UNITED STATES

SECURITIES AND EXCHANGE COMMISSION

Washington, D.C. 20549

 

**FORM 10-Q**

 

| x | **QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d)                            OF THE SECURITIES EXCHANGE ACT OF 1934** |
|---|------------------------------------------------------------------------------------------------------------------------|

|   | **For the quarterly period ended June 30,                            2008** |
|--------|-----------------------------------------------------------------------------|

 

| **Commission file number                            0-28572**.                      |
|-------------------------------------------------------------------------------------|
|                                                                                |
|                                                                                |
| **OPTIMAL                            GROUP INC.**                                   |
| (Exact name                            of registrant as specified in its charter)   |
|                                                                                |   |
|                                                                                |   |
| **Canada**                                                                          | **98-0160833** |
| (State or                            other jurisdiction                             | (I.R.S.                            Employer |
| of                            incorporation or organization)                        | Identification No.) |
|                                                                                |   |
|                                                                                |   |
| **3500 de                            Maisonneuve Blvd. West, Suite 800,**           | **(514)                            738-8885** |
| **Montreal, Quebec, Canada, H3Z 3C1**                                               |   |
| (Address of                            principal executive offices and postal code) | (Registrant                            telephone number, including area code) |
|                                                                                |   |
|                                                                                |

 

 

| 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.                      | YesxNoo                                                                  |                   |
|-----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|--------------------------------------------------------------------------|------------------------|
|                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                  |                                                                     |                   |
| Indicate by check mark                            whether the registrant is a large accelerated filer, an accelerated                            filer, a non-accelerated filer, or a smaller reporting company. See the                            definitions of “large accelerated filer”,                            “accelerated filer” and “smaller reporting                            company” in Rule 12b-2 of the Exchange Act (Check                            one): |                                                                     |
|                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                  |                                                                     |                   |   |   |
| Large                            Accelerated filero                                                                                                                                                                                                                                                                                                                                                                                                                                                                   | Accelerated                            filerx                            | Non-accelerated filero | Smaller                            reporting companyo |   |
|                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                        | (Do not                            check if a smaller reporting company) |                   |
|                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                  |                                                                     |                   |
| Indicate by check mark whether the registrant is a shell                            company (as defined in Rule 12b-2 of the Securities Exchange Act of                            1934).                                                                                                                                                                                                                                                                                                                             | YesoNox                                                                  |                   |
|                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                  |                                                                     |                   |
| At August 1, 2008, the                            registrant had 25,829,090 common shares designated as Class                            “A” shares (without nominal or par value)                            outstanding.

                                                                                                                                                                                                                                                                         |                                                                     |
|                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                       |                                                                          |                        |  |  |  |  |

 

1

 

 

----

 

**OPTIMAL GROUP INC.**

 

**PART I. FINANCIAL INFORMATION**

 

**Item 1. Financial Statements**

 

             

             

             

             

             

             

Consolidated Financial Statements of

(Unaudited)

             

**OPTIMAL GROUP INC.**

             

Periods ended June 30, 2008 and 2007

(expressed in U.S. dollars)

             

             

 

2

 

 

----

**OPTIMAL GROUP INC.**

Consolidated Financial Statements

(Unaudited)

             

Periods ended June 30, 2008 and 2007

(expressed in U.S. dollars)

 

**Financial Statements**

|   | Consolidated Balance                            Sheets | 4 |
|--------|--------------------------------------------------------|---|

|   | Consolidated Statements of                            Operations and Comprehensive Loss | 5 |
|--------|-----------------------------------------------------------------------------------------|---|

|   | Consolidated Statements of                            Shareholders’ Equity | 6 |
|--------|----------------------------------------------------------------------------------|---|

|   | Consolidated Statements of                            Cash Flows | 7 |
|--------|------------------------------------------------------------------|---|

|   | Notes to Consolidated                            Financial Statements | 8 |
|--------|-----------------------------------------------------------------------|---|

             

             

                3

 

             

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| **OPTIMAL GROUP INC.**                                                                            |   |                                      |                                          |          |
|---------------------------------------------------------------------------------------------------|--------|-------------------------------------------|-----------------------------------------------|---------------|
| Consolidated Balance Sheets                                                                       |   |                                      |                                          |          |
| (Unaudited)                                                                                       |   |                                      |                                          |          |
|                                                                                              |   |                                      |                                          |          |
| June                            30, 2008 and December 31, 2007                                    |   |                                      |                                          |          |
| (expressed in thousands of U.S. dollars)                                                          |   |                                      |                                          |          |
|                                                                                              |   |                                      |                                          |          |
|                                                                                              |   | June                            30,  | December                            31,  |
|                                                                                              |   | 2008                                 |                                          | 2007     |
| Assets                                                                                            |   |                                      |                                          |          |
| Current assets:                                                                                   |   |                                      |                                          |          |
| Cash                            and cash equivalents                                              | $      | 51,000                               | $                                             | 47,193   |
| Cash                            held as reserves                                                  |   | 5,768                                |                                          | 6,869    |
| Short-term investments                                                                            |   | 2,383                                |                                          | 12,477   |
| Short-term investments held as reserves                                                           |   | 1,795                                |                                          | 1,710    |
| Settlement assets                                                                                 |   | 1,402                                |                                          | 4,715    |
| Accounts and other receivables                                                                    |   | 19,367                               |                                          | 18,513   |
| Inventories                                                                                       |   | 15,954                               |                                          | 3,103    |
| Income taxes receivable and refundable investment tax                            credits          |   | 576                                  |                                          | 4,169    |
| Prepaid expenses and deposits                                                                     |   | 1,403                                |                                          | 1,958    |
| Future income taxes                                                                               |   | 876                                  |                                          | 714      |
|                                                                                              |   |                                      | 100,524                                  |          | 101,421  |
|                                                                                              |   |                                      |                                          |          |
| Restricted cash (note 7 (a))                                                                      |   | 19,183                               |                                          | 19,183   |
| Property and equipment                                                                            |   | 5,597                                |                                          | 4,670    |
| Goodwill                                                                                          |   | 36,026                               |                                          | 66,210   |
| Intangible assets                                                                                 |   | 77,817                               |                                          | 86,858   |
| Future income taxes                                                                               |   | –                    |                                          | 6,200    |
| Other asset                                                                                       |   | –                    |                                          | 5,739    |
|                                                                                              |   |                                      |                                          |          |
|                                                                                              | $      | 239,147                              | $                                             | 290,281  |
| Liabilities and Shareholders' Equity                                                              |   |                                      |                                          |          |
| Current liabilities:                                                                              |   |                                      |                                          |          |
| Accounts payable and accrued liabilities                                                          | $      | 52,978                               | $                                             | 47,083   |
| Customer reserves and security deposits                                                           |   | 19,233                               |                                          | 21,324   |
| Income taxes payable                                                                              |   | 7,681                                |                                          | 7,251    |
| Future income taxes                                                                               |   | 1,124                                |                                          | 1,270    |
|                                                                                              |   |                                      | 81,016                                   |          | 76,928  |
|                                                                                              |   |                                      |                                          |          |
| Future income taxes                                                                               |   | 10,886                               |                                          | 11,648   |
|                                                                                              |   |                                      |                                          |          |
| Shareholders' equity:                                                                             |   |                                      |                                          |          |
| Share capital                                                                                     |   | 210,741                              |                                          | 211,998  |
| Warrants                                                                                          |   | 2,696                                |                                          | 2,696    |
| Additional paid-in capital                                                                        |   | 32,798                               |                                          | 29,561   |
| Deficit                                                                                           |   | (97,506)                                  |                                          | (41,066)      |
| Accumulated other comprehensive loss                                                              |   | (1,484)                                   |                                          | (1,484)       |
|                                                                                              |   |                                      | 147,245                                  |          | 201,705  |
| Contingencies (note 7)

Subsequent event (note 17)

                                         |   |                                      |                                          |          |
|                                                                                              | $      | 239,147                              | $                                             | 290,281  |
|                                                                                              |
|                                                                                              |
| See accompanying notes                            to unaudited consolidated financial statements. |
|                                                                                                   |        |                                           |                                               |               |  |

             

4

 

 

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| **OPTIMAL GROUP INC.**                                                                                        |                        |
|---------------------------------------------------------------------------------------------------------------|-----------------------------|
| Consolidated Statements of Operations and Comprehensive                            Loss                       |                        |
| (Unaudited)                                                                                                   |                        |
|                                                                                                          |                        |
| Periods ended June 30, 2008 and 2007                                                                          |                        |
| (expressed in thousands of U.S. dollars, except per                            share amounts)                 |                        |
|                                                                                                          |
|                                                                                                          | Three months ended June 30, | Six months ended June 30, |
|                                                                                                          | 2008                   | 2007  | 2008  | 2007  |
|                                                                                                          |                        |   |   |   |   |   |   |   |
| Revenues                                                                                                      | $                           | 41,578  | $ | 28,042  | $ | 72,829  | $ | 58,108  |
|                                                                                                          |                        |   |   |   |   |   |   |   |
| Expenses:                                                                                                     |                        |   |   |   |   |   |   |   |
| Transaction processing and cost of sales                                                                      |                        | 26,668  |   | 18,096  |   | 46,063  |   | 36,769  |
| Selling, general and administrative                                                                           |                        | 13,705  |   | 5,803  |   | 26,285  |   | 13,474  |
| Amortization of intangibles pertaining to transaction                            processing and cost of sales |                        | 4,832  |   | 3,227  |   | 9,596  |   | 6,336  |
| Amortization of equipment pertaining to cost of                            sales                              |                        | 832  |   | -    |   | 1,661  |   | –    |
| Amortization of equipment pertaining to selling, general                            and administrative        |                        | 337  |   | 316  |   | 642  |   | 650  |
| Stock-based compensation pertaining to selling, general                            and administrative         |                        | 1,880  |   | 30  |   | 2,451  |   | 6,027  |
| Research and development                                                                                      |                        | 1,155  |   | 601  |   | 2,750  |   | 1,264  |
| Operating leases                                                                                              |                        | 540  |   | 282  |   | 960  |   | 514  |
| Impairment of goodwill (note 4)                                                                               |                        | 29,097  |   | -    |   | 29,097  |   | -    |
|                                                                                                          |                        |   |   |   |   |   |   |   |
|  

Loss before undernoted item                                                                           |                        | (37,468) |   | (313) |   | (46,676) |   | (6,926) |
|                                                                                                          |                        |   |   |   |   |   |   |   |
| Investment income                                                                                             |                        | 243  |   | 1,576  |   | 689  |   | 3,477  |
|                                                                                                          |                        |   |   |   |   |   |   |   |
| (Loss) earnings before income tax provision and                            non-controlling interest           |                        | (37,225) |   | 1,263  |   | (45,987) |   | (3,449) |
|                                                                                                          |                        |   |   |   |   |   |   |   |
| Income tax provision                                                                                          |                        | 11,169  |   | 106  |   | 10,453  |   | 887  |
|                                                                                                          |                        |   |   |   |   |   |   |   |
| (Loss) earnings before non-controlling                            interest                                    |                        | (48,394) |   | 1,157  |   | (56,440) |   | (4,336) |
|                                                                                                          |                        |   |   |   |   |   |   |   |
| Non-controlling interest                                                                                      |                        | -    |   | -    |   | -    |   | (159) |
|                                                                                                          |                        |   |   |   |   |   |   |   |
| Net (loss) earnings and comprehensive (loss)                            income                                | $                           | (48,394) | $ | 1,157  | $ | (56,440) | $ | (4,495) |
|                                                                                                          |                        |   |   |   |   |   |   |   |
| Weighted average number of shares:                                                                            |                        |   |   |   |   |   |   |   |
| Basic                                                                                                         |                        | 25,852,211  |   | 23,854,507  |   | 25,910,169  |   | 23,853,710  |
| Plus impact of stock options and warrants                                                                     |                        | -    |   | 542,407  |   | -    |   | 617,135  |
|                                                                                                          |                        |   |   |   |   |   |   |   |
| Diluted                                                                                                       |                        | 25,852,211  |   | 24,396,914  |   | 25,910,169  |   | 24,470,845  |
|                                                                                                          |                        |   |   |   |   |   |   |   |
| Earnings (loss) per share:                                                                                    |                        |   |   |   |   |   |   |   |
| Basic                                                                                                         | $                           | (1.87) | $ | 0.05  | $ | (2.18) | $ | (0.19) |
| Diluted                                                                                                       |                        | (1.87) |   | 0.05  |   | (2.18) |   | (0.19) |
|                                                                                                          |                        |   |   |   |   |   |   |   |
|                                                                                                          |
|                                                                                                          |
| See accompanying notes to unaudited consolidated                            financial statements.             |
|                                                                                                               |                             |  |  |  |  |  |  |  |  |

 

 

5

 

 

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| **OPTIMAL GROUP INC.**                                                           |
|----------------------------------------------------------------------------------|
| Consolidated Statements of Shareholders’                            Equity |
| (Unaudited)                                                                      |
|                                                                             |
| Periods ended June 30, 2008 and 2007                                             |
|                                                                             | (expressed in thousands of U.S. dollars) |
|                                                                                  |  |

 

|                                                                                         |                                 |   |                          |      |                          |   |                          |   |                          |   | Accu-                    |   |                      |
|----------------------------------------------------------------------------------------------|--------------------------------------|--------|-------------------------------|-----------|-------------------------------|--------|-------------------------------|--------|-------------------------------|--------|-------------------------------|--------|---------------------------|
|                                                                                         |                                 |   |                          |      |                          |   |                          |   |                          |   | mulated                  |   |                      |
|                                                                                         |                                 |   |                          |      |                          |   | Addi-                    |   |                          |   | other                    |   |                      |
|                                                                                         |                                 |   |                          |      |                          |   | tional                   |   |                          |   | compre-                  |   |                      |
|                                                                                         | Class “A” shares         |   |                          |      | paid-in                  |   |                          |   | hensive                  |   |                          |
|                                                                                         | Number      |   | Dollars                  |      | Warrants                 |   | capital                  |   | Deficit                  |   | loss                     |   | Total                |
|                                                                                         |                                 |   |                          |      |                          |   |                          |   |                          |   |                          |   |                      |
| Balance, December 31, 2007                                                                   | 25,983,148                      | $      | 211,998                  |  

$ |  

2,696            | $      | 29,561                   | $      | (41,066)                      | $      | (1,484)                       | $      | 201,705              |
|                                                                                         |                                 |   |                          |      |                          |   |                          |   |                          |   |                          |   |                      |
| Cancellation of shares pursuant to stock buyback program                            (note 5) | (154,058)                            |   | (1,257)                       |      | **–**    |   | 786                      |   | **–**    |   | **–**    |   | (471)                     |
|                                                                                         |                                 |   |                          |      |                          |   |                          |   |                          |   |                          |   |                      |
| Stock-based compensation (note 8)                                                       | **–**           |   | **–**    |      | **–**    |   | 2,451                    |   | **–**    |   | **–**    |   | 2,451                |
|                                                                                         |                                 |   |                          |      |                          |   |                          |   |                          |   |                          |   |                      |
| Net loss                                                                                     | **–**           |   | **–**    |      | **–**    |   | **–**    |   | (56,440)                      |   | **–**    |   | (56,440)                  |
|                                                                                         |                                 |   |                          |      |                          |   |                          |   |                          |   |                          |   |                      |
| Balance, June 30, 2008                                                                       | 25,829,090                      | $      | 210,741                  |  

$ |  

2,696            | $      | 32,798                   | $      | (97,506)                      | $      | (1,484)                       | $      | 147,245              |
|  

                                                                                |                                 |   |                          |      |                          |   |                          |   |                          |   |                          |   |                      |
| Balance, December 31, 2006                                                                   | 23,849,090                      | $      | 202,252                  |  

$ | **–**    | $      | 23,169                   | $      | (4,555)                       | $      | (1,484)                       | $      | 219,382              |
|                                                                                         |                                 |   |                          |      |                          |   |                          |   |                          |   |                          |   |                      |
| Exercise of stock options:                                                                   |                                 |   |                          |      |                          |   |                          |   |                          |   |                          |   |                      |
| Cash proceeds                                                                                | 10,708                          |   | 52                       |      | **–**    |   | –        |   | –        |   | –        |   | 52                   |
| Ascribed value                                                                               | –               |   | 55                       |      | **–**    |   | (55)                          |   | –        |   | –        |   | –    |
|                                                                                         |                                 |   |                          |      |                          |   |                          |   |                          |   |                          |   |                      |
| Stock-based compensation (note 8)                                                            | –               |   | –        |      | **–**    |   | 6,027                    |   | –        |   | –        |   | 6,027                |
|                                                                                         |                                 |   |                          |      |                          |   |                          |   |                          |   |                          |   |                      |
| Net loss                                                                                     | –               |   | –        |      | **–**    |   | –        |   | (4,495)                       |   | –        |   | (4,495)                   |
|                                                                                         |                                 |   |                          |      |                          |   |                          |   |                          |   |                          |   |                      |
| Balance, June 30, 2007                                                                       | 23,859,798                      | $      | 202,359                  |  

$ | **–**    | $      | 29,141                   | $      | (9,050)                       | $      | (1,484)                       | $      | 220,966              |

|                                                                                              |
|---------------------------------------------------------------------------------------------------|
|                                                                                              |
| See accompanying notes to unaudited consolidated                            financial statements. |

             

 

6

 

 

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| **OPTIMAL GROUP INC.**                                                                                    |
|-----------------------------------------------------------------------------------------------------------|
| Consolidated Statements of Cash Flows                                                                     |
| (Unaudited)                                                                                               |
|                                                                                                      |
| Periods ended June 30, 2008 and 2007                                                                      |
| (expressed in thousands of U.S. dollars)                                                                  |
|                                                                                                      |
|                                                                                                      | Three months ended

June 30, | Six months ended

June 30, |
|                                                                                                      |   | 2008  |   | 2007  |   | 2008  |   | 2007  |
|                                                                                                      |   |   |   |   |   |   |   |   |
| Cash flows from (used in) operating                            activities:                                |   |   |   |   |   |   |   |   |
| Net (loss) earnings                                                                                       | $ | (48,394) | $ | 1,157  | $ | (56,440) | $ | (4,495) |
| Adjustments for items not affecting cash:                                                                 |   |   |   |   |   |   |   |   |
| Non-controlling interest                                                                                  |   | -    |   | -    |   | -    |   | 159  |
| Amortization                                                                                              |   | 6,001  |   | 3,543  |   | 11,899  |   | 6,986  |
| Gain on settlement of litigation                                                                          |   | -    |   | (1,612) |   | -    |   | (1,612) |
| Impairment of goodwill                                                                                    |   | 29,097  |   | -    |   | 29,097  |   | -    |
| Future income taxes                                                                                       |   | 11,730  |   | (421) |   | 10,637  |   | (997) |
| Stock-based compensation                                                                                  |   | 1,880  |   | 30  |   | 2,451  |   | 6,027  |
| Foreign exchange                                                                                          |   | (15) |   | (108) |   | (21) |   | (138) |
| Net change in operating assets and liabilities (note                            11 (a))              |   | 2,877  |   | (22,295) |   | (418) |   | (45,584) |
|                                                                                                      |   |   | 3,176  |   | (19,706) |   | (2,795) |   | (39,654) |
|                                                                                                      |   |   |   |   |   |   |   |   |
| Cash flows from (used in) financing                            activities:                                |   |   |   |   |   |   |   |   |
| Repurchase of Class "A" shares                                                                            |   | (148) |   | -    |   | (471) |   | -    |
| Proceeds from exercise of RSUs in OPIL                                                                    |   | -    |   | -    |   | -    |   | 58  |
| Proceeds from issuance of Class "A" shares                                                                |   | -    |   | 34  |   | -    |   | 52  |
| Decrease in bank indebtedness                                                                             |   | -    |   | -    |   | -    |   | (8,581) |
|                                                                                                      |   |   | (148) |   | 34  |   | (471) |   | (8,471) |
|                                                                                                      |   |   |   |   |   |   |   |   |   |
| Cash flows from (used in) investing                            activities:                                |   |   |   |   |   |   |   |   |
| Purchase of equipment and intangible assets                                                               |   | (2,063) |   | (976) |   | (3,380) |   | (2,058) |
| Proceeds from maturity of short-term                            investments                               |   | 4,318  |   | 5,138  |   | 10,094  |   | 71,621  |
| Decrease in long-term receivables                                                                         |   | -    |   | 27  |   | 368  |   | 362  |
| Repurchase of OPIL shares                                                                                 |   | -    |   | -   |   | -    |   | (16,463) |
| Transaction costs                                                                                         |   | -    |   | (6) |   | -    |   | (1,748) |
|                                                                                                      |   |   | 2,255  |   | 4,183  |   | 7,082  |   | 51,714  |
|                                                                                                      |   |   |   |   |   |   |   |   |   |
| Effect of exchange rate changes on cash and cash                            equivalents during the period |   | 15  |   | 108  |   | (9) |   | 155  |
|                                                                                                      |   |   |   |   |   |   |   |   |
| Increase (decrease) in cash and cash                            equivalents                               |   | 5,298  |   | (15,381) |   | 3,807  |   | 3,744  |
|                                                                                                      |   |   |   |   |   |   |   |   |
| Cash and cash equivalents, beginning of                            period                                 |   | 45,702  |   | 123,047  |   | 47,193  |   | 103,922  |
|                                                                                                      |   |   |   |   |   |   |   |   |
| Cash and cash equivalents, end of period                                                                  | $ | 51,000  | $ | 107,666  | $ | 51,000  | $ | 107,666  |
|                                                                                                      |
| Supplemental cash flow information (note 11)                                                              |
|                                                                                                      |
| See accompanying notes to unaudited consolidated                            financial statements.         |
|                                                                                                           |  |  |  |  |  |  |  |  |  |  |  |

 

7

 

 

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| **OPTIMAL GROUP INC.**                                                                                  |
|---------------------------------------------------------------------------------------------------------|
| Notes to Consolidated Financial Statements                                                              |
| (Unaudited)                                                                                             |
|                                                                                                    |
| Periods ended June 30, 2008 and 2007                                                                    |
| (expressed in thousands of U.S. dollars, except share                            and per share amounts) |
|                                                                                                    |

             

| **1.** | **Nature of operations:** |
|--------|---------------------------|

These consolidated financial statements have been prepared by management            in accordance with Canadian generally accepted accounting principles            (“GAAP”). The unaudited consolidated balance sheet as at June 30, 2008, the            unaudited consolidated statements of operations and comprehensive loss and cash flows            for the periods ended June 30, 2008 and 2007 and the unaudited consolidated statements            of shareholders’ equity for the periods ended June 30, 2008 and 2007 reflect all            adjustments which, in the opinion of management, are necessary to present a fair            statement of the results of the interim periods. These interim consolidated financial            statements follow the same accounting policies and methods of their application as            described in note 4 to the annual audited consolidated financial statements for            the year ended December 31, 2007, except as described in note 2 below. The            interim consolidated financial statements do not include all disclosures required for            annual financial statements and should be read in conjunction with the most recent            annual audited consolidated financial statements of Optimal Group Inc. (“the            Company”) as at and for the year ended December 31, 2007.

