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

FORM 10-Q
(Mark One)
[ X ] QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES
EXCHANGE ACT OF 1934

For the quarterly period ended June 30, 2005

[ ] TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES
EXCHANGE ACT OF 1934

For the transition period from to

COMMISSION FILE NUMBER 000-27267

I/OMAGIC CORPORATION

(Exact Name of Registrant as Specified in Its Charter)

Nevada 33-0773180
- ------------------------------- ------------------------------------
(State or Other Jurisdiction of (I.R.S. Employer Identification No.)
Incorporation or Organization)

4 Marconi, Irvine, CA 92618
- ---------------------------------------- ----------
(Address of principal executive offices) (Zip Code)

(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 an accelerated filer (as defined in
Rule 12b-2 of the Exchange Act). Yes [ ] No [X]

As of August 15, 2005, there were 4,529,672 shares of the issuer's common stock
issued and outstanding.

I/OMAGIC CORPORATION AND SUBSIDIARY

TABLE OF CONTENTS

Page
Number
------

PART I - FINANCIAL INFORMATION

Item 1. Financial Statements

Consolidated Balance Sheets - June 30, 2005 (unaudited)
and December 31, 2004 3

Consolidated Statements of Income - For the three
and six months ended June 30, 2005 and 2004 (unaudited) 5

Consolidated Statements of Cash Flows - For the six
months ended June 30, 2005 and 2004 (unaudited) 6

Notes to Consolidated Financial Statements 7

Item 2. Management's Discussion and Analysis of Financial Condition
and Results of Operations 17

Item 3. Quantitative and Qualitative Disclosures About Market Risk 48

Item 4. Controls and Procedures 48

PART II - OTHER INFORMATION

Item 1. Legal Proceedings 52

Item 2. Unregistered Sale of Equity Securities and Use of Proceeds 53

Item 3. Defaults Upon Senior Securities 53

Item 4. Submission of Matters to a Vote of Security Holders 53

Item 5. Other Information 53

Item 6. Exhibits 54

SIGNATURES 55

EXHIBITS FILED WITH THIS REPORT 56

PART I - FINANCIAL INFORMATION

ITEM 1. FINANCIAL STATEMENTS

I/OMAGIC CORPORATION
AND SUBSIDIARY
CONSOLIDATED BALANCE SHEETS
JUNE 30, 2005 (UNAUDITED) AND DECEMBER 31, 2004

ASSETS

JUNE 30, DECEMBER 31,
2005 2004
-------------------------
(unaudited)

CURRENT ASSETS
Cash and cash equivalents. . . . . . . . . . . . . . . . . . . . . . $ 1,704,871 $ 3,587,807
Restricted cash. . . . . . . . . . . . . . . . . . . . . . . . . . . 218,654 1,044,339
Accounts receivable, net of allowance for doubtful
accounts of $42,337 (unaudited) and $24,946 . . . . . . . . . . 12,455,653 14,598,422
Inventory, net of allowance for obsolete inventory of $0 (unaudited)
and $1,463,214. . . . . . . . . . . . . . . . . . . . . . . . . 8,211,750 6,146,766
Inventory in transit . . . . . . . . . . . . . . . . . . . . . . . . 52,412 513,672
Prepaid expenses and other current assets. . . . . . . . . . . . . . 1,259,561 741,244
----------- -----------
Total current assets. . . . . . . . . . . . . . . . . . . . . . 23,902,901 26,632,250
PROPERTY AND EQUIPMENT, net of accumulated depreciation of
$1,360,873 (unaudited) and $1,256,036. . . . . . . . . . . . . 204,078 307,661
TRADEMARK, net of accumulated amortization
of $5,484,244 (unaudited) and $5,449,780 . . . . . . . . . . . 465,336 499,800
OTHER ASSETS . . . . . . . . . . . . . . . . . . . . . . . . . . . . 27,032 27,032
----------- -----------
TOTAL ASSETS. . . . . . . . . . . . . . . . . . . . . . . . . . $24,599,347 $27,466,743
=========== ===========

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

I/OMAGIC CORPORATION
AND SUBSIDIARY
CONSOLIDATED BALANCE SHEETS
JUNE 30, 2005 (UNAUDITED) AND DECEMBER 31, 2004

LIABILITIES AND STOCKHOLDERS' EQUITY

JUNE 30, DECEMBER 31,
2005 2004
------------- -------------
(unaudited)

CURRENT LIABILITIES
Line of credit. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $ 4,191,279 $ 5,962,891
Accounts payable and accrued expenses. . . . . . . . . . . . . . . . . . 4,762,922 5,221,719
Accounts payable - related parties . . . . . . . . . . . . . . . . . . . 7,742,858 7,346,596
Reserves for customer returns and price protection . . . . . . . . . . . 470,640 573,570
------------- -------------
Total current liabilities. . . . . . . . . . . . . . . . . . . . . . . 17,167,699 19,104,776
------------- -------------
COMMITMENTS AND CONTINGENCIES . . . . . . . . . . . . . . . . . . . . . . - -
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
4,529,672 (unaudited) and 4,529,672 shares issued and outstanding. 4,530 4,530
Additional paid-in capital. . . . . . . . . . . . . . . . . . . . . . . . 31,557,988 31,557,988
Treasury stock, 13,493 (unaudited) and 13,493 shares, at cost . . . . . . (126,014) (126,014)
Accumulated deficit . . . . . . . . . . . . . . . . . . . . . . . . . . . (24,004,856) (23,074,537)
------------- -------------
Total stockholders' equity . . . . . . . . . . . . . . . . . . . . . . 7,431,648 8,361,967
------------- -------------
TOTAL LIABILITIES AND STOCKHOLDERS' EQUITY . . . . . . . . . . . . . $ 24,599,347 $ 27,466,743
============= =============

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

I/OMAGIC CORPORATION
AND SUBSIDIARY
CONSOLIDATED STATEMENTS OF INCOME
FOR THE THREE AND SIX MONTHS ENDED JUNE 30, 2005 AND 2004
(UNAUDITED)

THREE MONTHS ENDED JUNE 30, SIX MONTHS ENDED JUNE 30,
2005 2004 (RESTATED) 2005 2004 (RESTATED)
----------------------------- --------------------------- ------------ ----------------
(unaudited) (unaudited) (unaudited) (unaudited)

NET SALES. . . . . . . . . . . . . . . $ 9,557,611 $ 7,489,828 $18,594,423 $ 22,963,347
COST OF SALES. . . . . . . . . . . . . 8,040,306 7,052,324 16,495,186 20,270,578
----------------------------- --------------------------- ------------ ----------------
GROSS PROFIT . . . . . . . . . . . . . 1,517,305 437,504 2,099,237 2,692,769
----------------------------- --------------------------- ------------ ----------------
OPERATING EXPENSES
Selling, marketing, and advertising. . 123,224 170,899 297,425 651,011
General and administrative . . . . . . 1,042,376 1,453,412 2,459,841 2,819,771
Depreciation and amortization. . . . . 60,728 208,969 139,301 418,240
----------------------------- --------------------------- ------------ ----------------
Total operating expenses. . . . . . 1,226,328 1,833,280 2,896,567 3,889,022
----------------------------- --------------------------- ------------ ----------------
PROFIT (LOSS) FROM OPERATIONS. . . . . 290,978 (1,395,776) (797,330) (1,196,253)
----------------------------- --------------------------- ------------ ----------------
OTHER INCOME (EXPENSE)
Interest income. . . . . . . . . . . . 245 33 282 252
Interest expense . . . . . . . . . . . (64,798) (39,912) (142,151) (84,047)
Other income (expense) . . . . . . . . 2,948 (12,610) 11,280 (20,421)
----------------------------- --------------------------- ------------ ----------------
Total other income (expense) (61,605) (52,489) (130,589) (104,216)
----------------------------- --------------------------- ------------ ----------------

INCOME (LOSS) BEFORE INCOME TAXES. . . 229,372 (1,448,265) (927,919) (1,300,469)
PROVISION FOR (BENEFIT FROM) INCOME
TAXES. . . . . . . . . . . . . . . . 2,400 (892) 2,400 2,196
----------------------------- --------------------------- ------------ ----------------
NET INCOME (LOSS). . . . . . . . . . . $ 226,972 $ (1,447,373) $ (930,319) $ (1,302,665)
============================= =========================== ============ ================
BASIC AND DILUTED INCOME (LOSS) PER
SHARE. . . . . . . . . . . . . . . . $ 0.05 ($0.32) ($0.21) ($0.29)
============================= =========================== ============ ================
BASIC AND DILUTED WEIGHTED-AVERAGE
SHARES OUTSTANDING . . . . . . . . . 4,529,672 4,529,672 4,529,672 4,529,672
============================= =========================== ============ ================

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

I/OMAGIC CORPORATION
AND SUBSIDIARY
CONSOLIDATED STATEMENTS OF CASH FLOWS
FOR THE SIX MONTHS ENDED JUNE 30, 2005 AND 2004
(UNAUDITED)

SIX MONTHS ENDED JUNE 30,
2005 2004
(RESTATED)
--------------------------- -------------
(unaudited) (unaudited)

CASH FLOWS FROM OPERATING ACTIVITIES
Net loss. . . . . . . . . . . . . . . . . . . . . . . . $ (930,319) $ (1,302,665)
Adjustments to reconcile net income (loss) to net cash
provided by (used in) operating activities
Depreciation and amortization . . . . . . . . . . . . . 104,837 128,872
Amortization of trademarks. . . . . . . . . . . . . . . 34,464 289,368
Allowance for doubtful accounts . . . . . . . . . . . . 91,581 120,000
Reserve for customer returns and allowances . . . . . . (102,931) (376,634)
Reserve for obsolete inventory. . . . . . . . . . . . . 536,566 368,596
(Increase) decrease in
Accounts receivable . . . . . . . . . . . . . . . . . . 2,051,188 8,243,013
Inventory . . . . . . . . . . . . . . . . . . . . . . . (2,601,550) 2,534,392
Inventory in transit. . . . . . . . . . . . . . . . . . 461,261 -
Prepaid expenses and other current assets . . . . . . . (518,317) (376,385)
Other assets. . . . . . . . . . . . . . . . . . . . . . - 25,952
Decrease in
Accounts payable and accrued expenses . . . . . . . . . (458,796) (1,190,219)
Accounts payable - related parties. . . . . . . . . . . 396,262 (6,703,433)
Settlement payable. . . . . . . . . . . . . . . . . . . - (1,000,000)
--------------------------- -------------
Net cash provided by (used in) operating activities . . (935,754) 760,857
--------------------------- -------------

CASH FLOWS FROM INVESTING ACTIVITIES
Purchase of property and equipment . . . . . . . . . (1,255) (20,975)
Restricted cash. . . . . . . . . . . . . . . . . . . 825,685 195,952
--------------------------- -------------

Net cash provided by investing activities. . . . . . 824,430 174,977
--------------------------- -------------
CASH FLOWS FROM FINANCING ACTIVITIES
Net payments on line of credit. . . . . . . . . . . . . (1,771,612) (1,422,396)
--------------------------- -------------
Net cash used in financing activities . . . . . . . . . ( 1,771,612) ( 1,422,396)
--------------------------- -------------
Net increase (decrease) in cash and cash equivalents. . (1,882,936) (486,562)
CASH AND CASH EQUIVALENTS, BEGINNING OF PERIOD. . . . . 3,587,807 4,005,705
--------------------------- -------------
CASH AND CASH EQUIVALENTS, END OF PERIOD. . . . . . . . $ 1,704,871 $ 3,519,143
=========================== =============
SUPPLEMENTAL DISCLOSURES OF CASH FLOW INFORMATION
INTEREST PAID. . . . . . . . . . . . . . . . . . . . . $ 141,816 $ 86,111
=========================== =============
INCOME TAXES PAID. . . . . . . . . . . . . . . . . . . $ 2,400 $ 2,196
=========================== =============

The accompanying notes are an integral part of these 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.

