**SECURITIES AND EXCHANGE COMMISSION**

**WASHINGTON,D.C.  20549**

 

**FORM 10-K/A**

**Amendment No. 2 to Form 10-K**

 

**ANNUALREPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES**

**EXCHANGEACT OF 1934**

 

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

 

**DSI TOYS,INC.**

(Exact name ofRegistrant 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’stelephone 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 if disclosure of delinquentfilers pursuant to Item 405 of Regulation S-K is not contained herein, and willnot be contained, to the best of Registrant’s knowledge, in definitive proxy orinformation statements incorporated by reference in Part III of this Form 10-Kor any amendment to this Form 10-K. o

                Indicate by check mark whether the Registrant is anaccelerated filer (as defined in Rule 12b-2 of the Securities Exchange Actof 1934).Yes  o    No   ý

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

                As of May 1, 2003 there were 10,866,365 shares ofcommon stock, $.01 par value, outstanding.

 

 

 

 

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                This Amendment No.2 on Form 10-K/A (this “Amendment”) is being filed in order to amend theRegistrant’s Annual Report on Form 10-K for the fiscal year ended December 31,2002, filed with the Securities and Exchange Commission on March 28, **2003, as amended byAmendment No. 1 on Form 10-K/A filed with the Securities and ExchangeCommission on May 15, 2003 (collectively,****“**Form 10-K”) to revise information in Part II, Item 6.Selected Consolidated Financial Data; Part II, Item 7, Management’s Discussionand Analysis of Financial Condition and Results of Operations — ***SignificantAccounting Policies*****; and the**ConsolidatedFinancial Statements and the Notes thereto.

 

                This Amendment is limited inscope to the portions of the Form 10-K set forth above and does not in any wayamend, update or change any other items or disclosures contained in the Form10-K.

 

**PARTII**

**ITEM 6.  SELECTED CONSOLIDATED FINANCIAL DATA**

 

The following table sets forth selected consolidatedfinancial data for the Company.  Theselected consolidated financial data were derived from the Company’sconsolidated financial statements.  Alldollar amounts are stated in thousands, except per share data.

 

The information should be read in conjunction with“Management’s Discussion and Analysis of Financial Condition and Results ofOperations” and the financial statements and notes thereto included elsewherein this report.

 
| **Statement  of Operations Data:** |   | **December  31,   2002** |   | **December  31,   2001** |   | **December  31,   2000** |   | **December  31,   1999** |   | **January  31,  1999** |   |
|------------------------------------|--------|--------------------------|--------|--------------------------|--------|--------------------------|--------|--------------------------|--------|------------------------|--------|
| Net sales                          |   | $                        | 49,816 |                     | $      | 67,956                   |   | $                        | 70,472 |                   | $      | 47,562 |   | $ | 52,724 |   |
| Income (loss)  before income taxes |   | (5,736                   | )      | (1,058                   | )      | (1,326                   | )      | 2,150                    |   | (1,337                 | )      |
| Net income  (loss)                 |   | (8,012                   | )      | (1,449                   | )      | (849                     | )      | 1,281                    |   | (1,004                 | )      |
| Basic earnings  (loss) per share   |   | $                        | (.82   | )                        | $      | (.16                     | )      | $                        | (.09   | )                      | $      | .17 |   | $ | (.17 | ) |
| Diluted earnings  (loss) per share |   | $                        | (.82   | )                        | $      | (.16                     | )      | $                        | (.09   | )                      | $      | .16 |   | $ | (.17 | ) |
|                               |   |                     |   |                     |   |                     |   |                     |   |                   |   |
|                                    |        |                          |        |                          |        |                          |        |                          |        |                        |        |  |  |  |  |  |  |

 
| **Balance  Sheet Data:**                  |   | **December  31,   2002** |   | **December  31,   2001** |   | **December  31,   2000** |   | **December  31,   1999** |   | **January  31,  1999** |   |
|-------------------------------------------|--------|--------------------------|--------|--------------------------|--------|--------------------------|--------|--------------------------|--------|------------------------|--------|
| Working capital                           |   | $                        | (6,480 | )                        | $      | 9,144                    |   | $                        | 4,536  |                   | $      | 6,326 |   | $ | 391 |   |
| Total assets                              |   | 28,671                   |   | 31,313                   |   | 29,999                   |   | 15,027                   |   | 11,411                 |   |
| Long-term debt,  including capital leases |   | 4,554                    |   | 12,500                   |   | 10,755                   |   | 2,393                    |   | 2,541                  |   |
| Total  liabilities                        |   | 27,566                   |   | 22,179                   |   | 22,072                   |   | 8,038                    |   | 10,549                 |   |
| Shareholders’  equity                |   | 1,105                    |   | 9,134                    |   | 7,927                    |   | 6,989                    |   | 861                    |   |
|                                      |   |                     |   |                     |   |                     |   |                     |   |                   |   |
|                                           |        |                          |        |                          |        |                          |        |                          |        |                        |        |  |  |  |  |  |

 

 

 

**ITEM7.  MANAGEMENT’S DISCUSSION AND ANALYSISOF 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*® communications products, KAWASAKI®electronic musical instruments, *GearHead*TMremote control vehicles, *DJ Skribble*®*’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 Knows Her NameTM*talking doll, *Childhood VersesTM*nursery rhyme dolls*, Little Darlings®* dolls and CollectiblePlush, 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 consists of Youth Electronics products andMusical Instruments.  Products in theYouth Electronics line include walkie-talkies, wrist watch walkie-talkies,  audio products and novelty electronicproducts.  The category brands include *Tech-Link*® communications products,walkie-talkies and bike alarms, the Company’s new *BioScan*TM *Room GuardianTM*andDJ Skribble*®’s SpinheadsTM*, a newline 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, interactive plush toys, play sets,accessories, and girls’ activity toys. The Girls’ Toys portfolio of brands includes *Baby Knows Her NameTM, Lovin’ TouchTM, Childhood VersesTM, Pride &Joy®,*and*Little Darlings®,*alongwith interactive plush products and girls’ activity products such as*Twist and Twirl BraiderTM.*

 

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

 

*ProductIntroductions* -New product introductions during 2002 included KAWASAKI® foldable keyboards anddrumpads, the *LazerDoodle*TMelectronic drawing toy, the *Somersault Sara*TMinteractive electronic doll, and the *DualFusionTM*radio control vehicle.

