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UNITED STATES

SECURITIES AND EXCHANGE COMMISSION

Washington, D. C. 20549

FORM 10-Q

For the quarterly period ended March 31, 2005

OR

For the transition period from                      to                     

Commission File Number 001-31396

LeapFrog Enterprises, Inc.

(Exact Name of Registrant, As Specified in its Charter)

6401 Hollis Street, Suite 150, Emeryville, California 94608-1071

(Address of Principal Executive Offices, Including Zip Code)

Registrant’s Telephone Number, Including Area Code: (510) 420-5000

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 whether the registrant is an accelerated filer (as defined in Rule 12b-2 of the Exchange Act). Yes x No ¨

The number of shares of Class A common stock, par value $0.0001, and Class B common stock, par value $0.0001, outstanding as of April 29, 2005, was 34,109,481 and 27,614,263, respectively.

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TABLE OF CONTENTS

Part I

Financial Information

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PART I.

FINANCIAL INFORMATION

LEAPFROG ENTERPRISES, INC.

CONSOLIDATED BALANCE SHEETS

(In thousands, except per share data)

See accompanying notes.

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LEAPFROG ENTERPRISES, INC.

CONSOLIDATED STATEMENTS OF OPERATIONS

(In thousands, except per share data)

(Unaudited)

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LEAPFROG ENTERPRISES, INC.

CONSOLIDATED STATEMENTS OF CASH FLOWS

(In thousands)

(Unaudited)

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LEAPFROG ENTERPRISES, INC.

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

(In thousands, except per share data)

(Unaudited)

The accompanying unaudited consolidated financial statements and related disclosures have been prepared in accordance with accounting principles generally accepted in the United States applicable to interim financial information and with the instructions to Form 10-Q and Rule 10-01 of Regulation S-X. In the opinion of management, all adjustments (which include normal recurring adjustments) considered necessary for a fair presentation of the financial position and interim results of LeapFrog Enterprises, Inc. (the “Company”) as of and for the periods presented have been included. The consolidated financial statements include the accounts of the Company and its wholly owned subsidiaries. All significant intercompany accounts and transactions have been eliminated. Because the Company’s business is seasonal, results for interim periods are not necessarily indicative of those that may be expected for a full year.

Certain amounts in the financial statements for prior periods have been reclassified to conform to the current period’s presentation. In the third quarter of 2004, we changed our disclosure of receivable allowances to include only allowances for doubtful accounts to better conform to the prevailing practice in our industry. All prior period financial statements have been adjusted to conform to the current period’s presentation.

The consolidated balance sheet at December 31, 2004 has been derived from the audited consolidated financial statements at that date, but does not include all of the information and footnotes required by accounting principles generally accepted in the United States for complete financial statements. The financial information included herein should be read in conjunction with the Company’s consolidated financial statements and related notes in its 2004 Annual Report on Form 10-K filed with the Securities and Exchange Commission (“SEC”) on March 29, 2005 (our “2004 Form 10-K”).

The Company generally grants stock options to its employees for a fixed number of shares with an exercise price equal to the fair value of the shares on the date of grant. As allowed under the Statement of Financial Accounting Standards No. 123, “Accounting for Stock-Based Compensation” (“SFAS 123”), the Company has elected to follow Accounting Principles Board Opinion No. 25, “Accounting for Stock Issued to Employees” (“APB 25”) and related interpretations in accounting for stock awards to employees. Accordingly, no compensation expense is recognized in the Company’s financial statements in connection with stock options granted to employees where exercise prices are equal to or greater than fair value. Deferred compensation expense for options granted to employees is determined as the difference between the fair market value of the Company’s common stock on the date options were granted, in excess of the exercise price.

Stock-based compensation arrangements with nonemployees are accounted for in accordance with SFAS 123 and EITF No. 96-18, “Accounting for Equity Instruments that Are Issued to Other than Employees for Acquiring, or in Conjunction with Selling Goods or Services,” using a fair value approach. The compensation costs of these arrangements are subject to remeasurement over the vesting terms as earned.

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LEAPFROG ENTERPRISES, INC.

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

(In thousands, except per share data)

(Unaudited)

For purposes of disclosures pursuant to SFAS 123, as amended by SFAS 148, “Accounting for Stock-Based Compensation—Transition and Disclosure,” the estimated fair value of options is amortized over the options’ vesting periods. The following table illustrates the effect on net loss and net loss per common share if we had applied the fair value recognition provisions of SFAS 123 to stock-based employee compensation:

In December 2004, the FASB issued SFAS No. 123R, “Share-Based Payment.” SFAS No. 123R requires employee stock options and rights to purchase shares under stock participation plans to be accounted for under the fair value method, and eliminates the ability to account for these instruments under the intrinsic value method prescribed by APB Opinion No. 25, and allowed under the original provisions of SFAS No. 123. SFAS No. 123R requires the use of an option pricing model for estimating fair value, which is amortized to expense over the service periods. SFAS No. 123R allows for either prospective recognition of compensation expense or retrospective recognition, which may be back to the original issuance of SFAS No. 123 or only to interim periods in the year of adoption.