On July 6, 2004, the Company completed the merger of its wholly-owned
subsidiary, I/OMagic Corporation, a California corporation, with and into the
Company.

NOTE 2 - RESTATEMENT OF 2004 FINANCIAL STATEMENTS

The Company previously accounted for its sales incentives by reducing gross
sales at the time sales incentives were offered to its retailers. Upon further
examination of its accounting methodology for sales incentives, and a
quantitative analysis of its historical sales incentives, the Company determined
that it made an error in its application of the relevant accounting principles
under SFAS 48, as interpreted under Topic 13, and determined that it should have
estimated and recorded sales incentives at the time its products were sold.
Under SFAS 48, as interpreted under Topic 13, the eventual sales price must be
fixed or determinable before revenue can be recognized. Due to the nature and
extent of the Company's sales incentive history, the Company should have been
assessing its revenue recognition criteria to determine whether it was able to
effectively estimate or determine its eventual sales price. The Company has
determined the effect of the correction on its previously issued financial
statements and has restated the accompanying financial statements and the
financial information below for the three and six months ended June 30, 2004.

The Company previously accounted for product returns using a method that did not
take into account the different return characteristics of categories of similar
products and also did not adequately take into account the variability over time
of product return rates. The Company conducted a quantitative analysis of its
historical product return data to determine moving averages of product return
rates by groupings of similar products. Following completion of this analysis,
the Company determined that it made an error in its method of estimating product
returns. The Company has determined the effect of the correction on its
previously issued financial statements and has restated the accompanying
financial statements and the financial information below for the three and six
months ended June 30, 2004.

The effects of the restatement on net sales, cost of sales, gross profit, net
income, basic and diluted income per common share, reserves for product returns
and sales incentives, and stockholders' equity as of and for the three months
ended June 30, 2004 are as follows:

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

Net sales. . . . . . . . . . . . . . . . . . . . . $ 7,191,541 $ 298,287 $ 7,489,828
Cost of sales. . . . . . . . . . . . . . . . . . . 6,940,415 111,909 7,052,324
Gross profit . . . . . . . . . . . . . . . . . . . 251,126 186,378 437,504
Net income (loss). . . . . . . . . . . . . . . . . $ (1,633,751) $ 186,378 $ (1,447,373)

PROFIT (LOSS) PER COMMON SHARE:
Basic . . . . . . . . . . . . . . . . . . . . . $ (0.36) $ 0.04 $ (0.32)
Diluted . . . . . . . . . . . . . . . . . . . . $ (0.36) $ 0.04 $ (0.32)
Reserves for product returns and sales incentives. $ 550,576 $ (114,954) $ 435,622
Stockholders' equity . . . . . . . . . . . . . . . $ 15,001,213 $ 114,954 $ 15,116,167

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

Net sales . . . . . . . . . . . . . . . . . . . . $ 22,551,760 $ 411,587 $ 22,963,347
Cost of sales . . . . . . . . . . . . . . . . . . 19,932,830 337,748 20,270,578
Gross profit. . . . . . . . . . . . . . . . . . . 2,618,930 73,839 2,692,769
Net income. . . . . . . . . . . . . . . . . . . . $ (1,376,504) $ 73,839 $ (1,302,665)

PROFIT PER COMMON SHARE:
Basic. . . . . . . . . . . . . . . . . . . . . $ (0.30) $ 0.01 $ (0.29)
Diluted. . . . . . . . . . . . . . . . . . . . $ (0.30) $ 0.01 $ (0.29)
Reserves for product returns and sales incentives $ 550,576 $ (114,954) $ 435,622
Stockholders' equity. . . . . . . . . . . . . . . $ 15,001,213 $ 114,954 $ 15,116,167

NOTE 3 - SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES

BASIS OF PRESENTATION

The accompanying unaudited consolidated financial statements have been prepared
in accordance with the rules and regulations of the Securities and Exchange
Commission and, therefore, do not include all information and notes necessary
for a fair presentation of financial position, results of operations, and cash
flows in conformity with generally accepted accounting principles. The
unaudited consolidated financial statements include the accounts of I/OMagic and
its subsidiary. The operating results for interim periods are unaudited and are
not necessarily an indication of the results to be expected for the full fiscal
year. In the opinion of management, the results of operations as reported for
the interim periods reflect all adjustments which are necessary for a fair
presentation of operating results. These financial statements should be read in
conjunction with the Company's Form 10-K for the year ended December 31, 2004.

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.

RECENT ACCOUNTING PRONOUNCEMENTS

In May 2005, the Financial Accounting Standards Board ("FASB") issued Statement
of Accounting Standards (SFAS) No. 154, "Accounting Changes and Error
Corrections" an amendment to Accounting Principles Bulletin (APB) Opinion No.
20, "Accounting Changes", and SFAS No. 3, "Reporting Accounting Changes in
Interim Financial Statements" though SFAS No. 154 carries forward the guidance
in APB No. 20 and SFAS No. 3 with respect to accounting for changes in
estimates, changes in reporting entity, and the correction of errors.
SFAS No. 154 establishes new standards on accounting for changes in accounting
principles, whereby all such changes must be accounted for by retrospective
application to the financial statements of prior periods unless it is
impracticable to do so. SFAS No. 154 is effective for accounting changes and
error corrections made in fiscal years beginning after December 15, 2005, with
early adoption permitted for changes and corrections made in years beginning
after May 2005. Management does not expect adoption of SFAS No. 154 to have a
material impact on the Company's financial statements.

In March 2005, the FASB issued FASB Interpretation ("FIN") No. 47, "Accounting
for Conditional Asset Retirement Obligations". FIN No. 47 clarifies that the
term conditional asset retirement obligation as used in FASB Statement No. 143,
"Accounting for Asset Retirement Obligations," refers to a legal obligation to
perform an asset retirement activity in which the timing and (or) method of
settlement are conditional on a future event that may or may not be within the
control of the entity. The obligation to perform the asset retirement activity
is unconditional even though uncertainty exists about the timing and (or) method
of settlement. Uncertainty about the timing and/or method of settlement of a
conditional asset retirement obligation should be factored into the measurement
of the liability when sufficient information exists. This interpretation also
clarifies when an entity would have sufficient information to reasonably
estimate the fair value of an asset retirement obligation. FIN No. 47 is
effective no later than the end of fiscal years ending after December 15, 2005
(which would be December 31, 2005 for calendar-year companies). Retrospective
application of interim financial information is permitted but is not required.
Management does not expect adoption of FIN No. 47 to have a material impact on
the Company's financial statements.

STOCK-BASED COMPENSATION

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

Pro forma information regarding net loss and loss per share is required by SFAS
No. 123 and has been determined as if the Company had accounted for its employee
stock options under the fair value method of SFAS No. 123. For the six months
ended June 30, 2005, no options to purchase common stock were granted. For the
six months ended June 30, 2004, 126,375 options to purchase common stock were
granted.

For purposes of pro forma disclosures, the estimated fair value of the options
is amortized to expense over the options' vesting periods. Adjustments are made
for options forfeited prior to vesting. The effect on net loss and basic and
diluted loss per share had compensation costs for the Company's stock option
plans been determined based on a fair value at the date of grant consistent with
the provisions of SFAS No. 123 for the six months ended June 30, 2005
(unaudited) and 2004 (unaudited) is as follows:

SIX MONTHS ENDED JUNE 30,
---------------------------
(unaudited)
2005 2004
(RESTATED)
--------------------------- ------------

Net income (loss)
As reported. . . . . . . . . . . . . . . . . . . . . . . . . . . $ (930,319) $(1,302,665)

Add stock based compensation expense included in net income,
net of tax. . . . . . . . . . . . . . . . . . . . . . . . . . - -

Deduct total stock based employee compensation expense
determined under fair value method for all awards, net of tax. (43,788) (30,268)
--------------------------- ------------
PRO FORMA. . . . . . . . . . . . . . . . . . . . . . . . . . . . $ (974,107) $(1,332,933)
=========================== ============
Income (loss) per common share
Basic - as reported. . . . . . . . . . . . . . . . . . . . . . . $ (0.21) $ (0.29)
Basic - pro forma. . . . . . . . . . . . . . . . . . . . . . . . $ (0.22) $ (0.29)
Diluted - as reported. . . . . . . . . . . . . . . . . . . . . . $ (0.21) $ (0.29)
Diluted - pro forma. . . . . . . . . . . . . . . . . . . . . . . $ (0.22) $ (0.29)

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.

As of June 30, 2005 (unaudited) and June 30, 2004 (unaudited) the Company had
potential common stock as follows:

2005 2004
---- ----
Weighted average common shares
outstanding during the period 4,529,672 4,529,672

Incremental shares assumed to be outstanding
since the beginning of the period related
to stock options and warrants outstanding (unaudited) - -
- -
Fully diluted weighted average common shares and
potential common stock 4,529,672 4,594,047
========= =========

The following potential common shares have been excluded from the computation of
diluted earnings per share for the three months ended June 30, 2004 (unaudited)
and the six months ended June 30, 2005 (unaudited) and June 30, 2004 (unaudited)
since their effect would have been anti-dilutive, and for the three months ended
June 30, 2005 (unaudited) due to the exercise price being greater than the
Company's weighted average stock price for the period.

June 30,
--------
(unaudited)
2005 2004
---- ----

Stock options outstanding 121,950 58,908
Warrants outstanding 20,000 40,004
---------- -----------
TOTAL 141,950 98,912
---------- -----------

NOTE 4 - INVENTORY

Inventory consisted of the following:

June 30, December 31,
2005 2004
---------- -------------
(unaudited)

Component parts. . . . . . . . . . . . . . . . . $1,492,075 $ 2,123,173
Finished goods - warehouse . . . . . . . . . . . 2,048,565 2,614,202
Finished goods - consigned . . . . . . . . . . . 4,671,110 2,872,605
Reserves for obsolete and slow moving inventory. 0 (1,463,214)
---------- --------------
TOTAL. . . . . . . . . . . . . . . . . . . . . . $8,211,750 $ 6,146,766
========== ==============

NOTE 5 - PROPERTY AND EQUIPMENT

Property and equipment as of June 30, 2005 (unaudited) and December 31, 2004
consisted of the following:

June 30, December 31,
2005 2004
---------- -------------
(unaudited)

Computer equipment and software . . . . . . . . $1,052,740 $ 1,051,485
Warehouse equipment . . . . . . . . . . . . . . 55,238 55,238
Office furniture and equipment. . . . . . . . . 266,889 266,889
Vehicles. . . . . . . . . . . . . . . . . . . . 91,304 91,304
Leasehold improvements. . . . . . . . . . . . . 98,780 98,780
---------- -------------
1,564,951 1,563,696
Less accumulated depreciation and amortization. 1,360,873 1,256,035
---------- -------------
TOTAL . . . . . . . . . . . . . . . . . . . . . $ 204,078 $ 307,661
========== =============

For the six months ended June 30, 2005 and 2004, depreciation and amortization
expense was $104,837 (unaudited) and $128,872 (unaudited), respectively.

