**U. S. SECURITIES AND 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 June 30,  2005** |
|                                              |       |                                                                                   |
| **o**                                             | ** ** | **TRANSITION REPORT UNDER SECTION 13 OR 15(d)  OF THE EXCHANGE ACT**                   |

 

**Forthe transition period from                   to                   **

** **

**CommissionFile Number: 000-50638**

 

**GRAYMARK PRODUCTIONS, INC.**

(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)

 

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

 

**APPLICABLE ONLY TO ISSUERS INVOLVED IN BANKRUPTCY**

**PROCEEDINGS DURING THE PRECEDING FIVE YEARS**

 

Check whether theregistrant filed all documents and reports required to be filed by Section 12,13 or 15(d) of the Exchange Act after the distribution of securities under aplan confirmed by a court.  Yes ý No o

 

**APPLICABLE ONLY TO CORPORATE ISSUERS**

 

State the numberof shares outstanding of each of issuer’s classes of common equity, as of thelatest practicable date:  As of August12, 2005, 8,258,425 shares of the issuer’s common stock, $0.0001 par value,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 June 30, 2005

 

TABLE OF CONTENTS

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

 

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

 

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**PART I. FINANCIAL INFORMATION**

 

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

 

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

 

**Item 2.****   ****Management’s Discussion and Analysis or Plan ofOperation**

 

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

 

**Overview**

 

We operatedhistorically as a limited liability company, GrayMark Productions, L.L.C. thatwas formed in August 2001.  Sincecommencement of our operations in August 2001, we did not generated a materialamount of revenue from operations until June 2005 when we generated $450,000 ofrevenue from our first motion film project, *Cloud9*.  Effective August 18, 2003,pursuant to an exchange agreement, the owners of the member interests inGrayMark Productions, L.L.C. exchanged their respective member interests inGrayMark Productions, L.L.C. for 4,870,000 shares of our common stock.  As a result of this exchange, GrayMarkProductions, L.L.C. became a wholly-owned subsidiary of GrayMark Productions,Inc. and the plan of operation of GrayMark Productions, L.L.C. became that ofGrayMark Productions, Inc.

 

We have completedproduction of our first motion picture project, *Cloud 9*, and have entered into licensing agreements coveringthe foreign and domestic distribution and broadcast rights to this motionpicture.  In June 2005, we received anon-refundable advance of $450,000 from the domestic distributionlicensee.  We have competed the filmingand are in the post-production of our second motion picture film project, *The Hunt*, and are in pre-production of ourthird motion picture project, *Surveillance*.

 

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

 

**MovieDevelopment and Production**

 

The movieindustry generally consists of two principal activities, production anddistribution.  Production encompasses thedevelopment, financing and creation of feature-length movies.  Distribution entails the promotion andmarketing of movies in the various media markets, including theatrical, homevideo and television presentation.

 

We primarilyproduce English language motion pictures intended for domestic theatricalrelease and ancillary market release (home video and television, includingpay-per-view, cable, satellite and network broadcast), that have productionbudgets of $250,000 to $3 million (“low-budget motion pictures,” “low budgetmovies” or “low-budget films”).  Weinitially anticipated producing motion pictures that had production budgets of$2 million to $5 million, but based on the production of our first two motionpictures, we believe that a range of $250,000 to $3 million is appropriate.

 

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

 

Rather thanretain and employ personnel to develop screenplays and perform other moviedevelopment activities, we typically acquire movies for production that are inthe development phase, generally to the point that the initial screenplay hasbeen written, and that are low-budget films. In the pre-production and production phases of a 

 

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motion picture, we intend tohire skilled creative and production personnel, including cinematographers,editors, costume designers, set designers, sound and lighting technicians andactors on an as needed basis.

 

We expect toenter into various production cost and revenue sharing arrangements, includingjoint ventures, partnerships and limited liability companies, on amovie-by-movie basis.  These sharingarrangements are intended to complement or expand our business to permit theproduction of a greater number of movies, while sharing the financial risks ofthe movie.  We may not realize theanticipated financial benefits when we entered into these arrangements.  In addition, the negotiation of thesearrangements, whether successful or not, could require us to incur significantcosts and cause diversion of management’s time and resources.  Accordingly, the costs of obtaining thesesharing arrangements will increase our invested cost in a movie withoutproviding a correlating increase in the movies revenues and, consequently,adversely affect the financial performance of the movie.

 

Following ourproduction of the 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).  Depending upon our ability to obtainfavorable distribution arrangements, which depends in many cases upon thedistributor’s assessment of the movie’s revenue potential, a particular moviemay be distributed in the domestic and international theatrical markets as wellas the ancillary markets. As of the date of this report, we have not enteredinto any arrangements for the theatrical release of our produced andin-production motion pictures.  Asubstantial amount of time may elapse between our expenditure of funds in theproduction of a motion picture and the receipt of revenue from the motionpicture.

 

Our producedmovies will be distributed domestically pursuant to licensing arrangements withunrelated third-parties that are independently engaged in the promotion anddistribution of movies.  Our foreignmarket distribution arrangements will be pursuant to sale or license of theinternational distribution rights to an unrelated third-party distributor foreither a single up-front payment (in U.S. currency) without any retainedparticipation in international source revenues or for the right to receive apercentage of gross receipts received by the distributor.  As of the date of this report, we haveentered into domestic (United States and Canada) distribution arrangementscovering our three motion picture projects and have entered into internationaldistribution arrangements covering *Cloud 9*.

 

Our ability toobtain international market distribution, whether in the ancillary market orthe 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 and governments,

 

•              cultural barriers,

 

•              wars and acts of terrorism, and

 

•              the spread of severe acute respiratorysyndrome, or SARS.

 

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

 

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**RecentDevelopments**

 

*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 entered into three agreements covering thedomestic (United States and Canada) and international distribution of *Cloud 9* in the ancillary market (homevideo market) and as the broadcast rights (pay and free television, video ondemand and pay-per-view) for *Cloud 9*.  Pursuant to the agreement covering domesticdistribution (“Domestic Agreement”), the Production Company received in June2005 a non-refundable advance of $450,000 on our share of the net receipts fromthe domestic distribution of *Cloud 9*that was distributed to us.  The DomesticAgreement allows the licensee to receive a distribution fee equal to 20% ofgross domestic receipts of *Cloud 9*afterits recoupment of all manufacturing, distribution and marketing costs fromthose receipts.

 

During June 2005,the Production Company entered in to an agreement for the internationaldistribution of *Cloud 9*(“InternationalAgreement”).  Under the InternationalAgreement the licensee is entitled to receive recoupment of its manufacturing,distribution and marketing costs and thereafter a distribution fee of equal to15% of gross international receipts up to $2,000,000 and 10% of grossinternational receipts above $2,000,000.

 

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

 

As a result ofthe agreements with the director, casting company, actors and co-financeproviders, our residual net profits interest in *Cloud 9* is 30.6% after recoupment and payment of alldistribution costs, expenses and fees. Furthermore, our co-finance providers are entitled to receive the first$500,000 of proceeds we receive from the licensing of the distribution rightsof *Cloud 9* of which we have paid$450,000.  After giving effect to therecovery of the $500,000 contributions to the production costs of *Cloud 9* under the co-financing agreementsand then the recovery of our production costs and other invested costs andinterest, our net profits interest in *Cloud9* will be 30.6%.  Inconjunction with the production of *Cloud 9*,the producers formed Out of the Blue Productions, LLC (the “Production Company”).  Our entitlement to distributions from theProduction Company and the profits interest granted to Bert Reynolds providefor interest at a rate of 2% above the prime rate (limited to 5%) for purposesof determining recovery of the production and other costs of *Cloud 9*.