On April 14, 2005, the SEC announced that it would provide a phased-in implementation process for SFAS No.123R. The SEC requires that registrants which are not small business issuers adopt Statement 123R’s fair value method of accounting for share-based payments to employees no later than the beginning of the first fiscal year beginning after June 15, 2005. We are currently determining the impact that the proposed statement will have on our results of operations and financial position for 2005 and beyond. The Company plans to implement this pronouncement for fiscal year 2006 and is currently evaluating transition methods.

Cash and cash equivalents consist of cash, money market funds, and highly liquid short-term fixed income municipal securities with an original maturity of 90 days or less. Concentration of credit risk is limited by diversifying investments among a variety of high credit-quality issuers.

The Company classifies all investments as available-for-sale. Available-for-sale securities are carried at estimated fair value, based on available market information, with unrealized gains and losses, if any, reported as a component of stockholders’ equity. Short-term investments consist primarily of fixed-income municipal securities auction rate municipal securities, and auction rate preferred securities that are highly liquid in nature and represent the investment of cash that is available for current operations. Long-term investments consist of municipal bonds with greater than one-year maturities. At March 31, 2005, the Company had $3,730 in long-term investments, and no long-term investments at March 31, 2004. At December 31, 2004, the Company had $3,737 in long-term investments. These long-term investments are included in “Other assets” in our consolidated balance sheet.

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LEAPFROG ENTERPRISES, INC.

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

(In thousands, except per share data)

(Unaudited)

The cost of securities sold is based on the specific identification method. Concentration of credit risk is limited by diversifying investments among a variety of high credit-quality issuers. At March 31, 2005, March 31, 2004 and December 31, 2004 the carrying value of these securities approximated their fair value.

The Company did not have any remaining restricted cash at March 31, 2005. Restricted cash at December 31, 2004, consisted of cash used to collateralize irrevocable standby letters of credit to several of our contract manufacturers and one technology partner. The standby letters of credit guaranteed performance of the obligations of certain of our foreign subsidiaries to pay for trade payables and contractual obligations. The associated letters of credit were cancelled in the three months ended March 31, 2005, and the cash collateral classified in “restricted cash” in the Company’s consolidated balance sheet at December 31, 2004 was released.

Inventories consist of the following:

Valuation of work in process inventory is an estimation of the Company’s liability to its contract manufacturers for products in production at the end of each fiscal period. This estimation is based upon normal production lead-times for products the Company has scheduled to receive in subsequent periods, plus a valuation of products it specifically knows are either completed or delayed in production beyond the normal lead-time flow.

In January 2004, the Company entered into a ten-year technology license agreement with a third party to jointly develop and customize our respective technologies to be combined in a platform and related licensed products. The agreement calls for license fee payments totaling $6,000, of which $5,000 was paid in 2004 and $1,000 was paid during the quarter ended March 31, 2005. This license fee is included in intangible assets on the consolidated balance sheet and is being amortized on a straight-line basis over the life of the contract.

Comprehensive loss is comprised of net loss and currency translation adjustment.

The Company’s effective tax rate was 29.5% for the three months ended March 31, 2005 and 34.3% for the same period in 2004. The lower effective tax rate in 2005 was primarily due to the benefits resulting from the changes in our international sourcing operations.

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LEAPFROG ENTERPRISES, INC.

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

(In thousands, except per share data)

(Unaudited)

The Company transacts business in various foreign currencies, primarily in the British Pound, Canadian Dollar and Euros. In order to protect itself against reductions in the value and volatility of future cash flows caused by changes in currency exchange rates, the Company implemented a foreign exchange hedging program for its transaction exposure on January 9, 2004. The program utilizes foreign exchange forward contracts to hedge foreign currency exposures of underlying non-functional currency monetary assets and liabilities that are subject to remeasurement. The exposures are generated primarily through intercompany sales in foreign currencies. The hedging program reduces, but does not always eliminate, the impact of the remeasurement of balance sheet items due to movements of currency exchange rates.

The Company does not use forward exchange hedging contracts for speculative or trading purposes. All forward contracts are carried on the balance sheet as assets or liabilities and the contract’s corresponding gains and losses are recognized immediately in earnings to offset the changes in fair value of the assets or liabilities being hedged. These gains and losses are included in “Other income (expense), net” on the consolidated statement of operations.

The Company realized net gains of $130 and $863 for the three months ended March 31, 2005 and March 31, 2004, respectively, related to its foreign currency exposure and hedging contracts.