NOTE 6 - ACCOUNTS PAYABLE AND ACCRUED EXPENSES

Accounts payable and accrued expenses consisted of the following:

June 30, December 31,
2005 2004
---------- -------------

Accounts payable . . . . . . . . . . . . . $ 576,046 $ 1,282,082
Accrued rebates and marketing. . . . . . . 3,612,037 3,231,655
Accrued compensation and related benefits. 124,253 158,896
Other. . . . . . . . . . . . . . . . . . . 450,586 549,086
---------- -------------
TOTAL. . . . . . . . . . . . . . . . . . . $4,762,922 $ 5,221,719
========== =============

NOTE 7 - 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
line of credit with United National Bank was replaced by a line of credit from
GMAC Commercial Finance. On March 9, 2005, the Company entered into a Loan and
Security Agreement for an asset-based line of credit with GMAC Commercial
Finance LLC ("GMAC"). The line of credit allows the Company to borrow up to a
maximum of $10.0 million. The line of credit expires on March 9, 2008 and is
secured by substantially all of the Company's assets. The line of credit allows
for a sublimit of $2.0 million for outstanding letters of credit. Advances on
the line of credit bear interest at the floating commercial loan rate initially
equal to the prime rate plus 0.75%. The prime rate as of June 30, 2005 was
6.00%. The Company also has the option to use the 30-day LIBOR rate (as
determined by the London Interbank Market) plus an initial amount of 3.50%.

These rates are applicable if the average amount available for borrowing
for the prior six month period is between $1.0 million and $3.5 million. If the
average amount available for borrowing is less than $1.0 million, then the rates
applicable to all amounts borrowed increase by 0.5%. If the average amount
available for borrowing is greater than $3.5 million, then the rates applicable
to all amounts borrowed decrease by 0.25%. For the unused portion of the line,
the Company is to pay on a monthly basis, an unused line fee in the amount of
0.25% of the average unused portion of the line for the preceding month.

The Loan Agreement contains one financial covenant-that the Company maintain at
the end of each measurement period through and including September 30, 2005, a
fixed charge coverage ratio (the ratio of (a) EBITDA minus internally funded
Capital Expenditures to (b) the sum of any scheduled principal and interest
payments on all funded debt and income taxes paid or payable) of at least 1.2 to
1.0 and a fixed charge coverage ratio of at least 1.5 to 1.0 for all

measurement periods thereafter. A measurement period is defined in the Loan
Agreement as the three month period ending March 31, 2005, the six month period
ending June 30, 2005, the nine month period ending September 30, 2005, the
twelve month period ending December 31, 2005, and thereafter the twelve month
period ending on March 31, June 30, September 30, and December 31 of each year
during the term of the credit facility. As of March 31 2005, the Company was in
breach of the financial covenant.

On May 23, 2005, the Company entered into a Letter Agreement with GMAC with
respect to a certain financial covenant under the Company's Loan and Security
Agreement with GMAC dated March 9, 2005. The Letter Agreement amended the Loan
Agreement to exclude the required Fixed Charge Coverage Ratio for the
Measurement Period ending March 31, 2005. The Letter Agreement amended the
financial covenant such that the Company maintain a fixed charge coverage ratio
of at least 1.0 to 1.0 for the months of April 2005 and May 2005, a fixed charge
coverage ratio of at least 1.2 to 1.0 for the three months ended June 30, 2005
and the six months ended September 30, 2005, and a fixed charge coverage ratio
of at least 1.5 to 1.0 for the nine months ended December 31, 2005 and for each
twelve month period thereafter ending on March 31, June 30, September 30, and
December 31 during the term of the credit facility. As a result of this Letter
Agreement, the Company is no longer in breach of this covenant for the period
ended March 31, 2005. The Company was in breach of the new covenant for the
month ended April 30, 2005. The Company was in compliance with the new covenant
for the month ended May 31, 2005 and the three months ended June 30, 2005.

On June 30, 2005, the Company entered into a First Amendment To Loan And
Security Agreement ("First Amendment") with GMAC with respect to the certain
financial covenant. The First Amendment amended the Letter Agreement of May 23,
2005 to exclude the required fixed charge coverage ratio for the measurement
period ending April 30, 2005 and May 31, 2005. All other Fixed Charge Coverage
Ratios remained the same. The Company was in compliance with the new covenant
for the three months ended June 30, 2005.

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 new credit facility was initially used to pay off the Company's outstanding
balance with United National Bank as of March 10, 2005, which balance was
$3,809,320, and was also used to pay $25,000 of the Company's closing fees for
the GMAC line of credit. The line of credit will be used for general operations.
The outstanding balance with GMAC as of June 30, 2005 was $4,191,279. The
amount available to the Company for borrowing as of June 30, 2005 was $118,270.

NOTE 8 - TRADE CREDIT FACILITIES WITH RELATED PARTIES

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 six months ended June 30, 2005, the Company purchased $12.1 million
(unaudited) of inventory under this arrangement. As of June 30, 2005, there
were $6,554,441 (unaudited) in trade payables outstanding under this
arrangement.

On June 6, 2005, the Company entered into an agreement for a trade credit
facility with a related party whereby the related party has agreed to purchase
and manufacture inventory on the Company's behalf. 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. Upon effectiveness of the Agreement, the Company was required to pay the
related party $1.5 million as an early payment for all invoices coming due for
payment. $1.0 million was paid on April 28, 2005 and $500,000 was paid on April
29, 2005. Any early payment funds remaining three months after the date of the
Agreement shall be refunded to the Company immediately. Once the $1.5 million
has been exhausted, or three months from the date of the Agreement has expired,
whichever is sooner, the Company shall pay the related party 10% of the purchase
price on any purchase order 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 six months
ended June 30, 2005, the Company purchased $1.4 million (unaudited) of inventory
under a prior agreement and $1.3 million under this arrangement. As of June 30,
2005, there were $1,188,417 (unaudited) in trade payables under this
arrangement. See also Note 11, Subsequent Events.

NOTE 9 - 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 $187,604 (unaudited) and $179,211 (unaudited) for the six
months ended June 30, 2005 and 2004, respectively, and is included in general
and administrative expenses in the accompanying statements of income.

LITIGATION

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

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

On March 9, 2005, the Company entered into a Settlement Agreement with
Magnequench International, Inc., releasing all claims against the Company in
exchange for certain information and covenants by the Company, including
disclosure of identities of certain of its suppliers of alleged infringing
products, a covenant to provide sample products for testing purposes and a
covenant to not source products from suppliers of alleged infringing products,
provided that, among other

limitations, another supplier makes those products available to the Company in
sufficient quantities. A dismissal of the case was filed with the court on April
15, 2005.

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

On May 20, 2005, the Company filed a complaint for breach of contract, breach of
implied covenant of good faith and fair dealing, and common counts against
OfficeMax North America, Inc., or defendant, in the Superior Court of the State
of California for the County of Orange, Case No. 05CC06433. The complaint seeks
damages of in excess of $22 million arising out of the defendants' breach of
contract under an agreement entered into in May 2001. On or about June 20, 2005,
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) (the
"California Case"). On or about June 28, 2005, the Company and OfficeMax jointly
filed a stipulation in requesting that the United States District Court in
California temporarily stay the California Case pending the outcome of the
Motion in Ohio. The outcome of this action is presently uncertain. However,
the Company believes that all of its claims are meritorious. See also, Note 11,
Subsequent Events.

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 10 - RELATED PARTY TRANSACTIONS

During the six months ended June 30, 2005 and 2004, the Company made purchases
from related parties totaling approximately $13,332,465 (unaudited) and
$13,190,065 (unaudited), respectively.

During the six months ended June 30, 2005 and 2004, the Company had trade
payables to related parties totaling approximately $7,742,858 (unaudited) and
$3,666,686 (unaudited), respectively.

NOTE 11 - SUBSEQUENT EVENTS

Stock Option Plan
- -------------------
On July 14, 2005, the Company granted options to purchase an aggregate of
370,000 shares of the Company's common stock under its 2002 and 2003 Employee
Stock Option Plans. The market price of the Company's stock was $2.50 as of
July 14, 2005. Options covering 240,000 shares of common stock have an
exercise price of $2.50 each and options covering 130,000 shares of common stock
have an exercise price of $2.75 each. 50% vest immediately and the balance
vests equally over four years from the date of issuance. The stock options
expire five years from the date of grant.

Trade Credit Facility with Related Party
- ---------------------------------------------
On July 21, 2005, the Company entered into an Amended and Restated Agreement
(the "Amendment") with a related party that amended certain terms of a June 6,
2005 agreement entered between the Company and that certain related party. The
Amendment resulted in material amendments to the agreement to (i) apply the
terms of the agreement retroactively so that the agreement is effective as of
April 29, 2005; (ii) change the payment terms of the 10% down payment for
products ordered from payment within one week of the Company's purchase order to
payment within ten days of the related party's invoice date; (iii) define the
related party's invoice date as no earlier than the shipment date of products to
the Company; and (iv) designate all purchase orders as F.O.B. the Company's
warehouse in Irvine, California, unless otherwise agreed upon in writing by both
parties. See also Note 8.

Consulting Agreement
- ---------------------
On July 8, 2005, the Company entered into an Amended and Restated Consulting
Agreement for public investor relations services. The agreement has a term of
one-year and compensation to be paid at $3,500 per month. The Company will pay
$2,500 per month of the compensation in cash consideration and $1,000 per month
(or $12,000 for the term of the agreement) in equity compensation in lieu of
cash compensation by issuing the consultant warrants to purchase 150,000 shares
of common stock, consisting of warrants to purchase 50,000 shares of common
stock with an exercise price of $3.00, warrants to purchase 50,000 shares of
common stock with an exercise price of $4.00 and warrants to purchase 50,000
shares of common stock with an exercise price of $6.00. The warrants vest
immediately and expire eighteen months from issuance. The Amended and Restated
Consulting Agreement also terminated the Company's previous March 9, 2004
agreement with this consultant and cancelled 20,000 warrants issued pursuant to
that agreement.

Litigation - I/OMagic v. OfficeMax North America, Inc. ("California Case")
- --------------------------------------------------------------------------------

On July 6, 2005, the United States District Court in California denied the
parties joint stipulation request to temporarily stay the California Case and
instead ordered that OfficeMax answer the complaint by August 1, 2005. On
August 1, 2005, OfficeMax filed its Answer and Counter-Claim against the
Company. The Counter-Claim against the Company alleges four causes of action
against the Company: breach of contract, unjust enrichment, quantum valebant,
and an action for declaratory relief. The Counter-Claim alleges, among other
things, that the Company is liable to Office/Max 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 has never been reimbursed. The Counter-Claim seeks,
among other things, at least $138,000 from the Company, along with pre-judgment
interest, attorneys' fees and costs of suit. As of the date of this Report, the
Company has not yet responded to the Counter-Claim. The Company intends to deny
all of the affirmative claims set forth in the Counter-Claim, deny any
wrongdoing or liability, deny that OfficeMax is entitled to obtain any relief,
and plans to vigorously contest the Counter-Claim. The outcome of this action
is presently uncertain. However, the Company believes that all of its claims
and defenses are meritorious.

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 "Risk Factors" and under other captions contained elsewhere in
this report.

OVERVIEW

We are a leading provider of optical data storage products and also sell a
range of portable magnetic data storage products which we call our GigaBank
products. In addition, and to a much lesser extent, we sell digital
entertainment and other products. Our data storage products collectively
accounted for approximately 99% of our net sales in 2004 and for over 99% in the
first six months of 2005, and our digital entertainment and other products
collectively accounted for only approximately 1% of our net sales in 2004 and
far less than 1% in the first six months of 2005.

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

We sell our products through computer, consumer electronics and office
supply superstores and other retailers in over 10,000 retail locations
throughout North America. Our network of retailers enables us to offer products
to consumers across North America, including every major metropolitan market in
the United States. 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 , however, from time to time, we also sell products under our
Hi-Val and Digital Research Technologies brand names.

Our net sales declined by $4.4 million, or 19.0%, to $18.6 million in the
first six months of 2005 from $23.0 million in the first six months of 2004. Our
net loss decreased by $373,000 to $930,000 in the first six months of 2005 from
a net loss of $1.3 million in the first six months of 2004. We believe that this
significant decline in our operating results is due, in large part, to the
following factors:

- - Decreased sales. As discussed further below, we believe that our
substantial decline in net sales in the first six months of 2005 as
compared to the first six months of 2004 was primarily due to the
following factors:
- the rapid and continued decline in sales of our CD-based
products;
- lower average selling prices of our DVD-based products;
- slower than anticipated growth in sales of our DVD-based products;
and
- a decrease in net sales to Best Buy due to its expanded operation
Of private label programs in 2005, in addition to a
- decrease in net sales to RadioShack USA that resulted in net returns
of $312,000 for

the first six months of 2005 due to a transition in product
category offerings at RadioShack USA stores,
- all of which was partially offset by an increase in net sales to
Staples.

- - Decreased gross margins. Our gross margin was reduced by 0.4% which
represented a decline of 3.4% to 11.3% in the first six months of
2005 as compared to gross margin of 11.7% in the first six months of 2004.
This decline was primarily due to the Company's decision to increase
market development fund and cooperative advertising costs, rebate
promotion costs and slotting fees from $3.5 million, or 11.2% of gross
sales, during the first six months of 2004 to $3.6 million, or 13.6% of
gross sales, during the first six months of 2005.

We believe that the significant decline in our net sales during the first
six months of 2005 as compared to the first six months of 2004 resulted in part
from the rapid and continued decline in sales of our CD-based products. We
elected to de-emphasize CD-based products because we believe that they are
included as a standard component in most new computer systems and because
DVD-based products are backward-compatible with CDs. Predominantly based on
market forces, but also partly as a result of our decision to de-emphasize
CD-based products, our sales of recordable CD-based products declined by 74.2%
to $1.6 million in the first six months of 2005 from $6.2 million in the first
six months of 2004.

We believe that another factor contributing to the significant decrease in
our net sales for the first six months of 2005 as compared to the same period in
2004 was an industry-wide decrease over these periods of approximately 27% in
the average selling prices of recordable DVD drives. We believe that these lower
average selling prices were primarily the result of a slower than anticipated
growth in DVD-compatible applications and infrastructure, which resulted in
lower demand for DVD-based products. In addition, 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 six
months of 2005, our sales of recordable DVD-based products decreased 34.4% to
$9.9 million as compared to $15.1 million in sales of recordable DVD-based
products for the same period in 2004.

Another factor contributing significantly to the decline in our net sales
during the first six months of 2005 as compared to the first six months of 2004
was the continued and expanded operation of private label programs by Best Buy.
Our sales to Best Buy declined in the first six months of 2005 to $64,000 as
compared to $4.5 million of sales in the first six months of 2004. We believe
that this decrease reflects, at least in part, Best Buy's increased sales
beginning in 2004 of private label products that compete with products that we
sell.

total net sales over the next twelve months. In the third quarter of 2004, we
began selling our GigaBank products, and sales of these devices accounted for
approximately 27.0% of our total net sales in the fourth quarter of 2004. Sales
of our GigaBank products increased to $6.1 million in the first six months of
2005 as compared to no sales of these products in the first six months of 2004.
Sales of our GigaBank products represented 33.3% of our total net sales in the
first six months 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 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.

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. Although our use of a
consignment sales model results in greater exposure to the danger of declining
average selling prices, it 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 six months of 2005, our annualized
inventory turnover level was 4.5 as compared to 6.8 for the first six months of
2004, representing a period-to-period decrease of 34% as a result of a 19%
decrease in net sales and an 87% increase in consigned inventory at our
consignment customers' warehouses or retail locations offset by an 18% decrease
in on-hand and in-transit inventory. The increase in consigned inventory relates
directly to the introduction of our new USB portable data storage devices with
our customers. The decrease in our on-hand and in-transit inventory reflects our
efforts to more efficiently use funds by not purchasing excess amounts of
on-hand inventory. The decline in inventory turnover for the first six months of
2005 included $537,000 in additional reserves for slow-moving and obsolete
inventory as compared to $369,000 in additional reserves for slow-moving and
obsolete inventory in the first six months of 2004. For the year 2004, our
annualized inventory turnover level was 7.2 as compared to 6.6 in 2003,
representing a period-to-period increase of 9% primarily as a result of a 37%
decline in inventory offset by a 30% decrease in net sales. The decline in
inventory in 2004 included $2.0 million in additional reserves for slow-moving
and obsolete inventory.

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

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 sale 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. Products held by a
retailer under our consignment sales model are recorded as our inventory at
offsite locations until their resale by the retailer.

Consignment sales represented a growing percentage of our net sales from
2001 through 2003. However, during 2004, our consignment sales model accounted
for 32% of our total net sales as compared to 37% of our total net sales in
2003, representing a 13% decrease, 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. During
the first six months of 2005 our consignment sales model accounted for 34% of
our total net sales as compared to 32% of our total net sales in the first six
months of 2004, representing a 6% increase, primarily as a result of consigning

more products to Staples and Office Depot. Although consignment sales declined
as a percentage of our net sales in 2004, and increased as a percentage of our
net sales in the second quarter of 2005 as compared to the same period in 2004,
it is not yet clear whether consignment sales as a percentage of our total net
sales will decline or grow on an annual basis.

During 2001, 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 six months of 2005 and
during the years 2004 and 2003, our six largest retailers accounted for
approximately 95%, 78% and 88%, 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 data storage 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
PNY Technologies, Sony, Seagate Technology and Western Digital offer products
similar to our GigaBank 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 six months of 2005, our sales incentives were $832,000, or
3.2% of gross sales, as compared to $1.1 million, or 3.7% of gross sales, in the
first six months of 2004, all of which was offset against gross sales. In 2004,
our sales incentives were $2.5 million, or 4.2% of gross sales, all of which was
offset against gross sales. In 2003, our sales incentives were $2.9 million, or
3.5% 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 six months of 2005,
our market development fund and cooperative advertising costs, rebate promotion
costs and slotting fees were $3.6 million, or 13.6% 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 $3.5
million, or 11.6% of gross sales, in the first six months of 2004, all of which
was offset against gross sales. These costs and fees increased as a percentage
of our net gross sales in the first six months of 2005, increasing to 13.6% of
our gross sales from 11.6% of our gross sales in the first six months of 2004,
primarily as a result of instituting sales incentives and marketing promotions
in order to promote our double layer recordable DVD drives. 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. In 2003, our market development fund and cooperative
advertising costs, rebate promotion costs and slotting fees were $8.4 million,
or 10.3% 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 six months of 2005 we increased our
inventory reserve and recorded a corresponding increase in cost of goods sold of
$537,000 for inventory for which recorded cost exceeded the current market price
of this inventory on hand. For the first six months of 2004, we decreased our
inventory reserve and recorded a corresponding decrease in cost of goods sold of
$368,000. 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. For the
first six months of 2005 and 2004, 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) 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 13.4%. 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.

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:

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

- - 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.

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

THREE MONTHS ENDED JUNE 30, 2005 (UNAUDITED) COMPARED TO THREE MONTHS ENDED JUNE
30, 2004 (UNAUDITED)

RESULTS AS A PERCENTAGE
DOLLAR PERCENTAGE OF NET SALES FOR THE
THREE MONTHS ENDED VARIANCE VARIANCE THREE MONTHS ENDED
JUNE 30, -------- -------- JUNE 30,
-------------------- FAVORABLE FAVORABLE --------------------
2004 2004
---- ----
2005 (RESTATED) (UNFAVORABLE) (UNFAVORABLE) 2005 (RESTATED)
---- ---------- ------------- ------------- ---- ----------
(in thousands)

Net sales . . . . . . . . . . . . . . $ 9,558 $ 7,490 $ 2,068 27.6% 100.0% 100.0%
Cost of sales . . . . . . . . . . . . 8,041 7,052 (989) (14.0) 84.1 94.1
-------------------- ------------ ---------- ------------ ------- ------
Gross profit. . . . . . . . . . . . . 1,517 438 1,079 246.3 15.9 5.9
Selling, marketing and advertising
expenses . . . . . . . . . . . . . . 123 171 48 28.1 1.3 2.3
General and administrative
expenses . . . . . . . . . . . . . . 1,042 1,454 412 28.3 10.9 19.4
Depreciation and amortization . . . . 61 209 148 70.8 0.6 2.8
-------------------- ------------ ---------- ------------ ------- ------
Operating income (loss) . . . . . . . 291 (1,396) 1,687 120.8 3.1 (18.6)
Net interest expense. . . . . . . . . (65) (40) (25) (62.5) (0.7) (0.5)
Other income (expense). . . . . . . . 3 (12) 15 125.0 - (0.2)
-------------------- ------------ ---------- ------------ ------- ------
Income (loss) from operations before
provision for income taxes. . . . . 229 (1,448) 1,677 115.8 2.4 (19.3)
Income tax provision (benefit). . . . 2 (1) 3 300.0 - -
-------------------- ------------ ---------- ------------ ------- ------
Net income (loss) . . . . . . . . . . $ 227 $ (1,447) $ 1,674 115.7% 2.4% (19.3)%
==================== ============ ========== ============ ======= ======

Net Sales. We believe that the increase in the amount of $2.1 million in
net sales from $7.5 million for the three months ended June 30, 2004 to $9.6
million for the three months ended June 30, 2005 is primarily due to a
substantial increase in the sale of our GigaBank USB portable data storage
devices and an increase in the sales of DVD-based products. These increases were
partially offset by the continued decline in sales of our CD-based products. We
also saw a significant increase in our sales to Staples, offset primarily by a
decrease of nearly 100% in sales to Best Buy due to the Company's decision to
discontinue its sales of media and CD-based products and Best Buy's
implementation of private label programs.

Sales of our GigaBank products represented 32.8% of our total net sales in
the second quarter of 2005. Our sales of GigaBank USB portable storage devices
increased to $3.1 million in the second quarter of 2005 from $0 in the second
quarter of 2004. Our sales of DVD-based products increased 17.8% to $5.3 million
in the second quarter of 2005 from $4.5 million in the second quarter of 2004.
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 61.1% to $778,000 in the second quarter of 2005 from $2.0
million in the second quarter of 2004.

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 second quarter of
2005. Our business focus is predominantly on DVD-based optical data storage
products. In addition to CD- and DVD-based optical data storage products, we
also focus on and sell a line of GigaBank 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 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 products, and sales of these devices accounted
for approximately 27.0% of our total net sales in the fourth quarter of 2004.
The increase in gross profit as a percentage of our net sales was primarily due
to a decrease in market development fund and cooperative advertising costs,
rebate promotion costs and slotting fees from

$1.5 million, or 13.0% of gross sales, during the second quarter of 2004, to
$1.2 million, or 9.4% of gross sales, during the second quarter of 2005. In
addition, sales incentives decreased from $439,000, or 3.9% of gross sales,
during the second quarter of 2004, to $378,000, or 2.9% of gross sales, during
the second quarter of 2005.

A change in the allowance for product returns also resulted in an
adjustment of $41,000 causing a decrease in sales in the second quarter of 2005
as compared to an adjustment of $194,000 that resulted in an increase in sales
in the second quarter of 2004.

