**UNITEDSTATESSECURITIES AND EXCHANGE COMMISSION**

**Washington, D. C. 20549**

 

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**FORM 10-QSB**

 

**(Mark One)**

 

**x****QUARTERLY REPORT UNDER SECTION13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934**

 

**For the quarterly period endedSeptember 30, 2006**

 

**o****TRANSITION REPORT UNDER SECTION13 OR 15(d) OF THE EXCHANGE ACT**

 

**For the transition period from                   to                   **

 

**Commission File Number: 000-50638**

 

**GRAYMARKPRODUCTIONS, INC.**

(Exact name of smallbusiness issuer in its charter)

 
| **OKLAHOMA**                                                                        |   | **20-0180812**                        |
|-------------------------------------------------------------------------------------|--------|---------------------------------------|
| (State or other  jurisdiction of  incorporation or organization)                    |   | (I.R.S. Employer  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 since last report) |

 

Check whether the issuer (1) filed all reports required to be filed bySection 13 or 15(d) of the Exchange Act during the past 12 months (or forshorter period that the registrant was required to file such reports), and (2)has been subject to such filing requirements for the past 90 days.  Yes x No o

 

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

 

**APPLICABLEONLY TO ISSUERS INVOLVED IN BANKRUPTCY**

**PROCEEDINGSDURING THE PRECEDING FIVE YEARS**

 

Check whether the registrant filed all documents and reports requiredto be filed by Section 12, 13 or 15(d) of the Exchange Act after thedistribution of securities under a plan confirmed by a court.  Yes o No o

 

**APPLICABLEONLY TO CORPORATE ISSUERS**

 

State the number of shares outstanding of each of issuer’s classes ofcommon equity, as of the latest practicable date: As of November 13, 2006,8,562,107 shares of the issuer’s common stock, $0.0001 par value, wereoutstanding.

 

Transitional Small Business Disclosure Format (Check One): Yes o No x

 

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**GRAYMARKPRODUCTIONS, INC**.

FORM 10-QSB

For the QuarterEnded September 30, 2006

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

 

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

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**PARTI. FINANCIAL INFORMATION**

**Item1.****           FinancialStatements**

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

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

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

**Overview**

Since commencementof our operations in August 2001, 2005 was the first year that we receivedsignificant revenue from our motion picture productions.  In June 2005, we received a $450,000non-refundable advance under licensing agreements covering the foreign anddomestic distribution and broadcast rights to our first motion picture project,*Cloud 9*.  During the nine months ending September 30,2006, we earned revenue of approximately $272,000 from the internationaldistribution of *Cloud 9* andapproximately $31,000, $29,000 and $60,000, respectively, from theinternational distribution of *The Hunt,Surveillance*and*Soul’s Midnight*.  We are currently in post-production of ourmotion picture film project, *Fingerprints*.

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

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

**MovieDevelopment and Production**

The movie industry generally consists of two principalactivities, production and distribution. Production encompasses the development, financing and creation offeature-length movies.  Distributionentails the promotion and marketing of movies in the various media markets,including theatrical, home video and television presentation.  We typically acquire developed or “packaged”films from third parties, rather than retain and employ personnel to developfilms for our production.  Furthermore,our movies are typically distributed pursuant to licensing arrangements withunrelated third-parties that are independently engaged in the promotion anddistribution of movies.  Our approach toacquisition, production, and distribution is to balance our financial risksagainst the probability of commercial success of each movie project.

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

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Rather than retainand employ personnel to develop screenplays and perform other movie developmentactivities, we typically acquire low-budget movie projects for production thatare in the development phase, generally to the point that the initialscreenplay has been written.  In thepre-production and production phases of a motion picture, we hire skilledcreative and production personnel, including cinematographers, editors, costumedesigners, set designers, sound and lighting technicians and actors on an asneeded basis.

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

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

Our producedmovies are distributed domestically pursuant to licensing arrangements withunrelated third parties that are independently engaged in the promotion anddistribution of movies.  Our foreignmarket distribution arrangements are 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 all of our motion picture projects and have entered into internationaldistribution arrangements covering *Cloud 9,The Hunt,**Surveillance*and*Soul’s Midnight*.

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

·                                          changesin local regulatory requirements, including restrictions on content,

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

·                                          differingdegrees of protection for intellectual property,

·                                          instabilityof foreign economies and governments,

·                                          culturalbarriers, and

·                                          warsand acts of terrorism.

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

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**Recent Developments**

***Cloud 9.***  In conjunction with the production of *Cloud 9*, with the other producers of *Cloud 9*, we formed Out of the Blue Productions,LLC (the “Production Company”).  TheProduction Company has entered into three agreements covering the domestic(United States and Canada) and international distribution of *Cloud 9* in the ancillary market (homevideo market) and 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.  This advancewas recognized as revenue in June 2005 upon delivery of the completedfilm.  The Domestic Agreement allows thelicensee to receive a distribution fee equal to 20% of gross domestic receiptsof *Cloud 9*after its recoupmentof all manufacturing, distribution and marketing costs from thosereceipts.  *Cloud 9* was released in the domestic video market duringJanuary 2006.  The domestic distributorof *Cloud 9* is not required toreport revenue results to us until 60 days after the end of each calendarquarter.  We will record revenue from thedomestic distribution of *Cloud 9*on the date that we receive detailed reporting of the sales results from thedomestic distributor and can accurately determine our revenues from thisdistribution.  In July 2006, we receivedthe first reporting from the domestic distributor and based on the sales datarevised our ultimate revenue estimate. This resulted in an impairment charge to film costs of $1,445,014.

During June 2005,the Production Company entered in to an agreement for the internationaldistribution of *Cloud 9*(“InternationalAgreement”).  Under the InternationalAgreement the licensee is entitled to receive recoupment of its manufacturing,distribution 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. During the nine months ended September 30, 2006, we earned approximately$272,000 of revenue under this agreement.

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

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

***The Hunt*.**  During March 2005, wecommenced and completed principal filming of our second motion picture projecttitled, *The Hunt*.  *The Hunt*has been released in the international market and is expected to be releaseddomestically during the first quarter of 2007. We have incurred total production costs for *The Hunt* of approximately $387,000 as of September 30, 2006.

In July 2005, weentered into an agreement for the domestic distribution of *The Hunt*. The agreement grants the licensee a distribution fee equal to 22.5% ofgross receipts and allows for the recoupment of all manufacturing, distributionand marketing costs.  We have alsoentered into an agreement for the international distribution of *The Hunt*. The agreement grants the licensee a distribution fee equal to 20% ofgross receipts and allows for the recoupment of all

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manufacturing,distribution and marketing costs.  Duringthe nine months ended September 30, 2006, we earned approximately $31,000 fromthe international distribution of *The Hunt*.

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

***Surveillance*. **During August 2005, we commenced andcompleted principal filming of our third motion picture project titled, *Surveillance*.  *Surveillance*has been released in the international market and is expected to bereleased domestically later in 2006.  Wehave incurred total production costs for *Surveillance*of approximately $591,000 as of September 30, 2006.

In July 2005, weentered into an agreement for the domestic distribution of *Surveillance*.  The agreement grants the licensee adistribution fee equal to 25% of gross receipts and allows for the recoupmentof all manufacturing, distribution and marketing costs.  We have also entered into an agreement forthe international distribution of *Surveillance*.  The agreement grants the licensee adistribution fee equal to 20% of gross receipts and allows for the recoupmentof all manufacturing, distribution and marketing costs.  During the nine months ended September 30,2006, we earned approximately $29,000 from the international distribution of *Surveillance*.