 

*Post-Production of The Hunt*. During March 2005, we commenced and completed principal filming of oursecond motion picture project titled, *TheHunt*.  We are currently inpost-production of *The Hunt*.  We anticipate that the total production costsfor *The Hunt* will beapproximately $427,000.

 

In July 2005, weentered into an agreement for the domestic distribution of *The Hunt*. The agreement grants the licensee a distribution fee equal to 22.5% ofgross receipts and allows for the recoupment of all manufacturing, distributionand marketing costs.  In addition, wesold 35% of the copyright interest in *TheHunt* to the licensee for an amount equal to 50% of the budget of *The Hunt*. The company that developed the story concept for *The Hunt* retained a 25% interest in the netreceipts of *The Hunt*.  Net receipts is defined as receipts after werecoup our production costs, interest and overhead.

 

*Pre-Production and Filming of Surveillance*. During May 2005, we commenced the pre-production phase of our thirdmotion picture project titled, *Surveillance*.  We anticipate completing the filming of thismovie in August 2005.  We anticipate thatour total production costs for *Surveillance*will be approximately $569,000.

 

In July 2005, weentered into an agreement for the domestic distribution of *Surveillance*.  The agreement grants the licensee adistribution fee equal to 25% of gross receipts and allows for the recoupmentof all manufacturing, distribution and marketing costs.  In addition, we sold 50% of the copyrightinterest in *Surveillance* to thelicensee for an amount equal to 50% of the budget of *Surveillance*.

 

3

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**OutputAgreement**

 

In June 2005 weentered into an agreement providing Image Entertainment (“Image”) with thefirst-look right at the movies we produce (the “Output Agreement”).  Image will have 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*.  If Image were to choosenot 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.  Imageagreed to fund up to 50% of each production budget for mutually agreed uponmotion 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.

 

For a term of 20years, Image will have domestic distribution rights of each motion picture weco-produce with Image.  Image is entitledto receive a 25% distribution fee from gross domestic sales and a back-endprofit participation from all sales after payment of the distribution fee.  In general, the back-end profit participationinterest and ownership interest in each co-produced motion picture will bebased upon Image’s funding of the budgeted share of production costs.  The actual back-end profit participationpercentage shall be equal to the percentage Image funds of the motion pictureproject after recovery from sales of the mutually approved expenses.  Our joint exploitation of the broadcastrights with Image have been left to future negotiation.

 

**AccountingMethods**

 

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

 

In June 2000, theAccounting Standards Executive Committee of the American Institute of CertifiedPublic Accountants issued Statement of Position 00-2, Accounting by Producersor Distributors of Films (“SoP 00-2”). SoP 00-2 establishes accounting standards for producers or distributorsof films, including changes in revenue recognition, capitalization andamortization of costs of acquiring films and television programs and accountingfor exploitation costs, including advertising and marketing expenses. Theseaccounting standards are as follows:

 

•              advertising and marketing costsare expensed the first time the advertising takes place; and

 

•              the capitalization of productioncosts for episodic television series is limited to revenue that has beencontracted for on an episode-by-episode basis until the time that the criteriafor recognizing secondary market revenues are met.

 

We capitalize thecosts of production, including financing costs, to investment in motionpictures.  These costs will be amortizedto direct operating expenses in accordance with SoP 00-2. These costs arestated at the lower of unamortized motion picture costs or fair value (netpresent value).  These costs for anindividual motion picture will be amortized in the proportion that currentperiod actual revenues bear to management’s estimates of the total revenueexpected to be received from the motion picture over a period not to exceed 10years from the date of delivery.  We willbe required to regularly review and revise when necessary the total revenueestimates of each motion picture produced. As a result, if revenue estimates change with respect to a motionpicture, it may be necessary to write down all or a portion of the unamortizedcosts of the motion picture.  There is noassurance that revised revenue estimates will not occur that result insignificant write-downs affecting our results of operations and financialcondition.

 

Revenue from thesale or licensing of motion pictures will be recognized upon meeting allrecognition requirements of SoP 00-2. Revenue from the theatrical release of motion pictures will berecognized at the time of exhibition based on our participation in box officereceipts.  If applicable, revenue fromthe sale of DVDs in the retail market, net of an allowance for estimatedreturns, will be recognized on the later of shipment to the customer or “streetdate” (when it is available for sale by the customer).  Furthermore, if applicable, under revenuesharing arrangements, 

 

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rental revenue would berecognized when we would become entitled to receipts.  For contracts that provide for rights toexploit a motion picture on multiple media (e.g. theatrical, video, television)with a fee for a single motion picture where the contract specifies thepermissible timing of release to various media, the fee will be allocated tothe various media based on an assessment of the relative fair value of therights to exploit each media and will be recognized as the movie is released toeach media.  For multiple-title contractswith a fee, the fee will be allocated on a title-by-title basis, based on anassessment of the relative fair value of each title.  If applicable, revenues from televisionlicensing are recognized when the motion picture becomes available to thelicensee for telecast.  Cash paymentsreceived are to be recorded as deferred revenue until all the conditions ofrevenue recognition have been met.  Ifapplicable, we will 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 maybe differences between actual returns and allowances and our historicalexperience that we currently do not have.

 

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

 

•              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 maintain appropriateaccounting records

 

making it difficult todetermine a producer’s actual share of revenues upon audit.

 

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

 

**RecentAccounting Pronouncements**

 

*SFAS 123(R)* – In December 2004, the Financial AccountingStandards 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-Based Compensation*,and supersedes *Accounting Principles Board*(APB) Opinion No. 25, *Accounting for StockIssued to Employees*.  SFAS123(R) requires compensation costs related to share-based payment transactionsto be recognized in the financial statements over the period that an employeeprovides service in exchange for the award. Public companies are required to adopt the new standard using a modifiedprospective method and may elect to restate prior periods using the modifiedretrospective method.  Under the modifiedprospective method, companies are required to record compensation cost for newand modified awards over the related vesting period of such awardsprospectively and record compensation cost prospectively for the unvestedportion at time of adoption, of previously issued and outstanding awards overthe remaining vesting period of such awards. No change to prior periods presented is permitted under the modifiedprospective method.  Under the modifiedretrospective method, companies record compensation costs for prior periodsretroactively through restatement of such periods using the exact pro formaamounts disclosed in the companies’ footnotes. Also, in the period of adoption and after, companies record compesationcost based on the modified prospective method. SFAS 123(R) is effective for periods beginning after December 15,2005.  Early application is encouraged,but not required.

 

We have not yetdetermined the date or method of adoption. If we were to adopt SFAS 123(R) on December 15, 2005 using the modifiedprospective method, we estimate that there will be no stock-based compensationexpense for the year ending December 31, 2005. If we elect to adopt SFAS 123(R) using the modified retrospectivemethod, we are permitted to either retroactively restate only the 2005 interimperiods or restate all prior periods.  Ifwe elect to restate prior periods using the modified retrospective method, netloss for the year ended December 31, 2004, would be restated and would increaseby $63,574.  Net loss for the threemonths ended June 30, 2005, would not be impacted.

