**SECURITIES AND EXCHANGE COMMISSION**

**WASHINGTON, D.C. 20549**

 

**FORM 10-K/A**

**Amendment No. 1 to Form 10-K**

 

**ANNUAL REPORT PURSUANT TO SECTION 13 OR 15(d) OF THESECURITIESEXCHANGE ACT OF 1934**

 

| **For the fiscal year ended:** | **Commission  File Number:** |
|--------------------------------|------------------------------|
| **December 31,  2002**         | **0-22545**                  |

 

**DSI TOYS, INC.**

(Exact name of Registrant as specified in its charter)

** **

| **Texas**                                                             |   | **74-1673513**                        |
|-----------------------------------------------------------------------|--------|---------------------------------------|
| (State or other jurisdiction  of incorporation or organization)       |   | (I.R.S. Employer  Identification No.) |
|                                                                  |   |                                  |
| **10110 West Sam  Houston Parkway South,  Suite 150  Houston, Texas** |   | **77099**                             |
| (Address of principal executive offices)                              |   | (Zip Code)                            |

 

Registrant’s telephone number, including area code:  **(713) 365-9900**

 

**Securitiesregistered pursuant to Section 12(b) of the Act:**

 

| **Title of each class**      |   | **Name of each exchange on which  registered** |
|------------------------------|--------|------------------------------------------------|
| Common Stock, $.01 par value |   | Over the Counter Bulletin Board                |

 

**Securitiesregistered pursuant to Section 12(g) of the Act:**

 

None

 

Indicate by check mark whether the Registrant (1) hasfiled all reports required to be filed by Section 13 or 15(d) of the SecuritiesExchange Act of 1934 during the preceding 12 months (or for such shorter periodthat the Registrant was required to file such reports), and (2) has beensubject to such filing requirements for the past 90 days.  Yes  ý   No  o

 

Indicate by check mark ifdisclosure of delinquent filers pursuant to Item 405 of Regulation S-K is notcontained herein, and will not be contained, to the best of Registrant’sknowledge, in definitive proxy or information statements incorporated by referencein Part III of this Form 10-K or any amendment to this Form 10-K.  o

 

Indicate by check mark whetherthe Registrant is an accelerated filer (as defined in Rule 12b-2 of the Securities Exchange Act of 1934). Yes  o    No   ý

 

The aggregate market value of thevoting common stock held by non-affiliates of the Registrant as of June 28,2002 was $1,899,183.

 

As of May 1, 2003 there were10,866,365 shares of common stock, $.01 par value, outstanding.

 

 

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This Amendment No. 1 on Form 10-K/A (this “Amendment”)is being filed in order to amend the Registrant’s Annual Report on Form 10-Kfor the fiscal year ended December 31, 2002, filed with the Securities andExchange Commission on March 28, 2003 (“Form 10-K”) to revise information inPart II, Item 7. Management’s Discussion and Analysis of Financial Conditionand Results of Operations – *Fiscal Year 2002 Compared to Fiscal Year 2001*,*FiscalYear 2001 Compared to Fiscal Year 2000*, and *Liquidity and Capital Resources*;Part II, Item 7A. Quantitaitve and Qualitative Disclosures about Market Risk;and Notes 2 and 7 to the Consolidated Financial Statements.

 

This Amendment is limited in scope to the portions ofthe Form 10-K set forth above and does not in any way amend, update or changeany other items or disclosures contained in the Form 10-K.

 

**PART II**

 

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

 

**General**

 

The following discussion and analysis should be readin conjunction with the financial statements and notes thereto, and theinformation included elsewhere herein.

 

The Company designs, develops, markets and distributeshigh quality, innovative dolls, toys and consumer electronics products.  Core products include *Tech-Link*® communicationsproducts, KAWASAKI® electronic musical instruments, *GearHead*TM remote controlvehicles, *DJSkribble*®*’s Spinheads*TM musical figures and toys, afull range of special feature doll brands including *Sweet Faith®*, *Pride &Joy®*, *Too Cute Twins*®, *Lovin’ TouchTM*life-like dolls,*Baby KnowsHer NameTM*talking doll, *Childhood VersesTM*nursery rhyme dolls*, LittleDarlings®* dolls and Collectible Plush, including *Kitty,Kitty, Kittens®*and*Puppy, Puppy, Puppies*.

 

The Company has three major product categories:Juvenile Audio Products, Girls’ Toys and Boys’ Toys.

 

*JuvenileAudio Products* - The Juvenile Audio Product category consistsof Youth Electronics products and Musical Instruments.  Products in the Youth Electronics lineinclude walkie-talkies, wrist watch walkie-talkies,  audio products and novelty electronic products.  The category brands include *Tech-Link*®communications products, walkie-talkies and bike alarms, the Company’s new *BioScan*TM*RoomGuardianTM*and DJ Skribble*®’s SpinheadsTM*, a new line of musical toys*.*  The Musical Instrument line includes thebranded line of KAWASAKI® guitars, drum pads, saxophones and keyboards.

 

*Girls’Toys* - The Girls’ Toys product category includes dolls, interactiveplush toys, play sets, accessories, and girls’ activity toys.  The Girls’ Toys portfolio of brands includes*BabyKnows Her NameTM, Lovin’ TouchTM, Childhood VersesTM, Pride & Joy®,*and*LittleDarlings®,*along with interactive plush products and girls’ activityproducts such as*Twist and Twirl BraiderTM.*

 

*Boys’Toys -* The Boys’ Toys product category includes radio controland infra-red control vehicles.  Thebrands in this product category are *GearHead*TM radio control vehicles,including the *Insector*®, and the unique ultra-articulated *StreetSavageTM*and *Crazy Taxi*®, based on the popular Sega ofAmerica, Inc. arcade and home video game of the same name.

 

*ProductIntroductions* - New product introductions during 2002included KAWASAKI® foldable keyboards and drumpads, the *LazerDoodle*TM electronicdrawing toy, the *Somersault Sara*TM interactive electronic doll, and the *Dual FusionTM*radio control vehicle.

 

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**SignificantAccounting Policies**

 

Our significant accounting policies are more fullydescribed in Note 2 to our consolidated financial statements.  Certain of our accounting policies requirethe application of significant judgment by management in selecting theappropriate assumptions for calculating financial estimates.  By their nature, these judgments are subjectto an inherent degree of uncertainty. These judgments are based on our historical experience, terms withcurrent customers, our observance of trends in the industry, informationprovided by our customers and information available from other outside sources,as appropriate.  Our significantaccounting policies include:

 

*RevenueRecognition –* The Company recognizes revenue when productsare shipped and title passes to unaffiliated customers.  In most cases, title transfers to ourcustomers when the product has been presented to shipment forwarders on FOBAsia sales and when the product is picked up from our distribution facilitieson domestic sales. Provision is made currently for  returns of defective and slow-moving merchandise, priceprotection and customer allowances and is included as a reduction of accountsreceivable and sales. The provision is primarily based on known returns andallowances provided to customers for sales activities, as well as anhistorically based estimate of potential unknown customers’ allowances andclaims.  Shipping and handling revenuesare not included in net sales, rather they are included as a contra-expense incost of goods sold with the shipping and handling costs associated with inboundand outbound freight. The Securities and Exchange Commission’s Staff AccountingBulletin (SAB) No. 101, “Revenue Recognition,” provides guidance on theapplication of generally accepted accounting principles to selected revenuerecognition issues.  The Company hasconcluded that its revenue recognition policy is appropriate and in accordancewith generally accepted accounting principles and SAB No. 101.

 

*Allowancefor Doubtful Accounts*– Accounts receivable are reduced by an allowance for amounts that maybecome uncollectible in the future.  TheCompany’s estimate for its allowance is based on two methods which are combinedto determine the total amount reserved. First, the Company evaluates specific accounts where we have informationthat the customer may have an inability to meet its financial obligations(bankruptcy, etc.).  In these cases, theCompany uses its judgement, based on the best available facts andcircumstances, and records a specific reserve for that customer against amountsdue to reduce the receivable to the amount that is expected to becollected.  These specific reserves arereevaluated and adjusted as additional information is received that impacts theamounts reserved.  Second, a generalreserve is established for all other customers based on historical collectionand write-off experience.  Ifcircumstances change, the Company’s estimates of the recoverability of amountsdue the Company could be reduced by a material amount.

 

*Allowancefor Returns and Defectives*– The Company records a provisionfor estimated sales returns and defectives on sales in the same period as therelated revenue is recorded.  Our salesto customers generally do not give them the right to return products or tocancel firm orders.  However, as iscommon in the industry, we sometimes accept returns for stock balancing andnegotiate accommodations to customers, which include price discounts, creditsand returns, when demand for specific product falls below expectations.  Additionally, customers are given credit forany defective products they may have received. The allowance estimates are based on historical sales returns anddefective rates, analysis of credit memo data and other known factors.  If the data the Company uses to calculatethese estimates does not properly reflect future returns and defectives,revenue could be overstated and future operating results adversely affected.

 

*Inventories*– Inventory is valued at the lower of cost or market.  The Company reviews the book value of slow-moving items,discounted product lines and individual products to determine if these itemsare properly valued.  The Companyidentifies these items and assesses the ability to dispose of them at a pricegreater than cost.  If it is determinedthat cost is less than market value, then cost is used for inventoryvaluation.  If market value is less thancost, then the Company establishes a reserve for the amount required to valuethe inventory at market.  If the Companyis not able to achieve its expectations of the net realizable value of theinventory at its current value, the Company would adjust its reserveaccordingly.

 

*DeferredTaxes* – The Company recognizes deferred tax assets andliabilities based on the differences between the financial statement carryingamounts and the tax bases of assets and liabilities.  Generally accepted accounting principles require that we reviewdeferred tax assets for recoverability and if needed, establish a valuationallowance for those amounts deemed unrecoverable.  The review considers historical taxable income, projected futuretaxable income, and the expected timing of the reversals of temporarydifferences.  Deferred tax 

 

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assets of the Company are primarily the result of unused net operatingloss carry-forwards and foreign tax credits which expire over a range of years.

 

The Company recorded a $4.0 million charge in fiscalyear 2002 to establish a valuation allowance for all of its deferred taxassets, including $2.2 million of deferred tax assets related to prioryears.  The valuation allowance wasdetermined in accordance with the provisions of Statement of FinancialAccounting Standards (SFAS) 109, “Accounting for Income Taxes,” which placesprimary importance on the Company’s cumulative operating results in the mostrecent periods when assessing the need for a valuation allowance.  In 2001, the Company recorded a valuationallowance of $566,000 related to foreign tax credits expiring in 2002, as itwas determined that it was more likely than not that these credits would not berealized.

 

*Goodwill*– The Company made an acquisition in 2000 that included a significant amount ofgoodwill and other intangible assets. Under generally accepted accounting principles through December 31,2001, these assets were amortized over their useful lives, and were to betested periodically to determine if they were recoverable from future operatingearnings over their useful lives.  Werecorded goodwill amortization expense of $513,396 and $513,360, respectivelyin 2001 and 2000.

 

Effective in 2002, goodwill is no longer amortized butis subject to at least an annual impairment test based on its estimated fairvalue.  Other intangible assets meetingcertain criteria will continue to be amortized over their useful lives and alsosubject to an impairment test.  Thereare many assumptions and estimates underlying the determination, includingfuture cash flow and operating results. Management engaged an independent company to assist in valuing the Company’sgoodwill as of December 31, 2002 and 2001. Based on these reviews, no impairment charge is required.

 

**Resultsof Operations**

 

The following table sets forth the Company’s resultsof operations as a percentage of net sales for the fiscal years indicated:

 
|                                          |   | **2002** |   | **2001** |   | **2000** |   |
|-----------------------------------------------|--------|----------|--------|----------|--------|----------|--------|
| Net  sales                                    |   | 100.0    | %      | 100.0    | %      | 100.0    | %      |
| Cost  of goods sold                           |   | 77.8     |   | 70.7     |   | 71.1     |   |
| Gross  profit                                 |   | 22.2     |   | 29.3     |   | 28.9     |   |
| Selling,  general and administrative expenses |   | 32.1     |   | 29.6     |   | 28.9     |   |
| Operating  income (loss)                      |   | (9.9     | )      | (0.3     | )      | 0.0      |   |
| Interest  expense                             |   | (1.8     | )      | (1.7     | )      | (2.1     | )      |
| Other  income                                 |   | 0.2      |   | 0.4      |   | 0.2      |   |
| Income  (loss) before income taxes            |   | (11.5    | )      | (1.6     | )      | (1.9     | )      |
| Benefit  from (provision for) income taxes    |   | (4.6     | )      | (0.5     | )      | 0.7      |   |
|                                          |   |     |   |     |   |     |   |
| Net  income (loss)                            |   | (16.1    | )%     | (2.1     | )%     | (1.2     | )%     |

 

***Fiscal Year 2002 Compared to Fiscal Year 2001***

 

*NetSales.*  Net salesduring fiscal 2002 decreased $18.1 million, or 26.7%, to $49.8 million, from$67.9 million in fiscal 2001.  Thedecrease is primarily due to the continued overall sluggish U.S. retail climateand shifts in consumer preferences that were not met by the Company’s productline. Additionally, mechanical engineering redesign work required on two keypromoted products resulted in an approximate four-week production delay.  The delay, combined with the time lost dueto the west-coast dock strike, limited the availability of key products for theearly Christmas shipment window and resulted in cancelled orders. Thoughproduction was caught-up quickly, the shorter available retail selling periodand retailer’s concerns about reductions in allocations by consumers forChristmas buying contributed to reduced ordering activity.

 

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Net sales of Juvenile Audio Products in fiscal 2002decreased $6.3 million, or 23.8%, to $20.1 million, from $26.3 million in 2001.The major product groups in this category are Youth Electronics (formerly YouthCommunications) and Musical Instruments. Youth Electronics provided $7.6million in 2002 sales, a decrease of $7.0 million, or 48.5%, when compared to2001 sales of $14.6 million.  The YouthElectronics decrease is due to continued sales declines in children’swalkie-talkies, reflecting a product shift to role-play and spy related productsand continued price pressures, and a decrease in sales of the *e-BrainTM*personal communicator, which was introduced in the fall of 2001.  Musical Instruments increased $800,000, or7.3%, to $12.5 million in 2002 sales as compared to $11.7 million in 2001sales.  The increase reflects theintroduction in 2002 of new folding instruments, the Pro Series lines ofkeyboards and drum-pads, which was partially offset by declines in sing-a-longproducts and other de-emphasized musical instruments.

 

Net sales of Girls’ Toys decreased $11.5 million, or36.6%, to $20.0 million in fiscal 2002 from $31.5 million during fiscal 2001.The decrease reflects reduced sales of the *EliteTM, Little Darlings®*, and *Pride andJoy®* doll lines, interactive dolls such as *Too Cute Twins®, Susie So SmartTM*and *HushL’l Baby®*, and the *Air Nails SalonTM* girls activity toy.  This decrease was partially offset by salesof 2002 production introductions, the *Somersault SaraTM* doll and the girlsactivity toy, *Twist and Twirl BraiderTM*.

 

Net sales of Boys’ Toys decreased $2.4 million, or27.4%, to $6.2 million during fiscal 2002 from $8.6 million in fiscal 2001.Reduced sales of the *Insector®* R/C vehicle, introduced in 2000,and 2001 close-out sales of *Data-DawgTM*, were partially offset by salesof the new 2002 R/C product, *Dual FusionTM*.

 

Net sales of products in other categories increased$2.0 million, or 133.1%, to $3.5 million in fiscal 2002 from $1.5 million in2001.  The increase is primarily drivenby sales of the new 2002 drawing-toy, LazerDoodle, and was partially offset bydecreases in sales of doorbells, preschool products and other electronic games.

 

 Net sales tocustomers in countries other than the United States by the Company’s foreignsubsidiary in fiscal 2002 decreased $2.3 million, or 19.4%, to $9.4 million,compared to 2001 net sales of $11.7 million. The decreased sales reflect thesoft overall world retail market, the effect of exchange rate issues,competition with knock-offs of proprietary products, and political instabilityin several countries and regions. Additionally, production delays that limited the availability of keyproducts resulted in some canceled orders and lost sales.

 

*GrossProfit*. Gross profit decreased $8.8 million or 44.4%, to$11.1 million during fiscal 2002 from $19.9 million in fiscal 2001.  Gross profit as a percentage of net salesdecreased to 22.2% during fiscal 2002 from 29.3% in fiscal 2001.  The gross profit dollar decrease reflectsreduced sales, in conjunction with the lower percentage of net sales duringfiscal 2002 over 2001.  The percentagedecrease reflects an increased provision for slow-moving inventory, price pressuresdue to the slow moving U.S. economy and increased allowances required to moveinventory in customers stores.

 

*Selling,General and Administrative Expenses*. Selling, general andadministrative expenses decreased $4.1 million to $16.0 million, or 20.6%, from$20.1 million in fiscal 2001.  Decreasesoccurred in nearly all areas in 2002, including a $1.4 million reduction in baddebt expense due to the 2001 provision for Kmart’s bankruptcy filing.  Additionally, employee expense, travel andentertainment, and general office expense decreased approximately $988,000,$203,000 and $482,000 respectively, due in part to the closure of the Company’sNew Jersey office in the fourth quarter of 2001 and management’s focus onreducing general office expense.  Professionalfees decreased approximately $168,000, primarily due to the expiration of aconsulting agreement with a director (and former CEO).  Sales commissions and advertising expensedecreased $240,000 and $155,000 respectively, reflecting the lower sales amounts.  A $112,000 reduction in depreciation expenseas assets became fully depreciated was offset by a $146,000 increase in otherexpenses, including product insurance and losses on assets sales orabandonment. Goodwill amortization decreased $514,000, due to the adoption infiscal 2002 of a new accounting pronouncement that eliminated amortization.

 

*InterestExpense.***** Interest expense decreased $243,000, or 21.1%, to $912,000 infiscal 2002 from $1.2 million in fiscal 2001 as a result of lower interestrates on the Company’s floating rate debt.

 

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*IncomeTaxes.***** The Company generated in fiscal 2002 a loss before income taxes of$5.7 million compared to a $1.0 million loss before income taxes in fiscal2001. These losses, combined with a $1.3 million loss before income taxes infiscal 2000, provide negative evidence of the ability to realize the future taxbenefits associated with the Company’s deferred tax assets. As a result, theCompany recorded a deferred tax asset valuation allowance of $4.0 million in2002, consisting of $2.2 million generated in prior years and $1.8 million forthe fiscal year ended 2002. Additionally, the Company incurred and recorded a foreign tax expense ofapproximately $70,000 in 2002.

 

*NetLoss.*** **TheCompany’s net loss for fiscal 2002 was $8.0 million compared to a net loss of$1.4 million for fiscal 2001.  Theprimary driving factor was the significant decrease in sales and margin amountsin 2002 compared with 2001, which more than offset gains made in reducingselling, general, and administrative expense.

 

***Fiscal Year 2001 Compared to Fiscal Year 2000***

 

*NetSales*.  Net salesduring fiscal 2001 decreased $2.5 million, or 3.6%, to $67.9 million from $70.4million in fiscal 2000. The decrease was due primarily to reduced sales ofBoys’ Toys and Juvenile Audio products, partially offset by sales of Girls’Toys.

 

Net sales of Juvenile Audio Products decreased $1.5million, or 5.2%, to $26.3 million during fiscal 2001 from $27.8 million duringfiscal 2000.  The major product groupsin this category are Youth Electronics and Musical Instruments, providing $14.6million and $11.7 million respectively in 2001 sales, compared to $14.2 millionand $13.6 million respectively in 2000. The Youth Electronics product group increase reflects sales of *e-Brain*TMpersonal communicator, introduced in fall 2001, partially offset by decreasesin walkie-talkie sales, due to increased competition in non-brandedproducts.  Musical Instruments salesdecreased primarily in keyboards, which is a result of decreased warehouse clubbusiness with one non-primary customer.

 

Net sales of Girls’ Toys increased $3.5 million, or12.4%, to $31.5 million in fiscal 2001 from $28.0 million in fiscal 2000.  The sales increase in Girls’ Toys was drivenby the television promoted *Too Cute TwinsTM* doll line, the girlsactivity toy *Air Nails*Salon*TM* and the plush toy *Kitty Kitty Kittens®*, whichwas partially offset by declines in sales of dolls in the *Pride & Joy®*, *Elite*®and other general doll lines.

 

Net sales of Boys’ Toys decreased $4.1 million, or32.4%, to $8.6 million during fiscal 2001 from $12.7 million in fiscal2000.  The decrease is due primarily tothe discontinuation of the *Blockmen®* line of products sold in 2000and decreased sales of the primary 2000 R/C vehicle, *Insector®*, and other boys’items, which was partially offset by sales of the new 2001 R/C vehicle, *StreetSavageTM*.