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**Significant AccountingPolicies**

Our significantaccounting policies are more fully described in Note 2 to our consolidatedfinancial statements.  Certain of ouraccounting policies require the application of significant judgment bymanagement in selecting the appropriate 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*— TheCompany recognizes revenue when products are shipped and title passes tounaffiliated customers.  In most cases,title transfers to our customers when the product has been presented toshipment forwarders on FOB Asia sales and when the product is picked up fromour 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 and handling revenues are included in netsales, and cost of goods sold includes the shipping and handling costsassociated with inbound and outbound freight. The Securities and ExchangeCommission’s Staff Accounting Bulletin (SAB) No. 101, “Revenue Recognition,”provides guidance on the application of generally accepted accountingprinciples to selected revenue recognition issues.  The Company has concluded that its revenue recognition policy isappropriate and in accordance with generally accepted accounting principles andSAB No. 101.

*Allowancefor Doubtful Accounts*—  Accounts receivable arereduced by an allowance for amounts that may become uncollectible in thefuture.  The Company’s estimate for itsallowance is based on two methods which are combined to determine the totalamount reserved.  First, the Companyevaluates specific accounts where we have information that the customer mayhave an inability to meet its financial obligations (bankruptcy, etc.).  In these cases, the Company uses itsjudgement, based on the best available facts and circumstances, and records aspecific reserve for that customer against amounts due to reduce the receivableto the amount that is expected to be collected.  These specific reserves are reevaluated and adjusted asadditional information is received that impacts the amounts reserved.  Second, a general reserve is established forall other customers based on historical collection and write-offexperience.  If circumstances change,the Company’s estimates of the recoverability of amounts due the Company couldbe reduced by a material amount.

*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 include price discounts, credits andreturns, 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 ofcost or market.  The Company reviews thebook value of slow-moving items, discounted product lines and individual productsto determine if these items are properly valued.  The Company identifies these items and assesses the ability todispose of them at a price greater than cost. If it is determined that cost is less than market value, then cost isused for inventory valuation.  If marketvalue is less than cost, then the Company establishes a reserve for the amountrequired to value the inventory at market. If the Company is not able to achieve its expectations of the netrealizable value of the inventory at its current value, the Company wouldadjust its reserve accordingly.

*DeferredTaxes* — TheCompany recognizes deferred tax assets and liabilities based on the differencesbetween the financial statement carrying amounts and the tax bases of assetsand liabilities.  Generally acceptedaccounting principles require that we review deferred tax assets forrecoverability and if needed, establish a valuation allowance for those amountsdeemed unrecoverable.  The reviewconsiders historical taxable income, projected future taxable income, and theexpected timing of the reversals of temporary differences.  Deferred tax 

 

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assets of theCompany are primarily the result of unused net operating loss carry-forwardsand foreign tax credits which expire over a range of years.

The Company recorded a$4.0 million charge in fiscal year 2002 to establish a valuation allowance forall of its deferred tax assets, including $2.2 million of deferred tax assetsrelated to prior years.  The valuationallowance was determined in accordance with the provisions of Statement ofFinancial Accounting Standards (SFAS) 109, “Accounting for Income Taxes,” whichplaces primary importance on the Company’s cumulative operating results in themost recent 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 in2000 that included a significant amount of goodwill and other intangibleassets.  Under generally acceptedaccounting principles through December 31, 2001, these assets were amortizedover their useful lives, and were to be tested periodically to determine ifthey were recoverable from future operating earnings over their usefullives.  We recorded goodwillamortization expense of $513,396 and $513,360, respectively in 2001 and 2000.

Effective in 2002,goodwill is no longer amortized but is subject to at least an annual impairmenttest based on its estimated fair value. Other intangible assets meeting certain criteria will continue to beamortized over their useful lives and also subject to an impairment test.  There are many assumptions and estimatesunderlying the determination, including future cash flow and operatingresults.  Management engaged anindependent company to assist in valuing the Company’s goodwill as of December31, 2002 and 2001.  Based on thesereviews, no impairment charge is required.

**Results ofOperations**

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 sales during fiscal 2002 decreased $18.1million, or 26.7%, to $49.8 million, from $67.9 million in fiscal 2001.  The decrease is primarily due to thecontinued overall sluggish U.S. retail climate and shifts in consumerpreferences that were not met by the Company’s product line. Additionally,mechanical engineering redesign work required on two key promoted productsresulted 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 ofJuvenile Audio Products in fiscal 2002 decreased $6.3 million, or 23.8%, to$20.1 million, from $26.3 million in 2001. The major product groups in thiscategory are Youth Electronics (formerly Youth Communications) and MusicalInstruments. Youth Electronics provided $7.6 million in 2002 sales, a decreaseof $7.0 million, or 48.5%, when compared to 2001 sales of $14.6 million.  The Youth Electronics decrease is due tocontinued sales declines in children’s walkie-talkies, reflecting a productshift to role-play and spy related products and continued price pressures, anda 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’ Toysdecreased $11.5 million, or 36.6%, to $20.0 million in fiscal 2002 from $31.5million during fiscal 2001. The decrease reflects reduced sales of the *EliteTM, Little Darlings®*, and *Pride and Joy®* doll lines, interactivedolls such as *Too Cute Twins®, Susie SoSmartTM* and *Hush L’l Baby®*,and the *Air Nails SalonTM* girlsactivity toy.  This decrease waspartially offset by sales of 2002 production introductions, the *Somersault SaraTM* doll and the girlsactivity toy, *Twist and Twirl BraiderTM*.

Net sales of Boys’Toys decreased $2.4 million, or 27.4%, 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 2001close-out sales of *Data-DawgTM*,were partially offset by sales of the new 2002 R/C product, *Dual FusionTM*.

Net sales ofproducts in other categories increased $2.0 million, or 133.1%, to $3.5 millionin fiscal 2002 from $1.5 million in 2001. The increase is primarily driven by sales of the new 2002 drawing-toy,LazerDoodle, and was partially offset by decreases in sales of doorbells,preschool products and other electronic games.

 Net sales to customers in countries otherthan the United States by the Company’s foreign subsidiary in fiscal 2002decreased $2.3 million, or 19.4%, to $9.4 million, compared to 2001 net salesof $11.7 million. The decreased sales reflect the soft overall world retailmarket, the effect of exchange rate issues, competition with knock-offs ofproprietary products, and political instability in several countries andregions.  Additionally, productiondelays that limited the availability of key products resulted in some canceledorders and lost sales.

*GrossProfit*. Grossprofit decreased $8.8 million or 44.4%, to $11.1 million during fiscal 2002from $19.9 million in fiscal 2001. Gross profit as a percentage of net sales decreased to 22.2% duringfiscal 2002 from 29.3% in fiscal 2001. The gross profit dollar decrease reflects reduced sales, in conjunctionwith the lower percentage of net sales during fiscal 2002 over 2001.  The percentage decrease reflects anincreased provision for slow-moving inventory, price pressures due to the slowmoving U.S. economy and increased allowances required to move inventory incustomers stores.

