**Form
      10-K**





**SECURITIES
      AND EXCHANGE COMMISSION**





**Washington,
      D.C. 20549**





[
      X
      ] Annual
      Report pursuant to section 13 or 15(d) of the Securities and Exchange Act of
      1934 for the fiscal year


ended
      December 31, 2005.





[ ] Transition
      Report pursuant to section 13 or 15(d) of the Securities Exchange Act of 1934
      for the transition


period
      from _____ to _____.





Commission
      file number 0-22635





**RC2
      Corporation**


(Exact
      name of Registrant as Specified in Its Charter)





Delaware
            
            36-4088307(State
                or Other Jurisdiction of Incorporation or Organization)
            
            (IRS
                Employer Identification No.)1111
                West 22ndStreet, Suite 320, Oak Brook, Illinois
            
            60523(Address
                of principal executive offices)
            
            (Zip
                Code)Registrant’s
                telephone number, including area code: 630-573-7200Securities
                registered pursuant to Section 12(b) of the Exchange Act:Title
                of each class
            
            Name
                of each exchange on which registeredNA
            
            NASecurities
                registered pursuant to Section 12(g) of the Exchange Act:Common
                Stock, Par Value $0.01 Per Share(Title
                of class)





Indicate
      by check mark if the Registrant is a well-known seasoned issuer, as defined
      by
      Rule 405 of the Securities Act.


Yes X No  ___





Indicate
      by check mark if Registrant is not required to file reports pursuant to Section
      13 of 15(d) of the Exchange Act.


Yes ___ No X




Indicate
      by check mark whether the Registrant (1) has filed all reports required to
      be
      filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during
      the
      preceding 12 months (or for such shorter period that the Registrant was required
      to file such reports), and (2) has been subject to such filing requirements
      for
      the past 90 days.


Yes X No  ___





Indicate
      by check mark if disclosure of delinquent filers pursuant to Item 405 of
      Regulation S-K is not contained herein, and will not be contained, to the best
      of the Registrant’s knowledge, in definitive proxy or information statements
      incorporated by reference in Part III of this Form 10-K or any amendment to
      this
      Form 10-K.      [   ]





Indicate
      by check mark whether the Registrant is a large accelerated filer, an
      accelerated filer, or a non-accelerated filer. See definition of “accelerated
      filer and large accelerated filer” in Exchange Act Rule 12b-2.


Large
      accelerated filer [ X ]       Accelerated filer
      [ 
 ]           
Non-accelerated filer [   ]





Indicate
      by check mark whether the Registrant is a shell company (as defined in Rule
      12b-2 of the Exchange Act).


Yes
___NoX





Aggregate
      market value of the Registrant’s common stock held by non-affiliates as of June
      30, 2005 (the last business day of the Registrant’s most recently completed
      second quarter): $713,141,868. Shares of common stock held by any executive
      officer or director of the Registrant have been excluded from this computation
      because such persons may be deemed to be affiliates. This determination of
      affiliate status is not a conclusive determination for other
      purposes.





Number
      of
      shares of the Registrant’s common stock outstanding as of February 24,
      2006:  20,739,752





DOCUMENTS
      INCORPORATED BY REFERENCE





Portions
      of the Proxy Statement for the 2006 Annual Meeting of the Stockholders of the
      Registrant are incorporated by reference into Part III of this
      report.





As
      used
      in this report, the terms “we,” “us,” “our,” “RC2 Corporation,” “RC2” and the
“Company” mean RC2 Corporation and its subsidiaries, unless the context
      indicates another meaning, and the term “common stock” means our common stock,
      par value $0.01 per share.





Special
      Note Regarding Forward-Looking Statements





Certain
      statements contained in this report are considered “forward-looking statements”
within the meaning of the Private Securities Litigation Reform Act of 1995.
      These statements may be identified by the use of forward-looking words or
      phrases such as “anticipate,” “believe,” “could,” “expect,” “intend,” “may,”
“hope,” “plan,” “potential,” “should,” “estimate,” “predict,” “continue,”
“future,” “will,” “would” or the negative of these terms or other words of
      similar meaning. Such forward-looking statements are inherently subject to
      known
      and unknown risks and uncertainties. Our actual results and future developments
      could differ materially from the results or developments expressed in, or
      implied by, these forward-looking statements. Factors that may cause actual
      results to differ materially from those contemplated by such forward-looking
      statements include, but are not limited to, those described under the caption
      “Risk Factors” in Item 1A of this report. We undertake no obligation to make any
      revisions to the forward-looking statements contained in this filing or to
      update them to reflect events or circumstances occurring after the date of
      this
      filing.





**Part
      I**








**Item
      1.   Business**





**Overview**





We
      are a
      leading designer, producer and marketer of innovative, high-quality toys,
      collectibles, hobby and infant care products that are targeted to consumers
      of
      all ages. Our leadership position is measured by sales and brand recognition.
      Our infant and preschool products are marketed under our Learning Curve® family
      of brands which include The First Years® by Learning Curve and Lamaze brands as
      well as popular and classic licensed properties such as *Thomas
      & Friends* , *Bob
      the Builder* , *Winnie
      the*  *Pooh* ,
      John
      Deere and *Sesame
      Street* .
      We
      market our collectible and hobby products under a portfolio of brands including
      Johnny Lightning®, Racing Champions®, Ertl®, Ertl Collectibles®, AMT®, Press
      Pass®, JoyRide® and JoyRide Studios®. We reach our target consumers through
      multiple channels of distribution supporting more than 25,000 retail outlets
      throughout North America, Europe, Australia and Asia Pacific.





Our
      die-cast replicas are produced in various sizes such as 1:9, 1:18, 1:24 and
      1:64
      scales. The “scale” measures the size of the product in proportion to the car,
      truck, tractor or other item being replicated, and a larger scale results in
      a
      smaller replica. For example, a 1:24 scale vehicle replica is approximately
      eight inches long whereas a 1:64 scale vehicle replica is approximately three
      inches long. For additional information regarding the process of die-casting,
      see “Production - Die-Casting.”




**Business
      Segments**





The
      Company’s reportable segments are North America and International. The North
      America segment includes the United States, Canada and Mexico. The International
      segment includes non-North America markets. The discussion in this Form 10-K
      applies to all segments except where otherwise stated. For additional
      information on the Company’s segment reporting, including net sales, operating
      income and assets, see Note 5 to our consolidated financial statements included
      elsewhere herein.





2


**Corporate
      History**





We
      are a
      Delaware corporation that was originally formed in April 1996 as a holding
      company to combine the domestic operations of a privately held Illinois
      corporation formed in 1989 and the operations of four affiliated foreign
      corporations. We were originally named Collectible Champions, Inc. In 1997,
      we
      changed our name to Racing Champions Corporation before our initial public
      offering. In 2002, we changed our name to Racing Champions Ertl Corporation
      to
      reflect our integration of the business of The Ertl Company, Inc. (Ertl). In
      2003, following our acquisition of Learning Curve International, Inc., we
      changed our name to RC2 Corporation.





On
      March
      4, 2003, with an effective date of February 28, 2003, we acquired Learning
      Curve
      International, Inc. (Learning Curve) and certain of its affiliates
      (collectively, LCI) through a merger of a wholly owned subsidiary of RC2 with
      and into Learning Curve for approximately $104.4 million in cash (excluding
      transaction expenses) and 666,666 shares of our common stock, including $12.0
      million in escrow to secure Learning Curve’s indemnification obligations under
      the merger agreement. LCI develops and markets a variety of high-quality,
      award-winning traditional children’s toys for every stage from birth through age
      eight. This transaction was accounted for under the purchase method of
      accounting, and accordingly, the operating results of LCI have been included
      in
      our consolidated statements of earnings since the effective date of the
      acquisition. The purchase was funded with a credit facility (See Note 7 to
      the
      consolidated financial statements).





The
      escrow amount to secure Learning Curve’s indemnification obligations under the
      merger agreement was approximately $2.9 million at December 31, 2005. In the
      merger agreement, Learning Curve agreed to indemnify the Company for losses
      relating to breaches of Learning Curve’s representations, warranties and
      covenants in the merger agreement and for specified liabilities relating to
      Learning Curve’s historical business. In February and April 2005, the Company
      had notified the representatives of the former Learning Curve stockholders
      of
      certain claims relating to a tax audit and other matters. Subsequent to December
      31, 2005, an agreement was reached with the representatives of the former
      Learning Curve stockholders resolving all open escrow claims and disbursing
      all
      amounts in escrow other than approximately $0.3 million which will remain in
      the
      escrow to pay certain of our expenses to pursue a pending malpractice litigation
      claim.





On
      June
      7, 2004, the Company acquired substantially all of the assets of Playing Mantis,
      Inc. (Playing Mantis) with an effective date of June 1, 2004. Closing
      consideration consisted of $17.0 million of cash (excluding transaction
      expenses) and 91,388 shares of the Company’s common stock. Additional cash
      consideration of up to $4.0 million could have been earned in the transaction
      by
      Playing Mantis of which $2.0 million was based on achieving net sales and margin
      targets in 2004 and the remaining $2.0 million was based on achieving net sales
      targets in 2005. The contingent consideration was not payable because the net
      sales and margin targets were not met in either 2004 or 2005. Playing Mantis
      designs and markets collectible vehicle replicas under the Johnny Lightning® and
      Polar Lights® brands. Playing Mantis’ products are primarily sold at mass
      merchandising, hobby, craft, drug and grocery chains. This transaction has
      been
      accounted for under the purchase method of accounting and, accordingly, the
      operating results of Playing Mantis have been included in our consolidated
      statements of earnings since the effective date of the acquisition. The excess
      of the aggregate purchase price over the fair market value of net assets
      acquired of approximately $11.0 million has been recorded as goodwill in the
      accompanying consolidated balance sheet at December 31, 2005.





On
      September 15, 2004, the Company acquired The First Years Inc. (TFY) for
      approximately $156.1 million in cash (excluding transaction expenses). TFY
      is an
      international developer and marketer of infant and toddler care and play
      products sold under The First Years® by Learning Curve brand name and under
      various licenses, including Disney’s *Winnie
      the Pooh* .
      TFY’s
      products are sold at toy, mass merchandising, drug and grocery chains, and
      at
      specialty retailers. This transaction has been accounted for under the purchase
      method of accounting and, accordingly, the operating results of TFY have been
      included in the accompanying consolidated statements of earnings since the
      effective date of the acquisition. The purchase was funded with the Company’s
      new credit facility (See Note 7 to the consolidated financial statements).
      The
      excess of the aggregate purchase price over the fair market value of net assets
      acquired of approximately $73.4 million has been recorded as goodwill in the
      accompanying consolidated balance sheet at December 31, 2005.


3


**Products**





We
      group
      our products into three product categories:  infant products;
      children’s toys; and collectible products. This presentation is consistent with
      how we view our business. We provide a diverse offering of highly detailed,
      authentic replicas and stylized toys and infant products known for their quality
      workmanship. Our products currently retail from $0.99 to $599.99. We have
      successfully expanded our product offering and, by offering a wide range of
      products at varying price points, we believe our products appeal to a broad
      range of consumers. The following chart summarizes our current product
      categories:




**Category**
              **Key
                  Licensed Properties**
              **Key
                  Brands**
              **Price
                  Range**
 Infant
                    Products
                Lamaze
                Learning
                    Curve
                $0.99
                    - $149.99*Winnie
                    the Pooh*
                LamazeDisney
                    Princess
                The
                    First Years by Learning Curve*Finding
                      Nemo**Sesame
                    Street*
 Children’s
                  Toys
              *Thomas
                  & Friends*
              Learning
                  Curve
              $1.99
                  - $599.99*Bob
                the Builder*
              Thomas
                  Wooden RailwayJohn
                  Deere
              Take
                    Along Thomas*Bob
                    the Builder Project: Build It*Take
                  Along*Bob
                  the Builder*John
                  Deere PreschoolJohnny
                  Lightning*Monsters
                  of Destruction*
 Collectible
                    Products
                Ford
                Johnny
                    Lightning
                $1.00
                    - $179.99General
                    Motors
                ErtlDaimlerChrysler
                Ertl
                    CollectiblesChip
                    Foose
                AMTNASCAR
                JL
                    Full ThrottleNHRA
                American
                    MuscleJohn
                    Deere
                JoyRideHalo
                JoyRide
                    StudiosRacing
                    ChampionsPress
                    Pass


***Infant
        Products.*** This
        category includes a wide range of infant products including products relating
        to
        feeding, care/safety and play. Products in this category include:
 
 **·**
              Lamaze
                  infant toys with features that encourage developmental and interactive
                  play; and
 
 **·**
              The
                  First Years by Learning Curve, a full line of feeding, care/safety
                  and
                  play products for infants, including the Take & Toss®, Soothie and
                  Nature SensationsTM product lines.
 In
          2005,
          we introduced new products under the Lamaze Infant Development System line
          which
          incorporate features such as lights and sounds. Under The First Years by
          Learning Curve brand, we introduced the Nature Sensations product line
          which
          encourages baby to achieve fundamental milestones by using the sensations
          of
          nature, such as sights, sounds and touch, to learn. Additionally under
          The First
          Years by Learning Curve brand, we introduced a full line of *Finding
          Nemo* bath
          accessories, as well as Sesame Street Beginnings feeding and teething products
          which feature the *Sesame
          Street* baby
          characters.
 
 In
          2006,
          we will introduce the Soothie bottles product line under The First Years
          by
          Learning Curve brand. These wide-mouth bottles will offer the same shaped,
          medical grade silicone nipple as those used on Soothie pacifiers. Additionally
          under The First Years by Learning Curve brand, we will expand the Take
&
Toss product line to include sippy and straw cups featuring such licensed
          properties as *Thomas
          & Friends* , *Bob
          the Builder* , *The
          Wiggles* , *Barney* , *Sesame
          Street* ,
          Disney
          Princess, *Winnie
          the Pooh* , *Finding
          Nemo* and *Spiderman* .
          We will
          also introduce the Lamaze Two Can Play product line which encourages
          parent/caregiver and baby to interact and play
          together.


4




***Children’s
        Toys.*** This
        category includes product lines that are marketed to parents, grandparents,
        caregivers and giftgivers of children. Products in this category
        include:





**·**
            Thomas
                Wooden Railway and Take Along Thomas, wooden and die-cast engines,
                vehicles, destinations and playsets marketed under our Learning Curve
                brand, as well as foot-to-floor and battery-operated
                ride-ons;





**·**
            *Bob
                the Builder Project: Build It*and Take Along*Bob
                the Builder*,
                characters, vehicles, playsets and role-play toys marketed under
                our
                Learning Curve brand;





**·**
            John
                Deere farm, construction, ride-on and role-play activity toys;
                and





**·**
            *Monsters
                of Destruction*monster trucks marketed under our Johnny Lightning
                brand.





In
      2005,
      we launched the *Bob
      the Builder* product
      lines. The *Bob
      the Builder* product
      lines pair classic construction play with all new and exciting characters.
      The
      debut of this product line coincided with new episodes of the *Bob
      the Builder* television series on PBS and PBS KIDS Sprout. Additionally in 2005, we
      introduced foot-to-floor and battery-operated Thomas ride-ons which were carried
      exclusively at Toys “R” Us and the battery-operated John Deere Buck
      ATV.





In
      2006,
      we will expand the distribution of our ride-ons, as well as introduce our first *Bob
      the Builder* ride-on.
      We will introduce new Thomas Wooden Railway destinations and engines and offer
      new sets and a track system for the Take Along Thomas product line. We will
      launch the *Monsters
      of Destruction* product
      line under the Johnny Lightning brand which will include monster trucks that
      compete in the *Monsters
      of Destruction* live
      events and as seen on The Outdoor Channel. Each monster truck will include
      detailed decorations, working suspensions, cool wheels and other play features.
      We will expand our John Deere toy line to include a radio controlled tractor
      complete with lights and sounds, as well as a 21 inch construction “Big
      Loader.”




***Collectible
          Products.*** Our
          collectible products category consists of automotive, high performance
          and
          racing vehicle replicas, agricultural, construction and outdoor sports
          vehicle
          replicas, sports trading cards, apparel and collectible figures. Products
          in this category include:
 
 **·**
                Johnny
                    Lightning, American Muscle and JoyRide collectible die-cast classic,
                    high
                    performance, entertainment-themed and late model automobiles
                    and
                    trucks;
 
 **·**
                Ertl
                    Collectibles die-cast custom imprint cars and trucks, various
                    scales of
                    delivery trucks and tractor trailers and vintage and modern tractors,
                    farm
                    implements and construction vehicles of major original equipment
                    manufacturers (OEMs) such as John Deere and Case New
                    Holland;
 
 **·**
                AMT
                    plastic model kits principally of vintage and high performance
                    automobiles, stylized cars, trucks and SUV’s and entertainment-themed
                    vehicles;
 
 **·**
                JL
                    Full Throttle, highly detailed and stylized die-cast vehicle
                    replicas
                    which incorporate the latest automotive looks and trends from
                    Southern
                    California and around the world;
 
 **·**
                JoyRide
                    Studios collectible figures of characters from Microsoft Xbox's
                    Halo and
                    Halo 2; and
 
 **·**
                Racing
                    Champions die-cast funny cars, top fuel dragsters, pro stock
                    cars and pro
                    stock motorcycles representing a large number of the vehicles
                    competing in
                    the National Hot Rod Association (NHRA) Drag Racing Series.
 We
        market
        our 1:64 th scale
        die-cast replicas to consumers for purchase as either toys or collectibles.
        Our
        larger scaled, highly detailed die-cast replicas are primarily targeted to
        adult
        collectors. Collectors, by their nature, make multiple purchases of die-cast
        replicas because of their affinity for classic, high performance and late
        model
        cars, trucks, hot rods and tuners, vintage and modern tractors, farm implements,
        construction vehicles and all-terrain vehicles. Tuners are cars that are
        extensively modified by enthusiasts for performance and style. These collectors
        value the authenticity of these replicas and the enjoyment of building their
        own
        unique collections. Our model kits are primarily 1:25 th scale
        and are purchased by adult hobbyists who enjoy building and collecting a
        range
        of models. We also produce die-cast replicas, sports trading cards
        and apparel under licenses from a number of NASCAR and NHRA race
        teams.


5


In
        2005,
        we expanded our Johnny Lightning and JoyRide vehicle replica product lines.
        A
        series of 1:24 th scale
        collectible vehicles was introduced under the Johnny Lightning product line.
        These vehicles featured die-cast bodies and chassis with opening hoods, factory
        paint schemes and customized details. We also introduced die-cast replicas
        under
        the JoyRide collectible vehicle brand, including replicas of vehicles seen
        on
        the *American Hot Rod* television series, in *RIDES*magazine and
        at Formula D drifting events. Formula D drifting events showcase vehicles
        that
        have the ability to drive sideways at high speeds and at extreme angles without
        losing control. Additionally, we introduced die-cast replicas of the *Dukes
        of Hazzard* and
        Disney’s *Herbie
        The Love Bug* vehicles, as well as model kits of the *Star
        Wars* vehicles, in conjunction with the related movie releases in 2005.
 
 In
        2006,
        we will launch the new JL Full Throttle product line featuring highly detailed
        and stylized cars, trucks and SUV’s incorporating the latest automotive looks
        and trends from Southern California and around the world. This product line
        will
        feature the original customized designs of Chip Foose, including vehicles
        from
        the hit TLC show *Overhaulin’* .
        Additionally, we will introduce new vehicles in our *The
        Fast and The Furious* product
        line to coincide with the release in 2006 of *The*  *Fast
        and*  *The*  *Furious:
        Tokyo Drift* movie.


**Licenses**





We
      market
      a significant portion of our products with licenses from other parties. We
      have
      license agreements with entertainment publishing and media companies; automotive
      and truck manufacturers; agricultural, construction and outdoor sports vehicle
      and equipment manufacturers; major race sanctioning bodies; and race team
      owners, sponsors and drivers. A significant element of our strategy depends
      on
      our ability to identify and obtain licenses for recognizable and respected
      brands and properties. Our licenses reinforce our brands and establish our
      products’ authenticity, credibility and quality with consumers, and in some
      cases, provide for new product development opportunities and expand distribution
      channels. Our licenses are limited in scope and duration and authorize the
      sale
      of specific licensed products generally on a nonexclusive basis.  For
      the
      year ended December 31, 2005, net sales of the Company’s products with the
      licensed properties of*Thomas
      & Friends*and John
      Deere each accounted for more than 10.0% of our net sales. No other licensed
      property accounted for more than 10.0% of our net sales for the year ended
      December 31, 2005.As of December 31, 2005, approximately 60.0% of
      our licenses required us to make minimum guaranteed royalty payments whether
      or
      not we meet specific sales targets. Aggregate future minimum guaranteed royalty
      payments as of December 31, 2005 is approximately $20.0 million, with the
      individual license minimum guarantees ranging from $1.00 to $7.5 million. 
Royalty expense related to licenses with minimum guarantees for the year ended
      December 31, 2005 was $13.6 million. We have over 700 license agreements,
      with terms generally of two to three years. Any termination of or failure to
      renew our significant licenses, or inability to develop and enter into new
      licenses, could limit our ability to market our products or develop new products
      and reduce our net sales and profitability. Over the next two years, license
      agreements in connection with several of our key licensed properties, including
      licenses for certain *Thomas &
      Friends*, *Winnie the Pooh*, Disney Princess, *Finding
      Nemo* and DaimlerChrysler Corporation products, are scheduled to
      expire. Competition for licenses could require us to pay licensors higher
      royalties and higher minimum guaranteed payments in order to obtain or retain
      attractive licenses, which could increase our expenses.





**Channels
      of Distribution**





Our
      products are available through more than 25,000 retail outlets located in North
      America, Europe, Australia and Asia Pacific. We market our products through
      multiple channels of distribution in order to maximize our sales opportunities
      for our broad product offering. Products with lower price points are generally
      sold in chain retailer channels while products with more detailed features
      and
      higher prices are typically sold in hobby, collector and independent toy stores
      and through wholesalers and OEM dealers. We believe we have a leading position
      in multiple distribution channels and that this position enhances our ability
      to
      secure additional licenses, extends the reach of our products to consumers
      and
      mitigates the risk of concentration by channel or customer.





***Chain
      Retailers.*** Our
      products marketed through this channel are targeted predominately at price
      conscious end-users. As a result, the majority of our products marketed through
      this channel are designed to span lower price points and generally retail for
      less than $30.00. Customers included in this channel have more than ten retail
      locations and can include a wide range of retailers such as book, farm and
      ranch, automotive and craft/hobby stores, as well as the national discount
      retailers. Key customers in our chain retailer channel include Toys “R”
Us/Babies “R” Us, Wal-Mart, Target, Tractor Supply Company, Kohl’s and Michaels
      Stores, Inc. Sales in 2005 to chain retailers were 62.3% of our net
      sales.





***Specialty
      and Hobby Wholesalers and Retailers.*** We sell
      many of the products available at chain retailers as well as higher priced
      products with special features to specialty and hobby wholesalers and retailers
      which comprised 25.5% of our net sales in 2005. We reach these customers
      directly through our internal telesales group and business-to-business website
      located at www.myRC2.com and through specialty toy representatives and
      collectible and toy trade shows. Key customers in our specialty and hobby
      wholesaler and retailer channel include Learning Express, Great Planes Model
      Manufacturing Company, All Aboard Toys and Horizon Hobby.


6


***OEM
      Dealers.*** We often
      sell licensed products to the licensing OEM’s dealer network. OEM licensing
      partners benefit from our OEM dealer sales through the opportunity to receive
      royalties from additional product sales through the OEM’s dealer network. We
      often provide OEM dealers with a short-term exclusivity period where the OEM
      dealers have the opportunity to purchase new products for a short period
      (generally 90 to 360 days) before the products become available through other
      distribution channels. Key customers in our OEM dealer channel include John
      Deere, Case New Holland and Polaris. Sales in 2005 to OEM dealers were 8.1%
      of
      our net sales.





***Corporate
      Promotional Accounts.*** We
      believe we have the top position in North America in the die-cast vehicle
      corporate promotional channel. Corporate promotional products allow a company
      to
      promote its products, reinforce its brands and reward employees and customers.
      In this channel, we can cost-effectively accommodate both large-unit orders
      and
      lower-unit orders due to our extensive tooling library, our flexible, dedicated
      suppliers and the nature of our operations. This gives us a competitive
      advantage over our larger competitors because it allows our product sourcing
      to
      be flexible enough to accommodate small production runs. Key customers in our
      corporate promotional channel include Matco Tools and Texaco. Corporate
      promotional accounts comprised 3.6% of our net sales in 2005.





***Direct
      to Consumers.*** In 2005,
      we made certain products available for direct sales to consumers through company
      stores and a business-to-consumer website located at www.diecastexpress.com.
      Effective January 1, 2005, we discontinued our trackside distribution.
      Individual products sold directly to consumers sell at prices similar to those
      found at retailers, hobby stores and dealers and constituted 0.5% of our net
      sales in 2005.





**Trademarks**





We
      have
      registered several trademarks with the U.S. Patent and Trademark Office,
      including the trademarks RC2®, Learning Curve®, The First Years®, Johnny
      Lightning®, Ertl®, AMT®, Racing Champions®, Press Pass®, and Polar Lights®. A
      number of these trademarks are also registered in foreign countries. We believe
      our trademarks hold significant value, and we plan to build additional value
      through increased consumer awareness of our many other trade names and
      trademarks.





**Sales
      and Marketing**





Our
      sales
      organization consists of an internal sales force and external sales
      representative organizations. Our internal sales force provides direct customer
      contact with nearly all of our retail chain and key wholesale accounts. A number
      of accounts are designated as “house accounts” and are handled exclusively by
      our internal sales staff. Our inside sales and customer service groups use
      telephone calls, mailings, faxes and e-mails to directly contact OEM dealers
      and
      smaller volume customers such as collector, hobby, specialty and independent
      toy
      stores.





Our
      internal sales force is supplemented by external sales representative
      organizations. These external sales representative organizations provide more
      frequent customer contact and solicitation of the national, regional and
      specialty retailers and supported 30.4% of our net sales in 2005. External
      sales
      representatives generally earn commissions of 1.0% to 15.0% of the net sales
      price from their accounts. Their commissions are unaffected by the involvement
      of our internal sales force with a customer or sale.





The
      Company maintains a business-to-business website under the name www.myRC2.com.
      This website, targeted at smaller volume accounts, allows qualified customers
      to
      view new product offerings, place orders, check open order shipping status
      and
      review past orders. We believe that www.myRC2.com leverages our internal sales
      force, inside sales group and customer service group by providing customers
      with
      greater information access and more convenient ordering capability.





Our
      marketing programs are directed toward adult collectors, parents and children,
      current consumers and potential new consumers that fit the demographic profile
      of our target market. Our objectives include increasing awareness of our product
      offerings and brand names, as well as executing consumer promotions. We utilize
      the following media vehicles in our marketing plans.





**·**
            *Advertising.*
                We place print advertisements in publications with high circulation
                and
                targeted penetration in key vertical categories such as parenting,
                gift,
                hobby, die-cast, trading cards and action figures. We run commercials
                on a
                selective basis on television programs that target key
                consumers.





**·**
            *Public
                Relations.*We
                have developed a sustained trade and consumer public relations effort
                to
                build relationships with editors at publications targeted across
                all of
                our product lines. Ongoing press releases keep editors abreast of
                new
                product introductions, increase our credibility and market acceptance,
                and
                encourage the editorial staffs of these publications to give more
                coverage
                to our products.


7





**·**
            *Co-op
                Advertising.*We
                work closely with retail chains to plan and execute ongoing
                retailer-driven promotions and advertising. The programs usually
                involve
                promotion of our products in retail customers’ print circulars, mailings
                and catalogs, and sometimes include placing our products in high-traffic
                locations within retail stores.





**·**
            *Internet.*The Internet is an increasingly important part of our marketing plan
                because consumers have quickly adopted the Internet as a preferred
                way to
                communicate with others about their product preferences and purchases.
                Our
                website, www.rc2corp.com, highlights our products, lists product
                release
                dates and collects market data directly from consumers. We also gather
                consumer information through consumer letters, e-mails, telephone
                calls,
                product surveys and focus groups.