The increase in net sales for the second quarter of 2005 was comprised of a
$6.8 million increase in net sales resulting from an increase in the volume of
products sold including a high volume of unit sales of certain non-recurring
items. This increase was partially offset by a $4.5 million decrease in net
sales resulting from lower average product sales prices associated with the sale
of these non-recurring items. We also had a decrease of $234,000 resulting from
a change in our reserves for future returns on sales. We had a decrease of $1.2
million in net sales for the second quarter of 2005 for our CD-based products
resulting from a decrease of $293,000 from lower average product sales prices
and a decrease of $925,000 from the volume of products sold. We had an increase
of $818,000 in net sales for the second quarter of 2005 for our DVD-based
products resulting from an increase of $1.8 million in the volume of products
sold offset by a decrease of $935,000 from lower average product sales prices.
The $3.1 million increase in net sales for the second quarter of 2005 for our
GigaBank USB portable storage devices resulted entirely from an increase in the
volume of products sold, as we had no sales of these products during the second
quarter of 2004.

Gross Profit. The increase in gross profit of $1.1 million from $438,000
for the second quarter of 2004 to $1.5 million for the second quarter of 2005 is
primarily due to an increase in net sales of $2.1 million, a decrease in market
development fund and cooperative advertising costs, rebate promotion costs and
slotting fees and a decrease in our reserve for slow-moving inventory. The
increase in gross profit as a percentage of our net sales was primarily due to a
decrease in market development fund and cooperative advertising costs, rebate
promotion costs and slotting fees from 13.0% of gross sales during the second
quarter of 2004 to 9.4% of gross sales during the second quarter of 2005. Our
direct product costs, inventory shrinkage and related freight costs decreased
from 94.2% of net sales for the second quarter of 2004 to 84.1% of net sales for
the second quarter of 2005, primarily due to the decrease in market development
fund and cooperative advertising costs, rebate promotion costs and slotting fees
in addition to sales incentives.

Our inventory reserve increased by $175,000 in the second quarter of 2005
as compared to $269,000 in the second quarter of 2004 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 decreased by $48,000 in the second quarter of 2005 as
compared to the second quarter of 2004. This decrease was primarily due to a
$21,000 reduction in commissions as a result of reduced sales volume and a
$24,000 reduction in payroll and related expenses due to fewer personnel and
lower retailer performance charges.

General and Administrative Expenses. General and administrative expenses
decreased by $412,000 in the second quarter of 2005 as compared to the second
quarter of 2004. This decrease was

primarily due to a $201,000 decrease in payroll and related expenses, a $60,000
decrease in bad debt expense, a $56,000 decrease in financing fees and a $47,000
decrease in financial relations expenses.

Depreciation and Amortization Expenses. The $148,000 decrease in
depreciation and amortization expenses is primarily due to decreased
amortization of our trademarks resulting from an impairment in the value of our
Hi-Val and Digital Research Technologies trademarks in the aggregate amount of
$3.7 million recorded as of December 31, 2004.

Other Income (Expense). Other income (expense) increased by $10,000 in the
second quarter of 2005 as compared to the second quarter of 2004. Net interest
expense increased by $25,000 due to both greater borrowings under our lines of
credit and higher interest rates in the second quarter of 2005 as compared to
the second quarter of 2004. This was partially offset by an increase in income
in the amount of $15,000 related to foreign currency transactions in connection
with our sales in Canada.

SIX MONTHS ENDED JUNE 30, 2005 (UNAUDITED) COMPARED TO SIX MONTHS ENDED JUNE 30,
2004 (UNAUDITED)

RESULTS AS A
PERCENTAGE
OF NET SALES
FOR THE
DOLLAR PERCENTAGE SIX MONTHS
SIX MONTHS ENDED VARIANCE VARIANCE ENDED
------------ -------------- JUNE 30,
JUNE 30, FAVORABLE FAVORABLE 2004
------------------ 2004 ------------- --------------
2005 (RESTATED) (UNFAVORABLE) (UNFAVORABLE) 2005 (RESTATED)
------------------ ------------ -------------- ------------- ------ ----------
(in thousands)

Net sales. . . . . . . . . . . . . . . . . . $ 18,594 $ 22,963 $ (4,369) (19.0)% 100.0% 100.0%
Cost of sales. . . . . . . . . . . . . . . . 16,495 20,270 3,775 18.6 88.7 88.3
------------------ ------------ -------------- ------------- ------ ----------
Gross profit . . . . . . . . . . . . . . . . 2,099 2,693 (594) (22.1) 11.3 11.7
Selling, marketing and advertising expenses. 297 651 354 54.4 1.6 2.8
General and administrative expenses. . . . . 2,460 2,820 360 12.8 13.2 12.3
Depreciation and amortization. . . . . . . . 139 419 280 66.8 0.8 1.8
------------------ ------------ -------------- ------------- ------ ----------
Operating loss . . . . . . . . . . . . . . . (797) (1,197) 400 33.4 (4.3) (5.2)
Net interest expense . . . . . . . . . . . . (142) (84) (58) (69.0) (0.8) (0.4)
Other income (expense) . . . . . . . . . . . 11 (20) 31 155.0 0.1 (0.1)
------------------ ------------ -------------- ------------- ------ ----------
Loss from operations before provision
for income taxes. . . . . . . . . . . . . (928) (1,301) 373 28.7 (5.0) (5.7)
Income tax provision . . . . . . . . . . . . 2 2 - - - -
------------------ ------------ -------------- ------------- ------ ----------
Net Loss . . . . . . . . . . . . . . . . . . $ (930) $ (1,303) $ 373 28.6% (5.0)% (5.7)%
================== ============ ============== ============= ====== ==========

Net Sales. As discussed above, we believe that the significant decrease in
the amount of $4.4 million in net sales from $23.0 million for the six months
ended June 30, 2004 to $18.6 million for the six months ended June 30, 2005 is
primarily due to the following factors: the continued decline in sales of our
CD-based products; lower average selling prices of DVD-based products; slower
than anticipated growth and decrease in sales of our DVD-based products; and the
continued operation of private label programs by Best Buy. The decline in net
sales caused by these factors was partially offset by a substantial increase in
the sale of our GigaBank USB portable data storage devices.

We believe that the significant decline in our net sales during the six
months ended June 30, 2005 as compared to the six months ended June 30, 2004
resulted in part from the rapid and continued decline in sales of our CD-based
products. Predominantly based on market forces, but also partly as a result of
our decision to de-emphasize CD-based products, our sales of recordable CD-based
products declined by 74.2% to $1.6 million in the first six months of 2005 from
$6.2 million in the first six months of 2004.

In addition, we believe that an industry-wide decrease of approximately 27%
in the average selling prices of recordable DVD drives in the first six months
of 2005 as compared to the first six months of 2004 resulted in a significant
decline in our net sales. We believe that these lower average selling prices
were primarily the result of a slower than anticipated growth in DVD-compatible
applications and infrastructure, which resulted in lower demand for DVD-based
products. 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 six months of 2005, sales of our
recordable DVD-based products decreased 34.4% to $9.9 million as compared to
$15.1 million in sales of our recordable DVD-based products for the same period
in 2004.

In addition to the other 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 six months of 2005. Our
business focus is predominantly on DVD-based optical data storage products. In
addition to CD- and DVD-based optical data storage products, we also focus on
and sell a line of GigaBank 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 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 products, and sales of these devices accounted for approximately 27.0%
of our total net sales in the fourth quarter of 2004. Sales of our GigaBank
products increased to $6.1 million in the first six months of 2005 as compared
to no sales of these products in the first six months of 2004. Sales of our
GigaBank products represented 33.3% of our total net sales in the first six
months of 2005.

Another factor contributing significantly to the decline in our net sales
during the first six months of 2005 as compared to the same period in 2004 was
the continued and expanded operation of private label programs by Best Buy. We
had only $64,000 in sales to Best Buy in the first six months of 2005,
representing a decrease of nearly 100% from $4.5 million in sales to Best Buy in
the same period in 2004. We believe that this decrease reflects, at least in
part, Best Buy's increased sales of private label products that compete with
products that we sell.

The decrease in gross profit as a percentage of our net sales was primarily
due to an increase in market development fund and cooperative advertising costs,
rebate promotion costs and slotting fees from $3.5 million, or 11.6% of gross
sales, during the first six months of 2004, to $3.6 million, or 13.6% of gross
sales, during the first six months of 2005. These costs and fees increased
primarily as a result of our more extensive marketing and rebate promotions used
to promote our double-layer recordable DVD drives.

A change in the allowance for product returns also resulted in an
adjustment of $369,000 causing an increase in sales in the first six months of
2005 as compared to an adjustment of $1.2 million that resulted in an increase
in sales in the first six months of 2004.

The overall decrease in net sales for the first six months of 2005 was
comprised of a $5.8 million decrease in net sales resulting from lower average
product sales prices, including a high volume of unit sales of certain
non-recurring items in the second quarter of 2005. This decrease was partially
offset by a $2.3 million increase in net sales resulting from an increase in the
volume of products sold associated

with the sale of these non-recurring items in the second quarter of 2005. We
also had a decrease of $875,000 resulting from a change in our reserves for
future returns on sales. We had a decrease of $4.5 million in net sales for the
first six months of 2005 for our CD-based products resulting from a decrease of
$550,000 from lower average product sales prices and a decrease of $4.0 million
from the volume of products sold. We had a decrease of $5.3 million in net sales
for the first six months of 2005 for our DVD-based products resulting from a
decrease of $4.3 million from lower averge product sales prices and a decrease
of $1.0 million from the volume of products sold. The $6.1 million increase in
net sales for the first six months of 2005 for our GigaBank USB portable storage
devices resulted entirely from an increase in the volume of products sold, as we
had no sales of these products for the first six months of 2004.

Gross Profit. The decrease in gross profit of $594,000 from $2.7 million
for the first six months of 2004 to $2.1 million for the first six months of
2005 is primarily due to a decline in net sales of $4.4 million, an increase in
market development fund and cooperative advertising costs, rebate promotion
costs and slotting fees and an increase in our reserve for slow-moving
inventory. The decrease in gross profit as a percentage of our net sales was
primarily due to an increase in market development fund and cooperative
advertising costs, rebate promotion costs and slotting fees from 11.6% of gross
sales during the first six months of 2004 to 13.6% of gross sales during the
first six months of 2005. These costs and fees increased primarily as a result
of instituting marketing promotions in order to promote our double-layer
recordable DVD drives. Our direct product costs, inventory shrinkage and related
freight costs increased from 88.3% of net sales for the first six months of 2004
to 88.7% of net sales for the first six months of 2005, primarily due to the
increase in market development fund and cooperative advertising costs, rebate
promotion costs and slotting fees.

Our inventory reserve increased by $537,000 in the first six months of 2005
as compared to $369,000 in the first quarter of 2004 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 decreased by $354,000 in the first six months of 2005 as
compared to the first six months of 2004. This decrease was primarily due to no
advertising expenses incurred in the first six months of 2005 as compared to
advertising expenses of $241,000 incurred in the first six months of 2004. In
addition, this decrease partially resulted from lower commissions as a result of
reduced sales volume and reduced payroll and related expenses due to fewer
personnel and lower retailer performance charges.

General and Administrative Expenses. General and administrative expenses
decreased by $360,000 in the first six months of 2005 as compared to the first
six months of 2004. This decrease was primarily due to a $256,000 decrease in
payroll and related expenses and a $101,000 decrease in financial relations
expenses.

Depreciation and Amortization Expenses. The $280,000 decrease in
depreciation and amortization expenses is primarily due to decreased
amortization of our trademarks resulting from an impairment in the value of our
Hi-Val and Digital Research Technologies trademarks in the aggregate amount of
$3.7 million recorded as of December 31, 2004.

Other Income (Expense). Other income (expense) increased by $27,000 in the
first six months of 2005 as compared to the first six months of 2004. Net
interest expense increased by $58,000 due to both greater borrowings under our
lines of credit and higher interest rates in the first six months of 2005

as compared to the first six months of 2004. This was partially offset by an
increase in income in the amount of $31,000 related to foreign currency
transactions in connection with our sales in Canada.

LIQUIDITY AND CAPITAL RESOURCES

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. We also have the
option to use the 30-day LIBOR rate (as determined by the London Interbank
Market) plus an initial amount of 3.50%. 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 contains one financial covenant which requires that we maintain a
certain fixed charge coverage ratio. The covenant was modified by a May 23, 2005
Letter Agreement with GMAC and again by a June 30, 2005 First Amendment To Loan
And Security Agreement ("First Amendment"). The First Amendment requires that we
maintain a fixed charge coverage ratio of at least 1.2 to 1.0 for the three
months ended June 30, 2005 and the six months ended September 30, 2005. The
ratio becomes 1.5 to 1.0 for the nine months ended December 31, 2005 and for the
twelve months in all subsequent quarters. 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 June 30, 2005, we owed GMAC Commercial Finance approximately
$4.2 million and had available to us approximately $118,000 of additional
borrowings.

In January 2003, we entered into a trade credit facility with Lung Hwa
Electronics. Lung Hwa Electronics is a stockholder and subcontract manufacturer
and supplier of I/OMagic. Under the terms of the facility, Lung Hwa Electronics
has agreed to purchase inventory on our behalf. We can purchase up to $10.0
million of inventory, with payment terms of 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. As security for the trade credit facility, we paid Lung Hwa
Electronics a $1.5 million security deposit during 2003. As of June 30, 2005,
all of this deposit had been applied against outstanding trade payables as the
agreement allowed us to apply the security deposit against our outstanding trade
payables. This trade credit facility is for an indefinite term; however, either
party has the right to terminate the facility upon 30 days' prior written notice
to the other party.

In July 2005, we entered into an amended and restated trade credit facility
agreement with Lung Hwa Electronics, with the terms retroactive to April 29,
2005. Under the terms of the amended and restated trade credit facility, we can
purchase up to $15.0 million of inventory, with payment terms of 120 days
following the date of invoice by Lung Hwa Electronics for inventory purchased
directly from Lung Hwa

Electronics and 90 days following the date of invoice by Lung Hwa Electronics
for inventory purchased from a third party through Lung Hwa Electronics on our
behalf. A 10% deposit is required to be made by us to Lung Hwa Electronics
within 10 days of Lung Hwa Electronics' invoice date. 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. As of June 30, 2005, we owed Lung Hwa
Electronics $1.2 million in trade payables under this agreement.

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 June
30, 2005, we owed BTC USA $6.6 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 principal sources of liquidity have been cash provided by operations
and borrowings under our bank and trade credit facilities. Our principal uses of
cash have been to finance working capital, capital expenditures and debt service
requirements. We anticipate that these sources and uses will continue to be our
principal sources and uses of cash in the future. As of June 30, 2005, we had
working capital of $6.7 million, an accumulated deficit of $24.0 million, $1.7
million in cash and cash equivalents and $12.5 million in net accounts
receivable. This compares with working capital of $7.5 million, an accumulated
deficit of $23.1 million, $3.6 million in cash and cash equivalents and $14.6
million in net accounts receivable as of December 31, 2004.

For the six months ended June 30, 2005, our cash decreased $1.9 million, or
52.8%, from $3.6 million to $1.7 million as compared to a decrease of $487,000,
or 12.2%, for the six months ended June 30, 2004 from $4.0 million to $3.5
million.

Cash used in our operating activities totaled $936,000 during the six
months ended June 30, 2005 as compared to cash provided by our operating
activities of $761,000 during the six months ended June 30, 2004. This $1.7
million increase in cash used in our operating activities primarily resulted
from a decrease of $4.4 million in net sales in the first six months of 2005 as
compared to the first six months of 2004. This decrease in net sales and other
factors resulted in a $6.2 million decrease in cash resulting from an increase
in accounts receivable and a $5.1 million decrease in cash from an increase in
our inventory. These decreases in cash were partially offset by increases in
cash resulting from a $731,000 increase in accounts payable and accrued
expenses, a $7.1 million increase in the use of our trade credit

facilities with related parties, a decrease in legal settlements payable of $1.0
million as we made the final payment in the first quarter of 2004 on the
settlement of a litigation matter, a $274,000 increase in reserves for product
returns and allowances, and a $168,000 increase in our reserve for obsolete
inventory.

Cash provided by our investing activities totaled $824,000 during the first
six months of 2005 as compared to cash provided by our investing activities of
$175,000 the first six months of 2004. Our investing activities consisted of
restricted cash related to our United National Bank loan and purchases of
property and equipment.

Cash used in our financing activities totaled $1.8 million during the first
six months of 2005 as compared to cash used in our financing activities of $1.4
million for the first six months of 2004. 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 $375,000 on our GMAC Commercial Finance line of
credit during the first six months of 2005.

Our net loss decreased 28.5% to $930,000 for the first six months of 2005
from $1.3 million for the first six months of 2004, primarily resulting from a
25.6% decrease in operating expenses to $2.9 million in the first six months of
2005 from $3.9 million in the first six months of 2004, offset by a 19.1%
decrease in our net sales to $18.6 million in the first six months of 2005 from
$23.0 million in the first six months of 2004. If either the absolute level or
the downward trend of our net loss or net sales continues or increases, we could
experience significant shortages of liquidity and our ability to purchase
inventory and to operate our business may be significantly impaired, which could
lead to further declines in our operating performance and financial condition.

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

We believe that the significant decline in our net sales during the first
six months of 2005, as compared to the same period in 2004, resulted in part
from a continued decline in sales of our CD-based products, lower average
selling prices of DVD-based products, slower than anticipated growth and a
decline in sales of our DVD-based products, and the continued operation of
private label programs by Best Buy.

Despite the decline in our results of operations during the first six
months of 2005, 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 June 30, 2005 was $4.8 million as compared to a backlog at
June 30, 2004 of $2.6 million. Based on historical trends, we anticipate that
our June 30, 2005 backlog may be reduced by approximately 13.4%, or $643,000, to
a net amount of $4.2 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 May 2005, the FASB issued Statement of Accounting Standards (SFAS) No.
154, "Accounting Changes and Error Corrections" an amendment to Accounting
Principles Bulletin (APB) Opinion No. 20, "Accounting Changes", and SFAS No. 3,
"Reporting Accounting Changes in Interim Financial Statements" though SFAS No.
154 carries forward the guidance in APB No. 20 and SFAS No. 3 with respect to
accounting for changes in estimates, changes in reporting entity, and the
correction of errors.

SFAS No. 154 establishes new standards on accounting for changes in
accounting principles, whereby all such changes must be accounted for by
retrospective application to the financial statements of prior periods unless it
is impracticable to do so. SFAS No. 154 is effective for accounting changes and
error corrections made in fiscal years beginning after December 15, 2005, with
early adoption permitted for changes and corrections made in years beginning
after May 2005. We do not expect adoption of SFAS No. 154 to have a material
impact on our financial statements.

In March 2005, the FASB issued FASB Interpretation ("FIN") No. 47,
"Accounting for Conditional Asset Retirement Obligations". FIN No. 47 clarifies
that the term conditional asset retirement obligation as used in FASB Statement
No. 143, "Accounting for Asset Retirement Obligations," refers to a legal
obligation to perform an asset retirement activity in which the timing and (or)
method of settlement are conditional on a future event that may or may not be
within the control of the entity. The obligation to perform the asset retirement
activity is unconditional even though uncertainty exists about the timing and
(or) method of settlement. Uncertainty about the timing and/or method of
settlement of a conditional asset retirement obligation should be factored into
the measurement of the liability when sufficient information exists. This
interpretation also clarifies when an entity would have sufficient information
to reasonably estimate the fair value of an asset retirement obligation. FIN No.
47 is effective no later than the end of fiscal years ending after December 15,
2005 (which would be December 31, 2005

for calendar-year companies). Retrospective application of interim financial
information is permitted but is not required. We do not expect adoption of FIN
No. 47 to have a material impact on our financial statements.

RISK FACTORS

An investment in our common stock involves a high degree of risk. In
addition to the other information in this Quarterly Report and in our other
filings with the Securities and Exchange Commission, including our subsequent
reports on Forms 10-Q, 10-K and 8-K , you should carefully consider the
following discussion, which summarizes material risks, before deciding to invest
in shares of our common stock or to maintain or increase your investment in
shares of our common stock. Any of the following risks, if they actually occur,
would likely harm our business, financial condition and results of operations.
As a result, the trading price of our common stock could decline, and you could
lose all or part of the money you paid to buy our common stock.

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

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

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

We have incurred net losses in each of the last five years and for the six
months ended June 30, 2005. As of June 30, 2005, we had an accumulated deficit
of approximately $24.0 million. During 2004, 2003, 2002, 2001, 2000 and the six
months ended June 30, 2005, we incurred net losses in the amounts of
approximately $8.1 million, $460,000, $8.8 million, $5.4 million, $6.2 million
and $930,000, respectively. Historically, we have relied upon cash from
operations and financing activities to fund all of the cash requirements of our
business. If our extended period of net losses continues, this will result in
negative cash flow and may hamper current operations and may prevent us from
expanding our business. We cannot assure you that we will attain, sustain or
increase profitability on a quarterly or annual basis in the future. If we do
not achieve, sustain or increase profitability, our business will be adversely
affected and our stock price may decline.

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

The vast majority of our sales are generated from a small number of
retailers. During the first six months of 2005, net sales to our three largest
retailers, Staples, Office Depot and CompUSA represented approximately 46%, 17%
and 15%, respectively, or an aggregate of approximately 78%, of our total net
sales. During 2004, net sales to our five largest retailers, Staples, Circuit
City, Best Buy, Office Depot and CompUSA represented approximately 32%, 17%,
11%, 10% and 10%, respectively, or an aggregate of approximately 80%, of our
total net sales. We expect that we will continue to depend upon a small number
of retailers for a significant majority of our sales for the foreseeable future.

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

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

All of our significant retailers issue purchase orders solely in their own
discretion, often only one to two weeks before the requested date of shipment.
Our retailers are generally able to cancel orders or delay the delivery of
products on short notice. In addition, our retailers may decide not to purchase
products from us for any reason. Accordingly, we cannot assure you that any of
our current retailers will continue to purchase our products in the future. As a
result, our sales volume and profitability could decline rapidly with little or
no warning whatsoever. For example, our sales to Best Buy decreased 99% from
$5.0 million for the year 2004 to $64,000 for the first six months of 2005. In
addition, our sales to Radio Shack USA decreased 118% from $1.7 million for the
year 2004 to a credit of $312,000 (due to returns in excess of gross sales) for
the first six months of 2005.

We cannot rely on long-term purchase orders or commitments to protect us
from the negative financial effects of a decline in demand for our products. The
limited certainty of product orders can make it difficult for us to forecast our
sales and allocate our resources in a manner consistent with our actual sales.
Moreover, our expense levels are based in part on our expectations of future
sales and, if our expectations regarding future sales are inaccurate, we may be
unable to reduce costs in a timely manner to adjust for sales shortfalls.
Furthermore, because we depend on a small number of retailers for the vast
majority of our sales, the magnitude of the ramifications of these risks, is
greater than if our sales were less concentrated within a small number of
retailers. As a result of our lack of long-term purchase orders and purchase
commitments we may experience a rapid decline in our sales and profitability.