 

Net sales of products in other categories decreasedapproximately $460,000, or 0.5%, to $1.5 million during fiscal 2001 from $1.9million in fiscal 2000.  The decrease isattributable to lower sales of games, video phones, doorbells and otherdiscontinued lines, which was partially offset by increased sales of preschoolproducts.

 

Net sales to customers in countries other than theUnited States by the Company’s foreign subsidiary decreased $1.6 million, or12.0%, to $11.7 million during fiscal 2001, compared to $13.3 million in fiscal2000.  The decrease reflects thestrength of the U.S. dollar against foreign currencies, thereby negativelyaffecting sales distributors potential retail price points and margins.  International net sales were 17.2% of totalnet sales for fiscal 2001 as compared to 18.9% of total net sales in fiscal2000.

 

*GrossProfit**.***  Gross profit decreased approximately$400,000, or 2.0%, to $19.9 million during fiscal 2001 from $20.3 million infiscal 2000.  Gross profit as apercentage of net sales increased to 29.3% during fiscal 2001 from 28.9% infiscal 2000.  The percentage increasereflects the continued focus on sales of proprietary products, such as the *Too CuteTwinsTM* doll, *Air Nails Salon*TM girls’ activity toy, andthe *StreetSavage*TM R/C vehicle, versus lower margin, more volume-drivennon-proprietary products.  Proprietaryproducts, which were 80% of our total net sales in 2001, generate a highermargin percentage.

 

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*Selling,General and Administrative Expenses.** ***Selling,general and administrative expenses decreased $200,000 to $20.1 million, or1.3%, during fiscal 2001 from $20.3 million in fiscal 2000.  The decrease reflects reductions ofapproximately $945,000 and $846,000 in advertising and commission expenses dueto lower sales volume.  Additionally,professional fees decreased $356,000, as expenses associated with the 2000Meritus merger were non-reoccuring, along with a $120,000 decrease in variousoperating expenses.  Partiallyoffsetting these decreases was an approximate $525,000 increase in employeecompensation, due to employee additions and a significant increase inreceivables’ bad debt expense. The $1.7 million provision for uncollectibleaccounts receivable is primarily related to the January 2002 bankruptcy filingof Kmart Corp.

 

*InterestExpense.* Interest expense decreased approximately $319,000,or 21.6%, to $1.2 million in fiscal 2001 from $1.5 million during fiscal2000.  The decrease was due primarily tolower interest borrowing rates in 2001 as compared to 2000.

 

*IncomeTaxes.***** In fiscal 2001, the Company generated a lossbefore income taxes of $1.0 million compared to a $1.3 million loss before incometaxes during fiscal 2000.  A significantcontributor to the 2001 loss was a $1.7 million provision for uncollectibleaccounts receivable.  The provision isnot included in taxable income for 2001, but will be included in taxable incomein a future year when the underlying receivables are written-off against theprovision.  As a result, the Companybelieves its ability to use foreign tax credits expiring in 2002 has beenpotentially negated, and therefore has recorded a $566,000 valuation allowancefor the credits in 2001.

 

*NetLoss.** ***The Company’snet loss for fiscal 2001 was approximately $1.4 million compared to a net lossof approximately $849,000 for fiscal 2000. The 2001 net loss was due in significant part to the required increasein the uncollectible receivables provision related to the Kmartbankruptcy.  The $1.7 million provisionoffset all other gains made in reduction of selling, general and administrativeexpense by management in response to the reduced 2001 sales volumes from 2000.

 

**Liquidityand Capital Resources**

 

The Company historically has funded its operations andcapital requirements by cash generated from operations and borrowings.  The Company’s primary capital needs haveconsisted of acquisitions of inventory, financing accounts receivable andcapital expenditures for product development.

 

The Company’s operating activities provided net cashof $5.2 million during fiscal 2002, consisting primarily of decreases inaccounts receivable and increases in accounts payable.  The accounts receivable decrease is due toreduced sales during the fourth quarter of 2002. This decrease, combined withdecreased third quarter sales, negatively impacted the funds available to paysuppliers and key vendors, including television advertising, resulting in asignificant increase in accounts payable. Net cash used in investing activitiesduring fiscal 2002 was approximately $2.1 million and was mostly due to capitalexpenditures.  Net cash used byfinancing activities was $1.6 million in 2002, resulting from payments onlong-term debt. The Company’s working capital at December 31, 2002, was ($6.5)million and unrestricted cash was approximately $1.7 million. See “TheRevolver.”

 

The seasonal nature of the toy business results incomplex working capital needs.  TheCompany’s working capital needs, which the Company generally satisfies throughshort-term borrowings, are greatest in the last two fiscal quarters. To managethese working capital requirements, the Company maintains credit facilitiescollateralized principally by accounts receivable and inventory.  The Company currently maintains theRevolver, and through DSI(HK), the Dao Heng Credit Facility and the StandardChartered Facility.  The Company hasguaranteed DSI(HK)’s obligations under the Dao Heng Credit Facility and theStandard Chartered Facility.

 

### *The Revolver*

### * *

The Company’s net losses for the period ended December31, 2002, and its overall financial condition resulted in the Company being outof compliance with the minimum net worth and net income covenants requiredunder the Revolver.  Therefore, theCompany’s $7.0 million debt under the Revolver as of December 31, 2002, hasbeen reclassified as a current liability. As a result, the Company’s current liabilities exceeded its currentassets by $6.5 million as of December 31, 2002. If Sunrock were to acceleratethe Revolver, which it has the option to do, the $7.0 million debt would becomeimmediately due and payable.

 

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Sunrock has recently completed a transaction withWells Fargo & Company in which Wells Fargo purchased most of  Sunrock’s existing loans.  Sunrock has retained certain creditfacilities, including the Revolver. Based on discussions with Sunrock, the Company’s management believesthat although Sunrock will not amend the Revolver, nor grant a waiver for theCompany’s non-compliance, Sunrock will not accelerate the Revolver at thistime.

 

### *Dao Heng Facilityand Standard Chartered Facility*

### * *

The Dao Heng Facility and the Standard Chartered Facilitywere obtained on December 4, 2001, and April 29, 2002, respectively, aresubject to periodic review, and may be canceled by the bank upon notice.  The Standard Chartered Facility affordsDSI(HK) a credit limit in the aggregate of up to HKD 19,000,000 (approximatelyUS $2.4 million as of December 31, 2002) in the form of a line of creditfinancing facility based on actual shipments of product and opened letters ofcredit.  The Dao Heng Facility affordsDSI(HK) a credit limit in the aggregate of up to US$6,000,000. The Company hasguaranteed DSI(HK)’s obligations under the Dao Heng Credit Facility and theStandard Chartered Facility.

 

### *AdditionalFinancing*

### * *

On March 19, 2001, the Company issued to MVII anInvestment Warrant to acquire 1.8 million shares of the Company’s common stockat a purchase price of $2.7 million. The Investment Warrant was exercisable in whole or in part for aten-year period beginning on June 3, 2002. In connection with the issuance of the Investment Warrant, the Companyand MVII entered into a Registration Rights Agreement, pursuant to which MVIIwas granted certain piggyback registration rights with respect to the shares ofthe common stock underlying the Warrant. Shares of common stock acquired by MVII upon exercise of the Warrant aresubject to the terms of a Shareholders’ and Voting Agreement dated as of April5, 1999, among MVII and certain of the Company’s other shareholders.  Proceeds from the sale of the InvestmentWarrant were used by the Company for current working capital.

 

On January 31, 2002, at the request of Nasdaq and withthe agreement of MVII, the Company issued an amended and restated InvestmentWarrant, which amended and restated in its entirety the Investment Warrant byremoving all anti-dilution provisions.  In addition, the Company and MVII entered into an Amended andRestated Registration Rights Agreement, which amended and restated in itsentirety the Registration Rights Agreement, by removing all of the provisions regardingthe anti-dilution provisions of the original Investment Warrant.

 

On August 21, 2002, MVII converted the pre-paidInvestment Warrant into 1.8 million shares of common stock.  Upon issuance of these shares, MVII directlyowned 5,994,238 shares of common stock.

 

In connection with the acquisition of MeritusIndustries, Inc., in January 2000, the Company borrowed $5 million from MVII,evidenced by a promissory note dated January 7, 2000 (the “MVII Note”).  The Company re-borrowed on March 6, 2002, May21, 2002, and March 10, 2003 a total of $1.35 million of the original principalthat the Company had paid on the MVII Note. The proceeds were used to finance the normal business operations of theCompany.

 

On August 19, 2002, the Company executed a Guaranteein favor of Standard Chartered Bank, guaranteeing the Standard CharteredFacility on behalf of DSI(HK) up to an amount not to exceed HKD 19,000,000(approximately US$2.4 million at December 31, 2002).  The Revolver was amended on August 14, 2002, to permit thisGuarantee.

 

The Company is obligated to make future minimumroyalty payments under certain of its license agreements.  As of December 31, 2002, the Company wasrequired to make an aggregate of approximately $250,000 in payments ofguaranteed royalties under certain licenses in fiscal 2002 and $835,000thereafter through fiscal 2007. Included in these amounts, are minimum royalties due Kawasaki under aSeptember 11, 2002 amendment to the original license agreement, extending thelicense through 2007.

 

The Company made approximately $1.5 million in capitalexpenditures in fiscal 2002 consisting primarily of purchases of tools, moldsand information technology systems.

 

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The Company purchases goods, services and suppliesfrom a number of vendors.  The Companycurrently is in arrears in making its payment obligations to certain of thesevendors.

 

### *Going Concern*

### * *

The Company’s viability as a going concern isdependent upon successful negotiations with Sunrock, a new lender, or asubstantial capital infusion, as well as sustained profitable operations. Theaccompanying financial statements do not include any adjustments that might benecessary if the Company is unable to continue as a going concern.

 

To the extent the Company’s cash reserves and cashflows from operations are insufficient to meet future cash requirements, theCompany will need to successfully raise additional capital through an equityinfusion or the issuance of debt.  TheCompany’s executive management believes that the Company will be required toeither obtain a new revolving loan or obtain necessary additional capital toallow the Company to continue its normal operations for the foreseeable future.However, there can be no assurance the Company will meet its projected operatingresults or be successful either in obtaining additional capital, or obtaining anew revolving loan.

 

The Company has held discussions and negotiations withseveral lenders regarding a credit facility to replace the Revolver.  Management is negotiating with one of thoseinstitutions regarding a replacement credit facility that will become effectiveat the close of the anticipated going private transaction, which is discussedimmediately below.  Management believes thatthe going private transaction will close and that the Company will be able tocontinue its operations until that time.

 

### *Going PrivateTransaction*

### * *

Since the Company’s cash reserves and cash flows fromoperations no longer meet its cash requirements, the Company has exploredvarious alternatives to raise additional capital.

 

In January 2003, after other alternatives for theCompany had been exhausted, E. Thomas Martin, the Chairman of the Company’sBoard of Directors, and certain other officers, directors and shareholders ofthe Company (the “Buyer Group”) began serious consideration of a going-privatetransaction.  On January 27, 2003, theBoard of Directors invited the Buyer Group to submit an offer to the Companyfor a going-private transaction.  Inanticipation of such an offer, and upon consultation with the Company’s outsidelegal counsel, the Board of Directors appointed directors M.D. Davis and JosephN. Matlock as a special committee of independent, disinterested directors forthe purpose of considering, evaluating and negotiating any proposed transactionon behalf of the shareholders who are not members of the Buyer Group and makinga recommendation to the Board of Directors. The Board of Directors alsoauthorized the special committee to retain, at the Company’s expense,independent legal and financial advisors.

 

On January 28, 2003, the Buyer Group proposed to theCompany a going-private transaction by way of a merger that would result in thepurchase of shares of common stock held by the shareholders who are not membersof the Buyer Group for $0.44 per share.

 

On January 29, 2003, the Company issued a pressrelease confirming receipt of the Buyer Group’s proposal and announcing thatits Board of Directors had formed a special committee of independent,disinterested directors.

 

The special committee considered several investmentbankers to serve as independent financial advisors to the specialcommittee.  On February 4, 2003, afterevaluating, among other factors, each considered investment bank’s expertise,responsiveness, knowledge of the Company, fees and toy industry experience, thespecial committee approved the retention of Chaffe & Associates, Inc.(“Chaffe”) as its financial advisor in connection with the proposal of theBuyer Group.

 

On February 20, 2003, the special committee met withrepresentatives of Chaffe and Haynes and Boone, LLP (“Haynes and Boone”), legalcounsel for the special committee. The purpose of the meeting was to review andconsider the $0.44 per share proposal by the Buyer Group and to discuss withthe special committee’s financial and legal advisors a negotiating strategy.Chaffe reviewed with the special committee its evaluation of the Company andthe $0.44 per share proposal based upon Chaffe’s extensive, though not yetcomplete, investigation of the Company. 

 

8

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The special committee concluded that, based on then-currentinformation, it would not approve the proposal by the Buyer Group of $0.44 pershare and discussed possible counteroffers to the Buyer Group’s proposal,including an alternative royalty structure.

 

On February 28, 2003, the special committee again metwith representatives of Chaffe and Haynes and Boone. At the meeting, Chaffereviewed with the special committee its evaluation of the Company and the $0.44per share proposal in light of Chaffe’s concluded investigation of theCompany.  The special committeeconcluded that, based on then-current information, it would not approve theproposal by the Buyer Group of $0.44 per share and discussed possiblecounteroffers to the Buyer Group’s proposal, including an alternative royaltystructure.  Legal counsel for thespecial committee was then directed to communicate the rejection of the BuyerGroup’s offer to counsel for the Buyer Group and to propose a counter offer of$0.61 per share.

 

On March 4, 2003, legal counsel for the Buyer Groupinformed the special committee that the Buyer Group had rejected the specialcommittee’s counter offer of $0.61 per share but had increased its offer to$0.47 per share.

 

On March 5, 2003, the special committee met withrepresentatives of Chaffe and Haynes and Boone to review and consider the $0.47per share counter offer by the Buyer Group and chose to make anothercounteroffer of $0.50 per share to the Buyer Group.  M.D. Davis communicated the $0.50 per share counter offer to theBuyer Group.

 

On March 5, 2003, the Buyer Group rejected the specialcommittee’s latest counteroffer and reiterated its offer to purchase the commonstock owned by the shareholders who are not members of the Buyer Group for$0.47.  The same day, the specialcommittee met with representatives of Chaffe and Haynes and Boone.  Representatives of Chaffe delivered an oralopinion (which was subsequently confirmed in writing) that, on the basis of andsubject to the matters discussed with the special committee, including finalnegotiation of the merger agreement, the proposed $0.47 per share cash pricewas fair, from a financial point of view, to the Company’s shareholders, otherthan the members of the Buyer Group. The special committee then unanimously determined that the proposedmerger was fair to, advisable and in the best interests of the Company and itsshareholders, other than the members of the Buyer Group, subject to finalnegotiation of the merger agreement. Counsel for the special committee then advised counsel for the BuyerGroup that the special committee had recommended acceptance of the BuyerGroup’s proposal of $0.47 per share, subject to final negotiation of the mergeragreement.

 

Between March 5, 2003 and March 26, 2003, the specialcommittee, the Buyer Group, the Company and representatives of Carrington,Coleman, Sloman & Blumenthal, LLP, legal counsel to the Company, and Haynesand Boone negotiated the non-price terms of the draft merger agreement.

 

On March 26, 2003, the special committee met to reviewthe terms of the merger agreement and the merger. A representative of Chaffemade a presentation to the special committee describing the analysis supportingits opinion that the $0.47 per share cash consideration was fair, from afinancial point of view, to the Company’s shareholders who are not members ofthe Buyer Group.  Based upon the opinionprovided by Chaffe and its own investigation, the special committee unanimouslyvoted to recommend that the Board of Directors approve the merger agreement andthe merger. Later that day, the Board of Directors met, received a presentationfrom Chaffe, and received the recommendation of the special committee.  Based upon the opinion of Chaffe and therecommendation of the special committee, the Board of Directors determined thatthe proposed merger was fair to, advisable and in the best interests of theCompany and its shareholders.  The Boardof Directors unanimously voted to approve the merger agreement and the mergerand recommended that the shareholders of the Company approve the mergeragreement and the merger.

 

On March 27, 2003, the merger agreement wassigned.  The Company issued a pressrelease announcing the merger agreement.

 

If the shareholders of the Company approve the merger,the Company’s shares will be delisted from the over-the-counter Bulletin Boardelectronic quotation system and its common stock will be deregistered under theSecurities Exchange Act of 1934. The Company will continue in business as aprivately-held Texas corporation.

 

9

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**RecentAccounting Pronouncements**

 

SFAS No. 141 entitled “*Business Combinations*” wasissued in June 2001 and became effective July 1, 2001.  SFAS No. 141 requires that all businesscombinations be accounted for using the purchase method of accounting, whichrequires that acquisitions be recorded at fair value as of the date ofacquisition.  The pooling-of-interestsmethod of accounting allowed under prior standards, which reflected businesscombinations using historical financial information, is now prohibited.

 

In June 2001, the FASB issued SFAS No. 142 entitled “*Goodwill andOther Intangible Assets,”* which became effective on January 1,2002.  Under SFAS No. 142, existinggoodwill is no longer amortized, but is tested for impairment using a fairvalue approach.  SFAS No. 142 requiresgoodwill to be tested for impairment at a level referred to as a reportingunit, generally one level lower than reportable segments.  SFAS No. 142 required us to perform thefirst goodwill impairment test on all reporting units within six months ofadoption.  The first step is to comparethe fair value with the book value of a reporting unit.  If the fair value of the reporting unit isless than its book value, the second step will be to calculate the impairmentloss, if any. After the initial adoption, we will test goodwill for impairmenton an annual basis and between annual tests if an event occurs or circumstanceschange that would more likely than not reduce the fair value of a reportingunit below its carrying amount.  TheCompany adopted SFAS 142 effective January 1, 2002.  Management engaged an independent company to assist in valuingthe Company’s goodwill at December 31, 2002 and 2001.  Based on these reviews, an impairment charge was not required asof December 31, 2002 and 2001.

 

In June 2001, the FASB issued SFAS No. 143, “*Accountingfor Asset Retirement Obligations.” *ThisStatement addresses financial accounting and reporting for obligationsassociated with the retirement of tangible long-lived assets and the associatedasset retirement costs.  Due to thenature of our business, this new accounting pronouncement is not expected tohave a significant impact on our reported results of operations and financialcondition.

 

In August 2001, the FASB issued SFAS No. 144, “*Accountingfor the Impairment or Disposal of Long-Lived Assets,”* whichaddresses financial accounting and reporting for the impairment or disposal oflong-lived assets.  This statementsupersedes SFAS No. 121, “*Accounting for the Impairment of Long-Lived Assetsand for Long-Lived Assets to be Disposed Of,”*and the accounting andreporting provisions of APB Opinion No. 30, “*Reporting the Results of Operations –Reporting the Effects of a Disposal of a Business and Extraordinary, Unusualand Infrequently Occurring Events and Transactions,”* for thedisposal of a segment of a business. This Statement also amends ARB No. 51, “*ConsolidatedFinancial Statements,”*to eliminate the exception to consolidationfor a subsidiary for which control is likely to be temporary.  SFAS No. 144 became effective on January 1,2002, and interim periods within fiscal 2003, with early applicationencouraged.  The provisions of thisStatement generally are to be applied prospectively. This accountingpronouncement is not expected to have a significant impact on our reportedresults of operations and financial condition.

 

In April 2002, SFAS No. 145, “Recision of FASBStatements No. 4, 44 and 64, Amendment of FASB No. 13, and TechnicalCorrections,” was issued. This statement provides guidance on theclassification of gains and losses from the extinguishment of debt and on theaccounting for certain specified lease transactions. The adoption of thisstatement is not expected to have a material impact on the Company’sconsolidated financial position, results of operations or cash flows.

 

In June 2002, SFAS No. 146, “Accounting for CostsAssociated with Exit or Disposal Activities,” was issued. This statementprovides guidance on the recognition and measurement of liabilities associatedwith disposal activities and is effective on January 1, 2003. The adoption ofthis statement is not expected to have a material impact on the Company’sconsolidated financial position, results of operations or cash flows.

 

10

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In December 2002, the FASB issued SFAS No. 148, “*Accountingfor Stock-Based Compensation – Transition and Disclosure, An Amendment ofFAS No. 123*.”  Thisstatement addresses the acceptable transitional methods when the fair valuemethod of accounting for stock-based compensation covered in SFAS No. 123is elected.  Additionally, the statementprescribes tabular disclosure of specific information in the “*Summary ofSignificant Accounting Policies*” regardless of the method used andalso required interim disclosure of similar information.  The Company has adopted this statementeffective with the fiscal year ending December 31, 2002.  The Company has not elected the fair valuemethod, but continues accounting for stock-based compensation by the intrinsicmethod prescribed by APB Opinion 25. The disclosure required by SFAS 148 is included in the Summary ofSignificant Accounting Policies.