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

***Soul’s Midnight*. **During November 2005, we commenced andcompleted the filming of our fourth motion picture titled, *Soul’s Midnight*.  We have incurred total production costs for *Soul’s Midnight* of approximately $662,000as of September 30, 2006.

We have enteredinto an agreement for the domestic distribution of *Soul’s Midnight*.  Theagreement grants the licensee a distribution fee equal to 25% of gross receiptsand allows for the recoupment of all manufacturing, distribution and marketingcosts.  We have also entered into anagreement for the international distribution of *Soul’s Midnight*.  Theagreement grants the licensee a distribution fee equal to 20% of gross receiptsand allows for the recoupment of all manufacturing, distribution and marketingcosts.  During the nine months endedSeptember 30, 2006, we received a non-refundable advance of $60,000 from theinternational distribution of *Soul’sMidnight*.

In addition, wesold 25% of the copyright interest in *Soul’sMidnight* to the licensee for an amount equal to 25% of the budget of*Soul’s Midnight*.  We also sold 50% of the copyright interest in*Soul’s Midnight* to the creatorsof the script for an amount equal to 50% of the budget.  As of September 30, 2006, we have received$513,000 from the minority interests under the terms of the agreement.

***Fingerprints.*** During April 2006, we commenced and completedthe filming of our fifth motion picture project titled, *Fingerprints*.  We have incurred total production costs for *Fingerprints* of approximately $576,000 asof September 30, 2006.

We have enteredinto an agreement for the domestic distribution of *Fingerprints*.  Theagreement grants the licensee a distribution fee equal to 25% of gross receiptsand allows for the recoupment of all manufacturing, distribution and marketingcosts.  In addition, we sold 42.5% of thecopyright interest in *Fingerprints*to the licensee for an amount equal to 42.5% of the budget of *Fingerprints*.  We also sold 20% of the copyright interest in*Fingerprints* to the creators

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of the script for anamount equal to 20% of the budget.  As ofSeptember 30, 2006, we have received $406,250 from the minority interests underthe terms of the agreement.

***Summary Motion Picture Revenue Participation and Net Rightsin Distribution.***  The following summarizes the revenueparticipations before and after net profit participations in our films *The Hunt*, *Surveillance,Soul’s Midnight* and *Fingerprints*:

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

 

The table belowsummarizes the distribution fees negotiated as of September 30, 2006 on a permovie basis (markets that have no distribution agreements in place areidentified as “n/a”):

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

 

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

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

·                                          theconsummation of a “Qualified Financing;” or

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

Upon consummationof a Qualified Financing, the outstanding principal amount of the Notes and allaccrued and unpaid interest (collectively the “Note Balance”) willautomatically convert into shares of our common stock or other

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equity securities equalto 120% of the Note Balance divided by the price per share of our common stockor other equity securities sold in the Qualified Financing.  The maximum price or value of our commonstock or other equity securities into which the Note Balance converts may notexceed the equivalent of $1.10 per common stock share.  Qualified Financing refers to any equityfinancing pursuant to which we receive aggregate gross cash proceeds of$2,000,000 or more on or before the Maturity Date.

In conjunctionwith issuance of the Notes, we and the holder of the Notes entered into commonstock purchase warrant agreements, each evidencing warrants exercisable on orbefore August 5, 2010 for the first note and October 25, 2010 for the secondnote.  Two agreements provide for thepurchase of 250,000 (500,000 total) common stock shares at $2.00 and the othertwo agreements provide for the purchase of 250,000 (500,000 total) common stockshares at $3.00.

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

***Output Agreement.***  In June 2005, we entered into an agreementproviding Image Entertainment (“Image”) with the first-look right at the movieswe produce (the “Output Agreement”). Image has a “first look” on all projects up to $2,000,000 that weundertake during the three-year period beginning on the date of delivery of *The Hunt* which was delivered in February2006.  If Image were to choose not tobecome involved in a motion picture project, we have the right to produce anddistribute the motion picture with another person without any furtherobligation to Image.  Image agreed to fundup to 50% of each production budget for mutually agreed upon motion pictureprojects.  This funding is payable inthree installments:  20% of the approvedproduction budget through pre-production, 60% through the physical shootingschedule, 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 is equal to the percentage Image funds of the motion picture projectafter recovery from sales of the mutually approved expenses.  Our joint exploitation of the broadcastrights with Image have been left to future negotiation.

**AccountingMethods**

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

In June 2000, theAccounting Standards Executive Committee of the American Institute of CertifiedPublic Accountants issued Statement of Position 00-2, Accounting 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:

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

·                                          thecapitalization of production costs for episodic television series is limited torevenue that has been contracted for on an episode-by-episode basis until thetime that the criteria for recognizing secondary market revenues are met.

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We capitalize thecosts of production, including financing costs, to investment in motionpictures.  These costs are amortized todirect operating expenses in accordance with SoP 00-2. These costs are statedat the lower of unamortized motion picture costs or fair value (net presentvalue).  Costs for an individual motionpicture are amortized in the proportion that current period actual revenuesbear to management’s estimates of the total revenue expected to be receivedfrom the motion picture over a period not to exceed 10 years from the date ofdelivery.  We are required to regularlyreview and revise when necessary the total revenue estimates of each motionpicture produced.  As a result, ifrevenue estimates change with respect to a motion picture, it may be necessaryto write down all or a portion of the unamortized costs of the motionpicture.  There is no assurance thatrevised revenue estimates will not occur that result in significant write-downsaffecting our results of operations and financial condition.

Revenue from thesale or licensing of motion pictures will be recognized upon meeting allrecognition requirements of SoP 00-2. Revenue from the theatrical release of motion pictures will berecognized at the time of exhibition based on our participation in box officereceipts.  If applicable, revenue fromthe sale of DVDs in the retail market, net of an allowance for estimatedreturns, is recognized on the later of shipment to the customer or “street date”(when it is available for sale by the customer).  Furthermore, if applicable, under revenuesharing arrangements, rental revenue is recognized when we become entitled toreceipts.  For contracts that provide forrights to exploit a motion picture on multiple media (e.g. theatrical, video,television) with a fee for a single motion picture where the contract specifiesthe permissible timing of release to various media, the fee is allocated to thevarious media based on an assessment of the relative fair value of the rightsto exploit each media and will be recognized as the movie is released to eachmedia.  For multiple-title contracts witha fee, the fee is allocated on a title-by-title basis, based on an assessmentof the relative fair value of each title. If applicable, revenues from television licensing are recognized whenthe motion picture becomes available to the licensee for telecast.  Cash payments received are recorded asdeferred revenue until all the conditions of revenue recognition have beenmet.  If applicable, we accrue for videoreturns and provide for allowances in the financial statements based onprevious returns and our allowances history on a title-by-title basis in eachof the video businesses. In this case, there may be differences between actualreturns and allowances and our historical experience that we currently do nothave.  Revenues earned from the sale ofDVDs through distribution agreements are recognized when sales from thesedistributors are known or can be accurately estimated.

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

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

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

Although we do nothave any experience related to auditing distributors’ revenue accounting, weanticipate that the costs associated with this type of audit may be substantialand may vary significantly from distributor-to-distributor and even picture-to-picture.  Therefore, there is no assurance that, in allcases, we will be able to obtain an accurate accounting of exhibition revenuesor that audits will result in increases in the revenues that justify the associatedaudit costs.

**RecentAccounting Pronouncements**

*SFAS123(R)* – In December 2004, the Financial Accounting StandardsBoard (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,

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*Accountingfor Stock Issued to Employees*.  We adopted SFAS 123(R) on January 1, 2006using the modified prospective method as described in the standard.  Under the modified prospective method, we arerequired to record compensation cost for new and modified awards over therelated vesting period of such awards prospectively and record compensationcost prospectively for the unvested portion at time of adoption, of previouslyissued and outstanding awards over the remaining vesting period of suchawards.  As of January 1, 2006, we had nounvested outstanding awards and as a result, the adoption of SFAS123(R) had noimpact on our consolidated financial statements or consolidated results ofoperations.