At March 31, 2005, the Company had outstanding foreign exchange forward contracts, all with maturities of approximately one month, to purchase and sell approximately $19,500 in foreign currencies, including British Pounds, Canadian Dollars, Euros and Mexican Pesos. At March 31, 2005, the fair value of these contracts was not significant. The counterparties to these contracts are substantial and creditworthy multinational commercial banks. The risks of counterparty nonperformance associated with these contracts are not considered to be material. Notwithstanding the Company’s efforts to manage foreign exchange risk, there can be no assurances that its hedging activities will adequately protect against the risks associated with foreign currency fluctuations.

The Company follows the provisions of SFAS No. 128, Earnings Per Share (“SFAS 128”), which requires the presentation of basic net income (loss) per common share and diluted net income (loss) per common share. Basic net income (loss) per common share excludes any dilutive effects of options, warrants and convertible securities.

The following table sets forth the computation of basic and diluted net loss per share:

If the Company had reported net income for the three months ended March 31, 2005 and March 31, 2004, the calculations of diluted net income per Class A and B share would have included as of March 31, 2005 and March 31, 2004 additional common equivalent shares of 537 and 2,157, respectively, related to outstanding stock options and unvested stock (determined using the treasury stock method).

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LEAPFROG ENTERPRISES, INC.

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

(In thousands, except per share data)

(Unaudited)

The Company’s reportable segments include U.S. Consumer, International and Education and Training.

The U.S. Consumer segment includes the design, production and marketing of technology-based educational toys and books, sold primarily through U.S. retail channels. In the International segment, the Company designs, markets and sells products for sale mainly through retail channels in non-U.S. markets. The Education and Training segment includes the SchoolHouse division, which designs, produces and markets educational instructional materials sold primarily to pre-kindergarten through 8^th grade school systems. The Education and Training segment also designs, produces and markets adult learning products.

Due to the seasonal nature of our business, the first quarter sales trend and product mix is not necessarily indicative of our expected full year results.

In March 2005, the Company renewed the lease for its corporate headquarters in Emeryville, California. The new lease is retroactive to January 1, 2005 and expires March 31, 2015. The Company’s minimum lease obligations over the term of the lease are $20,000.

LeapFrog Enterprises, Inc. v. Fisher-Price, Inc. and Mattel, Inc.

In October 2003, the Company filed a complaint in the federal district court of Delaware against Fisher-Price, Inc., No. 03-927 GMS, alleging that the Fisher-Price PowerTouch learning system violates United States Patent No. 5,813,861.

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LEAPFROG ENTERPRISES, INC.

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

(In thousands, except per share data)

(Unaudited)

In September 2004, Mattel, Inc. was joined as a defendant. The Company is seeking damages and injunctive relief. Trial by jury is set for May 16, 2005.

LeapFrog Enterprises, Inc. v. Lexington Insurance Co.

On October 21, 2004, the Company filed a complaint in the Superior Court of the State of California, County of Alameda, against Lexington Insurance Co., No. RG04181463, alleging breach of contract and bad faith in denying the Company coverage for the Company’s costs with respect to patent infringement claims filed against the Company in three prior litigations. The Company is seeking approximately $3.5 million in damages to recover the Company’s defense fees and indemnity payments.

In re LeapFrog Enterprises, Inc. Derivative Litigation

In July 2004, the Superior Court of the State of California, County of Alameda, granted the Company’s motion to dismiss with prejudice the consolidated derivative lawsuit, denying plaintiffs’ leave to amend the complaint, and entered final judgment in the action in favor of the Company and the individual officers and directors. In September 2004, the plaintiffs have appealed the dismissal. The dismissed derivative lawsuit was a consolidation of the Santos v. Michael Wood, et al. complaint, filed in December 2003, and a complaint captioned Capovilla v. Michael Wood, et al ., filed in March 2004. Both complaints alleged causes of action for breach of fiduciary duty, abuse of control, gross mismanagement, waste of corporate assets, unjust enrichment and violations of the California Corporations Code, based upon allegations that certain of the Company’s officers and directors issued or caused to be issued alleged false statements and allegedly sold portions of their stock holdings while in the possession of adverse, non-public information. In April 2004, the Superior Court consolidated both the Santos and Capovilla actions into a single action captioned In re LeapFrog Enterprises, Inc. Derivative Litigation, No. RG03130947.

