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UNITED STATES

SECURITIES AND EXCHANGE COMMISSION

Washington, D.C. 20549

FORM 10-K

For the fiscal year ended April 30, 2005

or

For the transition period from              to             

Commission file number 1-7923

HANDLEMAN COMPANY

(Exact name of registrant as specified in its charter)

248-362-4400

(Registrant’s telephone number, including area code)

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

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

NONE

(Title of Class)

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 at least the past 90 days.    YES  x    NO  ¨

Indicate by check mark if disclosure of delinquent filers pursuant to Item 405 of Regulation S-K (§229.405 of this chapter) is not contained herein, and will not be contained, to the best of registrant’s knowledge, in definitive proxy or information statements incorporated by reference in Part III of this Form 10-K or any amendment to this Form 10-K.  ¨

Indicate by check mark whether the registrant is an accelerated filer (as defined in Rule 12b-2 of the Act).    YES  x    NO  ¨

State the aggregate market value of the voting and non-voting common equity held by non-affiliates computed by reference to the price at which the common equity was last sold, or the average bid and asked price of such common equity, as of the last business day of the registrant’s most recently completed second fiscal quarter. The aggregate market value as of October 30, 2004 was $473,505,000.

Indicate the number of shares outstanding of each of the registrant’s classes of common stock, as of the latest practicable date. The number of shares of common stock outstanding as of June 17, 2005 was 21,445,906.

DOCUMENTS INCORPORATED BY REFERENCE

Certain sections of the definitive Proxy Statement to be filed for the 2005 Annual Meeting of Shareholders are incorporated by reference into Part III.

PART I

Handleman Company, a Michigan corporation (herein referred to as the “Company” or “Handleman” or “Registrant”), which has its executive offices in Troy, Michigan, is the successor to a proprietorship formed in 1934, and to a partnership formed in 1937.

Copies of the Forms 10-K, Forms 10-Q, Forms 8-K and all amendments to those reports are available, as soon as reasonably practicable after said material is electronically filed with or furnished to the Securities and Exchange Commission, free of charge on the Registrant’s website, www.handleman.com. The Company’s Code of Business Conduct and Ethics (“Code”) is also available on the Company’s website, as well as any changes to or waivers from the Code. The Company’s Audit Committee Charter, Compensation Committee Charter, Corporate Governance and Nominating Committee Charter, and Corporate Governance Guidelines are also available on the website. Written requests for copies of these materials may be directed to Investor Relations at the Company’s executive offices.

DESCRIPTION OF BUSINESS:

The Company is a category manager and distributor of pre-recorded music to mass merchants in the United States (“U.S.”), United Kingdom (“UK”) and Canada; and provides category management services only in Brazil and Argentina. As a category manager, the Company manages a broad assortment of titles required to optimize sales in retail stores and provides direct-to-store shipments, marketing of the selections, in-store merchandising and product exchange. Handleman Company had previously operated in two business segments: category management and distribution operations, formerly known as Handleman Entertainment Resources (“H.E.R.”) and proprietary operations, formerly known as North Coast Entertainment (“NCE”). The Company’s proprietary operations included licensing and manufacture of proprietary and public domain music and video product. During the second quarter of fiscal 2004, the Company sold certain of its subsidiary companies (generally known as Anchor Bay Entertainment) within its proprietary operations business segment. See Note 2 of Notes to Consolidated Financial Statements for additional information regarding discontinued operations. As a result of the sale of such subsidiary companies, beginning in fiscal 2005, the Company’s operations only comprised category management and distribution operations.

The accounting policies of the segments are the same as those described in Note 1 of Notes to Consolidated Financial Statements, Accounting Policies. Segment data includes intersegment revenues, as well as a charge allocating all corporate costs to the operating segments. The Company evaluated performance of its segments and allocated resources to them based on income before interest, income taxes and minority interest. See Note 10 of Notes to Consolidated Financial Statements for additional information regarding segment activities.

