UNITED STATES

SECURITIES AND EXCHANGE COMMISSION

Washington, D.C. 20549

FORM 10-K/A

(Amendment No. 1)

x ANNUAL REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934

For the fiscal year ended January 31, 2006

OR

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

For the transition period from            to            

Commission File Number 0-15827

SHARPER IMAGE CORPORATION

(Exact name of registrant as specified in its charter)

Delaware	94-2493558
(State or other jurisdiction of incorporation or organization)	(I.R.S. Employer Identification NO.)
350 The Embarcadero, 6th Floor, San Francisco, California	94105
(Address of principal executive offices)	(Zip Code)

Registrant’s telephone number including area code: (415) 445-6000

Securities registered pursuant to Section 12(b) of the Act:

Common Stock, par value $.01	NASDAQ
(Title of Class)	(Name of exchange on which registered)

Securities registered pursuant to Section 12(g) of the Act:

None

Indicate by check mark if the Registrant is a well-known seasoned issuer, as defined in Rule 405 of the Securities Act.    Yes  ¨    No  x

Indicate by check mark if the Registrant is not required to file reports pursuant to Section 13 or Section 15(d) of the Act.    Yes  ¨    No  x

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

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

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

Large accelerated filer    ¨            Accelerated filer  x            Non-accelerated filer  ¨

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

The aggregate market value of the voting common stock held by non-affiliates of the Registrant based on the reported last sale price for the common stock on the NASDAQ National Market on July 31, 2005, was $176,980,568

As of February 28, 2007 14,973,397 shares of the Registrant’s common stock were outstanding.

DOCUMENTS INCORPORATED BY REFERENCE

Portions of the Registrant’s Proxy Statement for the 2006 Annual Meeting of Stockholders are incorporated by reference in the Registrant’s Annual Report on Form 10-K.

EXPLANATORY NOTE

Sharper Image Corporation is filing this Amendment No. 1 to its Annual Report on Form 10-K filed with the Securities and Exchange Commission on May 1, 2006. This filing amends and restates our previously reported financial statements for the three fiscal years ended January 31, 2006 to reflect non-cash compensation expense associated with the issuance of stock options, as discussed in Note B to the Financial Statements.

As previously reported, our Board of Directors voluntarily initiated an independent review of our historical stock option practices and related accounting matters. The review was conducted by a special committee of the Board with the assistance of independent legal counsel and independent accounting experts. The Special Committee’s review included all employee stock options granted from fiscal year 1994 (the fiscal year ended January 31, 1995) through 2005 (the fiscal year ended January 31, 2006). The Special Committee has completed its review, and its findings and recommendations have been accepted by the Board of Directors. Based on its review, the Special Committee concluded that the documentary evidence did not support the measurement dates the Company originally used to determine compensation expense for most option grants to employees made during the fiscal years ending January 31, 1996 through January 31, 2006. The Special Committee recommended the use of alternate measurement dates with respect to these grants. For purposes of accounting for option grants, Accounting Principles Board Opinion No. 25, “Accounting for Stock Issued to Employees” (“APB 25”) provides that the measurement date occurs when both the number of shares that the employee is entitled to receive is fixed and the exercise price associated with the grant is known. With respect to the option grants under review, the Special Committee sought to determine, based on the available evidence for each of the grants, when all prerequisites had been met in order to determine the proper measurement date for each of the granted options. In addition to the foregoing, the Special Committee's review indicated that in several instances, options were granted with measurement dates immediately preceding, or immediately after, Company press releases; however, the Special Committee has determined that the timing of such grants does not, in and of itself, require any accounting adjustments.

We have determined in situations in which the closing price of our common stock on the measurement date exceeded the stated exercise price on the original grant date, recognition of stock-based compensation expense and related tax effects is required. We have recorded non-cash compensation expense of $17.7 million, approximately $10.5 million after tax, in the aggregate over the fiscal years 1995 through 2005. This compensation expense results in a net decrease to pre-tax earnings in fiscal 2001 to fiscal 2005 of an aggregate of $12.8 million. Of this amount, $6.2 million relates to options originally granted in fiscal years prior to fiscal 2001. As of February 1, 2006 (the first day of our 2006 fiscal year), the aggregate amount of unamortized compensation expense relating to these option grants totaled approximately $0.1 million.

This Amendment No. 1 amends and restates the following items of our Form 10-K as affected by the review of our historical stock option practices and related accounting matters: (i) Part II, Item 6—Selected Financial Data; (ii) Part II, Item 7 – Management’s Discussion and Analysis of Financial Condition and Results of Operations; (iii) Part II, Item 8 – Financial Statements and Supplementary Data; (iv) Part II, Item 9A – Controls and Procedures; and, (v) Part IV, Item 15 – Exhibits and Financial Statement Schedules.

All information in our Annual Report on Form 10-K for the fiscal year ended January 31, 2006, as amended by this Amendment No. 1, speaks as of the date of the original filing of our Form 10-K for such period and does not reflect any subsequent information or events, except as expressly noted in this Amendment No. 1 and except for Exhibits 31.1, 31.2, 32.1 and 32.2. All information contained in this Amendment No. 1 is subject to updating and supplementing as provided in our reports, as amended, filed with the Securities and Exchange Commission subsequent to the date of the initial filing of our Annual Report on Form 10-K for the fiscal year ended January 31, 2006.

FORWARD-LOOKING STATEMENTS

This Amendment No. 1 to the Annual Report on Form 10-K/A and the documents incorporated herein by reference of Sharper Image Corporation (referred to as the “Company,” “The Sharper Image,” “Sharper Image,” “it,” “we,” “our,” “ours” and “us”) contain forward-looking statements within the meaning of federal securities laws that have been made pursuant to the provisions of the Private Securities Litigation Reform Act of 1995. Such forward-looking statements are based on current expectations, estimates and projections about the Company’s industry, management’s beliefs and certain assumptions made by the Company’s management. Words such as “anticipates,” “expects,” “intends,” “plans,” “believes,” “seeks,” “estimates,” or variations of such words and similar expressions, are intended to identify such forward-looking statements. These statements are not guarantees of future performance and are subject to certain risks, uncertainties and assumptions that are difficult to predict. Therefore, actual results may differ materially from those expressed or forecasted in any such forward-looking statements. These risks include, among other factors, whether the Company’s stock remains listed on the NASDAQ Global Market, the Company’s ability to continue to find or develop and to offer attractive merchandise to customers, the market potential for products in design, changes in business and economic conditions, risks associated with the expansion of its retail store, catalog and Internet operations, and changes in the competitive environment in which it operates. Unless required by law, we undertake no obligation to update publicly any forward-looking statements, whether as a result of new information, future events or otherwise. However, readers should carefully review the statements set forth in other reports or documents we file from time to time with the Securities and Exchange Commission, particularly the Quarterly Reports on Form 10-Q and any Current Reports on Form 8-K.

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SHARPER IMAGE CORPORATION

AMENDMENT NO. 1 TO

ANNUAL REPORT ON FORM 10-K/A

FISCAL YEAR ENDED JANUARY 31, 2006

		Page No.
	Explanatory Note	i
	PART II
Item 6	Selected Financial Data	2
Item 7	Management’s Discussion and Analysis of Financial Condition and Results of Operations	3
Item 8	Financial Statements and Supplementary Data	17
Item 9A	Controls and Procedures	36
	PART IV
Item 15	Exhibits and Financial Statement Schedules	41
Signatures		42

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PART II

ITEM 6. SELECTED FINANCIAL DATA

The Company’s restated financial statements as of January 31, 2006 and 2005 and for each of the three fiscal years in the period ended January 31, 2006, audited by Deloitte & Touche LLP, the Company’s independent registered public accounting firm, are included in Item 8, “Financial Statements and Supplementary Data” of this Amendment No. 1 on Form 10-K/A. The following historical operating results data for the years ended January 31, 2006, 2005 and 2004 and balance sheet data as of January 31, 2006 and 2005 has been derived from the restated financial statements of the Company included herein. The operating results data for the years ended January 31, 2003 and 2002 and balance sheet data as of January 31, 2004, 2003 and 2002 are derived from restated financial statements of the Company not included herein. The information set forth below should be read in conjunction with “Management’s Discussion and Analysis of Financial Condition and Results of Operations” and the financial statements and notes thereto of the Company included elsewhere in this document. All fiscal years have been restated herein to reflect adjustments related to non-cash compensation expense associated with the issuance of options granted from fiscal year 1995 through fiscal 2005. See Item 7, “Management’s Discussion and Analysis of Financial Condition and Results of Operations—Restatement of Financial Statements” and Note B, “Restatement of Financial Statements” in the Notes to Financial Statements included in Part II, Item 8, “Financial Statements and Supplementary Data” of this Amendment No. 1 on Form 10-K/A.

Dollars are in thousands except for earnings per share and statistics	Fiscal Year Ended January 31,
	2006 (Fiscal 2005)			2005 (Fiscal 2004)			2004 (Fiscal 2003)			2003 (3) (Fiscal 2002)			2002 (3) (Fiscal 2001)
	As Restated			As Restated			As Restated			As Restated			As Restated
Operating Results
Revenue	$	668,993		$	760,003		$	647,511		$	513,769		$	389,105
Earnings (loss) before income taxes		(28,882	)		20,333			37,206			23,551			(2,688	)
Net earnings (loss)		(16,136	)		11,555			20,961			13,895			(1,637	)
Earnings (loss) per common share—
Basic	$	(1.07	)(1)	$	0.74	(1)	$	1.45	(1)	$	1.13		$	(0.14	)
Diluted	$	(1.07	)(1)	$	0.71	(1)	$	1.38	(1)	$	1.07		$	(0.14	)
Balance Sheet Data
Working capital	$	95,490		$	131,028		$	127,108		$	67,830		$	51,411
Total assets		326,401			376,100			315,333			215,724			163,592
Long-term notes payable		—			—			—			—			2,033
Stockholders’ equity		182,045			207,174			185,925			117,525			94,956
Current ratio		1.85			1.95			2.14			1.75			1.83
Statistics
Number of stores at year end		190			175			149			127			109
Comparable store sales increase (decrease)		(16.0	)%		(1.1	)%		15.3	%		13.6	%		(16.0	)%
Annualized net sales per sq ft	$	505		$	618		$	676		$	627		$	578
Number of catalogs mailed		98,617,000			97,755,000			86,296,000			77,772,000			70,135,000
Average revenue per transaction
Stores	$	140		$	151		$	142		$	128		$	118
Catalog	$	202		$	215		$	198		$	199		$	174
Internet(2)	$	152		$	153		$	148		$	145		$	127
Return on average stockholders’ equity		(8.3	)%		5.9	%		13.8	%		13.1	%		(1.7	)%
Book value per share	$	12.14		$	13.20		$	12.13		$	9.30		$	7.93
Weighted average number of shares outstanding
Basic		15,066,843			15,634,355			14,446,128			12,327,157			11,904,562
Diluted		15,066,843			16,227,719			15,178,773			12,957,761			11,904,562

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(1) The earnings per common equivalent share reflect the effect of the additional 2.1 million shares issued in the May 2003 stock offering.

(2) Includes results from the Company’s and eBay’s auction sites.

(3) These periods have been restated to conform with corrections as discussed in Note B, “Restatement of Financial Statements” in the Notes to Financials Statements included in Part II, Item 8, “Financials Statements and Supplementary Data” of this Amendment No. 1 on Form 10-K/A.

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

The following discussion and analysis should be read together with the Company’s financial statements and related notes thereto included in Item 8 in this Amendment No. 1 on Form 10-K/A and gives effect to the restatement discussed in Note B of the Notes to Financial Statements.

Our business and the associated risks has changed since the date this report was originally filed with the SEC, and we undertake no obligation to update the forward-looking statements contained in this Management’s Discussion and Analysis of Financial Condition and Results of Operations. Further, except for the forward-looking statements included in Item 9A, “Controls and Procedures” and under the heading “Restatement of Financial Statements” under this Item 7, all forward-looking statements contained in this Amendment No. 1 on Form 10-K/A to our Annual Report, unless they are specifically otherwise stated to be made as of a different date, are made as of the original filing date of our Annual Report on Form 10-K for the year ended January 31, 2006. This Amendment No. 1 amends and restates the following items of our Form 10-K as affected by the review of our historical stock option practices and related accounting matters: (i) Part II, Item 6—Selected Financial Data; (ii) Part II, Item 7 – Management’s Discussion and Analysis of Financial Condition and Results of Operations; (iii) Part II, Item 8 – Financial Statements and Supplementary Data; (iv) Part II, Item 9A – Controls and Procedures; and, (v) Part IV, Item 15 – Exhibits and Financial Statement Schedules. All information in our Annual Report on Form 10-K for the fiscal year ended January 31, 2006, as amended by this Amendment No. 1, speaks as of the date of the original filing of our Form 10-K for such period and does not reflect any subsequent information or events, except as expressly noted in this Amendment No. 1.

RESTATEMENT OF FINANCIAL STATEMENTS

On August 24, 2006, following the issuance of an analyst report regarding the stock option granting practices of the Company and several other companies in the retail business sector, the Board of Directors constituted a special committee to conduct a review of our historical stock option granting practices. The members of the Special Committee are Howard Liebman (Chairman), Howard Gross, Michael Koeneke and David Meyer, each of whom joined the Board of Directors in July 2006.

The Special Committee retained, as independent counsel, the law firm Skadden, Arps, Slate, Meagher & Flom (“Skadden”) LLP to assist it in its review. Skadden has not previously acted as counsel on behalf of the Company. Skadden, in turn, retained Chicago Partners LLC to provide expert accounting assistance. The Special Committee’s review included all employee stock options granted from fiscal year 1994 (the fiscal year ended January 31, 1995) through 2005 (the fiscal year ended January 31, 2006).

In connection with the review, Skadden interviewed fourteen individuals (some on multiple occasions) involved in our option granting process, including the former Chief Executive Officer, the former Chief Financial Officer, the former President/Chief Operating Officer, and their respective assistants, and the former Controller as well as our directors, advisors and employees. In addition, Skadden reviewed: (a) documents kept in hard copy form at our headquarters; (b) documents retained by our current and former outside counsel; (c) documents and emails provided by certain outside directors; and (d) electronic data, including emails and electronic documents, stored on Company hard drives, email servers, backup tapes and file servers.

On September 18, 2006, we announced that, based on the Special Committee’s review through such date, we had reached a determination to restate our financial statements for the three fiscal years ended January 31, 2006 and the fiscal quarter ended April 30, 2006. We also reported that we would delay the filing of the Quarterly Report on Form 10-Q for the period ended July 31, 2006 pending completion of the Special Committee review. On December 18, 2006, we announced the delay of our Quarterly Report on Form 10-Q for the period ended October 31, 2006.

The Special Committee has completed its review, and its findings and recommendations have been accepted by our Board of Directors. Based on its review, the Special Committee concluded that the documentary evidence did not support the measurement dates the Company originally used to determine compensation expense for most option grants to employees

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made during the fiscal years ending January 31, 1996 through January 31, 2006. The Special Committee recommended the use of alternate measurement dates with respect to these grants. For purposes of accounting for option grants, Accounting Principles Board Opinion No. 25, “Accounting for Stock Issued to Employees” (“APB 25”) provides that the measurement date occurs when both the number of shares that the employee is entitled to receive is fixed and the exercise price associated with the grant is known. With respect to the option grants under review, the Special Committee sought to determine, based on the available evidence for each of the grants, when all prerequisites had been met in order to determine the proper measurement date for each of the granted options. As explained in more detail below, the Special Committee reviewed, among other things, board of directors minutes, unanimous written consents and communications with the Company's directors, including facsimiles and e-mails, as well as electronically stored drafts of letters, consents and other documents, in order to determine when the option grants under review were likely approved. Further, the Special Committee reviewed these records, as well as e-mail communications among management, draft grant lists and SEC filings in order to determine when the details regarding the grants under review (including the employees who were to receive options and the number of shares each employee was entitled to receive) were likely finalized. The measurement date selected for each grant was the first date on which it appeared both that (a) the grants had been approved and (b) the details regarding the grant had been fixed.

In addition to the foregoing, the Special Committee’s review indicated that in several instances, options were granted with measurement dates immediately preceding, or immediately after, Company press releases; however, the Special Committee has determined that the timing of such grants does not, in and of itself, require any accounting adjustments.

We have determined that in situations in which the closing price of our common stock on the measurement date exceeded the stated exercise price on the original grant date, recognition of stock-based compensation expense and related tax effects is required. We have recorded non-cash compensation expense of $17.7 million, approximately $10.5 million after tax, in the aggregate over the fiscal years 1995 through 2005. This compensation expense results in a net decrease to pre-tax earnings in fiscal 2001 to fiscal 2005 of an aggregate of $12.8 million. Of this amount, $6.2 million relates to options originally granted in fiscal years prior to fiscal 2001. As of February 1, 2006 (the first day of our 2006 fiscal year), the aggregate amount of unamortized compensation expense relating to these option grants totaled approximately $0.1 million. We believe the Special Committee made the appropriate judgments and assumptions in selecting alternate measurement dates.

Summary of Special Committee's Findings

Under our employee stock option plans in effect during the periods under review, option grants required the approval of a committee of the board of directors; the compensation committee fulfilled that function during fiscal 1997 to the present and the stock option committee of the board of directors fulfilled that function in earlier years.