The Company’s revenues and expenses are subject to seasonal            variations. The results of operations and cash flows for any quarter are not            necessarily indicative of the results or cash flows for an entire year.

All amounts in the attached notes are unaudited unless otherwise            specifically identified.

             

| **2.** | **Changes in accounting policies:** |
|--------|-------------------------------------|

|   | (a) | New accounting policies: |
|--------|-----|--------------------------|

Effective January 1, 2008, the Company adopted the Canadian Institute of            Chartered Accountants ("CICA") Handbook Section 1535,*Capital            Disclosures*, CICA Handbook Section 3862,*Financial Instruments - Disclosure*, and            CICA Handbook Section 3863,*Financial Instruments -            Presentation.*The sectionsrelate to disclosure and            presentation only and did not have an impact on the Company’s financial results            (refer to notes 12 and 13).

Effective January 1, 2008, the Company also adopted CICA Handbook            Section 3031,*Inventories*, which            replaces Section 3030 and harmonizes the Canadian standards related to inventories with            International Financial Reporting Standards ("IFRS"). This section provides changes to            the measurement and more extensive guidance on the determination of cost, including            allocation of overhead; narrows the permitted cost formulas; and expands the disclosure            requirements to increase transparency. The adoption of this standard did not have a            significant impact on the consolidated financial statements.

Inventories are measured at the lower of cost and net realizable value.            At June 30, 2008, inventories consist of raw materials of $15,369 and finished goods of            $585.

             

 

8

 

 

----

             

| **OPTIMAL GROUP INC.**                                                                                  |
|---------------------------------------------------------------------------------------------------------|
| Notes to Consolidated Financial Statements,                            Continued                        |
| (Unaudited)                                                                                             |
|                                                                                                    |
| Periods ended June 30, 2008 and 2007                                                                    |
| (expressed in thousands of U.S. dollars, except share                            and per share amounts) |
|                                                                                                    |

| **2.** | **Changes in accounting policies                            (continued):** |
|--------|----------------------------------------------------------------------------|

|   | (b) | Future accounting policies: |
|--------|-----|-----------------------------|

In February 2008, the CICA issued Section 3064,*Goodwill and Intangible Assets*, which will            replace Section 3062,*Goodwill and Other Intangible            Assets,*and Section 3450,*Research            and Development Costs*. The standard provides guidance on the            recognition of intangible assets in accordance with the definition of an asset and the            criteria for asset recognition, as well as clarifying the application of the concept of            matching revenues and expenses, whether these assets are separately acquired or            internally developed. This standard applies to interim and annual financial statements            relating to fiscal years beginning on or after October 1, 2008. The adoption of this            standard is not expected to have a significant impact on the Company’s financial            results.

In 2005, the Accounting Standards Board of Canada announced that            accounting standards in Canada are to converge with International Financial Reporting            Standards ("IFRS"). In February 2008, the CICA confirmed the change over date from            current Canadian GAAP to IFRS to be January 1, 2011. While IFRS uses a conceptual            framework similar to Canadian GAAP, there are significant differences in accounting            policies which must be addressed. The Company has not yet fully assessed the future            impact of these new standards on the consolidated financial statements.

             

| **3.** | **Business acquisitions 2007:** |
|--------|---------------------------------|

|   | (a) | Optimal Acquisition Inc.: |
|--------|-----|---------------------------|

On February 23, 2007, Optimal Acquisition Inc. completed the acquisition            of all of the outstanding shares held by non-controlling shareholders of Optimal            Payments (Ireland) Limited for $16,463, which as of that date became a wholly-owned            subsidiary of the Company. As a result of the acquisition, non-controlling interest is            no longer recorded in the consolidated financial statements. The transaction was            accounted for using the purchase method.

|   | (b) | Wow Wee Limited: |
|--------|-----|------------------|

On November 7, 2007, the Company completed its previously announced            acquisition of substantially all of the assets of Wow Wee Limited, a privately-held            Hong Kong-based developer, marketer and supplier of technology-based, consumer robotic,            toy and entertainment products, as well as substantially all of the assets of WowWee            Marketing, Inc., with offices in California, and Wow Wee Group Company, with            offices in Canada (collectively, “WowWee”). WowWee Marketing, Inc. and Wow            Wee Group Company were service providers to Wow Wee Limited in the operation of            its business. The Company believes that the acquisition will provide the WowWee            business with greater financial and operational resources to grow both in North America            and internationally, and that the Company will be able to build upon the existing            consumer-focused franchise of the business, by capitalizing on its corporate brands            through the development of a cross-platform entertainment media strategy.

 

9

 

 

----

| **OPTIMAL GROUP INC.**                                                                                  |
|---------------------------------------------------------------------------------------------------------|
| Notes to Consolidated Financial Statements,                            Continued                        |
| (Unaudited)                                                                                             |
|                                                                                                    |
| Periods ended June 30, 2008 and 2007                                                                    |
| (expressed in thousands of U.S. dollars, except share                            and per share amounts) |
|                                                                                                    |

| **3.** | **Business acquisitions 2007                            (continued):** |
|--------|------------------------------------------------------------------------|

|   | (b) | Wow Wee Limited (continued): |
|--------|-----|------------------------------|

The total purchase price was $60,421, consisting of a cash consideration            of $46,570, the issuance of 2,169,197 Class"A"shares with a fair value of $10,000, 820,000 warrants to purchase            820,000 Class "A"shares having an estimated fair value of $2,696 and transaction costs of            approximately $1,155. The warrants have an exercise price of $5.56 per share and are            exercisable for a period of seven years.

The acquisition was accounted for using the purchase method, and the            results of WowWee were consolidated with those of the Company from the date of            acquisition. The Company has allocated the purchase price on a preliminary basis to the            assets acquired and the liabilities assumed based on management’s best estimate            of their fair values and taking into account all relevant information available at that            time. Since the Company is still in the process of finalizing the valuation of certain            intangible assets and other assets acquired and liabilities assumed at the date of            acquisition, the allocation of the purchase price is subject to change. The Company            expects to finalize the allocation of the purchase price by the end of 2008. The            following table presents the estimated fair value of the assets purchased and            liabilities assumed from WowWee on November 7, 2007.

             

 

10

 

 

----

| **OPTIMAL GROUP INC.**                                                                                  |
|---------------------------------------------------------------------------------------------------------|
| Notes to Consolidated Financial Statements,                            Continued                        |
| (Unaudited)                                                                                             |
|                                                                                                    |
| Periods ended June 30, 2008 and 2007                                                                    |
| (expressed in thousands of U.S. dollars, except share                            and per share amounts) |
|                                                                                                    |

 

| **3.** | **Business acquisitions 2007                            (continued):** |
|--------|------------------------------------------------------------------------|

|   | (b) | Wow Wee Limited                            (continued): |
|--------|-----|---------------------------------------------------------|

 

|                          |                                     |   |
|-------------------------------|------------------------------------------|--------|
| Assets acquired:              |                                     |   |
| Cash and cash equivalents     | $                                        | 483    |
| Accounts receivable           |                                     | 9,722  |
| Inventories                   |                                     | 5,568  |
| Income tax receivable         |                                     | 2,966  |
| Prepaid expenses and deposits |                                     | 771    |
| Property and equipment        |                                     | 1,991  |
| Customer relationships        |                                     | 21,171 |
| Intellectual property         |                                     | 5,520  |
| Tradename                     |                                     | 14,797 |
| Goodwill                      |                                     | 36,028 |
|                          |                                     |   | 99,017 |
|                          |                                     |   |   |
|                          | Liabilities assumed:                     |   |   |
|                          | Accounts payable and accrued liabilities |   | 32,301 |
|                          | Future income taxes                      |   | 6,295 |
|                          |                                     |   | 38,596 |
|                          |                                     |   |   |
|                          | Net assets acquired                      | $      | 60,421 |
|                               |                                          |        |  |  |

             

| Consideration:             |   |   |
|----------------------------|--------|--------|
| Cash                       | $      | 46,570 |
| 2,169,197 Class "A" shares |   | 10,000 |
| Warrants                   |   | 2,696  |
| Transaction costs          |   | 1,155  |
|                       |   |   |
| Total purchase price       | $      | 60,421 |

             

Goodwill recorded in connection with this transaction is not expected to            be deductible for tax purposes.

The fair value of the warrants was estimated using the Black-Scholes            model using the following assumptions: exercise price $5.56, share price $5.48,            volatility 56%, risk-free rate 3.74%, and dividend yield 0%.

During the six-month period ended June 30, 2008, the Company reduced the            goodwill on acquisition by $1,085 to record fair value adjustments as at the date of            acquisition for accounts receivable ($1,427), property and equipment ($466) and            accounts payable and accrued liabilities ($124).

 

11

 

 

----

| **OPTIMAL GROUP INC.**                                                                                  |
|---------------------------------------------------------------------------------------------------------|
| Notes to Consolidated Financial Statements,                            Continued                        |
| (Unaudited)                                                                                             |
|                                                                                                    |
| Periods ended June 30, 2008 and 2007                                                                    |
| (expressed in thousands of U.S. dollars, except share                            and per share amounts) |
|                                                                                                    |

| **4.** | **Goodwill and other intangible assets:** |
|--------|-------------------------------------------|

             

| June 30, 2008                       |
|-----------------------------------------------|
|                                          | Gross  |   |   |
|                                          |   | carrying  |   | Accumulated  |   | Net book  |
|                                          |   | amount  |   | amortization  |   | value  |
|                                          |   |   |   |   |   |   |
| Goodwill                                      | $ | 36,026  | $ | –    | $ | 36,026  |
|                                          |   |   |   |   |   |   |
| Customer relationships and service agreements |   | 86,482  |   | 31,598  |   | 54,884  |
| ISO/ISA relations                             |   | 7,180  |   | 2,821  |   | 4,359  |
| Intellectual property                         |   | 5,520  |   | 1,227  |   | 4,293  |
| Tradename                                     |   | 14,798  |   | 1,972  |   | 12,826  |
| Other                                         |   | 6,688  |   | 5,233  |   | 1,455  |
|                                          |   | 120,668  |   | 42,851  |   | 77,817  |
|                                          |   |   |   |   |   |   |
|                                          | $ | 156,694  | $ | 42,851  | $ | 113,843  |

             

             

| December 31, 2007                   |
|-----------------------------------------------|
|                                          | Gross  |   |   |
|                                          |   | carrying  |   | Accumulated  |   | Net book  |
|                                          |   | amount  |   | amortization  |   | value  |
|                                          |   |   |   |   |   |   |
| Goodwill                                      | $ | 66,210  | $ | –    | $ | 66,210  |
|                                          |   |   |   |   |   |   |
| Customer relationships and service agreements |   | 86,482  |   | 25,502  |   | 60,980  |
| ISO/ISA relations                             |   | 7,180  |   | 2,308  |   | 4,872  |
| Intellectual property                         |   | 5,520  |   | 307  |   | 5,213  |
| Tradename                                     |   | 14,798  |   | 493  |   | 14,305  |
| Other                                         |   | 6,134  |   | 4,646  |   | 1,488  |
|                                          |   | 120,114  |   | 33,256  |   | 86,858  |
|                                          |   |   |   |   |   |   |
|                                          | $ | 186,324  | $ | 33,256  | $ | 153,068  |

             

At December 31, 2007, the net book value of goodwill was $66,210, of            which $37,113 related to the consumer robotic, toy and entertainment products segment            and $29,097 related to the payment processing segment. Goodwill in the payment            processing segment at December 31, 2007 was net of impairment charges of $22,552            provided for in 2007.

As discussed in note 3 (b), goodwill in the consumer robotic, toy and            entertainment products segment was reduced by $1,085 during the six-month period ended            June 30, 2008, as a result of fair value adjustments to certain assets and liabilities            at the date of acquisition.

 

12

 

 

----

| **OPTIMAL GROUP INC.**                                                                                  |
|---------------------------------------------------------------------------------------------------------|
| Notes to Consolidated Financial Statements,                            Continued                        |
| (Unaudited)                                                                                             |
|                                                                                                    |
| Periods ended June 30, 2008 and 2007                                                                    |
| (expressed in thousands of U.S. dollars, except share                            and per share amounts) |
|                                                                                                    |

 

| **4.** | **Goodwill and other intangible assets                            (continued):** |
|--------|----------------------------------------------------------------------------------|

At June 30, 2008, the Company tested goodwill for impairment in the            payment processing segment as the Company determined that there was a more likely than            not expectation that a significant portion, or this entire segment, would be sold over            the course of the next 12 months. As a result of this analysis, the goodwill in the            segment was determined to be impaired since the estimated fair value to be realized as            proceeds from transactions would be less than the carrying value of the segment            including goodwill. As a result, the Company recorded a non-cash goodwill impairment            loss of $29,097 in the second quarter of 2008 in the payment processing segment. The            balance of goodwill at June 30, 2008 relates entirely to the Company’s consumer            robotic, toy and entertainment products segment. Refer to note 17.

             

| **5.** | **Share capital:** |
|--------|--------------------|

On November 6, 2007, the Board of Directors renewed the stock buyback            program authorizing the Company to purchase up to 5% of its outstanding Class "A"            shares. The Company may purchase the Class "A" shares on the open market through the            facilities of the Nasdaq Stock Market over the course of 12 months commencing November            21, 2007 and ending November 20, 2008. All shares purchased under the stock buyback            program will be cancelled. During the six months ended June 30, 2008, 154,058 Class "A"            shares having a book value of $1,257 have been repurchased for a total consideration of            $471. The excess of the book value of the shares over the purchase price, in the amount            of $786, was added to the additional paid-in capital.

             

| **6.** | **Stock options and warrants:** |
|--------|---------------------------------|

|   | (a) | Optimal Group Inc.: |
|--------|-----|---------------------|

The Company has a stock option plan that provides for the granting of            options to employees and directors for the purchase of the Company’s Class "A"            shares to be issued from treasury. Options may be granted by the Board of Directors for            terms of up to ten years. The Board of Directors establishes the exercise period,            vesting terms and other conditions for each grant at the grant date. The maximum number            of shares that may be issued under the plan is 9,000,000. Options may be granted with            exercise prices at the then current market price.

 

13

 

 

----

| **OPTIMAL GROUP INC.**                                                                                  |
|---------------------------------------------------------------------------------------------------------|
| Notes to Consolidated Financial Statements,                            Continued                        |
| (Unaudited)                                                                                             |
|                                                                                                    |
| Periods ended June 30, 2008 and 2007                                                                    |
| (expressed in thousands of U.S. dollars, except share                            and per share amounts) |
|                                                                                                    |

 

| **6.** | **Stock options and warrants                            (continued):** |
|--------|------------------------------------------------------------------------|

|   | (a) | Optimal Group Inc.                            (continued): |
|--------|-----|------------------------------------------------------------|

Details of outstanding stock options are as follows:

             

|                                  |            |   | Weighted   |
|---------------------------------------|-----------------|--------|-----------------|
|                                  |            |   | average    |
|                                  |            |   | exercise   |
|                                  | Number of  |   | price      |
|                                  | options    |   | per share  |
|                                  |            |   |            |
| Options outstanding December 31, 2007 | 5,538,541       | $      | 6.26       |
|                                  |            |   |            |
| Expired/cancelled                     | (34,000)        |   | 6.34       |
|                                  |            |   |            |
| Options outstanding June 30, 2008     | 5,504,541       | $      | 6.26       |

During the six-month period ended June 30, 2008, no options were            granted.

As at June 30, 2008, 5,504,541 stock options could potentially dilute            basic earnings per share in the future. They were not included in the computation of            diluted earnings per share because to do so would have been anti-dilutive for the            period ended June 30, 2008.

The following table summarizes information about the options outstanding            and exercisable at June 30, 2008:

             

| Options outstanding | Options exercisable |
|---------------------|---------------------|
|                |                | Weighted |   |   |   |   |   |   |   |   |
|                |                | average |   |   |   | Weighted |   |   |   | Weighted |
|                |                | remaining |   |   |   | average |   |   |   | average |
|                |                | contractual |   |   |   | exercise |   |   |   | exercise |
| Exercise            |                | life |   |   |   | price per |   |   |   | price per |
| price/share         |                | (years) |   | Number |   | share |   | Number |   | share |
|                |                |   |   |   |   |   |   |   |   |   |
| $7.10               |                | 5.83 |   | 3,840,041 | $ | 7.10 |   | 3,840,041 | $ | 7.10 |
| $9.36               |                | 3.47 |   | 37,500 |   | 9.36 |   | 12,500 |   | 9.36 |
| $4.21               |                | 6.38 |   | 1,627,000 |   | 4.21 |   | **–**    |   | **–**    |
|                |                |   |   |   |   |   |   |   |   |   |
|                |                |   |   | 5,504,541 | $ | 6.26 |   | 3,852,541 | $ | 7.11 |

             

 

14

 

 

----

| **OPTIMAL GROUP INC.**                                                                                  |
|---------------------------------------------------------------------------------------------------------|
| Notes to Consolidated Financial Statements,                            Continued                        |
| (Unaudited)                                                                                             |
|                                                                                                    |
| Periods ended June 30, 2008 and 2007                                                                    |
| (expressed in thousands of U.S. dollars, except share                            and per share amounts) |
|                                                                                                    |

 

| **6.** | **Stock options and warrants                            (continued):** |
|--------|------------------------------------------------------------------------|

|   | (a) | Optimal Group Inc. (continued): |
|--------|-----|---------------------------------|

At June 30, 2008, there are 820,000 warrants outstanding, exercisable at            $5.56 per share. These warrants expire in November 2014 and 50% are exercisable in            November 2008 and the balance is exercisable in November 2009. All of these warrants            could potentially dilute basic earnings per share in the future. The warrants were not            included in the computation of diluted earnings per share because to do so would have            been anti-dilutive for the period ended June 30, 2008.

|   | (b) | Terra Payments Inc.: |
|--------|-----|----------------------|

Details of the stock options outstanding under the Terra Payments Inc.            plan as at June 30, 2008 are as follows:

             

| U.S. dollar exercise price   | Canadian dollar exercise price |
|----------------------------------------|--------------------------------|
|                                   |                           | Weighted average  |
|                                   |                           | Exercise price  |   | exercise price  |
|                                   | Number                    | per share  | Number  | per share  |
|                                   |                           |   |   |   |   |   |
| Balance, December 31, 2007             | 134,113                   | $ | 7.43  | 140,709  | $ | 8.26  |
|                                   |                           |   |   |   |   |   |
| Expired/cancelled                      | **–**     |   | **–**    | (18,604) |   | 4.83  |
|                                   |                           |   |   |   |   |   |
| Balance, June 30, 2008                 | 134,113                   | $ | 7.43 | 122,105 | $ | 8.78  |

             

All of these options were fully vested.

These options expire on various dates up to April 2009.

The 134,113 options outstanding with a U.S. dollar exercise price of            $7.43 have a remaining contractual life of 0.75 year as at June 30, 2008.

As at December 31, 2007, there were 21,978 warrants outstanding, which            expired in March 2008.

There are 256,218 Terra options that could potentially dilute basic            earnings per share in the future that were not included in the computation of diluted            earnings per share because to do so would have been anti-dilutive for the period ended            June 30, 2008.

             

15

 

 

----

| **OPTIMAL GROUP INC.**                                                                                  |
|---------------------------------------------------------------------------------------------------------|
| Notes to Consolidated Financial Statements,                            Continued                        |
| (Unaudited)                                                                                             |
|                                                                                                    |
| Periods ended June 30, 2008 and 2007                                                                    |
| (expressed in thousands of U.S. dollars, except share                            and per share amounts) |
|                                                                                                    |

 

| **7.** | **Contingencies:** |
|--------|--------------------|

|   | (a) | As previously announced, immediately                            following the enactment of the Unlawful Internet Gambling Enforcement                            Act of 2006 ("the Act") on October 13, 2006, the Company’s then                            majority-owned subsidiary, OPIL, ceased to process settlement                            transactions originating from United States consumers. This represented                            a substantial portion of its revenues derived from processing                            transactions from online gambling. The Company is exposed to adverse                            consequences as a result of possible enforcement proceedings,                            governmental investigations or lawsuits initiated against it in                            jurisdictions where online gambling is or becomes restricted or                            prohibited. |
|--------|-----|---------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|

Following announcements by the U.S. Attorney’s Office in the            Southern District of New York relating to its investigation of the U.S. Internet            gambling industry, the Company announced on May 8, 2007 that it has initiated            discussions with the U.S. Attorney’s Office in the Southern District of New York            and is in the process of responding to a voluntary request for information issued by            the U.S. Attorney’s Office. In connection with such ongoing investigation, the            Company announced on May 11, 2007 that it had received a copy of warrants of seizure            issued by the U.S. Attorney’s Office against funds of certain payment processors            that were on deposit with two U.S. banks. These funds included $19,183 on deposit to            the credit of Company affiliates. The total amount seized of $19,183 is presented as            restricted cash on the consolidated balance sheets. No provision has been recorded by            the Company for this matter because the outcome of these discussions and the amount of            loss, if any, are not currently determinable.

While best estimates have been used for reporting financial statement            items subject to measurement uncertainty, management considers that it is possible that            changes in future conditions in the near term could require a material change in the            recognized amounts of certain assets and liabilities. “Near term” is            considered to be within one year from the date of the financial statements.

|   | (b) | Optimal Payments Inc. has received a                            request for information from the U.S. Attorney’s office in the                            Eastern District of New York pertaining to its former involvement in                            processing transactions for Internet pharmacies. Optimal Payments Inc.                            is currently in discussions with that Office relating to those                            processing activities. No provision has been recorded by Optimal                            Payments Inc. for this matter because the outcome of these discussions                            and the amount of loss, if any, are not determinable. |
|--------|-----|-----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|

|   | (c) | The Company is party to litigation                            arising in the normal course of operations. The Company does not expect                            the resolution of such matters to have a material adverse effect on its                            financial position or results of operations. However, the results of                            legal proceedings cannot be predicted with certainty. Should the                            Company fail to prevail in any of these legal matters or should several                            legal matters be resolved against the Company in the same reporting                            period, the consolidated operating results of a particular reporting                            period could be materially adversely affected. |
|--------|-----|------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|

 

16

 

 

----

             

| **OPTIMAL GROUP INC.**                                                                                  |
|---------------------------------------------------------------------------------------------------------|
| Notes to Consolidated Financial Statements,                            Continued                        |
| (Unaudited)                                                                                             |
|                                                                                                    |
| Periods ended June 30, 2008 and 2007                                                                    |
| (expressed in thousands of U.S. dollars, except share                            and per share amounts) |
|                                                                                                    |

 

| **7.** | **Contingencies (continued):** |
|--------|--------------------------------|

|   | (d) | In the sale or other disposition of                            assets out of the ordinary course of business, in addition to possible                            indemnification relating to failure to perform covenants and breach of                            representations and warranties, the Company might agree to indemnify                            the buyer against claims from its past conduct of its business.                            Typically, the term and amount of such indemnification will be limited                            by agreement. No provision has been made in these financial statements                            with respect to this item as the Company does not expect to make any                            payments for these items and the standby liability is                            nominal. |
|--------|-----|-------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|

             

| **8.** | **Stock-based compensation:** |
|--------|-------------------------------|

Stock-based compensation expenses in the consolidated statements of            operations was comprised of:

             

|                                                                                  |   | Three months ended        |   | Six months                            ended |
|---------------------------------------------------------------------------------------|--------|---------------------------|--------|---------------------------------------------|
|                                                                                  |   | June 30,                  |   | June                            30          |
|                                                                                  |   | 2008                 |   | 2007                                   |   | 2008  |   | 2007  |
| Expense related to options granted in 2004 amended in                            2008 | $      | 1,356                     | $      | –                      | $ | 1,356 | $ | –    |
| Expense related to options granted in 2006                                            |   | 17                        |   | 30                                     |   | 73 |   | 60  |
| Expense related to options granted in 2007                                            |   | 507                       |   | –                      |   | 1,022 |   | –    |
| Expense related to OPIL restricted share unit                            plan         |   | –    |   | –                      |   | –    |   | 5,967  |
|                                                                                  |   |                      |   |                                        |   |   |   |   |
|                                                                                  | $      | 1,880                     | $      | 30                                     | $ | 2,451 | $ | 6,027  |

             

In June 2008, the shareholders approved a modification to the expiry            date of 3,840,041 options exercisable at $7.10 per share from April 29, 2009 to April            29, 2014. Since these options were vested at the date of modification, the incremental            value of $1,356 of the fair value of the modified option over the value of the old            option immediately before its terms were modified was expensed in the quarter ended            June 30, 2008.

 

17

 

 

----

| **OPTIMAL GROUP INC.**                                                                                  |
|---------------------------------------------------------------------------------------------------------|
| Notes to Consolidated Financial Statements,                            Continued                        |
| (Unaudited)                                                                                             |
|                                                                                                    |
| Periods ended June 30, 2008 and 2007                                                                    |
| (expressed in thousands of U.S. dollars, except share                            and per share amounts) |
|                                                                                                    |

             

| **9.** | **Income taxes:** |
|--------|-------------------|

The income tax provision differs from the amount computed by applying            the combined Canadian federal and Québec provincial tax rates to earnings before            income taxes. The reasons for the difference and the related tax effects are as            follows:

             

|                                                                                                 |   | Three                            months ended |   | Six months                            ended |
|------------------------------------------------------------------------------------------------------|--------|-----------------------------------------------|--------|---------------------------------------------|
|                                                                                                 |   | June                            30,           |   | June                            30          |
|                                                                                                 |   | 2008                                     |   | 2007                                   |   | 2008  |   | 2007  |
|                                                                                                 |   |                                          |   |                                        |   |   |   |   |
| (Loss) earnings before income taxes and non-controlling                            interest          | $      | (37,225)                                      | $      | 1,263                                  | $ | (45,987) | $ | (3,449) |
|                                                                                                 |   |                                          |   |                                        |   |   |   |   |
| Combined Canadian federal and provincial income taxes at                            31% (2007 - 32%) | $      | (11,502)                                      | $      | 404                                    | $ | (14,210) | $ | (1,105) |
| Foreign exchange(1)                                                                                  |   | (477)                                         |   | (1,152)                                     |   | (226) |   | (1,290) |
| Change in valuation allowance                                                                        |   | (277)                                         |   | 1,285                                  |   | 391  |   | 1,539  |
| Difference in tax rates in foreign                            jurisdictions                          |   | 323                                      |   | (280)                                       |   | 1,021  |   | (311) |
| Stock-based compensation not deductible                                                              |   | 582                                      |   | 10                                     |   | 759  |   | 1,930  |
| Impairment of goodwill not deductible                                                                |   | 8,991                                    |   | –                      |   | 8,991  |   | –    |
| Amortization of other asset                                                                          |   | 5,739                                    |   | –                      |   | 5,739  |   | 236  |
| Write-off of previously recognized future income tax                            assets               |   | 7,582                                    |   | –                      |   | 7,582  |   | –    |
| Permanent differences and other                                                                      |   | 208                                      |   | (161)                                       |   | 406  |   | (112) |
|                                                                                                 |   |                                          |   |                                        |   |   |   |   |
| Income tax provision                                                                                 | $      | 11,169                                   | $      | 106                                    | $ | 10,453  | $ | 887  |

             

|   | (1) | For purposes of calculating the                            income tax provision of the Company, a tax liability (recovery) is                            recognized on foreign exchange gains or losses which arise on the                            conversion into Canadian dollars of the net monetary assets denominated                            in U.S. dollars; such conversion is required for tax purposes. As these                            financial statements are presented in U.S. dollars, these foreign                            exchange gains or losses do not impact (loss) earnings before income                            taxes, even though the income tax provision would include a tax effect                            for these items. Future fluctuations in the foreign exchange rate                            between the Canadian and U.S. dollar will change the amount of the                            foreign exchange gains or losses and, thus, the provision for income or                            recovery taxes thereon. |
|--------|-----|----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|

 

18

 

 

----

| **OPTIMAL GROUP INC.**                                                                                  |
|---------------------------------------------------------------------------------------------------------|
| Notes to Consolidated Financial Statements,                            Continued                        |
| (Unaudited)                                                                                             |
|                                                                                                    |
| Periods ended June 30, 2008 and 2007                                                                    |
| (expressed in thousands of U.S. dollars, except share                            and per share amounts) |
|                                                                                                    |

 

| **9.** | **Income taxes (continued):** |
|--------|-------------------------------|

The provision for income taxes is composed of the following:

             

|                 | Three months ended June 30, | Six months ended June 30, |
|----------------------|-----------------------------|---------------------------|
|                 |                        | 2008                 |   | 2007  |   | 2008  |   | 2007  |
|                 |                        |                      |   |   |   |   |   |   |
| Current income taxes | $                           | (561)                     | $ | 527  | $ | (184) | $ | 1,884  |
| Future income taxes  |                        | 11,730               |   | (421) |   | 10,637  |   | (997) |
|                 |                        |                      |   |   |   |   |   |   |
|                 | $                           | 11,169               | $ | 106  | $ | 10,453  | $ | 887  |

             

As a result of the goodwill impairment loss relating to the payment            processing segment referred to in note 4, the Company also amortized $5,739 of the            other (tax) asset as a future tax expense in the second quarter of 2008, representing            the remaining portion of this asset that was realized at June 30, 2008. In addition,            the Company wrote off $7,582 of previously recognized future tax assets that no longer            met the criteria for recognition.

             

| **10.** | **Segmented information:** |
|---------|----------------------------|

As of November 7, 2007, as a result of the acquisition of the assets of            WowWee as discussed in note 3 (b), the Company operates in two segments: the            consumer robotic, toy and entertainment products segment and the payment processing            segment.

Comparative figures have been reclassified to conform with this new            presentation.

 

19

 

 

----

| **OPTIMAL GROUP INC.**                                                                                  |
|---------------------------------------------------------------------------------------------------------|
| Notes to Consolidated Financial Statements,                            Continued                        |
| (Unaudited)                                                                                             |
|                                                                                                    |
| Periods ended June 30, 2008 and 2007                                                                    |
| (expressed in thousands of U.S. dollars, except share                            and per share amounts) |
|                                                                                                    |

 

| **10.** | **Segmented information (continued):** |
|---------|----------------------------------------|

|   | (a) | Information on the                            operating segments is as follows: |
|--------|-----|---------------------------------------------------------------------------------|

             

|                                                               |                                              | Consumer                 |              |               |   |
|--------------------------------------------------------------------|---------------------------------------------------|-------------------------------|-------------------|--------------------|--------|
|                                                               | robotic, toy                            and  |                          |              |               |
|                                                               | entertainment                                | Payment                  |              |               |
|                                                               | products                                     | processing               | Unallocated  | Consolidated  |
|                                                               |                                              |                          |              |               |   |   |   |   |
| Three-month period ended June 30,                            2008: |                                              |                          |              |               |   |   |   |   |
|                                                               |                                              |                          |              |               |   |   |   |   |
| Revenues                                                           | $                                                 | 15,486                   | $                 | 26,092        | $      | **–**    | $ | 41,578  |
|                                                               |                                              |                          |              |               |   |   |   |   |
| Transaction processing and cost of sales                           |                                              | 10,750                   |              | 15,918        |   | **–**    |   | 26,668  |
| Selling, general and administrative                                |                                              | 6,123                    |              | 7,456         |   | 126  |   | 13,705  |
| Research and development                                           |                                              | 657                      |              | 498           |   | **–**    |   | 1,155  |
| Operating leases                                                   |                                              | 237                      |              | 303           |   | **–**    |   | 540  |
|                                                               |                                              | (2,281)                       |              | 1,917         |   | (126) |   | (490) |
|                                                               |                                              |                          |              |               |   |   |   |   |
| Stock-based compensation                                           |                                              | 45                       |              | 17            |   | 1,818  |   | 1,880  |
| Impairment loss                                                    |                                              | **–**    |              | 29,097        |   | **–**    |   | 29,097  |
| Amortization                                                       |                                              | 2,748                    |              | 3,211         |   | 42  |   | 6,001  |
|                                                               |                                              | (5,074)                       |              | (30,408)           |   | (1,986) |   | (37,468) |
|                                                               |                                              |                          |              |               |   |   |   |   |
| Investment (expense) income                                        |                                              | (97)                          |              | 170           |   | 170  |   | 243  |
|                                                               |                                              |                          |              |               |   |   |   |   |
| Loss                            before income taxes                |                                              | (5,171)                       |              | (30,238)           |   | (1,816) |   | (37,225) |
|                                                               |                                              |                          |              |               |   |   |   |   |
| Income tax (recovery) provision                                    |                                              | (548)                         |              | 11,717        |   | **–**    |   | 11,169  |
|                                                               |                                              |                          |              |               |   |   |   |   |
| Net loss                                                           | $                                                 | (4,623)                       | $                 | (41,955)           | $      | (1,816) | $ | (48,394) |
|                                                               |                                              |                          |              |               |   |   |   |   |

             

 

20

 

 

----

| **OPTIMAL GROUP INC.**                                                                                  |
|---------------------------------------------------------------------------------------------------------|
| Notes to Consolidated Financial Statements,                            Continued                        |
| (Unaudited)                                                                                             |
|                                                                                                    |
| Periods ended June 30, 2008 and 2007                                                                    |
| (expressed in thousands of U.S. dollars, except share                            and per share amounts) |
|                                                                                                    |

 

| **10.** | **Segmented information (continued):** |
|---------|----------------------------------------|

|   | (a) | Information on the                            operating segments is as follows (continued): |
|--------|-----|---------------------------------------------------------------------------------------------|

             

|                                                             |                                              | Consumer                 |              |               |   |
|------------------------------------------------------------------|---------------------------------------------------|-------------------------------|-------------------|--------------------|--------|
|                                                             | robotic, toy                            and  |                          |              |               |
|                                                             | entertainment                                | Payment                  |              |               |
|                                                             | products                                     | processing               | Unallocated  | Consolidated  |
|                                                             |                                              |                          |              |               |   |   |   |   |
| Six-month period ended June 30,                            2008: |                                              |                          |              |               |   |   |   |   |
|                                                             |                                              |                          |              |               |   |   |   |   |
| Revenues                                                         | $                                                 | 20,386                   | $                 | 52,443        | $      | **–**    | $ | 72,829  |
|                                                             |                                              |                          |              |               |   |   |   |   |
| Transaction processing and cost of sales                         |                                              | 14,460                   |              | 31,603        |   | **–**    |   | 46,063  |
| Selling, general and administrative                              |                                              | 11,121                   |              | 14,989        |   | 175  |   | 26,285  |
| Research and development                                         |                                              | 1,275                    |              | 1,475         |   | **–**    |   | 2,750  |
| Operating leases                                                 |                                              | 474                      |              | 486           |   | **–**    |   | 960  |
|                                                             |                                              | (6,944)                       |              | 3,890         |   | (175) |   | (3,229) |
|                                                             |                                              |                          |              |               |   |   |   |   |
| Stock-based compensation                                         |                                              | 97                       |              | 73            |   | 2,281  |   | 2,451  |
| Impairment loss                                                  |                                              | **–**    |              | 29,097        |   | **–**    |   | 29,097  |
| Amortization                                                     |                                              | 5,396                    |              | 6,453         |   | 50  |   | 11,899  |
|                                                             |                                              | (12,437)                      |              | (31,733)           |   | (2,506) |   | (46,676) |
|                                                             |                                              |                          |              |               |   |   |   |   |
| Investment (expense) income                                      |                                              | (141)                         |              | 387           |   | 443  |   | 689  |
|                                                             |                                              |                          |              |               |   |   |   |   |
| Loss                            before income taxes              |                                              | (12,578)                      |              | (31,346)           |   | (2,063) |   | (45,987) |
|                                                             |                                              |                          |              |               |   |   |   |   |
| Income tax (recovery) provision                                  |                                              | (770)                         |              | 11,223        |   | **–**    |   | 10,453  |
|                                                             |                                              |                          |              |               |   |   |   |   |
| Net loss                                                         | $                                                 | (11,808)                      | $                 | (42,569)           | $      | (2,063) | $ | (56,440) |
|                                                             |                                              |                          |              |               |   |   |   |   |

Revenues from the consumer robotic, toy and entertainment products            segment is subject to seasonal variability with a significant portion of revenues            generated in the third and fourth quarters of each calendar year.

In the periods ended June 30, 2007, the Company only operated in the            payment processing segment.

             

21

 

 

----

| **OPTIMAL GROUP INC.**                                                                                  |
|---------------------------------------------------------------------------------------------------------|
| Notes to Consolidated Financial Statements,                            Continued                        |
| (Unaudited)                                                                                             |
|                                                                                                    |
| Periods ended June 30, 2008 and 2007                                                                    |
| (expressed in thousands of U.S. dollars, except share                            and per share amounts) |
|                                                                                                    |

 

| **10.** | **Segmented information (continued):** |
|---------|----------------------------------------|

|   | (a) | Information on the                            operating segments is as follows (continued): |
|--------|-----|---------------------------------------------------------------------------------------------|

             

|                                                                                                                                               |                                              | Consumer    |                |                      |   |                      |
|----------------------------------------------------------------------------------------------------------------------------------------------------|---------------------------------------------------|------------------|---------------------|---------------------------|--------|---------------------------|
|                                                                                                                                               | robotic, toy                            and  |             |                |                      |   |
|                                                                                                                                               | entertainment                                | Payment     | Eliminations/  |                      |   |
|                                                                                                                                               | products                                     | processing  | unallocated    | Consolidated         |   |
|                                                                                                                                               |                                              |             |                |                      |   |                      |   |   |
| June 30,                            2008:                                                                                                          |                                              |             |                |                      |   |                      |   |   |
|                                                                                                                                               |                                              |             |                |                      |   |                      |   |   |
| Total assets                                                                                                                                       | $                                                 | 117,459     | $                   | 88,333               | $      | 33,355               | $ | 239,147  |
|                                                                                                                                               |                                              |             |                |                      |   |                      |   |   |
| Total additions paid for equipment and other                            intangibles for the six months ended June 30, 2008                         |                                              | 2,646       |                | 193                  |   | 541                  |   | 3,380  |
|                                                                                                                                               |                                              |             |                |                      |   |                      |   |   |
| December 31,                            2007:                                                                                                      |                                              |             |                |                      |   |                      |   |   |
|                                                                                                                                               |                                              |             |                |                      |   |                      |   |   |
| Total assets                                                                                                                                       | $                                                 | 104,560     | $                   | 140,050              | $      | 45,671               | $ | 290,281  |
|                                                                                                                                               |                                              |             |                |                      |   |                      |   |   |
| Total additions to goodwill for the year ended                            December 31, 2007                                                        |                                              | 37,113      |                | 2,406                |   | –    |   | 39,519  |
|                                                                                                                                               |                                              |             |                |                      |   |                      |   |   |
| Total                            additions to equipment and other intangibles for the year ended                            December 31, 2007 |                                              |             |                |                      |   |                      |   |   |
| -                            through business acquisition                                                                                          |                                              | 43,945      |                | –    |   | –    |   | 43,945  |
| -                            other                                                                                                                 |                                              | 1,597       |                | 3,112                |   | 35                   |   | 4,744  |
|                                                                                                                                               |                                              |             |                |                      |   |                      |   |   |
|                                                                                                                                                    |                                                   |                  |                     |                           |        |                           |  |  |  |  |  |

             

|   | (b) | Geographic information is                            as follows: |
|--------|-----|------------------------------------------------------------------|

             

|            |     |                      |   | Property and equipment,   |
|-----------------|----------|---------------------------|--------|---------------------------|
|            | Revenues | goodwill and intangibles  |
|            |     | Three months ended        |   | Six months ended          |   | June 30,  |   | December 31,  |
|            |     | June 30,                  |   | June 30,                  |   |   |   |   |
|            |     | 2008                 |   | 2007                 |   | 2008  |   | 2007  |   | 2008  |   | 2007  |
|            |     |                      |   |                      |   |   |   |   |   |   |   |   |
| United States   | $        | 26,949               | $      | 21,318               | $ | 49,468  | $ | 42,318  | $ | 42,236  | $ | 58,429  |
| Central America |     | 2,816                |   | 3,026                |   | 5,734  |   | 8,086  |   | –    |   | –    |
| Canada          |     | 1,973                |   | 1,807                |   | 3,742  |   | 3,585  |   | 2,919  |   | 19,695  |
| Europe          |     | 7,292                |   | 1,610                |   | 9,641  |   | 3,298  |   | 28  |   | 1,649  |
| Hong Kong       |     | –    |   | –    |   | –    |   | –    |   | 74,257  |   | 77,965  |
| Other           |     | 2,548                |   | 281                  |   | 4,244  |   | 821  |   | –    |   | –    |
|            |     |                      |   |                      |   |   |   |   |   |   |   |   |
|            | $        | 41,578               | $      | 28,042               | $ | 72,829  | $ | 58,108  | $ | 119,440  | $ | 157,738  |
|                 |          |                           |        |                           |  |  |  |  |  |  |  |  |  |  |  |

             

Revenues are attributed to countries based on the location of the            customers. The "Other" caption includes countries in Africa, Australia and Asia            (excluding Hong Kong).

 

22

 

 

----

| **OPTIMAL GROUP INC.**                                                                                  |
|---------------------------------------------------------------------------------------------------------|
| Notes to Consolidated Financial Statements,                            Continued                        |
| (Unaudited)                                                                                             |
|                                                                                                    |
| Periods ended June 30, 2008 and 2007                                                                    |
| (expressed in thousands of U.S. dollars, except share                            and per share amounts) |
|                                                                                                    |

 

| **11.** | **Supplemental disclosure of cash flow and other                            information:** |
|---------|--------------------------------------------------------------------------------------------|

|   | (a) | Net change in operating                            assets and liabilities: |
|--------|-----|----------------------------------------------------------------------------|

             

|                                                                                                | Three months endedJune 30, | Six months endedJune 30,  |
|-----------------------------------------------------------------------------------------------------|----------------------------|---------------------------|
|                                                                                                |                       | 2008                 |   | 2007  |   | 2008  |   | 2007  |
|                                                                                                |                       |                      |   |   |   |   |   |   |
| Cash and short-term investments held as                            reserves                         | $                          | 245                  | $ | 7,441  | $ | 1,016  | $ | 8,320  |
| Restricted cash                                                                                     |                       | –    |   | (19,182) |   | –    |   | (19,182) |
| Settlement assets                                                                                   |                       | 921                  |   | 213  |   | 3,313  |   | 5,053  |
| Accounts receivable                                                                                 |                       | (5,208)                   |   | (916) |   | 236  |   | 457  |
| Inventories                                                                                         |                       | (8,095)                   |   | –    |   | (12,851) |   | –    |
| Income taxes receivable and refundable investment tax                            credits receivable |                       | 2,903                |   | (363) |   | 3,593  |   | (432) |
| Prepaid expenses and deposits                                                                       |                       | (316)                     |   | (122) |   | 37  |   | 1,322  |
| Accounts payable and accrued liabilities                                                            |                       | 13,757               |   | 971  |   | 5,665  |   | (5,720) |
| Income taxes payable                                                                                |                       | (344)                     |   | (696) |   | 664  |   | 519  |
| Customer reserves and security deposits                                                             |                       | (986)                     |   | (9,641) |   | (2,091) |   | (35,921) |
|                                                                                                |                       |                      |   |   |   |   |   |   |
| Net change in operating assets and                            liabilities                           | $                          | 2,877                | $ | (22,295) | $ | (418) | $ | (45,584) |

             

             

|   | (b) | Cash paid for                            interest and income taxes: |
|--------|-----|---------------------------------------------------------------------|

 

| Interest     | $      | 77   | $      | –    | $      | 100  | $      | 41   |
|--------------|--------|-----------|--------|---------------------------|--------|-----------|--------|-----------|
| Income taxes |   | 150  |   | 461                  |   | 150  |   | 679  |
|         |   |      |   |                      |   |      |   |      |

             

|   | (c) | Cash and cash                            equivalents: |
|--------|-----|-------------------------------------------------------|

             

|                                                                                                    |   | June 30,  |   | December 31,         |
|---------------------------------------------------------------------------------------------------------|--------|----------------|--------|---------------------------|
|                                                                                                    |   | 2008      |   | 2007                 |
|                                                                                                    |   |           |   |                      |
| Cash and cash equivalents consist of:                                                                   |   |           |   |                      |
| Cash balances with banks                                                                                | $      | 35,118    | $      | 47,193               |
| Short-term investments, bearing interest at 2.26% to                            5.50% (2007 - nil) |   | 15,882    |   | –    |
|                                                                                                    |   |           |   |                      |
|                                                                                                    | $      | 51,000    | $      | 47,193               |

             

 

23

 

 

----

| **OPTIMAL GROUP INC.**                                                                                  |
|---------------------------------------------------------------------------------------------------------|
| Notes to Consolidated Financial Statements,                            Continued                        |
| (Unaudited)                                                                                             |
|                                                                                                    |
| Periods ended June 30, 2008 and 2007                                                                    |
| (expressed in thousands of U.S. dollars, except share                            and per share amounts) |
|                                                                                                    |

 

| **11.** | **Supplemental disclosure of cash flow and other                            information (continued):** |
|---------|--------------------------------------------------------------------------------------------------------|

|   | (d) | Non-cash                            transactions: |
|--------|-----|---------------------------------------------------|

             

|                                                                                                                            |   |   | June                            30,  |   | December                            31,  |
|---------------------------------------------------------------------------------------------------------------------------------|--------|--------|-------------------------------------------|--------|-----------------------------------------------|
|                                                                                                                            |   |   | 2008                                 |   | 2007                                     |
|                                                                                                                            |   |   |                                      |   |                                          |
| Addition of property, equipment and intangibles included                            in accounts payable and accrued liabilities |   | $      | 240                                  | $      | –                        |
| Shares and warrants issued in connection with                            WowWee                                                 |   |   | –                    |   | 12,696                                   |
| Adjustments to WowWee purchase price equation to                            goodwill                                            |   |   | 1,085                                |   | –                        |
|                                                                                                                            |   |   |                                      |   |                                          |

             

|   | (e) | Foreign exchange: |
|--------|-----|-------------------|

Included in “Selling, general and administrative expenses”            in the consolidated statement of operations and comprehensive loss is a foreign            exchange loss relating to financial assets and liabilities of $3 for the three-month            period ended June 30, 2008 (June 30, 2007 - $331) and $417 for the six-month            period ended June 30, 2008 (June 30, 2007 - $310).

             

| **12.** | **Capital disclosures:** |
|---------|--------------------------|

The Company’s objective is to maintain a strong capital base to            maintain investor, creditor and market confidence and to sustain future development of            the business.

Management defines capital as the Company’s shareholders’            equity, excluding accumulated other comprehensive income. The Company does not have any            debt.

In order to maximize flexibility in financing the Company’s            ongoing growth and be able to take advantage of additional new capital investment and            acquisition opportunities, the Company does not currently pay a dividend. To maintain            or adjust the capital structure, the Company may also repurchase existing shares, issue            new shares or long-term debt, or sell assets to adjust to changes in economic            conditions and the risk characteristic of the underlying assets. (Refer to note 5 as to            the Company's stock buyback program.)

There were no changes to the Company’s approach to capital            management during the period. Neither the Company nor any of its subsidiaries is            subject to externally imposed capital requirements.

             

24

 

 

----

| **OPTIMAL GROUP INC.**                                                                                  |
|---------------------------------------------------------------------------------------------------------|
| Notes to Consolidated Financial Statements,                            Continued                        |
| (Unaudited)                                                                                             |
|                                                                                                    |
| Periods ended June 30, 2008 and 2007                                                                    |
| (expressed in thousands of U.S. dollars, except share                            and per share amounts) |
|                                                                                                    |

 

| **13.** | **Financial risk management:** |
|---------|--------------------------------|

This note provides disclosures relating to the nature and extent of the            Company’s exposure arising from financial instruments, including interest rate            risk, foreign currency risk, credit risk and liquidity risk and how the Company manages            these risks.

|   | (a) | Interest rate risk: |
|--------|-----|---------------------|

Interest rate risk is the risk that the fair value or future cash flows            of a financial instrument will fluctuate because of changes in market interest            rates.

Short-term investments (including those held in reserve) consist of            short-term notes invested at fixed interest rates. The risk that the Company will            realize a loss as a result of a decline in the fair value of these investments is            limited because although available for sale, these investments are short-term and are            generally held to maturity.

The Company is exposed primarily to interest rate fluctuations as a            result of cash (including cash held in reserve) which bears interest at variable            interest rates. A 0.5% increase to the interest rate would have decreased the net loss            and comprehensive loss by $116 in the six-month periods. An equal but opposite effect            would result assuming a 0.5% decrease in interest rates.

|   | (b) | Foreign currency risk: |
|--------|-----|------------------------|

A significant portion of the Company’s cash flows and financial            assets and liabilities are denominated in U.S. dollars, which is the Company’s            functional and reporting currency. Foreign currency risk is limited to the portion of            the Company’s business transactions denominated in currencies other than U.S.            dollars, primarily for head office expenses in Canada. For the Company’s foreign            currency transactions, fluctuations in the respective exchange rates relative to the            U.S. dollar will create volatility in the Company’s cash flows and the reported            amounts for revenues and selling, general and administrative expenses in its            consolidated statement of operations on a period-to-period basis. Additional earnings            variability arises from the translation of monetary assets and liabilities denominated            in currencies other than U.S. dollars at the rates of exchange at each balance sheet            date, the impact of which is reported as a foreign exchange gain and loss which is            included as part of selling, general and administrative expenses in the statement of            operations and comprehensive loss.

The Company’s objective in managing its foreign currency risk is            to minimize its net exposures to foreign currency cash flows, by transacting with third            parties in U.S. dollars to the maximum extent possible and practical and holding cash            and cash equivalents in U.S. dollars. The Company monitors and forecasts the values of            net foreign currency cash flow and balance sheet exposures and with the aid of external            consultants manages its cash flow to hold on hand sufficient levels of foreign            currencies to meet its obligations.

 

25

 

 

----

| **OPTIMAL GROUP INC.**                                                                                  |
|---------------------------------------------------------------------------------------------------------|
| Notes to Consolidated Financial Statements,                            Continued                        |
| (Unaudited)                                                                                             |
|                                                                                                    |
| Periods ended June 30, 2008 and 2007                                                                    |
| (expressed in thousands of U.S. dollars, except share                            and per share amounts) |
|                                                                                                    |

 

| **13.** | **Financial risk management (continued):** |
|---------|--------------------------------------------|

|   | (b) | Foreign currency risk                            (continued): |
|--------|-----|---------------------------------------------------------------|

The following table provides an indication of the Company’s            significant foreign currency exposures:

             

|                                     | June 30, 2008 |
|------------------------------------------|---------------|
|                                     | CAD      | GBP  | EURO  |
|                                     |          |   |   |
| Cash and cash equivalents                | 4,026    | 455  | 554  |
| Short-term investments                   | -             | –    | 220  |
| Accounts payable and accrued liabilities | (7,440)       | (765) | (578) |
| Customer reserves and security deposits  | (100)         | (365) | (214) |
|                                     |          |   |   |
| Balance sheet exposure                   | (3,514)       | (675) | (18) |

             

As at June 30, 2008, all the short-term investments held in reserve were            denominated in U.S. dollars.

In addition to the foreign currency exposures noted above, the Company            also incurs a portion of its operating costs in its consumer robotic, toy and            entertainment products segment, in Hong Kong dollars. However, the Company does not            view its exposure to the Hong Kong dollar as a significant foreign exchange risk since            the Hong Kong dollar is pegged to the U.S. dollar and fluctuates very            slightly.

The following are the exchange rates applied during the three- and            six-month periods ended June 30, 2008:

             

|        | Average rate Q1 | Average rate Q2 | Rate as at June 30, 2008 |
|-------------|-----------------|-----------------|--------------------------|
|        |            |            |                     |
| CAD to USD  | 0.9953          | 0.9901          | 0.9807                   |
| GBP to USD  | 1.9779          | 1.9721          | 1.9906                   |
| EURO to USD | 1.4984          | 1.5633          | 1.5748                   |
|        |            |            |                     |

             

Based on the Company’s foreign currency exposures noted above,            varying the above exchange rates to reflect a 5% weakening of the U.S. dollar would            affect earnings and comprehensive earnings as follows:

             

|                 | CAD    | GBP                | EURO   |
|----------------------|--------|--------------------|--------|
|                 |   | Six months ended   |   | Six months ended |   | Six months ended |
|                 |   | June 30, 2008 |   | June 30, 2008 |   | June 30, 2008 |
|                 |   |               |   |   |   |   |
| Increase in net loss |   | $(176)             |   | $(34) |   | $(1) |

             

An assumed 5% strengthening of the U.S. dollar would have an equal but            opposite effect on the above currencies to the amounts shown above.

 

26

 

 

----

| **OPTIMAL GROUP INC.**                                                                                  |
|---------------------------------------------------------------------------------------------------------|
| Notes to Consolidated Financial Statements,                            Continued                        |
| (Unaudited)                                                                                             |
|                                                                                                    |
| Periods ended June 30, 2008 and 2007                                                                    |
| (expressed in thousands of U.S. dollars, except share                            and per share amounts) |
|                                                                                                    |

 

| **13.** | **Financial risk management (continued):** |
|---------|--------------------------------------------|

|   | (c) | Credit risk: |
|--------|-----|--------------|

Credit risk is the risk of an unexpected loss if a customer or counter            party to a financial instrument fails to meet its contractual obligations. Financial            instruments that potentially subject the Company to concentrations of credit risk            consist primarily of cash and cash equivalents, short-term investments and accounts            receivable:

|   | (i) | Cash and cash equivalents and short-term                            investments: |
|--------|-----|----------------------------------------------------------------------------------|

The credit risk relating to cash and cash equivalents is limited because            the counterparties are highly-rated American and European financial institutions. The            credit risk related to short-term investments is limited because they consist of            discounted notes issued by high-credit, quality corporations. The Company has            investment policies to provide guidance on investing available cash resources. In            general, these policies stress the preservation of capital with investments allowed in            notes issued by corporations with credit rankings of not less than R-1mid.

|   | (ii) | Accounts receivable: |
|--------|------|----------------------|

Consumer robotic, toy and entertainment            segment:

Credit risk for this segment arises primarily from the segment’s            trade receivables. Allowances are provided for potential losses. The amounts disclosed            in the balance sheet are net of these allowances for bad debts. Accounts receivable are            assessed for impairment on a case by case basis when they are past due or when            objective evidence is received that a customer will default. The Company takes into            consideration the customer’s payment history, its credit worthiness and the            current economic environment in which the customer operates to assess impairments. All            bad debts are charged to selling, general and administrative expenses on the statement            of operations and comprehensive loss.

The credit risk for trade receivables is concentrated as the majority of            sales are to a relatively small group of wholesale distributors and mass market            retailers. However, the majority of these wholesale distributors and mass market            retailers are large companies which have been customers for a number of years.            Customers do not provide collateral in exchange for credit.

Payment processing segment:

Disputes between credit card holders and merchants may arise as a result            of, among other things, consumer dissatisfaction with merchandise quality or services            provided by merchants. Such disputes may not be resolved in the merchant’s favour            which means the transaction amount is refunded to the consumer and in certain cases            charged to the merchant. If the merchant has insufficient funds, the Company bears the            credit risk for the full amount of the transaction. Management evaluates the risk of            such transactions and estimates the loss for disputed transactions based primarily on            historical experience and other relevant factors.

             

27

 

 

----

| **OPTIMAL GROUP INC.**                                                                                  |
|---------------------------------------------------------------------------------------------------------|
| Notes to Consolidated Financial Statements,                            Continued                        |
| (Unaudited)                                                                                             |
|                                                                                                    |
| Periods ended June 30, 2008 and 2007                                                                    |
| (expressed in thousands of U.S. dollars, except share                            and per share amounts) |
|                                                                                                    |

 

| **13.** | **Financial risk management (continued):** |
|---------|--------------------------------------------|

|   | (c) | Credit risk (continued): |
|--------|-----|--------------------------|

|   | (ii) | Accounts receivable (continued): |
|--------|------|----------------------------------|

Payment processing segment            (continued):

The Company retains a portion of amounts owed to certain merchants            (based on processing dollar volume) as reserves to help offset its exposure to            chargebacks and other losses for merchant transactions that have been previously            processed and on which revenues have been recorded. Management analyzes the adequacy of            its reserve for merchant losses in each reporting period. The reserve for merchant            losses is comprised of specifically identifiable reserves for merchant transactions for            which losses can be estimated and an estimate of loss in the remaining portfolio based            on experience.

The net charge for the provision for merchant losses is included in            selling, general and administrative expenses in the statement of operations and            comprehensive loss. As at June 30, 2008, the reserve for losses on merchant accounts is            included in "Accounts payable and accrued liabilities" on the balance sheet.

The payment processing segment’s credit risk is also decreased            because its customers consist of a diverse portfolio of small- and medium-sized            merchants and because of the strong proprietary risk management expertise it has            developed to help reduce the inherently higher risk associated with card-not-present            transactions.

The maximum credit exposure to the Company is the carrying amount of            financial assets plus credit risk on chargebacks, as previously explained, which are            provided for separately.

Included in accounts and other receivables are trade receivables in the            consumer robotic, toy and entertainment segment of $13,311. The aging of the trade            receivables at the reporting date was as follows:

             

|                 |   | June 30,     |
|----------------------|--------|--------------|
|                 |   | 2008         |
|                 |   |         |
| Not past due         | $      | 10,218  |
| Past due 0-30 days   |   | 2,567   |
| Past due 31-60 days  |   | 75      |
| Past due 61-120 days |   | 451     |
|                 |   |         |
| Trade receivables    | $      | 13,311  |

             

 

28

 

 

----

| **OPTIMAL GROUP INC.**                                                                                  |
|---------------------------------------------------------------------------------------------------------|
| Notes to Consolidated Financial Statements,                            Continued                        |
| (Unaudited)                                                                                             |
|                                                                                                    |
| Periods ended June 30, 2008 and 2007                                                                    |
| (expressed in thousands of U.S. dollars, except share                            and per share amounts) |
|                                                                                                    |

 

| **13.** | **Financial risk management (continued):** |
|---------|--------------------------------------------|

|   | (c) | Credit risk                            (continued): |
|--------|-----|-----------------------------------------------------|

|   | (ii) | Accounts receivable                            (continued): |
|--------|------|-------------------------------------------------------------|

A breakdown of trade receivables by type of customer is presented            below:

             

|                  |   | June 30,     |
|-----------------------|--------|--------------|
|                  |   | 2008         |
|                  |   |         |
| Distributors          | $      | 7,044   |
| Mass-market retailers |   | 6,267   |
|                  |   |         |
|                  | $      | 13,311  |

             

|   | (d) | Liquidity risk: |
|--------|-----|-----------------|

Liquidity risk is the risk that the Company will not be able to meet its            financial obligations as they fall due. The Company manages liquidity risk through the            management of its capital structure and by continuously monitoring actual and projected            cash flows. In recent years, the Company has financed its acquisitions through mainly            internally-generated funds.

The Company has a revolving credit facility in its consumer robotic, toy            and entertainment products segment, for a maximum of $5,000 subject to annual            renewal.

As at June 30, 2008, the Company has $51,000 of cash and cash            equivalents and has no outstanding balance on its revolving line of credit.

The following are the contractual maturities of financial liabilities at            June 30, 2008:

             

|                                     |   | Carrying amount |   | 0 to 12 months |
|------------------------------------------|--------|-----------------|--------|----------------|
|                                     |   |            |   |           |
| Accounts payable and accrued liabilities | $      | 52,978          | $      | 52,978         |
| Customer reserves and security deposits  |   | 19,233          |   | 19,233         |
|                                     |   |            |   |           |
| Total                                    | $      | 72,211          | $      | 72,211         |

             

| **14.** | **Financial instruments:** |
|---------|----------------------------|

|   | (a) | Fair values: |
|--------|-----|--------------|

The Company has determined that the fair value of its short-term            financial assets and liabilities approximates their respective fair values as at the            balance sheet dates because of the short-term maturity of those instruments.

 

29

 

 

----

| **OPTIMAL GROUP INC.**                                                                                  |
|---------------------------------------------------------------------------------------------------------|
| Notes to Consolidated Financial Statements,                            Continued                        |
| (Unaudited)                                                                                             |
|                                                                                                    |
| Periods ended June 30, 2008 and 2007                                                                    |
| (expressed in thousands of U.S. dollars, except share                            and per share amounts) |
|                                                                                                    |

 

| **14.** | **Financial instruments (continued):** |
|---------|----------------------------------------|

|   | (b) | Financial income and expense: |
|--------|-----|-------------------------------|

The following components of income and expense relating to financial            instruments are included in the statement of operations and comprehensive            loss:

|   | (i) | Interest income and expense: |
|--------|-----|------------------------------|

             

|                                                                              | For the three months ending |           | For the six months ending |
|-----------------------------------------------------------------------------------|-----------------------------|----------------|---------------------------|
|                                                                              |                        | June 30,  |                      | June 30,  |   | June 30,  |   | June 30,  |
|                                                                              |                        | 2008      |                      | 2007  |   | 2008  |   | 2007  |
|                                                                              |                        |           |                      |   |   |   |   |   |
| Interest income on available-for-sale financial                            assets | $                           | (266)          | $                         | (1,503) | $ | (728) | $ | (3,411) |
| Other                                                                             |                        | 23        |                      | (73) |   | 39  |   | (66) |
|                                                                              |                        |           |                      |   |   |   |   |   |
| Total                                                                             | $                           | (243)          | $                         | (1,576) | $ | (689) | $ | (3,477) |

             

Interest income on available-for-sale financial assets consists of            interest earned from cash and cash equivalents and short-term investments invested in            short-term deposits.

|   | (ii) | Impairment losses recognized on trade receivables in                            consumer robotic, toy and entertainment products segment: |
|--------|------|-------------------------------------------------------------------------------------------------------------------------------------------|

The Company recorded a bad debt expense of $11 for the three-month            period ended June 30, 2008 (June 30, 2007 - nil) and $15 for the six-month period ended            June 30, 2008 (June 30, 2007 - nil) in “Selling, general and administrative            expenses” in the statement of operations and comprehensive loss.

             

30

 

 

----

| **OPTIMAL GROUP INC.**                                                                                  |
|---------------------------------------------------------------------------------------------------------|
| Notes to Consolidated Financial Statements,                            Continued                        |
| (Unaudited)                                                                                             |
|                                                                                                    |
| Periods ended June 30, 2008 and 2007                                                                    |
| (expressed in thousands of U.S. dollars, except share                            and per share amounts) |
|                                                                                                    |

 

| **15.** | **Canadian/U.S. reporting differences:** |
|---------|------------------------------------------|

The consolidated financial statements of the Company are prepared in            accordance with Canadian GAAP, which conform, in all material respects, with U.S. GAAP,            except as described below:

|   | (a) | Consolidated balance sheets: |
|--------|-----|------------------------------|

Differences between Canadian and U.S. GAAP in the presentation of share            capital, additional paid-in capital and deficit are as follows:

|   | (i) | Share capital: |
|--------|-----|----------------|

             

|                                                                                |   | June 30,  |   | December 31,  |
|-------------------------------------------------------------------------------------|--------|----------------|--------|--------------------|
|                                                                                |   | 2008      |   | 2007          |
|                                                                                |   |           |   |               |
| Share capital in accordance with Canadian                            GAAP           | $      | 210,741   | $      | 211,998       |
| Stock-based compensation costs on options exercised                            (1): |   |           |   |               |
| Cumulative effect of prior years                                                    |   | 39,868    |   | 39,868        |
| Change in reporting currency (2)                                                    |   | 2,588     |   | 2,588         |
|                                                                                |   |           |   |               |
| Share capital in accordance with U.S. GAAP                                          | $      | 253,197   | $      | 254,454       |

             

|   | (ii) | Additional paid-in                            capital: |
|--------|------|--------------------------------------------------------|

             

|                                                                                   |   | June 30,  |   | December 31,  |
|----------------------------------------------------------------------------------------|--------|----------------|--------|--------------------|
|                                                                                   |   | 2008      |   | 2007          |
|                                                                                   |   |           |   |               |
| Additional paid-in capital in accordance with Canadian                            GAAP | $      | 32,798    | $      | 29,561        |
| Stock-based compensation costs                            (1):                         |   |           |   |               |
| Cumulative effect of prior years                                                       |   | 68,757    |   | 68,757        |
| Stock-based compensation costs on options exercised                            (1):    |   |           |   |               |
| Cumulative effect of prior years                                                       |   | (39,868)       |   | (39,868)           |
| Change in reporting currency (2)                                                       |   | 968       |   | 968           |
|                                                                                   |   |           |   |               |
| Additional paid-in capital in accordance with U.S.                            GAAP     | $      | 62,655    | $      | 59,418        |

             

 

31

 

 

----

| **OPTIMAL GROUP INC.**                                                                                  |
|---------------------------------------------------------------------------------------------------------|
| Notes to Consolidated Financial Statements,                            Continued                        |
| (Unaudited)                                                                                             |
|                                                                                                    |
| Periods ended June 30, 2008 and 2007                                                                    |
| (expressed in thousands of U.S. dollars, except share                            and per share amounts) |
|                                                                                                    |

 

| **15.** | **Canadian/U.S. reporting differences                            (continued):** |
|---------|---------------------------------------------------------------------------------|

|   | (a) | Consolidated balance sheets                            (continued): |
|--------|-----|---------------------------------------------------------------------|

|   | (iii) | Deficit: |
|--------|-------|----------|

             

|                                                                     |   | June 30,  |   | December 31,  |
|--------------------------------------------------------------------------|--------|----------------|--------|--------------------|
|                                                                     |   | 2008      |   | 2007          |
|                                                                     |   |           |   |               |
| Deficit in accordance with Canadian GAAP                                 | $      | (97,506)       | $      | (41,066)           |
| Stock-based compensation costs                            (1):           |   |           |   |               |
| Cumulative effect of prior years                                         |   | (68,757)       |   | (68,757)           |
| Stock-based compensation to non-employees                            (1) |   | (834)          |   | (834)              |
| Change in reporting currency (2)                                         |   | (1,189)        |   | (1,189)            |
|                                                                     |   |           |   |               |
| Deficit in accordance with U.S. GAAP                                     | $      | (168,286)      | $      | (111,846)          |

             

|   | (1) | Stock-based compensation: |
|--------|-----|---------------------------|

For U.S. GAAP purposes, the Company adopted Statement of Financial            Accounting Standards (SFAS) No. 123R,*Share-based            Payments*, on January 1, 2006, which requires the expensing of            all options based on the grant date fair value, over the period during which the            employee is required to provide service. The Company adopted SFAS No. 123R using the            modified prospective approach, which requires application of the standard to all awards            granted, modified or cancelled after January 1, 2006 and to all awards for which            the requisite service has not been rendered as at such date. Previously, effective            January 1, 2003, the Company adopted the fair value recognition provisions of SFAS No.            123R.

A description of the Company's stock option plans is presented in note            6.

The aggregate intrinsic value for outstanding and exercisable options at            June 30, 2008 represents the pre-tax intrinsic value based on the Company’s            closing stock price at June 30, 2008, which would have been received by option holders            had they exercised their securities at that date. The aggregate intrinsic value of all            outstanding and exercisable options was nil. No options were exercised during the            period ended June 30, 2008.

|   | (2) | Change in reporting currency: |
|--------|-----|-------------------------------|

Under Canadian GAAP, at the time of change in reporting currency, the            historical financial statements were presented using a translation of convenience.            Under U.S. GAAP, the financial statements, including prior years, are translated            according to the current rate method. Accordingly, the cumulative translation account            included as part of accumulated other comprehensive income in shareholders' equity            under Canadian GAAP does not exist for U.S. GAAP purposes.

 

32

 

 

----

| **OPTIMAL GROUP INC.**                                                                                  |
|---------------------------------------------------------------------------------------------------------|
| Notes to Consolidated Financial Statements,                            Continued                        |
| (Unaudited)                                                                                             |
|                                                                                                    |
| Periods ended June 30, 2008 and 2007                                                                    |
| (expressed in thousands of U.S. dollars, except share                            and per share amounts) |
|                                                                                                    |

 

| **15.** | **Canadian/U.S. reporting differences                            (continued):** |
|---------|---------------------------------------------------------------------------------|

|   | (b) | Accumulated other comprehensive income                            (loss): |
|--------|-----|---------------------------------------------------------------------------|

Accumulated other comprehensive income (loss) under U.S. GAAP, which            resulted solely from the translation of the financial statements up to June 30, 2000,            the date the Company adopted the United States dollar as its measurement currency, in            accordance with the current rate method, is $(3,018) as at June 30, 2008 and            December 31, 2007.

|   | (c) | FIN 48 - Accounting for tax uncertainties: |
|--------|-----|--------------------------------------------|

For U.S. GAAP purposes, the Company adopted Financial Accounting            Standards Board Interpretation No. 48,*Accounting for            Uncertainty in Income Taxes - an Interpretation of FASB Statement No. 109            (FIN* *48)*on January 1, 2007*.*FIN 48 clarifies the accounting for income taxes recognized in a            company's financial statements in accordance with FASB statement No. 109. FIN 48            prescribes a more-likely-than-not recognition threshold for tax uncertainties. For U.S.            GAAP tax purposes, unrecognized tax benefits would be classified as non-current other            liabilities. The Company recognizes interest and penalties related to unrecognized tax            benefits in income tax expense. At June 30, 2008 and December 31, 2007, the total            liability for unrecognized tax benefits was approximately $15,000 and $14,500,            respectively, of which $8,700 and $8,200, respectively, would impact the annual            effective rate if realized. The increase during the year is represented by foreign            exchange fluctuations, additional interest and other increases to the            reserve.

The Company and its subsidiaries file income tax returns with federal            and provincial tax authorities within Canada. The Company's foreign affiliates file            income tax returns in various jurisdictions, the most significant of which are the            United States and Hong Kong. In general, the Company is subject to examination by            taxing authorities for years after 2000. The Canadian tax authorities have commenced            examinations of tax returns for certain Canadian subsidiaries for the taxation years            2003 to 2006.

|   | (d) | SFAS No. 157 - Fair value measurements: |
|--------|-----|-----------------------------------------|

On January 1, 2008, the Company adopted Statement of Financial            Accounting Standards (SFAS) No. 157,*Fair Value            Measurements*. SFAS No. 157 clarifies the principle that fair            value should be based on the assumptions market participants would use when pricing an            asset or liability and establishes a fair value hierarchy that prioritizes the            information used to develop those assumptions. Under the standard, fair value            measurements would be separately disclosed by level within the fair value            hierarchy.

 

33

 

 

----

| **OPTIMAL GROUP INC.**                                                                                  |
|---------------------------------------------------------------------------------------------------------|
| Notes to Consolidated Financial Statements,                            Continued                        |
| (Unaudited)                                                                                             |
|                                                                                                    |
| Periods ended June 30, 2008 and 2007                                                                    |
| (expressed in thousands of U.S. dollars, except share                            and per share amounts) |
|                                                                                                    |

 

| **15.** | **Canadian/U.S. reporting differences                            (continued):** |
|---------|---------------------------------------------------------------------------------|

|   | (d) | SFAS No. 157 - Fair value                            measurements (continued): |
|--------|-----|--------------------------------------------------------------------------------|

Assets measured at fair value on a recurring basis:

             

|                          |   | Fair value measurements at reporting date                            using |
|-------------------------------|--------|----------------------------------------------------------------------------|
|                          |   |                                                                       |   | Quoted prices in  |   | Significant  |   | Significant  |
|                          |   |                                                                       |   | active markets  |   | other  |   | unobservable  |
|                          |   | June 30,                                                                   |   | for identical  |   | observable  |   | inputs  |
|                          |   | 2008                                                                       |   | assets (level 1) |   | inputs (level 2) |   | (level 3) |
|                          |   |                                                                       |   |   |   |   |   |   |
| Available-for-sale securities | $      | 4,178                                                                      | $ | 4,178 | $ | –    | $ | –    |

The Company has elected to defer for one year the application of            Statement No. 157 for non-financial assets and non-financial liabilities (except for            items that are recognized or disclosed at fair value in the financial statements on a            recurring basis).

|   | (e) | Recent accounting pronouncements: |
|--------|-----|-----------------------------------|

SFAS No. 141R - Business combinations:

In December 2007, the FASB issued a revised standard on accounting for            business combinations. The major changes to accounting for business combinations            include the following: all business acquisitions would be measured at fair value; the            existing definition of a business would be expanded; pre-acquisition contingencies            would be measured at fair value; most acquisition-related costs would be recognized as            expenses as incurred (they would no longer be part of the purchase consideration);            obligations for contingent consideration would be measured and recognized at fair value            at the acquisition date (measurement would no longer need to wait until the contingency            is settled); non-controlling interests would be measured at fair value at the date of            acquisition (i.e., 100% of the assets and liabilities would be measured at fair value            even when an acquisition is for less than 100%); goodwill, if any, arising on a            business combination reflects the excess of the fair value of the acquiree, as a whole,            over the net amount of the recognized identifiable assets acquired and liabilities            assumed, and would be allocated to the acquirer and the non-controlling interest. The            statement is effective for periods beginning on or after January 1, 2009. The Company            will apply the standard for acquisitions occurring after this date.

             

 

34

 

 

----

| **OPTIMAL GROUP INC.**                                                                                  |
|---------------------------------------------------------------------------------------------------------|
| Notes to Consolidated Financial Statements,                            Continued                        |
| (Unaudited)                                                                                             |
|                                                                                                    |
| Periods ended June 30, 2008 and 2007                                                                    |
| (expressed in thousands of U.S. dollars, except share                            and per share amounts) |
|                                                                                                    |

 

| **15.** | **Canadian/U.S. reporting differences                            (continued):** |
|---------|---------------------------------------------------------------------------------|

|   | (e) | Recent accounting pronouncements                            (continued): |
|--------|-----|--------------------------------------------------------------------------|

SFAS No. 160 - Non-controlling interest in consolidated financial            statements:

In December 2007, the FASB issued a revised standard on accounting for            non-controlling interests and transactions with non-controlling interest holders in            consolidated financial statements. This statement specifies that non-controlling            interests are to be treated as a separate component of equity, not as a liability or            other item outside of equity. Because non-controlling interests are an element of            equity, increases and decreases in the parent’s ownership interest that leave            control intact are accounted for as capital transactions rather than as step            acquisitions or generating dilution gains or losses. The carrying amount of the            non-controlling interests is adjusted to reflect the changes in ownership interests,            and any difference between the amount by which the non-controlling interests are            adjusted and the fair value of the consideration paid or received is recognized            directly in equity attributable to the controlling interests.

This standard requires net income and comprehensive income to be            displayed for both the controlling and the non-controlling interests. Additional            required disclosures and reconciliations include a separate schedule that shows the            effects of any transactions with the non-controlling interests on the equity            attributable to the controlling interests.

The statement is effective for periods beginning on or after December            15, 2008. SFAS No. 160 will be applied prospectively to all non-controlling interests,            including any that arose before the effective date. The Company does not expect the            adoption of SFAS No. 160 to materially affect its consolidated financial            statements.

SFAS No. 161 - Disclosures about derivative instruments and hedging            activities, an amendment to FASBStatement No. 133:

In March 2008, the FASB issued the above-noted statement, which requires            qualitative disclosures about objectives and strategies for using derivatives,            quantitative disclosures about fair value amounts of gains and losses on derivative            instruments, and disclosures about credit-risk related contingent features on            derivative agreements. The statement is effective for periods beginning on or after            November 15, 2008. The Company does not expect the adoption of SFAS No. 161 to            materially affect its consolidated financial statements.

SFAS No. 162 - The hierarchy of generally accepted accounting principles            and SFAS 163 - Accounting for financial guarantee insurance contracts:

In May 2008, the FASB issued the above-noted statements. The Company            does not expect the adoption of these statements to affect its consolidated financial            statements.

             

35

 

 

----

| **OPTIMAL GROUP INC.**                                                                                  |
|---------------------------------------------------------------------------------------------------------|
| Notes to Consolidated Financial Statements,                            Continued                        |
| (Unaudited)                                                                                             |
|                                                                                                    |
| Periods ended June 30, 2008 and 2007                                                                    |
| (expressed in thousands of U.S. dollars, except share                            and per share amounts) |
|                                                                                                    |

 

| **16.** | **Comparative figures:** |
|---------|--------------------------|

Certain of the comparative figures have been reclassified in order to            conform with the current period’s presentation.

             

| **17.** | **Subsequent event:** |
|---------|-----------------------|

On August 5, 2008, the Company entered into agreements to dispose of the            Canadian “card present” business and the “card not present”            business of its payment processing segment. Proceeds on sale comprise a total cash            consideration of $9,000, of which $7,500 is payable upon closing and the remainder            through various instalments over a two-year period following the anniversary date of            the closing of the transactions. The Company retains rights to residual payments and            other interests in merchant account portfolios in the payment processing segment not            included in these transactions. The Company believes that it is more likely than not            that the remaining interest in this segment will be sold over the course of the next            12 months.

             

             

             

             

36

 

             

----

| **Item 2.** | **MANAGEMENT DISCUSSION AND ANALYSIS OF FINANCIAL                            CONDITION AND RESULTS OF OPERATIONS** |
|-------------|--------------------------------------------------------------------------------------------------------------------|

             

 

The following discussion of the financial condition and results of            operations of our Company describes our business, seasonality and trends within our            business environment, the critical accounting policies of our Company that will help            you understand our interim consolidated financial statements, and the principal factors            affecting our results of operations, liquidity and capital resources. This discussion            should be read in conjunction with our consolidated financial statements and management            discussion and analysis for the year ended December 31, 2007, and the factors set forth            below under “Cautionary Statements Regarding Forward-Looking Statements”.            We prepare our interim consolidated financial statements in accordance with generally            accepted accounting principles (“GAAP”) in Canada, with a reconciliation to            U.S. GAAP, as disclosed in note 15 of the notes to our interim consolidated financial            statements.

             

***In this Form 10-Q, except where otherwise indicated, references to            “dollars” or “$” are to United States dollars, references to            our “common shares” are to our Class “A” shares, references to            “our interim consolidated financial statements” are to our interim            consolidated financial statements as at and for the period ended June 30, 2008, which            are included in “Item 1. Financial Statements”, and all dollar amounts,            except those expressed in millions of dollars, are rounded to the nearest thousand. Any            reference in this report to uniform resource locator (URL) website locations are            inactive textual references only and the contents of such websites do not form a part            of this Form 10-Q.***

             

**Cautionary Statements Regarding Forward-Looking            Statements**

 

This Form 10-Q contains certain forward-looking statements within the            meaning of Section 27A of the Securities Act of 1933 and Section 21E of the Securities            Exchange Act of 1934.Words such as “expects”, “intends”,            “anticipates”, “plans”, “believes”,            “seeks”, “estimates”, or variations of such words and similar            expressions are intended to identify such forward-looking statements. Forward-looking            statements include, but are not limited to, statements about our current expectations            with respect to our future growth strategies, results, opportunities and prospects,            competitive position and industry environment. These forward-looking statements are            subject to a number of risks, uncertainties and other factors that could cause our            actual results, performance, prospects or opportunities, or those of the markets we            serve, to differ materially from those expressed in, or implied by, these            forward-looking statements, including:

 

|   | **•** | existing and future governmental regulations and                            disputes with governmental authorities; |
|--------|------------|---------------------------------------------------------------------------------------------------------------------|

             

|   | **•** | general economic, legal and business conditions in                            the markets we serve; |
|--------|------------|-----------------------------------------------------------------------------------------------------|

             

|   | **•** | consumer confidence in the security of financial                            information transmitted via the Internet; |
|--------|------------|-----------------------------------------------------------------------------------------------------------------------|

             

|   | **•** | levels of consumer and merchant fraud, disputes                            between consumers and merchants and merchant insolvency; |
|--------|------------|-------------------------------------------------------------------------------------------------------------------------------------|

             

|   | **•** | liability for merchant chargebacks; |
|--------|------------|-------------------------------------|

             

|   | **•** | our ability to safeguard against breaches of privacy                            and security when processing electronic transactions and use of our                            payments systems for illegal purposes; |
|--------|------------|-----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|

             

|   | **•** | the imposition of and our compliance with rules and                            practice procedures implemented by credit card and check clearing                            associations; |
|--------|------------|-------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|

             

|   | **•** | our ability to adapt to changes in technology,                            including technology relating to electronic payments                            systems; |
|--------|------------|--------------------------------------------------------------------------------------------------------------------------------------------------------------------|

             

|   | **•** | our ability to protect our intellectual                            property; |
|--------|------------|------------------------------------------------------------------------------|

             

37

 

             

----

|   | **•** | our relationships with our suppliers and the banking                            associations that we rely upon to process our electronic                            transactions; |
|--------|------------|-----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|

             

|   | **•** | disruptions in the function of our electronic                            payments systems and technological defects; |
|--------|------------|----------------------------------------------------------------------------------------------------------------------|

             

|   | **•** | our ability to complete, integrate and benefit from                            acquisitions, divestitures, joint ventures and strategic                            alliances; |
|--------|------------|-------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|

             

|   | **•** | our ability to retain key personnel; |
|--------|------------|--------------------------------------|

             

|   | **•** | currency exchange rate fluctuations; |
|--------|------------|--------------------------------------|

             

|   | **•** | our ability to successfully implement our strategies                            for our recently acquired WowWee business; |
|--------|------------|----------------------------------------------------------------------------------------------------------------------------|

             

|   | **•** | changing consumer preferences for electronics and                            play products; |
|--------|------------|---------------------------------------------------------------------------------------------|

             

|   | **•** | the seasonality of retail sales; |
|--------|------------|----------------------------------|

             

|   | **•** | concentration among our major retail customers for                            the products of our WowWee business; |
|--------|------------|--------------------------------------------------------------------------------------------------------------------|

             

|   | **•** | economic, social and political conditions in China,                            where WowWee’s products are manufactured; |
|--------|------------|--------------------------------------------------------------------------------------------------------------------------------|

             

|   | **•** | the price and supply of raw materials used to                            manufacture WowWee’s products; |
|--------|------------|---------------------------------------------------------------------------------------------------------------|

             

|   | **•** | product liability claims and product                            recalls; |
|--------|------------|--------------------------------------------------------------------------|

             

|   | **•** | increased competition; |
|--------|------------|------------------------|

             

|   | **•** | litigation; and |
|--------|------------|-----------------|

             

|   | **•** | the factors described under Item 1A “Risk                            Factors” in our Annual Report on Form 10-K for the year ended                            December 31, 2007. |
|--------|------------|----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|

             

There may be additional risks and uncertainties and other factors that            we do not currently view as material or that are not presently known by us. The forward            looking statements made in this document are only made as of the date of this            document.

             

Except as required by applicable securities laws, we undertake no            obligation to publicly update or revise any forward-looking statement, whether as a            result of new information, future events, changes in circumstances or any other reason            after the date of this quarterly report.

             

The Private Securities Litigation Reform Act of 1995 provides a            “safe harbor” for forward-looking statements to encourage companies to            provide prospective information about their companies without fear of litigation. We            are relying on the “safe harbor” provisions of the Private Securities            Litigation Reform Act in connection with the forward-looking statements included in            this quarterly report.

             

**Overview**

             

We operate in two business segments. Through WowWee (our business            segment established by our acquisition in November 2007 and comprised of WowWee Group            Limited, WowWee Canada Inc. and WowWee USA, Inc.), we design, develop, market and            distribute technology-based, consumer robotic, toy and entertainment products. Through            Optimal Payments (our business segment comprised of Optimal Payments Inc. and its            related affiliates), we process credit card payments for small and medium-sized            Internet businesses, mail-order/telephone-order (MOTO) merchants and retail            point-of-sale merchants, and process electronic checks and direct debits online and by            telephone.

 

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On August 5, 2008, we entered into two separate agreements to dispose of            the Canadian “card present” business and the “card not present”            business of our payment processing segment. Proceeds on sale comprise a total cash            consideration of $9.0 million, of which $7.5 million is payable upon closing and the            remainder through various installments over a two-year period following the anniversary            date of the closing of the transactions. Closing of the transactions is expected to            occur on August 29, 2008. We retain the rights to residual payments and other interests            in merchant account portfolios in the payment processing segment not included in these            transactions. We believe that it is more likely than not that our remaining interest in            this segment will be sold over the course of the next twelve months.

 

**Our Industry Segments**

 

As at June 30, 2008, we operate in two business segments: WowWee and            Optimal Payments (see note 10 of the notes to our interim consolidated financial            statements).

 

**WOWWEE**

 

Based in Hong Kong, with offices in La Jolla, California and Montreal,            Quebec, WowWee designs, develops, markets and distributes technology-based, consumer            robotic, toy and entertainment products. For 2008, WowWee’s product offerings            encompass four distinct lines: WowWee Robotics, WowWee Flytech, WowWee Alive and WowWee            Technologies.

 

WowWee’s products are sold in a range of brick and mortar channels            including grocery stores, pharmacies, toy stores, department stores and high-end            consumer technologies stores. A majority of our retailer customers in the United States            also carry the full line of WowWee products on their Internet sales sites.            WowWee’s products are available for purchase online at WowWee’s website            (http://www.wowweestore.com) and are also made through Internet-based “e-tailers” such            as Amazon.com and Buy.com.

 

WowWee’s products are produced in China by third party            manufacturers with which WowWee has long-standing relationships. Consistent with            industry practice, the use of third party manufacturers allows WowWee to avoid            incurring fixed manufacturing costs, while improving flexibility, capacity and            production technology. By outsourcing its manufacturing process, WowWee maintains a            flexible business model that enables it to be responsive to changing technology. In            addition, once a product has reached its commercialization phase, WowWee is able to            manage inventory risk by manufacturing products based upon actual customer orders as            well as forecasts. Upon final assembly, some products can be shipped directly from the            manufacturing locations to retailers and distributors, with title to the products            passing to retailer customers in China. Although WowWee does not conduct the day-to-day            manufacturing of its products, it is extensively involved in the design of the product            prototype and production tools, dies and moulds for its products and seeks to ensure            quality control by actively reviewing the production process and testing the products            produced by its manufacturers. WowWee employs quality control inspectors who rotate            among its manufacturers’ factories to monitor the production of substantially all            of its products. WowWee’s quality assurance personnel oversee compliance with            applicable regulations during each phase of product development, and perform compliance            testing, and coordinate third party independent compliance testing, on all WowWee            products. Once pre-production testing has been completed and production has been            approved, WowWee’s quality assurance personnel monitor production at the            manufacturer’s facility for compliance with WowWee’s quality            requirements.

 

Within the United States and Canada, WowWee sells its products directly            to its retailer customers through its direct sales channel and through independent            sales representatives. For retailers across the rest of the world, WowWee utilizes a            network of distributors located in various jurisdictions. WowWee products are also            available for sale through WowWee’s Internet-based store. In 2007, approximately            55% of its products were sold in North America, with the balance being sold            internationally. WowWee does not have written agreements with its customers. Instead,            sales are generally made based on purchase orders, primarily against letters of credit.            Historically, the majority of bookings and orders are received during the first two            quarters of the year, with shipments occurring throughout the year as new products            become available. The majority of product shipments occur during the third and fourth            quarters of the year. Revenue is recognized when (i) persuasive evidence of an            arrangement exists; (ii) products are shipped to customers who assume risk of loss,            (iii) collection of the respective receivable is probable and (iv) sales price is fixed            or determinable. In practice, this results in revenue being recognized when the product            is shipped from Hong Kong. Accruals for customer discounts, rebates, incentives and            allowances are recorded when the related revenues are recognized.

 

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WowWee’s engineering and design team develops new technologies            using internal capabilities and seeks to identify emerging or underutilized innovations            that are currently being developed or that are available in the marketplace. In order            to leverage the man-hours invested in product development, older generations of            products frequently form the foundation for the next generation of products as well as            new product lines. New technologies are then integrated to enhance the overall            functionality of the product. In sourcing technologies, WowWee reviews the latest            technology innovations at trade-shows, conferences, colleges and universities, on the            Internet, and through word-of-mouth. WowWee regularly reviews technologies or product            concepts from third party sources that it believes could have potential synergies with            WowWee’s current product line or that could be successfully commercialized based            upon WowWee’s development process. WowWee also licenses third party technologies            for development within unique consumer applications developed by WowWee.

 

We expect to implement specific strategies in order to enhance            WowWee’s growth and financial performance. These strategies include:

 

|   | **•** | expanding sales and distribution through a broadening                            of the sales channels, particularly outside North America in emerging                            markets; |
|--------|------------|--------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|

|   | **•** | expanding product design, development and production                            capabilities to produce an increased number of products at varying                            price points; |
|--------|------------|---------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|

|   | **•** | broadening development initiatives into products that                            combine computer connectivity, utility and entertainment; |
|--------|------------|--------------------------------------------------------------------------------------------------------------------------------------------|

|   | **•** | embarking on branded entertainment initiatives,                            licensing, publishing and merchandising; and |
|--------|------------|-------------------------------------------------------------------------------------------------------------------------|

|   | **•** | evaluating potential acquisition                            opportunities. |
|--------|------------|----------------------------------------------------------------------------|

 

**OPTIMALPAYMENTS**

 

Optimal Payments provides technology and services that businesses            require to accept credit card, electronic check and direct debit payments. Optimal            Payments processes credit card payments for card-not-present and card-present            transactions, including Internet businesses, mail-order/telephone-order merchants, and            retail point-of-sale merchants. Optimal Payments also processes checks and direct            debits online and by telephone.

             

Optimal Payments generates revenues primarily from fees charged to            merchants for processing services. Fees charged to merchants typically include a            discount rate, based upon a percentage of the dollar amounts processed, and a variety            of fixed transaction fees. Merchant fees charged are based upon the merchant’s            transaction volume and risk profile. Generally, higher discount rates are charged for            card-not-present transactions than for card-present transactions in order to compensate            for the higher cost of underwriting and managing the increased chargeback risk            associated with these transactions. Other fees are derived from a variety of fixed            transaction fees, including fees for monthly minimum charge volume requirements,            statement fees, annual fees and fees for other miscellaneous items, such as handling            chargebacks. Revenue is recognized primarily at the time the transaction is performed.            Where Optimal Payments is the primary party responsible for providing processing            services, revenue is recorded on a gross basis and amounts paid to the acquiring            processing supplier are recorded as part of our transaction processing expenses. Where            Optimal Payments is not the primary party in providing a merchant with processing            services, we record revenue net of amounts paid to the acquiring processing            supplier.

             

Disputes between a customer and a merchant periodically arise as a            result of, among other things, consumer dissatisfaction with merchandise quality or            services provided by a merchant. Such disputes may not always be resolved in the            merchant’s favor. If a dispute is not resolved in the merchant’s favor, the            transaction is charged back to Optimal Payments and the purchase price is refunded to            the merchant’s customer. If Optimal Payments is unable to collect the charged            back amount from the merchant, it bears the credit risk for the full amount of the            transaction. As a result, Optimal Payments’ acquiring processing suppliers            require it to maintain certain amounts with them as reserves. Amounts withheld from            Optimal Payments by its acquiring processing suppliers as reserves are included as            current assets on our balance sheet under the line item “held as reserves”.            Optimal Payments retains a percentage of amounts owed to certain merchants based on            processing dollar volume, typically for a six-month period, to absorb potential losses            arising as a result of, among other things, disputes between consumers and merchants or            credit card or check clearing association fines related to chargeback activity. The            aggregate amount withheld is included under the line item “Customer reserves and            security deposits” on the balance sheets contained in our interim consolidated            financial statements.

 

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On August 5, 2008, we entered into two separate agreements to dispose of            the Canadian “card present” business and the “card not present”            business of our payment processing segment. Proceeds on sale comprise a total cash            consideration of $9.0 million, of which $7.5 million is payable upon closing and the            remainder through various installments over a two-year period following the anniversary            date of the closing of the transactions. Closing of the transactions is expected to            occur on August 29, 2008. We retain the rights to residual payments and other interests            in merchant account portfolios in the payment processing segment not included in these            transactions. We believe that it is more likely than not that our remaining interest in            this segment will be sold over the course of next twelve months.

 

**Seasonality**

             

Revenue derived from the Optimal Payments business segment is currently            not subject to seasonality. Revenue derived from the WowWee business segment is subject            to seasonal variability with a significant portion of revenues generated in the third            and fourth quarter of each calendar year.

 

**Critical Accounting Policies and Estimates**

 

Our interim consolidated financial statements have been prepared in            accordance with Canadian GAAP, which requires us to make numerous estimates and            assumptions. Financial results as determined by actual events could differ from those            estimates and assumptions, and therefore affect our reported results of operations and            financial position. Changes in accounting policies are more fully described in note 3            of the notes to our annual audited consolidated financial statements included in our            Form 10-K Annual Report for the year ended December 31, 2007 and note 2 of the notes to            our interim consolidated financial statements. Our significant accounting policies are            more fully described in note 4 of the notes to our annual audited consolidated            financial statements included in our Form 10-K Annual Report for the year ended            December 31, 2007. The critical accounting policies described here are those that are            most important to the depiction of our financial condition and results of operations.            The preparation of financial statements also involves significant management judgment            in making estimates about the effect of matters that are inherently uncertain. While            best estimates have been used for reporting financial statement items subject to            measurement uncertainty, management considers that it is possible, based on existing            knowledge, that changes in future conditions in the near term could affect the reported            amounts of assets and liabilities and disclosures of contingent assets and liabilities.            “Near term” is considered to be within one year from the date of the            financial statements.

             

***Stock-based Compensation***

 

We use the fair value-based method to account for stock-based            compensation and other stock-based payments, such as stock options. Under the fair            value-based method, compensation cost is measured at fair value at the date of grant            and is expensed over the award’s vesting period. The fair value of stock options            granted is determined at the date of grant using the Black-Scholes option pricing            model, which requires certain assumptions, including future stock price volatility,            risk-free interest rates, and expected time to exercise. Changes to any of these            assumptions, or the use of a different option pricing model, would result in different            fair values for stock-based compensation.

             

***Reserve for Losses on Merchant Accounts***

 

When a consumer pays a merchant for goods or services online and the            consumer subsequently disputes the online transaction, the amount of the disputed item            gets charged back to the merchant and the credit card or clearing bank association may            levy a fee against it. In addition, if a merchant’s chargeback rate becomes            excessive, the associations can also require it to pay fines. If the credit card or            clearing bank association is unable to collect from the merchant the amount charged            back and the amount of such fines, Optimal Payments would be responsible to remit these            amounts to the association. In turn, Optimal Payments attempts to recover such amounts            from the merchant. However, it may not always be successful in doing so, for reasons            which could include merchant insolvency. We evaluate the risk associated with merchants            and consumers and estimate our loss based primarily on historical experience and other            relevant factors. Our loss reserves comprise specifically identifiable reserves for            merchant transactions for which losses can be estimated and an estimate of loss in the            remaining portfolio based on experience.

 

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***Allowance for Doubtful Accounts***

 

Our allowance for doubtful accounts is based on management’s            assessment of the business environment, customers’ financial condition,            historical collection experience, accounts receivable aging, customer disputes and the            collectability of specific customer accounts. If there were a deterioration of a major            customer’s creditworthiness, or actual defaults were higher than our historical            experience, our estimates of the recoverability of amounts due to us could be            overstated, which could have an adverse impact on our operating results. The allowance            for doubtful accounts is also affected by the time at which uncollectible accounts            receivable balances are actually written off.

             

Major customers’ accounts are monitored on an ongoing basis; more            in depth reviews are performed based on changes in customer’s financial condition            and/or the level of credit being extended. When a significant event occurs, such as a            bankruptcy filing by a specific customer, and on a quarterly basis, the allowance is            reviewed for adequacy and the balance or accrual rate is adjusted to reflect current            risk prospects.

 

***Sales Incentives***

 

Sales are recorded net of sales returns and discounts, which are            estimated at the time of shipment. We routinely enter into arrangements with our            customers to provide sales incentives, support customer promotions, and provide            allowances for returns. Such programs are based primarily on customer purchases,            customer performance of specified promotional activities, and other specified factors            such as sales to consumers. Accruals for these programs are recorded as sales            adjustments that reduce gross revenue in the period the related revenue is            recognized.

 

***Reserve for Inventory Obsolescence***

             

We value our inventory at the lower of cost or net realizable value.            Based upon a consideration of quantities on hand, actual and projected sales volume,            anticipated product selling prices and product lines planned to be discontinued,            slow-moving and obsolete inventory is written down to its net realizable            value.

 

Failure to accurately predict and respond to consumer demand could            result in our underproducing popular items or overproducing less popular items.            Furthermore, significant changes in demand for our products would impact            management’s estimates in establishing our inventory provision.

             

Management estimates are monitored on a quarterly basis and a further            adjustment to reduce inventory to its net realizable value is recorded, as an increase            to cost of sales, when deemed necessary under the lower of cost or market            standard.

 

***Goodwill and Other Intangibles***

 

We account for business acquisitions using the purchase method.            Accordingly, the purchase price of a business acquisition is allocated to its            identifiable net assets, including identifiable intangible assets, on the basis of            estimated fair values as at the date of purchase, with any excess being assigned to            goodwill. We estimate the fair value of assets and liabilities acquired at the date of            acquisition using a projected discounted cash flow method and other valuation methods.            We make a number of significant estimates when calculating fair value using a projected            discounted cash flow method. These estimates include estimating projected future cash            flows, the number of years used, the discount rate and others. We believe that our            estimates and valuation methods are reasonable. They are consistent with our inherent            planning and reflect our best estimates, but they have inherent uncertainties that            management may not be able to control.

 

Goodwill is not amortized but rather evaluated under an impairment            approach. Other intangible assets with finite lives continue to be amortized over their            estimated useful lives. The amounts recorded as intangible assets at the date of            acquisition represent the estimated fair value of these assets based on estimated            future cash flows discounted at appropriate discount rates. In addition, in our            assessment of impairment, we are required to determine the fair value of the businesses            from which the goodwill and intangibles originated. For intangibles with finite lives,            we make estimates of future cash flows to be generated from the related            assets.

 

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Due to the subjective nature of assessing impairment, significant            changes in the assumptions used to develop the estimate could materially affect the            conclusion regarding the future cash flows necessary to support the valuation of            long-lived assets and goodwill. The valuation of goodwill involves a high degree of            judgment and consists of a comparison of the fair value of a reporting unit with its            book value. Impairment is determined by estimating the fair value of a reporting unit            and comparing that value to the reporting unit’s book value. If the implied fair            value is more than the book value of the reporting unit, an impairment loss is not            indicated. If impairment exists, the fair value of the reporting unit is allocated to            all of its assets and liabilities excluding goodwill, with the excess amount            representing the fair value of goodwill. An impairment loss is measured as the amount            by which the book value of the reporting unit’s goodwill exceeds the estimated            fair value of that goodwill.

 

***Income Taxes***

 

We provide for income taxes using the asset and liability method of tax            allocation. Under this method, future income tax assets and liabilities are determined            based on deductible or taxable temporary differences between financial statement values            and tax values of assets and liabilities using substantively enacted income tax rates            expected to be in effect for the year in which the differences are expected to reverse.            We establish a valuation allowance against future income tax assets if, based on            available information, it is more likely than not that some or all of the future income            tax assets will not be realized. In assessing the recoverability of tax assets, we            consider whether it is more likely than not that some portion or all of the tax assets            will not be realized. The ultimate realization of the future tax assets is dependent            upon the generation of future taxable income during the periods in which the temporary            differences become deductible. We consider the scheduled reversal of tax liabilities,            projected future taxable income, and tax planning strategies in making this            assessment.

 

Our income tax provision and related income tax assets and liabilities            are calculated based on actual income in the various jurisdictions in which we            operate.  Significant judgment is required in interpreting tax regulations in            the Canadian and foreign jurisdictions, and in evaluating worldwide uncertain tax            positions.  Actual results could differ materiality from those judgments, and            changes in judgments could materially affect our consolidated financial            statements.

             

***Contingent Liabilities***

 

Our former gaming payment processing services segment derived a            substantial portion of its revenue prior to October 13, 2006 from processing            transactions from U.S.-based gaming. Therefore, we may be exposed to adverse            consequences as a result of enforcement proceedings, governmental investigations or            lawsuits initiated against us in jurisdictions where gaming is or becomes restricted or            prohibited. Following announcements by the U.S. Attorney’s Office in the Southern            District of New York relating to its investigation of the U.S. Internet gambling            industry, we announced on May 8, 2007 that we had initiated discussions with the U.S.            Attorney’s Office in the Southern District of New York and are in the process of            responding to a voluntary request for information issued by the U.S. Attorney’s            Office. In connection with the ongoing investigation, we announced on May 11, 2007 that            we had received a copy of warrants of seizure issued by the U.S. Attorney’s            Office against funds of certain payment processors that were on deposit with two U.S.            banks. These funds included $19.2 million on deposit to the credit of our affiliates.            The total amount seized of $19.2 million is presented as restricted cash on the            consolidated balance sheets. We have not recorded any provision for this matter because            the outcome of these discussions and the amount of loss, if any, are not            determinable.

 

We are also party to litigation arising in the normal course of            operations. The results of legal proceedings cannot be predicted with certainty. Should            we fail to prevail in any of these legal matters or should several legal matters be            resolved against us in the same reporting period, the consolidated operating results of            a particular reporting period could be materially adversely affected. While best            estimates have been used for reporting financial statement items subject to measurement            uncertainty, management considers that it is possible that changes in future conditions            in the near term could require a material change in the recognized amounts of certain            assets and liabilities. “Near term” is considered to be within one year            from the date of the financial statements.

 

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**Recent Accounting Pronouncements**

 

| ***(a)*** | ***New Accounting                            Policie**s* |
|-----------|----------------------------------------------------------|

 

The following accounting standards have recently been issued by the            Canadian Institute of Chartered Accountants (CICA), and the Financial Accounting            Standards Board (FASB) that are relevant to our company. References to FASB and            Statement of Financial Accounting Standards (SFAS) relate to U.S. GAAP and therefore            may affect the note to our consolidated financial statements that discloses            Canadian/U.S. GAAP differences.

             

*Capital Disclosures*

 

On January 1, 2008 we adopted Section 1535,*Capital Disclosures*, which established            guidelines for disclosure of both qualitative and quantitative information that enables            users of financial statements to evaluate the entity’s objectives, policies and            processes for managing capital. This new standard relates to disclosure only and did            not impact our financial results.

 

*Financial Instruments*

 

On January 1, 2008 we adopted Section 3862,*Financial Instruments - Disclosure*, which            describes the required disclosure for the assessment of the significance of financial            instruments for an entity’s financial position and performance and of the nature            and extent of risk arising from financial instruments to which the entity is exposed            and how the entity manages those risks. In addition we adopted Section 3863,*Financial Instruments – Presentation*,            which establishes standards for presentation of financial instruments and non-financial            derivatives. It carries forward the presentation related requirements of Section            3861,*Financial Instruments - Disclosure and            Presentation*. These new standards relate to disclosure only            and did not impact our financial results.

 

*Inventories*

 

On January 1, 2008 we adopted Section 3031,*Inventories*, which replaces Section 3030            and harmonizes the Canadian standards related to inventories with the International            Financial Reporting Standards (“IFRS”). This Section provides changes to            the measurement and more extensive guidance on the determination of cost, including            allocation of overhead; narrows the permitted cost formulas; requires impairment            testing; and expands the disclosure requirements to increase transparency. The adoption            of this standard did not have a significant impact on our interim consolidated            financial statements.

             

*SFAS No. 157 - Fair value measurements*

             

On January 1, 2008 we adopted SFAS No. 157,*Fair Value Measurements*. SFAS No. 157            clarifies the principle that fair value should be based on the assumptions market            participants would use when pricing an asset or liability and establishes a fair value            hierarchy that prioritizes the information used to develop those assumptions. Under the            standard, fair value measurements would be separately disclosed by level within the            fair value hierarchy. The standard did not have a significant impact on our interim            consolidated financial statements.

             

| ***(b)*** | ***Future Accounting                            Pronouncements*** |
|-----------|-------------------------------------------------------------------|

 

The following accounting pronouncements have recently been issued by the            CICA and the FASB and may be relevant to our company. References to FASB and SFAS            relate to U.S. GAAP and therefore may affect the note to our consolidated financial            statements that discloses Canadian/U.S. GAAP differences.

             

             

44

 

             

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*Goodwill and intangible assets*

             

In February 2008, the CICA issued Section 3064,*Goodwill and Intangible Assets*, which will            replace Section 3062,*Goodwill and Other Intangible            Assets*and Section 3450*, Research            and Development Costs*. The standard provides guidance on the            recognition of intangible assets in accordance with the definition of an asset and the            criteria for asset recognition, as well as clarifying the application of the concept of            matching revenues and expenses, whether these assets are separately acquired or            internally developed. This standard applies to interim and annual financial statements            relating to fiscal years beginning on or after October 1, 2008. We expect that the            adoption of this standard will not have a significant impact on our financial            results.

 

*International Financial Reporting Standards*

 

In 2005, the Accounting Standards Board of Canada announced that            accounting standards in Canada are to converge with IFRS. In February 2008, the            CICA confirmed the change-over date from current Canadian GAAP to IFRS to be January 1,            2011. While IFRS uses a conceptual framework similar to Canadian GAAP, there are            significant differences in accounting policies which must be addressed. We have not yet            fully assessed the future impact of these new standards on our consolidated financial            statements.

             

*SFAS No. 141R, Business Combinations*

 

In December 2007, the FASB issued a revised standard on accounting for            business combinations. The major changes to accounting for business combinations            include the following: all business acquisitions would be measured at fair value; the            existing definition of a business would be expanded; certain pre-acquisition            contingencies would be measured at fair value; most acquisition-related costs would be            recognized as expenses are incurred (they would no longer be part of the purchase            consideration); obligations for contingent consideration would be measured and            recognized at fair value at the date of acquisition (measurement and recognition would            no longer be dependent on settlement of the contingency); non-controlling interests            would be measured at fair value at the date of acquisition (i.e., 100% of the assets            and liabilities would be measured at fair value even when an acquisition is less than            100%); goodwill, if any, arising on a business combination reflects the excess of the            fair value of the acquiree, as a whole, over the net amount of the recognized            identifiable assets acquired and liabilities assumed, and would be allocated to the            acquirer and the non-controlling interest. The statement is effective for periods            beginning on or after January 1, 2009. We will apply the standard for acquisitions            occurring after this date.

             

*SFAS No. 160 - Non-controlling interest in consolidated financial            statements*

             

In December 2007, the FASB issued a revised standard on accounting for            non-controlling interests and transactions with non-controlling interest holders in            consolidated financial statements. This statement specifies that non-controlling            interests are to be treated as a separate component of equity, not as a liability or            other items outside of equity. Because non-controlling interests are an element of            equity, increases and decreases in the parent’s ownership interest that leave            control intact are accounted for as capital transactions rather than as a step            acquisition or dilution gains or losses. The carrying amount of the non-controlling            interests is adjusted to reflect the changes in ownership interests, and any difference            between the amount by which the non-controlling interests are adjusted and the fair            value of the consideration paid or received is recognized directly in equity            attributable to the controlling interests.

             

This standard requires net income and comprehensive income to be            displayed for both the controlling and the non-controlling interests. Additional            required disclosures and reconciliations include a separate schedule that shows the            effects of any transactions with the non-controlling interests on the equity            attributable to the controlling interests.

             

The statement is effective for periods beginning on or after December            15, 2008. SFAS 160 will be applied prospectively to all non-controlling interests,            including any that arose before the effective date. We do not expect the adoption of            SFAS 160 to materially impact our consolidated financial statements.

 

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*SFAS No. 161 - Disclosures about derivative instruments and hedging            activities, an amendment to FASB Statement No. 133*

 

In March 2008, the FASB issued the above-noted statement, which requires            qualitative disclosures about objectives and strategies for using derivatives,            quantitative disclosures about fair value amounts of and gains and losses on derivative            instruments, and disclosures about credit-risk related contingent features on            derivative agreements. The statement is effective for periods beginning on or after            November 15, 2008. We do not expect the adoption of SFAS No. 161 to materially            affect our consolidated financial statements.

 

*SFAS No. 162 – The Hierarchy of Generally Accepted Accounting            Principles and SFAS 163 - Accounting for Financial Guarantee Insurance            Contracts*

             

In May 2008, the FASB issued the above-noted statements. We do not            expect the adoption of these statements to affect our consolidated financial            statements.

 

**Financial Condition**

 

As at June 30, 2008, cash and cash equivalents, cash held as reserves,            short-term investments, short-term investments held as reserves and settlement assets            totaled $62.3 million (including $7.6 million held as reserves) compared to $73.0            million (including $8.6 million held as reserves) as at December 31, 2007.

The decrease in cash and cash equivalents, and short-term investments is            primarily due to the use of cash and cash equivalents in operations, in WowWee for the            seasonal build-up of inventories to meet orders to be shipped in the second half of the            year and the purchase of equipment, and in Optimal Payments due to the reduction of            customer reserves and security deposits. As described above, a significant portion of            cash and cash equivalents, and short-term investments have a corresponding liability as            these cash amounts are derived from reserves and security deposits which are due to            customers (see “Our Industry Segments – Optimal Payments”). As at            June 30, 2008 and December 31, 2007, our cash and cash equivalents, short-term            investments and settlement assets positions, net of customer reserves and security            deposits, were as follows:

 

|                                    | **June 30,** | **December 31,** |   |
|-----------------------------------------|--------------|------------------|--------|
| (U.S. dollars, in thousands)            | **2008**     | **2007**         |   |
|                                    |         |             |   |   |
| Cash and cash equivalents               | $            | 51,000      | $      | 47,193  |
| Cash held as reserves                   |         | 5,768       |   | 6,869  |
| Short-term investments                  |         | 2,383       |   | 12,477  |
| Short-term investments held as reserves |         | 1,795       |   | 1,710  |
| Settlement assets                       |         | 1,402       |   | 4,715  |
|                                    |         | 62,348      |   | 72,964  |
|                                    |         |             |   |   |
| Less:                                   |         |             |   |   |
| Customer reserves and security deposits |         | (19,233)         |   | (21,324) |
| Net cash position                       | $            | 43,115      | $      | 51,640  |
|                                         |              |                  |        |  |  |

             

Our portfolio of liquid and investment grade short-term investments            consists of U.S. denominated discounted and undiscounted notes and bonds.

             

Working capital, excluding cash and short-term investments held as            reserves, as at June 30, 2008 was $11.9 million, as compared to $15.9 million at            December 31, 2007. This decrease is due primarily to the use of cash by WowWee in the            six-months ended June 30, 2008 due to the seasonality of its revenues.We expect WowWee            to use cash in the first half of the year for manufacturing costs required to fulfill            sales orders, and to generate cash in the second half of the year as orders are shipped            and subsequently collected.

             

Accounts and other receivables, as at June 30, 2008 were $19.4 million,            as compared to $18.5 million at December 31, 2007. The increase is due primarily to the            seasonal increase in revenues derived from WowWee.

 

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----

 

Intangible assets decreased by $9.1 million, from $86.9 million as at            December 31, 2007 to $77.8 million as at June 30, 2008 due to amortization recorded in            the six-month period ended June 30, 2008.

 

Customer reserves and security deposits as at June 30, 2008 were $19.2            million, as compared to $21.3 million as at December 31, 2007. The decrease of $2.1            million is primarily due to decreased processing volume in Optimal Payments.

             

Shareholders’ equity as at June 30, 2008 was $147.2 million as            compared to $201.7 million as at December 31, 2007. The decrease is attributable            primarily to the results of operations net of stock-based compensation and the            cancellation of shares pursuant to our stock buyback            program*.*

             

**Results of Operations**

 

Revenue derived from Optimal Payments is currently not subject to            seasonality. Revenue derived from WowWee is subject to seasonal variability with a            significant portion of revenues expected to be generated in the third and fourth            quarter of each calendar year.

 

*Six-month period ended June 30, 2008 compared to the six-month period            ended June 30, 2007*

 

Revenues increased by $14.7 million, from $58.1 million for the            six-month period ended June 30, 2007 to $72.8 million for the six-month period ended            June 30, 2008. The increase consists of additional revenues of $20.4 million resulting            from our acquisition of WowWee, offset by a decrease in revenues in Optimal Payments as            a result of lower merchant volumes from normal attrition and discontinuing business            with unprofitable merchant accounts.

 

Transaction processing expenses and cost of sales increased by $9.3            million, from $36.8 million for the six-month period ended June 30, 2007 to $46.1            million for the six-month period ended June 30, 2008. The increase consists of            additional cost of sales of $14.5 million in WowWee, offset by a decrease in            transaction processing due to lower volumes in Optimal Payments.

             

Selling, general and administrative expenses increased by $12.8 million,            from $13.5 million for the six-month period ended June 30, 2007 to $26.3 million for            the six-month period ended June 30, 2008. The increase in selling, general and            administrative expenses is due primarily to our acquisition of WowWee. The level of            selling, general and administrative expenses is not subject to significant seasonal            variability.

             

Amortization of intangibles pertaining to transaction processing            increased by $3.3 million, from $6.3 million for the six-month period ended June 30,            2007 to $9.6 million for the six-month period ended June 30, 2008. The increase in            amortization is due primarily to the intangible assets acquired in connection with our            acquisition of WowWee.

             

Amortization of equipment pertaining to cost of sales was $1.7 million.            This expense arises from our acquisition of WowWee and is related to the amortization            of moulds used in the production of our products.

             

Amortization of property and equipment pertaining to selling, general            and administration for the six-month period ended June 30, 2008 and 2007 remained            constant at $0.6 million.

             

Stock-based compensation pertaining to selling, general and            administrative expense decreased by $3.5 million, from $6.0 million for the six-month            period ended June 30, 2007 to $2.5 million for the six-month period ended June 30,            2008. As a result of our acquisition of all of the issued and outstanding ordinary            shares of FireOne Group plc held by non-controlling shareholders in February 2007, all            of the unvested restricted share units became exercisable and the remaining unamortized            compensation cost of $6.0 million was recognized. In June 2008, the expiry dates of            outstanding options issued in 2004 were extended by five years. Since these options            were vested at the date of modification, the incremental value of $1.4 million of the            fair value of the modified options over the value of the options immediately prior to            their modification was recognized as an expense in the quarter ended June 30,            2008.

             

Research and development expenses increased by $1.5 million, from $1.3            million for the six-month period ended June 30, 2007 to $2.8 million for the six-month            period ended June 30, 2008. The increase in research and development expenses is due            primarily to our acquisition of WowWee.

 

47

 

 

----

             

At December 31, 2007 the net book value of goodwill was $66.2 million,            of which $37.1 million related to WowWee and $29.1 million related to Optimal Payments.            Goodwill in Optimal Payments at December 31, 2007, was net of impairment charges of            $22.6 million provided for in 2007.

             

As discussed in note 3(b) of the notes to the interim consolidated            financial statements, goodwill in WowWee was reduced by $1.1 million during the period            ended June 30, 2008, as a result of fair value adjustments to certain assets and            liabilities as at the date of acquisition. Since we are still in the process of            finalizing the valuation of certain intangible assets and other assets acquired and            liabilities assumed as at the date of acquisition, the allocation of the purchase price            is subject to change. We expect to finalize the allocation of the purchase price by the            end of 2008.

             

At June 30, 2008, we also tested goodwill for impairment in Optimal            Payments as we determined that there was a more likely than not expectation that a            significant portion, or the entirety of this segment, would be sold over the course of            the next twelve months. As a result of this analysis, the goodwill in the segment was            determined to be impaired since the estimated fair value to be realized as proceeds            from transactions which are expected to be finalized within the next twelve months            would be less than the carrying value of the segment including goodwill. As a result,            we recorded a non-cash, pre-tax goodwill impairment loss of $29.1 million in the second            quarter of 2008 in Optimal Payments.

             

Investment income decreased by $2.8 million, from $3.5 million during            the six-month period ended June 30, 2007 to $0.7 million for the six-month period ended            June 30, 2008. The decrease is due primarily to the lower cash position during the            six-month period ended June 30, 2008, as a result of funds used to acquire WowWee in            November 2007.

             

The provision for income taxes was $10.5 million for the six-month            period ended June 30, 2008, as compared to $0.9 million for the six-month period ended            June 30, 2007. Significant components of the consolidated tax provision for the            six-month period ended June 30, 2008 included the effect of non-deductible goodwill            impairment, amortization of other (tax) asset and the write-off of previously            recognized future tax assets. As a result of the goodwill impairment loss relating to            Optimal Payments, we also amortized $5.7 million of the other tax asset as a future tax            expense in the second quarter of 2008, representing the remaining portion of this asset            that was realized at June 30, 2008. In addition, we wrote-off $7.6 million of            previously recognized future tax assets that no longer met the criteria for            recognition.

             

Other items in the 2008 tax provision included tax differences in tax            rates in foreign jurisdictions and non-deductible stock-based compensation. In 2008, a            greater portion of our operations was taxable in Hong Kong at a lower effective tax            rate than in Canada, which affected the provision by $1.0 million compared to a            recovery of $0.3 million for the six-month period ended June 30, 2007. In addition, the            2008 tax provision includes the tax effect of non-deductible stock-based compensation            expense in the amount of $0.8 million. In 2007, the tax effect of stock-based            compensation expense was $1.9 million as a result of the acceleration of vesting and            exercise of restricted share units in connection with the privatization of FireOne            Group plc.

 

Our tax provision also includes the effect of future taxes on unrealized            foreign exchange gains and losses, which arise upon the conversion into Canadian            dollars of net monetary assets and liabilities denominated in U.S. dollars for purposes            of determining taxable income under Canadian income tax regulations. Since the U.S.            dollar is our measurement currency and our consolidated financial statements are            presented in U.S. dollars, these foreign exchange gains and losses do not affect            earnings before income taxes. In the six-month period ended June 30, 2008, our tax            provision includes a future tax recovery of $0.2 million related to foreign exchange,            as compared to $1.3 million for the six-month period ended June 30, 2007.

 

We did not record non-controlling interest for the six-month period            ended June 30, 2008, as compared to $0.2 million for the six-month period ended June            30, 2007. The decrease results primarily from our acquisition in February 2007 of all            of the issued and outstanding ordinary shares of FireOne Group plc held by            non-controlling shareholders. After this date, non-controlling interest is no longer            recorded.

 

48

 

 

----

                        Our net loss for the six-month period ended June 30, 2008 was $56.4 million (or $2.18            per share), as compared to a net loss of $4.5 million (or $0.19 per share – basic            and diluted) for the six-month period ended June 30, 2007. The increase is due            primarily to a non-cash impairment loss from Optimal Payments of $29.1 million for            goodwill, as well as related charges of $5.7 million for the other asset and $7.6            million of future tax assets that no longer meet the criteria for recognition at June            30, 2008 in this segment. In addition, the results of operations include a loss of            $11.8 million from WowWee, which we expect will generate most of its annual revenues in            the third and fourth quarters.

             

EBITDA was a loss of $3.2 million (or a loss of $0.12 per share) for the            six-month period ended June 30, 2008, as compared to $6.1 million (or $0.25 per diluted            share) for the six-month period ended June 30, 2007.

             

  EBITDA is a non-GAAP financial measure. A reconciliation of this            non-GAAP financial information is presented in the table below. We use non-GAAP            measures to assess our operating performance. Earnings and other measures adjusted to a            basis other than GAAP do not have standardized meanings and are unlikely to be            comparable to similar measures used by other companies. Accordingly, this non-GAAP            financial measure they should not be considered in isolation. We use EBITDA to measure            our performance from one period to the next without the variation caused by certain            adjustments that could potentially distort the analysis of trends in our operating            performance, and because we believe it provides meaningful information on our financial            condition and operating results.

 

  EBITDA, as we use it, is calculated as earnings before investment            income, taxes, depreciation and amortization and excludes the impacts of impairment            loss, non-controlling interest, stock-based compensation and discontinued operations.            We believe it is useful to exclude these items as they are either non-cash expenses,            items that cannot be influenced by management in the short term, or items that do not            impact core operating performance. Excluding these items does not imply they are            non-recurring.

 

             

| Reconciliation                            of Non-GAAP Financial Information                                   |
|---------------------------------------------------------------------------------------------------------------|
| (expressed in                            thousands of U.S. dollars, except per share amounts)                 |
|                                                                                                          |   |   |   |   |
|                                                                                                          |   | **Six                            months ended** |
|                                                                                                          |   | **June                            30,** |
|                                                                                                          |   | **2008** |   | **2007** |
|                                                                                                          |   | Unaudited |   | Unaudited |
|                                                                                                          |   |   |   |   |
| Net (loss)                                                                                                    | $ | (56,440) | $ | (4,495) |
|                                                                                                          |   |   |   |   |
| Add (deduct):                                                                                                 |   |   |   |   |
| Amortization of intangibles pertaining to transaction                            processing and cost of sales |   | 9,596  |   | 6,336  |
| Amortization of equipment pertaining to selling, general                            and administrative        |   | 642  |   | 650  |
| Amortization of equipment pertaining to cost of                            sales                              |   | 1,661  |   | - |
| Stock-based compensation pertaining to selling, general                            and administrative         |   | 2,451  |   | 6,027  |
| Non-controlling interest                                                                                      |   | - |   | 159  |
| Investment income                                                                                             |   | (689) |   | (3,477) |
| Income tax provision                                                                                          |   | 10,453  |   | 887  |
| Impairment loss                                                                                               |   | 29,097  |   | - |
|                                                                                                          |   |   |   |   |
| EBITDA                                                                                                        | $ | (3,229) | $ | 6,087  |
|  

Diluted shares                                                                                        |   | 25,910,169  |   | 24,470,845  |
|                                                                                                          |   |   |   |   |
| EBITDA per diluted share                                                                                      | $ | (0.12) | $ | 0.25  |

             

 

49

 

 

----

*Three-month period ended June 30, 2008 compared to the three-month            period ended June 30, 2007*

 

Revenues increased by $13.6 million, from $28.0 million for the            three-month period ended June 30, 2007 to $41.6 million for the three-month period            ended June 30, 2008. The increase consists of additional revenues of $15.5 million            resulting from our acquisition of WowWee, offset by a decrease in revenues in Optimal            Payments as a result of lower merchant volumes from normal attrition and discontinuing            business with unprofitable merchant accounts.

             

Transaction processing and cost of sales increased by $8.6 million, from            $18.1 million during the three-month period ended June 30, 2007 to $26.7 million for            the three-month period ended June 30, 2008. The increase consists of additional cost of            sales of $10.8 million in WowWee, offset by a decrease in transaction processing due to            lower volumes in Optimal Payments.

             

Selling, general and administrative expenses increased by $7.9 million,            from $5.8 million for the three-month period ended June 30, 2007 to $13.7 million for            the three-month period ended June 30, 2008. The increase in selling, general and            administrative expenses is due primarily to our acquisition of WowWee. The level of            selling, general and administrative expenses is not subject to significant seasonable            variability.

 

Amortization of intangibles pertaining to transaction processing costs            and cost of sales increased by $1.6 million, from $3.2 million during the three-month            period ended June 30, 2007 to $4.8 million for the three-month period ended June 30,            2008. The increase in amortization is due primarily to the intangible assets acquired            in connection with our acquisition of WowWee.

 

Amortization of equipment pertaining to cost of sales of $0.8 million            for the three-month period ended June 30, 2008. This expense arises from our            acquisition of WowWee and is related to the amortization of moulds used in the            production of our products.

 

Amortization of property and equipment pertaining to selling, general            and administrative for the three-months period ended June 30, 2008 and 2007 remained            constant at $0.3 million.

             

Stock based compensation pertaining to selling, general and            administrative increased by $1.9 million, from a nominal amount during the three-month            period ended June 30, 2007 to $1.9 million during the three-month period ended June 30,            2008. This increase is due to additional compensation resulting from the five-year            extension of the expiry dates of outstanding options issued in 2004.Since these options            were vested at the date of modification, the incremental value of $1.4 million of the            fair value of the modified option over the value of the options immediately prior to            their modification was recognized as an expense in the quarter ended June 30,            2008.

 

Research and development expenses increased by $0.6 million, from $0.6            for the three-month period ended June 30, 2007 to $1.2 million for the three-month            period ended June 30, 2008. The increase in research and development expenses is due            primarily to our acquisition of WowWee.

             

At December 31, 2007 the net book value of goodwill was $66.2 million,            of which $37.1 million related to WowWee and $29.1 million related to Optimal Payments.            Goodwill in Optimal Payments as at December 31, 2007, was net of impairment charges of            $22.6 million provided for in 2007.

             

As discussed in note 3(b) of the notes to the interim consolidated            financial statements, goodwill in WowWee was reduced by $1.1 million during the period            ended June 30, 2008, as a result of fair value adjustments to certain assets and            liabilities as at the date of acquisition. Since we are still in the process of            finalizing the valuation of certain intangible assets and other assets acquired and            liabilities assumed as at the date of acquisition, the allocation of the purchase price            is subject to change. We expect to finalize the allocation of the purchase price by the            end of 2008.

 

50

 

 

----

At June 30, 2008, we also tested goodwill for impairment in Optimal            Payments as we determined that there was a more likely than not expectation that a            significant portion, or the entirety of this segment, would be sold over the course of            the next twelve months. As a result of this analysis, the goodwill in the segment was            determined to be impaired since the estimated fair value to be realized as proceeds            from transactions which are expected to be finalized over the course of the next twelve            months would be less than the carrying value of the segment including goodwill. As a            result, we recorded a non-cash, pre-tax goodwill impairment loss of $29.1 million in            the second quarter of 2008 in Optimal Payments.

             

Investment income decreased by $1.4 million, from $1.6 million during            the three-month period ended June 30, 2007 to $0.2 million for the three-month period            ended June 30, 2008. The decrease is due primarily to the lower cash position during            the three-month period ended June 30, 2008, as a result of funds used to acquire WowWee            in November 2007.

             

The provision for income taxes was $11.2 million for the three-month            period ended June 30, 2008, as compared to a charge of $0.1 million for the three-month            period ended June 30, 2007. Significant components of the consolidated tax provision            for the three-month period ended June 30, 2008 included non-deductible goodwill            impairment, amortization of other (tax) asset and write-off of previously recognized            future tax assets. As a result of the goodwill impairment loss relating to Optimal            Payments, we also amortized $5.7 million of the other tax asset as a future tax expense            in the second quarter of 2008, representing the remaining portion of this asset that            was realized at June 30, 2008. In addition, we wrote-off $7.6 million of previously            recognized future tax assets that no longer met the criteria for            recognition.

             

Other items in the 2008 tax provision included differences in tax rates            in foreign jurisdictions and non-deductible stock-based compensation. In 2008, a            greater portion of our operations was taxable in Hong Kong at a lower effective tax            rate than in Canada, which affected the provision by $0.3 million compared to a            recovery of $0.3 million for the three-month period ended June 30, 2007. In addition,            the 2008 provision includes the tax effect of non-deductible stock-based compensation            expense in the amount of $0.6 million, as compared to a nominal amount in            2007.

 

Our tax provision also includes the effect of future taxes on unrealized            foreign exchange gains and losses, which arise upon the conversion into Canadian            dollars of net monetary assets and liabilities denominated in U.S. dollars for purposes            of determining taxable income under Canadian income tax regulations. Since the U.S.            dollar is our measurement currency and our interim consolidated financial statements            are presented in U.S. dollars, these foreign exchange gains and losses do not affect            earnings before income taxes. In the three-months period ended June 30, 2008, our tax            provision includes a future tax recovery of $0.5 million related to foreign exchange            compared to a recovery of $1.2 million for the three-months period ended June 30,            2007.

 

Our net loss for the three-month period ended June 30, 2008 was $48.4            million (or $1.87 per diluted share), compared to a net earnings of $1.2 million (or            $0.05 per share – basic and diluted) for the three-month period ended June 30,            2007.The            increase is due primarily to a non-cash impairment loss from Optimal Payments of $29.1            million for goodwill, as well as related charges of $5.7 million for the other assets            and $7.6 million of future tax assets that no longer meet the criteria for recognition            at June 30, 2008 in this segment. In addition, the results of operations include a loss            of $4.6 million from WowWee, which we expect will generate most of its annual revenues            in the third and fourth quarters.

             

EBITDA was a loss of $0.5 million (or a loss of $0.02 per diluted share)            for the three-month period ended June 30, 2008, as compared to earnings of $3.3 million            (or $0.13 per diluted share) for the three-month period ended June 30, 2007.

             

EBITDA is a non-GAAP financial measure. A reconciliation of this            non-GAAP financial information is presented in the table below. We use non-GAAP            measures to assess our operating performance. Earnings and other measures adjusted to a            basis other than GAAP do not have standardized meanings and are unlikely to be            comparable to similar measures used by other companies. Accordingly, this non-GAAP            financial measure should not be considered in isolation. We use EBITDA to measure our            performance from one period to the next without the variation caused by certain            adjustments that could potentially distort the analysis of trends in our operating            performance, and because we believe it provides meaningful information on our financial            condition and operating results.

 

51

 

 

----

 

EBITDA, as we use it, is calculated as earnings before investment            income, taxes, depreciation and amortization and excludes the impacts of impairment            loss, non-controlling interest, stock-based compensation and discontinued operations.            We believe it is useful to exclude these items as they are either non-cash expenses,            items that cannot be influenced by management in the short term, or items that do not            impact core operating performance. Excluding these items does not imply they are            non-recurring.

             

| Reconciliation                            of Non-GAAP Financial Information                                   |
|---------------------------------------------------------------------------------------------------------------|
| (expressed in                            thousands of U.S. dollars, except per share amounts)                 |
|                                                                                                          |   |   |   |   |
|                                                                                                          |   | **Three                            months ended** |
|                                                                                                          |   | **June                            30,** |
|                                                                                                          |   | **2008** |   | **2007** |
|                                                                                                          |   | Unaudited |   | Unaudited |
|                                                                                                          |   |   |   |   |
| Net (loss) earnings                                                                                           | $ | (48,394) | $ | 1,157  |
|                                                                                                          |   |   |   |   |
| Add (deduct):                                                                                                 |   |   |   |   |
| Amortization of intangibles pertaining to transaction                            processing and cost of sales |   | 4,832  |   | 3,227  |
| Amortization of equipment pertaining to selling, general                            and administrative        |   | 337  |   | 316  |
| Amortization of equipment pertaining to cost of                            sales                              |   | 832  |   | - |
| Stock-based compensation pertaining to selling, general                            and administrative         |   | 1,880  |   | 30  |
| Investment income                                                                                             |   | (243) |   | (1,576) |
| Income tax provision                                                                                          |   | 11,169  |   | 106  |
| Impairment loss                                                                                               |   | 29,097  |   | - |
|                                                                                                          |   |   |   |   |
| EBITDA                                                                                                        | $ | (490) | $ | 3,260  |
|  

Diluted shares                                                                                        |   | 25,852,211  |   | 24,396,914  |
|                                                                                                          |   |   |   |   |
| EBITDA per diluted share                                                                                      | $ | (0.02) | $ | 0.13  |

 

 

**Liquidity and Capital Resources**

 

As at June 30, 2008, cash and cash equivalents, cash held as reserves,            short-term investments, short-term investments held as reserves and settlement assets            totaled $62.3 million (including $7.6 million held as reserves), as compared to $73.0            million (including $8.6 million held as reserves) as at December 31, 2007.

The decrease in cash and cash equivalents, and short-term investments is            primarily due to the use of cash and cash equivalents in operations, in WowWee for            seasonal build-up of inventories to meet orders to be shipped in the second half of the            year and the purchase of equipment and in Optimal Payments due to the reduction of            customer reserves and security deposits. As described above, a significant portion of            cash and cash equivalents, and short-term investments have a corresponding liability as            these cash amounts are derived from reserves and security deposits which are due to            customers (see “Our Industry Segments – Optimal Payments”).            Settlement assets result from timing differences in the settlement process of Optimal            Payments. Settlement assets are typically funded to us within days from the transaction            processing date.

Operating activities generated $3.2 million of cash and cash equivalents            in the three-month period ended June 30, 2008, as compared to $19.7 million of cash            used for the three-month period ended June 30, 2007. This change is due mainly to a            reduction in cash payments made regarding customer reserves and security deposits.In            2007, we paid out a significant amount of these reserves as a result of the cessation            of the U.S. based gaming portion of the payment processing segment.

 

52

 

 

----

Investing activities generated$2.3 million of cash and cash equivalents            for the three-month period ended June 30, 2008, as compared to generating $4.2 million            of cash and cash equivalents for the three-month period ended June 30, 2007, which            included proceeds from maturities of short-term investments of $5.1 million. During the            three-month period ended June 30, 2008, $4.3 million was received from the proceeds on            maturity of short-term investments, and $2.1 million was used to acquire equipment and            intangible assets primarily related to WowWee.

 

We believe that our cash, cash equivalents and short-term investments            will be adequate to meet our needs for at least the next 12 months.

             

We have no financial obligations of significance, including any            off-balance sheet arrangements, other than long-term lease commitments for our premises            in the United States, Canada and Hong Kong.

 

| **Item 3.** | **Quantitative and Qualitative Disclosures About                            Market Risk** |
|-------------|-------------------------------------------------------------------------------------------|

             

There have been no material changes to the disclosures about market risk            contained in our Annual Report on Form 10-K for the year ended December 31,            2007.

 

| **Item 4.** | **Controls and Procedures** |
|-------------|-----------------------------|

 

As of June 30, 2008 (the “Evaluation Date”), under the            supervision and with the participation of our management, including our Chief Executive            Officer and our Chief Financial Officer, we evaluated the effectiveness of the design            and operation of our disclosure controls and procedures, as defined in Rule 13a-15(e)            or 15d-15(e) under the Securities Exchange Act of 1934, as amended (the “Exchange            Act”). Based upon this evaluation, our Chief Executive Officer and our Chief            Financial Officer concluded that, as of the Evaluation Date, our disclosure controls            and procedures were effective to ensure that information required to be disclosed by us            in the reports filed or submitted by us under the Exchange Act is recorded, processed,            summarized and reported within the time periods specified in the SEC’s rules and            forms.

 

Additionally, under the supervision and with the participation of our            management, including our Chief Executive Officer and our Chief Financial Officer, we            concluded that there have been no changes in our internal control over financial            reporting during our most recent fiscal quarter that have materially affected, or are            reasonably likely to materially affect, our internal control over financial            reporting.

 

**PART II. OTHER INFORMATION**

 

| **Item 1.** | **Legal Proceedings** |
|-------------|-----------------------|

             

There were no material changes to the disclosure of legal proceedings            contained in our Annual Report on Form 10-K for the year ended December 31, 2007,            except as discussed in our Quarterly Report on Form 10-Q for the three-months ended            March 31, 2008 and as follows.

             

Optimal Payments has received a request for information from U.S.            Attorney’s Office in the Eastern District of New York pertaining to its former            involvement in processing payment transactions for Internet pharmacies. Optimal            Payments is currently in discussions with that office relating to those processing            activities.

 

| **Item 1A.** | **Risk Factors** |
|--------------|------------------|

             

There were no material changes to the disclosure of risk factors            contained in our Annual Report on Form 10-K for the year ended December 31,            2007.

 

 

53

 

 

----

| **Item                            2.** | **Unregistered                            Sales of Equity Securities and Use of Proceeds** |
|----------------------------------------|--------------------------------------------------------------------------------------------|

 

There were no sales of unregistered equity securities during the            three-month period ending June 30, 2008. The following table is a summary of our            purchases of common shares during the three-month period ended June 30,            2008.

 

| **Optimal                            Group Inc. 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 Plans or Programs(1)** | **Maximum                            Number of Shares that May Yet Be Purchased Under the Plans or                            Programs(1)** |
|                                                                             |   |   |   |   |
| April 1, 2008                            to April 30, 2008                       | 0 | 0 | 0 | 1,126,142 |
| May 1, 2008                            – May 31, 2008                      | 25,000 | 2.8500 | 25,000 | 1,101,142 |
| June 1, 2008 to                            June 30, 2008                         | 8,600 | 2.7000 | 8,600 | 1,092,542 |
|                                                                             |   |   |   |   |
| Total                                                                            | 33,600 | 2.8309 | 33,600 | 1,092,542 |

 

|   | (1) | We made all purchases of our common                            shares under our stock purchase program publicly announced on November                            6, 2007 under which we are authorized to purchase up to 1,300,000                            shares, being approximately 5.0% of the 26,036,548 common shares                            outstanding as at November 14, 2007. We are authorized under our 2007                            stock purchase program to purchase our common shares on the open market                            through the facilities of the Nasdaq Stock Market from time to time                            over the course of the 12-month period that commenced on November 21,                            2007 and ends on November 20, 2008. |
|--------|-----|---------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|

             

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

 

The registrant has nothing to report under this item.

 

| **Item                            4.** | **Submission                            of Matters to a Vote of Security Holders** |
|----------------------------------------|------------------------------------------------------------------------------------|

 

We held our annual and special meeting of shareholders on June 25, 2008.            The following resolutions were adopted:

             

| **Resolution**                                                                                                                      | **Votes For** | **Votes Against** | **Withheld** | **Non-Voted** |
|-------------------------------------------------------------------------------------------------------------------------------------|---------------|-------------------|--------------|---------------|
| Election of Tommy Boman as                            Director(1)                                                                   | 14,262,313    | N/A               | 1,203,456    | 0             |
| Election of                            Holden L. Ostrin as Director(1)                                                              | 14,251,098    | N/A               | 1,214,671    | 0             |
| Election of                            Stephen J. Shaper as Director(1)                                                             | 14,255,927    | N/A               | 1,209,842    | 0             |
| Appointment of                            KPMG LLP as Auditors                                                                 | 15,095,932    | N/A               | 369,754      | 0             |
| Amendment to                            extend termination date of certain outstanding five-year                            options | 10,214,502    | 1,586,931         | N/A          | 3,664,663     |

| (1) | Tommy Boman, Holden L. Ostrin and                            Stephen J. Shaper were elected to hold office until the close of the                            2011 annual meeting of shareholders. The following directors did not                            stand for election and continue in office for the following respective                            periods: |
|-----|-------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|

Henry M. Karp, Jonathan J. Ginns and Sydney Sweibel each to hold office            until the close of the 2010 annual meeting of shareholders, and Neil S. Wechsler, James            S. Gertler and Thomas D. Murphy each to hold office until the close of the 2009 annual            meeting of shareholders.

 

54

 

 

----

             

| **Item                            5.** | **Other                            Information** |
|----------------------------------------|--------------------------------------------------|

             

The registrant has nothing to report under this item.

             

| **Item 6.** | **Exhibits** |
|-------------|--------------|

 

Exhibits

 

| **Exhibit Number** | **Exhibit**                                                                                                                                                                                                     |
|--------------------|-----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|
|               |                                                                                                                                                                                                            |
| 31.1               | Certification pursuant to Section 302 of the                            Sarbanes-Oxley Act of 2002.                                                                                                             |
| 31.2               | Certification pursuant to Section 302 of the                            Sarbanes-Oxley Act of 2002.                                                                                                             |
| 32.1               | Certification pursuant to Section 1350, Chapter 63 of                            Title 18, United States Code, as adopted pursuant to Section 906 of the                            Sarbanes-Oxley Act of 2002. |
| 32.2               | Certification pursuant to Section 1350, Chapter 63 of                            Title 18, United States Code, as adopted pursuant to Section 906 of the                            Sarbanes-Oxley Act of 2002. |

 

 

**Signatures**

 

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

             

 

| August 6, 2008 | **Optimal Group Inc.** |
|----------------|------------------------|
|           |                   |   |
|           |                   |   |
|           | By:                    | /s/ NEIL S. WECHSLER |
|           |                   | Neil S. Wechsler, Co-Chairman |
|           |                   | and Chief Executive Officer |
|           |                   | (Principal Executive Officer) |

 

|   |   |                                      |
|--------|--------|-------------------------------------------|
|   | By:    | /s/ GARY S. WECHSLER                      |
|   |   | Gary S. Wechsler, Chief Financial Officer |
|   |   | (Principal Accounting Officer)            |

 

             

 

55