**Competition**





We
      compete with several large domestic and foreign companies, such as Mattel,
      Inc.
      and Hasbro, Inc., with private label products sold by many of our retail
      customers and with other producers of infant products, toys and collectibles.
      Competition in the distribution of our products is intense, and the principal
      methods of competition consist of product appeal, ability to capture shelf
      or
      rack space, timely distribution, price and quality. Competition is also based
      on
      the ability to obtain license agreements for existing and new products to be
      sold through specific distribution channels or retail outlets. We believe that
      our competitive strengths include our knowledge of the markets we serve, our
      ability to bring products to market rapidly and efficiently, our dedicated
      and
      integrated suppliers, our multiple channels of distribution, our well-known
      brands supported by respected licenses, our diversified product categories
      and
      our established and loyal consumer base. Many of our competitors have longer
      operating histories, greater brand recognition and greater financial, technical,
      marketing and other resources than we have.





**Production**





We
      believe we are an industry leader in bringing new products to market rapidly
      and
      efficiently. Our integrated design and engineering expertise, extensive library
      of product designs, molds and tools and dedicated suppliers enable us to be
      first to market with many innovative products.





***Far
      East Product Sourcing.*** We have
      operations in Kowloon, Hong Kong and in the RC2 Industrial Zone in Dongguan
      City, China and employ 215 people in Hong Kong and China who oversee the
      sourcing of the majority of our products. This group assists our suppliers
      in
      sourcing raw materials and packaging, performs engineering and graphic art
      functions, executes the production schedule, provides on-site quality control,
      facilities third-party safety testing and coordinates the delivery of shipments
      for export from China.





***Far
      East Production.*** All of
      our products are manufactured in China, except for certain plastic ride-ons,
      certain infant products, sports trading cards and certain apparel items. Our
      China-based product sourcing accounted for approximately 91.6% of our product
      purchases in 2005. We primarily use seven third-party, dedicated suppliers
      who
      manufacture only our products in eight factories, three of which are located
      in
      the RC2 Industrial Zone. The RC2 Industrial Zone is the name of a factory
      complex developed in 1997 and located in Dongguan City, China (approximately
      50
      miles from Hong Kong) where three of our third-party, dedicated suppliers
      operate three freestanding factory facilities. Most of our third-party,
      dedicated suppliers have been supplying us for more than ten years. These seven
      third-party, dedicated suppliers produced approximately 48.4% of our China-based
      product purchases in 2005. In order to supplement our third-party, dedicated
      suppliers, we use several other suppliers in China. All products are
      manufactured to our specifications using molds and tooling that we own. These
      suppliers own the manufacturing equipment and machinery, purchase raw materials,
      hire workers and plan production. We purchase fully assembled and packaged
      finished goods in master cartons for distribution to our customers. We enter
      into purchase orders with our foreign suppliers and generally do not enter
      into long-term contracts.





***Die-Casting.*** All of
      our die-cast products are manufactured in China. Die-casting for our products
      involves the use of custom molds to shape melted zinc alloy into our die-cast
      products. Our suppliers purchase zinc alloy and conduct the die-cast
      manufacturing process at their facilities.





***Domestic
      Production.*** The
      production of certain plastic ride-ons, certain infant products, sports trading
      cards and certain apparel items is completed primarily by U.S.-based suppliers.
      We create the product design and specifications and coordinate the manufacturing
      activities. We generally prefer to coordinate the production of these products
      through a limited number of suppliers and believe that a number of alternate
      suppliers are available.





8


***Tooling.*** To
      create new products, we continuously invest in new tooling. Tooling represents
      the majority of our capital expenditures. Depending on the size and complexity
      of the product, the cost of tooling a product generally ranges from $3,000
      to
      $250,000. For many of our products, we eliminate significant tooling time by
      utilizing our extensive tooling library of more than 25,000 tools. We own all
      of
      our tools and provide them to our suppliers during production. Tools are
      returned to us when a product is no longer in production and are stored for
      future use.





***Product
      Safety.*** Our
      products are designed, manufactured, packaged and labeled to conform with all
      safety requirements under U.S. federal and other applicable laws and
      regulations, industry developed voluntary standards and product specific
      standards, and are periodically reviewed and approved by independent safety
      testing laboratories. We carry product liability insurance coverage with a
      limit
      of over $50 million per occurrence.





***Logistics.*** Our
      customers purchase our products either in the United States, United Kingdom,
      Australia, Canada or Germany or directly from China. We own a distribution
      facility in Dyersville, Iowa, lease distribution facilities in Rochelle,
      Illinois and Australia, and use independent warehouses in California, Canada,
      the United Kingdom, Belgium and Germany.





**Seasonality**





We
      have
      experienced, and expect to continue to experience, substantial fluctuations
      in
      our quarterly net sales and operating results, which is typical of many
      companies in our industry. Our business is highly seasonal due to high consumer
      demand for our products during the year-end holiday season. Approximately 62.5%
      of our net sales for the three years ended December 31, 2005, were generated
      in
      the second half of the year, with September, October and November being the
      largest shipping months. As a result, consistent with industry practice, our
      investment in working capital, mainly inventory and accounts receivable, is
      typically highest during the third and fourth quarters and lowest during the
      first quarter.





**Customers**





We
      derive
      a significant portion of our sales from some of the world’s largest retailers
      and OEM dealers. Our top five customers accounted for 38.0%, 37.9% and 47.6%
      of
      our net sales in 2003, 2004 and 2005, respectively. Toys “R” Us/Babies “R” Us,
      our largest customer, accounted for 10.5% and 14.8% of our net sales in 2004
      and
      2005, respectively. Wal-Mart accounted for 10.8% and 13.1% of our net sales
      in
      2003 and 2005, respectively. Target accounted for 11.7% of our net sales in
      2005. Other than Toys “R” Us/Babies “R” Us, Wal-Mart and Target, no customer
      accounted for more than 10.0% of our net sales in 2005. Other than Toys “R”
Us/Babies “R” Us, no customer accounted for more than 10.0% of our net sales in
      2004. Other than Wal-Mart, no customer accounted for more than 10.0% of our
      net
      sales in 2003. Many of our retail customers generally purchase large quantities
      of our product on credit, which may cause a concentration of accounts receivable
      among some of our largest customers.





**Employees**





As
      of
      December 31, 2005, we had 842 employees, 62 of whom were employed part-time.
      We
      emphasize the recruiting and training of high-quality personnel, and to the
      extent possible, promote people from within RC2. A collective bargaining
      agreement covers 117 of our employees, all of whom work in the distribution
      facility in Dyersville, Iowa. We consider our employee relations to be good.
      Our
      continued success will depend, in part, on our ability to attract, train and
      retain qualified personnel at all of our locations.





**Available
      Information**





We
      maintain our corporate website at www.rc2corp.com and we make available, free
      of
      charge, through this website our annual report on Form 10-K, quarterly reports
      on Form 10-Q, current reports on Form 8-K, and amendments to those reports
      that
      we file with or furnish to the Securities and Exchange Commission (the
      Commission), as soon as reasonably practicable after we electronically file
      such
      material with, or furnish it to, the Commission. Information on our website
      is
      not part of this report. This report includes all material information about
      the
      Company that is included on the Company’s website and is otherwise required to
      be included in this report.





9


**Item
      1A.   Risk Factors**





The
      risks
      described below are not the only risks we face. Additional risks that we do
      not
      yet know of or that we currently think are immaterial may also impair our
      business operations. If any of the events or circumstances described in the
      following risks actually occur, our business, financial condition or results
      of
      operations could be materially adversely affected. In such cases, the trading
      price of our common stock could decline.





**Our
      net sales and profitability depend on our ability to continue to conceive,
      design and market products that appeal to consumers.**





The
      introduction of new products is critical in our industry and to our growth
      strategy. Our business depends on our ability to continue to conceive, design
      and market new products and upon continuing market acceptance of our product
      offering. Rapidly changing consumer preferences and trends make it difficult
      to
      predict how long consumer demand for our existing products will continue or
      what
      new products will be successful. Our current products may not continue to be
      popular or new products that we introduce may not achieve adequate consumer
      acceptance for us to recover development, manufacturing, marketing and other
      costs. A decline in consumer demand for our products, our failure to develop
      new
      products on a timely basis in anticipation of changing consumer preferences
      or
      the failure of our new products on a timely basis in anticipation of changing
      consumer preferences or the failure of our new products to achieve and sustain
      consumer acceptance could reduce our net sales and profitability.





**Competition
      for licenses could increase our licensing costs or limit our ability to market
      products.**





We
      market
      a significant portion of our products with licenses from other parties. These
      licenses are limited in scope and duration and generally authorize the sale
      of
      specific licensed products on a nonexclusive basis. Our license agreements
      often
      require us to make minimum guaranteed royalty payments that may exceed the
      amount we are able to generate from actual sales of the licensed products.
      Any
      termination of or failure to renew our significant licenses, or inability to
      develop and enter into new licenses, could limit our ability to market our
      products or develop new products and reduce our net sales and
      profitability.  For
      the
      year ended December 31, 2005, net sales of the Company’s products with the
      licensed properties of*Thomas
      & Friends*and John
      Deere each accounted for more than 10.0% of our net sales.Over the next two years, license agreements in connection with several
      key licensed properties, including licenses for certain *Thomas &
Friends*, *Winnie the Pooh,* Disney Princess, *Finding Nemo*
      and DaimlerChrysler Corporation products, are scheduled to expire. Competition
      for licenses could require us to pay licensors higher royalties and higher
      minimum guaranteed payments in order to obtain or retain attractive licenses,
      which could increase our expenses. In addition, licenses granted to other
      parties, whether or not exclusive, could limit our ability to market products,
      including products we currently market, which could cause our net sales and
      profitability to decline. ****





**Competition
      in our markets could reduce our net sales and
      profitability.**





We
      operate in highly competitive markets. We compete with several large domestic
      and foreign companies such as Mattel, Inc. and Hasbro, Inc., with private label
      products sold by many of our retail customers and with other producers of infant
      products, toys and collectibles. Many of our competitors have longer operating
      histories, greater brand recognition and greater financial, technical, marketing
      and other resources than we have. In addition, we may face competition from
      new
      participants in our markets because the collectible, toy and infant product
      industries have limited barriers to entry. We experience price competition
      for
      our products, competition for shelf space at retailers and competition for
      licenses, all of which may increase in the future. If we cannot compete
      successfully in the future, our net sales and profitability will likely
      decline.


10


**We
      may experience difficulties in integrating strategic
      acquisitions.**





As
      part
      of our growth strategy, we intend to pursue acquisitions that are consistent
      with our mission and enable us to leverage our competitive strengths. We
      acquired Learning Curve International, Inc. effective February 28, 2003, Playing
      Mantis, Inc. effective June 1, 2004 and The First Years Inc. effective September
      15, 2004. The integration of acquired companies and their operations into our
      operations involves a number of risks including:





**·**
            the
                acquired business may experience losses which could adversely affect
                our
                profitability;


**·**
            unanticipated
                costs relating to the integration of acquired businesses may increase
                our
                expenses;


**·**
            possible
                failure to obtain any necessary consents to the transfer of licenses
                or
                agreements of the acquired company; **·**
            possible
                failure to maintain customer, licensor and other relationships after
                the
                closing of the transaction of the acquired
                company;


**·**
            difficulties
                in achieving planned cost-savings and synergies may increase our
                expenses
                or decrease our net sales;


**·**
            diversion
                of management’s attention could impair their ability to effectively manage
                our business operations; and


**·**
            unanticipated
                management or operational problems or liabilities may adversely affect
                our
                profitability and financial
                condition.





Additionally,
      to finance our strategic acquisitions, we have borrowed funds under our credit
      facility and we may borrow additional funds to complete future acquisitions.
      This debt leverage could adversely affect our profit margins and limit our
      ability to capitalize on future business opportunities. A portion of this debt
      is also subject to fluctuations in interest rates.





**We
      depend on the continuing willingness of chain retailers to purchase and provide
      shelf space for our products.**





In
      2005,
      we sold 62.3% of our products to chain retailers. Our success depends upon
      the
      continuing willingness of these retailers to purchase and provide shelf space
      for our products. We do not have long-term contracts with our customers. In
      addition, our access to shelf space at retailers may be reduced by store
      closings, consolidation among these retailers and competition from other
      products. An adverse change in our relationship with or the financial viability
      of one or more of our customers could reduce our net sales and
      profitability.





**We
      may not be able to collect outstanding accounts receivable from our major retail
      customers.**





Many
      of
      our retail customers generally purchase large quantities of our products on
      credit, which may cause a concentration of accounts receivable among some
      of our largest customers. Our profitability may be harmed if one or more of
      our largest customers were unable or unwilling to pay these accounts receivable
      when due or demand credits or other concessions for products they are unable
      to
      sell. We only maintain credit insurance for some of our major customers and
      the
      amount of this insurance generally does not cover the total amount of the
      accounts receivable. At December 31, 2004 and 2005, our credit insurance covered
      approximately 8.4% and 7.2%, respectively, of our gross accounts receivable.
      Insurance coverage for future sales is subject to reduction or
      cancellation.





**We
      rely on a limited number of foreign suppliers in China to manufacture a majority
      of our products.**





We
      rely
      on seven third-party, dedicated suppliers in China to manufacture a majority
      of
      our products in eight factories, three of which are located in close proximity
      to each other in the RC2 Industrial Zone manufacturing complex in China. Our
      China-based product sourcing accounted for approximately 91.6% of our product
      purchases in 2005. The seven third-party, dedicated suppliers who manufacture
      only our products accounted for approximately 48.4% of our China-based product
      purchases in 2005. We enter into purchase orders with our foreign suppliers
      and
      generally do not enter into long-term contracts. Because we rely on these
      suppliers for flexible production and have integrated these suppliers with
      our
      development and engineering teams, if these suppliers do not continue to
      manufacture our products exclusively, our product sourcing would be adversely
      affected. Difficulties encountered by these suppliers such as fire, accident,
      natural disaster or an outbreak of a contagious disease at one or more of their
      facilities, could halt or disrupt production at the affected facilities, delay
      the completion of orders, cause the cancellation of orders, delay the
      introduction of new products or cause us to miss a selling season applicable
      to
      some of our products. Any of these risks could increase our expenses or reduce
      our net sales.


11


**Increases
      in the cost of the raw materials used to manufacture our products could increase
      our cost of sales and reduce our gross margins.**





Since
      our
      products are manufactured by third-party suppliers, we do not directly purchase
      the raw materials used to manufacture our products. However, the prices we
      pay
      our suppliers may increase if their raw materials, labor or other costs
      increase. We may not be able to pass along such price increases to our
      customers. As a result, increases in the cost of raw materials, labor or other
      costs associated with the manufacturing of our products could increase our
      cost
      of sales and reduce our gross margins.





**Currency
      exchange rate fluctuations could increase our expenses.**





Our
      net
      sales are primarily denominated in U.S. dollars, with approximately 14.1%
      of our net sales in 2005 denominated in British pounds sterling, Australian
      dollars, Euros or Canadian dollars. Our purchases of finished goods from Chinese
      manufacturers are denominated in Hong Kong dollars. Expenses for these
      manufacturers are denominated in Chinese Renminbi. As a result, any material
      increase in the value of the Hong Kong dollar or the Renminbi relative to the
      U.S. dollar or the British pounds sterling would increase our expenses and
      therefore could adversely affect our profitability. We are also subject to
      exchange rate risk relating to transfers of funds denominated in British pounds
      sterling, Australian dollars, Canadian dollars or Euros from our foreign
      subsidiaries to the United States. Historically, we have not hedged our foreign
      currency risk.





**Because
      we rely on foreign suppliers and we sell products in foreign markets, we are
      susceptible to numerous international business risks that could increase our
      costs or disrupt the supply of our products.**





Our
      international operations subject us to risks including:





**·**
            economic
                and political instability;


**·**
            restrictive
                actions by foreign governments;


**·**
            greater
                difficulty enforcing intellectual property rights and weaker laws
                protecting intellectual property
                rights;


**·**
            changes
                in import duties or import or export
                restrictions;


**·**
            timely
                shipping of product and unloading of product through West Coast ports,
                as
                well as timely rail/truck delivery to the Company’s warehouses and/or a
                customer’s warehouse;


**·**
            complications
                in complying with the laws and policies of the United States affecting
                the
                importation of goods, including duties, quotas and taxes;
                and


**·**
            complications
                in complying with trade and foreign tax
                laws.





Any
      of
      these risks could disrupt the supply of our products or increase our expenses.
      The costs of compliance with trade and foreign tax laws increases our expenses,
      and actual or alleged violations of such laws could result in enforcement
      actions or financial penalties that could result in substantial
      costs.





**Product
      liability, product recalls and other claims relating to the use of our products
      could increase our costs.**





Because
      we sell infant products, toys and collectibles to consumers, we face product
      liability risks relating to the use of our products. We also must comply with
      a
      variety of product safety and product testing regulations. If we fail to comply
      with these regulations or if we face product liability claims, we may be subject
      to damage awards or settlement costs that exceed our insurance coverage and
      we
      may incur significant costs in complying with recall requirements. In addition,
      substantially all of our licenses give the licensor the right to terminate
      if
      any products marketed under the license are subject to a product liability
      claim, recall or similar violations of product safety regulations or if we
      breach covenants relating to the safety of the products or their compliance
      with
      product safety regulations. A termination of a license could adversely affect
      our net sales. Even if a product liability claim is without merit, the claim
      could harm our reputation and divert management’s attention and resources from
      our business.





**Trademark
      infringement or other intellectual property claims relating to our products
      could increase our costs.**





Our
      industry is characterized by frequent litigation regarding trademark and patent
      infringement and other intellectual property rights. We are and have been a
      defendant in trademark and patent infringement claims and claims of breach
      of
      license from time to time, and we may continue to be subject to such claims
      in
      the future. The defense of intellectual property litigation is both costly
      and
      disruptive of the time and resources of our management even if the claim is
      without merit. We also may be required to pay substantial damages or settlement
      costs to resolve intellectual property litigation.


12


**Our
      debt covenants may limit our ability to complete acquisitions, incur debt,
      make
      investments, sell assets, merge or complete other significant
      transactions.**





Our
      credit agreement includes provisions that place limitations on a number of
      our
      activities, including our ability to:





**·**
            incur
                additional debt;


**·**
            create
                liens on our assets or make
                guarantees;


**·**
            make
                certain investments or loans;


**·**
            pay
                dividends; or


**·**
            dispose
                of or sell assets or enter into a merger or similar
                transaction.





**Sales
      of our products are seasonal, which causes our operating results to vary from
      quarter to quarter.**





Sales
      of
      our products are seasonal. Historically, our net sales and profitability have
      peaked in the third and fourth quarters due to the holiday season buying
      patterns. Seasonal variations in operating results may cause us to increase
      our
      debt levels and interest expense in the second and third quarters and may tend
      to depress our stock price during the first and second quarters.





**The
      trading price of our common stock has been volatile and investors in our common
      stock may experience substantial losses.**





The
      trading price of our common stock has been volatile and may become volatile
      again in the future. The trading price of our common stock could decline or
      fluctuate in response to a variety of factors, including:





**·**
            our
                failure to meet the performance estimates of securities
                analysts;


**·**
            changes
                in financial estimates of our net sales and operating results or
                buy/sell
                recommendations by securities
                analysts;


**·**
            the
                timing of announcements by us or our competitors concerning significant
                product developments, acquisitions or financial
                performance;


**·**
            fluctuation
                in our quarterly operating results;


**·**
            substantial
                sales of our common stock;


**·**
            general
                stock market conditions; or


**·**
            other
                economic or external factors.





You
      may
      be unable to sell your stock at or above your purchase price.





**We
      may face future securities class action lawsuits that could require us to pay
      damages or settlement costs and otherwise harm our
      business.**





A
      securities class action lawsuit was filed against us in 2000 following a decline
      in the trading price of our common stock from $17.00 per share on June 21,
      1999
      to $6.50 per share on June 28, 1999. We settled this lawsuit in 2002 with a
      $1.8
      million payment, covered by insurance, after incurring legal costs of $1.0
      million that were not covered by insurance. Future volatility in the price
      of
      our common stock may result in additional securities class action lawsuits
      against us, which may require that we pay substantial damages or settlement
      costs in excess of our insurance coverage and incur substantial legal costs,
      and
      which may divert management’s attention and resources from our
      business.





**Various
      restrictions in our charter documents, Delaware law and our credit agreement
      could prevent or delay a change in control of us which is not supported by
      our
      board of directors.**





We
      are
      subject to a number of provisions in our charter documents, Delaware law and
      our
      credit agreement that may discourage, delay or prevent a merger, acquisition
      or
      change of control that a stockholder may consider favorable. These anti-takeover
      provisions include:





**·**
            advance
                notice procedures for nominations of candidates for election as directors
                and for stockholder proposals to be considered at stockholders’
                meetings;


**·**
            covenants
                in our credit agreement restricting mergers, asset sales and similar
                transactions and a provision in our credit agreement that triggers
                an
                event of default upon the acquisition by a person or a group of persons
                of
                beneficial ownership of 33 1/3% or more of our outstanding common
                stock;
                and


**·**
            the
                Delaware anti-takeover statute contained in Section 203 of the Delaware
                General Corporation Law.





13





Section
      203 of the Delaware General Corporation Law prohibits a merger, consolidation,
      asset sale or other similar business combination between RC2 and any stockholder
      of 15% or more of our voting stock for a period of three years after the
      stockholder acquires 15% or more of our voting stock, unless (1) the transaction
      is approved by our board of directors before the stockholder acquires 15% or
      more of our voting stock, (2) upon completing the transaction the stockholder
      owns at least 85% of our voting stock outstanding at the commencement of the
      transaction, or (3) the transaction is approved by our board of directors and
      the holders of 66 2/3% of our voting stock excluding shares of our voting stock
      owned by the stockholder.





**Item
      1B.   Unresolved Staff Comments**





Not
      applicable.





**Item
      2.   Properties**





As
      of
      December 31, 2005, our facilities were as follows:





**Description**
            **Square
                Feet**
            
            **Location**
            **Lease
                Expiration**Corporate
                headquarters
            27,050
            
            Oak
                Brook, IL
            April
                2013RC2
                Brands, Inc. warehouse
            400,000
            
            Rochelle,
                IL
            November
                2019RC2
                Brands, Inc. office and warehouse
            368,000
            
            Dyersville,
                IA
            OwnedRC2
                Brands, Inc. warehouse (1)
            166,000
            
            Dyersville,
                IA
            OwnedRC2
                Brands, Inc. office
            21,650
            
            Stoughton,
                MA
            August
                2010RC2
                Brands, Inc. office
            108
            
            Kansas
                City, MO
            May
                2007RC2
                Brands, Inc. office
            320
            
            Danbury,
                CT
            Month-to-monthRC2
                Brands, Inc. office
            1,932
            
            Huntington
                Beach, CA
            May
                2007RC2
                Brands, Inc. office
            2,755
            
            Bentonville,
                AR
            October
                2008RC2
                Brands, Inc. office (2)
            15,309
            
            Chicago,
                IL
            May
                2007RC2
                Brands, Inc. office (3)
            1,100
            
            Bentonville,
                AR
            February
                2007RC2
                Brands, Inc. showroom
            9,240
            
            New
                York, NY
            April
                2009RC2
                Brands, Inc. company store
            5,500
            
            Oakbrook
                Terrace, IL
            July
                2010RC2
                South, Inc. office
            6,864
            
            Charlotte,
                NC
            April
                2007Hong
                Kong office
            10,296
            
            Kowloon,
                Hong Kong
            July
                2006RC2
                Industrial Zone office, warehouse,
              and
                storage
            61,398
            
            Dongguan
                City, China
            March
                2006RC2
                Industrial Zone quarters
            70,345
            
            Dongguan
                City, China
            August
                2008Racing
                Champions International Limited office
            8,419
            
            Exeter,
                United Kingdom
            October
                2013Racing
                Champions International
              Limited
                showroom
            987
            
            Northhampton,
                United Kingdom
            March
                2006Racing
                Champions International Limited office
            667
            
            Saint
                Germain en Laye, France
            December
                2012Racing
                Champions International Limited office
            603
            
            Laren,
                Holland
            December
                2010RC2
                Canada Corporation office
            2,220
            
            New
                Market, Ontario
            March
                2007RC2
                Canada Corporation warehouse (4)
            47,000
            
            Concord,
                Ontario
            May
                2010RC2
                Deutschland GmbH office
            2,621
            
            Marsdof,
                Germany
            December
                2007RC2
                Australia, Pty. Ltd. office and warehouse
            49,127
            
            Mount
                Waverly, Victoria, Australia
            December
                2009





(1)
            38,000
                square feet of the Dyersville, IA warehouse has been sublet and is
                not
                being used in our operations.


(2)
            As
                of April 2004, the Chicago office was no longer being used in operations.
                The space is currently being offered for
                sublease.


(3)
            This
                facility is no longer being used in our operations. We will allow
                the
                lease to expire.


(4)
            As
                of January 1, 2004, the Canadian warehouse was no longer being used
                in our
                operations and has been subsequently sublet.





**Item
      3.   Legal Proceedings**





The
      Company has certain contingent liabilities resulting from litigation and claims
      incident to the ordinary course of business. Management believes that the
      probable resolution of such contingencies will not materially affect the
      financial position or the results of the Company’s operations.




**Item
        4.   Submission of Matters to a Vote of Security
        Holders**
 
 No
        matters were submitted to a vote of security holders during the fourth quarter
        of the fiscal year ended December 31, 2005.


14




**Part
      II**








**Item
      5.   Market for Registrant’s Common Equity, Related Stockholder
      Matters and Issuer Purchases of Equity Securities**




Stock
      Price Information




Our
      common stock trades on the Nasdaq National Market under the symbol “RCRC.” The
      following table sets forth the high and low closing sales prices for our common
      stock as reported by Nasdaq for the periods indicated.





**2004:**
            **High**
            **Low**First
                Quarter
            $28.18
            $20.75Second
                Quarter
            $35.54
            $25.47Third
                Quarter
            $35.31
            $29.86Fourth
                Quarter
            $34.13
            $27.23





**2005:**
            **High**
            **Low**First
                Quarter
            $34.64
            $28.56Second
                Quarter
            $38.40
            $31.82Third
                Quarter
            $41.27
            $33.24Fourth
                Quarter
            $37.26
            $31.90





As
      of
      December 31, 2005, there were approximately 149 holders of record of our common
      stock. We believe the number of beneficial owners of our common stock on that
      date was substantially greater.




Dividend
      Policy




We
      have
      not paid any cash dividends on our common stock. We intend to retain any
      earnings for use in operations to repay indebtedness and for expenses of our
      business, and therefore, do not anticipate paying any cash dividends in the
      foreseeable future. Our credit agreement prohibits the Company from declaring
      or
      paying any dividends on any class or series of our capital stock. This
      prohibition will apply as long as any credit is available or outstanding under
      the credit agreement that currently has a maturity date of September 14,
      2008.




**Issuer
        Purchases of Equity Securities**
  **Period**
                
                **Total**
                  **Number**
                  **Of
                    Shares**
                  **Purchased**
                
                **Average**
                  **Price**
                  **Paid
                    Per**
                  **Share**
                
                **Total
                    Number**
                  **Of
                    Shares**
                  **Purchased**
                  **As
                    Part of Publicly**
                  **Announced
                    Program**
                
                **Maximum
                    Number**
                  **Of
                    Shares that**
                  **May**
                  **Yet
                    be Purchased**
                  **Under
                    the Program**October
                    1, 2005 - October 31, 2005
                
                
                -
                
                $
                -
                
                
                -
                
                
                -November
                    1, 2005 - November 30, 2005
                
                
                5,092
                
                $
                38.14
                
                
                -
                
                
                -December
                    1, 2005 - December 31, 2005
                
                
                -
                
                $
                -
                
                
                -
                
                
                -Total
                
                
                5,092
                
                $
                38.14
                
                
                -
                
                
                -
 The
        shares reflected on the table above represent shares of the Company's common
        stock surrendered in lieu of payment on a receivable. The Company does not
        currently have a stock repurchase program in effect.
 15
  **Item
        6.   Selected Financial Data**





The
      following table presents selected consolidated financial data, which should
      be
      read along with our consolidated financial statements and the notes to those
      statements and with “Item 7-Management’s Discussion and Analysis of Financial
      Condition and Results of Operations.”  The consolidated statements of
      earnings for the years ended December 31, 2003, 2004 and 2005, and the
      consolidated balance sheet data as of December 31, 2004 and 2005, are derived
      from our audited consolidated financial statements included elsewhere herein.
      The consolidated statements of earnings for the years ended December 31, 2001
      and 2002, and the consolidated balance sheet data as of December 31, 2001,
      2002
      and 2003, are derived from our audited consolidated financial statements which
      are not included herein.