Stockholder Class Action

On December 2, 2003, a class action complaint entitled Miller v. LeapFrog Enterprises, Inc., et al. , No. 03-5421 RMW, was filed in federal district court for the Northern District of California against the Company and certain of its current and former officers and directors alleging violations of the Securities Exchange Act of 1934, or 1934 Act. Subsequently, three similar actions were filed in the same court: Weil v. LeapFrog Enterprises, Inc., et al. , No. 03-5481 MJJ; Abrams v. LeapFrog Enterprises Inc., et al. , No. 03-5486 MJJ; and Ornelas v. LeapFrog Enterprises, Inc., et al., No. 03-5593 SBA. Each of those complaints purports to be a class action lawsuit brought on behalf of persons who acquired the Company’s Class A common stock during the period of July 24, 2003 through October 21, 2003. On February 18, 2004, the plaintiff in the Weil action amended her complaint and now seeks to maintain a class action on behalf of persons who acquired the Company’s Class A common stock during the period of July 24, 2003 through February 10, 2004. All of the complaints allege that the defendants caused the Company to make false and misleading statements about the Company’s business and forecasts about the Company’s financial performance, and that certain of its individual officers and directors sold portions of their stock holdings while in the possession of adverse, non-public information. The Weil complaint also alleges that the Company’s financial statements were false and misleading. The complaints do not specify the amount of damages sought. The court has not yet appointed a lead class plaintiff, and a consolidated complaint has not been filed. Discovery has not commenced and no trial date has been set. The Company anticipates that all of the actions will ultimately be consolidated into one action and that a consolidated amended complaint will be filed after the appointment of a lead plaintiff.

On April 25, 2005, a class action complaint entitled The Parnassus Fund et al. v. LeapFrog Enterprises, Inc., et al., No. 05-01695 JSW, was filed in federal district court for the Northern District of California against the Company, its current CEO and former CFO alleging violations of the Securities Exchange Act of 1934. The complaint purports to be a class action lawsuit brought on behalf of persons who acquired LeapFrog securities during the period of February 11, 2004 through October 18, 2004. The complaint alleges that the defendants caused the Company to make false and misleading statements about its business, operations, management and value of its common stock, which allowed insiders to sell the Company’s common stock at artificially inflated prices and which caused plaintiffs to purchase the Company’s common stock at artificially inflated prices. The complaint does not specify the amount of damages sought. The Company has not yet responded to the complaint, discovery has not commenced, and no trial date has been established.

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FORWARD-LOOKING STATEMENTS

The following discussion and analysis should be read with our financial statements and notes included elsewhere in this quarterly report on Form 10-Q. This report contains “forward-looking statements” within the meaning of the Private Securities Litigation Reform Act of 1995. These statements may be identified by the use of forward-looking words or phrases such as “anticipate,” “believe,” “could,” “expect,” “intend,” “may,” “plan,” “potential,” “should,” “will,” and “would” or any variations of words with similar meanings. These forward-looking statements relate to future events or our future financial performance and involve known and unknown risks, uncertainties and other factors that may cause our actual results, levels of activity, performance or achievements to differ materially from any future results, levels of activity, performance or achievements expressed or implied by these forward-looking statements. Specific factors that might cause such a difference include, but are not limited to, risks and uncertainties discussed in this report, including those discussed under the heading “Risk Factors That May Affect Our Results and Stock Price” and those that are or may be discussed from time to time in our public announcements and filings with the SEC, such as in our 2004 Form 10-K, under the heading “Management’s Discussion and Analysis of Financial Condition and Results of Operations” and our future Forms 8-K, 10-Q and 10-K. We undertake no obligation to revise the forward-looking statements contained in this quarterly report on Form 10-Q to reflect events or circumstances occurring after the date of the filing of this report.

OVERVIEW

We design, develop and market technology-based educational platforms, related interactive content research-based curriculum, and stand-alone products for sale to retailers, distributors and schools. We operate three business segments, which we refer to as U.S. Consumer, International, and Education and Training. To date, we have sold our products predominantly through the toy sections of major retailers and to educational institutions. For further information regarding our three business segments, see Note 23 to our consolidated financial statements contained in our 2004 Form 10-K.

LeapFrog’s mission is to become the leading brand for quality, technology-based educational products for home, school and work for all ages around the world. We believe that LeapFrog is in the early stage of accomplishing this mission. To date, we have established our brand and products largely focused on infants, toddlers, and children in preschool through grade school and primarily in the U.S. retail market. We believe that LeapFrog is, first and foremost, an educational products company, and we use the toy form and price points to make learning fun and cost-effective. As a result, our sales in our U.S. Consumer and International segments, our largest business segments, currently are generated in the toy aisles of retailers. The market for toy retailers has seen, and continues to see consolidation. In addition to the traditional channel of specialty toy retailers, of which Toys “R” Us has become the major player, the mass-market retail channel has grown in importance. For example, Wal-Mart, Target and a number of regional mass-market retailers have seen growth in their market shares within the U.S. toy retail market. The mass-market retailers have certain competitive advantages in the highly seasonal toy market because they have the ability to dedicate a significant amount of shelf space to toys during the fall holiday season, and then reduce the allocated shelf space for toys during the rest of the year. In addition, these mass-market retailers have greater financial resources and lower operating expenses than traditional specialty toy retailers and have driven down pricing and reduced profit margins for us and other players in the retail toy industry. We anticipate that the toy industry’s dependence on mass-market retailers will continue to grow.