The following table sets forth revenues and the percentage contribution to revenues from continuing operations for the fiscal years ended April 30, 2005 (“Fiscal 2005”), May 1, 2004 (“Fiscal 2004”) and May 3, 2003 (“Fiscal 2003”) (in millions of dollars):

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General

As category manager and distributor of pre-recorded music, the Company manages the selection, acquisition, delivery, retail ticketing, display and return of music product for the Company’s retail customers’ (“retailers”) stores. The following discussion pertains to these activities.

The Company’s vendors and customers use category management and distribution services for a variety of reasons:

The Company distributes throughout vast geographic regions, but adapts individual store selections to local tastes. In fiscal 2005, approximately 77% of the Company’s revenues were in North America and approximately 23% were in the UK.

The music industry, in which the Company predominately operates, is seasonal in nature. Approximately 32% of U.S. music industry sales occur during the last three months of the calendar year, with the month of December accounting for approximately 17% of annual sales. Therefore, in order to meet consumer demand, the Company’s second and third fiscal quarters ended October 30, 2004 and January 31, 2005, respectively, represented a higher proportion of annual revenues and net income than did its first and fourth quarters ended July 31, 2004 and April 30, 2005, respectively. As a result of the seasonal nature of the Company’s business, certain working capital items are higher at some interim reporting dates than at others. For example, inventory and accounts payable are typically higher at the end of the Company’s second quarter as a result of increased inventory purchases in anticipation of higher holiday season shipments, whereas accounts receivable is typically higher at the end of the Company’s third quarter due to accounts receivable from holiday season shipments not yet paid by customers. See Note 12 of Notes to Consolidated Financial Statements for disclosure of quarterly results which indicates the seasonality of the Company’s business.

Vendors

The Company purchases from many different vendors. The volume of purchases from individual vendors fluctuates from year to year based upon the salability of selections being offered by such vendors. Though a small number of major, financially sound vendors account for a high percentage of purchases, product must be selected from a variety of additional vendors in order to maintain an adequate selection for consumers. The Company must closely monitor its inventory exposure and accounts payable balances with smaller vendors that may not have the financial resources to honor their return commitments.

Since the public’s taste for the products the Company supplies is broad and varied, Handleman is required to maintain sufficient inventories to satisfy diverse tastes. The Company minimizes the effect of obsolescence

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through planned purchasing methods and computerized inventory controls. Since substantially all vendors from which the Company purchases product offer some level of return allowances and price protection, the Company’s exposure to markdown risk is limited unless vendors are unable to fulfill their return obligations or non-salable product purchases exceed vendor return limitations. Vendors offer a variety of return programs, ranging from a 100% returns to a zero returns allowance. Some vendors offer incentive and penalty arrangements to limit returns. Accordingly, the Company may possess in its inventories non-salable product that can only be returned to vendors with cost penalties or may be non-returnable until the Company can comply with the provisions of the vendors’ return policies.

The Company generally does not have distribution contracts with its vendors; consequently, its relationships with them may be discontinued at any time by such vendors, or by Handleman.

Customers

Handleman Company’s customers utilize its services for a variety of reasons. Products must be selected from a multitude of vendors offering numerous titles, different formats (e.g., compact discs, music DVDs) and different payment and return arrangements. In addition, retailers utilize category managers due to the complexity of managing the numerous stock keeping units (“SKUs”) required per department, the variability of salable items among individual stores of a retailer, the wide array of programs offered by the multitude of vendors, the “hits” nature of the business and the risk of inventory obsolescence. By utilizing the Company’s category management services, customers avoid substantially all of the risks inherent in product selection and the risk of inventory obsolescence.

The Company must anticipate consumer demand for individual titles. In order to maximize sales, the Company must be able to immediately react to “breakout” titles, while simultaneously minimizing inventory exposure for artists or titles which do not sell.