 

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**Results ofOperations**

 

The followingtable sets forth selected results of our operations for the three months andsix months ended June 30, 2005 and 2004. The following information was derived and taken from our unauditedfinancial statements appearing elsewhere in this report.

 
| ** **                                                         | ** ** | **For the Three Months Ended   June 30,** | ** ** | **For the Six Months Ended   June 30,** | ** ** |
|--------------------------------------------------------------------|------------|-------------------------------------------|------------|-----------------------------------------|------------|
| ** **                                                         | ** ** | **2005**                                  | ** ** | **2004**                                | ** ** | **2005** | ** ** | **2004** | ** ** |
| Revenue                                                            |       | $                                         | 450,000    |                                    | $          | — |   | $ | 450,000 |   | $ | — |   |
| Operating expenses:                                                |       |                                      |       |                                    |       |   |   |   |   |
| Amortization of film costs                                         |       | 409,237                                   |       | —                                  |       | 409,237 |   | — |   |
| Film participation costs                                           |       | 4,167                                     |       | —                                  |       | 4,167 |   | — |   |
| Salaries and employee benefits                                     |       | 68,777                                    |       | 57,620                                  |       | 136,097 |   | 117,990 |   |
| Legal and professional fees                                        |       | 22,833                                    |       | 59,163                                  |       | 43,313 |   | 74,818 |   |
| Stock transfer and reporting costs                                 |       | 2,339                                     |       | 3,015                                   |       | 4,376 |   | 3,015 |   |
| Film marketing                                                     |       | —                                    |       | 4,200                                   |       | — |   | 4,200 |   |
| Consulting and management fees                                     |       | —                                    |       | 5,000                                   |       | — |   | 10,000 |   |
| Obligation related to non-timely filing of  registration statement |       | —                                    |       | (44,325                                 | )          | — |   | — |   |
| Other                                                              |       | 10,127                                    |       | 11,295                                  |       | 16,177 |   | 19,377 |   |
|                                                               |       |                                      |       |                                    |       |   |   |   |   |
| Total operating expenses                                           |       | 517,480                                   |       | 95,968                                  |       | 613,367 |   | 229,400 |   |
|                                                               |       |                                      |       |                                    |       |   |   |   |   |
| Operating loss                                                     |       | (67,480                                   | )          | (95,968                                 | )          | (163,367 | ) | (229,400 | ) |
|                                                               |       |                                      |       |                                    |       |   |   |   |   |
| Other income (expense):                                            |       |                                      |       |                                    |       |   |   |   |   |
| Interest and other income                                          |       | 1,059                                     |       | 3,391                                   |       | 4,791 |   | 11,374 |   |
|                                                               |       |                                      |       |                                    |       |   |   |   |   |
| Net loss before income taxes                                       |       | (66,421                                   | )          | (92,577                                 | )          | (158,576 | ) | (218,026 | ) |
| Provision for income taxes                                         |       | —                                    |       | —                                  |       | — |   | — |   |
|                                                               |       |                                      |       |                                    |       |   |   |   |   |
| Net loss                                                           |       | $                                         | (66,421    | )                                       | $          | (92,577 | ) | $ | (158,576 | ) | $ | (218,026 | ) |

 

**Comparisonof the Three-Month Periods Ended June 30, 2005 and 2004**

 

During the threemonths ended June 30, 2004, our operations had advanced to the development andproduction of motion picture projects and we were in the filming phase on ourfirst motion picture, *Cloud 9*.  During the three months ended June 30, 2004,we incurred salary and benefits expense of $57,620 for the management andadministrative team put in place during 2004. Legal and professional fees of $59,163 were incurred during the threemonths ended June 30, 2004 and were attributable to legal and auditing servicesincurred in conjunction with our United States Securities and ExchangeCommission registration and reporting. During the three months ended June 30, 2004, we paid a $5,000 consultingfee for services performed in relation to rewriting a script for a potentialfilm project.  In December 2003, weconcluded a private placement offering of common stock.  In conjunction with the offering, we agreedto register under the Securities Act of 1933 the common stock shares issued asa result of the private placement offering and to obtain effectiveness of theregistration on or before July 14, 2004. As of March 31, 2004, due to theuncertainty of when our registration would become effective, we recorded a$44,325 obligation to security holders. This obligation was reversed in June 2004 when we determined that theeffectiveness of the registration was within the requirements of the privateplacement.  Other expenses of $11,295were incurred during the three months ended June 30, 2004 and were primarilycomprised of expenses associated with the day to day operations of ourcorporate office.

 

During the threemonths ended June 30, 2005, we completed the negotiation of licensingagreements for the foreign, domestic and broadcast rights of *Cloud 9*. We generated revenue of $450,000 in conjunction with the domesticlicensing of *Cloud 9*.  Based on our estimate of the total ultimaterevenue from *Cloud 9*, weamortized $409,237 of the film costs incurred on *Cloud 9*.  We were inthe post-production phase of our second motion picture project, *The Hunt*

 

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and the pre-production phaseof our third motion picture project, *Surveillance*.  Our operational expenses were similar innature to those incurred in 2004.  Duringthe three months ended June 30, 2005, we incurred salary and benefits expenseof $68,777, a $11,157 increase over 2004. This increase is attributable to increased salaries for our President andour Chief Financial Officer.  Legal andprofessional fees of $22,833 were incurred during the three months ended June30, 2005 and were attributable to legal and auditing services incurred inconjunction with our United States Securities and Exchange Commissionregistration and reporting.  We alsoincurred stock transfer and reporting costs of $2,339.  Other expenses of $10,127 were incurredduring the three months ended June 30, 2005 and were primarily comprised ofexpenses associated with the day-to-day operations of our corporate office.

 

**Comparisonof the Six-Month Periods Ended June 30, 2005 and 2004**

 

During the sixmonths ended June 30, 2004, our operations had advanced to the development andproduction of motion picture projects and we were in the filming phase on ourfirst motion picture project titled *Cloud 9*.  During the six months ended June 30, 2004, weincurred salary and benefits expense of $117,990 for the management andadministrative team put in place during 2004. Legal and professional fees of $74,818 were incurred during the sixmonths ended June 30, 2004 and were attributable to legal and auditing servicesincurred in conjunction with our public filings.  During the six months ended June 30, 2004, wepaid a $10,000 consulting fee for services performed in relation to rewriting ascript for a potential film project.  Wealso incurred film marketing costs of $4,200 relating to the marketing of *Cloud 9*. Other expenses of $22,392 were incurred during the six months ended June30, 2004 and were primarily comprised of expenses associated with the day today operations of our corporate office.

 

During the sixmonths ended June 30, 2005, we completed the negotiation of licensingagreements for the foreign, domestic and broadcast rights of *Cloud 9*. We generated revenue of $450,000 in conjunction with the domesticlicensing of *Cloud 9*.  Based on our estimate of the total ultimaterevenue from *Cloud 9*, weamortized $409,237 of the film costs incurred on *Cloud 9*.  We were inthe post-production phase of our second motion picture project, *The Hunt* and the pre-production phase ofour third motion picture project, *Surveillance*.  Our operational expenses were similar innature to those incurred in 2004.  Duringthe six months ended June 30, 2005, we incurred salary and benefits expense of$68,777, a $11,157 increase over 2004. This increase is attributable to increased salaries for our Presidentand our Chief Financial Officer.  Legaland professional fees of $22,833 were incurred during the six months ended June30, 2005 and were attributable to legal and auditing services incurred inconjunction with our United States Securities and Exchange Commissionregistration and reporting.  We alsoincurred stock transfer and reporting costs of $2,339.  Other expenses of $10,127 were incurredduring the six months ended June 30, 2005 and were primarily comprised ofexpenses associated with the day to day operations of our corporate office.