*Selling,General and Administrative Expenses*. Selling, general and administrative expensesdecreased $4.1 million to $16.0 million, or 20.6%, from $20.1 million in fiscal2001.  Decreases occurred in nearly allareas in 2002, including a $1.4 million reduction in bad debt expense due tothe 2001 provision for Kmart’s bankruptcy filing.  Additionally, employee expense, travel and entertainment, andgeneral office expense decreased approximately $988,000, $203,000 and $482,000respectively, due in part to the closure of the Company’s New Jersey office inthe fourth quarter of 2001 and management’s focus on reducing general officeexpense.  Professional fees decreasedapproximately $168,000, primarily due to the expiration of a consultingagreement with a director (and former CEO). Sales commissions and advertising expense decreased $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, or21.1%, to $912,000 in fiscal 2002 from $1.2 million in fiscal 2001 as a resultof lower interest rates on the Company’s floating rate debt.

 

 

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*IncomeTaxes.***** The Company generated in fiscal 2002 a lossbefore income taxes of $5.7 million compared to a $1.0 million loss before incometaxes in fiscal 2001. These losses, combined with a $1.3 million loss beforeincome taxes in fiscal 2000, provide negative evidence of the ability torealize the future tax benefits associated with the Company’s deferred taxassets. As a result, the Company recorded a deferred tax asset valuationallowance of $4.0 million in 2002, consisting of $2.2 million generated inprior years and $1.8 million for the fiscal year ended 2002.  Additionally, the Company incurred andrecorded a foreign tax expense of approximately $70,000 in 2002.

*NetLoss.*** **The Company’s net loss for fiscal 2002was $8.0 million compared to a net loss of $1.4 million for fiscal 2001.  The primary driving factor was thesignificant decrease in sales and margin amounts in 2002 compared with 2001,which more than offset gains made in reducing selling, general, andadministrative expense.

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

*NetSales*.  Net sales during fiscal 2001 decreased $2.5million, or 3.6%, to $67.9 million from $70.4 million in fiscal 2000. Thedecrease was due primarily to reduced sales of Boys’ Toys and Juvenile Audioproducts, partially offset by sales of Girls’ Toys.

Net sales ofJuvenile Audio Products decreased $1.5 million, or 5.2%, to $26.3 millionduring fiscal 2001 from $27.8 million during fiscal 2000.  The major product groups in this categoryare Youth Electronics and Musical Instruments, providing $14.6 million and$11.7 million respectively in 2001 sales, compared to $14.2 million and $13.6million respectively in 2000.  The YouthElectronics product group increase reflects sales of *e-Brain*TM personal communicator, introduced in fall 2001,partially offset by decreases in walkie-talkie sales, due to increasedcompetition in non-branded products. Musical Instruments sales decreased primarily in keyboards, which is aresult of decreased warehouse club business with one non-primary customer.

Net sales ofGirls’ Toys increased $3.5 million, or 12.4%, to $31.5 million in fiscal 2001from $28.0 million in fiscal 2000.  Thesales increase in Girls’ Toys was driven by the television promoted *Too Cute TwinsTM* doll line, the girlsactivity toy *Air Nails*Salon*TM* and the plush toy *Kitty Kitty Kittens®*, which was partiallyoffset by declines in sales of dolls in the *Pride& Joy®*, *Elite*® andother general doll lines.

Net sales of Boys’Toys decreased $4.1 million, or 32.4%, to $8.6 million during fiscal 2001 from$12.7 million in fiscal 2000.  Thedecrease is due primarily to the 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 offsetby sales of the new 2001 R/C vehicle, *StreetSavageTM*.

Net sales of products inother categories decreased approximately $460,000, or 0.5%, to $1.5 millionduring fiscal 2001 from $1.9 million in fiscal 2000.  The decrease is attributable to lower sales of games, video phones,doorbells and other discontinued lines, which was partially offset by increasedsales of preschool products.

 Net sales to customers in countries otherthan the United States by the Company’s foreign subsidiary decreased $1.6million, or 12.0%, to $11.7 million during fiscal 2001, compared to $13.3million in fiscal 2000.  The decreasereflects the strength of the U.S. dollar against foreign currencies, therebynegatively affecting sales distributors potential retail price points andmargins.  International net sales were 17.2%of total net sales for fiscal 2001 as compared to 18.9% of total net sales infiscal 2000.

*GrossProfit**.*** Gross profit decreased approximately $400,000, or 2.0%, to $19.9 millionduring fiscal 2001 from $20.3 million in fiscal 2000.  Gross profit as a percentage of net sales increased to 29.3%during fiscal 2001 from 28.9% in fiscal 2000. The percentage increase reflects the continued focus on sales ofproprietary products, such as the *Too CuteTwinsTM* doll, *Air Nails Salon*TMgirls’ activity toy, and the *Street Savage*TMR/C vehicle, versus lower margin, more volume-driven non-proprietaryproducts.  Proprietary products, whichwere 80% of our total net sales in 2001, generate a higher margin percentage.

 

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*Selling,General and Administrative Expenses.** ***Selling, general and administrative expenses decreased$200,000 to $20.1 million, or 1.3%, during fiscal 2001 from $20.3 million infiscal 2000.  The decrease reflectsreductions of approximately $945,000 and $846,000 in advertising and commissionexpenses due to lower sales volume. Additionally, professional fees decreased $356,000, as expensesassociated with the 2000 Meritus merger were non-reoccuring, along with a$120,000 decrease in various operating expenses.  Partially offsetting these decreases was an approximate $525,000increase in employee compensation, due to employee additions and a significantincrease in receivables’ bad debt expense. The $1.7 million provision foruncollectible accounts receivable is primarily related to the January 2002bankruptcy filing of Kmart Corp.

*InterestExpense.* Interestexpense decreased approximately $319,000, or 21.6%, to $1.2 million in fiscal2001 from $1.5 million during fiscal 2000. The decrease was due primarily to lower interest borrowing rates in 2001as compared to 2000.

*IncomeTaxes.***** In fiscal 2001, the Company generated a loss before income taxesof $1.0 million compared to a $1.3 million loss before income taxes duringfiscal 2000.  A significant contributorto the 2001 loss was a $1.7 million provision for uncollectible accountsreceivable.  The provision is notincluded in taxable income for 2001, but will be included in taxable income in afuture 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.** ***TheCompany’s net loss for fiscal 2001 was approximately $1.4 million compared to anet loss of approximately $849,000 for fiscal 2000.  The 2001 net loss was due in significant part to the requiredincrease in 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.