Partially as a result of the influence of the mass-market retailers, Toys “R” Us recently conducted a strategic evaluation of its worldwide assets, and in March 2005 entered into an agreement to be acquired by a private investment group. This change in ownership may result in the closure of several Toys “R” Us stores and a reduction in the number of products that Toys “R” Us purchases from us.

Our Education and Training segment, which is represented almost entirely by our SchoolHouse division, currently targets the pre-kindergarten through 8^th grade school market in the United States, including sales directly to educational institutions, to teacher supply stores and through catalogs aimed at educators. We believe that our SchoolHouse business will continue to grow as a result of the federal funding available for U.S. schools to purchase our products, the growing emphasis in the United States for formative assessments in schools in order to address the needs of students not performing at grade level, the need for early intervention and English Language Development solutions, and the increased focus on teacher quality and the need for professional development. In addition, as we continue to invest in the business, we intend to leverage economies of scale and increased expertise of our sales team, particularly with our growing installed base of SchoolHouse customers.

LeapFrog Realignment Plan

As disclosed in our 2004 Form 10-K, in the first quarter of 2005, we announced a three-pronged company-wide realignment initiative designed to address the following objectives:

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The following is an update on our progress with respect to each prong of our realignment initiative.

Restoring profitability.

We announced in February that we would reduce our workforce by over 180 people in our U.S. Consumer and International segments. We are currently on track with our headcount reduction plans. Under these plans, as of March 31, 2005, nearly 90 persons had left LeapFrog, with another 90 persons to phase out their employment over the next several months. The financial benefit of these headcount reductions will start to be realized in the second quarter of 2005, but we will not realize the full benefit of our workforce reduction until later in the year. These cost savings achieved in our realignment plan will mitigate investments we are making behind growth in our SchoolHouse division, information technology and marketing of new growth initiatives, such as the FLY pentop computer.

Strengthening our infrastructure and business processes.

Over the last several years, we have evolved from a small, focused, entrepreneurial organization, to a complex, global educational product company. We are aggressively taking action to make sure the right people and processes are in place for the future. We have strengthened our executive team through the hiring of a new Chief Information Officer in February and a new Senior Vice President of Supply Chain and Operations in April 2005. We also made improvements in our planning processes and are seeking to improve our service levels to our retail customers this fall. Further, we have installed an integrated strategic planning process driven at the senior levels of the organization and accompanied by additional metrics and controls and monthly operating reviews. That said, there remains work to be completed and actions to be taken to continue strengthening our infrastructure and business processes.

Generating growth.

We continue to prepare for the launch of our FLY pentop computer in fall 2005, and we are planning to capitalize on the success of our Leapster handheld by launching our Leapster L-MAX system, which is our first entry into the television-based entertainment and education platform market, in the second half of 2005. In the first quarter, we ran our “Titles for Teachers” campaign, our first consumer advertising that emphasized the strength of our products in schools as well as leveraged the popularity of our brand at retail.

Critical Accounting Policies, Judgments and Estimates

Our management’s discussion and analysis of our financial condition and results of operations is based upon our consolidated financial statements, which have been prepared in accordance with accounting principles generally accepted in the United States. The preparation of these financial statements requires us to make estimates and judgments that affect the reported amounts of assets, liabilities, revenues, expenses and reported disclosures. On an on-going basis, we evaluate our estimates, including those related to revenue recognition, allowances for accounts receivable, inventories and related allowances, intangible assets, stock-based compensation and income taxes. We base our estimates on historical experience and on various other assumptions we believe are reasonable under the circumstances, the results of which form the basis for making judgments about the carrying values of assets and liabilities that are not readily apparent from other sources. Actual results may differ from these estimates under different assumptions or conditions.

Our significant accounting policies are more fully described in Note 2 to our consolidated financial statements included in our 2004 Form 10-K. However, some of our accounting policies are particularly important to the portrayal of our financial position and results of operations and require the application of significant judgment by our management. We believe the following critical accounting policies are the most significant in affecting judgments and estimates used in the preparation of our consolidated financial statements.

Revenue Recognition

We recognize revenue upon shipment of our products provided that there are no significant post-delivery obligations to the customer and collection is reasonably assured. Net sales represent gross sales less negotiated price allowances based primarily on volume purchasing levels, estimated returns, allowances for defective products, markdowns, and other sales allowances. A small portion of our revenue related to training, subscriptions and our Mind Station product, is deferred and recognized as revenue over a period of one to 18 months. Deferred revenue represented less than 1% of our net sales in each of the first quarters ended March 31, 2005 and March 31, 2004.