**Year
                  Ended December 31,****2001**
              
              **2002**
              
              **2003**
              
              **2004**
              
              **2005****Consolidated
                  Statements of Earnings:**
              
              (In
                  thousands, except per share data)Net
                  sales
              
              $
              204,661
              
              $
              214,925
              
              $
              310,946
              
              $
              381,425
              
              $
              504,445Cost
                  of sales (1)
              
              
              99,481
              
              
              102,763
              
              
              148,908
              
              
              193,497
              
              
              258,948Gross
                  profit
              
              
              105,180
              
              
              112,162
              
              
              162,038
              
              
              187,928
              
              
              245,497Selling,
                  general and administrative expenses (1)
              
              
              69,266
              
              
              70,238
              
              
              104,467
              
              
              126,265
              
              
              155,413Impairment
                  of intangible assets
              
              
              —
              
              
              —
              
              
              327
              
              
              4,318
              
              
              —Amortization
                  of intangible assets
              
              
              3,376
              
              
              —
              
              
              30
              
              
              94
              
              
              1,385Gain
                  on sale of W. Britain product line
              
              
              —
              
              
              —
              
              
              —
              
              
              —
              
              
              (1,953
              )Operating
                  income
              
              
              32,538
              
              
              41,924
              
              
              57,214
              
              
              57,251
              
              
              90,652Interest
                  expense, net
              
              
              6,470
              
              
              1,835
              
              
              3,477
              
              
              4,063
              
              
              5,983Other
                  expense (income)
              
              
              277
              
              
              (603
              )
              
              (145
              )
              
              (508
              )
              
              146Income
                  before income taxes
              
              
              25,791
              
              
              40,692
              
              
              53,882
              
              
              53,696
              
              
              84,523Income
                  tax expense
              
              
              10,668
              
              
              15,947
              
              
              15,465
              
              
              19,718
              
              
              31,393Net
                  income
              
              $
              15,123
              
              $
              24,745
              
              $
              38,417
              
              $
              33,978
              
              $
              53,130Net
                  income per share:Basic
              
              $
              1.03
              
              $
              1.55
              
              $
              2.25
              
              $
              1.82
              
              $
              2.58Diluted
              
              $
              1.00
              
              $
              1.47
              
              $
              2.12
              
              $
              1.72
              
              $
              2.47Weighted
                  average shares outstanding:Basic
              
              
              14,663
              
              
              15,981
              
              
              17,060
              
              
              18,687
              
              
              20,613Diluted
              
              
              15,159
              
              
              16,829
              
              
              18,105
              
              
              19,761
              
              
              21,532
 
 **As
                  of December 31,****2001**
              
              **2002**
              
              **2003**
              
              **2004**
              
              **2005****Consolidated
                  Balance Sheet Data:**Working
                  capital
              
              $
              26,392
              
              $
              49,540
              
              $
              70,471
              
              $
              112,931
              
              $
              113,286Total
                  assets
              
              
              235,523
              
              
              236,287
              
              
              381,829
              
              
              585,748
              
              
              629,736Total
                  debt
              
              
              62,000
              
              
              8,000
              
              
              85,000
              
              
              131,250
              
              
              82,647Total
                  stockholders’ equity
              
              $
              118,099
              
              $
              170,881
              
              $
              225,299
              
              $
              346,762
              
              $
              398,951
 (1)
        Depreciation expense was approximately $9.2 million, $9.1 million, $12.0
        million, $15.3 million and $14.5 million for the years ended December 31,
        2001,
        2002, 2003, 2004 and 2005, respectively.





General
      Note: Results for 2003 include the results of LCI from March 1, 2003. Results
      for 2004 include the results of Playing Mantis from June 1, 2004 and TFY from
      September 16, 2004. As these acquisitions were accounted for using the purchase
      method of accounting, periods prior to the acquisition effective dates do not
      include any results for LCI, Playing Mantis or TFY.


16


**Item
      7.   Management’s Discussion and Analysis of Financial Condition and
      Results of Operations**





**Overview**





We
      are a
      leading designer, producer and marketer of innovative, high-quality toys,
      collectibles, hobby and infant care products that are targeted to consumers
      of
      all ages. We reach our target consumers through multiple channels of
      distribution supporting more than 25,000 retail outlets throughout North
      America, Europe, Australia and Asia Pacific. Our product categories include
      (i)
      infant products; (ii) children’s toys; and (iii) collectible products. We market
      a significant portion of our products with licenses from other parties, and
      we
      are currently a party to over 700 license agreements.





***The
      First Years Acquisition.*** On
      September 15, 2004, we acquired The First Years Inc. (TFY). TFY is an
      international developer and marketer of infant and toddler care and play
      products sold under The First Years® by Learning Curve brand name and under
      various licenses, including Disney’s *Winnie
      the Pooh* .
      This
      transaction has been accounted for under the purchase method of accounting
      and,
      accordingly, the operating results of TFY have been included in our consolidated
      statements of earnings since the effective date of the acquisition.





***Playing
      Mantis Acquisition.*** On
      June
      7, 2004, we acquired substantially all of the assets of Playing Mantis, Inc.
      (Playing Mantis) with an effective date of June 1, 2004. Playing Mantis designs
      and markets collectible vehicle replicas under the Johnny Lightning® and Polar
      Lights® brands. This transaction has been accounted for under the purchase
      method of accounting and, accordingly, the operating results of Playing Mantis
      have been included in our consolidated statements of earnings since the
      effective date of the acquisition.





***Learning
      Curve Acquisition.*** On March
      4, 2003, with an effective date of February 28, 2003, we acquired Learning
      Curve
      International, Inc. (Learning Curve) and certain of its affiliates
      (collectively, LCI) through the merger of a wholly owned subsidiary of RC2
      with
      and into Learning Curve. LCI develops and markets a variety of high-quality,
      award-winning children’s and infant toys for every stage of childhood from birth
      through age eight. This transaction has been accounted for under the purchase
      method of accounting and, accordingly, the operating results of LCI have been
      included in our consolidated statements of earnings since the effective date
      of
      the acquisition.





***Integration
      Initiatives.*** During
      2004 and 2005, we focused on integrating our Playing Mantis and TFY
      acquisitions. As of December 31, 2004, Playing Mantis was fully integrated.
      During 2005, we continued our efforts integrating TFY with numerous initiatives
      to achieve synergies and cost savings in several areas including payroll,
      systems development and maintenance, corporate and administrative, and sales
      and
      marketing expenses. We believe that the cumulative cost savings to be realized
      in the 24 months after the acquisitions will be approximately
      $15.0million.





***Sales.*** Our
      sales are primarily derived from the sale of collectible, toy and infant
      products and are recognized upon transfer of title of product to our customers.
      We market our products through a variety of distribution channels, including
      chain retailers, specialty and hobby wholesalers and retailers, OEM dealers,
      corporate promotional accounts and direct to consumers. For the years ended
      December 31, 2003, 2004 and 2005, sales to chain retailers comprised 48.8%,
      52.3% and 62.3%, respectively, of our net sales.





Our
      products are marketed and distributed in North America, Europe, Australia and
      Asia Pacific. International sales constituted 14.9%, 13.3% and 14.2% of our
      net
      sales for the years ended December 31, 2003, 2004 and 2005, respectively. We
      expect international sales to increase over the next several years as we expand
      our geographic reach. Our net sales have not been materially impacted by foreign
      currency fluctuations.





We
      derive
      a significant portion of our sales from some of the world’s largest retailers
      and OEM dealers. Our top five customers accounted for 38.0%, 37.9% and 47.6%
      of
      our net sales in 2003, 2004 and 2005, respectively. Toys “R” Us/Babies “R” Us,
      our largest customer, accounted for 10.5% and 14.8% of our net sales in 2004
      and
      2005, respectively. Wal-Mart accounted for 10.8% and 13.1% of our net sales
      in
      2003 and 2005, respectively. Target accounted for 11.7% of our net sales in
      2005. Other than Wal-Mart, no customer accounted for more than 10.0% of our
      net
      sales in 2003. In 2004, other than Toys “R” Us/Babies “R” Us, no customer
      accounted for more than 10.0% of our net sales. In 2005, other than Toys “R”
Us/Babies “R” Us, Wal-Mart and Target, no customer accounted for more than 10.0%
      of our net sales.





We
      provide certain customers the option to take delivery of our products either
      in
      the United States, United Kingdom, Australia, Canada or Germany with credit
      terms generally ranging from 30 to 90 days or directly in China with payment
      made by irrevocable letter of credit or wire transfer. We generally grant price
      discounts on direct sales from China resulting in lower gross margins.
      However, shipments direct from China lower our distribution and administrative
      costs, so we believe that our operating income margin is comparable for products
      delivered in China versus products shipped in the United States, United Kingdom,
      Australia, Canada or Germany. For the years ended December 31, 2003, 2004 and
      2005, direct sales from China constituted 9.6%, 13.0% and 10.3%, respectively,
      of our net sales.





17





We
      do not
      ordinarily sell our products on consignment, and we generally accept returns
      only for defective merchandise. In certain instances, where retailers are unable
      to resell the quantity of products that they have purchased from us, we may,
      in
      accordance with industry practice, assist retailers in selling such excess
      inventory by offering credits and other price concessions, which are typically
      evaluated and issued annually. Returns and allowances on an annual basis have
      ranged from 3.4% to 6.3% of our net sales over the last three
      years.





***Expenses.*** Our
      products are manufactured by third-parties, principally located in China. Cost
      of sales primarily consists of purchases of finished products, which accounted
      for 80.4%, 79.5% and 81.7% of our cost of sales in 2003, 2004 and 2005,
      respectively. The remainder of our cost of sales primarily includes tooling
      depreciation, freight-in from suppliers and concept and design expenses.
      Substantially all of our purchases of finished products from the Far East are
      denominated in Hong Kong dollars, and therefore, subject to currency
      fluctuations. Historically, we have not incurred substantial exposure due to
      currency fluctuations because the Hong Kong government has maintained a policy
      of linking the Hong Kong dollar and the U.S. dollar since 1983. A future
      increase in the value of the Hong Kong dollar relative to the U.S. dollar may
      increase our cost of sales and decrease our gross margins. ****





Additionally,
      if our suppliers experience increased raw material, labor or other costs and
      pass along such cost increases to us through higher prices for finished goods,
      our cost of sales would increase, and to the extent we are unable to pass such
      price increases along to our customers, our gross margins would
      decrease.





Our
      quarterly gross margins can also be affected by the mix of product that is
      shipped during each quarter.  Individual product lines within each category
      carry gross margins that vary significantly and can cause quarterly
      fluctuations, based on the timing of these individual shipments throughout
      the
      year. Due to the 2004 acquisition of TFY, which has higher sales of non-licensed
      products that carry lower selling prices and gross margins than the Company
      had
      historically prior to 2004, we anticipate our annual gross margins will fall
      in
      the range of 47% to 51%.





Selling,
      general and administrative expenses primarily consist of royalties, employee
      compensation, advertising and marketing expenses, freight-out to customers
      and
      sales commissions. Royalties vary by product category and are generally paid
      on
      a quarterly basis. Multiple royalties may be paid to various licensors on a
      single product. In 2005, aggregate royalties by product ranged from
      approximately 1.0% to 22.0% of our net sales price. Royalty expense was
      approximately 8.5%, 8.4% and 6.8% of our net sales for the years ended December
      31, 2003, 2004 and 2005, respectively. Sales commissions ranged from 1.0% to
      15.0% of the net sales price and are generally paid quarterly to our external
      sales representative organizations. Sales subject to commissions represented
      31.2%, 30.7% and 30.4% of our net sales for the years ended December 31, 2003,
      2004 and 2005, respectively. Sales commission expense was 1.6%, 1.6% and 1.3%
      of
      our net sales for the years ended December 31, 2003, 2004 and 2005,
      respectively.





***Seasonality.*** We have
      experienced, and expect to continue to experience, substantial fluctuations
      in
      our quarterly net sales and operating results, which is typical of many
      companies in our industry. Our business is highly seasonal due to high consumer
      demand for our products during the year-end holiday season. Approximately 62.5%
      of our net sales for the three years ended December 31, 2005, were generated
      in
      the second half of the year. As a result, our investment in working capital,
      mainly inventory and accounts receivable, is typically highest during the third
      and fourth quarters and lowest during the first quarter.


18


**Results
      of Operations**





**Year
                Ended December 31,****2003**
            
            
            **2004**
            
            
            **2004
                Pro Forma**
            
            
            **2005****Amount**
            
            **Percent**
            
            
            **Amount**
            
            **Percent**
            
            
            **Amount**
            
            **Percent**
            
            
            **Amount**
            
            **Percent**(In
                thousands, except per share data)Net
                sales
            
            $
            310,946
            
            
            100.0
            %
            
            $
            381,425
            
            
            100.0
            %
            
            $
            489,481
            
            
            100.0
            %
            
            $
            504,445
            
            
            100.0
            %Cost
                of sales
            
            
            148,908
            
            
            47.9
            
            
            
            193,497
            
            
            50.7
            
            
            
            254,818
            
            
            52.1
            
            
            
            258,948
            
            
            51.3Gross
                profit
            
            
            162,038
            
            
            52.1
            
            
            
            187,928
            
            
            49.3
            
            
            
            234,663
            
            
            47.9
            
            
            
            245,497
            
            
            48.7Selling,
                general and
              administrative
                expenses
            
            
            104,467
            
            
            33.6
            
            
            
            126,265
            
            
            33.1
            
            
            
            163,150
            
            
            33.3
            
            
            
            155,413
            
            
            30.8Impairment
                of
              intangible
                assets
            
            
            327
            
            
            0.1
            
            
            
            4,318
            
            
            1.1
            
            
            
            4,318
            
            
            0.9
            
            
            
            —
            
            
            —Amortization
                of
              intangible
                assets
            
            
            30
            
            
            —
            
            
            
            94
            
            
            —
            
            
            
            375
            
            
            —
            
            
            
            1,385
            
            
            0.3Gain
                on sale of W.
              Britain
                product line
            
            
            —
            
            
            —
            
            
            
            —
            
            
            —
            
            
            
            —
            
            
            —
            
            
            
            (1,953
            )
            
            (0.4
            )Operating
                income
            
            
            57,214
            
            
            18.4
            
            
            
            57,251
            
            
            15.1
            
            
            
            66,820
            
            
            13.7
            
            
            
            90,652
            
            
            18.0Interest
                expense, net
            
            
            3,477
            
            
            1.1
            
            
            
            4,063
            
            
            1.1
            
            
            
            8,352
            
            
            1.7
            
            
            
            5,983
            
            
            1.3Other
                (income) expense
            
            
            (145
            )
            
            (0.1
            )
            
            
            (508
            )
            
            (0.1
            )
            
            
            (687
            )
            
            (0.1
            )
            
            
            146
            
            
            —Income
                before
              income
                taxes
            
            
            53,882
            
            
            17.4
            
            
            
            53,696
            
            
            14.1
            
            
            
            59,155
            
            
            12.1
            
            
            
            84,523
            
            
            16.7Income
                tax expense
            
            
            15,465
            
            
            5.0
            
            
            
            19,718
            
            
            5.2
            
            
            
            22,784
            
            
            4.7
            
            
            
            31,393
            
            
            6.2Net
                income
            
            $
            38,417
            
            
            12.4
            %
            
            $
            33,978
            
            
            8.9
            %
            
            $
            36,371
            
            
            7.4
            %
            
            $
            53,130
            
            
            10.5
            %Net
                income per share:Basic
            
            
            2.25
            
            
            
            
            
            
            1.82
            
            
            
            
            
            
            1.94
            
            
            
            
            
            
            2.58Diluted
            
            
            2.12
            
            
            
            
            
            
            1.72
            
            
            
            
            
            
            1.84
            
            
            
            
            
            
            2.47Weighted
                average
              shares
                outstanding:Basic
            
            
            17,060
            
            
            
            
            
            
            18,687
            
            
            
            
            
            
            18,726
            
            
            
            
            
            
            20,613Diluted
            
            
            18,105
            
            
            
            
            
            
            19,761
            
            
            
            
            
            
            19,800
            
            
            
            
            
            
            21,532





Note:
      2004 pro forma amounts assume that the Playing Mantis and The First Years
      acquisitions occurred as of January 1, 2004.





**Operating
      Highlights**





Net
      sales
      for the year ended December 31, 2005, increased approximately 32.2% primarily
      due to the addition of TFY. Gross margin decreased to 48.7% for 2005 from 49.3%
      for 2004. The
      gross
      margin for 2004 includes $3.0 million in charges related to the write-off of
      undepreciated tooling and to provide for inventory related to the discontinued
      product lines and trackside distribution. Selling, general and
      administrative expenses as a percentage of net sales decreased to 30.8% for
      2005
      from 33.1% for 2004. Operating income increased to $90.7 million for 2005
      compared to $57.3 million for 2004. Operating
      income for 2005 includes $2.0 million in gain on the sale of assets related
      to
      the sale of our W. Britain product line.  Operating income for 2004
      includes $8.5 million in non-recurring charges related to the discontinuance
      of
      certain product lines and our NASCAR trackside distribution.As a
      percentage of net sales, operating income increased to 18.0% for 2005 from
      15.0%
      for 2004.





Results
      for 2005 were negatively impacted by a tax charge of approximately $0.5 million
      incurred as a result of repatriation of foreign earnings and by additional
      depreciation expense of approximately $0.5 million, net of income tax benefit,
      for tooling on discontinued product lines. These negative impacts were offset
      by
      a gain of $1.2 million, net of income tax expense, on the sale of the W. Britain
      product line and an income tax benefit of approximately $0.7 million due to
      a
      reduction of income tax accruals stemming from the resolution of specific
      outstanding state and foreign tax issues. The combined impact of these charges
      positively impacted diluted earnings per share for the year ended December
      31,
      2005 by approximately $0.05 per diluted share.


19


Results
      for 2004 were negatively impacted by the Company’s decision to discontinue
      certain low-performing product lines as well as its distribution at NASCAR
      trackside sales events. In 2004, the Company recorded a non-cash impairment
      charge of approximately $2.7 million, net of income tax benefits, to write-off
      intangible license and trademark assets recorded at the time of the Learning
      Curve acquisition. In addition, charges to write-off undepreciated tooling
      and
      fixed assets and to provide inventory and royalty reserves related to the
      discontinued product lines and trackside sales distribution totaled
      approximately $2.7 million, net of income tax benefits. The Company also
      recorded an adjustment to the income tax provision of approximately $0.6 million
      in 2004. The combined impact of these charges on the Company’s diluted earnings
      per share was approximately $0.30 for the year ended December 31, 2004.





Net
      income per diluted share for the year ended December 31, 2003 was positively
      impacted by $0.19 per diluted share as a result of a reduction in the income
      tax
      provision.





Results
      for 2004 include Playing Mantis from June 1, 2004 and TFY from September 16,
      2004. Results for 2003 include LCI from March 1, 2003.





**Year
      Ended December 31, 2005, Compared to Year Ended December 31,
      2004**





***Net
      Sales.***  Net
      sales
      increased $123.0 million, or 32.2%, to $504.4 million for 2005 from $381.4
      million for 2004. This sales increase was primarily attributable to the addition
      of TFY for the full year of 2005 versus only three and a half months in 2004,
      as
      well as the growth in our children’s toys category. Net sales increased in our
      children’s toys and infant products categories, but these increases were
      partially offset by a decrease in our collectible products
      category.





Net
      sales
      in our infant products category increased approximately 166.1% primarily due
      to
      the addition of TFY. Net sales in our children’s toys category increased
      approximately 32.7% primarily driven by strong performance of *Thomas
      & Friends* and John
      Deere toy vehicles and our ride-on products, as well as sales of our new *Bob
      the Builder* product
      line. Net sales in our collectible products category decreased approximately
      20.3% primarily due to the continued tough comparisons to both *The
      Fast and The Furious* and *American
      Chopper/Orange County Chopper* product
      lines in 2004, the discontinuance of the Memory Lane seasonal figures, lower
      overall NASCAR product sales and the discontinuance of distribution at NASCAR
      trackside events in 2005.





Actual
      net sales for 2005, excluding $4.7 million in net sales of previously
      discontinued product lines and the W. Britain product line, were $499.7 million,
      an increase of 7.3% when compared to 2004 pro forma net sales, excluding $23.7
      million in net sales from these same discontinued product lines and the W.
      Britain product line, of $465.8 million. Management
      has provided this non-GAAP financial information so that investors can more
      easily compare financial performance of the Company's current business
      operations from period to period. A reconciliation to the nearest GAAP financial
      measure follows:


2005
                  actual net sales
              
              $
              504.4
                  millionDeduct:
                  net sales of previouslydiscontinued
                  product lines andW.
                  Britain product line
              
              
              4.7
                  million$
              499.7
                  million
  2004
                      pro forma net sales
                
                $
                489.5
                      millionDeduct:
                    net sales of previouslydiscontinued
                    product lines andW.
                    Britain product line
                
                
                23.7
                      million$
                465.8
                    million
 ***Gross
        Profit.*** ** Gross
        profit increased $57.6 million, or 30.7%, to $245.5 million for 2005 from
        $187.9
        million for 2004. The gross profit margin (as a percentage of net sales)
        decreased to 48.7% for 2005 compared to 49.3% for 2004 and 47.9% for 2004
        pro
        forma.  Gross profit for 2004 and 2004 pro forma were adversely affected by
        $3.0 million in non-recurring charges to write-off undepreciated tooling
        and to
        provide for inventory related to the discontinued product lines and trackside
        sales distribution. There were no major changes in the components of cost
        of
        sales.





***Selling,
      General and Administrative Expenses.***  Selling,
      general and administrative expenses increased $29.1 million, or 23.0%, to $155.4
      million for 2005 from $126.3 million for 2004. As a percentage of net sales,
      selling, general and administrative expenses decreased to 30.8% for 2005 from
      33.1% for 2004. Selling, general and administrative expenses for 2004 include
      $1.2 million in non-recurring charges. The decrease in selling, general and
      administrative expenses as a percentage of net sales was primarily due to
      operating leverage gained from the increased sales from the 2004 acquisitions,
      integration cost savings and disciplined control over discretionary operating
      expenses.





***Operating
      Income.*** ** Operating income increased to $90.7 million for 2005 from $57.3 million for
      2004. As a percentage of net sales, operating income increased to 18.0% of
      net
      sales for 2005 from 15.0% for 2004. Operating income for 2005 includes $2.0
      million in gain on the sale of assets related to the sale of our W. Britain
      product line. Operating income for 2004 includes $8.5 million in non-recurring
      charges related to the discontinuance of certain product lines and our NASCAR
      trackside distribution.




***Net
      Interest Expense*** **.** Net
      interest expense of $6.0 million for 2005 and $4.1 million for 2004 relates
      primarily to bank term loans and lines of credit. The increase in net interest
      expense for 2005 was primarily due to the increase in average outstanding debt
      balances and an increase in the Company’s incremental borrowing rate.


20


***Income
      Tax.*** Income
      tax expense of $31.4 million for 2005 includes a tax charge of approximately
      $0.5 million, or $0.02 per diluted share, incurred as a result of repatriation
      of foreign earnings and a tax benefit of approximately $0.7 million, or $0.03
      per diluted share, relating to a reduction of income tax accruals stemming
      from
      the resolution of specific outstanding state and foreign tax issues. Income
      tax
      expense for 2005 includes provisions for federal, state and foreign income
      taxes
      at an effective rate of 37.1%. Income tax expense of $19.7 million for 2004
      includes an adjustment to the income tax provision of approximately $0.6
      million, or $0.03 per diluted share. Income tax expense in 2004 includes
      provisions for federal, state and foreign income taxes at an effective rate
      of
      36.7%.





**Year
      Ended December 31, 2004, Compared to Year Ended December 31,
      2003**





***Net
      Sales.*** Net
      sales increased $70.5 million, or 22.7%, to $381.4 million for 2004 from $310.9
      million for 2003. The increase was primarily attributable to the addition of
      the
      Learning Curve business for the entire year of 2004 compared with only ten
      months in 2003, as well as the additions of Playing Mantis and TFY as of the
      respective effective dates of closing such acquisitions in 2004. Net sales
      increases occurred in our children’s toys and infant products categories, but
      were partially offset by a decrease in our collectible products
      category.





Net
      sales
      in our children’s toys category increased 29.3% primarily due to strong sales in
      our *Thomas
      & Friends* and John
      Deere ride-on and toy vehicle product lines. Net sales in our infant products
      category increased 218.8% primarily due to the TFY acquisition and growth from
      Learning Curve’s Lamaze product line. Net sales in our collectible products
      category decreased 5.2% primarily due to the continued softness in the vehicle
      replica product lines, including *The
      Fast and The Furious* and
      NASCAR product lines, slightly offset by the Playing Mantis acquisition and
      the
      positive results from the new *American
      Chopper/Orange County Chopper* product
      line.





Net
      sales
      for the 2004 year excluding the Playing Mantis and TFY acquisitions of $332.0
      million increased by approximately 1.4% versus pro forma net sales for the
      year
      ended December 31, 2003 of $327.5 million. The pro forma net sales for 2003
      assume that the Learning Curve acquisition occurred as of January 1, 2003.
Management
      has provided this non-GAAP financial information so that investors can more
      easily compare financial performance of the Company's current business
      operations from period to period. A reconciliation to the nearest GAAP financial
      measure follows:





2004
                actual net sales
            
            $
            381.4
                millionDeduct:
                net sales relating to Playing Mantis and TFY
            
            
            49.4
                million$
            332.0
              million





***Gross
      Profit.*** Gross
      profit increased $25.9 million, or 16.0%, to $187.9 million for 2004 from $162.0
      million for 2003. The gross profit margin (as a percentage of net sales)
      decreased to 49.3% for 2004 from 52.1% for 2003 primarily due to increased
      product and freight costs, a less favorable product mix, the charges related
      to
      the write-off of undepreciated tooling and to provide for inventory related
      to
      the discontinued product lines and trackside distribution, and the impact of
      sales from Playing Mantis and TFY which generally carry lower gross profit
      margins than historical RC2 products. There were no major changes in the
      components of cost of sales.





***Selling,
      General and Administrative Expenses.*** Selling,
      general and administrative expenses increased $21.8 million, or 20.9%, to $126.3
      million for 2004 from $104.5 million for 2003. The increase in selling, general
      and administrative expenses was primarily driven by the inclusion of Playing
      Mantis and TFY which had not yet been fully impacted by integration cost
      savings, as well as the establishment of royalty reserves related to
      discontinued products. As a percentage of net sales, selling, general and
      administrative expenses decreased to 33.1% for 2004 from 33.6% for
      2003.





***Operating
      Income.*** Operating income increased slightly to $57.3 million for 2004 from $57.2 million
      for 2003. As a percentage of net sales, operating income decreased to 15.0%
      for
      2004 from 18.4% for 2003.





***Net
      Interest Expense.*** Net
      interest expense of $4.1 million for 2004 and $3.5 million for 2003 relates
      primarily to bank term loans and lines of credit. The increase in net interest
      expense for 2004 was primarily due to $0.5 million of deferred financing fees
      related to the March 4, 2003 credit facility which were written-off in
      conjunction with the new credit agreement dated September 15, 2004.





***Income
      Tax.*** Income
      tax expense of $19.7 million for 2004 includes an adjustment to the income
      tax
      provision of approximately $0.6 million, or $0.03 per diluted share. Income
      tax
      expense in 2004 includes provisions for federal, state and foreign income taxes
      at an effective rate of 36.7%. Income tax expense of $15.5 million for 2003
      includes a reduction of approximately $3.4 million, or $0.19 per diluted share,
      primarily due to the recognition of foreign net operating losses during the
      year
      and a reduction of income tax provision relating to the completion of an IRS
      tax
      audit for the fiscal years 1998 through 2000. Income tax expense, including
      the
      adjustments mentioned, includes provisions for federal, state and foreign income
      taxes at an effective tax rate of 28.7% for 2003.


21


**Liquidity
      and Capital Resources**





We
      generally fund our operations and working capital needs through cash generated
      from operations and borrowings under our credit facility. Our operating
      activities generated cash of approximately $59.1 million in 2005, $64.1 million
      in 2004 and $38.0 million in 2003.