**Liquidity andCapital 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’soperating activities provided net cash of $5.2 million during fiscal 2002,consisting primarily of decreases in accounts receivable and increases inaccounts payable.  The accountsreceivable decrease is due to reduced sales during the fourth quarter of 2002.This decrease, combined with decreased third quarter sales, negatively impactedthe funds available to pay suppliers and key vendors, including televisionadvertising, resulting in a significant increase in accounts payable. Net cashused in investing activities during fiscal 2002 was approximately $2.1 millionand was mostly due to capital expenditures. Net cash used by financing activities was $1.6 million in 2002, resultingfrom payments on long-term debt. The Company’s working capital at December 31,2002, was ($6.5) million and unrestricted cash was approximately $1.7 million.See “The Revolver.”

The seasonalnature of the toy business results in complex working capital needs.  The Company’s working capital needs, whichthe Company generally satisfies through short-term borrowings, are greatest inthe last two fiscal quarters. To manage these working capital requirements, theCompany maintains credit facilities collateralized principally by accountsreceivable and inventory.  The Companycurrently maintains the Revolver, and through DSI(HK), the Dao Heng CreditFacility and the Standard Chartered Facility. The Company has guaranteed DSI(HK)’s obligations under the Dao HengCredit Facility and the Standard Chartered Facility.

### *The Revolver*

The Company’s net lossesfor the period ended December 31, 2002, and its overall financial conditionresulted in the Company being out of compliance with the minimum net worth andnet income covenants required under the Revolver.  Therefore, the Company’s $7.0 million debt under the Revolver asof December 31, 2002, has been reclassified as a current liability.  As a result, the Company’s currentliabilities exceeded its current assets by $6.5 million as of December 31,2002. If Sunrock were to accelerate the Revolver, which it has the option todo, the $7.0 million debt would become immediately due and payable.

 

 

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Sunrock hasrecently completed a transaction with Wells Fargo & Company in which WellsFargo purchased most of  Sunrock’sexisting loans.  Sunrock has retainedcertain credit facilities, including the Revolver.  Based on discussions with Sunrock, the Company’s managementbelieves that although Sunrock will not amend the Revolver, nor grant a waiverfor the Company’s non-compliance, Sunrock will not accelerate the Revolver atthis time.

### *Dao Heng Facility and Standard Chartered Facility*

The Dao HengFacility and the Standard Chartered Facility were obtained on December 4, 2001,and April 29, 2002, respectively, are subject to periodic review, and may becanceled by the bank upon notice.  TheStandard Chartered Facility affords DSI(HK) a credit limit in the aggregate ofup to HKD 19,000,000 (approximately US $2.4 million as of December 31, 2002) inthe form of a line of credit financing facility based on actual shipments ofproduct and opened letters of credit. The Dao Heng Facility affords DSI(HK) a credit limit in the aggregate ofup to US$6,000,000. The Company has guaranteed DSI(HK)’s obligations under theDao Heng Credit Facility and the Standard Chartered Facility.

### *Additional Financing*

On March 19, 2001,the Company issued to MVII an Investment Warrant to acquire 1.8 million sharesof the Company’s common stock at a purchase price of $2.7 million.  The Investment Warrant was exercisable inwhole or in part for a ten-year period beginning on June 3, 2002.  In connection with the issuance of theInvestment Warrant, the Company and MVII entered into a Registration RightsAgreement, pursuant to which MVII was granted certain piggyback registrationrights with respect to the shares of the common stock underlying theWarrant.  Shares of common stockacquired by MVII upon exercise of the Warrant are subject to the terms of aShareholders’ and Voting Agreement dated as of April 5, 1999, among MVII andcertain of the Company’s other shareholders. Proceeds from the sale of the Investment Warrant were used by theCompany for current working capital.

On January 31,2002, at the request of Nasdaq and with the agreement of MVII, the Companyissued an amended and restated Investment Warrant, which amended and restatedin its entirety the Investment Warrant by removing all anti-dilutionprovisions.  In addition, the Companyand MVII entered into an Amended and Restated Registration Rights Agreement,which amended and restated in its entirety the Registration Rights Agreement,by removing all of the provisions regarding the anti-dilution provisions of theoriginal Investment Warrant.

On August 21,2002, MVII converted the pre-paid Investment Warrant into 1.8 million shares ofcommon stock.  Upon issuance of theseshares, MVII directly owned 5,994,238 shares of common stock.

In connection withthe acquisition of Meritus Industries, Inc., in January 2000, the Companyborrowed $5 million from MVII, evidenced by a promissory note dated January 7,2000 (the “MVII Note”).  The Companyre-borrowed on March 6, 2002, May 21, 2002, and March 10, 2003 a total of $1.35million of the original principal that the Company had paid on the MVIINote.  The proceeds were used to financethe normal business operations of the Company.

On August 19,2002, the Company executed a Guarantee in favor of Standard Chartered Bank, guaranteeingthe Standard Chartered Facility on behalf of DSI(HK) up to an amount not toexceed HKD 19,000,000 (approximately US$2.4 million at December 31, 2002).  The Revolver was amended on August 14, 2002,to permit this Guarantee.

The Company isobligated to make future minimum royalty payments under certain of its licenseagreements.  As of December 31, 2002,the Company was required to make an aggregate of approximately $250,000 inpayments of guaranteed royalties under certain licenses in fiscal 2002 and$835,000 thereafter 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 madeapproximately $1.5 million in capital expenditures in fiscal 2002 consistingprimarily of purchases of tools, molds and information technology systems.

 

 

7

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The Companypurchases goods, services and supplies from a number of vendors.  The Company currently is in arrears inmaking its payment obligations to certain of these vendors.

### *Going Concern*

The Company’sviability as a going concern is dependent upon successful negotiations withSunrock, a new lender, or a substantial capital infusion, as well as sustainedprofitable operations. The accompanying financial statements do not include anyadjustments that might be necessary if the Company is unable to continue as agoing concern.

To the extent theCompany’s cash reserves and cash flows from operations are insufficient to meetfuture cash requirements, the Company will need to successfully raiseadditional capital through an equity infusion or the issuance of debt.  The Company’s executive management believesthat the Company will be required to either obtain a new revolving loan orobtain necessary additional capital to allow the Company to continue its normaloperations for the foreseeable future. However, there can be no assurance theCompany will meet its projected operating results or be successful either inobtaining additional capital, or obtaining a new revolving loan.

The Company has helddiscussions and negotiations with several lenders regarding a credit facilityto replace the Revolver.  Management isnegotiating with one of those institutions regarding a replacement creditfacility that will become effective at the close of the anticipated goingprivate transaction, which is discussed immediately below.  Management believes that the going privatetransaction will close and that the Company will be able to continue itsoperations until that time.

### *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 the Company had been exhausted, E. Thomas Martin,the Chairman of the Company’s Board of Directors, and certain other officers,directors and shareholders of the Company (the “Buyer Group”) began seriousconsideration of a going-private transaction. On January 27, 2003, the Board of Directors invited the Buyer Group tosubmit an offer to the Company for a going-private transaction.  In anticipation of such an offer, and uponconsultation with the Company’s outside legal counsel, the Board of Directorsappointed directors M.D. Davis and Joseph N. Matlock as a special committee ofindependent, disinterested directors for the purpose of considering, evaluatingand negotiating any proposed transaction on behalf of the shareholders who arenot members of the Buyer Group and making a recommendation to the Board ofDirectors. The Board of Directors also authorized the special committee toretain, at the Company’s expense, independent legal and financial advisors.

On January 28,2003, the Buyer Group proposed to the Company a going-private transaction byway of a merger that would result in the purchase of shares of common stockheld by the shareholders who are not members of the Buyer Group for $0.44 pershare.

On January 29,2003, the Company issued a press release confirming receipt of the BuyerGroup’s proposal and announcing that its Board of Directors had formed aspecial committee of independent, disinterested directors.

The special committeeconsidered several investment bankers to serve as independent financialadvisors to the special committee.  OnFebruary 4, 2003, after evaluating, among other factors, each consideredinvestment bank’s expertise, responsiveness, knowledge of the Company, fees andtoy industry experience, the special committee approved the retention of Chaffe& Associates, Inc. (“Chaffe”) as its financial advisor in connection withthe proposal of the Buyer Group.

On February 20, 2003, thespecial committee met with representatives of Chaffe and Haynes and Boone, LLP(“Haynes and Boone”), legal counsel for the special committee. The purpose ofthe meeting was to review and consider the $0.44 per share proposal by theBuyer Group and to discuss with the special committee’s financial and legaladvisors a negotiating strategy. Chaffe reviewed with the special committee itsevaluation of the Company and the $0.44 per share proposal based upon Chaffe’sextensive, though not yet complete, investigation of the Company.  The special committee concluded that, basedon then-current information, it would not approve the proposal by the BuyerGroup of $0.44 per share and discussed possible counteroffers to the BuyerGroup’s proposal, including an alternative royalty structure.

 

8

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On February 28, 2003, thespecial committee again met with representatives of Chaffe and Haynes andBoone. At the meeting, Chaffe reviewed with the special committee itsevaluation of the Company and the $0.44 per share proposal in light of Chaffe’sconcluded investigation of the Company. The special committee concluded that, based on then-current information,it would not approve the proposal by the Buyer Group of $0.44 per share anddiscussed possible counteroffers to the Buyer Group’s proposal, including analternative royalty structure.  Legalcounsel for the special committee was then directed to communicate therejection of the Buyer Group’s offer to counsel for the Buyer Group and topropose a counter offer of $0.61 per share.

  On March 4, 2003, legal counsel for theBuyer Group informed the special committee that the Buyer Group had rejectedthe special committee’s counter offer of $0.61 per share but had increased itsoffer to $0.47 per share.

On March 5, 2003, thespecial committee met with representatives of Chaffe and Haynes and Boone toreview and consider the $0.47 per share counter offer by the Buyer Group andchose to make another counteroffer of $0.50 per share to the Buyer Group.  M.D. Davis communicated the $0.50 per sharecounter offer to the Buyer Group.

On March 5, 2003,the Buyer Group rejected the special committee’s latest counteroffer andreiterated its offer to purchase the common stock owned by the shareholders whoare not members of the Buyer Group for $0.47. The same day, the special committee met with representatives of Chaffeand Haynes and Boone.  Representativesof Chaffe delivered an oral opinion (which was subsequently confirmed inwriting) that, on the basis of and subject to the matters discussed with thespecial committee, including final negotiation of the merger agreement, theproposed $0.47 per share cash price was fair, from a financial point of view,to the Company’s shareholders, other than the members of the Buyer Group.  The special committee then unanimouslydetermined that the proposed merger was fair to, advisable and in the bestinterests of the Company and its shareholders, other than the members of theBuyer Group, subject to final negotiation of the merger agreement.  Counsel for the special committee thenadvised counsel for the Buyer Group that the special committee had recommendedacceptance of the Buyer Group’s proposal of $0.47 per share, subject to finalnegotiation of the merger agreement.

Between March 5, 2003 andMarch 26, 2003, the special committee, the Buyer Group, the Company andrepresentatives of Carrington, Coleman, Sloman & Blumenthal, LLP, legalcounsel to the Company, and Haynes and Boone negotiated the non–priceterms of the draft merger agreement.

On March 26, 2003, thespecial committee met to review the terms of the merger agreement and themerger. A representative of Chaffe made a presentation to the special committeedescribing the analysis supporting its opinion that the $0.47 per share cash considerationwas fair, from a financial point of view, to the Company’s shareholders who arenot members of the Buyer Group.  Basedupon the opinion provided by Chaffe and its own investigation, the specialcommittee unanimously voted to recommend that the Board of Directors approvethe merger agreement and the merger. Later that day, the Board of Directorsmet, received a presentation from Chaffe, and received the recommendation ofthe special committee.  Based upon theopinion of Chaffe and the recommendation of the special committee, the Board ofDirectors determined that the proposed merger was fair to, advisable and in thebest interests of the Company and its shareholders.  The Board of Directors unanimously voted to approve the mergeragreement and the merger and recommended that the shareholders of the Companyapprove the merger agreement and the merger.

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

If the shareholders ofthe Company approve the merger, the Company’s shares will be delisted from theover-the-counter Bulletin Board electronic quotation system and its commonstock will be deregistered under the Securities Exchange Act of 1934. TheCompany will continue in business as a privately-held Texas corporation.

 

 

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**Recent AccountingPronouncements**

SFAS No. 141entitled “*Business Combinations*”was issued 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, theFASB issued SFAS No. 142 entitled “*Goodwilland Other 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, theFASB issued SFAS No. 143, “*Accounting forAsset 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 theImpairment of Long-Lived Assets and for Long-Lived Assets to be Disposed Of,”*andthe accounting and reporting provisions of APB Opinion No. 30, “*Reporting the Results of Operations — Reporting theEffects of a Disposal of a Business and Extraordinary, Unusual and InfrequentlyOccurring Events and Transactions,”* for the disposal of a segment ofa business.  This Statement also amendsARB No. 51,  “*Consolidated Financial Statements,”*to eliminate theexception to consolidation for a subsidiary for which control is likely to betemporary.  SFAS No. 144 becameeffective on January 1, 2002, and interim periods within fiscal 2003, withearly application encouraged.  Theprovisions of this Statement generally are to be applied prospectively. Thisaccounting pronouncement is not expected to have a significant impact on ourreported results of operations and financial condition.

In April 2002,SFAS No. 145, “Recision of FASB Statements No. 4, 44 and 64, Amendment of FASBNo. 13, and Technical Corrections,” was issued. This statement providesguidance on the classification of gains and losses from the extinguishment ofdebt and on the accounting for certain specified lease transactions. Theadoption of this statement is not expected to have a material impact on theCompany’s consolidated financial position, results of operations or cash flows.