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Allowances for Accounts Receivable

We reduce accounts receivable by an allowance for amounts we believe will become uncollectible. This allowance is an estimate based primarily on our management’s evaluation of the customer’s financial condition, past collection history and aging of the receivable. If the financial condition of any of our customers deteriorates, resulting in impairment of its ability to make payments, additional allowances may be required.

We provide estimated allowances for product returns, charge backs, promotions and defectives on product sales in the same period that we record the related revenue. We estimate our allowances by utilizing historical information for existing products. For new products, we estimate our allowances for product returns on specific terms for product returns and our experience with similar products. In estimating returns, we analyze (i) historical returns and sales patterns, (ii) analysis of credit memo data, (iii) current inventory on hand at customers, (iv) changes in demand, and (v) introduction of new products. We continually assess our historical experience and adjust our allowances as appropriate, and consider other known factors. If actual product returns, charge backs, promotions and defective products are greater than our estimates, additional allowances may be required. Historically, our estimated reserves for accounts receivables, returns, charge backs, promotions and defectives have been adequate to cover actual charges.

In the third quarter of 2004, we changed our disclosure of receivable allowances to include only allowances for doubtful accounts to better conform to the prevailing practice in our industry. Our other receivable allowances include allowances for product returns, charge backs, defective products and promotional markdowns. These other allowances totaled $30.7 million at March 31, 2005 and $13.7 million at March 31, 2004. These allowances are now treated as reductions of gross accounts receivable. All prior period financial statements have been adjusted to conform to the current period’s presentation.

Inventories and Related Allowance For Slow-Moving, Excess and Obsolete Inventory

Inventories are stated at the lower of cost, on a first-in, first-out basis, or market value and are reduced by an allowance for slow-moving, excess and obsolete inventories. Our estimate for slow-moving, excess and obsolete inventories is based on our management’s review of on-hand inventories compared to their estimated future usage and demand for our products. If actual future usage and demand for our products are less favorable than those projected by our management, additional inventory write-downs may be required. Reserves for excess and obsolete inventory were $19.0 million and $3.7 million during the quarter ended March 31, 2005 and March 31, 2004, respectively.

Intangible Assets

Intangible assets, including excess purchase price over the cost of net assets acquired (Goodwill), arose from our September 23, 1997 acquisition of substantially all the assets and business of our predecessor, LeapFrog RBT, and our acquisition of substantially all the assets of Explore Technologies on July 22, 1998. At March 31, 2005, our intangible assets had a net balance of $29.0 million. The Financial Accounting Standards Board issued Statement of Financial Accounting Standards No. 142, “Goodwill and Other Intangible Assets” (SFAS 142). SFAS 142 requires the use of a nonamortization approach to account for goodwill and some other intangible assets. We adopted the pronouncement effective January 1, 2002, and accordingly we no longer amortize goodwill and other indefinite-lived intangible assets. As of March 31, 2005, we had $19.5 million, net of goodwill and other indefinite-lived intangible assets that are no longer subject to amortization. At December 31, 2004, we tested our goodwill and other intangible assets for impairment based on the fair value of the cash flows that the business could be expected to generate in the future, known as the income approach. Based on this assessment we determined that no adjustments were necessary to the stated values. Intangible assets also include patents, and trademarks and licenses, which include a ten-year technology license agreement entered into in January 2004 to jointly develop and customize our optical scanning technology.

The determination of related useful lives and whether the intangible assets are impaired involves significant judgment. Changes in strategy or market conditions could significantly impact these judgments and require that adjustments be recorded to asset balances. We review intangible assets, as well as other long-lived assets, for impairment whenever events or circumstances indicate that the carrying value may not be fully recoverable.

Content Development, Home Video Production and Tooling Capitalization

Our management is required to use its judgment in determining whether development costs meet the criteria for immediate expense or capitalization.

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We capitalize the prepublication costs of books as content development costs. Only costs incurred with outside parties are capitalized. At March 31, 2005, the capitalized content development balance was $11.5 million, of which $8.3 million pertained to our Education and Training segment. At March 31, 2004, the capitalized content development balance was $11.0 million, of which $8.2 million pertained to our Education and Training segment. We amortize these assets from the time of publication over their estimated useful lives, which we estimated to be three years, using the sum of year’s digits method. If the related content is deemed to have a shorter useful life, the remaining balance is written off over a shorter period of time or when the content is no longer used in production.