 

In November 2002, the FASB issued FASB InterpretationNo. 45 (FIN 45), “Guarantor’s Accounting and Disclosure Requirements forGuarantees, Including Indirect Guarantees of Indebtedness of Others,” whichestablished additional accounting and disclosure requirements when anenterprise guarantees the indebtedness of others.  The enterprise providing the guarantee is required to recognize aliability for the fair value of the obligation assumed and disclose the informationin its interim and annual financial statements.  The Company does not believe this will have a significant impacton our disclosures.

 

In January 2003, the FASB issued FASB InterpretatonNo. 46 (FIN 46), “Consolidation of Variable Interest Entities, aninterpretation of ARB No. 51.”  Theinterpretation defines when and who consolidates a “variable interest entity,”or “VIE.”  This new consolidation modelapplies to entities (i) where the equity investors (if any) do not have acontrolling financial interest, or (ii) whose equity investment at risk isinsufficient to finance that entity’s activities without receiving additionalsubordinated financial support from other parties and requires additionaldisclosures for all enterprises involved with the VIE.  FIN 46 is effective during 2003 depending onwhen the VIE is created.  The Companydoes not believe this will have a significant impact on our reported results ofoperations and financial condition.

 

**MeritusAcquisition**

 

Effective January 7, 2000, the Company acquiredMeritus by way of merger.  Pursuant tothe terms of the merger, the Company acquired all of the issued and outstandingstock of Meritus for 533,208 shares of the Company’s common stock and $2.57million in other consideration paid to the shareholders of Meritus.  Contemporaneously with the merger, theCompany satisfied $4.4 million of Meritus’ debt.  The merger was accounted for using the purchase method; thereforethe Company recorded the acquired assets at their fair market value, generatinga significant  amount of goodwill.  *(See Note 2 to the Consolidated FinancialStatements.)*

 

As a result of the merger, the Company added the *Baby Beans*®brand**softbean bag dolls, *Forever Girl Friends*® brand accessories for 11-1/2” fashiondolls, and *LittleDarlings®* brand value-priced action feature dolls to its productofferings, as well as the *Elite Dolls*TM brand,**which was created byMeritus specifically to manufacture and market “*Lifetime Play DollsTM*,” aline of exquisite 18” dolls and accessories suitable for playing or collecting.

 

**Inflation**

 

The Company does not believe that inflation in theUnited States,  Europe or Asia in recentyears has had a significant effect on its results of operations.

 

**Year2000**

 

The Company did not experience any Year 2000 issueswith its internal operating systems or with its customers or vendors.  In addition, the Company did not experienceany loss in revenues due to the Year 2000 issue.

 

11

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**CautionaryStatement**

 

Certain written and oral statements made orincorporated by reference from time to time by the Company or its representativesin this Form 10-K, other filings or reports with the Securities and ExchangeCommission, press releases, conferences, or otherwise, are “forward-lookingstatements” within the meaning of the Private Securities Litigation Reform Actof 1995.  The Company is including thisCautionary Statement to make applicable and take advantage of the safe harborprovisions of the Private Securities Litigation Reform Act of 1995 for any suchforward-looking statements. Forward-looking statements can be identified by the use of terminologysuch as “believe,” “anticipate,” “expect,” “estimate,” “may,” “will,” “should,”“project,” “continue,” “plans,” “aims,” “intends,” “likely,” or other words orphrases of similar terminology. Management cautions you that forward-looking statements involve risksand uncertainties which may cause actual results to differ materially from theforward-looking statements.  For adiscussion of some of the factors that may cause actual results to differmaterially from those suggested by forward-looking statements, please readcarefully the information under Item 1, “Risk Factors”, of this Form10-K.  In addition to the Risk Factorsand other important factors detailed herein and from time to time in otherreports filed by the Company with the Securities and Exchange Commission,including Forms 8-K, 10-Q, and 10-K, the following important factors couldcause actual results to differ materially from those suggested by anyforward-looking statements.

 

*Marketplace Risks*

 

•                  Increased competitive pressure, bothdomestically and internationally, which may negatively affect the sales of theCompany’s products;

 

•                  Changes in public and consumer taste,which may negatively affect the sales of the Company’s products;

 

•                  Significant changes in the playpatterns of children, whereby they are increasingly attracted to moredevelopmentally advanced products at younger ages, which may affect brandloyalty and the perceived value of and demand for the Company’s products; and

 

•                  Possible weaknesses in economicconditions, both domestically and internationally, which may negatively affectthe sales of the Company’s products and the costs associated with manufacturingand distributing these products.

 

*Financing Considerations*

 

•                  Currency fluctuations, which mayaffect the Company’s reportable income; significant changes in interest rates,both domestically and internationally, which may negatively affect theCompany’s cost of financing both its operations and investments.

 

•                  The ability of the Company to obtainthe financing required for its ongoing operations, which may negatively affectthe ability of the Company’s viability as a going concern.

 

*Other Risks*

 

•                  Changes in laws or regulations, bothdomestically and internationally, including those affecting consumer productsor trade restrictions, which may lead to increased costs or interruption innormal business operations of the Company;

 

•                  Future litigation or governmentalproceedings, which may lead to increased costs or interruption in normalbusiness operations of the Company; and

 

•                  Labor disputes, which may lead toincreased costs or disruption of any of the Company’s operations.

 

12

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The risks included herein and in Item 1 “Risk Factors”are not exhaustive.  Other sections ofthis Form 10-K may include additional factors which could materiallyand adversely impact the Company’s business, financial condition, and resultsof operations.  Moreover, the Companyoperates in a very competitive and rapidly changing environment.  New risk factors emerge from time to timeand it is not possible for management to predict all such risk factors on theCompany’s business, financial condition or results of operations or the extentto which any factor, or combination of factors, may cause actual results todiffer materially from those contained in any forward-looking statements.  Given these risks and uncertainties,investors should not place undue reliance on forward-looking statements as aprediction of actual results.

 

**ITEM7A.  QUANTITATIVE AND QUALITATIVEDISCLOSURES ABOUT MARKET RISK.**

 

The Company’s primary financial market risk exposureconsists of interest rate risk related to interest that we are obligated to payon our variable-rate debt. Interest rate risk is the risk that the Company’searnings are subject to fluctuations in interest rates on debt and is fullydependent upon the volatility of these rates.

 

The Company does not use derivative instruments tomoderate its exposure to interest rate risk. As a result, we will benefit from decreasing interest rates, but also beharmed by rising interest rates, on the fluctuating portion of our debt.  Accordingly, if we maintain our currentlevel of debt, a 100 basis point decrease in interest rates would result in anincrease in pre-tax income of approximately $120,000 for a given year.  However, a 100 basis point increase ininterest rates would result in a decrease in pre-tax income of approximately$120,000 for the same period.

 

13

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SIGNATURES

 

Pursuant to the requirements of Section 13 or 15(d) ofthe Securities Exchange Act of 1934, the Registrant has duly caused this reportto be signed on its behalf by the undersigned, thereunto duly authorized.

 
|                      |   | DSI Toys, Inc.                                          |
|---------------------------|--------|---------------------------------------------------------|
|                      |   |                                                    |
| Dated:  May 12, 2003 | By:    | /s/ JOSEPH S. WHITAKER                                  |
|                      |   | Joseph S. Whitaker                                      |
|                      |   | President,    Chief Executive Officer and Director |
|                      |   |                                                    |
| Dated:  May 12, 2003 | By:    | /s/ ROBERT L.  WEISGARBER                               |
|                      |   | Robert L.  Weisgarber    Chief Financial Officer   |

 

Pursuant to the requirements of the SecuritiesExchange Act of 1934, this report has been signed below by the followingpersons on behalf of the Registrant in the capacities and on the datesindicated.

 
| **Signature**         |   | **Title** |   | **Date**     |
|-----------------------|--------|-----------|--------|--------------|
|                  |   |      |   |         |
| /s/  E. THOMAS MARTIN |   | Chairman  |   | May 12, 2003 |
| E. Thomas Martin      |   |      |   |         |
|                  |   |      |   |         |
| /s/  M. D. DAVIS      |   | Director  |   | May 12, 2003 |
| M.D. Davis            |   |      |   |         |
|                  |   |      |   |         |
| /s/ JOSEPH N. MATLOCK |   | Director  |   | May 12, 2003 |
| Joseph N. Matlock     |   |      |   |         |
|                  |   |      |   |         |
| /s/  ROBERT L. BURKE  |   | Director  |   | May 12, 2003 |
| Robert L. Burke       |   |      |   |         |
|                  |   |      |   |         |
| /s/  JOHN MCSORLEY    |   | Director  |   | May 12, 2003 |
| John McSorley         |   |      |   |         |
|                  |   |      |   |         |
| /s/ WALTER S. REILING |   | Director  |   | May 12, 2003 |
| Walter  S. Reiling    |   |      |   |         |

 

14

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**CERTIFICATIONS**

 

 

I, Joseph S. Whitaker,President and Chief Executive Officer, certify that:

 

1.                                       Ihave reviewed this annual report on Form 10-K and Amendment No. 1 on Form10-K/A of DSI Toys, Inc. (“registrant”);

 

2.                                       Basedon my knowledge, this annual report does not contain any untrue statement of amaterial fact or omit to state a material fact necessary to make the statementsmade, in light of the circumstances under which such statements were made, notmisleading with respect to the period covered by this annual report;

 

3.                                       Basedon my knowledge, the financial statements, and other financial informationincluded in this annual report, fairly present in all material respects thefinancial condition, results of operations and cash flows of the registrant asof, and for, the periods presented in this annual report;

 

4.                                       Theregistrant’s other certifying officers and I are responsible for establishingand maintaining disclosure controls and procedures (as defined in Exchange ActRules 13a-14 and 15d-14) for the registrant and we have:

 

a)                                      Designedsuch disclosure controls and procedures to ensure that material informationrelating to the registrant, including its consolidated subsidiaries, is madeknown to us by others within those entities, particularly during the period inwhich this annual report is being prepared;

 

b)                                     Evaluatedthe effectiveness of the registrant’s disclosure controls and procedures as ofa date within 90 days prior to the filing date of this annual report (the“Evaluation Date”); and

 

c)                                      Presentedin this annual report our conclusions about the effectiveness of the disclosurecontrols and procedures based on our evaluation  as of the Evaluation Date;

 

5.                                       Theregistrant’s other certifying officers and I have disclosed, based on our mostrecent evaluation, to the registrants auditors and the audit committee ofregistrant’s board of directors (or persons performing the equivalentfunctions):

 

a)                                      Allsignificant deficiencies in the design or operation of internal controls whichcould adversely affect the registrant’s ability to record, process, summarizeand report financial data and have identified for the registrant’s auditors anymaterial weaknesses in internal controls; and have identified for theregistrant’s auditors any material weaknesses in internal controls; and

 

b)                                     Anyfraud, whether or not material, that involves management or other employees whohave a significant role in the registrant’s internal controls; and

 

6.                                       Theregistrant’s other certifying officers and I have indicated in this annualreport whether or not there were significant changes in internal controls or inother factors that could significantly affect internal controls subsequent tothe date of our most recent evaluation, including any corrective actions withregard to significant deficiencies and material weaknesses.

 

 
| Date:  | May 12, 2003 | /s/ Joseph S. Whitaker                 |
|--------|--------------|----------------------------------------|
|   |         | Joseph S. Whitaker                     |
|   |         | President and Chief  Executive Officer |

 

15

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I, Robert L. Weisgarber,Chief Financial Officer certify that:

 

1.                                       Ihave reviewed this annual report on Form 10-K and Amendment No. 1 on Form10-K/A of DSI Toys, Inc. (“registrant”);

 

2.                                       Basedon my knowledge, this annual report does not contain any untrue statement of amaterial fact or omit to state a material fact necessary to make the statementsmade, in light of the circumstances under which such statements were made, notmisleading with respect to the period covered by this annual report;

 

3.                                       Basedon my knowledge, the financial statements, and other financial informationincluded in this annual report, fairly present in all material respects thefinancial condition, results of operations and cash flows of the registrant asof, and for, the periods presented in this annual report;

 

4.                                       Theregistrant’s other certifying officers and I are responsible for establishingand maintaining disclosure controls and procedures (as defined in Exchange ActRules 13a-14 and 15d-14) for the registrant and we have:

 

a)                                      Designedsuch disclosure controls and procedures to ensure that material informationrelating to the registrant, including its consolidated subsidiaries, is madeknown to us by others within those entities, particularly during the period inwhich this annual report is being prepared;

 

b)                                     Evaluatedthe effectiveness of the registrant’s disclosure controls and procedures as of adate within 90 days prior to the filing date of this annual report (the“Evaluation Date”); and

 

c)                                      Presentedin this annual report our conclusions about the effectiveness of the disclosurecontrols and procedures based on our evaluation  as of the Evaluation Date;

 

5.                                       Theregistrant’s other certifying officers and I have disclosed, based on our mostrecent evaluation, to the registrants auditors and the audit committee ofregistrant’s board of directors (or persons performing the equivalentfunctions):

 

a)                                      Allsignificant deficiencies in the design or operation of internal controls whichcould adversely affect the registrant’s ability to record, process, summarizeand report financial data and have identified for the registrant’s auditors anymaterial weaknesses in internal controls; and have identified for theregistrant’s auditors any material weaknesses in internal controls; and

 

b)                                     Anyfraud, whether or not material, that involves management or other employees whohave a significant role in the registrant’s internal controls; and

 

6.                                       Theregistrant’s other certifying officers and I have indicated in this annualreport whether or not there were significant changes in internal controls or inother factors that could significantly affect internal controls subsequent tothe date of our most recent evaluation, including any corrective actions withregard to significant deficiencies and material weaknesses.

 

 
| Date:  | May 12, 2003 | /s/ Robert L.  Weisgarber |
|--------|--------------|---------------------------|
|   |         | Robert L. Weisgarber      |
|   |         | Chief Financial Officer   |

 

16

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**DSI TOYS, INC.**

 

**INDEX TOCONSOLIDATED FINANCIAL STATEMENTS AND SCHEDULES**

 
| Financial Statements                                                                      |
|-------------------------------------------------------------------------------------------|
|                                                                                      |
| Report of Independent Accountants                                                         |
|                                                                                      |
| Consolidated Balance Sheet at December 31, 2002  and 2001                                 |
|                                                                                      |
| Consolidated Statement of Operations for fiscal  years 2002, 2001 and 2000                |
|                                                                                      |
| Consolidated Statement of Cash Flows for fiscal  years 2002, 2001 and 2000                |
|                                                                                      |
| Consolidated Statement of Shareholders’ Equity  for fiscal years 2002, 2001 and 2000 |
|                                                                                      |
| Notes to Consolidated Financial Statements                                                |
|                                                                                      |
| Schedule                                                                                  |
|                                                                                      |
| II.                                                                                       | Valuation and Qualifying Accounts and Reserves |

 

All other schedules areomitted because they are not applicable or the required information is shown inthe financial statements or notes thereto.

 

F-1

----

 

**Repo****rt of IndependentAccountants**

 

 

To the Board of Directorsand Shareholders of

DSI Toys, Inc.

 

In our opinion, the consolidated financial statementslisted in the accompanying index present fairly, in all material respects, thefinancial position of DSI Toys, Inc. as of December 31, 2002 and 2001, andthe results of their operations and their cash flows for each of the threeyears in the period ended December 31, 2002, in conformity with accountingprinciples generally accepted in the United States of America.  In addition, in our opinion, the financialstatement schedule listed in the accompanying index presents fairly, in allmaterial respects, the information set forth therein when read in conjunctionwith the related consolidated financial statements.  These financial statements and financial statement schedule are theresponsibility of the Company’s management; our responsibility is to express anopinion on these financial statements and financial statement schedule based onour audits.  We conducted our audits ofthese statements in accordance with auditing standards generally accepted inthe United States of America, which require that we plan and perform the auditto obtain reasonable assurance about whether the financial statements are freeof material misstatement.  An auditincludes examining, on a test basis, evidence supporting the amounts anddisclosures in the financial statements, assessing the accounting principlesused and significant estimates made by management, and evaluating the overallfinancial statement presentation.  Webelieve that our audits provide a reasonable basis for our opinion.

 

The accompanying consolidated financial statementshave been prepared assuming that the Company will continue as a goingconcern.  As discussed in Note 1 to theconsolidated financial statements, the Company has incurred losses fromoperations and is in violation of certain lending covenants resulting in aworking capital deficiency.  Thesefactors raise substantial doubt about the Company’s ability to continue as agoing concern.  Management’s plans inregard to these matters are also described in Note 1.  The consolidated financial statements do not include anyadjustments that might result from the outcome of this uncertainty.

 

As discussed in Notes 2 and 5 to the consolidatedfinancial statements, in accordance with Statement of Financial AccountingStandards No. 142 “Goodwill and Other Intangible Assets” beginning in 2002, theCompany no longer amortizes goodwill.

 
|   | PricewaterhouseCoopers  LLP |
|--------|-----------------------------|

 

Houston, Texas

March 27, 2003

 

F-2

----

 

**DSI Toys, Inc.**

**ConsolidatedBalance Sheet**

 
|                                                                                                                                                                              |   | **December  31,  2002** |       | **December  31,  2001** |   |
|-----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|--------|-------------------------|------------|-------------------------|--------|
|                                                                                                                                                                              |   |                    |       |                    |   |
| **ASSETS**                                                                                                                                                                        |   |                    |       |                    |   |
|                                                                                                                                                                              |   |                    |       |                    |   |
| Current  Assets:                                                                                                                                                                  |   |                    |       |                    |   |
| Cash                                                                                                                                                                              |   | $                       | 1,737,329  |                    | $      | 284,637 |   |
| Accounts  receivable, net                                                                                                                                                         |   | 4,861,391               |       | 8,767,550               |   |
| Inventories                                                                                                                                                                       |   | 6,588,547               |       | 6,739,920               |   |
| Prepaid  expenses and other current assets                                                                                                                                        |   | 3,164,281               |       | 1,981,592               |   |
| Deferred  income taxes                                                                                                                                                            |   |                    |       | 893,000                 |   |
| Total  current assets                                                                                                                                                             |   | 16,351,548              |       | 18,666,699              |   |
|                                                                                                                                                                              |   |                    |       |                    |   |
| Property  and equipment, net                                                                                                                                                      |   | 2,192,941               |       | 1,769,284               |   |
| Deferred  income taxes                                                                                                                                                            |   | 1,312,000               |       |                    |   |
| Goodwill,  net                                                                                                                                                                    |   | 9,241,128               |       | 9,241,128               |   |
| Other  assets                                                                                                                                                                     |   | 885,085                 |       | 323,624                 |   |
|                                                                                                                                                                              |   | $                       | 28,670,702 |                    | $      | 31,312,735 |   |
|                                                                                                                                                                              |   |                    |       |                    |   |
| **LIABILITIES  AND SHAREHOLDERS’ EQUITY**                                                                                                                                    |   |                    |       |                    |   |
|                                                                                                                                                                              |   |                    |       |                    |   |
| Current  liabilities:                                                                                                                                                             |   |                    |       |                    |   |
| Accounts  payable and accrued liabilities                                                                                                                                         |   | $                       | 13,517,790 |                    | $      | 6,580,780 |   |
| Current  portion of long-term debt                                                                                                                                                |   | 8,240,923               |       | 1,120,650               |   |
| Current  portion of long-term debt due to a related party                                                                                                                         |   | 960,510                 |       | 1,751,485               |   |
| Income  taxes payable                                                                                                                                                             |   | 112,364                 |       | 69,638                  |   |
| Total  current liabilities                                                                                                                                                        |   | 22,831,587              |       | 9,522,553               |   |
| Long-term  debt                                                                                                                                                                   |   | 9,210,390               |       |                    |   |
| Long-term  debt due to a related party                                                                                                                                            |   | 4,554,042               |       | 3,289,552               |   |
| Deferred  income taxes                                                                                                                                                            |   | 179,902                 |       | 156,642                 |   |
| Total  liabilities                                                                                                                                                                |   | 27,565,531              |       | 22,179,137              |   |
| Commitments  and Contingencies (Notes 1 and 12)                                                                                                                                   |   |                    |       |                    |   |
| Shareholders’  equity:                                                                                                                                                       |   |                    |       |                    |   |
| Preferred  stock, $.01 par value, 5,000,000   shares authorized, none issued or outstanding                                                                                  |   |                    |       |                    |   |
| Common  stock, $.01 par value, 35,000,000 authorized,  10,866,365 and 9,066,365 shares issued and outstanding  respectively at December 31, 2002 and  December 31, 2001 |   | 108,664                 |       | 90,664                  |   |
| Additional  paid-in capital                                                                                                                                                       |   | 7,855,465               |       | 5,173,465               |   |
| Common  stock warrants                                                                                                                                                            |   | 102,500                 |       | 2,802,500               |   |
| Accumulated  other comprehensive loss                                                                                                                                             |   | (87,129                 | )          | (70,928                 | )      |
| Accumulated  earnings (deficit)                                                                                                                                                   |   | (6,874,329              | )          | 1,137,897               |   |
| Total  shareholders’ equity                                                                                                                                                  |   | 1,105,171               |       | 9,133,598               |   |
|                                                                                                                                                                              |   | $                       | 28,670,702 |                    | $      | 31,312,735 |   |

 

See accompanyingnotes to consolidated financial statements.