In June 2002, SFASNo. 146, “Accounting for Costs Associated with Exit or Disposal Activities,”was issued. This statement provides guidance on the recognition and measurementof liabilities associated with disposal activities and is effective on January1, 2003. The adoption of this statement is not expected to have a materialimpact on the Company’s consolidated financial position, results of operationsor cash flows.

 

 

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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 of Significant Accounting Policies*”regardless of the method used and also required interim disclosure of similarinformation.  The Company has adoptedthis statement effective 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, theFASB issued FASB Interpretation No. 45 (FIN 45), “Guarantor’s Accounting andDisclosure Requirements for Guarantees, Including Indirect Guarantees ofIndebtedness of Others,” which established additional accounting and disclosurerequirements when an enterprise guarantees the indebtedness of others.  The enterprise providing the guarantee isrequired to recognize a liability for the fair value of the obligation assumedand disclose the information in its interim and annual financialstatements.  The Company does notbelieve this will have a significant impact on our disclosures.

In January 2003, the FASBissued FASB Interpretaton No. 46 (FIN 46), “Consolidation of Variable InterestEntities, an interpretation of ARB No. 51.”  The interpretation defines when and who consolidates a “variableinterest entity,” or “VIE.”  This newconsolidation model applies to entities (i) where the equity investors (ifany) do not have a controlling financial interest, or (ii) whose equityinvestment at risk is insufficient to finance that entity’s activities withoutreceiving additional subordinated financial support from other parties andrequires additional disclosures 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.

**Meritus**Acquisition

Effective January7, 2000, the Company acquired Meritus by way of merger.  Pursuant to the terms of the merger, theCompany acquired all of the issued and outstanding stock of Meritus for 533,208shares of the Company’s common stock and $2.57 million in other considerationpaid to the shareholders of Meritus.  Contemporaneouslywith the merger, the Company satisfied $4.4 million of Meritus’ debt.  The merger was accounted for using thepurchase method; therefore the Company recorded the acquired assets at theirfair market value, generating a significant amount of goodwill.  *(See Note 2 to the Consolidated FinancialStatements.)*

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

**Inflation**

The Company doesnot believe that inflation in the United States,  Europe or Asia in recent years has had a significant effect onits results of operations.

**Year 2000**

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

 

 

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**CautionaryStatement**

Certain writtenand oral statements made or incorporated by reference from time to time by theCompany or its representatives in this Form 10-K, other filings or reports withthe Securities and Exchange Commission, press releases, conferences, orotherwise, are “forward-looking statements” within the meaning of the PrivateSecurities Litigation Reform Act of 1995. The Company is including this Cautionary Statement to make applicableand take advantage of the safe harbor provisions of the Private SecuritiesLitigation Reform Act of 1995 for any such forward-looking statements.  Forward-looking statements can be identifiedby the use of terminology such as “believe,” “anticipate,” “expect,”“estimate,” “may,” “will,” “should,” “project,” “continue,” “plans,” “aims,”“intends,” “likely,” or other words or phrases of similar terminology.  Management cautions you that forward-lookingstatements involve risks and uncertainties which may cause actual results todiffer materially from the forward-looking statements.  For a discussion of some of the factors thatmay cause actual results to differ materially from those suggested byforward-looking statements, please read carefully the information underItem 1, “Risk Factors”, of this Form 10-K.  In addition to the Risk Factors and other important factorsdetailed herein and from time to time in other reports filed by the Company withthe Securities and Exchange Commission, including Forms 8-K, 10-Q, and 10-K,the following important factors could cause actual results to differ materiallyfrom those suggested by any forward-looking statements.

*Marketplace Risks*

•                  Increased competitive pressure, both domestically andinternationally, which may negatively affect the sales of the Company’sproducts;

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

•                  Significant changes in the play patterns of children,whereby they are increasingly attracted to more developmentally advancedproducts at younger ages, which may affect brand loyalty and the perceivedvalue of and demand for the Company’s products; and

•                  Possible weaknesses in economic conditions,both domestically and internationally, which may negatively affect the sales ofthe Company’s products and the costs associated with manufacturing anddistributing these products.

*Financing Considerations*

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

•                  The ability of the Company to obtain thefinancing required for its ongoing operations, which may negatively affect theability of the Company’s viability as a going concern.

*Other Risks*

•                  Changes in laws or regulations, both domestically andinternationally, including those affecting consumer products or traderestrictions, which may lead to increased costs or interruption in normalbusiness operations of the Company;

•                  Future litigation or governmental proceedings, whichmay lead to increased costs or interruption in normal business operations of theCompany; and

•                  Labor disputes, which may lead to increased costs ordisruption of any of the Company’s operations.

 

 

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The risks includedherein and in Item 1 “Risk Factors” are not exhaustive.  Other sections of this Form 10–Kmay include additional factors which could materially and adversely impact theCompany’s business, financial condition, and results of operations.  Moreover, the Company operates in a verycompetitive and rapidly changing environment. New risk factors emerge from time to time and it is not possible formanagement to predict all such risk factors on the Company’s business,financial condition or results of operations or the extent to which any factor,or combination of factors, may cause actual results to differ materially fromthose contained in any forward-looking statements.  Given these risks and uncertainties, investors should not placeundue reliance on forward-looking statements as a prediction of actual results.

 

 

 

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**SIGNATURES**

Pursuant to therequirements of Section 13 or 15(d) of the Securities Exchange Act of 1934, theRegistrant has duly caused this report to be signed on its behalf by theundersigned, thereunto duly authorized.
|                              |   | DSI Toys, Inc.

                                          |
|-----------------------------------|--------|----------------------------------------------------------------|
| Dated:  **June 10,**  2003   | By:    | /s/ JOSEPH S. WHITAKER                                         |
|                              |   | Joseph S. Whitaker                                             |
|                              |   | President,  Chief Executive  Officer and Director

  |
|                              |   |                                                           |
| Dated:  **June 10,******2003 | By:    | /s/ ROBERT L. WEISGARBER                                       |
|                              |   | Robert L. Weisgarber

Chief Financial Officer                  |

 

Pursuant to therequirements of the Securities Exchange Act of 1934, this report has beensigned below by the following persons on behalf of the Registrant in thecapacities and on the dates indicated.

 

 
| **Signature**         |   | **Title** |   | **Date**      |
|-----------------------|--------|-----------|--------|---------------|
|                  |   |      |   |          |
| /s/  E. THOMAS MARTIN |   | Chairman  |   | June 10, 2003 |
| E. Thomas Martin      |   |      |   |          |
|                  |   |      |   |          |
| /s/  M. D. DAVIS      |   | Director  |   | June 10, 2003 |
| M.D. Davis            |   |      |   |          |
|                  |   |      |   |          |
| /s/ JOSEPH N. MATLOCK |   | Director  |   | June 10, 2003 |
| Joseph N. Matlock     |   |      |   |          |
|                  |   |      |   |          |
| /s/  ROBERT L. BURKE  |   | Director  |   | June 10, 2003 |
| Robert L. Burke       |   |      |   |          |
|                  |   |      |   |          |
| /s/  JOHN MCSORLEY    |   | Director  |   | June 10, 2003 |
| John McSorley         |   |      |   |          |
|                  |   |      |   |          |
| /s/ WALTER S. REILING |   | Director  |   | June 10, 2003 |
| Walter  S. Reiling    |   |      |   |          |

 

 

 

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**CERTIFICATIONS**

 

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

 

1.                                       I have reviewed this annual report onForm 10-K**,as amended by Amendment No. 1 on Form 10-K/A******and Amendment No. **2******on Form 10-K/A of DSI Toys, Inc.(“registrant”);

 

2.                                       Based on my knowledge, this annual reportdoes not contain any untrue statement of a material fact or omit to state amaterial fact necessary to make the statements made, in light of thecircumstances under which such statements were made, not misleading withrespect to the period covered by this annual report;

 

3.                                       Based on my knowledge, the financialstatements, and other financial information included in this annual report,fairly present in all material respects the financial condition, results ofoperations and cash flows of the registrant as of, and for, the periodspresented in this annual report;

 

4.                                       The registrant’s other certifyingofficers and I are responsible for establishing and maintaining disclosurecontrols and procedures (as defined in Exchange Act Rules 13a-14 and 15d-14)for the registrant and we have:

 

a)                                      Designed such disclosure controls andprocedures to ensure that material information relating to the registrant,including its consolidated subsidiaries, is made known to us by others withinthose entities, particularly during the period in which this annual report isbeing prepared;

 

b)                                     Evaluated the effectiveness of theregistrant’s disclosure controls and procedures as of a date within 90 daysprior to the filing date of this annual report (the “Evaluation Date”); and

 

c)                                      Presented in this annual report ourconclusions about the effectiveness of the disclosure controls and proceduresbased on our evaluation  as of theEvaluation Date;

 

5.                                       The registrant’s other certifyingofficers and I have disclosed, based on our most recent evaluation, to theregistrants auditors and the audit committee of registrant’s board of directors(or persons performing the equivalent functions):

 

a)                                      All significant deficiencies in thedesign or operation of internal controls which could adversely affect theregistrant’s ability to record, process, summarize and report financial dataand have identified for the registrant’s auditors any material weaknesses ininternal controls; and have identified for the registrant’s auditors anymaterial weaknesses in internal controls; and

 

b)                                     Any fraud, whether or not material, thatinvolves management or other employees who have a significant role in theregistrant’s internal controls; and

 

6.                                       The registrant’s other certifyingofficers and I have indicated in this annual report whether or not there weresignificant changes in internal controls or in other factors that couldsignificantly affect internal controls subsequent to the date of our mostrecent evaluation, including any corrective actions with regard to significantdeficiencies and material weaknesses.

 

 
| Date:  | June 10, 2003 | /s/ Joseph S. Whitaker                 |
|--------|---------------|----------------------------------------|
|   |          | Joseph S. Whitaker                     |
|   |          | President and Chief  Executive Officer |

 

 

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

 

1.                                       I have reviewed this annual report onForm 10-K**,as amended by Amendment No. 1 on Form 10-K/A******and Amendment No. **2**on Form 10-K/A of DSI Toys, Inc. (“registrant”);

 

2.                                       Based on my knowledge, this annual reportdoes not contain any untrue statement of a material fact or omit to state amaterial fact necessary to make the statements made, in light of thecircumstances under which such statements were made, not misleading withrespect to the period covered by this annual report;

 

3.                                       Based on my knowledge, the financialstatements, and other financial information included in this annual report,fairly present in all material respects the financial condition, results ofoperations and cash flows of the registrant as of, and for, the periods presentedin this annual report;

 

4.                                       The registrant’s other certifyingofficers and I are responsible for establishing and maintaining disclosurecontrols and procedures (as defined in Exchange Act Rules 13a-14 and 15d-14)for the registrant and we have:

 

a)                                      Designed such disclosure controls andprocedures to ensure that material information relating to the registrant,including its consolidated subsidiaries, is made known to us by others withinthose entities, particularly during the period in which this annual report isbeing prepared;

 

b)                                     Evaluated the effectiveness of theregistrant’s disclosure controls and procedures as of a date within 90 daysprior to the filing date of this annual report (the “Evaluation Date”); and

 

c)                                      Presented in this annual report ourconclusions about the effectiveness of the disclosure controls and proceduresbased on our evaluation  as of theEvaluation Date;

 

5.                                       The registrant’s other certifyingofficers and I have disclosed, based on our most recent evaluation, to theregistrants auditors and the audit committee of registrant’s board of directors(or persons performing the equivalent functions):

 

a)                                      All significant deficiencies in thedesign or operation of internal controls which could adversely affect theregistrant’s ability to record, process, summarize and report financial dataand have identified for the registrant’s auditors any material weaknesses ininternal controls; and have identified for the registrant’s auditors anymaterial weaknesses in internal controls; and

 

b)                                     Any fraud, whether or not material, thatinvolves management or other employees who have a significant role in theregistrant’s internal controls; and

 

6.                                       The registrant’s other certifyingofficers and I have indicated in this annual report whether or not there weresignificant changes in internal controls or in other factors that couldsignificantly affect internal controls subsequent to the date of our mostrecent evaluation, including any corrective actions with regard to significantdeficiencies and material weaknesses.

 
| Date:  | **June 10,******2003 | /s/ Robert L.  Weisgarber |
|--------|----------------------|---------------------------|
|   |                 | Robert L. Weisgarber      |
|   |                 | Chief Financial Officer   |

 

 

 

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**DSI TOYS, INC.**

 

**INDEX TO CONSOLIDATED FINANCIAL STATEMENTSAND 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

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**Repo****rt of Independent Accountants**

 

 

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 arethe responsibility of the Company’s management; our responsibility is toexpress an opinion on these financial statements and financial statementschedule based on our audits.  Weconducted our audits of these statements in accordance with auditing standardsgenerally accepted in the United States of America, which require that we planand perform the audit to obtain reasonable assurance about whether thefinancial statements are free of material misstatement.  An audit includes examining, on a testbasis, evidence supporting the amounts and disclosures in the financialstatements, assessing the accounting principles used and significant estimatesmade by management, and evaluating the overall financial statementpresentation.  We believe that ouraudits 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.  These factorsraise substantial doubt about the Company’s ability to continue as a goingconcern.  Management’s plans in regardto these matters are also described in Note 1. The consolidated financial statements do not include any adjustmentsthat 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 accompanying notes to consolidatedfinancial statements.

 

F-3

----

 

**DSI Toys, Inc.**

**ConsolidatedStatement of Operations**

 
|                                          |   | **Fiscal  Year** |       |
|-----------------------------------------------|--------|------------------|------------|
|                                          |   | **2002**         |       | **2001** |   | **2000** |   |
|                                          |   |             |       |   |   |   |   |
| Net  sales                                    |   | $                | 49,816,090 |   | $ | 67,956,319 |   | $ | 70,471,725 |   |
| Cost  of goods sold                           |   | 38,745,828       |       | 48,035,036 |   | 50,153,746 |   |
| 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**

###### **ConsolidatedStatement 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 TOCONSOLIDATED 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 initialpublic offering (the “Offering”) of 2,500,000 shares of common stock, whichprovided the Company net proceeds of $17.7 million.  All of the net proceeds were used to repay debt of theCompany.  In connection with theOffering, the Company issued warrants to purchase 250,000 shares of commonstock to the lead underwriters.  Suchwarrants are exercisable 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 cash flowsfrom operations are insufficient to meet future cash requirements, the Companywill need to successfully raise additional capital through an equity infusionor the issuance of debt.  The Company’sexecutive management believes that the Company will be required to eitherobtain a new revolving loan or obtain necessary additional capital to allow theCompany to continue its normal operations for the foreseeable future. However,there can be no assurance the Company will meet its projected operating resultsor be successful either in obtaining additional capital, or obtaining a newrevolving 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 wasincreased to $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. Certainreclassifications have been made to the prior year financial information tomake the presentation consistent with the current year financial presentation.

 

*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 included in net sales, and costs of goods sold includesthe shipping and handling costs associated 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 customers generallydo not give them the right to return products or to cancel firm orders.  However, as is common in the industry, wesometimes accept returns for stock balancing and negotiate accommodations tocustomers, which includes price discounts, credits and returns when demand forspecific products fall below expectations. Additionally, customers are given credit for any defective products theymay have received.  The allowance estimatesare based on historical sales returns and defective rates, analysis of creditmemo data and other known factors.  Ifthe data the Company uses to calculate these estimates does not properlyreflect future returns and defectives, revenue could be overstated and futureoperating 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 inventory valuation.  If market value is less than cost, then theCompany establishes a reserve for the amount required to value the inventory atmarket.  If the Company is not able toachieve its expectations of the net realizable value of the inventory at itscurrent value, the Company would adjust its reserve accordingly.

 

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 was determinedin accordance with the provisions of Statement of Financial AccountingStandards (SFAS) 109, “Accounting for Income Taxes,” which places primaryimportance on the Company’s cumulative operating results in the most recentperiods when assessing the need for a valuation allowance. The primary factorsconsidered in evaluating the realizability of the deferred tax assets andestablishing the valuation allowance were continued operating losses for theCompany through December 31, 2002, the Company’s projection of future operatingresults and the number of years it will take to recover the tax assets in adifficult market.  This evaluationprovides sufficient negative evidence to establish an additional valuationallowance under the provisions of SFAS 109. The Company intends to maintain a full valuation allowance for itsdeferred tax assets and net operating loss carryforwards until sufficientpositive evidence exists to support reversal of the allowance.  The establishment of this valuationallowance in no way affects the Company’s ability to reduce future tax expensethrough utilization of net operating losses and foreign income taxcredits.  However, currently there canbe no assurances 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 AccountingStandards, No. 142, “Goodwill and Other Intangible Assets,” (“FAS142”), whicheliminates amortization of goodwill beginning in January 2002 and requires anannual impairment test based on its estimated fair value, using futurediscounted cash flow 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 share calculationduring fiscal 2002, 2001, and 2000, because the options and warrants would beanti-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’sconsolidated financial 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 identifytheir reporting units and determine the aggregate carrying values and fairvalues of all such reporting units.  Tothe extent the carrying value of a reporting unit exceeds its relative fairvalue, a second 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 similarloan.  The Company’s viability as agoing concern is dependent upon successful negotiations with Sunrock, a newlender, or a substantial capital infusion, as well as sustained profitableoperations. The accompanying financial statements do not include anyadjustments that might be necessary if the Company is unable to continue as agoing 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 toperiodic review 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 theletter of credit are reimbursed to MVII by the Company.  Payment to MVII on the $5,000,000 promissorynote is subject to the terms of a subordination agreement between MVII and theRevolver bank, which places restrictions on payment to MVII, based on theborrowing capacity available 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 –*TheCompany recorded a $4.0 million charge in fiscal year 2002 to establish avaluation allowance for all of its deferred tax assets, including $2.2 millionof deferred tax assets generated in prior years.  The valuation allowance was calculated in accordance with theprovisions of Statement of Financial Accounting Standards (SFAS) 109,“Accounting for Income Taxes,” which places primary importance on the Company’scumulative operating results in the most recent periods when assessing the needfor 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 prepaidInvestment Warrant 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 for optionsgranted 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 toapproximately 17,000 square feet of office space at 10110 West Sam HoustonParkway, South, Houston, Texas, 77099. The lease requires monthly lease payments of $14,532, plus additionalannually adjustable monthly amounts for taxes, insurance, and operatingexpense.  The lease expires in September2007.

 

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                       |   | $                 | 22,500,667 |          | $      | 27,315,423       |   | $ | 49,816,090 |   |
| 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                       |   | $                 | 31,909,653 |          | $      | 36,046,666       |   | $ | 67,956,319 |   |
| 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                       |   | $                 | 27,181,042 |          | $      | 43,290,683       |   | $ | 70,471,725 |   |
| 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                |   | $                        | 5,189,853 |   | $ | 8,963,895 |   | $ | 20,712,076 |   | $ | 14,950,266 |   |
| 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                         |   | $                        | 6,726,163  |   | $ | 9,423,105 |   | $ | 29,949,779 |   | $ | 21,857,272 |   |
| 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                         |   | $                        | 6,917,720  |   | $ | 13,588,906 |   | $ | 29,929,689 |   | $ | 20,035,410 |   |
| 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 ofFulton County, 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 the purchasemethod; therefore the Company recorded the acquired assets at their estimatedfair market value.  Goodwill generatedby the transaction has been amortized over 20 years using the straight-linemethod in 2001 and 2000.  In 2002, andthereafter the market value of the goodwill will be evaluated annually and animpairment charge recorded if appropriate in accordance with Statement ofFinancial Accounting Standards No. 142, “Goodwill and 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

----

 
| 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

----

 
| 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

----

** **
| 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

----

 
| 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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