 

**Liquidityand Capital Resources**

 

In April 2004, wecompleted our private placement offering of our common stock shares andredeemable warrants in units of one common stock share and one redeemablewarrant. During 2003 and 2004, we received net proceeds of $2,535,224 from thisprivate placement offering.  During June2005, we received a $450,000 non-refundable advance on the domestic revenues ofCloud 9.  The $450,000 was subsequentlyused to reduce our co-finance liability on *Cloud9* from $500,000 to $50,000. Based upon our cash and cash equivalents at June 30, 2005 (that totaled$222,895), the anticipated revenue from our motion picture projects,*Cloud 9, The Hunt* and *Surveillance*, and the proceeds from thesell of profits interests in *The Hunt*and *Surveillance*,  we anticipate that our cash requirements willbe met for at least the next 12 months.

 

At June 30, 2005,we had working capital of $129,253. Operating activities for the six months ended June 30, 2005, used netcash of $205,038.  We used cash as theresult of a net loss of $158,576, which was reduced by depreciation andamortization of $2,432, amortization of film costs of $409,237, a decrease infilm deposits of $48,601 and an increase in accrued liabilities of$14,512.  Additional operating uses ofcash included the costs we incurred in the production of our motion pictureprojects totaling $521,244.  During thefirst six months of 2004, our operating activities used net cash of $2,355,072as the result of a net loss of $218,026 that was offset by depreciation of$2,433 and a decrease in accrued liabilities of $48,179.  Additional operating uses of cash during thesix months ended March 31, 2004, included the costs we incurred in theproduction of our motion picture project, *Cloud9*, totaling $2,187,658.

 

7

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Financing activitiesduring the six months ended June 30, 2005, used $450,000 for the repayment offilm co-financing agreements.  During thesix months ended June 30, 2004, our financing activities generated $521,750through the sale of stock of $21,750 and proceeds from film co-financingagreements of $500,000.

 

***Financial Commitments***

 

***FilmCapital, Inc. Agreement.**** *In March 2002, Messrs. Frederickson and Stansberry, members of GrayMarkProductions, L.L.C., entered into an agreement to pay FilmCapital, Inc. $50,000for services performed.  This liabilityis only payable in the event GrayMark Productions, L.L.C. or its affiliatesobtain funding for film projects from outside investors.  Messrs. Frederickson and Stansberry have eachrepresented that their intent was not to cause GrayMark Productions, L.L.C. tobe liable for this obligation and each has agreed to indemnify us for anyliability 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 this recordedliability, Messrs. Frederickson and Stansberry will be required immediately toreimburse 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.  Registrationof the common stock shares and redeemable warrants became effective July 13,2004.

 

Furthermore, wealso similarly agreed to register (and maintain effective of the registrationunder the 1933 Act for the seven-year period) the 443,250 common stock sharesunderlying the placement agent warrants sold to the underwriter of our privateplacement offering, Viewtrade Financial, and 383,425 common stock shares issuedpursuant to the one-year Financial Advisor Agreement to ViewtradeFinancial.  In accordance with thisobligation, we initially included these common stock shares in the registrationstatement that registered the private placement common stock shares andredeemable warrants; however, on February 27, 2004, Viewtrade Financial, on itsown behalf as well as the other holders of the placement agent warrants and therecipients and holders of the common stock shares assigned to affiliates ofViewtrade Financial, elected to remove those shares from the registrationstatement.  These common stock shares arecurrently subject to a one-year agreement that does not permit sale or transferexcept under very limited circumstances. Although we have been informed by our legal counsel that the commonstock shares other than those underlying the placement agent warrant may besold without further restriction pursuant to Rule 144 as promulgated by theSecurities and Exchange Commission, we intend to file a registration statementin accordance with this registration obligation during the last half of 2005.

 

***Office Space Arrangement*****.** Our corporate headquarters and offices arelocated at 101 North Robinson, Suite 920, Oklahoma City, Oklahoma.  These office facilities consist approximatelyof 1,500 square feet and are occupied under an unwritten month-to-month leasearrangement, requiring monthly rental payments of $500.  The costs of building-out and improving ouroffices was approximately $15,000 which we paid rather than Corporate Tower,LLC, our landlord.  Roy T. Oliver, one ofour greater than 5% shareholders and affiliates, controls Corporate Tower,LLC.  Mr. Oliver on behalf of CorporateTower, LLC has orally indicated that as of the date of this report there is nointent to terminate our occupancy of the office facilities.  Under Oklahoma law, termination of ourmonth-to-month lease arrangement requires at least 30 days prior writtennotice.  In the event of this termination,we believe there is adequate office space and facilities available in theOklahoma City area.  In the event we arerequired to move from our current office facilities, the terms of occupancy,including the increased rental payments, will be substantially different thanthose under which our office space is currently occupied and the annual rentalrate will probably be from $8 to $12 per square foot ($12,000 to $18,000 peryear based upon 1,500 square feet of office facilities).

 

8

----

 

***12-Month Overhead Budget***

 

Our budgetedoverhead 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***

 

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

 

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

 

We believe thatour operations as a result of our motion picture projects, *Cloud 9, The Hunt* and *Surveillance*, will achieveprofitability.  We provide no assurancethat

 

•              we will be successful in implementing ourbusiness plan or

 

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

 

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

 

**CautionaryStatement Relating to Forward Looking Information**

 

We have includedsome forward-looking statements in this section and other places in this reportregarding our expectations.  Theseforward-looking statements involve known and unknown risks, uncertainties andother factors which may cause our actual results, levels of activity,performance or achievements, or industry results, to be materially differentfrom any future results, levels of activity, performance or achievementsexpressed or implied by these forward-looking statements.  Some of these forward-looking statements canbe identified by the use of forward-looking terminology including “believes,” “expects,”“may,” “will,” “should” or “anticipates” or the negative thereof or other 

 

9

----

 

variations thereon orcomparable terminology, or by discussions of strategies that involve risks anduncertainties.  You should readstatements that 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.

 

We believe it isimportant to discuss our expectations; however, it must be recognized thatevents may occur in the future over which we have no control and which we arenot accurately able to predict.  Readersare cautioned to consider the specific business risk factors described underthe caption “Additional Factors that May Affect Our Future Results” appearingunder “Item 1. Description of Business” of our Annual Report on Form 10-KSBfiled with the United States Securities and Exchange Commission on March 29,2005, and not to place undue reliance on the forward-looking statementscontained herein, which speak only as of the date of this report.  We undertake no obligation to publicly reviseforward-looking statements to reflect events or circumstances that may ariseafter the date of this report.

 

**Item 3. Controls and Procedures**

 

Our ChiefExecutive Officer and Chief Financial Officer are responsible primarily forestablishing 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 andprocedures are designed to ensure that information required to be disclosed inour reports filed or submitted under the Exchange Act is accumulated andcommunicated to our management, including our principal executive and principalfinancial officers, or persons performing similar functions, as appropriate toallow timely decisions regarding required disclosure.

 

Furthermore, ourChief 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.  These policies and procedures (i) pertain tothe maintenance of records that, in reasonable detail, accurately and fairlyreflect the transactions and dispositions of our assets; (ii) providereasonable assurance that transactions are recorded as necessary to permitpreparation of financial statements in accordance with generally accepted accountingprinciples, and that our receipts and expenditures are being made only inaccordance with authorizations of our management and directors; and (iii)provide reasonable assurance regarding prevention or timely detection ofunauthorized acquisition, use or disposition of our assets that could have amaterial effect on our financial statements.

 

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

 

10

----

 

actions were necessary ortaken to correct significant deficiencies and material weaknesses in our internalcontrols and disclosure controls and procedures.

 

**PART II OTHER INFORMATION**

 

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

 

None

 

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

 

(a)           None

 

(b)           None

 

(c)           None

 

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

 

None

 

**Item 4.****   ****Submission of Matters to aVote of Security Holders**

 

None

 

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

 

None

 

**Item6.****   ****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.                                                                                                                                                                                                            |
|            |       |                                                                                                                                                                                                                                                                                                                                                                   |
| 10.1            |       | Home Video Rights  Acquisition Agreement between Twentieth Century Fox Home Entertainment LLC  and Registrant, dated as of February 24, 2005, incorporated by reference to  Exhibit 10.27 of Post-Effective Amendment No. 1 to Registration Statement on  Form SB-2 (No. 333-111819) filed with the Commission on June 15, 2005.                                       |
|            |       |                                                                                                                                                                                                                                                                                                                                                                   |
| 10.2            |       | Standard Terms and  Conditions – Home Video Rights Acquisition Agreement between Twentieth  Century Fox Home Entertainment LLC and Registrant, dated as of February 24,  2005, incorporated by reference to Exhibit 10.28 of Post-Effective Amendment  No. 1 to Registration Statement on Form SB-2 (No. 333-111819) filed with the  Commission on June 15, 2005. |
|            |       |                                                                                                                                                                                                                                                                                                                                                                   |
| 10.3            |       | Letter agreement between  Image Entertainment and Registrant, dated May 30, 2005.                                                                                                                                                                                                                                                                                      |

 

11

----

 
| 10.4   |   | Letter agreement between  Image Entertainment and Registrant, dated July 14, 2005, amending the letter  agreement dated May 30, 2005 to include the motion picture titled *The Hunt*.        |
|--------|--------|----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|
|   |   |                                                                                                                                                                                         |
| 10.5   |   | Letter agreement between  Image Entertainment and Registrant, dated July 14, 2005, amending the letter  agreement dated May 30, 2005 to include the motion picture titled *Surveillance*.    |
|   |   |                                                                                                                                                                                         |
| 10.6   |   | The Sales Agency Agreement  between Pinnacle Entertainment LLC and Out of the Blue Productions LLC, dated  June 28, 2005.                                                                    |
|   |   |                                                                                                                                                                                         |
| 31.1   |   | Certification of John  Simonelli, Chief Executive Officer of Registrant.                                                                                                                     |
|   |   |                                                                                                                                                                                         |
| 31.2   |   | Certification of Mark R.  Kidd, Chief Financial Officer and Controller of Registrant.                                                                                                        |
|   |   |                                                                                                                                                                                         |
| 32.1   |   | Certification Pursuant to  18 U.S.C. Section 1350, as Adopted Pursuant to Section 906 of Sarbanes-Oxley  Act of 2002 of John Simonelli, Chief Executive Officer of Registrant.               |
|   |   |                                                                                                                                                                                         |
| 32.2   |   | Certification Pursuant to  18 U.S.C. Section 1350, as Adopted Pursuant to Section 906 of Sarbanes-Oxley  Act of 2002 of Mark R. Kidd, Chief Financial Officer and Controller of  Registrant. |

 

**SIGNATURES**

 

In accordancewith the Exchange Act, the Registrant caused this report to be signed on itsbehalf by the undersigned, thereunto duly authorized.

 
|                  | GRAYMARK PRODUCTIONS, INC. |
|-----------------------|----------------------------|
|                  | (Registrant)               |
|                  |                       |
|                  | By:                        | /S/JOHN SIMONELLI |   |
|                  |                       | John Simonelli |
|                  |                       | Chief Executive Officer |   |
| Date: August 12, 2005 |                       |
|                  | By:                        | /S/MARK R. KIDD |   |   |
|                  |                       | Mark R. Kidd |   |
|                  |                       | Chief Financial Officer  and Controller |   |
| Date: August 12, 2005 |                       |
|                       |                            |  |  |  |  |  |  |  |  |

 

12

----

 

**GRAYMARK PRODUCTIONS, INC.**

 

**INDEX TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS**

 
| Condensed Consolidated Balance Sheets as of June 30, 2005 and          |   |
|------------------------------------------------------------------------|--------|
| December 31, 2004                                                      |   |
|                                                                   |   |
| Condensed Consolidated Statements of Operations for the                |   |
| Three Months Ended June 30, 2005 and 2004                              |   |
|                                                                   |   |
| Condensed Consolidated Statements of Operations for the                |   |
| Six Months Ended June 30, 2005 and 2004                                |   |
|                                                                   |   |
| Condensed Consolidated Statements of Shareholders’ Equity for the |   |
| Six Months Ended June 30, 2005                                         |   |
|                                                                   |   |
| Condensed Consolidated Statements of Cash Flows for the                |   |
| Six Months Ended June 30, 2005 and 2004                                |   |
|                                                                   |   |
| Notes to Condensed Consolidated Financial Statements                   |   |

 

F-1

----

 

**GRAYMARK PRODUCTIONS, INC.**

**(a Development Stage Enterprise)**

 

**Condensed Consolidated Balance Sheets**

**(Unaudited)**

 
| ** **                                                                                      | ** ** | **June 30,  2005** | ** ** | **December 31,  2004** | ** ** |
|-------------------------------------------------------------------------------------------------|------------|--------------------|------------|------------------------|------------|
| ASSETS                                                                                          |       |               |       |                   |       |
|                                                                                            |       |               |       |                   |       |
| Cash and cash equivalents                                                                       |       | $                  | 222,895    |                   | $          | 877,933 |   |
| Film deposits                                                                                   |       | —             |       | 48,601                 |       |
| Total current assets                                                                            |       | 222,895            |       | 926,534                |       |
|                                                                                            |       |               |       |                   |       |
| Fixed assets, net                                                                               |       | 18,758             |       | 21,190                 |       |
| Investment in films                                                                             |       | 2,339,952          |       | 2,227,945              |       |
| Total assets                                                                                    |       | $                  | 2,581,605  |                   | $          | 3,175,669 |   |
|                                                                                            |       |               |       |                   |       |
| LIABILITIES  AND SHAREHOLDERS’ EQUITY                                                      |       |               |       |                   |       |
|                                                                                            |       |               |       |                   |       |
| Liabilities:                                                                                    |       |               |       |                   |       |
| Accrued liabilities                                                                             |       | $                  | 93,642     |                   | $          | 79,130 |   |
| Total current liabilities                                                                       |       | 93,642             |       | 79,130                 |       |
| Film obligations                                                                                |       | 50,000             |       | 500,000                |       |
| Total liabilities                                                                               |       | 143,642            |       | 579,130                |       |
| 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; 8,258,425 issued and outstanding |       | 826                |       | 826                    |       |
| Paid-in capital                                                                                 |       | 3,837,689          |       | 3,837,689              |       |
| Deficit accumulated during development  stage                                                   |       | (1,400,552         | )          | (1,241,976             | )          |
| Total shareholders’ equity                                                                 |       | 2,437,963          |       | 2,596,539              |       |
| Total liabilities and shareholders’ equity                                                 |       | $                  | 2,581,605  |                   | $          | 3,175,669 |   |

 

See Accompanying Notes to Condensed Consolidated Financial Statements

 

F-2

----

 

**GRAYMARK PRODUCTIONS, INC.**

**(a Development Stage Enterprise)**

 

**Condensed Consolidated Statements of Operations**

**(Unaudited)**

 
| ** **                                                         | ** ** | **Three Months Ended   June 30,** | ** ** |
|--------------------------------------------------------------------|------------|-----------------------------------|------------|
| ** **                                                         | ** ** | **2005**                          | ** ** | **2004** | ** ** |
|                                                               |       |                              |       |   |   |
| Revenues                                                           |       | $                                 | 450,000    |   | $ | — |   |
|                                                               |       |                              |       |   |   |
| Operating expenses:                                                |       |                              |       |   |   |
| Amortization of film costs                                         |       | 409,237                           |       | — |   |
| Film participation costs                                           |       | 4,167                             |       | — |   |
| Salaries and employee benefits                                     |       | 68,777                            |       | 57,620 |   |
| Legal and professional fees                                        |       | 22,833                            |       | 59,163 |   |
| Stock transfer and reporting costs                                 |       | 2,339                             |       | 3,015 |   |
| Film marketing                                                     |       | —                            |       | 4,200 |   |
| Consulting and management fees                                     |       | —                            |       | 5,000 |   |
| Obligation related to non-timely filing of  registration statement |       | —                            |       | (44,325 | ) |
| Other                                                              |       | 10,127                            |       | 11,295 |   |
|                                                               |       |                              |       |   |   |
| Total operating expenses                                           |       | 517,480                           |       | 95,968 |   |
|                                                               |       |                              |       |   |   |
| Operating loss                                                     |       | (67,480                           | )          | (95,968 | ) |
|                                                               |       |                              |       |   |   |
| Other Income (Expense):                                            |       |                              |       |   |   |
| Interest and other income                                          |       | 1,059                             |       | 3,391 |   |
|                                                               |       |                              |       |   |   |
| Net loss before provision for income taxes                         |       | (66,421                           | )          | (92,577 | ) |
|                                                               |       |                              |       |   |   |
| Provision for income taxes                                         |       | —                            |       | — |   |
|                                                               |       |                              |       |   |   |
| Net loss                                                           |       | $                                 | (66,421    | ) | $ | (92,577 | ) |
|                                                               |       |                              |       |   |   |
| Net loss per share of common stock, basic  and diluted             |       | $                                 | (0.01      | ) | $ | (0.01 | ) |
|                                                               |       |                              |       |   |   |
| Weighted average number of common shares outstanding               |       | 8,258,425                         |       | 8,233,425 |   |

 

See Accompanying Notes to Condensed Consolidated Financial Statements

 

F-3

----

 

**GRAYMARK PRODUCTIONS, INC.**

**(a Development Stage Enterprise)**

 

**Condensed Consolidated Statements of Operations**

**(Unaudited)**

 
| ** **                                             | ** ** | **Six Months Ended   June 30,** | ** ** |
|--------------------------------------------------------|------------|---------------------------------|------------|
| ** **                                             | ** ** | **2005**                        | ** ** | **2004** | ** ** |
|                                                   |       |                            |       |   |   |
| Revenues                                               |       | $                               | 450,000    |   | $ | — |   |
|                                                   |       |                            |       |   |   |
| Operating expenses:                                    |       |                            |       |   |   |
| Amortization of film costs                             |       | 409,237                         |       | — |   |
| Film participation costs                               |       | 4,167                           |       | — |   |
| Salaries and employee benefits                         |       | 136,097                         |       | 117,990 |   |
| Legal and professional fees                            |       | 43,313                          |       | 74,818 |   |
| Stock transfer and reporting costs                     |       | 4,376                           |       | 3,015 |   |
| Film marketing                                         |       | —                          |       | 4,200 |   |
| Consulting and management fees                         |       | —                          |       | 10,000 |   |
| Other                                                  |       | 16,177                          |       | 19,377 |   |
|                                                   |       |                            |       |   |   |
| Total operating expenses                               |       | 613,367                         |       | 229,400 |   |
|                                                   |       |                            |       |   |   |
| Operating loss                                         |       | (163,367                        | )          | (229,400 | ) |
|                                                   |       |                            |       |   |   |
| Other Income (Expense):                                |       |                            |       |   |   |
| Interest and other income                              |       | 4,791                           |       | 11,374 |   |
|                                                   |       |                            |       |   |   |
| Net loss before provision for income taxes             |       | (158,576                        | )          | (218,026 | ) |
|                                                   |       |                            |       |   |   |
| Provision for income taxes                             |       | —                          |       | — |   |
|                                                   |       |                            |       |   |   |
| Net loss                                               |       | $                               | (158,576   | ) | $ | (218,026 | ) |
|                                                   |       |                            |       |   |   |
| Net loss per share of common stock, basic  and diluted |       | $                               | (0.02      | ) | $ | (0.03 | ) |
|                                                   |       |                            |       |   |   |
| Weighted average number of common shares  outstanding  |       | 8,258,425                       |       | 8,220,925 |   |

 

See Accompanying Notes to Condensed Consolidated Financial Statements

 

F-4

----

 

**GRAYMARK PRODUCTIONS, INC.**

**(a Development Stage Enterprise)**

 

**Condensed Consolidated Statements of Shareholders’Equity**

**(Unaudited)**

 
| ** **                           | ** ** | **Common Stock** | ** ** | **Additional   Paid-in** | ** ** | **Accumulated** | ** ** |
|--------------------------------------|------------|------------------|------------|--------------------------|------------|-----------------|------------|
| ** **                           | ** ** | **Shares**       | ** ** | **Amount**               | ** ** | **Capital**     | ** ** | **Deficit** | ** ** |
|                                 |       |             |       |                     |       |            |       |   |   |
| Balance, December 31, 2003           |       | 8,208,425        |       | $                        | 821        |            | $          | 3,790,944 |   | $ | (846,119 | ) |
|                                 |       |             |       |                     |       |            |       |   |   |
| Sale of stock                        |       | 25,000           |       | 2                        |       | 21,748          |       | — |   |
| Issuance of stock for legal services |       | 25,000           |       | 3                        |       | 24,997          |       | — |   |
| Net loss                             |       | —           |       | —                   |       | —          |       | (395,857 | ) |
|                                 |       |             |       |                     |       |            |       |   |   |
| Balance, December 31, 2004           |       | 8,258,425        |       | 826                      |       | 3,837,689       |       | (1,241,976 | ) |
|                                 |       |             |       |                     |       |            |       |   |   |
| Net loss                             |       | —           |       | —                   |       | —          |       | (158,576 | ) |
|                                 |       |             |       |                     |       |            |       |   |   |
| Balance, June 30, 2005               |       | 8,258,425        |       | $                        | 826        |            | $          | 3,837,689 |   | $ | (1,400,552 | ) |

 

See Accompanying Notes to Condensed Consolidated Financial Statements

 

F-5

----

 

**GRAYMARK PRODUCTIONS, INC.**

**(a Development Stage Enterprise)**

 

**Condensed Consolidated Statements of Cash Flows**

**(Unaudited)**

 
| ** **                                                                   | ** ** | **Six Months Ended  June 30,** | ** ** |
|------------------------------------------------------------------------------|------------|--------------------------------|------------|
| ** **                                                                   | ** ** | **2005**                       | ** ** | **2004** | ** ** |
|                                                                         |       |                           |       |   |   |
| Operating activities:                                                        |       |                           |       |   |   |
| Net loss                                                                     |       | $                              | (158,576   | ) | $ | (218,026 | ) |
| Adjustments to reconcile net loss to net  cash used by operating activities: |       |                           |       |   |   |
| Depreciation                                                                 |       | 2,432                          |       | 2,433 |   |
| Amortization of film costs                                                   |       | 409,237                        |       | — |   |
| Changes in assets and liabilities –   Film deposits                     |       | 48,601                         |       | — |   |
| Investment in films                                                          |       | (521,244                       | )          | (2,187,658 | ) |
| Accrued liabilities                                                          |       | 14,512                         |       | 48,179 |   |
|                                                                         |       |                           |       |   |   |
| Net cash used by operating activities                                        |       | (205,038                       | )          | (2,355,072 | ) |
|                                                                         |       |                           |       |   |   |
| Financing activities:                                                        |       |                           |       |   |   |
| Sale of stock                                                                |       | —                         |       | 21,750 |   |
| Partial repayment of film co-financing  agreements                           |       | (450,000                       | )          | — |   |
| Proceeds from film co-financing agreements                                   |       | —                         |       | 500,000 |   |
|                                                                         |       |                           |       |   |   |
| Net cash provided by (used by) financing  activities                         |       | (450,000                       | )          | 521,750 |   |
|                                                                         |       |                           |       |   |   |
| Net change in cash and cash equivalents                                      |       | (655,038                       | )          | (1,833,322 | ) |
|                                                                         |       |                           |       |   |   |
| Cash and cash equivalents at beginning of  period                            |       | 877,933                        |       | 2,953,159 |   |
|                                                                         |       |                           |       |   |   |
| Cash and cash equivalents at end of period                                   |       | $                              | 222,895    |   | $ | 1,119,837 |   |

 

See Accompanying Notes to Condensed Consolidated Financial Statements

 

F-6

----

 

**GRAYMARK PRODUCTIONS, INC.**

**(a Development Stage Enterprise)**

 

**Notes to Condensed ConsolidatedFinancial Statements**

**(Unaudited)**

 

**For the Periods Ended June 30, 2005 and 2004**

 

Note 1 – Nature of Business

 

GrayMarkProductions, Inc. (the “Company”) is organized in Oklahoma and an independentproducer and distributor of film entertainment content.  The Company began operations in 2001 as GrayMarkProductions, L.L.C. (the “LLC”), all of the assets of which were recentlyacquired by the Company through our incorporation-reorganization, effectiveAugust 18, 2003.

 

The Company hascompleted the production of its first motion picture project titled, *Cloud 9,*completed the filming of itssecond motion picture titled, *The Hunt*and is in pre-production of its third motion picture project titled, *Surveillance*.  The Company has negotiated agreements for themarketing and distribution of all three films. The Company intends to produce and distribute additional films that arecompleted and marketed using smaller budgets than those of major studios.  Management believes that producing anddistributing low- or modest-budget, commercially successful films will affordthe Company access to Hollywood talent and scripts and third-party productionpackages for acquisition, without compromising management’s approach tomanaging financial risk.

 

Note 2 – Summary ofSignificant Accounting Policies

 

*Interim Financial Information* – The unaudited condensedconsolidated financial statements have been prepared in accordance withgenerally accepted accounting principles for interim financial information,they do not include all of the information and footnotes required by generallyaccepted accounting principles for complete financial statements.

 

The accompanyingfinancial statements are unaudited, but include all adjustments (consistingonly of normal recurring adjustments) which are, in the opinion of management,necessary for a fair presentation of the financial position at such dates andof the operations and cash flows for the periods then ended.  Operating results for the periods ended June30, 2005 and 2004 are not necessarily indicative of results that may be expectedfor the entire year.

 

*Consolidation* – The accompanying consolidated financialstatements include the accounts of GrayMark Productions, Inc. and its majorityowned and controlled subsidiaries, with a provision for minorityinterests.  The Company controls asubsidiary company through a combination of existing voting interests and theability to exercise various rights under certain shareholder or operatingagreements.  The Company’s subsidiariesinclude GrayMark Productions, L.L.C. (the “LLC”), Out of the Blue Productions,LLC (“Out of the Blue”), The Hunt, The Motion Picture LLC (“The Hunt”) andSurveillance, The Motion Picture LLC (“Surveillance”).  The LLC became a subsidiary of the Company inAugust 2003 as a result of the incorporation-reorganization of theCompany.  Out of the Blue, a variableinterest entity, was formed in December 2003 as the entity under which theCompany’s first motion picture project, *Cloud9*, was produced.  At June 30,2005, the Company has funded $2,381,768 of the acquisition and production costsof *Cloud 9*.  The Company is entitled to recover itscapital contributions to Out of the Blue plus interest at 2% above the primerate (defined as “investment recoupment”) from cash distributions before theother interest owners and thereafter 50% of cash distributions and entitled toreceive a majority of the proceeds from rights sales, distribution and any andall 

 

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exploitation of thePicture.  The Company has 100% votingcontrol of Out of the Blue.  The Hunt andSurveillance are 100% owned by the Company.

 

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

 

*Revenue recognition* – Revenues from the sale of therights to a film are recognized when the feature film is available to thedistributor for exploitation and no conditions for delivery exist, which undermost sales contracts requires that full payment has been received from thedistributor.  Revenues from thetheatrical distribution of motion pictures are recognized when motion picturesare exhibited.  Revenues from video salesare recognized on the date that video units are made widely available for saleby retailers.  Revenues from the licensingof motion picture films are recorded when the material is available fortelecasting by the licensee and when certain other conditions are met.  Revenues from consulting services arerecognized when earned.

 

*Investment in Films* – Investment in films includescapitalizable direct negative costs, production overhead, interest anddevelopment costs and are stated at the lower of cost, less accumulatedamortization, or fair value.  Filmproduction and participation costs are expensed based on the ratio of thecurrent period’s gross revenues to estimated remaining total gross revenuesfrom all sources on an individual production basis.

 

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

 

*Accounting Changes* –

 

*SFAS 123(R)* – In December 2004, the Financial AccountingStandards 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-Based Compensation*,and supersedes *Accounting Principles Board*(APB) Opinion No. 25, *Accounting for StockIssued to Employees*.  SFAS123(R) requires compensation costs related to share-based payment transactionsto be recognized in the financial statements over the period that an employeeprovides service in exchange for the award. Public companies are required to adopt the new standard using a modifiedprospective method and may elect to restate prior periods using the modifiedretrospective method.  Under the modifiedprospective method, companies are required to record compensation cost for newand 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.  No changeto prior periods presented is permitted under the modified prospectivemethod.  Under the modified retrospectivemethod, companies record compensation costs for prior periods retroactivelythrough restatement of such periods using the exact pro forma amounts disclosedin the companies’ footnotes.  Also, inthe period of adoption and after, companies record compesation cost based onthe modified prospective method.  SFAS123(R) is effective for periods beginning after December 15, 2005.  Early application is encouraged, but notrequired.

 

The Company hasnot yet determined the date or method of adoption.  If the Company were to adopt SFAS 123(R) onDecember 15, 2005 using the modified prospective method, the Company estimatesthat there will be no stock-based compensation expense for the year endingDecember 31, 2005.  If the Company electsto adopt SFAS 123(R) using the modified retrospective method, it is permittedto either retroactively restate only the 2005 interim periods or restate allprior periods.  If the Company elects torestate prior periods using the modified retrospective method, net loss for theyear ended December 31, 2004, would be restated and would increase by$63,574.  Net loss for the three monthsended June 30, 2005, would not be impacted.

 

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Note 3 – Investment in Films

 
| ** **                                | ** ** | **June 30,  2005** | ** ** | **December 31,  2004** | ** ** |
|-------------------------------------------|------------|--------------------|------------|------------------------|------------|
|                                      |       |               |       |                   |       |
| Released, net of accumulated amortization |       | $                  | 1,994,546  |                   | $          | — |   |
| Completed and not released                |       | 310,051            |       | 2,217,945              |       |
| In progress                               |       | 24,855             |       | —                 |       |
| In development                            |       | 10,500             |       | 10,000                 |       |
|                                      |       |               |       |                   |       |
| Total                                     |       | $                  | 2,339,952  |                   | $          | 2,227,945 |   |

 

Note 4 – Film Obligations

 

During May 2004,the Company obtained $500,000 of funding under co-finance agreements for itsmotion picture project, *Cloud 9*.  The terms of the co-financing provide for theinvestors to recoup their contribution from the first proceeds of *Cloud 9*. After all *Cloud 9* costsare recouped by the Company, the investors are entitled to a profitparticipation in the Company’s profit from *Cloud9*.  As a group, the investorsare entitled to 20% of the net profits paid to the Company, but the investorsdo not have any ownership rights in the film. The $500,000 received under the co-financing agreements represents 21%of the anticipated total cost of *Cloud 9*.  During June 2005, $450,000 was repaid toinvestors from the first proceeds from *Cloud9*.  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              |       | 50,000                 |       |
| A company 50% owned by the Company’s chief  financial officer |       | 100,000              |       | —                 |       |
| Company shareholder                                                |       | 50,000               |       | —                 |       |
|                                                               |       |                 |       |                   |       |
| Total                                                              |       | $                    | 500,000    |                   | $          | 50,000 |   |

 

Note 5 – Film ProfitParticipation and Contingent Compensation

 

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

 

•              100% of revenue and proceeds fromthe rights sales, 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 fromthe rights sales, distribution and/or any and all exploitation of thePicture.  “Net Profits” is defined as thesum remaining after deduction of third party distribution fees; cash defermentsto cast, equipment suppliers, rights holders or any other approved party.

 

The Company’ssubsidiary, Out of the Blue Productions, LLC (the “Production Company”),entered into contingent compensation agreements with the director and certaincast members of *Cloud 9* in theform of “net and gross profit participations” that are customary in the filmindustry.  These participations aretypically based on the profit of a film after all production and distributioncosts have been recouped (“gross participation”) or all production anddistribution costs and overhead have been recouped (“net participations”).  A percentage of these “gross and net 

 

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profits”, as negotiatedbetween the participants, are paid out as contingent compensation for creativeparticipants in a motion picture film. The participations negotiated by the Production Company for *Cloud 9* total 23.5% of which the Company’sinterest in *Cloud 9* is burdenedby one-half of these net profit participations. The Company’s residual profits interest in *Cloud 9* is 30.6% after giving effect to the gross and netprofits participations given pursuant to contingent compensation arrangementsand the co-finance agreements (see Note 5 – Film Obligations).

 

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

 

Note 6 – Capital Structure

 

In September2004, the Company issued 25,000 shares of stock to the Company’s legal counselfor services rendered and fully performed. The shares were valued at the fair value of the services received of$25,000.

 

Note 6 – Stock Options andWarrants

 

Information withrespect to stock options and warrants outstanding follows:

 
| ** **                       | ** ** | **Shares** | ** ** | **Average   Exercise   Price** | ** ** |
|----------------------------------|------------|------------|------------|--------------------------------|------------|
|                             |       |       |       |                           |       |
| Outstanding at December 31, 2003 |       | 3,498,250  |       | $                              | 1.86       |   |
| Granted at market value          |       | 165,000    |       | 1.24                           |       |
| Exercised                        |       | —     |       | —                         |       |
| Forfeited                        |       | —     |       | —                         |       |
| Outstanding at December 31, 2004 |       | 3,663,250  |       | 1.84                           |       |
| Granted at market value          |       | —     |       | —                         |       |
| Exercised                        |       | —     |       | —                         |       |
| Forfeited                        |       | —     |       | —                         |       |
| Outstanding at June 30, 2005     |       | 3,663,250  |       | $                              | 1.84       |   |

 

In September2004, the Company issued options to the Company’s officers and directors forthe purchase of 140,000 shares of the Company’s stock at an exercise price of$1.10.  The options were issued under theCompany’s 2003 Stock Option Plan and 2003 Non-Employee Stock Option Plan Thesebecame exercisable on January 1, 2005 and will expire on December 31, 2009.

 
| ** **     | ** ** | **Options and Warrants Outstanding** | ** ** | **Options and Warrants  Exercisable** | ** ** |
|----------------|------------|--------------------------------------|------------|---------------------------------------|------------|
| ** **     | ** ** | **Shares  Outstanding  at 6/30/05**  | ** ** | **Average  Remaining  Life (Years)**  | ** ** | **Average  Exercise  Price** | ** ** | **Shares  Outstanding  at 6/30/05** | ** ** | **Average  Exercise  Price** | ** ** |
|           |       |                                 |       |                                  |       |   |   |   |   |   |   |
| $1.00 to $2.00 |       | 3,663,250                            |       | 3.4                                   |       | $ | 1.84 |   | 3,663,250 |   | $ | 1.84 |   |
|                |            |                                      |            |                                       |            |  |  |  |  |  |  |  |  |

 

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Note 7 – Subsequent Events

 

In July 2005, theCompany entered into agreements for the domestic distribution of its motionpicture projects titled *The Hunt*and *Surveillance*.  The agreement grants the licensee adistribution fee equal to 25% of gross receipts and allows for the recoupmentof all manufacturing, distribution and marketing costs.  In addition, the Company sold 35% and 50% ofthe copyright interests in *The Hunt*and *Surveillance*, respectively,for amounts equal to 50% of the budgets for *TheHunt* and *Surveillance*.

 

In August 2005,the Company issued a promissory note (the “Note”) in the principal amount of$750,000.  The Note is secured by allassets of the Company including all purchase agreements and any options orrights to acquire, all intellectual and real property, all assets andproperties of the Company and all of its existing and future subsidiaries.  The Note bears interest at the rate of 8% perannum.

 

The Note willbecome due and payable on the first to occur of: (i) July 27, 2007 (the“Maturity Date”); (ii) the consummation of a Qualified Financing; or (iii) thecontinuation of and Event of Default, as defined, for more than 30 daysfollowing notice of the occurrence of an Event of Default.  Upon consummation of a Qualified Financing,the outstanding principal amount of the Note and all accrued and unpaidinterest (collectively the “Note Balance”) will automatically convert intoshares of equity securities of the Company equal to 120% of the Note Balancedivided by the price per share of the equity securities sold in the QualifiedFinancing.  The maximum price or value ofthe equity securities into which the Note Balance converts may not exceed theequivalent of $1.10 per common stock share. Qualified Financing refers to any equity financing pursuant to which theCompany receives aggregate gross cash proceeds of $2,000,000 or more on orbefore the Maturity Date.

 

In conjunctionwith issuance of the Note, the Company and the holder of the Note entered intotwo common stock purchase warrant agreements, each evidencing warrantsexercisable on or before August 5, 2010. One agreement provides for the purchase of 250,000 common stock sharesat $2.00 and the other agreement provides for the purchase of 250,000 commonstock shares at $3.00.  In addition, theCompany’s financial advisor was paid a fee of $75,000 for services rendered inconjunction with execution of the Note.

 

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