Working
      capital increased $0.4 million to $113.3 million at December 31, 2005, from
      $112.9 million at December 31, 2004. Cash and cash equivalents increased $5.2
      million to $25.3 million at December 31, 2005, from $20.1 million at December
      31, 2004. Our accounts receivable increased $19.5 million to $113.1 million
      at
      December 31, 2005, from $93.6 million at December 31, 2004. Our inventory level
      increased $16.3 million to $71.3 million at December 31, 2005, from $55.0
      million at December 31, 2004.





Net
      cash
      used in investing activities was $6.6 million in 2005, $185.0 million in 2004
      and $114.1 million in 2003. The decrease in 2005 was primarily attributable
      to the 2004 acquisitions of Playing Mantis and TFY and a decrease in capital
      expenditures to $14.2 million in 2005 from $15.1 million in 2004. Capital
      expenditures for molds and tooling in 2005 and 2004 were $11.8 million and
      $10.9
      million, respectively, and we expect capital expenditures for 2006, principally
      for molds and tooling, to be approximately $16.0 million. In 2005, we also
      received proceeds from the sale of assets of $5.5 million, primarily on the
      sale
      of the Avon, Massachusetts facility, and proceeds from the sale of the W.
      Britain product line of $2.9 million. ****





Net
      cash
      used in financing activities in 2005 was $46.5 million. Net cash generated
      by
      financing activities in 2004 and 2003 was $123.4 million and $74.8 million,
      respectively. In 2005, we made payments of $16.6 million on our term loans.
      During 2005, we borrowed a total of $28.1 million and made total payments of
      $60.0 million on our lines of credit. At December 31, 2005, we had $89.5 million
      available on our lines of credit. Historically, we have used a significant
      portion of excess cash to pay down debt.





Upon
      the
      closing of the acquisition of TFY on September 15, 2004, the Company entered
      into a new credit facility to replace its March 4, 2003 credit facility (see
      below). The credit facility is comprised of an $85.0 million term loan and
      a
      $100.0 million revolving line of credit, both of which mature on September
      14,
      2008 with scheduled quarterly principal payments ranging from $3.8 million
      to
      $6.9 million commencing on December 31, 2004 and continuing thereafter with
      a
      final balloon payment upon maturity. A portion of the term loan has an interest
      rate of 3.45% plus applicable margin through the first three years of the
      facility. The remaining term loan and revolving line of credit bear
      interest, at the Company’s option, at a base rate or at a LIBOR rate plus
      applicable margin. The applicable margin is based on the Company’s ratio of
      consolidated debt to consolidated EBITDA (earnings before interest, taxes,
      depreciation and amortization) and varies between 1.00% and 1.75%. At December
      31, 2005, the margin in effect was 1.25% for LIBOR loans. The Company is also
      required to pay a commitment fee of 0.30% to 0.45% per annum on the average
      daily unused portion of the revolving line of credit. Under the terms of this
      credit facility, the Company is required to comply with certain financial and
      non-financial covenants. Among other restrictions, the Company is restricted
      in
      its ability to pay dividends, incur additional debt and make acquisitions above
      certain amounts. The key financial covenants include minimum EBITDA and interest
      coverage and leverage ratios. The credit facility is secured by working capital
      assets and certain intangible assets. On December 31, 2005, the Company had
      $74.7 million outstanding on this credit facility and was in compliance with
      all
      covenants.





In
      August
      2004, the Company completed a public offering of 2,655,000 shares of common
      stock and certain selling stockholders sold 220,000 shares of common stock
      at a
      price of $31.00 per share. The Company received proceeds of $77.8 million from
      the offering, net of underwriting discount, and used $74.0 million of the
      proceeds to repay outstanding debt.





Upon
      the
      closing of the acquisition of LCI on March 4, 2003, with an effective date
      of
      February 28, 2003, the Company entered into a credit facility to replace its
      previous credit facility. This credit facility was comprised of a $60.0 million
      term loan and an $80.0 million revolving line of credit, both of which were
      to
      mature on April 30, 2006. This facility was replaced with the September 2004
      credit facility discussed above.





The
      Company’s Hong Kong subsidiary maintains a credit agreement with a bank that
      provides for a line of credit of up to $2.0 million, which is renewable annually
      on January 1. Amounts borrowed under this line of credit bear interest at the
      bank’s prime rate or prevailing funding cost, whichever is higher, and are
      cross-guaranteed by the Company. As of December 31, 2004 and 2005, there were
      no
      outstanding borrowings under this line of credit.




The
        Company’s United Kingdom subsidiary maintains a line of credit with a bank for
        $0.4 million which expires on July 31, 2006. This line of credit bears interest
        at 1.0% over the bank’s base rate, and the total amount is subject to a letter
        of guarantee given by the Company. At December 31, 2004 and 2005, there were
        no
        amounts outstanding on this line of credit.


22


During
      2005, the Company’s United Kingdom subsidiary entered into an
      additional line of credit with a bank for $8.0 million which expires on
      September 14, 2008. This line of credit bears interest at 1.15% over the LIBOR
      rate, and the total amount is secured by a guarantee of the Company. At December
      31, 2005, the Company had $8.0 million outstanding on this line of credit.
      The
      original borrowings under this line of credit were denominated in equal parts
      of
      British pounds sterling and Euros.





The
      following table summarizes our significant contractual commitments at December
      31, 2005:





**Payment
                Due by Period**(In
                thousands)
              **Contractual
                Obligations**
            
            **Total**
            
            **2006**
            
            **2007-2008**
            
            **2009-2010**
            
            **2011
                and**
              **beyond**Long-term
                debt (including current portion)
            
            $
            82,647
            
            $
            25,230
            
            $
            57,417
            
            $
            —
            
            $
            —Minimum
                royalty guarantees
            
            
            19,896
            
            
            9,869
            
            
            10,022
            
            
            5
            
            
            —Operating
                leases
            
            
            30,214
            
            
            3,962
            
            
            6,303
            
            
            5,165
            
            
            14,784Unconditional
                purchase obligations
            
            
            3,449
            
            
            2,050
            
            
            1,049
            
            
            350
            
            
            —Total
                contractual cash obligations
            
            $
            136,206
            
            $
            41,111
            
            $
            74,791
            
            $
            5,520
            
            $
            14,784





We
      believe that our cash flows from operations, cash on hand and available
      borrowings will be sufficient to meet our working capital and capital
      expenditure requirements and provide us with adequate liquidity to meet
      anticipated operating needs in 2006. Working capital financing requirements
      are
      typically highest during the third and fourth quarters due to seasonal increases
      in demand for our infant products, toys and collectibles. Although operating
      activities are expected to provide sufficient cash, any significant future
      product or property acquisitions, including up-front licensing payments, may
      require additional debt or equity financing.





**Critical
      Accounting Policies and Estimates**





The
      Company makes certain estimates and assumptions that affect the reported amounts
      of assets and liabilities and the reported amounts of revenues and expenses.
      The
      accounting policies described below are those the Company considers critical
      in
      preparing its consolidated financial statements. These policies include
      significant estimates made by management using information available at the
      time
      the estimates are made. However, as described below, these estimates could
      change materially if different information or assumptions were
      used.





***Allowance
      for Doubtful Accounts.*** The
      allowance for doubtful accounts represents adjustments to customer trade
      accounts receivable for amounts deemed uncollectible. The allowance for doubtful
      accounts reduces gross trade receivables to their net realizable value and
      is
      disclosed on the face of the accompanying consolidated balance sheets. The
      Company’s allowance is based on management’s assessment of the business
      environment, customers’ financial condition, historical trends, customer payment
      practices, receivable aging and customer disputes. The Company has purchased
      credit insurance that covers a portion of its receivables from major customers.
      The Company will continue to proactively review its credit risks and adjust
      its
      customer terms to reflect the current environment.





***Inventory.*** Inventory, which consists of finished goods, has been written down for excess
      quantities and obsolescence, and is stated at the lower of cost or market.
      Cost
      is determined by the first-in, first-out method and includes all costs necessary
      to bring inventory to its existing condition and location. Market represents
      the
      lower of replacement cost or estimated net realizable value. Inventory
      write-downs are recorded for damaged, obsolete, excess and slow-moving
      inventory. The Company’s management uses estimates to record these write-downs
      based on its review of inventory by product category, length of time on hand
      and
      order bookings. Changes in public and consumer preferences and demand for
      product or changes in customer buying patterns and inventory management could
      impact the inventory valuation.


23


***Impairment
      of Long-Lived Assets, Goodwill and Other Intangible
      Assets.*** Long-lived assets have been reviewed for impairment based on SFAS No. 144,
      “Accounting for the Impairment of Long-Lived Assets and for Long-Lived Assets
      to
      be Disposed Of.” This Statement requires that an impairment loss be recognized
      whenever the carrying value of an asset exceeds the sum of the undiscounted
      cash
      flows expected to result from the use and eventual disposition of that asset,
      excluding future interest costs the entity would recognize as an expense when
      incurred. Goodwill and other intangible assets have been reviewed for impairment
      based on SFAS No. 142, “Goodwill and Other Intangible Assets.” Under SFAS No.
      142, goodwill and other intangible assets that have indefinite useful lives
      are
      not amortized, but rather tested at least annually for impairment. The
      Company’s management reviews for indicators that might suggest an impairment
      loss could exist. Testing for impairment requires estimates of expected cash
      flows to be generated from the use of the assets. Various uncertainties,
      including changes in consumer preferences, deterioration in the political
      environment or changes in general economic conditions, could impact the expected
      cash flows to be generated by an asset or group of assets. Intangible assets
      that have finite useful lives are amortized over their useful lives. The Company
      adopted SFAS No. 142 on January 1, 2002. Goodwill had been amortized over 40
      years on a straight-line basis through December 31, 2001. Approximately $88.7
      million of this goodwill is tax deductible over 15 years. ****





As
      of
      December 31, 2004 and 2005, goodwill, net of accumulated amortization, was
      approximately $282.4 million and $253.6 million, respectively. The decrease
      in
      goodwill at December 31, 2005, was primarily due to the completion of the
      Playing Mantis and TFY intangible valuations and the finalization of purchase
      accounting related to those acquisitions. The Company completed its annual
      goodwill impairment tests as of October 1, 2004 and 2005 which resulted in
      no
      impairment. The annual impairment test for intangible assets in 2005 resulted
      in
      no impairment to intangibles. However, impairment charges for intangible assets
      in the North America segment of $4.3 million have been included in the
      accompanying consolidated statement of earnings for the year ended December
      31,
      2004, as a result of the 2004 annual impairment test for intangible assets.
      The
      impairment charges were based upon the Company’s decision to discontinue certain
      low-performing product lines. ****





***Income
      Taxes.*** The
      Company records current and deferred income tax assets and liabilities.
      Management considers all available evidence in evaluating the realizability
      of
      the deferred tax assets and records valuation allowances against its deferred
      tax assets as needed. Management believes it is more likely than not that the
      Company will generate sufficient taxable income in the appropriate carry-forward
      periods to realize the benefit of its deferred tax assets. In determining the
      required liability, management considers certain tax exposures and all available
      evidence. However, if the available evidence were to change in the future,
      an
      adjustment to the tax-related balances may be required. Estimates for such
      tax
      contingencies are classified in other non-current liabilities on the
      accompanying consolidated balance sheets.





***Accrued
      Allowances.*** The
      Company ordinarily accepts returns only for defective merchandise. In certain
      instances, where retailers are unable to resell the quantity of products that
      they have purchased from the Company, the Company, may, in accordance with
      industry practice, assist retailers in selling excess inventory by offering
      credits and other price concessions, which are typically evaluated and issued
      annually. Other allowances can also be issued for defective merchandise, volume
      programs and co-op advertising. All allowances are accrued throughout the year,
      as sales are recorded. The allowances are based on the terms of the various
      programs in effect; however, management also takes into consideration historical
      trends and specific customer and product information when making its estimates.
      For the volume programs, the Company generally sets a volume target for the
      year
      with each participating customer and issues the discount if the target is
      achieved. The allowance for the volume program is accrued throughout the year,
      and if it becomes clear to management that the target for the participating
      customer will not be reached, the Company will change the estimate for that
      customer as required. The Company’s products currently carry a limited warranty
      which guarantees the product to be free from defects in material and workmanship
      under normal and intended use for a period of 90 days from the date of consumer
      purchase. Historical results of product warranty claims have shown that they
      have had an immaterial impact on the Company. Based upon the historical results,
      appropriate allowances for product warranty claims are accrued throughout the
      year.





***Accrued
      Royalties.*** Royalties are accrued based on the provisions in licensing agreements for
      amounts due on net sales during the period as well as management estimates
      for
      additional royalty exposures. Royalties vary by product category and are
      generally paid on a quarterly basis. Multiple royalties may be paid to various
      licensors on a single product. Royalty expense is included in selling, general
      and administrative expenses on the accompanying consolidated statements of
      earnings.


24


**Recently
      Issued Accounting Pronouncements**





In
      December 2004, the Financial Accounting Standards Board issued SFAS No. 123R,
      “Share-Based Payment.” This Statement is a revision of SFAS No. 123, “Accounting
      for Stock-Based Compensation” and supersedes APB Opinion No. 25, “Accounting for
      Stock Issued to Employees.” This Statement establishes standards for the
      accounting for transactions in which an entity exchanges its equity instruments
      for goods or services and also addresses transactions in which an entity incurs
      liabilities in exchange for goods and services that are based on the fair value
      of the entity’s equity instruments or that may be settled by the issuance of
      those instruments. This Statement applies to all awards unvested or granted
      after the required effective date and to awards modified, repurchased, or
      cancelled after that date. This Statement is effective as of the beginning
      of
      the first annual period beginning after June 15, 2005. The Company adopted
      this Statement for the quarter beginning January 1, 2006. We believe the best
      indication of the approximate impact on net income of adopting the provisions
      of
      this revised Statement may be determined by reviewing the table provided under
      the heading “Accounting for Stock-Based Compensation” in the accompanying notes
      to the consolidated financial statements. We plan to use the modified
      prospective method and accordingly will not be restating prior periods upon
      adoption of SFAS No. 123R.





**Item
      7A.   Quantitative and Qualitative Disclosures about Market
      Risk**





The
      Company’s exposure to market risk is limited to interest rate risk associated
      with the Company’s credit facilities and foreign currency exchange rate risk
      associated with the Company’s foreign operations.





Based
      on
      the Company’s interest rate exposure on variable rate borrowings at December 31,
      2005, a one percentage point increase in average interest rates on the Company’s
      borrowings would increase future interest expense by $43,504 per month and
      a
      five percentage point increase would increase future interest expense by $0.2
      million per month. The Company determined these amounts based on approximately
      $52.2 million of variable rate borrowings at December 31, 2005, multiplied
      by
      1.0% and 5.0%, respectively, and divided by twelve. The Company is currently
      not
      using any interest rate collars, hedges or other derivative financial
      instruments to manage or reduce interest rate risk. As a result, any increase
      in
      interest rates on the Company’s variable rate borrowings would increase interest
      expense and reduce net income.





The
      Company’s net sales are primarily denominated in U.S. dollars, except for
      approximately 14.1% of our net sales in 2005 denominated in British pounds
      sterling, Australian dollars, Euros and Canadian dollars. The Company’s
      purchases of finished goods from Chinese manufacturers are primarily denominated
      in Hong Kong dollars. Expenses for these manufacturers are primarily denominated
      in Chinese Renminbi. The Hong Kong dollar is currently pegged to the U.S.
      dollar. If the Hong Kong dollar ceased to be pegged to the U.S. dollar, a
      material increase in the value of the Hong Kong dollar relative to the U.S.
      dollar or the British pounds sterling would increase our expenses and therefore
      could adversely affect our profitability. A 10.0% change in the exchange rate
      of
      the U.S. dollar with respect to the Hong Kong dollar for the year ended December
      31, 2005 would have changed the total dollar amount of our gross profit by
      approximately 11.5%. During July 2005, China revalued the Chinese Renminbi,
      abandoning the former method of pegging the Chinese Renminbi to the U.S. dollar.
      As expenses for the Company’s Chinese manufacturers are primarily denominated in
      Chinese Renminbi, a material increase in the value of the Chinese Renminbi
      relative to the U.S. dollar would increase the Company’s expenses and therefore
      could adversely affect the Company’s profitability. A 10.0% change in the
      exchange rate of the U.S. dollar with respect to the British pounds sterling,
      the Australian dollar, the Euro or the Canadian dollar for the year ended
      December 31, 2005 would not have had a significant impact on the Company’s
      earnings. The Company is also subject to exchange rate risk relating to
      transfers of funds denominated in British pounds sterling, Australian dollars,
      Canadian dollars or Euros from its foreign subsidiaries to the United States.
      Historically, the Company has not used hedges or other derivative financial
      instruments to manage or reduce exchange rate risk.





**Item
      8.   Financial Statements and Supplementary Data**





**Financial
      Statements**





Our
      consolidated financial statements and notes thereto are filed under this item
      beginning on page F-1 of this report.


25


**Quarterly
      Results of Operations**





The
      following table sets forth our unaudited quarterly results of operations for
      2004 and 2005. We have prepared this unaudited information on a basis consistent
      with the audited consolidated financial statements contained in this report
      and
      this unaudited information includes all adjustments, consisting only of normal
      recurring adjustments, that we consider necessary for a fair presentation of
      our
      results of operations for the quarters presented. You should read this quarterly
      financial data along with the Condensed Consolidated Financial Statements and
      the related notes to those statements included in our Quarterly Reports on
      Form
      10-Q filed with the Commission. The operating results for any quarter are not
      necessarily indicative of the results for the annual period or any future
      period.





**Fiscal
                Year 2004**(In
                thousands, except per share data)
            
            **Q1**
            
            **Q2**
            
            **Q3**
            
            **Q4**Net
                sales
            
            $
            61,300
            
            $
            69,399
            
            $
            110,289
            
            $
            140,437Cost
                of sales (1)
            
            
            30,291
            
            
            32,661
            
            
            54,283
            
            
            76,262Gross
                profit
            
            
            31,009
            
            
            36,738
            
            
            56,006
            
            
            64,175Selling,
                general and administrative expenses (1)
            
            
            25,582
            
            
            26,559
            
            
            33,497
            
            
            40,627Impairment
                of intangible assets
            
            
            —
            
            
            —
            
            
            —
            
            
            4,318Amortization
                of intangible assets
            
            
            —
            
            
            —
            
            
            —
            
            
            94Operating
                income
            
            
            5,427
            
            
            10,179
            
            
            22,509
            
            
            19,136Interest
                expense, net
            
            
            786
            
            
            668
            
            
            1,011
            
            
            1,598Other
                expense (income)
            
            
            42
            
            
            (127
            )
            
            (345
            )
            
            (78
            )Income
                before income taxes
            
            
            4,599
            
            
            9,638
            
            
            21,843
            
            
            17,616Income
                tax expense
            
            
            1,657
            
            
            3,468
            
            
            7,864
            
            
            6,729Net
                income
            
            $
            2,942
            
            $
            6,170
            
            $
            13,979
            
            $
            10,887Net
                income per share:Basic
            
            $
            0.17
            
            $
            0.35
            
            $
            0.72
            
            $
            0.53Diluted
            
            $
            0.16
            
            $
            0.33
            
            $
            0.68
            
            $
            0.51Weighted
                average shares outstanding:Basic
            
            
            17,420
            
            
            17,540
            
            
            19,348
            
            
            20,413Diluted
            
            
            18,501
            
            
            18,655
            
            
            20,443
            
            
            21,418





(1)
      Depreciation expense was approximately $3.0 million, $3.0 million, $3.3 million
      and $6.0 million for Q1, Q2, Q3 and Q4 2004, respectively. Q4 2004 depreciation
      expense includes approximately $2.5 million relating to the write-off of
      undepreciated tooling for discontinued product lines.





**Fiscal
                Year 2005**(In
                thousands, except per share data)
            
            **Q1**
            
            **Q2**
            
            **Q3**
            
            **Q4**Net
                sales
            
            $
            96,489
            
            $
            108,811
            
            $
            142,567
            
            $
            156,578Cost
                of sales (1)
            
            
            47,367
            
            
            56,067
            
            
            72,833
            
            
            82,681Gross
                profit
            
            
            49,122
            
            
            52,744
            
            
            69,734
            
            
            73,897Selling,
                general and administrative expenses (1)
            
            
            35,561
            
            
            36,413
            
            
            39,943
            
            
            43,496Amortization
                of intangible assets
            
            
            94
            
            
            156
            
            
            845
            
            
            290Gain
                on sale of W. Britain product line
            
            
            —
            
            
            —
            
            
            (1,953
            )
            
            —Operating
                income
            
            
            13,467
            
            
            16,175
            
            
            30,899
            
            
            30,111Interest
                expense, net
            
            
            1,321
            
            
            1,714
            
            
            1,522
            
            
            1,426Other
                (income) expense
            
            
            (85
            )
            
            (266
            )
            
            4
            
            
            493Income
                before income taxes
            
            
            12,231
            
            
            14,727
            
            
            29,373
            
            
            28,192Income
                tax expense
            
            
            4,403
            
            
            4,964
            
            
            11,113
            
            
            10,913Net
                income
            
            $
            7,828
            
            $
            9,763
            
            $
            18,260
            
            $
            17,279Net
                income per share:Basic
            
            $
            0.38
            
            $
            0.47
            
            $
            0.88
            
            $
            0.83Diluted
            
            $
            0.37
            
            $
            0.45
            
            $
            0.85
            
            $
            0.80Weighted
                average shares outstanding:Basic
            
            
            20,496
            
            
            20,593
            
            
            20,656
            
            
            20,703Diluted
            
            
            21,433
            
            
            21,545
            
            
            21,594
            
            
            21,552





(1)   Depreciation
      expense was approximately $3.4 million, $3.2 million, $3.7 million and $4.2
      million for Q1, Q2, Q3 and Q4 2005, respectively.  Q4
      2005
      depreciation expense includes approximately $0.8 million relating to the
      write-off of undepreciated tooling for discontinued product
      lines.





General
      Note:  Results for 2004 include the results of Playing Mantis from June 1,
      2004 and the results of TFY from September 16, 2004. As these acquisitions
      were
      accounted for using the purchase method of accounting, periods prior to the
      acquisition effective dates do not include any results for Playing Mantis or
      TFY.


26


**Item
      9.   Changes in and Disagreements with Accountants on Accounting and
      Financial Disclosure**





Not
      applicable.





**Item
      9A.   Controls and Procedures**





**Evaluation
      of Disclosure Controls and Procedures**





As
      of the
      end of the period covered by this report, the Company carried out an evaluation
      under the supervision and with the participation of the Company’s management,
      including the Company’s Chief Executive Officer and Chief Financial Officer, of
      the Company’s disclosure controls and procedures (as defined in Rules 13a-15(e)
      and 15d-15(e) under the Securities Exchange Act of 1934, as amended). Based
      on
      this evaluation, the Company’s Chief Executive Officer and Chief Financial
      Officer concluded that, as of the end of such period, the Company’s disclosure
      controls and procedures were effective in recording, processing, summarizing
      and
      reporting, on a timely basis, information required to be disclosed by the
      Company in reports that the Company files with or submits to the Commission.
      It
      should be noted that in designing and evaluating the disclosure controls and
      procedures, management recognized that any controls and procedures, no matter
      how well designed and operated, can provide only reasonable assurance of
      achieving the desired control objectives, and management necessarily was
      required to apply its judgment in evaluating the cost-benefit relationship
      of
      possible controls and procedures. The Company has designed its disclosure
      controls and procedures to reach a level of reasonable assurance of achieving
      the desired control objectives and based on the evaluation described above,
      the
      Company’s Chief Executive Officer and Chief Financial Officer concluded that the
      Company’s disclosure controls and procedures were effective at reaching that
      level of reasonable assurance.





**Changes
      in Internal Control Over Financial Reporting**





There
      was
      no change in the Company’s internal control over financial reporting (as defined
      in Rules 13a-15(f) and 15d-15(f) under the Securities Exchange Act of 1934,
      as
      amended) during the Company’s most recently completed fiscal quarter that has
      materially affected, or is reasonably likely to materially affect, the Company’s
      internal control over financial reporting.





**Management’s
      Report on Internal Control Over Financial Reporting**





Management
      of the Company is responsible for establishing and maintaining effective
      internal control over financial reporting (as defined in Rule 13a-15(f) under
      the Securities Exchange Act of 1934, as amended). The Company’s internal control
      over financial reporting is designed to provide reasonable assurance to the
      Company’s management and board of directors regarding the preparation and fair
      presentation of published financial statements. The Company’s internal control
      over financial reporting includes those policies and procedures
      that:





(i) pertain
      to the maintenance of records that, in reasonable detail, accurately and fairly
      reflect the transactions and dispositions of the assets of the
      Company;





(ii) provide
      reasonable assurance that transactions are recorded as necessary to permit
      preparation of financial statements in accordance with generally accepted
      accounting principles, and that receipts and expenditures of the Company are
      being made only in accordance with authorizations of management and directors
      of
      the Company; and





(iii) provide
      reasonable assurance regarding prevention or timely detection of unauthorized
      acquisition, use or disposition of the Company’s assets that could have a
      material effect on the financial statements.





Because
      of its inherent limitations, internal control over financial reporting may
      not
      prevent or detect misstatements. Therefore, even those systems determined to
      be
      effective can provide only reasonable assurance with respect to financial
      statement preparation and presentation. Also, projections of any evaluation
      of
      effectiveness to future periods are subject to the risk that controls may become
      inadequate because of changes in conditions, or that the degree of compliance
      with the policies or procedures may deteriorate.





Management
      assessed the effectiveness of the Company’s internal control over financial
      reporting as of December 31, 2005. In making this assessment, management used
      the criteria set forth by the Committee of Sponsoring Organizations of the
      Treadway Commission (COSO) in *Internal
      Control-Integrated Framework* .
      Based
      on our assessment, management believes that, as of December 31, 2005, the
      Company’s internal control over financial reporting was effective based on those
      criteria.





KPMG
      LLP,
      the independent registered public accounting firm that audited the Company’s
      consolidated financial statements, has issued an attestation report on
      management’s assessment of the Company’s internal control over financial
      reporting, which appears on page F-3 hereof.





**Item
      9B.   Other Information**





Not
      applicable.


27





**Part
      III**





**Item
      10.   Directors and Executive Officers of the
      Registrant**





Information
      regarding the executive officers and directors of the Company is incorporated
      herein by reference to the discussions under “Election of Directors,” “Executive
      Officers,” “Section 16(a) Beneficial Ownership Reporting Compliance” and “Audit
      Committee Matters-Audit Committee Financial Expert” in the Company’s Proxy
      Statement for the 2006 Annual Meeting of Stockholders, which will be filed
      with
      the Commission on or before May 1, 2006. Information regarding the Company’s
      Code of Business Ethics is incorporated herein by reference to the discussion
      under “Corporate Governance Matters-Code of Business Ethics” in the Company’s
      Proxy Statement for the 2006 Annual Meeting of Stockholders.





The
      Audit
      Committee of our Board of Directors is an “audit committee” for purposes of
      Section 3(a)(58)(A) of the Securities Exchange Act of 1934. The members of
      the
      Audit Committee are John J. Vosicky (Chairman), John S. Bakalar and Daniel
      M.
      Wright.





**Item
      11.   Executive Compensation**





Information
      regarding executive compensation is incorporated herein by reference to the
      discussion under “Executive Compensation” and “Compensation of Directors” in the
      Company’s Proxy Statement for the 2006 Annual Meeting of Stockholders, which
      will be filed with the Commission on or before May 1, 2006.





**Item
      12.   Security Ownership of Certain Beneficial Owners and Management
      and Related Stockholder Matters**





Information
      regarding security ownership of certain beneficial owners and management is
      incorporated herein by reference to the discussion under “Security Ownership” in
      the Company’s Proxy Statement for the 2006 Annual Meeting of Stockholders, which
      will be filed with the Commission on or before May 1, 2006.





28


**Equity
      Compensation Plan Information**





The
      following table summarizes share information, as of December 31, 2005, for
      the
      Company’s equity compensation plans, including the RC2 Corporation 2005 Stock
      Incentive Plan, the Racing Champions Ertl Corporation Stock Incentive Plan,
      the
      Racing Champions Ertl Corporation Employee Stock Purchase Plan, the Racing
      Champions, Inc. 1996 Key Employees Stock Option Plan and the Wheels Sports
      Group, Inc. 1996 Omnibus Stock Plan. All of these plans have been approved
      by
      the Company’s stockholders, other than the Wheels Sports Group, Inc. 1996
      Omnibus Stock Plan, which was approved by Wheels Sports Group’s stockholders and
      assumed by the Company following its acquisition of Wheels Sports Group in
      1998.
      The Wheels Sports Group, Inc. 1996 Omnibus Stock Plan, the Racing
      Champions, Inc. 1996 Key Employee Stock Plan and the Racing Champions Ertl
      Corporation Stock Incentive Plan are dormant, and no future issuances are
      allowed under these plans.