Options were periodically granted to groups of our management-level employees (“Management Grants”), ranging from store managers to senior executives. Management Grants were made once annually in fiscal 1994, 1995, 1997-1999 and 2003-2005. In fiscal 1996, substantially all of the options granted in connection with the prior year’s Management Grant were cancelled and replaced with new options at a lower exercise price, however, no additional Management Grant was made. There were no Management Grants in fiscal 2000. In fiscal 2001, two Management Grants were made, one in March and one in November 2001. In fiscal 2002, options were granted in February 2002 to four members of our senior management, in addition to a grant to a broad group of management-level employees in July 2002. In addition to Management Grants, options were granted to certain newly hired or recently promoted employees (“New Hire/Promotion Grants”).

Our former senior management typically would make a recommendation to either the board or the compensation committee of whether a stock option grant was appropriate, the size of the grant and the identities of the grantees and would be responsible for obtaining compensation committee approval for the grants. Our former Chief Executive Officer, our former President/Chief Operating Officer and, in some instances, our former Chief Financial Officer, were the members of senior management primarily involved in the process of selecting grant dates and presenting option grants to the compensation committee for approval.

The Special Committee determined that we did not follow a uniform practice in obtaining and documenting compensation committee approval for option grants or in selecting grant dates. Further, the Special Committee determined that we did not retain adequate records documenting the grant approval process.

For substantially all of the grants under review, the option grants were documented with unanimous written consents of the compensation committee dated “as of” the originally selected grant date; however, the “as of” date reflected on the unanimous written consent typically did not coincide with the actual date the compensation committee approved the option grants or the date the terms of the options were known with finality. The review of our records indicated that the unanimous

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written consents were usually circulated for signature from several days to several weeks after the original grant date selected by us. In some instances, the grant appears to have been discussed or approved at a board meeting or through e-mails or telephonic conferences with the compensation committee members on or within a few days of the original grant date; in other instances, no record could be located of such discussions or approval.

The following table details the grants for which the Special Committee recommended alternative measurement dates:

Original Measurement Date*	Alternative Measurement Date	Total Options Granted	Stock Price on Original Measurement Date		Stock Price on Alternative Measurement Date		Difference		Additional Compensation Expense
4/12/1995 (A)	6/12/1995	300,000	$	5.63	$	7.00	$	1.38	$	412,500
3/26/1996 (B)	6/7/1996	529,700	$	3.75	$	5.00	$	1.25	$	662,125
3/26/1996 (B)	7/19/1996	28,700	$	3.75	$	4.00	$	0.25	$	7,175
11/3/1997 (C)	12/16/1997	67,000	$	3.00	$	3.75	$	0.75	$	50,250
11/2/1998 (C)	1/25/1999	342,500	$	3.88	$	13.13	$	9.25	$	3,168,125
9/24/1999 (D)	11/10/1999	1,014,100	$	9.00	$	16.75	$	7.75	$	7,859,275
3/8/2001 (C)	3/14/2001	423,050	$	8.50	$	9.03	$	0.53	$	224,217
11/5/2001(D)	12/13/2001	333,100	$	6.90	$	9.95	$	3.05	$	1,015,955
2/15/2002 (C)	4/1/2002	200,000	$	11.95	$	17.63	$	5.68	$	1,136,000
7/26/2002 (D)	9/18/2002	386,100	$	14.91	$	19.97	$	5.06	$	1,953,666
9/29/2003 (D)	10/1/2003	152,000	$	23.82	$	25.20	$	1.38	$	209,760
9/29/2003 (D)	10/20/2003	332,800	$	23.82	$	25.07	$	1.25	$	416,000
5/21/2004 (D)	7/8/2004	368,500	$	26.10	$	31.68	$	5.58	$	2,056,230
8/17/2005 (D)	8/31/2005	296,150	$	12.52	$	13.44	$	0.92	$	272,458
Sub-Total									$	19,443,736
New Hire and Promotion Grants (E)									$	433,010
Adjustment for Forfeitures									($	2,078,903	)
Total Compensation Expense									$	17,797,843

* See the lettered paragraphs (A-E) below for further discussion

With respect to the Management Grants, for grants made during fiscal 1996 through 2005, and for a grant made to the former Chief Executive Officer during fiscal 1995, the Special Committee was unable to identify documentation showing that, as of the original grant date selected by us, all prerequisites for establishing an accounting measurement date had been met. Accordingly, the Special Committee sought to determine, based on the available evidence for each of the grants, when all prerequisites had been met in order to establish a measurement date for the granted options.

(A) With respect to the Management Grants in fiscal 1995, April 12, 1995 was originally designated as the measurement date. The former Chief Executive Officer was granted 300,000 options and, at the same time, 300,000 options previously granted to him in 1994 were cancelled. As of April 1995, however, the former Chief Executive Officer was not eligible to participate in our stock option plan and proposed amendments to the stock option plan which would permit his participation were not approved by shareholders until June 12, 1995. The Special Committee determined that the 1994 grant to the former Chief Executive Officer had never become effective (and, accordingly, that no accounting adjustment was required) and that the 1995 grant should be measured for accounting purposes on June 12, 1995, the date on which shareholders approved the amendments to the stock option plan.

(B) The Management Grants with an originally designated measurement date in March 1996, were granted to certain employees who had received grants made in April 1995. No record could be located indicating that the stock option committee had discussed or approved the grant on or before the original grant date. Unanimous written consents relating to the grant were executed by the directors in May 1996. Under the terms of the resolutions adopted by the stock option committee, employees who had received options in April 1995 could elect to have such options cancelled in exchange for new options with a lower exercise price and revised vesting terms. The resolutions required such employees to give written notice of their election by June 7, 1996. After that date passed, a small number of employees were given extensions until July 19, 1996 to submit their elections. It was determined that the measurement date for this grant was the date on which employees were required to provide their election to have their April 1995 options cancelled in exchange for the new options.

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(C) For the Management Grants with originally designated measurement dates in November 1997, November 1998, March 2001, and February 2002, no record could be located indicating that the compensation committee had discussed or approved the grant on or before the original grant date. Communications with the directors or other records suggest that unanimous written consents for the grant were circulated several days or weeks after the original grant date. Although several of the individuals interviewed believed that the grants, including the number of options to be granted to senior management, likely would have been discussed with members of the compensation committee either at a board meeting or in telephone calls in advance of the unanimous written consents being circulated, no documentary evidence of such discussions could be located. The evidence indicated that the terms of the grant, including the number of options to be granted and the recipients, had been finalized by the time the directors signed the unanimous written consents. Thus, the measurement dates for these grants were our best estimate based on the Special Committee's review of available evidence, such as board minutes, e-mails and correspondence, of the date on which the directors likely executed the written consents.

(D) For the Management Grants with originally designated measurement dates in September 1999, November 2001, July 2002, September 2003, May 2004 and August 2005, the compensation committee members approved grants through e-mails or during board meetings or, in one instance, a teleconference on or within a few days before or after the original grant date. However, for each of these grants, no record could be found showing that final details regarding the number of options to be granted to each individual employee were fixed at the time the compensation committee members approved the grants, except for grants in September 2003 and August 2005 to Section 16 Officers (see discussion below). Thus, the Special Committee determined that the compensation committee members had approved these grants and delegated to management the task of finalizing the grant details. The measurement dates for these grants were our best estimate, based on the Special Committee’s review of available evidence — including e-mail communications, draft option grant lists, Form 4s filed with the SEC concerning grants to our Section 16 Officers, and the unanimous written consents later signed by the compensation committee members relating to the grants — of the date on which the grant details were likely finalized. For the September 2003 and August 2005 grants, the Special Committee determined that the grants to our Section 16 Officers should be measured on the date the directors first approved the grants (October 1, 2003 and August 17, 2005, respectively) (given that the director-approved grants to such officers could not be changed by management under our option plans without further compensation committee approval) and that the grants to other employees were finalized by, and should be measured on the date the unanimous written consent relating to the grants appears to have been submitted to the compensation committee members.

(E) With respect to New Hire/Promotion grants, we generally awarded options based on the employee’s position at the Company and valued the options at the date the employee started work or was promoted. However, in certain instances, options were granted on dates other than the hire or promotion date; for example, in a few instances new hire grants were dated as of the date the employee accepted a position with us. In addition, our practice for obtaining compensation committee approval for the New Hire/Promotion Grants was inconsistent. In some instances, the grants were approved by unanimous written consent weeks or months after the grant dates; in other instances no record of compensation committee approval could be located. Given our general practice of dating new hire and promotion grants on the date the employee started work, or was promoted, and the compensation committee’s historic acceptance of that practice, the Special Committee concluded that the compensation committee had delegated authority to management to make such grants, provided the grant dates coincided with the actual hire date or promotion date for the employee at issue. Thus, the Special Committee concluded that, in those instances where a newly hired or promoted employee was granted options with a measurement date prior to or subsequent to the employee’s hire or promotion date, the actual hire or promotion date should be used as the measurement date for such options. One exception involved a grant to our former Chief Financial Officer when he re-joined the Company in August 2005. The size of his grant was apparently still under negotiation when he started work with the Company and the Special Committee determined that the grant had properly been measured on the date, several days later, on which the compensation committee approved the grant. On the Special Committee’s recommendation, the Board of Directors has ratified the New Hire/Promotion Grants for which no record of compensation committee approval could be located.

With respect to the matters discussed above, it is conceivable that others viewing the same evidence might have selected different measurement dates and that a higher or lower compensation charge would have resulted. Solely for purposes of assessing the possible effect on compensation expense that using different measurement dates could have had, for the Management Grants discussed above, we selected the earliest and latest measurement dates (if any) that had any colorable support, and calculated compensation expense using the highest and lowest stock price during that range of dates. Based on this data, the resulting additional compensation expense could have been as low as $13.8 million or as high as $22.3 million.

Inadequate Controls and Remedial Measures

Based on the Special Committee’s review, our management has determined that we did not maintain adequate controls regarding the option granting process. In particular, we lacked a formal policy for granting and approving options and the

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procedures used were insufficient to ensure that all option grants complied with our stock option plans and applicable accounting rules. Our procedures, in particular the use of unanimous written consents with “as of” effective dates, provided insufficient control to ensure that all prerequisites of APB 25 had been met prior to the grant date and to prevent option grant dates from being selected with the benefit of hindsight.

The Special Committee could not rule out the possibility that the original grant dates for some of the grants were selected with the benefit of hindsight. For example, with respect to the 1996 Management Grant, correspondence between the former Chief Executive Officer and the directors suggests that the grant (which involved the cancellation of a prior grant in 1995 and the issuance of new options at a lower exercise price) was proposed in early May 1996, but the unanimous written consents which the directors on the stock option committee were requested to execute designated as the grant date March 26, 1996, the date on which our stock had traded at a year-to-date low. The September 1999 Management Grant was discussed at a morning meeting of the Board of Directors on Monday, September 27, 1999 but we designated Friday, September 24, 1999 as the grant date, when the price of our stock was $0.88 lower. (As indicated on the table above, the Special Committee recommended that the grant be measured as of November 10, 1999 because the grant list had not been completed when the directors met on September 27, 1999.) With respect to the May 2004 grant, the compensation committee members appear to have discussed the grant on May 19, 2004, but we selected May 21, 2004 as the grant date, when the price of our stock was $1.62 lower. (As indicated on the table above, the Special Committee recommended that the grant be measured as of July 8, 2004 because the grant list had not been completed when the compensation committee members first approved the grant on May 19, 2004.)

As noted above, our former Chief Executive Officer, former President/Chief Operating Officer and former Chief Financial Officer were the individuals in senior management primarily responsible for proposing option grants for director approval, selecting grant dates, and overseeing the documentation of the grants. Each of these individuals has left the Company and, in connection with negotiated severance agreements, has agreed to reductions in his or her severance payments substantially commensurate with the excess amounts he or she had earned exercising options over the amounts he or she would have earned had the same options been granted at an exercise price equal to our stock price on the measurement dates determined by the Special Committee. In addition, each of these individuals has agreed that the exercise price for any unexercised options he or she is entitled to retain would be adjusted to reflect such measurement dates.

The Special Committee has also recommended, and the Board of Directors has agreed, that we should improve our procedures relating to the granting of options. Accordingly, the Board of Directors has adopted the procedures set forth in Item 9A—Controls and Procedures—Remediation of Material Weaknesses.

MANAGEMENT OVERVIEW

Sharper Image Corporation (referred to as “The Sharper Image,” “Sharper Image,” “the Company,” “we,” “us” and “our”) is a leading specialty retailer of innovative, high quality products that are useful and entertaining and are designed to make life easier and more enjoyable. We market and sell our merchandise primarily through three integrated sales channels: The Sharper Image stores, The Sharper Image catalog, which includes revenue from all direct marketing activities and infomercials, and the Internet. We also market to other businesses through our corporate sales, where revenues are recorded in each of our three sales channels and our wholesale operations. Our fiscal years are ended January 31, 2006 (“fiscal 2005” or “2005”), January 31, 2005 (“fiscal 2004” or “2004”), and January 31, 2004 (“fiscal 2003” or “2003”).

CRITICAL ACCOUNTING POLICIES AND ESTIMATES

Our financial statements are based on accounting principles generally accepted in the United States of America, many of which require management to make significant estimates and assumptions (see Note A to the Financial Statements). We believe that the following are some of the more critical judgment areas in the application of our accounting policies that currently affect our financial condition and results of operation.

Revenue recognition. We recognize revenue at the point of sale at our retail stores and at the time of customer receipt for our catalog and direct marketing sales, including the Internet. We recognize revenue for sales to resellers or sales made on a wholesale basis when title passes to the purchaser at the time the products are shipped. Estimated reductions to revenue for customer returns are recorded based on our historical return rates. Revenues are recorded net of sale discounts and other rebates and incentives offered to customers. Deferred revenue represents merchandise certificates, gift cards and reward cards outstanding and unfilled cash orders at the end of the fiscal period. Delivery revenue is recognized at the time of customer receipt.

Merchandise inventories. We record inventory at lower of cost (first-in, first-out method) or market value. We reduce the carrying value of our inventory for estimated obsolescence or unmarketable inventory by an amount equal to the excess of the cost of inventory over the estimated market value based upon assumptions about future demand and market conditions. If actual market conditions are less favorable than those projected by management, additional reserves may be required.

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Accounts receivable. Counterparties to our accounts receivable include credit card issuers, corporate marketing incentive customers, wholesale customers, installment plan customers, merchandise vendors, and landlords from whom we expect to receive amounts due. An allowance for credit losses is recorded based on estimates of counterparties’ ability to pay. If the financial condition of these counterparts deteriorates, additional allowances may be required.

Impairment of long-lived assets. We review our long-lived assets for impairment when indicators of impairment are present and the undiscounted cash flow estimated to be generated by those assets is less than the asset’s carrying amount. Our policy is to evaluate long-lived assets for impairment at a store level for retail operations and an operating unit level for our other operations. Our retail stores typically take 18 months to achieve their full profit potential. If actual market conditions are less favorable than management’s projections, future write-offs may be necessary.

Income taxes. Income taxes are accounted for using an asset and liability approach that requires the recognition of deferred tax assets and liabilities for the expected future tax consequences of events then known to management that have been recognized in our financial statements or tax returns. In estimating future tax consequences, all expected future events then known to management are considered other than changes in the tax law or rates.

Stock-based Compensation Expense. In situations in which the closing price of our common stock on the measurement date exceeded the stated exercise price on the original grant date, we have recognized stock-based compensation expense and related tax effects. We have recorded pre-tax non-cash compensation of $1.5 million, $4.5 million and $2.2 million, in fiscal 2005, 2004 and 2003, respectively. Of these amounts in fiscal 2005 $0.1 million was recorded as buying and occupancy expenses, $1.4 million was recorded as general, selling and administrative expenses, in fiscal 2004, $0.2 million was recorded as buying and occupancy expenses, $4.3 million was recorded as general, selling and administrative expenses, and in fiscal 2003, $0.1 million was recorded as buying and occupancy expenses, $2.1 million was recorded as general, selling and administrative expenses.

Results of Operations

The Company enjoyed excellent revenue growth in fiscal years 2003 and 2004. Throughout these two and prior profitable years, two large and growing merchandise categories—air purifiers (which are developed in-house) and massage chairs (from a third-party maker)—accounted for a significant portion of our revenues. As described below, in 2005 aggregate net sales from these two product lines declined approximately $126 million compared to 2004 and resulted in the first net loss the Company has experienced in the past three years. Net sales for our other product lines, however, increased in 2005 by approximately $35 million, largely driven by sales of new products and branded electronics.

The decrease in the sales of the Company’s air purifiers followed the release in April 2005 of news stories that included criticisms of the Company’s Ionic Breeze silent air purifiers. These stories were widely distributed in the popular mass media, including television and newspapers. The Company publicly protested that the criticisms were unwarranted and untrue, and yet the negative effect on Ionic Breeze net revenues was sudden and significant. The Company responded promptly with product enhancements that were already in development, notably adding OzoneGuard by August 2005 to minimize the already low, and U.S. regulation compliant, by-product trace level of ozone, and with inventory adjustments and price promotions.

The Company’s massage chair sales decrease by July 2005 resulted from the changes in the competitive landscape for massage chairs under $1,000 with numerous new catalog, Internet and store retailers offering similar products. The third-party maker of all our under $1,000 massage chairs had greatly expanded their distribution of similar massage chairs, although with fewer features, to other sellers. The negative effect on our massage chair sales was significant and sudden. To offset the revenue declines, inventory was reduced and the chairs were offered at promotional prices throughout the balance of 2005 and into 2006.

A summary of our operating results is presented below. This discussion includes our results presented on the basis required by accounting principles generally accepted in the United States of America.