 

F-3

----

 

**DSI Toys, Inc.**

**ConsolidatedStatement of Operations**

 
|                                          |   | **Fiscal  Year** |       |
|-----------------------------------------------|--------|------------------|------------|
|                                          |   | **2002**         |       | **2001** |   | **2000** |   |
|                                          |   |             |       |   |   |   |   |
| Net  sales                                    |   | $                | 49,754,173 |   | $ | 67,906,409 |   | $ | 70,438,531 |   |
| Cost  of goods sold                           |   | 38,683,911       |       | 47,985,126 |   | 50,120,552 |   |
| Gross  profit                                 |   | 11,070,262       |       | 19,921,283 |   | 20,317,979 |   |
| Selling,  general and administrative expenses |   | 15,972,473       |       | 20,103,335 |   | 20,367,165 |   |
| Operating  loss                               |   | (4,902,211       | )          | (182,052 | ) | (49,186 | ) |
| Interest  expense                             |   | (911,792         | )          | (1,155,092 | ) | (1,473,909 | ) |
| Other  income                                 |   | 77,483           |       | 278,529 |   | 196,661 |   |
| Loss  before income taxes                     |   | (5,736,520       | )          | (1,058,615 | ) | (1,326,434 | ) |
| Benefit  from (provision for) income taxes    |   | (2,275,706       | )          | (390,903 | ) | 477,448 |   |
| Net  loss                                     |   | $                | (8,012,226 | ) | $ | (1,449,518 | ) | $ | (848,986 | ) |
|                                          |   |             |       |   |   |   |   |
| Basic  earnings per share                     |   |             |       |   |   |   |   |
|                                          |   |             |       |   |   |   |   |
| Loss  per share                               |   | $                | (0.82      | ) | $ | (0.16 | ) | $ | (0.09 | ) |
|                                          |   |             |       |   |   |   |   |
| Weighted  average shares outstanding          |   | 9,720,463        |       | 9,066,365 |   | 9,053,382 |   |
|                                          |   |             |       |   |   |   |   |
| Diluted  earnings per share                   |   |             |       |   |   |   |   |
|                                          |   |             |       |   |   |   |   |
| Loss  per share                               |   | $                | (0.82      | ) | $ | (0.16 | ) | $ | (0.09 | ) |
|                                          |   |             |       |   |   |   |   |
| Weighted  average shares  outstanding    |   | 9,720,463        |       | 9,066,365 |   | 9,053,382 |   |

 

See accompanyingnotes to consolidated financial statements.

 

F-4

----

 

**DSI Toys, Inc**

###### **Consolidated Statement of Cash Flows**

 
|                                                                                    |   | **Fiscal  Year** |       |
|-----------------------------------------------------------------------------------------|--------|------------------|------------|
|                                                                                    |   | **2002**         |       | **2001** |   | **2000** |   |
| Cash  flows from operating activities:                                                  |   |             |       |   |   |   |   |
| Net  loss                                                                               |   | $                | (8,012,226 | ) | $ | (1,449,518 | ) | $ | (848,986 | ) |
| Adjustments  to reconcile net loss to net cash provided (used) by operating activities: |   |             |       |   |   |   |   |
| Depreciation                                                                            |   | 1,071,983        |       | 1,334,392 |   | 1,551,632 |   |
| Amortization  and write-off of debt discount and issuance costs                         |   | 48,539           |       | 42,583 |   | 24,927 |   |
| Amortization  of goodwill                                                               |   |             |       | 513,396 |   | 513,360 |   |
| Provision  for bad debts                                                                |   | 303,872          |       | 1,717,931 |   | 222,021 |   |
| Loss  (gain) on sale or abandonment of equipment                                        |   | 24,474           |       | (25,957 | ) | 32,173 |   |
| Deferred  income taxes                                                                  |   | 2,228,260        |       | (72,207 | ) | (893,491 | ) |
| Changes  in assets and liabilities, excluding acquisitions:                             |   |             |       |   |   |   |   |
| Restricted  cash                                                                        |   |             |       | 150,000 |   |   |   |
| Accounts  receivable                                                                    |   | 3,602,287        |       | (3,962,598 | ) | (2,413,654 | ) |
| Inventories                                                                             |   | 151,373          |       | (52,725 | ) | (954,186 | ) |
| Income  taxes payable                                                                   |   | 42,726           |       | (42,687 | ) | (316,402 | ) |
| Prepaid  expenses                                                                       |   | (1,182,689       | )          | (240,647 | ) | (507,859 | ) |
| Accounts  payable and accrued liabilities                                               |   | 6,937,010        |       | (1,320,510 | ) | 1,039,373 |   |
| Net  cash provided (used) by operating activities                                       |   | 5,215,609        |       | (3,408,547 | ) | (2,551,092 | ) |
|                                                                                    |   |             |       |   |   |   |   |
| Cash  flows from investing activities:                                                  |   |             |       |   |   |   |   |
| Cash  used for acquisition of Meritus                                                   |   |             |       |   |   | (884,033 | ) |
| Capital  expenditures                                                                   |   | (1,529,837       | )          | (766,921 | ) | (1,249,944 | ) |
| Proceeds  from sale of equipment                                                        |   | 9,723            |       | 104,286 |   |   |   |
| Decrease  (increase) in other assets                                                    |   | (610,000         | )          | 137,120 |   | 273,087 |   |
| Net  cash used by investing activities                                                  |   | (2,130,114       | )          | (525,515 | ) | (1,860,890 | ) |
|                                                                                    |   |             |       |   |   |   |   |
| Cash  flows from financing activity:                                                    |   |             |       |   |   |   |   |
| Net  borrowings (repayments) under  revolving  lines of credit                     |   | (406,309         | )          | (613,604 | ) | 4,046,472 |   |
| Net  borrowings (repayments) on debt                                                    |   | (2,195,392       | )          | 2,790,465 |   | 400,684 |   |
| Net  borrowings (repayments) on long-term debt due to related parties                   |   | 473,515          |       | (674,478 | ) | 4,025,515 |   |
| Net  borrowings of other short-term debt                                                |   | 511,584          |       |   |   |   |   |
| Payments  of assumed Meritus debt                                                       |   |             |       |   |   | (4,382,541 | ) |
| Net  proceeds from issuance of warrants                                                 |   |             |       | 2,700,000 |   |   |   |
| Debt  and stock issue costs                                                             |   |             |       | (117,500 | ) | 35,000 |   |
| Net  cash provided (used) by financing activities                                       |   | (1,616,602       | )          | 4,084,883 |   | 4,125,130 |   |
| Effect  of exchange rate changes on cash                                                |   | (16,201          | )          | (43,866 | ) | (14,436 | ) |
| Net  increase (decrease) in cash                                                        |   | 1,452,692        |       | 106,955 |   | (301,288 | ) |
| Cash  and cash equivalents, beginning of year                                           |   | 284,637          |       | 177,682 |   | 478,970 |   |
| Cash  and cash equivalents, end of year                                                 |   | $                | 1,737,329  |   | $ | 284,637 |   | $ | 177,682 |   |

 

See accompanyingnotes to consolidated financial statements.

 

F-5

----

 

**DSI Toys, Inc.**

**ConsolidatedStatement of Shareholders’ Equity**

 
|                                                                                              |   | **Common  Stock** |   | **Additional  Paid-in** |    |        |   | **Accumulated  Other  Comprehensive** |   | **Accumulated  Earnings** |    | **Treasury**  |   |      |   |
|---------------------------------------------------------------------------------------------------|--------|-------------------|--------|-------------------------|---------|-------------|--------|---------------------------------------|--------|---------------------------|---------|---------------|--------|-----------|--------|
|                                                                                              |   | **Shares**        |   | **Amount**              |    | **Capital** |   | **Warrants**                          |   | **Income(Loss)**          |    | **(Deficit)** |   | **Stock** |   | **Totals** |   |
| Balance, December 31, 1999                                                                        |   | 8,719,000         |   | $                       | 87,190  |        | $      | 4,934,919                             |   | $                         | 102,500 |          | $      | (12,626   | )      | $ | 3,436,401 |   | $ | (1,559,395 | ) | $ | 6,988,989 |   |
| Comprehensive loss:                                                                               |   |              |   |                    |    |        |   |                                  |   |                      |    |          |   |      |   |   |   |
| Net Loss                                                                                          |   |              |   |                    |    |        |   |                                  |   |                      |    | (848,986      | )      |      |   | (848,986 | ) |
| Foreign Currency translation adjustments net of  tax                                              |   |              |   |                    |    |        |   |                                  |   | (14,436                   | )       |          |   |      |   | (14,436 | ) |
| Comprehensive Loss                                                                                |   |              |   |                    |    |        |   |                                  |   |                      |    |          |   |      |   | (863,422 | ) |
| Issuance of 347,365  common shares and   185,843 common shares  from the  treasury |   | 347,365           |   | 3,474                   |    | 238,546     |   |                                  |   |                      |    |          |   | 1,559,395 |   | 1,801,415 |   |
| Balance, December 31, 2000                                                                        |   | 9,066,365         |   | 90,664                  |    | 5,173,465   |   | 102,500                               |   | (27,062                   | )       | 2,587,415     |   |      |   | 7,926,982 |   |
| Comprehensive loss:                                                                               |   |              |   |                    |    |        |   |                                  |   |                      |    |          |   |      |   |   |   |
| Net Loss                                                                                          |   |              |   |                    |    |        |   |                                  |   |                      |    | (1,449,518    | )      |      |   | (1,449,518 | ) |
| Foreign Currency translation adjustments net of  tax                                              |   |              |   |                    |    |        |   |                                  |   | (43,866                   | )       |          |   |      |   | (43,866 | ) |
| Comprehensive Loss                                                                                |   |              |   |                    |    |        |   |                                  |   |                      |    |          |   |      |   | (1,493,384 | ) |
| Warrants Issued                                                                                   |   |              |   |                    |    |        |   | 2,700,000                             |   |                      |    |          |   |      |   | 2,700,000 |   |
| Balance, December 31, 2001                                                                        |   | 9,066,365         |   | 90,664                  |    | 5,173,465   |   | 2,802,500                             |   | (70,928                   | )       | 1,137,897     |   |      |   | 9,133,598 |   |
| Comprehensive loss:                                                                               |   |              |   |                    |    |        |   |                                  |   |                      |    |          |   |      |   |   |   |
| Net Loss                                                                                          |   |              |   |                    |    |        |   |                                  |   |                      |    | (8,012,226    | )      |      |   | (8,012,226 | ) |
| Foreign Currency translation adjustments net of  tax                                              |   |              |   |                    |    |        |   |                                  |   |                      |    | (16,201       | )      |      |   | (16,201 | ) |
| Comprehensive Loss                                                                                |   |              |   |                    |    |        |   |                                  |   |                      |    |          |   |      |   | (8,028,427 | ) |
| Warrants Exercised                                                                                |   | 1,800,000         |   | 18,000                  |    | 2,682,000   |   | (2,700,000                            | )      |                      |    |          |   |      |   |   |   |
| Balance, December 31, 2002                                                                        |   | 10,866,365        |   | $                       | 108,664 |        | $      | 7,855,465                             |   | $                         | 102,500 |          | $      | (87,129   | )      | $ | (6,874,329 | ) |   |   | $ | 1,105,171 |   |
|                                                                                                   |        |                   |        |                         |         |             |        |                                       |        |                           |         |               |        |           |        |  |  |  |  |  |  |  |  |  |

 

See accompanyingnotes to consolidated financial statements.

 

F-6

----

 

**DSI TOYS, INC.**

**NOTE****S TO CONSOLIDATED FINANCIAL STATEMENTS**

 

**NOTE 1 -Organization:**

 

DSI Toys, Inc. (the “Company”) was incorporated underthe laws of the State of Texas in November 1970.  The Company markets and distributes a variety of toys andchildren’s consumer electronics both within the United States andinternationally, primarily to retailers. The Company’s products are manufactured primarily in the People’sRepublic of China.

 

Effective May 1, 1997, the Company’s Articles ofIncorporation were amended to (i) authorize the issuance of 5,000,000 shares of$.01 par value preferred stock, (ii) change the par value of common stock to$.01 and (iii) reduce the authorized shares of common stock to 20,000,000shares.

 

On June 3, 1997, the Company completed its initial publicoffering (the “Offering”) of 2,500,000 shares of common stock, which providedthe Company net proceeds of $17.7 million. All of the net proceeds were used to repay debt of the Company.  In connection with the Offering, the Companyissued warrants to purchase 250,000 shares of common stock to the leadunderwriters.  Such warrants areexercisable at $10.80 per share and expired on May 28, 2002.

 

Effective May 28, 1999, the Company’s Articles ofIncorporation were amended to increase the authorized shares of common stock to35,000,000 shares.

 

Effective June 1, 1999, the Company consummatedtransactions with MVII, LLC (“MVII”) pursuant to a Stock Purchase and SaleAgreement dated April 15, 1999.  As aresult of those transactions, MVII made a total investment of $12 million inthe Company’s common stock, $5 million of which was paid directly to theCompany for the purchase of 2,458,491 shares of common stock.

 

On August 21, 2002, MVII converted a prepaidInvestment Warrant in exchange for 1.8 million shares of common stock.  The Investment Warrant was issued March 19,2001, for a cash purchase price of $2.7 million.  Proceeds from the sale of the Investment Warrant were used by theCompany for current working capital.

 

*Liquidityand Going Concern*

 

The Company’s viability as a going concern isdependent upon successful negotiations with Sunrock, a new lender, or asubstantial capital infusion, as well as sustained profitable operations. Theaccompanying financial statements do not include any adjustments that might benecessary if the Company is unable to continue as a going concern.

 

To the extent the Company’s cash reserves and cashflows from operations are insufficient to meet future cash requirements, theCompany will need to successfully raise additional capital through an equityinfusion or the issuance of debt.  TheCompany’s executive management believes that the Company will be required toeither obtain a new revolving loan or obtain necessary additional capital toallow the Company to continue its normal operations for the foreseeable future.However, there can be no assurance the Company will meet its projectedoperating results or be successful either in obtaining additional capital, orobtaining a new revolving loan.

 

Since the Company’s cash reserves and cash flows fromoperations no longer meet its cash requirements, the Company has exploredvarious alternatives to raise additional capital.

 

The Company has held discussions and negotiations withseveral lenders regarding a credit facility to replace the Revolver.  Management is negotiating with one of thoseinstitutions regarding a replacement credit facility that will become effectiveat the close of the anticipated going private transaction, which is discussedin greater detail below.  Managementbelieves that the going private transaction will close and that the Companywill be able to continue its operations until that time.

 

F-7

----

 

*Delisting*

 

On February 14, 2002, the Company received notice fromThe Nasdaq Stock Market, Inc. that the Company’s common stock had closed belowthe minimum price of US$1.00 per share requirement for continued listing on theNasdaq SmallCap Market under Marketplace Rule 4310(c)(4) (the “Rule”).  The Company was granted a 180 calendar daygrace period to comply with the Rule, but was still not in compliance with theRule on August 13, 2002, the final day of the grace period.  However, at such time the Company wasgranted an additional 180 calendar day grace period to comply with the Rulebecause it did meet the initial listing criteria for the Nasdaq SmallCap Marketunder Marketplace Rule 4310(c)(2)(A). The additional grace period expired onFebruary 10, 2003, without the Company being in compliance with the Rule.  On March 18, 2003, the Company receivednotification that its securities would be delisted from the Nasdaq SmallCapMarket at the opening of business on March 27, 2003.  The Company elected not to appeal the delisting determination andits common stock commenced trading on the over-the-counter Bulletin Boardelectronic quotation system effective with the opening of business on March 27,2003, under the ticker symbol “DSIT.”

 

### *Going Private Transaction*

### * *

Since the Company’s cash reserves and cash flows fromoperations no longer meet its cash requirements, the Company has exploredvarious alternatives to raise additional capital.

 

In January 2003, after other alternatives for theCompany had been exhausted, E. Thomas Martin, the Chairman of the Company’sBoard of Directors, and certain other officers, directors and shareholders ofthe Company (the “Buyer Group”) began serious consideration of a going-privatetransaction.  On January 27, 2003, theBoard of Directors invited the Buyer Group to submit an offer to the Companyfor a going-private transaction.

 

On January 28, 2003, the Buyer Group proposed to theCompany a going-private transaction by way of a merger that would result in thepurchase of shares of common stock held by the shareholders who are not membersof the Buyer Group for $0.44 per share.

 

The Board of Directors appointed a special committeeto review the proposed transaction.

 

Based on a series of negotiations between the specialcommittee and representatives of the Buyer Group, the purchase price was increasedto $0.47 per share.

 

On March 26, 2003, the Board of Directors unanimouslyvoted to approve the merger agreement and recommended that the shareholdersapprove the merger agreement and the merger.

 

On March 27, 2003, the merger agreement was signed andthe Company issued a press release announcing the merger agreement.

 

If the shareholders of the Company approve the merger,the Company’s shares will be delisted from the over-the-counter Bulletin Boardelectronic quotation system and its common stock will be deregistered under theSecurities Exchange Act of 1934. The Company will continue in business as aprivately-held Texas corporation.

 

**NOTE 2 -Summary of Significant Accounting Policies:**

 

Certain of our accounting policies require theapplication of significant judgment by management in selecting the appropriateassumptions for calculating financial estimates.  By their nature, these judgments are subject to an inherentdegree of uncertainty.  These judgmentsare based on our historical experience, terms with current customers, ourobservance of trends in the industry, information provided by our customers andinformation available from other outside sources, as appropriate.  Our significant accounting policies include:

 

F-8

----

 

*Basisof presentation*

 

The accompanying consolidated financial statementsinclude the accounts of wholly-owned subsidiary DSI(HK) Limited. Allsignificant intercompany transactions have been eliminated inconsolidation.  The Company’s fiscalyear is the year ending December 31 of the calendar year mentioned.

 

*Cashequivalents*

 

The Company considers investments with originalmaturity dates of three months or less from the date of purchase to be cashequivalents.  Restricted cash, held as acompensating balance under a revolving loan supported by letters of credit isnot considered a cash equivalent.

 

*RevenueRecognition*

 

The Company recognizes revenue when products areshipped and title passes to unaffiliated customers.  In most cases, title transfers to our customers when the producthas been presented to shipment forwarders on FOB Asia sales and when theproduct is picked up from our distribution facilities on domestic sales.Provision is made currently for returns of defective and slow-movingmerchandise, price protection and customer allowances and is included as areduction of accounts receivable and sales. The provision is primarily based onknown returns and allowances provided to customers for sales activities, aswell as an historically based estimate of potential unknown customers’allowances and claims.  Shipping andhandling revenues are not included in net sales, rather they are included as acontra-expense in cost of goods sold with the shipping and handling costsassociated with inbound and outbound freight.

 

*Allowancefor Doubtful Accounts*

 

Accounts receivable are reduced by an allowance foramounts that may become uncollectible in the future.  The Company’s estimate for its allowance is based on two methodswhich are combined to determine the total amount reserved.  First, the Company evaluates specificaccounts where we have information that the customer may have an inability tomeet its financial obligations (bankruptcy, etc.).  In these cases, the Company uses its judgment, based on the bestavailable facts and circumstances, and records a specific reserve for thatcustomer against amounts due to reduce the receivable to the amount that isexpected to be collected.  Thesespecific reserves are reevaluated and adjusted as additional information isreceived that impacts the amounts reserved. Second, a reserve is established for all other customers based onhistorical collection and write-off experience.  If circumstances change, the Company’s estimates of therecoverability of amounts due the Company could be reduced by a materialamount.

 

*Allowancefor Returns and Defectives*

 

The Company records a provision for estimated salesreturns and defectives on sales in the same period as the related revenue isrecorded.  Our sales to customersgenerally do not give them the right to return products or to cancel firmorders.  However, as is common in theindustry, we sometimes accept returns for stock balancing and negotiateaccommodations to customers, which includes price discounts, credits andreturns when demand for specific products fall below expectations.  Additionally, customers are given credit forany defective products they may have received. The allowance estimates are based on historical sales returns anddefective rates, analysis of credit memo data and other known factors.  If the data the Company uses to calculatethese estimates does not properly reflect future returns and defectives,revenue could be overstated and future operating results adversely affected.

 

*Inventories*

 

Inventory is valued at the lower of cost or market,with cost being determined on the average cost basis.  The Company reviews the book value of slow-moving items,discounted product lines and individual products to determine if these itemsare properly valued.  The Companyidentifies these items and assesses the ability to dispose of them at a pricegreater than cost.  If it is determinedthat cost is less than market value, then cost is used for inventoryvaluation.  If market value is less thancost, then the Company establishes a reserve for the amount required to valuethe inventory at market.  If the Companyis not able to achieve its expectations of the net realizable value of theinventory at its current value, the Company would adjust its reserveaccordingly.

 

F-9

----

 

*Propertyand equipment*

 

Property and equipment are recorded at cost.  Maintenance and repairs are charged tooperations, and replacements or betterments are capitalized.  Property or equipment sold, retired, orotherwise disposed of is removed from the accounts, and any gains or lossesthereon are included in operations during the period of disposal.  Depreciation is recorded over the estimateduseful lives of the related assets using the straight-line method.

 

*Debtissuance costs and debt discount*

 

Debt issuance costs and debt discount are amortizedover the term of the related debt on a straight-line basis.

 

*Advertising*

 

The cost of producing media advertising is capitalizedas incurred and expensed in the period in which the advertisement is firstshown.  During interim periods, mediacommunications costs are accrued in relation to sales when the advertising isclearly implicit in the related sales arrangement.  All media communication costs are expensed however in the fiscalyear incurred.  All other advertisingcosts are expensed in the period incurred. Television advertising expense totaled $3,015,000, $2,500,000 and$3,621,000 during fiscal 2002, 2001 and 2000, respectively.  Prepaid television advertising productioncosts of $65,000, $130,000 and $101,000 respectively are included in prepaidexpenses at December 31, 2002, 2001 and 2000. The Company entered into advertising barter transactions in which theCompany recorded $321,000, $730,000 and $529,000 in advertising expenses infiscal 2002, 2001 and 2000, respectively. In addition, prepaid expenses at December 31, 2000, included $200,000 inbartered, prepaid 2001 print advertising. There is no bartered prepaid advertising expense at December 31, 2002and 2001.  Management believes theseamounts approximate fair value.

 

*Incometaxes*

 

The Company accounts for deferred income taxes usingthe liability method, which provides for the recognition of deferred tax assetsand liabilities based upon temporary differences between the tax basis ofassets and liabilities and their carrying value for financial reportingpurposes.  Deferred tax expense orbenefit is the result of changes in deferred tax assets and liabilities duringthe period.  In estimating future taxconsequences, all expected future events are considered other than enactmentsof changes in the tax law or rates. U.S. deferred income taxes are provided on the undistributed earnings ofthe wholly-owned subsidiaries.

 

The Company recorded a $4.0 million charge in fiscalyear 2002 to establish a valuation allowance for all of its deferred taxassets, including $2.2 million of deferred tax assets generated in prioryears.  The valuation allowance wasdetermined in accordance with the provisions of Statement of FinancialAccounting Standards (SFAS) 109, “Accounting for Income Taxes,” which placesprimary importance on the Company’s cumulative operating results in the mostrecent periods when assessing the need for a valuation allowance. The primaryfactors considered in evaluating the realizability of the deferred tax assetsand establishing the valuation allowance were continued operating losses forthe Company through December 31, 2002, the Company’s projection of futureoperating results and the number of years it will take to recover the taxassets in a difficult market.  Thisevaluation provides sufficient negative evidence to establish an additionalvaluation allowance under the provisions of SFAS 109.  The Company intends to maintain a full valuation allowance forits deferred tax assets and net operating loss carryforwards until sufficientpositive evidence exists to support reversal of the allowance.  The establishment of this valuation allowancein no way affects the Company’s ability to reduce future tax expense throughutilization of net operating losses and foreign income tax credits.  However, currently there can be noassurances that the net operating losses will be utilized.

 

*Foreigncurrency translations*

 

The Company’s foreign subsidiary uses the localcurrency as the functional currency. Accordingly, assets and liabilities of the Company’s foreign subsidiaryare translated using the exchange rate in effect at the balance sheet date,while income and expenses are translated using average rates.  Translation adjustments are reported as aseparate component of shareholders’ equity.

 

F-10

----

 

*Fairvalue of financial instruments*

 

The Company’s financial instruments recorded on thebalance sheet include cash and cash equivalents, accounts receivable, accountspayable and debt.  Due to their shortmaturity, the fair value of cash and cash equivalents, accounts receivable andaccounts payable approximates carrying value. The fair value of the Company’s debt approximates the carrying amount ofthe debt as it is at variable market rates.

 

*Concentrationof credit risk and export sales*

 

Financial instruments which potentially subject theCompany to concentrations of credit risk consist primarily of tradereceivables.  The Company sells itsproducts principally to retail discount stores and toy stores.  Five customers comprise a significantportion of the Company’s sales (53% in 2002), and therefore, receivables fromone or all of these customers may, at any point in time, comprise a largeportion of the Company’s total receivables, providing an increasedconcentration of credit risk. Additionally, the customer base is primarily located in the UnitedStates, though overall the Company’s customer base is large and geographicallydispersed across the globe.  The Companyperforms ongoing credit evaluations of its customers to minimize credit risk,and for the majority of its FOB Asia sales, the Company obtains letters ofcredit from its customers supporting the accounts receivable.  (See Note 12).

 

*Useof estimates*

 

The preparation of financial statements in accordancewith accounting principles generally accepted in the United States of Americarequires management to make estimates and assumptions that affect the reportedamounts of assets and liabilities and disclosure of contingent assets andliabilities at the date of the financial statements and the reported amounts ofrevenues and expenses during the period. Because of the inherent uncertainties in their process, actual resultscould differ from such estimates. Management believes that the estimates are reasonable.

 

*Impairmentof assets*

 

The Company reviews for the impairment of long-livedassets, including goodwill, whenever events or changes in circumstancesindicate that the carrying amount of an asset may not be recoverable.

 

Goodwill has been amortized over 20 years using thestraight-line method in 2001 and 2000. In 2002, the Company adopted, Statement of Financial Accounting Standards,No. 142, “Goodwill and Other Intangible Assets,” (“FAS142”), which eliminatesamortization of goodwill beginning in January 2002 and requires an annualimpairment test based on its estimated fair value, using future discounted cashflow and other factors.

 

The Company engaged an independent company to assistin the fair value assessment as of December 31, 2002 and 2001.  Based on these assessments, an impairmentvaluation is not required.

 

*Earningsper share*

 

The Company reports both basic earnings per share,which is based on the weighted average number of common shares outstanding, anddiluted earnings per share, which is based on the weighted average number ofcommon shares and all dilutive potential common shares outstanding.

 

Stock options and warrants are the only potentiallydilutive shares the Company has outstanding at December 31, 2002. The 574,000shares, 729,500 shares and 866,500 shares, respectively of common stock optionsand warrants outstanding were not included in the diluted earnings per sharecalculation during fiscal 2002, 2001, and 2000, because the options andwarrants would be anti-dilutive.

 

F-11

----

 

*Stock-basedcompensation plans*

 

The Company applies Accounting Principles BoardOpinion No. 25, “Accounting for Stock Issued to Employees” (“APB 25”) andrelated interpretations in accounting for its plans and the disclosure-onlyprovisions of Statement of Financial Accounting Standards No. 123, “Accountingfor Stock-Based Compensation” (“SFAS 123”), and SFAS No. 148, “Accounting forStock-Based Compensation – Transition and Disclosure, An Amendment of FAS 123,”in disclosures regarding the plan.

 

The Company applies the intrinsic method proscribed byAPB 25 and related interpretations in accounting for its stock optionplan.  Accordingly, no compensation costhas been recognized by the Company for this plan.  The following table illustrates the effect on net loss and lossper share calculated as if compensation cost for the 1997 Plan was determinedbased upon the fair value at the grant date for awards under the planconsistent with the methodology prescribed under SFAS 123 for fiscal years2002, 2001 and 2000:

 
|                                                                                                                                  |   | **2002** |       | **2001** |   | **2000**   |   |
|---------------------------------------------------------------------------------------------------------------------------------------|--------|----------|------------|----------|--------|------------|--------|
| Net  loss, as reported                                                                                                                |   | $        | (8,012,226 | )        | $      | (1,449,518 | )      | $ | (848,986 | ) |
| Deduct:  Total stock-based employee compensation expense determined under fair value  based method for all awards, net of tax effects |   | (138,425 | )          | (319,900 | )      | (240,426   | )      |
| Pro  forma net loss                                                                                                                   |   | $        | (8,150,651 | )        | $      | (1,769,418 | )      | $ | (1,089,412 | ) |
| Loss  per share:                                                                                                                      |   |     |       |     |   |       |   |
| Basic  – as reported                                                                                                             |   | $        | (0.82      | )        | $      | (0.16      | )      | $ | (0.09 | ) |
| Basic  – pro forma                                                                                                               |   | $        | (0.84      | )        | $      | (0.20      | )      | $ | (0.12 | ) |
|                                                                                                                                  |   |     |       |     |   |       |   |
| Diluted  – as reported                                                                                                           |   | $        | (0.82      | )        | $      | (0.16      | )      | $ | (0.09 | ) |
| Diluted  – pro forma                                                                                                             |   | $        | (0.84      | )        | $      | (0.20      | )      | $ | (0.12 | ) |

 

*RecentAccounting Pronouncements*

 

In June 2001, SFAS No. 143, “Accounting for AssetRetirement Obligations,” was issued. The standard requires that legalobligations associated with the retirement of long-lived intangible assets berecorded at fair value when incurred and will be effective on January 1, 2003.The adoption of this statement is not expected to have a material impact on theCompany’s consolidated financial position, results of operations or cash flows.

 

In April 2002, SFAS No. 145, “Recision of FASBStatements No. 4, 44 and 64, Amendment of FASB No. 13, and TechnicalCorrections,” was issued. This statement provides guidance on theclassification of gains and losses from the extinguishment of debt and on theaccounting for certain specified lease transactions. The adoption of thisstatement is not expected to have a material impact on the Company’sconsolidated financial position, results of operations or cash flows.

 

In June 2002, SFAS No. 146, “Accounting for CostsAssociated with Exit or Disposal Activities,” was issued. This statementprovides guidance on the recognition and measurement of liabilities associatedwith disposal activities and is effective on January 1, 2003. The adoption ofthis statement is not expected to have a material impact on the Company’s consolidatedfinancial position, results of operations or cash flows.

 

In December 2002, the FASB issued SFAS No. 148,“Accounting for Stock-Based Compensation – Transition and Disclosure, AnAmendment of FAS No. 123.”  Thisstatement addresses the acceptable transitional methods when the fair valuemethod of accounting for stock-based compensation covered in SFAS No. 123is elected.  Additionally, the statementprescribes tabular disclosure of specific information in the “*Summary ofSignificant Accounting Policies*” regardless of the method used andalso required interim disclosure of similar information.  The Company has adopted this statementeffective with the fiscal year ending December 31, 2002.  The Company has not elected the fair valuemethod, but continues accounting for stock-based compensation by the intrinsicmethod prescribed by APB Opinion 25. The disclosure required by SFAS 148 is included in the Summary ofSignificant Accounting Policies.

 

F-12

----

 

In November 2002, the FASB issued FASB InterpretationNo. 45 (FIN 45), “Guarantor’s Accounting and Disclosure Requirements forGuarantees, Including Indirect Guarantees of Indebtedness of Others” whichestablished additional accounting and disclosure requirements when anenterprise guarantees the indebtedness of others.  The enterprise providing the guarantee is required to recognize aliability for the fair value of the obligation assumed and disclose theinformation in its interim and annual financial statements.  The Company does not believe this will havea significant impact on our disclosure.

 

In January 2003, the FASB issued FASB InterpretationNo. 46 (FIN 46), “Consolidation of Variable Interest Entities, aninterpretation of ARB No. 51.”  Theinterpretation defines when and who consolidates a “variable interest entity,”or “VIE.”  This new consolidation modelapplies to entities (i) where the equity investors (if any) do not have acontrolling financial interest, or (ii) whose equity investment at risk isinsufficient to finance that entity’s activities without receiving additionalsubordinated financial support from other parties and requires additionaldisclosures for all enterprises involved with the VIE.  FIN 46 is effective during 2003 depending onwhen the VIE is created.  The Companydoes not believe this will have a significant impact on our reported results ofoperations and financial condition.

 

**NOTE 3 -Accounts Receivable:**

 

Accounts receivable consist of the following:

 

|                       |   | **December  31, 2002** |      | **December  31, 2001** |   |
|----------------------------|--------|------------------------|-----------|------------------------|--------|
| Trade  receivables         |   | $                      | 9,205,491 |                   | $      | 12,717,550 |   |
| Provisions  for:           |   |                   |      |                   |   |
| Discounts  and markdowns   |   | (1,905,000             | )         | (1,472,706             | )      |
| Return  of defective goods |   | (395,000               | )         | (777,294               | )      |
| Doubtful  accounts         |   | (2,044,100             | )         | (1,700,000             | )      |
| Accounts  receivable, net  |   | $                      | 4,861,391 |                   | $      | 8,767,550 |   |

 

The 2002 provision for doubtful accounts includesamounts related to trade receivables for several companies filing forbankruptcy during 2002 and early 2003. Among these companies are Ames Department Stores, Inc. and FAO, Inc.,for which amounts were included in the 2002 expense for bad debts.  Additionally, the 2002 provision includes a$1,600,000 amount for Kmart Corp. that was charged to bad debt expense in 2001.

 

**NOTE 4 -Property and Equipment:**

 

Property and equipmentconsist of the following:

 

|                               |   | **Estimated  useful  lives** |   | **December  31,  2002** |      | **December  31, 2001** |   |
|------------------------------------|--------|------------------------------|--------|-------------------------|-----------|------------------------|--------|
| Molds                              |   | 3 years                      |   | $                       | 6,359,125 |                   | $      | 5,509,743 |   |
| Equipment,  furniture and fixtures |   | 3-7 years                    |   | 1,834,427               |      | 1,826,150              |   |
| Leasehold  improvements            |   | 10 years or lease  term      |   | 653,773                 |      | 1,221,473              |   |
| Automobiles                        |   | 3-5 years                    |   | —                  |      | 31,678                 |   |
|                               |   |                         |   | 8,847,325               |      | 8,589,044              |   |
| Less:  accumulated depreciation    |   |                         |   | (6,654,384              | )         | (6,819,760             | )      |
|                               |   |                         |   | $                       | 2,192,941 |                   | $      | 1,769,284 |   |

 

F-13

----

 

**Note 5 -Goodwill:**

 

Under SFAS No. 142, goodwill and intangible assetswith indefinite lives are no longer amortized but are reviewed annually (ormore frequently if indicators arise) for impairment.  According to SFAS No. 142, companies are required to identify theirreporting units and determine the aggregate carrying values and fair values ofall such reporting units.  To the extentthe carrying value of a reporting unit exceeds its relative fair value, asecond step of the SFAS NO. 142 impairment test is required.  This second step requires the comparison ofthe implied fair value of the reporting unit goodwill to its related carryingvalue, both of which must be measured by the company at the same point in timeeach year.  Any initial loss resultingfrom a goodwill impairment test must be recorded as a change in accountingprinciple.  The Company engaged anindependent company to assist in valuing the Company’s goodwill in accordancewith SFAS No. 142 for the years ended December 31, 2002 and 2001.  Based on these reviews, an impairment chargeis not required.

 

The changes in the carrying amount of goodwill foreach of the Company’s reportable business segments for the year ended December31, 2002 were as follows:

 
|                                   |   | **United  States** |      | **Hong Kong** |   | **Total** |   |
|----------------------------------------|--------|--------------------|-----------|---------------|--------|-----------|--------|
| Balances  as of January 1, 2002        |   | $                  | 9,241,128 |          | $      | —    |   | $ | 9,241,128 |   |
| Changes  to Goodwill during the period |   |               |      |          |   |      |   |   |   |   |
| Balances  as of December 31, 2002      |   | $                  | 9,241,128 |          | $      | —    |   | $ | 9,241,128 |

 

The following table shows what the Company’s net lossand loss per share would have been in 2001 and 2000 if goodwill had not beenamortized during those periods, compared to the net income and loss per sharerecorded for 2002: 

 
|                                   |   | **2002** |       | **2001** |   | **2000**   |   |
|----------------------------------------|--------|----------|------------|----------|--------|------------|--------|
|                                   |   |     |       |     |   |       |   |
| Reported  net loss                     |   | $        | (8,012,226 | )        | $      | (1,499,518 | )      | $ | (848,986 | ) |
| Add  back:  Goodwill amortization |   | —   |       | 513,396  |   | 513,360    |   |
| Adjusted  net loss                     |   | $        | (8,012,226 | )        | $      | (986,122   | )      | $ | (335,626 | ) |
|                                   |   |     |       |     |   |       |   |
| Basic  Earnings per Share:             |   |     |       |     |   |       |   |
| Reported  net loss                     |   | $        | (0.82      | )        | $      | (0.16      | )      | $ | (0.09 | ) |
| Goodwill  amortization                 |   | —   |       | 0.05     |   | 0.05       |   |
| Adjusted  net loss                     |   | $        | (0.82      | )        | $      | (0.11      | )      | $ | (0.04 | ) |
|                                   |   |     |       |     |   |       |   |
| Diluted  Earnings per Share:           |   |     |       |     |   |       |   |
| Reported  net loss                     |   | $        | (0.82      | )        | $      | (0.16      | )      | $ | (0.09 | ) |
| Goodwill  amortization                 |   | —   |       | 0.05     |   | 0.05       |   |
| Adjusted  net loss                     |   | $        | (0.82      | )        | $      | (0.11      | )      | $ | (0.04 | ) |

 

**NOTE 6 -Accounts Payable and Accrued Liabilities:**

 

Accounts payable and accrued liabilities consist ofthe following:

 
|                                  |   | **December  31, 2002** |       | **December  31, 2001** |   |
|---------------------------------------|--------|------------------------|------------|------------------------|--------|
| Trade  payables                       |   | $                      | 10,317,404 |                   | $      | 3,447,888 |   |
| Accrued  royalties                    |   | 1,638,290              |       | 1,512,586              |   |
| Accrued  compensation and commissions |   | 621,431                |       | 679,540                |   |
| Other                                 |   | 940,665                |       | 940,766                |   |
|                                  |   | $                      | 13,517,790 |                   | $      | 6,580,780 |   |

 

F-14

----

 

**NOTE 7 -Notes Payable:**

 

Indebtedness consists of the following:

 
|                                                                                                                                                                                                                                                                                                                                       |   | **December  31, 2002** |      | **December  31, 2001** |   |
|--------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|--------|------------------------|-----------|------------------------|--------|
| Primary  Debt                                                                                                                                                                                                                                                                                                                              |   |                   |      |                   |   |
| Bank  revolving line of credit for $17.5 million with a commercial bank,  collateralized by all of the Company’s U.S. accounts receivable, intangibles,  equipment, fixtures, and inventory, and 65% of the common stock of DSI(HK)  Limited, principal due on March 31, 2004; interest at prime plus .75% (5% at  December 31, 2002) |   | $                      | 7,014,998 |                   | $      | 9,210,390 |   |
| Revolving  bank loan drawn against a $6 million line of credit, collateralized by  customers’ letters of credit, fluctuating interest rate (4.25% at December  31, 2002)                                                                                                                                                              |   | 709,566                |      | —                 |   |
| Bank  installment loan, bearing interest at 4.5%; payable in 12 monthly payments of  HKD340,652 (approximately US$43,700 at December 31, 2002), including  principal and interest, with final payment due December 3, 2003.                                                                                                                |   | 511,585                |      | —                 |   |
| Short-term  loans from 3 banks discounted and collateralized by specific customer’s  letters of credit; interest ranging from 4.75% to 5.15%.                                                                                                                                                                                         |   | 1,080,235              |      |                   |   |
| Other                                                                                                                                                                                                                                                                                                                                      |   | 4,774                  |      | 40,415                 |   |
|                                                                                                                                                                                                                                                                                                                                       |   | 8,240,923              |      | 10,331,040             |   |
| Less:  current portion                                                                                                                                                                                                                                                                                                                     |   | 8,240,923              |      | 1,120,650              |   |
|                                                                                                                                                                                                                                                                                                                                       |   | $                      | —    |                   | $      | 9,210,390 |   |

 

The bank revolving credit facility (the “Revolver”)includes a $17.5 million revolving line of credit commitment, subject toavailability under a borrowing base calculated by reference to the level ofeligible accounts receivable and inventory, as defined in the agreement.  The Revolver matures on  March 31, 2004.  Interest on borrowings outstanding under the Revolver is payablemonthly in arrears at an annual rate equal to prime plus .75%.  In addition, an unused line fee at an annualrate equal to .50% applied to the amount by which $17.5 million exceeds theaverage daily principal balance during the month and a collateral managementfee of $2,500 is payable monthly.

 

The Revolver contains certain restrictive covenantsand conditions among which are prohibition on payment of dividends, limitationson further indebtedness, restrictions on dispositions and acquisitions ofassets, certain defined maximum allowed borrowing amounts, limitations onadvances to third parties, compliance with minimum net worth and net incomeamounts, and designation as “Senior Indebtedness” with respect to the relatedparty debt described below. The Company has no cross-default provisions in anyof its debt agreements.

 

The Company’s net losses for the year ended December31, 2002, resulted in the Company being out of compliance with the minimum networth and net income covenants required under the Revolver.  Therefore, the Company’s $7.0 million debtunder the Revolver as of December 31, 2002, has been reclassified as a currentliability.  As a result, the Company’scurrent liabilities exceeded its current assets by $6.5 million as of December31, 2002. If the Revolver, at the lender’s option, were to be accelerated, the$7.0 million debt would become immediately due and payable.

 

F-15

----

 

The Company in the past has been successful innegotiating the Revolver amendments to bring the Company back intocompliance.  Primary operations for thelender of the Revolver, Sunrock Capital Corp. were sold in February 2003,limiting the willingness of Sunrock to amend any remaining lendingagreements.  As a result, the Company isin discussions with several banks to replace the Revolver with a new similar loan.  The Company’s viability as a going concernis dependent upon successful negotiations with Sunrock, a new lender, or asubstantial capital infusion, as well as sustained profitable operations. Theaccompanying financial statements do not include any adjustments that might benecessary if the Company is unable to continue as a going concern.

 

To the extent the Company’s cash reserves and cashflows from operations are insufficient to meet future cash requirements, theCompany will need to successfully raise additional capital through an equityinfusion or the issuance of debt.  TheCompany’s executive management believes that the Company will be required toeither obtain a new revolving loan or obtain necessary additional capital toallow the Company to continue its normal operations for the foreseeable future.However, there can be no assurance the Company will meet its projectedoperating results or be successful either in obtaining additional capital, orobtaining a new revolving loan.

 

In addition to the above, the Company has available anadditional HKD $19,000,000 (approximately US $2.4 million) line of credit bankfacility (the “Standard Chartered Facility”). The facility is in the form of a credit financing facility based onactual shipments of product and opened letters of credit and bears interest atthe 3-month LIBOR rate plus 2%.  Thisfacility expires June 20, 2003.

 

The Company’s revolving bank loan drawn against a $6million line of credit and the Standard Chartered Facility are subject to periodicreview and may be canceled by the respective bank upon notice.

 
| **Related Party Debt**                                                                                                                                                                                                                                                                                                                           |   | **December  31, 2002** |      | **December  31, 2001** |   |
|--------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|--------|------------------------|-----------|------------------------|--------|
| Promissory  Note of $1,690,000 to Walter S. and Susan Reiling,  collateralized by a $868,000 Letter of Credit, subordinated to  other debt, payable in quarterly installments of $108,500 through January 7,  2005; including interest at 10.0375%.                                                                                         |   | $                      | 864,552   |                   | $      | 1,191,037 |   |
|                                                                                                                                                                                                                                                                                                                                             |   |                   |      |                   |   |
| Promissory  Note of $5,000,000 to MVII, Inc., subordinated to the  Revolver, payable in monthly installments  of $50,000 through July 2004 plus interest at prime plus 2% (6.25% at  December 31, 2002).  Additionally,  under certain conditions as stipulated by the Revolver a $300,000 payment may  be made on March 31 each year. |   | 4,650,000              |      | 3,850,000              |   |
|                                                                                                                                                                                                                                                                                                                                             |   | 5,514,552              |      | 5,041,037              |   |
| Less:  current portion                                                                                                                                                                                                                                                                                                                      |   | 960,510                |      | 1,751,485              |   |
|                                                                                                                                                                                                                                                                                                                                             |   | $                      | 4,554,042 |                   | $      | 3,289,552 |   |

 

The $868,000 Letter of Credit collateralizing the$1,690,000 promissory note, is provided for the benefit of the Company byMVII.  Expenses associated with the letterof credit are reimbursed to MVII by the Company.  Payment to MVII on the $5,000,000 promissory note is subject tothe terms of a subordination agreement between MVII and the Revolver bank,which places restrictions on payment to MVII, based on the borrowing capacityavailable to the Company under the Revolver.

 

The Company’s ability to meet its maturing debt andother cash requirements is dependent on the continuation of sufficient lendingarrangements, additional cash infusions, and/or cash from operations.  In connection with any future cash needs oracquisition opportunities, the Company may incur additional debt or issueadditional equity or debt securities depending on market conditions, as well asother factors.  However, there can be noassurance the Company will meet its projected operating results.

 

F-16

----

 

**NOTE 8 - Income Taxes:**

 

The components of income (loss) before provision for(benefit from) income taxes by fiscal year were as follows:

 

|     |   | **2002** |       | **2001**  |   | **2000**   |   |
|----------|--------|----------|------------|-----------|--------|------------|--------|
| Domestic |   | $        | (5,715,771 | )         | $      | (3,908,923 | )      | $ | (4,167,128 | ) |
| Foreign  |   | (20,749  | )          | 2,850,308 |   | 2,840,694  |   |
|     |   | $        | 5,736,520  |      | $      | (1,058,615 | )      | $ | (1,326,434 | ) |

 

The provision for income taxes (benefit) by fiscalyear is as follows:

 

|      |   | **2002**  |      | **2001** |   | **2000** |   |
|-----------|--------|-----------|-----------|----------|--------|----------|--------|
| Current:  |   |      |      |     |   |     |   |
| Federal   |   | $         | —    |     | $      | —   |   | $ | — |   |
| Foreign   |   | 34,244    |      | 363,992  |   | 324,473  |   |
|      |   | 34,244    |      | 363,992  |   | 324,473  |   |
|      |   |      |      |     |   |     |   |
| Deferred: |   |      |      |     |   |     |   |
| Federal   |   | 2,205,000 |      | (40,000  | )      | (949,000 | )      |
| Foreign   |   | 36,462    |      | 66,911   |   | 147,079  |   |
|      |   | 2,241,462 |      | 26,911   |   | (801,921 | )      |
|      |   | $         | 2,275,706 |     | $      | 390,903  |   | $ | (477,448 | ) |

 

The difference between income taxes (benefit) at thestatutory federal and the effective income tax rates by fiscal year is asfollows:

 

|                                        |   | **2002**  |       | **2001** |   | **2000** |   |
|---------------------------------------------|--------|-----------|------------|----------|--------|----------|--------|
| Taxes  (benefit) computed at statutory rate |   | $         | (1,950,417 | )        | $      | (359,929 | )      | $ | (450,987 | ) |
| U.S.  Permanent items                       |   | 18,600    |       | 191,002  |   | 190,256  |   |
| Split  Dollar Life Insurance                |   | —    |       | —   |   | (592,577 | )      |
| Valuation  allowance                        |   | 4,031,000 |       | 566,474  |   | 371,654  |   |
| Other,  net                                 |   | 176,523   |       | (6,644   | )      | 4,206    |   |
|                                        |   | $         | 2,275,706  |     | $      | 390,903  |   | $ | (477,448 | ) |

 

F-17

----

 

Deferred tax assets (liabilities) are comprised of thefollowing:

 

|                                          |   | **December  31,  2002** |      | **December  31,  2001** |   |
|-----------------------------------------------|--------|-------------------------|-----------|-------------------------|--------|
| Net  operating loss carry forward             |   | $                       | 1,152,000 |                    | $      | 610,000 |   |
| Allowance  for doubtful accounts              |   | 638,000                 |      | 578,000                 |   |
| Inventory  valuation adjustments              |   | 33,000                  |      | 29,000                  |   |
| Depreciation                                  |   | 178,000                 |      | 259,000                 |   |
| Accruals  for inventory returns and markdowns |   | 400,000                 |      | 133,000                 |   |
| Foreign  and alternative minimum tax credits  |   | 1,596,000               |      | 1,753,000               |   |
| Other                                         |   | 34,000                  |      | 57,000                  |   |
| Gross  deferred tax assets                    |   | 4,031,000               |      | 3,419,000               |   |
| Less  valuation allowance                     |   | (4,031,000              | )         | (566,000                | )      |
| Net  deferred tax assets                      |   | 0                       |      | 2,853,000               |   |
| Unremitted  earnings of foreign subsidiary    |   | 0                       |      | (648,000                | )      |
| Depreciation                                  |   | (179,902                | )         | (156,642                | )      |
| Other                                         |   | (109,861                | )         | (99,118                 | )      |
| Gross  deferred tax liabilities               |   | (289,763                | )         | (903,760                | )      |
| Net  deferred tax assets (liabilities)        |   | $                       | (289,763  | )                       | $      | 1,949,240 |   |

 

The Internal Revenue Service regulations restrict theutilization of U.S. net operating loss carryforwards and other tax attributessuch as foreign tax credits for any company in which an “ownership change” asdefined in Section 382 of the Internal Revenue Code has occurred.  In June of 1999, the Company had a Section382 change in ownership.  As a result,the Company’s U.S. net operating losses and tax credits generated before thisownership change are subject to limitation of approximately $1,230,000 peryear.  For the current fiscal year, thislimitation did not impact the Company’s utilization of U.S. net operatinglosses and foreign tax credits.

 

At December 31, 2002, the Company has approximately$1,514,000 in foreign tax credit carryforwards which expire between December31, 2002 through December 31, 2007.  TheCompany also has approximately $82,000 in alternative minimum tax creditcarryforwards which do not expire.  TheCompany has federal net operating loss carryforwards (NOL) of approximately$3,389,000 which expire in 2021.  TheCompany’s state net operating loss carryforward is not significant.  The benefit from utilization of netoperating loss carryforwards could be subject to further limitations ifsignificant ownership changes occur in the Company.  The Company’s ability to realize the entire benefit of itsdeferred tax asset requires that the Company achieve certain future earningslevels prior to the expiration of its foreign tax credit and NOL carryforwards.

 

*DeferredTaxes –*The Company recorded a $4.0 million charge in fiscalyear 2002 to establish a valuation allowance for all of its deferred taxassets, including $2.2 million of deferred tax assets generated in prioryears.  The valuation allowance wascalculated in accordance with the provisions of Statement of FinancialAccounting Standards (SFAS) 109, “Accounting for Income Taxes,” which placesprimary importance on the Company’s cumulative operating results in the mostrecent periods when assessing the need for a valuation allowance.

 

The primary factors considered in evaluating therealizability of the deferred tax assets and establishing the valuationallowance were continued operating losses for the Company through December 31,2002, the Company’s projection of future operating results and the number ofyears it will take to recover the tax assets in a difficult market.  This evaluation provides sufficient negativeevidence to establish an additional valuation allowance under the provision ofSFAS 109.  The company intends tomaintain a full valuation allowance for its deferred tax assets and netoperating loss carryforwards until sufficient positive evidence exists tosupport reversal of the allowance.  Theestablishment of this valuation allowance in no way affects the Company’sability to reduce future tax expense through utilization of net operatinglosses and foreign income tax credits.

 

F-18

----

 

**NOTE 9 -Employee Benefit Plan:**

 

The Company maintains a 401(k) Plan (the “Plan”) forthe benefit of its U.S. employees.  TheCompany may, at its discretion, provide funds to match employee contributionsto the Plan.  The Company contributedapproximately $51,000, $63,000 and $54,000 in fiscal 2002, 2001 and 2000,respectively, as employer matching contributions to employee contributions.

 

**NOTE 10- The Stock Option Plan and Warrants:**

 

The Company has reserved 388,888 common shares forissuance upon exercise of a warrant issued to a bank.  The warrant expires on December 11, 2005.  Upon completion of the going privatetransaction, such warrant will be exercisable at a purchase price of $0.47 pershare.

 

In connection with the Offering, the Company issuedwarrants to purchase 250,000 shares of common stock.  Such warrants are exercisable at $10.80 per share and expired May28, 2002.

 

On August 21, 2002, MVII converted a prepaid InvestmentWarrant in exchange for 1.8 million shares of common stock.  The Investment Warrant was issued March 19,2002, for a cash purchase price of $2.7 million.  Proceeds from the sale of the Investment warrant were used by theCompany for current working capital.

 

In May 1997, the Board of Directors adopted the DSIToys, Inc. 1997 Stock Option Plan (the “1997 Plan”) whereby certain employeesmay be granted stock options, appreciation rights or awards related to theCompany’s common stock.  Additionally,the Company may grant nonstatutory stock options (as defined in the 1997 Plan)to nonemployee board members.  The Boardof Directors authorized 600,000 shares to be available for grant pursuant tothe 1997 Plan.  Options expire no laterthan ten years from the date of grant.

 

Additional awards may be granted under the 1997 Planin the form of cash, stock or stock appreciation rights.  The stock appreciation right awards mayconsist of the right to receive payment in cash or common stock.  Any award may be subject to certainconditions, including continuous service with the Company or achievement ofbusiness objectives.

 

In May 1999, the 1997 Plan was amended to authorize900,000 shares to be available for grant.

 

In May 2000, the 1997 Plan was amended to authorize1,200,000 shares to be available for grant.

 

A summary of the option activity under the 1997 Plan,as amended, follows:

 
|                                      |   | **Number of  Outstanding Options** |   | **Weighted  Average  Option Price** |   |
|-------------------------------------------|--------|------------------------------------|--------|-------------------------------------|--------|
| Options  outstanding at December 31, 1999 |   | 746,500                            |   | $                                   | 3.63   |   |
| Granted                                   |   | 142,500                            |   | 3.19                                |   |
| Surrendered                               |   | (22,500                            | )      | 5.40                                |   |
| Options  outstanding at December 31, 2000 |   | 866,500                            |   | 3.51                                |   |
| Granted                                   |   | 103,000                            |   | 3.13                                |   |
| Surrendered                               |   | (240,000                           | )      | 3.29                                |   |
| Options  outstanding at December 31, 2001 |   | 729,500                            |   | 3.55                                |   |
| Granted                                   |   | 10,000                             |   | 3.13                                |   |
| Surrendered                               |   | (165,500                           | )      | 3.61                                |   |
| Options  outstanding at December 31, 2002 |   | 574,000                            |   | $                                   | 3.53   |   |

 

The weighted average fair value at date of grant foroptions granted during fiscal 2002, 2001 and 2000 was $3.13, $3.13 and $3.19respectively.  Vesting periods foroptions granted range from immediate to seven years from the date of grant inincrements between 5% and 90% per year.

 

F-19

----

 

Options outstanding at December 31, 2002, are asfollows:

 
| **Option Price** |              | **Number of  Outstanding  Options** |    | **Weighted  Average  Exercise  Price** |   | **Weighted  Average  Remaining  Contractual Life** |   | **Number of  Exercisable  Options** |   | **Weighted  Average  Exercise  Price** |   |
|------------------|-------------------|-------------------------------------|---------|----------------------------------------|--------|----------------------------------------------------|--------|-------------------------------------|--------|----------------------------------------|--------|
| $                | 3.125 – 3.49 |                                | 528,500 |                                   | $      | 3.14                                               |   | 7                                   |   | 265,100                                |   | $ | 3.13 |   |
| 8.00             |              | 45,500                              |    | $                                      | 8.00   |                                               | 5      |                                | 21,125 |                                   | $      | 8.00 |   |
|             |              | 574,000                             |    |                                   |   |                                               |   | 286,225                             |   |                                   |   |
|                  |                   |                                     |         |                                        |        |                                                    |        |                                     |        |                                        |        |  |  |  |

 

The Company applies the intrinsic method prescribed byAPB 25 and related interpretations in accounting for its stock optionplan.  Accordingly, no compensation costhas been recognized by the Company for this plan.  The following unaudited pro forma data is calculated as ifcompensation cost for the 1997 Plan was determined based upon the fair value atthe grant date for awards under the plan consistent with the methodologyprescribed under SFAS 123 for fiscal years 2002, 2001 and 2000:

 
|                                                                                                                                  |   | **2002** |       | **2001** |   | **2000**   |   |
|---------------------------------------------------------------------------------------------------------------------------------------|--------|----------|------------|----------|--------|------------|--------|
| Net  loss, as reported                                                                                                                |   | $        | (8,012,226 | )        | $      | (1,449,518 | )      | $ | (848,986 | ) |
| Deduct:  Total stock-based employee compensation expense determined under fair value  based method for all awards, net of tax effects |   | (138,425 | )          | (319,900 | )      | (240,426   | )      |
| Pro  forma net loss                                                                                                                   |   | $        | (8,150,651 | )        | $      | (1,769,418 | )      | $ | (1,089,412 | ) |
|                                                                                                                                  |   |     |       |     |   |       |   |
| Loss  per share:                                                                                                                      |   |     |       |     |   |       |   |
| Basic  – as reported                                                                                                             |   | $        | (0.82      | )        | $      | (0.16      | )      | $ | (0.09 | ) |
| Basic  – pro forma                                                                                                               |   | $        | (0.84      | )        | $      | (0.20      | )      | $ | (0.12 | ) |
|                                                                                                                                  |   |     |       |     |   |       |   |
| Diluted  – as reported                                                                                                           |   | $        | (0.82      | )        | $      | (0.16      | )      | $ | (0.09 | ) |
| Diluted  – pro forma                                                                                                             |   | $        | (0.84      | )        | $      | (0.20      | )      | $ | (0.12 | ) |

 

The fair value of each option granted is estimated onthe date of grant using the Black-Scholes options-repricing model with thefollowing weighted average assumptions used for grants in fiscal 2002, 2001 and2000: expected volatility of 80%, risk-free interest rate of 3.92% to 6.37%, nodividend yield and an expected life of seven years.

 

**NOTE 11- Related Party Transactions:**

 

The Company leased its office and warehouse in Houstonduring part of 2002 and in prior years from an entity owned by the previoussole shareholder of the Company.  Rentexpense on these leases was approximately $253,000, $367,000 and $325,000respectively for fiscal 2002, 2001, and 2000. Management believes that the rental rates approximate fair market value.

 

On June 11, 1999, the Company entered into aconsulting agreement with a director (and former CEO), for a term of threeyears.  Compensation for the three yearterm was $450,000 payable in equal monthly installments of $12,500.  The final payment covered by the agreementwas paid in May, 2002.

 

On January 7, 2000, the Company borrowed $5,000,000from MVII, LLC (a California limited liability company controlled by theChairman, and including certain other directors) evidenced by a PromissoryNote.  The Note, which bears interest ata rate of prime plus 2% per annum, requires monthly interest payments from thedate of the Note and principal payments subject to subordination terms of theRevolver (see Note 6).

 

F-20

----

 

Also on January 7, 2000, as discussed in Note 17, theCompany merged with Meritus Industries, Inc. Pursuant to the merger terms, one of Meritus’ primary shareholders wassubsequently elected to the Board of Directors.  In addition to the stock received in the transaction, theshareholder received $1.1 million in cash and a note receivable for $1.7 million. The note, bearing interest at 10.0375% per annum, requires quarterlyprincipal and interest payments beginning April 1, 2000.

 

On March 6, 2002 and May 21, 2002, pursuant to theterms of the Revolver and the MVII Note, the Company reborrowed an aggregate of$1,350,000 of the original principal that the Company had paid on the MVIINote.  Additionally, subsequent toDecember 31, 2002, on March 10, 2003, the Company reborrowed an additional$350,000.  The proceeds were used tofinance normal business operations of the Company.

 

Additional related party transactions are described inNotes 1, 11, 16 and 17.

 

**NOTE12 - Commitments and Contingencies:**

 

In the normal course of business, the Company isinvolved in product and intellectual property issues which sometimes result inlitigation.  It is the opinion ofmanagement that the ultimate resolution of such matters will not have amaterial adverse effect on the Company’s financial position, results ofoperations or cash flows, taken as a whole.

 

The Company and its subsidiary do not maintain anyoff-balance sheet debt or similar financing arrangements nor has either entityformed any special purpose entities for the purpose of maintaining off-balancesheet debt.

 

The Company leases its facilities under variousoperating leases which expire from 2001 to 2010.  Rent expense, including amounts paid to a related party, forfiscal 2002, 2001, and 2000 amounted to $1,024,188, $966,971 and $1,008,183respectively.  Aggregate minimum rentalcommitments under non-cancelable leases are as follows for the specified fiscalyears:

 
| 2003                 |   | $       | 1,086,628 |   |
|----------------------|--------|---------|-----------|--------|
| 2004                 |   | 980,991 |      |
| 2005                 |   | 975,854 |      |
| 2006                 |   | 801,725 |      |
| 2007                 |   | 320,507 |      |
| Thereafter thru 2010 |   | 390,404 |      |
|                 |   | $       | 4,556,109 |   |

 

In August 2002, the Company leased and relocated itsprimary executive offices, showroom and consumer service operations to approximately17,000 square feet of office space at 10110 West Sam Houston Parkway, South,Houston, Texas, 77099.  The leaserequires monthly lease payments of $14,532, plus additional annually adjustablemonthly amounts for taxes, insurance, and operating expense.  The lease expires in September 2007.

 

Additionally, the Company leased approximately 75,000square feet of warehouse space in Fife, Washington from a third party logisticscompany to serve as the Company’s primary domestic warehouse and distributioncenter.  The lease expires December 31,2006, and requires monthly payments of $31,500.  The lease is cancelable by either party with nine months notice.

 

Royalty expense under licensing agreements aggregatedapproximately $2,527,000, $3,310,000 and $2,989,000, in fiscal 2002, 2001 and2000, respectively.  At December 31,2002, minimum guaranteed royalties payable under these agreements of  $250,000 in fiscal 2003 and $835,000 through2007 are included in accrued royalties payable and prepaid expenses and otherassets.

 

The Company has employment agreements with executivesat December 31, 2002 that aggregate $403,000, are adjusted annually by the CPIchange, and expire in the next 3-23 months.

 

F-21

----

 

In fiscal 2000, the Company terminated its obligationsfor current and future insurance premium payments on certain life insurancepolicies.  In prior years, the Companypaid premiums for the policies owned by the Tommy and JoBeth Moss Joint LifeInsurance Trust, (the “Trust”), and was entitled to repayment of the advancedpremiums, plus related cumulative interest, upon the death of JoBeth Moss.  The Company agreed to forgo the cumulativeamounts due the Company in exchange for the Trust extinguishing the futureobligations for insurance premium payments.

 

**NOTE13 - Segment Information:**

** **

The Company designs, develops, markets and distributesa variety of toys and children’s consumer electronics.  These product lines are grouped into threemajor categories which represent the Company’s operating segments, as follows:

 

Juvenile Audio Products, comprised of YouthElectronics, including walkie-talkies, pre-school audio products, and pre-teenaudio products, and Musical Instruments, including electronic keyboards,drumpads and other musical toys; Girls’ Toys, including dolls, play sets andaccessories; and Boys’ Toys, including radio control vehicles, action figuresand western and military action toys.

 

These operating segments all have similar economiccharacteristics: the marketing of children’s products.  Based on these similarities, the Company’sproducts can be aggregated into one reportable segment for purposes of thisdisclosure.

 

The Company sells its products through (i) the HongKong operation, where products are shipped directly from contract manufacturersto the Company’s customers, and (ii) the United States operation, whereproducts are shipped from the Company’s warehouses in Houston, TX and Fife, WAto its customers.

 

Financial information for fiscal 2002, 2001, and 2000for the U.S. and Hong Kong operations is as follows:

 
|                            |   | **United States** |       | **Hong Kong** |   | **Consolidated** |   |
|---------------------------------|--------|-------------------|------------|---------------|--------|------------------|--------|
| **Fiscal  2002:**               |   |              |       |          |   |             |   |
| Net sales                       |   | $                 | 22,438,750 |          | $      | 27,315,423       |   | $ | 49,754,173 |   |
| Operating income (loss)         |   | (5,410,345        | )          | 508,134       |   | (4,902,211       | )      |
| Depreciation expense            |   | 296,592           |       | 775,391       |   | 1,071,983        |   |
| Capital expenditures            |   | 585,400           |       | 944,437       |   | 1,529,837        |   |
| Total assets at fiscal year end |   | $                 | 24,022,605 |          | $      | 4,648,097        |   | $ | 28,670,702 |   |
| **Fiscal  2001:**               |   |              |       |          |   |             |   |
| Net sales                       |   | $                 | 31,859,743 |          | $      | 36,046,666       |   | $ | 67,906,409 |   |
| Operating income (loss)         |   | (632,616          | )          | 450,564       |   | (182,052         | )      |
| Depreciation expense            |   | 469,033           |       | 865,359       |   | 1,334,392        |   |
| Capital expenditures            |   | 121,657           |       | 645,264       |   | 766,921          |   |
| Total assets at fiscal year end |   | $                 | 27,622,660 |          | $      | 3,690,075        |   | $ | 31,312,735 |   |
| **Fiscal  2000:**               |   |              |       |          |   |             |   |
| Net sales                       |   | $                 | 27,147,848 |          | $      | 43,290,683       |   | $ | 70,438,531 |   |
| Operating income (loss)         |   | (682,572          | )          | 633,386       |   | (49,186          | )      |
| Depreciation expense            |   | 733,186           |       | 818,446       |   | 1,551,632        |   |
| Capital expenditures            |   | 237,752           |       | 1,012,192     |   | 1,249,944        |   |
| Total assets at fiscal year end |   | $                 | 26,528,128 |          | $      | 3,471,012        |   | $ | 29,999,140 |   |

 

F-22

----

 

Sales to major customers that exceeded 10% of theCompany’s total net sales consist of the following for the specified fiscalyears:

 

|                  |   | **2002** |   | **2001** |   | **2000** |   |
|-----------------------|--------|----------|--------|----------|--------|----------|--------|
| Wal-Mart              |   | 27       | %      | 21       | %      | 18       | %      |
| Kmart                 |   |     |   | 10       | %      |     |   |
| Toys “R” Us |   |     |   |     |   | 12       | %      |

 

Approximately 19% of the Company’s sales were exportsto countries other than the United States during fiscal 2002, and 17% and 19%during fiscal 2001 and 2000, respectively.

 

**NOTE 14 - Supplemental Cash Flow Information:**

 

Additional cash flow information by fiscal year is asfollows:

 
|                                             |   | **2002** |    | **2001** |   | **2000**    |     |
|--------------------------------------------------|--------|----------|---------|----------|--------|-------------|----------|
|                                             |   |     |    |     |   |        |     |
| Cash  paid (received) for:                       |   |     |    |     |   |        |     |
| Interest                                         |   | $        | 935,363 |     | $      | 1,107,486   |     | $ | 1,104,296 |   |
| Income  taxes                                    |   | $        | 396,386 |     | $      | 385,926     |     | $ | 753,199 |   |
| Noncash  activities included in the following:   |   |     |    |     |   |        |     |
| Accounts  receivable write-offs (recoveries)     |   | $        | (36,890 | )        | $      | 438,089     |     | $ | (11,769 | ) |
| Acquisition  of Meritus:                         |   |     |    |     |   |        |     |
| Property,  plant and equipment acquired          |   |     |    |     |   | $           | (748,730 | ) |
| Accounts  receivable and other assets acquired   |   |     |    |     |   | (838,563    | )        |
| Liabilities  assumed                             |   |     |    |     |   | 7,475,172   |     |
| Note  payable issued to the Sellers              |   |     |    |     |   | 1,690,000   |     |
| Common  stock issues (including treasury shares) |   |     |    |     |   | 1,801,415   |     |
| Goodwill  resulting from Meritus acquisition     |   |     |    |     |   | (10,263,327 | )        |
| Net  cash paid for Meritus acquisition           |   |     |    |     |   | $           | (884,033 | ) |

 

F-23

----

 

**NOTE15 - Quarterly Financial Information (unaudited):**

** **
|                     |   | **Fiscal Quarter Ended** |      |
|--------------------------|--------|--------------------------|-----------|
|                     |   | **3/31/02**              |      | **6/30/02** |   | **9/30/02** |   | **12/31/02** |   |
| Net sales                |   | $                        | 5,188,860 |   | $ | 8,951,657 |   | $ | 20,683,800 |   | $ | 14,929,856 |   |
| Operating loss           |   | (1,936,905               | )         | (423,516 | ) | (424,670 | ) | (2,117,120 | ) |
| Loss before income taxes |   | (1,990,021               | )         | (738,000 | ) | (616,531 | ) | (2,391,968 | ) |
| Net loss                 |   | (1,313,414               | )         | (487,080 | ) | (3,749,058 | ) | (2,462,674 | ) |
| Basic loss per share     |   | $                        | (0.14     | ) | $ | (0.05 | ) | $ | (0.38 | ) | $ | (0.23 | ) |
| Diluted loss per share   |   | $                        | (0.14     | ) | $ | (0.05 | ) | $ | (0.38 | ) | $ | (0.23 | ) |

 
|                              |   | **Fiscal Quarter Ended** | ** ** |
|-----------------------------------|--------|--------------------------|------------|
|                              |   | **3/31/01**              |       | **6/30/01** |   | **9/30/01** |   | **12/31/01** |   |
| Net sales                         |   | $                        | 6,721,223  |   | $ | 9,416,184 |   | $ | 29,927,783 |   | $ | 21,841,219 |   |
| Operating income (loss)           |   | (2,188,188               | )          | (2,070,282 | ) | 3,531,705 |   | 544,713 |   |
| Income (loss) before income taxes |   | (2,421,792               | )          | (2,314,578 | ) | 3,312,353 |   | 365,402 |   |
| Net income (loss)                 |   | (1,549,947               | )          | (1,481,330 | ) | 1,981,289 |   | (399,530 | ) |
| Basic earnings (loss) per share   |   | $                        | (0.17      | ) | $ | (0.16 | ) | $ | 0.22 |   | $ | (0.04 | ) |
| Diluted earnings (loss) per share |   | $                        | (0.17      | ) | $ | (0.16 | ) | $ | 0.22 |   | $ | (0.04 | ) |

 
|                              |   | **Fiscal Quarter Ended** | ** ** |
|-----------------------------------|--------|--------------------------|------------|
|                              |   | **3/31/00**              |       | **6/30/00** |   | **9/30/00** |   | **12/31/00** |   |
| Net sales                         |   | $                        | 6,914,462  |   | $ | 13,582,505 |   | $ | 29,915,591 |   | $ | 20,025,973 |   |
| Operating income (loss)           |   | (1,735,467               | )          | 362,744 |   | 2,598,974 |   | (1,275,437 | ) |
| Income (loss) before income taxes |   | (1,995,260               | )          | 3,287 |   | 2,312,891 |   | (1,647,352 | ) |
| Net income (loss)                 |   | (1,276,913               | )          | 2,049 |   | 1,480,251 |   | (1,054,373 | ) |
| Basic earnings (loss) per share   |   | $                        | (0.14      | ) | $ | 0.00 |   | $ | 0.16 |   | $ | (0.12 | ) |
| Diluted earnings (loss) per share |   | $                        | (0.14      | ) | $ | 0.00 |   | $ | 0.16 |   | $ | (0.12 | ) |

#### ** **

#### **NOTE 16- Subsequent Events**

####  

The Company is the defendant in a lawsuit styled RymaxCorp. d/b/a Rymax Marketing Services, Inc, (“Rymax”) v. DSI Toys, Inc. in theSuperior Court of New Jersey Law Division: Morris County; civil action docket number MRSL-3799-02.  In the lawsuit, Rymax claims that theCompany failed to pay commissions due to Rymax and demands judgment for damagesin the amount of $45,061.67 plus interest, attorney fees and costs ofcourt.  The Company does not believe itowes these damages and may bring a counterclaim against Rymax for an amountexceeding $75,000.00 for goods shipped and sold to them.  At this time, the Company is attempting tonegotiate a settlement of the entire controversy.

 

The Company is the defendant in a lawsuit styled TheCartoon Network, LP, LLLP (“TCN”) v. DSI Toys, Inc. in the State Court of FultonCounty, State of Georgia, Civil Action File No. 03VS046924C.  In the lawsuit, TCN claims the Company isindebted to TCN for $725,051.70 for television advertisements aired by TCN,together with interest at the rate of 18% per annum until paid. The Company isin negotiations with TCN and believes it has recorded an adequate amount forthe ultimate settlement.

 

F-24

----

 

The Company has received a demand letter from theChapter 7 Trustee for bankruptcy cases that are pending in the SouthernDistrict of New York involving Play Co. Toys & Entertainment Corp., ToysInternational.Com, Inc. and Play Co. Toys Canyon Country, Inc.  The Trustee alleges that a payment receivedby the Company from Toys International.Com, Inc. in the amount of $93,834.56was a preferential transfer that is recoverable under Bankruptcy Code Sections547 and 550.  The Company has respondedto the demand letter that the payment was a payment on an invoice for deliveredgoods made in the regular course of business. At this time the Company and theTrustee are in negotiations to settle the matter in its entirety.

 

**NOTE 17 - Business Combination**

 

On January 7, 2000, the Company acquired by way of amerger all of the issued and outstanding stock of Meritus Industries, Inc.(“Meritus”) in exchange for (i) 600,000 unregistered shares of the Company’scommon stock, less 66,792 shares of the Company’s common stock, which shareswere initially held by the Company and payable to Walter and Susan Reiling (the“Reilings”) upon satisfaction of certain post-closing conditions as set forthin the Closing and Holdback Agreement between the parties; (ii) $884,034 incash; and (iii) the Company’s Subordinated Secured Promissory Note for$1,690,000 paid to the Reilings, who were the sole shareholders of Meritus. Atthe end of the holdback period (June 7, 2000), the post-closing conditions werenot satisfied and none of the held back (66,792) shares was paid to theReilings.  The market value of theshares issued was $1,081,415 and was satisfied by the issuance of 347,365shares of new stock and 185,843 shares in treasury stock.  Contemporaneously with the merger, theCompany satisfied approximately $4.4 million of Meritus’ debt.

 

The acquisition was accounted for utilizing thepurchase method; therefore the Company recorded the acquired assets at theirestimated fair market value.  Goodwillgenerated by the transaction has been amortized over 20 years using thestraight-line method in 2001 and 2000. In 2002, and thereafter the market value of the goodwill will beevaluated annually and an impairment charge recorded if appropriate inaccordance with Statement of Financial Accounting Standards No. 142, “Goodwilland Other Intangible Assets.”

 

Commensurate with the merger, the Company borrowed$5,000,000 from MVII, LLC, a California limited liability company controlled byE. Thomas Martin (“MVII”), evidenced by a promissory note dated January 7,2000.  The proceeds from the note wereused for the payment of the Meritus debt discussed above.

 

F-25

----

 

**DSI Toys, Inc. andSubsidiary**

**Valuat**ion and Qualifying Accounts and Reserves (Schedule II)

**(In thousands)**

** **

 
| **Description**                 |   | **Balance at  December  31, 1999** |   | **Deductions** |   | **Charged to  costs and  expenses** |   | **Balance at   December   31, 2000** |   | **Charged to  costs and  expenses** |   | **Deductions** |   | **Balance at  December 31,  2001** |   | **Charged to  costs and  expenses** |   | **Deductions** |   | **Balance at  December   31, 2002** |   |
|---------------------------------|--------|------------------------------------|--------|----------------|--------|-------------------------------------|--------|--------------------------------------|--------|-------------------------------------|--------|----------------|--------|------------------------------------|--------|-------------------------------------|--------|----------------|--------|-------------------------------------|--------|
| Reserves  deducted from assets: |   |                               |   |           |   |                                |   |                                 |   |                                |   |           |   |                               |   |                                |   |           |   |                                |   |
|                            |   |                               |   |           |   |                                |   |                                 |   |                                |   |           |   |                               |   |                                |   |           |   |                                |   |
| Trade receivables               |   | 186                                |   | 12             |   | 222                                 |   | 420                                  |   | 1,718                               |   | (438           | )      | 1,700                              |   | 304                                 |   | 40             |   | 2,044                               |   |
|                            |   |                               |   |           |   |                                |   |                                 |   |                                |   |           |   |                               |   |                                |   |           |   |                                |   |
| Discounts and  markdowns        |   | 729                                |   | (398           | )      | 1,339                               |   | 1,670                                |   | 1,558                               |   | (1,755         | )      | 1,473                              |   | 2,176                               |   | (1,744         | )      | 1,905                               |   |
|                            |   |                               |   |           |   |                                |   |                                 |   |                                |   |           |   |                               |   |                                |   |           |   |                                |   |
| Return of defective  goods      |   | 1,082                              |   | (1,889         | )      | 1,837                               |   | 1,030                                |   | 1,012                               |   | (1,265         | )      | 777                                |   | 1,115                               |   | (1,497         | )      | 395                                 |   |
|                            |   |                               |   |           |   |                                |   |                                 |   |                                |   |           |   |                               |   |                                |   |           |   |                                |   |
| Inventory                       |   | 100                                |   | (129           | )      | 379                                 |   | 350                                  |   | 412                                 |   | (392           | )      | 370                                |   | 1,150                               |   | (370           | )      | 1,150                               |   |
|                            |   | 2,097                              |   | (2,404         | )      | 3,777                               |   | 3,470                                |   | 4,700                               |   | (3,850         | )      | 4,320                              |   | 4,745                               |   | (3,571         | )      | 5,494                               |   |

 

S-1

----

 

**EXHIBIT INDEX**

** **
| 2.1    |   | Articles/Certificate of Merger of Meritus  Industries, Inc. into the Company, dated January 7, 2000 (filed as Exhibit 2.2  to the Company’s Form 8-K dated January 7, 2000), incorporated herein by  reference.                  |
|--------|--------|---------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|
|   |   |                                                                                                                                                                                                                                  |
| 3.1    |   | Amended and Restated Articles of Incorporation of  the Company. (1)                                                                                                                                                                   |
|   |   |                                                                                                                                                                                                                                  |
| 3.1.1  |   | Amendment to Amended and Restated Articles of  Incorporation of the Company (filed as Exhibit 3.1.1 to the Company’s Form  10-Q for the quarterly period ended April 30, 1999), incorporated herein by  reference. (3)           |
|   |   |                                                                                                                                                                                                                                  |
| 3.2    |   | Amended and Restated Bylaws of the Company. (1)                                                                                                                                                                                       |
|   |   |                                                                                                                                                                                                                                  |
| 3.3    |   | Amendment to Amended and Restated Bylaws of the  Company. (1)                                                                                                                                                                         |
|   |   |                                                                                                                                                                                                                                  |
| 4.1    |   | Form of Common Stock Certificate. (1)                                                                                                                                                                                                 |
|   |   |                                                                                                                                                                                                                                  |
| 4.2    |   | Form of Warrant Agreement among the Company and  Representatives to purchase 250,000 shares of common stock. (1)                                                                                                                      |
|   |   |                                                                                                                                                                                                                                  |
| 4.3    |   | Common Stock Purchase Warrant No. A-1 dated December  11, 1995, issued to Hibernia Corporation to purchase 388,888 shares of common  stock. (1)                                                                                       |
|   |   |                                                                                                                                                                                                                                  |
| 4.4    |   | Registration Rights Agreement by and between the  Company and Hibernia Corporation. (1)                                                                                                                                               |
|   |   |                                                                                                                                                                                                                                  |
| 4.5    |   | Registration Rights Agreement by and between the  Registrant and Tommy Moss. (1)                                                                                                                                                      |
|   |   |                                                                                                                                                                                                                                  |
| 4.6    |   | Form of Investment Warrant by and between the  Company and MVII, LLC, dated March 19, 2001(filed as Exhibit 4.6 to the  Company’s Form 10-K for the fiscal year ended December 31, 2000),  incorporated herein by reference.     |
|   |   |                                                                                                                                                                                                                                  |
| 4.7    |   | Registration Rights Agreement by and between the  Company and MVII, LLC, dated March 19, 2001 (filed as Exhibit 4.7 to the  Company’s Form 10-K for the fiscal year ended December 31, 2000),  incorporated herein by reference. |
|   |   |                                                                                                                                                                                                                                  |
| 4.8    |   | Amended and Restated Investment Warrant by and  between the Company and MVII, LLC, dated January 31, 2002. (2)                                                                                                                        |
|   |   |                                                                                                                                                                                                                                  |
| 4.9    |   | Amended and Restated Registration Rights Agreement  by and between the Company and MVII, LLC dated January 31, 2002. (2)                                                                                                              |
|   |   |                                                                                                                                                                                                                                  |
| 10.1   |   | 1997 Stock Option Plan. (1)                                                                                                                                                                                                           |
|   |   |                                                                                                                                                                                                                                  |
| 10.2   |   | Agreement for Sale of Stock between Rosie  Acquisition, L.L.C. and DSI Acquisition, Inc. and Diversified Specialists,  Inc. and Tommy Moss, dated December 11, 1995. (1)                                                              |
|   |   |                                                                                                                                                                                                                                  |
| 10.3   |   | Employment Agreement dated December 11, 1995 by and  between the Company and M. D. Davis. (1)                                                                                                                                         |
|   |   |                                                                                                                                                                                                                                  |
| 10.4   |   | Employment Agreement dated December 11, 1995 by and  between the Company and Richard R. Neitz. (1)                                                                                                                                    |
|   |   |                                                                                                                                                                                                                                  |
| 10.5   |   | Employment Agreement dated December 11, 1995 by and  between the Company and Yau Wing Kong. (1)                                                                                                                                       |
|   |   |                                                                                                                                                                                                                                  |
| 10.6   |   | Employment Agreement dated December 11, 1995 by and  between the Company and Dale Y. Chen. (1)                                                                                                                                        |

 