**Plan
                Category**
            **Number
                of**
              **Common
                Shares to Be**
              **Issued
                Upon Exercise**
              **of
                Outstanding Options,**
              **Warrants
                and Rights**
            **Weighted-average**
              **Exercise
                Price of**
              **Outstanding
                Options,**
              **Warrants
                and
                Rights**
            **Number
                of**
              **Common
                Shares**
              **Available
                for Future**
              **Issuance
                Under****Equity**
              **Compensation
                Plans**Equity
                compensation plans
              approved
                by stockholders
            1,564,140
            $16.16
            1,649,288Equity
                compensation plans not
              approved
                by stockholders
            —
            —
            —Total
            1,564,140
            $16.16
            1,649,288





**Item
      13.   Certain Relationships and Related Party
      Transactions**





Information
      regarding certain relationships and related transactions is incorporated herein
      by reference to the discussions under “Executive Compensation-Employment
      Agreements” and “Certain Relationships and Related Transactions” in the
      Company’s Proxy Statement for the 2006 Annual Meeting of Stockholders, which
      will be filed with the Commission on or before May 1, 2006.





**Item
      14.   Principal Accountant Fees and Services**





Information
      regarding the fees and services of the independent registered public accounting
      firm is incorporated herein by reference to the discussion under “Audit
      Committee Matters-Fees of Independent Registered Public Accounting Firm” in the
      Company’s Proxy Statement for the 2006 Annual Meeting of Stockholders, which
      will be filed with the Commission on or before May 1, 2006.


29


**PART
      IV**








**ITEM
      15.   Exhibits and Financial Statement Schedules**





(a)  
      The following documents are filed as part of this report:





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





The
      following consolidated financial statements of the Company are included in
      Item
      8 of this report:





Reports
      of Independent Registered Public Accounting Firm





Consolidated
      Balance Sheets as of December 31, 2004 and 2005





Consolidated
      Statements of Earnings for the Years Ended December 31, 2003, 2004 and
      2005





Consolidated
      Statements of Stockholders’ Equity for the Years Ended December 31, 2003, 2004
      and 2005





Consolidated
      Statements of Cash Flows for the Years Ended December 31, 2003, 2004 and
      2005





Notes
      to
      Consolidated Financial Statements





**2.** **Financial
      Statement Schedules**





Report
      of
      Independent Registered Public Accounting Firm





Financial
      Statement Schedule for the Years Ended December 31, 2003, 2004 and
      2005:





Schedule
              Number
            
            Description
            
            PageII
            
            Valuation
                and Qualifying Accounts
            
            34





All
      other
      schedules for which provision is made in the applicable accounting regulations
      of the Commission are
      not
      required under the related instructions, are inapplicable or the required
      information is shown in the financial
      statements or notes thereto, and therefore, have been omitted.





**3.** **Exhibits**




3.1
              Amended and Restated Certificate of Incorporation
                of the
                Company (incorporated by reference to Exhibit 3.1of
                the Company’s Quarterly Report on Form 10-Q for the quarter ended March
                31, 2002 (File No. 0-22635)).
  3.2
              First
                  Amendment to Amended and Restated Certificate of Incorporation
                  of the
                  Company (incorporated by reference
                  to Exhibit 3.2 of the Company’s Quarterly Report on Form 10-Q for the
                  quarter ended March 31,2002
                  (File No. 0-22635)).


3.3
            Certificate
                of Ownership and Merger changing the Company’s name to Racing Champions
                Ertl Corporation (incorporated
                by reference to Exhibit 3.3 of the Company’s Quarterly Report on Form 10-Q
                for the quarterended
                March 31, 2002 (File No.
                0-22635)).





3.4
            Certificate
                of Ownership and Merger changing the Company’s name to RC2 Corporation
                (incorporated by reference
                to Exhibit 3.4 of the Company’s Quarterly Report on Form 10-Q for the
                quarter ended March 31,2003
                (File No. 0-22635)).





3.5
            Amended
                and Restated By-Laws of the Company (incorporated by reference to
                Exhibit
                3.5 of the Company’s Quarterly
                Report on Form 10-Q for the quarter ended March 31, 2004 (File No.
                0-22635)).





30


10.1* Employment
      Agreement, dated as of April 4, 2005, between the Company and Curtis W.
      Stoelting (incorporated by
      reference to Exhibit 10.5 of the Company’s Quarterly Report on Form 10-Q for the
      quarter ended June 30, 2005
      (File No. 0-22635)).





10.2* Employment
      Agreement, dated as of April 4, 2005, between the Company and Peter J. Henseler (incorporated
      by reference to Exhibit 10.6 of the Company’s Quarterly Report on Form 10-Q for
      the quarter ended
      June 30, 2005 (File No. 0-22635)).





10.3* Employment
      Agreement, dated as of April 4, 2005, between the Company and Jody L. Taylor
      (incorporated by
      reference to Exhibit 10.7 of the Company’s Quarterly Report on Form 10-Q for the
      quarter ended June
      30,
      2005 (File No. 0-22635)).





10.4* Employment
      Agreement, dated as of April 4, 2005, between the Company and Helena Lo
      (incorporated by
      reference to Exhibit 10.8 of the Company’s Quarterly Report on Form 10-Q for the
      quarter ended J une
      30,
      2005 (File No. 0-22635)).





10.5* Employment
      Agreement, dated as of December 13, 2005, between the Company and Richard E.
      Rothkopf (incorporated
      by reference to Exhibit 99.1 of the Company’s Current Report on Form 8-K (File
      No. 0-22635) filed
      by
      the Company with the Securities and Exchange Commission on December 16,
      2005).





10.6* Separation
      Agreement and General Release, dated as of December 13, 2005, between the
      Company and John Walter
      Lee II (incorporated by reference to Exhibit 99.2 of the Company’s Current
      Report on Form 8-K (File
      No.
      0-22635) filed by the Company with the Securities and Exchange Commission on
      December 16, 2005).





10.7* RC2
      Corporation 2005 Stock Incentive Plan (incorporated by reference to Exhibit
      99.1
      of the Company’s Current
      Report on Form 8-K (File No. 0-22635) filed by the Company with the Securities
      and Exchange Commission
      on May 10, 2005).





10.8* Form
      of
      Grant Agreement for the RC2 Corporation 2005 Stock Incentive Plan (incorporated
      by reference to
      Exhibit 99.2 of the Company’s Current Report on Form 8-K (File No. 0-22635)
      filed by the Company with
      the
      Securities and Exchange Commission on May 10, 2005).





10.9* RC2
      Corporation Incentive Bonus Plan and RC2 Corporation Top Management Additional
      Bonus Plan (incorporated
      by reference to Exhibit 99.3 of the Company’s Current Report on Form 8-K (File No.
      0-22635) filed by the Company with the Securities and Exchange Commission on
      May
      10, 2005).





10.10* Outside
      Director Compensation Plan (incorporated by reference to Exhibit 10.4 to the
      Company’s Quarterly
      Report on Form 10-Q for the quarter ended June 30, 2005 (File No.
      0-22635)).





10.11* Racing
      Champions, Inc. 1996 Key Employees Stock Option Plan (incorporated by reference
      to Exhibit 10.19
      of
      the Company’s Registration Statement of Form S-1 (Registration No. 333-22493)
      filed by the Company with
      the
      Securities and Exchange Commission on February 27, 1997).





10.12* Racing
      Champions Ertl Corporation Stock Incentive Plan, as amended (incorporated by
      reference to Exhibit 10.5
      of
      the Company’s Quarterly Report on Form 10-Q for the quarter ended September 30,
      2002 (File No. 0-22635)).





10.13* Wheels
      Sports Group, Inc. 1996 Omnibus Stock Plan (incorporated by reference to Exhibit
      10.6 of the C ompany’s
      Quarterly Report on Form 10-Q for the quarter ended June 30, 1998 (File No.
      0-22635)).





10.14* Racing
      Champions Ertl Corporation Employee Stock Purchase Plan, as amended
      (incorporated by reference
      to Exhibit 10.4 of the Company’s Quarterly Report on Form 10-Q for the quarter
      ended September
      30, 2002 (File No. 0-22635)).


31




10.15      
      Agreement and Plan of Merger, dated February 3, 2003, among the Company, RBVD
      Sub I Inc., Racing Champions
      Worldwide Limited, Racing Champions Limited and Learning Curve International,
      Inc.(incorporated
      by reference to Exhibit 2.1 of the Company’s Current Report on Form 8-K dated
      March 4, 2003(File
      No.
      0-22635) filed by the Company with the Securities and Exchange Commission on
      March 18, 2003).


10.16 Agreement
      and Plan of Merger, dated June 4, 2004, among The First Years Inc., the Company
      and RBVD
      Acquisition Corp. (incorporated by reference to Exhibit 2.1 of the Company’s
      Current Report on
      Form
      8-K dated June 4, 2004 (File No. 0-22635) filed by the Company with the
      Securities and Exchange
      Commission on July 12, 2004).





10.17 Amended
      and Restated Credit Agreement, dated as of September 15, 2004, among the
      Company, certain of its
      subsidiaries, Harris Trust and Savings Bank, as lender and agent, and other
      lenders named therein (incorporated
      by reference to Exhibit 99.1 of the Company’s Current Report on Form 8-K dated
      September 15,
      2004
      (File No. 0-22635) filed by the Company with the Securities and Exchange
      Commission on September
      21, 2004).





10.18 First
      Amendment to Amended and Restated Credit Agreement, dated as of August 19,
      2005,
      amongthe
      Company, certain of its subsidiaries, Harris Trust and Savings, as lender and
      agent, and otherlenders
      named therein.





10.19 Second
      Amendment to Amended and Restated Credit Agreement, dated as of November 18,
      2005,among
      the
      Company, certain of its subsidiaries, Harris Trust and Savings Bank, as lender
      and agent,and
      other
      lenders named therein.




10.20* Employment
        Agreement, dated as of April 26,
        2004, between RC2 Brands, Inc. and Gregory J.
        Kilrea.




21
              Subsidiaries
                of the
                Company.


23.1
            Consent
                of Independent Registered Public
                Accounting Firm.





24
            Power
                of Attorney (included as part of the signature page
                hereof).





31.1
            Certification
                of Chief Executive Officer
                pursuant to Section 302 of the Sarbanes-Oxley Act of
                2002.





31.2
            Certification
                of Chief Financial Officer
                pursuant to Section 302 of the Sarbanes-Oxley Act of
                2002.





32.1** Certification
      of Chief Executive Officer and Chief Financial Officer pursuant to 18 U.S.C.
      Section 1350(Section
      906 of the Sarbanes-Oxley Act of 2002).





* Management
      contract or compensatory plan or arrangement.





** This
      certification is not “filed” for purposes of Section 18 of the Securities
      Exchange Act of 1934, as amended,
      or incorporated by reference into any filing under the Securities Act of 1933,
      as amended, or the Securities
      Exchange Act of 1934, as amended.





(b) Exhibits


The
      response to this portion of Item 15 is submitted as a separate section of this
      report.





(c) Financial
      Statement Schedules


The
      response to this portion of Item 15 is submitted as a separate section of this
      report.


32


**SIGNATURES**





Pursuant
      to the requirements of Section 13 or 15(d) of the Securities Exchange Act of
      1934, the registrant has duly caused this Form 10-K to be signed on its behalf
      by the undersigned, thereunto duly authorized.





**Date: 
                February 28, 2006**
            **RC2
                CORPORATION**By
                /s/ Curtis W. StoeltingCurtis
                W. Stoelting, Chief Executive
                Officer





**POWER
      OF ATTORNEY**





Each
      person whose signature appears below hereby appoints Curtis W. Stoelting and
      Jody L. Taylor, and each of them individually, his true and lawful
      attorney-in-fact, with power to act with or without the other and with full
      power of substitution and resubstitution, in any and all capacities, to sign
      any
      or all amendments to the Form 10-K and file the same with all exhibits thereto,
      and other documents in connection therewith, with the Securities and Exchange
      Commission, granting unto said attorneys-in-fact and agents full power and
      authority to do and perform each and every act and thing requisite and necessary
      to be done in and about the premises, as fully to all intents and purposes
      as he
      might or could do in person, hereby ratifying and confirming all that said
      attorneys-in-fact and agents, or their substitutes, may lawfully cause to be
      done by virtue hereof.





Pursuant
      to the requirements of the Securities Exchange Act of 1934, this Form 10-K
      has
      been signed below by the following persons on behalf of the Registrant and
      in
      the capacities and on the dates indicated.





/s/
                Robert E. Dods
            Chairman
                of the Board and
            February
                28, 2006Robert
                E. Dods
            Director/s/
                Boyd L. Meyer
            Vice
                Chairman and Director
            February
                28, 2006Boyd
                L. Meyer/s/
                Curtis W. Stoelting
            Chief
                Executive Officer and
            February
                28, 2006Curtis
                W. Stoelting
            Director
                (Principal Executive Officer)/s/
                Jody L. Taylor
            Chief
                Financial Officer and Secretary
            February
                28, 2006Jody
                L. Taylor
            (Principal
                Financial and Accounting Officer)/s/
                Peter K.K. Chung
            Director
            February
                28, 2006Peter
                K.K. Chung/s/
                Paul E. Purcell
            Director
            February
                28, 2006Paul
                E. Purcell/s/
                John S. Bakalar
            Director
            February
                28, 2006John
                S. Bakalar/s/
                John J. Vosicky
            Director
            February
                28, 2006John
                J. Vosicky/s/
                Daniel M. Wright
            Director
            February
                28, 2006Daniel
                M. Wright/s/
                Richard E. Rothkopf
            Director
            February
                28, 2006Richard
                E. Rothkopf/s/
                Thomas M. Collinger
            Director
            February
                28, 2006Thomas
                M. Collinger/s/
                Michael J. Merriman, Jr.
            Director
            February
                28, 2006Michael
                J. Merriman, Jr.


33


**REPORT
      OF INDEPENDENT REGISTERED PUBLIC ACCOUNTING FIRM**





The
      Board
      of Directors and Stockholders


RC2
      Corporation:





Under
      date of February 28, 2006, we reported on the consolidated balance sheets of
      RC2
      Corporation and subsidiaries as of December 31, 2004 and 2005, and the related
      consolidated statements of earnings, stockholders’ equity and cash flows for the
      years in the three-year period ended December 31, 2005. In connection with
      our
      audits of the aforementioned consolidated financial statements, we also audited
      the related consolidated financial statement schedule of Valuation and
      Qualifying Accounts. The financial statement schedule is the responsibility
      of
      the Company’s management. Our responsibility is to express an opinion on the
      financial statement schedule based on our audits.





In
      our
      opinion, this financial statement schedule, when considered in relation to
      the
      basic consolidated financial statements taken as a whole, presents fairly in
      all
      material respects, the information set forth therein.














KPMG
      LLP


Chicago,
      Illinois


February
      28, 2006













**Schedule
      II**





**Description**


**Valuation
      and Qualifying Accounts**




**Description**
              
              **Balance
                  at**
                **Beginning
                  of**
                **Year**
              
              
              **Charged
                  to**
                **Costs
                  and**
                **Expenses**
              
              
              **Charged
                  to**
                **Other**
                **Accounts**
              
              
              **Deductions**
              
              
              **Balance
                  at**
                **End
                  of**
                **Year**Allowance
                  for doubtful accounts:Year
                  ended December 31, 2003
              
              $
              2,600,576
              
              
              $
              2,077,735
              
              
              $
              1,825,339
              
              
              $
              (2,497,203
              )
              
              $
              4,006,447Year
                  ended December 31, 2004
              
              $
              4,006,447
              
              
              $
              1,083,083
              
              
              $
              481,182
              
              
              $
              (2,374,153
              )
              
              $
              3,196,559Year
                  ended December 31, 2005
              
              $
              3,196,559
              
              
              $
              966,453
              
              
              $
              (258,148
              )
              
              $
              (832,156
              )
              
              $
              3,072,708




34


**INDEX
      TO FINANCIAL STATEMENTS**










**RC2
      CORPORATION AND SUBSIDIARIES**





Reports
                  of Independent Registered Public Accounting
                  Firm
              F-2Consolidated
                  Balance Sheets as of December 31, 2004
                  and 2005
              F-4Consolidated
                  Statements of Earnings for the
                  Years Ended December 31, 2003, 2004 and 2005
              F-5Consolidated
                  Statements of Stockholders’ Equity
                  for the Years Ended December 31, 2003, 2004 and 2005
              F-6Consolidated
                  Statements of Cash Flows for the Years
                  Ended December 31, 2003, 2004 and 2005
              F-7Notes
                  to Consolidated Financial Statements
              F-8


F-1


**REPORT
      OF INDEPENDENT REGISTERED PUBLIC ACCOUNTING
      FIRM**





The
      Board
      of Directors and Stockholders


RC2
      Corporation:





We
      have
      audited the accompanying consolidated balance sheets of RC2 Corporation and
      subsidiaries as of December 31, 2004 and 2005, and the related consolidated
      statements of earnings, stockholders’ equity and cash flows for each of the
      years in the three-year period ended December 31, 2005. These consolidated
      financial statements are the responsibility of the Company’s management. Our
      responsibility is to express an opinion on these consolidated financial
      statements based on our audits.





We
      conducted our audits in accordance with the standards of the Public Company
      Accounting Oversight Board (United States). Those standards require that we
      plan
      and perform the audit to obtain reasonable assurance about whether the financial
      statements are free of material misstatement. An audit includes examining,
      on a
      test basis, evidence supporting the amounts and disclosures in the financial
      statements. An audit also includes assessing the accounting principles used
      and
      significant estimates made by management, as well as evaluating the overall
      financial statement presentation. We believe that our audits provide a
      reasonable basis for our opinion.





In
      our
      opinion, the consolidated financial statements referred to above present fairly,
      in all material respects, the financial position of RC2 Corporation and
      subsidiaries as of December 31, 2004 and 2005, and the results of their
      operations and their cash flows for each of the years in the three-year period
      ended December 31, 2005, in conformity with U.S. generally accepted accounting
      principles.





We
      also
      have audited, in accordance with the standards of the Public Company Accounting
      Oversight Board (United States), the effectiveness of RC2 Corporation’s internal
      control over financial reporting as of December 31, 2005, based on criteria
      established in Internal Control-Integrated Framework issued by the Committee
      of
      Sponsoring Organizations of the Treadway Commission (COSO), and our report
      dated
      February 28, 2006 expressed an unqualified opinion on management’s assessment
      of, and the effective operation of, internal control over financial
      reporting.











KPMG
      LLP


Chicago,
      Illinois


February
      28, 2006





F-2


**REPORT
      OF INDEPENDENT REGISTERED PUBLIC ACCOUNTING FIRM**





The
      Board
      of Directors and Stockholders


RC2
      Corporation:





We
      have
      audited management’s assessment, included in the accompanying Management Report
      on Internal Control Over Financial Reporting, that the RC2 Corporation
      maintained effective internal control over financial reporting as of December
      31, 2005, based on criteria established in Internal Control-Integrated Framework
      issued by the Committee of Sponsoring Organizations of the Treadway Commission
      (COSO). RC2 Corporation’s management is responsible for maintaining effective
      internal control over financial reporting and for its assessment of the
      effectiveness of internal control over financial reporting. Our responsibility
      is to express an opinion on management’s assessment and an opinion on the
      effectiveness of the Company’s internal control over financial reporting based
      on our audit.





We
      conducted our audit in accordance with the standards of the Public Company
      Accounting Oversight Board (United States). Those standards require that we
      plan
      and perform the audit to obtain reasonable assurance about whether effective
      internal control over financial reporting was maintained in all material
      respects. Our audit included obtaining an understanding of internal control
      over
      financial reporting, evaluating management’s assessment, testing and evaluating
      the design and operating effectiveness of internal control, and performing
      such
      other procedures as we considered necessary in the circumstances. We believe
      that our audit provides a reasonable basis for our opinion.





A
      company’s internal control over financial reporting is a process designed to
      provide reasonable assurance regarding the reliability of financial reporting
      and the preparation of financial statements for external purposes in accordance
      with generally accepted accounting principles. A company’s internal control over
      financial reporting includes those policies and procedures that (1) pertain
      to
      the maintenance of records that, in reasonable detail, accurately and fairly
      reflect the transactions and dispositions of the assets of the company; (2)
      provide reasonable assurance that transactions are recorded as necessary to
      permit preparation of financial statements in accordance with generally accepted
      accounting principles, and that receipts and expenditures of the company are
      being made only in accordance with authorizations of management and directors
      of
      the company; and (3) provide reasonable assurance regarding prevention or timely
      detection of unauthorized acquisition, use, or disposition of the company’s
      assets that could have a material effect on the financial
      statements.





Because
      of its inherent limitations, internal control over financial reporting may
      not
      prevent or detect misstatements. Also, projections of any evaluation of
      effectiveness to future periods are subject to the risk that controls may become
      inadequate because of changes in conditions, or that the degree of compliance
      with the policies or procedures may deteriorate.





In
      our
      opinion, management’s assessment that RC2 Corporation maintained effective
      internal control over financial reporting as of December 31, 2005, is fairly
      stated, in all material respects, based on criteria established in Internal
      Control-Integrated Framework issued by the Committee of Sponsoring Organizations
      of the Treadway Commission (COSO). Also, in our opinion, RC2 Corporation
      maintained, in all material respects, effective internal control over financial
      reporting as of December 31, 2005, based on the criteria established in Internal
      Control-Integrated Framework issued by the Committee of Sponsoring Organizations
      of the Treadway Commission (COSO).





We
      also
      have audited, in accordance with the standards of the Public Company Accounting
      Oversight Board (United States), the consolidated balance sheets of RC2
      Corporation and subsidiaries as of December 31, 2004 and 2005, and the related
      consolidated statements of earnings, stockholders’ equity and cash flows for
      each of the years in the three-year period ended December 31, 2005, and our
      report dated February 28, 2006 expressed an unqualified opinion on those
      consolidated financial statements.









KPMG
      LLP


Chicago,
      Illinois


February
      28, 2006


F-3


**CONSOLIDATED
      BALANCE SHEETS**


**December
                31,****2004**
            
            **2005****Assets**Current
                assets:Cash
                and cash equivalents
            
            $
            20,123,395
            
            $
            25,261,751Accounts
                receivable, net of allowances for doubtful accounts
              of
                $3,196,559 and $3,072,708
            
            
            93,616,367
            
            
            113,066,470Other
                receivables
            
            
            6,565,341
            
            
            2,284,425Inventory
            
            
            55,022,928
            
            
            71,260,176Assets
                held for sale
            
            
            4,185,959
            
            
            —Deferred
                income taxes and prepaid taxes, net
            
            
            8,263,659
            
            
            8,716,715Prepaid
                expenses
            
            
            6,602,609
            
            
            6,595,560Total
                current assets
            
            
            194,380,258
            
            
            227,185,097Property
                and equipment:Land
            
            
            699,498
            
            
            685,638Buildings
                and improvements
            
            
            8,049,231
            
            
            7,453,527Tooling
            
            
            85,253,552
            
            
            96,416,008Other
                equipment
            
            
            19,087,076
            
            
            19,149,481113,089,357
            
            
            123,704,654Less
                accumulated depreciation
            
            
            (64,232,922
            )
            
            (76,665,171
            )48,856,435
            
            
            47,039,483Goodwill
            
            
            282,367,323
            
            
            253,571,014Intangible
                assets, net
            
            
            58,243,316
            
            
            99,610,655Other
                non-current assets
            
            
            1,901,143
            
            
            2,330,153Total
                assets
            
            $
            585,748,475
            
            $
            629,736,402**Liabilities
                and stockholders’ equity**Current
                liabilities:Accounts
                payable
            
            $
            16,590,061
            
            $
            25,543,076Taxes
                payable, net
            
            
            —
            
            
            6,109,548Accrued
                expenses
            
            
            14,263,873
            
            
            19,596,548Accrued
                allowances
            
            
            18,563,026
            
            
            21,198,641Accrued
                royalties
            
            
            14,623,280
            
            
            14,874,078Line
                of credit
            
            
            —
            
            
            3,979,520Current
                maturities of bank term loans
            
            
            16,562,500
            
            
            21,250,000Other
                current liabilities
            
            
            846,618
            
            
            1,347,979Total
                current liabilities
            
            
            81,449,358
            
            
            113,899,390Lines
                of credit
            
            
            50,000,000
            
            
            13,979,520Bank
                term loans, less current maturities
            
            
            64,687,500
            
            
            43,437,500Deferred
                income taxes
            
            
            31,632,972
            
            
            49,313,058Other
                non-current liabilities
            
            
            11,216,229
            
            
            10,155,553Total
                liabilities
            
            
            238,986,059
            
            
            230,785,021Commitments
                and contingenciesStockholders’
                equity:Common
                stock, voting, $0.01 par value, 28,000,000 shares authorized,
              22,294,833
                shares issued and 20,462,659 shares outstanding at
              December
                31, 2004,and
                22,548,784 shares issued and 20,717,954
              shares
                outstandingat
                December 31, 2005
            
            
            222,948
            
            
            225,488Additional
                paid-in capital
            
            
            215,014,221
            
            
            219,646,877Accumulated
                other comprehensive income
            
            
            6,543,964
            
            
            1,126,596Retained
                earnings
            
            
            133,481,530
            
            
            186,611,878355,262,663
            
            
            407,610,839Treasury
                stock, at cost, 1,832,174 shares at December 31, 2004, and
              1,830,830
                shares at December 31, 2005
            
            
            (8,500,247
            )
            
            (8,659,458
            )Total
                stockholders’ equity
            
            
            346,762,416
            
            
            398,951,381Total
                liabilities and stockholders’ equity
            
            $
            585,748,475
            
            $
            629,736,402





The
      accompanying notes are an integral part of these consolidated financial
      statements.


F-4


**CONSOLIDATED
      STATEMENTS OF
      EARNINGS**





**Year
                Ended December 31,****2003**
            
            **2004**
            
            **2005**Net
                sales
            
            $
            310,945,668
            
            $
            381,424,739
            
            $
            504,444,934Cost
                of sales, related parties
            
            
            8,255,626
            
            
            7,846,269
            
            
            18,565,863Cost
                of sales, other
            
            
            140,651,980
            
            
            185,650,821
            
            
            240,381,915Gross
                profit
            
            
            162,038,062
            
            
            187,927,649
            
            
            245,497,156Selling,
                general and administrative expenses
            
            
            104,467,274
            
            
            126,264,737
            
            
            155,412,481Impairment
                of intangible assets
            
            
            327,000
            
            
            4,318,000
            
            
            —Amortization
                of intangible assets
            
            
            30,000
            
            
            93,750
            
            
            1,384,800Gain
                on sale of W. Britain product line
            
            
            —
            
            
            —
            
            
            (1,952,555
            )Operating
                income
            
            
            57,213,788
            
            
            57,251,162
            
            
            90,652,430Interest
                expense, net
            
            
            3,477,352
            
            
            4,063,290
            
            
            5,983,132Other
                (income) expense
            
            
            (145,447
            )
            
            (508,160
            )
            
            145,950Income
                before income taxes
            
            
            53,881,883
            
            
            53,696,032
            
            
            84,523,348Income
                tax expense
            
            
            15,464,620
            
            
            19,717,803
            
            
            31,393,000Net
                income
            
            $
            38,417,263
            
            $
            33,978,229
            
            $
            53,130,348Net
                income per share:Basic
            
            $
            2.25
            
            $
            1.82
            
            $
            2.58Diluted
            
            $
            2.12
            
            $
            1.72
            
            $
            2.47Weighted
                average shares outstanding:Basic
            
            
            17,059,589
            
            
            18,687,057
            
            
            20,612,846Diluted
            
            
            18,104,969
            
            
            19,761,156
            
            
            21,531,655





The
      accompanying notes are an integral part of these consolidated financial
      statements.


F-5


**CONSOLIDATED
      STATEMENTS OF STOCKHOLDERS’
EQUITY**




**Common
                Stock**
            
            **Treasury
                Stock**
            
            **Accumulated**
              **Other**
              **Comprehensive**
            
            **Additional**
              **Paid-In**
            
            **Retained**
            
            **Total**
              **Stockholders’**
            
            **Comprehensive****Shares**
            
            **Amount**
            
            **Shares**
            
            **Amount**
            
            **(Loss)
                Income**
            
            **Capital**
            
            **Earnings**
            
            **Equity**
            
            **Income****BALANCE,
                DECEMBER 31, 2002**
            
            
            16,463,371
            
            $
            182,936
            
            
            1,830,295
            
            $
            (7,809,565
            )
            $
            (1,284,509
            )
            $
            118,705,647
            
            $
            61,086,038
            
            $
            170,880,547Net
                income
            
            
            —
            
            
            —
            
            
            —
            
            
            —
            
            
            —
            
            
            —
            
            
            38,417,263
            
            
            38,417,263
            
            $
            38,417,263Stock
                issued upon option exercise
            
            
            232,731
            
            
            2,327
            
            
            —
            
            
            —
            
            
            —
            
            
            1,384,395
            
            
            —
            
            
            1,386,722
            
            
            —Tax
                benefit of stock option exercise
            
            
            —
            
            
            —
            
            
            —
            
            
            —
            
            
            —
            
            
            1,407,763
            
            
            —
            
            
            1,407,763
            
            
            —Stock
                issued in acquisition
            
            
            666,666
            
            
            6,667
            
            
            —
            
            
            —
            
            
            —
            
            
            7,803,325
            
            
            —
            
            
            7,809,992
            
            
            —Stock
                issued under ESPP
            
            
            10,580
            
            
            —
            
            
            (10,580
            )
            
            57,548
            
            
            —
            
            
            83,087
            
            
            —
            
            
            140,635
            
            
            —Reissue
                treasury stock
            
            
            7,250
            
            
            —
            
            
            (7,250
            )
            
            39,424
            
            
            —
            
            
            51,961
            
            
            —
            
            
            91,385
            
            
            —Other
                comprehensive income (loss):Foreign
                currency translation
              adjustments
            
            
            —
            
            
            —
            
            
            —
            
            
            —
            
            
            5,319,686
            
            
            —
            
            
            —
            
            
            5,319,686
            
            
            5,319,686Minimum
                pension liability
              adjustment,
                net of tax
            
            
            —
            
            
            —
            
            
            —
            
            
            —
            
            
            (154,610
            )
            
            —
            
            
            —
            
            
            (154,610
            )
            
            (154,610
            )Comprehensive
                income
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            $
            43,582,339**BALANCE,
                DECEMBER 31, 2003**
            
            
            17,380,598
            
            $
            191,930
            
            
            1,812,465
            
            $
            (7,712,593
            )
            $
            3,880,567
            
            $
            129,436,178
            
            $
            99,503,301
            
            $
            225,299,383Net
                income
            
            
            —
            
            
            —
            
            
            —
            
            
            —
            
            
            —
            
            
            —
            
            
            33,978,229
            
            
            33,978,229
            
            $
            33,978,229Public
                stock offering
            
            
            2,655,000
            
            
            26,550
            
            
            —
            
            
            —
            
            
            —
            
            
            77,459,532
            
            
            —
            
            
            77,486,082
            
            
            —Stock
                issued upon option exercise
            
            
            355,382
            
            
            3,554
            
            
            —
            
            
            —
            
            
            —
            
            
            2,068,645
            
            
            —
            
            
            2,072,199
            
            
            —Tax
                benefit of stock option exercise
            
            
            —
            
            
            —
            
            
            —
            
            
            —
            
            
            —
            
            
            3,075,619
            
            
            —
            
            
            3,075,619
            
            
            —Stock
                issued in acquisition
            
            
            91,388
            
            
            914
            
            
            —
            
            
            —
            
            
            —
            
            
            2,867,390
            
            
            —
            
            
            2,868,304
            
            
            —Stock
                issued under ESPP
            
            
            6,247
            
            
            —
            
            
            (6,247
            )
            
            33,984
            
            
            —
            
            
            106,857
            
            
            —
            
            
            140,841
            
            
            —Treasury
                stock acquisition
            
            
            (25,956
            )
            
            —
            
            
            25,956
            
            
            (821,638
            )
            
            —
            
            
            —
            
            
            —
            
            
            (821,638
            )
            
            —Other
                comprehensive income (loss):Foreign
                currency translation
              adjustments
            
            
            —
            
            
            —
            
            
            —
            
            
            —
            
            
            3,551,728
            
            
            —
            
            
            —
            
            
            3,551,728
            
            
            3,551,728Minimum
                pension liability
              adjustment,
                net of tax
            
            
            —
            
            
            —
            
            
            —
            
            
            —
            
            
            (888,331
            )
            
            —
            
            
            —
            
            
            (888,331
            )
            
            (888,331
            )Comprehensive
                income
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            $
            36,641,626**BALANCE,
                DECEMBER 31, 2004**
            
            
            20,462,659
            
            $
            222,948
            
            
            1,832,174
            
            $
            (8,500,247
            )
            $
            6,543,964
            
            $
            215,014,221
            
            $
            133,481,530
            
            $
            346,762,416Net
                income
            
            
            —
            
            
            —
            
            
            —
            
            
            —
            
            
            —
            
            
            —
            
            
            53,130,348
            
            
            53,130,348
            
            $
            53,130,348Stock
                issued upon option exercise
            
            
            253,951
            
            
            2,540
            
            
            —
            
            
            —
            
            
            —
            
            
            1,748,130
            
            
            —
            
            
            1,750,670
            
            
            —Tax
                benefit of stock option exercise
            
            
            —
            
            
            —
            
            
            —
            
            
            —
            
            
            —
            
            
            2,728,700
            
            
            —
            
            
            2,728,700
            
            
            —Stock
                issued under ESPP
            
            
            6,436
            
            
            —
            
            
            (6,436
            )
            
            35,012
            
            
            —
            
            
            155,826
            
            
            —
            
            
            190,838
            
            
            —Treasury
                stock acquisition
            
            
            (5,092
            )
            
            —
            
            
            5,092
            
            
            (194,223
            )
            
            —
            
            
            —
            
            
            —
            
            
            (194,223
            )
            
            —Other
                comprehensive loss:Foreign
                currency translation
              adjustments
            
            
            —
            
            
            —
            
            
            —
            
            
            —
            
            
            (5,031,967
            )
            
            —
            
            
            —
            
            
            (5,031,967
            )
            
            (5,031,967
            )Minimum
                pension liability
              adjustment,
                net of tax
            
            
            —
            
            
            —
            
            
            —
            
            
            —
            
            
            (385,401
            )
            
            —
            
            
            —
            
            
            (385,401
            )
            
            (385,401
            )Comprehensive
                income
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            $
            47,712,980**BALANCE,
                DECEMBER 31, 2005**
            
            
            20,717,954
            
            $
            225,488
            
            
            1,830,830
            
            $
            (8,659,458
            )
            $
            1,126,596
            
            $
            219,646,877
            
            $
            186,611,878
            
            $
            398,951,381





The
      accompanying notes are an integral part of these consolidated financial
      statements.


F-6


**CONSOLIDATED
      STATEMENTS OF CASH FLOWS**


**Year
                Ended December 31,****2003**
            
            **2004**
            
            **2005****Operating
                activities******Net
                income
            
            $
            38,417,263
            
            $
            33,978,229
            
            $
            53,130,348Adjustments
                to reconcile net income to net cash
              provided
                by operating activities:Depreciation
            
            
            11,950,461
            
            
            15,309,528
            
            
            14,474,618****Impairment
                of intangible assets
            
            
            327,000
            
            
            4,318,000
            
            
            —Provision
                for uncollectible accounts
            
            
            2,089,204
            
            
            767,169
            
            
            834,572Amortization
                and write-off of deferred financing costs
            
            
            246,129
            
            
            828,771
            
            
            482,830Amortization
                of intangible assets
            
            
            30,000
            
            
            93,750
            
            
            1,384,800Loss
                (gain) on disposition of assets
            
            
            112,852
            
            
            56,073
            
            
            (2,029,717
            )Deferred
                income taxes
            
            
            (6,757,457
            )
            
            8,385,752
            
            
            1,887,105Other
            
            
            —
            
            
            —
            
            
            15,667Changes
                in operating assets and liabilities:Accounts
                and other receivables
            
            
            (26,766,961
            )
            
            2,216,593
            
            
            (18,255,388
            )Inventory
            
            
            7,032,219
            
            
            5,488,130
            
            
            (18,541,693
            )Prepaid
                expenses
            
            
            1,242,176
            
            
            53,634
            
            
            287,883Accounts
                payable and accrued expenses
            
            
            170,564
            
            
            (2,783,957
            )
            
            26,024,691****Other
                liabilities
            
            
            9,857,813
            
            
            (4,630,769
            )
            
            (559,315
            )Net
                cash provided by operating activities
            
            
            37,951,263
            
            
            64,080,903
            
            
            59,136,401**Investing
                activities**Purchase
                of property and equipment
            
            
            (10,752,389
            )
            
            (15,091,603
            )
            
            (14,159,226
            )****Proceeds
                from disposition of property and equipment
            
            
            33,290
            
            
            166,656
            
            
            5,545,961Purchase
                of LCI, net of cash acquired
            
            
            (99,381,955
            )
            
            —
            
            
            —Purchase
                of Playing Mantis, net of cash acquired
            
            
            —
            
            
            (17,238,056
            )
            
            —Purchase
                of TFY, net of cash acquired
            
            
            —
            
            
            (154,567,407
            )
            
            39,335Proceeds
                from sale of W. Britain product line
            
            
            —
            
            
            —
            
            
            2,850,000Investment
                in Meteor The Monster Truck Company, LLC
            
            
            —
            
            
            —
            
            
            (750,000
            )(Increase)
                decrease in other non-current assets
            
            
            (3,963,090
            )
            
            1,745,373
            
            
            (168,936
            )Net
                cash used in investing activities
            
            
            (114,064,144
            )
            
            (184,985,037
            )
            
            (6,642,866
            )**Financing
                activities**Net
                cash proceeds from public stock offering
            
            
            —
            
            
            77,486,082
            
            
            —Issuance
                of stock upon option exercises
            
            
            1,386,722
            
            
            1,459,873
            
            
            1,750,670Issuance
                of stock under ESPP
            
            
            140,635
            
            
            140,841
            
            
            190,838Proceeds
                from bank term loans
            
            
            60,000,000
            
            
            85,000,000
            
            
            —Payments
                on bank term loans
            
            
            (10,000,000
            )
            
            (53,750,000
            )
            
            (16,562,500
            )Net
                borrowings (payments) on line of credit
            
            
            27,000,000
            
            
            15,000,000
            
            
            (31,914,229
            )Proceeds
                from reissuance of treasury stock
            
            
            91,385
            
            
            —
            
            
            —Payment
                of note payable
            
            
            (2,861,816
            )
            
            —
            
            
            —Financing
                fees paid
            
            
            (935,297
            )
            
            (1,942,193
            )
            
            —Net
                cash provided by (used in) financing activities
            
            
            74,821,629
            
            
            123,394,603
            
            
            (46,535,221
            )Effect
                of exchange rate changes on cash
            
            
            768,163
            
            
            1,051,857
            
            
            (819,958
            )Net
                (decrease) increase in cash and cash equivalents
            
            
            (523,089
            )
            
            3,542,326
            
            
            5,138,356Cash
                and cash equivalents, beginning of year
            
            
            17,104,158
            
            
            16,547,951
            
            
            20,123,395****Restricted
                cash
            
            
            (33,118
            )
            
            33,118
            
            
            —Cash
                and cash equivalents, end of year
            
            $
            16,547,951
            
            $
            20,123,395
            
            $
            25,261,751Supplemental
                disclosure of cash flow information:Cash
                paid for interest during the period
            
            $
            3,439,022
            
            $
            3,416,225
            
            $
            5,890,170Cash
                paid for income taxes during the period
            
            $
            8,754,396
            
            $
            11,986,769
            
            $
            22,471,705Cash
                refunds received for income taxes
            
            $
            777,527
            
            $
            344,861
            
            $
            6,249,913Non-cash
                  investing and financing activity during the period:666,666
                shares of stock issued for the purchase of LCI
            
            $
            7,809,992
            
            $
            —
            
            $
            —91,388
                shares of stock issued for the purchase of PlayingMantis
            
            $
            —
            
            $
            2,868,304
            
            $
            —Stock
                  received in exchange for option exercises and tax
                  withholdings
            
            $
            —
            
            $
            821,638
            
            $
            —Stock
                received in exchange for a receivable
            
            $
            —
            
            $
            —
            
            $
            194,223




The
      accompanying notes are an integral part of these consolidated financial
      statements.


F-7


**NOTES
      TO CONSOLIDATED FINANCIAL STATEMENTS**





**FOR
      THE YEARS ENDED DECEMBER 31, 2003, 2004 AND 2005**




**1.  
      DESCRIPTION OF BUSINESS**





Founded
      in 1989, RC2 Corporation and Subsidiaries, (collectively, the Company or RC2),
      is a leading designer, producer and marketer of innovative, high-quality toys,
      collectibles, hobby and infant care products targeted to consumers of all ages.
      RC2’s infant and preschool products are marketed under its Learning Curve®
family of brands which includes The First Years® by Learning Curve and Lamaze
      brands as well as popular and classic licensed properties such as *Thomas
      & Friends* , *Bob
      the Builder* , *Winnie
      the Pooh* ,
      John
      Deere and *Sesame
      Street* .
      RC2
      markets its collectible and hobby products under a portfolio of brands including
      Johnny Lightning®, Racing Champions®, Ertl®, Ertl Collectibles®, AMT®, Press
      Pass®, JoyRide®, and JoyRide Studios®. RC2 reaches its target consumers through
      multiple channels of distribution supporting more than 25,000 retail outlets
      throughout North America, Europe, Australia and Asia Pacific.





**2.  
      RECAPITALIZATION AND ACQUISITIONS**





**Recapitalization**





Purchase
      price in excess of the book value of the net assets acquired in connection
      with
      the Company’s recapitalization (Recapitalization) in 1996 of $88.7 million,
      which is deductible for tax purposes over 15 years, has been recorded as
      goodwill and through December 31, 2001, was being amortized on a straight-line
      basis over a 40-year period.





**RC2
      Corporation and The Ertl Company, Inc.**





On
      April
      13, 1999, the Company purchased all of the outstanding shares of The Ertl
      Company, Inc. (subsequently renamed RC2 Brands, Inc.) and certain of its
      affiliates. The excess of the aggregate purchase price over the fair market
      value of net assets acquired of approximately $31.1 million was being amortized
      on a straight-line basis over 40 years through December 31, 2001.





**RC2
      Corporation and Learning Curve International, Inc.**





On
      March
      4, 2003, with an effective date of February 28, 2003, the Company acquired
      Learning Curve International, Inc. (Learning Curve) and certain of its
      affiliates (collectively, LCI) through the merger of a wholly owned subsidiary
      of RC2 with and into Learning Curve for approximately $104.4 million in cash
      (excluding transaction expenses) and 666,666 shares of the Company’s common
      stock, including $12.0 million in escrow to secure Learning Curve’s
      indemnification obligations under the merger agreement. LCI develops and markets
      a variety of high-quality, award-winning children’s and infant toys for every
      stage of childhood from birth through age eight. This transaction has been
      accounted for under the purchase method of accounting and, accordingly, the
      operating results of LCI have been included in our consolidated statements
      of
      earnings since the effective date of the acquisition. The purchase was funded
      with a credit facility (See Note 7 - Debt).




The
      escrow amount to secure Learning Curve’s indemnification obligations under the
      merger agreement was approximately $2.9 million at December 31, 2005. In the
      merger agreement, Learning Curve agreed to indemnify the Company for losses
      relating to breaches of Learning Curve’s representations, warranties and
      covenants in the merger agreement and for specified liabilities relating to
      Learning Curve’s historical business. In February and April 2005, the Company
      had notified the representatives of the former Learning Curve stockholders
      of
      certain claims relating to a tax audit and other matters. Subsequent to December
      31, 2005, an agreement was reached with the representatives of the former
      Learning Curve stockholders resolving all open escrow claims and disbursing
      all
      amounts in escrow other than approximately $0.3 million which will remain in
      the
      escrow to pay certain of the Company’s expenses to pursue a pending malpractice
      litigation claim.


F-8


**RC2
      Corporation and Playing Mantis, Inc.**





On
      June
      7, 2004, the Company acquired substantially all of the assets of Playing Mantis,
      Inc. (Playing Mantis) with an effective date of June 1, 2004. Closing
      consideration consisted of $17.0 million of cash (excluding transaction
      expenses) and 91,388 shares of the Company’s common stock. Additional cash
      consideration of up to $4.0 million may have been earned in the transaction
      by
      Playing Mantis of which $2.0 million was based on achieving net sales and margin
      targets in 2004 and the remaining $2.0 million was based on achieving net sales
      targets in 2005. The contingent consideration was not payable because the net
      sales and margin targets were not met in either 2004 or 2005. Playing Mantis
      designs and markets collectible vehicle replicas under the Johnny Lightning® and
      Polar Lights® brands. Playing Mantis’ products are primarily sold at mass
      merchandising, hobby, craft, drug and grocery chains. This transaction has
      been
      accounted for under the purchase method of accounting and, accordingly, the
      operating results of Playing Mantis have been included in our consolidated
      statements of earnings since the effective date of the acquisition. The excess
      of the aggregate purchase price over the fair market value of net assets
      acquired of approximately $11.0 million has been recorded as goodwill in the
      accompanying consolidated balance sheet at December 31, 2005. During the quarter
      ended June 30, 2005, the Company completed its valuation of the assets acquired
      in the Playing Mantis transaction. As a result, approximately $3.3 million
      in
      other intangible assets have been recorded on the balance sheet that previously
      were reflected in goodwill.





The
      purchase price was allocated to the net assets of Playing Mantis based on their
      estimated relative fair market values on June 1, 2004 as follows:





(In
      thousands)





Total
                purchase price, including expenses, net of cash acquired
            
            
            
            
            $
            20,106Less:Current
                assets
            
            $
            5,424Property,
                plant and equipment
            
            
            4,111Intangible
                assets
            
            
            3,314Liabilities
            
            
            (3,777
            )
            
            (9,072
            )Excess
                of purchase price over net assets acquired
            
            
            
            
            $
            11,034





**RC2
      Corporation and The First Years Inc.**





On
      September 15, 2004, the Company acquired The First Years Inc. (TFY) for
      approximately $156.1 million in cash (excluding transaction expenses). TFY
      is an
      international developer and marketer of infant and toddler care and play
      products sold under The First Years® by Learning Curve brand name and under
      various licenses, including Disney’s *Winnie
      the Pooh* .
      TFY’s
      products are sold at toy, mass merchandising, drug and grocery chains, and
      at
      specialty retailers. This transaction has been accounted for under the purchase
      method of accounting and, accordingly, the operating results of TFY have been
      included in the accompanying consolidated statements of earnings since the
      effective date of the acquisition. The purchase was funded with the Company’s
      new credit facility (See Note 7 - Debt). The excess of the aggregate purchase
      price over the fair market value of net assets acquired of approximately $73.4
      million has been recorded as goodwill in the accompanying consolidated balance
      sheet at December 31, 2005. During the quarter ended September 30, 2005, the
      Company completed its valuation of the assets acquired in the TFY transaction.
      As a result, an additional $40.0 million in other intangible assets have been
      recorded on the balance sheet that previously were reflected in
      goodwill.


F-9


The
      purchase price was allocated to the net assets of TFY based on their estimated
      relative fair market values on September 15, 2004 as follows:





(In
      thousands)





Total
                purchase price, including expenses
            
            
            
            
            $
            154,528Less:Current
                assets
            
            $
            45,965Property,
                plant and equipment
            
            
            10,934Intangible
                assets
            
            
            58,238Other
                non-current assets
            
            
            175Liabilities
            
            
            (34,203
            )
            
            (81,109
            )Excess
                of purchase price over net assets acquired
            
            
            
            
            $
            73,419





The
      following table presents the unaudited pro forma consolidated results of
      operations for the years ended December 31, 2003 and 2004. The unaudited pro
      forma consolidated results of operations for the year ended December 31, 2003
      assume that the LCI, Playing Mantis and TFY acquisitions occurred as of January
      1, 2003. The unaudited pro forma consolidated results of operations for the
      year
      ended December 31, 2004 assume that the Playing Mantis and TFY acquisitions
      occurred as of January 1, 2003 (LCI was acquired effective February 28, 2003
      and
      is therefore already included in the results of operations for the year ended
      December 31, 2004).





(In
                thousands, except per share data)
            
            **2003**
            
            **2004**Net
                sales
            
            $
            491,564
            
            $
            489,481Net
                income
            
            $
            41,655
            
            $
            36,017Net
                income per share:Basic
            
            $
            2.41
            
            $
            1.92Diluted
            
            $
            2.27
            
            $
            1.82





Pro
      forma
      data does not purport to be indicative of the results that would have been
      obtained had these acquisitions actually occurred at January 1, 2003 and is
      not
      intended to be a projection of future results.





**3.  
      SIGNIFICANT ACCOUNTING POLICIES**





**Principles
      of Consolidation**





The
      consolidated financial statements include the accounts of RC2 Corporation and
      its wholly owned subsidiaries. All intercompany transactions and balances have
      been eliminated.





**Foreign
      Currency Translation/Transactions**





Foreign
      subsidiary assets and liabilities are recorded in local currencies and
      translated into U.S. dollars at the rates of exchange at the balance sheet
      date
      while income statement accounts and cash flows are translated at the average
      exchange rates in effect during the period. Unrealized gains and losses
      resulting from translation for the years ended December 31, 2003, 2004 and
      2005,
      have been recorded as components of accumulated other comprehensive income
      in
      stockholders’ equity. The net exchange losses resulting from transactions in
      foreign currencies for the years ended December 31, 2003 and 2005 were $0.4
      million and $0.5 million, respectively. The net exchange gains resulting from
      transactions in foreign currencies for the year ended December 31, 2004 was
      $29,916. These net exchange losses and gains are included in other (income)
      expense on the accompanying consolidated statements of earnings.





**Revenue
      Recognition**





The
      Company recognizes revenue based upon transfer of title of products to
      customers. The Company provides for estimated credits and other concessions
      at
      the time the sale is recorded, and these credits and other concessions are
      recorded as a reduction of gross sales. The Company’s revenue recognition policy
      is the same for each channel of distribution.


F-10


The
      Company ordinarily accepts returns only for defective merchandise. In certain
      instances, where retailers are unable to resell the quantity of products that
      they have purchased from the Company, the Company, may, in accordance with
      industry practice, assist retailers in selling excess inventory by offering
      credits and other price concessions, which are typically evaluated and issued
      annually. Other allowances can also be issued for defective merchandise, volume
      programs and co-op advertising. All allowances are accrued throughout the year,
      as sales are recorded. The Company’s products currently carry a limited warranty
      which guarantees the product to be free from defects in material and workmanship
      under normal and intended use for a period of 90 days from the date of consumer
      purchase. Historical results of product warranty claims have shown that they
      have had an immaterial impact on the Company. Based upon the historical results,
      appropriate allowances for product warranty claims are accrued throughout the
      year.





**Shipping
      and Handling Costs**





Shipping
      and handling costs, which comprise only those costs incurred to
      transport products to the customer, are included in selling, general
      and administrative expenses in the accompanying consolidated statements of
      earnings. For the years ended December 31, 2003, 2004 and 2005, shipping and
      handling costs were $11.0 million, $13.9 million and $19.5 million,
      respectively.





**Cash
      and Cash Equivalents**





The
      Company considers all highly liquid investments with original maturities of
      90
      days or less to be cash equivalents. Such investments are stated at cost, which
      approximates fair value.





**Use
      of Estimates**





The
      preparation of the financial statements in conformity with U.S. generally
      accepted accounting principles requires management to make estimates and
      assumptions that affect the amounts reported in the financial statements and
      accompanying notes. Actual results could differ from those
      estimates.





**Inventory**





Inventory,
      which consists of finished goods, has been written down for excess quantities
      and obsolescence and is stated at lower of cost or market. Cost is determined
      by
      the first-in, first-out method and includes all costs necessary to bring
      inventory to its existing condition and location. Market represents the lower
      of
      replacement cost or estimated net realizable value. Inventory write-downs are
      recorded for damaged, obsolete, excess and slow-moving inventory. The Company’s
      management uses estimates to record these write-downs based on its review of
      inventory by product category, length of time on hand and order bookings.
      Changes in public and consumer preferences and demand for product or changes
      in
      customer buying patterns and inventory management could impact the inventory
      valuation.





**Property
      and Equipment**





Property
      and equipment are recorded at cost. Depreciation is computed using the
      straight-line method for financial statement purposes at rates adequate to
      depreciate the cost of applicable assets over their expected useful lives.
      Accelerated methods are used for income tax purposes. Repairs and maintenance
      are charged to expense as incurred. Gains and losses resulting from sales,
      dispositions or retirements are recorded as incurred, at which time related
      costs and accumulated depreciation are removed from the accounts. The estimated
      useful lives used in computing depreciation for financial statement purposes
      are
      as follows:





**Asset
                Descriptions**
            **Estimated
                Useful Life**Buildings
                and improvements
            2
                -
                15 yearsTooling
            2
                -
                7 yearsOther
                equipment
            2
                -
                10 years




In 2004 and 2005, the Company recorded charges of
      approximately $2.5 million and $0.8 million, respectively, to write-off
      undepreciated tooling related to discontinued product lines primarily in the
      North America segment.  These charges are included in cost of sales, other
      in the accompanying consolidated statements of earnings for the years ended
      December 31, 2004 and 2005.




F-11


**Goodwill
      and Intangible Assets**





In
      accordance with the provisions of Statement of Financial Accounting Standards
      (SFAS) No. 142, “Goodwill and Other Intangible Assets,” the Company tests
      goodwill and other intangible assets with indefinite useful lives for impairment
      on an annual basis or on an interim basis if an event occurs that might reduce
      the fair value of the reporting unit below its carrying value. The Company
      completed its annual goodwill impairment tests as of October 1, 2003, 2004
      and
      2005 which resulted in no impairment. The annual impairment test for intangible
      assets in 2005 resulted in no impairment to intangibles. However, impairment
      charges for intangible assets in the North America segment of $0.3 million
      and
      $4.3 million have been included in the accompanying consolidated statements
      of
      earnings for the years ended December 31, 2003 and 2004, respectively, as a
      result of the 2003 and 2004 annual impairment tests of intangible assets. The
      impairment charges are based upon the Company’s decision to discontinue certain
      low-performing product lines. ****





The
      change in carrying value of goodwill by reporting unit for the years ended
      2004
      and 2005 is shown below:





(In
                thousands)
            
            **North
                America**
            
            **International**
            
            **Total**Balance
                at December 31, 2003
            
            $
            145,549
            
            $
            14,171
            
            $
            159,720LCI
                fair value allocation
            
            
            10,128
            
            
            (290
            )
            
            9,838Playing
                Mantis acquisition
            
            
            14,120
            
            
            —
            
            
            14,120TFY
                acquisition
            
            
            97,565
            
            
            —
            
            
            97,565Impact
                of currency exchange rate changes
            
            
            —
            
            
            1,124
            
            
            1,124Balance
                at December 31, 2004
            
            
            267,362
            
            
            15,005
            
            
            282,367Playing
                Mantis fair value allocation
            
            
            (3,086
            )
            
            —
            
            
            (3,086
            )TFY
                fair value allocation
            
            
            (24,146
            )
            
            —
            
            
            (24,146
            )Impact
                of currency exchange rate changes
            
            
            —
            
            
            (1,564
            )
            
            (1,564
            )Balance
                at December 31, 2005
            
            $
            240,130
            
            $
            13,441
            
            $
            253,571





The
      components of net intangible assets are as follows:





(In
                thousands)
            
            **2004**
            
            **2005**Gross
                amount of amortizable intangible assets:Customer
                relationships
            
            $
            —
            
            $
            8,704Other
            
            
            750
            
            
            2,962$
            750
            
            $
            11,666Accumulated
                amortization of amortizable intangible assets:Customer
                relationships
            
            $
            —
            
            $
            275Other
            
            
            94
            
            
            1,204$
            94
            
            $
            1,479Intangible
                assets not subject to amortization:Licenses
                and trademarks
            
            $
            57,416
            
            $
            89,272Other
            
            
            171
            
            
            152$
            57,587
            
            $
            89,424Total
                intangible assets, net
            
            $
            58,243
            
            $
            99,611





Other
      amortizable intangible assets consist primarily of patents, non-compete
      agreements and licenses and have estimated useful lives ranging from two to
      five
      years. Customer relationships have useful lives ranging from eight to fifty
      years.


F-12


Estimated
      amortization expense for the years ending December 31, are as
      follows:





(In
      thousands)


2006
            $1,0452007
            6332008
            5112009
            4132010
            211





**Other
      Non-current Assets**





Other
      non-current assets at December 31, 2004 consist primarily of deferred financing
      fees relating to the September 15, 2004 credit facility. Other non-current
      assets at December 31, 2005 consist primarily of deferred financing fees as
      well
      as the Company’s investment in Meteor The Monster Truck Company, LLC (see Note
      16 - Investment in Meteor The Monster Truck Company, LLC). The deferred
      financing fees are being amortized over the term of the debt agreement.
      Amortization of deferred financing fees for the years ended December 31, 2004
      and 2005, was approximately $0.8 million and $0.5 million, respectively, and
      is
      included in interest expense in the accompanying consolidated statements of
      earnings. Interest expense for the year ended December 31, 2004 includes $0.5
      million relating to the write-off of fees associated with the March 4, 2003
      credit facility.





**Allowance
      for Doubtful Accounts**





The
      allowance for doubtful accounts represents adjustments to customer trade
      accounts receivable for amounts deemed uncollectible. The allowance for doubtful
      accounts reduces gross trade receivables to their net realizable value and
      is
      disclosed on the face of the accompanying consolidated balance sheets. The
      Company’s allowance is based on management’s assessment of the business
      environment, customers’ financial condition, historical trends, customer payment
      practices, receivable aging and customer disputes. The Company has purchased
      credit insurance that covers a portion of its receivables from major customers.
      The Company will continue to proactively review its credit risks and adjust
      its
      customer terms to reflect the current environment.





**Accrued
      Allowances**





The
      Company ordinarily accepts returns only for defective merchandise. In certain
      instances, where retailers are unable to resell the quantity of products that
      they have purchased from the Company, the Company may, in accordance with
      industry practice, assist retailers in selling excess inventory by offering
      credits and other price concessions, which are typically evaluated and issued
      annually. Other allowances can also be issued for defective merchandise, volume
      programs and co-op advertising. All allowances are accrued throughout the year
      as sales are recorded. The allowances are based on the terms of the various
      programs in effect; however, management also takes into consideration historical
      trends and specific customer and product information when making its estimates.
      For the volume programs, the Company generally sets a volume target for the
      year
      with each participating customer and issues the discount if the target is
      achieved. The allowance for the volume program is accrued throughout the year
      and if it becomes clear to management that the target for a participating
      customer will not be reached, the Company will change the estimate for that
      customer as required. The Company’s products currently carry a limited warranty
      which guarantees the product to be free from defects in material and workmanship
      under normal and intended use for a period of 90 days from the date of consumer
      purchase. Historical results of product warranty claims have shown that they
      have had an immaterial impact on the Company. Based upon the historical results,
      appropriate allowances for product warranty claims are accrued throughout the
      year.





**Accrued
      Royalties**





Royalties
      are accrued based on the provisions in licensing agreements for amounts due
      on
      net sales during the period as well as management’s estimates for additional
      royalty exposures. Royalties vary by product category and are generally paid
      on
      a quarterly basis. Multiple royalties may be paid to various licensors on a
      single product. Royalty expense is included in selling, general and
      administrative expenses on the accompanying consolidated statements of
      earnings.


F-13


**Concentration
      of Credit Risk**





Concentration
      of credit risk is limited to trade accounts receivable and is subject to the
      financial conditions of certain major customers. Toys “R” Us/Babies “R” Us, our
      largest customer, accounted for 10.5% and 14.8% of our net sales in 2004 and
      2005, respectively. Wal-Mart accounted for 10.8% and 13.1% of our net sales
      in
      2003 and 2005, respectively. Target accounted for 11.7% of our net sales in
      2005. Other than Toys “R” Us/Babies “R” Us, Wal-Mart and Target, no customer
      accounted for more than 10.0% of our net sales in each period for the three
      years ended December 31, 2005.  Additionally, Toys “R” Us/Babies “R” Us
      accounted for approximately 13.1% and 18.3% of accounts receivable at
      December 31, 2004 and 2005, respectively, Target accounted for
      approximately 13.7% and 16.6% of accounts receivable at December 31, 2004
      and 2005, respectively, and Wal-Mart accounted for approximately 14.5% and
      12.1% of accounts receivable at December 31, 2004 and 2005, respectively. Other
      than Toys “R” Us/Babies “R” Us, Target and Wal-Mart, no customer accounted for
      more than 10.0% of accounts receivable at December 31, 2004 and 2005. The
      Company does not require collateral or other security to support customers’
receivables. The Company conducts periodic reviews of its customers’ financial
      condition and vendor payment practices to minimize collection risks on trade
      accounts receivable. The Company has purchased credit insurance, which covers
      a
      portion of its receivables from major customers. ****





**Supplier
      Concentration**





The
      Company’s purchases from two of its third-party, dedicated suppliers were 15.2%
      and 13.2% in 2003, 16.1% and 14.3% in 2004 and 14.1% and 11.8% in 2005, respectively, of its total product purchases. There
      were no
      other suppliers accounting for more than 10.0% of total product
      purchases in each period for the three years ended December 31,
      2005.




**Fair
      Value of Financial Instruments**





The
      carrying amounts of cash and cash equivalents, accounts receivable, accounts
      payable and accrued expenses approximate fair value because of the short-term
      nature of these items. The carrying amounts of the lines of credit and the
      bank
      term loans approximate their fair value.





**Derivative
      Instruments**





The
      Company had no derivative instruments during the years ended December 31, 2003,
      2004 and 2005.





**Advertising**





The
      Company expenses the production costs of advertising the first time the
      advertising takes place. Advertising expense for the years ended December 31,
      2003, 2004 and 2005, was approximately $1.9 million, $2.3 million and $3.9
      million, respectively.





Prepaid
      advertising expenses, such as prepayments on magazine advertisements and artwork
      costs of $0.3 million and $0.1 million, are included in prepaid expenses on
      the
      accompanying consolidated balance sheets at December 31, 2004 and 2005,
      respectively.





**Income
      Taxes**





The
      Company accounts for income taxes under SFAS No. 109, “Accounting for Income
      Taxes.” Under the asset and liability method of SFAS No. 109, deferred income
      taxes are recognized for the expected future tax consequences of temporary
      differences between financial statement carrying amounts and the tax bases
      of
      existing assets and liabilities, as well as net operating loss and tax credit
      carry-forwards, using enacted tax rates expected to apply to taxable income
      in
      the years in which those temporary differences are expected to be recovered
      or
      settled, or the carry-forwards applied. Management considers all available
      evidence in evaluating the realizability of the deferred tax assets and records
      valuation allowances against its deferred tax assets as needed. Management
      believes it is more likely than not that the Company will generate sufficient
      taxable income in the appropriate carry-forward periods to realize the benefit
      of its deferred tax assets. In determining the required liability, management
      considers certain tax exposures and all available evidence. Estimates for such
      tax contingencies are classified in other non-current liabilities on the
      accompanying consolidated balance sheets.


F-14


**Accounting
      for Stock-Based Compensation**





The
      Company accounts for stock-based compensation arrangements with employees in
      accordance with the provisions of Accounting Principles Board (APB) Opinion
      No.
      25, “Accounting for Stock Issued to Employees,” and complies with the disclosure
      provisions of SFAS No. 123, “Accounting for Stock-Based Compensation.” Under APB
      No. 25, compensation expense is based on the difference, if any, on the
      measurement date, between the estimated fair value of the Company’s stock and
      the exercise price of options to purchase that stock. The compensation expense
      is amortized on a straight-line basis over the vesting period of the options.
      To
      date, no compensation expense has been recorded related to stock-based
      compensation agreements with employees.





If
      compensation costs for stock options issued, including options issued for shares
      under the employee stock purchase plan (ESPP), had been determined based on
      the
      fair value at their grant date consistent with SFAS No. 123, the Company’s net
      income and net income per share would have been reduced to the following pro
      forma amounts:





**Year
                Ended December, 31**(In
                thousands, except per share data)
            
            **2003**
            
            **2004**
            
            **2005**Net
                income as reported
            
            $
            38,417
            
            $
            33.978
            
            $
            53,130Deduct:
                total stock-based employee compensation
              expense
                determined under fair value based
              method
                for all awards, net of related income tax benefit
            
            
            (958
            )
            
            (1,877
            )
            
            (2,061
            )Pro
                forma net income
            
            $
            37,459
            
            $
            32,101
            
            $
            51,069Basic
                net income per shareAs
                reported
            
            $
            2.25
            
            $
            1.82
            
            $
            2.58Pro
                forma
            
            $
            2.20
            
            $
            1.72
            
            $
            2.48Diluted
                net income per shareAs
                reported
            
            $
            2.12
            
            $
            1.72
            
            $
            2.47Pro
                forma
            
            $
            2.07
            
            $
            1.62
            
            $
            2.37





The
      fair
      value of each stock option, excluding options issued for shares under the
      employee stock purchase plan (ESPP), is estimated on the date of grant based
      on
      the Black-Scholes option pricing model that assumes among other things, no
      dividend yield, risk-free rates of return from 3.5% to 5.7%, volatility factors
      of 54.5% to 87.8% and expected life of seven to ten years. The weighted average
      fair value of options granted under the Company’s stock option plan for the
      years ended December 31, 2003, 2004 and 2005, was $11.64, $19.40 and $18.89
      per
      share, respectively.





The
      fair
      value of each option for shares issued under the ESPP was estimated using the
      Black-Scholes model with the following assumptions: risk-free rates of return
      from 0.9% to 3.6%, volatility factors of 24.7% to 85.3% and expected life of
      three months. The weighted average fair value of those purchase rights granted
      in 2003, 2004 and 2005 were $4.86, $8.43 and $7.08, respectively.





During
      the first quarter of 2005, the Company evaluated the method that it had
      historically used to calculate the volatility factors used in valuing stock
      options issued, both under the stock option plan and the ESPP. The Company
      had
      been using historical Company results to compute the volatility factors used
      in
      valuing the stock options issued. As the Company’s business has changed
      significantly as a result of the acquisitions completed, the historical stock
      price movements are not a good indicator of expected future results. Therefore,
      the Company changed the method used to calculate the volatility factor for
      those
      options issued under the stock option plan to correspond with the average
      volatility factor of those companies included in a recent peer group study
      conducted by a third-party on behalf of the Company. The Company also changed
      the method used to calculate the volatility factor for those options issued
      under the ESPP to that of the volatility during the most recent three month
      period, as it more accurately projects the expected volatility over the three
      month ESPP period being valued.





The
      pro
      forma disclosure is not likely to be indicative of pro forma results that may
      be
      expected in future years because of the fact that options vest over several
      years. Compensation expense is recognized over the vesting period and additional
      awards may be granted.


F-15


**Net
      Income Per Share**





The
      Company computes net income per share in accordance with SFAS No. 128, “Earnings
      Per Share.” Under the provisions of SFAS No. 128, basic net income per share is
      computed by dividing net income for the period by the weighted average number
      of
      common shares outstanding during the period. Diluted net income per share is
      computed by dividing net income for the period by the weighted average number
      of
      common and common equivalent shares outstanding during the period. The following
      table discloses the components of net income per share as required by SFAS
      No.
      128:





**For
                the Year Ended December 31, 2003**(In
                thousands, except per share data)
            
            Net
                Income
            
            Weighted
              Average
              Shares
            
            Per
                Share
              AmountBasic
                net income per share:
              Net
                income
            
            $
            38,417
            
            
            17,060
            
            $
            2.25Plus
                effect of dilutive securities:
              Stock
                options
            
            
            —
            
            
            1,045
            
            
            —Diluted
                net income per share:
              Net
                income plus assumed conversions
            
            $
            38,417
            
            
            18,105
            
            $
            2.12





Options
      to purchase 5,000 shares of common stock at $18.72 per share were outstanding
      during 2003, but were not included in the computation of diluted net income
      per
      share because the options’ exercise price was greater than the average market
      price of the common shares for the year.





**For
                the Year Ended December 31, 2004**(In
                thousands, except per share data)
            
            Net
                Income
            
            Weighted
              Average
              Shares
            
            Per
                Share
              AmountBasic
                net income per share:
              Net
                income
            
            $
            33,978
            
            
            18,687
            
            $
            1.82Plus
                effect of dilutive securities:
              Stock
                options
            
            
            —
            
            
            1,074
            
            
            —Diluted
                net income per share:
              Net
                income plus assumed conversions
            
            $
            33,978
            
            
            19,761
            
            $
            1.72





Options
      to purchase 73,110 shares of common stock at prices between $29.94 and $34.66
      per share were outstanding during 2004, but were not included in the computation
      of diluted net income per share because the options’ exercise price was greater
      than the average market price of the common shares for the year.





**For
                the Year Ended December 31, 2005**(In
                thousands, except per share data)
            
            Net
                Income
            
            Weighted
              Average
              Shares
            
            Per
                Share
              AmountBasic
                net income per share:
              Net
                income
            
            $
            53,130
            
            
            20,613
            
            $
            2.58Plus
                effect of dilutive securities:
              Stock
                options
            
            
            —
            
            
            919
            
            
            —Diluted
                net income per share:
              Net
                income plus assumed conversions
            
            $
            53,130
            
            
            21,532
            
            $
            2.47





Options
      to purchase 22,927 shares of common stock at prices between $35.52 and $36.54
      per share were outstanding during 2005, but were not included in the computation
      of diluted net income per share because the options’ exercise price was greater
      than the average market price of the common shares for the
      year.


F-16


**Comprehensive
      Income**





The
      Company reports comprehensive income in accordance with SFAS No. 130, “Reporting
      Comprehensive Income.” SFAS No. 130 requires companies to report all changes in
      equity during a period, except those resulting from investment by owners and
      distributions to owners, in a financial statement for the period in which they
      are recognized. The Company has chosen to disclose comprehensive income, which
      encompasses net income, foreign currency translation adjustments and minimum
      pension liability adjustments, net of income tax effects, as part of the
      accompanying consolidated statements of stockholders’ equity. The income tax
      benefit related to the components of comprehensive income in 2003, 2004 and
      2005
      was $0.1 million, $0.5 million and $0.2 million, respectively.





**Recently
      Issued Accounting Pronouncements**





In
      December 2004, the Financial Accounting Standards Board issued SFAS No. 123R,
      “Share-Based Payment.” This Statement is a revision of SFAS No. 123, “Accounting
      for Stock-Based Compensation” and supersedes APB Opinion No. 25, “Accounting for
      Stock Issued to Employees.” This Statement establishes standards for the
      accounting for transactions in which an entity exchanges its equity instruments
      for goods or services and also addresses transactions in which an entity incurs
      liabilities in exchange for goods and services that are based on the fair value
      of the entity’s equity instruments or that may be settled by the issuance of
      those instruments. This Statement applies to all awards unvested or granted
      after the required effective date and to awards modified, repurchased, or
      cancelled after that date. This Statement is effective as of the beginning
      of
      the first annual period beginning after June 15, 2005. The Company adopted
      this
      Statement for the quarter beginning January 1, 2006. We believe the best
      indication of the approximate impact on net income of adopting the provisions
      of
      this revised Statement may be determined by reviewing the table provided in
      Note
      3 under the heading “Accounting for Stock-Based Compensation.” We plan to use
      the modified prospective method and, accordingly, will not be restating prior
      periods upon adoption of SFAS No. 123R.





**Reclassifications**





Certain
      prior year amounts have been reclassified to conform to the current year
      presentation.





**4. 
       INSURANCE RECOVERY**





During
      2004, the Company received an insurance recovery of approximately $0.3 million
      relating to the lost margin on product destroyed during a fire at the Company’s
      third-party warehouse in the United Kingdom in October 2003. The insurance
      recovery is included in the Company’s cost of sales, other in the accompanying
      consolidated statement of earnings for the year ended December 31,
      2004.





**5. 
       BUSINESS SEGMENTS**





The
      Company is a leading designer, producer and marketer of innovative, high-quality
      toys, collectibles, hobby and infant care products targeted to consumers of
      all
      ages.





The
      Company’s reportable segments under SFAS No. 131, “Disclosure About Segments of
      an Enterprise and Related Information,” are North America and International. The
      North America segment includes the United States, Canada and Mexico. The
      International segment includes non-North America markets.





Segment
      performance is measured at the operating income level. Segment assets are
      comprised of all assets, net of applicable reserves and allowances.





F-17


Results
      are not necessarily those that would be achieved if each segment were an
      unaffiliated business enterprise. Information by segment and a reconciliation
      to
      reported amounts for the years ended December 31, 2003, 2004 and 2005 are as
      follows:





**Year
                Ended December 31,**(In
                thousands)
            
            **2003**
            
            **2004**
            
            **2005**Net
                sales:North
                America
            
            $
            276,893
            
            $
            331,707
            
            $
            434,057International
            
            
            46,479
            
            
            50,759
            
            
            71,699Sales
                and transfers between segments
            
            
            (12,426
            )
            
            (1,041
            )
            
            (1,311
            )Combined
                total
            
            $
            310,946
            
            $
            381,425
            
            $
            504,445Operating
                income:North
                America
            
            $
            50,959
            
            $
            49,595
            
            $
            74,287International
            
            
            6,255
            
            
            7,656
            
            
            16,365Combined
                total
            
            $
            57,214
            
            $
            57,251
            
            $
            90,652Depreciation
                and amortization:North
                America
            
            $
            10,497
            
            $
            13,554
            
            $
            14,376International
            
            
            1,483
            
            
            1,849
            
            
            1,483Combined
                total
            
            $
            11,980
            
            $
            15,403
            
            $
            15,859Capital
                expenditures:North
                America
            
            $
            7,478
            
            $
            14,232
            
            $
            13,113International
            
            
            3,274
            
            
            860
            
            
            1,046Combined
                total
            
            $
            10,752
            
            $
            15,092
            
            $
            14,159





**December
                31,****2004**
            
            **2005**Total
                assets:North
                America
            
            $
            525,526
            
            $
            558,452International
            
            
            60,222
            
            
            71,284Combined
                total
            
            $
            585,748
            
            $
            629,736





Certain
      assets and resources are jointly used between the North America and
      International segments. Intercompany allocations of such uses are not
      made.





Under
      the
      enterprise-wide disclosure requirements of SFAS No. 131, the Company reports
      net
      sales by product category and by distribution channel. The Company groups its
      products into three product categories:  infant products, children’s toys
      and collectible products. This presentation is consistent with how the Company
      views its business. Amounts for the years ended December 31, 2003, 2004 and
      2005, are as shown in the tables below.





**Year
                Ended December 31,**(In
                thousands)
            
            **2003**
            
            **2004**
            
            **2005**Children’s
                toys
            
            $
            128,715
            
            $
            166,406
            
            $
            220,818Infant
                    products
            
            
            18,876
            
            
            60,181
            
            
            160,165Collectible
                products
            
            
            163,355
            
            
            154,838
            
            
            123,462Net
                sales
            
            $
            310,946
            
            $
            381,425
            
            $
            504,445Chain
                retailers
            
            $
            151,883
            
            $
            199,637
            
            $
            314,469Specialty
                and hobby wholesalers and retailers
            
            
            91,721
            
            
            116,519
            
            
            128,504OEM
                dealers
            
            
            38,613
            
            
            37,810
            
            
            40,651Corporate
                promotional
            
            
            17,842
            
            
            18,216
            
            
            18,331Direct
                to consumers
            
            
            10,887
            
            
            9,243
            
            
            2,490Net
                sales
            
            $
            310,946
            
            $
            381,425
            
            $
            504,445




F-18


**6.  
      INCOME TAXES**





For
      financial reporting purposes, income before income taxes includes the following
      components:





**Year
                Ended December 31,**(In
                thousands)
            
            **2003**
            
            **2004**
            
            **2005**Income
                before income taxes:United
                States
            
            $
            47,755
            
            $
            47,072
            
            $
            70,402Foreign
            
            
            6,127
            
            
            6,624
            
            
            14,121$
            53,882
            
            $
            53,696
            
            $
            84,523





The
      significant components of income tax expense are as follows:





**Year
                Ended December 31,**(In
                thousands)
            
            **2003**
            
            **2004**
            
            **2005**CurrentFederal
            
            $
            10,615
            
            $
            8,350
            
            $
            24,831State
            
            
            2,506
            
            
            1,462
            
            
            1,170Foreign
            
            
            468
            
            
            1,520
            
            
            3,54513,589
            
            
            11,332
            
            
            29,546DeferredFederal
            
            
            2,480
            
            
            8,151
            
            
            217State
            
            
            (1,022
            )
            
            363
            
            
            1,356Foreign
            
            
            418
            
            
            (128
            )
            
            2741,876
            
            
            8,386
            
            
            1,847Income
                tax expense
            
            $
            15,465
            
            $
            19,718
            
            $
            31,393





During
      2003, the Company recorded a reduction in the income tax provision of
      approximately $1.6 million primarily related to the realization of tax benefits
      attributable to foreign net operating losses and a reduction of approximately
      $1.8 million related to the reduction in income tax accruals based on the
      completion of IRS audits for the fiscal years 1998 through 2000.





A
      reconciliation of the U.S. statutory federal tax rate and actual effective
      income tax rate is as follows:





**Year
                Ended December 31,****2003**
            
            **2004**
            
            **2005**U.S.
                statutory rate
            
            
            35.0
            %
            
            35.0
            %
            
            35.0
            %State
                taxes, net of federal benefit
            
            
            0.7
            
            
            2.1
            
            
            1.9Foreign
            
            
            (2.5
            )
            
            (1.1
            )
            
            —Foreign
                dividend impact
            
            
            —
            
            
            —
            
            
            0.6Other
            
            
            (4.5
            )
            
            0.7
            
            
            (0.4
            )Effective
                rate
            
            
            28.7
            %
            
            36.7
            %
            
            37.1
            %




F-19


The
      significant components of deferred tax assets and liabilities are as
      follows:





**December
                31,**(In
                thousands)
            
            **2004**
            
            **2005**Deferred
                tax assets attributable toBad
                debt allowance
            
            $
            961
            
            $
            881Inventory
            
            
            3,332
            
            
            2,500Sales
                allowance
            
            
            2,936
            
            
            4,391Net
                operating loss carry-forwards
            
            
            978
            
            
            193Accrued
                expenses
            
            
            1,849
            
            
            1,501Purchase
                accounting
            
            
            1,857
            
            
            950Other
            
            
            (352
            )
            
            1,746Total
                deferred tax assets
            
            
            11,561
            
            
            12,162Deferred
                tax liabilities attributable toGoodwill
                and intangible assets
            
            
            (30,205
            )
            
            (48,196
            )Property
                and equipment
            
            
            (4,809
            )
            
            (3,716
            )Other
            
            
            (1,012
            )
            
            (846
            )Total
                deferred tax liabilities
            
            
            (36,026
            )
            
            (52,758
            )Net
                deferred tax liability
            
            $
            (24,465
            )
            $
            (40,596
            )





Current
      deferred income taxes are presented with net prepaid taxes in the accompanying
      consolidated balance sheet at December 31, 2004. Net prepaid (payable) taxes
      at
      December 31, 2004 and 2005, were $1.1 million and $(6.1) million, respectively.
      Taxes in the amount of $2.6 million and $15.0 million were charged to goodwill
      in conjunction with the acquisitions of Playing Mantis and TFY during the years
      ended December 31, 2004 and 2005, respectively.





The
      American Jobs Creation Act of 2004 (the Act) enacted on October 22, 2004
      provides a special one-time incentive for U.S. multinational corporations to
      repatriate accumulated income earned abroad by providing an 85% exclusion from
      taxable income for certain dividends from controlled foreign corporations.
      In
      order to benefit from this incentive, the Company must reinvest the qualifying
      dividends in the U.S. under a domestic reinvestment plan approved by the Chief
      Executive Officer and Board of Directors. On December 23, 2005, after approval
      by the Company’s Chief Executive Officer and Board of Directors, the Company
      distributed $8.0 million from its United Kingdom subsidiaries and recorded
      $0.5
      million of federal and state tax expense in connection with this one-time
      repatriation. Planned uses of the repatriated funds include domestic
      expenditures relating to the compensation of U.S. employees as well as other
      permitted activities.





**7.  
      DEBT**





Upon
      the
      closing of the acquisition of TFY on September 15, 2004, the Company entered
      into a new credit facility to replace its March 4, 2003 credit facility (see
      below). The credit facility is comprised of an $85.0 million term loan and
      a
      $100.0 million revolving line of credit, both of which mature on September
      14,
      2008 with scheduled quarterly principal payments ranging from $3.8 million
      to
      $6.9 million commencing on December 31, 2004 and continuing thereafter with
      a
      final balloon payment upon maturity. A portion of the term loan has an interest
      rate of 3.45% plus applicable margin through the first three years of the
      facility. The remaining term loan and revolving line of credit bear interest,
      at
      the Company’s option, at a base rate or at a LIBOR rate plus applicable margin.
      The applicable margin is based on the Company’s ratio of consolidated debt to
      consolidated EBITDA (earnings before interest, taxes, depreciation and
      amortization) and varies between 1.00% and 1.75%. At December 31, 2005, the
      margin in effect was 1.25% for LIBOR loans. The Company is also required to
      pay
      a commitment fee of 0.30% to 0.45% per annum on the average daily unused portion
      of the revolving line of credit. Under the terms of this credit facility, the
      Company is required to comply with certain financial and non-financial
      covenants. Among other restrictions, the Company is restricted in its ability
      to
      pay dividends, incur additional debt and make acquisitions above certain
      amounts. The key financial covenants include minimum EBITDA and interest
      coverage and leverage ratios. The credit facility is secured by working capital
      assets and certain intangible assets. On December 31, 2005, the Company had
      $74.7 million outstanding on this credit facility and was in compliance with
      all
      covenants.


F-20


In
      conjunction with the new credit facility, the Company expensed approximately
      $0.5 million of deferred financing fees related to the Company’s March 2003
      credit facility in interest expense in the accompanying consolidated statement
      of earnings for the year ended December 31, 2004. In addition, the Company
      incurred approximately $1.9 million in financing fees on the new credit facility
      which is included in other non-current assets in the accompanying consolidated
      balance sheets at December 31, 2004 and 2005 and is being charged to interest
      expense through September 2008.





In
      August
      2004, the Company completed a public offering of 2,655,000 shares of common
      stock and certain selling stockholders sold 220,000 shares of common stock
      at a
      price of $31.00 per share. The Company received proceeds of $77.8 million from
      the offering, net of underwriting discount, and used $74.0 million of the
      proceeds to repay outstanding debt.





Upon
      the
      closing of the acquisition of LCI on March 4, 2003, with an effective date
      of
      February 28, 2003, the Company entered into a credit facility to replace its
      previous credit facility. This credit facility was comprised of a $60.0 million
      term loan and an $80.0 million revolving line of credit, both of which were
      to
      mature on April 30, 2006. This facility was replaced with the September 2004
      credit facility discussed above.





The
      Company’s Hong Kong subsidiary maintains a credit agreement with a bank that
      provides for a line of credit of up to $1.9 million, which is renewable annually
      on January 1. Amounts borrowed under this line of credit bear interest at the
      bank’s prime rate or prevailing funding cost, whichever is higher, and are
      cross-guaranteed by the Company. As of December 31, 2004 and 2005, there were
      no
      outstanding borrowings under this line of credit.


The
        Company’s United Kingdom subsidiary maintains a line of credit with a bank for
        $0.4 million which expires on July 31, 2006. This line of credit bears interest
        at 1.0% over the bank’s base rate, and the total amount is subject to a letter
        of guarantee given by the Company. At December 31, 2004 and 2005, there were
        no
        amounts outstanding on this line of credit.


During
      2005, the Company’s United Kingdom subsidiary entered into an
      additional line of credit with a bank for $8.0 million which expires on
      September 14, 2008. The line of credit bears interest at 1.15% over the LIBOR
      rate, and the total amount is secured by a guarantee of the Company. At December
      31, 2005, the Company had $8.0 million outstanding on this line of credit.
      The
      original borrowings under this line of credit were denominated in equal
      parts of British pounds sterling and Euros.





Non-current
      debt consists of the following:





**December
                31,**(In
                thousands)
            
            **2004**
            
            **2005**Term
                loans payable to banks, bearing interest at 3.45% and 4.22%
              as
                of December 31, 2004 and 4.70% and 5.64% as of
              December
                31, 2005, with quarterly principal payments of $3,750
              beginning
                December 31, 2004 through September 30, 2005,
              quarterly
                principal payments of $5,313 from December 31, 2005
              through
                September 30, 2007, quarterly principal payments of $6,875
              from
                December 31, 2007 through June 30, 2008
            
            $
            81,250
            
            $
            64,688U.S.
                revolving line of credit, bearing interest at 4.16% and 5.58%
              as
                of December 31, 2004 and 2005, respectively; matures on
              September
                14, 2008
            
            
            50,000
            
            
            10,000U.K.
                revolving line of credit, bearing interest at 5.77% and 3.65% as
                of
                December 31,
              2005;
                matures on September 14, 2008
            
            
            —
            
            
            7,959Less
                current maturities
            
            
            (16,563
            )
            
            (25,230
            )$
            114,687
            
            $
            57,417





F-21


**8. 
       COMMITMENTS AND CONTINGENCIES**





The
      Company markets a significant portion of its products with licenses from other
      parties. These licenses are generally limited in scope and duration and
      authorize the sales of specific licensed products on a nonexclusive basis.
      The
      Company has over 700 licenses with various vehicle and equipment manufacturers,
      race team owners, drivers, sponsors, agents and entertainment and media
      companies, generally for terms of one to three years. Many of the licenses
      include minimum guaranteed royalty payments that the Company must pay whether
      or
      not it meets specified sales targets. Aggregate future minimum guaranteed
      royalty payments are as follows:





**Year
                Ending December 31,**(In
                thousands)2006
            
            $
            9,8692007
            
            
            8,9682008
            
            
            1,0542009
            
            
            52010
                and thereafter
            
            
            —Total
            
            $
            19,896





Royalty
      expense for licenses, including guaranteed minimums, was $26.3 million, $32.0
      million and $34.5 million for 2003, 2004 and 2005, respectively.





Rental
      expense for office and warehouse space and equipment under cancelable and
      noncancelable operating leases amounted to approximately $3.6 million, $4.2
      million and $4.9 million for the years ended December 31, 2003, 2004 and 2005,
      respectively. Certain operating leases provide for scheduled increases in rental
      payments during the term of the lease or for no rent during part of the term
      of
      the lease. For these leases, the Company generally recognizes total rent expense
      on a straight-line basis over the minimum lease term. Commitments for future
      minimum lease payments for noncancelable operating leases with terms extending
      beyond one year at December 31, 2005 are as follows:





**Year
                Ending December 31,**(In
                thousands)2006
            
            $
            3,9622007
            
            
            3,2902008
            
            
            3,0132009
            
            
            2,8632010
            
            
            2,302Thereafter
            
            
            14,784Total
            
            $
            30,214





Commitments
      for future minimum payments with terms extending beyond one year at December
      31,
      2005, for noncancelable unconditional purchase obligations are as
      follows:





**Year
                Ending December 31,**(In
                thousands)2006
            
            $
            2,0502007
            
            
            6052008
            
            
            4442009
            
            
            3502010
                and thereafter
            
            
            —Total
            
            $
            3,449





Unconditional
      purchase obligations include agreements for purchases of product,
      tooling and services such as advertising and hardware and software
      maintenance agreements. Payments made and allowances given in connection with
      these cancelable and noncancelable long-term unconditional purchase
      obligations amounted to approximately $0.8 million, $0.6 million and $4.0
      million for the years ended December 31, 2003, 2004 and 2005, respectively.


F-22


In
      2004,
      the Company received approximately $1.2 million in the form of a grant and
      tax
      credits from state and local governments in exchange for agreeing to certain
      covenants, including a minimum capital investment and job creation goals
      relating to its Rochelle, Illinois distribution facility. The Company must
      employ a minimum of 50 employees in Rochelle from March 15, 2006 to December
      31,
      2008 to remain compliant with the terms of the award. Should the Company be
      unable to meet these minimum requirements, the Company may be required to
      forfeit or return a portion of benefits received.





Additionally
      in 2004, the Company received a $0.3 million forgivable loan and a 3-year
      interest free $0.1 million loan from the state of Iowa to assist in the
      expansion of the Dyersville, Iowa distribution facility in exchange for agreeing
      to certain covenants, including minimum job creation goals and wage obligations.
      The Company must employ a minimum of 92 employees at a specified rate and retain
      these employees for at least ninety days past the project completion date to
      remain compliant with the terms of the promissory note. Should the Company
      be
      unable to meet these requirements, the Company may be required to forfeit or
      return a portion of the benefits received. The total of $0.4
      million is presented in other non-current liabilities in the accompanying
      consolidated balance sheets at December 31, 2004 and 2005.





**9.  
      LEGAL PROCEEDINGS**





During
      the quarter ended December 31, 2003, Learning Curve settled the action brought
      by Playwood Toys, Inc. in the U.S. District Court for the Northern District
      of
      Illinois alleging that Learning Curve and certain of its officers and employees
      misappropriated one or more trade secrets relating to a toy wooden railroad
      track manufactured and sold by Learning Curve as Clickety Clack TrackTM. Pursuant
      to the settlement agreement, the Company, on behalf of Learning Curve, made
      a
      payment of $11.2 million to the plaintiff. The Company was entitled to
      indemnification for the settlement amount, less realizable tax benefits,
      pursuant to the merger agreement for the Company’s acquisition of Learning
      Curve, and the Company received $10.1 million from an escrow account as of
      December 31, 2003, to fund part of the settlement payment. On March 30, 2004,
      the Company made additional escrow claims of $0.3 million relating primarily
      to
      alleged breaches of Learning Curve’s representations and warranties in the
      merger agreement. On August 31, 2004, the Company increased its additional
      escrow claims to $0.5 million. The Company and representatives of the former
      Learning Curve shareholders entered into a letter agreement, dated December
      14,
      2004, which resolved all of the Company’s pending escrow claims as of the date
      of the letter agreement and the Company returned $2.8 million to the escrow
      account. The escrow amount was approximately $2.9 million at December 31, 2005.
      In February and April 2005, the Company had notified the representatives of
      the
      former Learning Curve shareholders of certain claims relating to a tax audit
      and
      other matters. Subsequent to December 31, 2005, an agreement was reached with
      the representatives of the former Learning Curve shareholders resolving all
      open
      escrow claims and disbursing all amounts in escrow other than approximately
      $0.3
      million which will remain in escrow to pay certain of the Company’s expenses to
      pursue a pending malpractice litigation claim.





The
      Company has certain contingent liabilities resulting from litigation and claims
      incident to the ordinary course of business. Management believes that the
      probable resolution of such contingencies will not materially affect the
      financial position or the results of the Company’s operations.





**10.  
      CAPITAL STOCK**





Authorized
      and outstanding shares and the par value of the Company’s voting common stock
      are as follows:





**Authorized**
              **Shares**
            **Par**
              **Value**
            **Shares
                Outstanding at**
              **December
                31, 2004**
            **Shares
                Outstanding at**
              **December
                31, 2005**Voting
                common stock
            28,000,000
            $0.01
            20,462,659
            20,717,954





During
      the year ended December 31, 2004, the Company sold 6,247 shares out of treasury
      to Company employees under the ESPP for $0.1 million.  In conjunction with
      the public offering in August 2004 discussed below, certain selling stockholders
      surrendered a total of 25,956 shares of the Company’s common stock to the
      Company as payment for the exercise price of certain options exercised as well
      as to fund withholding taxes. These shares were placed into treasury for $0.8
      million.  During the year ended December 31, 2005, the Company sold a total
      of 6,436 shares out of treasury to Company employees under the ESPP for $0.2
      million. During the fourth quarter of 2005, the Company received 5,092 shares
      in
      lieu of payment on a receivable. These shares were placed into treasury for
      $0.2
      million.  At December 31, 2005, the Company held 1,830,830 shares of its
      common stock in treasury.


F-23


In
      August
      2004, the Company completed a public offering of 2,655,000 shares of common
      stock and certain selling stockholders sold 220,000 shares of common stock
      at a
      price of $31.00 per share. The Company received proceeds of $77.8 million from
      the offering, net of underwriting discount, and used $74.0 million of the
      proceeds to repay outstanding debt. Additionally, the Company incurred $0.3
      million of costs associated with the offering and these costs have been
      reflected as a reduction of stockholders’ equity on the Company’s consolidated
      balance sheet at December 31, 2004.





As
      discussed in Note 2, the Company issued 91,388 shares of the Company’s common
      stock in June 2004 in connection with its acquisition of Playing
      Mantis.





**11.  
      STOCK OPTION PLAN**





The
      Company has an employee stock option plan for its key employees. The Company
      had
      reserved 415,041 shares of common stock for issuance under the plan. These
      options vested in equal installments over a five-year period. The options will
      expire on the earlier of the  tenth
      anniversary of the date of grant or 30 days after the date of termination of
      the
      employee’s employment with the Company. This plan is dormant, and no future
      issuances are authorized from this plan.




The
      Company maintains a stock incentive plan, under which options could be granted
      to purchase up to 2,300,000 shares of common stock to executives or key
      employees of the Company.  Some of the options that were granted vested
      immediately, and the rest vest over a five-year period. These options
      expire on thetenth
      anniversary of the date of grant or 90 days after the date of termination of
      the
      employee’s employment with the Company. Under this plan, cancelled options
      revert back into the plan and are available for future issuance. This plan
      became dormant in 2005 upon the approval of the 2005 Stock Incentive Plan,
      as
      discussed below. No future issuances are authorized from this
      plan.




The
      Company also maintains an omnibus stock plan, under which the Company had
      400,000 shares of its common stock reserved for issuance. This plan is dormant,
      and no future issuances are authorized from this plan.





During
      2005, a new stock incentive plan was approved by the Company’s stockholders.
      Under this plan, restricted stock awards or options to purchase stock may
      be granted for up to 1,200,000 shares of common stock to executives or key
      employees of the Company.  In 2005, 26,151 options to purchase shares of
      the Company's common stock were issued.  Options granted may vest
      immediately or over a five-year period. These options expire on the tenth
      anniversary of the date of grant or 90 days after the date of termination of
      the
      employee’s employment with the Company. Under this plan, cancelled options
      revert back into the plan and are available for future
      issuance.


F-24


Stock
      option activity for the Company’s stock option plans for the years ended
      December 31, 2003, 2004 and 2005, is as follows:





**Shares**
            
            **Exercise**
              **Prices**
            
            **Weighted**
              **Average**
              **Exercise**
              **Price**
            
            **Shares**
              **Available**
              **For
                Future**
              **Grants**Outstanding
                as of December 31, 2002
            
            
            1,593,255
            
            
            
            
            $
            6.17
            
            
            870,220**2003**Granted
            
            
            218,750
            
            $
            13.39-$15.10
            
            $
            13.64Exercised
            
            
            232,731
            
            $
            0.13-$15.00
            
            $
            5.96Cancelled
            
            
            4,000
            
            $
            14.05
            
            $
            14.05Outstanding
                as of December 31, 2003
            
            
            1,575,274
            
            
            
            
            $
            7.22
            
            
            655,470**2004**Granted
            
            
            346,135
            
            $
            24.78-$34.65
            
            $
            26.18Exercised
            
            
            355,382
            
            $
            0.13-$18.72
            
            $
            5.83Cancelled
            
            
            18,175
            
            $
            11.57-$14.05
            
            $
            13.18Outstanding
                as of December 31, 2004
            
            
            1,547,852
            
            
            
            
            $
            11.71
            
            
            321,135**2005**Granted
            
            
            288,242
            
            $
            29.42-$36.54
            
            $
            31.65Exercised
            
            
            253,951
            
            $
            0.13-$31.66
            
            $
            6.89Cancelled
            
            
            19,301
            
            $
            0.13-$31.27
            
            $
            13.93Outstanding
                as of December 31, 2005
            
            
            1,562,842
            
            
            
            
            $
            16.14
            
            
            1,173,849Exercisable
                as of December 31, 2005
            
            
            829,340
            
            
            
            
            $
            9.33





The
      following table summarizes information about stock options outstanding at
      December 31, 2005:





**Options
                Outstanding**
            
            **Options
                Exercisable****Range
                of**
              **Exercise
                Price**
            **Number**
              **Outstanding**
            **Weighted**
              **Average**
              **Remaining**
              **Contractual
                Life**
            **Weighted**
              **Average**
              **Exercise
                Price**
            
            **Number**
              **Exercisable**
            **Weighted**
              **Average**
              **Exercise
                Price**$ 
                1.41 to $  9.84
            640,436
            5.1
            $ 
                5.59
            
            553,436
            $ 
                5.22$10.94
                to $18.72
            305,641
            5.3
            $12.84
            
            185,591
            $12.28$24.78
                to $29.94
            300,156
            8.1
            $25.64
            
            54,512
            $25.84$31.27
                to $36.54
            316,609
            9.2
            $31.68
            
            35,801
            $32.44





**12. 
       EMPLOYEE STOCK PURCHASE PLAN**





The
      Company has an ESPP to provide employees of the Company with an opportunity
      to
      purchase common stock of the Company through accumulated payroll deductions.
      The
      plan allows eligible employees to purchase shares of the Company’s common stock
      through quarterly offering periods commencing on each January 1, April 1, July
      1
      and October 1. The option price for each share of common stock purchased equals
      90% of the last quoted sales price of a share of the Company’s common stock as
      reported by the Nasdaq National Market on the first day of the quarterly
      offering period or the last day of the quarterly offering period, whichever
      is
      lower. The Company has reserved 500,000 shares of common stock held in treasury
      for issuance under the plan. The plan will terminate on July 1, 2007, unless
      sooner terminated by the Board of Directors. In 2004, the Company sold 6,247
      shares out of treasury to Company employees under the ESPP for $0.1 million.
      In
      2005, the Company sold 6,436 shares out of treasury to Company employees under
      the ESPP for $0.2 million. In January 2006, 1,298 shares were issued out of
      treasury related to purchase rights granted on October 1,
      2005.


F-25


**13.  
      RELATED PARTY TRANSACTIONS**





The
      Company purchased approximately $8.3 million, $7.8 million and $13.5 million
      of
      product during 2003, 2004 and 2005, respectively, from a company in which a
      relative of a Company stockholder/director has ownership interests. Accounts
      payable to this company were $0.3 million and $0.5 million as of December 31,
      2004 and 2005, respectively. Additionally, in 2005, the Company began purchasing
      product from a second company in which the same individual has a partial
      ownership interest. The Company purchased approximately $5.1 million in 2005
      from this second company. Accounts payable to this second company at December
      31, 2005 were $0.1 million.





A
      director of the Company is an executive officer at a company from which we
      currently hold a license agreement.  Net sales for products under this
      license were $0.1 million for the year ended December 31, 2005.




The
      Company paid consulting fees of $37,723 during the year ended December 31,
      2004
      to a not-for-profit organization for which a Company stockholder/former
      Executive Vice President holds the positions of president, co-founder and board
      member. The Company also made charitable contributions of $50,000 and $37,500
      during the years ended December 31, 2004 and 2005, respectively, to this same
      organization.





The
      Company’s German subsidiary had sales transactions in 2003 and 2004 with a
      distributor that is owned by the former managing director of the Company’s
      German subsidiary. These sales transactions for the years ended December 31,
      2003 and 2004 were approximately $0.2 million and $0.1 million, respectively.
      This former managing director’s employment with the Company ended on August 31,
      2004, and the relationship with this distributor was terminated as of December
      31, 2004.





Rothkopf
      Enterprises, Inc., owned by a director of the Company, rented office space
      from
      the Company through April 30, 2004, for a monthly rental payment of $400. All
      rental payments were paid through that date.





The
      Company leased office and warehouse space located in Mishawaka, Indiana from
      a
      company owned by a former Executive Vice President of the Company for a monthly
      rent payment of $15,025. The lease expired on June 4, 2005 and all rental
      payments were paid through the expiration date.





**14. 
       EMPLOYEE BENEFIT PLANS**





The
      Company is self-insured on medical benefits offered to employees up to a limit
      of $0.1 million per employee or $2.0 million in aggregate. Claims are expensed
      when incurred, and a provision is recorded for claims incurred but not yet
      paid
      based on a monthly average of claims activity. The Company holds excess loss
      coverage for those amounts that exceed the self-insured limits.





The
      Company has a 401(k) savings plan. Employees meeting certain eligibility
      requirements, as defined, may contribute up to 100% of pre-tax gross wages,
      limited to a maximum annual amount as set periodically by the IRS. The Company
      makes matching contributions of 100% on the first 4% of employees’ annual wages
      and 50% on the next 6% of an employee’s annual wages. For the years ended
      December 31, 2003, 2004 and 2005, the Company contributions were approximately
      $0.4 million, $0.6 million and $1.2 million, respectively. Additionally, there
      were 401(k) plans associated with prior acquisitions to which contributions
      were
      made. All of these previous 401(k) plans were merged with the current Company
      401(k) savings plan.





Upon
      the
      acquisition of TFY in September 2004, the Company also continued The First
      Years
      Inc. and Affiliates Pension Plan through December 31, 2004. This Plan is a
      special type of qualified retirement plan commonly referred to as a money
      purchase pension plan. The Company made annual contributions at 7% of an
      employee’s total compensation plus 5.7% of an employee’s compensation in excess
      of the Social Security taxable wage base. As of January 1, 2005, this Plan
      became dormant and the Plan was amended to reflect future Company contributions
      at a rate of 0%. In February 2005, the Company made contributions under The
      First Years pension plan related to the 2004 plan year of approximately $0.9
      million.


F-26


The
      Company maintains a funded noncontributory defined benefit pension plan (the
      Plan) that covers a select group of the Company’s workforce covered by a
      collective bargaining agreement which were hired prior to January 1, 2002.
      The
      plan provides defined retirement benefits based on employees’ years of service.
      The Company uses a December 31 measurement date for this plan.





**Reconciliation
      of Beginning and End of Year Fair Value of Plan Assets and
      Obligations**





(In
                thousands)
            
            **2003**
            
            **2004**
            
            **2005****Change
                in benefit obligations**Benefit
                obligation at beginning of year
            
            $
            10,329
            
            $
            11,674
            
            $
            13,583Service
                cost
            
            
            122
            
            
            111
            
            
            108Interest
                cost
            
            
            668
            
            
            688
            
            
            768Actuarial
                loss
            
            
            926
            
            
            1,499
            
            
            558Benefits
                paid and plan expenses
            
            
            (371
            )
            
            (389
            )
            
            (418
            )Benefit
                obligation at end of year
            
            $
            11,674
            
            $
            13,583
            
            $
            14,599**Change
                in plan assets**Fair
                value of assets at beginning of year
            
            $
            7,148
            
            $
            8,877
            
            $
            10,587Actual
                return on plan assets
            
            
            1,411
            
            
            902
            
            
            606Employer
                contributions
            
            
            689
            
            
            1,197
            
            
            689Benefits
                paid and plan expenses
            
            
            (371
            )
            
            (389
            )
            
            (418
            )Fair
                value of assets at end of year
            
            $
            8,877
            
            $
            10,587
            
            $
            11,464**Reconciliation
                of funded status**Funded
                status
            
            $
            (2,797
            )
            $
            (2,996
            )
            $
            (3,135
            )Unrecognized
                net actuarial loss
            
            
            4,312
            
            
            5,594
            
            
            6,152Unrecognized
                prior service cost
            
            
            189
            
            
            171
            
            
            152Prepaid
                benefit cost
            
            $
            1,704
            
            $
            2,769
            
            $
            3,169





**Amounts
      Recognized in the Consolidated Balance Sheets**





(In
                thousands)
            
            **2003**
            
            **2004**
            
            **2005**Accrued
                benefit cost
            
            $
            (2,797
            )
            $
            (2,996
            )
            $
            (3,135
            )Intangible
                assets
            
            
            189
            
            
            171
            
            
            152Accumulated
                other comprehensive income
            
            
            4,312
            
            
            5,594
            
            
            6,152Net
                amount recognized
            
            $
            1,704
            
            $
            2,769
            
            $
            3,169Accumulated
                benefit obligation
            
            $
            11,674
            
            $
            13,583
            
            $
            14,599Fair
                value of plan assets
            
            
            8,877
            
            
            10,587
            
            
            11,464Unfunded
                accumulated benefit obligation
            
            $
            2,797
            
            $
            2,996
            
            $
            3,135





**Components
      of Net Periodic Benefit Cost**





**Year
                Ended December 31,**(In
                thousands)
            
            **2003**
            
            **2004**
            
            **2005**Service
                cost
            
            $
            122
            
            $
            111
            
            $
            108Interest
                cost
            
            
            668
            
            
            688
            
            
            768Expected
                return on plan assets
            
            
            (804
            )
            
            (866
            )
            
            (978
            )Amortization
                of prior service cost
            
            
            19
            
            
            19
            
            
            19Amortization
                of net loss
            
            
            76
            
            
            181
            
            
            372Net
                periodic benefit cost
            
            $
            81
            
            $
            133
            
            $
            289





**Additional
                information**Increase
                in minimum liability included
              in
                other comprehensive income
            
            $
            243
            
            $
            1,282
            
            $
            558




F-27




**Estimated
                Future Benefit Payments**2006
            
            $
            4762007
            
            
            4862008
            
            
            5242009
            
            
            5682010
            
            
            5912011
                to 2015
            
            $
            3,676





**Assumptions**





**2003**
            
            **2004**
            
            **2005****Weighted
                average Assumptions Used**
              **to
                Determine Benefit Obligations**
              **at
                December 31**Discount
                rate
            
            
            6.00
            %
            
            5.75
            %
            
            5.50
            %Rate
                of compensation increase
            
            
            N/A
            
            
            N/A
            
            
            N/A





**Weighted
                average Assumptions Used**
              **to
                Determine Net Periodic Benefit Cost**
              **for
                the Years Ended December 31**Discount
                rate
            
            
            6.50
            %
            
            6.00
            %
            
            5.75
            %Expected
                return on plan assets
            
            
            8.50
            %
            
            8.50
            %
            
            8.50
            %Rate
                of compensation increase
            
            
            N/A
            
            
            N/A
            
            
            N/A





**Expected
      Return on Plan Assets**





The
      Company employs a building-block approach in determining the long-term rate
      of
      return for plan assets. Historical markets are studied and long-term historical
      relationships between equities and fixed income securities are preserved
      consistent with the widely-accepted capital markets principle that assets with
      higher volatility generate a greater return over the long run. Current market
      factors such as inflation and interest rates are evaluated before long-term
      capital market assumptions are determined. The long-term portfolio return is
      established via a building-block approach with proper consideration of
      diversification and rebalancing. Peer data and historical returns are reviewed
      to check for reasonableness and appropriateness.





**Projected
      Annual Returns**





Based
      on
      the current target allocation of assets, the expected return model estimates
      a
      long-term average (50 th percentile) rate of return of 8.46% per year for the Plan, as is shown in the
      following table of projected annual returns.





**Percentile
                Returns****Time
                Period**
            **75th**
            **50th**
            **25****th**1
                year
            (0.04%)
            8.46%
            17.68%5
                years
            4.58%
            8.46%
            12.49%10
                years
            5.70%
            8.46%
            11.30%20
                years
            6.50%
            8.46%
            10.46%




F-28


**Plan
      Assets**





The
      allocation of assets between major asset categories as of December 31, 2004,
      and
      December 31, 2005, as well as the target allocation, are as
      follows:





**Percentage
                of Plan Assets**
              **at
                December 31,****Asset
                Category**
            
            **Target**
              **Allocation**
            
            **2004**
            
            **2005**Large
                cap domestic equity securities
            
            
            45
            %
            
            37
            %
            
            40
            %Mid
                cap domestic equity securities
            
            
            5
            
            
            9
            
            
            5Small
                cap domestic equity securities
            
            
            5
            
            
            7
            
            
            4International
                equity securities
            
            
            10
            
            
            12
            
            
            9Fixed
                income securities
            
            
            35
            
            
            35
            
            
            42Total
            
            
            100
            %
            
            100
            %
            
            100
            %





**Explanation
      of Investment Strategies and Policies**





The
      Company employs a total return investment approach whereby a mix of equities
      and
      fixed income investments are used to maximize the long-term return of plan
      assets for a prudent level of risk. The intent of this strategy is to minimize
      plan expenses by outperforming plan liabilities over the long run. Risk
      tolerance is established through careful consideration of plan liabilities,
      plan
      funded status and corporate financial condition.





The
      investment portfolio contains a diversified blend of equity and fixed income
      investments. Furthermore, equity investments are diversified across U.S. and
      non-U.S. stocks as well as growth, value and small and large capitalizations.
      Derivatives may be used to gain market exposure in an efficient and timely
      manner; however, derivatives may not be used to leverage the portfolio beyond
      the market value of the underlying investments. Investment risk is measured
      and
      monitored on an ongoing basis through annual liability measurements, periodic
      asset/liability studies and quarterly investment portfolio reviews.





**Employer
      Contributions**





There
      are
      no minimum required contributions to the Plan for fiscal year 2006. However,
      the
      Company may make contributions to the Plan at its discretion. These
      contributions could be influenced by pending legislation.





**15.  
      ASSETS HELD FOR SALE**





Assets
      held for sale in the amount of $4.2 million at December 31, 2004 primarily
      represent the land and building located in Avon, Massachusetts, which was
      acquired with the TFY acquisition. In 2005, the Company entered into a sales
      agreement for the land and building at this location and subsequently adjusted
      the value to the sales price, net of transaction costs, of $4.9
      million through purchase accounting. This sale was completed in 2005 and
      did not result in a gain on sale.





**16.  
      INVESTMENT IN METEOR THE MONSTER TRUCK COMPANY, LLC**





In
      July
      2005, the Company invested in Meteor The Monster Truck Company, LLC (Meteor).
      After recovery of its capital contributions and preferred returns, the Company
      will share in 7.5% of the profits and losses of Meteor. The Company has
      contributed $0.8 million to Meteor. The Company determined that the investment
      in Meteor will be accounted for using the equity method of accounting based
      on
      the Company’s ability to exercise significant influence over the operating and
      financial policies of Meteor as a result of its representation on the board
      of
      directors. The investment in Meteor of $0.7 million is included in other
      non-current assets on the accompanying consolidated balance sheet at December
      31, 2005. The decrease in the Company’s investment in Meteor of $15,667 relates
      to the recognition of its portion of Meteor’s net loss for the year ended
      December 31, 2005 and is included in selling, general and administrative
      expenses on the accompanying consolidated statement of earnings for the year
      ended December 31, 2005.


F-29


**17.  
      SALE OF PRODUCT LINE**





During
      the third quarter of 2005, the Company completed the sale of its W. Britain
      product line of collectible pewter toy soldiers and accessories for $2.9 million
      in cash. The sale resulted in a gain of $2.0 million which is included in
      operating income on the accompanying consolidated statement of earnings for
      the
      year ended December 31, 2005.





**18.  
      SUBSEQUENT EVENTS**





A
      purported class action lawsuit was filed in February 2006 in Illinois state
      court against Learning Curve International, Inc., RC2 Brands, Inc. and RC2
      Corporation in a case entitled Brady
      et al. v. Learning Curve International, Inc. et al .
      The
      lawsuit purports to include a proposed class of all purchasers of *Thomas
& Friends* Wooden Railway System trains and train accessories that were
      sold with a "lifetime guarantee." The complaint relates to a change in the
      Company's warranty policy regarding these *Thomas & Friends* products
      from a lifetime guarantee to a limited warranty for 90 days after the date
      of
      purchase, and alleges that this warranty change constituted a breach of express
      warranty, consumer fraud and deceptive business practices, and unjust
      enrichment. The plaintiffs seek actual damages, attorneys' fees, and injunctive
      relief. We dispute these claims and intend to vigorously defend our position,
      although no assurance can be given as to the outcome of this
      matter.


On
        January 27, 2006, the Company announced a voluntary recall of six different
        styles of liquid-filled teethers sold by The First Years Inc. due to possible
        bacterial contamination. Consumers who return a teether covered by the recall
        will receive a replacement teether and a free gift. The Company has not yet
        determined the amount of any expenses it may incur relating to this
        recall.  However, management currently believes that the total amount will
        not materially affect the Company's financial position or the results of
        the
        Company's operations.




F-30