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The following table presents our results of operations as a percentage of total revenues for the periods indicated:

	Fiscal Year Ended January 31,
	2006 (Fiscal 2005)		2005 (Fiscal 2004)		2004 (Fiscal 2003)
	As Restated		As Restated		As Restated
Revenues:
Net store sales	60.9	%	57.2	%	58.6	%
Net catalog sales	13.1		17.2		19.9
Net Internet sales	16.0		15.3		14.7
Net wholesale sales	7.2		7.7		4.2
Delivery	2.7		2.6		2.6
List rental and licensing	0.1		0.0		0.0
Total Revenues	100.0		100.0		100.0
Costs and Expenses:
Cost of products	51.1		45.0		43.3
Buying and occupancy	12.0		9.3		9.0
Advertising	17.0		19.7		19.0
General, selling and administrative	24.1		23.2		22.9
Operating income (loss)	(4.2	)	2.8		5.7
Other income (expense)	(0.1	)	(0.1	)	0.0
Earnings (loss) before income tax expense	(4.3	)	2.7		5.7
Income tax expense (benefit)	(1.9	)	1.2		2.5
Net earnings (loss)	(2.4	)%	1.5	%	3.2	%

The following table presents the components of our revenues for the periods indicated:

	Fiscal Year Ended January 31,
(Dollars in thousands)	2006 (Fiscal 2005)		2005 (Fiscal 2004)		2004 (Fiscal 2003)
Revenues:
Net store sales	$	407,098	$	434,696	$	379,349
Net catalog and direct marketing sales		87,945		130,535		128,652
Net Internet sales		107,222		116,297		95,086
Net wholesale sales		47,986		58,437		26,997
Total net sales		650,251		739,965		630,084
List rental and licensing		723		640		377
Delivery		18,019		19,398		17,050
Total revenues	$	668,993	$	760,003	$	647,511

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Year ended January 31, 2006 (fiscal 2005), compared to year ended January 31, 2005 (fiscal 2004)

Revenues. Total revenue decreased $91.0 million or 12.0% from the prior fiscal year. The decrease from fiscal 2005 as compared to fiscal 2004 was attributable to decreases of $42.6 million in catalog and direct marketing sales, $27.6 million from store sales, $10.5 million in wholesale sales and $9.1 million from Internet sales. The decrease in total revenue for fiscal 2005 as compared to fiscal 2004 was due primarily to an approximately $126 million decrease in net revenue from our air purification and our massage chair lines of products and decreased advertising spending, which generally affects sales in all selling channels, offset in part by an approximately $35 million increase in net revenues, largely driven by sales of new products and branded electronics. The decrease in the sale of our air purification products resulted from negative media coverage, increased competition and decreased advertising specifically designed for these products. The decrease in our massage chair product line resulted from increased competition at lower price points for similar products. A significant portion of our direct response advertising is devoted to the air purification product line. We require a certain sales-to-advertising expenditure ratio to justify continued advertising and accordingly reduced direct response advertising expenditures as sales of these products slowed.

Sales of Sharper Image Design and Sharper Image branded products decreased to approximately 67% of total revenues in fiscal 2005 from approximately 74% for fiscal 2004. We believe that the decrease in the percentage of revenues attributable to Sharper Image Design and Sharper Image branded products was due to decreased sales of our air purification line of products and Sharper Image branded massage chairs during the year as well as an increase in sales of brand name electronics. Returns and allowances for fiscal 2005 were 10.2% of sales, as compared to 9.8% for fiscal 2004, resulting in a $3.1 million decrease in revenues. We believe that the increase in returns and allowances for fiscal 2005 as compared to fiscal 2004 is due primarily to negative media coverage surrounding our air purification line of products and higher return rates on certain first generation electronic and toy products.

Net store sales for fiscal 2005 decreased $27.6 million, or 6.3%, while comparable store sales decreased by 16.0% from fiscal 2004. The decrease in net store sales was attributable primarily to a decrease of 16.0% in comparable store sales, a 7.5% decrease in the average revenue per transaction and to promotional discounts relating to a portion of our new product introductions that proved less popular than those introduced in prior years. The decreases in comparable store sales and in average revenue per transaction were primarily attributable to consumers’ lack of willingness to spend, the overall product mix offered, the decreases in sales of the air purification and massage chair product lines, and decreases in multimedia advertising, including infomercial advertising highlighting Sharper Image Design and Sharper Image branded products, particularly air purification products that sell at relatively higher price points. The decrease in net store sales was partially offset by the opening of 15 new stores, net, during fiscal 2005, resulting in a 3.4% increase in total store transactions for fiscal 2005. Average net sales per square foot for fiscal 2005 for all stores decreased to $505 from $618 in fiscal 2004. Average net sales per square foot for our comparable store base for fiscal 2005 was $522 as compared to $665 in the same prior year period. Average net sales per square foot are calculated by averaging over all stores the amount of each store’s net sales divided by that store’s total square footage under lease. Average revenue per transaction is calculated by dividing the amount of gross sales, exclusive of delivery revenue and sales taxes, per channel by the gross number of transactions in that channel.

Comparable store sales is not a measure that has been defined under accounting principles generally accepted in the United States of America. We define comparable store sales as sales from stores where selling square feet did not change by more than 15% in the previous 12 months and which have been open for at least 12 months. A store opened on or prior to the 15^th of a month is treated as open for the entire month. Stores generally become comparable once they have a full year of comparable sales for the annual calculation. We believe that comparable store sales, which excludes the effect of a change in the number of stores open, provides a more useful measure of the performance of our store sales channel than does the absolute change in aggregate net store sales. The 16.0% decrease in comparable store sales for fiscal 2005 as compared to fiscal 2004 was due to decreases in the sale of our air purification and our massage chair lines and difficult comparisons to high store volumes generated after several years of strong sales results.

Net catalog and direct marketing sales, which includes direct sales generated from catalog mailings, single product mailers, print advertising and infomercials, decreased $42.6 million or 32.6% for fiscal 2005 from fiscal 2004. This decrease was due primarily to a decrease in sales of the Company’s air purification and massage chair line of products, a decrease of $14.5 million or 28.9% in infomercial advertising expense, a 21.5% decrease in The Sharper Image catalog pages circulated, and a 35.2% decrease in single product mailers circulated. The decrease in net catalog and direct marketing sales for fiscal 2005 reflects a 5.9% decrease in average revenue per transaction, and a 21.3% decrease in transactions compared to fiscal 2004.

For fiscal 2005 and 2004, 33.9% and 31.1% of the net catalog and direct marketing sales were generated from infomercial direct sales. We continually review our advertising initiatives, including the pages and number of catalogs and

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single product mailers circulated, and the amount of and return on investment from infomercial advertising in our efforts to improve revenues from catalog and direct marketing advertising. Actual advertising expenses for fiscal 2006 may be higher or lower than our current plans.

Net Internet sales from our www.sharperimage.com Website and The Sharper Image and eBay auction Websites in fiscal 2005 decreased $9.1 million, or 7.8%, from fiscal 2004. This decrease was attributable primarily to an 8.6% decrease in Internet transactions and a 0.5% decrease in average revenue per transaction partially attributable to lower sales of higher-priced products such as the Company’s air purifier and massage chair line and a 1.6% decrease in Internet advertising which includes paid-for search engine key word placement and revenue share costs incurred for affiliate programs.

Net wholesale sales for fiscal year 2005 decreased $10.5 million, or 17.9%, compared to fiscal 2004. The decrease is primarily due to decreasing Sharper Image Design product sales, particularly air purifiers, to our existing wholesale customer base and to test programs with new wholesale customers. We believe that the wholesale business, pursued with select partners, will continue to strengthen our brand name and broaden our customer base.

Cost of Products. Cost of products for fiscal 2005 increased $0.3 million, or 0.1%, from fiscal 2004. This increase is due primarily to changes in our merchandise mix. The gross margin rate for fiscal 2005 was 48.9% as compared to the fiscal 2004 rate of 55.0%. The decrease in the gross margin rate was a result of a combination of higher unit costs for certain third-party products, primarily branded MP3 players, increases in promotional and incentive activities and product markdowns. Additionally, declining sales of our air purification line of products had a negative impact on our gross margins as these products generally carry higher than Company average gross margins. We also focused on managing down our inventory levels in the fourth quarter of 2005 and began aggressive promotional activities on many products, including air purification products and massage chair products. These actions are continuing into 2006.

Our gross margin rate fluctuates with changes in our merchandise mix, primarily Sharper Image Design and Sharper Image branded products, which changes as we make new items available in various categories or introduce new proprietary products. The variation in merchandise mix from category to category from year to year is characteristic of sales results being driven by individual products rather than by general product lines. Additionally, the auction sites and other selected promotional activities such as free shipping offers negatively impact the gross margin rate. Our gross margins may not be comparable to those of other retailers since some retailers include the costs related to their distribution network in cost of products while we, and other retailers, exclude them from gross margin and include them instead in general, selling and administrative expenses. We cannot accurately predict future gross margin rates.

Buying and Occupancy. Buying and occupancy costs, for fiscal 2005 increased $8.9 million, or 12.6%, from fiscal 2004. reflecting a full year of occupancy costs for the 28 new stores opened in fiscal 2004, the occupancy costs associated with the 20 new stores opened in fiscal 2005 and rent increases for some existing store locations upon lease renewal, partially offset by five store closures during fiscal 2005. Buying and occupancy expenses as a percentage of revenues, increased to 12.0% in 2005, compared to 9.3% in 2004. In fiscal 2005, we opened a total of 20 new stores.

Advertising. Advertising expenses for fiscal 2005 decreased $36.1 million, or 24.0%, from fiscal 2004. The decrease in advertising expense was attributable primarily to a decrease of $14.5 million, or 28.9%, in infomercial advertising expense, a 30.4% decrease in magazine and print advertising and a 35.9% decrease in radio advertising. Also contributing to the decrease in advertising was a 21.5% decrease in the number of The Sharper Image catalog pages circulated and a 35.2% decrease in the number of solo mailers circulated. Although we believe these initiatives contributed to the decline in sales in the stores, catalog and direct marketing and Internet channels, declining sales overall dictated that we reduce advertising spending in 2005 and there can be no assurance of the future success of these advertising initiatives.

General, Selling and Administrative General, selling and administrative (“GS&A”) expenses for fiscal 2005 decreased $14.6 million, or 8.3%, from fiscal 2004. The inclusion of stock-based compensation caused the GS&A expenses to decrease by $2.8 million in 2005 when compared to fiscal year 2004. Excluding stock-based compensation expense, GS&A expenses for fiscal 2005 decreased $11.7 million, or 6.8%, from fiscal 2004, of which approximately $11 million was due primarily to variable expenses from lower net sales. Also contributing were decreases of $2.8 million for distribution center shipping costs incurred for product delivery to our retail store locations and for airfreight costs due to the 2004 West Coast port slowdown that were not incurred in the current year and $0.2 million for professional fees, including legal and accounting fees resulting from Sarbanes-Oxley compliance. These decreases were partially offset by an increase of $2.0 million for depreciation and amortization expense.

GS&A expenses as a percentage of revenues, increased to 24.1% in 2005, compared to 23.2% in 2004. Excluding stock-based compensation expense, GS&A expenses for fiscal 2005 as a percentage of total revenues increased to 23.9%, as compared to 22.6% for fiscal 2004, primarily due to declining sales partially offset by cost savings described above. To address the challenges of lower sales in fiscal 2005 during the second half of fiscal 2005, we acted vigorously to reduce our expense structure, notably in store and corporate payroll, advertising spending and other general and administrative expenses.

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Other Income (Expense). The decrease in other expense, net is primarily due to higher interest income earned in fiscal 2005 due to higher interest rates, partially offset by lower average investment balances in fiscal 2005 compared to 2004 offset in part by higher interest expense incurred on our revolving line of credit as borrowings for the holiday season were significantly higher in 2005.

Income Taxes. The effective tax rate was 44.1% for fiscal 2005 and 43.2% for fiscal 2004. The higher tax benefit rate in fiscal 2005 is primarily the result of a federal research and development tax credit accepted by the IRS and recorded by the Company in fiscal 2005. The effective tax rate for 2004 was adversely affected by $0.7 million of compensation that was not deductible for income tax purposes.

Year ended January 31, 2005 (fiscal 2004), compared to year ended January 31, 2004 (fiscal 2003).

Revenues. Total revenue increased $112.5 million or 17.4% from the prior fiscal year. The increase in total revenue for fiscal 2004 as compared to fiscal 2003 was due primarily to the opening of 26 net new stores during fiscal 2004, increases in net wholesale sales and net Internet sales and, to a lesser extent, the decrease in returns and allowances described below. The popularity of our Sharper Image Design and Sharper Image branded products continued to be a key factor in the increases in total revenues in all our selling channels. Sales of Sharper Image Design and Sharper Image branded products increased to approximately 74% of total revenues in fiscal 2004 from approximately 73% for fiscal 2003. We believe that the increase in the percentage of revenues attributable to Sharper Image Design and Sharper Image branded products was due to the modification of certain third party branded products to make them exclusive to Sharper Image branded product offerings, the introduction of the Professional Series^™ line of Ionic Breeze^® Silent Air Purifiers in the third fiscal quarter of 2004, and other key Sharper Image Design proprietary products. The increase in net sales was partially offset by a comparable store sales decrease of 1.1% from fiscal 2003. We also believe that the increased investment in our advertising initiatives in fiscal 2004 and 2003, which include the significant increase in infomercial advertising and Internet advertising, primarily highlighting selected Sharper Image Design and Sharper Image branded products and the 13.3% increase in catalogs circulated contributed to the higher revenues in all selling channels. Returns and allowances for fiscal 2004 were 9.8% sales, as compared to 10.7% for fiscal 2003, resulting in a $6.6 million increase in total revenues in all selling channels. We believe that the decrease in returns and allowances for fiscal 2004 as compared to fiscal 2003 is due primarily to improved quality control in the production of various top-selling Sharper Image branded products that have resulted from improvements made in response to customer feedback and lower return rates on certain electronic products.

Net store sales for fiscal 2004 increased $55.3 million, or 14.6%, while comparable store sales decreased by 1.1% from fiscal 2003. The increase in net store sales was attributable primarily to the opening of 28 new stores during fiscal 2004, a 10.1% increase in total store transactions for fiscal 2004 and a 6.5% increase in the average revenue per transaction, as compared to fiscal 2003. The increase in net store sales was partially offset by a comparable store sales decrease of 1.1% from fiscal 2003, a soft economy marked by consumers’ lack of willingness to spend, some new production introductions that proved less popular than anticipated, and congestion at West Coast ports, particularly in the fourth quarter, which generated extra freight costs and caused a shortage of key holiday items during critical selling weeks, and the closure of two stores at lease maturity. The increase in average revenue per transaction was attributable primarily to the overall product mix offered, and multimedia advertising strategies, including infomercial advertising highlighting Sharper Image Design and Sharper Image branded products, particularly our air purification products. Average net sales per square foot for fiscal 2004 for all stores decreased to $618 from $676 in fiscal 2003. Average net sales per square foot for the Company’s comparable store base for fiscal 2004 was $665 as compared to $710 in the same prior year period. Average net sales per square foot is calculated by averaging over all stores the amount of each store’s net sales divided by that store’s total square footage under lease. Average revenue per transaction is calculated by dividing the amount of gross sales, exclusive of delivery revenue and sales taxes, per channel by the gross number of transactions in that channel.

Comparable store sales is not a measure that has been defined under accounting principles generally accepted in the United States of America. We define comparable store sales as sales from stores where selling square feet did not change by more than 15% in the previous 12 months and which have been open for at least 12 months. A store opened on or prior to the 15^th of a month is treated as open for the entire month. Stores generally become comparable once they have a full year of comparable sales for its annual calculation. We believe that comparable store sales, which excludes the effect of a change in the number of stores open, provides a more useful measure of the performance of our store sales channel than does the absolute change in aggregate net store sales. The 1.1% decrease in comparable store sales for fiscal 2004 as compared to fiscal 2003 was due to lower than optimal inventory levels of popular merchandise, product introductions that did not generate high demands during the fiscal year and high consumer demand for other popular gift items not available during the holiday season.

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Net catalog and direct marketing sales, which include direct sales generated from catalog mailings, single product mailers, print advertising and infomercials, for fiscal 2004 increased $1.9 million or 1.5%, from fiscal 2003. This increase was due primarily to a 23.2% increase in infomercial advertising expense, a 20.5% increase in The Sharper Image catalog pages circulated, which includes a 13.3% increase in The Sharper Image catalogs circulated, partially offset by a 7.8% decrease in single product mailers circulated. The increase in net catalog and direct marketing sales for fiscal 2004 reflects an 8.5% increase in average revenue per transaction, partially offset by a 5.9% decrease in transactions compared to fiscal 2003. For fiscal 2004 and 2003, 31.1% and 29.4% of the net catalog and direct marketing sales were generated from infomercial direct sales.

Net Internet sales, from our www.sharperimage.com Website and The Sharper Image and eBay auction Websites in fiscal 2004 increased $21.2 million, or 22.3%, from fiscal 2003. This increase was attributable primarily to a 16.4% increase in Internet transactions and a 3.3% increase in average revenue per transaction resulting from a 40.8% increase in Internet advertising which includes paid-for search engine key word placement and revenue share costs incurred for affiliate programs.

Net wholesale sales for fiscal year 2004 increased $31.4 million, or 116.5%, compared to fiscal 2003. The increase is attributable primarily to increasing Sharper Image Design product sales to our existing wholesale customer base and to test programs with new wholesale customers. We believe that the wholesale business, pursued with select partners, will continue to strengthen our brand name and broaden our customer base.

Cost of Products. Cost of products for fiscal 2004 increased $61.5 million, or 21.9%, from fiscal 2003. This increase is due primarily to the higher sales volume. The gross margin rate for fiscal 2004 was 55.0% as compared to the fiscal 2003 rate of 56.7%. The decrease in the gross margin rate was a result of a combination of increased air freight related to the West Coast port slowdown, higher unit cost for certain third-party products, increases in promotional and incentive activities and selective product markdowns offset by the increased gross margin from wholesale sales.

Our gross margin rate fluctuates with changes in our merchandise mix, primarily Sharper Image Design and Sharper Image branded products, which changes as we make new items available in various categories or introduce new proprietary products. The variation in merchandise mix from category to category from year to year is characteristic of sales results being driven by individual products rather than by general product lines. Additionally, the auction sites and other selected promotional activities, such as free shipping offers, in part tend to offset the rate of increase in gross margin rate. Our gross margins may not be comparable to those of other retailers, since some retailers include the costs related to their distribution network in cost of products while we, and other retailers, exclude them from gross margin and include them instead in general, selling and administrative expenses. We cannot accurately predict future gross margin rates.

Buying and Occupancy. Buying and occupancy costs for fiscal 2004 increased $12.8 million, or 22.1%, from fiscal 2003 reflecting a full year of occupancy costs for the 25 new stores opened in fiscal 2003, the occupancy costs associated with the 28 new stores opened in fiscal 2004 and rent increases for some existing store locations upon lease renewal, partially offset by two store closures during fiscal 2004 and by three store closures during fiscal 2003. Buying and occupancy expenses as a percentage of revenues, increased from 9.0% in fiscal 2003 to 9.3% in fiscal 2004. In fiscal 2004, we opened a total of 28 new stores, achieving our goal of a 15%-20% increase in the number of stores.

Advertising. Advertising expenses for fiscal 2004 increased $26.6 million, or 21.6%, from fiscal 2003. The increase in advertising expense was attributable primarily to a 23.2% increase in infomercial advertising expense, a 99.5% increase in magazine and print advertising, and a 40.8% increase in Internet advertising, which includes search engine key word placement and revenue share costs incurred for affiliate programs, which was partially offset by a 28.7% decrease in radio advertising. Also contributing to the increase in advertising was a 20.5% increase in the number of The Sharper Image catalog pages circulated, which includes a 13.3% increase in the number of The Sharper Image catalogs circulated.

Advertising expenses as a percentage of total revenues increased to 19.7% for fiscal 2004 compared to 19.0% for fiscal 2003. We believe that expansion of all advertising initiatives contributed to the sales increases for fiscal 2004 and increased brand awareness.

General, Selling and Administrative. General, selling and administrative (“GS&A”) expenses, for fiscal 2004 increased $27.5 million, or 18.5%, from fiscal 2003. The inclusion of stock-based compensation caused the GS&A expenses to increase by $ 2.2 million in 2004 when compared to fiscal year 2003. Excluding stock-based compensation expense, GS&A expenses for fiscal 2004 increased $25.3 million, or 17.3%, from fiscal 2003, with $10.0 million due primarily to variable expenses from increased net sales. Also contributing to the increase were increases of $6.0 million for professional fees, including legal and accounting fees resulting from Sarbanes-Oxley compliance, $4.7 million for distribution center shipping costs incurred for product delivery to our retail store locations and to increased airfreight costs due to the West Coast port slowdown and $1.4 million for depreciation and amortization expense related to technological enhancements and the expansion of our distribution centers.

13

GS&A expenses as a percentage of revenues increased to 23.2% in 2004, compared to 22.9% in 2003. Excluding stock-based compensation expense, GS&A expenses for fiscal 2004 as a percentage of total revenues remained consistent at 22.6% as compared to fiscal 2003.

Other Income (Expense). The increase in other expense, net is primarily due to the disposal of certain fixed assets, partially offset by interest income earned on higher investment balances generated from the proceeds from our public stock offering and improved operating results.

Income Taxes. The effective tax rate was 43.2% for fiscal 2004 and 43.7% for fiscal 2003. The effective tax rate for 2004 and 2003 was adversely affected by $0.7 million and $1.7 million, respectively, of compensation that was not deductible for income tax purposes.

LIQUIDITY AND CAPITAL RESOURCES

We met our short-term liquidity needs and our capital requirements during fiscal 2005 with cash generated from operations, reduction of inventories, borrowings from our line of credit, trade credits and existing cash balances.

Net cash provided by operating activities was $3.4 million for fiscal 2005 as compared to $57.8 million for fiscal 2004. Fiscal 2005 net cash provided by operating activities declined by $54.4 million compared to fiscal 2004, which was due in part to a reduction in net earnings and an increase in deferred catalog costs and other long-term assets as compared to fiscal 2004. The decrease in net cash between fiscal 2005 and 2004 was also due to the decrease in accounts payable, accrued expenses and the increase in deferred income taxes and prepaid expenses and was partially offset by reductions in inventory and accounts receivable balances.

Net cash provided by investing activities totaled $22.4 million for fiscal 2005, which was primarily due to the net proceeds from the sale and purchase of short-term investments. The proceeds from the sales of these investments were used for capital expenditures for new and remodeled stores, technological enhancements, tooling costs for Sharper Image Design products and the expansion of our distribution facilities, totaling $34.1 million in fiscal 2005 compared to $49.6 million in fiscal 2004. In fiscal 2005, we opened 20 new stores and remodeled three stores, whereas we opened 28 new stores and remodeled eight stores in fiscal 2004.

Net cash used by financing activities totaled $10.2 million during fiscal 2005, which was primarily the result of our expenditure of $10.6 million to repurchase shares of our Common Stock. Net cash provided by financing activities totaled $2.4 million during fiscal 2004, which was primarily due to $4.2 million in proceeds from the issuance of common stock in connection with our stock option plan, partially offset by our repurchase of our Common Stock of $1.8 million.

The Company has a revolving secured credit facility with Wells Fargo Bank, National Association, which was amended in February 2006. The credit facility expires on February 2, 2010, and allows borrowings and letters of credit up to a maximum of $55 million. In addition, through October 31, 2007, the Company may, at its option, seek to increase the maximum amount by up to $30 million on no more than five occasions in minimum increments of $5 million provided that at no time shall the maximum amount exceed $85 million. Borrowings outstanding under the credit facility prior to amendment in February 2006 bear interest at either the adjusted LIBOR rate plus 1.50% or at Wells Fargo’s prime rate less 0.25%. Borrowings under the amended credit facility bear interest at either the LIBOR rate plus a margin ranging from 1.25% to 1.75% based on average excess availability or at Wells Fargo’s prime rate less up to .25% based on average excess availability. Borrowings under the credit facility are secured by the Company’s inventory, accounts receivable and specified other assets.

The credit facility contains financial covenants that only apply during an event of default or when the borrowing base is drawn below a specified level. These financial covenants require the Company to maintain a minimum EBITDA (as defined) on a rolling 12-month basis of $25 million and to maintain capital expenditures below a specified level based on the Company’s projections. The credit facility contains limitations on incurring additional indebtedness, making additional investments and permitting a change of control. As of January 31, 2006, letter of credit commitments outstanding under the credit facility were $3.6 million and borrowings outstanding were $0.2 million. The Company believes that it is in compliance with all of its debt covenants as of January 31, 2006.

Stock Repurchase Program

In October 2004, the Board of Directors authorized a stock repurchase program to acquire up to one million shares of outstanding common stock in the open market. As of January 31, 2006, we had repurchased and retired a total of 810,000 shares under this program, including 710,000 shares repurchased and retired, at a weighted average cost of $14.99 per share and a total cost of approximately $10.6 million during fiscal year 2005.

14

Stock Based Compensation

On January 23, 2006, the Compensation Committee approved the accelerated vesting of all unvested options with an exercise price of and in excess of $11.95. This accelerated vesting, which became effective on the date of approval, affects options to purchase approximately 747,000 shares of our common stock with exercise prices ranging from $11.95 to $21.99. The acceleration does not apply to unexpired options held by former employees.

The accelerated vesting is expected to eliminate future compensation expense we would otherwise recognize in our income statement with respect to such accelerated options due to our adoption of FASB Statement No. 123R (Share-Based Payment) effective on February 1, 2006. Because these options have exercise prices significantly in excess of our stock price, which closed at $9.12 on January 23, 2006, the Committee believed that these options would not offer sufficient incentive to employees when compared to the potential future compensation expense that would be attributable to such options. The estimated maximum future expense that is eliminated is approximately $3.7 million. We will incur compensation expense in connection with FASB Statement No. 123R for all other options outstanding. In addition to the accounting consequences, the Committee believed that the accelerated vesting may have a positive effect on employee morale and retention.

Commercial Commitments

The table below presents significant commercial credit facilities and their associated expiration dates as of January 31, 2006.

(Dollars in millions)

Maximum Amount of Commitment Expiration per Period

Maximum Commercial Commitments	Less than 1 Year		1-4 Years		Total Amount Committed
Revolving Credit Facility*	$	50.0	$	0.0	$	50.0
Total Commercial Commitment	$	50.0	$	0.0	$	50.0

* On February 2, 2006, the Company entered into an amendment to the credit facility. See “Liquidity and Capital Resources.”

Contractual Obligations

The following table below presents significant contractual obligations at January 31, 2006.

(Dollars in millions) Contractual Obligations	Less than 1 Year		1-3 Years		4-5 Years		After 5 Years		Total
Revolving Credit Facility Letters of Credit	$	3.6		—		—		—	$	3.6
Operating Leases(1)		39.9	$	77.3	$	72.6	$	106.2		296.0
Purchase Obligations(2)		37.2		—		—		—		37.2
Total Contractual Cash Obligations	$	80.7	$	77.3	$	72.6	$	106.2	$	336.8

⁽¹⁾ Our operating leases are described in Note F of the Notes to the Financial Statements.

⁽²⁾ As of January 31, 2006, we had $37.2 million of outstanding purchase orders, which were primarily related to orders for general merchandise inventories. Such purchase orders are generally cancelable at the discretion of the Company until the order has been shipped. The table above excludes certain immaterial executory contracts for goods and services that tend to be recurring in nature and similar in amount year after year.

Due to declining sales and an operating loss in 2005, partially offset by inventory reductions at the end of fiscal 2005 compared to fiscal 2004, we generated $3.4 million in cash provided by operating activities during 2005. Absent unfavorable economic conditions or deviations from projected demand for our products, particularly during the fourth quarter, we continue to expect to achieve positive cash flow from operations on an annual basis, although we likely will need to finance holiday and new-store increases in inventories through trade credits and our credit facility. We believe we will be able to fund our capital expenditures for new and remodeled stores, technological enhancements and tooling costs for Sharper Image Design products through existing cash balances, investments, cash generated from operations, trade credits and, as necessary, our credit facility.

15

New Accounting Standards

In December 2004, the Financial Accounting Standards Board (FASB) issued Statement of Financial Accounting Standards (“SFAS”) No. 123 (Revised 2004), “Share-Based Payment” (“SFAS No. 123R”) which replaces SFAS No. 123, supersedes Accounting Principles Board (APB) No. 25 and related interpretations and amends SFAS No. 95, “Statement of Cash Flows.” The provisions of SFAS No. 123R are similar to those of SFAS No. 123; however, SFAS No. 123R requires all share-based payments to employees, including grants of employee stock options, to be recognized in the financial statement as compensation cost based on their fair value on the date of the grant. The fair value of the share-based awards will be determined using an option-pricing model on the grant date. SFAS No. 123R is effective at the beginning of the first fiscal year beginning after June 15, 2005. The Company will adopt SFAS No. 123R in the first quarter of fiscal 2006. Due to the accelerated vesting of certain stock options in fiscal 2005 and fiscal 2004, the adoption of SFAS No. 123R is not expected to have a material impact on the Company’s financial statements upon adoption in the first quarter of 2006, although the future impact of the adoption of SFAS No. 123R is dependent upon the future issuance of stock option grants that will be determined by the Company’s compensation committee.

In November 2004, the FASB issued SFAS No. 151, “Inventory Costs—An Amendment of Accounting Research Bulletin No. 43, Chapter 4” (“SFAS No. 151”). SFAS No. 151 clarifies that abnormal amounts of idle facility expense, freight, handling costs and spoilage should be expensed as incurred and not included in overhead. The provisions in SFAS No. 151 must be applied prospectively to the Company’s inventory costs incurred after January 1, 2006. The adoption of SFAS No. 151 is not expected to have an impact on the Company’s financial statements.

In March 2005, the FASB issued FASB Interpretation No. (“FIN”) 47, “Accounting for Conditional Asset Retirement Obligations, an interpretation of FASB Statement No. 143.” This Interpretation clarifies the term conditional 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. Accordingly, an entity is required to recognize a liability for the fair value of a conditional asset retirement obligation if the fair value of the liability can be reasonably estimated. The adoption of FIN 47 in the fourth quarter of fiscal 2005 did not have a material effect on the Company’s financial statements.

In May 2005, the FASB issued SFAS No. 154, “Accounting Changes and Error Corrections.” SFAS No. 154 changes the requirements for the accounting for, and reporting of, a change in accounting principle. Previously, voluntary changes in accounting principles were generally recognized by way of a cumulative effect adjustment within net earnings during the period of change. SFAS No. 154 requires retrospective application to prior period financial statements, unless it is impracticable to determine either the period-special effects or the cumulative effect of the change. SFAS No. 154 is effective for accounting changes made in fiscal years beginning after December 15, 2005; however, the statement does not change the transition provisions of any existing accounting pronouncements. The Company does not believe the adoption of SFAS No. 154 will have a material effect on its financial statements.

In October 2005, the FASB issued FSP FAS 13-1, “Accounting for Rental Costs Incurred during a Construction Period,” which addresses the accounting for rental costs associated with operating leases that are incurred during a construction period. This FSP requires that rental costs associated with ground or building operating leases incurred during a construction period be recognized as rental expense and included in income from continuing operations. The guidance in this FSP shall be applied to the first reporting period beginning after December 15, 2005, with early adoption permitted. The adoption of FSP FAS 13-1 will not have a material impact on the Company’s financial statements.

ITEM 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA

16

R EPORT OF INDEPENDENT REGISTERED PUBLIC ACCOUNTING FIRM

To the Board of Directors and Stockholders of

Sharper Image Corporation:

We have audited the accompanying balance sheets of Sharper Image Corporation (the “Company”), as of January 31, 2006 and 2005, and the related statements of operations, stockholders’ equity, and cash flows for each of the three fiscal years in the period ended January 31, 2006. These financial statements are the responsibility of the Company’s management. Our responsibility is to express an opinion on these financial statements based on our audits.

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

In our opinion, such financial statements present fairly, in all material respects, the financial position of Sharper Image Corporation as of January 31, 2006 and 2005 and the results of its operations and its cash flows for each of the three fiscal years in the period ended January 31, 2006 in conformity with accounting principles generally accepted in the United States of America.

As discussed in Note B to the financial statements, the accompanying financial statements have been restated.

We have also audited, in accordance with the standards of the Public Company Accounting Oversight Board (United States), the effectiveness of the Company’s internal control over financial reporting as of January 31, 2006 based on the criteria established in Internal Control-Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission and our report dated May 1, 2006, (March 1, 2007 as to the effect of the material weakness described in Management’s Report on Internal Controls over Financial Reporting (as revised)), expressed an unqualified opinion on management’s assessment of the effectiveness of the Company’s internal control over financial reporting and an adverse opinion on the effectiveness of the Company’s internal control over financial reporting because of material weaknesses.

/s/ DELOITTE & TOUCHE LLP

San Francisco, California

May 1, 2006, (March 1, 2007 as to the effects of the restatement discussed in Note B)

17

SHARPER IMAGE CORPORATION

BALANCE SHEETS

(Dollars in thousands, except per share amounts)	January 31, 2006		January 31, 2005
	(As Restated, see Note B)		( As Restated, see Note B)
Assets
Current assets:
Cash and equivalents	$	42,808	$	27,149
Short-term investments		10,350		66,900
Accounts receivable, net of allowance for doubtful accounts of $1,098 and $1,578		17,347		25,638
Merchandise inventories		104,298		124,038
Deferred income taxes		15,809		14,917
Prepaid expenses and other		17,513		10,590
Total current assets		208,125		269,232
Property and equipment, net		106,828		100,509
Deferred catalog costs and other assets		11,448		6,359
Total assets	$	326,401	$	376,100
Liabilities and stockholders’ equity
Current liabilities:
Accounts payable	$	38,436	$	51,424
Accrued expenses		16,173		23,737
Accrued compensation		4,705		7,364
Reserve for refunds		17,270		19,609
Revolving loan		237		—
Deferred revenue		35,814		32,061
Income taxes payable		—		4,009
Total current liabilities		112,635		138,204
Deferred taxes and other liabilities		31,721		30,722
Commitments and contingencies		—		—
Total liabilities		144,356		168,926
Stockholders’ equity:
Preferred stock, $0.01 par value:
Authorized, 3,000,000 shares: Issued and outstanding, none		—		—
Common stock, $0.01 par value:
Authorized, 50,000,000 shares: Issued 14,948,730, and 15,737,260 shares. Outstanding 14,948,730, and 15,637,260 shares		149		157
Additional paid-in capital		113,825		117,190
Retained earnings		68,071		91,607
Treasury stock		—		(1,780	)
Total stockholders’ equity		182,045		207,174
Total liabilities and stockholders’ equity	$	326,401	$	376,100

See Notes to Financial Statements.

18

SHARPER IMAGE CORPORATION

STATEMENTS OF OPERATIONS

	Fiscal Year Ended January 31,
(Dollars in thousands, except per share amounts)	2006 (Fiscal 2005)			2005 (Fiscal 2004)			2004 (Fiscal 2003)
	( As Restated, see Note B)			(As Restated, see Note B)			( As Restated, see Note B)
Revenues:
Net sales	$	650,251		$	739,965		$	630,084
Delivery		18,019			19,398			17,050
List rental and licensing		723			640			377
		668,993			760,003			647,511
Costs and expenses:
Cost of products		342,107			341,823			280,338
Buying and occupancy		79,875			70,948			58,103
Advertising		113,904			149,958			123,339
General, selling and administrative		161,531			176,088			148,582
		697,417			738,817			610,362
Other income (expense):
Interest income		1,160			1,005			785
Interest expense		(745	)		(367	)		(291	)
Other expense		(873	)		(1,491	)		(437	)
		(458	)		(853	)		57
Earnings (loss) before income taxes		(28,882	)		20,333			37,206
Income tax expense (benefit)		(12,746	)		8,778			16,245
Net earnings (loss)	$	(16,136	)	$	11,555		$	20,961
Earnings (loss) per common share:
Basic	$	(1.07	)	$	0.74		$	1.45
Diluted	$	(1.07	)	$	0.71		$	1.38
Weighted average shares used in the computation of earnings (loss) per common share:
Basic		15,066,843			15,634,355			14,446,128
Diluted		15,066,843			16,227,719			15,178,773

See Notes to Financial Statements.

19

SHARPER IMAGE CORPORATION

STATEMENTS OF STOCKHOLDERS’ EQUITY

(Dollars in thousands)	Common Stock					Additional Paid-in Capital (as Restated See Note B)			Treasury Shares					Retained Earnings (as Restated, see Note B)			Total (as Restated, see Note B)
	Shares		Amount						Shares		Amount
Balance at January 31, 2003, as previously reported	12,638,952		$	126		$	49,950		—		$	—		$	64,771		$	114,847
Cumulative effect of restatement (see Note B)							8,358								(5,680	)		2,678
Balance at January 31, 2003, (as restated, see Note B)	12,638,952			126			58,308		—			—			59,091			117,525
Issuance of common stock for stock options exercised (including income tax benefit of $2,566)	546,259			6			6,711		—			—			—			6,717
Issuance of common stock due to stock follow-on offering (net of expenses)	2,137,424			21			38,494		—			—			—			38,515
Stock based compensation							2,207											2,207
Net earnings															20,961			20,961
Balance at January 31, 2004 (as restated, see Note B)	15,322,635			153			105,720		—			—			80,052			185,925
Issuance of common stock for stock options exercised (including income tax benefit of $2,815)	414,625			4			6,973		—			—			—			6,977
Stock based compensation							4,497											4,497
Treasury stock purchased	—			—			—		(100,000	)		(1,780	)		—			(1,780	)
Net earnings															11,555			11,555
Balance at January 31, 2005 (as restated, see Note B)	15,737,260			157			117,190		(100,000	)		(1,780	)		91,607			207,174
Issuance of common stock for stock options exercised	21,470			—			140		—			—			—			140
Stock based compensation							1,509											1,509
Treasury stock purchased									(710,000	)		(10,642	)		—			(10,642	)
Treasury stock retired	(810,000	)		(8	)		(5,014	)	810,000			12,422			(7,400	)		—
Net loss															(16,136	)		(16,136	)
Balance at January 31, 2006 (as restated, see Note B)	14,948,730		$	149		$	113,825		—		$	—		$	68,071		$	182,045

See Notes to Financial Statements.

20

SHARPER IMAGE CORPORATION

STATEMENTS OF CASH FLOWS

	Fiscal Year Ended January 31,
(Dollars in thousands)	2006 (Fiscal 2005)			2005 (Fiscal 2004)			2004 (Fiscal 2003)
	(As Restated, see Note B)			(As Restated, see Note B)			(As Restated, see Note B)
Cash provided by (used for) operating activities:
Net earnings (loss)	$	(16,136	)	$	11,555		$	20,961
Adjustments to reconcile net earnings (loss) to net cash provided by operating activities:
Depreciation and amortization		27,109			21,056			16,426
Tax benefit from stock option exercises		—			2,815			2,566
Deferred rent expenses and landlord allowances		(1,619	)		119			97
Stock based compensation		1,509			4,497			2,207
Deferred income taxes		(7,485	)		4,903			(1,467	)
Loss on disposal of equipment		1,924			1,437			744
Change in operating assets and liabilities:
Accounts receivable		8,291			(4,580	)		(8,461	)
Merchandise inventories		19,740			(14,614	)		(35,099	)
Prepaid catalog costs, prepaid expenses and other		(12,045	)		(2,905	)		(2,575	)
Accounts payable, reserve for refunds and accrued expenses		(29,925	)		20,698			10,415
Deferred revenue and other liabilities		12,020			12,788			15,323
Cash provided by operating activities		3,383			57,769			21,137
Cash provided by (used for) investing activities:
Property and equipment expenditures		(34,124	)		(49,573	)		(35,195	)
Purchases of short-term investments		(37,250	)		(191,600	)		(131,675	)
Sales of short-term investments		93,800			173,300			98,075
Cash provided by (used for) investing activities		22,426			(67,873	)		(68,795	)
Cash provided by (used for) financing activities:
Proceeds from issuance of common stock upon exercise of stock options		255			4,162			4,151
Repurchase of common stock		(10,642	)		(1,780	)		—
Payments made for financing fees								(770	)
Proceeds from revolving credit facility		36,837			—			—
Principal payments on notes payable and revolving credit facility		(36,600	)		—			—
Proceeds from issuance of common stock due to follow-on stock offering, net of expenses		—			—			38,515
Cash provided by (used for) financing activities		(10,150	)		2,382			41,896
Net increase (decrease) in cash and equivalents		15,659			(7,722	)		(5,762	)
Cash and equivalents at beginning of period		27,149			34,871			40,633
Cash and equivalents at end of period	$	42,808		$	27,149		$	34,871
Supplemental disclosure of cash paid for:
Interest	$	417		$	192		$	131
Income taxes	$	6,749		$	7,876		$	9,615

See Notes to Financial Statements.

21

SHARPER IMAGE CORPORATION

NOTES TO FINANCIAL STATEMENTS

Note A—Summary of Significant Accounting Policies

Nature of Operations and Basis of Presentation

Sharper Image Corporation (referred to as the “Company,” “The Sharper Image,” “Sharper Image” and “it”) is a specialty retailer of innovative, high quality products. The Company offers a unique assortment of products in the electronics, recreation and fitness, personal care, houseware, travel, toy, gifts and other categories. The Sharper Image merchandising philosophy focuses principally on new and creative proprietary Sharper Image Design products and exclusive Sharper Image branded products and, to a lesser extent, on third party branded products. The Company designs and develops its Sharper Image Design products, while Sharper Image branded products are generally designed by the Company with third parties. The fiscal years ended January 31, 2006, 2005 and 2004 represent fiscal years 2005, 2004 and 2003, respectively.

Accounting Estimates

The preparation of financial statements in conformity with accounting principles generally accepted in the United States of America 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 revenues and expenses during the reporting period. Actual results could differ from those estimates. The Company’s significant accounting judgments and estimates include depreciable lives of long-lived assets, long-lived asset impairment, inventory valuation and reserve for refunds.

Revenue Recognition

The Company recognizes revenue at the point of sale at its retail stores and at the time of customer receipt for its catalog and direct marketing sales, including the Internet. The Company recognizes revenue for sales to resellers or sales made on a wholesale basis when title passes to the purchaser at the time the products are shipped. Estimated reductions to revenue for customer returns are based upon historical return rates. Revenues are recorded net of sale discounts and other rebates and incentives offered to customers. Deferred revenue represents merchandise certificates, gift cards and reward cards outstanding and unfilled cash orders at the end of the fiscal period. Delivery revenue is recognized at the time of delivery to customers.

Cost of Products

Cost of products includes total cost of products sold, inventory shrink, letter of credit fees, inventory write-downs, inbound freight costs, costs to refurbish products for resale, inspection costs, cost of customer accommodations and promotions and costs to deliver product to customers.

Buying and Occupancy

Buying and occupancy includes salaries and stock-based compensation for merchandise buyers, occupancy costs for all store locations and distribution facilities including rent, utilities, real estate taxes, common area maintenance, repairs and maintenance, depreciation on leasehold improvements and fixtures, janitorial services and waste removal.

General, Selling and Administrative

General, selling and administrative (“GS&A”) includes all costs related to sales associates and corporate personnel, including payroll and benefits and stock-based compensation; store supplies and signs; third party fees including credit card fees, telemarketing expenses, Internet hosting charges, check guarantee fees and professional fees; telephone charges for the corporate office as well as toll-free phone numbers for catalog and other direct marketing orders; freight charges related to delivery of product from distribution centers to stores and between distribution centers (freight out); purchasing, receiving and other warehouse costs; corporate insurance; depreciation on corporate assets such as computers and distribution center facilities; and bad debt expense. Distribution center costs, which include personnel, payroll and benefits, supplies, freight out and professional fees included in GS&A were $24.5 million, $29.1 million and $22.5 million for fiscal 2005, 2004 and 2003, respectively. Of the distribution costs incurred above, freight out was $12.7 million, $15.5 million and $10.8 million for fiscal 2005, 2004, and 2003, respectively.

22

Start-up Activities

All start-up and pre-opening costs, which include supplies, payroll, benefits, store signs, rent and utilities, are expensed as incurred.

Other Expense

Other expense includes the net loss related to the disposal of fixed assets. Net loss on disposal of assets totaled $1.9 million, $1.5 million and $0.7 million in fiscal 2005, 2004 and 2003.

Deferred Catalog and Advertising Costs

Direct costs incurred for the production and distribution of catalogs are capitalized and then amortized, once the catalog is mailed, over the expected sales period, which does not exceed three months. Advertising costs reported as assets include $3.6 million and $4.9 million in deferred catalog costs as of January 31, 2006, and January 31, 2005, respectively. In addition, the Company also reported $0.1 million and $0.4 million of advertising costs for prepaid newspaper and magazine advertisements that were recorded as assets as of January 31, 2006, and January 31, 2005, respectively. Catalog and single product mailer expenses incurred were $42.0 million, $50.8 million, and $42.6 million for fiscal 2005, 2004 and 2003, respectively. Other advertising costs are expensed as incurred and amounted to $71.9 million, $99.2 million and $80.7 million for the fiscal years ended January 31, 2006, 2005, and 2004, respectively.

Fair Value of Financial Instruments

The carrying values of cash, short-term investments, accounts receivable, accounts payable and revolving loan debt approximate their estimated fair values.

Cash and Equivalents

Cash and equivalents represent cash and short-term, highly liquid investments with original maturities of three months or less. Receivables from banks related to debit and credit cards are shown in accounts receivable and totaled $2.5 million and $4.8 million at January 31, 2006, and 2005, respectively.

Short-term Investments

Investments consist of auction rate securities, which the Company normally liquidates within 35 days of purchase in an auction process. These securities are held as available for sale and are therefore classified as short-term investments. The difference between the fair market value and cost of auction rate securities is immaterial.

Merchandise Inventories

Merchandise inventories are stated at lower of cost (first-in, first-out method) or market. The Company reduces the carrying value of its inventory for estimated obsolescence or unmarketable inventory equal to the difference between the cost of inventory and the estimated market value based upon assumptions about future demand and market conditions.

Property and Equipment

Property and equipment are stated at cost, net of accumulated depreciation. Depreciation is computed using the straight-line method over the estimated useful lives of the various assets which range from three to 10 years for office furniture and equipment and transportation equipment, and 40 years for buildings. Leasehold improvements are amortized using the straight-line method over the lesser of their estimated useful lives or the term of the applicable leases, which range from less than one year to 12 years.

Costs incurred in the development of the Company’s Internet Website and enhancements to the Company’s information infrastructure are capitalized once the preliminary project stage is completed and management authorizes and commits to funding a computer software project and it is probable that the project will be completed and the software will be used to perform the function intended. Costs incurred for training and ongoing maintenance are expensed as incurred.

Other Long-Term Assets

The Company designs and produces its own proprietary products for sale. External costs incurred for tooling, dies, patents and trademarks are capitalized and amortized over the estimated life of these products, which is generally two years. At January 31, 2006, and 2005, capitalized costs included in other long-term assets, net of related amortization, were both $4.0 million.

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Income Taxes

Income taxes are accounted for using an asset and liability approach that requires the recognition of deferred tax assets and liabilities for the expected future tax consequences of events then known to management that have been recognized in the Company’s financial statements or tax returns. In estimating future tax consequences, all expected future events then known to management are considered other than changes in the tax law or rates.

Store Closure Reserves

The present value of expected future lease costs and other closure costs are recorded when the store is closed. Severance and other employee-related costs are recorded in the period in which the closure and related severance packages are communicated to the affected employees. Accretion of the discounted present value of expected future costs is recorded in operations. Store closure reserves are reviewed and adjusted periodically based on changes in estimates. Approximately $25,000 was recorded for store closure reserves as of January 31, 2006, and approximately $80,000 was recorded at January 31, 2005.

Accounts Payable and Accrued Expenses

Accounts payable and accrued expenses represent amounts owed to third parties at the end of each period presented.

Reserve for Refunds

Customers may return purchased items for an exchange or refund. The Company records a reserve for estimated product returns, net of cost of goods sold, based on historical return trends together with current product sales performance. If actual returns, net of cost of goods sold, are different than those projected by management, the estimated sales returns reserve will be adjusted accordingly.

Deferred Rent

Rental expense is recorded on a straight-line basis starting on the possession date. The difference between the average rental amount charged to expense or capitalized during the leasehold improvement construction period and the amount payable under the lease is recorded as deferred rent. At January 31, 2006, and 2005, the balance of deferred rent was $10.8 million and $9.2 million, respectively, and is included in long-term liabilities on the accompanying balance sheets.

Stock-Based Compensation

The Company has one stock-based employee compensation plan, as described in Note G. The Company accounts for stock-based employee compensation using the intrinsic value method in accordance with the provisions of Accounting Principles Board Opinion No. 25, Accounting for Stock Issued to Employees (“APB 25”). Although it is the Company’s policy to grant stock options with an exercise price equal to the market price of the underlying common stock on the date of grant these financial statements reflect non-cash compensation expense associated with the issuance of options which were not granted in accordance with the Company’s policy. See Note B.

On January 24, 2005, the Compensation Committee of the Company’s Board of Directors approved the accelerated vesting of all unvested options awarded to employees and officers which had exercise prices greater than $22 per share. Options to purchase approximately 875,000 shares became exercisable immediately as a result of the vesting acceleration.

On January 23, 2006, the Compensation Committee of the Company’s Board of Directors approved the accelerated vesting of all unvested options with an exercise price of and in excess of $11.95. This accelerated vesting, which became effective on the date of approval, affects options to purchase approximately 747,000 shares of the Company’s common stock with exercise prices ranging from $11.95 to $21.99. The acceleration does not apply to unexpired options held by former employees.

The accelerated vesting accelerated recognition of compensation expense for options with alternate measurement dates and eliminates future compensation expense the Company would otherwise recognize in its income statement and pro forma disclosure with respect to all accelerated options once Statement of Financial Accounting Standards (“SFAS”) No. 123R (Share-Based Payment) becomes effective on February 1, 2006. The Company will incur compensation expense in connection with FASB Statement No. 123R for all other options outstanding. The following table reflects the impact of the accelerated vesting on the stock-based compensation recorded in the Company’s financial results as well as the pro-forma impact in fiscal 2005, 2004 and 2003:

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	Fiscal Year Ended
	January 31, 2006	January 31, 2005	January 31, 2004
Recorded stock-based compensation expense:
Stock-based compensation related to original vesting	749	2,489	2,207
Additional expense recognized due to accelerated vesting	760	2,008	—
Total recorded stock-based compensation	1,509	4,497	2,207

	Fiscal Year Ended
	January 31, 2006	January 31, 2005	January 31, 2004
Pro forma stock-based compensation expense:
Stock-based compensation related to original vesting	6,511	15,655	5,258
Additional expense recognized due to accelerated vesting	603	1,663	—
Total pro forma stock-based compensation	7,114	17,318	5,258

The following table illustrates the effect on net earnings (loss) and earnings (loss) per share if the Company had applied the fair value recognition provisions of SFAS No. 123, Accounting for Stock-Based Compensation, to all stock-based employee compensation:

	Fiscal year ended January 31,
	2006 (Fiscal 2005)			2005 (Fiscal 2004)			2004 (Fiscal 2003)
(Dollars in thousands, except per share amounts)	(As Restated, see Note B)			(As Restated, see Note B)			(As Restated, see Note B)
Net earnings (loss)	$	(16,136	)	$	11,555		$	20,961
Add: Total stock – based employee compensation expense included in earnings, net of related tax effects		907			2,654			1,296
Deduct: Total stock-based employee compensation expense determined under fair value-based method for all awards, net of related tax effects(1)		(4,276	)		(10,218	)		(3,086	)
Pro forma net earnings (loss)	$	(19,505	)	$	3,991		$	19,171
Basic earnings (loss) per share:
Reported	$	(1.07	)	$	0.74		$	1.45
Pro forma	$	(1.29	)	$	0.26		$	1.33
Diluted earnings (loss) per share:
Reported	$	(1.07	)	$	0.71		$	1.38
Pro forma	$	(1.29	)	$	0.25		$	1.26

(1) The Company estimates the fair value of stock option grants using the Black-Scholes option pricing model, with the following weighted average assumptions:

	Fiscal year ended January 31,
	2006 (Fiscal 2005)		2005 (Fiscal 2004)		2004 (Fiscal 2003)
Dividend yield	—		—		—
Expected volatility	48	%	48	%	52	%
Risk-free interest rate	4.50	%	3.50	%	3.12	%
Expected life (years)	5		5		5

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Comprehensive Income

Comprehensive income consists of net earnings or loss for the current period and other comprehensive income (certain income, expenses, gains and losses that currently bypass the income statement are reported directly as a separate component of equity). Comprehensive income does not differ from the net earnings or losses for the Company for the years ended January 31, 2006, 2005 and 2004.

New Accounting Standards

In December 2004, the Financial Accounting Standards Board (FASB) issued SFAS No. 123 (Revised 2004), “Share-Based Payment” (“SFAS No. 123R”) which replaces SFAS No. 123, supercedes Accounting Principles Board (APB) No. 25 and related interpretations and amends SFAS No. 95, “Statement of Cash Flows.” The provisions of SFAS No. 123R are similar to those of SFAS No. 123; however, SFAS No. 123R requires all share-based payments to employees, including grants of employee stock options, to be recognized in the financial statement as compensation cost based on their fair value on the date of the grant. The fair value of the share-based awards will be determined using an option-pricing model on the grant date. SFAS No. 123R is effective at the beginning of the first fiscal year beginning after June 15, 2005. The Company will adopt SFAS No. 123R in the first quarter of fiscal 2006. Due to the accelerated vesting of certain stock options in fiscal 2005 and fiscal 2004, the adoption of SFAS No. 123R in the first quarter of 2006 is not expected to have a material impact on the Company’s financial statements, although the future impact of the adoption of SFAS No. 123R is dependent upon the future issuance of stock option grants that will be determined by the Company’s Compensation Committee.

In November 2004, the FASB issued SFAS No. 151, “Inventory Costs—An Amendment of Accounting Research Bulletin No. 43, Chapter 4” (“SFAS No. 151”). SFAS No. 151 clarifies that abnormal amounts of idle facility expense, freight, handling costs and spoilage should be expensed as incurred and not included in overhead. The provisions in SFAS No. 151 must be applied prospectively to the Company’s inventory costs incurred after January 1, 2006. The adoption of SFAS No. 151 is not expected to have an impact on the Company’s financial statements.

In March 2005, the FASB issued FASB Interpretation No. (“FIN”) 47, “Accounting for Conditional Asset Retirement Obligations, an interpretation of FASB Statement No. 143.” This Interpretation clarifies that the term conditional 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. Accordingly, an entity is required to recognize a liability for the fair value of a conditional asset retirement obligation if the fair value of the liability can be reasonably estimated. The adoption of FIN 47 in the fourth quarter of fiscal 2005 did not have a material effect on the Company’s financial statements.

In May 2005, the FASB issued SFAS No. 154, “Accounting Changes and Error Corrections—a Replacement of APB No. 20 and SFAS No. 3.” SFAS No. 154 changes the requirements for the accounting for, and reporting of, a change in accounting principle. Previously, voluntary changes in accounting principles were generally recognized by way of a cumulative effect adjustment within net earnings during the period of change. SFAS No. 154 requires retrospective application to prior period financial statements, unless it is impracticable to determine either the period-special effects or the cumulative effect of the change. SFAS No. 154 is effective for accounting changes made in fiscal years beginning after December 15, 2005; however, the statement does not change the transition provisions of any existing accounting pronouncements. The Company does not believe the adoption of SFAS No. 154 will have a material effect on its financial statements.

In October 2005, the FASB issued FSP FAS 13-1, “Accounting for Rental Costs Incurred during a Construction Period”, which addresses the accounting for rental costs associated with operating leases that are incurred during a construction period. This FSP requires that rental costs associated with ground or building operating leases incurred during a construction period be recognized as rental expense and included in income from continuing operations. The guidance in this FSP shall be applied to the first reporting period beginning after December 15, 2005, with early adoption permitted. The adoption of FSP FAS 13-1 will not have a material impact on the Company’s financial statements.

Note B – Restatement of Financial Statements

On August 24, 2006, following the issuance of an analyst report regarding the stock option granting practices of the Company and several other companies in the retail business sector, the Board of Directors constituted a Special Committee to conduct a review of the Company’s historical stock option granting practices. The Special Committee’s review included all employee stock options granted from fiscal year 1994 (the fiscal year ended January 31, 1995) through 2005 (the fiscal year ended January 31, 2006).

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The Special Committee has completed its review, and its findings and recommendations have been accepted by the Company’s Board of Directors. Based on its review, the Special Committee concluded that the documentary evidence did not support the measurement dates the Company originally used to determine compensation expense for most option grants to employees made during the fiscal years ending January 31, 1996 through January 31, 2006. The Special Committee recommended the use of alternate measurement dates with respect to these grants. For purposes of accounting for option grants, APB 25 provides that the measurement date occurs when both the number of shares that the employee is entitled to receive is fixed and the exercise price associated with the grant is known. With respect to the option grants under review, the Special Committee sought to determine, based on the available evidence for each of the grants, when all prerequisites had been met in order to determine the proper measurement date for each of the granted options. In addition to the foregoing, the Special Committee’s review indicated that in several instances, options were granted with measurement dates immediately preceeding or immediately after, the Company’s press releases; however, the Special Committee has determined that the timing of such grants does not, in and of itself, require any accounting adjustments.

In situations in which the closing price of the Company’s common stock on the measurement date exceeded the stated exercise price on the original grant date, the Company has recognized stock-based compensation expense and related tax effects. The Company has recorded non-cash compensation expense of $17.7 million, approximately $10.5 million after tax, in the aggregate over the fiscal years 1995 through 2005. As a result of the foregoing, the Company has restated the accompanying financial statements for the fiscal years 2005, 2004, and 2003. As of February 1, 2006 (the first day of the Company’s 2006 fiscal year), the aggregate amount of unamortized compensation expense relating to these option grants totaled approximately $0.1 million.

The Company recorded an adjustment of $5.7 million to beginning retained earnings as of the beginning of fiscal year 2003, which consists of the following:

	Fiscal Year Ended January 31,
(Dollars in thousands)	1996		1997		1998		1999		2000		2001		2002		2003		Total
Stock based compensation expense – pre tax	$	193	$	289	$	154	$	343	$	1,486	$	2,435	$	2,413	$	2,187	$	9,500
Stock based compensation expense – net of tax		116		173		92		206		892		1,463		1,448		1,290		5,680

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A summary of the significant effects of the restatement is as follows:

Balance Sheet

	January 31, 2006				January 31, 2005
(Dollars in thousands)	As Previously Reported		As Restated		As Previously Reported		As Restated
Prepaid expenses and other	$	19,873	$	17,513	$	10,590	$	10,590
Total current assets		210,485		208,125		269,232		269,232
Total assets		328,761		326,401		376,100		376,100
Income taxes payable		—		—		1,649		4,009
Total current liabilities		112,635		112,635		135,844		138,204
Deferred taxes and other liabilities		35,693		31,721		34,249		30,722
Total liabilities		148,328		144,356		170,093		168,926
Additional paid in capital		100,373		113,825		105,090		117,190
Retained earnings		79,911		68,071		102,540		91,607
Total stockholders equity		180,433		182,045		206,007		207,174

Results of Operations

(Dollars in thousands, except per share amounts)	Fiscal Year Ended January 31, 2006						Fiscal Year Ended January 31, 2005				Fiscal Year Ended January 31, 2004
	As Previously Reported			As Restated			As Previously Reported		As Restated		As Previously Reported		As Restated
Buying and occupancy	$	79,818		$	79,875		$	70,771	$	70,948	$	58,013	$	58,103
General, selling and administrative		160,079			161,531			171,768		176,088		146,465		148,582
Earnings (loss) before income taxes		(27,373	)		(28,882	)		24,830		20,333		39,413		37,206
Income tax expense (benefit)		(12,144	)		(12,746	)		10,180		8,778		16,294		16,245
Net earnings(loss)		(15,229	)		(16,136	)		14,650		11,555		23,119		20,961
Basic earnings (loss) per common share:		(1.01	)		(1.07	)		0.94		0.74		1.60		1.45
Diluted earnings(loss) per common share:		(1.01	)		(1.07	)		0.90		0.71		1.51		1.38
Weighted average number of shares outstanding - Diluted		15,066,843			15,066,843			16,290,060		16,227,719		15,333,235		15,178,773

Statement of Cash Flows

(Dollars in thousands),	Fiscal Year Ended January 31, 2006						Fiscal Year Ended January 31, 2005				Fiscal Year Ended January 31, 2004
	As Previously Reported			As Restated			As Previously Reported		As Restated		As Previously Reported			As Restated
Net earnings (loss)	$	(15,229	)	$	(16,136	)	$	14,650	$	11,555	$	23,119		$	20,961
Adjustments to reconcile net earnings(loss) to net cash provided by operating activities:
Tax benefit from stock option exercises		42			—			3,721		2,815		4,622			2,566
Deferred income taxes		(6,925	)		(7,485	)		6,106		4,903		(1,821	)		(1,467	)
Compensation expense associated with stock option grants		—			1,509			—		4,497		—			2,207
Accounts payable, reserve for refunds and accrued expenses		(29,925	)		(29,925	)		19,991		20,698		8,762			10,415
Cash provided by operating activities		3,383			3,383			57,769		57,769		21,137			21,137

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Note C—Property and Equipment

Property and equipment is summarized as follows:

	January 31,
(Dollars in thousands)	2006		2005
Leasehold improvements	$	55,021	$	44,076
Furniture, fixtures and equipment and other capitalized costs		147,243		139,554
Land		53		53
Building		2,874		2,874
		205,191		186,557
Less accumulated depreciation and amortization		98,363		86,048
	$	106,828	$	100,509

Note D—Revolving Loan and Notes Payable

The Company has a revolving secured credit facility with Wells Fargo Bank, National Association. The credit facility allows borrowings against a “borrowing base” determined by inventory levels and specified accounts receivable. The credit facility is secured by the Company’s inventory, accounts receivable, and specified other assets. Borrowings under the credit facility bear interest at either the adjusted LIBOR rate plus 1.50% or at Wells Fargo’s prime rate less 0.25%.

On February 2, 2006, the Company entered into an amendment to the credit facility. The amendment extended the maturity date to February 2, 2010, and allows borrowings and letters of credit up to a maximum of $55 million. In addition, through October 31, 2007, the Company may, at its option, seek to increase the maximum credit amount by up to $30 million on no more than five occasions in minimum increments of $5 million, provided that at no time shall the maximum credit amount exceed $85 million. Borrowings under the amended credit facility bear interest at either the LIBOR rate plus a margin ranging from 1.25% to 1.75% based on average excess availability or at Wells Fargo’s prime rate less up to 0.25% based on average excess availability. As of January 31, 2006, the interest rate on outstanding borrowings was 7.25%.

The credit facility contains financial covenants that only apply during an event of default or when the borrowing base is drawn below a specified level. These financial covenants require the Company to maintain a minimum EBITDA (as defined) on a rolling 12-month basis of $25 million and to maintain capital expenditures below a specified level based on the Company’s projections. The credit facility contains limitations on incurring additional indebtedness and making additional investments and does not permit a change of control. As of January 31, 2006, letter of credit commitments outstanding under the credit facility were $3.6 million and $0.2 million of borrowings outstanding. The Company believes that it is in compliance with all of its debt covenants as of January 31, 2006.

Note E—Income Taxes

	Fiscal year ended January 31,
	2006 (Fiscal 2005)			2005 (Fiscal 2004)		2004 (Fiscal 2003)
(Dollars in thousands)	(As restated, see Note B)			(As restated, see Note B)		(As restated, see Note B)
Current:
Federal	$	(6,070	)	$	3,885	$	16,175
State		851			661		2,803
		(5,219	)		4,516		18,978
Deferred:
Federal		(4,972	)		3,638		(2,334	)
State		(2,555	)		624		(399	)
		(7,527	)		4,262		(2,733	)
	$	(12,746	)	$	8,778	$	16,245

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The difference between the effective income tax rate and the United States federal income tax rate is summarized as follows:

	Fiscal year ended January 31,
	2006 (Fiscal 2005)		2005 (Fiscal 2004)		2004 (Fiscal 2003)
	(As restated, see Note B)		(As restated, see Note B)		(As restated, see Note B)
Federal tax rate	34.0	%	35.0	%	35.2	%
State income tax, less federal benefit	5.9		6.0		6.1
Benefit of R&D tax credits from prior years	2.0		—		—
Non-deductible compensation	—		2.2		2.4
Other	2.2		—		—
Effective tax rate	44.1	%	43.2	%	43.7	%

Deferred taxes result from differences in the recognition of expense for income tax and financial reporting purposes. The principal components of deferred tax assets (liabilities) are as follows:

	January 31,
	2006				2005
	Deferred Tax Assets		Deferred Tax Liabilities		Deferred Tax Assets		Deferred Tax Liabilities
(Dollars in thousands)	(As restated, see Note B)		(As restated, see Note B)		(As restated, see Note B)		(As restated, see Note B)
Current:
Nondeductible reserves	$	16,500		—	$	15,615		—
Deferred catalog costs			$	691		—	$	732
State taxes		—		—		34		—
Current		16,500		691		15,649		732
Non current:
Deferred rent		2,888		—		2,299		—
Depreciation		—		4,582		—		9,740
Deductible software costs		—		6,667		—		6,060
Stock –based compensation		3,972				3,527
Other		3,055		—		2,162		—
Non current		9,915		11,249		7,988		15,800
Total	$	26,415	$	11,940	$	23,637	$	16,532

The net of the current deferred tax assets and liabilities is recorded in deferred taxes on the accompanying balance sheets. The net of the federal noncurrent deferred tax assets and liabilities is recorded in deferred taxes and other liabilities on the accompanying balance sheets. The net of the deferred state tax assets and liabilities is recorded in deferred catalog and other assets. The current income tax receivable of $9.9 million as of January 31, 2006, is recorded in prepaid expenses and other on the accompanying balance sheet.

Note F—Leases

The Company leases retail facilities, offices and equipment under operating leases for terms expiring at various dates through 2017. Under the terms of certain of the leases, rents are adjusted annually for changes in the consumer price index and increases in property taxes. The aggregate minimum annual lease payments under leases in effect at January 31, 2006, are as follows:

(Dollars in thousands)
Fiscal year ending January 31,
2007	$	39,879
2008		39,164
2009		38,184
2010		37,129
2011		35,437
Thereafter		106,193
Total minimum lease commitments	$	295,986

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Many of the Company’s leases contain predetermined fixed escalations of the minimum rentals during the initial term. For these leases, the Company has recognized the related rental expense on a straight-line basis and has recorded the difference between the expense charged to income or capitalized in fixed assets and amounts payable under the leases as Other Liabilities on the accompanying balance sheet. Some store leases also contain provisions that the Company pay percentage rent for sales that exceed a certain threshold.

Some store leases contain renewal options for periods ranging up to five years. Most leases also provide for payment of operating expenses, real estate taxes and many for additional rent based on a percentage of sales.

Rental expense for all operating leases was as follows:

	Fiscal year ended January 31,
(Dollars in thousands)	2006 (Fiscal 2005)		2005 (Fiscal 2004)		2004 (Fiscal 2003)
Minimum rentals	$	39,865	$	35,281	$	30,108
Percentage rentals and other charges		17,470		15,640		12,286
	$	57,335	$	50,921	$	42,394

Note G—Stockholders’ Equity

During fiscal 2000, the Company adopted the 2000 Stock Incentive Plan. The 2000 Stock Incentive Plan is divided into four separate equity incentive programs and will allow the issuance of non-qualified options to key employees, non-employee Board members and consultants. An automatic increase of shares available for issuance will occur on the first trading day of each fiscal year, beginning with fiscal 2001, by an amount equal to 3% of the total number of shares of common stock outstanding on the last trading day of the immediately preceding fiscal year. In no event will the annual increase exceed 500,000 shares.

In October 2004, the Board of Directors authorized a stock repurchase program to acquire up to 1,000,000 shares of outstanding common stock in the open market. During fiscal 2004 and 2005, the Company repurchased 810,000 shares of its common stock at a total cost of approximately $12.4 million, a weighted average cost of $15.34 per share.

Options issued to key employees and consultants will generally vest over a four- to six-year period from the date of the grant. Options issued to non-employee Board members will be immediately exercisable, vest over one year of board service from the date of the grant. Any shares purchased under the option plan will be subject to repurchase by the Company at the exercise price paid per share, upon the optionee’s cessation of Board service prior to vesting.

On January 23, 2006, the Compensation Committee of the Board of Directors of the Company approved the accelerated vesting of all unvested options with an exercise price of and in excess of $11.95. This accelerated vesting, which became effective on the date of approval, affects options to purchase approximately 747,000 shares of the Company’s common stock with exercise prices ranging from $11.95 to $21.99. The acceleration does not apply to unexpired options held by former employees. On January 24, 2005, the Company’s Compensation Committee of the Board of Directors approved the accelerated vesting of all unvested options awarded to employees and officers which had exercise prices greater than $22 per share. Options to purchase approximately 875,000 shares became exercisable immediately as a result of the vesting acceleration. See Note A-“Stock Based Compensation.”

The following table reflects the activity under this plan:

	Number of Options		Weighted average exercise price
Balance at January 31, 2003	2,695,371		$	9.83
Granted (weighted average fair value of $11.53)	580,500			23.18
Exercised	(546,259	)		7.20
Canceled	(41,960	)		9.99
Balance at January 31, 2004	2,687,652		$	13.24
Granted (weighted average fair value of $16.37)	455,550		$	26.62
Exercised	(414,625	)		10.03
Canceled	(16,800	)		24.66
Balance at January 31, 2005	2,711,777		$	15.91
Granted (weighted average fair value of $6.88)	624,400		$	12.99
Exercised	(21,470	)		8.06
Canceled	(274,500	)		17.61
Balance at January 31, 2006	3,040,207		$	15.21
Exercisable at January 31, 2004	1,272,652		$	10.88
Exercisable at January 31, 2005	2,235,837		$	16.86
Exercisable at January 31, 2006	2,984,127		$	15.37

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Options outstanding					Options exercisable
Range of exercise prices	Number of options outstanding	Weighted average remaining contractual Life (years)	Weighted average exercise price		Number of options exercisable	Weighted average exercise price
$2.00 — $3.99	5,533	2.5	$	3.54	5,533	$	3.54
4.00 —   7.99	209,990	6.0		6.89	153,910		6.88
8.00 — 11.99	998,744	5.0		9.53	998,744		9.53
12.00 — 14.99	851,040	8.8		13.55	851,040		13.55
15.00 — 23.99	561,700	7.9		22.39	561,700		22.39
24.00 — 35.99	413,200	8.9		27.00	413,200		27.00
$2.00 —$35.99	3,040,207	7.2	$	15.21	2,984,127	$	15.37

Note H—Earnings per Share

Basic earnings per share are computed by dividing net earnings (loss) by the weighted average number of common shares outstanding during the period. Diluted earnings per share are computed by dividing net earnings (loss) by the weighted average number of common shares and dilutive common equivalent shares (stock options) outstanding during the period. The following is a reconciliation of the number of shares used in the Company’s basic and diluted earnings per share computations:

	Fiscal year ended January 31,
	2006 (Fiscal 2005)	2005 (Fiscal 2004)	2004 (Fiscal 2003)
Basic weighted average number of shares outstanding	15,066,843	15,634,355	14,446,128
Application of treasury stock method on stock options outstanding:
Assumed options exercised due to exercise price being less than average market price, net of assumed stock repurchases	—	593,364	732,645
Diluted weighted average number of shares outstanding	15,066,843	16,227,719	15,178,773

The potential effects of stock options were excluded from the diluted earnings per share for the year ended January 31, 2006 because their inclusion in net loss periods would be anti-dilutive to the loss per share calculation. The computations of diluted earnings per share in fiscal 2005, 2004 and 2003 exclude options to purchase 1,392,940, 447,450 and 31,100 common shares, respectively, because their exercise price exceeded the average market price for the period and thus their effect would have been anti dilutive.

Note I—401(k) Savings Plan

The Company maintains a defined contribution 401(k) Savings Plan covering all employees who have completed one year of service with at least 1,000 hours and who are at least 21 years of age. The Company makes employer matching contributions at its discretion. Company contributions amounted to $258,000, $274,000, and $190,000 for the fiscal years ended January 31, 2006, 2005 and 2004, respectively.

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Note J—Commitments and Contingencies

The Company is party to various legal proceedings arising from normal business activities. Except as noted below, management believes that the resolution of these matters will not have a material adverse effect on the Company’s financial position or results of operations.

On or before April 15, 2006, there were five Class Actions filed against the Company alleging inaccurate advertising claims on behalf of the Ionic Breeze Quadra, including its failure to perform as claimed. The actions are filed on behalf of purchasers of the Ionic Breeze Quadra in the State Courts of California (San Francisco) and Florida (Jacksonville), as well as the U.S. District Courts of Maryland and Florida (Miami). Only the San Francisco action has been certified for class representation, a ruling which is on appeal by the Company. The Florida State Court action is stayed pending resolution of the ongoing San Francisco case. The Maryland and Florida federal cases are in the initial stages of procedure. The Company believes these lawsuits, which are virtually identical, are without merit and has been and intends to continue resisting them vigorously. Recognizing that the combined claims of the plaintiffs, if fully successful, would result in several millions of dollars of liability, the Company does not believe that the ultimate resolution of these lawsuits will have a material adverse effect on the financial position of the Company, although an adverse outcome in one or more of these lawsuits will have a material adverse effect on the results of operations for any one period. Further, litigation can consume substantial financial and management resources and no assurances can be given that any adverse outcome would not be material to the financial position of the Company.

Note K—Segment Information

The Company classifies its business interests into three reportable segments: retail stores, catalog and direct marketing and Internet. The accounting policies of the segments are the same as those described in the Summary of Significant Accounting Policies (Note A). The Company evaluates performance and allocates resources based on operating contribution, which excludes unallocated corporate general and administrative costs and income taxes. The Company’s reportable segments are strategic business units that offer the same products and utilize common merchandising, distribution and marketing functions, as well as common information systems and corporate administration. The Company does not have inter segment sales, but the segments are managed separately because each segment has different channels for selling the products.

Financial information for the Company’s business segments is as follows:

	Year ended January 31,
	2006 (Fiscal 2005)			2005 (Fiscal 2004)			2004 (Fiscal 2003)
(Dollars in thousands)	(As restated, see Note B)			(As restated, see Note B)			(As restated, see Note B)
Revenues
Stores	$	407,098		$	434,696		$	379,349
Catalog and direct marketing		87,945			130,535			128,652
Internet		107,222			116,297			95,086
Other		66,728			78,475			44,424
Total revenues	$	668,993		$	760,003		$	647,511
Operating contributions
Stores	$	18,090		$	56,410		$	53,919
Catalog and direct marketing		(5,637	)		4,753			20,461
Internet		6,342			11,856			15,324
Unallocated		(47,677	)		(52,686	)		(52,498	)
Earnings (loss) before income taxes	$	(28,882	)	$	20,333		$	37,206
Depreciation and amortization
Stores	$	14,145		$	10,386		$	7,734
Catalog and direct marketing		—			—			—
Internet		1,740			2,253			3,071
Unallocated		11,224			8,417			5,621
Total depreciation and amortization	$	27,109		$	21,056		$	16,426
Capital asset expenditures
Stores	$	23,782		$	28,176		$	21,774
Catalog and direct marketing		—			—			—
Internet		927			2,895			1,727
Unallocated		9,415			18,502			11,694
Total capital asset expenditures	$	34,124		$	49,573		$	35,195
Assets
Stores	$	74,596		$	65,854		$	51,197
Catalog and direct marketing		—			—			—
Internet		1,700			2,513			1,974
Unallocated		250,105			307,733			262,162
Total assets	$	326,401		$	376,100		$	315,333

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Note L—Quarterly Financial Information (Unaudited)

	Fiscal Year Ended January 31, 2006 Three months ended
	(As previously reported) (3)
(Dollars in thousands, except per share amounts)	April 30, 2005			July 31, 2005			October 31, 2005			January 31, 2006
Revenues	$	144,882		$	137,296		$	123,115		$	263,700
Expenses
Cost of products		66,337			71,276			62,212			142,282
Buying and occupancy		18,827			19,574			19,771			21,646
Advertising		32,484			22,603			23,272			35,545
General, selling and administrative		34,970			34,941			36,451			53,717
Other income (expense)—net		109			(197	)		(137	)		(233	)
Earnings (loss) before income taxes		(7,627	)		(11,295	)		(18,728	)		10,277
Income tax expense (benefit)		(3,051	)		(4,518	)		(8,228	)		3,653
Net earnings (loss)	$	(4,576	)	$	(6,777	)	$	(10,500	)	$	6,624
Net earnings (loss) per share
Basic(1)	$	(0.30	)	$	(0.45	)	$	(0.70	)	$	0.44
Diluted(2)	$	(0.30	)	$	(0.45	)	$	(0.70	)	$	0.44

	Fiscal Year Ended January 31, 2006 Three months ended
	(As restated) (3)
(Dollars in thousands, except per share amounts)	April 30, 2005			July 31, 2005			October 31, 2005			January 31, 2006
Revenues	$	144,882		$	137,296		$	123,115		$	263,700
Expenses
Cost of products		66,337			71,276			62,212			142,282
Buying and occupancy		18,833			19,580			19,778			21,684
Advertising		32,484			22,603			23,272			35,545
General, selling and administrative		35,154			35,122			36,642			54,613
Other income (expense)—net		109			(197	)		(137	)		(233	)
Earnings (loss) before income taxes		(7,817	)		(11,482	)		(18,926	)		9,343
Income tax expense (benefit)		(3,127	)		(4,593	)		(8,307	)		3,281
Net earnings (loss)	$	(4,690	)	$	(6,889	)	$	(10,619	)	$	6,062
Net earnings (loss) per share
Basic(1)	$	(0.31	)	$	(0.46	)	$	(0.71	)	$	0.41
Diluted(2)	$	(0.31	)	$	(0.46	)	$	(0.71	)	$	0.40

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	Fiscal Year Ended January 31, 2005 Three months ended
	(As previously reported) (3)
(Dollars in thousands, except per share amounts)	April 30, 2004		July 31, 2004		October 31, 2004			January 31, 2005
Revenues	$	156,405	$	148,963	$	153,623		$	301,012
Expenses
Cost of products		62,760		66,380		71,041			141,642
Buying and occupancy		16,049		16,963		16,970			20,789
Advertising		37,072		28,755		33,030			51,101
General, selling and administrative		37,393		36,768		38,775			58,832
Other income (expense)—net		116		62		(107	)		(924	)
Earnings (loss) before income taxes		3,247		159		(6,300	)		27,724
Income tax expense (benefit)		1,332		66		(2,583	)		11,365
Net earnings (loss)	$	1,915	$	93	$	(3,717	)	$	16,359
Net earnings (loss) per share
Basic(1)	$	0.12	$	0.01	$	(0.24	)	$	1.04
Diluted(2)	$	0.12	$	0.01	$	(0.24	)	$	1.01

	Fiscal Year Ended January 31, 2005 Three months ended
	(As restated) (3)
(Dollars in thousands, except per share amounts)	April 30, 2004		July 31, 2004			October 31, 2004			January 31, 2005
Revenues	$	156,405	$	148,963		$	153,623		$	301,012
Expenses
Cost of products		62,760		66,380			71,041			141,642
Buying and occupancy		16,072		16,992			16,981			20,903
Advertising		37,072		28,755			33,030			51,101
General, selling and administrative		37,939		37,442			39,448			61,259
Other income (expense)—net		116		62			(107	)		(924	)
Earnings (loss) before income taxes		2,678		(544	)		(6,984	)		25,183
Income tax expense (benefit)		1,201		(102	)		(2,753	)		10,432
Net earnings (loss)	$	1,477	$	(442	)	$	(4,231	)	$	14,751
Net earnings (loss) per share
Basic(1)	$	0.10	$	(0.03	)	$	(0.27	)	$	0.94
Diluted(2)	$	0.09	$	(0.03	)	$	(0.27	)	$	0.92

(1) Basic earnings per share is calculated for interim periods including the effect of stock options exercised in prior interim periods. Basic earnings per share for the fiscal year are calculated using weighted shares outstanding based on the date stock options were exercised. Therefore, basic earnings per share for the cumulative four quarters may not equal fiscal year basic earnings per share.

(2) Diluted net earnings per share for the fiscal year and for quarters with net earnings are computed based on weighted average common and common equivalent shares outstanding which include common stock equivalents (stock options). Net loss per share for quarters with net losses is computed based solely on weighted average common shares outstanding. Therefore, the net earnings (loss) per share for each quarter do not sum up to the earnings per share for the full fiscal year.

(3) See Note B of Notes to Financial Statements for a description of the Company’s restatement.

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ITEM 9A. CONTROLS AND PROCEDURES

Evaluation of Disclosure Controls and Procedures.

The Company conducted an evaluation, under the supervision and with the participation of the Company’s management, including the Interim Chief Executive Officer and Interim Chief Financial Officer, of the effectiveness of the design and operation of its disclosure controls and procedures (as such term is defined in Rules 13a-15(e) and 15d-15(e) under the Securities Exchange Act of 1934, as amended (the “Exchange Act”)) as of the end of the period covered by this report. There are inherent limitations to the effectiveness of any system of disclosure controls and procedures, including the possibility of human error and the circumvention or overriding of the controls and procedures. Accordingly, even effective disclosure controls and procedures can only provide reasonable assurance of achieving their control objectives.

At the time that our Annual Report on Form 10-K for the year ended January 31, 2006 was filed on May 1, 2006, our then Chief Executive Officer and then Chief Financial Officer concluded that our disclosure controls and procedures were not effective as of January 31, 2006, because of a material weakness in internal control over the selection and application of accounting policies for complex and non-routine transactions, as discussed below. Subsequent to that evaluation, in connection with the restatement and filing of this Annual Report on Form 10-K/A, our management, including our current Interim Chief Executive Officer and Interim Chief Financial Officer, re-evaluated our disclosure controls and procedures and concluded that our disclosure controls and procedures were not effective as of January 31, 2006, and identified an additional material weakness in our internal control over financial reporting relating to option grant practices as discussed below.

Management’s Annual Report on Internal Control Over Financial Reporting (as Revised)

The Company’s management is responsible for establishing and maintaining adequate internal control over financial reporting as defined in Rules 13a-15(f) and 15d-15(f) under the Securities Exchange Act of 1934. The Company’s internal control over financial reporting is a process designed to provide reasonable assurance regarding the reliability of financial reporting and the preparation of financial statements for external purposes in accordance with generally accepted accounting principles.

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

The Company’s management has assessed the effectiveness of its internal control over financial reporting as of January 31, 2006. This evaluation was based on the framework in Internal Control—Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission (“COSO”). In Management’s Report on Internal Control over Financial Reporting included in our original Annual Report on Form 10-K for the year ended January 31, 2006 filed on May 1, 2006, our prior management, including our then Chief Executive Officer and then Chief Financial Officer, concluded that as of January 31, 2006, the Company’s internal control over financial reporting was not effective based on the criteria described in the COSO Internal Control—Integrated Framework.

A material weakness is a control deficiency, or combination of control deficiencies, that results in a more than remote likelihood that a material misstatement of the annual or interim financial statements will not be prevented or detected.

Management identified the following material weakness in connection with its original assessment. The Company did not design and implement adequate controls over the selection and application of accounting policies for complex and non-routine transactions. As a result, certain audit adjustments to the 2005 financial statements, which were not material individually, but which affected various financial statement line items, were necessary to present the financial statements in accordance with generally accepted accounting principles.

We have restated our financial statements to reflect non-cash compensation expense associated with the issuance of options as described more fully in Note B to the consolidated financial statements. In connection with the restatement, our current management, including our current Interim Chief Executive Officer and Interim Chief Financial Officer has determined that the lack of adequate controls over the granting of stock options and the related documentation constituted a material weakness in internal control over financial reporting. This weakness resulted in the use of incorrect accounting measurement dates for certain stock option grants and resulted in the errors in the recorded amount of compensation expense and the related restatement.

As a result of the additional material weakness identified in connection with the restatement of our consolidated financial statements management has revised its assessment to include such weakness. Additionally, because of the existence of the material weaknesses, our current management concluded that the Company did not maintain effective internal control over financial reporting as of January 31, 2006, based on the criteria described in the COSO Internal Control—Integrated Framework.

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Management’s revised assessment of the effectiveness of the Company’s internal control over financial reporting as of January 31, 2006, has been audited by Deloitte & Touche LLP, the Company’s independent registered public accounting firm, as stated in their report which appears herein.

Material Weaknesses in Internal Control Over Financial Reporting

Material Weakness Relating to Internal Control Over the Selection and Application of Accounting Policies for Complex and Non-Routine Transactions

The material weaknesses resulted in accounting errors related to treasury stock retirement, long lived asset impairment and income taxes. The Company did not properly account for the retirement of its treasury stock, which resulted in a reclassification between equity accounts. There was no net effect on shareholders’ equity. The Company retired its treasury stock for only the second time in its history and therefore accounting for retirement of treasury stock was not only complex but non-routine. In its year end determination of long lived asset impairment, the Company did not properly calculate whether two under performing stores were impaired. Initially, the Company determined that an impairment charge would be required, but subsequent calculation revealed that no such impairment existed. The Company reversed the initial impairment entry. The Company did not properly account for income taxes. A key member of the accounting staff, who accounted for income taxes in prior years, left the Company in late December 2005. While a new tax manager was hired in late December 2005, it was not possible to transition all of the knowledge and experience in such a short period of time. However, as of January 31, 2006, the tax accounts have been properly stated. Additionally, due to numerous unplanned events including departure of key accounting personnel in December 2005, the Company needed additional time to complete the year-end closing process. The untimely closing of the books resulted in the delay in filing of the Form 10-K.

Material Weakness Relating to Option Grant Practices

Based on the Special Committee’s review, as set forth in Item 7—Management’s Discussion and Analysis of Financial Condition and Results of Operations—Restatement of Financial Statements, our management has determined that we did not maintain adequate controls regarding the option granting process. In particular, we lacked a formal policy for granting and approving options and the procedures used were insufficient to ensure that all option grants complied with our stock option plans and applicable accounting rules. Our procedures, in particular the use of unanimous written consents with “as of” effective dates, provided insufficient control to ensure that all prerequisites of APB 25 had been met prior to the grant date and to prevent option grant dates from being selected with the benefit of hindsight.

The Special Committee could not rule out the possibility that the original grant dates for some of the grants were selected with the benefit of hindsight. For example, with respect to the 1996 Management Grant, correspondence between the former Chief Executive Officer and the directors suggests that the grant (which involved the cancellation of a prior grant in 1995 and the issuance of new options at a lower exercise price) was proposed in early May 1996, but the unanimous written consents which the directors on the stock option committee were requested to execute designated as the grant date March 26, 1996, the date on which our stock had traded at a year-to-date low. The September 1999 Management Grant was discussed at a morning meeting of the Board of Directors on Monday, September 27, 1999 but we designated Friday, September 24, 1999 as the grant date, when the price of our stock was $0.88 lower. (As indicated on the table in Item 7—Management’s Discussion and Analysis of Financial Condition and Results of Operations—Restatement of Financial Statements, the Special Committee recommended that the grant be measured as of November 10, 1999 because the grant list had not been completed when the directors met on September 27, 1999.) With respect to the May 2004 grant, the compensation committee members appear to have discussed the grant on May 19, 2004, but we selected May 21, 2004 as the grant date, when the price of our stock was $1.62 lower. (As indicated on the table in Item 7—Management’s Discussion and Analysis of Financial Condition and Results of Operations—Restatement of Financial Statements, the Special Committee recommended that the grant be measured as of June 7, 2004 because the grant list had not been completed when the compensation committee members first approved the grant on May 19, 2004.)

Remediation of Material Weaknesses

Remediation of Material Weakness Relating to the Selection and Application of Accounting Policies for Complex and Non-Routine Transactions

The Company is in the process of creating a formal process related to the design and implementation of control over the selection and application of accounting policies for complex, non-routine transactions. This process will include the early identification of complex, non-routine transactions and documentation by the Company’s accounting staff. Regular meetings

37

with accounting staff and executive level officers involved and familiar with accounting issues related to complex, non routine transactions, will be held to review the initial documentation. As required, outside legal and/or accounting advice will be obtained. In addition, the Company is evaluating adding additional accounting resources and making system enhancements in order to shorten its closing process.

Remediation of Material Weakness Relating to Option Grant Practices

Our former Chief Executive Officer, former President/Chief Operating Officer and former Chief Financial Officer were the individuals in senior management primarily responsible for proposing option grants for director approval, selecting grant dates, and overseeing the documentation of the grants. Each of these individuals has left the Company and, in connection with negotiated severance agreements, has agreed to reductions in his or her severance payments substantially commensurate with the excess amounts he or she had earned exercising options over the amounts he or she would have earned had the same options been granted at an exercise price equal to our stock price on the measurement dates determined by the Special Committee. In addition, each of these individuals has agreed that the exercise price for any unexercised options he or she is entitled to retain would be adjusted to reflect the alternative measurement dates.

The Special Committee has also recommended, and the Board of Directors has agreed, that we should improve our procedures relating to the granting of options. Accordingly, the Board of Directors has adopted the following procedures with respect to all future annual option grants:

• All grants will be dated no earlier than the date all required approvals have been obtained and the exercise price for each grant will be set no lower than the closing price of the Company's stock on the grant date. The Company will no longer use “as of” dating for the approval of option grants.

• All annual grants will be approved by the compensation committee, which grants will generally be considered and approved by the compensation committee at a meeting during the first quarter of each calendar year subsequent to the Company publicly reporting financial results for its most recently completed fiscal year. The compensation committee retains discretion to review the Company’s need for other equity grants. Prior to approval, a list identifying the names of grantees and number of options to be granted shall be presented to the compensation committee.

• To the extent the Board of Directors or compensation committee approves option grants at a meeting, minutes will be kept to which shall be appended any list of option grants approved at such meeting.

• To the extent the Board of Directors or compensation committee approves option grants by unanimous written consent, the grant date will be no earlier than the date the last required unanimous written consent is executed. Each committee member must date his or her signature on any such consent to reflect the date of actual signature. Any such consent shall include or have appended to it a list of all grantees and shares awarded to each such grantee.

• A member of the Company's legal and accounting staffs will be consulted regarding, andwill oversee the documentation of and accounting for all stock option grants.

• Any grant, other than an annual grant, made to a “Section 16” officer will be approved by the compensation committee following receipt of a list of proposed grantees.

• Any grant, other than an annual grant, made to employees other than “Section 16” officers may be approved by a single designated board member pursuant to a delegation of authority. Such delegation must include general parameters as to such grants, including the range of options available for grant to particular levels of employees that are hired or promoted. Any grant beyond these parameters will require approval of the compensation committee.

• All new hire grants made to employees other than “Section 16” officers shall be granted effective on the fifteenth (15^th) day of the month following the commencement of such person's employment with the Company, or in the event that such date is not a business day, on the first business day thereafter.

• With respect to all grants, the Company shall maintain records of the list provided to the committee, individual director and/or Board for review and approval. Any changes made to the submitted list shall be made prior to approval and shall be documented.

In addition, the corporate secretarial function will be upgraded so that a central, secure location is established for maintenance of minutes of meetings of the Board and its Committees. Appropriate records will be maintained documenting any actions taken by the Board or its Committees by written consent or pursuant to express delegation. This function will be under the supervision of the person performing the Corporate Secretarial function.

The Board may revise the above procedures from time to time. The Company will also monitor industry and regulatory practices with respect to stock option grants and will revise its procedures in this area to conform to “best practices” to the extent appropriate.

Changes in Internal Control over Financial Reporting

There were no changes in the Company’s internal control over financial reporting identified in connection with the evaluation required by paragraph (d) of Exchange Act Rules 13a-15(e) or 15d-15(e) that was conducted during the last fiscal quarter that have materially affected, or are reasonably likely to materially affect, the Company’s internal control over financial reporting. The changes described above under Remediation of Material Weaknesses have been implemented subsequent to the end of the fiscal period covered by this Amendment No. 1 to the Company’s Annual Report on Form 10-K, and have materially affected the Company’s internal control over financial reporting.

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REPORT OF INDEPENDENT REGISTERED PUBLIC ACCOUNTING FIRM

To the Board of Directors and Stockholders of

Sharper Image Corporation:

We have audited management’s assessment, included in the accompanying “Management’s Annual Report on Internal Control Over Financial Reporting (as Revised)” that Sharper Image Corporation (the “Company”) did not maintain effective internal control over financial reporting as of January 31, 2006, because of the effect of the material weaknesses identified in management’s assessment based on criteria established in Internal Control—Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission. The Company’s management is responsible for maintaining effective internal control over financial reporting and for its assessment of the effectiveness of internal control over financial reporting. Our responsibility is to express an opinion on management’s assessment and an opinion on the effectiveness of the Company’s internal control over financial reporting based on our audit.

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

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

Because of the inherent limitations of internal control over financial reporting, including the possibility of collusion or improper management override of controls, material misstatements due to error or fraud may not be prevented or detected on a timely basis. Also, projections of any evaluation of the effectiveness of the internal control over financial reporting to future periods are subject to the risk that the controls may become inadequate because of changes in conditions, or that the degree of compliance with the policies or procedures may deteriorate.

A material weakness is a significant deficiency, or combination of significant 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. The following material weaknesses have been identified and included in management’s revised assessment: (1) The Company did not design and implement adequate controls over the selection and application of accounting policies for complex, non-routine transactions. As a result, certain audit adjustments to the 2005 financial statements, which were not material individually, but which affected various financial statement line items, were necessary to present the financial statements in accordance with generally accepted accounting principles. These deficiencies were concluded to be a material weakness due to the actual misstatements identified, the potential for additional misstatements, and the lack of other mitigating controls to detect the misstatements. (2) The Company did not have adequate controls over the granting of stock options and the related documentation. These material weaknesses were considered in determining the nature, timing and extent of audit tests applied in our audit of the financial statements of the Company as of and for the year ended January 31, 2006 (as restated), and this report does not affect our reports on such financial statements.

In our opinion, management’s assessment that the Company did not maintain effective internal control over financial reporting as of January 31, 2006, is fairly stated, in all material respects, based on the criteria established in Internal Control—Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission. Also in our opinion, because of the effect of the material weaknesses described above on the achievement of the objectives of the control criteria, the Company has not maintained effective internal control over financial reporting as of January 31, 2006, based on the criteria established in Internal Control—Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission.

39

We have also audited, in accordance with the standards of the Public Company Accounting Oversight Board (United States), the financial statements as of and for the year ended January 31, 2006 (as restated), of the Company and our reports dated May 1, 2006 (March 1, 2007, as to the effects of the restatement discussed in Note B) expressed unqualified opinions on those financial statements.

/s/ DELOITTE & TOUCHE LLP

San Francisco, California

May 1, 2006 (March 1, 2007 as to the effects of the material weakness related to historical option grants)

40

PART IV

ITEM 15. EXHIBITS AND FINANCIAL STATEMENT SCHEDULES

(1) List of Financial Statements.

The following financial statements of Sharper Image Corporation and the related notes thereto are included herein in Part V, Item 8:

Report of Independent Registered Public Accounting Firm	17
Balance Sheets at January 31, 2006 (As Restated) and 2005 (As Restated)	18
Statements of Operations for the years ended January 31, 2006 (As Restated) 2005 (As Restated) and 2004 (As Restated)	19
Statements of Stockholders’ Equity for the years ended January 31, 2006 (As Restated), 2005 (As Restated) and 2004 (As Restated)	20
Statements of Cash Flows for the years ended January 31, 2006 (As Restated), 2005 (As Restated) and 2004 (As Restated)	21
Notes to Financial Statements	22
(2) List of Financial Statement Schedules
Schedule II—Valuation and Qualifying Accounts	43
Report of Independent Registered Accounting Firm on Financial Statement Schedule	44
(3) List of Exhibits

Incorporated herein by reference is a list of the Exhibits contained in the Exhibit Index, which begins on page 43 of this report.

41

SIGNATURES

Pursuant to the requirements of Section 13 or 15(d) of the Securities Exchange Act of 1934, the Registrant has duly caused this Amendment No. 1 to its Annual Report on Form 10-K/A to be signed on its behalf by the undersigned, thereunto duly authorized, in the City of San Francisco, State of California, on the first day of March, 2007.

SHARPER IMAGE CORPORATION		SHARPER IMAGE CORPORATION
By:	/s/ Jerry W. Levin	By:	/s/Daniel W. Nelson
	Jerry W. Levin Interim Chief Executive Officer, Chairman (Principal Executive Officer)		Daniel W. Nelson Senior Vice President Interim Chief Financial Officer (Principal Financial Officer)

42

SHARPER IMAGE CORPORATION

SCHEDULE II—VALUATION AND QUALIFYING ACCOUNTS

(Dollars in thousands)

COLUMN A	COLUMN B		COLUMN C			COLUMN D			COLUMN E
DESCRIPTION	Balance at Beginning of Period		Additions Charged to Costs & Expense			Deductions			Balance at End of Period
ACCOUNTS RECEIVABLE
YEAR ENDED JANUARY 31, 2006:
Allowance for doubtful accounts	$	1,578	$	187		$	667		$	1,098
YEAR ENDED JANUARY 31, 2005:
Allowance for doubtful accounts	$	1,339	$	525		$	286		$	1,578
YEAR ENDED JANUARY 31, 2004:
Allowance for doubtful accounts	$	1,045	$	1,527		$	1,233		$	1,339
SALES
YEAR ENDED JANUARY 31, 2006:
Reserve for refunds	$	19,609	$	79,778		$	82,117		$	17,270
YEAR ENDED JANUARY 31, 2005:
Reserve for refunds	$	17,161	$	82,880	(1)	$	80,432	(1)	$	19,609
YEAR ENDED JANUARY 31, 2004:
Reserve for refunds	$	12,498	$	76,366	(1)	$	71,703	(1)	$	17,161

⁽¹⁾ The 2005 and 2004 additions and deductions for the reserve for refunds have been revised to present activity on a gross basis that was previously presented on a net basis.

43

REPORT OF INDEPENDENT REGISTERED PUBLIC ACCOUNTING FIRM

Board of Directors and Stockholders of

Sharper Image Corporation

We have audited the financial statements of Sharper Image Corporation as of January 31, 2006 and 2005, and for each of the three fiscal years in the period ended January 31, 2006 and have issued our report thereon dated May 1, 2006 (March 1, 2007 as to the effect of the restatement discussed in Note B), (which report expresses an unqualified opinion and includes an explanatory paragraph related to the restatement described in Note B) and we have also audited management’s assessment of the effectiveness of the Company’s internal control over financial reporting as of January 31, 2006, and the effectiveness of the Company’s internal control over financial reporting as of January 31, 2006, and have issued our report thereon dated May 1, 2006 (March 1, 2007 as to the effect of the material weakness related to grants of stock options) (which report expresses an unqualified opinion on management’s assessment of the effectiveness of the Company’s internal control over financial reporting and an adverse opinion on the effectiveness of the Company’s internal control over financial reporting because of material weaknesses); such financial statements and reports are included elsewhere in this Amendment No. 1 on Form 10-K/A. Our audits also included the financial statement schedule of the Company listed in Item 15. This financial statement schedule is the responsibility of the Company’s management. Our responsibility is to express an opinion based on our audits. In our opinion, such financial statement schedule, when considered in relation to the basic financial statements taken as a whole, presents fairly, in all material respects, the information set forth therein.

/s/ DELOITTE & TOUCHE LLP

San Francisco, California

May 1, 2006

44

EXHIBIT INDEX

3.1	Certificate of Incorporation. (Incorporated by reference to Exhibit 3.1 to the Registration Statement on Form S-1 (Registration No. 33-12755)).
3.1.1	Certificate of Amendment of the Restated Certificate of Incorporation, dated as of September 6, 2005 (Incorporated by reference to Exhibit 3.1 to Form 10-Q for the quarter ended July 31, 2005).
3.2	Amended and Restated Bylaws of Sharper Image Corporation as of June 6, 2005 (Incorporated by reference to Exhibit 3.2 to Form 10-Q for the quarter ended April 30, 2005).
3.3	Form of Certificate of Designation of Series A Junior participating Preferred Stock. (Incorporated by reference to Exhibit 3.01 to Amendment No. 2 to the Registration Statement on Form S-2).
4.1	Form of Rights Certificate. (Incorporated by reference to Exhibit 4.01 to Amendment No. 2 to the Registration Statement on Form S-2).
4.2	Form of Rights Agreement dated June 7, 1999. (Incorporated by reference to Exhibit 4.02 to Amendment No. 2 to the Registration Statement on Form S-2).
10.1	Cash or Deferred Profit Sharing Plan, as amended. (Incorporated by reference to Exhibit 10.2 to Registration Statement on Form S-1 (Registration No. 33-12755)).
10.2	Cash or Deferred Profit Sharing Plan Amendment No. 3. (Incorporated by reference to Exhibit 10.15 to Form 10-K for fiscal year ended January 31, 1988).
10.3	Cash or Deferred Profit Sharing Plan Amendment No. 4. (Incorporated by reference to Exhibit 10.16 to Form 10-K for fiscal year ended January 31, 1988).
10.4	Form of Director Indemnification Agreement. (Incorporated by reference to Exhibit 10.42 to the Registration Statement on Form S-1 (Registration No. 33-12755)).
10.5	The Sharper Image 401(K) Savings Plan. (Incorporated by reference to Exhibit 10.21 to the Registration Statement on Form S-8 (Registration No. 33-80504) dated June 21, 1994).
10.6	Officer Non-Qualified Deferred Compensation Plan. (Incorporated by reference to Exhibit 10.27 to Form 10-Q for the quarter ended October 31, 2003).
10.7	Employment Agreement dated October 21, 2002 between the Company and Richard Thalheimer. (Incorporated by reference to Exhibit 10.26 to Form 10-Q for the quarter ended October 31, 2003).
10.8	Loan and Security Agreement dated October 31, 2003 between the Company and Wells Fargo Retail Finance, LLC. (Incorporated by reference to Exhibit 10.1 to Form 10-Q for the quarter ended October 31, 2003).
10.9	Agreement dated October 20, 2003 between the Company and Tracy Y. Wan to extend medical benefits beyond employment term with the Company (Incorporated by reference to Exhibit 10.16 to Form 10-K for the fiscal year ended January 31, 2005).
10.10	Lease Agreement dated May 11, 2004 between the Company and Sri Hills Plaza Venture LLC (Incorporated by reference to Exhibit 10.1 to Form 10-Q for the quarter ended April 30, 2004).
10.11	First Amendment to Loan and Security Agreement dated February 6, 2004, between the Company and Wells Fargo Retail Finance, LLC. (Incorporated by reference to Exhibit 10.1 to Form 10-Q for the quarter ended October 31, 2004).
10.12	Second Amendment to Loan and Security Agreement dated July 6, 2004 between the Company and Wells Fargo Retail Finance, LLC. (Incorporated by reference to Exhibit 10.2 to Form 10-Q for the quarter ended October 31, 2004).
10.13	Form of Indemnification Agreement between the Company and Officers of the Company (Incorporated by reference to Exhibit 10.20 to form 10-K for the fiscal year ended January 31, 2005).
10.14	Third Amendment to Loan and Security Agreement dated February 18, 2005 between the Company and Wells Fargo Retail Finance, LLC. (Incorporated by reference to Exhibit 10.1 to Form 8-K filed February 22, 2005).
10.15	Fourth Amendment to Loan and Security Agreement dated November 1, 2005 between the Company and Wells Fargo Retail Finance, LLC. (Incorporated by reference to Exhibit 10.15 of the Annual Report on Form 10-K filed May 1, 2006)

10.16	Fifth Amendment to Loan and Security Agreement dated February 2, 2006 between the Company and Wells Fargo Retail Finance, LLC. (Incorporated by reference to Exhibit 10.1 to form 8-K filed February 7, 2006).
10.17	Offer letter dated August 18, 2005 between the Company and Jeffrey P. Forgan (Incorporated by reference to Exhibit 10.1 to Form 8-K/A filed August 30, 2005).
23.1	Consent of Independent Registered Public Accounting Firm.
31.1	Certification by Interim Chief Executive Officer pursuant to Rule 13a-14(a) or 15d-14(a), as adopted pursuant to Section 302 of the Sarbanes-Oxley Act of 2002.
31.2	Certification by Interim Chief Financial Officer pursuant to Rule 13a-14(a) or 15d-14(a), as adopted pursuant to Section 302 of the Sarbanes-Oxley Act of 2002.
32.1	Certification by Interim Chief Executive Officer pursuant to Section 906 of the Sarbanes-Oxley Act of 2002.
32.2	Certification by Interim Chief Financial Officer pursuant to Section 906 of the Sarbanes-Oxley Act of 2002.