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

Optical data storage products and digital entertainment products are widely
available from manufacturers and other suppliers around the world. Our retailers
have included Best Buy, Circuit City, CompUSA, Office Depot, Radio Shack and
Staples. Sales to these six retailers collectively accounted for 84% of our net
sales for 2004 and for the first six months of 2005. Each of these retailers has
substantially greater resources than we do, and has the ability to directly
import or private-label data storage and digital entertainment products from
manufacturers and other suppliers around the world, including from some of our
own subcontract manufacturers and suppliers. For example, Best Buy, our largest
retailer, already has a private label program and sells certain products that
compete with some of our products. We had only $64,000 in sales to Best Buy in
the first six months of 2005, representing a decrease of nearly 100% from $4.5
million in the first six months of 2004. We believe that this decrease reflects,
at least in part, Best Buy's increased sales of private label products that
compete with products that we sell. Our retailers may believe that higher profit
margins can be achieved if they implement a direct import or private-label
program, excluding us from the sales channel. Accordingly, one or more of our
largest retailers may stop

buying products from us in favor of a direct import or private-label program. As
a consequence, our sales and profitability could decline significantly.

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

Our accounts receivable represented 51%, 53% and 46% of our total assets as
of June 30, 2005, December 31, 2004 and December 31, 2003, respectively. As of
June 30, 2005, 79% of our accounts receivable represented amounts owed by two
retailers, each of whom represented over 10% of the total amount of our accounts
receivable. Similarly, as of December 31, 2004, 73% of our accounts receivable
represented amounts owed by two retailers, each of whom represented over 10% of
the total amount of our accounts receivable. As a result of the substantial
amount and concentration of our accounts receivable, if any of our major
retailers fails to timely pay us amounts owed, we could suffer a significant
decline in cash flow and liquidity which would negatively affect our ability to
make payments under our line of credit with GMAC Commercial Finance and which,
in turn, could adversely affect our ability to borrow funds to purchase
inventory to sustain or expand our current sales volume. Accordingly, if any of
our major retailers fails to timely pay us amounts owed, our sales and
profitability may decline.

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

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

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

Sales of our data storage products accounted for over 99% of our net sales
in the first six months of 2005 and approximately 99% in the year 2004. Except
for our digital entertainment and other products, which accounted for less than
1% of our net sales in the first six months of 2005 and in the year 2004, we
have not diversified our product categories outside of the data storage
industry. We expect data storage products to continue to account for the vast
majority of our net sales for the foreseeable future. As a result, our net sales
and profitability would be significantly and adversely impacted by a downturn in
the demand for data storage products.

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

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

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

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

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

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

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

Data storage products are subject to rapid technological changes which
often cause product obsolescence. Companies within the data storage industry are
continuously developing new products with heightened performance and
functionality. This puts pricing pressure on existing products and constantly
threatens to make them, or causes them to be, obsolete. Our typical product life
cycle is extremely short

and ranges from only three to twelve months, generating lower average selling
prices as the cycle matures. If we fail to accurately anticipate the
introduction of new technologies, we may possess significant amounts of obsolete
inventory that can only be sold at substantially lower prices and profit margins
than we anticipated. In addition, if we fail to accurately anticipate the
introduction of new technologies, we may be unable to compete effectively due to
our failure to offer products most demanded by the marketplace. If any of these
failures occur, our sales, profit margins and profitability will be adversely
affected.

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

We retain most risks of ownership of products in our consignment sales
channels. These products remain our inventory until their resale by our
retailers. The turnover frequency of our inventory on consignment is critical to
generating regular cash flow in amounts necessary to keep financing costs to
targeted levels and to purchase additional inventory. If this inventory turnover
is not sufficiently frequent, our financing costs may exceed targeted levels and
we may be unable to generate regular cash flow in amounts necessary to purchase
additional inventory to meet the demand for other products. In addition, as a
result of our products' short life-cycles, which generate lower average selling
prices as the cycles mature, low inventory turnover levels may force us to
reduce prices and accept lower margins to sell consigned products. As of June
30, 2005 and December 31, 2004, we carried and financed inventory valued at
approximately $4.7 million and $2.9 million, respectively, in our consignment
sales channels. Sales generated through consignment sales were approximately 34%
and 32%, respectively, of our total net sales for the six months ended June 30,
2005 and for the year ended December 31, 2004. If we fail to select high
turnover products for our consignment sales channels, our sales, profitability
and financial resources may decline.

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

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

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

Our products rely on intellectual property developed, owned or licensed by
third parties. From time to time, intellectual property infringement claims have
been asserted against us. We expect to continue to be subjected to such claims
in the future. Intellectual property infringement claims may also be asserted
against our retailers as a result of selling our products. As a consequence, our
retailers could assert indemnification claims against us. If any third party is
successful in asserting an infringement claim against us, we could be required
to acquire licenses, which may not be available on commercially reasonable
terms, if at all, to discontinue selling certain products to pay substantial
monetary damages

or to develop non-infringing technologies, none of which may be feasible. Both
infringement and indemnification claims could be time-consuming and costly to
defend or settle and would divert management's attention and our resources away
from our business. In addition, we may lack sufficient litigation defense
resources, therefore any one of these developments could place substantial
financial and administrative burdens on us and our sales and earnings may be
adversely affected.

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

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

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

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

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

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

As a consequence of this core strategy, we are exposed to consumer
rejection of our new and enhanced products to a greater degree than if we
offered products later in their industry life cycle. For example, our
anticipated future sales are largely dependent on future consumer demand for
DVD-based products displacing current consumer demand for CD-based products as
well as increasing demand for portable magnetic data storage devices such as our
GigaBank products. Accordingly, future sales and any future profits from
DVD-based products and our GigaBank line of products are substantially dependent
upon widespread consumer acceptance of DVD-based products and portable data
storage

devices. If this widespread consumer acceptance of DVD-based products
and our GigaBank products does not occur, or is delayed, our sales and earnings
will be adversely affected.

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

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

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

We sell our products primarily under our I/OMagic brand name and, from time
to time, also sell products under our Digital Research Technologies and Hi-Val
brand names. Each of these trademarks has been registered by us with the United
States Patent & Trademark Office. We also sell products under various product
names such as "MediaStation," "DataStation," Digital Photo Library , EasyPrint
and GigaBank . One of our key business strategies is to use our brand and
product names to successfully compete in the data storage industry. We have
expended significant resources promoting our brand and product names and we have
registered trademarks for our three brand names. However, we cannot assure you
that the registration of our brand name trademarks, or our other actions to
protect our non-registered product names, will deter or prevent their
unauthorized use by others. We also cannot assure you that other companies,
including our competitors, will not use our product names. If other companies,
including our competitors, use our brand or product names, consumer confusion
could result, meaning that consumers may not recognize us as the source of our
products. This would reduce the value of goodwill associated with these brand
and product names. This consumer confusion and the resulting reduction in
goodwill could cause us to lose market share and cause our sales to decline.

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

We are accustomed to conducting business through traditional retail sales
channels. Consumers purchase our products predominantly through a small number
of retailers. For example, during the first six months of 2005, five of our
retailers accounted for 92% of our total net sales. Similarly, during 2004, five
of our retailers accounted for 80% of our total net sales. We currently generate
only a small number of direct sales of our products through our Internet
websites. We believe that many of our target consumers are knowledgeable about
technology and comfortable with the use of the Internet for product purchases.
Consumers may increasingly prefer alternative sales channels, such as direct
mail order

or direct purchase from manufacturers. In addition, Internet commerce
is becoming increasingly accepted by consumers as a convenient, secure and
cost-effective method of purchasing data storage and digital entertainment
products. The migration of consumer purchasing habits from traditional retailers
to Internet retailers could have a significant impact on our ability to sell our
products. We cannot assure you that we will be able to predict and respond to
increasing consumer preference of alternative sales channels. If we are unable
to adapt to alternative sales channels, sales of our products may decline.

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

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

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

The market price of our common stock has fluctuated significantly in the
past and may continue to fluctuate significantly in the future. During the first
six months of 2005, the high and low closing bid prices of a share of our common
stock were $3.75 and $0.75, respectively. During 2004, the high and low closing
bid prices of a share of our common stock were $4.50 and $3.00, respectively.
The market price of our common stock may continue to fluctuate in response to
one or more of the following factors, many of which are beyond our control:

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

- - regulatory developments or increased enforcement;
- - fluctuations in our quarterly or annual operating results;
- - additions or departures of key personnel; and
- - future sales of our common stock or other securities.

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

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

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

As of August 15, 2005, there were approximately 4.5 million shares of our
common stock outstanding. As a group, our executive officers, directors and 10%
shareholders beneficially own approximately 3.5 million of these shares.
Accordingly, our common stock has a public float of approximately 1.0 million
shares held by a relatively small number of public investors. In addition, we
have a registration statement on Form S-8 in effect covering 133,334 shares of
common stock issuable upon exercise of options under our 2002 Stock Option Plan
and a registration statement on Form S-8 in effect covering 400,000 shares of
common stock issuable upon exercise of options under our 2003 Stock Option Plan.
Currently, options covering 121,950 shares of common stock are outstanding under
our 2002 Stock Option Plan and options covering 370,000 shares of common stock
were issued July 14, 2005 under our 2003 Stock Option Plan. The shares of common
stock issued upon exercise of these options will be freely tradable without
restriction or further registration, except to the extent purchased by one of
our affiliates.

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

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

As a group, our executive officers, directors, and 10% stockholders
beneficially own or control approximately 75% of our outstanding shares of
common stock (after giving effect to the exercise of all outstanding vested
options exercisable within 60 days from August 15, 2005). As a result, our
executive officers, directors, and 10% stockholders, acting as a group, have
substantial control over the outcome of corporate actions requiring stockholder
approval, including the election of directors, any merger, consolidation or sale
of all or substantially all of our assets, or any other significant corporate
transaction.

Some of these controlling stockholders may have interests different than yours.
For example, these stockholders may delay or prevent a change in control of
I/OMagic, even one that would benefit our stockholders, or pursue strategies
that are different from the wishes of other investors. The significant
concentration of stock ownership may adversely affect the trading price of our
common stock due to investors' perception that conflicts of interest may exist
or arise.

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

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

- - our board of directors is authorized, without prior stockholder approval,
to create and issue preferred stock, commonly referred to as "blank check"
preferred stock, with rights senior to those of our common stock;

- - our stockholders are permitted to remove members of our board of directors
only upon the vote of at least two-thirds of the outstanding shares of stock
entitled to vote at a meeting called for such purpose or by written consent; and

- - our board of directors are expressly authorized to make, alter or repeal
our bylaws.

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

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

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

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

Broker-dealer practices in connection with transactions in "penny stocks"
are regulated by penny stock rules adopted by the Securities and Exchange
Commission. Penny stocks are, generally, equity securities with a price of less
than $5.00 per share that trade on the OTC Bulletin Board or the Pink Sheets.
The penny stock rules require a broker-dealer, prior to a transaction in a penny
stock not otherwise exempt from the rules, to deliver a standardized risk
disclosure document that provides

information about penny stocks and the nature and level of risks in investing in
the penny stock market. The broker-dealer also must provide the prospective
investor with current bid and offer quotations for the penny stock and the
amount of compensation to be paid to the broker-dealer and its salespeople in
the transaction. Furthermore, if the broker-dealer is the sole market maker, the
broker-dealer must disclose this fact and the broker-dealer's presumed control
over the market, and must provide each holder of penny stock with a monthly
account statement showing the market value of each penny stock held in the
customer's account. In addition, broker-dealers who sell penny stocks to persons
other than established customers and "accredited investors" must make a special
written determination that the penny stock is a suitable investment for the
prospective investor and receive the purchaser's written agreement to the
transaction. These requirements may have the effect of reducing the level of
trading activity in a penny stock, such as our common stock, and investors in
our common stock may find it difficult to sell their shares.

