |   |
| Film deposits                                                                |       | 32,500                                 |       | 37,201 |   |
| Accounts receivable                                                          |       | (58,612                                | )          | — |   |
| Prepaid loan fees                                                            |       | 18,493                                 |       | — |   |
| Investment in films                                                          |       | (226,976                               | )          | (337,849 | ) |
| Accrued liabilities                                                          |       | 31,780                                 |       | 71,386 |   |
|                                                                         |       |                                   |       |   |   |
| Net cash used by operating activities                                        |       | (132,819                               | )          | (320,201 | ) |
|                                                                         |       |                                   |       |   |   |
| Investing activities:                                                        |       |                                   |       |   |   |
| Minority interests - contributions                                           |       | 119,500                                |       | — |   |
|                                                                         |       |                                   |       |   |   |
| Net cash provided by financing activities                                    |       | 119,500                                |       | — |   |
|                                                                         |       |                                   |       |   |   |
| Financing activities:                                                        |       |                                   |       |   |   |
| Repayment of film obligations                                                |       | (50,000                                | )          | — |   |
|                                                                         |       |                                   |       |   |   |
| Net cash used in financing activities                                        |       | (50,000                                | )          | — |   |
|                                                                         |       |                                   |       |   |   |
| Net change in cash and cash equivalents                                      |       | (63,319                                | )          | (320,201 | ) |
|                                                                         |       |                                   |       |   |   |
| Cash and cash equivalents at beginning of period                             |       | 1,153,840                              |       | 877,933 |   |
|                                                                         |       |                                   |       |   |   |
| Cash and cash equivalents at end of period                                   |       | $                                      | 1,090,521  |   | $ | 557,732 |   |
|                                                                         |       |                                   |       |   |   |
| Noncash Investing and Financing Activities:                                  |       |                                   |       |   |   |
| Issuance of stock for convertible notes  interest expense                    |       | $                                      | 26,167     |   | $ | — |   |
|                                                                         |       |                                   |       |   |   |
| Cash Paid for Interest and Income Taxes:                                     |       |                                   |       |   |   |
| Interest expense                                                             |       | $                                      | —     |   | $ | — |   |
| Income taxes                                                                 |       | $                                      | —     |   | $ | — |   |

 

See Accompanying Notes to Condensed Consolidated Financial Statements

 

F-5

----

 

**GRAYMARK PRODUCTIONS, INC.**

 

**Notes to Condensed Consolidated Financial Statements**

**(Unaudited)**

 

**For the Periods Ended March 31, 2006 and 2005**

 

Note1 – Nature of Business

 

GraymarkProductions, Inc. (the “Company”) is organized in Oklahoma and is anindependent producer and distributor of film entertainment content. The Companybegan operations in 2001 as Graymark Productions, L.L.C. (“Graymark LLC”), allof the assets of which were acquired by the Company through ourincorporation-reorganization, effective August 18, 2003.

 

TheCompany produces and distributes films that are completed and marketed usingsmaller budgets than those of major studios. The Company has completed theproduction and released its first and second motion picture projects titled, *Cloud 9* and *The Hunt*. The Company has also completed the filming and isin post-production on its third and fourth motion pictures titled, *Surveillance* and *Soul’s Midnight*. The Company is inpre-production and filming stage of its fifth motion picture project titled, *Fingerprints*. The Company has negotiatedagreements for the domestic marketing and distribution of all five films andfor the international marketing and distribution of *Cloud 9*, *The Hunt*and *Surveillance*. Managementbelieves that producing and distributing low- or modest-budget, commerciallysuccessful films affords the Company access to Hollywood talent and scripts andthird-party production packages for acquisition, without compromisingmanagement’s approach to managing financial risk.

 

Note2 – Summary of Significant Accounting Policies

 

*Interim Financial Information* – The unaudited condensed consolidated financialstatements included herein have been prepared in accordance with generallyaccepted accounting principles for interim financial statements and withRegulation S-X. Accordingly, they do not include all of the information andfootnotes required by generally accepted accounting principles for completefinancial statements. In the opinion of management, all adjustments (consistingof normal recurring adjustments) considered necessary for a fair presentationhave been included. Operating results for the three months ended March 31,2006 are not necessarily indicative of results that may be expected forthe year ended December 31, 2006. The condensed consolidated financialstatements should be read in conjunction with the consolidated financialstatements and notes thereto included in the Company’s Form 10-KSB for theyear ended December 31, 2005. The December 31, 2005 condensedconsolidated balance sheet was derived from audited financial statements.

 

*Consolidation* – The accompanying consolidated financial statements include theaccounts of Graymark Productions, Inc. and its majority owned andcontrolled subsidiaries. The Company controls a subsidiary company through acombination of existing voting interests and the ability to exercise variousrights under certain shareholder or operating agreements. The Company’ssubsidiaries include Graymark Productions, L.L.C. (the “LLC”), Out of the BlueProductions, LLC (“Out of the Blue”), The Hunt, The Motion Picture LLC (“TheHunt”), Surveillance, The Motion Picture LLC (“Surveillance”), Soul’s MidnightLLC (“Soul’s Midnight”) and Fingerprints LLC (“Fingerprints”). The LLC became asubsidiary of the Company in August 2003 as a result of theincorporation-reorganization of the Company. Out of the Blue was formed in December 2003as the entity under which the Company’s first motion picture project, *Cloud 9*, was produced. The Company hasfunded 100% of the acquisition and production costs of *Cloud 9*. 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. The Company has 100%voting control of Out of the Blue. The Hunt, Surveillance and Soul’s Midnightare 100% owned by the Company.

 

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*Use of estimates* – The preparation of financial statements in conformity with generallyaccepted accounting principles requires management of the Company to makeestimates and assumptions that affect the amounts reported in the financialstatements and accompanying notes. Actual results could differ from thoseestimates.

 

*Revenue recognition* – Revenues from the sale of the rights to a film are recognized whenthe feature film is available to the distributor for exploitation and noconditions for delivery exist, which under most sales contracts requires thatfull payment has been received from the distributor. Revenues from thetheatrical distribution of motion pictures are recognized when motion picturesare exhibited. Revenues from video sales are recognized on the date that videounits are made widely available for sale by retailers. Revenues from thelicensing of motion picture films are recorded when the material is availablefor telecasting by the licensee and when certain other conditions are met. Revenuesfrom consulting services are recognized when earned.

 

*Investment in Films* – Investment in films includes capitalizable direct negative costs,production overhead, interest and development costs and are stated at the lowerof cost, less accumulated amortization, or fair value. Film production andparticipation costs are expensed based on the ratio of the current period’sgross revenues to estimated remaining total gross revenues from all sources onan individual production basis.

 

Investmentin films is stated at the lower of amortized cost or estimated fair value on anindividual film basis. The valuation of investment in films is reviewed on atitle-by-title basis, when an event or change in circumstances indicate thatthe fair value of a film is less than its unamortized cost. The fair value ofthe film is determined using management’s future revenue and cost estimates anda discounted cash flow approach. Additional amortization is recorded in theamount by which the unamortized costs exceed the estimated fair value of thefilm. Estimates of future revenue involve measurement uncertainty and it istherefore possible that reductions in the carrying value of investment in filmsmay be required as a consequence of changes in management’s future revenueestimates.

 

*Recently Issued Accounting Standards* –

 

*SFAS 123(R)* – In December 2004, the Financial Accounting Standards Board(FASB) issued Statement of Financial Accounting Standards (SFAS) No. 123(R),*Share-Based Payment*. SFAS 123(R)replaces SFAS No. 123, *Accounting for Stock-BasedCompensation*, and supersedes *AccountingPrinciples Board* (APB) Opinion No. 25, *Accounting for Stock Issued to Employees*. Weadopted SFAS 123(R) on January 1, 2006 using the modified prospectivemethod as described in the standard. Under the modified prospective method, weare required 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 such awards.As of January 1, 2006, we had no unvested outstanding awards and as aresult, the adoption of SFAS123(R) had no impact on our consolidated financialstatements or consolidated results of operations.

 

Note3 – Investment in Films

 
| ** **                                | ** ** | **March 31,  2006** | ** ** | **December 31,  2005** | ** ** |
|-------------------------------------------|------------|--------------------------|------------|-----------------------------|------------|
|                                      |       |                     |       |                        |       |
| Released, net of accumulated amortization |       | $                        | 2,831,605  |                        | $          | 2,012,439 |   |
| Completed and not released                |       | —                   |       | 375,790                     |       |
| In progress                               |       | 694,207                  |       | 1,070,188                   |       |
| In development                            |       | —                   |       | —                      |       |
|                                      |       |                     |       |                        |       |
| Total                                     |       | $                        | 3,525,812  |                        | $          | 3,458,417 |   |

 

TheCompany estimates that 100% of the unamortized investment in films at March 31,2006 will be amortized within the next three years. Approximately $2,302,000 offilm costs are expected to be amortized during the next twelve months. Noparticipation liabilities are expected to be paid during the next twelvemonths.

 

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Note4 – Convertible Note Payable

 

InAugust 2005, the Company issued a promissory note (the “Note”) in theprincipal amount of $750,000. The Note is secured by all assets of the Companyincluding all purchase agreements and any options or rights to acquire, allintellectual and real property, all assets and properties of the Company andall of its existing and future subsidiaries. The Note bears interest at therate of 8% per annum. Interest due on the note is payable quarterly and can bepaid in cash or shares of Company stock.

 

TheNote will become due and payable on the first to occur of: (i) July 27,2007 (the “Maturity Date”); (ii) the consummation of a QualifiedFinancing; or (iii) the continuation of and Event of Default, as defined,for more than 30 days following notice of the occurrence of an Event of Default.Upon consummation of a Qualified Financing, the outstanding principal amount ofthe Note and all accrued and unpaid interest (collectively the “Note Balance”)will automatically convert into shares of equity securities of the Companyequal to 120% of the Note Balance divided by the price per share of the equitysecurities sold in the Qualified Financing. The maximum price or value of theequity securities into which the Note Balance converts may not exceed theequivalent of $1.10 per common stock share. Qualified Financing refers to anyequity financing pursuant to which the Company receives aggregate gross cashproceeds of $2,000,000 or more on or before the Maturity Date.

 

Inconjunction with issuance of the Note, the Company and the holder of the Noteentered into two common stock purchase warrant agreements, each evidencingwarrants exercisable on or before August 5, 2010. One agreement providesfor the purchase of 250,000 common stock shares at $2.00 and the otheragreement provides for the purchase of 250,000 common stock shares at $3.00.

 

Thefair value of each warrant issued was estimated on the date of issuance usingthe Black-Scholes option pricing model with the following assumptions used:weighted average risk free interest rate of 4.0%; no dividend yield; volatilityof 78%; and expected life less than five years. The fair value of the optionswere based on the difference between the present value of the exercise price ofthe option and the estimated fair value price of the common share. The fair valueof the warrants was estimated to be $244,776 and was recorded as paid-incapital. The value of the warrants will increase interest expense over the lifeof the Note.

 

Inaddition, the Company’s financial advisor was paid a fee of $75,000 forservices rendered in conjunction with execution of the Note. The fee wasrecorded as a prepaid loan fee and will be amortized over the life of the Note.

 

Note5 – Film Obligations

 

DuringMay 2004, the Company obtained $500,000 of funding under co-financeagreements for its motion picture project, *Cloud9*. The terms of the co-financing provide for the investors to recouptheir contribution from the first proceeds of *Cloud9*. After all *Cloud 9*costs are recouped by the Company, the investors are entitled to a profit participationin the Company’s profit from *Cloud 9*.As a group, the investors are entitled to 20% of the net profits paid to theCompany, but the investors do not have any ownership rights in the film. The$500,000 received under the co-financing agreements represents 21% of theanticipated total cost of *Cloud 9*.During June 2005 and January 2006, $450,000 and $50,000,respectively, was repaid to investors from the first proceeds from *Cloud 9*. The funding under theco-financing agreements came from related parties to the Company as describedbelow:

 
| **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    |                   | $          | — |   |

 

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Note6 – Film Profit Participation and Contingent Compensation

 

Pursuantto an investor agreement between the Company and the developers of thescreenplay for *Cloud 9*(the “Picture”),the Company shares the development and productions costs and revenue of *Cloud 9*. For its financial contribution tothe costs of making *Cloud 9*, theCompany is entitled to receive the following:

 

•                                          100% of revenue and proceeds from the rightssales, distribution and/or any and all exploitation of *Cloud 9* until the Company recovers itsinvestment in the Picture, plus interest at the prime rate plus 2% per annumfrom the date of the contribution until the Company is repaid its investment inthe Picture.

 

•                                          50% of “net profits” received from the rightssales, distribution and/or any and all exploitation of the Picture. “NetProfits” is defined as the sum remaining after deduction of third partydistribution fees; cash deferments to cast, equipment suppliers, rights holdersor any other approved party.

 

TheCompany’s subsidiary, Out of the Blue Productions, LLC (the “Production Company”),entered into contingent compensation agreements with the director and certaincast members of *Cloud 9* in the form of“net and gross profit participations” that are customary in the film industry. Theseparticipations are typically based on the profit of a film after all productionand distribution costs have been recouped (“gross participation”) or allproduction and distribution costs and overhead have been recouped (“netparticipations”). A percentage of these “gross and net profits”, as negotiatedbetween the participants, are paid out as contingent compensation for creativeparticipants 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. TheCompany’s residual profits interest in *Cloud9* is 30.6% after giving effect to the gross and net profitsparticipations given pursuant to contingent compensation arrangements and theco-finance agreements (see Note 5 – Film Obligations).

 

TheProduction Company also agreed to pay additional contingent bonuses to certaincast members when aggregate United States and Canada box office receipts asreported in Daily Variety reach various levels between $8,500,000 and$20,000,000. The total contingent amounts that would be paid if box officereceipts reach $20,000,000 is $300,000.

 

Pursuantto an output agreement between the Company and a third-party distributioncompany (“Distributor”), the Distributor has a first-look right at the moviesproduced by the Company. Pursuant to the agreement, the Distributor has agreedto fund up to 50% of each production budget on mutually agreed upon motionpicture projects. The Distributor will be entitled to a respective percentageof all gross receipts on those projects.

 

Thefollowing summarizes 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 | % | 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          |       | 37.5              | %          | 62.5               | %          | 36 | % | 60 | % | 4 | % |
| Production costs to be paid |       | 37.5              | %          | 62.5               | %          |   |   |   |   |   |   |

 

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Note7 – Distribution Agreements

 

TheCompany has entered into various distribution agreements for the marketing anddistribution of it’s films in the domestic, broadcast and international markets.These agreements provide for the distributor to earn a distribution fee fromthe gross proceeds generated by each picture in the applicable market. Thetable below summarizes the distribution fees negotiated as of March 31,2006 (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                 |       |

 

Note8 – Capital Structure

 

InJanuary 2006, the Company issued 21,274 shares of common stock to payaccrued interest due of $26,267, as of December 31, 2005, on the Company’sconvertible notes payable.

 

Note9 – Subsequent Events

 

InApril 2006, the Company issued 42,858 shares of common stock to payaccrued interest of $30,000 due, as of March 31, 2006, on the Company’sconvertible notes payable.

 

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