E-1

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| 10.7   |   | Employment Agreement dated December 11, 1995 by and  between the Company and Thomas V. Yarnell. (1)                                                                                                                                                                                                                          |
|--------|--------|------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|
|   |   |                                                                                                                                                                                                                                                                                                                         |
| 10.8   |   | Employment Agreement dated March 16, 1997 by and  between the Company and J. Russell Denson. (1)                                                                                                                                                                                                                             |
|   |   |                                                                                                                                                                                                                                                                                                                         |
| 10.9   |   | Letter Loan Agreement between the Company and Bank  One, Texas, N.A. dated December 11, 1995, evidencing a revolving line of  credit and a term note (the “Bank One Letter Loan Agreement”). (1)                                                                                                                   |
|   |   |                                                                                                                                                                                                                                                                                                                         |
| 10.10  |   | First Amendment to Bank One Letter Loan Agreement,  dated January 31, 1996. (1)                                                                                                                                                                                                                                              |
|   |   |                                                                                                                                                                                                                                                                                                                         |
| 10.11  |   | Second Amendment to Bank One Letter Loan Agreement,  dated August 1, 1996. (1)                                                                                                                                                                                                                                               |
|   |   |                                                                                                                                                                                                                                                                                                                         |
| 10.12  |   | Third Amendment to Bank One Letter Loan Agreement,  dated November 14, 1996. (1)                                                                                                                                                                                                                                             |
|   |   |                                                                                                                                                                                                                                                                                                                         |
| 10.13  |   | Fourth Amendment to Bank One Letter Loan Agreement,  dated January 31, 1997. (1)                                                                                                                                                                                                                                             |
|   |   |                                                                                                                                                                                                                                                                                                                         |
| 10.14  |   | Fifth Amendment to Bank One Letter Loan Agreement,  dated January 31, 1997. (1)                                                                                                                                                                                                                                              |
|   |   |                                                                                                                                                                                                                                                                                                                         |
| 10.15  |   | Line of Credit Facility with State Street Bank and  Trust Company, Hong Kong Branch, dated April 1, 1997, evidencing a $5,000,000  line of credit. (1)                                                                                                                                                                       |
|   |   |                                                                                                                                                                                                                                                                                                                         |
| 10.16  |   | Underwriting Agreement dated May 28, 1997 among the  Company, the Tommy Moss Living Trust, Hibernia Corporation and Tucker Anthony  Incorporated and Sutro & Co. Incorporated (filed as Exhibit 10.1 to the  Company’s Form 10-Q for the quarterly period ended April 30, 1997),  incorporated herein by reference. |
|   |   |                                                                                                                                                                                                                                                                                                                         |
| 10.17  |   | Warrant Agreement dated May 28, 1997 by and among  the Company, Tucker Anthony Incorporated and Sutro & Co. Incorporated  (filed as Exhibit 10.2 to the Company’s Form 10-Q for the quarterly period  ended April 30, 1997), incorporated herein by reference.                                                      |
|   |   |                                                                                                                                                                                                                                                                                                                         |
| 10.18  |   | Renewal and Modification of Line of Credit Facility  with State Street Bank and Trust Company, Hong Kong Branch, dated June 6,  1997, evidencing an $8,000,000 line of credit (filed as Exhibit 10.1 to the  Company’s Form 10-Q for the quarterly period ended July 31, 1997),  incorporated herein by reference.      |
|   |   |                                                                                                                                                                                                                                                                                                                         |
| 10.19  |   | Debenture by DSI(HK) Limited to State Street Bank  and Trust Company, Hong Kong Branch, dated July 29, 1997 (filed as Exhibit  10.2 to the Company’s Form 10-Q for the quarterly period ended July 31,  1997), incorporated herein by reference.                                                                        |
|   |   |                                                                                                                                                                                                                                                                                                                         |
| 10.20  |   | Amended and Restated Bank One Letter Loan Agreement,  dated October 22, 1997 (filed as Exhibit 10.1 to the Company’s Form 10-Q for  the quarterly period ended October 31, 1997), incorporated herein by  reference.                                                                                                    |
|   |   |                                                                                                                                                                                                                                                                                                                         |
| 10.21  |   | First Amendment to Amended and Restated Bank One  Letter Loan Agreement, dated January 31, 1998 (filed as Exhibit 10.21 to the  Company’s Form 10-K for the annual period ended January 31, 1998),  incorporated herein by reference.                                                                                   |
|   |   |                                                                                                                                                                                                                                                                                                                         |
| 10.22  |   | Second Amendment to Amended and Restated Bank One  Letter Loan Agreement, dated September 30, 1998 (filed as Exhibit 10.22 to  the Company’s Form 10-Q for the quarterly period ended October 31, 1998),  incorporated herein by reference.                                                                             |
|   |   |                                                                                                                                                                                                                                                                                                                         |
| 10.23  |   | Employment Agreement dated August 20, 1998 by and  between the Company and Howard G. Peretz. (3)                                                                                                                                                                                                                             |
|   |   |                                                                                                                                                                                                                                                                                                                         |
| 10.24  |   | Loan and Security Agreement by and between the  Company and Sunrock Capital Corp. dated February 2, 1999. (3)                                                                                                                                                                                                                |

 

E-2

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| 10.25  |   | Stock Pledge Agreement by and between the Company  and Sunrock Capital Corp. dated February 2, 1999. (3)                                                                                                                                                                                                                                       |
|--------|--------|------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|
|   |   |                                                                                                                                                                                                                                                                                                                                           |
| 10.26  |   | Assignment of Deposit Account by and between the  Company and Sunrock  Capital Corp.  dated February 2, 1999. (3)                                                                                                                                                                                                                         |
|   |   |                                                                                                                                                                                                                                                                                                                                           |
| 10.27  |   | Trademark Security Agreement by and between the  Company and Sunrock Capital Corp. dated February 2, 1999. (3)                                                                                                                                                                                                                                 |
|   |   |                                                                                                                                                                                                                                                                                                                                           |
| 10.28  |   | Patent Collateral Assignment by and between the  Company and Sunrock Capital Corp. dated February 2, 1999. (3)                                                                                                                                                                                                                                 |
|   |   |                                                                                                                                                                                                                                                                                                                                           |
| 10.29  |   | Stock Purchase and Sale Agreement dated April 15, 1999  by and between the Company and MVII, LLC (filed as Exhibit 2 to the Company’s  Schedule 14D-9 filed by the Company on April 22, 1999), incorporated herein  by reference.                                                                                                         |
|   |   |                                                                                                                                                                                                                                                                                                                                           |
| 10.30  |   | Stock Purchase and Sale Agreement, dated April 15,  1999, between the Company and MVII, LLC (filed as Exhibit 99.2 to the  Schedule 14D-9 filed by the Company on April 22, 1999), incorporated herein  by reference.                                                                                                                          |
|   |   |                                                                                                                                                                                                                                                                                                                                           |
| 10.31  |   | Shareholders’ and Voting Agreement dated April 15,  1999, by and among the Company, MVII, LLC, certain management shareholders of  the Company and a limited partnership controlled by a management shareholder  (filed as Exhibit 99.4 to the Schedule 14D-9 filed by the Company on April  22, 1999), incorporated herein by reference. |
|   |   |                                                                                                                                                                                                                                                                                                                                           |
| 10.32  |   | Registration Rights Agreement dated April 15, 1999,  by and among the Company, MVII, LLC, certain management shareholders of the  company and a limited partnership controlled by a management shareholder  (filed as Exhibit 99.5 to the Schedule 14D-9 filed by the Company on April 22,  1999), incorporated herein by reference.           |
|   |   |                                                                                                                                                                                                                                                                                                                                           |
| 10.33  |   | Irrevocable Proxy dated April 15, 1999, between  MVII, LLC and Conrad. (4)                                                                                                                                                                                                                                                                     |
|   |   |                                                                                                                                                                                                                                                                                                                                           |
| 10.34  |   | Irrevocable Proxy dated April 15, 1999, between  MVII, LLC and Davis. (4)                                                                                                                                                                                                                                                                      |
|   |   |                                                                                                                                                                                                                                                                                                                                           |
| 10.35  |   | Irrevocable Proxy dated April 15, 1999, between  MVII, LLC and Matlock. (4)                                                                                                                                                                                                                                                                    |
|   |   |                                                                                                                                                                                                                                                                                                                                           |
| 10.36  |   | Irrevocable Proxy dated April 15, 1999, between  MVII, LLC and Rust Capital. (4)                                                                                                                                                                                                                                                               |
|   |   |                                                                                                                                                                                                                                                                                                                                           |
| 10.37  |   | Irrevocable Proxy dated April 15, 1999, between  MVII, LLC and Smith. (4)                                                                                                                                                                                                                                                                      |
|   |   |                                                                                                                                                                                                                                                                                                                                           |
| 10.38  |   | Consulting Agreement dated June 1, 1999, between the  Company and Davis. (4)                                                                                                                                                                                                                                                                   |
|   |   |                                                                                                                                                                                                                                                                                                                                           |
| 10.39  |   | Amendment dated May 5, 1999, to Loan and Security  Agreement, dated as of February 2, 1999, by and between Sunrock Capital Corp.  and the Company. (4)                                                                                                                                                                                         |
|   |   |                                                                                                                                                                                                                                                                                                                                           |
| 10.40  |   | Amendment No. 1 dated June 30, 1999, to Loan and  Security Agreement, by and between Sunrock Capital Corp. and the Company. (5)                                                                                                                                                                                                                |
|   |   |                                                                                                                                                                                                                                                                                                                                           |
| 10.41  |   | Employment Agreement dated June 17, 1999 by and  between the Company and Michael J. Lyden. (5)                                                                                                                                                                                                                                                 |
|   |   |                                                                                                                                                                                                                                                                                                                                           |
| 10.42  |   | Employment Agreement dated June 1, 1999, by and  between the Company and Joseph S. Whitaker. (5)                                                                                                                                                                                                                                               |
|   |   |                                                                                                                                                                                                                                                                                                                                           |
| 10.43  |   | Amendment to 1997 Stock Option Plan dated May 24,  1999. (5)                                                                                                                                                                                                                                                                                   |

** **

E-3

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** **
| 10.44  |   | Restated Employment Agreement dated December 31,  1999, by and between DSI(HK) Limited and Yau Wing Kong (filed as Exhibit  10/44 to the Company’s Form 10-K for the 11 month period ended December 31,  1999), and incorporated herein by reference.                |
|--------|--------|---------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|
|   |   |                                                                                                                                                                                                                                                                      |
| 10.45  |   | Agreement and Plan of Merger between Meritus  Industries, Inc. et al. and the Company, dated October 7, 1999 (filed as  Exhibit 10.45 to the Company’s Form 10-Q for the quarterly period ended  October 31, 1999), incorporated herein by reference.                |
|   |   |                                                                                                                                                                                                                                                                      |
| 10.46  |   | Closing and Holdback Agreement dated January 7,  2000, by and between the Company and Meritus Industries, Inc., et al. (filed  as Exhibit 2.3 to the Company’s Form 8-K dated January 7, 2000), incorporated  herein by reference.                                   |
|   |   |                                                                                                                                                                                                                                                                      |
| 10.47  |   | Shareholders’ and Voting Agreement dated January 7,  2000, by and among the Company, MVII, LLC and Walter S. and Susan Reiling  (filed as Exhibit 10.1 to the Company’s Form 8-K dated January 7, 2000),  incorporated herein by reference.                     |
|   |   |                                                                                                                                                                                                                                                                      |
| 10.48  |   | Limited Irrevocable Proxy dated January 7, 2000,  between MVII, LLC and Walter S. and Susan Reiling (filed as Exhibit 10.2 to  the Company’s Form 8-K dated January 7, 2000), incorporated herein by  reference.                                                     |
|   |   |                                                                                                                                                                                                                                                                      |
| 10.49  |   | Registration Rights Agreement dated January 7, 2000,  by and between the Company and Walter S. and Susan Reiling (filed as Exhibit  10.3 to the Company’s Form 8-K dated January 7, 2000), incorporated herein by  reference.                                        |
|   |   |                                                                                                                                                                                                                                                                      |
| 10.50  |   | Subordinated Secured Promissory Note dated January  7, 2000, from the Company to Walter S. and Susan Reiling (filed as Exhibit  10.4 to the Company’s Form 8-K dated January 7, 2000), incorporated herein by  reference.                                            |
|   |   |                                                                                                                                                                                                                                                                      |
| 10.51  |   | Promissory Note dated January 7, 2000, from the  Company to MVII, LLC (filed as Exhibit 10.5 to the Company’s Form 8-K dated  January 7, 2000), incorporated herein by reference.                                                                                    |
|   |   |                                                                                                                                                                                                                                                                      |
| 10.52  |   | Amendment No. 2 dated January 7, 2000, to Loan and  Security Agreement, by and between Sunrock Capital Corp. and the Company  (filed as Exhibit 10.6 to the Company’s Form 8-K dated January 7, 2000),  incorporated herein by reference.                            |
|   |   |                                                                                                                                                                                                                                                                      |
| 10.53  |   | Employment Agreement dated January 7, 2000, by and  between the Company and Beth Reiling (filed as Exhibit 10.7 to the Company’s  Form 8-K dated January 7, 2000), incorporated herein by reference.                                                                 |
|   |   |                                                                                                                                                                                                                                                                      |
| 10.54  |   | Employment Agreement dated January 7, 2000, by and  between the Company and Joseph Reiling (filed as Exhibit 10.8 to the  Company’s Form 8-K dated January 7, 2000), incorporated herein by reference.                                                               |
|   |   |                                                                                                                                                                                                                                                                      |
| 10.55  |   | Amendment No. 2 to DSI Toys, Inc. 1997 Stock Option  Plan (filed as Exhibit 10.11 to the Company’s Form 10-Q for the quarterly  period ended June 30, 2000), incorporated herein by reference.                                                                       |
|   |   |                                                                                                                                                                                                                                                                      |
| 10.56  |   | Amendment No. 3 dated July 14, 2000, to Loan and  Security Agreement, by and between Sunrock Capital Corp. and the Company  (filed as Exhibit 10.12 to the Company’s Form 10-Q for the quarterly period  ended June 30, 2000), incorporated herein by reference.     |
|   |   |                                                                                                                                                                                                                                                                      |
| 10.57  |   | Amendment No. 4 dated March 30, 2001, to Loan and  Security Agreement, by and between Sunrock Capital Corp. and the Company  (filed as Exhibit 10.57 to the Company’s Form 10-K for the annual period  ended December 31, 2000), incorporated herein by reference.   |
|   |   |                                                                                                                                                                                                                                                                      |
| 10.58  |   | Employment Agreement dated April 1, 2001, but  executed April 23, 2001, by and between the   Company and Gregory A. Barth (filed as Exhibit 10.2 to the Company’s  Form 10-Q for the quarterly period ended March 31, 2001), incorporated herein  by reference. |

 

 

E-4

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| 10.59  |   | Amendment No. 5 to Loan and Security Agreement,  dated August 13, 2001, by and between Sunrock Capital Corp. and the Company  (filed as Exhibit 10.3 to the Company’s Form 10-Q for the quarterly period  ended June 30, 2001), incorporated herein by reference.       |
|--------|--------|------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|
|   |   |                                                                                                                                                                                                                                                                         |
| 10.60  |   | Amendment No. 6 to Loan and Security Agreement,  dated August 13, 2001, by and between Sunrock Capital Corp. and the Company  (filed as Exhibit 10.4 to the Company’s Form 10-Q for the quarterly period  ended June 30, 2001), incorporated herein by reference.       |
|   |   |                                                                                                                                                                                                                                                                         |
| 10.61  |   | First Amendment to Employment Agreement by and  between the Company and Joseph S. Whitaker, dated December 1, 2001. (2)                                                                                                                                                      |
|   |   |                                                                                                                                                                                                                                                                         |
| 10.62  |   | Line of Credit Facility with Dao Heng Bank Limited  evidencing a $6,000,000 line of credit, dated December 4, 2001. (2)                                                                                                                                                      |
|   |   |                                                                                                                                                                                                                                                                         |
| 10.63  |   | Memorandum of Re-borrowing of Principal by and  between the Company and MVII, LLC, dated March 6, 2002. (2)                                                                                                                                                                  |
|   |   |                                                                                                                                                                                                                                                                         |
| 10.64  |   | Amendment No. 7 dated March 20, 2002, to Loan and  Security Agreement by and between Sunrock Capital Corp. and the Company. (2)                                                                                                                                              |
|   |   |                                                                                                                                                                                                                                                                         |
| 10.65  |   | Unconditional Guaranty Agreement dated March 20,  2002, by the Company and Dao Heng Bank Limited (2).                                                                                                                                                                        |
|   |   |                                                                                                                                                                                                                                                                         |
| 10.66  |   | Amendment No. 8 dated March 29, 2002, to Loan and  Security Agreement by and between Sunrock Capital Corp. and the Company. (2)                                                                                                                                              |
|   |   |                                                                                                                                                                                                                                                                         |
| 10.67  |   | Banking Facility Agreement by and between Standard  Chartered Bank and the Company dated April 29, 2002 (filed as Exhibit 10.5 to  the Company’s Form 10-Q for the quarterly period ending June 30, 2002),  incorporated herein by reference.                           |
|   |   |                                                                                                                                                                                                                                                                         |
| 10.68  |   | Memorandum of Reborrowing of Principal by and  between the Company and MVII, LLC dated May 21, 2002  (filed as Exhibit 10.6 to the Company’s  Form 10-Q for the quarterly period ending June 30, 2002), incorporated herein  by reference.                         |
|   |   |                                                                                                                                                                                                                                                                         |
| 10.69  |   | Amendment No. 9 dated June 12, 2002, to Loan and  Security Agreement by and between Sunrock Capital Corp. and the Company  (filed as Exhibit 10.7 to the Company’s Form 10-Q for the quarterly period  ending June 30, 2002), incorporated herein by reference.         |
|   |   |                                                                                                                                                                                                                                                                         |
| 10.70  |   | Amendment No. 10 dated August 14, 2002, to Loan and  Security Agreement by and between Sunrock Capital Corp. and the Company  (filed as Exhibit 10.8 to the Company’s Form 10-Q for the quarterly period  ending September 30, 2002), incorporated herein by reference. |
|   |   |                                                                                                                                                                                                                                                                         |
| 10.71  |   | Guarantee Agreement dated August 19, 2002, by and  between Standard Chartered Bank and the Company (filed as Exhibit 10.71 to  the Company’s Form 10-Q for the quarterly period ending September 30, 2002),  incorporated herein by reference.                          |
|   |   |                                                                                                                                                                                                                                                                         |
| 10.72  |   | Memorandum of Reborrowing of Principal by and  between the Company and MVII, LLC dated March 10, 2003 (filed as Exhibit  10.72 to the Company’s Form 10-K for the annual period ending December 31,  2002), incorporated herein by reference.                           |
|   |   |                                                                                                                                                                                                                                                                         |
| 99.1   |   | DSI Toys, Inc. Audit Committee of the Board of  Directors, Charter, adopted by the Board of Directors on May 23, 2000 (filed  as Exhibit 99.1 to the Company’s Form 10-Q for the quarterly period ended  June 30, 2000), incorporated herein by reference.              |

 

E-5

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| 99.2   |   | Amendment No. 1 to the Audit Committee of the Board  of Directors Charter, adopted by the Board of Directors on March 31, 2001  (filed as Exhibit 99.2 to the Company’s Form 10-K for the annual period ended  December 31, 2000), incorporated herein by reference. |
|--------|--------|---------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|
|   |   |                                                                                                                                                                                                                                                                      |
| 99.3*  |   | Certification of the Chief Executive Officer  pursuant to Section 1350 of Chapter 63, Title 18 of the United States Code  for the annual period ending December 31, 2002.                                                                                                 |
|   |   |                                                                                                                                                                                                                                                                      |
| 99.4*  |   | Certification of the Chief Financial Officer  pursuant to Section 1350 of Chapter 63, Title 18 of the United States Code  for the annual period ending December 31, 2002.                                                                                                 |

 

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| (1)    | Filed as a part of the Registrant’s Registration  Statement on Form S-1 (No. 333-23961) and incorporated herein by reference.                                  |
|--------|---------------------------------------------------------------------------------------------------------------------------------------------------------------------|
|   |                                                                                                                                                                |
| (2)    | Filed as the indicated numbered exhibit to the  Company’s Form 10-K for the annual period ended December 31, 2001, and  incorporated herein by reference.      |
|   |                                                                                                                                                                |
| (3)    | Filed as the indicated numbered exhibit to the  Company’s Form 10-K for the annual period ended January 31, 1999, and  incorporated herein by reference.  |
|   |                                                                                                                                                                |
| (4)    | Filed as the indicated numbered exhibit to the  Company’s Form 10-Q for the quarterly period ended April 30, 1999, and  incorporated herein by reference. |
|   |                                                                                                                                                                |
| (5)    | Filed as the indicated numbered exhibit to the  Company’s Form 10-Q for the quarterly period ended July 31, 1999, and  incorporated herein by reference.  |
|   |                                                                                                                                                                |
| *      | Filed herewith                                                                                                                                                      |

 

E-6

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