ITEM 3. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK

Our operations were not subject to commodity price risk during the first
three months of 2005. Our sales to a foreign country (Canada) were approximately
1.2% of our total sales for the first six months of 2005, 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, 2005, 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, 2005, our disclosure controls and procedures were not effective at the
reasonable assurance level due to the material weaknesses described below.

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

A material weakness is a control deficiency (within the meaning of the
Public Company Accounting Oversight Board (PCAOB) Auditing Standard No. 2) or
combination of control deficiencies, that results in more than a remote
likelihood that a material misstatement of the annual or interim financial
statements will not be prevented or detected. Management has identified the
following four material weaknesses which have caused management to conclude
that, as of March 31, 2005, our disclosure controls and procedures were not
effective at the reasonable assurance level:

1. In conjunction with preparing our Form 10-K for the period ended
December 31, 2004 and our registration statement on Form S-1, and after
receiving comments from the Staff of the Securities and Exchange Commission
relating to our registration statement on Form S-1, management reviewed, in the
first quarter of 2005, our revenue recognition methodologies as they relate to
sales incentives and product returns. As a result of this review, management
concluded, in the first quarter of 2005, that our controls over the selection
and monitoring of appropriate assumptions and factors affecting the recording of
revenue and the related sales incentives and product returns were not in
accordance with generally accepted accounting principles and that our revenue
for the years ended December 31, 2003 and 2002 and for each of the quarterly
periods in the years ended December 31, 2003 and 2002, and through the nine
months ended September 30, 2004, had been misstated. Based upon this conclusion,
our Audit Committee and senior management decided, in the second quarter of
2005, to restate our financial statements as of and for the years ended December
31, 2003 and 2002 and for each of the quarterly periods in the years ended
December 31, 2003 and 2002, and through the nine months ended September 30,
2004, to reflect the corrections in our revenue recognition methodologies.

Management evaluated, in the second quarter of 2005 and as of March 31,
2005, the impact of this restatement on our assessment of our disclosure
controls and procedures and concluded, in the second quarter of 2005 and as of
March 31, 2005, that the control deficiency that resulted in the incorrect
recording of revenue and the related sales incentives and product returns
represented a material weakness.

2. We did not maintain documentation supporting certain inventory reserves
and did not analyze our inventory reserve account on a timely basis. Management
evaluated, in the second quarter of 2005 and as of March 31, 2005, the impact of
our inventory accounting practices on our assessment of our disclosure controls
and procedures and concluded, in the second quarter of 2005 and as of March 31,
2005, that the control deficiency that resulted in the failure to maintain
documentation supporting certain inventory reserves and the failure to analyze
our inventory reserve account on a timely basis represented a material weakness.
This control deficiency did not result in a material misstatement of our
consolidated financial statements.

3. As a result of our restatement of prior periods' financial results, as
discussed above, we were unable to meet our requirements to timely file our Form
10-K for the year ended December 31, 2004 and our Form 10-Q for the quarter
ended March 31, 2005. Management evaluated, in the second quarter of 2005 and as
of March 31, 2005, 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 concluded, in the second quarter of 2005 and as of
March 31, 2005, that the control deficiency that resulted in the inability to
timely make these filings represented a material weakness.

4. We did not maintain a sufficient complement of finance and accounting
personnel with adequate depth and skill in the application of generally accepted
accounting principles with respect to: (i) revenue recognition, specifically
relating to sales incentives and product returns, and (ii) inventory reserves,
specifically relating to maintenance of documentary support of certain inventory
reserves and the timeliness and frequency of our analysis of our inventory
reserve account. In addition, we did not maintain a sufficient complement of
finance and accounting personnel to handle the matters necessary to timely file
our Form 10-K for the year ended December 31, 2004 and our Form 10-Q for the
quarter

ended March 31, 2005. Management evaluated, in the second quarter of 2005 and as
of March 31, 2005, the impact of our lack of sufficient finance and accounting
personnel on our assessment of our disclosure controls and procedures and
concluded, in the second quarter of 2005 and as of March 31, 2005, that the
control deficiency that resulted in our lack of sufficient personnel represented
a material weakness.

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

Remediation of Material Weaknesses

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

1. We have revised our revenue recognition methodology as it relates to
sales incentives. We previously accounted for sales incentives by reducing gross
sales at the time sales incentives were offered to our retailers. Upon further
examination of our accounting methodology for sales incentives, and a
quantitative analysis of our historical sales incentives, we determined that we
made an error in our application of the relevant accounting principles under
SFAS 48, as interpreted under Topic 13, and determined that we should have
estimated and recorded sales incentives at the time our products were sold.
Under SFAS 48, as interpreted under Topic 13, the eventual sales price must be
fixed or determinable before revenue can be recognized. Due to the nature and
extent of our sales incentive history, we should have been assessing our revenue
recognition criteria to determine whether we were able to effectively estimate
or determine our eventual sales price. We have determined the effect of the
correction on our previously issued financial statements and have restated our
financial statements for the years ended December 31, 2002 and 2003. Beginning
with the quarter ended December 31, 2004, we recorded an estimate of sales
incentives based on our actual sales incentive rates over a trailing twelve
month period, adjusted for any known variations, which we charged to operations
and offset against gross sales at the time products were sold with a
corresponding accrual for our estimated sales incentive liability. This accrual
- - our sales incentive reserve - is to be reduced by deductions on future
payments taken by our retailers relating to actual sales incentives. The
revision of our revenue recognition methodology as it relates to sales
incentives was completed in the second quarter of 2005. We began using this new
methodology for the quarter ended December 31, 2004 and all periods included in
this report now reflect this change. In addition, this methodology applies to
all periods subsequent to December 31, 2004.

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

appropriate adjustments to our estimated return rates. We have determined the
effect of the correction on our previously issued financial statements and have
restated our financial statements for the years ended December 31, 2002 and
2003. The revision of our revenue recognition methodology as it relates to
product returns was completed in the second quarter of 2005. We began using this
new methodology for the quarter ended December 31, 2004 and all periods included
in this report now reflect this change. In addition, this methodology applies to
all periods subsequent to December 31, 2004.

Management believes that the remediation described in item 1 immediately
above has remediated the corresponding material weakness also described above.
Management is unable, however, to estimate our capital or other expenditures
associated with this remediation.

2. We have implemented additional review procedures over the selection and
monitoring of appropriate assumptions and factors affecting our inventory
reserves to ensure that inventory balances are reduced to their net realizable
values on a timely basis. We have also revised our methodology in relation to
slow-moving or obsolete inventory. Slow-moving inventory is comprised of
products that have not been sold within six months. Obsolete inventory is
comprised of products that are no longer compatible with current hardware or
software. We previously reviewed our slow-moving and obsolete inventory in
detail twice a year, during our June 30 and December 31 physical inventories, in
regards to our lower of cost or market valuations. Our inventory reviews for the
quarters ended March 31 and September 30 were less detailed. We have implemented
a new procedure that requires that our purchasing manager review slow-moving and
obsolete inventory in detail at the end of each quarter and propose any
necessary increases to our inventory reserve. The implementation of these review
procedures and the revision of our inventory accounting methodology was
completed in the second quarter of 2005. We began using this new procedure and
revised methodology for the quarter ended December 31, 2004 and the financial
data for the quarter ended March 31, 2005 included in this report reflects this
change. This new procedure and revised methodology will apply to all subsequent
periods.

Management believes that the remediation described in item 2 immediately
above has remediated the corresponding material weakness also described above.
Management is unable, however, to estimate our capital or other expenditures
associated with this remediation.

3. 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 process. 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 process. Additionally, in
the second quarter of 2005, we created a new position-Vice President of
Corporate Compliance-to further assist us in timely making required filings with
the Securities and Exchange Commission and ensuring the accuracy of our
financial reporting and the effectiveness of our disclosure controls and
procedures. We are currently in the process of filling this position with an
appropriate candidate. We also intend, in 2005, to implement enhancements to our
financial reporting processes, including increased training of our finance and
accounting staff regarding financial reporting requirements and the evaluation
and further implementation of automated procedures within our MIS financial
reporting system.

Management expects that the remediation described in item 3 immediately
above will remediate the corresponding material weakness also described above by
December 31, 2005. Management is unable, however, to estimate our capital or
other expenditures associated with this remediation.

4. Please see item 3 immediately above.

Management expects that the remediation described in item 4 immediately
above will remediate the corresponding material weakness also described above by
December 31, 2005. Management is unable, however, to estimate our capital or
other expenditures associated with this remediation.

Changes in Internal Control over Financial Reporting

The changes noted above are the only changes during our most recently
completed fiscal quarter that have materially affected or are reasonably likely
to materially affect, our internal control over financial reporting, as defined
in Rules 13a-15(f) and 15d-15(f) under the Exchange Act.

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

Magnequench International, Inc.

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

OfficeMax North America, Inc.

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

On May 20, 2005, 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 seeks
damages of in excess of $22 million arising out of the defendants' breach of
contract under an agreement entered into in May 2001. On or about June 20, 2005,
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) (the
"California Case"). On or about June 28, 2005, I/OMagic and OfficeMax jointly
filed a stipulation in requesting that the United States District Court in
California temporarily stay the California Case pending the outcome of the
Motion in Ohio. On July 6, 2005, the United States District Court in California
denied the parties joint stipulation request and instead ordered that OfficeMax
answer the complaint by August 1, 2005. On August 1, 2005, OfficeMax filed its
Answer and Counter-Claim against us. The Counter-Claim against us alleges four
causes of action against us: breach of contract, unjust enrichment, quantum
valebant, and an action for declaratory relief. The Counter-Claim alleges, among
other things, that we are liable to OfficeMax in the amount of no less than
$138,000 under the terms of a vendor agreement between the two parties and the
return of computer peripheral products to us by OfficeMax. The Counter-Claim
seeks, among other things, at least $138,000 from us, along with pre-judgment
interest, attorneys' fees and costs of suit. As of the date of this Report, we
have not yet responded to the Counter-Claim. We intend to deny all of the
affirmative claims set forth in the Counter-Claim, deny any wrongdoing or
liability, deny that OfficeMax is entitled to obtain any relief, and plan to
vigorously contest the Counter-Claim. The outcome of this action is presently
uncertain. However, we believe that all of our claims and defenses are
meritorious.

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 2. UNREGISTERED SALE 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 Certifications Required by Rule 13a-14(a) of the Securities Exchange Act
of 1934, as amended, as Adopted Pursuant to Section 302 of the
Sarbanes-Oxley Act of 2002*

32 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: August 15, 2005 By: /s/ Tony Shahbaz
-------------------
Tony Shahbaz, President and Chief
Executive Officer (principal
executive officer)

Dated: August 15, 2005 By: /s/ Steve Gillings
---------------------
Steve Gillings, Chief Financial
Officer
(principal financial and
accounting officer)

EXHIBITS FILED WITH THIS REPORT

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

31 Certifications Required by Rule 13a-14(a) of the Securities Exchange Act
of 1934, as amended, as Adopted Pursuant to Section 302 of the
Sarbanes-Oxley Act of 2002

32 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