We capitalize costs related to the production of home video in accordance with AICPA Statement of Accounting Position No 00-2, “Accounting by Producers or Distributors of Film.” Video production costs are amortized based on the ratio of the current period’s gross revenues to estimated remaining total gross revenues from all sources on an individual production basis. At March 31, 2005 and March 31, 2004, the capitalized video production balance was $2.5 million and $1.2 million, respectively. If the related video production costs are deemed to have lower gross revenues than originally expected, the remaining balance is written off when the revised revenues are earned.

Amortization of content development costs and video production are classified as “cost of sales” in our consolidated statements of operations.

We capitalize costs related to manufacturing tools developed for our products. At March 31, 2005 and March 31, 2004, the capitalized manufacturing tools balance was $22.9 million and $17.6 million, respectively. We depreciate these assets on a straight-line basis, in cost of sales, over an estimated useful life of two years. If the related product line or our manufacturing production results in a shorter life than originally expected, we write-off the remaining balance when we remove the tool from production.

Stock-Based Compensation

We account for employee stock options using the intrinsic value method in accordance with Accounting Principles Board Opinion No. 25, “Accounting for Stock Issued to Employees,” or APB 25, whereby compensation is generally not recorded for options granted at fair value to employees and directors.

In connection with stock options granted to employees in August 2001, we recorded an aggregate of $3.3 million of deferred compensation in stockholders’ equity for the year ended December 31, 2001. These options were considered compensatory because the deemed fair value of the underlying shares of Class A common stock in August 2001, as subsequently determined, was greater than the exercise price of the options. In accordance with APB 25, this deferred compensation will be amortized to expense through the second quarter of 2005 as the options vest. As of March 31, 2005, $2,000 remained to be amortized to expense.

Stock-based compensation arrangements to non-employees are accounted for in accordance with SFAS 123, “Accounting for Stock-Based Compensation,” and EITF No. 96-18, “Accounting for Equity Instruments that Are Issued to Other than Employees for Acquiring, or in Conjunction with Selling Goods or Services,” using a fair value approach. The compensation costs of these arrangements are subject to re-measurement over the vesting terms as earned.

In 2004, Mr. Kalinske, our Chief Executive Officer, entered into a new employment agreement providing for, among other things, acceleration of vesting and extension of the exercise period of his stock options upon the termination of his employment by LeapFrog without cause or by Mr. Kalinske for good reason (as defined in the agreement) or a change in control of LeapFrog during the term of the applicable agreement. Under applicable accounting principles, upon any termination of employment or change in control resulting in such acceleration or extension, we would be required to recognize compensation expense. The amount of any such compensation expense would depend on the number of option shares affected by the acceleration or extension and could be material to our financial results.

Prior to our July 2002 initial public offering, we granted stock appreciation rights under our Amended and Restated Employee Equity Participation Plan that are measured at each period end against the fair value of the Class A common stock at that time. The resulting difference between periods is recognized as expense at each period-end measurement date based on the vesting of the rights. Concurrent with the initial public offering of our Class A common stock, we stopped granting stock appreciation rights under our Employee Equity Participation Plan.

In February 2002, we converted 337,500 stock appreciation rights into options to purchase an aggregate of 337,500 shares of Class A common stock. Deferred compensation of approximately $0.9 million related to the unvested portion was amortized to expense as the options vested. As of March 31, 2005, this expense was fully amortized.

In July 2002, we converted all 1,585,580 stock appreciation rights into options to purchase an aggregate of 1,585,580 shares of Class A common stock. The expense related to the conversion of the vested stock appreciation rights was $1.5 million through July 2002 based on vested rights with respect to 192,361 shares of Class A common stock

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outstanding as of July 25, 2002 at our initial public offering price of $13.00 per share. Our deferred compensation expense in connection with the conversion of 1,310,594 unvested stock appreciation rights held by employees to options to purchase 1,310,594 shares of Class A common stock was $4.0 million. In accordance with generally accepted accounting principles, beginning in the third quarter of 2002 and for the subsequent 16 quarters, we will recognize this expense over the remaining vesting period of the options into which the unvested rights are converted. Deferred compensation related to the unvested portion will be amortized to expense as the options vest. To the extent any of the unvested options are forfeited, our actual expense recognized could be lower than currently anticipated. As of March 31, 2005, $0.3 million remained to be amortized to expense.

Income Taxes

We account for income taxes using the liability method. Under this method, deferred tax assets and liabilities are determined based on differences between financial reporting and tax bases of assets and liabilities and are measured using enacted tax rates and laws that will be in effect when the differences are expected to reverse.

Our tax provision includes sufficient accruals for possible future assessments that may result from the examination of federal, state, or international tax returns. Our tax contingency accruals may be adjusted if there are changes in circumstances, such as changes in tax law, tax audits, or other factors, which may cause management to revise its estimates. The amounts ultimately paid on any possible future assessments may differ from the amounts accrued and may result in an increase or reduction to the effective tax rate in the year of resolution.

