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UNITED STATES
SECURITIES AND EXCHANGE COMMISSION
WASHINGTON, D.C. 20549

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AMENDMENT NO. 1
TO
FORM 10-K
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FOR ANNUAL AND TRANSITION REPORT
PURSUANT TO SECTIONS 13 OF 15(D) OF THE
SECURITIES EXCHANGE ACT OF 1934

|X| ANNUAL REPORT PURSUANT TO SECTION 13 OR 15(D) OF THE SECURITIES
EXCHANGE ACT OF 1934
FOR THE FISCAL YEAR ENDED DECEMBER 31, 2004

|_| TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(D) OF THE SECURITIES
EXCHANGE ACT OF 1934
FOR THE TRANSITION PERIOD FROM __________ TO __________

COMMISSION FILE NUMBER: 000-27267

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I/OMAGIC CORPORATION
(EXACT NAME OF REGISTRANT AS SPECIFIED IN ITS CHARTER)

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NEVADA 33-0773180
(STATE OR OTHER JURISDICTION OF (I.R.S. EMPLOYER IDENTIFICATION NO.)
INCORPORATION OR ORGANIZATION)

4 MARCONI, IRVINE, CA 92618
(ADDRESS OF PRINCIPAL EXECUTIVE OFFICES) (ZIP CODE)

REGISTRANT'S TELEPHONE NUMBER, INCLUDING AREA CODE: (949) 707-4800

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SECURITIES REGISTERED PURSUANT TO SECTION 12(B) OF THE ACT: NONE

SECURITIES REGISTERED PURSUANT TO SECTION 12(G) OF THE ACT:
COMMON STOCK, $.001 PAR VALUE
(TITLE OF CLASS)

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Indicate by check mark whether the registrant (1) has filed all reports
required to be filed by Section 13 or 15(d) of the Securities Exchange Act of
1934 during the preceding 12 months (or for such shorter period that the
registrant was required to file such reports), and (2) has been subject to such
filing requirements for the past 90 days. Yes |X| No |_|

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

Indicate by check mark whether the registrant is an accelerated filer (as
defined in Exchange Act Rule 12b-2). Yes |_| No |X|

The aggregate market value of the voting common equity held by
nonaffiliates of the registrant computed by reference to the closing sale price
of such stock, was approximately $2,000,000, as of March 31, 2005, the last
business day of the registrant's most recently completed fiscal quarter. The
registrant has no non-voting common equity.

The number of shares of the registrant's common stock, $.001 par value,
outstanding as of June 29, 2005 was 4,529,672.

DOCUMENTS INCORPORATED BY REFERENCE: None.

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TABLE OF CONTENTS

PAGE
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PART I

Item 1. Business........................................................... 2

Item 2. Properties......................................................... 15

Item 3. Legal Proceedings.................................................. 15

Item 4. Submission of Matters to a Vote of Security Holders................ 16

PART II

Item 5. Market For Registrant's Common Equity, Related Stockholder
Matters and Issuer Purchases of Equity Securities.................. 17

Item 6. Selected Financial Data............................................ 18

Item 7. Management's Discussion and Analysis of Financial Condition
and Results of Operations.......................................... 20

Item 7A. Quantitative and Qualitative Disclosures About Market Risk......... 46

Item 8. Financial Statements and Supplementary Data........................ 46

Item 9. Changes in and Disagreements with Accountants on Accounting
and Financial Disclosure........................................... 46

Item 9A. Controls and Procedures............................................ 46

Item 9B. Other Information.................................................. 46

PART III

Item 10. Directors and Executive Officers of the Registrant................. 47

Item 11. Executive Compensation............................................. 48

Item 12. Security Ownership of Certain Beneficial Owners and Management
and Related Stockholder Matters.................................... 50

Item 13. Certain Relationships and Related Transactions..................... 52

Item 14. Principal Accountant Fees and Services............................. 54

PART IV

Item 15. Exhibits, Financial Statement Schedules............................ 54

Index to Consolidated Financial Statements and Supplemental Information......F-1

Index To Exhibits

Signatures

Exhibits Attached to This Report

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PART I

ITEM 1. BUSINESS.

INTRODUCTORY NOTE

This Annual Report on Form 10-K contains "forward-looking statements."
These forward-looking statements include, but are not limited to, statements
relating to our anticipated financial performance, business prospects, new
developments, new strategies and similar matters, and/or statements preceded by,
followed by or that include the words "believe," "may," "could," "expect,"
"anticipate," "estimate," "intend," "plan," "seek," or similar expressions. We
have based these forward-looking statements on our current expectations and
projections about future events, based on the information currently available to
us. These forward-looking statements are subject to risks, uncertainties and
assumptions, including those described under the heading "Risk Factors" in Item
7 of this Annual Report on Form 10-K that may affect the operations,
performance, development and results of our business. You are cautioned not to
place undue reliance on these forward-looking statements, which speak only as of
the date stated, or if no date is stated, as of the date of this Annual Report
on Form 10-K. We undertake no obligation to publicly update or revise any
forward-looking statements, whether as a result of new information, future
events or any other reason except as we may be required to do under applicable
law. In light of these risks, uncertainties and assumptions, the forward-looking
events discussed in this Annual Report on Form 10-K may not occur.

Interested readers can access our Annual Reports on Form 10-K, Quarterly
Reports on Form 10-Q, current reports on Form 8-K, and any amendments to those
reports filed or furnished pursuant to Section 13(a) or 15(d) of the Securities
Exchange Act of 1934, as amended, through the United States Securities and
Exchange Commission's website at http://www.sec.gov. These reports can be
accessed free of charge.

We own or have rights to use all of the product names, brand names and
trademarks that we use in conjunction with the sale of our products, including
our I/OMagic(R), Hi-Val(R) and Digital Research Technologies(R) brand names and
related logos, and our "MediaStation," "DataStation," Digital Photo Library(TM),
EasyPrint(TM) and GigaBank(TM) product names. In addition, this report refers to
other product names, trade names and trademarks that are the property of their
respective owners.

For purposes of this Annual Report, unless the context indicates otherwise,
references to "we," "us," "our," "I/OMagic," and the "Company" means or refers
to I/OMagic Corporation.

COMPANY OVERVIEW

We operate primarily in the data storage industry and, to a much lesser
extent, we also sell digital entertainment and other products. We sell our
products primarily in the United States and, to a much lesser extent, in Canada,
together known as the North American retail marketplace. During 2004, sales
generated within the United States accounted for approximately 98.2% of our net
sales and sales generated within Canada accounted for approximately 1.8% of our
net sales. For the years ended December 31, 2003 and 2002 sales generated within
the United States accounted for approximately 98.5 % and 99.0%, respectively, of
our net sales and sales generated within Canada accounted for approximately 1.5%
and 1.0%, respectively, of our net sales.

Our product offerings predominantly consist of optical data storage
products and portable magnetic data storage products. Our optical data storage
products include recordable compact disc, or CD, drives and recordable digital
video or versatile disc, or DVD, drives. Our CD and DVD drives are primarily for
use with personal computers, or PCs. Although we have sold various media in the
past, such as floppy disks and CDs, we do not currently sell media products. Our
portable magnetic data storage products, which we call our GigaBank(TM)
products, consist of compact and portable universal serial bus, or USB, hard
disk drives that plug into any standard USB port and that provide from 2.2
gigabytes, or 2,200 megabytes, to up to 100 gigabytes, or 100,000 megabytes, of
storage capacity, depending on the user's operating system and other factors. We
have designed our GigaBank(TM) products as cost-effective portable alternatives
to flash media devices and standard hard disk drives. Our data storage products
accounted for approximately 99% of our net sales for 2004. We also sell digital
entertainment and other products, which accounted for only approximately 1% of
our net sales for that period.

For the years ended December 31, 2004 and 2003, we believe that we achieved
the number three and one market shares, respectively, in both unit and dollar
sales of "after-market" compact disc rewritable, or CD-RW, drives in North
America. "After-market" products are products not built into a PC at the time of
its initial purchase. We launched our dual-format recordable DVD drives in July
2003. We believe that we were able to achieve the number two market share in
both unit and dollar sales of after-market recordable DVD drives in North
America during 2004. We believe that the markets for DVD-based data storage

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products and for compact and portable magnetic data storage devices, such as our
GigaBank(TM) products, will experience significant growth over the next few
years and that we are in a position to benefit from this growth in terms of
sales and market share.

We sell our products through computer, consumer electronics and office
supply superstores and other major North American retailers, including Best Buy,
Best Buy Canada, Circuit City, CompUSA, Fred Meyer Stores, Microcenter, Office
Depot, RadioShack, Staples, and Target. We sell our products in over 10,000
retail locations throughout North America. Our retailers collectively operate
retail locations throughout North America. We also have relationships with other
retailers, catalog companies and Internet retailers such as Buy.com, Dell, PC
Mall and Tiger Direct.

Our sales have historically been seasonal. The seasonality of our sales is
in direct correlation to the seasonality experienced by our retailers and the
seasonality of the consumer electronics industry. After adjusting for the
addition of new retailers, our fourth quarter has historically generated the
strongest sales, which correlates to well-established consumer buying patterns
during the Thanksgiving through Christmas holiday season. Our first and third
quarters have historically shown some strength from time to time based on
post-holiday season sales in the first quarter and back-to-school sales in the
third quarter. Our second quarter has historically been our weakest quarter for
sales, again following well-established consumer buying patterns.

Our most significant retailers during the past few years have been Best
Buy, Circuit City, CompUSA, Office Depot and Staples. Collectively, these five
retailers accounted for 80% of our net sales during 2004, including 32%, 17%,
11%, 10% and 10% of our total net sales for that period which were generated
from Staples, Circuit City, Best Buy, Office Depot and CompUSA, respectively.

We market our products primarily under one brand name. Our primary brand
name is I/OMagic(R). We also, from time to time, market products under our
Hi-Val(R) and Digital Research Technologies(R) brand names. We sell our data
storage products primarily under our I/OMagic(R) brand name, bundling various
hardware devices with different software applications to meet different consumer
needs.

We do not directly manufacture any of the products that we sell. We
subcontract manufacture or source our products in Asia, predominantly in Taiwan
and China, which allows us to offer products at highly competitive prices. Most
of our subcontract manufacturers and suppliers have substantial product
development resources and facilities, and are among the major component
manufacturers and suppliers in their product categories, which we believe
affords us substantial flexibility in offering new and enhanced products. Some
of our largest subcontract manufacturers and suppliers are also our
stockholders, including Behavior Tech Computer Corp. and its affiliated
companies, or BTC, and Lung Hwa Electronics Co., Ltd. BTC and Lung Hwa
Electronics also provide us with significant trade lines of credit. We believe
that BTC is among the largest optical storage drive manufacturers in the world
and Lung Hwa Electronics is a supplier of USB hard disk drives, including some
of our GigaBank(TM) products, as well as a major manufacturer of digital
entertainment products. Certain of these subcontract manufacturers and suppliers
provide us with significant benefits by allowing us to purchase products on
terms more advantageous than we believe are generally available in our industry.
These advantageous terms include generous trade lines of credit and extended
payment terms which allows us to utilize more capital resources for other
aspects of our business. See "Management," and "Certain Relationships and
Related Transactions."

I/OMagic Corporation was incorporated under the laws of the State of Nevada
in October 1992. We have one subsidiary, IOM Holdings, Inc., a Nevada
corporation. Our principal executive offices are located in Irvine, California
and our main telephone number is (949) 707-4800.

INDUSTRY OVERVIEW

Storing, managing, protecting, retrieving and transferring data has become
critical to individuals and businesses due to their increasing dependence on and
participation in data-intensive activities. The data storage industry is growing
in response to the needs of individuals and businesses to store, manage,
protect, retrieve and transfer increasing amounts of data resulting from:

o the growth in the number of PCs, and the increase in the number, size
and complexity of computer networks and software programs;

o the emergence and development of new data-intensive activities, such
as e-mail, e-commerce, and the increasing availability of products and
services over the Internet, together with the rise in bandwidth
available to access and download data from over the Internet; and

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o the existence and availability of increasing amounts of digital
entertainment data, such as music, movie, photographic, video game and
other multi-media data.

Traditional PC data generally includes document, e-mail, financial and
historical, software program and other data. The data storage industry has grown
significantly over the last two decades as the PC has become a virtually
indispensable tool in the home and office, resulting in increasing amounts of
traditional PC data. As a result of these and other developments, traditional PC
data storage requirements have correspondingly increased.

Digital entertainment data generally includes music, photographic, movie
and video game data. For nearly two decades, music has been offered on CDs as
the prevailing standard. In the mid-to-late 1990s, the ability to copy CDs, and
to download, remix, and copy or "burn" music to a personalized CD began to gain
popularity and made the recordable CD drive, or "CD burner," a desirable
component of the PC. With the growth and acceptance of the Internet and the
advent of on-line music availability, the demand for on-line music has increased
and as a result, the demand for faster and easier data storage and retrieval has
grown.

We believe that the increasing amount of traditional PC and digital
entertainment data that is being generated and used is stimulating increased
demand for products offering data storage, management, protection, retrieval and
transfer. We also believe that those products that offer flexibility and
high-capacity storage in a cost-effective, user-friendly manner are in highest
demand.

KEY FACTORS DRIVING GROWTH IN THE DATA STORAGE INDUSTRY

We believe that the following factors, among others, are driving and will
continue to drive growth in the data storage industry:

o INCREASED DATA-INTENSIVE USE OF THE INTERNET. As individuals and
businesses continue to increase their data-intensive use of the
Internet for communications, commerce and data retrieval, the
corresponding need to utilize data storage devices for the storage,
management, protection, retrieval and transfer of data -- especially
high-capacity, cost-effective data storage devices -- will continue to
grow. In addition, bandwidth is increasing and is expected to continue
to increase. Increasing bandwidth allows faster data transfer rates
over the Internet and makes use of the Internet for data-intensive
activities more convenient and cost-effective.

o GROWTH IN NEW TYPES OF DATA. The growth in new types of data such as
music, photographic, movie, and video game data, including
high-resolution audio and video data, requires far greater storage
capacity than traditional PC text data. We believe that individual
consumers and businesses increasingly depend on their abilities to
store, manage, protect, retrieve and transfer these types of data
using data storage devices.

o GROWTH IN THE CRITICAL IMPORTANCE OF DATA. Business databases contain
information about customers, suppliers, competitors and industry
trends that may be analyzed and potentially transformed into a
valuable asset and a competitive advantage. Efficiently storing,
managing, protecting, retrieving and transferring this information has
become increasingly important to many businesses.

o DECREASE IN THE COST OF STORING DATA. The cost of data storage
continues to decrease with advances in technology and improved
manufacturing processes. This decrease in cost encourages and enables
individuals and businesses to purchase more data storage media and
devices.

o CONVERGENCE OF TECHNOLOGIES. Product offerings are beginning to embody
the convergence of data storage and digital entertainment playback
technologies. For instance, a digital video recorder, or DVR, can
operate as the primary tool for storage, management, protection,
retrieval and transfer of traditional PC data as well as digital
entertainment data such as music, photos, movies, video games and
other multi-media.

TYPES OF DATA STORAGE MEDIA

The following types of data storage media are the principal means through
which traditional PC data as well as digital entertainment data can be stored,
managed, protected, retrieved and transferred:

o MAGNETIC. Magnetic data storage drives store digital data by
magnetically altering minutely small areas of a magnetic media surface
so that specific areas represent either a "1" or a "0." Indeed, all
digital data is comprised of different combinations of "1s" and "0s"

-4-

regardless of the media on which the data is stored. Examples of
magnetic data storage media include floppy disks, Zip(R) disks,
magnetic tape and hard disk drives, including compact and portable
hard disk drives, such as our GigaBank(TM) products.

o OPTICAL. Optical data storage drives store digital data by using
lasers to alter minutely small areas of an optical media surface.
Examples of optical data storage media include CDs and DVDs.

o SOLID STATE. Solid state storage devices store digital data by
applying electronic charges to alter minutely small areas of a memory
chip or card. Examples of solid state media include flash memory
chips, flash memory cards and thumbdrives. Thumbdrives are more
commonly known as universal serial bus, or USB, drives which are
small, portable flash memory devices that plug into any standard USB
drive. Solid state media is typically used for digital data storage in
digital cameras, personal digital assistants, or PDAs, cellular phones
and MP3 players.

RELATIVE ADVANTAGES AND DISADVANTAGES OF TYPES OF DATA STORAGE MEDIA

Each of the principal types of data storage media generally available to
consumers has certain advantages and disadvantages. These include:

MAGNETIC MEDIA

o HARD DISKS. Hard disks are fixed media and typically are not
removable, thus prohibiting the physical transport of data and
portability of the drive itself. Relative to other available media,
hard disks have high capacity, holding up to approximately 500
gigabytes, or 500,000 megabytes, depending on the user's operating
system and other factors, and offer a low cost per megabyte. Hard
disks have a fixed storage capacity and are not scalable. Hard disks
offer fast data access times and data transfer rates and generally
good reliability, but data protection and retrieval is dependent on
drive reliability. Hard disks require another device or medium for
data back-up purposes or for data transportability; however certain
hard disk drives, such as our GigaBank(TM) products, allow physical
transport of data and drive portability.

o FLOPPY DISKS. Floppy disks are removable media allowing physical
transport of data. External floppy disk drives allow portability of
the drive itself. Floppy disks benefit from being "legacy" products
with a large existing user base and a low cost per unit for a floppy
disk. Relative to other available media, floppy disks have extremely
low capacity, holding up to approximately 1.44 megabytes per disk
depending on the user's operating system and other factors, and
represent a very high cost per megabyte. In addition, floppy disks
typically employ older, less efficient storage, management,
protection, retrieval and transfer technology, and offer moderate data
access times and data transfer rates, moderate reliability and a
tendency towards degradation over time which risks the loss of data
stored on the disk.

o ZIP(R) DISKS. Zip(R) disks are removable media allowing physical
transport of data. External Zip(R) disk drives allow portability of
the drive itself. Relative to other available media, Zip(R) disks have
moderate capacity, holding up to approximately 750 megabytes per disk
depending on the user's operating system and other factors, and
represent a moderate cost per megabyte. Zip(R) disks themselves have a
moderate cost per unit and offer moderate data access times and data
transfer rates. A special Zip(R) drive is required to utilize Zip(R)
disk technology and media.

o MAGNETIC TAPE. Magnetic tape is removable media allowing physical
transport of data. Magnetic tape drives are typically larger than
other storage drives, making them comparatively less portable.
Relative to other available media, magnetic tape has moderate to high
capacity, holding up to approximately 80 gigabytes, or 80,000
megabytes, depending on the user's operating system and other factors,
and represents a moderate cost per megabyte. While magnetic tape
itself is not expensive, magnetic tape drives have a high cost per
unit. Magnetic tape media typically employs older, less efficient
storage, management, protection, retrieval and transfer technology,
and offers slow data access times but fast data transfer rates,
moderate reliability and a tendency towards degradation over time
which risks the loss of data stored on the tape.

OPTICAL MEDIA

o COMPACT DISCS. CDs are removable media allowing physical transport of
data. External CD drives allow portability of the drive itself.
Relative to other available media, CDs have moderate capacity, holding
up to approximately 700 megabytes, depending on the user's operating
system and other factors, and offer virtually unlimited storage
capacity with the use of additional low cost CDs. CDs offer only
moderate data access times and data transfer rates as compared to hard

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disk technologies; however, new technology continues to improve data
access times for this media. CDs are also compatible with numerous
devices ranging from PCs to CD and DVD players typically found in the
home and office. Unlike hard disks, the integrity of data protection
and retrieval is not drive-dependent, since a reliability problem with
an optical drive will not affect digital data already stored on a CD,
and ease of transport allows access to data using another drive if a
problem exists with a user's primary drive unit. In addition, unlike
magnetic media, use of CDs results in limited or no degradation of the
CD itself.

o DIGITAL VIDEO OR DIGITAL VERSATILE DISCS. The relative advantages and
disadvantages of DVD drives and media are generally the same as for CD
drives and media. However, as compared to other available media, DVDs
are moderate to high capacity, holding up to approximately 4.3
gigabytes, or 4,300 megabytes, on a single-layer DVD drive and up to
8.5 gigabytes, or 8,500 megabytes, on a double-layer DVD drive,
depending on the user's operating system and other factors.

SOLID STATE MEDIA

o FLASH MEMORY CHIPS. Flash memory chips are generally not removable
media. Typically, flash memory chips are used in portable devices such
as digital cameras, PDAs and cellular phones. Relative to other
available media, flash memory chips have moderate capacity, holding up
to approximately 2 gigabyte, or 2,000 megabytes, depending on the
user's operating system and other factors, and offer very high cost
per megabyte and high cost per unit. Flash memory chips are highly
reliable, consume very little power and offer very fast data access
times and data transfer rates, but require another device or medium
for data back-up purposes.

o FLASH MEMORY CARDS. The relative advantages and disadvantages of flash
memory cards are generally the same as for flash memory chips.
However, flash memory cards are removable media allowing physical
transport of data.

INDUSTRY CHALLENGES AND TRENDS

We believe that the challenges currently facing the data storage industry
include:

o NEED FOR HIGH-CAPACITY, COST-EFFECTIVE AND FLEXIBLE MEDIA AND RELATED
DATA STORAGE DEVICES. We believe that, as a result of the rapid growth
in data and in new applications requiring or using high data-content
movies, photos, music and games and other multi-media content, the
data storage industry needs to offer higher capacity, more
cost-effective and flexible media and data storage devices. To meet
this need, the data storage industry has shifted its product offerings
to DVD-based technologies as well as to compact and portable hard disk
drives such as our GigaBank(TM) products.

o NEED TO IDENTIFY AND SATISFY CONSUMER DEMANDS AND PREFERENCES. The
data storage industry is characterized in part by rapidly changing
consumer demands and preferences for higher levels of product
performance and functionality. We believe that, to be successful,
companies in this industry must closely identify changes in consumer
demands and preferences and introduce both new and enhanced data
storage products to provide higher levels of performance and
functionality than existing products.

We believe that trends in the data storage industry include the trend
toward higher capacity optical storage media and related drives, including the
trend away from CD-based media and devices and towards DVD-based media and
devices. We believe that unit sales of recordable CD drives in the North
American retail marketplace declined to approximately 1.5 million in 2004 from
approximately 3.5 million in 2003, while unit sales of recordable DVD drives
grew to approximately 2.2 million in 2004 from approximately 1.1 million in
2003. This decline in unit sales of recordable CD drives represents a 57%
decrease in 2004 from 2003 and the growth in unit sales of recordable DVD drives
represents in excess of a 100% increase in 2004 from 2003.

Another trend in the data storage industry is the progression toward
smaller, more portable hard disk drives such as our GigaBank(TM) products.

Developing trends in the data storage industry include the early adoption
of super-high-capacity optical data storage devices using technology such as
Blu-ray DVD or High-definition DVD. Blu-ray DVD technology is expected to expand
DVD capacity up to tenfold and is expected to allow, for the first time in a
device widely available to consumers, the storage and retrieval of high
definition videos and images for playback on high-definition DVD players and
compatible televisions and monitors. A competing new technology also exists
called High-definition DVD, or HD-DVD. The storage capacity of HD-DVD is limited

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to approximately 60% of a Blu-ray DVD. Proponents of HD-DVD technology contend,
however, that it has less compatibility problems with existing DVD technology as
compared to Blu-ray DVD technology and that data compression software reduces
the importance of the greater storage capacity offered by Blu-ray DVD
technology.

It is not yet clear whether Blu-ray DVD or HD-DVD will become the dominant
technology, if they will coexist, or if a new technology will emerge.
Nonetheless, we believe that the increased performance offered by these
technologies will likely result in increased consumer demand for optical data
storage devices. Furthermore, we believe that regardless of which technology
becomes the dominant technology, we will be able to incorporate either
technology into our product offerings in much the same way as we do today with
the large number of format types ranging from recordable and rewritable CD-based
products to DVD-based products.

THE I/OMAGIC SOLUTION

We sell optical and magnetic data storage products in the North American
retail marketplace. We believe that we possess a combination of core
competencies that provide us with a competitive advantage, including the ability
to successfully identify consumer needs and preferences, use our sales and
distribution channels to sell new and enhanced products, efficiently bring to
market newly developed products and enhanced products, efficiently manage our
product supply chain, and use our brands and merchandising efforts to market and
sell data storage products. In addition, we sell digital entertainment and other
products in the North American retail marketplace.

Successfully executing our core competencies yields substantial benefits
including the ability to:

o rapidly bring both new and enhanced products to market in a
cost-effective manner;

o offer high-value products which combine performance, functionality and
reliability at competitive prices; and

o establish and maintain a large market presence for our core data
storage product offerings resulting in significant market share.

We work closely with our retailers to promote our products, monitor
consumer demands and preferences and stay at the forefront of the market for
data storage products. We also work closely with our subcontract manufacturers
and suppliers and benefit from their substantial research and development
resources and economies of scale. As a result of working with our retailers,
subcontract manufacturers and suppliers, we are able to rapidly bring new and
enhanced data storage products to market in a cost-effective manner.

The market intelligence we gain through consultation with our retailers,
subcontract manufacturers and suppliers enables us to deliver products that
combine performance and functionality demanded by the marketplace. Obtaining
these products through our subcontract manufacturers and suppliers, along with
efficient management of our supply chain, allows us to offer these products at
competitive prices.

We sell our products through computer, consumer electronics and office
supply superstores and other retailers who collectively operate retail locations
throughout North America. Our network of retailers enables us to offer products
to consumers across North America, including nearly every major metropolitan
market in the United States. Over the past three years, our largest retailers
have included Best Buy, Circuit City, CompUSA, Staples, Office Depot and
OfficeMax.

As a result of our access to a large retail network, we believe that we
have established and will maintain a large market presence for our core data
storage product offerings, resulting in significant market share. We believe
that in 2004 and 2003 we achieved the number three and number one market shares,
respectively, in both unit and dollar sales of CD-RW drives in North America. We
believe that the data storage industry is shifting from CD-based products to
DVD-based products. As a result, we launched our dual-format recordable DVD
drives in July 2003. We believe that in 2004 and 2003 we achieved the number two
and number four market shares, respectively, in both unit and dollar sales of
recordable DVD drives in North America.

Historically, we focused on optical data storage products, such as CD and
DVD drives. We continue to focus on optical data storage products but also focus
on a line of portable magnetic data storage products, called our GigaBank(TM)
products, which are compact and portable universal serial bus, or USB, hard disk
drives that plug into any standard USB port, to respond to the demands and
preferences of the data storage marketplace. We believe that the market for data
storage products, especially "after-market" devices that can be purchased
separately from and easily used in conjunction with a standard PC, has shifted
its demand largely to optical media and drives as well as to compact and
portable hard disk drives. We believe that optical media and drives represent

-7-

the optimal combination of high-capacity storage capability, cost-effectiveness
and flexibility. Magnetic hard-disk and drive technology is the closest
competitor to optical media in the contexts of storage capacity,
cost-effectiveness and flexibility. However, while the storage capacity of any
given hard disk is fixed, optical media has virtually unlimited storage capacity
through the addition of low-cost CDs or DVDs. Moreover, optical media has far
more flexibility than hard disk media, allowing users to store music, photos and
movies utilizing a stand-alone recorder or a desktop or laptop PC and then play
them back on standalone CD or DVD players. In addition, hard disk media is
usually built into a PC, lacking effective portability and ease of physical
transport of data. However, since late 2004, we have also focused on our
GigaBank(TM) products as a cost-effective portable alternative to flash media
devices and standard hard disk drives.

We believe that our focus on optical data storage products and our
GigaBank(TM) products is also consistent with the proliferation of digital
entertainment devices. Digital cameras, MP3 players and other digital
entertainment devices are well-complemented by the use of optical media for data
back-up and high-capacity storage purposes. Existing solid state media, while
convenient in many respects, offers relatively low storage capacity and
relatively poor cost effectiveness. Accordingly, optical media, with its high
storage capacity, cost effectiveness and convenience, together with a related
drive unit, is a complementary product for consumers who desire to store,
manage, protect, retrieve and transfer digital data used in conjunction with
their digital entertainment devices. In addition, for greater storage capacity
and portability at cost-effective prices, we offer our GigaBank(TM) products.

OUR STRATEGY

Our primary goal is to remain a leading provider of optical data storage
products and to expand our market share of portable magnetic data storage
products. Our business strategy to achieve this goal includes the following
elements:

o CONTINUE TO DEVELOP AND SOLIDIFY OUR NORTH AMERICAN RETAIL NETWORK. We
have developed, and plan to continue to develop and solidify, close
working relationships with leading North American computer, consumer
electronic and office supply superstores and other retailers. These
retailers carry many of the products that we sell. As we offer both
new and enhanced data storage, digital entertainment and other
products, we intend to continue to utilize our existing relationships
with these retailers to offer and sell these products to consumers.

o CONTINUE TO DEVELOP AND EXPAND OUR STRATEGIC SUBCONTRACT AND SUPPLY
RELATIONSHIPS. We have developed, and plan to continue to develop and
expand, strategic relationships with subcontract manufacturers and
suppliers, such as Behavior Tech Computer Corp. and Lung Hwa
Electronics Co, Ltd. in Asia. These relationships allow us to enhance
our product offerings and benefit from these subcontract
manufacturers' and suppliers' continued development of new and
improved data storage, digital entertainment and other products. Some
of these relationships are particularly strong because some of our
subcontract manufacturers and suppliers are also our stockholders. We
plan to continue to develop and explore other subcontract manufacturer
and supplier relationships as well. By continuing to subcontract
manufacture and source our products, we intend to continue to increase
our operating leverage by delivering products incorporating new
technology without having to make the substantial investment in, or
having to incur the fixed costs associated with product development
and manufacturing in an industry characterized by rapid product
innovation and obsolescence.

o CONTINUE TO DEVELOP AND OFFER HIGH VALUE PRODUCTS. We intend to
continue to work in conjunction with our retailers, subcontract
manufacturers and suppliers to enhance existing products and develop
new products to satisfy consumer demands and preferences. We believe
that our target consumers seek high value products that combine
performance, functionality and reliability at prices competitive with
other leading products offered in the marketplace. We believe that our
core competencies such as our ability to efficiently bring to market
newly developed products and enhanced products and to efficiently
manage our product supply chain will enable us to enhance our products
and offer new products in a cost-effective and timely manner. We
intend to continue to focus on high value product offerings by
promoting and offering our products that are affordable alternatives
to higher-priced products offered by some of our competitors.

o EXPAND INTO NEW SALES CHANNELS. We plan to expand our market
penetration beyond our existing retailers into new sales channels to
include corporate and government procurers, value-added resellers and
value-added distributors. In addition, through our company websites
located at http://www.iomagic.com, http://www.dr-tech.com and
http://www.hival.com, we plan to increase sales of our products over
the Internet by continuing to offer select products for direct
purchase by consumers, conduct special promotions and offer downloads
to existing and potential purchasers of our products.

-8-

o MARKET PRODUCTS TO OUR EXISTING CONSUMER BASE. We intend to market
new, enhanced and current products to existing purchasers of our
products. We also believe that existing users of our products can be
an important source of referrals for potential new purchasers of our
products.

OUR PRODUCTS

We have two primary data storage product categories: our optical data
storage product category and our portable magnetic data storage product
category. Our optical data storage products consist of a range CD and DVD drives
that store traditional PC data as well as music, photos, movies, games and other
multi-media. These products are designed principally for general data storage
purposes. Our portable magnetic data storage products consist of a range of hard
disk drives that we call our GigaBank(TM) products.

OUR OPTICAL DATA STORAGE PRODUCTS

Our optical data storage products are based on one or more of the following
technology formats which allow the storage, management, protection, retrieval
and transfer of data:

TECHNOLOGY MEANING DATA STORAGE AND RETRIEVAL CAPABILITY(1)
- ---------- ------- ----------------------------------------

CD-ROM Compact Disc-Read Only Memory Retrieval only

CD-R Compact Disc-Recordable Retrieval and single-session storage

CD-RW Compact Disc-Rewritable Retrieval and multi-session storage

DVD-ROM Digital Video Disc-Read Only Memory Retrieval only

DVD-R or Digital Video Disc-Recordable Retrieval and single-session storage
DVD+R

DVD-RW or Digital Video Disc-Rewritable Retrieval and multi-session storage and backward
DVD+RW compatibility with CDs

DVD+/-RW+/-R Dual Format Digital Video Disc-Rewritable Retrieval and multi-session storage and backward
and Recordable compatibility with CDs and DVD-Rs

CD-RW+DVD Compact Disc-Rewritable DVD Retrieval and multi-session storage and backward
compatibility with CDs and DVD-ROMs

- ------------

(1) Single-session storage media and devices allow storage on a disc only a
single time, whereas multi-session storage media and devices allow repeated
storage, erasure and re-storage of data. Backward compatible devices permit
the use of media based on older technology in devices employing newer
technology, such as DVD-based devices which permit the use of CD media.

Many of the technologies identified in the table above are competing
formats. We seek to deliver optical data storage products that enable the
storage, management, protection, retrieval and transfer of data to and from all
major formats to satisfy the needs of consumers regardless of their choice of
format. Because certain formats ultimately may be rejected or disfavored by the
marketplace, we do not base our products on a single format or on a small number
of formats. We seek to offer products that are cross-compatible over numerous
formats to offer the most comprehensive solution available to the broadest range
of consumers.

Our optical data storage products currently include:

o Internal and external optical data storage drives based on the
following technologies: CD-ROM, CD-RW, DVD-ROM, DVD+R, DVD+RW,
DVD+/-RW+/-R or CD-RW+DVD;

o External CD-RW and DVD+RW drives that integrate a recordable drive and
a built-in seven-in-one, or 7-n-1, digital media card reader with a
proprietary external casing that features a three-way adjustable
lighting system allowing the user to adjust the lighting to blue, red
or purple, which we call our MediaStation devices; our 7-n-1 digital

-9-

media card reader supports seven different types of solid state memory
devices: CompactFlash, Microdrives(R), Multimedia Card, Secure
Digital, Memory Stick, Memory Stick Pro and SmartMedia;

o Internal dual format DVD recordable drives that integrate a recordable
drive and a built-in 7-n-1 digital media card reader; and

o Disc duplicator systems that are stand-alone units that do not require
a computer connection and that copy information from a source disc,
such as a CD or DVD, to a compatible target disc.

We also offer optical data storage products that use double-layer DVD
technology, which doubles DVD capacity to approximately 8.5 gigabytes, or 8,500
megabytes, depending on the user's operating system and other factors. We plan
to continue our efforts to enhance our optical data storage products by
increasing performance and functionality as well as reducing the size of their
drive units and enclosures to increase portability and ergonomics.

We believe that sales of recordable CD drives in the North American retail
marketplace declined to approximately $95 million in 2004 from approximately
$266 million in 2003. This decline represents a 64% decrease in sales in 2004
from 2003. However, this decline was partially offset by the growth in
recordable DVD drives. We also believe that sales of recordable DVD drives in
the North American retail marketplace increased to approximately $297 million in
2004 from approximately $235 million in 2003. This growth represents a 26%
increase in sales in 2004 from 2003. In addition, we believe that unit sales of
DVD recordable drives increased to approximately 2.2 million units in 2004 from
approximately 1.0 million units in 2003. This growth represents in excess of a
100% increase in unit sales in 2004 from 2003.

OUR PORTABLE MAGNETIC DATA STORAGE PRODUCTS

Our existing and planned portable magnetic data storage products currently
include.

o GigaBank(TM) USB hard disk drives with dimensions measuring 2.0"W x
2.5"L x 0.5"D that provide from up to 2.2 gigabytes, or 2,200
megabytes, to up to 8.0 gigabytes, or 8,000 megabytes, of storage
capacity, depending on the user's operating system and other factors;

o GigaBank(TM)ELITE USB hard disk drives with dimensions measuring
2.75"W x 4.5"L x 0.625"D that provide from up to 40 gigabytes, or
40,000 megabytes, to up to 80 gigabytes, or 80,000 megabytes, of
storage capacity, depending on the user's operating system and other
factors; and

o GigaBank(TM)PREMIER USB hard disk drives with dimensions measuring
3.5"W x 5.75"L x 1.0"D that provide from up to 80 gigabytes, or 80,000
megabytes, to up to 120 gigabytes, or 120,000 megabytes, of storage
capacity, depending on the user's operating system and other factors.

The growth in the availability of digital data, such as movie, photographic
and music data has generated new data storage applications and created
significant demand for portable data storage devices. The typical portable data
storage device is compact, often small enough to fit in a pocket, consumes low
power, is durable, re-writable and is versatile due to its ease of operation. In
addition, most of these portable data storage devices do not require a separate
power source other than through a standard USB port. USB portable storage
devices, such as USB flash drives and compact USB hard disk drives, that compete
with our CD- and DVD-based data storage products were introduced in late 2002
and sales of these devices have continued to represent an increased share of the
market for data storage products. In the third quarter of 2004, we began selling
our GigaBank(TM) products, which are compact and portable external hard disk
drives with a built-in USB connector.

Our GigaBank(TM) products are designed to provide cost-effective portable
alternatives to flash media devices and standard hard disk drives. We believe
that our GigaBank(TM) line of products represents a substantial opportunity for
sales growth. We also believe that sales of our GigaBank(TM) products will, over
the next twelve months, grow as a percentage of our net sales.

OUR DIGITAL ENTERTAINMENT AND OTHER PRODUCTS

Our digital entertainment and other products currently include:

o External floppy disk drives that integrate a floppy disk drive and a
built-in 7-n-1, digital media card reader with a proprietary external
casing that features a three-way adjustable lighting system allowing
the user to adjust the lighting to blue, red or purple, which we call
our DataStation devices;

-10-

o Case enclosures for external or portable data storage drives;

o Our Digital Photo Library(TM) system, which consists of 20 gigabyte
palm-sized portable external hard disk drives with built-in 7-n-1
media card readers that facilitate the convenient storage of
high-resolution digital music, photos and movies and other data files,
enabling the transfer of these files from a flash memory card to a
hard disk drive and eliminating the need for purchasing multiple, less
cost-effective flash memory cards; and

o Do-it-yourself digital photo accessories such as our EasyPrint(TM)
line of products that allow users to create personalized photo frames,
key chains, magnets and pocket-sized photo albums from their own
digital photos using our proprietary photo-enhancing and printing
software.

We believe that the markets for digital entertainment and other consumer
electronics and peripheral products are expanding. We intend to continue to
monitor these markets and develop and sell digital entertainment and other
consumer electronics and peripheral products as we are able to identify products
that we believe we can sell competitively. Currently, our digital entertainment
and other consumer electronics and peripheral products represent only a minor
product category. These products accounted for only approximately 1% of our net
sales during 2004 and approximately 6% of our net sales during 2003.

PRODUCT WARRANTIES

Our products are subject to limited warranties of up to one year in
duration. These warranties cover only repair or replacement of the product. Our
subcontract manufacturers and suppliers provide us with warranties of a duration
at least as long as the warranties provided to consumers. The warranties
provided by our subcontract manufacturers and suppliers cover repair or
replacement of the product.

PRODUCT OFFERINGS

Our product offerings are primarily directed toward satisfying the demands
of the North American retail marketplace for data storage products. We also sell
digital entertainment and other products in the North American retail
marketplace. We operate in industries that are subject to rapid technological
change, product obsolescence and rapid changes in consumer demands and
preferences. We attempt to anticipate and respond to these changes by focusing
on the following primary objectives:

o ENHANCEMENT OF EXISTING PRODUCTS. We seek to offer products with
increased performance and expanded functionality to satisfy existing
and emerging consumer demands and preferences. Our enhanced product
offerings are directed toward, among other things, offering increased
data storage and retrieval speeds, and enhanced user-friendliness and
ease of product installation. These product offerings are also focused
on products with reduced manufacturing costs to enable us to maintain
and improve gross margins while continuing to offer high-value
products to consumers.

o DEVELOPMENT OF NEW PRODUCTS. We seek to offer new products that, among
other things, use existing technology and adopt new technology to
satisfy existing and emerging consumer demands and preferences. Our
new product offerings typically focus on the implementation of
existing technology to offer products that are compatible with a wide
range of formats. These offerings also typically include
implementation of new technology to offer products that deliver better
solutions to the core needs of the data storage marketplace such as
high-capacity, cost-effective, flexible and portable data storage,
management, protection, retrieval and transfer.

Our retailers, subcontract manufacturers and our suppliers play an
important role in the enhancement of our existing products and the development
of new products. We work closely with our retailers, subcontract manufacturers
and our suppliers to identify existing market trends, predict future market
trends and monitor the sales performance of our products.

Many of our retailers are among the largest computer, consumer electronics
and office supply retailers in North America. Over the past three years, our
retailers have included Best Buy, Circuit City, CompUSA, Office Depot,
OfficeMax, RadioShack and Staples. Through their close contact with the
marketplace for data storage products, our retailers are able to provide us with
important information about consumer demands and preferences.

Many of our subcontract manufacturers and suppliers have substantial
product development resources and facilities in Asia, and are among the major
component manufacturers and suppliers in their product categories. Some of our
largest subcontract manufacturers and suppliers are also our stockholders,

-11-

including BTC and Lung Hwa Electronics. We believe that BTC is among the largest
optical storage drive manufacturers in the world and Lung Hwa Electronics is a
supplier of USB hard disk drives, including some of our GigaBank(TM) products,
as well as a major manufacturer of digital entertainment products. These
subcontract manufacturers and suppliers expend substantial resources on
research, development and design of new technologies and efficient manufacturing
processes.

Our Irvine, California headquarters houses a product development team that
coordinates and manages the subcontract logistics and product development
efforts of our subcontract manufacturers and suppliers in Asia. At our Irvine
facility, we also develop user manuals, product packaging and marketing
literature as well as installation guides and supplemental materials, including
software and hardware designed to permit user-friendly product installation.

We do not have a traditional research and development program. Instead, we
work closely with our retailers, subcontract manufacturers and suppliers and
conduct various other activities in connection with the enhancement of our
existing products and the offering of new products. We have not, in any
reporting period, made any material expenditures on research and development
activities relating to the development of new products, services or techniques
or the improvement of existing products, services or techniques. Our efforts are
largely directed at the evaluation of new products and enhancements to existing
products rather than the actual development of new products or product
enhancements.

Our representatives meet frequently with our subcontract manufacturers,
suppliers and our retailers to identify and discuss emerging trends and to
address the sales performance of our products. We provide and receive
product-related input to and from our subcontract manufacturers, suppliers and
our retailers. Much of the input that we provide arises from our technical
service department, which is responsible for assisting end-users in installing
and successfully utilizing our products. Problems in the installation or
utilization of our products are reported to management by our technical service
department and often provide the basis for existing product enhancements. New
products are developed and offered by our subcontract manufacturers and
suppliers, and offered by us and in turn by our retailers largely on the basis
of market research and trends identified in the data storage, digital
entertainment and computer peripheral industries. We also monitor industry trade
publications and technical papers to understand emerging trends and new
technologies and to plan for new product offerings.

We believe that these activities assist us in attempting to achieve our
goal of being among the first-to-market with new and enhanced product offerings
based on established technologies.

OPERATIONS

We do not directly manufacture any of the products that we sell. We
subcontract manufacture or source our data storage, digital entertainment and
other products. We believe that by outsourcing the manufacturing of our products
to our subcontract manufacturers or sourcing them from our suppliers, we benefit
from:

o LOWER OVERHEAD COSTS. By subcontract manufacturing or sourcing our
products we believe that we benefit from lower overhead costs
resulting from the elimination of capital expenditures related to
owning and operating manufacturing facilities, such as expenditures
related to acquiring a manufacturing plant, property and equipment,
and staffing, as well as the ongoing cash requirements to fund such an
operation.

o ECONOMIES OF SCALE. By subcontract manufacturing or sourcing our
products with some of the largest production facilities available in
the industry, we believe that we benefit from our subcontract
manufacturers' and suppliers' economies of scale, which enable us to
keep unit production costs low, our supply chain management efficient
and our expansion or contraction of product orders flexible in
response to changing consumer demands and preferences.

o ENGINEERING AND MANUFACTURING RESOURCES. By subcontract manufacturing
our products we believe that we benefit from our subcontract
manufacturers' substantial engineering and manufacturing resources,
which aid us in offering new and enhanced products and enable us to
rapidly bring them to market in a cost-effective manner.

o DIVERSIFICATION OF MANUFACTURING RISKS. By subcontract manufacturing
to, or sourcing our products from, a group of manufacturers or
suppliers, we believe that we are able to diversify the risks
associated with employing a single manufacturer or supplier. We also
believe that we are potentially able to expand our opportunities with
respect to new products as they arise by virtue of the varying
expertise of those manufacturers and suppliers.

-12-

o REDUCTION OF POTENTIAL LIABILITIES. By subcontract manufacturing or
sourcing our products we believe that we reduce potential significant
liabilities associated with direct product manufacturing, including
environmental liabilities and liabilities resulting from warranty
claims. We believe that the reduction in potential liabilities
decreases our business risks and results in tangible economic benefits
such as cost savings related to insurance and the operation of
compliance programs.

We believe that the relatively low overhead costs resulting from
subcontract manufacturing or sourcing the products we offer for sale, the
economies of scale of our subcontract manufacturers and suppliers, and the
engineering and manufacturing resources of our subcontract manufacturers enable
us to offer products combining high levels of performance, functionality and
reliability at prices competitive with other leading products offered in the
marketplace.

We utilize a subcontract logistics and product development consultant
located in Taipei, Taiwan. Our consultant assists us in identifying new
products, qualifying prospective manufacturing facilities and coordinating
product purchases and shipments from some of our subcontract manufacturers and
suppliers. The majority of our products are shipped directly by our subcontract
manufacturers or suppliers to our packaging, storage and distribution facility
in Irvine. These products are then packaged and shipped by us either directly to
retail locations across North America or to a centralized distribution center.
Product shipments are primarily made through major commercial carriers.

QUALITY CONTROL

Our primary subcontract manufacturers and suppliers are among the major
computer and electronic component manufacturers and suppliers in Asia who we
believe have rigorous quality control and shipping guidelines. We regularly
inspect and test product samples, periodically tour our subcontract
manufacturing and supply facilities, monitor defective product returns and test
defective products.

SALES AND MARKETING

We believe that during 2004 and 2003 we ranked as number three and number
one, respectively, in unit and dollar sales of CD-RW drives in the North
American retail marketplace, competing against companies such as Memorex, Sony
and TDK. Our goal is to achieve and maintain a similar ranking for our DVD-based
products and our GigaBank(TM) products.

We primarily sell our products through retailers who collectively operate
locations throughout North America. These include nationally-recognized
computer, consumer electronics and office supply superstores. In addition, we
sell our products through Internet retailers and mail order catalogs.

Our North American retailers include Best Buy, Best Buy Canada, Circuit
City, CompUSA, Fred Meyer Stores, Microcenter, Office Depot, RadioShack,
Staples, and Target. We also have relationships with other retailers and with
catalog companies and Internet retailers such as Buy.com, Dell, PC Mall and
Tiger Direct.

We cooperate with our retailers to promote our products and brand names. We
participate in co-sponsored events with our retailers and industry trade shows
such as CES(R) and RetailVision(R). We participate in these events and trade
shows in order to develop new relationships with potential retailers and
maintain close relationships with our existing retailers. We also fund
co-operative advertising campaigns, develop custom product features and
promotions, provide direct personal contact with our sales representatives and
develop and procure certain products as requested by our retailers. We cooperate
with our retailers to use point-of-sale and mail-in rebate promotions to
increase sales of our products. We also utilize sales circulars and our close
working relationships with our significant retailers to obtain national exposure
for our products and our brands. We believe that these marketing efforts help
generate additional shelf-space for our products with our major retailers,
promote retail traffic and sales of our products, and enhance our goodwill with
these retailers.

We maintain a large database containing information regarding many
end-users of our products. Through a targeted, direct marketing strategy, we
intend to offer these end-users other products to establish repeat end-user
customers, increase our product sales and promote brand loyalty.

We plan to expand our market penetration beyond traditional and Internet
retailers to include corporate and government procurers, value-added resellers
and value-added distributors. We currently sell and plan to continue to sell
products, conduct special promotions, and offer downloads on our company
websites to existing and potential end-user customers. Our websites are located
at http://www.iomagic.com, http://www.dr-tech.com and http://www.hival.com.

-13-

COMPETITION

We operate primarily in the highly-competitive data storage industry. We
believe that our data storage products compete with other types of data storage
devices such as internal, external and portable hard disk drives, magnetic tape
drives, floppy disk drives and flash memory devices, as well as internal and
external optical data storage products offered by other companies.

Companies that offer products similar to our optical data storage products
include BenQ, Hewlett-Packard, Lite-On, Memorex, Philips Electronics, Samsung
Electronics, Sony and TDK. We also indirectly compete against original equipment
manufacturers such as Dell and Hewlett-Packard to the extent that they
manufacture their own computer peripheral products or incorporate the
functionalities offered by our products directly into PCs. Companies that offer
products similar to our portable magnetic data storage products include PNY
Technologies, Sony, Seagate Technology and Western Digital.

We believe that our ability to compete in the data storage industry depends
on many factors, including the following:

o PRODUCT VALUE. The performance, functionality, reliability and price
of our products are critical elements of our ability to compete. We
believe that we offer, and that our target consumers seek, products
that combine higher levels of performance, functionality and
reliability at lower prices than other leading products offered in the
marketplace. We focus on offering these high value products by
positioning them as affordable alternatives to products offered by
leading brands such as Hewlett-Packard, Memorex, TDK and Sony.

o MARKET PENETRATION. Market penetration and brand recognition are
critical elements of our ability to compete. Most consumers purchase
products similar to ours from off-the-shelf retailers such as large
computer, consumer electronics and office supply superstores. Market
penetration in the industries in which we compete is typically based
on the number of retailers who offer a company's products and the
amount of shelf-space allocated to those products. We believe that our
broad-based, high value product offerings, our retailer support, our
consumer support and our cooperative marketing and other promotional
efforts promote close working relationships with our retailers and
improve our ability to obtain critical shelf-space which enables us to
establish, maintain and increase market penetration.

o PRODUCT ENHANCEMENT AND DEVELOPMENT AND TIME-TO-MARKET. Enhancement of
our existing products, development of new products and rapid
time-to-market to satisfy evolving consumer demands and preferences
are key elements of our ability to compete. Consumers continuously
demand higher levels of performance and functionality in data storage
products. We attempt to compete successfully by bringing products with
higher levels of performance and functionality rapidly to market to
satisfy changing consumer demands and preferences. We believe that the
research and development efforts and economies of scale of our major
subcontract manufacturers and suppliers enable us to rapidly introduce
enhanced products and new products offering higher levels of
performance and functionality. Our products are often among the
first-to-market with new features and technology to be made widely
available to consumers.

INTELLECTUAL PROPERTY

We currently rely on a combination of contractual rights, copyrights,
trademarks and trade secrets to protect our proprietary rights. I/OMagic(R),
Hi-Val(R) and Digital Research Technologies(R) are our registered trademarks. We
also sell products under various product names such as MediaStation,
DataStation, Digital Photo Library(TM), EasyPrint(TM) and GigaBank(TM). As we
develop new products, we may file federal trademark applications covering the
trademarks under which we sell those products. There can be no assurance that we
will eventually secure a registered trademark covering these products. We
currently do not have any issued or pending patents.

We own, license or have otherwise obtained the right to use certain
technologies incorporated in our products. We may receive infringement claims
from third parties relating to our products and technologies. In those cases, we
intend to investigate the validity of the claims and, if we believe the claims
have merit, to respond through licensing or other appropriate actions. To the
extent claims relate to technology included in components purchased from
third-party vendors for incorporation into our products, we would forward those
claims to the appropriate vendor. If we or our product manufacturers are unable
to license or otherwise provide any necessary technology on a cost-effective
basis, we could be prohibited from marketing products containing that
technology, incur substantial costs in redesigning products incorporating that
technology, or incur substantial costs defending any legal action taken against
us.

-14-

We have been, and may in the future be, notified of claims asserting that
we may be infringing certain patents, trademarks and other intellectual property
rights of third parties. We cannot predict the outcome of such claims and there
can be no assurance that such claims will be resolved in our favor. An
unfavorable resolution of such claims may have a material adverse effect on our
business, prospects, financial condition and results of operations. The data
storage industry, has been characterized by significant litigation relating to
infringement of patents and other intellectual property rights. We have in the
past been engaged in infringement litigation, both as plaintiff and defendant.
There can be no assurance that future intellectual property claims will not
result in litigation.

If infringement is established, we may be required to pay substantial
damages or we may be enjoined from manufacturing and selling an infringing
product. In addition, the costs of engaging in the prosecution or defense of
intellectual property claims may be substantial regardless of the outcome.

A number of our agreements with our retailers provide that we will defend,
indemnify and hold harmless our retailers from damages and costs that arise from
product warranty claims or claims for injury or damage resulting from defects in
our products. If such claims are asserted against us, our insurance coverage may
not be adequate to cover the costs associated with our defense of those claims
or any resulting liability we would incur if those claims are successful. A
successful claim brought against us for product defects that is in excess of, or
excluded from, our insurance coverage could have a material adverse affect on
our business and results of operations.

GOVERNMENT REGULATION

Our products are designed by our subcontract manufacturers to comply with a
significant number of regulations and industry standards, some of which are
evolving as new technologies are deployed. We believe that we are currently in
compliance with each applicable regulation and industry standard. In the United
States, our products must comply with various regulations defined by the United
States Federal Communications Commission, or FCC, and Underwriters Laboratories,
or other nationally recognized test laboratories. We also must comply with
numerous import/export regulations. The regulatory process in the United States
can be time-consuming and can require the expenditure of substantial resources.
We cannot assure you that the FCC will grant the requisite approvals for any of
our products on a timely basis, or at all. The failure of our products to
comply, or delays in compliance, with the various existing and evolving
standards could negatively impact our ability to sell our products. United
States regulations regarding the manufacture and sale of data communications
devices are subject to future change. We cannot predict what impact, if any,
such changes may have upon our business.

EMPLOYEES

As of June 29, 2005, we had approximately 50 full-time employees. We have
no collective bargaining agreements with our employees. We believe that our
relationship with our employees is good.

ITEM 2. PROPERTIES

Our corporate headquarters is located in Irvine, California in a leased
facility of approximately 55,000 square feet. This facility contains all of our
operations, including sales, marketing, finance, administration, production,
shipping and receiving. The lease term began on September 1, 2003 and expires on
August 31, 2006, with an option to extend the lease for another three year term
upon providing notice 60 days prior to expiration of the current lease term. Our
monthly lease payments are $25,480, $26,244, and $27,032 during the first,
second, and third years of the lease, respectively. Under the option to extend
the lease, monthly lease payments would be determined according to the then
prevailing market price for the first year, and an increase of 3% per annum for
years two and three. We believe this facility is adequate for our anticipated
business purposes for the foreseeable future. We have no other leased or owned
real property.

ITEM 3. LEGAL PROCEEDINGS

HI-VAL, INC.

-15-

March 28, 2003, all parties to the action entered into a Settlement Agreement
and Release which settled this action prior to the entry of a final judgment. As
part of the Settlement Agreement and Release, Mr. Shahbaz and Mr. Su
relinquished their interests in Alex Properties and the Vakilis relinquished
66,667 shares of our common stock, of which 13,333 shares were transferred to a
third party designated by the Vakilis. In addition, we agreed to make payments
totaling $4.0 million in cash and entered into a new written lease agreement
with Alex Properties relating to the real property in Santa Ana, California,
which we physically occupied. On September 30, 2003, pursuant to the terms of
the lease agreement, we vacated this real property. During the latter part of
2003 and continuing into the first quarter of 2004, Mark and Mitra Vakili and
Alex Properties alleged that we had improperly caused damage to the Santa Ana
facility. On or about February 15, 2004, all parties to the original Settlement
Agreement and Release executed a First Amendment to Settlement Agreement and
Release, releasing all defendants from all of these new claims conditioned upon
the making of the final $1.0 million payment under the Settlement Agreement and
Release by February 17, 2004, rather than on the original due date of March 15,
2004. We made this payment, and a dismissal of the case was filed with the court
on March 8, 2004.

HORWITZ AND BEAM

On May 30, 2003, I/OMagic and IOM Holdings, Inc. filed a complaint for
breach of contract and legal malpractice against Lawrence W. Horwitz, Gregory B.
Beam, Horwitz & Beam, Lawrence M. Cron, Horwitz & Cron, Kevin J. Senn and Senn
Palumbo Mealemans, LLP, our former attorneys and their respective law firms, in
the Superior Court of the State of California for the County of Orange. The
complaint seeks damages of $15 million arising out of the defendants'
representation of I/OMagic and IOM Holdings, Inc. in an acquisition transaction
and in a separate arbitration matter. On November 6, 2003, we filed our First
Amended Complaint against all defendants. Defendants have responded to our First
Amended Complaint denying our allegations. Defendants Lawrence W. Horwitz and
Lawrence M. Cron have also filed a Cross-Complaint against us for attorneys'
fees in the approximate amount of $79,000. We have denied their allegations in
the Cross-Complaint. As of the date of this report, discovery has commenced and
a trial date in this action has been set for September 12, 2005. The outcome of
this action is presently uncertain. However, we believe that all of our claims
are meritorious.

MAGNEQUENCH INTERNATIONAL, INC.

On March 15, 2004, Magnequench International, Inc., or plaintiff, filed an
Amended Complaint for Patent Infringement in the United States District Court of
the District of Delaware against, among others, I/OMagic, Sony Corp., Acer Inc.,
Asustek Computer, Inc., Iomega Corporation, LG Electronics, Inc., Lite-On
Technology Corporation and Memorex Products, Inc., or defendants. The complaint
seeks to permanently enjoin defendants from, among other things, selling
products that allegedly infringe one or more claims of plaintiff's patents. The
complaint also seeks damages of an unspecified amount, and treble damages based
on defendants' alleged willful infringement. In addition, the complaint seeks
reimbursement of plaintiff's costs as well as reasonable attorney's fees, and a
recall of all existing products of defendants that infringe one or more claims
of plaintiff's patents that are within the control of defendants or their
wholesalers and retailers. Finally, the complaint seeks destruction (or
reconfiguration to non-infringing embodiments) of all existing products in the
possession of defendants that infringe one or more claims of plaintiff's
patents. On March 9, 2005, we entered into a Settlement Agreement with
Magnequench International, Inc., releasing all claims against us in exchange for
certain information and covenants by us, including disclosure of identities of
certain of our suppliers of alleged infringing products, a covenant to provide
sample products for testing purposes and a covenant to not source products from
suppliers of alleged infringing products, provided that, among other
limitations, another supplier makes those products available to us in sufficient
quantities. A dismissal of the case was filed with the court on April 15, 2005.

OFFICEMAX NORTH AMERICA, INC.

On May 6, 2005, OfficeMax North America, Inc., or plaintiff, filed a
Complaint for Declaratory Judgment in the United States District Court of the
Northern District of Ohio against I/OMagic. The complaint seeks declaratory
relief regarding whether plaintiff is still obligated to us under certain
previous agreements between the parties. The complaint also seeks plaintiff's
costs as well as reasonable attorneys' fees. The complaint arises out of our
contentions that plaintiff is still obligated to us under an agreement entered
into in May 2001 and plaintiff's contention that it has been released from such
obligation. As of the date of this report, we have filed a motion to dismiss, or
in the alternative, a motion to stay the plaintiff's action against us. The
outcome of this action is presently uncertain. However, at this time, we do not
expect the defense or outcome of this action to have a material adverse affect
on our business, financial condition or results of operations.

On May 20, 2005, I/OMagic filed a complaint for breach of contract, breach
of implied covenant of good faith and fair dealing, and common counts against
OfficeMax North America, Inc., or defendant, in the Superior Court of the State
of California for the County of Orange. The complaint seeks damages in excess of
$22 million arising out of the defendants' breach of contract under an agreement
entered into in May 2001. On or about June 20, 2005, defendant removed this
complaint to the United States District Court for the Central District of
California. I/OMagic and OfficeMax have jointly requested that the United States
District Court for the Central District of California temporarily stay this case
pending the outcome of our motion to dismiss, or in the alternative, our motion
to stay OfficeMax's action against us in the United States District Court of the
Northern District of Ohio. The outcome of this action is presently uncertain.
However, we believe that all of our claims are meritorious.

-16-

ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS

We held our 2004 annual meeting of stockholders on December 21, 2004. As of
the close of business on November 22, 2004, the record date for the meeting, we
had outstanding 4,529,672 shares of common stock. A total of 2,449,638 shares of
common stock were represented in person or by proxy at the meeting and
constituted a quorum. At the meeting, the following three proposals were
presented and voted on:

(1) to elect the following five directors: Tony Shahbaz, Anthony Andrews,
Steel Su, Daniel Hou and Daniel Yao.

o All nominees were re-elected by a vote of 2,448,372 shares "for" and
1,266 shares "withheld."

(2) to ratify the selection of Singer Lewak Greenbaum & Goldstein LLP as
our independent certified public accountants to audit our financial statements
for the year ending December 31, 2004:

o This proposal was approved by a vote of 2,449,618 shares "for" and 20
shares "against" with no abstentions.

-17-

PART II

ITEM 5. MARKET FOR REGISTRANT'S COMMON EQUITY, RELATED STOCKHOLDER MATTERS AND
ISSUER PURCHASES OF EQUITY SECURITIES

MARKET INFORMATION

Our common stock has been traded on the OTC Bulletin Board under the symbol
"IOMG" since December 20, 2002. Prior to that, it traded on the OTC Bulletin
Board under the symbol "IOMC" since March 25, 1996. The table below shows for
each fiscal quarter indicated the high and low closing bid prices for shares of
our common stock. This information has been obtained from the OTC Bulletin
Board. The prices shown reflect inter-dealer prices, without retail mark-up,
mark-down, or commission and may not necessarily represent actual transactions.

PRICE RANGE
-----------
LOW HIGH
--- ----
2003:
First Quarter (January 1 - March 31)......... $ 3.00 $ 10.00
Second Quarter (April 1 - June 30)........... 3.50 11.00
Third Quarter (July 1 - September 30)........ 4.98 7.99
Fourth Quarter (October 1 - December 31)..... 3.50 7.00

2004:
First Quarter................................ $ 4.20 $ 3.00
Second Quarter............................... 4.50 3.45
Third Quarter................................ 4.45 3.50
Fourth Quarter............................... 3.60 3.00

SECURITY HOLDERS

As of June 29, 2005, we had 4,529,672 shares of common stock outstanding
held of record by approximately 70 shareholders. These holders of record include
depositories that hold shares of stock for brokerage firms which, in turn, hold
shares of stock for numerous beneficial owners.

DIVIDENDS

We have not paid dividends on our common stock to date. Our line of credit
with GMAC Commercial Finance prohibits the payment of cash dividends on our
common stock. We currently intend to retain future earnings to fund the
development and growth of our business and, therefore, do not anticipate paying
cash dividends on our common stock within the foreseeable future. Any future
payment of dividends on our common stock will be determined by our board of
directors and will depend on our financial condition, results of operations,
contractual obligations and other factors deemed relevant by our board of
directors.

RECENT SALES OF UNREGISTERED SECURITIES

In March 2004, we issued warrants to purchase 10,000 shares of common stock
at an exercise price of $4.00 per share to an investor relations firm in
connection with services to be rendered. The warrants expire on September 9,
2005.

In March 2004, we issued warrants to purchase 10,000 shares of common stock
at an exercise price of $6.00 per share to an investor relations firm in
connection with services to be rendered. The warrants expire on September 9,
2005.

In March 2004, we issued options to purchase an aggregate of 64,375 shares
of common stock under our 2002 Stock Option Plan at an exercise price of $3.50
per share to certain of our officers, directors and employees. The options
expire on March 9, 2014.

In March 2004, we issued options to purchase an aggregate of 62,000 shares
of common stock under our 2002 Stock Option Plan at an exercise price of $3.85
per share to certain of our officers, directors and employees. The options
expire on March 9, 2009.

-18-

The issuances of our securities in the above-referenced transactions were
effected in reliance upon the exemption from registration under Section 4(2) of
the Securities Act of 1933, as amended, as transactions not involving a public
offering. Exemption from the registration provisions of the Securities Act is
claimed on the basis that such transactions did not involve any public offering
and the purchasers were sophisticated with access to the kind of information
registration would provide including our most recent Annual Report on Form 10-K
and our most recent Quarterly Report on Form 10-Q.

ITEM 6. SELECTED FINANCIAL DATA

The following financial information should be read in conjunction with the
consolidated audited financial statements and the notes to those statements
beginning on page F-1 of this report, and the section entitled "Management's
Discussion and Analysis of Financial Condition and Results of Operations"
included elsewhere in this report. The consolidated statements of operations
data for the years ended December 31, 2004, 2003 and 2002 and the consolidated
balance sheet data at December 31, 2004, 2003 and 2002 are derived from, and are
qualified in their entirety by reference to, the consolidated audited financial
statements beginning on page F-1 of this report. The consolidated statements of
operations data with respect to the years ended December 31, 2001 and 2000 and
the consolidated balance sheet data at December 31, 2001 and 2000 are derived
from, and are qualified in their entirety by reference to, our audited financial
statements not included in this report. The historical results that appear below
are not necessarily indicative of results to be expected for any future periods.

YEAR ENDED DECEMBER 31,
-----------------------
2004 2003 2002 2001 2000
---- ---- ---- ---- ----
(AS RESTATED) (AS RESTATED) (AS RESTATED) (AS RESTATED)

CONSOLIDATED STATEMENTS OF OPERATIONS DATA:
Net sales ..................................... $ 44,396,551 $ 63,587,454 $ 80,952,712 $ 68,112,311 $ 61,048,101
Cost of sales ................................. 41,418,750 54,643,371 73,564,456 61,951,641 53,126,489
------------- ------------- ------------- ------------- -------------
Gross profit .................................. 2,977,801 8,944,083 7,388,256 6,160,670 7,921,612
Operating expenses ............................ 10,881,017 9,236,912 10,022,445 10,180,839 10,126,111
------------- ------------- ------------- ------------- -------------
Income (loss) from operations ................. (7,903,216) (292,829) (2,634,189) (4,020,169) (2,204,499)
Total other expense ........................... (151,116) (194,337) (5,525,033) (376,431) (4,963,286)
------------- ------------- ------------- ------------- -------------
Loss from operations before income taxes ...... (8,054,332) (487,166) (8,159,222) (4,396,600) (7,167,785)
Income tax (benefit) expense .................. 2,532 (27,148) 685,372 981,266 (999,600)
============= ============= ============= ============= =============
Net loss ...................................... $ (8,056,864) $ (460,018) $ (8,844,594) $ (5,377,866) $ (6,168,185)
============= ============= ============= ============= =============
Basic loss per share .......................... $ (1.78) $ (0.10) $ (1.95) $ (1.19) $ (2.35)
============= ============= ============= ============= =============
Diluted loss per share ........................ $ (1.78) $ (0.10) $ (1.95) $ (1.19) $ (2.35)
============= ============= ============= ============= =============
Weighted-average shares outstanding, basic .... 4,529,672 4,529,672 4,528,894 4,528,341 2,629,894
============= ============= ============= ============= =============
Weighted-average shares outstanding, diluted .. 4,529,672 4,529,672 4,528,894 4,528,341 2,629,894
============= ============= ============= ============= =============
CONSOLIDATED BALANCE SHEET DATA:
Cash and cash equivalents ..................... $ 3,587,807 $ 4,005,705 $ 5,138,111 $ 4,423,623 $ 3,502,546
Working capital ............................... 7,527,474 11,051,270 11,524,146 19,272,671 22,402,110
Total assets .................................. 27,466,743 40,112,792 41,757,969 54,925,501 53,098,438
Stockholders' equity .......................... 8,361,967 16,418,832 16,962,536 17,848,830 23,222,971
Redeemable convertible preferred stock ........ $ -- $ -- $ -- $ 9,000,000 $ 9,000,000
============= ============= ============= ============= =============

No cash dividends on our common stock were declared during any of the
periods presented above.

Various factors materially affect the comparability of the information
presented in the above table. These factors relate primarily to the acquisition
of the assets of Hi-Val, Inc. and Digital Research Technologies. Each of the
years ended December 31, 2004, 2003, 2002, 2001 and 2000 were significantly
affected by our acquisition of IOM Holdings, Inc. in December 2000. IOM
Holdings, Inc. acquired the assets of Hi-Val, Inc. in March 2000 and the assets
of Digital Research Technologies in November 2000. In addition, certain years
were affected by management's decisions regarding income tax expense or benefit.

The financial data for 2000 reflects the contribution by our Hi-Val(R)- and
Digital Research Technologies(R)-branded products of an aggregate of $13.8
million, or 22.7%, of our total net sales for 2000, and an increase in net loss
of $4.0 million. Our I/OMagic(R)-branded products contributed $47.0 million, or
77.3%, of our total net sales for 2000. We also recorded an income tax benefit
of $1.0 million relating to deferred tax assets. We have restated, among other
items, our net sales, cost of sales, gross profit, net loss, basic and diluted
loss per common share and stockholders' equity for 2000. Our net sales were
previously reported as $60,805,437 and have been increased by $242,664 to
$61,048,101. Our gross profit was previously reported as $7,678,948 and has been
increased by $242,664 to $7,921,612. Our net loss was previously reported as
$6,410,849 and has been reduced by $242,664 to $6,168,185. Our basic and diluted
loss per common share was previously reported as $2.44 and has been reduced by
$0.09 to $2.35. Our stockholders' equity was previously reported as $22,659,571
and has been increased by $563,400 to $23,222,971. See our consolidated
financial statements - "Note 2 - Restatement of 2000, 2001, 2002 and 2003
Financial Statements" included elsewhere in this report.

-19-

The financial data for 2001 reflects the contribution by our Hi-Val(R)- and
Digital Research Technologies(R)-branded products of an aggregate of $41.5
million, or 61.0%, of our total net sales for 2001, and $2.5 million of gross
margin. Our I/OMagic(R)-branded products contributed $26.6 million, or 39.0%, of
our total net sales for 2001, and $3.6 million of gross margin. We increased our
inventory reserve by $400,000 and recorded a reserve against $851,000 in
accounts receivable relating to accounts receivable acquired as part of the
acquisition of the assets of Hi-Val, Inc. In addition, we also amortized $1.9
million of the value of our Hi-Val(R) and Digital Research Technologies(R)
trademarks. In aggregate, we had $3.2 million in acquisition-related reserves
and expenses during 2001. We have restated, among other items, our net sales,
cost of sales, gross profit, net loss, basic and diluted loss per common share
and stockholders' equity for 2001. Our net sales were previously reported as
$67,788,959 and have been increased by $323,352 to $68,112,311. Our gross profit
was previously reported as $5,012,625 and has been increased by $1,148,045 to
$6,160,670. Our net loss was previously reported as $5,547,645 and has been
decreased by $169,779 to $5,377,866. Our basic and diluted loss per common share
was previously reported as $1.23 and has been decreased by $0.04 to $1.19. Our
stockholders' equity was previously reported as $17,115,651 and has been
increased by $733,179 to $17,848,830. See our consolidated financial statements
- - "Note 2 - Restatement of 2000, 2001, 2002 and 2003 Financial Statements"
included elsewhere in this report.

The financial data for 2002 reflects the contribution by our Hi-Val(R)- and
Digital Research Technologies(R)-branded products of an aggregate of $45.4
million, or 56.1%, of our total net sales for 2002, and $2.5 million of gross
margin. Our I/OMagic(R)-branded products contributed $35.5 million, or 43.9%, of
our total net sales for 2002, and $4.9 million of gross margin. We increased our
inventory reserve by $2.1 million and recorded a reserve against $1.3 million in
accounts receivable primarily related to accounts receivable acquired as part of
the acquisition of IOM Holdings, Inc. We also amortized $916,000 of the value of
our Hi-Val(R) and Digital Research Technologies(R) trademarks and recorded a
reserve against $1.7 million in deferred tax assets. In addition, we incurred
$5.2 million for acquisition-related legal settlement costs and related legal
fees. See "Business - Legal Proceedings" and our consolidated financial
statements - "Note 12 - Commitments and Contingencies" included elsewhere in
this report. In the aggregate, in 2002 we had $11.2 million in
acquisition-related reserves and expenses or that otherwise resulted from
one-time events during 2002. We have restated, among other items, our net sales,
cost of sales, gross profit, net loss, basic and diluted loss per common share
and stockholders' equity for 2002. Our net sales were previously reported as
$83,529,708 and have been reduced by $2,576,996 to $80,952,712. Our gross profit
was previously reported as $8,863,885 and has been reduced by $1,475,629 to
$7,388,256. Our net loss was previously reported as $8,347,231 and has been
increased by $497,363 to $8,844,594. Our basic and diluted loss per common share
was previously reported as $1.84 and has been increased by $0.11 to $1.95. Our
stockholders' equity was previously reported as $16,726,720 and has been
increased by $235,816 to $16,962,536. See our consolidated financial statements
- - "Note 2 - Restatement of 2000, 2001, 2002 and 2003 Financial Statements"
included elsewhere in this report.

The financial data for 2003 reflects the contribution by our Hi-Val(R)- and
Digital Research Technologies(R)-branded products of an aggregate of $24.7
million, or 38.8%, of our total net sales for 2003, and $3.3 million of gross
margin. Our I/OMagic(R)-branded products contributed $38.9 million, or 61.2%, of
our total net sales for 2003, and $5.7 million of gross margin. We recorded a
reserve against $1.5 million in accounts receivable primarily related to
accounts receivable acquired as part of the acquisition of IOM Holdings, Inc.,
and we amortized $579,000 of the value of our Hi-Val(R) and Digital Research
Technologies(R) trademarks, for an aggregate of $2.1 million in
acquisition-related reserves and expenses during 2003. We have restated, among
other items, our net sales, cost of sales, gross profit, net loss, basic and
diluted loss per common share and stockholders' equity for 2003. Our net sales
were previously reported as $62,222,513 and have been increased by $1,364,941 to
$63,587,454. Our gross profit was previously reported as $9,138,784 and has been
reduced by $194,701 to $8,944,083. Our net loss was previously reported as
$265,317 and has been increased by $194,701 to $460,018. Our basic and diluted
loss per common share was previously reported as $0.06 and has been increased by
$0.04 to $0.10. Our stockholders' equity was previously reported as $16,377,717
and has been increased by $41,115 to $16,418,832. See our consolidated financial
statements - "Note 2 - Restatement of 2000, 2001, 2002 and 2003 Financial
Statements" included elsewhere in this report.

The financial data for 2004 reflects the contribution by our Hi-Val(R)- and
Digital Research Technologies(R)-branded products of an aggregate of $7.5
million, or 16.9%, of our total net sales for 2004, and $705,000 of gross
margin. Our I/OMagic(R)-branded products contributed $36.9 million, or 83.1%, of
our total net sales for 2004, and $2.3 million of gross margin. We amortized
$579,000 of the value of our Hi-Val(R) and Digital Research Technologies(R)
trademarks and we recorded an impairment of the Hi-Val(R) and Digital Research
Technologies(R) trademarks of $3.7 million to reduce the net book value to
$500,000 based on a valuation as of year end 2004, for an aggregate of $4.3
million in acquisition-related expenses during 2004.

-20-

ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS
OF OPERATIONS

THE FOLLOWING DISCUSSION SHOULD BE READ IN CONJUNCTION WITH OUR
CONSOLIDATED AUDITED FINANCIAL STATEMENTS AND THE RELATED NOTES AND THE OTHER
FINANCIAL INFORMATION INCLUDED ELSEWHERE IN THIS REPORT. THIS DISCUSSION
CONTAINS FORWARD-LOOKING STATEMENTS REGARDING THE DATA STORAGE AND DIGITAL
ENTERTAINMENT INDUSTRIES AND OUR EXPECTATIONS REGARDING OUR FUTURE PERFORMANCE,
LIQUIDITY AND CAPITAL RESOURCES. OUR ACTUAL RESULTS COULD DIFFER MATERIALLY FROM
THOSE EXPRESSED IN THESE FORWARD-LOOKING STATEMENTS AS A RESULT OF ANY NUMBER OF
FACTORS, INCLUDING THOSE SET FORTH UNDER "RISK FACTORS" AND UNDER OTHER CAPTIONS
CONTAINED ELSEWHERE IN THIS REPORT.

OVERVIEW

We are a leading provider of optical data storage products and also sell a
range of portable magnetic data storage products which we call our GigaBank(TM)
products. In addition, and to a much lesser extent, we sell digital
entertainment and other products. Our data storage products collectively
accounted for approximately 99% of our net sales in 2004 and our digital
entertainment and other products collectively accounted for only approximately
1% of our net sales in 2004.

Our data storage products consist of a range of products that store
traditional PC data as well as music, photos, movies, games and other
multi-media content. These products are designed principally for general data
storage purposes. Our digital entertainment products consist of a range of
products that focus on digital music, photos and movies. These products are
designed principally for entertainment purposes.

We sell our products through computer, consumer electronics and office
supply superstores and other retailers in over 10,000 retail locations
throughout North America. Our network of retailers enables us to offer products
to consumers across North America, including every major metropolitan market in
the United States. Over the last three years, our largest retailers have
included Best Buy, Circuit City, CompUSA, Office Depot, OfficeMax and Staples.
Our principle brand is I/OMagic(R), however, from time to time, we also sell
products under our Hi-Val(R) and Digital Research Technologies(R) brand names.

Our net sales declined by $19.2 million, or 30.2%, to $44.4 million in 2004
from $63.6 million in 2003 and our net loss increased by $7.6 million, or
1,652%, to $8.1 million in 2004 from $460,000 in 2003. We believe that this
significant decline in our operating results is due, in large part, to the
following factors:

o DECREASED SALES. As discussed further below, we believe that our
substantial decline in net sales in 2004 as compared to 2003 was
primarily due to the following factors:

o the rapid and continued decline in sales of our CD-based
products;

o slower than anticipated growth in sales of our DVD-based
products; and

o sales to Best Buy, our largest customer in 2003 and 2002,
declined substantially in 2004 due to the expanded operation of
private label programs, and we did not sell any products to
OfficeMax in 2004 as compared to substantial sales of products to
OfficeMax in 2003.

o DECREASED GROSS MARGINS. Our gross margins declined by 52.5% to 6.7%
in 2004 as compared to gross margins of 14.1% in 2003. This decline
was primarily due to an increase in our reserve for slow-moving and
obsolete inventory to $2.0 million in 2004 from $125,000 in 2003.

o IMPAIRMENT OF TRADEMARKS. In 2004, we recorded an impairment of our
Hi-Val(R) and Digital Research Technologies(R) trademarks in the
amount of $3.7 million after determining their value to be
significantly impaired. Sales of Hi-Val(R)- and Digital Research
Technologies(R)-branded products declined by $16.4 million, or 68.0%,
to $7.6 million in 2004 from $24.8 million in 2003. In addition, we
reduced our forecasts for sales of Hi-Val(R)- and Digital Research
Technologies(R)-branded products in future years.

We believe that the significant decline in our net sales during 2004 as
compared to 2003 resulted in part from the rapid and continued decline in sales
of our CD-based products. We elected to de-emphasize CD-based products because
we believe that they are included as a standard component in most new computer
systems and because DVD-based products are backward-compatible with CDs.
Predominantly based on market forces, but also partly as a result of our
decision to de-emphasize CD-based products, our sales of recordable CD-based
products declined by 76.1% to $7.1 million in 2004 from $29.7 million in 2003.
Sales of our recordable DVD-based products increased by 50.0% to $29.4 million
in 2004 from $19.6 million in 2003. These results suggest that our sales of
recordable CD-based products declined by $22.6 million in 2004 as compared to

-21-

2003, which decline was only partially offset by an increase in sales of our
recordable DVD-based products by $9.8 million for the same periods, resulting in
an overall decline of sales of our recordable optical data storage products of
$12.8 million in 2004 as compared to 2003.

Also, an industry-wide decline in CD-based product sales occurred more
rapidly than the industry-wide increase in sales of DVD-based data storage
products. We believe that lower than expected demand for DVD-based products
resulted in part from slower than anticipated growth in DVD-compatible
applications and infrastructure. Also, the market for DVD-based products was
extremely competitive during 2004 and was characterized by abundant product
supplies. We believe that, based on industry forecasts that predicted
significant sales growth of DVD-based data storage products, suppliers produced
quantities of these products that were substantial and excessive relative to the
ultimate demand for those products. As a result of these relatively substantial
and excessive quantities, the market for DVD-based data storage products
experienced intense competition and downward pricing pressures resulting in
lower than expected overall dollar sales. The effects of these factors on sales
of our DVD-based products were substantially similar in this regard to that of
the data storage industry.

Two additional factors that we believe contributed to the decline in our
sales in 2004 as compared to 2003 were very short product life-cycles and the
imminent availability of double-layer recordable DVD drives, which can increase
storage capacity to up to twice the capacity of single-layer recordable DVD
drives. We believe that these factors led consumers to delay purchases in
anticipation of products incorporating faster drive speeds, which allow users to
more quickly store and access data, and new technologies. During 2004, DVD
drives of increasing speeds were introduced into the marketplace in very rapid
succession. However, during this time, we expected our DVD-based products to
experience longer product life-cycles similar in duration to the life-cycles of
our CD-based products. We believe that consumer perception of shorter product
life-cycles led consumers to delay purchases in anticipation of succeeding
products incorporating faster data storage and access speeds. In addition, we
expected that double-layer recordable DVD drives would be available commencing
in the fourth quarter of 2004; however, the market's transition from
single-layer to double-layer recordable DVD drives began earlier than expected
in the third quarter of 2004, confirming what we believe were consumer
expectations regarding the imminent availability of products incorporating
double-layer recordable DVD technology. We began selling our double-layer
recordable DVD drives at the end of the third quarter of 2004; however, sales of
our double-layer recordable DVD drives have not been as robust as expected
partially as a result of the lack of reasonably-priced DVD media.

USB portable data storage devices, such as USB flash drives and compact USB
hard disk drives that compete with our CD- and DVD-based data storage products
were introduced in late 2002 and sales of these devices, as well as Apple's
Ipod(R) and other MP3 players, have continued to represent an increasing share
of the market for data storage products. We believe that these portable data
storage devices, which are an alternative to optical data storage products, have
accordingly caused a decline in the relative market share of CD- and DVD-based
optical data storage products and likewise caused a decline in our sales of CD-
and DVD-based products in 2004. In the third quarter of 2004, we began selling
our GigaBank(TM) products, which are compact and portable hard disk drives with
a built-in USB connector, to complement our optical data storage products.

Another factor contributing significantly to the decline in our net sales
during 2004 as compared to 2003 was the continued and expanded operation of
private label programs by Best Buy. Our sales to Best Buy, who was our largest
retailer during 2003 and 2002, declined in 2004 to $5.0 million, representing a
decrease of 72.5% from $18.2 million in 2003. We believe that this decrease
reflects, at least in part, Best Buy's increased sales of private label products
that compete with products that we sell. Although we expect this decline in
sales to Best Buy to continue in subsequent reporting periods as a result of
continued private label programs, management intends to use its best efforts to
insure that we retain Best Buy as one of our major retailers. Management is
currently in discussions with Best Buy regarding the sale of other products not
currently sold to, or private-labeled by, Best Buy. However, there can be no
assurance that we will be successful in selling any of these products, or any
products at all, to Best Buy. If our sales to Best Buy continue to decline, our
business and results of operations will continue to be materially and adversely
affected.

Our business focus is predominantly on DVD-based optical data storage
products. In addition to CD- and DVD-based optical data storage products, we
also focus on and sell a line of GigaBank(TM) products, which are compact and
portable hard disk drives with a built-in USB connector. We expect to broaden
our range of data storage products by expanding our GigaBank(TM) product line
and we anticipate that sales of these devices will increase as a percentage of
our total net sales over the next twelve months. In the fourth quarter of 2004,
our GigaBank(TM) products accounted for approximately 27.0% of our total net
sales, and for the year ended December 31, 2004, with only approximately three
months of sales our GigaBank(TM) products, accounted for approximately 8.7% of
our total net sales.

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One of our core strategies is to be among the first-to-market with new and
enhanced product offerings based on established technologies. We expect to apply
this strategy, as we have done in the contexts of CD- and DVD-based technologies
and for our GigaBank(TM) products, to next-generation super-high capacity
optical data storage devices using technology such as Blu-ray DVD or
High-definition DVD. This strategy extends not only to new products, but also to
enhancements of existing products. We believe that by employing this strategy,
we will be able to maintain relatively high average selling prices and margins
and avoid relying on the highly competitive market of last-generation and older
devices.

Our business faces the significant risk that certain of our retailers will
implement a private label or direct import program, or expand their existing
programs, especially for higher margin products. Our retailers may believe that
higher profit margins can be achieved if they implement a direct import or
private label program, excluding us from the sales channel. For example, as
noted above, our sales to Best Buy, who was our largest retailer during 2003 and
2002, declined in 2004 to $5.0 million, representing a decrease of 72.5% from
$18.2 million in 2003. We believe that this decrease reflects, at least in part,
Best Buy's increased sales of private label products that compete with products
that we sell. Our challenge will be to deliver products and provide service to
our retailers in a manner and at a level that makes private label or direct
importation of products less attractive to our retailers, while maintaining
product margins at levels sufficient to allow for profitability that meets or
exceeds our goals.

OPERATING PERFORMANCE AND FINANCIAL CONDITION

We focus on numerous factors in evaluating our operating performance and
our financial condition. In particular, in evaluating our operating performance,
we focus primarily on net sales, net product margins, net retailer margins,
rebates and sales incentives, and inventory turnover as well as operating
expenses and net income.

NET SALES. Net sales is a key indicator of our operating performance. We
closely monitor overall net sales, as well as net sales to individual retailers,
and seek to increase net sales by expanding sales to additional retailers and
expanding sales to existing retailers both by increasing sales of existing
products and introducing new products. Management monitors net sales on a weekly
basis, but also considers sales seasonality, promotional programs and product
life-cycles in evaluating weekly sales performance. As net sales increase or
decrease from period to period, it is critical for management to understand and
react to the various causes of these fluctuations, such as successes or failures
of particular products, promotional programs, product pricing, retailer
decisions, seasonality and other causes. Where possible, management attempts to
anticipate potential changes in net sales and seeks to prevent adverse changes
and stimulate positive changes by addressing the expected causes of adverse and
positive changes. We believe that our good working relationships with our
retailers enable us to monitor closely consumer acceptance of particular
products and promotional programs which in turn enable us to better anticipate
changes in market conditions.

NET PRODUCT MARGINS. Net product margins, from product-to-product and
across all of our products as a whole, is an important measurement of our
operating performance. We monitor margins on a product-by-product basis to
ascertain whether particular products are profitable or should be phased out as
unprofitable products. In evaluating particular levels of product margins on a
product-by-product basis, we focus on attaining a level of net product margin
sufficient to contribute to normal operating expenses and to provide a profit.
The level of acceptable net product margin for a particular product depends on
our expected product sales mix. However, we occasionally sell products for
certain strategic reasons to, for example, complete a product line or for
promotional purposes, without a rigid focus on historical product margins or
contribution to operating expenses or profitability.

NET RETAILER MARGINS. We seek to manage profitability on a retailer level,
not solely on a product level. Although we focus on net product margins on a
product-by-product basis and across all of our products as a whole, our primary
focus is on attaining and building profitability on a retailer-by-retailer
level. For this reason, our mix of products is likely to differ among our
various retailers. These differences result from a number of factors, including
retailer-to-retailer differences, products offered for sale and promotional
programs.

REBATES AND SALES INCENTIVES. Rebates and sales incentives offered to
customers and retailers are an important aspect of our business and are
instrumental in obtaining and maintaining market leadership through competitive
pricing in generating sales on a regular basis as well as stimulating sales of
slow moving products. We focus on rebates and sales incentives costs as a
proportion of our total net sales to ensure that we meet our expectations of the
costs of these programs and to understand how these programs contribute to our
profitability or result in unexpected losses.

INVENTORY TURNOVER. Our products' life-cycles typically range from 3-12
months, generating lower average selling prices as the cycles mature. We attempt
to keep our inventory levels at amounts adequate to meet our retailers' needs
while minimizing the danger of rapidly declining average selling prices and
inventory financing costs. By focusing on inventory turnover levels, we seek to
identify slow-moving products and take appropriate actions such as
implementation of rebates and sales incentives to increase inventory turnover.

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Our use of a consignment sales model with certain retailers results in
increased amounts of inventory that we must carry and finance. Our use of a
consignment sales model results in greater exposure to the danger of declining
average selling prices, however our consignment sales model allows us to more
quickly and efficiently implement promotional programs and pricing adjustments
to sell off slow-moving inventory and prevent further price erosion.

Our targeted inventory turnover levels for our combined sales models is 6
to 8 weeks of inventory, which equates to an annual inventory turnover level of
approximately 6.5 to 8.5. In 2004, our annualized inventory turnover level was
7.2 as compared to 6.6 in 2003, representing a period-to-period increase of 9%
primarily as a result of a 37% decline in inventory offset by a 30% decrease in
net sales. The decline in inventory in 2004 included $2.0 million in additional
reserves for slow-moving and obsolete inventory. For 2003, our inventory
turnover level was 6.6 as compared to 9.1 for 2002, representing a
period-to-period decrease of 27% primarily as a result of a 9% increase in
inventory and a 21% decrease in net sales.

OPERATING EXPENSES. We focus on operating expenses to keep these expenses
within budgeted amounts in order to achieve or exceed our targeted
profitability. We budget certain of our operating expenses in proportion to our
projected net sales, including operating expenses relating to production,
shipping, technical support, and inside and outside commissions and bonuses.
However, most of our expenses relating to general and administrative costs,
product design and sales personnel are essentially fixed over large sales
ranges. Deviations that result in operating expenses in greater proportion than
budgeted signal to management that it must ascertain the reasons for the
unexpected increase and take appropriate action to bring operating expenses back
into the budgeted proportion.

NET INCOME. Net income is the ultimate goal of our business. By managing
the above factors, among others, and monitoring our actual results of
operations, our goal is to generate net income at levels that meet or exceed our
targets.

In evaluating our financial condition, we focus primarily on cash on hand,
available trade lines of credit, available bank line of credit, anticipated
near-term cash receipts, and accounts receivable as compared to accounts
payable. Cash on hand, together with our other sources of liquidity, is critical
to funding our day-to-day operations. Funds available under our line of credit
with GMAC Commercial Finance are also an important source of liquidity and a
measure of our financial condition. We use our line of credit on a regular basis
as a standard cash management procedure to purchase inventory and to fund our
day-to-day operations without interruption during periods of slow collection of
accounts receivable. Anticipated near-term cash receipts are also regarded as a
short-term source of liquidity, but are not regarded as immediately available
for use until receipt of funds actually occurs.

The proportion of our accounts receivable to our accounts payable and the
expected maturity of these balance sheet items is an important measure of our
financial condition. We attempt to manage our accounts receivable and accounts
payable to focus on cash flows in order to generate cash sufficient to fund our
day-to-day operations and satisfy our liabilities. Typically, we prefer that
accounts receivable are matched in duration to, or collected earlier than,
accounts payable. If accounts payable are either out of proportion to, or due
far in advance of, the expected collection of accounts receivable, we will
likely have to use our cash on hand or our line of credit to satisfy our
accounts payable obligations, without relying on additional cash receipts, which
will reduce our ability to purchase and sell inventory and may impact our
ability, at least in the short-term, to fund other parts of our business.

SALES MODELS

We employ three primary sales models: a standard terms sales model, a
consignment sales model and a special terms sales model. We generally use one of
these three primary sales models, or some combination of these sales models,
with each of our retailers.

STANDARD TERMS

Currently, the majority of our net sales are on a terms basis. Under our
standard terms sales model, a retailer is obligated to pay us for products sold
to it within a specified number of days from the date of sale of products to the
retailer. Our standard terms are typically net 60 days. We typically collect
payment from a retailer within 60 to 75 days following the sale of products to a
retailer.

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CONSIGNMENT

Consignment sales represented a growing percentage of our net sales from
2001 through 2003. However, during 2004, our consignment sales model accounted
for 32% of our total net sales as compared to 37% of our total net sales in
2003, representing a 14% decrease, primarily as a result of consigning fewer
products to Best Buy, which is our largest consignment retailer, which was
partially offset by an increase in consigning more products to Staples. During
2003, our consignment sales model accounted for 37% of our total net sales as
compared to 30% of our total net sales in 2002, representing a 23% increase.
Although consignment sales declined as a percentage of our net sales in 2004, it
is not yet clear whether consignment sales as a percentage of our total net
sales will continue to decline or resume growing.

During 2002 and 2003, we increased the use of our consignment sales model
based in part on the preferences of some of our retailers. Our retailers often
prefer the benefits resulting from our consignment sales model over our standard
terms sales model. These benefits include payment by a retailer only in the
event of resale of a consigned product, resulting in less risk borne by the
retailer of price erosion due to competition and technological obsolescence.
Deferring payment until following the sale of a consigned product also enables a
retailer to avoid having to finance the purchase of that product by using cash
on hand or by borrowing funds and incurring borrowing costs. In addition,
retailers also often operate under budgetary constraints on purchases of certain
products or product categories. As a result of these budgetary constraints, the
purchase by a retailer of certain products typically will cause reduced
purchasing power for other products. Products consigned to a retailer ordinarily
fall outside of these budgetary constraints and do not cause reduced purchasing
power for other products. As a result of these benefits, we believe that we are
able to sell more products by using our consignment sales model than by using
only our standard terms sales model.

Managing an appropriate level of consignment sales is an important
challenge. As noted above, the payment period for products sold on consignment
is based on the day consigned products are resold by a retailer, and the payment
period for products sold on a standard terms basis is based on the day the
product is sold initially to the retailer, independent of the date of resale of
the product. Accordingly, we generally prefer that higher-turnover inventory is
sold on a consignment basis while lower-turnover inventory is sold on a
traditional terms basis. Management focuses closely on consignment sales to
manage our cash flow to maximize liquidity as well as net sales. Close attention
is directed toward our inventory turnover levels to ensure that they are
sufficiently frequent to maintain appropriate liquidity. Our consignment sales
model enables us to have more pricing control over inventory sold through our
retailers as compared to our standard terms sales model. If we identify a
decline in inventory turnover levels for products in our consignment sales
channels, we can implement price modifications more quickly and efficiently as
compared to the implementation of sales incentives in connection with our
standard terms sales model. This affords us more flexibility to take action to
attain our targeted inventory turnover levels.

We retain most risks of ownership of products in our consignment sales
channels. These products remain our inventory until their resale by our
retailers. The turnover frequency of our inventory on consignment is critical to
generating regular cash flow in amounts necessary to keep financing costs to
targeted levels and to purchase additional inventory. If this inventory turnover
is not sufficiently frequent, our financing costs may exceed targeted levels and
we may be unable to generate regular cash flow in amounts necessary to purchase
additional inventory to meet the demand for other products. In addition, as a
result of our products' short life-cycles, which generate lower average selling
prices as the cycles mature, low inventory turnover levels may force us to
reduce prices and accept lower margins to sell consigned products. If we fail to
select high turnover products for our consignment sales channels, our sales,
profitability and financial resources may decline.

SPECIAL TERMS

We occasionally employ a special terms sales model. Under our special terms
sales model, the payment terms for the purchase of our products are negotiated
on a case-by-case basis and typically cover a specified quantity of a particular
product. We ordinarily do not offer any rights of return or rebates for products
sold under our special terms sales model. Our payment terms are ordinarily

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shorter under our special terms sales model than under our standard terms or
consignment sales models and we typically require payment in advance, at the
time of sale, or shortly following the sale of products to a retailer.

RETAILERS

Historically, a limited number of retailers have accounted for a
significant percentage of our net sales. During 2004, 2003 and 2002, our six
largest retailers accounted for approximately 84%, 80% and 90%, respectively, of
our total net sales. We expect that sales of our products to a limited number of
retailers will continue to account for a majority of our sales in the
foreseeable future. We do not have long-term purchase agreements with any of our
retailers. If we were to lose any of our major retailers or experience any
material reduction in orders from any of them, and were unable to replace our
sales to those retailers, it could have a material adverse effect on our
business and results of operations.

SEASONALITY

Our products have historically been affected by seasonal purchasing
patterns. The seasonality of our sales is in direct correlation to the
seasonality experienced by our retailers and the seasonality of the consumer
electronics industry. After adjusting for the addition of new retailers, our
fourth quarter has historically generated the strongest sales, which correlates
to well-established consumer buying patterns during the Thanksgiving through
Christmas holiday season. Our first and third quarters have historically shown
some strength from time to time based on post-holiday season sales in the first
quarter and back-to-school sales in the third quarter. Our second quarter has
historically been our weakest quarter for sales, again following
well-established consumer buying patterns. The impact of seasonality on our
future results will be affected by our product mix, which will vary from quarter
to quarter.

PRICING PRESSURES

We face downward pricing pressures within our industry that arise from a
number of factors. The products we sell are subject to rapid technological
change and obsolescence. Companies within the data storage and digital
entertainment and related industries are continuously developing new products
with heightened performance and functionality. This puts downward pricing
pressures on existing products and constantly threatens to make them, or causes
them to be, obsolete. Our typical product life-cycle is extremely short and
ranges from only three to twelve months, generating lower average selling prices
as the cycle matures.

In addition, the data storage industry is extremely competitive. Numerous
large competitors such as BenQ, Hewlett-Packard, Sony, TDK and other competitors
such as Lite-On, Memorex, Philips Electronics and Samsung Electronics compete
with us in the optical data storage industry. Numerous large competitors such as
PNY Technologies, Sony, Seagate Technology and Western Digital offer products
similar to our GigaBank(TM) products. Intense competition within our industry
exerts downward pricing pressures on products that we offer. Also, one of our
core strategies is to offer our products as affordable alternatives to
higher-priced products offered by our larger competitors. The effective
execution of this business strategy results in downward pricing pressure on
products that we offer because our products must appeal to consumers partially
based on their attractive prices relative to products offered by our large
competitors. As a result, we are unable to rely as heavily on other non-price
factors such as brand recognition and must consistently maintain lower prices.

Finally, the actions of our retailers often exert downward pricing
pressures on products that we offer. Our retailers pressure us to offer products
to them at attractive prices. In doing this, we do not believe that the overall
goal of our retailers is to increase their margins on these products. Instead,
we believe that our retailers pressure us to offer products to them at
attractive prices in order to increase sales volume and consumer traffic, as
well as to compete more effectively with other retailers of similar products.
Additional downward pricing pressure also results from the continuing threat
that our retailers may begin to directly import or private-label products that
are identical or very similar to our products. Our pricing decisions with regard
to certain products are influenced by the ability of retailers to directly
import or private-label identical or similar products. Therefore, we constantly
seek to maintain prices that are highly attractive to our retailers and that
offer less incentive to our retailers to commence or maintain direct import or
private-label programs.

CRITICAL ACCOUNTING POLICIES AND ESTIMATES

Our discussion and analysis of our financial condition and results of
operations are based upon our consolidated financial statements, which have been
prepared in accordance with accounting principles generally accepted in the
United States. The preparation of these financial statements requires us to make
estimates and judgments that affect the reported amounts of assets and
liabilities and disclosure of contingent assets and liabilities at the date of
the financial statements and the reported amount of net sales and expenses for
each period. The following represents a summary of our critical accounting

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policies, defined as those policies that we believe are the most important to
the portrayal of our financial condition and results of operations and that
require management's most difficult, subjective or complex judgments, often as a
result of the need to make estimates about the effects of matters that are
inherently uncertain.

REVENUE RECOGNITION

We recognize revenue under three primary sales models: a standard terms
sales model, a consignment sales model and a special terms sales model. We
generally use one of these three primary sales models, or some combination of
these sales models, with each of our retailers.

STANDARD TERMS

Under our standard terms sales model, a retailer is obligated to pay us for
products sold to it within a specified number of days from the date that title
to the products is transferred to the retailer. Our standard terms are typically
net 60 days from the transfer of title to the products to a retailer. We
typically collect payment from a retailer within 60 to 75 days from the transfer
of title to the products to a retailer. Transfer of title occurs and risk of
ownership passes to a retailer at the time of shipment or delivery, depending on
the terms of our agreement with a particular retailer. The sale price of our
products is substantially fixed or determinable at the date of sale based on
purchase orders generated by a retailer and accepted by us. A retailer's
obligation to pay us for products sold to it under our standard terms sales
model is not contingent upon the resale of those products. We recognize revenue
for standard terms sales at the time title to products is transferred to a
retailer.

CONSIGNMENT

Under our consignment sales model, a retailer is obligated to pay us for
products sold to it within a specified number of days following our notification
by the retailer of the resale of those products. Retailers notify us of their
resale of consigned products by delivering weekly or monthly sell-through
reports. A sell-through report discloses sales of products sold in the prior
period covered by the report -- that is, a weekly or monthly sell-through report
covers sales of consigned products in the prior week or month, respectively. The
period for payment to us by retailers relating to their resale of consigned
products corresponding to these sell-through reports varies from retailer to
retailer. For sell-through reports generated weekly, we typically collect
payment from a retailer within 30 days of the receipt of those reports. For
sell-through reports generated monthly, we typically collect payment from a
retailer within 15 days of the receipt of those reports. At the time of a
retailer's resale of a product, title is transferred directly to the consumer.
Risk of theft or damage of a product, however, passes to a retailer upon
delivery of that product to the retailer. The sale price of our products is
substantially fixed or determinable at the date of sale based on a product
sell-through report generated by a retailer and delivered to us. Except in the
case of theft or damage, a retailer's obligation to pay us for products
transferred under our consignment sales model is entirely contingent upon the
resale of those products. Products held by a retailer under our consignment
sales model are recorded as our inventory at offsite locations until their
resale by the retailer. Because we retain title to products in our consignment
sales channels until their resale by a retailer, revenue is not recognized until
the time of resale. Accordingly, price modifications to inventory maintained in
our consignment sales channels do not have an effect on the timing of revenue
recognition. We recognize revenue for consignment sales in the period during
which resale occurs.

SPECIAL TERMS

Under our special terms sales model, the payment terms for the purchase of
our products are negotiated on a case-by-case basis and typically cover a
specified quantity of a particular product. The result of our negotiations is a
special agreement with a retailer that defines how and when transfer of title
occurs and risk of ownership shifts to the retailer. We ordinarily do not offer
any rights of return or rebates for products sold under our special terms sales
model. A retailer is obligated to pay us for products sold to it within a
specified number of days from the date that title to the products is transferred
to the retailer, or as otherwise agreed to by us. Our payment terms are
ordinarily shorter under our special terms sales model than under our standard
terms or consignment sales models and we typically require payment in advance,
at the time of transfer of title to the products or shortly following the
transfer of title to the products to a retailer. Transfer of title occurs and
risk of ownership passes to a retailer at the time of shipment, delivery,
receipt of payment or the date of invoice, depending on the terms of our
agreement with the retailer. The sale price of our products is substantially
fixed or determinable at the date of sale based on our agreement with a
retailer. A retailer's obligation to pay us for products sold to it under our
special terms sales model is not contingent upon the resale of those products.
We recognize revenue for special terms sales at the time title to products is
transferred to a retailer.

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SALES INCENTIVES

From time to time, we enter into agreements with certain retailers
regarding price decreases that are determined by us in our sole discretion.
These agreements allow those retailers (subject to limitations) a credit equal
to the difference between our current price and our new reduced price on units
in the retailers' inventories or in transit to the retailers on the date of the
price decrease.

We record an estimate of sales incentives based on our actual sales
incentive rates over a trailing twelve-month period, adjusted for any known
variations, which are charged to operations and offset against gross sales at
the time products are sold with a corresponding accrual for our estimated sales
incentive liability. This accrual--our sales incentive reserve--is reduced by
deductions on future payments taken by our retailers relating to actual sales
incentives.

At the end of each quarterly period, we analyze our existing sales
incentive reserve and apply any necessary adjustments based upon actual or
expected deviations in sales incentive rates from our applicable historical
sales incentive rates. The amount of any necessary adjustment is based upon the
amount of our remaining field inventory, which is calculated by reference to our
actual field inventory last conducted, plus inventory-in-transit and less
estimated product sell-through. The amount of our sales incentive liability for
each product is equal to the amount of remaining field inventory for that
product multiplied by the difference between our current price and our new
reduced price to our retailers for that product. This data, together with all
data relating to all sales incentives granted on products in the applicable
period, is used to adjust our sales incentive reserve established for the
applicable period.

In 2004, our sales incentives were $2.5 million, or 4.2% of gross sales,
all of which was offset against gross sales, as compared to $2.9 million, or
3.5% of gross sales, in 2003, all of which was offset against gross sales. In
2002, our sales incentives were $5.3 million, or 5.1% of gross sales, all of
which was offset against gross sales.

MARKET DEVELOPMENT FUND AND COOPERATIVE ADVERTISING COSTS, REBATE PROMOTION
COSTS AND SLOTTING FEES

Market development fund and cooperative advertising costs, rebate promotion
costs and slotting fees are charged to operations and offset against gross sales
in accordance with Emerging Issues Task Force Issue No. 01-9. Market development
fund and cooperative advertising costs and rebate promotion costs are each
promotional costs. Slotting fees are fees paid directly to retailers for
allocation of shelf-space in retail locations. In 2004, our market development
fund and cooperative advertising costs, rebate promotion costs and slotting fees
were $7.8 million, or 13% of gross sales, all of which was offset against gross
sales, as compared to market development fund and cooperative advertising costs,
rebate promotion costs and slotting fees of $8.4 million, or 10% of gross sales,
in 2003, all of which was offset against gross sales. These costs and fees
increased as a percentage of our net sales in 2004, increasing to 13% of our
gross sales from 10% of our gross sales in 2003, primarily as a result of
instituting sales incentives and marketing promotions in order to lower the
quantity of single-layer recordable DVD recordable drives in our retail sales
channels to enable a more rapid transition to sales of double-layer recordable
DVD recordable drives and strong promotional activity for our double-layer DVD
recordable drives during the 2004 year-end holidays. In 2002, our market
development fund and cooperative advertising costs, rebate promotion costs and
slotting fees were $9.3 million, all of which was offset against gross sales.
These costs for 2002 were reduced by $1.5 million in the second quarter of 2002
as previously reported due to a change in estimate of our rebate promotion
costs. Our 2000, 2001 and 2002 statements were restated to allocate the $1.5
million reduction in rebate promotions, based on rebate promotions for those
years.

Consideration generally given by us to a retailer is presumed to be a
reduction of selling price, and therefore, a reduction of gross sales. However,
if we receive an identifiable benefit that is sufficiently separable from our
sales to that retailer, such that we could have paid an independent company to
receive that benefit and we can reasonably estimate the fair value of that
benefit, then the consideration is characterized as an expense. We estimate the
fair value of the benefits we receive by tracking the advertising done by our
retailers on our behalf and calculating the value of that advertising using a
comparable rate for similar publications.

INVENTORY OBSOLESCENCE ALLOWANCE

Our warehouse supervisor, production supervisor and production manager
physically review our warehouse inventory for slow-moving and obsolete products.
All products of a material amount are reviewed quarterly and all products of an
immaterial amount are reviewed annually. We consider products that have not been
sold within six months to be slow-moving. Products that are no longer compatible
with current hardware or software are considered obsolete. The potential for
re-sale of slow-moving and obsolete inventories is considered through market
research, analysis of our retailers' current needs, and assumptions about future
demand and market conditions. The recorded cost of both slow-moving and obsolete
inventories is then reduced to its estimated market value based on current
market pricing for similar products. We utilize the Internet to provide
indications of market value from competitors' pricing, third party inventory
liquidators and auction websites. The recorded costs of our slow-moving and
obsolete products are reduced to current market prices when the recorded costs

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exceed those market prices. For 2004 we increased our inventory reserve and
recorded a corresponding increase in cost of goods sold of approximately $2.0
million for inventory for which recorded cost exceeded the current market price
of this inventory on hand. For 2003, we increased our inventory reserve and
recorded a corresponding increase in cost of goods sold of $125,000. For 2004,
2003 and 2002, we increased our inventory reserve and recorded a corresponding
increase in cost of goods sold of approximately $2.0 million, $125,000, and $2.1
million, respectively, for inventory for which recorded cost exceeded the
current market price of this inventory on hand. All adjustments establish a new
cost basis for inventory as we believe such reductions are permanent declines in
the market price of our products. Generally, obsolete inventory is sold to
companies that specialize in the liquidation of these items while we continue to
market slow-moving inventories until they are sold or become obsolete. As
obsolete or slow-moving inventory is sold, we reduce the reserve by proceeds
from the sale of the products. During 2004, 2003, and 2002, we sold inventories
previously reserved for and accordingly reduced the reserve by approximately
$1.1 million, $670,000 and $1.6 million, respectively. For 2004, 2003 and 2002,
gains recorded as a result of sales of obsolete inventory above the reserved
amount were not significant to our results of operations and accounted for less
than 1% our total net sales. Although we have no specific statistical data on
this matter, we believe that our practices are reasonable and consistent with
those of our industry.

INVENTORY ADJUSTMENTS

Our warehouse supervisor, production supervisor and production manager
physically review our warehouse inventory for obsolete or damaged
inventory-related items on a monthly basis. Inventory-related items (such as
sleeves, manuals or broken products no longer under warranty from our
subcontract manufacturers or suppliers) which are considered obsolete or damaged
are reviewed by these personnel together with our Controller or Chief Financial
Officer. At the discretion of our Controller or Chief Financial Officer, these
items are physically disposed of and we make corresponding accounting
adjustments resulting in inventory adjustments. In addition, on a monthly basis,
our detail inventory report and our general ledger are reconciled by our
Controller and any variances result in a corresponding inventory adjustment.
Although we have no specific statistical data on this matter, we believe that
our practices are reasonable and consistent with those of our industry.

ALLOWANCE FOR DOUBTFUL ACCOUNTS

We maintain allowances for doubtful accounts for estimated losses resulting
from the inability of our retailers to make required payments. Our current
retailers consist of either large national or regional retailers with good
payment histories with us. Since we have not experienced any previous payment
defaults with any of our current retailers, our allowance for doubtful accounts
is minimal. We perform periodic credit evaluations of our retailers and maintain
allowances for potential credit losses based on management's evaluation of
historical experience and current industry trends. If the financial condition of
our retailers were to deteriorate, resulting in the impairment of their ability
to make payments, additional allowances may be required. New retailers are
evaluated through Dunn & Bradstreet before terms are established. Although we
expect to collect all amounts due, actual collections may differ.

PRODUCT RETURNS

We have a limited 90-day to one year time period for product returns from
end-users; however, our retailers generally have return policies that allow
their customers to return products within only fourteen to thirty days after
purchase. We allow our retailers to return damaged or defective products to us
following a customary return merchandise authorization process. We have no
informal return policies. We utilize actual historical return rates to determine
our allowance for returns in each period. Gross sales is reduced by estimated
returns and cost of sales is reduced by the estimated cost of those sales. We
record a corresponding accrual for the estimated liability associated with the
estimated returns. This estimated liability is based on the gross margin of the
products corresponding to the estimated returns. This accrual is offset each
period by actual product returns.

Our current estimated weighted average future product return rate is
approximately 9.0%. As noted above, our return rate is based upon our past
history of actual returns and we estimate amounts for product returns for a
given period by applying this historical return rate and reducing actual gross
sales for that period by a corresponding amount. Our historical return rate for
a particular product is the life-to-date return rate of similar products. This
life-to-date return rate is updated monthly. We also compare this life-to-date
return rate to our trailing 18-month return rate to determine whether any
material changes in our return rate have occurred that may not be reflected in
the life-to-date return rate. We believe that using a trailing 18-month return
rate takes two key factors into consideration, specifically, an 18-month return
rate provides us with a sufficient period of time to establish recent historical

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trends in product returns for each product category, and provides us with a
period of time that is short enough to account for recent technological shifts
in our product offerings in each product category. If an unusual circumstance
exists, such as a product category that has begun to show materially different
actual return rates as compared to life-to-date return rates, we will make
appropriate adjustments to our estimated return rates. Factors that could cause
materially different actual return rates as compared to life-to-date return
rates include product modifications that simplify installation, a new product
line, within a product category, that needs time to better reflect its return
performance and other factors. Although we have no specific statistical data on
this matter, we believe that our practices are reasonable and consistent with
those of our industry.

Our warranty terms under our arrangements with our suppliers are that any
product that is returned by a retailer or retail customer as defective can be
returned by us to the supplier for full credit against the original purchase
price. We incur only minimal shipping costs to our suppliers in connection with
the satisfaction of our warranty obligations.

RESULTS OF OPERATIONS

The tables presented below, which compare our results of operations from
one period to another, present the results for each period, the change in those
results from one period to another in both dollars and percentage change and the
results for each period as a percentage of net sales. The columns present the
following:

o The first two data columns in each table show the absolute results for
each period presented.

o The columns entitled "Dollar Variance" and "Percentage Variance" show
the change in results, both in dollars and percentages. These two
columns show favorable changes as a positive and unfavorable changes
as negative. For example, when our net sales increase from one period
to the next, that change is shown as a positive number in both
columns. Conversely, when expenses increase from one period to the
next, that change is shown as a negative in both columns.

o The last two columns in each table show the results for each period as
a percentage of net sales.

YEAR ENDED DECEMBER 31, 2004 COMPARED TO YEAR ENDED DECEMBER 31, 2003

RESULTS AS A
PERCENTAGE OF
NET SALES FOR
THE YEAR
YEAR ENDED DOLLAR PERCENTAGE ENDED
DECEMBER 31, VARIANCE VARIANCE DECEMBER 31,
------------ -------- -------- ------------
2004 2003 2004 2003
---- ---- FAVORABLE FAVORABLE ---- ----
(RESTATED) (UNFAVORABLE) (UNFAVORABLE) (RESTATED)
---------- ------------- ------------- ----------
(IN THOUSANDS)

Net sales $ 44,397 $ 63,587 $ (19,190) (30.2)% 100.0% 100.0%
Cost of sales 41,419 54,643 13,224 24.2 93.3 85.9
---------- ---------- ---------- ---------- ---------- ----------
Gross profit 2,978 8,944 (5,966) (66.7) 6.7 14.1
Selling, marketing and advertising expenses 1,008 1,507 499 33.1 2.3 2.4
General and administrative expenses 5,343 6,462 1,119 17.3 12.0 10.1
Depreciation and amortization 834 1,268 434 34.2 1.9 2.0
Impairment of trademarks 3,696 -- (3,696) -- 8.3 --
---------- ---------- ---------- ---------- ---------- ----------
Operating income (loss) (7,903) (293) (7,610) (25,972.7) (17.8) (0.4)
Net interest expense (201) (248) 47 19.0 (0.4) (0.4)
Other income 50 54 (4) (7.4) 0.1 0.1
---------- ---------- ---------- ---------- ---------- ----------
Loss from operations before provision
for income taxes (8,054) (487) (7,567) (1,553.8) (18.1) (0.7)
Income tax provision (benefit) 3 (27) (30) (111.1) -- --
---------- ---------- ---------- ---------- ---------- ----------
Net loss $ (8,057) $ (460) $ (7,597) (1,651.5)% (18.1)% (0.7)%
========== ========== ========== ========== ========== ==========

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NET SALES. As discussed above, we believe that the significant decrease in
the amount of $19.2 million in net sales from $63.6 million in 2003 to $44.4
million in 2004 is primarily due to the following factors: the continued decline
in sales of our CD-based products; slower than anticipated growth in sales of
our DVD-based products; and the continued operation of private label programs by
Best Buy; and a significant decline in sales to OfficeMax. The decline in net
sales caused by these factors was partially offset by a substantial increase in
sales to Staples.

We believe that the significant decline in our net sales during 2004 as
compared to 2003 resulted in part from the rapid and continued decline in sales
of our CD-based products. Predominantly based on market forces, but also partly
as a result of our decision to de-emphasize CD-based products, our sales of
recordable CD-based products declined by 76.1% to $7.1 million in 2004 from
$29.7 million in 2003. Sales of our recordable DVD-based products increased by
50.0% to $29.4 million in 2004 from $19.6 million in 2003. These results suggest
that our sales of recordable CD-based products declined by $22.6 million in 2004
as compared to 2003, which decline was only partially offset by an increase in
sales of our recordable DVD-based products by $9.8 million for the same periods,
resulting in an overall decline of sales of our recordable optical data storage
products of $12.8 million in 2004 as compared to 2003.

We believe that USB portable data storage devices, which are an alternative
to optical data storage products, have caused a decline in the relative market
share of CD- and DVD-based optical data storage products and likewise caused a
decline in our sales of CD- and DVD-based products in 2004. In the third quarter
of 2004, we began selling our GigaBank(TM) products, which are compact and
portable hard disk drives with a built-in USB connector, and sales of these
devices accounted for approximately 27.0% of our total net sales in the fourth
quarter of 2004 and 8.7% of our total net sales for the year ended December 31,
2004 with only approximately three months of sales of these devices.

Another factor contributing significantly to the decline in our net sales
during 2004 was the continued and expanded operation of private label programs
by Best Buy. Our sales to Best Buy, who was our largest retailer during 2003 and
2002, declined in 2004 to $5.0 million, representing a decrease of 72.5% from
$18.2 million in 2003. We believe that this decrease reflects, at least in part,
Best Buy's increased sales of private label products that compete with products
that we sell.

Also contributing to the overall decline in net sales for 2004 was a $6.2
million, or 100%, decrease in sales to OfficeMax as compared to 2003. This
decline was primarily the result of disagreements with OfficeMax relating to
amounts we believed we were owned and deductions claimed by OfficeMax for 2003
and, as a result, we discontinued sales to OfficeMax in January 2004. We entered
into a new vendor agreement with OfficeMax in November 2004 in anticipation of
resuming sales. As of the date of this report, OfficeMax has paid us for our
previously-disputed deductions and we have commenced shipping new orders to
OfficeMax. However, we are currently in dispute with OfficeMax concerning
certain marketing arrangements and related purchase commitments that we believe
were made to us by OfficeMax. There can be no assurance that sales to OfficeMax
will continue.

These decreases in sales to Best Buy and OfficeMax were partially offset by
an increase in sales to Staples of $8.7 million, or 158%, for 2004 as compared
to 2003.

-31-

In addition, we instituted additional sales incentives and marketing
promotions in the third quarter of 2004 in order to lower the quantity of
single-layer DVD recordable drives in our retail sales channels to enable a more
rapid transition to sales of double-layer DVD recordable drives. Our sales
incentives in 2004 were $2.5 million, or 4.2% of gross sales, as compared to
$2.9 million, or 3.5% of gross sales, in 2003, all of which was offset against
gross sales. Our market development fund and cooperative advertising costs,
promotion costs and slotting fees in 2004 were $7.8 million, or 13.0% of gross
sales, as compared to $8.4 million, or 10.4% of gross sales in 2003, all of
which were offset against gross sales. We incurred additional promotion costs in
the fourth quarter of 2004 relating to our double-layer DVD recordable drives.

Also, sales of certain de-emphasized products declined by $5.8 million to
$2.8 million in 2004 from $8.6 million in 2003. A change in the allowance for
product returns also resulted in an adjustment of $1.1 million causing an
increase in sales in 2004 as compared to an adjustment of $1.4 million causing
an increase in sales in 2003, resulting in a decrease of $313,000 in sales in
2004 as compared to 2003.

The significant decrease in net sales for 2004 was comprised of a decrease
in net sales in the amount of $28.9 million resulting from a decrease in the
volume of products sold and a decrease in the amount of $313,000 resulting from
a change in our reserves for future returns on sales. These decreases were
partially offset by an increase in net sales in the amount of $10.0 million
resulting from higher average product sales prices. The decrease in the volume
of products sold was consistent with reduced sales of our CD-based products, as
noted above.

We have restated our net sales for 2003 to correct an error in the manner
in which we accrued for sales incentives and product returns. We previously
accrued for sales incentives at the time they were offered. We have corrected
the manner in which we accrue for sales incentives to accrue for sales
incentives at the time of sale of products to our retailers. We have revised our
methodology for estimating future product returns by using the actual historical
rate of return by category of similar products. See "Management's Discussion and
Analysis of Financial Condition and Results of Operations - Critical Accounting
Policies and Estimates" above. Our previously-reported net sales for 2003 were
$62.2 million. Our restated net sales for 2003 are $63.6 million. Our
restatement also resulted in decreases in the amount of reserves for product
returns, sales incentives and rebate promotions in the aggregate amount of
$41,115 for 2003. See our consolidated financial statements - "Note 2 -
Restatement of 2000, 2001, 2002 and 2003 Financial Statements" included
elsewhere in this report.

GROSS PROFIT. The decrease in gross profit, both in dollar terms and as a
percentage of net sales, is primarily due to a reduction in net sales in the
amount of $19.2 million, or 30.2%, in 2004 as compared to 2003. Another factor
contributing to our decrease in gross profit is an increase in the amount of
$1.9 million in our slow-moving and obsolete inventory charges to $2.0 million
in 2004 from $125,000 in 2003. In 2004, most inventory over 2-years old was
fully reserved for and no material amounts of slow-moving or obsolete inventory
were sold in 2004. We plan to take more aggressive measures in 2005 to sell
remaining slow-moving or obsolete inventory. Due to the short life-cycle of many
of our products resulting from, in part, the effects of technological change, we
expect to experience additional slow-moving and obsolete inventory charges in
the future. However, we cannot predict with any certainty the future level of
these charges.

In addition, product costs as a percentage of net sales increased to 82.3%
in 2004 from 79.6% in 2003. The increase in product costs primarily resulted
from increases in sales incentives, market development fund and cooperative
advertising costs, rebate promotion costs and slotting fees as a percentage of
net sales to 23.3% in 2004 from 17.7% in 2003.

SELLING, MARKETING AND ADVERTISING EXPENSES. The decrease in selling,
marketing and advertising expenses was primarily due to a decline in commissions
in the amount of $180,000 as a result of reduced sales volume and a reduction in
payroll and related expenses in the amount of $154,000 as a result of fewer
personnel.

GENERAL AND ADMINISTRATIVE EXPENSES. The decrease in general and
administrative expenses is primarily due to a reduction in bad debt expense in
the amount of $1.3 million. Bad debt expense was $203,000 in 2004 as compared to
$1.5 million in 2003. The decrease in general and administrative expenses is
also due to a reduction in phone and utilities expenses in the amount of
$118,000, a reduction in product design expenses in the amount of $83,000, a
reduction in warehouse supplies in the amount of $77,000 and a reduction in
outside assembly expenses in the amount of $65,000 resulting from lower sales
volume in 2004 as compared to 2003. These reductions were partially offset by an
increase in legal expenses in the amount of $430,000 as a result of increased
legal fees relating to current litigation and as a result of an adjustment in
2003 for an over-accrual of legal expenses. Legal expenses were $395,000 in 2004
as compared to a credit in the amount of $35,000 in 2003.

DEPRECIATION AND AMORTIZATION EXPENSES. The decrease in depreciation and
amortization expenses is primarily due to accelerated amortization in 2003 on
our prior Santa Ana facility which was originally to be leased through 2010. At
the beginning of 2003, we decided to move to a larger facility by the end of
September 2003 and thus, we accelerated our amortization by $389,000 in 2003.

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IMPAIRMENT OF TRADEMARKS. We conducted a valuation on our Hi-Val(R) and
Digital Research Technologies(R) trademarks for possible impairment as of
December 31, 2004. Based upon this valuation, we determined that there had been
a significant impairment in the value of the trademarks due to lower sales of
products under the Hi-Val(R) and Digital Research Technologies(R) brands in 2004
and lower sales forecasted by us for subsequent periods. Therefore, we recorded
an impairment in the value of the trademarks of $3.7 million as of December 31,
2004. This impairment will result in a reduction of $509,796 in amortization
expense to $68,940 from $578,736 in each of the next five years.

OTHER INCOME (EXPENSE). Other income (expense) decreased by $43,000 in
2004, as compared to 2003, primarily due to a decrease in interest expense in
the amount of $47,000 to $201,000 in 2004 as compared to $248,000 in 2003 as a
result of reduced borrowings under our credit facility.

INCOME TAX EXPENSE (BENEFIT). Income taxes provision increased by $30,000
in 2004 to $3,000 as compared to a $27,000 benefit in 2003. In 2003, our income
taxes represented primarily refunds we received.

YEAR ENDED DECEMBER 31, 2003 COMPARED TO YEAR ENDED DECEMBER 31, 2002

RESULTS AS A
PERCENTAGE OF
NET SALES FOR
THE YEAR
YEAR ENDED DOLLAR PERCENTAGE ENDED
DECEMBER 31, VARIANCE VARIANCE DECEMBER 31,
------------ -------- -------- ------------
2003 2002 2003 2002
---- ---- FAVORABLE FAVORABLE ---- ----
(RESTATED) (RESTATED) (UNFAVORABLE) (UNFAVORABLE) (RESTATED) (RESTATED)
---------- ---------- ------------- ------------- ---------- ----------
(IN THOUSANDS)

Net sales $ 63,587 $ 80,953 $ (17,366) (21.5)% 100.0% 100.0%
Cost of sales 54,643 73,564 18,921 25.7 85.9 90.9
---------- ---------- ---------- ---------- ---------- ----------
Gross profit 8,944 7,389 1,555 21.0 14.1 9.1
Selling, marketing and advertising expenses 1,507 1,438 (69) (4.8) 2.4 1.8
General and administrative expenses 6,462 7,361 899 12.2 10.1 9.1
Depreciation and amortization 1,268 1,224 (44) (3.6) 2.0 1.5
---------- ---------- ---------- ---------- ---------- ----------
Operating income (loss) (293) (2,634) 2,341 88.9 (0.4) (3.3)
Net interest expense (248) (384) 136 35.4 (0.4) (0.4)
Settlement expense and related legal costs 0 (5,180) 5,180 100.0 -- (6.4)
Other income 54 39 15 38.5 0.1 --
---------- ---------- ---------- ---------- ---------- ----------
Loss from operations before provision
for income taxes (487) (8,159) 7,672 94.0 (0.7) (10.1)
Income tax provision (benefit) (27) 686 713 103.9 -- 0.8
---------- ---------- ---------- ---------- ---------- ----------

Net loss $ (460) $ (8,845) $ 8,385 94.8% (0.7)% (10.9)%
========== ========== ========== ========== ========== ==========

NET SALES. The significant decrease in net sales for 2003 is primarily due
to our strategic decision to de-emphasize the sale of certain products, coupled
with reduced sales of our CD-based products. The principal reason for the
reduction in CD-based product sales was reduced promotional activities, such as
mail-in and point-of-sale rebates, for these products because of our
concentration in the production and sale of our new dual-format DVD recordable
devices which we introduced in July 2003. Also contributing to the overall
decline in net sales for 2003 was a $13.2 million, or 67.8%, decrease in net
sales to OfficeMax as compared to 2002. This decline was primarily the result of
our mutual agreement with OfficeMax to discontinue sales between April and
October 2003 because we did not want to offer rebates and sales incentives as
heavily as OfficeMax believed was necessary. Although we resumed sales of our
dual-format DVD recordable drives to OfficeMax in November and December 2003, we
experienced disagreements with OfficeMax relating to amounts we believed we were
owed and deductions claimed by OfficeMax and, as a result, discontinued sales in
January 2004. There can be no assurance that sales to OfficeMax will resume.

We have restated our net sales for 2003 to correct an error in the manner
in which we accrued for sales incentives, product returns and rebate promotions.
We previously accrued for sales incentives at the time they were offered. We
have corrected the manner in which we accrue for sales incentives to accrue for
sales incentives at the time of sale of products to our retailers. We have
revised our methodology for estimating future product returns by using the
actual historical rate of return by category of similar products. See
"Management's Discussion and Analysis of Financial Condition and Results of
Operations - Critical Accounting Policies and Estimates" above. Our
previously-reported net sales for 2003 and 2002 were $62.2 million and $83.5
million, respectively, representing a decrease in net sales in the amount of
$21.3 million in 2003 as compared to 2002. Our restated net sales for 2003 and
2002 are $63.6 million and $81.0 million, respectively, representing a decrease
in net sales in the amount of $17.4 million in 2003 as compared to 2002. Our
restatement also resulted in a reduction in the amount of reserves for product

-33-

returns, sales incentives and rebate promotions for 2003 in the aggregate amount
of $41,115 and a reduction in the amount of reserves for product returns and
sales incentives for 2002 in the aggregate amount of $235,816. See our
consolidated financial statements - "Note 2 - Restatement of 2000, 2001, 2002
and 2003 Financial Statements" included elsewhere in this report.

In addition, our restatement resulted in a change in the components of the
decrease in net sales in 2003 as compared to 2002. The decrease in net sales
resulting from a decrease in the volume of products sold was previously reported
as $40.6 million and as restated is $40.0 million. This decrease was partially
offset by an increase in net sales resulting from higher average product sales
prices, which was previously reported as $21.7 million and as restated is $21.8
million. The decrease in the volume of products sold was consistent with our
strategic decision to de-emphasize the sale of certain products, such as media
products, but also resulted from reduced sales of our CD-based products as noted
above. The decrease in net sales was also partially due to a change in our
reserves for future returns on sales, which was previously reported as $2.4
million and as restated is $935,000.

GROSS PROFIT. Of the $1.5 million increase in gross profit from $7.4
million in 2002 to $8.9 million in 2003, $1.3 million resulted from our
restatement. $1.2 million of the year-to-year increase resulted from an increase
of $1.2 million in restated rebate promotions for 2002 as compared to no
restatement change in 2003. $680,000 of the year-to-year increase resulted from
an increase of $439,000 in the product returns allowance for 2002 as compared to
a decrease of $241,000 in the product returns allowance for 2003. These
increases were partially offset by a $622,000 year-to-year decrease in restated
sales incentives which resulted from a $187,000 increase in 2002 as compared to
a $435,000 decrease in 2003.

A reduction in freight costs from $4.5 million in 2002 to $2.1 million in
2003 contributed $2.4 million to gross profit. Of this $2.4 million reduction,
an estimated $1.1 million is due to lower net sales in 2003 as compared to 2002.
An estimated $1.3 million is due to both lower air freight costs during 2003 as
compared to 2002 primarily because in late 2002 our air freight costs increased
significantly due to port strikes in California and the shipment of more product
to our warehouse in Irvine, California with freight charges paid by our vendors
in 2003 as compared to 2002. Our products are typically shipped from our Asian
subcontract manufacturers via less expensive ocean freight as opposed to
comparatively costly air freight.

Another contributing factor to our improvement in gross profit was a $2.0
million reduction in our slow-moving and obsolete inventory charges from $2.1
million, or 2.6% of net sales, for 2002 to $125,000, or 0.2% of net sales, for
2003. During 2002, we reduced the cost of our inventory to market for permanent
declines in the market for certain of our products. Many of these slow-moving or
obsolete products were subsequently sold at the revised market price, and
occasionally we sold slow-moving or obsolete products in excess of revised
market prices; however, these amounts were not significant to our results of
operations and accounted for less than 1.0% of our total net sales. We had an
additional charge to gross profit in 2003 of $214,000 for obsolete inventory
sold below the amount reserved. Due to the short life-cycle of many of our
products resulting from, in part, the effects of technological change, we expect
to experience additional slow-moving and obsolete inventory charges in the
future. However, we cannot predict with any certainty the future level of these
charges.

A reduction to gross profit in the amount of $672,000 resulted from a
reduction in sales for 2003 as compared to 2002.

SELLING, MARKETING AND ADVERTISING EXPENSES. The increase in selling,
marketing and advertising expenses was primarily due to an increase in
advertising expenses of $404,000 offset by a decrease in outside commissions in
the amount of $205,000 as a result of reduced sales volume and a decrease in
travel related expenses of $66,000.

GENERAL AND ADMINISTRATIVE EXPENSES. The decrease in general and
administrative expenses is primarily due to a reduction in legal expenses of
$411,000 as a result of the settlement of certain litigation matters, a $223,000
reduction in payroll and related expenses due to our planned reduced headcount
in 2003 for our U.S. operations, a $152,000 reduction in insurance expenses, and
a $202,000 reduction in warehouse supplies and outside assembly of product due
to lower sales in 2003. These reductions were partially offset by a $179,000
increase in bad debt expenses to $1.5 million in 2003 from $1.3 million in 2002
and a $72,000 increase in product design expenses.

DEPRECIATION AND AMORTIZATION EXPENSES. The increase in depreciation and
amortization expenses is primarily due to accelerated amortization on our prior
Santa Ana facility which was originally to be leased through 2010. At the
beginning of 2003, we decided to move to a larger facility by the end of
September 2003 and thus, we accelerated our amortization by $389,000 in 2003.
Amortization of our Hi-Val(R) and Digital Research Technologies(R) trademarks
was reduced by $338,000 during 2003 because of our decision in 2002 to increase
the useful lives of the trademarks by an additional ten years. As a result,
during the second quarter of 2002, we decreased the amount of annual
amortization of these trademarks, which was originally based on useful lives of
five years.

-34-

OTHER INCOME (EXPENSE). Other income (expense) decreased by $5.3 million as
compared to 2002. This significant decrease is primarily due to a $5.2 million
expense we recorded in 2002 relating to settlement costs and related legal
expenses in connection with a significant litigation matter. During 2003,
interest expense decreased by $136,000 to $248,000 due to reduced borrowings
under our line of credit.

INCOME TAX EXPENSE (BENEFIT). Income taxes provision decreased by $712,000
to a $27,000 benefit in 2003 as compared to an expense of $685,000 in 2002. In
2003, our income taxes represented primarily refunds we received. In 2002, our
income tax provision represented the write-off of deferred tax assets.

LIQUIDITY AND CAPITAL RESOURCES

Our principal sources of liquidity have been cash provided by operations
and borrowings under our bank and trade credit facilities. Our principal uses of
cash have been to finance working capital, capital expenditures and debt service
requirements. We anticipate that these uses will continue to be our principal
uses of cash in the future. As of December 31, 2004, we had working capital of
$7.5 million, an accumulated deficit of $23.1 million, $3.6 million in cash and
cash equivalents and $14.6 million in net accounts receivable. This compares
with working capital of $11.1 million, an accumulated deficit of $15.0 million,
$4.0 million in cash and cash equivalents and $18.4 million in net accounts
receivable as of December 31, 2003.

For the year ended December 31, 2004, our cash decreased $418,000, or
10.5%, from $4.0 million to $3.6 million as compared to a decrease of $1.1
million, or 21.6%, for the year ended December 31, 2003 from $5.1 million to
$4.0 million.

Cash used in our operating activities totaled $1.6 million during the year
ended December 31, 2004 as compared to cash provided by our operating activities
of $3.6 million during the year ended December 31, 2003. This decrease of $5.1
million in cash provided by our operating activities primarily resulted from:

o a $19.2 million decrease in net sales in 2004 as compared to 2003;
o a $10.8 million decrease in the use of our trade credit facilities as
a result of the decrease in net sales;
o a $1.2 million decrease in other accounts payable, also as a result of
the decrease in net sales; and
o a $1.3 million decrease in the allowance for doubtful accounts
relating to the writeoff of our reserve for past due accounts
receivable primarily associated with the acquisition of IOM Holdings,
Inc., the magnitude of which is not expected to occur in future
periods.

These decreases in cash were partially offset by:

o a $1.9 million decrease in warehouse, consigned and in-transit
inventory, primarily as a result of the decrease in net sales;
o a $4.5 million decrease in accounts receivable, also as a result of
the decrease in net sales;
o a $1.9 million increase in our reserve for slow-moving and obsolete
inventory;
o a $3.7 million increase in our writedown of our Hi-Val(R) and Digital
Research Technologies(R) trademarks;
o an $892,000 increase in accrued expenses, including increased accrued
market development fund and cooperative advertising costs, promotion
costs and slotting fees; and
o a $1.0 million decrease in legal settlements payable as we made the
final payment to settle the Vakili litigation in the first quarter of
2004.

Cash provided by our investing activities totaled $1.1 million during 2004
as compared to cash used in our investing activities of $174,000 during 2003.
Our investing activities in 2004 consisted of a reduction of $1.1 million in
restricted cash related to our United National Bank loan offset by $22,000 for
purchases of property and equipment.

Cash provided by our financing activities totaled $24,000 during 2004 as
compared to cash used in our financing activities of $4.5 million for 2003. We
paid down $7.0 million of our $10.4 million ChinaTrust Bank loan balance in
early 2003 through funds generated by our operations. In September 2003, we paid
the remaining balance of $3.4 million with our new line of credit through United
National Bank. We borrowed $2.5 million more under our United National Bank line
of credit, net of interim payments, to fund our operations. We also used $83,000
for the repurchase of shares of our common stock in 2003. We have no further
plans relating to the repurchase of shares of our common stock.

On August 15, 2003, we entered into an asset-based business loan agreement
with United National Bank. The agreement provided for a revolving loan of up to
$6.0 million secured by substantially all of our assets and initially was to
expire on September 1, 2004 and which, on numerous occasions in 2004 and 2005,
was extended to its final expiration date on March 11, 2005. Advances of up to
65% of eligible accounts receivable bore interest at a floating interest rate

-35-

equal to the prime rate of interest as reported in THE WALL STREET JOURNAL plus
0.75%. As of December 31, 2004, the interest rate was 6.0%. The agreement also
contained five restrictive financial covenants: our quick ratio must be at least
1.0; our tangible net worth must be no lower than $10.5 million; our debt to
tangible net worth ratio must not exceed 2.0; our current ratio must be no lower
than 1.25 and we must be profitable for the year ended December 31, 2004. As of
December 31, 2004, we were in compliance with the quick and current ratio
covenants. As of December 31, 2004, we were not in compliance with the tangible
net worth, debt to tangible net worth ratio and profitability covenants. As a
consequence, we were in default under our line of credit with United National
Bank. On March 9, 2005, we replaced our asset-based line of credit with United
National Bank with an asset-based line of credit with GMAC Commercial Finance.
As of December 31, 2004, we owed United National Bank approximately $5.9 million
and had available to us approximately $40,000 of additional borrowings.

Our asset-based line of credit with GMAC Commercial Finance expires on
March 9, 2008 and allows us to borrow up to $10.0 million. The line of credit
bears interest at a floating interest rate equal to the prime rate of interest
plus 0.75%. This interest rate is adjustable upon each movement in the prime
lending rate. If the prime lending rate increases, our interest rate expense
will increase on an annualized basis by the amount of the increase multiplied by
the principal amount outstanding under our credit facility. Our obligations
under our loan agreement with GMAC Commercial Finance are secured by
substantially all of our assets and guaranteed by our wholly-owned subsidiary,
IOM Holdings, Inc. The loan agreement has one financial covenant which requires
us to have a fixed charge coverage ratio of at least 1.2 to 1.0 for the three
months ended June 30, 2005 and the six months ended September 30, 2005. The
ratio becomes 1.5 to 1.0 for the nine months ended December 31, 2005, for the
twelve month period ending March 31, 2006 and for each twelve month period
ending on the end of each calendar quarter thereafter. We have been in violation
of this financial covenant in the past and may be in violation of this financial
covenant in the future. If we are unable to attain the financial covenant
ratios, then GMAC Commercial Finance has the option to immediately terminate the
line of credit and the unpaid principal balance and all accrued interest on
the unpaid balance will then be immediately due and payable. If the loan were to
be called and we were unable to obtain alternative financing, we would lack
adequate funds to acquire inventory in amounts sufficient to sustain or expand
our current sales operation. In addition, we would be unable to fund our
day-to-day operations.

Our new credit facility was initially used to pay off our outstanding loan
balance as of March 10, 2005 with United National Bank, which balance was
approximately $3.8 million, and was also used to pay $25,000 of our closing fees
in connection with securing the credit facility. As of March 31, 2005, we owed
GMAC Commercial Finance approximately $4.8 million and had available to us
approximately $284,000 of additional borrowings.

On June 6, 2005, we entered into a new trade credit facility with Lung Hwa
Electronics that replaced our previous $10.0 million trade credit facility.
Under the terms of the new facility, Lung Hwa Electronics has agreed to purchase
and manufacture inventory on our behalf. We can purchase up to $15.0 million of
inventory through Lung Hwa Electronics as an international purchasing office or
manufactured by Lung Hwa Electronics. For inventory purchased through Lung Hwa
Electronics, the payment terms are 120 days following the date of invoice by
Lung Hwa Electronics. Lung Hwa Electronics charges us a 5% handling fee on a
supplier's unit price. A 2% discount of the handling fee is applied if we reach
an average running monthly purchasing volume of $750,000. Returns made by us,
which are agreed to by a supplier, result in a credit to us for the handling
charge. For inventory manufactured by Lung Hwa Electronics, the payment terms
are 90 days following the date of invoice by Lung Hwa Electronics. Upon
effectiveness of the trade credit facility, we paid $1.5 million to Lung Hwa
Electronics as an early payment for all invoices coming due for payment. Any
early payment funds remaining three months after the date of the commencement of
the trade credit facility are to be refunded to us immediately. Once the $1.5
million has been exhausted, or three months from the date of the commencement of
the trade credit facility has expired, whichever is sooner, we are to pay Lung
Hwa Electronics, within one week of the purchase order, 10% of the purchase
price on any purchase orders issued to Lung Hwa Electronics as a down-payment
for the order. The trade credit facility has an initial term of one year after
which the facility will continue indefinitely if not terminated at the end of
the initial term. At the end of the initial term and at any time thereafter,
either party has the right to terminate the facility upon 30 days' prior written
notice to the other party. As of March 31, 2005, we owed Lung Hwa Electronics
$488,000 in trade payables.

In February 2003, we entered into a Warehouse Services and Bailment
Agreement with Behavior Tech Computer (USA) Corp., or BTC USA. Under the terms
of the agreement, BTC USA has agreed to supply and store at our warehouse up to
$10.0 million of inventory on a consignment basis. We are responsible for
insuring the consigned inventory, storing the consigned inventory for no charge,
and furnishing BTC USA with weekly statements indicating all products received
and sold and the current level of consigned inventory. The agreement also
provides us with a trade line of credit of up to $10.0 million with payment
terms of net 60 days, without interest. The agreement may be terminated by
either party upon 60 days' prior written notice to the other party. As of
December 31, 2004, we owed BTC USA $7.3 million under this arrangement. BTC USA
is a subsidiary of Behavior Tech Computer Corp., one of our significant
stockholders. Mr. Steel Su, a director of I/OMagic, is the Chief Executive
Officer of Behavior Tech Computer Corp. See "Certain Relationships and Related
Transactions."

Lung Hwa Electronics and BTC USA provide us with significantly preferential
trade credit terms. These terms include extended payment terms, substantial
trade lines of credit and other preferential buying arrangements. We believe
that these terms are substantially better terms than we could likely obtain from
other subcontract manufacturers or suppliers. In fact, we believe that our trade
credit facility with Lung Hwa Electronics is likely unique and could not be
replaced through a relationship with an unrelated third party. If either of Lung
Hwa Electronics or BTC USA does not continue to offer us substantially the same
preferential trade credit terms, our ability to finance inventory purchases
would be harmed, resulting in significantly reduced sales and profitability. In
addition, we would incur additional financing costs associated with shorter
payment terms which would also cause our profitability to decline. See "Certain
Relationships and Related Transactions."

Our net loss increased 1,661% to $8.1 million in 2004 from $460,000 in
2003, primarily resulting from a 30.2% decline in net sales to $44.4 million in
2004 from $63.6 million in 2003. If either the absolute level or the downward
trend of our net loss or net sales continues or increases, we could experience
significant shortages of liquidity and our ability to purchase inventory and to
operate our business may be significantly impaired, which could lead to further
declines in our operating performance and financial condition.

-36-

If, like Best Buy, any other of our major retailers, or a significant
number of our smaller retailers, implement or expand private label programs
covering products that compete with our products, our net sales will likely
continue to decline and our net losses are likely to increase, which in turn
could have a material and adverse impact on our liquidity, financial condition
and capital resources. We expect the decline in our sales to Best Buy to
continue in subsequent reporting periods as a result of continued private label
programs; however, management intends to use its best efforts to insure that we
retain Best Buy as one of our major retailers. We cannot assure you that Best
Buy will remain one of our major retailers or that we will successfully sell any
products through Best Buy.

Despite the decline in our results of operations in 2004, we believe that
current and future available capital resources, revenues generated from
operations, and other existing sources of liquidity, including our trade credit
facilities with Lung Hwa Electronics and BTC USA and our credit facility with
GMAC Commercial Finance will be sufficient to fund our anticipated working
capital and capital expenditure requirements at least for the next twelve
months. If, however, our capital requirements or cash flow vary materially from
our current projections or if unforeseen circumstances occur, we may require
additional financing. Our failure to raise capital, if needed, could restrict
our growth, limit our development of new products or hinder our ability to
compete.

BACKLOG

Our backlog at December 31, 2004 was $3.7 million as compared to a backlog
at December 31, 2003 of $5.3 million. Based on historical trends, we anticipate
that our December 31, 2004 backlog may be reduced by approximately 11%, or
approximately $400,000, to a net amount of $3.3 million as a result of returns
and reclassification of certain expenses as reductions to net sales. Our backlog
may not be indicative of our actual sales beyond a rotating six-week cycle. The
amount of backlog orders represents revenue that we anticipate recognizing in
the future, as evidenced by purchase orders and other purchase commitments
received from retailers. The shipment of these orders for non-consigned
retailers or the sell-through of our products by consigned retailers causes
recognition of the purchase commitments as revenue. However, there can be no
assurance that we will be successful in fulfilling such orders and commitments
in a timely manner, that retailers will not cancel purchase orders, or that we
will ultimately recognize as revenue the amounts reflected as backlog based upon
industry trends, historical sales information, returns and sales incentives.

CONTRACTUAL OBLIGATIONS

The following table outlines payments due under our significant contractual
obligations over the next five years, exclusive of interest:

PAYMENTS DUE BY PERIOD
----------------------
CONTRACTUAL
OBLIGATIONS LESS THAN 1 1-3 4-5 AFTER 5
AT DECEMBER 31, 2004 TOTAL YEAR YEARS YEARS YEARS
- -------------------- ----- ---- ----- ----- -----

Long Term Debt $ -- $ -- $ -- $ -- $ --
Capital Lease Obligations -- -- -- -- --
Operating Leases 608,097 368,771 233,506 5,820 --
Unconditional Purchase Obligations -- -- -- -- --
---------- ---------- ---------- ---------- ----------
Total Contractual Cash Obligations $ 608,097 $ 368,771 $ 233,506 $ 5,820 $ --
========== ========== ========== ========== ==========

The above table outlines our obligations as of December 31, 2004 and does
not reflect the changes in our obligations that occurred after that date.

-37-

IMPACT OF NEW ACCOUNTING PRONOUNCEMENTS

In December 2004, the FASB issued SFAS No. 123(R), "Share-Based Payment".
SFAS 123(R) amends SFAS No. 123, "Accounting for Stock-Based Compensation", and
APB Opinion No. 25, "Accounting for Stock Issued to Employees". SFAS No. 123(R)
requires that the cost of share-based payment transactions (including those with
employees and non-employees) be recognized in the financial statements. SFAS No.
123(R) applies to all share-based payment transactions in which an entity
acquires goods or services by issuing (or offering to issue) its shares, share
options, or other equity instruments (except for those held by an ESOP) or by
incurring liabilities (1) in amounts based (even in part) on the price of the
company's shares or other equity instruments, or (2) that require (or may
require) settlement by the issuance of a company's shares or other equity
instruments. This statement is effective (1) for public companies qualifying as
SEC small business issuers, as of the first interim period or fiscal year
beginning after December 15, 2005, or (2) for all other public companies, as of
the first interim period or fiscal year beginning after June 15, 2005, or (3)
for all nonpublic entities, as of the first fiscal year beginning after December
15, 2005. On April 14, 2005, the Securities and Exchange Commission amended the
compliance dates to allow companies to implement Statement No. 123R at the
beginning of their next fiscal year, instead of the next reporting period, that
begins after June 15, 2005, or December 15, 2005 for small business issuers.
Management is currently assessing the impact of this statement on its financial
position and results of operations.

In December 2004, the FASB issued SFAS No. 153, "Exchanges of Nonmonetary
Assets," an amendment to Opinion No. 29, "Accounting for Nonmonetary
Transactions". SFAS No. 153 eliminates certain differences in the guidance in
Opinion No. 29 as compared to the guidance contained in standards issued by the
International Accounting Standards Board. The amendment to Opinion No. 29
eliminates the fair value exception for nonmonetary exchanges of similar
productive assets and replaces it with a general exception for exchanges of
nonmonetary assets that do not have commercial substance. Such an exchange has
commercial substance if the future cash flows of the entity are expected to
change significantly as a result of the exchange. SFAS No. 153 is effective for
nonmonetary asset exchanges occurring in periods beginning after June 15, 2005.
Earlier application is permitted for nonmonetary asset exchanges occurring in
periods beginning after December 16, 2004. This statement is not applicable to
us.

In December 2004, the FASB issued SFAS No. 152, "Accounting for Real Estate
Time-Sharing Transactions". The FASB issued this statement as a result of the
guidance provided in AICPA Statement of Position (SOP) 04-2, "Accounting for
Real Estate Time-Sharing Transactions". SOP 04-2 applies to all real estate
time-sharing transactions. Among other items, the SOP provides guidance on the
recording of credit losses and the treatment of selling costs, but does not
change the revenue recognition guidance in SFAS No. 66, "Accounting for Sales of
Real Estate", for real estate time-sharing transactions. SFAS No. 152 amends
Statement No. 66 to reference the guidance provided in SOP 04-2. SFAS No. 152
also amends SFAS No. 67, "Accounting for Costs and Initial Rental Operations of
Real Estate Projects", to state that SOP 04-2 provides the relevant guidance on
accounting for incidental operations and costs related to the sale of real
estate time-sharing transactions. SFAS No. 152 is effective for years beginning
after June 15, 2005, with restatements of previously issued financial statements
prohibited. This statement is not applicable to us.

In November 2004, the FASB issued SFAS No. 151, "Inventory Costs". SFAS No.
151 amends the accounting for abnormal amounts of idle facility expense,
freight, handling costs, and wasted material (spoilage) under the guidance in
ARB No. 43, Chapter 4, "Inventory Pricing". Paragraph 5 of ARB No. 43, Chapter
4, previously stated that ". . . under some circumstances, items such as idle
facility expense, excessive spoilage, double freight, and rehandling costs may
be so abnormal as to require treatment as current period charges. . . ." This
statement requires that those items be recognized as current-period charges
regardless of whether they meet the criterion of "so abnormal." In addition,
this statement requires that allocation of fixed production overheads to the
costs of conversion be based on the normal capacity of the production
facilities. This statement is effective for inventory costs incurred during
fiscal years beginning after June 15, 2005. This statement is not applicable to
us.

RISK FACTORS

AN INVESTMENT IN OUR COMMON STOCK INVOLVES A HIGH DEGREE OF RISK. IN
ADDITION TO THE OTHER INFORMATION IN THIS ANNUAL REPORT AND IN OUR OTHER FILINGS
WITH THE SECURITIES AND EXCHANGE COMMISSION, INCLUDING OUR SUBSEQUENT REPORTS ON
FORMS 10-Q AND 8-K, YOU SHOULD CAREFULLY CONSIDER THE FOLLOWING RISK FACTORS
BEFORE DECIDING TO INVEST IN SHARES OF OUR COMMON STOCK OR TO MAINTAIN OR
INCREASE YOUR INVESTMENT IN SHARES OF OUR COMMON STOCK. THE RISKS AND
UNCERTAINTIES DESCRIBED BELOW ARE NOT THE ONLY ONES WE FACE. ADDITIONAL RISKS
AND UNCERTAINTIES NOT PRESENTLY KNOWN TO US OR THAT WE CURRENTLY DEEM IMMATERIAL
MAY ALSO AFFECT OUR BUSINESS, FINANCIAL CONDITION AND OPERATING RESULTS. IF ANY
OF THE FOLLOWING RISKS, OR ANY OTHER RISKS NOT DESCRIBED BELOW, ACTUALLY OCCUR,
IT IS LIKELY THAT OUR BUSINESS, FINANCIAL CONDITION AND OPERATING RESULTS COULD
BE SERIOUSLY HARMED. AS A RESULT, THE TRADING PRICE OF OUR COMMON STOCK COULD
DECLINE, AND YOU COULD LOSE PART OR ALL OF YOUR INVESTMENT.

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IF WE CONTINUE TO SUSTAIN LOSSES, WE WILL BE IN VIOLATION OF THE GMAC
COMMERCIAL FINANCE COVENANT AND WE MAY BE UNABLE TO BORROW FUNDS TO PURCHASE
INVENTORY, TO SUSTAIN OR EXPAND OUR CURRENT SALES VOLUME AND TO FUND OUR
DAY-TO-DAY OPERATIONS.

Our credit facility with GMAC Commercial Finance has one covenant which
requires us to have a fixed charge coverage ratio of at least 1.2 to 1.0 for the
three months ended June 30, 2005 and the six months ended September 30, 2005.
The ratio becomes 1.5 to 1.0 for the nine months ended December 31, 2005, for
the twelve month period ending March 31, 2006 and for each twelve month period
ending on the end of each calendar quarter thereafter. We have been in violation
of this financial covenant in the past and may be in violation of this financial
covenant in the future. If we are unable to attain the financial covenant
ratios, then GMAC Commercial Finance has the option to immediately terminate the
line of credit and the unpaid principal balance and all accrued interest on the
unpaid balance will then be immediately due and payable. If the loan were to be
called and we were unable to obtain alternative financing, we would lack
adequate funds to acquire inventory in amounts sufficient to sustain or expand
our current sales operation. In addition, we would be unable to fund our
day-to-day operations.

WE HAVE INCURRED SIGNIFICANT LOSSES IN THE PAST, AND WE MAY CONTINUE TO INCUR
SIGNIFICANT LOSSES IN THE FUTURE. IF WE CONTINUE TO INCUR LOSSES, WE WILL
EXPERIENCE NEGATIVE CASH FLOW WHICH MAY HAMPER CURRENT OPERATIONS AND MAY
PREVENT US FROM EXPANDING OUR BUSINESS.

We have incurred net losses in each of the last five years and for the
quarter ended March 31, 2005. As of March 31, 2005, we had an accumulated
deficit of approximately $24.2 million. During 2004, 2003, 2002, 2001, 2000 and
the quarter ended March 31, 2005, we incurred net losses in the amounts of
approximately $8.1 million, $460,000, $8.8 million, $5.4 million, $6.2 million
and $1.2 million, respectively. Historically, we have relied upon cash from
operations and financing activities to fund all of the cash requirements of our
business. If our extended period of net losses continues, this will result in
negative cash flow and may hamper current operations and may prevent us from
expanding our business. We cannot assure you that we will attain, sustain or
increase profitability on a quarterly or annual basis in the future. If we do
not achieve, sustain or increase profitability, our business will be adversely
affected and our stock price may decline.

WE HAVE IDENTIFIED MATERIAL WEAKNESSES IN OUR DISCLOSURE CONTROLS AND
PROCEDURES. OUR BUSINESS AND STOCK PRICE MAY BE ADVERSELY AFFECTED IF WE DO
NOT REMEDIATE THESE MATERIAL WEAKNESSES OR IF WE HAVE OTHER MATERIAL
WEAKNESSES IN OUR DISCLOSURE CONTROLS AND PROCEDURES.

Following their evaluation of our disclosure controls and procedures, our
Chief Executive Officer and Chief Financial Officer concluded that certain
material weaknesses in our disclosure controls and procedures existed as of
December 31, 2004 and as of March 31, 2005. As a result of these material
weaknesses, our Chief Executive Officer and Chief Financial Officer concluded
that our disclosure controls and procedures were not effective at the reasonable
assurance level as of December 31, 2004 and as of March 31, 2005. The existence
of one or more material weaknesses in our disclosure controls and procedures
could result in errors in our financial statements and substantial costs and
resources may be required to rectify these material weaknesses. If we are unable
to produce reliable financial reports, investors could lose confidence in our
reported financial information, the market price of our stock could decline
significantly, we may be unable to obtain additional financing to operate and
expand our business, and our business and financial condition could be harmed.

WE DEPEND ON A SMALL NUMBER OF RETAILERS FOR THE VAST MAJORITY OF OUR SALES.
A REDUCTION IN BUSINESS FROM ANY OF THESE RETAILERS COULD CAUSE A SIGNIFICANT
DECLINE IN OUR SALES AND PROFITABILITY.

The vast majority of our sales are generated from a small number of
retailers. During 2004, net sales to our five largest retailers, Staples,
Circuit City, Best Buy, Office Depot and CompUSA represented approximately 32%,
17%, 11%, 10% and 10%, respectively, of our total net sales. During 2004,
aggregate net sales to these five retailers represented approximately 80% of our
total net sales. We expect that we will continue to depend upon a small number
of retailers for a significant majority of our sales for the foreseeable future.

Our agreements with these retailers do not require them to purchase any
specified number of products or dollar amount of sales or to make any purchases
whatsoever. Therefore, we cannot assure you that, in any future period, our
sales generated from these retailers, individually or in the aggregate, will
equal or exceed historical levels. We also cannot assure you that, if sales to
any of these retailers cease or decline, we will be able to replace these sales
with sales to either existing or new retailers in a timely manner, or at all. A
cessation or reduction of sales, or a decrease in the prices of products sold to
one or more of these retailers has significantly reduced our net sales for one
or more reporting periods in the past and could, in the future, cause a
significant decline in our net sales and profitability.

OUR LACK OF LONG-TERM PURCHASE ORDERS AND COMMITMENTS COULD LEAD TO A RAPID
DECLINE IN OUR SALES AND PROFITABILITY.

All of our significant retailers issue purchase orders solely in their own
discretion, often only one to two weeks before the requested date of shipment.
Our retailers are generally able to cancel orders or delay the delivery of
products on short notice. In addition, our retailers may decide not to purchase
products from us for any reason. Accordingly, we cannot assure you that any of
our current retailers will continue to purchase our products in the future. As a
result, our sales volume and profitability could decline rapidly with little or
no warning whatsoever. For example, in 2004 we did not sell any of our products
to OfficeMax which resulted in a 100% decrease in sales to OfficeMax in 2004 as
compared to 2003. This significant decline in sales was one of the primary
reasons for the 30% decline in net sales for 2004 as compared to 2003. This
decline was primarily the result of disagreements with OfficeMax relating to
amounts we believed we were owned and deductions claimed by OfficeMax for 2003
and, as a result, we discontinued sales to OfficeMax in January 2004.

We cannot rely on long-term purchase orders or commitments to protect us
from the negative financial effects of a decline in demand for our products. The
limited certainty of product orders can make it difficult for us to forecast our
sales and allocate our resources in a manner consistent with our actual sales.
Moreover, our expense levels are based in part on our expectations of future
sales and, if our expectations regarding future sales are inaccurate, we may be
unable to reduce costs in a timely manner to adjust for sales shortfalls.

-39-

Furthermore, because we depend on a small number of retailers for the vast
majority of our sales, the magnitude of the ramifications of these risks, is
greater than if our sales were less concentrated within a small number of
retailers. As a result of our lack of long-term purchase orders and purchase
commitments we may experience a rapid decline in our sales and profitability.

ONE OR MORE OF OUR LARGEST RETAILERS MAY DIRECTLY IMPORT OR PRIVATE LABEL
PRODUCTS THAT ARE IDENTICAL OR VERY SIMILAR TO OUR PRODUCTS. THIS COULD CAUSE
A SIGNIFICANT DECLINE IN OUR SALES AND PROFITABILITY.

Optical data storage products and digital entertainment products are widely
available from manufacturers and other suppliers around the world. Our largest
retailers include Best Buy, Circuit City, CompUSA, Staples and Office Depot.
Collectively, these five retailers accounted for 80% of our net sales in 2004.
Each of these retailers has substantially greater resources than we do, and has
the ability to directly import or private-label data storage and digital
entertainment products from manufacturers and other suppliers around the world,
including from some of our own subcontract manufacturers and suppliers. For
example, Best Buy, our largest retailer, already has a private label program and
sells certain products that compete with some of our products. Sales to Best Buy
in 2004 totaled $5.0 million representing a decrease of 72.5% from $18.2 million
in 2003. We believe that this decrease reflects, at least in part, Best Buy's
increased sales of private label products that compete with products that we
sell. Our retailers may believe that higher profit margins can be achieved if
they implement a direct import or private-label program, excluding us from the
sales channel. Accordingly, one or more of our largest retailers may stop buying
products from us in favor of a direct import or private-label program. As a
consequence, our sales and profitability could decline significantly.

HISTORICALLY, A SUBSTANTIAL PORTION OF OUR ASSETS HAVE BEEN COMPRISED OF
ACCOUNTS RECEIVABLE REPRESENTING AMOUNTS OWED BY A SMALL NUMBER OF RETAILERS.
WE EXPECT THIS TO CONTINUE IN THE FUTURE. IF ANY OF THESE RETAILERS FAILS TO
TIMELY PAY US AMOUNTS OWED, WE COULD SUFFER A SIGNIFICANT DECLINE IN CASH
FLOW AND LIQUIDITY WHICH, IN TURN, COULD CAUSE US TO BE UNABLE PAY OUR
LIABILITIES AND PURCHASE AN ADEQUATE AMOUNT OF INVENTORY TO SUSTAIN OR EXPAND
OUR CURRENT SALES VOLUME.

Our accounts receivable represented 53%, 46% and 46% of our total assets as
of December 31, 2004, 2003 and 2002, respectively. As of December 31, 2004, 73%
of our accounts receivable represented amounts owed by two retailers, each of
which represented over 10% of the total amount of our accounts receivable.
Similarly, as of December 31, 2003, 63% of our accounts receivable represented
amounts owed by three retailers, each of which represented over 10% of the total
amount of our accounts receivable. As a result of the substantial amount and
concentration of our accounts receivable, if any of our major retailers fails to
timely pay us amounts owed, we could suffer a significant decline in cash flow
and liquidity which would negatively affect our ability to make payments under
our line of credit with GMAC Commercial Finance and which, in turn, could
adversely affect our ability to borrow funds to purchase inventory to sustain or
expand our current sales volume. Accordingly, if any of our major retailers
fails to timely pay us amounts owed, our sales and profitability may decline.

WE RELY HEAVILY ON OUR CHIEF EXECUTIVE OFFICER, TONY SHAHBAZ. THE LOSS OF HIS
SERVICES COULD ADVERSELY AFFECT OUR ABILITY TO SOURCE PRODUCTS FROM OUR KEY
SUPPLIERS AND OUR ABILITY TO SELL OUR PRODUCTS TO OUR RETAILERS.

Our success depends, to a significant extent, upon the continued services
of Tony Shahbaz, who is our Chairman of the Board, President, Chief Executive
Officer and Secretary. For example, Mr. Shahbaz has developed key personal
relationships with our suppliers and retailers, including with our subcontract
manufacturers. We greatly rely on these relationships in the conduct of our
operations and the execution of our business strategies. Mr. Shahbaz and some of
these subcontract manufacturers and suppliers have acquired interests in
business entities that own shares of our common stock. Further, some of these
manufacturers also directly hold shares of our common stock. See "Certain
Relationships and Related Transactions." The loss of Mr. Shahbaz could,
therefore, result in the loss of our favorable relationships with one or more of
our subcontract manufacturers or suppliers. Although we have entered into an
employment agreement with Mr. Shahbaz, that agreement is of limited duration and
is subject to early termination by Mr. Shahbaz under certain circumstances. In
addition, we do not maintain "key person" life insurance covering Mr. Shahbaz or
any other executive officer. The loss of Mr. Shahbaz could significantly delay
or prevent the achievement of our business objectives. Consequently, the loss of
Mr. Shahbaz could adversely affect our business, financial condition and results
of operations.

THE HIGH CONCENTRATION OF OUR SALES WITHIN THE DATA STORAGE INDUSTRY COULD
RESULT IN A SIGNIFICANT REDUCTION IN NET SALES AND NEGATIVELY AFFECT OUR
EARNINGS IF DEMAND FOR THOSE PRODUCTS DECLINES.

Sales of our data storage products accounted for approximately 99% and 94%,
respectively, of our net sales in 2004 and 2003. Except for our digital
entertainment and other products, which accounted for only approximately 1% and
6%, respectively, of our net sales in 2004 and in 2003, we have not diversified
our product categories outside of the data storage industry. We expect data

-40-

storage products to continue to account for the vast majority of our net sales
for the foreseeable future. As a result, our net sales and profitability would
be significantly and adversely impacted by a downturn in the demand for data
storage products.

IF WE FAIL TO ACCURATELY FORECAST THE COSTS OF OUR PRODUCT REBATE OR OTHER
PROMOTIONAL PROGRAMS, WE MAY EXPERIENCE A SIGNIFICANT DECLINE IN CASH FLOW
AND OUR BRAND IMAGE MAY BE ADVERSELY AFFECTED RESULTING IN REDUCED SALES AND
PROFITABILITY.

We rely heavily on product rebates and other promotional programs to
establish, maintain and increase sales of our products. If we fail to accurately
forecast the costs of these programs, we may fail to allocate sufficient
resources to these programs. For example, we may fail to have sufficient funds
available to satisfy mail-in product rebates. If we are unable to satisfy our
promotional obligations, such as providing cash rebates to consumers, our brand
image and goodwill with consumers and retailers would be harmed, which may
result in reduced sales and profitability. In addition, our failure to
adequately forecast the costs of these programs may result in unexpected
liabilities causing a significant decline in cash flow and capital resources
with which to operate our business.

OUR TWO PRINCIPAL SUBCONTRACT MANUFACTURERS AND SUPPLIERS PROVIDE US WITH
SIGNIFICANTLY PREFERENTIAL TRADE CREDIT TERMS. IF EITHER OF THESE
MANUFACTURERS DOES NOT CONTINUE TO OFFER US SUBSTANTIALLY THE SAME
PREFERENTIAL CREDIT TERMS, OUR SALES AND PROFITABILITY WOULD DECLINE
SIGNIFICANTLY.

Lung Hwa Electronics and Behavior Tech Computer Corp., our two principal
subcontract manufacturers and suppliers, provide us with significantly
preferential trade credit terms. These terms include extended payment terms,
substantial trade lines of credit and other preferential buying arrangements. We
believe that these terms are substantially better terms than we could likely
obtain from other subcontract manufacturers or suppliers. In fact, we believe
that our trade credit facility with Lung Hwa Electronics is likely unique and
could not be replaced through a relationship with an unrelated third party. If
either of these subcontract manufacturers and suppliers does not continue to
offer us substantially the same preferential trade credit terms, our ability to
finance inventory purchases would be harmed, resulting in significantly reduced
sales and profitability. In addition, we would incur additional financing costs
associated with shorter payment terms which would also cause our profitability
to decline. See "Certain Relationships and Related Transactions."

THE DATA STORAGE INDUSTRY IS EXTREMELY COMPETITIVE. ALL OF OUR SIGNIFICANT
COMPETITORS HAVE GREATER FINANCIAL AND OTHER RESOURCES THAN WE DO, AND ONE OR
MORE OF THESE COMPETITORS COULD USE THEIR GREATER RESOURCES TO GAIN MARKET
SHARE AT OUR EXPENSE.

The data storage industry is extremely competitive. All of our significant
competitors in the data storage industry, including BenQ, Hewlett-Packard,
Lite-On, Memorex, Philips Electronics, Samsung Electronics, Sony and TDK have
substantially greater production, financial, research and development,
intellectual property, personnel and marketing resources than we do. As a
result, each of these companies could compete more aggressively and sustain that
competition over a longer period of time than we could. Our lack of resources
relative to all of our significant competitors may cause us to fail to
anticipate or respond adequately to technological developments and changing
consumer demands and preferences, or may cause us to experience significant
delays in obtaining or introducing new or enhanced products. These failures or
delays could reduce our competitiveness and cause a decline in our market share
and sales.

DATA STORAGE PRODUCTS ARE SUBJECT TO RAPID TECHNOLOGICAL CHANGES. IF WE FAIL
TO ACCURATELY ANTICIPATE AND ADAPT TO THESE CHANGES, THE PRODUCTS WE SELL
WILL BECOME OBSOLETE, CAUSING A DECLINE IN OUR SALES AND PROFITABILITY.

Data storage products are subject to rapid technological changes which
often cause product obsolescence. Companies within the data storage industry are
continuously developing new products with heightened performance and
functionality. This puts pricing pressure on existing products and constantly
threatens to make them, or causes them to be, obsolete. Our typical product life
cycle is extremely short and ranges from only three to twelve months, generating
lower average selling prices as the cycle matures. If we fail to accurately
anticipate the introduction of new technologies, we may possess significant
amounts of obsolete inventory that can only be sold at substantially lower
prices and profit margins than we anticipated. In addition, if we fail to
accurately anticipate the introduction of new technologies, we may be unable to
compete effectively due to our failure to offer products most demanded by the
marketplace. If any of these failures occur, our sales, profit margins and
profitability will be adversely affected.

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IF WE FAIL TO SELECT HIGH TURNOVER PRODUCTS FOR OUR CONSIGNMENT SALES
CHANNELS, OUR FINANCING COSTS MAY EXCEED TARGETED LEVELS, WE MAY BE UNABLE TO
FUND ADDITIONAL PURCHASES OF INVENTORY AND WE MAY BE FORCED TO REDUCE PRICES
AND ACCEPT LOWER MARGINS TO SELL CONSIGNED PRODUCTS, WHICH WOULD CAUSE OUR
SALES, PROFITABILITY AND FINANCIAL RESOURCES TO DECLINE.

We retain most risks of ownership of products in our consignment sales
channels. These products remain our inventory until their resale by our
retailers. The turnover frequency of our inventory on consignment is critical to
generating regular cash flow in amounts necessary to keep financing costs to
targeted levels and to purchase additional inventory. If this inventory turnover
is not sufficiently frequent, our financing costs may exceed targeted levels and
we may be unable to generate regular cash flow in amounts necessary to purchase
additional inventory to meet the demand for other products. In addition, as a
result of our products' short life-cycles, which generate lower average selling
prices as the cycles mature, low inventory turnover levels may force us to
reduce prices and accept lower margins to sell consigned products. As of
December 31, 2004 and 2003, we carried and financed inventory valued at
approximately $2.9 million and $4.2 million, respectively, in our consignment
sales channels. Sales generated through consignment sales were approximately 32%
and 37%, respectively, of our total net sales in 2004 and 2003. If we fail to
select high turnover products for our consignment sales channels, our sales,
profitability and financial resources may decline.

OUR INDEMNIFICATION OBLIGATIONS TO OUR RETAILERS FOR PRODUCT DEFECTS COULD
REQUIRE US TO PAY SUBSTANTIAL DAMAGES, WHICH COULD HAVE A SIGNIFICANT
NEGATIVE IMPACT ON OUR PROFITABILITY AND FINANCIAL RESOURCES.

A number of our agreements with our retailers provide that we will defend,
indemnify and hold them and their customers, harmless from damages and costs
that arise from product warranty claims or from claims for injury or damage
resulting from defects in our products. If such claims are asserted against us,
our insurance coverage may not be adequate to cover the costs associated with
our defense of those claims or the cost of any resulting liability we incur if
those claims are successful. A successful claim brought against us for product
defects that is in excess of, or excluded from, our insurance coverage could
adversely affect our profitability and financial resources and could make it
difficult or impossible for us to adequately fund our day-to-day operations.

IF WE ARE SUBJECTED TO ONE OR MORE INTELLECTUAL PROPERTY INFRINGEMENT CLAIMS,
OUR SALES, EARNINGS AND FINANCIAL RESOURCES MAY BE ADVERSELY AFFECTED.

Our products rely on intellectual property developed, owned or licensed by
third parties. From time to time, intellectual property infringement claims have
been asserted against us. We expect to continue to be subjected to such claims
in the future. Intellectual property infringement claims may also be asserted
against our retailers as a result of selling our products. As a consequence, our
retailers could assert indemnification claims against us. If any third party is
successful in asserting an infringement claim against us, we could be required
to acquire licenses, which may not be available on commercially reasonable
terms, if at all, to discontinue selling certain products to pay substantial
monetary damages or to develop non-infringing technologies, none of which may be
feasible. Both infringement and indemnification claims could be time-consuming
and costly to defend or settle and would divert management's attention and our
resources away from our business. In addition, we may lack sufficient litigation
defense resources, therefore any one of these developments could place
substantial financial and administrative burdens on us and our sales and
earnings may be adversely affected.

IF WE FAIL TO SUCCESSFULLY MANAGE THE EXPANSION OF OUR BUSINESS, OUR SALES
MAY NOT INCREASE COMMENSURATELY WITH OUR CAPITAL INVESTMENTS, WHICH WOULD
CAUSE OUR PROFITABILITY TO DECLINE.

We plan to offer new data storage and digital entertainment products in the
future. In particular, we plan to offer additional DVD-based products and
additional products in our line of GigaBank(TM) products, as well as products
with heightened performance and added functionality. We also plan to offer a
next-generation DVD-based product, such as Blu-ray DVD or HD-DVD, depending on
which of these competing formats we believe is most likely to prevail in the
marketplace. These planned product offerings will require significant
investments of capital and management's close attention. In offering new digital
entertainment products, our resources and personnel are likely to be strained
because we have little experience in the digital entertainment industry. Our
failure to successfully manage our planned product expansion could result in our
sales not increasing commensurately with our capital investments, causing a
decline in our profitability.

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A SIGNIFICANT PRODUCT DEFECT OR PRODUCT RECALL COULD MATERIALLY AND ADVERSELY
AFFECT OUR BRAND IMAGE, CAUSING A DECLINE IN OUR SALES, AND COULD REDUCE OR
DEPLETE OUR FINANCIAL RESOURCES.

A significant product defect could materially harm our brand image and
could force us to conduct a product recall. This could result in damage to our
relationships with our retailers and loss of consumer loyalty. Because we are a
small company, a product recall would be particularly harmful to us because we
have limited financial and administrative resources to effectively manage a
product recall and it would detract management's attention from implementing our
core business strategies. As a result, a significant product defect or product
recall could materially and adversely affect our brand image, causing a decline
in our sales, and could reduce our deplete our financial resources.

IF OUR PRODUCTS ARE NOT AMONG THE FIRST-TO-MARKET, OR IF CONSUMERS DO NOT
RESPOND FAVORABLY TO EITHER OUR NEW OR ENHANCED PRODUCTS, OUR SALES AND
EARNINGS WILL DECLINE.

One of our core business strategies is to be among the first-to-market with
new and enhanced products based on established technologies. We believe that our
I/OMagic(R) brand is perceived by the retailers and end-users of our products as
among the leaders in the data storage industry. We also believe that these
retailers and end-users view products offered under our I/OMagic(R) brand as
embodying newly established technologies or technological enhancements. For
instance, in introducing new and enhanced optical data storage products and
portable magnetic data storage devices such as our GigaBank(TM) products, we
seek to be among the first-to-market, offering heightened product performance
such as faster data recordation and access speeds. If our products are not among
the first-to-market, our competitors may gain market share at our expense, which
would decrease our net sales and earnings.

As a consequence of this core strategy, we are exposed to consumer
rejection of our new and enhanced products to a greater degree than if we
offered products later in their industry life cycle. For example, our
anticipated future sales are largely dependent on future consumer demand for
DVD-based products displacing current consumer demand for CD-based products as
well as increasing demand for portable magnetic data storage devices such as our
GigaBank(TM) products. Accordingly, future sales and any future profits from
DVD-based products and our GigaBank(TM) line of products are substantially
dependent upon widespread consumer acceptance of DVD-based products and portable
data storage devices. If this widespread consumer acceptance of DVD-based
products and our GigaBank(TM) products does not occur, or is delayed, our sales
and earnings will be adversely affected.

A LABOR STRIKE OR CONGESTION AT A SHIPPING PORT AT WHICH OUR PRODUCTS ARE
SHIPPED OR RECEIVED COULD PREVENT US FROM TAKING TIMELY DELIVERY OF
INVENTORY, WHICH COULD CAUSE OUR SALES AND PROFITABILITY TO DECLINE.

From time to time, shipping ports experience labor strikes, work stoppages
or congestion which delay the delivery of imported products. The port of Long
Beach, California, through which most of our products are imported from Asia,
experienced a labor strike in September 2002 which lasted nearly two weeks. As a
result, there was a significant disruption in our ability to deliver products to
our retailers, which caused our sales to decline. Any future labor strike, work
stoppage or congestion at a shipping port at which our products are shipped or
received would prevent us from taking timely delivery of inventory and cause our
sales to decline. In addition, many of our retailers impose penalties for both
early and late product deliveries, which could result in significant additional
costs to us. In the event of a similar labor strike or work stoppage in the
future, or in the event of congestion, in order to meet our delivery obligations
to our retailers and avoid penalties for missed delivery dates, we may be
required to arrange for alternative means of product shipment, such as air
freight, which could add significantly to our product costs. We would typically
be unable to pass these extra costs along to either our retailers or to
consumers. Also, because the average selling prices of our products decline,
often rapidly, during their short product life cycle, delayed delivery of
products could yield significantly less than expected sales and profits.

FAILURE TO ADEQUATELY PROTECT OUR TRADEMARK RIGHTS COULD CAUSE US TO LOSE
MARKET SHARE AND CAUSE OUR SALES TO DECLINE.

We sell our products primarily under our I/OMagic(R) brand name and, from
time to time, also sell products under our Hi-Val(R) and Digital Research
Technologies(R) brand names. Each of these trademarks has been registered by us
with the United States Patent & Trademark Office. We also sell products under
various product names such as "MediaStation," "DataStation," Digital Photo
Library(TM), EasyPrint(TM) and GigaBank(TM). One of our key business strategies
is to use our brand and product names to successfully compete in the data
storage industry. We have expended significant resources promoting our brand and
product names and we have registered trademarks for our three brand names.
However, we cannot assure you that the registration of our brand name
trademarks, or our other actions to protect our non-registered product names,
will deter or prevent their unauthorized use by others. We also cannot assure

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you that other companies, including our competitors, will not use our product
names. If other companies, including our competitors, use our brand or product
names, consumer confusion could result, meaning that consumers may not recognize
us as the source of our products. This would reduce the value of goodwill
associated with these brand and product names. This consumer confusion and the
resulting reduction in goodwill could cause us to lose market share and cause
our sales to decline.

CONSUMER ACCEPTANCE OF ALTERNATIVE SALES CHANNELS MAY INCREASE. IF WE ARE
UNABLE TO ADAPT TO THESE ALTERNATIVE SALES CHANNELS, SALES OF OUR PRODUCTS
MAY DECLINE.

We are accustomed to conducting business through traditional retail sales
channels. Consumers purchase our products predominantly through a small number
of retailers. For example, during 2004, five of our retailers accounted for 80%
of our total net sales. Similarly, during 2003, five of our retailers accounted
for 72% of our total net sales. We currently generate only a small number of
direct sales of our products through our Internet websites. We believe that many
of our target consumers are knowledgeable about technology and comfortable with
the use of the Internet for product purchases. Consumers may increasingly prefer
alternative sales channels, such as direct mail order or direct purchase from
manufacturers. In addition, Internet commerce is becoming increasingly accepted
by consumers as a convenient, secure and cost-effective method of purchasing
data storage and digital entertainment products. The migration of consumer
purchasing habits from traditional retailers to Internet retailers could have a
significant impact on our ability to sell our products. We cannot assure you
that we will be able to predict and respond to increasing consumer preference of
alternative sales channels. If we are unable to adapt to alternative sales
channels, sales of our products may decline.

OUR OPERATIONS ARE VULNERABLE BECAUSE WE HAVE LIMITED REDUNDANCY AND BACKUP
SYSTEMS.

Our internal order, inventory and product data management system is an
electronic system through which our retailers place orders for our products and
through which we manage product pricing, shipment, returns and other matters.
This system's continued and uninterrupted performance is critical to our
day-to-day business operations. Despite our precautions, unanticipated
interruptions in our computer and telecommunications systems have, in the past,
caused problems or stoppages in this electronic system. These interruptions, and
resulting problems, could occur in the future. We have extremely limited ability
and personnel to process purchase orders and manage product pricing and other
matters in any manner other than through this electronic system. Any
interruption or delay in the operation of this electronic system could cause a
significant decline in our sales and profitability.

OUR STOCK PRICE IS HIGHLY VOLATILE, WHICH COULD RESULT IN SUBSTANTIAL LOSSES
FOR INVESTORS PURCHASING SHARES OF OUR COMMON STOCK AND IN LITIGATION AGAINST
US.

The market price of our common stock has fluctuated significantly in the
past and may continue to fluctuate significantly in the future. During the first
three months of 2005, the high and low closing bid prices of a share of our
common stock were $3.25 and $1.74, respectively. During 2004, the high and low
closing bid prices of a share of our common stock were $4.50 and $3.00,
respectively. During 2003, the high and low closing bid prices of a share of our
common stock were $8.50 and $3.50, respectively. The market price of our common
stock may continue to fluctuate in response to one or more of the following
factors, many of which are beyond our control:

o changes in market valuations of similar companies;
o stock market price and volume fluctuations generally;
o economic conditions specific to the data storage or digital
entertainment products industries;
o announcements by us or our competitors of new or enhanced products or
technologies or of significant contracts, acquisitions, strategic
relationships, joint ventures or capital commitments;
o the loss of one or more of our top retailers or the cancellation or
postponement of orders from any of those retailers;
o delays in our introduction of new products or technological
innovations or problems in the functioning of these new products or
innovations;
o disputes or litigation concerning our rights to use third parties'
intellectual property or third parties' infringement of our
intellectual property;
o changes in our pricing policies or the pricing policies of our
competitors;
o changes in foreign currency exchange rates affecting our product costs
and pricing;
o regulatory developments or increased enforcement;
o fluctuations in our quarterly or annual operating results;
o additions or departures of key personnel; and
o future sales of our common stock or other securities.

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The price at which you purchase shares of our common stock may not be
indicative of the price that will prevail in the trading market. You may be
unable to sell your shares of common stock at or above your purchase price,
which may result in substantial losses to you.

In the past, securities class action litigation has often been brought
against a company following periods of stock price volatility. We may be the
target of similar litigation in the future. Securities litigation could result
in substantial costs and divert management's attention and our resources from
our business. Any of the risks described above could have an adverse effect on
our business, financial condition and results of operations and therefore on the
price of our common stock.

OUR COMMON STOCK HAS A SMALL PUBLIC FLOAT AND SHARES OF OUR COMMON STOCK
ELIGIBLE FOR PUBLIC SALE COULD CAUSE THE MARKET PRICE OF OUR STOCK TO DROP,
EVEN IF OUR BUSINESS IS DOING WELL.

As of June 29, 2005, there were approximately 4.5 million shares of our
common stock outstanding. As a group, our executive officers, directors and 10%
shareholders beneficially own approximately 3.5 million of these shares.
Accordingly, our common stock has a public float of approximately 1.0 million
shares held by a relatively small number of public investors. In addition, we
have a registration statement on Form S-8 in effect covering 133,334 shares of
common stock issuable upon exercise of options under our 2002 Stock Option Plan
and a registration statement on Form S-8 in effect covering 400,000 shares of
common stock issuable upon exercise of options under our 2003 Stock Option Plan.
Currently, options covering 121,950 shares of common stock are outstanding under
our 2002 Stock Option Plan and no options are outstanding under our 2003 Stock
Option Plan. The shares of common stock issued upon exercise of these options
will be freely tradable without restriction or further registration, except to
the extent purchased by one of our affiliates.

We cannot predict the effect, if any, that future sales of shares of our
common stock into the public market will have on the market price of our common
stock. However, as a result of our small public float, sales of substantial
amounts of common stock, including shares issued upon the exercise of stock
options or warrants, or an anticipation that such sales could occur, may
materially and adversely affect prevailing market prices for our common stock.

IF THE OWNERSHIP OF OUR COMMON STOCK CONTINUES TO BE HIGHLY CONCENTRATED, IT
MAY PREVENT YOU AND OTHER STOCKHOLDERS FROM INFLUENCING SIGNIFICANT CORPORATE
DECISIONS AND MAY RESULT IN CONFLICTS OF INTEREST THAT COULD CAUSE OUR STOCK
PRICE TO DECLINE.

As a group, our executive officers, directors, and 10% stockholders
beneficially own or control approximately 75% of our outstanding shares of
common stock (after giving effect to the exercise of all outstanding vested
options exercisable within 60 days from June 29, 2005). As a result, our
executive officers, directors, and 10% stockholders, acting as a group, have
substantial control over the outcome of corporate actions requiring stockholder
approval, including the election of directors, any merger, consolidation or sale
of all or substantially all of our assets, or any other significant corporate
transaction. Some of these controlling stockholders may have interests different
than yours. For example, these stockholders may delay or prevent a change in
control of I/OMagic, even one that would benefit our stockholders, or pursue
strategies that are different from the wishes of other investors. The
significant concentration of stock ownership may adversely affect the trading
price of our common stock due to investors' perception that conflicts of
interest may exist or arise.

OUR ARTICLES OF INCORPORATION, OUR BYLAWS AND NEVADA LAW EACH CONTAIN
PROVISIONS THAT COULD DISCOURAGE TRANSACTIONS RESULTING IN A CHANGE IN
CONTROL OF I/OMAGIC, WHICH MAY NEGATIVELY AFFECT THE MARKET PRICE OF OUR
COMMON STOCK.

Our articles of incorporation and our bylaws contain provisions that may
enable our board of directors to discourage, delay or prevent a change in the
ownership of I/OMagic or in our management. In addition, these provisions could
limit the price that investors would be willing to pay in the future for shares
of our common stock. These provisions include the following:

o our board of directors is authorized, without prior stockholder
approval, to create and issue preferred stock, commonly referred to as
"blank check" preferred stock, with rights senior to those of our
common stock;
o our stockholders are permitted to remove members of our board of
directors only upon the vote of at least two-thirds of the outstanding
shares of stock entitled to vote at a meeting called for such purpose
or by written consent; and
o our board of directors are expressly authorized to make, alter or
repeal our bylaws.

-45-

In addition, we may be subject to the restrictions contained in Sections
78.378 through 78.3793 of the Nevada Revised Statutes which provide, subject to
certain exceptions and conditions, that if a person acquires a "controlling
interest," which is equal to either one-fifth or more but less than one-third,
one-third or more but less than a majority, or a majority or more of the voting
power of a corporation, that person is an "interested stockholder" and may not
vote that person's shares. The effect of these restrictions may be to
discourage, delay or prevent a change in control of I/OMagic.

WE CANNOT ASSURE YOU THAT AN ACTIVE MARKET FOR OUR SHARES OF COMMON STOCK
WILL DEVELOP OR, IF IT DOES DEVELOP, WILL BE MAINTAINED IN THE FUTURE. IF AN
ACTIVE MARKET DOES NOT DEVELOP, YOU MAY NOT BE ABLE TO READILY SELL YOUR
SHARES OF OUR COMMON STOCK.

On March 25, 1996, our common stock commenced trading on the OTC Bulletin
Board. Since that time, there has been limited trading in our shares, at widely
varying prices, and the trading to date has not created an active market for our
shares. We cannot assure you that an active market for our shares will be
established or maintained in the future. If an active market is not established
or maintained, you may not be able to readily sell your shares of our common
stock.

BECAUSE WE ARE SUBJECT TO "PENNY STOCK" RULES, THE LEVEL OF TRADING ACTIVITY
IN OUR COMMON STOCK MAY BE REDUCED. IF THE LEVEL OF TRADING ACTIVITY IS
REDUCED, YOU MAY NOT BE ABLE TO READILY SELL YOUR SHARES OF OUR COMMON STOCK.

Broker-dealer practices in connection with transactions in "penny stocks"
are regulated by penny stock rules adopted by the Securities and Exchange
Commission. Penny stocks are, generally, equity securities with a price of less
than $5.00 per share that trade on the OTC Bulletin Board or the Pink Sheets.
The penny stock rules require a broker-dealer, prior to a transaction in a penny
stock not otherwise exempt from the rules, to deliver a standardized risk
disclosure document that provides information about penny stocks and the nature
and level of risks in investing in the penny stock market. The broker-dealer
also must provide the prospective investor with current bid and offer quotations
for the penny stock and the amount of compensation to be paid to the
broker-dealer and its salespeople in the transaction. Furthermore, if the
broker-dealer is the sole market maker, the broker-dealer must disclose this
fact and the broker-dealer's presumed control over the market, and must provide
each holder of penny stock with a monthly account statement showing the market
value of each penny stock held in the customer's account. In addition,
broker-dealers who sell penny stocks to persons other than established customers
and "accredited investors" must make a special written determination that the
penny stock is a suitable investment for the prospective investor and receive
the purchaser's written agreement to the transaction. These requirements may
have the effect of reducing the level of trading activity in a penny stock, such
as our common stock, and investors in our common stock may find it difficult to
sell their shares.

-46-

ITEM 7A. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK.

Our operations were not subject to commodity price risk during 2004. Our
sales to a foreign country (Canada) were approximately 1.8% of our total sales,
and thus we experienced negligible foreign currency exchange rate risk. We do
not hedge against this risk.

On March 9, 2005, we replaced our asset-based line of credit with United
National Bank with an asset-based line of credit with GMAC Commercial Finance.
The new line of credit is for an amount of up to $10.0 million. The new line of
credit provides for an interest rate equal to the prime lending rate plus 0.75%.
This interest rate is adjustable upon each movement in the prime lending rate.
If the prime lending rate increases, our interest rate expense will increase on
an annualized basis by the amount of the increase multiplied by the principal
amount outstanding under our credit facility.

ITEM 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA

Reference is made to the financial statements included in this report,
which begin at Page F-1.

ITEM 9. CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND
FINANCIAL DISCLOSURE

None.

ITEM 9A. CONTROLS AND PROCEDURES

Evaluation of Disclosure Controls and Procedures

We conducted an evaluation, with the participation of our Chief Executive
Officer and Chief Financial Officer, of the effectiveness of the design and
operation of our disclosure controls and procedures, as defined in Rules
13a-15(e) and 15d-15(e) under the Securities Exchange Act of 1934, as amended,
or the Exchange Act, as of December 31, 2004, 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 Securities Exchange Commission's rules and forms,
including to ensure that information required to be disclosed by us in the
reports filed or submitted by us under the Exchange Act is accumulated and
communicated to our management, including our principal executive and principal
financial officers, or persons performing similar functions, as appropriate to
allow timely decisions regarding required disclosure. Based on that evaluation,
our Chief Executive Officer and Chief Financial Officer have concluded that as
of December 31, 2004, our disclosure controls and procedures were not effective
at the reasonable assurance level due to the material weaknesses described
below.

In light of the material weaknesses described below, we performed
additional analysis and other post-closing procedures to ensure our consolidated
financial statements were prepared in accordance with generally accepted
accounting principles. Accordingly, we believe that the consolidated financial
statements included in this report fairly present, in all material respects, our
financial condition, results of operations and cash flows for the periods
presented.

A material weakness is a control deficiency (within the meaning of the
Public Company Accounting Oversight Board (PCAOB) Auditing Standard No. 2) or
combination of control deficiencies, that results in more than a remote
likelihood that a material misstatement of the annual or interim financial
statements will not be prevented or detected. Management has identified the
following four material weaknesses which have caused management to conclude
that, as of December 31, 2004, our disclosure controls and procedures were not
effective at the reasonable assurance level:

1. In conjunction with preparing our Form 10-K for the period ended
December 31, 2004 and our registration statement on Form S-1, management
reviewed our revenue recognition methodologies as they relate to sales
incentives and product returns. As a result of this review, management concluded
that our controls over the selection and monitoring of appropriate assumptions
and factors affecting the recording of revenue and the related sales incentives
and product returns were not in accordance with generally accepted accounting
principles and that our revenue for the years ended December 31, 2003 and 2002
and for each of the quarterly periods in the years ended December 31, 2003 and
2002, and through the nine months ended September 30, 2004, had been misstated.
Based upon this conclusion, our Audit Committee and senior management decided to
restate our financial statements as of and for the years ended December 31, 2003
and 2002 and for each of the quarterly periods in the years ended December 31,
2003 and 2002, and through the nine months ended September 30, 2004, to reflect
the corrections in our revenue recognition methodologies.

Management evaluated the impact of this restatement on our assessment of
our disclosure controls and procedures and has concluded that the control
deficiency that resulted in the incorrect recording of revenue and the related
sales incentives and product returns represented a material weakness.

2. We did not maintain documentation supporting certain inventory reserves
and did not analyze our inventory reserve account on a timely basis. Management
evaluated the impact of our inventory accounting practices on our assessment of
our disclosure controls and procedures and has concluded that the control
deficiency that resulted in the failure to maintain documentation supporting
certain inventory reserves and the failure to analyze our inventory reserve
account on a timely basis represented a material weakness. This control
deficiency did not result in a material misstatement of our consolidated
financial statements.

3. As a result of our restatement of prior periods' financial results, as
discussed above, we were unable to meet our requirements to timely file our Form
10-K for the year ended December 31, 2004. Management evaluated the impact of
our inability to timely file periodic reports with the Securities and Exchange
Commission on our assessment of our disclosure controls and procedures and has
concluded that the control deficiency that resulted in the inability to timely
make these filings represented a material weakness.

4. We did not maintain a sufficient complement of finance and accounting
personnel with adequate depth and skill in the application of generally accepted
accounting principles with respect to: (i) revenue recognition, specifically
relating to sales incentives and product returns, and (ii) inventory reserves,
specifically relating to maintenance of documentary support of certain inventory
reserves and the timeliness and frequency of our analysis of our inventory
reserve account. In addition, we did not maintain a sufficient complement of
finance and accounting personnel to handle the matters necessary to timely file
our Form 10-K for the year ended December 31, 2004. Management evaluated the
impact of our lack of sufficient finance and accounting personnel on our
assessment of our disclosure controls and procedures and has concluded that the
control deficiency that resulted in our lack of sufficient personnel represented
a material weakness.

To address these material weaknesses, management performed additional
analyses and other procedures to ensure that the financial statements included
herein fairly present, in all material respects, our financial position, results
of operations and cash flows for the periods presented.

Remediation of Material Weaknesses

To remediate the material weaknesses in our disclosure controls and
procedures identified above, we have done the following subsequent to December
31, 2004, which correspond to the four material weaknesses identified above:

1. We have revised our revenue recognition methodology as it relates to
sales incentives. We previously accounted for sales incentives by reducing gross
sales at the time sales incentives were offered to our retailers. Upon further
examination of our accounting methodology for sales incentives, and a
quantitative analysis of our historical sales incentives, we determined that we
made an error in our application of the relevant accounting principles under
SFAS 48, as interpreted under Topic 13, and determined that we should have
estimated and recorded sales incentives at the time our products were sold.
Under SFAS 48, as interpreted under Topic 13, the eventual sales price must be
fixed or determinable before revenue can be recognized. Due to the nature and
extent of our sales incentive history, we should have been assessing our revenue
recognition criteria to determine whether we were able to effectively estimate
or determine our eventual sales price. We have determined the effect of the
correction on our previously issued financial statements and have restated our
financial statements for the years ended December 31, 2002 and 2003. Beginning
with the quarter ended December 31, 2004, we recorded an estimate of sales
incentives based on our actual sales incentive rates over a trailing twelve
month period, adjusted for any known variations, which we charged to operations
and offset against gross sales at the time products were sold with a
corresponding accrual for our estimated sales incentive liability. This accrual
- - our sales incentive reserve - is to be reduced by deductions on future
payments taken by our retailers relating to actual sales incentives.

We have revised our revenue recognition methodology as it relates to
product returns. We previously accounted for product returns using a method that
did not take into account the different return characteristics of categories of
similar products and also did not adequately take into account the variability
over time of product return rates. We conducted a quantitative analysis of our
historical product return data to determine moving averages of product return
rates by groupings of similar products. Following completion of this analysis,
we determined that we made an error in our method of estimating product returns.
As a result of this analysis, we determined that a more appropriate method would
be to apply an actual trailing 18-month return rate by product category against
actual gross sales for the period. We believe that using a trailing 18-month
return rate takes two key factors into consideration, specifically, an 18-month
return rate provides us with a sufficient period of time to establish recent
historical trends in product returns for each product category, and provides us
with a period of time that is short enough to account for recent technological
shifts in our product offerings in each product category. If an unusual
circumstance exists, such as a product category that has begun to show
materially different actual return rates as compared to life-to-date return
rates, we will make appropriate adjustments to our estimated return rates. We
have determined the effect of the correction on our previously issued financial
statements and have restated our financial statements for the years ended
December 31, 2002 and 2003. We began using this new methodology in the quarter
ended December 31, 2004.

2. We have implemented additional review procedures over the selection and
monitoring of appropriate assumptions and factors affecting our inventory
reserves to ensure that inventory balances are reduced to their net realizable
values on a timely basis. We have also revised our methodology in relation to
slow-moving or obsolete inventory. Slow-moving inventory is comprised of
products that have not been sold within six months. Obsolete inventory is
comprised of products that are no longer compatible with current hardware or
software. We previously reviewed our slow-moving and obsolete inventory in
detail twice a year, during our June 30 and December 31 physical inventories, in
regards to our lower of cost or market valuations. Our inventory reviews for the
quarters ended March 31 and September 30 were less detailed. We have implemented
a new procedure that requires that our purchasing manager review slow-moving and
obsolete inventory in detail at the end of each quarter and propose any
necessary increases to our inventory reserve. This procedure became effective
for the quarter ended December 31, 2004 and is effective for each quarter
thereafter.

3. In connection with making the changes discussed above to our disclosure
controls and procedures, in addition to working with our independent auditors,
we retained a third-party consultant, who is an experienced partner of a
registered public accounting firm specializing in public company financial
reporting, to advise us and our Audit Committee regarding our financial
reporting process. We also engaged another third-party accounting firm, other
than our independent auditors, to assist us with our financial reporting
process. Additionally, as of the date of this report, we have created a new
position-Vice President of Corporate Compliance-to further assist us in timely
making required filings with the Securities and Exchange Commission and ensuring
the accuracy of our financial reporting and the effectiveness of our disclosure
controls and procedures. We are currently in the process of filling this
position with an appropriate candidate. We also intend, in 2005, to implement
enhancements to our financial reporting processes, including increased training
of our finance and accounting staff regarding financial reporting requirements
and the evaluation and further implementation of automated procedures within our
MIS financial reporting system.

4. Please see item 3 immediately above.

Changes in Internal Control over Financial Reporting

Except as noted above, there were no changes in our internal control over
financial reporting, as defined in Rules 13a-15(f) and 15d-15(f) under the
Exchange Act, during our most recently completed fiscal quarter that have
materially affected, or are reasonably likely to materially affect, our internal
control over financial reporting.

ITEM 9B. OTHER INFORMATION

None.

-47-

PART III

ITEM 10. DIRECTORS AND EXECUTIVE OFFICERS OF THE REGISTRANT

DIRECTORS AND EXECUTIVE OFFICERS

The names, ages and positions held by our directors and executive officers
as of June 29, 2005 and their business experience are as follows:

NAME AGE TITLES
- ---- --- ------
Tony Shahbaz 43 Chairman of the Board, President, Chief Executive
Officer, Secretary, Director
Steve Gillings 55 Chief Financial Officer
Steel Su 53 Director
Daniel Hou(1) 56 Director
Daniel Yao(1) 48 Director

- ------------
(1) Member of the Audit Committee, Compensation Committee and Nominating
Committee.

TONY SHAHBAZ is a founder of I/OMagic and has served as our Chairman of the
Board, President, Chief Executive Officer, Secretary and as a director since
September 1993, and as our Chief Financial Officer from September 1993 to
October 2002. Prior to founding I/OMagic, Mr. Shahbaz was employed by Western
Digital Corporation from September 1986 to March 1993. During his tenure at
Western Digital Corporation, Mr. Shahbaz held several positions including Vice
President of Worldwide Sales for its Western Digital Paradise division, and
Regional Director of Asia Pacific Sales and Marketing Operations.

STEVE GILLINGS has served as our Chief Financial Officer since October
2002. Prior to assuming this position, Mr. Gillings served as our Vice President
of Finance from October 2000 to October 2002 and as our Controller from November
1997 to October 2000. Mr. Gillings received a B.S. degree in Accounting from the
University of California at Berkeley in 1971 and an M.B.A. degree in Finance
from California State University Fullerton in 1992.

STEEL SU has served as a director of I/OMagic since September 2000 and is a
founder of Behavior Tech Computer Corp., one of our principal subcontract
manufacturers and stockholders and has served as its Chairman since 1980. Mr. Su
has served and continues to serve as a director or chairman of the following
affiliates of Behavior Tech Computer Corp.: Behavior Design Corporation
(chairman), Behavior Tech Computer (USA) Corp. (chairman), Behavior Tech
Computer Affiliates, N.V. (chairman) and BTC Korea Co., Ltd. (director). Mr. Su
has served as chairman of Gennet Technology Corp., Emprex Technologies Corp.,
Maritek Inc. and MaxD Technology Inc. since 1992, 1998, 1999 and 2000,
respectively. Mr. Su has also served as a director of Aurora Systems Corp. and
Wearnes Peripherals International (PTE) Limited since 1998 and 2000,
respectively. Mr. Su received a B.S. degree in Electronic Engineering from Ching
Yuan Christian University, Taiwan in 1974 and an M.B.A. degree from National
Taiwan University in 2001.

DANIEL HOU has served as a director of I/OMagic since January 1998. Since
1986, Mr. Hou has served as the President of Hou Electronics, Inc., a computer
peripheral supplier that he founded and that is one of our stockholders. Mr. Hou
is a member and past President of the Southern California Chinese Computer
Association and is an active member of the American Chemistry Society. Mr. Hou
received a B.A. degree in Chemistry from National Chung-Hsing University, Taiwan
in 1973 and a Masters degree in Material Science from the University of Utah in
1978.

DANIEL YAO has served as a director of I/OMagic since February 2001 and has
been a Chief Strategy Officer for Ritek Corporation, an affiliate of Citrine
Group Limited, one of our stockholders, since July 2000. Prior to joining Ritek,
Mr. Yao served as the Senior Investment Consultant for Core Pacific Securities
Capital from July 1998 to July 2000. Prior to that, Mr. Yao was an Executive
Vice President for ABN Amro Bank in Taiwan from July 1996 to July 1998. Mr. Yao
received a B.A. degree in Business Management from National Taiwan University in
1978 and a M.B.A. degree from the University of Rochester in New York in 1984.

Our directors are elected annually and hold office until the next annual
meeting of stockholders, until their respective successors are elected and
qualified or until their earlier death, resignation or removal.

-48-

SECTION 16(A) BENEFICIAL OWNERSHIP REPORTING COMPLIANCE

Section 16(a) of the Securities Exchange Act of 1934, as amended, requires
our executive officers, directors and persons who beneficially own more than 10%
of a registered class of our equity securities ("reporting persons") to file
initial reports of ownership and reports of changes in ownership of our common
stock and other equity securities with the Securities and Exchange Commission.
The reporting persons are required by the Securities and Exchange Commission
regulations to furnish us with copies of all reports that they file.

Based solely upon a review of copies of the reports furnished to us during
our fiscal year ended December 31, 2004 and thereafter, or any written
representations received by us from reporting persons that no other reports were
required, we believe that all Section 16(a) filing requirements applicable to
our reporting persons during 2004 were complied with, except as described below.

The following individuals did not timely file the following numbers of
Forms 4 to report the following numbers of transactions: Mr. Tony Shahbaz -- 1
report, 2 transactions; and Mr. Steel Su -- 1 report, 1 transaction.

CODES OF ETHICS

Our board of directors has adopted a Code of Business Conduct and Ethics
that applies to all of our directors, officers and employees and an additional
Code of Business Ethics that applies to our Chief Executive Officer and Senior
Financial Officers. We have included these codes in the exhibit list to this
report.

We intend to satisfy the disclosure requirement under Item 10 of Form 8-K
relating to amendments to or waivers from provision of these codes that relate
to one or more of the items set forth in Item 406(b) of Regulation S-K, by
describing on our Internet website, within five business days following the date
of a waiver or a substantive amendment, the date of the waiver or amendment, the
nature of the amendment or waiver, and the name of the person to whom the waiver
was granted.

Information on our Internet website is not, and shall not be deemed to be,
a part of this report or incorporated into any other filings we make with the
Securities and Exchange Commission.

ITEM 11. EXECUTIVE COMPENSATION

COMPENSATION OF EXECUTIVE OFFICERS

The following table provides information concerning the annual and
long-term compensation for the years ended December 31, 2004, 2003 and 2002
earned for services in all capacities as an employee by our Chief Executive
Officer and each of our other executive officers who received an annual salary
and bonus of more than $100,000 for services rendered to us during 2004:

SUMMARY COMPENSATION TABLE

ANNUAL COMPENSATION
-------------------
NAME AND PRINCIPAL POSITION YEAR SALARY BONUS
- --------------------------- ---- ------ -----
Tony Shahbaz............................ 2004 $ 198,500 $ 60,702
Chairman, President, Chief 2003 $ 198,500 $ 28,259
Executive Officer and Secretary 2002 $ 202,259 $ 89,067

Steve Gillings.......................... 2004 $ 95,000 $ 2,500
Chief Financial Officer 2003 $ 95,000 $ 5,000
2002(1) $ 84,537 $ 12,000

- ------------
(1) Mr. Gillings became an executive officer of I/OMagic on October 10, 2002.

-49-

OPTION GRANTS IN LAST FISCAL YEAR

The following table provides information regarding options granted in the
year ended December 31, 2004 to the executive officers named in the summary
compensation table. We did not grant any stock appreciation rights during 2004.
This information includes hypothetical potential gains from stock options
granted in 2004. These hypothetical gains are based entirely on assumed annual
growth rates of 5% and 10% in the value of our common stock price over the
ten-year life of the stock options granted in 2004. These assumed rates of
growth were selected by the Commission for illustrative purposes only and are
not intended to predict future stock prices, which will depend upon market
conditions and our future performance and prospects.

POTENTIAL
REALIZABLE VALUE
AT ASSUMED RATES
NUMBER OF PERCENTAGE OF OF STOCK PRICE
SECURITIES TOTAL OPTIONS APPRECIATION FOR
UNDERLYING GRANTED TO EXERCISE OPTION TERM(3)
GRANT OPTIONS EMPLOYEES IN PRICE EXPIRATION ---------------------
NAMED OFFICER DATE GRANTED(1) FISCAL YEAR(2) PER SHARE DATE 5% 10%
- ------------------------ -------- ---------- -------------- --------- ---------- ---------------------

Tony Shahbaz............ 3/9/2004 59,000 46.7% $3.85 3/9/2009 $36,402 $105,420
Steve Gillings.......... 3/9/2004 13,000 10.3% $3.50 3/9/2014 $28,615 $72,515

- ----------
(1) The options vested immediately in the amount of 40% on the date of grant
with the balance vesting in equal monthly installments commencing April 9,
2004.
(2) Based on options to purchase 126,375 shares granted to our employees during
2004.
(3) Calculated using the potential realizable value of each grant.

AGGREGATED OPTION EXERCISES AND FISCAL YEAR-END VALUES

The following table provides information regarding the value of unexercised
options held by the named executive officers as of December 31, 2004. None of
the named executives officers acquired shares through the exercise of options
during 2004.

NUMBER OF
SECURITIES UNDERLYING VALUE ($) OF UNEXERCISED
UNEXERCISED OPTIONS AT IN-THE-MONEY OPTIONS AT
DECEMBER 31, 2004 DECEMBER 31, 2004 (1)
------------------------------ ------------------------------
NAME EXERCISABLE UNEXERCISABLE EXERCISABLE UNEXERCISABLE
- --------------------------- ----------- ------------- ----------- -------------

Tony Shahbaz............... 33,433 25,567 $ -- $ --
Steve Gillings............. 7,367 5,633 $ -- $ --

- ----------
(1) Based on the last reported sale price of our common stock of $3.75 on
December 31, 2004, as reported on the OTC Bulletin Board, less the exercise
price of the options.

EMPLOYMENT CONTRACTS AND TERMINATION OF EMPLOYMENT AND CHANGE-IN-CONTROL
ARRANGEMENTS

On October 15, 2002, we entered into an employment agreement with Tony
Shahbaz. Under the terms of the employment agreement, which were retroactively
effective as of January 1, 2002, Mr. Shahbaz serves as our President and Chief
Executive Officer and is entitled to receive an initial annual salary of
$198,500 and is eligible to receive quarterly bonuses equal to 7% of our
quarterly net income. Mr. Shahbaz is also entitled to a monthly car allowance
equal to $1,200. The employment agreement terminates on October 15, 2007;
however, it is subject to automatic renewal. Under the terms of the employment
agreement, if Mr. Shahbaz is terminated for cause, he is entitled to receive
four times his annual salary and any and all warrants and options granted to him
shall be extended an additional seven years from date of termination and upon
termination without cause, he is entitled to receive his remaining salary amount
for the remaining outstanding term of the agreement. Mr. Shahbaz's employment
agreement further provides that the agreement shall not be terminated without
the prior written consent of Mr. Shahbaz in the event of a merger, transfer of
assets, or dissolution of I/OMagic, and that the rights, benefits, and
obligations under the agreement shall be assigned to the surviving or resulting
corporation or the transferee of our assets.

BOARD COMMITTEES

Our board of directors currently has an Audit Committee, a Compensation
Committee and a Nominating Committee.

-50-

The Audit Committee selects our independent auditors, reviews the results
and scope of the audit and other services provided by our independent auditors
and reviews our financial statements for each interim period and for our year
end. Since November 2002, this committee has consisted of Mr. Hou and Mr. Yao.
Our board of directors has determined that Mr. Yao is an Audit Committee
financial expert. Our board of directors has also determined that Mr. Hou and
Mr. Yao are "independent" as defined in NASD Marketplace Rule 4200(a)(15). Our
Nominating Committee is presently conducting a search for a third independent
director to become a member of our audit committee in order to satisfy the
requirements of Nasdaq that we have an audit committee comprised of at least
three independent directors.

The Compensation Committee is responsible for establishing and
administering our policies involving the compensation of all of our executive
officers and establishing and recommending to our board of directors the terms
and conditions of all employee and consultant compensation and benefit plans.
Since April 2004, this committee has consisted of Mr. Hou and Mr. Yao.

The Nominating Committee selects nominees for the board of directors. Since
April 2004, the Nominating Committee has consisted of Mr. Hou and Mr. Yao. The
Nominating Committee utilizes a variety of methods for identifying and
evaluating nominees for director, including candidates that may be referred by
stockholders. Stockholders that desire to recommend candidates for evaluation
may do so by contacting I/OMagic in writing, identifying the potential candidate
and providing background information. Candidates may also come to the attention
of the Nominating Committee through current board members, professional search
firms and other persons. In evaluating potential candidates, the Nominating
Committee will take into account a number of factors, including, among others,
the following:

o independence from management;
o relevant business experience and industry knowledge;
o judgment, skill, integrity and reputation;
o existing commitments to other businesses;
o corporate governance background;
o financial and accounting background; and
o the size and composition of the board.

COMPENSATION COMMITTEE INTERLOCKS AND INSIDER PARTICIPATION

None of our executive officers served on the compensation committee of
another entity or on any other committee of the board of directors of another
entity performing similar functions during 2004. During 2003 and until April
2004, Mr. Shahbaz, our Chief Executive Officer, President and Secretary, was a
member of the Compensation Committee. While a member of that committee, Mr.
Shahbaz did not make any salary recommendations to our Compensation Committee or
our board of directors regarding salary increases for key executives.

COMPENSATION OF DIRECTORS

Our directors do not receive any compensation for their services, however
each director is entitled to reimbursement of his reasonable expenses incurred
in attending board of directors' meetings.

ITEM 12. SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT AND
RELATED STOCKHOLDER MATTERS

As of June 29, 2005, a total of 4,529,672 shares of our common stock were
outstanding. The following table sets forth information as of that date
regarding the beneficial ownership of our common stock by:

o each person known by us to own beneficially more than five percent, in
the aggregate, of the outstanding shares of our common stock as of the
date of the table;
o each of our directors;
o the named executive officers in the Summary Compensation Table
contained elsewhere in this Annual Report; and
o all of our directors and executive officers as a group.

Beneficial ownership is determined in accordance with the rules of the
Securities and Exchange Commission and generally includes voting or investment
power with respect to securities. Except as indicated in the footnotes to the
table, we believe each security holder possesses sole voting and investment
power with respect to all of the shares of common stock owned by such security
holder, subject to community property laws where applicable. In computing the

-51-

number of shares beneficially owned by a security holder and the percentage
ownership of that security holder, shares of common stock subject to options,
warrants or preferred stock held by that person that are currently exercisable
or convertible or are exercisable or convertible into shares of common stock
within 60 days after the date of the table are deemed outstanding. Those shares,
however, are not deemed outstanding for the purpose of computing the percentage
ownership of any other person or group.

AMOUNT AND NATURE
NAME AND ADDRESS OF BENEFICIAL PERCENT
OF BENEFICIAL OWNER(1) TITLE OF CLASS OWNERSHIP OF CLASS OF CLASS
- ---------------------- -------------- ------------------ --------

Tony Shahbaz.................................................. Common 2,398,991(2) 52.5%
Steel Su...................................................... Common 575,561(3) 12.7%
Sung Ki Kim................................................... Common 375,529(4) 8.3%
Daniel Yao.................................................... Common 342,918(5) 7.6%
Daniel Hou.................................................... Common 135,436(6) 3.0%
Steve Gillings................................................ Common 9,101(7) *
All executive officers and directors as a group (5 persons)... Common 3,462,007(8) 75.5%

- ------------
* Less than 1.0%

(1) Unless otherwise indicated, the address of each person in this table is c/o
I/OMagic Corporation, 4 Marconi, Irvine, CA 92618. Messrs. Shahbaz and
Gillings are executive officers of I/OMagic Corporation. Messrs. Shahbaz,
Su, Hou and Yao are directors.

(2) Consists of: (i) 510,795 shares of common stock and 41,299 shares of common
stock underlying options held individually by Mr. Shahbaz; (ii) 1,240,423
shares of common stock held by Susha, LLC, a California limited liability
company, or Susha California; (iii) 566,668 shares of common stock held by
Susha, LLC, a Nevada limited liability company, or Susha Nevada; and (iv)
39,806 shares of common stock held by King Eagle Enterprises, Inc., a
California corporation. Mr. Shahbaz has sole voting and sole investment
power over all of the shares held by Susha California and Susha Nevada. Mr.
Shahbaz and Behavior Tech Computer Corp. are equal owners of the membership
interests in Susha California and Susha Nevada.

(3) Consists of 406,794 shares of common stock and 2,100 shares of common stock
underlying options held individually by Mr. Su, and 166,667 shares of
common stock held by Behavior Tech Computer Corp. Mr. Su is the Chief
Executive Officer of Behavior Tech Computer Corp. and has sole voting and
sole investment power over the shares held by Behavior Tech Computer Corp.

(4) Represents 375,529 shares of common stock held by BTC Korea Co., Ltd., or
BTC Korea. Since October 22, 2003, Mr. Kim has served as Chief Executive
Officer and President of BTC Korea and has sole voting and sole investment
power over the shares held by BTC Korea. The address for Mr. Kim is c/o BTC
Korea Co., Ltd., 160-5, Kajwa-Dong Seo-Ku, Incheon City, Korea.

(5) Consists of 2,100 shares of common stock underlying options held
individually by Mr. Yao and 340,818 shares of common stock held by Citrine
Group Limited, a wholly owned subsidiary of Ritek Corporation. Mr. Yao
currently serves as the Chief Strategy Officer of Ritek Corporation. Mr.
Yao has sole voting and sole investment power over the shares held by
Citrine Group Limited. The address for Mr. Yao is c/o Citrine Group
Limited, No. 42, Kuanfu N. Road, 30316 R.O.C., HsinChu Industrial Park,
Taiwan.

(6) Consists of 2,100 shares of common stock underlying options held
individually by Mr. Hou, and 133,336 shares of common stock held by Hou
Electronics, Inc. Mr. Hou has sole voting and sole investment power over
the shares held by Hou Electronics, Inc.

(7) Consists of 9,101 shares of common stock underlying options held
individually by Mr. Gillings.

(8) Includes 56,700 shares of common stock underlying options.

EQUITY COMPENSATION PLAN INFORMATION

The following table provides information about our common stock that may be
issued upon the exercise of options, warrants, and rights under all of our
existing equity compensation plans as of December 31, 2004.

-52-

NUMBER OF SECURITIES
REMAINING AVAILABLE FOR
NUMBER OF SECURITIES TO WEIGHTED-AVERAGE FUTURE ISSUANCE UNDER
BE ISSUED UPON EXERCISE EXERCISE PRICE EQUITY COMPENSATION
OF OUTSTANDING OF OUTSTANDING OPTIONS, PLANS (EXCLUDING
OPTIONS, WARRANTS WARRANTS SECURITIES REFLECTED
AND RIGHTS AND RIGHTS IN COLUMN (A))
PLAN CATEGORY (A) (B) (C)
- ------------- ----------------------- ---------------------- -----------------------

Equity compensation plans approved by
security holders............................. 126,000 $ 3.67 407,334
Equity compensation plans not approved
by security holders ......................... -- $ -- --
Warrants issued for services................... 20,000 $ 5.00 --
----------- -------- ----------
Total 146,000 $ 3.85 407,334

ITEM 13. CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS

In January 2003, we entered into a trade credit facility with Lung Hwa
Electronics, one of our stockholders, subcontract manufacturers and suppliers.
Under the terms of the facility, Lung Hwa Electronics agreed to purchase
inventory on our behalf. We could purchase up to $10.0 million of this inventory
from Lung Hwa Electronics, with payment terms of 120 days following the date of
invoice. Lung Hwa Electronics charged us a 5% handling fee on a supplier's unit
price. A 2% discount of the handling fee, so that the net handling fee is 3%,
was applied if we reached an average running monthly purchasing volume of
$750,000. Returns made by us, which were agreed to by a supplier, resulted in a
credit to us for the handling charge. As security for the trade credit facility,
we paid Lung Hwa Electronics a $1.5 million security deposit during 2003. As of
December 31, 2004, $1.5 million of this deposit had been applied against
outstanding trade payables as allowed under the trade credit facility agreement.
This trade credit facility was for an indefinite term, however, either party had
the right to terminate the facility upon 30 days' written notice to the other
party. In connection with the entry into the new trade credit facility with Lung
Hwa Electronics described below, we entered into a Termination Agreement
effective June 6, 2005 that terminated our $10.0 million trade credit facility
with Lung Hwa Electronics.

On June 6, 2005, we entered into a new trade credit facility with Lung Hwa
Electronics. Under the terms of the new facility, Lung Hwa Electronics has
agreed to purchase and manufacture inventory on our behalf. We can purchase up
to $15.0 million of inventory through Lung Hwa Electronics as an international
purchasing office or manufactured by Lung Hwa Electronics. For inventory
purchased through Lung Hwa Electronics, the payment terms are 120 days following
the date of invoice by Lung Hwa Electronics. Lung Hwa Electronics charges us a
5% handling fee on a supplier's unit price. A 2% discount of the handling fee is
applied if we reach an average running monthly purchasing volume of $750,000.
Returns made by us, which are agreed to by a supplier, result in a credit to us
for the handling charge. For inventory manufactured by Lung Hwa Electronics, the
payment terms are 90 days following the date of invoice by Lung Hwa Electronics.
Upon effectiveness of the trade credit facility, we paid $1.5 million to Lung
Hwa Electronics as an early payment for all invoices coming due for payment. Any
early payment funds remaining three months after the date of the commencement of
the trade credit facility are to be refunded to us immediately. Once the $1.5
million has been exhausted, or three months from the date of the commencement of
the trade credit facility has expired, whichever is sooner, we are to pay Lung
Hwa Electronics, within one week of the purchase order, 10% of the purchase
price on any purchase orders issued to Lung Hwa Electronics as a down-payment
for the order. The trade credit facility has an initial term of one year after
which the facility will continue indefinitely if not terminated at the end of
the initial term. At the end of the initial term and at any time thereafter,
either party has the right to terminate the facility upon 30 days' prior written
notice to the other party.

As of December 31, 2004, we owed Lung Hwa Electronics $0 million in trade
payables. During 2004, we purchased $2.5 million of inventory from Lung Hwa
Electronics. During 2003, we purchased $12.7 million of inventory from Lung Hwa
Electronics. During 2002, we purchased no inventory from Lung Hwa Electronics.

We believe that many of the terms available to us under our trade credit
facility with Lung Hwa Electronics are advantageous as compared to terms
available from unrelated third parties. For example, Lung Hwa Electronics
extends us 120 day payment terms. We believe that the best payment terms that we
could likely obtain from unrelated third parties would be 60-day payment terms;
however, payment in advance or within 30 days is more customary. Also, Lung Hwa
Electronics charges us a 5% handling fee on a supplier's unit price, but applies
a 2% discount of the handling fee, so that the net handling fee is 3%, if we
reach an average running monthly purchasing volume of $750,000. In addition,
under our trade credit facility with Lung Hwa Electronics, the level of security
provided by us to Lung Hwa Electronics was initially $1.5 million, which we
expect will ultimately be $0, and thereafter will only be 10% of each product
order, for a $15.0 million trade credit facility. We believe that the payment
terms, handling fee and the level of security required are all substantially
better terms that we could obtain from unrelated third parties. In fact, we
believe that our trade credit facility is likely unique and could not be
replaced through a relationship with an unrelated third party.

Our relationship and our trade credit facility with Lung Hwa Electronics
enables us to acquire products from manufacturers who we believe are some of the
largest electronics manufacturers in the world. We buy products through Lung Hwa
Electronics by using Lung Hwa Electronics' size and purchasing power as a source
of credit strength. If we were to acquire these products directly from the
manufacturers, we would likely be required to send payment in advance of
shipment of those products. Due to our relatively small size, we would likely be
unable to qualify for extended payment terms of even 30 days. Accordingly, we
believe that our relationship and trade credit facility with Lung Hwa
Electronics is likely unique, could not be replaced through a relationship with
an unrelated third party and is important in enabling us to secure certain
products that we sell.

In February 2003, we entered into a Warehouse Services and Bailment
Agreement with BTC USA, an affiliate of several of our stockholders, namely BTC,
BTC Korea Co., Ltd., Behavior Tech Computer (BVI) Corp. and BTC Taiwan, as well
as an affiliate of one of our principal subcontract manufacturers, namely
Behavior Tech Computer Corp. Under the terms of the agreement, BTC USA has
agreed to supply and store at our warehouse up to $10.0 million of inventory on
a consignment basis. We are responsible for insuring the consigned inventory,
storing the consigned inventory for no charge; and furnishing BTC USA with
weekly statements indicating all products received and sold and the current
level of consigned inventory. The agreement also provides us with a trade line
of credit of up to $10.0 million with payment terms of net 60 days, without
interest. The agreement may be terminated by either party upon 60 days' prior
written notice to the other party. As of December 31, 2004, we owed BTC USA $7.3
million under this arrangement. As of December 31, 2003, we owed BTC USA $8.3
million under this arrangement. During 2004, we purchased $19.2 million of
inventory from BTC USA. During 2003 we purchased $20.1 million of inventory from

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BTC USA. Steel Su, a director of I/OMagic, is the Chief Executive Officer of
BTC. BTC USA, its affiliates and Mr. Su also have beneficial ownership in or are
otherwise affiliated with the following affiliates of BTC and BTC USA: BTC Korea
Co., Ltd., Behavior Tech Computer (BVI) Corp., BTC Taiwan, Susha, LLC, a Nevada
limited liability company, and Susha, LLC, a California limited liability
company, each of which is also a stockholder of our company. Mr. Shahbaz, our
Chief Executive Officer, President, Secretary and a Director, also has
beneficial ownership in, and sole voting control of, Susha, LLC, a Nevada
limited liability company, and Susha, LLC, a California limited liability
company. See "Security Ownership of Certain Beneficial Owners and Management and
Related Stockholder Matters."

We believe that many of the terms available to us under our Warehouse
Services and Bailment Agreement with BTC USA are advantageous as compared to
terms available from unrelated third parties. For example, this Agreement allows
us to store up to $10.0 million of consigned inventory at our warehouse, without
obligation to pay BTC USA for the inventory until 60 days after we take title to
the inventory. We believe that it is unlikely that unrelated third parties would
permit this consignment arrangement and that we would instead be subject to
standard payment terms, the best of which would likely be 60-day payment terms;
however, either payment in advance or within 30 days is more customary. Our
$10.0 million line of credit with 60 days payment terms without interest may
also permit terms better than we could obtain from unrelated third parties. The
best payment terms under a line of credit with a unrelated third party
subcontract manufacturer or supplier would likely be 60 day payment terms;
however, payment in advance or within 30 days is more customary.

Our relationships with Lung Hwa Electronics and BTC USA provide us with
numerous advantages. We believe that both entities are significant suppliers
within their industries and have substantial manufacturing and product
development capabilities and resources. The advantageous terms we are able to
obtain from them allow us to utilize more capital resources for other aspects of
our business and to remain competitive with larger, more established companies.
In addition, we are better able to manage our cash flow as a result of our
significant trade line of credit with Lung Hwa Electronics and our consignment
arrangement with BTC USA. We believe that these advantageous terms contribute
positively to our results of operations.

In the past, equity investments by Lung Hwa Electronics and BTC USA, or its
affiliates, have enabled us to obtain inventory with little or no cash
expenditures, which we believe has helped us establish, maintain and grow our
business. We believe that our relationships with these related parties has in
the past benefited our business and contributed positively to our historical
results of operations.

We leased our previous facility, located in Santa Ana, California, from
January 2001 through September 2003 from Alex Properties, an entity owned
through late March 2003 by Mr. Shahbaz, our Chief Executive Officer, President,
Secretary and Director, and Mr. Su, a director and beneficial owner of I/OMagic.
In late March 2003, the ownership of Alex Properties was transferred to Mark
Vakili as part of the settlement of a lawsuit. See "Business -- Legal
Proceedings" elsewhere in this report. In 2003, we paid $86,000 to Alex
Properties for rent while it was owned by Mr. Shahbaz and Mr. Su.

We are a party to an employment agreement with Mr. Shahbaz, our Chief
Executive Officer, President, Secretary and a Director. See "Management --
Employment Contracts and Termination of Employment and Change-in-Control
Arrangements."

-54-

ITEM 14. PRINCIPAL ACCOUNTANT FEES AND DISCLOSURES

The following table sets forth the aggregate fees billed to us by Singer
Lewak Greenbaum & Goldstein LLP for professional services rendered for the years
ended December 31, 2004 and 2003

FEE CATEGORY 2004 2003
- ------------ ---- ----
Audit Fees..................................... $ 171,000 $ 237,000
Audit-Related Fees............................. 349,000 --
Tax Fees....................................... 10,000 18,000
All Other Fees................................. -- --
---------- ----------
Total $ 530,000 $ 255,000

AUDIT FEES. Consists of fees billed for professional services rendered for
the audit of I/OMagic's consolidated financial statements and review of the
interim consolidated financial statements included in quarterly reports and
services that are normally provided by Singer Lewak Greenbaum & Goldstein LLP in
connection with statutory and regulatory filings or engagements.

AUDIT-RELATED FEES. Consists of fees billed for professional services for
consents relating to I/OMagic's registration statement, and amendments thereto,
on Form S-1.

TAX FEES. Consists of fees billed for professional services for tax
compliance, tax advice and tax planning. These services include assistance
regarding federal, state and international tax compliance, tax audit defense,
customs and duties, mergers and acquisitions, and international tax planning.

Our audit committee pre-approves all services provided by Singer Lewak
Greenbaum & Goldstein LLP.

PART IV

ITEM 15. EXHIBITS, FINANCIAL STATEMENT SCHEDULES

(a)(1), (a)(2) and (d) Financial Statements and Financial Statement Schedules

Reference is made to the financial statements and financial statement
schedule listed on and attached following the Index to Consolidated Financial
Statements and Supplemental Information contained on page F-1 of this report.

(a)(3) and (c) Exhibits

Reference is made to the exhibits listed on the Index to Exhibits that
follows the financial statements and financial statement schedule.

-55-

I/OMAGIC CORPORATION
AND SUBSIDIARY
INDEX TO RESTATED CONSOLIDATED FINANCIAL STATEMENTS
AND SUPPLEMENTAL INFORMATION
DECEMBER 31, 2004

PAGE
----

REPORT OF INDEPENDENT REGISTERED PUBLIC ACCOUNTING FIRM................... F-2

RESTATED CONSOLIDATED FINANCIAL STATEMENTS

Restated Consolidated Balance Sheets.................................. F-3

Restated Consolidated Statements of Operations........................ F-4

Restated Consolidated Statements of Stockholders' Equity.............. F-5

Restated Consolidated Statements of Cash Flows........................ F-6

Notes to Restated Consolidated Financial Statements................... F-8

SUPPLEMENTAL INFORMATION

Report of Independent Registered Public Accounting Firm on
Restated Financial Statement Schedule............................... F-33

Valuation and Qualifying Accounts--Schedule II........................ F-34

F-1

REPORT OF INDEPENDENT REGISTERED PUBLIC ACCOUNTING FIRM

To the Board of Directors
I/OMagic Corporation and subsidiary
Irvine, California

We have audited the accompanying consolidated balance sheets of I/OMagic
Corporation and subsidiary as of December 31, 2004 and 2003 (restated), and the
related consolidated statements of operations, stockholders' equity, and cash
flows for the year ended December 31, 2004, and for each of the two years in the
period ended December 31, 2003 (restated). These financial statements are the
responsibility of the Company's management. Our responsibility is to express an
opinion on these financial statements based on our audits.

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

In our opinion, the consolidated financial statements referred to above present
fairly, in all material respects, the consolidated financial position of
I/OMagic Corporation and subsidiary as of December 31, 2004 and 2003 (restated),
and the results of their operations and their cash flows for the year ended
December 31, 2004 and for each of the two years in the period ended December 31,
2003 (restated) in conformity with accounting principles generally accepted in
the United States of America.

As described in Note 2 to the financial statements, the Company has restated its
financial statements for each of the two years in the period ended December 31,
2003 for a correction of errors related to recording certain product returns,
sales incentives and rebate promotions.

/s/ SINGER LEWAK GREENBAUM & GOLDSTEIN LLP

Los Angeles, California
April 18, 2005

F-2

I/OMAGIC CORPORATION
AND SUBSIDIARY
CONSOLIDATED BALANCE SHEETS

DECEMBER 31,
---------------------------
2004 2003
------------ ------------
(RESTATED)(1)

CURRENT ASSETS
Cash and cash equivalents ........................................................... $ 3,587,807 $ 4,005,705
Restricted cash ..................................................................... 1,044,339 2,185,664
Accounts receivable, net of allowance for doubtful accounts of $24,946 and $20,553 .. 14,598,422 18,439,893
Inventory, net of allowance for obsolete inventory of $1,463,214 and $505,029 ....... 6,146,766 9,706,708
Inventory in transit ................................................................ 513,672 --
Prepaid expenses and other current assets ........................................... 741,244 407,260
------------ ------------
Total current assets ........................................................ 26,632,250 34,745,230
PROPERTY AND EQUIPMENT, net ............................................................. 307,661 539,943
TRADEMARKS, net of accumulated amortization of $5,449,780 and $4,871,044 ................ 499,800 4,774,635
OTHER ASSETS ............................................................................ 27,032 52,984
------------ ------------
TOTAL ASSETS ................................................................ $ 27,466,743 $ 40,112,792
============ ============

- ---------------
(1) See Notes to Restated Consolidated Financial Statements - "Note 2 - Restatement of 2000, 2001, 2002 and 2003
Financial Statements."

LIABILITIES AND STOCKHOLDERS' EQUITY

DECEMBER 31,
---------------------------
2004 2003
------------ ------------
(RESTATED)(1)
CURRENT LIABILITIES
Line of credit ...................................................................... $ 5,962,891 $ 5,938,705
Accounts payable and accrued expenses ............................................... 5,221,719 5,572,879
Accounts payable - related parties .................................................. 7,346,596 10,370,119
Reserves for product returns and sales incentives ................................... 573,570 812,258
Current portion of settlement payable ............................................... -- 1,000,000
------------ ------------
Total liabilities ........................................................... 19,104,776 23,693,961
------------ ------------

STOCKHOLDERS' EQUITY
Preferred stock, $0.001 par value 10,000,000 shares authorized
Series A, 1,000,000 shares authorized, 0 and 0 shares issued and outstanding -- --
Series B, 1,000,000 shares authorized, 0 and 0 shares issued and outstanding -- --
Common stock, $0.001 par value 100,000,000 shares authorized 4,529,672 and 4,529,672
shares issued and outstanding .................................................... 4,530 4,530
Additional paid-in capital .......................................................... 31,557,988 31,557,988
Treasury stock, 13,493 and 13,493 shares, at cost ................................... (126,014) (126,014)
Accumulated deficit ................................................................. (23,074,537) (15,017,673)
------------ ------------
Total stockholders' equity .................................................. 8,361,967 16,418,831
------------ ------------
TOTAL LIABILITIES AND STOCKHOLDERS' EQUITY .................................. $ 27,466,743 $ 40,112,792
============ ============

- ---------------
(1) See Notes to Restated Consolidated Financial Statements - "Note 2 - Restatement of 2000, 2001, 2002 and 2003
Financial Statements."

The accompanying Notes are an integral part of these financial statements.

F-3

I/OMAGIC CORPORATION
AND SUBSIDIARY
CONSOLIDATED STATEMENTS OF OPERATIONS

YEARS ENDED DECEMBER 31,
--------------------------------------------
2004 2003 2002
------------ ------------ ------------
(RESTATED)(1) (RESTATED)(1)

NET SALES .................................................. $ 44,396,551 $ 63,587,454 $ 80,952,712
COST OF SALES .............................................. 41,418,750 54,643,371 73,564,456
------------ ------------ ------------
GROSS PROFIT ............................................... 2,977,801 8,944,083 7,388,256
------------ ------------ ------------
OPERATING EXPENSES
Selling, marketing, and advertising ................ 1,008,248 1,507,222 1,437,704
General and administrative ......................... 5,343,125 6,461,613 7,360,904
Depreciation and amortization ...................... 833,545 1,268,077 1,223,837
Impairment of trademarks .......................... 3,696,099 -- --
------------ ------------ ------------
Total operating expenses ................... 10,881,017 9,236,912 10,022,445
------------ ------------ ------------
LOSS FROM OPERATIONS ....................................... (7,903,216) (292,829) (2,634,189)
------------ ------------ ------------
OTHER INCOME (EXPENSE)
Interest income .................................... 430 378 2,047
Interest expense ................................... (201,310) (248,754) (385,948)
Currency transaction gain (loss) ................... 49,764 55,693 --
Settlement expense and related legal costs ......... -- -- (5,179,891)
Gain (loss) on disposal of property and equipment .. -- (61) 38,759
Other income (expense) ............................. -- (1,593) --
------------ ------------ ------------
Total other income (expense) ............... (151,116) (194,337) (5,525,033)
------------ ------------ ------------
LOSS BEFORE PROVISION FOR (BENEFIT FROM) INCOME TAXES ...... (8,054,332) (487,166) (8,159,222)
PROVISION FOR (BENEFIT FROM) INCOME TAXES .................. 2,532 (27,148) 685,372
------------ ------------ ------------
NET LOSS ................................................... $ (8,056,864) $ (460,018) $ (8,844,594)
============ ============ ============
BASIC AND DILUTED LOSS PER SHARE ........................... $ (1.78) $ (0.10) $ (1.95)
============ ============ ============
BASIC AND DILUTED WEIGHTED-AVERAGE SHARES OUTSTANDING ...... 4,529,672 4,529,672 4,528,894
============ ============ ============

- ---------------
(1) See Notes to Restated Consolidated Financial Statements - "Note 2 - Restatement of 2000, 2001, 2002
and 2003 Financial Statements."

The accompanying Notes are an integral part of these financial statements.

F-4

I/OMAGIC CORPORATION
AND SUBSIDIARY
CONSOLIDATED STATEMENTS OF STOCKHOLDERS' EQUITY

PREFERRED STOCK
SERIES A ---------------------------- SERIES B
------------ ------------
ADDITIONAL ADDITIONAL
PAID-IN PAID-IN
SHARES AMOUNT CAPITAL SHARES AMOUNT CAPITAL
------------ ------------ ------------ ------------ ------------ ------------

BALANCE, DECEMBER 31, 2001 AS
ORIGINALLY STATED...................... 875,000 $ 875 $ 6,999,125 250,000 $ 250 $ 1,999,750
OPENING BALANCE ADJUSTMENT ................ -- -- -- -- -- --
BALANCE, DECEMBER 31, 2001 (RESTATED)(1) .. 875,000 875 6,999,125 250,000 250 1,999,750
PURCHASE OF TREASURY STOCK ................ -- -- -- -- -- --
REPURCHASE OF SERIES A - REDEEMABLE
CONVERTIBLE PREFERRED STOCK ........... (875,000) (875) (6,999,125) -- -- --
REPURCHASE OF SERIES B - REDEEMABLE
CONVERTIBLE PREFERRED STOCK ........... -- -- -- (250,000) (250) (1,999,750)
ISSUANCE OF COMMON STOCK IN CONNECTION
WITH THE EXERCISE OF WARRANTS ......... -- -- -- -- -- --
NET LOSS .................................. -- -- -- -- -- --
------------ ------------ ------------ ------------ ------------ ------------
BALANCE, DECEMBER 31, 2002 (RESTATED)(1) .. -- -- -- -- -- --
------------ ------------ ------------ ------------ ------------ ------------
PURCHASE OF TREASURY STOCK ................ -- -- -- -- -- --
NET LOSS .................................. -- -- -- -- -- --
------------ ------------ ------------ ------------ ------------ ------------
BALANCE, DECEMBER 31, 2003 (RESTATED)(1) .. -- -- -- -- -- --
------------ ------------ ------------ ------------ ------------ ------------
NET LOSS .................................. -- -- -- -- -- --
------------ ------------ ------------ ------------ ------------ ------------
BALANCE, DECEMBER 31, 2004 ................ -- $ -- $ -- -- $ -- $ --
------------ ------------ ------------ ------------ ------------ ------------

(CONTINUED ON PAGE F-5A)

F-5

(CONTINUED FROM PAGE F-5)

COMMON STOCK ADDITIONAL
--------------------------- PAID-IN TREASURY ACCUMULATED
SHARES AMOUNT CAPITAL STOCK DEFICIT TOTAL
------------ ------------ ------------ ------------ ------------ ------------

BALANCE, DECEMBER 31, 2001 AS
ORIGINALLY STATED...................... 4,528,839 $ 4,529 $ 31,557,359 $ -- $(14,446,237) $ 26,115,651
OPENING BALANCE ADJUSTMENT ................ -- -- -- -- 733,176 733,176
BALANCE, DECEMBER 31, 2001 (RESTATED)(1) .. 4,528,839 4,529 31,557,359 -- (13,713,061) 26,848,827
PURCHASE OF TREASURY STOCK ................ -- -- -- (42,330) -- (42,330)
REPURCHASE OF SERIES A - REDEEMABLE
CONVERTIBLE PREFERRED STOCK ........... -- -- -- -- 6,222,222 (777,778)
REPURCHASE OF SERIES B - REDEEMABLE
CONVERTIBLE PREFERRED STOCK ........... -- -- -- -- 1,777,778 (222,222)
ISSUANCE OF COMMON STOCK IN CONNECTION
WITH THE EXERCISE OF WARRANTS ......... 833 1 629 -- -- 630
NET LOSS .................................. -- -- -- -- (8,844,594) (8,844,594)
------------ ------------ ------------ ------------ ------------ ------------
BALANCE, DECEMBER 31, 2002 (RESTATED)(1) .. 4,529,672 4,530 31,557,988 (42,330) (14,557,655) 16,962,533
------------ ------------ ------------ ------------ ------------ ------------
PURCHASE OF TREASURY STOCK ................ -- -- -- (83,684) -- (83,684)
NET LOSS .................................. -- -- -- -- (460,018) (460,018)
------------ ------------ ------------ ------------ ------------ ------------
BALANCE, DECEMBER 31, 2003 (RESTATED)(1) .. 4,529,672 4,530 31,557,988 (126,014) (15,017,673) 16,418,831
------------ ------------ ------------ ------------ ------------ ------------
NET LOSS .................................. -- -- -- -- (8,056,864) (8,056,864)
------------ ------------ ------------ ------------ ------------ ------------
BALANCE, DECEMBER 31, 2004 ................ 4,529,672 $ 4,530 $ 31,557,988 $ (126,014) $(23,074,537) $ 8,361,967
------------ ------------ ------------ ------------ ------------ ------------

- ---------------
(1) See Notes to Restated Consolidated Financial Statements - "Note 2 - Restatement of 2000, 2001, 2002 and 2003 Financial
Statements."

The accompanying Notes are an integral part of these financial statements.

F-5A

I/OMAGIC CORPORATION
AND SUBSIDIARY
CONSOLIDATED STATEMENTS OF CASH FLOWS

YEAR ENDED DECEMBER 31,
--------------------------------------------
2004 2003 2002
------------ ------------ ------------
(RESTATED)(1) (RESTATED)(1)

CASH FLOWS FROM OPERATING ACTIVITIES
Net loss ............................................................. $ (8,056,864) $ (460,018) $ (8,844,594)
Adjustments to reconcile net income (loss) to net cash
provided by (used in) operating activities
Depreciation and amortization .................................. 254,809 689,341 307,505
(Gain) loss on disposal of property and equipment .............. -- 61 (38,759)
Amortization of trademarks ..................................... 578,736 578,736 916,332
Impairment of trademarks ....................................... 3,696,099 -- --
Allowance for doubtful accounts ................................ 200,000 1,478,089 1,300,000
Reserves for product returns and sales incentives .............. (238,688) 282,176 (1,587,257)
Reserves for obsolete inventory ................................ 2,046,217 125,000 1,670,200
Valuation allowance on deferred income taxes ................... -- -- 777,045
(Increase) decrease in
Accounts receivable ......................................... 3,641,471 (862,783) 7,489,342
Inventory ................................................... 1,000,052 (916,430) 1,426,227
Prepaid expenses and other current assets ................... (333,984) (378,304) 2,263,469
Other assets ................................................ 25,952 (27,032) 14,288
Increase (decrease) in
Accounts payable and accrued expenses ....................... (351,160) (1,712,369) (3,467,787)
Accounts payable--related parties ........................... (3,023,523) 7,762,841 (2,965,802)
Settlement payable .......................................... (1,000,000) (3,000,000) 4,000,000
------------ ------------ ------------
Net cash provided by (used in) operating activities .................. (1,560,883) 3,559,308 3,260,209
------------ ------------ ------------
CASH FLOWS FROM INVESTING ACTIVITIES
Proceeds from disposal of property and equipment .................... -- 500 74,000
Restricted cash ..................................................... 1,141,325 (3,632) (2,182,032)
Purchase of property and equipment .................................. (22,526) (170,776) (135,597)
------------ ------------ ------------
Net cash provided by (used in) investing activities ................. 1,118,799 (173,908) (2,243,629)
------------ ------------ ------------
CASH FLOWS FROM FINANCING ACTIVITIES
Net borrowings (payments) on line of credit ......................... 24,186 (4,434,122) 750,586
Payments on capital lease obligations ............................... -- -- (10,978)
Purchase of treasury stock .......................................... -- (83,684) (42,330)
Payments on repurchase of redeemable convertible preferred stock .... -- -- (1,000,000)
Proceeds from exercise of warrants .................................. -- -- 630
------------ ------------ ------------
Net cash provided by (used in) financing activities ..................... 24,186 (4,517,806) (302,092)
------------ ------------ ------------
Net increase (decrease) in cash and cash equivalents .................... (417,898) (1,132,406) 714,488
CASH AND CASH EQUIVALENTS, BEGINNING OF PERIOD .......................... 4,005,705 5,138,111 4,423,623
------------ ------------ ------------
CASH AND CASH EQUIVALENTS, END OF PERIOD ................................ $ 3,587,807 $ 4,005,705 $ 5,138,111
============ ============ ============
SUPPLEMENTAL DISCLOSURES OF CASH FLOW INFORMATION
INTEREST PAID ........................................................... $ 192,488 $ 229,379 $ 363,171
============ ============ ============
INCOME TAXES PAID (REFUNDED) ............................................ $ 2,532 $ (3,083) $ (91,055)
============ ============ ============

- ---------------
(1) See Notes to Restated Consolidated Financial Statements - "Note 2 - Restatement of 2000, 2001, 2002 and 2003
Financial Statements."

The accompanying Notes are an integral part of these financial statements.

F-6

I/OMAGIC CORPORATION
AND SUBSIDIARY
CONSOLIDATED STATEMENTS OF CASH FLOWS
- --------------------------------------------------------------------------------

SUPPLEMENTAL SCHEDULE OF NON-CASH INVESTING AND FINANCING ACTIVITIES

The Company did not have any non-cash transactions during the year ended
December 31, 2004 and 2003.

During the year ended December 31, 2002, the Company entered into the
following non-cash transactions:

o Paid $1.0 million to repurchase 875,000 shares of Series A redeemable
convertible preferred stock and 250,000 shares of Series B redeemable
convertible preferred stock, valued at $7.0 million and $2.0 million,
respectively. The gain on repurchase of $8.0 million was netted against
accumulated deficit in the consolidated balance sheet.

F-7

I/OMAGIC CORPORATION
AND SUBSIDIARY
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
- --------------------------------------------------------------------------------

NOTE 1 - ORGANIZATION AND BUSINESS

I/OMagic Corporation ("I/OMagic"), a Nevada corporation, and its subsidiary
(collectively, the "Company") develops, manufactures through subcontractors
or obtains from suppliers, markets, and distributes data storage and
digital entertainment products for the consumer electronics market. The
Company sells its products in the United States and Canada to distributors
and retailers. On July 6, 2004 the Company completed the merger of its
wholly owned subsidiary, I/OMagic Corporation, a California corporation,
with and into the Company.

NOTE 2 - RESTATEMENT OF 2000, 2001, 2002 AND 2003 FINANCIAL STATEMENTS

The Company previously accounted for its sales incentives by reducing gross
sales at the time sales incentives were offered to its retailers. Upon
further examination of its accounting methodology for sales incentives, and
a quantitative analysis of its historical sales incentives, the Company
determined that it made an error in its application of the relevant
accounting principles under SFAS 48, as interpreted under Topic 13, and
determined that it should have estimated and recorded sales incentives at
the time its products were sold. Under SFAS 48, as interpreted under Topic
13, the eventual sales price must be fixed or determinable before revenue
can be recognized. Due to the nature and extent of the Company's sales
incentive history, the Company should have been assessing its revenue
recognition criteria to determine whether it was able to effectively
estimate or determine its eventual sales price. The Company has determined
the effect of the correction on its previously issued financial statements
and has restated the accompanying financial statements for the year ended
December 31, 2002 and 2003 and has restated the financial information below
for the years ended December 31, 2001, 2002 and 2003.

The Company previously accounted for product returns using a method that
did not take into account the different return characteristics of
categories of similar products and also did not adequately take into
account the variability over time of product return rates. The Company
conducted a quantitative analysis of its historical product return data to
determine moving averages of product return rates by groupings of similar
products. Following completion of this analysis, the Company determined
that it made an error in its method of estimating product returns. The
Company has determined the effect of the correction on its previously
issued financial statements and has restated the accompanying financial
statements for the year ended December 31, 2002 and 2003 and has restated
the financial information below for the years ended December 31, 2001, 2002
and 2003.

The Company previously accounted for an adjustment reducing rebate
promotions for $1.5 million in the year 2002 as a change in estimate. The
Company determined that it had made an error in its accounting for the
adjustment and reallocated the adjustment to the years 1998 through 2002
based on the pro-rata amount of rebate promotions recorded in each of those
years. The Company has determined the effect of the correction on its
previously issued financial statements and has restated the accompanying
financial statements for the years ended December 31, 2002 and 2003 and has
restated the financial information below for the years ended December 31,
2000, 2001, 2002 and 2003.

The Company has recalculated its provision for income taxes for the years
ended December 31, 2001 and 2002 as a result of the restatements for sales
incentives, product returns and rebate promotions, and has restated the
financial information below for the years ended December 31, 2000, 2001,
2002 and 2003.

The effects of the restatement on net sales, cost of sales, gross profit,
net loss, basic and diluted loss per common share, accounts payable and
accrued expenses, and stockholders' equity as of and for the year ended
December 31, 2000 are as follows:

F-8

I/OMAGIC CORPORATION
AND SUBSIDIARY
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
- --------------------------------------------------------------------------------

AS ORIGINALLY RESTATEMENT
REPORTED ADJUSTMENTS AS RESTATED
-------- ----------- -----------

Net sales ............................................. $ 60,805,437 $ 242,664 $ 61,048,101
Cost of sales ......................................... 53,126,489 -- 53,126,489
Gross profit .......................................... 7,678,948 242,664 7,921,612
Net income (loss) ..................................... $ (6,410,849) $ 242,664 $ (6,168,185)

PROFIT (LOSS) PER COMMON SHARE:
Basic .............................................. $ (2.44) $ 0.09 $ (2.35)
Diluted ............................................ $ (2.44) $ 0.09 $ (2.35)
Accounts payable and accrued expenses ................. $ 5,584,951 $ (563,400) $ 5,021,551
Stockholders' equity .................................. $ 22,659,571 $ 563,400 $ 23,222,971

NOTE 2 - RESTATEMENT OF 2000, 2001, 2002 AND 2003 FINANCIAL STATEMENTS
(CONTINUED)

The effects of the restatement on net sales, cost of sales, gross profit,
net loss, basic and diluted loss per common share, reserves for product
returns, sales incentives and rebate promotions, accounts payable and
accrued expenses, and stockholders' equity as of and for the year ended
December 31, 2001 are as follows:

AS ORIGINALLY RESTATEMENT
REPORTED ADJUSTMENTS AS RESTATED
-------- ----------- -----------

Net sales ............................................. $ 67,788,959 $ 323,352 $ 68,112,311
Cost of sales ......................................... 62,776,334 (824,693) 61,951,641
Gross profit .......................................... 5,012,625 1,148,045 6,160,670
Provision for income taxes ............................ 3,000 978,266 981,266
Net income (loss) ..................................... $ (5,547,645) $ 169,779 $ (5,377,866)

PROFIT (LOSS) PER COMMON SHARE:
Basic .............................................. $ (1.23) $ 0.04 $ (1.19)
Diluted ............................................ $ (1.23) $ 0.04 $ (1.19)
Reserves for product returns and sales incentives ..... $ 2,605,679 $ (488,343) $ 2,117,336
Accounts payable and accrued expenses ................. $ 12,027,498 $ (1,223,102) $ 10,804,396
Stockholders' equity .................................. $ 17,115,651 $ 733,179 $ 17,848,830

The effects of the restatement on net sales, cost of sales, gross profit,
provision for (benefit from) income taxes, net loss, basic and diluted loss
per common share, reserves for product returns, sales incentives and rebate
promotions, and stockholders' equity as of and for the year ended December
31, 2002 are as follows:

AS ORIGINALLY RESTATEMENT
REPORTED ADJUSTMENTS AS RESTATED
-------- ----------- -----------

Net sales ............................................. $ 83,529,708 $ (2,576,996) $ 80,952,712
Cost of sales ......................................... 74,665,823 (1,101,367) 73,564,456
Gross profit .......................................... 8,863,885 (1,475,629) 7,388,256
Provision for (benefit from) income taxes ............. 1,663,638 (978,266) 685,372
Net loss .............................................. $ (8,347,231) $ (497,363) $ (8,844,594)

LOSS PER COMMON SHARE:
Basic .............................................. $ (1.84) $ (0.11) $ (1.95)
Diluted ............................................ $ (1.84) $ (0.11) $ (1.95)
Reserves for product returns and sales incentives ..... $ 765,898 $ (235,816) $ 530,082
Stockholders' equity .................................. $ 16,726,720 $ 235,816 $ 16,962,536

F-9

I/OMAGIC CORPORATION
AND SUBSIDIARY
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
- --------------------------------------------------------------------------------

NOTE 2 - RESTATEMENT OF 2000, 2001, 2002 AND 2003 FINANCIAL STATEMENTS
(CONTINUED)

The effects of the restatement on net sales, cost of sales, gross profit,
net loss, basic and diluted loss per common share, reserves for product
returns, sales incentives and rebate promotions, and stockholders' equity
as of and for the year ended December 31, 2003 are as follows:

AS ORIGINALLY RESTATEMENT
REPORTED ADJUSTMENTS AS RESTATED
-------- ----------- -----------

Net sales ............................................ $ 62,222,513 $ 1,364,941 $ 63,587,454
Cost of sales ........................................ 53,083,729 1,559,642 54,643,371
Gross profit ......................................... 9,138,784 (194,701) 8,944,083
Net income (loss) .................................... $ (265,317) $ (194,701) $ (460,018)

PROFIT (LOSS) PER COMMON SHARE:
Basic ............................................. $ (0.06) $ (0.04) $ (0.10)
Diluted ........................................... $ (0.06) $ (0.04) $ (0.10)
Reserves for product returns, sales incentives and
rebate promotions .................................. $ 853,373 $ (41,115) $ 812,258
Stockholders' equity ................................. $ 16,377,717 $ 41,115 $ 16,418,832

NOTE 3 - SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES

Principles of Consolidation
---------------------------

The consolidated financial statements include the accounts of I/OMagic and
its subsidiary, IOM Holdings, Inc. All material intercompany accounts and
transactions have been eliminated.

Stock Split
-----------

On December 6, 2002, the Company amended its Articles of Incorporation to
effect a 1-for-15 reverse stock split as of December 20, 2002. All share
and per share data have been retroactively restated to reflect this reverse
stock split.

Revenue Recognition
-------------------

The Company recognizes revenue in accordance with Staff Accounting Bulletin
("SAB") 101, "Revenue Recognition", updated by SAB's 103 and 104, "Update
of Codification of Staff Accounting Bulletins." Under SAB 104, revenue is
recognized when persuasive evidence of an arrangement exists, delivery has
occurred or services have been rendered, the seller's price to the buyer is
fixed or determinable, and collectibility is reasonably assured. The
Company applies the specific provisions of Statement of Financial
Accounting Standards ("SFAS") No. 48, "Revenue Recognition when Right of
Return Exists." Under SFAS No. 48, product revenue is recorded at the
transfer of title to the products to a retailer, net of estimated
allowances and returns and sales incentives. Transfer of title occurs and
risk of ownership passes to a retailer at the time of shipment or delivery,
depending on the terms of the Company's agreement with a particular
retailer. The criteria for revenue recognition in SFAS No. 48 are satisfied
as follows: the sales price is substantially fixed or determinable at the
date of sale; there is an obligation by the retailer to pay the Company
which is not contingent upon resale of the product by the retailer and
which does not change if the product is stolen or damaged while in the
retailer's possession; the retailer has separate economic substance (is an
independent third party unaffiliated with the Company); the Company does
not have significant obligations to the retailer for future performance at
the time of sale to directly bring about the sale of the product by the
retailer; and, the amount of future returns can be reasonably estimated
(based upon the Company's prior periods' actual returns). For transactions
not satisfying the conditions for revenue recognition under SFAS No. 48,
product revenue is deferred until the conditions are met, net of an
estimate for cost of sales. Consignment sales are recognized when the
Company's retailers sell its products to retail customers, at which point
the retailers incur an obligation to pay the Company.

F-10

I/OMAGIC CORPORATION
AND SUBSIDIARY
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
- --------------------------------------------------------------------------------

NOTE 3 - SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES (CONTINUED)

Revenue Recognition (Continued)
-------------------------------

In accordance with EITF 01-9, "Accounting for Consideration Given by a
Vendor to a Customer including a Reseller of the Vendor's Products," the
Company reduces its product revenue for marketing promotions, Market
Development Fund and Cooperative Advertising costs.

The Company recognizes revenue under three primary sales models: a standard
terms sales model, a consignment sales model and a special terms sales
model. The Company generally uses one of these three primary sales models,
or some combination of these sales models, with each of its retailers.
Under each of these sales models the Company's payment terms are explicitly
stated and agreed to by the Company and the retailer before goods are
shipped, thereby making our fee fixed or determinable before revenue is
recognized.

STANDARD TERMS

Under the Company's standard terms sales model, a retailer is obligated to
pay the Company for products sold to it within a specified number of days
from the date that title to the products is transferred to the retailer.
The Company's standard terms are typically net 60 days from the transfer of
title to the products to a retailer. The Company typically collects payment
from a retailer within 60 to 75 days from the transfer of title to the
products to a retailer. Transfer of title occurs and risk of ownership
passes to a retailer at the time of shipment or delivery, depending on the
terms of the Company's agreement with a particular retailer. The sale price
of the Company's products is substantially fixed or determinable at the
date of sale based on purchase orders generated by a retailer and accepted
by the Company. A retailer's obligation to pay the Company for products
sold to it under the Company's standard terms sales model is not contingent
upon the resale of those products. The Company recognizes revenue for
standard terms sales at the time title to products is transferred to a
retailer, net of an estimate for sales incentives, rebates and returns.

CONSIGNMENT

Under the Company's consignment sales model, a retailer is obligated to pay
the Company for products sold to it within a specified number of days
following notification to the Company by the retailer of the resale of
those products. Retailers notify the Company of their resale of consigned
products by delivering weekly or monthly sell-through reports. A
sell-through report discloses sales of products sold in the prior period
covered by the report -- that is, a weekly or monthly sell-through report
covers sales of consigned products in the prior week or month,
respectively. The period for payment to the Company by retailers relating
to their resale of consigned products corresponding to these sell-through
reports varies from retailer to retailer. For sell-through reports
generated weekly, the Company typically collects payment from a retailer
within 30 days of the receipt of those reports. For sell-through reports
generated monthly, the Company typically collects payment from a retailer
within 15 days of the receipt of those reports. At the time of a retailer's
resale of a product, title is transferred directly to the consumer. Risk of
theft or damage of a product, however, passes to a retailer upon delivery
of that product to the retailer. The sale price of the Company's products
is substantially fixed or determinable at the date of sale based on a
product sell-through report generated by a retailer and delivered to the
Company. Except in the case of theft or damage, a retailer's obligation to
pay the Company for products transferred under the Company's consignment
sales model is entirely contingent upon the resale of those products.
Products held by a retailer under the Company's consignment sales model are
recorded as the Company's inventory at offsite locations until their resale
by the retailer. Because the Company retains title to products in its
consignment sales channels until their resale by a retailer, revenue is not
recognized until the time of resale. Accordingly, price modifications to
inventory maintained in the Company's consignment sales channels do not
have an effect on the timing of revenue recognition. The Company recognizes
revenue for consignment sales in the period during which resale occurs.

F-11

I/OMAGIC CORPORATION
AND SUBSIDIARY
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
- --------------------------------------------------------------------------------

NOTE 3 - SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES (CONTINUED)

SPECIAL TERMS

Under the Company's special terms sales model, the payment terms for the
purchase of the Company's products are negotiated on a case-by-case basis
and typically cover a specified quantity of a particular product. The
result of the Company's negotiations is a special agreement with a retailer
that defines how and when transfer of title occurs and risk of ownership
shifts to the retailer.

The Company ordinarily does not offer any rights of return or rebates for
products sold under its special terms sales model. A retailer is obligated
to pay the Company for products sold to it within a specified number of
days from the date that title to the products is transferred to the
retailer, or as otherwise agreed to by the Company. The Company's payment
terms are ordinarily shorter under its special terms sales model than under
its standard terms or consignment sales models and the Company typically
requires payment in advance, at the time of transfer of title to the
products or shortly following the transfer of title to the products to a
retailer. However, under its special terms sales model, the Company often
requires payment in advance or at the time of transfer of title to the
products to a retailer. Transfer of title occurs and risk of ownership
passes to a retailer at the time of shipment, delivery, receipt of payment
or the date of invoice, depending on the terms of the Company's agreement
with the retailer. The sale price of the Company's products is
substantially fixed or determinable at the date of sale based on the
Company's agreement with a retailer. A retailer's obligation to pay the
Company for products sold to it under the Company's special terms sales
model is not contingent upon the resale of those products. The Company
recognizes revenue for special terms sales at the time title to products is
transferred to a retailer.

Comprehensive Income
--------------------

The Company utilizes SFAS No. 130, "Reporting Comprehensive Income." This
statement establishes standards for reporting comprehensive income and its
components in a financial statement. Comprehensive income as defined
includes all changes in equity (net assets) during a period from non-owner
sources. Examples of items to be included in comprehensive income, which
are excluded from net income, include foreign currency translation
adjustments and unrealized gains and losses on available-for-sale
securities. For the years ended December 31, 2004, 2003, and 2002,
comprehensive income is not presented in the Company's financial statements
since the Company did not have any of the items of comprehensive income in
any period presented.

Foreign Currency
----------------

Gains and losses from foreign currency transactions, such as those
resulting from the settlement of foreign receivables, are included in the
consolidated statement of operations.

Cash and Cash Equivalents
-------------------------

For purposes of the statements of cash flows, the Company considers all
highly liquid investments purchased with original maturities of three
months or less to be cash equivalents.

Restricted Cash
---------------

Cash of $1,044,339 and $2,085,664 at December 31, 2004 and December 31,
2003, respectively, was restricted to pay down any outstanding balance on
the Company's line of credit with United National Bank.

Cash of $100,000 at December 31, 2003, which was used to back a Letter of
Credit with a retailer, was considered restricted.

F-12

I/OMAGIC CORPORATION
AND SUBSIDIARY
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
- --------------------------------------------------------------------------------

NOTE 3 - SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES (CONTINUED)

Inventory
---------

Inventory is stated at the lower of cost, using the weighted-average
method, which approximates the first-in, first-out method or market.

Product Warranties
------------------

The Company's products are subject to limited warranties ranging in
duration of up to one year. These warranties cover only repair or
replacement of the product. The Company's subcontract manufacturers and
suppliers provide the Company with warranties of a duration at least as
long as the warranties provided by the Company to consumers. The warranties
provided by the Company's subcontract manufacturers and suppliers cover
repair or replacement of the product. The Company has a specific right of
offset against its subcontract manufacturers and suppliers for defective
products, therefore the amount of the Company's warranty claims is not
material.

Property and Equipment
----------------------

Property and equipment are recorded at cost, less accumulated depreciation
and amortization. Depreciation and amortization are provided using the
straight-line method over estimated useful lives as follows:

Computer equipment and software 5 years
Warehouse equipment 7 years
Office furniture and equipment 5 to 7 years
Equipment under capital leases 5 years
Vehicles 5 years
Leasehold improvements Estimated useful life
or lease term whichever
is shorter

Expenditures for major renewals and betterments that extend the useful
lives of property and equipment are capitalized. Expenditures for
maintenance and repairs are charged to expense as incurred. Depreciation
expense on assets acquired under capital leases is included with
depreciation expense on owned assets.

Trademarks
----------

The Hi-Val(R) and Digital Research Technologies(R) trademarks acquired in
April 2000 were originally being amortized over a 5-year period. A
valuation in early 2002 established that the trademarks had an additional
10-year life. Therefore, effective with the second quarter 2002, the
Company extended the amortization period by ten years. The Company
continually evaluates whether events or circumstances have occurred that
indicate the remaining estimated value of the trademarks may not be
recoverable.

In accordance with SFAS No. 142, "Goodwill and other Intangible Assets,"
the Company conducted its required valuation on the trademarks for possible
impairment as of December 31, 2004. Based upon this valuation, the Company
determined that there had been a significant impairment in the value of the
trademarks due to lower sales of products under the Hi-Val(R) and Digital
Research Technologies(R) brands in 2004 and lower sales forecasted by the
Company for subsequent periods. Therefore, the Company wrote down the value
of the trademarks by $3,696,099 as of December 31, 2004. This writedown
will result in a reduction of $509,796 in amortization expense to $68,940
from $578,736 in each of the next five years.

Accounting for the Impairment of Long-Lived Assets
--------------------------------------------------

The Company adopted SFAS No. 144, "Accounting for the Impairment or
Disposal of Long-Lived Assets." SFAS No. 144 requires impairment losses to
be recorded on long-lived assets used in operations when indicators of
impairment are present and the undiscounted cash flows estimated to be
generated by those assets are less than the assets' carrying amount.
Management determined that there was no impairment of long-lived assets
during the years ended December 31, 2004, 2003, and 2002 other than the
impairment of the Company's Hi-Val(R) and Digital Research Technologies(R)
trademarks during the year ended December 31, 2004.

F-13

I/OMAGIC CORPORATION
AND SUBSIDIARY
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
- --------------------------------------------------------------------------------

NOTE 3 - SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES (CONTINUED)

Fair Value of Financial Instruments
-----------------------------------

For certain of the Company's financial instruments, including cash and cash
equivalents, accounts receivable, prepaid expenses and other current
assets, line of credit, accounts payable and accrued expenses, accounts
payable--related parties, reserve for customer returns and allowances, and
settlement payable, the carrying amounts approximate fair value due to
their short maturities.

Stock-Based Compensation
------------------------

SFAS No. 123, "Accounting for Stock-Based Compensation" as amended by SFAS
No. 148, "Accounting for Stock-Based Compensation-Transition and
Disclosure," establishes and encourages the use of the fair value based
method of accounting for stock-based compensation arrangements under which
compensation cost is determined using the fair value of stock-based
compensation determined as of the date of grant and is recognized over the
periods in which the related services are rendered. The statement also
permits companies to elect to continue using the current intrinsic value
accounting method specified in Accounting Principles Bulletin ("APB")
Opinion No. 25, "Accounting for Stock Issued to Employees," to account for
stock-based compensation issued to employees. The Company has elected to
use the intrinsic value based method and has disclosed the pro forma effect
of using the fair value based method to account for its stock-based
compensation. For stock-based compensation issued to non-employees, the
Company uses the fair value method of accounting under the provisions of
SFAS No. 123.

Pro forma information regarding net loss and loss per share is required by
SFAS No. 123 and has been determined as if the Company had accounted for
its employee stock options under the fair value method of SFAS No. 123. For
the year ended December 31, 2004 options to purchase up to 126,375 shares
of common stock of the Company were granted. For the years ended December
31, 2003 and 2002, options were not granted.

For purposes of pro forma disclosures, the estimated fair value of the
options is amortized to expense over the options' vesting period.
Adjustments are made for options forfeited prior to vesting. The effect on
net loss and basic and diluted loss per share had compensation costs for
the Company's stock option plans been determined based on a fair value at
the date of grant consistent with the provisions of SFAS No. 123 for the
years ended December 31, 2004, 2003, and 2002 is as follows:

YEAR ENDED DECEMBER 31,
-----------------------
2004 2003 2002
---- ---- ----
(RESTATED)(1) (RESTATED)(1)

Net loss
As reported $ (8,056,864) $ (460,018) $ (8,844,594)
Add stock based compensation expense included in net
income, net of tax -- -- --
Deduct total stock based employee compensation expense
determined under fair value method for all awards,
net of tax (75,673) -- (88,880)
------------- ------------- -------------
PRO FORMA $ (8,132,537) $ (460,018) $ (8,933,474)
------------- ------------- -------------
Earnings per common share
Basic - as reported $ (1.78) $ (0.10) $ (1.95)
Basic - pro forma $ (1.80) $ (0.10) $ (1.97)
Diluted - as reported $ (1.78) $ (0.10) $ (1.95)
Diluted - pro forma $ (1.80) $ (0.10) $ (1.97)

- ---------------
(1) See Note 2 - Restatement of 2000, 2001, 2002 and 2003 Financial Statements.

F-14

I/OMAGIC CORPORATION
AND SUBSIDIARY
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
- --------------------------------------------------------------------------------

NOTE 3 - SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES (CONTINUED)

Advertising Costs
-----------------

The Company expenses advertising costs as incurred. For the years ended
December 31, 2004, 2003, and 2002, advertising costs were $262,584,
$160,000 and $3,500, respectively.

Income Taxes
------------

Deferred income taxes are recognized for the tax consequences in future
years of differences between the tax basis of assets and liabilities and
their financial reporting amounts at each period end, based on enacted tax
laws and statutory tax rates applicable to the periods in which the
differences are expected to affect taxable income. Valuation allowances are
established, when necessary, to reduce deferred tax assets to the amount
expected to be realized. The provision for income taxes represents the tax
payable for the period, if any, and the change during the period in
deferred tax assets and liabilities.

Earnings (Loss) Per Share
-------------------------

The Company calculates earnings (loss) per share in accordance with SFAS
No. 128, "Earnings Per Share." Basic earnings (loss) per share is computed
by dividing the net income (loss) available to common stockholders by the
weighted-average number of common shares outstanding. Diluted income (loss)
per share is computed similar to basic income (loss) per share, except that
the denominator is increased to include the number of additional common
shares that would have been outstanding if the potential common shares had
been issued and if the additional common shares were dilutive.

The following potential common shares have been excluded from the
computations of diluted net income (loss) per share for the years ended
December 31, 2004, 2003, and 2002 because the effect would have been
anti-dilutive.

YEAR ENDED DECEMBER 31,
-----------------------
2004 2003 2002
---- ---- ----
Stock options outstanding 126,000 -- 20,000
Warrants outstanding 20,000 40,008 --
Redeemable convertible preferred stock -- -- --
-------- -------- --------
TOTAL 146,000 40,008 20,000
======== ======== ========

Estimates
---------

The preparation of financial statements requires management to make
estimates and assumptions that affect the reported amounts of assets and
liabilities and disclosure of contingent assets and liabilities at the date
of the financial statements and the reported amounts of revenue and
expenses during the reporting period. Actual results could differ from
those estimates.

F-15

I/OMAGIC CORPORATION
AND SUBSIDIARY
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
- --------------------------------------------------------------------------------

NOTE 3 - SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES (CONTINUED)

Sales Incentive Reserve
-----------------------

From time to time, the Company enters into agreements with certain
retailers regarding price decreases that are determined by the Company in
its sole discretion. These agreements allow those retailers (subject to
limitations) a credit equal to the difference between the Company's current
price and its new reduced price on units in the retailers' inventories or
in transit to the retailers on the date of the price decrease.

The Company records an estimate of sales incentives based on its actual
sales incentive rates over a trailing twelve-month period, adjusted for any
known variations, which are charged to operations and offset against gross
sales at the time products are sold. The Company also records a
corresponding accrual for its estimated sales incentive liability. This
accrual--the Company's sales incentive reserve--is reduced by deductions on
future payments taken by the Company's retailers relating to actual sales
incentives.

At the end of each quarterly period, the Company analyzes its existing
sales incentive reserve and applies any necessary adjustments based upon
actual or expected deviations in sales incentive rates from the Company's
applicable historical sales incentive rates. The amount of any necessary
adjustment is based upon the amount of the Company's remaining field
inventory, which is calculated by reference to the Company's actual field
inventory last conducted, plus inventory-in-transit and less estimated
product sell-through. The amount of the Company's sales incentive liability
for each product is equal to the amount of remaining field inventory for
that product multiplied by the difference between the Company's current
price and its new reduced price to its retailers for that product. This
data, together with all data relating to all sales incentives granted on
products in the applicable period, is used to adjust the Company's sales
incentive reserve established for the applicable period.

In 2004, the Company's sales incentives were $2.5 million, or 4.2% of gross
sales, all of which was offset against gross sales, as compared to $2.9
million, or 3.5% of gross sales, in 2003, all of which was offset against
gross sales. In 2002, the Company's sales incentives were $5.3 million, or
5.1% of gross sales, all of which was offset against gross sales.

Rebate Promotions Accruals
--------------------------

The Company periodically offers rebate promotions to retailers which are
provided to their end-user customers. During the period of the rebate
promotion, the Company reduces sales by the estimated amount of the rebate
promotion with a corresponding accrual for the estimated liability.
Estimates for rebate promotions are based on a number of variable factors
that depend on the specific program or product. These variables include the
length of the rebate promotion, the estimated sales during the promotion,
and the anticipated redemption rate of the program based on historical
experience.

For the year 2002, the rebate promotions accrual initially was reduced by
$1.5 million due to a change in estimate of the Company's promotion
liability. The Company has restated its financial statements for 2000, 2001
and 2002 to allocate the $1.5 million reduction based upon rebate
promotions expenses in those years.

Market Development Fund/Cooperative Advertising Accruals
--------------------------------------------------------

The Company has agreements with certain retailers in which the retailer is
allowed to use a set percentage of its purchases of the Company's products
for various marketing purposes. The purpose of these agreements is to
encourage advertising and promotional events to promote the sale of the
Company's products. Each period the Company reduces sales by the estimated
amounts to be deducted by the retailers on future payments with a
corresponding increase in the accrual for the estimated liability.

F-16

I/OMAGIC CORPORATION
AND SUBSIDIARY
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
- --------------------------------------------------------------------------------

NOTE 3 - SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES (CONTINUED)

Product Returns
---------------

The Company has a limited 90-day to one year time period for product
returns from end-users; however, its retailers generally have return
policies that allow their customers to return products within only fourteen
to thirty days after purchase. The Company allows its retailers to return
damaged or defective products to it following a customary return
merchandise authorization process. The Company has no informal return
policies. The Company utilizes actual historical return rates to determine
its allowance for returns in each period. Gross sales is reduced by
estimated returns and cost of sales is reduced by the estimated cost of
those sales. The Company records a corresponding accrual for the estimated
liability associated with the estimated returns. This estimated liability
is based on the gross margin of the products corresponding to the estimated
returns. This accrual is offset each period by actual product returns.

As noted above, the Company's return rate is based upon its past history of
actual returns and the Company estimates amounts for product returns for a
given period by applying this historical return rate and reducing actual
gross sales for that period by a corresponding amount. The Company's
historical return rate for a particular product is the life-to-date return
rate of similar products. This life-to-date return rate is updated monthly.
The Company also compares this life-to-date return rate to its trailing
18-month return rate to determine whether any material changes in the
Company's return rate have occurred that may not be reflected in the
life-to-date return rate. The Company believes that using a trailing
18-month return rate takes two key factors into consideration,
specifically, an 18-month return rate provides the Company with a
sufficient period of time to establish recent historical trends in product
returns for each product category, and provides it with a period of time
that is short enough to account for recent technological shifts in the
Company's product offerings in each product category. If an unusual
circumstance exists, such as a product category that has begun to show
materially different actual return rates as compared to life-to-date return
rates, the Company will make appropriate adjustments to its estimated
return rates. Factors that could cause materially different actual return
rates as compared to life-to-date return rates include product
modifications that simplify installation; a new product line, within a
product category, that needs time to better reflect its return performance;
and other factors. For the years ended December 31, 2004, 2003, and 2002,
the Company had reserves for product returns totaling $270,706, $364,989,
and $498,232, respectively, which reflect the estimated gross margin effect
for future returns.

The Company's warranty terms under its arrangements with its suppliers are
that any product that is returned by a retailer or retail customer as
defective can be returned by the Company to the supplier for full credit
against the original purchase price. The Company incurs only minimal
shipping costs to its suppliers in connection with the satisfaction of its
warranty obligations.

Inventory Obsolescence Allowance
--------------------------------

The Company's warehouse supervisor, production supervisor and production
manager physically review the Company's warehouse inventory for slow moving
and obsolete products. All products of a material amount are reviewed
quarterly and all products of an immaterial amount are reviewed annually.
The Company considers products that have not been sold within six months to
be slow moving. Product that is no longer compatible with current hardware
or software is considered obsolete. The potential for re-sale of slow
moving and obsolete inventories is considered through market research,
analysis of the Company's retailers' current needs, and assumptions about
future demand and market conditions. The recorded cost of both slow-moving
and obsolete inventories is then reduced to its estimated market value
based on current market pricing for similar products. The Company utilizes
the Internet to provide indications of market value from competitors'
pricing, third party inventory liquidators and auction websites. The
recorded costs of the Company's slow moving and obsolete products are
reduced to current market prices when the recorded costs exceed such market
prices. All adjustments establish a new cost basis for inventory as the
Company believes such reductions are permanent declines in the market price
of its products. Generally, obsolete inventory is sold to companies that
specialize in the liquidation of such items while the Company continues to
market slow-moving inventories until they are sold or become obsolete. As
obsolete or slow moving inventory is sold, the Company reduces the reserve
by proceeds from the sale of the products.

F-17

I/OMAGIC CORPORATION
AND SUBSIDIARY
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
- --------------------------------------------------------------------------------

NOTE 3 - SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES (CONTINUED)

Inventory Adjustments
---------------------

The Company's warehouse supervisor, production supervisor and production
manager physically review the Company's warehouse inventory for obsolete or
damaged inventory-related items on a monthly basis. Inventory-related items
(such as sleeves, manuals or broken products no longer under warranty from
the Company's subcontract manufacturers and suppliers) which are considered
obsolete or damaged are reviewed by these personnel together with the
Company's Controller or Chief Financial Officer. At the discretion of the
Company's Controller or Chief Financial Officer, these items are physically
disposed of and the Company makes corresponding accounting adjustments
resulting in inventory adjustments. In addition, on a monthly basis, the
Company's detail inventory report and its general ledger are reconciled by
the Company's Controller and any variances result in a corresponding
inventory adjustment.

Allowance for Doubtful Accounts
-------------------------------

The Company maintains allowances for doubtful accounts for estimated losses
resulting from the inability of its retailers to make required payments. If
the financial condition of the Company's retailers were to deteriorate,
resulting in the impairment of their ability to make payments, additional
allowances may be required. Since the Company's current retailers are
national retailers with a good payment history with the Company, its
allowance for doubtful accounts is minimal.

The Company performs periodic credit evaluations of its retailers and
maintains allowances for potential credit losses based on management's
evaluation of historical experience and current industry trends. Although
the Company expects to collect amounts due, actual collections may differ.

Recently Issued Accounting Pronouncements
-----------------------------------------

In December 2004, the FASB issued SFAS No. 123(R), "Share-Based Payment".
SFAS 123(R) amends SFAS No. 123, "Accounting for Stock-Based Compensation",
and APB Opinion No. 25, "Accounting for Stock Issued to Employees". SFAS
No. 123(R) requires that the cost of share-based payment transactions
(including those with employees and non-employees) be recognized in the
financial statements. SFAS No. 123(R) applies to all share-based payment
transactions in which an entity acquires goods or services by issuing (or
offering to issue) its shares, share options, or other equity instruments
(except for those held by an ESOP) or by incurring liabilities (1) in
amounts based (even in part) on the price of the company's shares or other
equity instruments, or (2) that require (or may require) settlement by the
issuance of a company's shares or other equity instruments. This statement
is effective (1) for public companies qualifying as SEC small business
issuers, as of the first interim period or fiscal year beginning after
December 15, 2005, or (2) for all other public companies, as of the first
interim period or fiscal year beginning after June 15, 2005, or (3) for all
nonpublic entities, as of the first fiscal year beginning after December
15, 2005. On April 14, 2005, the Securities and Exchange Commission amended
the compliance dates to allow companies to implement Statement No. 123R at
the beginning of their next fiscal year, instead of the next reporting
period, that begins after June 15, 2005, or Dec. 15, 2005 for small
business issuers. Management is currently assessing the impact of this
statement on its financial position and results of operations.

In December 2004, the FASB issued SFAS No. 153, "Exchanges of Nonmonetary
Assets," an amendment to Opinion No. 29, "Accounting for Nonmonetary
Transactions". SFAS No. 153 eliminates certain differences in the guidance
in Opinion No. 29 as compared to the guidance contained in standards issued
by the International Accounting Standards Board. The amendment to Opinion
No. 29 eliminates the fair value exception for nonmonetary exchanges of
similar productive assets and replaces it with a general exception for
exchanges of nonmonetary assets that do not have commercial substance. Such
an exchange has commercial substance if the future cash flows of the entity
are expected to change significantly as a result of the exchange. SFAS No.
153 is effective for nonmonetary asset exchanges occurring in periods
beginning after June 15, 2005. Earlier application is permitted for
nonmonetary asset exchanges occurring in periods beginning after December
16, 2004. This statement is not applicable to the Company.

F-18

I/OMAGIC CORPORATION
AND SUBSIDIARY
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
- --------------------------------------------------------------------------------

NOTE 3 - SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES (CONTINUED)

In December 2004, the FASB issued SFAS No. 152, "Accounting for Real Estate
Time-Sharing Transactions". The FASB issued this statement as a result of
the guidance provided in AICPA Statement of Position (SOP) 04-2,
"Accounting for Real Estate Time-Sharing Transactions". SOP 04-2 applies to
all real estate time-sharing transactions. Among other items, the SOP
provides guidance on the recording of credit losses and the treatment of
selling costs, but does not change the revenue recognition guidance in SFAS
No. 66, "Accounting for Sales of Real Estate", for real estate time-sharing
transactions. SFAS No. 152 amends Statement No. 66 to reference the
guidance provided in SOP 04-2. SFAS No. 152 also amends SFAS No. 67,
"Accounting for Costs and Initial Rental Operations of Real Estate
Projects", to state that SOP 04-2 provides the relevant guidance on
accounting for incidental operations and costs related to the sale of real
estate time-sharing transactions. SFAS No. 152 is effective for years
beginning after June 15, 2005, with restatements of previously issued
financial statements prohibited. This statement is not applicable to the
Company.

In November 2004, the FASB issued SFAS No. 151, "Inventory Costs". SFAS No.
151 amends the accounting for abnormal amounts of idle facility expense,
freight, handling costs, and wasted material (spoilage) under the guidance
in ARB No. 43, Chapter 4, "Inventory Pricing". Paragraph 5 of ARB No. 43,
Chapter 4, previously stated that ". . . under some circumstances, items
such as idle facility expense, excessive spoilage, double freight, and
rehandling costs may be so abnormal as to require treatment as current
period charges. . . ." This statement requires that those items be
recognized as current-period charges regardless of whether they meet the
criterion of "so abnormal." In addition, this statement requires that
allocation of fixed production overheads to the costs of conversion be
based on the normal capacity of the production facilities. This statement
is effective for inventory costs incurred during fiscal years beginning
after June 15, 2005. This statement is not applicable to the Company.

Reclassifications
-----------------

Certain amounts included in the prior years' financial statements have been
reclassified to conform with the current year presentation. Such
reclassifications did not have any effect on reported net loss.

NOTE 4 - RISKS AND UNCERTAINTIES

Technological Obsolescence
--------------------------

The data storage and digital entertainment industries are characterized by
rapid technological advancement and change. Should demand for the Company's
products prove to be significantly less than anticipated, the ultimate
realizable value of such products could be substantially less than the
amounts reflected in the accompanying balance sheets.

Reliance on Independent and Related Party Manufacturers/Subcontractors/
Suppliers
-----------------------------------------------------------------------

The Company does not maintain its own manufacturing or production
facilities and does not intend to do so in the foreseeable future. The
Company anticipates that its products will be manufactured, and independent
companies, some of which are stockholders of the Company, will supply its
raw materials and components. Many of these independent and related party
manufacturers/subcontractors/suppliers may manufacture and supply products
for the Company's existing and potential competitors. As is customary in
the manufacturing industry, the Company does not have any material ongoing
licensing or other supply agreements with its manufacturers and suppliers.
Typically, the purchase order is the Company's "agreement" with the
manufacturer or supplier. Therefore, any of these companies could terminate
their relationships with the Company at any time. In the event the Company
was to have difficulties with its present manufacturers and suppliers, the
Company could experience delays in supplying products to its retailers.

Reliance on Retail Distributors
-------------------------------

The Company's success will depend to a significant extent upon the ability
to develop and maintain a multi-channel distribution system with retail
distributors to sell the Company's products in the marketplace. There
cannot be any assurance that the Company will be successful in obtaining
and retaining the retail distributors it requires to continue to grow and
expand its marketing and sales efforts.

F-19

I/OMAGIC CORPORATION
AND SUBSIDIARY
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
- --------------------------------------------------------------------------------

NOTE 5 - CONCENTRATIONS OF RISK

Cash and Cash Equivalents
-------------------------

The Company maintains its cash and cash equivalent balances in several
banks located in Southern California and a financial institution that from
time to time exceed amounts insured by the Federal Deposit Insurance
Corporation up to $100,000 per bank and by the Securities Investor
Protection Corporation up to $500,000 per financial institution. As of
December 31, 2004 and 2003, balances totaling $4,404,578 and $6,375,233,
respectively, were uninsured. The Company has not experienced any losses in
such accounts and believes it is not exposed to any significant credit risk
on cash.

Retailers
---------

During the year ended December 31, 2004, the Company had net sales to five
major retailers that represented 32%, 17%, 11%, 10% and 10% of net sales.
As of December 31, 2004, accounts receivable from these five retailers were
57%, 6%, 0%, 3% and 16% of accounts receivable, respectively.

During the year ended December 31, 2003, the Company had net sales to five
major retailers that represented 29%, 14%, 10%, 10% and 10% of net sales.
As of December 31, 2003, accounts receivable from these five retailers were
13%, 4%, 8%, 7% and 17% of accounts receivable, respectively.

During the year ended December 31, 2002, the Company had net sales to four
major retailers that represented 29%, 25%, 16%, and 15% of net sales. As of
December 31, 2002, accounts receivable from these four retailers were 25%,
28%, 17%, and 16% of accounts receivable, respectively.

Suppliers
---------

During the year ended December 31, 2004, the Company purchased inventory
from one related party vendor that represented 55% of purchases. In
addition, the Company purchased inventory from a second vendor that
represented 13% of purchases. As of December 31, 2004, there was one
supplier that represented 85% of accounts payable - related parties.

During the year ended December 31, 2003, the Company purchased inventory
from two related party vendors that represented 45% and 26% of purchases.
In addition, the Company purchased inventory from a third vendor that
represented 13% of purchases. As of December 31, 2003, there were two
suppliers that represented 69% and 17% of accounts payable - related
parties.

During the year ended December 31, 2002, the Company purchased inventory
from two related party vendors that represented 47% and 18% of purchases.
As of December 31, 2002, there were two suppliers that represented 60% and
12% of accounts payable and accounts payable--related parties.

NOTE 6 - INVENTORY

Inventory as of December 31, 2004 and 2003 consisted of the following:

DECEMBER 31,
------------
2004 2003
---- ----

Component parts $ 2,123,173 $ 3,658,140
Finished goods--warehouse 2,614,202 2,317,765
Finished goods--consigned 2,872,605 4,235,832
Reserves for inventory (1,463,214) (505,029)
------------ ------------
TOTAL $ 6,146,766 $ 9,706,708
============ ============

Consigned inventory is located at the stores and distribution centers of
certain retailers with which the Company has consignment agreements. The
inventory is owned by the Company until sold by the retailers.

F-20

I/OMAGIC CORPORATION
AND SUBSIDIARY
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
- --------------------------------------------------------------------------------

NOTE 7 - PROPERTY AND EQUIPMENT

Property and equipment as of December 31, 2004 and 2003 consisted of the
following:

DECEMBER 31,
------------
2004 2003
---- ----
Computer equipment and software $ 1,051,485 $ 1,041,979
Warehouse equipment 55,238 55,238
Office furniture and equipment 266,889 264,629
Vehicles 91,304 91,304
Leasehold improvements 98,780 88,020
----------- -----------
1,563,696 1,541,170
Less accumulated depreciation
and amortization 1,256,035 1,001,227
----------- -----------
TOTAL $ 307,661 $ 539,943
=========== ===========

For the years ended December 31, 2004, 2003, and 2002, depreciation and
amortization expense was $254,808, $689,341 and $307,505, respectively.
Included in depreciation and amortization expense for the year ended
December 31, 2003 is $389,000 related to the accelerated amortization of
the leasehold improvements at the Company's prior Santa Ana facility. At
the beginning of 2003, the Company decided to move to a larger facility by
the end of September 2003 and therefore amortized the remaining leasehold
improvements balance at December 31, 2002 through September 2003.

NOTE 8 - TRADEMARKS

Trademarks as of December 31, 2004 and 2003 consisted of the following:

DECEMBER 31,
------------
2004 2003
---- ----
Trademarks $ 9,645,679 $ 9,645,679
Less writedown 3,696,099 --
Less accumulated amortization 5,449,780 4,871,044
----------- -----------
TOTAL $ 499,800 $ 4,774,635
=========== ===========

For the years ended December 31, 2004, 2003, and 2002, amortization expense
was $578,736, $578,736 and $916,332, respectively. In accordance with SFAS
No. 142, the Company performed its required valuation on its Hi-Val(R) and
Digital Research Technologies(R) trademarks for possible impairment as of
December 31, 2004. Based upon this valuation, the Company determined that
there had been a significant impairment in the value of the trademarks due
to lower sales of products under the Hi-Val(R) and Digital Research
Technologies(R) brands in 2004 and lower sales forecasted by the Company
for subsequent periods. Therefore, the Company recorded an impairment of
the value of the trademarks of $3,696,099 as of December 31, 2004. This
impairment will result in a reduction of $509,796 in amortization expense
to $68,940 from $578,736 in each of the next five years.

NOTE 9 - ACCOUNTS PAYABLE AND ACCRUED EXPENSES

Accounts payable and accrued expenses as of December 31, 2004 and 2003
consisted of the following:

DECEMBER 31,
------------
2004 2003
---- ----
(RESTATED)(1)
Accounts payable $ 1,282,082 $ 2,525,509
Accrued rebates and marketing 3,231,655 2,369,544
Accrued compensation and related benefits 158,896 192,002
Other 549,086 485,824
----------- -----------
TOTAL $ 5,221,719 $ 5,572,879
=========== ===========

- ---------------
(1) See Note 2 - Restatement of 2000, 2001, 2002 and 2003 Financial Statements.

F-21

I/OMAGIC CORPORATION
AND SUBSIDIARY
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
- --------------------------------------------------------------------------------

NOTE 10 - LINE OF CREDIT

On January 1, 2002, the Company obtained a $9.0 million asset-based line of
credit (with a sub-limit of $8.0 million) with ChinaTrust Bank (USA) that
was to expire December 15, 2003. The credit facility contained a number of
restrictive financial covenants. On each of December 31, 2002, March 31,
2003, and June 30, 2003, the Company was not in compliance with certain of
those financial covenants. However, the Company subsequently obtained
waivers of these violations from the lender. The waiver relating to the
December 31, 2002 covenant violation also modified the original expiration
date of December 15, 2003 to October 15, 2003. Subsequently, the Company
replaced this line of credit with a line of credit from United National
Bank.

On August 15, 2003, the Company entered into an agreement for an
asset-based line of credit with United National Bank, effective August 18,
2003. The line allows the Company to borrow up to a maximum of $6.0
million. The line of credit expires September 1, 2004 and is secured by a
UCC filing on substantially all of the Company's assets. Advances on the
line bear interest at the floating commercial loan rate equal to the prime
rate as reported in THE WALL STREET JOURNAL plus 0.75%. As of December 31,
2004, the interest rate was 6.00%. The agreement also calls for the Company
to be in compliance with certain financial covenants. As of December 31,
2004, the Company was in compliance with all financial covenants except the
financial covenant that the Company's tangible net worth be at least $10.5
million and the financial covenant that the Company make at least $1 in the
year 2004.

The new line of credit was initially used to pay off the outstanding
balance with ChinaTrust Bank (USA) as of September 2, 2003, which was
$3,379,827. The outstanding balance with United National Bank as of
December 31, 2004 and 2003 was $5,962,891 and $5,938,705, respectively. The
amount available to the Company for borrowing as of December 31, 2004 was
$37,109. On March 9, 2005 the line of credit with United National Bank was
replaced by a line of credit from GMAC Commercial Finance (see Note 19 -
Subsequent Events).

NOTE 11 - TRADE CREDIT FACILITIES WITH RELATED PARTIES

In connection with a 1997 Strategic Alliance Agreement, the Company has
available a trade line of credit with a related party for purchases up to
$2.0 million. Purchases are non-interest bearing and are due 75 days from
the date of receipt. The credit agreement can be terminated or changed at
any time. As of December 31, 2003, there was $0 in trade payables
outstanding under this arrangement. This trade line of credit was
terminated on March 31, 2004.

Pursuant to an oral agreement, the Company also has available an additional
trade line of credit with a related party that provides a trade credit
facility of up to $3.0 million carrying net 60 day terms, as defined. As of
December 31, 2003, there was $0 in trade payables outstanding under this
arrangement. This trade line of credit was terminated on March 31, 2004.

In January 2003, the Company entered into a trade credit facility with a
related party, whereby the related party has agreed to purchase inventory
on behalf of the Company. The agreement allows the Company to purchase up
to $10.0 million, with payment terms of 120 days following the date of
invoice. The third party will charge the Company a 5% handling fee on the
supplier's unit price. A 2% discount to the handling fee will be applied if
the Company reaches an average running monthly purchasing volume of
$750,000. Returns made by the Company, which are agreed by the supplier,
will result in a credit to the Company for the handling charge. As security
for the trade facility, the Company paid the related party a security
deposit of $1.5 million, of which $750,000 may be applied against
outstanding accounts payables to the related party after six months. As of
December 31, 2004, $1.5 million had been applied against outstanding
accounts payables to the related party. The agreement is for 12 months. At
the end of the 12-month period, either party may terminate the agreement
upon 30 days' written notice. Otherwise, the agreement will remain
continuously valid without effecting a newly signed agreement. Both parties
have the right to terminate the agreement one year following the inception
date by giving the other party 30 days written notice of termination. As of
December 31, 2004, there were $0 in trade payables under this arrangement.

F-22

I/OMAGIC CORPORATION
AND SUBSIDIARY
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
- --------------------------------------------------------------------------------

NOTE 11 - TRADE CREDIT FACILITIES WITH RELATED PARTIES (CONTINUED)

In February 2003, the Company entered into an agreement with a related
party, whereby the related party agreed to supply and store at the
Company's warehouse up to $10.0 million of inventory on a consignment
basis. Under the agreement, the Company will insure the consignment
inventory, store the consignment inventory for no charge, and furnish the
related party with weekly statements indicating all products received and
sold and the current consignment inventory level. The agreement may be
terminated by either party with 60 days written notice. In addition, this
agreement provides for a trade line of credit of up to $10.0 million with
payment terms of net 60 days, non-interest bearing. During 2004, 2003 and
2002 the Company purchased $19.2 million, $20.1 million and $10.0 million
of inventory, respectively, under this or prior arrangements from this
related party. As of December 31, 2004 and December 31, 2003, there were
$7,346,596 and $8,322,946, respectively, in trade payables outstanding
under this arrangement.

NOTE 12 - COMMITMENTS AND CONTINGENCIES

Leases
------

The Company leases its facilities and certain equipment under
non-cancelable, operating lease agreements, expiring through December 2008.

The Company previously leased its facilities from a related party that was,
through March 2003, under the control of an officer of the Company. In
March 2003, in connection with the settlement of the Vakili lawsuit (see
Litigation), an officer of the Company relinquished control, to the
Vakilis, of the entity that owned the warehouse and office space that was
being leased by the Company. Under the terms of the settlement agreement,
the lease dated April 1, 2000, as amended on June 1, 2000 and which
originally expired in March 2010, was terminated and replaced with a new
lease. The new lease required monthly payments of $28,687 and expired on
September 30, 2003. The Company moved to its current facilities in
September 2003.

Future minimum lease payments under these non-cancelable operating lease
obligations at December 31, 2004 are as follows:

YEAR ENDING
DECEMBER 31,
------------
2005 $ 368,771
2006 227,686
2007 5,820
2008 5,820
------------
TOTAL $ 608,097
============

Rent expense was $366,574, $420,425 and $431,590 for the years ended
December 31, 2004, 2003 and 2002, respectively, and is included in general
and administrative expenses in the accompanying statements of income.

Service Agreements
------------------

Periodically, the Company enters into various agreements for services
including, but not limited to, public relations, financial consulting, and
manufacturing consulting. The agreements generally are ongoing until such
time they are terminated, as defined. Compensation for services is paid
either on a fixed monthly rate or based on a percentage, as specified, and
may be payable in shares of the Company's common stock. During the years
ended December 31, 2004, 2003, and 2002, the Company incurred expenses of
$364,588, $333,982, and $349,056, respectively, in connection with such
arrangements. These expenses are included in general and administrative
expenses in the accompanying statements of operations.

F-23

I/OMAGIC CORPORATION
AND SUBSIDIARY
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
- --------------------------------------------------------------------------------

NOTE 12 - COMMITMENTS AND CONTINGENCIES (CONTINUED)

Employment Contract
-------------------

The Company entered into an employment agreement with one of its officers
on October 15, 2002, which expires on October 15, 2007. The agreement,
which is effective as of January 1, 2002, calls for an initial salary of
$198,500, and provides for certain expense allowances. In addition, the
agreement provides for a quarterly bonus equal to 7% of the Company's
quarterly net income. For the years ended December 31, 2004, 2003, and
2002, bonuses totaling $60,702, $28,259, and $89,067, respectively, were
paid under the terms of this agreement. As of December 31, 2004 and 2003,
the accrued bonuses were $0 and $0, respectively.

Retail Agreements
-----------------

In connection with certain retail agreements, the Company has agreed to pay
for certain marketing development and advertising on an ongoing basis.
Marketing development and advertising costs are generally agreed upon at
the time of the event. The Company also records a liability for co-op
marketing based on management's evaluation of historical experience and
current industry and Company trends.

In May 2001, the Company entered into an agreement to pay certain market
development and advertising funds. The agreement provided that the Company
was to pay $6.0 million in marketing expenses to a retailer in connection
with the retailer's purchase of $60 million in products over a period of
one year. In June 2001, the Company began selling to and recognizing
revenue from the retailer. All revenue recognized under the terms of this
agreement was offset by a proportionate amount of marketing and promotional
funds allocated to the same periods in which the revenue was recognized.
From June to December 2001, the Company recorded $3.8 million of the market
development and advertising funds. This amount directly correlated to the
revenue recognized during those periods and the Company netted the same
amount against its revenues for those periods. The term of the agreement
continued into 2002 and from January to November 2002, the Company recorded
$2.1 million of the market development and advertising funds. This amount
directly correlated to the revenue recognized during those periods and the
Company netted the same amount against its revenues for those periods. The
market development and advertising funds were primarily used by the
retailer to launch the Company's products through sales promotions, printed
media and weekly sales circulars distributed by the retailer. After the
aggregate $60 million sales amount was achieved, the Company discontinued
all sales and promotional activities under this agreement.

For the years ended December 31, 2004, 2003, and 2002, the Company incurred
$1,701,178, $2,893,200 and $3,388,570, respectively, related to its retail
agreements with its retailers. These amounts are netted against revenue in
the accompanying statements of operations.

Litigation
----------

On August 2, 2001, Mark and Mitra Vakili filed a complaint in the Superior
Court of the State of California for the County of Orange against Tony
Shahbaz, our Chairman, President, Chief Executive Officer and Secretary.
This complaint was later amended to add Alex Properties and Hi-Val, Inc. as
plaintiffs, and I/OMagic, IOM Holdings, Inc., Steel Su, a director of
I/OMagic, and Meilin Hsu, an officer of Behavior Tech. Computer Corp., as
defendants. The final amended complaint alleged causes of action based upon
breach of contract, fraud, breach of fiduciary duty and negligent
misrepresentation and sought monetary damages and rescission. As a result
of successful motions for summary judgment, I/OMagic, Mr. Su and Ms. Hsu
were dismissed as defendants. On February 18, 2003, a jury verdict adverse
to the remaining defendants was rendered, and on or about March 28, 2003,
all parties to the action entered into a Settlement Agreement and Release
which settled this action prior to the entry of a final judgment. As part
of the Settlement Agreement and Release, Mr. Shahbaz and Mr. Su
relinquished their interests in Alex Properties and the Vakilis
relinquished 66,667 shares of the Company's common stock, of which 13,333
shares were transferred to a third party designated by the Vakilis. In
addition, the Company agreed to make payments totaling $4.0 million in cash
and entered into a new written lease agreement with Alex Properties
relating to the real property in Santa Ana, California, which the Company
physically occupied. On September 30, 2003, pursuant to the terms of the
lease agreement, the Company vacated this real property. During the latter
part of 2003 and continuing into the first quarter of 2004, Mark and Mitra
Vakili and Alex Properties alleged that the Company had improperly caused
damage to the Santa Ana facility. On or about February 15, 2004, all
parties to the original Settlement Agreement and Release executed a First
Amendment to Settlement Agreement and Release, releasing all defendants
from all of these new claims conditioned upon the making of the final $1.0
million payment under the Settlement Agreement and Release by February 17,
2004, rather than on the original due date of March 15, 2004. The Company
made this payment, and a dismissal of the case was filed with the court on
March 8, 2004.

F-24

I/OMAGIC CORPORATION
AND SUBSIDIARY
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
- --------------------------------------------------------------------------------

NOTE 12 - COMMITMENTS AND CONTINGENCIES (CONTINUED)

Litigation (Continued)
----------

On May 30, 2003, I/OMagic and IOM Holdings, Inc. filed a complaint for
breach of contract and legal malpractice against Lawrence W. Horwitz,
Gregory B. Beam, Horwitz & Beam, Lawrence M. Cron, Horwitz & Cron, Kevin J.
Senn and Senn Palumbo Mealemans, LLP, the Company's former attorneys and
their respective law firms, in the Superior Court of the State of
California for the County of Orange. The complaint seeks damages of $15.0
million arising out of the defendants' representation of I/OMagic and IOM
Holdings, Inc. in an acquisition transaction and in a separate arbitration
matter. On November 6, 2003, the Company filed its First Amended Complaint
against all defendants. Defendants have responded to the Company's First
Amended Complaint denying the Company's allegations. Defendants Lawrence W.
Horwitz and Lawrence M. Cron have also filed a Cross-Complaint against the
Company for attorneys' fees in the approximate amount of $79,000. The
Company has denied their allegations in the Cross-Complaint. As of the date
of this report, discovery has commenced and a trial date in this action has
been set for September 12, 2005. The outcome of this action is presently
uncertain. However, the Company believes that all of its claims are
meritorious.

On March 15, 2004, Magnequench International, Inc., or plaintiff, filed an
Amended Complaint for Patent Infringement in the United States District
Court of the District of Delaware (Civil Action No. 04-135 (GMS)) against,
among others, the Company, Sony Corp., Acer Inc., Asustek Computer, Inc.,
Iomega Corporation, LG Electronics, Inc., Lite-On Technology Corporation
and Memorex Products, Inc., or defendants. The complaint seeks to
permanently enjoin defendants from, among other things, selling products
that allegedly infringe one or more claims of plaintiff's patents. The
complaint also seeks damages of an unspecified amount, and treble damages
based on defendants' alleged willful infringement. In addition, the
complaint seeks reimbursement of plaintiff's costs as well as reasonable
attorney's fees, and a recall of all existing products of defendants that
infringe one or more claims of plaintiff's patents that are within the
control of defendants or their wholesalers and retailers. Finally, the
complaint seeks destruction (or reconfiguration to non-infringing
embodiments) of all existing products in the possession of defendants that
infringe one or more claims of plaintiff's patents. The Company has filed a
response denying plaintiff's claims and asserting defenses to plaintiff's
causes of action alleged in the complaint.

On March 9, 2005, the Company entered into a Settlement Agreement with
Magnequench International, Inc., releasing all claims against the Company
in exchange for certain information and covenants by the Company, including
disclosure of identities of certain of its suppliers of alleged infringing
products, a covenant to provide sample products for testing purposes and a
covenant to not source products from suppliers of alleged infringing
products, provided that, among other limitations, another supplier makes
those products available to the Company in sufficient quantities. A
dismissal of the case was filed with the court on April 15, 2005.

In addition, the Company is involved in certain legal proceedings and
claims which arise in the normal course of business. Management does not
believe that the outcome of these matters will have a material affect on
the Company's financial position or results of operations.

NOTE 13 - REDEEMABLE CONVERTIBLE PREFERRED STOCK

During December 2000, the Company amended its Articles of Incorporation to
authorize 10,000,000 shares of preferred stock, of which 1,000,000 shares
are designated as Series A preferred stock. Preferred stockholders of the
Series A preferred stock do not have voting powers and are entitled to
receive dividends on an equal basis with the holders of common stock of the
Company.

In addition, the Company designated 1,000,000 shares as Series B preferred
stock. The Series B stockholder has the same rights as the Series A
holders, except the Company will be obligated to redeem any issued shares
which have been outstanding for two years.

On October 25, 2002, the Company repurchased all of the issued Series A and
Series B redeemable convertible preferred stock totaling 875,000 and
250,000 shares, respectively, for a payment of $1.0 million. The gain on
repurchase of $8.0 million was netted against accumulated deficit in the
accompanying consolidated balance sheet.

F-25

I/OMAGIC CORPORATION
AND SUBSIDIARY
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
- --------------------------------------------------------------------------------

NOTE 14 - COMMON STOCK

Amendment to Articles of Incorporation
--------------------------------------

On January 12, 2001, the Company amended its Articles of Incorporation to
increase the number of authorized common shares from 50,000,000 to
100,000,000. On December 6, 2002, the Company amended its Articles of
Incorporation to effect a 1-for-15 reverse stock split as of December 20,
2002.

Common Stock Issued in Connection with the Exercise of Warrants
---------------------------------------------------------------

During the year ended December 31, 2002, the Company issued an aggregate of
833 shares of common stock in connection with the exercise of A Warrants in
the year ended December 31, 2001 for cash of $630 or at a per share price
of $0.75.

Treasury Stock
--------------

On February 12, 2002, the Company announced the approval by the Board of
Directors of the Company to redeem its own stock in open market
transactions of up to $500,000. During the year ended December 31, 2002,
the Company purchased 4,226 shares of common stock for $42,330 on the open
market. During the year ended December 31, 2003, the Company purchased
9,267 shares of common stock for $83,684 on the open market. It is the
Company's intention to cancel these shares.

NOTE 15 - WARRANTS AND STOCK OPTIONS

Warrants
--------

During the years ended December 31, 2001 and 2000, the Company issued
warrants to purchase 8,000 and 2,667 shares, respectively, of restricted
common stock to the Company's prior law firm and a consultant,
respectively. The warrants were exercisable at prices ranging from $4.50 to
$30.00 (fair market value or higher) per share for one year. Management of
the Company determined that no additional amounts would have been paid to
such law firm for services as invoiced services were paid in cash.
Accordingly, the Company did not record legal or consulting expense. During
the years ended December 31, 2001 and 2000, 0 and 2,667 warrants,
respectively, were exercised. As of December 31, 2003, none of the
remaining warrants were exercised, and such warrants expired.

During the year ended December 31, 2004, the Company issued warrants to
purchase 20,000 shares of common stock to a financial advisory firm, 10,000
of which are exercisable at $4.00 per share and 10,000 of which are
exercisable at $6.00 per share. These warrants vested immediately and
expire in September 2005.

During the year ended December 31, 2003, the Company issued warrants to
purchase 20,004 shares of common stock to an investor relations firm. The
warrants were exercisable at $9.78 per share and vested over six months
from grant date. These warrants expired in July 2004.

During the year ended December 31, 2003, the Company issued warrants to
purchase 20,004 shares of common stock to a financial advisory firm. The
warrants are exercisable at $9.78 per share and vest over six months from
grant date. These warrants expire in July 2004. The value of the warrants
was not material.

Stock Option Plans
------------------

The Company has the following two stock option plans:

o 2002 Stock Option Plan (the "2002 Plan")

o 2003 Stock Option Plan (the "2003 Plan")

The total number of shares of the Company's common stock authorized for
issuance under the 2002 Plan and the 2003 Plan are 133,334, and 400,000,
respectively.

F-26

I/OMAGIC CORPORATION
AND SUBSIDIARY
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
- --------------------------------------------------------------------------------

NOTE 15 - WARRANTS AND STOCK OPTIONS (CONTINUED)

Under the 2002 Plan and the 2003 Plan (collectively, the "Company Plans")
options granted may be either "incentive stock options," within the meaning
of Section 422 of the Internal Revenue Code, or "nonqualified options."
Incentive options granted under the Company Plans must have an exercise
price of not less than the fair market value of a share of common stock on
the date of grant unless the optionee owns more than 10% of the total
voting securities of the Company. In this case, the exercise price will not
be less than 110% of the fair market value of a share of common stock on
the date of grant. Incentive stock options may not be granted to an
optionee under any of the Company Plans if the aggregate fair market value,
as determined on the date of grant, of the stock with respect to which
incentive stock options are exercisable by such optionee in any calendar
year under the Company Plans, exceeds $100,000. Nonqualified options
granted under the Company Plans must have an exercise price of not less
than the fair market value of a share of common stock on the date of grant.
Nonqualified options granted under the Company Plans must have an exercise
price of not less than 85% of the fair market value of a share of common
stock on the date of grant.

Under the Company Plans, options may be exercised during a period of time
fixed by the committee administering the Company Plans (which could include
the entire Board of Directors). Options granted under the Company Plans
must vest at a rate not less than 20% per year over a consecutive five-year
period. No option granted under any of the Company Plans may be exercised
more than 10 years after the date of grant. Incentive stock options granted
to an optionee who owns more than 10% of the voting securities of the
Company may not be exercised more than five years after the date of grant.

In April 1996, the Company issued options to purchase restricted shares of
common stock at $0.15 per share, which was below market, to two employees,
resulting in the Company recording deferred compensation of $124,000, which
was being amortized over five years, the vesting period of the options.
During the year ended December 31, 1997, one of the employees left the
Company and forfeited his options. Accordingly, the Company reversed the
deferred compensation relating to this employee. During the year ended
December 31, 2001, 3,333 of these options were exercised.

As of December 31, 2004, 2003, and 2002, the balance of deferred
compensation totaled $0, $0, and $0, respectively.

In January 2000, the Company granted an aggregate of 134,167 stock options
(the "2000 Options") under the Company's 1997 Incentive and Non-Statutory
Stock Option Plan (the "1997 Plan") and the 1998 Incentive and
Non-Statutory Stock Option Plan (the "1998 Plan"). On March 21, 2000, the
Company's board of directors approved, upon advice of prior legal counsel,
the extension of the termination date for each of the 1997 Plan and 1998
Plan to December 31, 2000 in order to cover the grant of the 2000 Options
that were intended to be made on January 2000. The original termination
date for the 1997 Plan and 1998 Plan was December 31, 1997 and December 31,
1998, respectively. Note 14 to the Company's consolidated financial
statements dated December 31, 2003, contained in the Company's annual
report on Form 10-K filed with the Securities and Exchange Commission on
April 14, 2004, reflected the grant of the 2000 Options.

On June 27, 2004, the Company was advised by its current legal counsel that
the Company did not have the authority to grant the 2000 Options under the
1997 Plan and 1998 Plan because the board of directors did not have the
authority to extend the termination date of either the 1997 Plan or the
1998 Plan after the date each of these plans had expired pursuant to their
original terms. The 1997 Plan and the 1998 Plan terminated pursuant to
their own terms on December 31, 1997 and December 31, 1998, respectively.
As a result, the 2000 Options were never granted by the Company and have
never been outstanding. The information in this Note 15 reflects the
foregoing.

F-27

I/OMAGIC CORPORATION
AND SUBSIDIARY
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
- --------------------------------------------------------------------------------

NOTE 15 - WARRANTS AND STOCK OPTIONS (CONTINUED)

The following summarizes options and warrants granted and outstanding as of
December 31, 2004, 2003, 2002 and 2001:

NUMBER OF SHARES WEIGHTED-
---------------- AVERAGE
NON- EXERCISE
EMPLOYEE EMPLOYEE TOTAL PRICE
-------- -------- ----- -----

Outstanding, December 31, 2001 40,000 -- 40,000 $ 22.13
Expired, cancelled (20,000) -- (20,000) $ 27.30
---------- ---------- ---------- ----------
Outstanding, December 31, 2002 20,000 -- 20,000 $ 16.95
Granted 40,008 40,008 $ 8.49
Expired, cancelled (20,000) -- (20,000) $ 16.95
---------- ---------- ---------- ----------
Outstanding, December 31, 2003 -- 40,008 40,008 $ 8.49
Granted 126,375 20,000 146,375 $ 3.85
Expired, cancelled (375) (40,008) (40,383) $ 8.44
---------- ---------- ---------- ----------
Outstanding, December 31, 2004 126,000 20,000 146,000 $ 3.85
========== ========== ========== ==========
Exercisable, December 31, 2004 71,388 20,000 91,388 $ 3.96
========== ========== ========== ==========

The following table is a summary of the stock options and warrants as of
December 31, 2004:

WEIGHTED- WEIGHTED-
AVERAGE AVERAGE
WEIGHTED- EXERCISE EXERCISE
AVERAGE PRICE OF PRICE OF
RANGE OF STOCK OPTIONS STOCK OPTIONS REMAINING OPTIONS AND OPTIONS AND
EXERCISE AND WARRANTS AND WARRANTS CONTRACTUAL WARRANTS WARRANTS
PRICES OUTSTANDING EXERCISABLE LIFE OUTSTANDING EXERCISABLE
------ ----------- ----------- ---- ----------- -----------

$ 3.50-3.85 126,000 71,388 9.25 years $ 3.67 $ 3.67
$ 4.00-6.00 20,000 20,000 0.75 years $ 5.00 $ 5.00
-------------- -------------- ---------- ------------- --------------
146,000 91,388 8.09 YEARS $ 3.85 $ 3.96
============== ============== ---------- ------------- --------------

The Black-Scholes option valuation model was developed for use in
estimating the fair value of traded options, which have no vesting
restrictions and are fully transferable. In addition, option valuation
models require the input of highly subjective assumptions including the
expected stock price volatility. Because the Company's employee stock
options have characteristics significantly different from those of traded
options, and because changes in the subjective input assumptions can
materially affect the fair value estimate, in management's opinion, the
existing models do not necessarily provide a reliable single measure of the
fair value of its employee stock options.

NOTE 16 - INCOME TAXES

The components of the income tax provision (benefit) for the years ended
December 31, 2004, 2003, and 2002 were as follows:

2004 2003 2002
---- ---- ----
(RESTATED)(1) (RESTATED)(1)
Current $ 2,532 $ (27,148) $ 2,400
Deferred -- -- 682,972
---------- ---------- ----------
TOTAL $ 2,532 $ (27,148) $ 685,372
========== ========== ==========

- ---------------
(1) See Note 2 - Restatement of 2000, 2001, 2002 and 2003 Financial Statements

F-28

I/OMAGIC CORPORATION
AND SUBSIDIARY
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
- --------------------------------------------------------------------------------

NOTE 16 - INCOME TAXES (CONTINUED)

Income tax expense (benefit) for the years ended December 31, 2004, 2003,
and 2002 differed from the amounts computed applying the federal statutory
rate of 34% to pre-tax income as a result of:

2004 2003 2002
---- ---- ----
(RESTATED)(1) (RESTATED)(1)

Computed "expected" tax benefit $(2,738,340) $ (165,636) $(2,774,135)
Income in income taxes resulting from expenses not
deductible for tax purposes 7,955 8,106 12,087
Change in beginning of the year balance of the
valuation allowance for deferred tax assets
allocated to income tax expense 3,199,890 (179,295) 3,753,597
Return to provision adjustment -- 247,767 --
State and local income taxes, net of tax benefit (466,973) 91,458 21,206
Other -- (29,548) (327,383)
----------- ----------- -----------
TOTAL $ 2,532 $ (27,148) $ 685,372
=========== =========== ===========

- ---------------
(1) See Note 2 - Restatement of 2000, 2001, 2002 and 2003 Financial Statements

Significant components of the Company's deferred tax assets and liabilities
for federal income taxes at December 31, 2004 and 2003 consisted of the
following:

2004 2003
---- ----
(RESTATED)(1)

Deferred tax assets
Net operating loss carryforward $ 9,093,879 $ 7,049,202
Allowance for doubtful accounts 10,687 8,805
Allowances for product returns 115,970 156,361
Allowances for sales incentives 129,747 191,610
Accrued compensation 68,789 66,915
Amortization of trademarks 2,609,562 1,053,703
Settlement payable and related accrued legal expenses -- 428,400
Inventory 738,002 370,973
Other 14,836 14,235
Valuation allowance (12,098,999) (8,899,109)
------------ ------------
Total deferred tax assets 682,473 441,095
------------ ------------

Deferred tax liabilities
State tax (676,333) (434,955)
Other (6,140) (6,140)
------------ ------------
Total deferred tax liabilities (682,473) (441,095)
------------ ------------
NET DEFERRED TAX ASSETS/LIABILITIES $ -- $ --
============ ============

- ---------------
(1) See Note 2 - Restatement of 2000, 2001, 2002 and 2003 Financial Statements

F-29

I/OMAGIC CORPORATION
AND SUBSIDIARY
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
- --------------------------------------------------------------------------------

NOTE 16 - INCOME TAXES (CONTINUED)

As of December 31, 2004 and 2003, the valuation allowance for deferred tax
assets, totaled approximately $12,098,999 million and $8,899,109,
respectively. For the years ended December 31, 2004, 2003, and 2002, the
net change in the valuation allowance was $3,199,890 (increase), $179,295
(increase) and $3,753,597 (increase), respectively.

The valuation allowance was increased in 2001 to reserve the change in the
value of the deferred tax asset based on the Company's performance for that
year. For the year ended December 31, 2001, the Company determined that its
ability to use the $683,000 in deferred tax assets was not impaired since
the Company had income in 1999 and losses in 2000, 2001 and the Company
expected to be profitable in 2002. For the year ended December 31, 2002,
the Company determined that its ability to use the $683,000 in deferred tax
assets was impaired due to losses in 2000, 2001 and 2002 because the
inability to show net income for three consecutive years brought into
question the Company's ability to obtain future profitability. For 2002,
the Company believed that in accordance with SFAS No. 109 it was "more
likely than not" that the deferred tax asset would not be utilized.

As of December 31, 2004, the Company had net operating loss carryforwards
for federal and state income tax purposes of approximately $23,137,000 and
$13,885,000, respectively, that expire through 2024 and 2014, respectively.
The utilization of net operating loss carryforwards may be limited under
the provisions of Internal Revenue Code Section 382 and similar state
provisions due to the change in ownership.

NOTE 17 - RELATED PARTY TRANSACTIONS

During the years ended December 31, 2004, 2003, and 2002, the Company made
purchases from related parties totaling $21,725,485, $32,754,145, and
$12,705,232, respectively.

Until March 28, 2003, the Company leased its warehouse and office space
from a related party under the control of an officer of the Company. During
the years ended December 31, 2003 and 2002, the Company made rental
payments totaling $86,018 and $344,070, respectively, to this related
party.

NOTE 18 - SELECTED QUARTERLY FINANCIAL DATA-UNAUDITED

Quarterly Financial Data--As Restated
-------------------------------------

The following tables are summaries of the unaudited quarterly financial
information for the years ended December 31, 2004, 2003 and 2002.

FIRST SECOND THIRD FOURTH TOTAL
YEAR ENDED DECEMBER 31, 2004 QUARTER QUARTER QUARTER QUARTER YEAR
- ---------------------------- ------- ------- ------- ------- ----
(RESTATED) (RESTATED) (RESTATED)

(IN THOUSANDS, EXCEPT PER SHARE DATA)

Net sales $ 15,474 $ 7,490 $ 9,947 $ 11,486 $ 44,397
Gross profit 2,256 438 555 (271) 2,978
Operating expenses 2,056 1,834 1,698 5,293 10,881
Operating income (loss) 200 (1,396) (1,143) (5,564) (7,903)
Other income (expense) (52) (52) (26) (21) (151)
Pre-tax income (loss) 148 (1,448) (1,169) (5,585) (8,054)
Income tax provision (benefit) 3 (1) -- 1 3
Net income (loss) $ 145 $ (1,447) $ (1,169) $ (5,586) $ (8,057)
Net income (loss) per common share diluted $ 0.03 $ (0.32) $ (0.26) $ (1.23) $ (1.78)

F-30

I/OMAGIC CORPORATION
AND SUBSIDIARY
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
- --------------------------------------------------------------------------------

NOTE 18 - SELECTED QUARTERLY FINANCIAL DATA-UNAUDITED (CONTINUED)

FIRST SECOND THIRD FOURTH TOTAL
YEAR ENDED DECEMBER 31, 2003 QUARTER QUARTER QUARTER QUARTER YEAR
- ---------------------------- ------- ------- ------- ------- ----
(RESTATED) (RESTATED) (RESTATED) (RESTATED) (RESTATED)

(IN THOUSANDS, EXCEPT PER SHARE DATA)

Net sales $ 17,104 $ 12,369 $ 14,016 $ 20,098 $ 63,587
Gross profit 1,987 1,511 2,419 3,027 8,944
Operating expenses 2,150 3,162 1,825 2,100 9,237
Operating income (loss) (163) (1,651) 594 927 (293)
Other income (expense) (80) (26) (44) (44) (194)
Pre-tax income (loss) (243) (1,677) 550 883 (487)
Income tax provision (benefit) (2) 1 (2) (24) (27)
Net income (loss) $ (241) $ (1,678) $ 552 $ 907 $ (460)
Net income (loss) per common share diluted $ (0.05) $ (0.37) $ 0.12 $ 0.20 $ (0.10)

FIRST SECOND THIRD FOURTH TOTAL
YEAR ENDED DECEMBER 31, 2002 QUARTER QUARTER QUARTER QUARTER YEAR
- ---------------------------- ------- ------- ------- ------- ----
(RESTATED) (RESTATED) (RESTATED) (RESTATED) (RESTATED)

(IN THOUSANDS, EXCEPT PER SHARE DATA)

Net sales $ 25,525 $ 13,259 $ 20,711 $ 21,458 $ 80,953
Gross profit 3,349 310 1,541 2,188 7,388
Operating expenses 2,946 2,633 2,513 1,931 10,023
Operating income (loss) 403 (2,323) (972) 257 (2,635)
Other income (expense) (84) (181) (83) (5,177) (5,525)
Pre-tax income (loss) 319 (2,504) (1,055) (4,920) (8,160)
Income tax provision (benefit) -- 500 185 -- 685
Net income (loss) $ 319 $ (3,004) $ (1,240) $ (4,920) $ (8,845)
Net income (loss) per common share diluted $ 0.07 $ (0.66) $ (0.27) $ (1.09) $ (1.95)

Quarterly Financial Data--Restatement Adjustments
-------------------------------------------------

F-31

I/OMAGIC CORPORATION
AND SUBSIDIARY
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
- --------------------------------------------------------------------------------

NOTE 18 - SELECTED QUARTERLY FINANCIAL DATA-UNAUDITED (CONTINUED)

The Company has recalculated its provision for income taxes for the years
ended December 31, 2001 and 2002 as a result of the restatements for sales
incentives, product returns and rebate promotions.

Based on the foregoing, the Company has determined the effect of these
corrections on its previously issued financial statements and has restated
the unaudited quarterly financial information below, reconciling the
restatement adjustments on a quarterly basis, for the first three quarterly
periods of the year ended December 31, 2004 and for all quarterly periods
in the years ended December 31, 2003 and 2002. The Company did not restate
its quarterly financial information for the quarterly period ended December
31, 2004.

AS ORIGINALLY RESTATEMENT
FIRST QUARTER ENDED MARCH 31, 2004 REPORTED ADJUSTMENTS AS RESTATED
---------------------------------- -------- ----------- -----------
(IN THOUSANDS, EXCEPT PER SHARE DATA)

Net sales $ 15,360 $ 114 $ 15,474
Gross profit (loss) 2,368 (112) 2,256
Operating expenses 2,056 - 2,056
Operating income (loss) 312 (112) 200
Other expense (52) - (52)
Pre-tax income (loss) 260 (112) (148)
Income tax provision 3 - 3
Net income (loss) $ 257 $ (112) $ 145
Net income (loss) per common share diluted $ 0.06 $ (0.03) $ 0.03

AS ORIGINALLY RESTATEMENT
SECOND QUARTER ENDED JUNE 30, 2004 REPORTED ADJUSTMENTS AS RESTATED
---------------------------------- -------- ----------- -----------
(IN THOUSANDS, EXCEPT PER SHARE DATA)
Net sales $ 7,192 $ 298 $ 7,490
Gross profit 251 186 437
Operating expenses 1,833 - 1,833
Operating income (loss) (1,582) 186 (1,396)
Other expense (52) - (52)
Pre-tax income (loss) (1,634) 186 (1,448)
Income tax benefit (1) - (1)
Net income (loss) $ (1,633) $ 186 $ (1,447)
Net income (loss) per common share diluted $ (0.36) $ 0.04 $ (0.32)

AS ORIGINALLY RESTATEMENT
THIRD QUARTER ENDED SEPTEMBER 30, 2004 REPORTED ADJUSTMENTS AS RESTATED
-------------------------------------- -------- ----------- -----------
(IN THOUSANDS, EXCEPT PER SHARE DATA)
Net sales $ 8,303 $ 1,644 $ 9,947
Gross profit (loss) (352) 907 555
Operating expenses 1,698 - 1,698
Operating income (loss) (2,050) 907 (1,143)
Other expense (26) - (26)
Pre-tax income (loss) (2,076) 907 (1,169)
Income tax provision (benefit) - - -
Net income (loss) $ (2,076) $ 907 $ (1,169)
Net income (loss) per common share diluted $ (0.46) $ 0.20 $ (0.26)

F-32

I/OMAGIC CORPORATION
AND SUBSIDIARY
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
- --------------------------------------------------------------------------------

NOTE 18 - SELECTED QUARTERLY FINANCIAL DATA-UNAUDITED (CONTINUED)

AS ORIGINALLY RESTATEMENT
FIRST QUARTER ENDED MARCH 31, 2003 REPORTED ADJUSTMENTS AS RESTATED
---------------------------------- -------- ----------- -----------
(IN THOUSANDS, EXCEPT PER SHARE DATA)
Net sales $ 17,064 $ 40 $ 17,104
Gross profit (loss) 2,436 (450) 1,986
Operating expenses 2,150 - 2,150
Operating income (loss) 286 (450) (164)
Other expense (80) - (80)
Pre-tax income (loss) 206 (450) (244)
Income tax benefit (3) - (3)
Net income (loss) $ 209 $ (450) $ (241)
Net income (loss) per common share diluted $ 0.05 $ (0.10) $ (0.05)

AS ORIGINALLY RESTATEMENT
SECOND QUARTER ENDED JUNE 30, 2003 REPORTED ADJUSTMENTS AS RESTATED
---------------------------------- -------- ----------- -----------
(IN THOUSANDS, EXCEPT PER SHARE DATA)
Net sales $ 12,793 $ (424) $ 12,369
Gross profit (loss) 1,910 (399) 1,511
Operating expenses 3,162 - 3,162
Operating loss (1,252) (399) (1,651)
Other expense (26) - (26)
Pre-tax loss (1,278) (399) (1,677)
Income tax provision 1 - 1
Net loss $ (1,279) $ (399) $ (1,678)
Net loss per common share diluted $ (0.28) $ (0.09) $ (0.37)

AS ORIGINALLY RESTATEMENT
THIRD QUARTER ENDED SEPTEMBER 30, 2003 REPORTED ADJUSTMENTS AS RESTATED
-------------------------------------- -------- ----------- -----------
(IN THOUSANDS, EXCEPT PER SHARE DATA)
Net sales $ 13,505 $ 511 $ 14,016
Gross profit 2,062 357 2,419
Operating expenses 1,825 - 1,825
Operating income 237 357 594
Other expense (44) - (44)
Pre-tax income 193 357 550
Income tax benefit (2) - (2)
Net income $ 195 $ 357 $ 552
Net income per common share diluted $ 0.04 $ 0.08 $ 0.12

AS ORIGINALLY RESTATEMENT
FOURTH QUARTER ENDED DECEMBER 31, 2003 REPORTED ADJUSTMENTS AS RESTATED
-------------------------------------- -------- ----------- -----------
(IN THOUSANDS, EXCEPT PER SHARE DATA)
Net sales $ 18,860 $ 1,238 $ 20,098
Gross profit 2,730 297 3,027
Operating expenses 2,100 - 2,100
Operating income 630 297 927
Other expense (44) - (44)
Pre-tax income 586 297 883
Income tax benefit (24) - (24)
Net income $ 610 $ 297 $ 907
Net income per common share diluted $ 0.13 $ 0.07 $ 0.20

F-33

I/OMAGIC CORPORATION
AND SUBSIDIARY
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
- --------------------------------------------------------------------------------

NOTE 18 - SELECTED QUARTERLY FINANCIAL DATA-UNAUDITED (CONTINUED)

AS ORIGINALLY RESTATEMENT
FIRST QUARTER ENDED MARCH 31, 2002 REPORTED ADJUSTMENTS AS RESTATED
---------------------------------- -------- ----------- -----------
(IN THOUSANDS, EXCEPT PER SHARE DATA)
Net sales $ 26,720 $ (1,195) $ 25,525
Gross profit (loss) 4,045 (696) 3,349
Operating expenses 2,946 - 2,946
Operating income (loss) 1,099 (696) 403
Other expense (84) - (84)
Pre-tax income (loss) 1,015 (696) 319
Income tax provision - - -
Net income (loss) $ 1,015 $ (696) $ 319
Net income (loss) per common share diluted $ 0.21 $ (0.14) $ 0.07

AS ORIGINALLY RESTATEMENT
SECOND QUARTER ENDED JUNE 30, 2002 REPORTED ADJUSTMENTS AS RESTATED
---------------------------------- -------- ----------- -----------
(IN THOUSANDS, EXCEPT PER SHARE DATA)
Net sales $ 14,086 $ (827) $ 13,259
Gross profit (loss) 849 (539) 310
Operating expenses 2,633 - 2,633
Operating loss (1,784) (539) (2,323)
Other expense (181) - (181)
Pre-tax loss (1,965) (539) (2,504)
Income tax provision 500 - 500
Net loss $ (2,465) $ (539) $ (3,004)
Net loss per common share diluted $ (0.54) $ (0.12) $ (0.66)

AS ORIGINALLY RESTATEMENT
THIRD QUARTER ENDED SEPTEMBER 30, 2002 REPORTED ADJUSTMENTS AS RESTATED
-------------------------------------- -------- ----------- -----------
(IN THOUSANDS, EXCEPT PER SHARE DATA)
Net sales $ 20,393 $ 318 $ 20,711
Gross profit (loss) 1,555 (13) 1,542
Operating expenses 2,514 - 2,514
Operating loss (959) (13) (972)
Other expense (83) - (83)
Pre-tax loss (1,042) (13) (1,055)
Income tax provision (benefit) 499 (314) 185
Net income (loss) $ (1,541) $ 301 $ (1,240)
Net income (loss) per common share diluted $ (0.34) $ 0.07 $ (0.27)

AS ORIGINALLY RESTATEMENT
FOURTH QUARTER ENDED SEPTEMBER 30, 2002 REPORTED ADJUSTMENTS AS RESTATED
--------------------------------------- -------- ----------- -----------
(IN THOUSANDS, EXCEPT PER SHARE DATA)
Net sales $ 22,331 $ (873) $ 21,458
Gross profit (loss) 2,415 (228) 2,187
Operating expenses 1,929 - 1,929
Operating loss 486 (228) 258
Other expense (5,177) - (5,177)
Pre-tax loss (4,691) (228) (4,919)
Income tax provision (benefit) 665 (664) 1
Net income (loss) $ (5,356) $ 436 $ (4,920)
Net income (loss) per common share diluted $ (1.17) $ 0.09 $ (1.09)

F-34

I/OMAGIC CORPORATION
AND SUBSIDIARY
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
- --------------------------------------------------------------------------------

NOTE 19 - SUBSEQUENT EVENTS

Line of Credit
--------------

On March 9, 2005, the Company entered into a Loan and Security Agreement
for an asset-based line of credit with GMAC Commercial Finance LLC
("GMAC"). The line of credit allows the Company to borrow up to a maximum
of $10.0 million. The line of credit expires on March 9, 2008 and is
secured by substantially all of the Company's assets. The line of credit
allows for a sublimit of $2.0 million for outstanding letters of credit.
Advances on the line of credit bear interest at the floating commercial
loan rate initially equal to the prime rate plus 0.75%. The prime rate as
of March 9, 2005 was 5.50%. The Company also has the option to use the
LIBOR rate plus an initial amount of 3.50%.

These rates are applicable if the average amount available for borrowing
for the prior six month period is between $1.0 million and $3.5 million. If
the average amount available for borrowing is less than $1.0 million, then
the rates applicable to all amounts borrowed increase by 0.25%. If the
average amount available for borrowing is greater than $3.5 million, then
the rates applicable to all amounts borrowed decrease by 0.25%. For the
unused portion of the line, the Company is to pay on a monthly basis, an
unused line fee in the amount of 0.25% of the average unused portion of the
line for the preceding month.

The Loan Agreement contains one financial covenant--that the Company
maintain at the end of each measurement period through and including
September 30, 2005, a fixed charge coverage ratio of at least 1.2 to 1.0
and a fixed charge coverage ratio of at least 1.5 to 1.0 for all
measurement periods thereafter. A measurement period is defined in the Loan
Agreement as the three month period ending March 31, 2005, the six month
period ending June 30, 2005, the nine month period ending September 30,
2005, the 12 month period ending December 31, 2005, and thereafter the
twelve month period ending on March 31, June 30, September 30, and December
31 of each year during the term of the credit facility.

The obligations of the Company under the Loan Agreement are secured by
substantially all of the Company's assets and guaranteed by the Company's
wholly-owned subsidiary, IOM Holdings, Inc. (the "Subsidiary"). The
obligations of the Company and the guarantee obligations of its Subsidiary
are secured pursuant to a Pledge and Security Agreement executed by the
Company, a Collateral Assignment Agreement executed by the Company, a
Guaranty Agreement executed by its Subsidiary, a General Security Agreement
executed by its Subsidiary, an Intellectual Property Security Agreement and
Collateral Assignment executed by the Company, and an Intellectual Property
Security Agreement and Collateral Assignment executed by its Subsidiary
(collectively, the "Security Agreements").

The new credit facility was initially used to pay off the Company's
outstanding balance with United National Bank as of March 10, 2005, which
balance was $3,809,320, and was also used to pay $25,000 of the Company's
closing fees for the GMAC line of credit. The line of credit will be used
for general operations.

On May 23, 2005, the Company entered into a Letter Agreement (the "Letter
Agreement") with GMAC with respect to a certain financial covenant under
the Company's Loan and Security Agreement with GMAC dated March 9, 2005
(the "Loan Agreement"). The Letter Agreement amended the Loan Agreement to
exclude the required Fixed Charge Coverage Ratio for the Measurement Period
ending March 31, 2005. As of March 31 2005, the Company was in breach of
the financial covenant; however, as a result of this Letter Agreement, the
Company is no longer in breach of this covenant. The Letter Agreement also
amended the Loan Agreement to include new Fixed Charge Coverage Ratio
Measurement Periods ending April 30 and May 31, 2005.

On June 30, 2005, the Company entered into a First Amendment to Loan and
Security Agreement (the "Amendment") with GMAC with respect to a certain
financial covenant under the Loan Agreement. The Amendment amended the Loan
Agreement to exclude the required Fixed Charge Coverage Ratio for the
Measurement Periods ending April 30 and May 31, 2005. As of April 30, 2005,
the Company was in breach of the financial covenant;
however, as a result of this Amendment, the Company is no longer in breach
of this covenant. The Letter Agreement also amended the Loan Agreement to
include new Fixed Charge Coverage Ratio Measurement Periods ending April 30
and May 31, 2005.

F-35

I/OMAGIC CORPORATION
AND SUBSIDIARY
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
- --------------------------------------------------------------------------------

NOTE 19 - SUBSEQUENT EVENTS (CONTINUED)

Litigation
----------

On May 6, 2005, OfficeMax North America, Inc., or plaintiff, filed a
Complaint for Declaratory Judgment in the United States District Court of
the Northern District of Ohio against the Company. The complaint seeks
declaratory relief regarding whether plaintiff is still obligated to the
Company under certain previous agreements between the parties. The
complaint also seeks plaintiff's costs as well as reasonable attorneys'
fees. The complaint arises out of the Company's contentions that plaintiff
is still obligated to the Company under an agreement entered into in May
2001 and plaintiff's contention that it has been released from such
obligation. As of the date of this report, the Company has filed a motion
to dismiss, or in the alternative, a motion to stay the plaintiff's action
against the Company. The outcome of this action is presently uncertain.
However, at this time, the Company does not expect the defense or outcome
of this action to have a material adverse affect on its business, financial
condition or results of operations.

On May 20, 2005, the Company filed a complaint for breach of contract,
breach of implied covenant of good faith and fair dealing, and common
counts against OfficeMax North America, Inc., or defendant, in the Superior
Court of the State of California for the County of Orange. The complaint
seeks damages in excess of $22 million arising out of the defendants'
breach of contract under an agreement entered into in May 2001. On or about
June 20, 2005, defendant removed this complaint to the United States
District Court for the Central District of California. The Company and
OfficeMax have jointly requested that the United States District Court for
the Central District of California temporarily stay this case pending the
outcome of the Company's motion to dismiss, or in the alternative, the
Company's motion to stay OfficeMax's action against the Company in the
United States District Court of the Northern District of Ohio. The outcome
of this action is presently uncertain. However, the Company believes that
all of its claims are meritorious.

Agreement with Lung Hwa Electronics Co., Ltd.
---------------------------------------------

On June 6, 2005, the Company entered into an agreement for a trade credit
facility with Lung Hwa Electronics Co., Ltd. ("LHE"). LHE is a stockholder
and subcontract manufacturer and supplier of I/OMagic. Under the terms of
the facility, LHE has agreed to purchase and manufacture inventory on
behalf of the Company. The Company can purchase up to $15.0 million of
inventory either (i) through LHE as an international purchasing office, or
(ii) manufactured by LHE. For inventory purchased through LHE the payment
terms are 120 days following the date of invoice by LHE and LHE charges the
Company a 5% handling fee on a supplier's unit price. A 2% discount of the
handling fee is applied if the Company reaches an average running monthly
purchasing volume of $750,000. Returns made by the Company, which are
agreed to by a supplier, result in a credit to the Company for the handling
charge. For inventory manufactured by LHE, the payment terms are 90 days
following the date of the invoice by LHE. Upon effectiveness of the
Agreement, the Company is required to pay LHE $1.5 million as an early
payment for all invoices coming due for payment. Any early payment funds
remaining three months after the date of the Agreement shall be refunded to
the Company immediately. Once the $1.5 million has been exhausted, or three
months from the date of the Agreement has expired, whichever is sooner, the
Company shall pay LHE 10% of the purchase price on any purchase orders
issued to LHE, as a down-payment for the order, within one week of the
purchase order. The Agreement has an initial term of one year after which
the Agreement will continue indefinitely if not terminated at the end of
the initial term. At the end of the initial term and at any time
thereafter, either party has the right to terminate the facility upon 30
days' prior written notice to the other party.

In connection with the entry into the agreement with LHE described above,
the Company entered into a Termination Agreement effective June 6, 2005
that terminated the Company's previous January 23, 2003 agreement with LHE
that provided a $10 million trade credit facility to the Company.

F-36

I/OMAGIC CORPORATION
AND SUBSIDIARY
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
- --------------------------------------------------------------------------------

REPORT OF INDEPENDENT REGISTERED PUBLIC ACCOUNTING FIRM
ON FINANCIAL STATEMENT SCHEDULE

To the Board of Directors
I/OMagic Corporation and subsidiary
Irvine, California

Our audits were made for the purpose of forming an opinion on the basic restated
consolidated financial statements taken as a whole. The consolidated
supplemental schedule II is presented for purposes of complying with the
Securities and Exchange Commission's rules and is not a part of the basic
restated consolidated financial statements. This schedule has been subjected to
the auditing procedures applied in our audits of the basic restated consolidated
financial statements and, in our opinion, is fairly stated in all material
respects in relation to the basic restated consolidated financial statements
taken as a whole.

/s/ SINGER LEWAK GREENBAUM & GOLDSTEIN LLP

Los Angeles, California
April 18, 2005

F-37

I/OMAGIC CORPORATION
AND SUBSIDIARY
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
- --------------------------------------------------------------------------------

ADDITIONS
BALANCE, ADDITIONS (DEDUCTIONS) BALANCE,
BEGINNING CHARGED TO FROM END
OF YEAR OPERATIONS RESERVE OF YEAR
------- ---------- ------- -------

ALLOWANCE FOR DOUBTFUL ACCOUNTS

DECEMBER 31, 2004 $ 20,553 $ 202,654 $ (198,261) $ 24,946
DECEMBER 31, 2003 $ 2,135,660 $ 1,478,089 $ (3,593,196) $ 20,553
DECEMBER 31, 2002 $ 2,679,118 $ 1,300,000 $ (1,843,458) $ 2,135,660

RESERVES FOR OBSOLETE INVENTORY

DECEMBER 31, 2004 $ 505,029 $ 2,046,217 $ (1,088,032) $ 1,463,214
DECEMBER 31, 2003 $ 1,046,812 $ 125,000 $ (666,783) $ 505,029
DECEMBER 31, 2002 $ 558,703 $ 2,070,200 $ (1,582,091) $ 1,046,812

RESERVES FOR PRODUCT RETURNS AND SALES INCENTIVES

DECEMBER 31, 2004 $ 812,258 $ 4,043,212 $ (4,281,900) $ 573,570
DECEMBER 31, 2003 $ 530,082 $ 3,566,648 $ (3,284,472) $ 812,258
DECEMBER 31, 2002 $ 2,117,339 $ 7,469,768 $ (9,057,025) $ 530,082

F-38

INDEX TO EXHIBITS

EXHIBIT
NUMBER DESCRIPTION
- ------ -----------

3.1 Amended and Restated Articles of Incorporation of I/OMagic Corporation
filed with the Secretary of State of Nevada on December 6, 2002 (7)

3.2 Amended and Restated Bylaws of I/OMagic Corporation dated July 25,
2002 (1)

10.1 Employment Agreement dated October 15, 2002 between I/OMagic
Corporation and Tony Shahbaz (#) (2)

10.2 I/OMagic Corporation 2002 Stock Option Plan (#) (3)

10.3 Agreement dated January 23, 2003 between I/OMagic Corporation and Lung
Hwa Electronics Co., Ltd. (4)

10.4 Warehouse Services and Bailment Agreement dated February 3, 2003
between I/OMagic Corporation and Behavior Tech Computer (USA) Corp.
(4)

10.5 I/OMagic Corporation 2003 Stock Option Plan (#) (6)

10.6 Standard Industrial/Commercial Single-Tenant Lease-Net dated July 1,
2003 between Laro Properties, L.P. and I/OMagic Corporation (5)

10.7 Form of Indemnification Agreement (8)

10.8 Trademark License Agreement dated July 24, 2004 by and between IOM
Holdings, Inc. and I/OMagic Corporation (8)

10.9 Business Loan Agreement (Asset Based) dated August 15, 2003 between
United National Bank and I/OMagic Corporation (5)

10.10 Promissory Note dated August 15, 2003 between United National Bank and
I/OMagic Corporation (5)

10.11 Commercial Security Agreement dated August 15, 2003 between United
National Bank and I/OMagic Corporation (5)

10.12 Letter Agreement dated March 18, 2004 between United National Bank and
I/OMagic Corporation (7)

10.13 Change in Terms Agreement dated August 6, 2004 between I/OMagic
Corporation and United National Bank (9)

10.14 Extension Letter dated October 27, 2004 from United National Bank (10)

10.15 Change in Terms Agreement dated November 1, 2004 between I/OMagic
Corporation and United National Bank (11)

10.16 Change in Terms Agreement dated December 1, 2004 between I/OMagic
Corporation and United National Bank (12)

10.17 Change in Terms Agreement dated December 15, 2004 between I/OMagic
Corporation and United National Bank (13)

10.18 Change in Terms Agreement dated January 31, 2005 between I/OMagic
Corporation and United National Bank (14)

10.19 Change in Terms Agreement dated February 18, 2005 between I/OMagic
Corporation and United National Bank (15)

10.20 Change in Terms Agreement dated March 1, 2005 between I/OMagic
Corporation and United National Bank (16)

10.21 Loan and Security Agreement entered into between I/OMagic Corporation
and GMAC Commercial Finance LLC, dated March 9, 2005 (17)

10.22 Pledge and Security Agreement executed by I/OMagic Corporation, dated
March 9, 2005 (17)

10.23 Collateral Assignment Agreement executed by I/OMagic Corporation,
dated March 9, 2005 (17)

10.24 Guaranty Agreement entered into between IOM Holdings, Inc., and GMAC
Commercial Finance LLC dated March 9, 2005 (17)

EXHIBIT
NUMBER DESCRIPTION
- ------ -----------

10.25 General Security Agreement entered into between IOM Holdings, Inc. and
GMAC Commercial Finance LLC, dated March 9, 2005 (17)

10.26 Intellectual Property Security Agreement and Collateral Assignment
entered into between I/OMagic Corporation and GMAC Commercial Finance
LLC, dated March 9, 2005 (17)

10.27 Intellectual Property Security Agreement and Collateral Assignment
entered into between IOM Holdings, Inc. and GMAC Commercial Finance
LLC, dated March 9, 2005 (17)

10.28 Letter Agreement between GMAC Commercial Finance LLC and I/OMagic
Corporation dated May 23, 2005 (18)

10.29 Termination Agreement between Lung Hwa Electronics Co., Ltd. and
I/OMagic Corporation dated June 6, 2005 (19)

10.30 Agreement between Lung Hwa Electronics Co., Ltd. and I/OMagic
Corporation dated June 6, 2005 (19)

10.31 First Amendment to Loan and Security Agreement between GMAC Commercial
Finance LLC and I/OMagic Corporation dated June 30, 2005 (20)

14.1 I/OMagic Corporation Code of Business Conduct and Ethics dated March
15, 2004 (7)

14.2 I/OMagic Corporation Code of Business Ethics for CEO and Senior
Financial Officers dated March 15, 2004 (7)

14.3 Charter of the Audit Committee of the Board of Directors of I/OMagic
Corporation dated March 15, 2004 (7)

21.1 Subsidiaries of the Registrant (8)

23.1 Consent of Independent Registered Public Accounting Firm*

31 Certifications Required by Rule 13a-14(a) of the Securities Exchange
Act of 1934, as amended, as Adopted Pursuant to Section 302 of the
Sarbanes-Oxley Act of 2002*

32 Certification of Chief Executive Officer and Chief Financial Officer
Pursuant to 18 U.S. C. Section 350, as Adopted Pursuant to Section 906
of the Sarbanes-Oxley Act of 2002*

- ---------------
* Filed herewith.

(#) Management contract or compensatory plan, contract or arrangement required
to be filed as an exhibit.
(1) Incorporated by reference to the Registrant's quarterly report on Form 10-Q
for the quarterly period ended June 30, 2002 (File No. 000-27267).
(2) Incorporated by reference to the Registrant's quarterly report on Form 10-Q
for the quarterly period ended September 30, 2002 (File No. 000-27267).
(3) Incorporated by reference to Registrant's definitive proxy statement for
the annual meeting of stockholders held November 4, 2002.
(4) Incorporated by reference to the Registrant's annual report on Form 10-K
for the year ended December 31, 2002 (File No. 000-27267).
(5) Incorporated by reference to the Registrant's quarterly report on Form 10-Q
for the quarterly period ended June 30, 2003 (File No. 000-27267).
(6) Incorporated by reference to the Registrant's definitive proxy statement
for the annual meeting of stockholders held December 18, 2003.
(7) Incorporated by reference to the Registrant's annual report on Form 10-K
for the year ended December 31, 2003 (File No. 000-27267).
(8) Incorporated by reference to the Registrant's registration statement on
Form S-1/A No. 1 filed by the Registrant with the Securities and Exchange
Commission on July 30, 2004 (Reg. No. 333-115208).
(9) Incorporated by reference to the Registrant's quarterly report on Form 10-Q
for the quarterly period ended June 30, 2004 (File No. 000-27267).
(10) Incorporated by reference to the Registrant's registration statement on
Form S-1/A No. 2 filed by the Registrant with the Securities and Exchange
Commission on October 27, 2004 (Reg. No. 333-115208).
(11) Incorporated by reference to the Registrant's quarterly report on Form 10-Q
for the quarterly period ended September 30, 2004 (File No. 000-27267).
(12) Incorporated by reference to the Registrant's current report on Form 8-K
filed by the Registrant with the Securities and Exchange Commission on
December 3, 2004 (File No. 000-27267).
(13) Incorporated by reference to the Registrant's current report on Form 8-K
filed by the Registrant with the Securities and Exchange Commission on
December 20, 2004 (File No. 000-27267).
(14) Incorporated by reference to the Registrant's current report on Form 8-K
filed by the Registrant with the Securities and Exchange Commission on
January 31, 2005 (File No. 000-27267).
(15) Incorporated by reference to the Registrant's current report on Form 8-K
filed by the Registrant with the Securities and Exchange Commission on
February 18, 2005 (File No. 000-27267).
(16) Incorporated by reference to the Registrant's current report on Form 8-K
filed by the Registrant with the Securities and Exchange Commission on
March 4, 2005 (File No. 000-27267).
(17) Incorporated by reference to the Registrant's current report on Form 8-K
filed by the Registrant with the Securities and Exchange Commission on
March 14, 2005 (File No. 000-27267).

(18) Incorporated by reference to the Registrant's quarterly report on Form 10-Q
for the quarterly period ended March 31, 2005 (File No. 000-27267).
(19) Incorporated by reference to the Registrant's current report on Form 8-K
filed by the Registrant with the Securities and Exchange Commission on June
13, 2005 (File No. 000-27267).
(20) Incorporated by reference to the Registrant's registration statement on
Form S-1/A No. 5 filed by the Registrant with the Securities and Exchange
Commission on July 1, 2005 (Reg. No. 333-115208).

SIGNATURES

Pursuant to the requirements of Section 13 or 15(d) of the Securities
Exchange Act of 1934, the registrant has duly caused this report to be signed on
its behalf by the undersigned, thereunto duly authorized on this 1st day of
July, 2005.

I/OMAGIC CORPORATION

/s/ TONY SHAHBAZ
----------------------------------
Tony Shahbaz
Chief Executive Officer, President
and Secretary

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

SIGNATURE TITLE DATE
--------- ----- ----

/s/ TONY SHAHBAZ Chief Executive Officer, President and Secretary July 1, 2005
- ------------------------- (Principal Executive Officer)
Tony Shahbaz

/s/ STEVE GILLINGS Chief Financial Officer (Principal Accounting and July 1, 2005
- ------------------------- Financial Officer)
Steve Gillings

/s/ DANIEL HOU Director July 1, 2005
- -------------------------
Daniel Hou

/s/ DANIEL YAO Director July 1, 2005
- -------------------------
Daniel Yao

/s/ STEEL SU Director July 1, 2005
- -------------------------
Steel Su

EXHIBITS FILED WITH THIS REPORT

EXHIBIT
NUMBER DESCRIPTION
------ -----------

23.1 Consent of Independent Registered Public Accounting Firm

31 Certifications Required by Rule 13a-14(a) of the Securities
Exchange Act of 1934, as amended, as Adopted Pursuant to Section
302 of the Sarbanes-Oxley Act of 2002

32 Certification of Chief Executive Officer and Chief Financial
Officer Pursuant to 18 U.S.C. Section 1350, as Adopted Pursuant
to Section 906 of the Sarbanes-Oxley Act of 2002