*SFAS155* – In February 2006, the FASB issued Statement No. 155, *“Accounting for Certain Hybrid Financial Instruments”*(“SFAS 155”), which amends FASB Statements No. 133 and 140.  This Statement permits fair valueremeasurement for any hybrid financial instrument containing an embeddedderivative that would otherwise require bifurcation, and broadens a QualifiedSpecial Purpose Entity’s (“QSPE”) permitted holdings to include passivederivative financial instruments that pertain to other derivative financialinstruments.  This Statement is effectivefor all financial instruments acquired, issued or subject to a remeasurementevent occurring after the beginning of an entity’s first fiscal year beginningafter September 15, 2006.  This Statementhas no current applicability to the Company’s financial statements.  Management plans to adopt this Statement onJanuary 1, 2007 and it is anticipated that the initial adoption of thisStatement will not have a material impact on the Company’s financial position,results of operations, or cash flows.

*FIN48* – In June 2006, the FASB issued Interpretation 48, *“Accounting for Uncertainty in Income Taxes”*(“FIN 48”), an interpretation of FASB Statement No. 109, *“Accounting for Income Taxes.”*  FIN 48 clarifies the accounting and reportingfor income taxes where interpretation of the law is uncertain.  FIN 48 prescribes a comprehensive model forthe financial statement recognition, measurement, presentation and disclosureof income tax uncertainties with respect to positions taken or expected to betaken in income tax returns.  FIN 48 iseffective for fiscal years beginning after December 15, 2006.  This Statement has no current applicabilityto the Company’s financial statements. Management plans to adopt this Statement on January 1, 2007 and it isanticipated that the initial adoption of FIN 48 will not have a material impacton the Company’s financial position, results of operations, or cash flows.

*SFAS157* – In September 2006, the FASB issued Statement No. 157, *“Fair Value Measurements”*  (“SFAS No. 157”).  SFAS 157 addresses how companies shouldmeasure fair value when they are required to use a fair value measure forrecognition or disclosure purposes under GAAP. SFAS 157 defines fair value, establishes a framework for measuring fairvalue and expands disclosures about fair value measurements.  SFAS 157 is effective for fiscal yearsbeginning after November 15, 2007, with earlier adoption permitted.  Management is assessing the impact of theadoption of this Statement.

*SFAS158* – In September 2006, the FASB issued Statement No. 158, *“Employers’ Accounting for Defined Benefit Pensionand Other Postretirement Plans”* (“SFAS 158”), an amendment of FASBStatements No. 87, 88, 106 and 132(R). SFAS 158 requires (a) recognition of the funded status (measured as thedifference between the fair value of the plan assets and the benefitobligation) of a benefit plan as an asset or liability in the employer’sstatement of financial position, (b) measurement of the funded status as of theemployer’s fiscal year-end with limited exceptions, and (c) recognition ofchanges in the funded status in the year in which the changes occur throughcomprehensive income.  The requirement torecognize the funded status of a benefit plan and the disclosure requirementsare effective as of the end of the fiscal year ending after December 15,2006.  The requirement to measure theplan assets and benefit obligations as of the date of the employer’s fiscalyear-end statement of financial position is effective for fiscal years endingafter December 15, 2008.  This Statementhas no current applicability to the Company’s financial statements.  Management plans to adopt this Statement onDecember 31, 2006 and it is anticipated the adoption of SFAS 158 will not havea material impact to the Company’s financial position, results of operations,or cash flows.

*SAB108* – In September 2006, the Securities Exchange Commissionissued Staff Accounting Bulletin No. 108 (“SAB 108”).  SAB 108 addresses how the effects of prioryear uncorrected misstatements should be considered when quantifyingmisstatements in current year financial statements.  SAB 108 requires companies to quantifymisstatements using a balance sheet and income statement approach and toevaluate whether either approach results in quantifying

8

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an error that is materialin light of relevant quantitative and qualitative factors.  When the effect of initial adoption ismaterial, companies will record the effect as a cumulative effect adjustment tobeginning of year retained earnings and disclose the nature and amount of eachindividual error being corrected in the cumulative adjustment.  SAB 108 will be effective beginning January1, 2007 and it is anticipated that the initial adoption of SAB 108 will nothave a material impact on the Company’s financial position, results ofoperations, or cash flows.

**Results of Operations**

Thefollowing table sets forth selected results of our operations for the three andnine months ended September 30, 2006 and 2005. The following information was derived and taken from our unauditedfinancial statements appearing elsewhere in this report.

|                               | ** ** | **For the Three Months Ended  September 30,** | ** ** | **For the Nine Months Ended  September 30,** | ** ** |
|-------------------------------|------------|------------------------------------------------------------------------|------------|-----------------------------------------------------------------------|------------|
| ** **                    | ** ** | **2006**                                                               | ** ** | **2005**                                                              | ** ** | **2006** | ** ** | **2005** | ** ** |
| Revenue                       |       | $                                                                      | 154,522    |                                                                  | $          | — |   | $ | 391,388 |   | $ | 450,000 |   |
| Expenses:                     |       |                                                                   |       |                                                                  |       |   |   |   |   |
| Direct operating              |       | 132,092                                                                |       | —                                                                |       | 323,543 |   | 413,404 |   |
| Impairment of film costs      |       | —                                                                 |       | 10,500                                                                |       | 1,445,014 |   | 10,500 |   |
| General and administrative    |       | 101,521                                                                |       | 117,586                                                               |       | 302,647 |   | 315,116 |   |
| Depreciation                  |       | 1,216                                                                  |       | 1,216                                                                 |       | 3,649 |   | 3,649 |   |
|                          |       |                                                                   |       |                                                                  |       |   |   |   |   |
| Total expenses                |       | 234,829                                                                |       | 129,302                                                               |       | 2,074,853 |   | 742,669 |   |
|                          |       |                                                                   |       |                                                                  |       |   |   |   |   |
| Operating loss                |       | (80,307                                                                | )          | (129,302                                                              | )          | (1,683,465 | ) | (292,669 | ) |
|                          |       |                                                                   |       |                                                                  |       |   |   |   |   |
| Other income  (expense):      |       |                                                                   |       |                                                                  |       |   |   |   |   |
| Interest and other income     |       | 7,168                                                                  |       | 3,450                                                                 |       | 23,814 |   | 8,241 |   |
| Interest expense              |       | (92,945                                                                | )          | (39,306                                                               | )          | (276,784 | ) | (39,306 | ) |
| Minority interests            |       | (13,248                                                                | )          | —                                                                |       | (18,088 | ) | — |   |
|                          |       |                                                                   |       |                                                                  |       |   |   |   |   |
| Net other income (expense)    |       | (99,025                                                                | )          | (35,856                                                               | )          | (271,058 | ) | (31,065 | ) |
|                          |       |                                                                   |       |                                                                  |       |   |   |   |   |
| Net loss before  income taxes |       | (179,332                                                               | )          | (165,158                                                              | )          | (1,954,523 | ) | (323,734 | ) |
| Provision for  income taxes   |       | —                                                                 |       | —                                                                |       | — |   | — |   |
|                          |       |                                                                   |       |                                                                  |       |   |   |   |   |
| Net loss                      |       | $                                                                      | (179,332   | )                                                                     | $          | (165,158 | ) | $ | (1,954,523 | ) | $ | (323,734 | ) |

 

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

Our consolidatedrevenues for the three months ended September 30, 2006 (the “2006 3rd Quarter”)were $154,522 and were attributable to the international distribution of *Cloud 9,**TheHunt, Surveillance* and *Soul’sMidnight*.  We did not generateany revenue in the prior year’s third quarter.

Direct operatingexpenses primarily include amortization of film costs and participationcosts.  Our direct operating expenses of$132,092 for the 2006 3rd Quarter were 85% of revenues.  The ratio of direct operating expenses torevenue is dependent on our estimate of the ultimate revenue of each film.  During the third quarter of 2005, we incurredan impairment of film costs of $10,500 associated with the elimination of twofilm projects in progress.

General andadministration expenses of $101,521 for the 2006 3rd Quarter decreased $16,065,or 14%, from $117,586 in the prior year’s quarter.  The decrease in general and administrationexpenses was primarily due to a decrease in legal and professional feesassociated with our reporting and filing requirements as a public company and adecrease in consulting services which were offset by an increase in our monthlylease expense and an increase in salaries and wages.

9

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During the 20063rd Quarter, we realized interest income of $7,168, compared to $3,450 in theprior year’s third quarter.  Thisincrease was attributable to a corresponding increase in the balance of cashand cash equivalents held in interest bearing accounts and an increase in theyield earned on those accounts.

We incurredinterest expense of $92,945 during the 2006 3rd Quarter that was attributableto our convertible notes payable, amortization of prepaid loan fees andamortization of warrants issued with the convertible notes payable.  We incurred interest expense $39,306 duringthe third quarter of 2005.  The increasein interest expense from 2005 to 2006 is attributable to an increase in theamount of convertible notes payable.

Minority interestsin our earnings for the 2006 3rd Quarter were $13,248 and were attributable tominority interests in our movies *The Hunt*,*Surveillance* and *Soul’s Midnight*.

**Comparisonof the Nine-Month Periods Ended September 30, 2006 and 2005**

Our consolidatedrevenues for the nine months ended September 30, 2006 were $391,388 and wereattributable to the international distribution of *Cloud 9,**The Hunt,Surveillance*and*Soul’s Midnight*.  We generated $450,000 of revenue in the prioryear’s first quarter from the non-refundable advance we received on thedomestic distribution of *Cloud 9*.

Direct operatingexpenses primarily include amortization of film costs and participationcosts.  Our direct operating expenses of$323,543 for the nine months ended September 30, 2006 were 83% of revenues.  Our direct operating expenses of $413,404 forthe nine months ended September 30, 2005 were 92% of revenues.  The ratio of direct operating expenses torevenue is dependent on our estimate of the ultimate revenue of each film.

As of June 30, 2006,our domestic distributor had reported to us domestic DVD sales of approximately100,000 units.  Based on the actualresults through June 30, 2006, we do not feel that we can be reasonably assuredof receiving domestic revenue in excess of the $450,000 non-refundable advancewe received in 2005.  As a result, wewrote down the carrying value of *Cloud 9*by $1,445,014 to $393,000 which is equal to the amount that managementestimates will be collected through continuing international distribution andbroadcast distribution of *Cloud 9*.  During the third quarter of 2005, we incurredan impairment of film costs of $10,500 associated with the elimination of twofilm projects in progress.

General andadministration expenses of $302,647 for the nine months ended September 30,2006 decreased 4% from $315,116 in the prior year’s first nine months.  The decrease in general and administrationexpenses was primarily due to a decrease in legal and professional feesassociated with our reporting and filing requirements as a public company,decrease in consulting services and a decrease in employee benefits which wereoffset by an increase in our monthly lease expense and an increase in salariesand wages.

During the firstnine months of 2006, we realized interest income of $23,814, compared to $8,241in the prior year’s first nine months. This increase was attributable to a corresponding increase in thebalance of cash and cash equivalents held in interest bearing accounts and anincrease in the yield earned on those accounts.

We incurredinterest expense of $276,784 during the first nine months of 2006 that wasattributable to our convertible notes payable, amortization of prepaid loanfees and amortization of warrants issued with the convertible notes payable.  The increase in interest expense from 2005 to2006 is attributable to an increase in the amount of convertible notes payable.

Minority interestsin our earnings for the nine months ended September 30, 2006 were $18,088 andwere attributable to minority interests in our movies *The Hunt, Surveillance* and *Soul’s Midnight*.

10

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**Liquidity and Capital Resources**

Our liquidity andcapital resources are provided principally through cash generated fromoperations, issuance of convertible notes payable and equity offerings.  Our cash and cash equivalents at September30, 2006 totaled approximately $931,000. As of September 30, 2006, we had working capital of approximately$214,000.

In April 2004, wecompleted our private placement offering of our common stock shares andredeemable warrants in units of one common stock share and one redeemablewarrant.  During 2003 and 2004, wereceived net proceeds of $2,535,224 from this private placement offering.

During 2005, wereceived $1,500,000 in proceeds from the issuance of convertible promissorynotes.

Operatingactivities for the nine months ended September 30, 2006, used net cash of$623,045 compared to operating activities for the nine months ended September30, 2005 which used $406,412.  Theincrease in cash flows used by operating activities was attributable to adecrease of revenue generated during the first nine months of 2006 and anincrease in expenditures for film costs.

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

Financingactivities during the nine months ended September 30, 2006, used cash of$50,000 for the repayment of film obligations. Financing activities during the nine months ended September 30, 2005,generated $300,000.  In June 2005, weused $450,000 for the repayment of film obligations and in July 2005, wereceived $750,000 from the issuance of a convertible note payable.  During the first nine months of 2006, weissued 122,956 shares of common stock as payment of accrued interest (in theamount of $86,167) due on convertible notes payable.

***Financial Commitments***

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

Furthermore, wealso similarly agreed to register (and maintain effective of the registrationunder the 1933 Act for the seven-year period) the 443,250 common stock sharesunderlying the placement agent warrants sold to the underwriter of our privateplacement offering, Viewtrade Financial, and 383,425 common stock shares issuedpursuant to the one-year 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

11

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affiliates of ViewtradeFinancial, elected to remove those shares from the registration statement.  Although we have been informed by our legalcounsel that the common stock shares, other than those underlying the placementagent warrants, may be sold without further restriction pursuant to Rule 144 aspromulgated by the Securities and Exchange Commission, we anticipate filing aregistration statement in accordance with this registration obligation duringthe last half of 2006.

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

***12-Month Overhead Budget***

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

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

 

***Additional Financial Commitments***

Other than 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 will achieveprofitability.  We provide no assurancethat

12

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·                                          we will be successful in implementing ourbusiness plan or

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

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

Futurecommitments under contractual obligations by expected maturity date atSeptember 30, 2006 are as follows:

|                            | ** ** | **< 1 year** | ** ** | **1-3 years** | ** ** | **3-5 years** | ** ** | **> 5 years** | ** ** | **Total** | ** ** |
|----------------------------|------------|---------------------------|------------|--------------------|------------|--------------------|------------|----------------------------|------------|-----------|------------|
|                       |       |                      |       |               |       |               |       |                       |       |      |       |
| Convertible  notes payable |       | $                         | 750,000    |               | $          | 750,000            |       | $                          | —     |      | $          | — |   | $ | 1,500,000 |   |
| Operating leases           |       | 25,608                    |       | —             |       | —             |       | —                     |       | 25,608    |       |
|                       |       |                      |       |               |       |               |       |                       |       |      |       |
|                       |       | $                         | 775,608    |               | $          | 750,000            |       | $                          | —     |      | $          | — |   | $ | 1,525,608 |   |

 

**CautionaryStatement Relating to Forward Looking Information**

Wehave included some forward-looking statements in this section and other placesin this report regarding our expectations. These forward-looking statements involve known and unknown risks,uncertainties and other factors which may cause our actual results, levels ofactivity, performance or achievements, or industry results, to be materiallydifferent from any future results, levels of activity, performance orachievements expressed 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 othervariations thereon or comparable terminology, or by discussions of strategiesthat involve risks and uncertainties. You should read statements that contain these words carefully becausethey:

·                                          discuss our future expectations;

·                                          contain projections of our futureoperating results or of our future financial condition; or

·                                          state other “forward-looking”information.

Webelieve it is important to discuss our expectations; however, it must berecognized that events may occur in the future over which we have no controland which we are not accurately able to predict.  Readers are cautioned to consider thespecific business risk factors described under the caption “Additional Factorsthat May Affect Our Future Results” appearing under “Item 1. Description ofBusiness” of our Annual Report on Form 10-KSB filed with the United StatesSecurities and Exchange Commission on March 24, 2006, and not to place unduereliance on the forward-looking statements contained herein, which speak onlyas of the date of this report.  Weundertake no obligation to publicly revise forward-looking statements toreflect events or circumstances that may arise after the date of this report.

**Item 3.    Controls and Procedures**

OurChief Executive Officer and Chief Financial Officer are responsible primarilyfor establishing and maintaining disclosure controls and procedures designed toensure that information required to be disclosed in our reports filed orsubmitted under the Securities Exchange Act of 1934, as amended (the “ExchangeAct”) is recorded, processed, summarized and reported within the time periodsspecified in the rules and forms of the U.S. Securities and ExchangeCommission.  These controls 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

13

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decisions regardingrequired disclosure.

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

OurChief Executive Officer and Chief Financial Officer, based upon theirevaluation of the effectiveness of our disclosure controls and procedures andthe internal controls over financial reporting as of the last day of the periodcovered by this report, concluded that our disclosure controls and proceduresand internal controls over financial reporting were fully effective as of thelast day of the period covered by this report and reported to our auditors andboard of directors that no change occurred in our disclosure controls andprocedures and internal control over financial reporting occurred during theperiod covered by this report that would materially affect or is reasonablylikely to materially affect our disclosure controls and procedures or internalcontrol over financial reporting.  Inconducting their evaluation of our disclosure controls and procedures andinternal controls over financial reporting, these executive officers did notdiscover any fraud that involved management or other employees who have asignificant role in our disclosure controls and procedures and internalcontrols over financial reporting. Furthermore, there were no significant changes in our disclosurecontrols and procedures, internal controls over financial reporting, or otherfactors that could significantly affect our disclosure controls and proceduresor internal controls over financial reporting subsequent to the date of theirevaluation.  Because no significantdeficiencies or material weaknesses were discovered, no corrective actions werenecessary or taken to correct significant deficiencies and material weaknessesin our internal controls and disclosure controls and procedures.

**PART II OTHER INFORMATION**

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

None

**Item 2.    UnregisteredSales of Equity Securities and Use of Proceeds**

(a)           During the nine months endedSeptember 30, 2006, we issued 122,956 shares of our common stock to SXJE, LLC,the holder of certain convertible promissory notes, in payment of the accruedinterest of $86,167 (see Item 2. Management’s Discussion and Anaylsis or Planof Operation — Recent Developments — Convertible Note Financing).  These were issued pursuant to registrationexemptions under Section 4(6) of the Securities Act and Rule 506 of RegulationD.  SXJE, LLC qualifies as an “accreditedinvestor” within the meaning of Rule 501(a) of Regulation D.  No commissions or other form of remunerationwas paid in connection with the issuance of these shares of common stock.

(b)           None

(c)                                  None

**Item 3.****           Defaults Upon SeniorSecurities**

None

14

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**Item 4.****           Submission of Mattersto a Vote of Security Holders**

None

**Item5.****           OtherInformation**

None

**Item 6.    Exhibits**

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

 

15

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**SIGNATURES**

Inaccordance with the Exchange Act, the Registrant caused this report to besigned on its behalf by the undersigned, thereunto duly authorized.
|                          | GRAYMARK PRODUCTIONS, INC. |
|--------------------------|----------------------------|
|                     | (Registrant)               |
|                     |                       |
|                     |                       |
|                     | By:                        | /S/JOHN  SIMONELLI |   |
|                     |                       |   | John Simonelli |
| Date: November  13, 2006 |                       |   | Chief Executive  Officer |
|                     |                       |   |
|                     |                       |   |
|                     | By:                        | /S/MARK R. KIDD |   |
|                     |                       |   | Mark R. Kidd |
| Date: November  13, 2006 |                       |   | Chief Financial  Officer and Controller |
|                          |                            |  |  |  |  |

 

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**GRAYMARKPRODUCTIONS, INC.**

**INDEXTO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS**
| Condensed Consolidated  Balance Sheets as of September 30, 2006 and December 31, 2005                         |   |   |
|---------------------------------------------------------------------------------------------------------------|--------|--------|
|                                                                                                          |   |   |
| Condensed  Consolidated Statements of Operations for the Three Months Ended September  30, 2006 and 2005      |   |   |
|                                                                                                          |   |   |
| Condensed  Consolidated Statements of Operations for the Nine Months Ended September 30,  2006 and 2005       |   |   |
|                                                                                                          |   |   |
| Condensed  Consolidated Statements of Shareholders’ Equity for the Nine Months Ended  September 30, 2006 |   |   |
|                                                                                                          |   |   |
| Condensed  Consolidated Statements of Cash Flows for the Nine Months Ended September 30,  2006 and 2005       |   |   |
|                                                                                                          |   |   |
| Notes  to Condensed Consolidated Financial Statements                                                         |   |   |

 

F-1

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**GRAYMARKPRODUCTIONS, INC.**

**CondensedConsolidated Balance Sheets**

**(Unaudited)**
| ** **                                                                                                                                                                             | ** ** | **September  30,  2006** | ** ** | **December 31,  2005** | ** ** |
|----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|------------|--------------------------|------------|-----------------------------|------------|
| ASSETS                                                                                                                                                                                 |       |                     |       |                        |       |
|                                                                                                                                                                                   |       |                     |       |                        |       |
| Cash and cash  equivalents                                                                                                                                                             |       | $                        | 931,179    |                        | $          | 1,153,840 |   |
| Film deposits                                                                                                                                                                          |       | —                   |       | 32,500                      |       |
| Accounts receivable                                                                                                                                                                    |       | 26,479                   |       | —                      |       |
|                                                                                                                                                                                   |       |                     |       |                        |       |
| Total current  assets                                                                                                                                                                  |       | 957,658                  |       | 1,186,340                   |       |
|                                                                                                                                                                                   |       |                     |       |                        |       |
| Fixed assets, net                                                                                                                                                                      |       | 12,676                   |       | 16,325                      |       |
| Prepaid loan fees                                                                                                                                                                      |       | 70,890                   |       | 126,986                     |       |
| Investment in films                                                                                                                                                                    |       | 2,458,124                |       | 3,458,417                   |       |
|                                                                                                                                                                                   |       |                     |       |                        |       |
| Total assets                                                                                                                                                                           |       | $                        | 3,499,348  |                        | $          | 4,788,068 |   |
|                                                                                                                                                                                   |       |                     |       |                        |       |
| LIABILITIES AND  SHAREHOLDERS’ EQUITY                                                                                                                                             |       |                     |       |                        |       |
|                                                                                                                                                                                   |       |                     |       |                        |       |
| Liabilities:                                                                                                                                                                           |       |                     |       |                        |       |
| Accounts payable  and accrued liabilities                                                                                                                                              |       | $                        | 94,125     |                        | $          | 101,659 |   |
| Current portion  of convertible notes payable, net of discount of $100,594                                                                                                             |       | 649,406                  |       | —                      |       |
|                                                                                                                                                                                   |       |                     |       |                        |       |
| Total current  liabilities                                                                                                                                                             |       | 743,531                  |       | 101,659                     |       |
|                                                                                                                                                                                   |       |                     |       |                        |       |
| Film obligations                                                                                                                                                                       |       | —                   |       | 50,000                      |       |
| Convertible  notes payable, net of discounts of $55,925 and $287,207 at September 30, 2006  and December 31, 2005, respectively                                                        |       | 694,075                  |       | 1,212,793                   |       |
|                                                                                                                                                                                   |       |                     |       |                        |       |
| Total  liabilities                                                                                                                                                                     |       | 1,437,606                |       | 1,364,452                   |       |
|                                                                                                                                                                                   |       |                     |       |                        |       |
| Minority interests                                                                                                                                                                     |       | 1,462,570                |       | 994,097                     |       |
|                                                                                                                                                                                   |       |                     |       |                        |       |
| Shareholders’ Equity:                                                                                                                                                             |       |                     |       |                        |       |
| Preferred stock  $0.0001 par value, 10,000,000 authorized; no shares issued and outstanding                                                                                            |       | —                   |       | —                      |       |
| Common stock  $0.0001 par value, 90,000,000 shares authorized; 8,412,107 issued and outstanding  at September 30, 2006 (8,289,151 shares issued and outstanding at December  31, 2005) |       | 841                      |       | 829                         |       |
| Paid-in capital                                                                                                                                                                        |       | 4,346,016                |       | 4,221,852                   |       |
| Accumulated  deficit                                                                                                                                                                   |       | (3,747,685               | )          | (1,793,162                  | )          |
|                                                                                                                                                                                   |       |                     |       |                        |       |
| Total  shareholders’ equity                                                                                                                                                       |       | 599,172                  |       | 2,429,519                   |       |
|                                                                                                                                                                                   |       |                     |       |                        |       |
| Total liabilities and  shareholders’ equity                                                                                                                                       |       | $                        | 3,499,348  |                        | $          | 4,788,068 |   |

 

See AccompanyingNotes to Condensed Consolidated Financial Statements

F-2

----

**GRAYMARKPRODUCTIONS, INC.**

**CondensedConsolidated Statements of Operations**

**(Unaudited)**
| ** **                                                               | ** ** | **Three Months Ended  September 30,** | ** ** |
|--------------------------------------------------------------------------|------------|------------------------------------------------------|------------|
| ** **                                                               | ** ** | **2006**                                             | ** ** | **2005** | ** ** |
|                                                                     |       |                                                 |       |   |   |
| Revenues                                                                 |       | $                                                    | 154,522    |   | $ | — |   |
|                                                                     |       |                                                 |       |   |   |
| Expenses:                                                                |       |                                                 |       |   |   |
| Direct operating                                                         |       | 132,092                                              |       | — |   |
| Impairment of  film costs                                                |       | —                                               |       | 10,500 |   |
| General and  administrative                                              |       | 101,521                                              |       | 117,586 |   |
| Depreciation                                                             |       | 1,216                                                |       | 1,216 |   |
|                                                                     |       |                                                 |       |   |   |
| Total expenses                                                           |       | 234,829                                              |       | 129,302 |   |
|                                                                     |       |                                                 |       |   |   |
| Operating loss                                                           |       | (80,307                                              | )          | (129,302 | ) |
|                                                                     |       |                                                 |       |   |   |
| Other Income (Expense):                                                  |       |                                                 |       |   |   |
| Interest and  other income                                               |       | 7,168                                                |       | 3,450 |   |
| Interest expense                                                         |       | (92,945                                              | )          | (39,306 | ) |
|                                                                     |       |                                                 |       |   |   |
| Net other income  (expense)                                              |       | (85,777                                              | )          | (35,856 | ) |
|                                                                     |       |                                                 |       |   |   |
| Net loss before provision  for income taxes and minority interests       |       | (166,084                                             | )          | (165,158 | ) |
|                                                                     |       |                                                 |       |   |   |
| Provision for income  taxes                                              |       | —                                               |       | — |   |
| Minority interests                                                       |       | (13,248                                              | )          | — |   |
|                                                                     |       |                                                 |       |   |   |
| Net loss                                                                 |       | $                                                    | (179,332   | ) | $ | (165,168 | ) |
|                                                                     |       |                                                 |       |   |   |
| Net loss per share of  common stock, basic and diluted                   |       | $                                                    | (0.02      | ) | $ | (0.02 | ) |
|                                                                     |       |                                                 |       |   |   |
| Weighted average number of common shares outstanding, basic and  diluted |       | 8,412,107                                            |       | 8,265,092 |   |

 

See AccompanyingNotes to Condensed Consolidated Financial Statements

F-3

----

**GRAYMARKPRODUCTIONS, INC.**

**CondensedConsolidated Statements of Operations**

**(Unaudited)**
| ** **                                                               | ** ** | **Nine Months Ended  September 30,** | ** ** |
|--------------------------------------------------------------------------|------------|-----------------------------------------------------|------------|
| ** **                                                               | ** ** | **2006**                                            | ** ** | **2005** | ** ** |
|                                                                     |       |                                                |       |   |   |
| Revenues                                                                 |       | $                                                   | 391,388    |   | $ | 450,000 |   |
|                                                                     |       |                                                |       |   |   |
| Expenses:                                                                |       |                                                |       |   |   |
| Direct operating                                                         |       | 323,543                                             |       | 413,404 |   |
| Impairment of  investment in films                                       |       | 1,445,014                                           |       | 10,500 |   |
| General and  administrative                                              |       | 302,647                                             |       | 315,116 |   |
| Depreciation                                                             |       | 3,649                                               |       | 3,649 |   |
|                                                                     |       |                                                |       |   |   |
| Total expenses                                                           |       | 2,074,853                                           |       | 742,669 |   |
|                                                                     |       |                                                |       |   |   |
| Operating loss                                                           |       | (1,683,465                                          | )          | (292,669 | ) |
|                                                                     |       |                                                |       |   |   |
| Other Income (Expense):                                                  |       |                                                |       |   |   |
| Interest and  other income                                               |       | 23,814                                              |       | 8,241 |   |
| Interest expense                                                         |       | (276,784                                            | )          | (39,306 | ) |
|                                                                     |       |                                                |       |   |   |
| Net other income  (expense)                                              |       | (252,970                                            | )          | (31,065 | ) |
|                                                                     |       |                                                |       |   |   |
| Net loss before  provision for income taxes and minority interests       |       | (1,936,435                                          | )          | (323,734 | ) |
|                                                                     |       |                                                |       |   |   |
| Provision for income  taxes                                              |       | —                                              |       | — |   |
| Minority interests                                                       |       | (18,088                                             | )          | — |   |
|                                                                     |       |                                                |       |   |   |
| Net loss                                                                 |       | $                                                   | (1,954,523 | ) | $ | (323,734 | ) |
|                                                                     |       |                                                |       |   |   |
| Net loss per share of  common stock, basic and diluted                   |       | $                                                   | (0.23      | ) | $ | (0.04 | ) |
|                                                                     |       |                                                |       |   |   |
| Weighted average number of common shares outstanding, basic and  diluted |       | 8,358,605                                           |       | 8,260,647 |   |

 

See AccompanyingNotes to Condensed Consolidated Financial Statements

F-4

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**GRAYMARKPRODUCTIONS, INC.**

**CondensedConsolidated Statements of Shareholders’ Equity**

**(Unaudited)**
| ** **                                         | ** ** | **Common Stock** | ** ** | **Paid-in** | ** ** | **Accumulated** | ** ** |
|----------------------------------------------------|------------|-----------------------|------------|-------------|------------|-----------------|------------|
| ** **                                         | ** ** | **Shares**            | ** ** | **Amount**  | ** ** | **Capital**     | ** ** | **Deficit** | ** ** |
|                                               |       |                  |       |        |       |            |       |   |   |
| Balance, December 31,  2004                        |       | 8,258,425             |       | $           | 826        |            | $          | 3,837,689 |   | $ | (1,241,976 | ) |
|                                               |       |                  |       |        |       |            |       |   |   |
| Issuance of  stock for consulting services         |       | 10,000                |       | 1           |       | 14,499          |       | — |   |
| Issuance of  stock for investor relations services |       | 10,000                |       | 1           |       | 9,374           |       | — |   |
| Issuance of  stock for convertible notes interest  |       | 10,726                |       | 1           |       | 10,832          |       | — |   |
| Warrants issued  with convertible notes            |       | —                |       | —      |       | 349,458         |       | — |   |
| Net loss                                           |       | —                |       | —      |       | —          |       | (551,186 | ) |
|                                               |       |                  |       |        |       |            |       |   |   |
| Balance, December 31,  2005                        |       | 8,289,151             |       | 829         |       | 4,221,852       |       | (1,793,162 | ) |
|                                               |       |                  |       |        |       |            |       |   |   |
| Issuance of  stock for convertible notes interest  |       | 122,956               |       | 12          |       | 86,155          |       | — |   |
| Issuance of  stock options                         |       | —                |       | —      |       | 38,009          |       | — |   |
| Net loss                                           |       | —                |       | —      |       | —          |       | (1,954,523 | ) |
|                                               |       |                  |       |        |       |            |       |   |   |
| Balance, September 30, 2006                        |       | 8,412,107             |       | $           | 841        |            | $          | 4,346,016 |   | $ | (3,747,685 | ) |

 

See AccompanyingNotes to Condensed Consolidated Financial Statements

F-5

----

**GRAYMARKPRODUCTIONS, INC.**

**CondensedConsolidated Statements of Cash Flows**

**(Unaudited)**
| ** **                                                                   | ** ** | **Nine Months Ended  September 30,** | ** ** |
|------------------------------------------------------------------------------|------------|-----------------------------------------------------|------------|
| ** **                                                                   | ** ** | **2006**                                            | ** ** | **2005** | ** ** |
|                                                                         |       |                                                |       |   |   |
| Operating activities:                                                        |       |                                                |       |   |   |
| Net loss                                                                     |       | $                                                   | (1,954,523 | ) | $ | (323,734 | ) |
| Adjustments to  reconcile net loss to net cash used by operating activities: |       |                                                |       |   |   |
| Depreciation                                                                 |       | 3,649                                               |       | 3,649 |   |
| Amortization of  film costs                                                  |       | 327,710                                             |       | 409,237 |   |
| Impairment of  investment in films                                           |       | 1,434,514                                           |       | 10,500 |   |
| Issuance of  common stock for convertible notes interest                     |       | 86,167                                              |       | — |   |
| Interest expense  allocated to warrants                                      |       | 130,688                                             |       | 21,795 |   |
| Non-cash stock  option compensation                                          |       | 38,009                                              |       | — |   |
| Issuance of  common stock for consulting services                            |       | —                                              |       | 14,500 |   |
| Minority  interests                                                          |       | 18,088                                              |       | — |   |
| Changes in  assets and liabilities –                                    |       |                                                |       |   |   |
| Film deposits                                                                |       | 32,500                                              |       | 44,101 |   |
| Accounts  receivable                                                         |       | (26,479                                             | )          | — |   |
| Prepaid loan  fees                                                           |       | 56,096                                              |       | (68,322 | ) |
| Investment in  films                                                         |       | (761,931                                            | )          | (524,948 | ) |
| Accrued  liabilities                                                         |       | (7,534                                              | )          | 6,810 |   |
|                                                                         |       |                                                |       |   |   |
| Net cash used by  operating activities                                       |       | (623,046                                            | )          | (406,412 | ) |
|                                                                         |       |                                                |       |   |   |
| Investing activities:                                                        |       |                                                |       |   |   |
| Minority interests  - contributions                                          |       | 450,385                                             |       | — |   |
|                                                                         |       |                                                |       |   |   |
| Net cash  provided by investing activities                                   |       | 450,385                                             |       | — |   |
|                                                                         |       |                                                |       |   |   |
| Financing activities:                                                        |       |                                                |       |   |   |
| Proceeds from  convertible notes payable                                     |       | —                                              |       | 505,224 |   |
| Proceeds from  warrants issued with convertible notes payable                |       | —                                              |       | 244,776 |   |
| Repayment of  film obligations                                               |       | (50,000                                             | )          | (450,000 | ) |
|                                                                         |       |                                                |       |   |   |
| Net cash  provided by (used in) financing activities                         |       | (50,000                                             | )          | 300,000 |   |
|                                                                         |       |                                                |       |   |   |
| Net change in cash and  cash equivalents                                     |       | (222,661                                            | )          | (106,412 | ) |
|                                                                         |       |                                                |       |   |   |
| Cash and cash  equivalents at beginning of period                            |       | 1,153,840                                           |       | 877,933 |   |
|                                                                         |       |                                                |       |   |   |
| Cash and cash  equivalents at end of period                                  |       | $                                                   | 931,179    |   | $ | 771,521 |   |
|                                                                         |       |                                                |       |   |   |
| Noncash Investing and  Financing Activities:                                 |       |                                                |       |   |   |
| Issuance of  stock for convertible notes interest                            |       | $                                                   | 86,167     |   | $ | — |   |
|                                                                         |       |                                                |       |   |   |
| Cash Paid for Interest  and Income Taxes:                                    |       |                                                |       |   |   |
| Interest expense                                                             |       | $                                                   | —     |   | $ | — |   |
| Income taxes                                                                 |       | $                                                   | —     |   | $ | — |   |

 

See AccompanyingNotes to Condensed Consolidated Financial Statements

F-6

----

**GRAYMARKPRODUCTIONS, INC.**

**Notes toCondensed Consolidated Financial Statements**

**(Unaudited)**

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

Note 1 – Nature ofBusiness

GraymarkProductions, Inc. (the “Company”) is organized in Oklahoma and is an independentproducer and distributor of film entertainment content.  The Company began operations in 2001 asGraymark Productions, L.L.C. (“Graymark LLC”), all of the assets of which wereacquired by the Company through our incorporation-reorganization, effective August18, 2003.

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

Note 2 – Summaryof Significant Accounting Policies

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

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

F-7

----

Under the terms ofthe Out of the Blue operating agreement, the Company has 100% voting control ofOut of the Blue.  The Hunt, Surveillanceand Soul’s Midnight are 100% owned by the Company.

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

*Revenuerecognition* – Revenues from the sale of the rights to a filmare recognized when the feature film is available to the distributor forexploitation and no conditions for delivery exist, which under most salescontracts requires that full payment has been received from thedistributor.  Revenues from the theatricaldistribution of motion pictures are recognized when motion pictures areexhibited.  Revenues from video sales arerecognized on the date that video units are made widely available for sale byretailers.  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.

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

Investment infilms is stated at the lower of amortized cost or estimated fair value on anindividual film basis.  The valuation ofinvestment in films is reviewed on a title-by-title basis, when an event 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.  Additionalamortization is recorded in the amount by which the unamortized costs exceedthe estimated fair value of the film. Estimates of future revenue involve measurement uncertainty and it istherefore possible that reductions in the carrying value of investment in filmsmay be required as a consequence of changes in management’s future revenueestimates.

*RecentlyIssued Accounting Standards* – 

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

*SFAS155* – In February 2006, the FASB issued Statement No. 155, *“Accounting for Certain Hybrid Financial Instruments”*(“SFAS 155”), which amends FASB Statements No. 133 and 140.  This Statement permits fair valueremeasurement for any hybrid financial instrument containing an embeddedderivative that would otherwise require bifurcation, and broadens a QualifiedSpecial Purpose Entity’s (“QSPE”) permitted holdings to include passivederivative financial instruments that pertain to other derivative financialinstruments.  This Statement is effectivefor all financial instruments acquired, issued or subject to a remeasurementevent occurring after the beginning of an entity’s first fiscal year beginningafter September 15, 2006.  This Statementhas no current applicability to the Company’s financial statements.  Management plans to adopt this Statement onJanuary 1, 2007 and it is anticipated that the initial adoption of thisStatement will not have a material impact on the Company’s financial position,results of operations, or cash flows.

*FIN48* – In June 2006, the FASB issued Interpretation 48, *“Accounting for Uncertainty in Income Taxes”*(“FIN 48”), an interpretation of FASB Statement No. 109, *“Accounting for Income Taxes.”*  FIN 48 clarifies the accounting and reportingfor income taxes where interpretation of the law is uncertain.  FIN 48 prescribes a comprehensive model forthe

F-8

----

financialstatement recognition, measurement, presentation and disclosure of income taxuncertainties with respect to positions taken or expected to be taken in incometax returns.  FIN 48 is effective forfiscal years beginning after December 15, 2006. This Statement has no current applicability to the Company’s financialstatements.  Management plans to adoptthis Statement on January 1, 2007 and it is anticipated that the initialadoption of FIN 48 will not have a material impact on the Company’s financialposition, results of operations, or cash flows.

*SFAS157* – In September 2006, the FASB issued Statement No. 157, *“Fair Value Measurements”*  (“SFAS No. 157”).  SFAS 157 addresses how companies shouldmeasure fair value when they are required to use a fair value measure forrecognition or disclosure purposes under GAAP. SFAS 157 defines fair value, establishes a framework for measuring fairvalue and expands disclosures about fair value measurements.  SFAS 157 is effective for fiscal yearsbeginning after November 15, 2007, with earlier adoption permitted.  Management is assessing the impact of theadoption of this Statement.

*SFAS158* – In September 2006, the FASB issued Statement No. 158, *“Employers’ Accounting for Defined Benefit Pensionand Other Postretirement Plans”* (“SFAS 158”), an amendment of FASBStatements No. 87, 88, 106 and 132(R). SFAS 158 requires (a) recognition of the funded status (measured as thedifference between the fair value of the plan assets and the benefitobligation) of a benefit plan as an asset or liability in the employer’sstatement of financial position, (b) measurement of the funded status as of theemployer’s fiscal year-end with limited exceptions, and (c) recognition ofchanges in the funded status in the year in which the changes occur throughcomprehensive income.  The requirement torecognize the funded status of a benefit plan and the disclosure requirementsare effective as of the end of the fiscal year ending after December 15,2006.  The requirement to measure the planassets and benefit obligations as of the date of the employer’s fiscal year-endstatement of financial position is effective for fiscal years ending afterDecember 15, 2008.  This Statement has nocurrent applicability to the Company’s financial statements.  Management plans to adopt this Statement onDecember 31, 2006 and it is anticipated the adoption of SFAS 158 will not havea material impact to the Company’s financial position, results of operations,or cash flows.

*SAB108* – In September 2006, the Securities Exchange Commissionissued Staff Accounting Bulletin No. 108 (“SAB 108”).  SAB 108 addresses how the effects of prioryear uncorrected misstatements should be considered when quantifyingmisstatements in current year financial statements.  SAB 108 requires companies to quantifymisstatements using a balance sheet and income statement approach and toevaluate whether either approach results in quantifying an error that ismaterial in light of relevant quantitative and qualitative factors.  When the effect of initial adoption ismaterial, companies will record the effect as a cumulative effect adjustment tobeginning of year retained earnings and disclose the nature and amount of eachindividual error being corrected in the cumulative adjustment.  SAB 108 will be effective beginning January1, 2007 and it is anticipated that the initial adoption of SAB 108 will nothave a material impact on the Company’s financial position, results ofoperations, or cash flows.

Note 3 –Investment in Films

|                                                           | ** ** | **September 30,  2006** | ** ** | **December 31,  2005** | ** ** |
|-----------------------------------------------------------|------------|------------------------------|------------|-----------------------------|------------|
|                                                      |       |                         |       |                        |       |
| Released, net of  accumulated amortization and impairment |       | $                            | 1,882,278  |                        | $          | 2,012,439 |   |
| Completed and  not released                               |       | —                       |       | 375,790                     |       |
| In progress                                               |       | 575,846                      |       | 1,070,188                   |       |
| In development                                            |       | —                       |       | —                      |       |
|                                                      |       |                         |       |                        |       |
| Total                                                     |       | $                            | 2,458,124  |                        | $          | 3,458,417 |   |

 

TheCompany estimates that 100% of the unamortized investment in films at September30, 2006 will be amortized within the next three years.  Approximately $1,702,000 of film costs areexpected to be amortized during the next twelve months.  No participation liabilities are expected tobe paid during the next 12 months.

F-9

----

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

Note 4 –Convertible Note Payable

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

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

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

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

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

Note 5 – FilmObligations

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

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

 

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Note 6 – FilmProfit Participation and Contingent Compensation

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

·                                          100% of revenue and proceeds from therights 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 from therights sales, distribution and/or any and all exploitation of the Picture.  “Net Profits” is defined as the sum remainingafter deduction of third party distribution fees; cash deferments to 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 profits”,as negotiated between the participants, are paid out as contingent compensationfor creative participants in a motion picture film.  The participations negotiated by theProduction Company for *Cloud 9*total 23.5% of which the Company’s interest in *Cloud9* is burdened by one-half of these net profit participations.  The Company’s residual profits interest in *Cloud 9* is 30.6% after giving effect tothe gross and net profits participations given pursuant to contingentcompensation arrangements and the co-finance agreements (see Note 5 – 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.

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

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

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

 

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Note 7 –Distribution Agreements

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

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

 

Note 8 – CapitalStructure

During 2006, theCompany has issued 122,956 shares of common stock to pay accrued interest dueon the Company’s convertible notes payable.

Note 9 – StockOptions and Warrants

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

To estimate thegrant-date fair value of its stock options, the Company uses the Black-Scholesoption pricing model with the following assumptions used for grants:  weighted average risk free interest rate of5.0%; no dividend yield; volatility of 46%; and expected life less than fiveyears.  The fair value of the optionswere based on the difference between the present value of the exercise price ofthe option and the estimated fair value price of the common share.  The fair value of the 140,000 options wasestimated to be $38,009 which was recorded as compensation expense over therequisite service period of June 15, 2006 to October 1, 2006.

Note 10 – RelatedParty Transactions

The Company’scorporate offices are located in a building owned by an entity controlled byone of our greater

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than 5%shareholders.  The office space isoccupied under a month to month lease. Rent expense applicable to the corporate offices for the nine monthsended September 30, 2006 and 2005 was $14,570 and $4,709, respectively.

Note 11 –Subsequent Events

In October 2006,the Company issued 150,000 shares of common stock to pay accrued interest of$30,000 due, as of September 30, 2006, on the Company’s convertible notespayable.

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