RESULTS OF OPERATIONS

The following table sets forth selected information concerning our results of operations as a percentage of consolidated net sales for the periods indicated:

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Net Sales

Net sales increased by $0.3 million, or 0.3%, from $71.6 million in the three months ended March 31, 2004 to $71.9 million in the three months ended March 31, 2005. On a constant currency basis, which assumes that the foreign currency rates were the same in the first quarter of 2005 as in the same period of 2004, our net sales decreased by 0.4%. Net sales mix continues to become more weighted toward our International and Education and Training segments.

Net sales for each segment, in dollars and as a percentage of total company net sales, were as follows:

U.S. Consumer. Our U.S. Consumer segment’s net sales decreased by $2.2 million, or 5%, from $46.5 million in the three months ended March 31, 2004 to $44.3 million in the three months ended March 31, 2005. Due to the seasonal nature of our business, the first quarter sales trend and product mix are not necessarily indicative of our expected full year results.

Net sales of platform, software and stand-alone products in dollars and as a percentage of the segment’s net sales were as follows:

The net sales decrease in the U.S. Consumer segment in the three months ended March 31, 2005 compared to the same period in 2004 was a result of the following factors:

We believe our competitive and retail environment will remain challenging in 2005. We also anticipate that the challenges in implementing new supply chain initiatives will continue into the second quarter of 2005. We recently hired a new Chief Information Officer and Senior Vice President of Supply Chain and Operations to lead the teams executing our realignment initiatives. We are working on new sales and marketing programs in our U.S. Consumer segment designed to revitalize our LeapPad business. In addition, a number of platforms, such as our FLY pentop computer and our Leapster L-MAX handheld for television-based learning, are expected to be introduced in fall 2005.

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International. Our International segment’s net sales increased by $1.5 million, or 9%, from $16.0 million in the three months ended March 31, 2004 to $17.5 million in the three months ended March 31, 2005. The increase in international net sales is the result of our continuing efforts to establish business and promote our products in various international locations. The net sales increase in this segment was primarily due to:

While we expect lower growth rates in 2005 than we experienced in 2004, we anticipate the positive sales trend in our International segment overall to continue through the end of 2005, as we localize and launch even more learning products into our international markets. The Leapster handheld, the LeapPad Plus Writing platform and the LittleTouch LeapPad platform were introduced into many of our international markets in the second half of 2004. However, in the United Kingdom and Canada, the rate of growth has slowed, reflecting the maturing of these businesses.

Education and Training. Our Education and Training segment’s net sales increased by $1.0 million, or 10%, from $9.1 million in the three months ended March 31, 2004 to $10.1 million in the three months ended March 31, 2005. Our Education and Training segment’s net sales increase was a result of the following factors:

We expect the net sales increase trend in this segment to continue as we expand our reach of the LeapFrog brand in schools across the United States through organic growth and possible strategic transactions.

Gross Profit

Gross profit for each segment and the related percentage of each segment’s net sales were as follows:

U.S. Consumer. The 11.3 percentage point decrease in our gross profit margin in our U.S. Consumer segment for the three months ended March 31, 2005 compared to the same period in 2004 was primarily due to:

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We anticipate the lower gross profit margin for our U.S. Consumer segment compared to 2004 to continue into the second quarter of 2005, primarily due to product mix issues, such as lower sales of higher margin products, and to a lesser degree the higher distribution center cost structure and expenses noted above.

International. The 1.1 percentage point decline in gross profit margin in our International segment for the three months ended March 31, 2005 compared to the same period in 2004, was primarily due to a change in product mix resulting from the sales of an increased volume of lower margin platforms and higher warehousing and freight costs.

Education and Training. The 7.3 percentage point increase in our Education and Training segment’s gross profit margin for the three months ended March 31, 2005 compared to the same period in 2004, was primarily due to increased net sales leverage achieved as the segment’s fixed expenses represent a lower percentage of those sales.

Selling, General and Administrative Expenses

Selling, general and administrative expenses for each of our segments and the related percentage of each segment’s net sales were as follows:

As we do not allocate indirect selling, general and administrative expenses from our U.S. Consumer segment to our other segments, the selling, general and administrative expenses attributed to our U.S. Consumer segment includes indirect selling, general and administrative expenses attributable to our International and Education and Training segments.

The $6.4 million increase in selling, general and administrative expenses was primarily due to:

We anticipate financial benefits from our cost reduction strategies will be more evident in late 2005, as severance expenses associated with the termination of employees are offset by savings in salary expense in early 2005. We anticipate selling and administrative expenses to fall in dollars and as a percentage of sales in the latter part of 2005, as we continue to implement our cost reduction strategies.

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Research and Development Expenses

Research and development expenses for each of our segments and the related percentage of each segment’s net sales were as follows: