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U. S. SECURITIES AND EXCHANGE COMMISSION
WASHINGTON, D.C. 20549

FORM 10-Q

(Mark One)
|X| QUARTERLY REPORT UNDER SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE
ACT OF 1934
For the quarterly period ended MARCH 31, 2006

| | TRANSITION REPORT UNDER SECTION 13 OR 15(D) OF THE SECURITIES EXCHANGE
ACT OF 1934
For the transition period from ______ to _______

Commission File Number: 0-27267

I/OMAGIC CORPORATION
(Name of small business issuer as specified in its charter)

NEVADA 33-0773180
(State or other jurisdiction (I.R.S. Employer
of incorporation or organization) Identification No.)

4 MARCONI
IRVINE, CALIFORNIA 92618
(Address of principal executive offices)

(949) 707-4800
(Registrant's telephone number, including Area Code)

NOT APPLICABLE.
(Former name, former address and former fiscal year,
if changed since last report)

Indicate by check 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 whether the registrant is a large accelerated filer,
an accelerated filer, or a non-accelerated filer. See definition of "accelerated
filer and large accelerated filer" in Rule 12b-2 of the Exchange Act. Check one:

Indicate by check mark whether the registrant is a shell company (as
defined in Rule 12b-2 of the Exchange Act). Yes | | No |X|

As of May 15, 2006, there were 4,537,292 shares of the issuer's common
stock issued and outstanding.

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I/OMAGIC CORPORATION AND SUBSIDIARY

TABLE OF CONTENTS

PART I
FINANCIAL INFORMATION

PAGE
----

Item 1. Financial Statements

Consolidated Balance Sheets - March 31, 2006 (unaudited) and
December 31, 2005..................................................... 3

Consolidated Statements of Income - for the three months
ended March 31, 2006 and 2005 (unaudited)............................. 5

Consolidated Statements of Cash Flows - for the three months ended
March 31, 2006 and 2005 (unaudited)................................... 6

Notes to Consolidated Financial Statements (unaudited).................... 7

Item 2. Management's Discussion and Analysis of Financial Condition
and Results of Operation.................................................. 15

Item 3. Quantitative and Qualitative Disclosures About Market Risk................ 34

Item 4. Controls and Procedures................................................... 35

PART II
OTHER INFORMATION

Item 1. Legal Proceedings......................................................... 37

Item 1A. Risk Factors.............................................................. 38

Item 2. Unregistered Sales of Equity Securities and Use of Proceeds............... 38

Item 3. Defaults Upon Senior Securities........................................... 38

Item 4. Submission of Matters to a Vote of Security Holders....................... 38

Item 5. Other Information......................................................... 38

Item 6. Exhibits.................................................................. 38

Signatures .......................................................................... 39

Exhibits Filed with This Report......................................................... 40

PART I - FINANCIAL INFORMATION

ITEM 1. FINANCIAL STATEMENTS

I/OMAGIC CORPORATION
AND SUBSIDIARY
CONSOLIDATED BALANCE SHEETS
MARCH 31, 2006 (UNAUDITED) AND DECEMBER 31, 2005

ASSETS

MARCH 31, DECEMBER 31,
2006 2005
----------- -----------
(unaudited)

CURRENT ASSETS
Cash and cash equivalents $ 2,828,816 $ 4,056,541
Restricted cash 17,166 30,864
Accounts receivable, net of allowance for doubtful
accounts of $51,574 (unaudited) and $3,145 10,358,234 13,091,546
Inventory, net of allowance for obsolete inventory
of $21,266 (unaudited) and $29,690 6,457,614 6,917,878
Inventory in transit 372,925 66,478
Prepaid expenses and other current assets 1,361,837 1,484,084
----------- -----------

Total current assets 21,396,592 25,647,391

PROPERTY AND EQUIPMENT, net of accumulated depreciation
of $1,452,570 (unaudited) and $1,422,943 143,276 172,005
TRADEMARKS, net of accumulated amortization
of $5,535,940 (unaudited) and $5,518,708 413,640 430,872
OTHER ASSETS 27,032 27,032
----------- -----------

TOTAL ASSETS $21,980,540 $26,277,300
=========== ===========

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

I/OMAGIC CORPORATION
AND SUBSIDIARY
CONSOLIDATED BALANCE SHEETS
MARCH 31, 2006 (UNAUDITED) AND DECEMBER 31, 2005

LIABILITIES AND STOCKHOLDERS' EQUITY

MARCH 31, DECEMBER 31,
2006 2005
------------ ------------
(unaudited)

CURRENT LIABILITIES
Line of credit $ 5,108,887 $ 5,053,582
Accounts payable and accrued expenses 5,376,402 5,925,668
Accounts payable - related parties 5,365,334 8,222,078
Reserves for customer returns and sales incentives 551,058 494,289
------------ ------------

Total current liabilities 16,401,681 19,695,617
------------ ------------

STOCKHOLDERS' EQUITY
Preferred Stock
10,000,000 shares authorized, $0.001 par value
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
4,537,292 (unaudited) and 4,529,672 shares issued and outstanding 4,538 4,532
Additional paid-in capital 31,564,422 31,595,952
Treasury stock, 0 (unaudited) and 13,493 shares, at cost -- (126,014)
Accumulated deficit (25,990,101) (24,892,787)
------------ ------------

Total stockholders' equity 5,578,859 6,581,683
------------ ------------

TOTAL LIABILITIES AND STOCKHOLDERS' EQUITY $ 21,980,540 $ 26,277,300
============ ============

I/OMAGIC CORPORATION
AND SUBSIDIARY
CONSOLIDATED STATEMENTS OF INCOME
FOR THE THREE MONTHS ENDED MARCH 31, 2006 AND 2005
(UNAUDITED)

THREE MONTHS ENDED MARCH 31,
2006 2005
----------- -----------
(unaudited) (unaudited)

NET SALES $ 8,993,898 $ 9,036,812
COST OF SALES 8,240,510 8,454,880
----------- -----------

GROSS PROFIT 753,388 581,932
----------- -----------

OPERATING EXPENSES
Selling, marketing, and advertising 232,055 174,201
General and administrative 1,490,723 1,417,465
Depreciation and amortization 46,860 78,573
----------- -----------

Total operating expenses 1,769,638 1,670,239
----------- -----------

LOSS FROM OPERATIONS (1,016,250) (1,088,308)
----------- -----------
OTHER INCOME (EXPENSE)
Interest income 91 37
Interest expense (80,139) (77,353)
Other income (expense) (1,016) 8,332
----------- -----------

Total other income (expense) (81,064) (68,984)
----------- -----------
LOSS BEFORE PROVISION FOR INCOME TAXES (1,097,314) (1,157,291)
PROVISION FOR INCOME TAXES -- --
----------- -----------

NET LOSS $(1,097,314) $(1,157,291)
=========== ===========

BASIC LOSS PER SHARE $ (0.24) $ (0.26)
=========== ===========

DILUTED LOSS PER SHARE $ (0.24) $ (0.26)
=========== ===========

BASIC WEIGHTED-AVERAGE SHARES OUTSTANDING 4,528,959 4,529,672
----------- -----------

DILUTED WEIGHTED-AVERAGE SHARES OUTSTANDING 4,528,959 4,529,672
----------- -----------

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

I/OMAGIC CORPORATION
AND SUBSIDIARY
CONSOLIDATED STATEMENTS OF CASH FLOWS
FOR THE THREE MONTHS ENDED MARCH 31, 2006 AND 2005
(UNAUDITED)

THREE MONTHS ENDED MARCH 31,
2006 2005
----------- -----------
(unaudited) (unaudited)
CASH FLOWS FROM OPERATING ACTIVITIES
Net loss $(1,097,314) $(1,157,291)
Adjustments to reconcile net loss to net cash
used in operating activities
Depreciation and amortization 29,627 61,341
Amortization of trademarks 17,232 17,232
Allowance for doubtful accounts 56,634 85,000
Reserve for customer returns and sales incentives 56,770 197,732
Reserve for obsolete inventory 120,815 361,663
Stock based compensation expense 39,558 --
(Increase) decrease in
Accounts receivable 2,676,678 1,711,302
Inventory 339,449 (1,707,452)
Inventory in transit (306,447) 1,467
Prepaid expenses and other current assets 122,247 (447,142)
Decrease in
Accounts payable and accrued expenses (549,266) (595,679)
Accounts payable - related parties (2,856,744) (74,441)
----------- -----------

Net cash used in operating activities (1,350,761) (1,546,268)
----------- -----------

CASH FLOWS FROM INVESTING ACTIVITIES
Purchase of property and equipment (899) (1,255)
Restricted cash 13,698 777,892
----------- -----------

Net cash provided by investing activities 12,799 776,637
----------- -----------

CASH FLOWS FROM FINANCING ACTIVITIES
Net borrowings (payments) on line of credit 55,305 (1,159,730)
Exercise of stock options 54,932 --
----------- -----------

Net cash provided by (used in) financing activities 110,237 (1,159,730)
----------- -----------

Net decrease in cash and cash equivalents (1,227,725) (1,929,361)
CASH AND CASH EQUIVALENTS, BEGINNING OF PERIOD 4,056,541 3,587,807
----------- -----------

CASH AND CASH EQUIVALENTS, END OF PERIOD $ 2,828,816 $ 1,658,446
=========== ===========
SUPPLEMENTAL DISCLOSURES OF CASH FLOW INFORMATION
INTEREST PAID $ 77,877 $ 79,724
=========== ===========
INCOME TAXES PAID $ -- $ --
=========== ===========

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

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") develop, manufacture through subcontractors,
market, and distribute data storage and digital entertainment products to the
consumer electronics markets.

NOTE 2 - SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES

BASIS OF PRESENTATION

The accompanying unaudited consolidated financial statements of I/OMagic
Corporation have been prepared pursuant to the rules and regulations of the
Securities and Exchange Commission ("SEC") regarding interim financial
reporting. Accordingly, they do not include all of the information and footnotes
required by generally accepted accounting principles for annual financial
statements and should be read in conjunction with the consolidated financial
statements for the year ended December 31, 2005, and notes thereto included in
the Company's Annual Report on Form 10-KSB, filed with the SEC on March 31,
2006. In the opinion of management, the accompanying unaudited consolidated
financial statements contain all adjustments, consisting only of adjustments of
a normal recurring nature, necessary for a fair presentation of the Company's
financial position as of March 31, 2006, and its results of operations for the
periods presented. These unaudited consolidated financial statements are not
necessarily indicative of the results to be expected for the entire year.

The unaudited consolidated financial statements include IOM Holdings, Inc. (the
"Subsidiary") Intercompany transactions and balances have been eliminated in
consolidation.

USE OF 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.

STOCK-BASED COMPENSATION

On January 1, 2006, the Company adopted Statements of Financial Accounting
Standards No. 123 (revised 2004), "Share-Based Payment," ("SFAS 123(R)") which
requires the measurement and recognition of compensation expense for all
share-based payment awards made to employees and directors based on estimated
fair values. SFAS 123(R) supersedes the Company's previous accounting under
Accounting Principles Board Opinion No. 25, "Accounting for Stock Issued to
Employees" ("APB 25") for periods beginning in fiscal 2006. In March 2005, the
Securities and Exchange Commission issued Staff Accounting Bulletin No. 107
("SAB 107") relating to SFAS 123(R). The Company has applied the provisions of
SAB 107 in its adoption of SFAS 123(R).

The Company adopted SFAS 123(R) using the modified prospective transition
method, which requires the application of the accounting standard as of January
1, 2006, the first day of the Company's fiscal year 2006. The Company's
financial statements as of and for the three months ended March 31, 2006 reflect
the impact of SFAS 123(R). In accordance with the modified prospective
transition method, the Company's financial statements for prior periods have not
been restated to reflect, and do not include, the impact of SFAS 123(R).
Stock-based compensation expense recognized under SFAS 123(R) for employee and
directors for the three months ended March 31, 2006 was $39,558. Basic and
diluted loss per share for the quarter ended March 31, 2006 would have been
$0.23 per share, if the Company had not adopted SFAS 123(R), compared to
reported basic and diluted loss per share of $0.24 per share.

The following table illustrates the effect on net loss and loss per share if the
Company had applied the fair value recognition provisions of SFAS 123 to
stock-based awards granted under the Company's stock option plans for the three
months ended March 31, 2005. For purposes of this pro-forma disclosure, the fair
value of the options is estimated using the Black-Scholes-Merton option-pricing
formula ("Black-Scholes model") and amortized to expense generally over the
options' requisite service periods (vesting periods).

Net loss as reported $(1,157,291)
Plus: Stock-based compensation expense recognized
in the Statement of Income, net of tax --
Less: Stock-based compensation expense determined under
fair-value based method, net of tax (22,077)
-----------
Pro forma net loss $(1,179,368)
===========
Net loss per share
As reported - basic and diluted $ (0.26)
Pro forma - basic and diluted $ (0.26)

SFAS 123(R) requires companies to estimate the fair value of share-based payment
awards to employees and directors on the date of grant using an option-pricing
model. The value of the portion of the award that is ultimately expected to vest
is recognized as expense over the requisite service periods in the Company's
Statements of Operations. Stock-based compensation expense recognized in the
Statements of Operations for the first quarter of fiscal 2006 included
compensation expense for share-based payment awards granted prior to, but not
yet vested as of January 1, 2006 based on the grant date fair value estimated in
accordance with the pro-forma provisions of SFAS 123 and compensation expense
for the share-based payment awards granted subsequent to January 1, 2006, for
which there was none in the quarter ended March 31, 2006, based on the grant
date fair value estimated in accordance with the provisions of SFAS 123(R). For
stock-based awards issued to employees and directors, stock-based compensation
is attributed to expense using the straight-line single option method, which is
consistent with how the prior-period pro formas were provided. As stock-based
compensation expense recognized in the Statements of Operations for the first
quarter of fiscal 2006 is based on awards ultimately expected to vest, it has
been reduced for estimated forfeitures. SFAS 123(R) requires forfeitures to be
estimated at the time of grant and revised, if necessary, in subsequent periods
if actual forfeitures differ from those estimates. In its pro-forma information
required under SFAS 123 for the periods prior to fiscal 2006, the Company
accounted for forfeitures as they occurred.

Prior to the adoption of SFAS 123(R), the Company accounted for stock-based
awards to employees and directors using the intrinsic value method in accordance
with APB 25. Under the intrinsic value method, the Company recognized
share-based compensation equal to the award's intrinsic value at the time of
grant over the requisite service periods using the straight-line method.
Forfeitures were recognized as incurred. During the quarter ended March, 31,
2005, there was no stock-based compensation expense recognized in the Statements
of Operations for awards issued to employees and directors as the awards had no
intrinsic value at the time of grant because their exercise prices equaled the
fair values of the common stock at the time of grant.

The Company's determination of fair value of share-based payment awards to
employees and directors on the date of grant using the Black-Scholes model,
which is affected by the Company's stock price as well as assumptions regarding
a number of highly complex and subjective variables. These variables include,
but are not limited to the Company's expected stock price volatility over the
expected term of the awards, and actual and projected employee stock option
exercise behaviors. Prior to 2006, when valuing awards, the Company used the
awards' contractual term as a proxy for the expected life of the award and
historical volatility to approximate expected volatility. During 2006, there
have been no new awards.

The Company has elected to adopt the detailed method provided in SFAS 123(R) for
calculating the beginning balance of the additional paid-in capital pool ("APIC
pool") related to the tax effects of employee stock-based compensation, and to
determine the subsequent impact on the APIC pool and Statements of Cash Flows of
the tax effects of employee stock-based compensation awards that are outstanding
upon adoption of SFAS 123(R).

RECENT ACCOUNTING PRONOUNCEMENTS

In March 2006, the FASB issued SFAS No. 156, "Accounting for Servicing of
Financial Assets," which provides an approach to simplify efforts to obtain
hedge-like (offset) accounting. This Statement amends FASB SFAS No. 140,
"Accounting for Transfers and Servicing of Financial Assets and Extinguishments
of Liabilities", with respect to the accounting for separately recognized
servicing assets and servicing liabilities. The Statement (1) requires an entity
to recognize a servicing asset or servicing liability each time it undertakes an
obligation to service a financial asset by entering into a servicing contract in
certain situations; (2) requires that a separately recognized servicing asset or
servicing liability be initially measured at fair value, if practicable; (3)
permits an entity to choose either the amortization method or the fair value
method for subsequent measurement for each class of separately recognized
servicing assets or servicing liabilities; (4) permits at initial adoption a
one-time reclassification of available-for-sale securities to trading securities
by an entity with recognized servicing rights, provided the securities
reclassified offset the entity's exposure to changes in the fair value of the
servicing assets or liabilities; and (5) requires separate presentation of
servicing assets and servicing liabilities subsequently measured at fair value
in the balance sheet and additional disclosures for all separately recognized
servicing assets and servicing liabilities. SFAS No. 156 is effective for all
separately recognized servicing assets and liabilities as of the beginning of an
entity's fiscal year that begins after September 15, 2006, with earlier adoption
permitted in certain circumstances. The Statement also describes the manner in
which it should be initially applied. The Company does not believe that SFAS No.
156 will have a material impact on its financial position, results of operations
or cash flows.

In February 2006, the FASB issued SFAS No. 155, "Accounting for Certain Hybrid
Financial Instruments", which amends SFAS No. 133, "Accounting for Derivatives
Instruments and Hedging Activities" and SFAS No. 140, "Accounting for Transfers
and Servicing of Financial Assets and Extinguishment of Liabilities." SFAS No.
155 amends SFAS No. 133 to narrow the scope exception for interest-only and
principal-only strips on debt instruments to include only such strips
representing rights to receive a specified portion of the contractual interest
or principle cash flows. SFAS No. 155 also amends SFAS No. 140 to allow
qualifying special-purpose entities to hold a passive derivative financial
instrument pertaining to beneficial interests that itself is a derivative
instrument. The Company is currently evaluating the impact of this new standard,
but the Company believes that this new standard will not have a material impact
on its financial position, results of operations, or cash flows.

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 computation of
diluted earnings per share for the three months ended March 31, 2006 (unaudited)
and 2005 (unaudited) since their effect would have been anti-dilutive.

2006 2005
------- -------
Stock options outstanding 424,550 122,950
Warrants outstanding 180,000 20,000
------- -------
TOTAL 604,550 142,950
------- -------

NOTE 3 - INVENTORY

Inventory consisted of the following:

MARCH 31, DECEMBER 31,
2006 2005
----------- -----------
(unaudited)
Component parts $ 1,788,904 $ 2,491,594
Finished goods - warehouse 1,418,775 1,034,877
Finished goods - consigned 3,271,200 3,421,097
Reserves for obsolete and slow moving inventory (21,265) (29,690)
----------- -----------
TOTAL $ 6,457,614 $ 6,917,878
=========== ===========

NOTE 4 - PROPERTY AND EQUIPMENT

Property and equipment as of March 31, 2006 (unaudited) and December 31, 2005
consisted of the following:

MARCH 31, DECEMBER 31,
2006 2005
---------- ----------
(unaudited)
Computer equipment and software $1,060,698 $1,059,799
Warehouse equipment 55,238 55,238
Office furniture and equipment 281,974 281,974
Vehicles 91,304 91,304
Leasehold improvements 106,633 106,633
---------- ----------
1,595,847 1,595,948
Less accumulated depreciation and amortization 1,452,571 1,422,943
---------- ----------
TOTAL $ 143,276 $ 172,005
========== ==========

For the three months ended March 31, 2006 (unaudited) and 2005 (unaudited),
depreciation and amortization expense was $29,628 and $61,341, respectively.

NOTE 5 - LINE OF CREDIT

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
allowed the Company to borrow up to a maximum of $6.0 million. The 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. 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 is to be
used for general operations. 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 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. The Company currently is not using
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 Company
also has the option to use the LIBOR rate plus an initial amount of 3.50%. The
prime rate as of March 31, 2006 was 7.75%. 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 a fixed charge coverage ratio of at least 1.5
to 1.0. A measurement period is defined in the Loan Agreement as the three month
period ended March 31, 2005, the six month period ended June 30, 2005, the nine
month period ended September 30, 2005, the 12 month period ended 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. As of March 31, 2006, the Company was in breach of the financial
covenant; however, the Company received a waiver of this breach from GMAC
Commercial Finance on May 8, 2006.

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.

The outstanding balance with GMAC as of March 31, 2006 was $5,108,887
(unaudited). The amount available to the Company for borrowing as of March 31,
2006 was $198,982 (unaudited).

NOTE 6 - ACCOUNTS PAYABLE AND ACCRUED EXPENSES

Accounts payable and accrued expenses consisted of the following:

MARCH 31, DECEMBER 31,
2006 2005
---------- ------------
(unaudited)
Accounts payable $2,539,036 $ 1,477,459
Accrued rebates and marketing 2,258,068 3,848,545
Accrued compensation and related benefits 180,862 187,771
Other 398,436 411,893
---------- ------------
TOTAL $5,376,402 $ 5,925,668
========== ============

NOTE 7 - TRADE CREDIT FACILITIES WITH RELATED PARTIES

In January 2003, the Company entered into a trade credit facility with a related
party, whereby the related party agreed to purchase inventory on behalf of the
Company. The agreement allowed the Company to purchase up to $10.0 million, with
payment terms of 120 days following the date of invoice. The third party was to
charge the Company a 5% handling fee on the supplier's unit price. A 2% discount
to the handling fee applied if the Company reached an average running monthly
purchasing volume of $750,000. Returns made by the Company, which were agreed by
the supplier, resulted in a credit to the Company for the handling charge. As
security for the trade credit facility, the Company paid the related party a
security deposit of $1.5 million, of which $750,000 could 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 was for 12 months. At the end of
the 12-month period, either party was entitled to terminate the agreement upon
30 days' written notice. Otherwise, the agreement would remain continuously
valid without requiring a newly signed agreement. Both parties had the right to
terminate the agreement one year following the inception date by giving the
other party 30 days written notice of termination. During 2004, the Company
purchased $2.5 million of inventory under this arrangement. As of December 31,
2004, there were $0 in trade payables under this arrangement. This trade line of
credit was terminated on June 6, 2005 and a new trade facility was entered into.
The agreement containing the terms of the new trade credit facility was amended
and restated on July 21, 2005 to provide that the new facility would be
retroactive to April 29, 2005.

Under the terms of the new facility, the related party 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 the related party as an
international purchasing office, or (ii) manufactured by the related party. For
inventory purchased through the related party, the payment terms are 120 days
following the date of invoice by the related party and the related party 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 the related party, the payment terms are 90 days
following the date of the invoice by the related party. The Company is to pay
the related party 10% of the purchase price on any purchase orders issued to the
related party, 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. During the first three months of 2006, the Company purchased $2.5 million
(unaudited) of inventory under this arrangement. As of March 31, 2006, there
were $3,840,294 (unaudited) in trade payables under this arrangement.

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
the three months ended March 31, 2006, the Company purchased $870,000
(unaudited) of inventory under this arrangement. As of March 31, 2006, there
were $1,525,040 (unaudited) in trade payables outstanding under this
arrangement.

NOTE 8 - COMMITMENTS AND CONTINGENCIES

LEASES

The Company leases its facilities and certain equipment under non-cancelable
operating lease agreements that expire through December 2008. The Company moved
to its current facilities in September 2003.

Rent expense was $96,118 (unaudited) and $92,333 (unaudited) for the three
months ended March 31, 2006 and 2005, respectively, and is included in general
and administrative expenses in the accompanying statements of income.

LITIGATION
On or about 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, Inc., Lawrence M. Cron, Horwitz & Cron, Kevin J. Senn and
Senn Palumbo Meulemans, 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 sought 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 or about November 6, 2003,
the Company filed its First Amended Complaint against all defendants. Defendants
responded to the Company's First Amended Complaint denying the Company's
allegations. Defendants Lawrence W. Horwitz and Lawrence M. Cron also filed a
Cross-Complaint against the Company for attorneys' fees in the approximate
amount of $79,000. The Company denied the allegations in the Cross-Complaint.
Trial began on February 6, 2006 and on March 10, 2006, the jury ruled in the
Company's favor against Lawrence W. Horwitz, Horwitz & Beam, Inc., Lawrence M.
Cron, Horwitz & Cron and Senn Palumbo Meulemans, LLP, and awarded the Company
$3.0 million in damages. The Company has not collected any of this amount.
Judgment was entered on or about April 5, 2006. However, defendants have since
filed a motion for new trial and a motion for judgment notwithstanding the
verdict which could impact the Judgment. Both of these motions are presently
scheduled to be heard by the Court on May 31, 2006. Furthermore, defendants have
indicated that, if these motions are unsuccessful, they plan to appeal the
Judgment.

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, Case No. 05CC06433. The complaint sought
damages of in excess of $22 million arising out of the defendants' alleged
breach of contract under an agreement entered into in May 2001. On or about June
20, 2005, OfficeMax removed the case against OfficeMax to the United States
District Court for the Central District of California, Case No. SA CV05-0592

DOC(MLGx). On August 1, 2005, OfficeMax filed its Answer and Counter-Claim
against the Company. The Counter-Claim against the Company alleged four causes
of action against the Company: breach of contract, unjust enrichment, quantum
valebant, and an action for declaratory relief. The Counter-Claim alleged, among
other things, that the Company was liable to OfficeMax in the amount of no less
than $138,000 under the terms of a vendor agreement executed between the Company
and OfficeMax in connection with the return of computer peripheral products to
the Company for which OfficeMax alleged it was never reimbursed. The
Counter-Claim sought, among other things, at least $138,000 from the Company,
along with pre-judgment interest, attorneys' fees and costs of suit. The Company
filed a response denying all of the affirmative claims set forth in the
Counter-Claim, denying any wrongdoing or liability, and denying that OfficeMax
was entitled to obtain any relief. See Note 11.

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 9 - RELATED PARTY TRANSACTIONS

During the three months ended March 31, 2006 and 2005, the Company made
purchases from related parties totaling approximately $3,355,635 (unaudited) and
$7,495,622 (unaudited), respectively.

As of March 31, 2006 and December 31, 2005, the Company had trade payables to
related parties totaling approximately $5,365,334 (unaudited) and $8,222,078,
respectively.

NOTE 10 - STOCK OPTIONS AND WARRANTS

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.
The plans are collectively referred to as the "Plans," which are more fully
described in the Company's annual report on Form 10-K for the year ended
December 31, 2005. As of December 31, 2005, there were options to acquire
478,550 shares of common stock issued to employees and directors that were
outstanding under the Plans, and warrants issued to consultants to acquire
180,000 shares of common stock that were outstanding.
The weighted average exercise prices, remaining contractual lives and aggregate
intrinsic values for options and warrants granted, exercisable, and expected to
vest under the Plans as of December 31, 2005 were as follows:

Weighted-
Weighted- Average
Average Remaining
Number of Exercise Contractual
Shares Price Life (Years) Intrinsic Value
------- -------- ------------ ---------------
As of December 31, 2005:

Outstanding 478,550 $ 2.84 4.72 $1,105,408

Expected to Vest 465,000 $ 2.84 4.71 $1,076,000

Exercisable 287,493 $ 2.91 4.77 $ 644,054

Aggregate intrinsic value excludes those options that are not "in-the-money" as
of December 31, 2005. Awards that are expected to vest take into consideration
estimate forfeitures for awards not yet vested.

The weighted average exercise prices, remaining contractual lives and aggregate
intrinsic values for warrants granted, exercisable, and expected to vest as of
December 31, 2005 were as follows:

Weighted-
Weighted- Average
Average Remaining
Number of Exercise Contractual
Shares Price Life (Years) Intrinsic Value
------- -------- ------------ ---------------

As of December 31, 2005:

Outstanding 180,000 $ 4.83 0.97 $ 172,500

Expected to Vest 180,000 $ 4.83 0.97 $ 172,500

Exercisable 180,000 $ 4.83 0.97 $ 172,500

Aggregate intrinsic value excludes those warrants that are not "in-the-money" as
of December 31, 2005. Awards that are expected to vest take into consideration
estimate forfeitures for awards not yet vested.

Prior to 2005, there were no options exercised. Options exercised in 2005 were
immaterial. The total fair value of shares vested during the years ended
December 31, 2003, 2004 and 2005, were $0, $12,275 and $463,781, respectively.

As of December 31, 2005, there was $377,000 of total unrecognized compensation
costs related to non-vested share-based compensation arrangements granted,
including warrants. That cost is expected to be recognized over the
weighted-average period of 4.5 years.

When options are exercised, the Company's policy is to issue new shares to
satisfy share option exercises.

NOTE 11 - SUBSEQUENT EVENTS

In April 2006, the Company's case against OfficeMax North America, Inc. was
settled in its entirety. See Note 8. In settling the matter, each party denied
liability and wrongdoing and the settlement was entered into solely for the
purpose of compromising and settling the litigation and in order to avoid the
risk, cost, and burden of litigation and participation therein. Pursuant to the
settlement, OfficeMax paid $2,375,000 (unaudited) to the Company.

ITEM 2. 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 IN OUR MOST RECENT ANNUAL REPORT ON FORM 10-K AND OUR
CONSOLIDATED UNAUDITED FINANCIAL STATEMENTS AND THE RELATED NOTES AND OTHER
FINANCIAL INFORMATION INCLUDED ELSEWHERE IN THIS REPORT. THIS DISCUSSION
CONTAINS FORWARD-LOOKING STATEMENTS REGARDING THE DATA STORAGE INDUSTRY 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 THE "RISK FACTORS" SECTION OF OUR MOST RECENT ANNUAL REPORT ON
FORM 10-K 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 2005 and for the first
quarter of 2006, and our digital entertainment and other products collectively
accounted for only approximately 1% of our net sales in 2005 and for the first
quarter of 2006.

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 8,000 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. In the past three years, our 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 $43,000, or 0.5%, to $9.0 million in the
first quarter of 2006 from $9.0 million in the first quarter of 2005. Our net
loss decreased by $60,000 to $1.1 million in the first quarter of 2006 from a
net loss of $1.2 million in the first quarter of 2005. Our operating results
were due, in large part, to the following factors:

o NET SALES. Out net sales in the first quarter of 2006 as compared
to the first quarter of 2005 were primarily due to the following
combination of factors:

o a rapid and continued decline in sales of our CD-based
products;
o lower average selling prices of our DVD-based products; and
o slower than anticipated growth in sales of our DVD-based
products; offset by
o a 47% increase in sales of our GigaBank(TM) products.

o GROSS PROFIT. Our gross margins increased by 31.3% to 8.4% in the
first quarter of 2006 as compared to gross margins of 6.4% in the
first quarter of 2005. This increase was primarily due to a
decrease in charges to our inventory reserve from $362,000, or
2.7% of gross sales, during the first quarter of 2005 to $121,000,
or 0.9% of gross sales, during the first quarter of 2006.

A combination of factors affected our net sales, including 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 70.3% to $257,000 in the first
quarter of 2006 from $866,000 in the first quarter of 2005.

Another factor affecting our net sales for the first quarter of 2006 as
compared to the same period in 2005 was lower than expected demand for DVD-based
products which resulted in part from slower than anticipated growth in
DVD-compatible applications and infrastructure. Also, the market for DVD-based
products continued to be extremely competitive 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. For the first quarter of 2006, our sales of
recordable DVD-based products decreased by 15.2% to $3.9 million as compared to
$4.6 million in sales of recordable DVD-based products for the same period in
2005.

In addition to the factors described above, 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 the first quarter of 2006. 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 third quarter of 2004, we began selling our
GigaBank(TM) products. Sales of our GigaBank(TM) products increased to $4.3
million, or 48.6% of our net sales, in the first quarter of 2006 as compared to
$2.9 million, or 33.8% of our net sales, in the first quarter of 2005.

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. 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. One of our
challenges will be to deliver products and provide services 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.

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. For the first quarter of 2006, our annualized
inventory turnover level was 5.6 as compared to 4.8 for the first quarter of
2005, representing a period-to-period increase of 17% primarily as a result of a
14% decrease in inventory. The increase in inventory turnover for the first
quarter of 2006 included $121,000 in additional reserves for slow-moving and
obsolete inventory as compared to $362,000 in additional reserves for
slow-moving and obsolete inventory in the first quarter of 2005. For the year
2005, our annualized inventory turnover level was 4.8 as compared to 7.5 in
2004, representing a period-to-period decrease of 36% primarily as a result of a
42% decrease in net sales, which was partially offset by a 10% decrease in
inventory. The decline in inventory in 2004 included $2.0 million in additional
reserves for slow-moving and obsolete inventory.

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.

CONSIGNMENT

Consignment sales represented a growing percentage of our net sales
from 2001 through 2003. However, during 2004, our consignment sales model
accounted for 31% of our total net sales as compared to 37% of our total net
sales in 2003, primarily as a result of consigning fewer products to Best Buy,
which was our largest consignment retailer, which was partially offset by an
increase in consigning more products to Staples. In 2005, our consignment sales
model accounted for 33% of our total net sales as compared to 31% of our total
net sales in 2004. During the first quarter of 2006 our consignment sales model
accounted for 51% of our total net sales as compared to 38% of our total net
sales in the first quarter of 2005, representing a 34% increase, primarily as a
result of consigning more products to both Office Depot and Staples. Although
consignment sales increased as a percentage of our net sales in 2005 as compared
to 2004 and increased as a percentage of our net sales in the first quarter of
2006 as compared to the first quarter of 2005, it is not clear whether
consignment sales as a percentage of our total net sales will grow or decline in
the future.

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 as 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 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 the first quarter of 2006 and
during the year 2005, our six largest retailers accounted for approximately 93%
and 92%, 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 industry 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 Iomega, LaCie, PNY Technologies, Sony, Seagate Technology
and Western Digital offer products similar to our GigaBank(TM) and
EZNetshare(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
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.

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 the first quarter of 2006, our sales incentives were $220,000, or
1.7% of gross sales, all of which was offset against gross sales, as compared to
$453,000, or 3.3% of gross sales, in the first quarter of 2005, all of which was
offset against gross sales. In 2005, our sales incentives were $1.3 million, or
2.6% 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 the first quarter of 2006,
our market development fund and cooperative advertising costs, rebate promotion
costs and slotting fees were $2.3 million, or 17.7% 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 $2.4
million, or 17.6% of gross sales, in the first quarter of 2005, all of which was
offset against gross sales. These costs and fees were higher as a percentage of
our net sales in the first quarter of 2006 and 2005, as compared to all of 2005
and 2004, primarily as a result of instituting sales incentives and marketing
promotions in order to promote our double layer recordable DVD drives. In 2005,
our market development fund and cooperative advertising costs, rebate promotion
costs and slotting fees were $7.0 million, or 13.3% of gross sales, all of which
was offset against gross sales. In 2004, our market development fund and
cooperative advertising costs, rebate promotion costs and slotting fees were
$7.8 million, or 13.0% of gross sales, all of which was offset against gross
sales.

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
exceed those market prices. For the first quarter of 2006 we increased our
inventory reserve and recorded a corresponding increase in cost of goods sold of
$121,000 for inventory for which recorded cost exceeded the current market price
of this inventory on hand. For the first quarter of 2005, we increased our
inventory reserve and recorded a corresponding increase in cost of goods sold of
$362,000 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. We reduce our
inventory reserve as we reduce the values of specific products in our detailed
inventory report based upon our lower-of-cost-or-market analysis. During the
first quarter of 2006 and 2005, we reduced the values of specific products and
accordingly reduced the reserve by $129,000 and $0, respectively. For the first
quarter of 2006 and 2005, 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% of 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
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.

STOCK-BASED COMPENSATION

On January 1, 2006, we adopted Statements of Financial Accounting
Standards No. 123 (revised 2004), "Share-Based Payment," or SFAS 123(R), which
requires the measurement and recognition of compensation expense for all
share-based payment awards made to employees and directors based on estimated
fair values. SFAS 123(R) supersedes our previous accounting under Accounting
Principles Board Opinion No. 25, or APB 25, "Accounting for Stock Issued to
Employees" for periods beginning in fiscal 2006. In March 2005, the Securities
and Exchange Commission issued Staff Accounting Bulletin No. 107, or SAB 107,
relating to SFAS 123(R). We have applied the provisions of SAB 107 in our
adoption of SFAS 123(R).

We adopted SFAS 123(R) using the modified prospective transition
method, which requires the application of the accounting standard as of January
1, 2006, the first day of our fiscal year 2006. Our financial statements as of
and for the three months ended March 31, 2006 reflect the impact of SFAS 123(R).
In accordance with the modified prospective transition method, our financial
statements for prior periods have not been restated to reflect, and do not
include, the impact of SFAS 123(R). Stock-based compensation expense recognized
under SFAS 123(R) for employee and directors for the three months ended March
31, 2006 was $39,558. Basic and diluted loss per share for the quarter ended
March 31, 2006 would have been $0.23 per share, if we had not adopted SFAS
123(R), compared to reported basic and diluted loss per share of $0.24 per
share.

The following table illustrates the effect on net loss and loss per
share if we had applied the fair value recognition provisions of SFAS 123 to
stock-based awards granted under our stock option plans for the three months
ended March 31, 2005. For purposes of this pro-forma disclosure, the fair value
of the options is estimated using the Black-Scholes-Merton option-pricing
formula ("Black-Scholes model") and amortized to expense generally over the
options' requisite service periods (vesting periods)

Net loss as reported $(1,157,291)
Plus: Stock-based compensation expense recognized
in the Statement of Income, net of tax --
Less: Stock-based compensation expense determined
under fair-value based method, net of tax (22,077)
-----------
Pro forma net loss $(1,179,368)
===========
Net loss per share
As reported - basic and diluted $ (0.26)
Pro forma - basic and diluted $ (0.26)

SFAS 123(R) requires companies to estimate the fair value of
share-based payment awards to employees and directors on the date of grant using
an option-pricing model. The value of the portion of the award that is
ultimately expected to vest is recognized as expense over the requisite service
periods in our Statements of Operations. Stock-based compensation expense
recognized in the Statements of Operations for the first quarter of fiscal 2006
included compensation expense for share-based payment awards granted prior to,
but not yet vested as of January 1, 2006 based on the grant date fair value
estimated in accordance with the pro-forma provisions of SFAS 123 and
compensation expense for the share-based payment awards granted subsequent to
January 1, 2006, for which there was none in the quarter ended March 31, 2006,
based on the grant date fair value estimated in accordance with the provisions
of SFAS 123(R). For stock-based awards issued to employees and directors,
stock-based compensation is attributed to expense using the straight-line single
option method, which is consistent with how the prior-period pro formas were
provided. As stock-based compensation expense recognized in the Statements of
Operations for the first quarter of fiscal 2006 is based on awards ultimately
expected to vest, it has been reduced for estimated forfeitures. SFAS 123(R)
requires forfeitures to be estimated at the time of grant and revised, if
necessary, in subsequent periods if actual forfeitures differ from those
estimates. In its pro-forma information required under SFAS 123 for the periods
prior to fiscal 2006, we accounted for forfeitures as they occurred.

Prior to the adoption of SFAS 123(R), we accounted for stock-based
awards to employees and directors using the intrinsic value method in accordance
with APB 25. Under the intrinsic value method, we recognized share-based
compensation equal to the award's intrinsic value at the time of grant over the
requisite service periods using the straight-line method. Forfeitures were
recognized as incurred. During the quarter ended March, 31, 2005, there was no
stock-based compensation expense recognized in the Statements of Operations for
awards issued to employees and directors as the awards had no intrinsic value at
the time of grant because their exercise prices equaled the fair values of the
common stock at the time of grant.

Our determination of fair value of share-based payment awards to
employees and directors on the date of grant using the Black-Scholes model,
which is affected by our stock price as well as assumptions regarding a number
of highly complex and subjective variables. These variables include, but are not
limited to our expected stock price volatility over the expected term of the
awards, and actual and projected employee stock option exercise behaviors. Prior
to 2006, when valuing awards, we used the awards' contractual term as a proxy
for the expected life of the award and historical volatility to approximate
expected volatility. During 2006, there have been no new awards.

We have elected to adopt the detailed method provided in SFAS 123(R)
for calculating the beginning balance of the additional paid-in capital pool, or
APIC pool, related to the tax effects of employee stock-based compensation, and
to determine the subsequent impact on the APIC pool and Statements of Cash Flows
of the tax effects of employee stock-based compensation awards that are
outstanding upon adoption of SFAS 123(R).

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.

THREE MONTHS ENDED MARCH 31, 2006 (UNAUDITED) COMPARED TO THREE MONTHS ENDED MARCH 31, 2005 (UNAUDITED)

RESULTS AS A
PERCENTAGE
DOLLAR PERCENTAGE OF NET SALES FOR THE
THREE MONTHS ENDED VARIANCE VARIANCE THREE MONTHS ENDED
MARCH 31, ------------ ------------ MARCH 31,
-------------------- FAVORABLE FAVORABLE -----------------------
2006 2005 (UNFAVORABLE) (UNFAVORABLE) 2006 2005
-------- -------- ------------ ------------ --------- ----------
(in thousands)

Net sales................................ $ 8,994 $ 9,037 $ (43) (0.5)% 100.0% 100.0%
Cost of sales............................ 8,241 8,455 214 2.5 91.6 93.6
-------- -------- ------------ ------------ --------- ----------
Gross profit............................. 753 582 171 29.4 8.4 6.4
Selling, marketing and advertising
expenses............................... 232 174 (58) (33.3) 2.6 1.9
General and administrative expenses...... 1,490 1,417 (73) (5.2) 16.6 15.7

Depreciation and amortization............ 47 79 32 40.5 0.5 0.9
-------- -------- ------------ ------------ --------- ----------
Operating loss........................... (1,016) (1,088) 72 6.6 (11.3) (12.0)
Net interest expense..................... (80) (77) (3) (3.9) (0.9) (0.9)
Other income (expense)................... (1) 8 (9) 112.5 -- 0.1
-------- -------- ------------ ------------ --------- ----------
Loss from operations before provision
for income taxes....................... (1,097) (1,157) 60 5.2 (12.2) (12.8)
Income tax provision..................... -- -- -- -- -- --
-------- -------- ------------ ------------ --------- ----------
Net loss................................. $ (1,097) $ (1,157) $ 60 0.2% (12.2)% (12.8)%
======== ======== ============ ============ ========= ==========

NET SALES. As discussed above, we believe that our operating results
were due in large part to a combination of factors, including the continued
decline in sales of our CD-based products; lower average selling prices of our
DVD-based products; and slower than anticipated growth in sales of our DVD-based
products; all of which were offset by a substantial increase in sales of our
GigaBank(TM) products.

Sales of our CD-based products experienced a rapid and continued
decline in the first quarter of 2006 as compared to the first quarter of 2005.
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 70.3% to $257,000 in the first quarter of 2006 from
$866,000 in the first quarter of 2005.

Our net sales for the first quarter of 2006 were affected by a $3.9
million decrease in net sales resulting from lower average product sales prices,
which was partially offset by a $3.7 million increase in net sales resulting
from an increase in volume of products sold. We also had an increase of $144,000
in net sales for the first quarter of 2006 resulting from a change in our
reserves for future returns on sales.

We had a decrease of $609,000 in net sales of our CD-based products for
the first quarter of 2006 comprised of a $143,000 decrease due to lower average
product sales prices and a $466,000 decrease due to a decrease in the volume of
products sold.

We had a decrease of $610,000 in net sales of our DVD-based products
for the first quarter of 2006 comprised of a $1.5 million decrease due to lower
average product sales prices, which was partially offset by a $918,000 increase
due to an increase in the volume of products sold.

We had an increase of $1.4 million in net sales of our GigaBank(TM)
products for the first quarter of 2006 comprised of a $1.9 million increase due
to an increase in the volume of products sold, which was partially offset by a
$492,000 decrease due to lower average product sales prices.

GROSS PROFIT. The increase in gross profit of $171,000 from $582,000
for the first quarter of 2005 to $753,000 for the first quarter of 2006 is
primarily due to a decrease in market development fund and cooperative
advertising costs, rebate promotion costs and new store expenses and a decrease
in our direct product costs, inventory shrinkage and related freight costs as a
percentage of net sales. The increase in gross profit as a percentage of our net
sales was partially due to a decrease in the dollar amount of market development
fund and cooperative advertising costs, rebate promotion costs and slotting
fees, although they slightly increased as a percentage of gross sales from 17.6%
during the first quarter of 2005 to 17.7% of gross sales during the first
quarter of 2006. These costs and fees were incurred primarily in connection with
the promotion of our double-layer recordable DVD drives. Our direct product
costs, inventory shrinkage and related freight costs decreased from 93.6% of net
sales for the first quarter of 2005 to 91.6% of net sales for the first quarter
of 2005, primarily due to the decrease in the inventory reserve.

Our inventory reserve increased by $121,000 in the first quarter of
2006 as compared to $362,000 in the first quarter of 2005 due to our adjustment
of the value of our slow-moving and obsolete inventory. As a result of the short
life cycles of many of our products resulting from, in part, the effects of
rapid 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.

SELLING, MARKETING AND ADVERTISING EXPENSES. Selling, marketing and
advertising expenses increased by $58,000 in the first quarter of 2006 as
compared to the first quarter of 2005. This increase was primarily due to
$53,000 of display expenses incurred in the first quarter of 2006 as compared to
no display expenses incurred in the first quarter of 2005.

GENERAL AND ADMINISTRATIVE EXPENSES. General and administrative
expenses increased by $73,000 in the first quarter of 2006 as compared to the
first quarter of 2005. This increase was primarily due to a $132,000 increase in
legal fees mainly in relation to trial expenses and a $45,000 increase in audit
fees. The increase in general and administrative expenses was partially offset
by a $96,000 decrease in financing fees related to our new line of credit signed
in March 2005.

DEPRECIATION AND AMORTIZATION EXPENSES. The $32,000 decrease in
depreciation and amortization expenses is due to some of our fixed assets
becoming fully depreciated since the first quarter of 2005.

OTHER INCOME (EXPENSE). Other income (expense) increased by $12,000 in
the first quarter of 2006 as compared to the first quarter of 2005. Net interest
expense increased by $3,000 due higher interest rates in the first quarter of
2006 as compared to the first quarter of 2005. In addition, we incurred $9,000
in expense related to foreign currency transactions in connection with our sales
in Canada.

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 provide working capital, finance capital
expenditures and satisfy our debt service requirements. We anticipate that these
sources and uses will continue to be our principal sources and uses of cash in
the future. As of March 31, 2006, we had working capital of $5.0 million, an
accumulated deficit of $26.0 million, $2.8 million in cash and cash equivalents
and $10.4 million in net accounts receivable. This compares with working capital
of $6.0 million, an accumulated deficit of $24.9 million, $4.1 million in cash
and cash equivalents and $13.1 million in net accounts receivable as of December
31, 2005.

For the quarter ended March 31, 2006, our cash decreased $1.3 million,
or 31.7%, from $4.1 million to $2.8 million as compared to a decrease of $1.9
million, or 52.8%, for the quarter ended March 31, 2005 from $3.6 million to
$1.7 million.

Cash used in our operating activities totaled $1.4 million during the
first quarter of 2006 as compared to cash used in our operating activities of
$1.6 million during the first quarter of 2005. This $200,000 decrease in cash
used in our operating activities primarily resulted from:

o a $1.7 million increase comprised of a $33,000 increase in 2006 as
compared to a $1.7 million decrease in 2005 resulting from a $1.0
million increase in warehouse inventory in 2005 and a $700,000
increase in consigned inventory in 2005;

o a $1.5 million increase comprised of an $1.1 million increase in
2006 as compared to a $480,000 decrease in 2005 resulting from an
increase in the use of other accounts payable;

o a $1.0 million increase comprised of a $2.7 million increase in
2006 as compared to a $1.7 million increase in 2005 resulting from
decreases in accounts receivable due to faster collections; and

o a $569,000 increase comprised of a $122,000 increase in 2006
resulting from a decrease in prepaid expenses as compared to a
$447,000 decrease in 2005 resulting from an increase in prepaid
expenses.

These increases in cash were partially offset by:

o a $2.8 million decrease in accounts payable - related parties
resulting in part from a $1.5 million increase in the use of other
accounts payable and payment of outstanding invoices;

o a $1.5 million decrease in accrued expenses due to charge-backs
from customers on marketing expenses in 2006; and

o a $241,000 decrease in our reserve for slow-moving and obsolete
inventory.

Cash provided by our investing activities totaled $13,000 during the
first quarter of 2006 as compared to cash provided by our investing activities
of $777,000 during the first quarter of 2005. Our investing activities during
the first quarter of 2006 consisted of restricted cash related to our GMAC
Commercial Finance line of credit and nominal purchases of property and
equipment. Our investing activities during the first quarter of 2005 consisted
of restricted cash related to our United National Bank loan and nominal
purchases of property and equipment.

Cash provided by our financing activities totaled $110,000 during the
first quarter of 2006 as compared to cash used in our financing activities of
$1.2 million for the first quarter of 2005. We had $55,000 in net borrowings on
our GMAC Commercial Finance line of credit and received $55,000 upon the
exercise of employee stock options in the first quarter of 2006. We paid down
$2.2 million of our United National Bank loan through funds generated by our
operations during the first quarter of 2005. We paid down the balance of $3.8
million of our United National Bank loan through our new line of credit with
GMAC Commercial Finance and we borrowed an additional $1.0 million under our
GMAC Commercial Finance line of credit during the first quarter of 2005.

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 equal to the prime rate of interest as reported in THE WALL STREET JOURNAL
plus 0.75%. 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.

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 maintain a fixed charge coverage ratio of at least 1.5 to 1.0 for the
three months ended June 30, 2005, the six months ended September 30, 2005, the
nine months ended December 31, 2005, the twelve months ended 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, 2006, we owed
GMAC Commercial Finance approximately $5.1 million and had available to us
approximately $199,000 of additional borrowings. As of that date, we were in
breach of the financial covenant; however, we received a waiver of this breach
from GMAC Commercial Finance on May 8, 2006.

On June 6, 2005, we entered into a new trade credit facility with Lung
Hwa Electronics, which is one of our stockholders, 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 an aggregate of up to $15.0 million of inventory manufactured by
Lung Hwa Electronics or manufactured by third parties, in which case we use Lung
Hwa Electronics as an international purchasing office. For inventory
manufactured by third parties and 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. 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. The agreement containing the terms of the new trade credit
facility was amended and restated on July 21, 2005 to provide that the new
facility would be retroactive to April 29, 2005. As of March 31, 2006, we owed
Lung Hwa Electronics $3.8 million 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 March
31, 2006, we owed BTC USA $1.5 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.

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.

Our net loss decreased 0.2% to $1.1 million for the first quarter of
2006 from $1.2 million for the first quarter of 2005, primarily resulting from a
29.4% increase in gross profit to $753,000 in the first quarter of 2006 from
$582,000 in the first quarter of 2005, which was partially offset by a 5.9%
increase in operating expenses to $1.8 million in the first quarter of 2006 from
$1.7 million in the first quarter of 2005. If either the absolute level or the
downward trend of our net loss 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.

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.

If any 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 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. However, management
intends to use its best efforts to insure that we retain our current retailers
and try to expand sales to those major retailers to which we currently do not
sell our products. We cannot assure you that our existing retailers will remain
our customers or that we will successfully sell any products to other retailers.

Despite our continued losses, including during the first quarter of
2006, 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 for at least 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 March 31, 2006 was $4.8 million as compared to a backlog
at March 31, 2005 of $4.4 million. Based on historical trends, we anticipate
that our March 31, 2006 backlog may be reduced by approximately 9.0%, or
$432,000, to a net amount of $4.4 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.

IMPACT OF NEW ACCOUNTING PRONOUNCEMENTS

In March 2006, the FASB issued SFAS No. 156, "Accounting for Servicing
of Financial Assets," which provides an approach to simplify efforts to obtain
hedge-like (offset) accounting. This Statement amends FASB SFAS No. 140,
"Accounting for Transfers and Servicing of Financial Assets and Extinguishments
of Liabilities", with respect to the accounting for separately recognized
servicing assets and servicing liabilities. The Statement (1) requires an entity
to recognize a servicing asset or servicing liability each time it undertakes an
obligation to service a financial asset by entering into a servicing contract in
certain situations; (2) requires that a separately recognized servicing asset or
servicing liability be initially measured at fair value, if practicable; (3)
permits an entity to choose either the amortization method or the fair value
method for subsequent measurement for each class of separately recognized
servicing assets or servicing liabilities; (4) permits at initial adoption a
one-time reclassification of available-for-sale securities to trading securities
by an entity with recognized servicing rights, provided the securities
reclassified offset the entity's exposure to changes in the fair value of the
servicing assets or liabilities; and (5) requires separate presentation of
servicing assets and servicing liabilities subsequently measured at fair value
in the balance sheet and additional disclosures for all separately recognized
servicing assets and servicing liabilities. SFAS No. 156 is effective for all
separately recognized servicing assets and liabilities as of the beginning of an
entity's fiscal year that begins after September 15, 2006, with earlier adoption
permitted in certain circumstances. The Statement also describes the manner in
which it should be initially applied. We do not believe that SFAS No. 156 will
have a material impact on our financial position, results of operations or cash
flows.

In February 2006, the FASB issued SFAS No. 155, "Accounting for Certain
Hybrid Financial Instruments", which amends SFAS No. 133, "Accounting for
Derivatives Instruments and Hedging Activities" and SFAS No. 140, "Accounting
for Transfers and Servicing of Financial Assets and Extinguishment of
Liabilities." SFAS No. 155 amends SFAS No. 133 to narrow the scope exception for
interest-only and principal-only strips on debt instruments to include only such
strips representing rights to receive a specified portion of the contractual
interest or principle cash flows. SFAS No. 155 also amends SFAS No. 140 to allow
qualifying special-purpose entities to hold a passive derivative financial
instrument pertaining to beneficial interests that itself is a derivative
instrument. We are currently evaluating the impact of this new standard but we
believes that this new standard will not have a material impact on our financial
position, results of operations, or cash flows.

ITEM 3. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK

Our operations were not subject to commodity price risk during the
first three months of 2006. Our sales to a foreign country (Canada) were less
than 1% of our total sales for the first three months of 2006, and thus we
experienced negligible foreign currency exchange rate risk. We do not hedge
against this risk.

We currently have an asset-based business loan agreement with GMAC
Commercial Finance in the amount of up to $10.0 million. The line of credit
provides for an interest rate equal to the prime lending rate as reported in THE
WALL STREET JOURNAL 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 the GMAC
Commercial Finance business loan agreement.

ITEM 4. 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 March 31, 2006, 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 March 31, 2006, our disclosure controls and procedures were not effective at
the reasonable assurance level due to the material weaknesses described below.

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 two material weaknesses which have caused management to conclude that,
as of March 31, 2006, our disclosure controls and procedures were not effective
at the reasonable assurance level:

1. As a result of our restatement of prior periods' 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, we were unable to meet our
requirements to timely file our Form 10-K for the year ended December 31, 2004
and our Form 10-Q for the quarter ended March 31, 2005. Although we were able to
timely file our Forms 10-Q for the quarters ended June 30, 2005 and September
30, 2005, our Form 10-K for the year ended December 31, 2005 and our Form 10-Q
for the quarter ended March 31, 2006, management evaluated, in the second
quarter of 2006 and as of March 31, 2006, 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, in the
second quarter of 2006 and as of March 31, 2006, that the control deficiency
that resulted in the inability to timely make these filings represented a
material weakness.

2. 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 and our Form 10-Q for the quarter
ended March 31, 2005. Although we were able to timely file our Forms 10-Q for
the quarters ended June 30, 2005 and September 30, 2005, our Form 10-K for the
year ended December 31, 2005 and our Form 10-Q for the quarter ended March 31,
2006, 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, in the second quarter of 2006 and as of March 31, 2006, that
the control deficiency that resulted in our lack of sufficient personnel
represented a material weakness.

REMEDIATION OF MATERIAL WEAKNESSES

To remediate the material weaknesses in our disclosure controls and
procedures identified above, we have done the following, in the periods
specified below, which correspond to the two material weaknesses identified
above:

1. In connection with making the changes discussed above to our
disclosure controls and procedures, in addition to working with our independent
auditors, in the fourth quarter of 2004, 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 processes. We also engaged, in the

fourth quarter of 2004, another third-party accounting firm, other than our
independent auditors, to assist us with our financial reporting processes. These
third-parties have assisted us in altering our financial reporting processes,
which we expect will better enable us to timely file our periodic reports. In
the third quarter of 2005, we further improved our ability to timely make
required filings by implementing additional automated reporting procedures with
respect to product returns and sales incentives through enhancements to our MIS
financial reporting system that expedite our internal reporting processes and
our periodic reviews by our independent auditors. In addition, we allocated and
continue to allocate part of the time of certain company personnel with
accounting experience to assist us in generating reports and schedules necessary
to timely file our periodic reports. Prior to this time, these personnel focused
their time on other matters. We also intend, in 2006, to continue 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.

Management expects that the remediation described in item 1 immediately
above will remediate the corresponding material weakness also described above by
June 30, 2006. Management estimates that we have paid the third-party consultant
approximately $37,000 in connection with his services and estimates that we have
paid the third-party accounting firm approximately $63,000 in connection with
its services. Management is unable to estimate our capital or other expenditures
associated with the allocation of time of certain company personnel to assist us
in generating reports and schedules necessary to timely file our periodic
reports, our enhancements to our MIS financial reporting system or our
additional capital or other expenditures related to higher fees paid to our
independent auditors in connection with their review of this remediation.

2. Management believes that the procedures we implemented in connection
with the restatement of our financial statements, and the circumstances
surrounding the restatement, have led to a greater depth of understanding by
management of revenue recognition principles. Management also believes that
these procedures, and the circumstances surrounding the restatement, have led to
improved and expedited financial reporting processes as a result of more
detailed and accurate recording of sales incentives and product returns as they
relate to revenue recognition. In addition, management believes that these
procedures, and the circumstances surrounding the restatement, have led to
improved and expedited financial reporting processes as a result of more
detailed and accurate recording of charges to our inventory reserve. Management
further believes that the involvement of the third-party consultant and the
third-party accounting firm, as discussed above, has led to improved procedures
and controls with respect to these matters. In addition, as noted above, we
allocated and continue to allocate part of the time of certain company personnel
with accounting experience to assist us in generating reports and schedules
necessary to timely file our periodic reports and we believe that this has
assisted us, and will continue to assist us, in timely filing our periodic
reports.

Management expects that the remediation described in item 2 immediately
above will remediate the corresponding material weakness also described above by
June 30, 2006. As noted above, management estimates that we have paid the
third-party consultant approximately $37,000 in connection with his services and
estimates that we have paid the third-party accounting firm approximately
$63,000 in connection with its services. Management is unable to estimate our
capital or other expenditures associated with the allocation of time of certain
company personnel to assist us in generating reports and schedules necessary to
timely file our periodic reports or our additional capital or other expenditures
related to higher fees paid to our independent auditors in connection with their
review of this remediation.

CHANGES IN INTERNAL CONTROL OVER FINANCIAL REPORTING

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.

PART II - OTHER INFORMATION

ITEM 1. LEGAL PROCEEDINGS

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 Meulemans, 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 denied the allegations in the
Cross-Complaint. Trial began on February 6, 2006 and on March 10, 2006, the jury
ruled in our favor against Lawrence W. Horwitz, Horwitz & Beam, Inc., Lawrence
M. Cron, Horwitz & Cron and Senn Palumbo Meulemans, LLP, and awarded us $3.0
million in damages. We have not collected any of this amount. Judgment was
entered on or about April 5, 2006. However, defendants have since filed a motion
for new trial and a motion for judgment notwithstanding the verdict which could
impact the Judgment. Both of these motions are presently scheduled to be heard
by the Court on May 31, 2006. Furthermore, defendants have indicated that, if
these motions are unsuccessful, they plan to appeal the Judgment.

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
claims relating to this action were settled in connection with the settlement of
the litigation described immediately below.

On May 20, 2005, we 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, Case No. 05CC06433. The complaint sought
damages of in excess of $22 million arising out of the defendants' alleged
breach of contract under an agreement entered into in May 2001. On or about June
20, 2005, OfficeMax removed the case against OfficeMax to the United States
District Court for the Central District of California, Case No. SA CV05-0592
DOC(MLGx). On August 1, 2005, OfficeMax filed its Answer and Counter-Claim
against us. The Counter-Claim against us alleged four causes of action: breach

of contract, unjust enrichment, quantum valebant, and an action for declaratory
relief. The Counter-Claim alleged, among other things, that the we were liable
to OfficeMax in the amount of no less than $138,000 under the terms of a vendor
agreement executed between us and OfficeMax in connection with the return of
computer peripheral products to us for which OfficeMax alleged it was never
reimbursed. The Counter-Claim sought, among other things, at least $138,000 from
us, along with pre-judgment interest, attorneys' fees and costs of suit. We
filed a response denying all of the affirmative claims set forth in the
Counter-Claim, denying any wrongdoing or liability, and denying that OfficeMax
was entitled to obtain any relief. In April of 2006, the case was settled in its
entirety. In settling the matter, each party denied liability and wrongdoing and
the settlement was entered into solely for the purpose of compromising and
settling the litigation and in order to avoid the risk, cost, and burden of
litigation and participation therein. Pursuant to the settlement, OfficeMax paid
us $2,375,000.

In addition, we are 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 effect on our financial
position or results of operations.

ITEM 1A. RISK FACTORS

In addition to the other information set forth in this report, you
should carefully consider the factors discussed under "Risk Factors" in our
Annual Report on Form 10-K for the year ended December 31, 2005, which could
materially affect our business, financial condition and results of operations.
The risks described in our Annual Report on Form 10-K are not the only risks we
face. Additional risks and uncertainties not currently known to us or that we
currently deem to be immaterial also may materially adversely affect our
business, financial condition and results of operations.

ITEM 2. UNREGISTERED SALES OF EQUITY SECURITIES AND USE OF PROCEEDS

None.

ITEM 3. DEFAULTS UPON SENIOR SECURITIES

None.

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

None.

ITEM 5. OTHER INFORMATION

None.

ITEM 6. EXHIBITS

Exhibit
Number Description
------ -----------

31.1 Certification 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*

31.2 Certification 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*

32.1 Certifications 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*

_________________________
* Filed herewith.

SIGNATURES

Pursuant to the requirements of the Securities Exchange Act of 1934,
the registrant caused this report to be signed on its behalf by the undersigned,
thereunto duly authorized.

I/OMAGIC CORPORATION

Dated: May 15, 2006 By: /s/ Tony Shahbaz
-------------------------------------------------
Tony Shahbaz, President and Chief
Executive Officer (principal executive officer)

Dated: May 15, 2006 By: /s/ Steve Gillings
-------------------------------------------------
Steve Gillings, Chief Financial Officer
(principal financial and accounting officer)

EXHIBITS FILED WITH THIS REPORT

Exhibit
Number Description
- ------ -----------

31.1 Certification 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

31.2 Certification 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

32.1 Certifications 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