Customers are also offered a variety of “value-added” services:

Store Service:     Sales representatives visit individual retail stores and meet with store management to discuss upcoming promotions, special merchandising efforts, department changes, current programs, or breaking releases which will increase revenues. In addition, these sales representatives sell titles and promotions of local interest, as well as certain store displays. They also monitor inventory levels, check merchandise displays and install point-of-purchase advertising materials.

Advertising:     The Company supplies point-of-purchase materials and assists customers in preparing radio, television and print advertisements.

Fixturing:     The Company provides specially designed fixtures that emphasize product visibility and accessibility.

Shipping and Handling:     The Company coordinates delivery of product to each store.

Product Exchange:     The Company protects its customers against product markdowns by offering the privilege of exchanging slower-selling product for newer product.

The nature of the Company’s business lends itself to computerized ordering, distribution and store inventory management techniques. The Company is able to tailor the inventories of individual stores to reflect the customer profile of each store and to adjust inventory levels, product mix and selections according to seasonal and current selling trends.

Using proprietary processes and systems to forecast consumer demand, the Company determines the selections to be offered in its customers’ retail stores and ships these selections to the stores from one of its distribution centers. Slow-selling items are removed from the stores by the Company and are recycled for redistribution to other stores or for return to the vendors. Returns from customer stores occur for a variety of reasons, including new releases that did not achieve their expected sales potential, advertised product to be

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returned after the promotion has ended, regularly scheduled realignment pick-ups and customer directed returns. The Company (for financial reporting purposes) reduces gross sales and direct product costs for estimated future returns at the time of revenue recognition.

The table below sets forth percentage contribution to revenues from continuing operations for the Company’s two largest customers:

Handleman generally does not have contracts with its customers, and such relationships may be changed or discontinued at any time by the customers or Handleman; the discontinuance of, or a significant unfavorable change in, the relationship with either of the two largest customers would have a materially adverse effect upon the Company’s future sales and earnings.

During the fourth quarter of fiscal 2005, the Company announced a change in its business relationship with Kmart. In September 2004, Kmart initiated two tests in a limited number of its stores to assess category management, distribution and in-store merchandising of music. As a result of the tests, Handleman Company was advised that it will continue to provide category management and distribution to approximately 1,070 Kmart stores. Another supplier will provide music to Kmart’s remaining stores (approximately 400). In addition, Kmart will assume responsibility for the performance of in-store merchandising in all of its stores.

The Company expects its annual revenues to be reduced by approximately $50 million, or about four percent, due to these changes in its business arrangement with Kmart, which will take place during the first quarter of fiscal 2006. The Company believes these changes will not have a significant impact on Handleman Company’s ongoing operating income (income before investment income, net and income taxes), as the Company anticipates that it will be able to offset the impact of the lower sales level with cost reductions and sales growth with other customers.

See Item 3, Legal Proceedings, and Note 9 of Notes to Consolidated Financial Statements for a description of legal proceedings between Kmart and Handleman Company.

Operations

The Company distributes products from facilities in North America and the United Kingdom. Besides economies of scale and through-put considerations in determining the number of facilities it operates, the Company must also consider freight costs to and from customers’ stores and the importance of timely delivery of new releases. Due to the nature of the music business, display of new releases close to vendor authorized “street dates” is an important driver of both retail sales and customer satisfaction.

The Company utilizes both a third party Enterprise Resource Planning (“ERP”) suite and proprietary systems to automate and integrate the functions of ordering product, receiving, warehousing, order fulfillment, ticket printing and perpetual inventory maintenance. The proprietary inventory management system also provides the basis for title specific billing which allows the Company to better serve its customers.

The Company has automated distribution equipment in its distribution facilities located in Indianapolis, Indiana; Toronto, Ontario; and Warrington, United Kingdom. Previously, the Company also operated in Sparks, Nevada. In early fiscal 2006, the Company will begin operating automated distribution equipment in a new distribution facility in Richmond, Virginia.

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Within its facilities, the Company operates return centers to expedite the processing of customer returns, including use of automated return processing equipment in the United States and Canada. In order to minimize inventory investment, customer returns must be sorted and identified for either redistribution or return to vendors as expeditiously as possible. An item returned from one store may be required for shipment to another store. Therefore, timely recycling prevents purchasing duplicate product for a store whose order could be filled with returns from other stores.

Other Developments

The Company is in the process of implementing an ERP suite of software products. The Company anticipates that this integrated, flexible system will facilitate the Company’s growth with existing and new customers. This implementation involves replacing or modifying certain legacy systems. The Company is aware of the inherent risks associated with replacing and changing these core systems, including, but not limited to, capturing data, inventory management and supply chain disruptions. The Company believes it is taking appropriate action to mitigate the risks through testing, training and staging implementation. The Company anticipates that the implementation of these systems will continue to take place in a phased approach over an approximate three-year period which began in fiscal 2004. As of April 30, 2005, the Company has successfully implemented the new software in its U.S. operations, with the exception of certain modules that were scheduled to be implemented in mid-fiscal 2006. Upon completion of the U.S. implementation, the Company plans to implement the ERP suite in its Canadian operations in late fiscal 2006; with implementation in the UK operations scheduled for fiscal 2007. There can be no assurances that the Company will successfully implement these new systems as planned or that they will occur without supply chain or other disruptions or without impacts on inventory management. These disruptions or impacts, if not anticipated and appropriately mitigated, could have a materially adverse effect on the Company’s financial condition and results of operations.

Competition

Handleman is primarily a category manager of music products. The business of the Company is highly competitive as to both price and alternative supply arrangements. Besides competition among the Company’s customers, the Company’s customers compete with alternative sources from which consumers could acquire the same product, such as (1) specialty retail outlets, (2) electronic specialty stores, (3) record clubs, (4) internet direct sales, including direct to home shipment and direct downloading through a consumer’s home computer, and (5) music product piracy via the internet. New methods of in-home delivery of entertainment software products are continually being introduced. The Company also competes directly for sales to its customers with (1) manufacturers that bypass wholesalers and sell directly to retailers, (2) independent distributors, and (3) other category managers. In addition, some large retailers have “vertically integrated” so as to provide their own category management and/or in-store merchandising. Some of these companies, however, also purchase from independent category managers.

The Company believes that the distribution of home entertainment products will remain highly competitive and that customer service, retailer performance and continual progress in operational efficiencies are the keys to growth and profitability in this competitive environment.

* * * * * * * * * *

See Management’s Discussion and Analysis of Financial Condition and Results of Operations for additional information regarding the Company’s activities.

As of April 30, 2005, the Company has approximately 2,300 employees; none were unionized.

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As of April 30, 2005, the Company occupied leased warehouses located in Indianapolis, Indiana; Toronto, Ontario; Warrington, United Kingdom and four leased satellite sales offices located in the states of Maryland, Michigan, California and Arkansas, as well as the Canadian provinces of Alberta and Quebec. The Company also has a temporary storage facility in Indiana through the first quarter of fiscal 2006 and an unoccupied sales office in the state of New York.

The Company has entered into lease agreements for a warehouse in Richmond, Virginia and a satellite sales office in Minnesota. Both leases are expected to commence in the first quarter of fiscal 2006.

The Company owns its 130,000 square foot corporate office building located in Troy, Michigan.

In January 2002, Kmart Corporation filed for Chapter 11 bankruptcy protection and requested that the Bankruptcy Court designate Handleman Company and several other companies “critical trade vendors.” The Bankruptcy Court granted Kmart’s request and as a result of being named a critical trade vendor, Handleman received $49.0 million in payment of Kmart’s obligations. In April 2003, the United States District Court ruled that the Bankruptcy Court’s designation regarding critical trade vendors was not appropriate under the Bankruptcy Code. In May 2003, Kmart emerged from bankruptcy. In June 2003, Kmart filed a complaint before the Bankruptcy Court requesting that the Bankruptcy Court require the Company to repay the $49.0 million critical trade vendor payment, although the April 2003 District Court’s order did not require repayment of the amounts received by the critical trade vendors. During the third quarter of fiscal 2005, the Company settled this legal proceeding with Kmart. This settlement did not have a material impact on the financial results of the Company for the fiscal year ended April 30, 2005.

See Note 2 of Notes to Consolidated Financial Statements for a discussion of contingencies related to discontinued operations.

There are no additional pending legal proceedings to which the Registrant or any of its subsidiaries is a party, other than routine legal matters which are incidental to the business and the ultimate outcome of which are not expected to be material to future results of consolidated operations, financial position and cash flows. The Company has provided for all claims and legal proceedings based on its best estimate of the amounts it expects to pay.

In fiscal 2003, the Securities and Exchange Commission (“SEC”) initiated a formal investigation relating to a transaction entered into in fiscal 2001 with a non-music vendor by a subsidiary of the Company. In response to this SEC investigation, the Company, through its Audit Committee, conducted its own internal review which focused on the accounting treatment for two non-music vendor contracts (one of which was the subject of the SEC investigation). These contracts were approximately $1.0 million each (both occurring in fiscal 2001). As a result of this review, the Company determined that both contracts should have been recorded as financing arrangements and the two transactions were reflected as such in the Company’s financial statements for fiscal years 2002 and 2001. The Company was advised on February 8, 2005 that the SEC’s investigation was terminated and that the staff of the SEC did not recommend enforcement action against the Company to the Commission.

None.

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PART II

The Company’s common stock is traded on the New York Stock Exchange under the symbol “HDL.”

Below is a summary of the market price of the Company’s common stock:

As of June 17, 2005, the Company had 2,722 shareholders of record.

Below is a summary of the dividends declared during the past two fiscal years:

ISSUER PURCHASES OF EQUITY SECURITIES

On February 23, 2005, the Company’s Board of Directors authorized a new 15% share repurchase program. Under this authorization, which has no expiration date, the Company can repurchase up to 15% of its then outstanding balance of 21,787,611 shares. This 15% share repurchase authorization replaced the prior 20% authorization, under which the Company had repurchased 4,745,600 shares of the 5,138,449 authorized to be repurchased. There were no shares repurchased under the 20% authorization during the fourth quarter ended April 30, 2005. The Company has had no other share repurchase plans expire or terminate during fiscal 2005. The total number of shares purchased excludes 42,754 shares delivered back to the Company to satisfy the exercise price and tax withholding obligation related to certain stock option exercises. The table below sets forth information with respect to shares repurchased under the new 15% authorization in the fourth quarter ended April 30, 2005:

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Amounts related to operations at Anchor Bay Entertainment have been classified as discontinued operations for all periods presented as a result of the sale of those subsidiary companies during fiscal 2004. Accordingly, income from continuing operations for fiscal 2005 and 2004 substantially included only category management and distribution operations. Fiscal 2003, 2002 and 2001, though predominately reflective of category management and distribution operations, also included (i) results from Madacy Entertainment, which was sold during fiscal 2003, and (ii) activity from remaining proprietary operations, other than those companies which were sold during fiscal 2004. See Notes 2 and 10 of Notes to Consolidated Financial Statements for additional information regarding discontinued operations and the Company’s operating segments, respectively.

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The Company had previously operated in two business segments: category management and distribution operations, formerly known as Handleman Entertainment Resources (“H.E.R.”), and proprietary operations, formerly known as North Coast Entertainment (“NCE”). The category management and distribution operating segment, principally related to pre-recorded music product, operates in North America and the United Kingdom (“UK”). Proprietary operations included licensing and manufacture of proprietary and public domain music and video product. As a result of the sale of certain subsidiary companies, as discussed below, beginning in the fiscal year ended April 30, 2005, the Company’s operations only comprise category management and distribution operations.

During the second quarter of fiscal 2004, which ended November 1, 2003, the Company sold certain of its subsidiary companies (generally known as Anchor Bay Entertainment) within its proprietary operations business segment. In accordance with accounting standards, the financial results of these subsidiary companies were reported separately as discontinued operations in the Company’s Consolidated Statements of Income for all periods presented, since the ongoing operations and cash flows of these companies were eliminated from the ongoing operations of the Company upon completion of the sale. As a result, income from continuing operations for fiscal years 2005 and 2004, which ended April 30, 2005 and May 1, 2004, respectively, substantially included only category management and distribution operations. Fiscal year 2003, which ended May 3, 2003, though predominately reflective of category management and distribution operations, also included (i) results from Madacy Entertainment, which was sold during the third quarter of fiscal 2003, and (ii) activity from remaining proprietary operations, other than those companies which were sold in the second quarter of fiscal 2004. Reference should be made to Note 2 and Note 10 of Notes to Consolidated Financial Statements for additional information regarding discontinued operations and the Company’s operating segments, respectively.

Unless otherwise noted, the following discussion relates only to results from continuing operations.

The following table sets forth revenues and the percentage contribution to consolidated revenues from continuing operations for the fiscal years ended April 30, 2005, May 1, 2004 and May 3, 2003 (in millions of dollars):

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Revenues from continuing operations by geographic area, which is based upon the country in which the legal subsidiary is domiciled, for the fiscal years ended April 30, 2005, May 1, 2004 and May 3, 2003 are as follows (in millions of dollars):

See Note 10 of Notes to Consolidated Financial Statements for information regarding long-lived assets by geographic region.

Critical Accounting Policies

The Company’s discussion and analysis of its financial condition and results of operations are based upon the Company’s consolidated financial statements, which have been prepared in accordance with accounting principles generally accepted in the United States of America. The preparation of these financial statements requires the Company to make estimates and assumptions that affect the reported amounts of assets, liabilities, revenues and expenses, and the related disclosure of contingent assets and liabilities. The Company continually evaluates its estimates and assumptions, which are based on historical experience and other various factors that are believed to be reasonable under the circumstances. The results of these estimates and assumptions form the basis for making judgments about the carrying values of certain assets and liabilities. Historically, actual results have not significantly deviated from those determined using the estimates and assumptions described above.

The following are the Company’s critical accounting policies:

Recognition of Revenues and Future Returns – The Company recognizes revenues upon delivery of product to customers (“FOB destination”). As a category manager of music product, the Company coordinates freight service for product purchased by its customers with the assumption of risk effectively remaining with the Company until its customers receive the product. Customer inspection of merchandise is not a condition of the sale. The Company also manages product returns which include both salable and non-salable product, as well as damaged merchandise, and provides credits for such customer returns. The Company reduces revenues and direct product costs for estimated future returns at the time of revenue recognition. The estimate for future returns includes both salable and non-salable product. On a quarterly basis, the Company reviews the estimate for future returns and records adjustments as necessary.

Stock-Based Compensation – The Company has stock-based compensation plans in the form of stock options, performance shares and restricted stock. Beginning in fiscal 2004, the Company adopted the fair value based method of accounting for stock compensation plans, on a prospective basis, utilizing the Black-Scholes option pricing model. Under the fair value method, the Company measures awards as of the grant date and compensation expense is recognized over the service period, which is usually the vesting period. The Company includes the value of stock-based compensation in compensation expense; however, stock-based awards granted prior to adoption of the fair value method are accounted for under the variable accounting method. Under variable accounting, the excess of market value over the option price of outstanding stock options is determined at each reporting period and aggregate compensation expense is adjusted and recognized over the vesting period. Compensation expense associated with vested options continues to be adjusted to the market value of the options until the options are either

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exercised or terminated. Stock-based compensation expense is included as a component of selling, general and administrative expenses.

Pension Expense – The determination of pension obligation, costs and liabilities related to the Company’s pension plans is dependent upon the selection of certain assumptions used by the Company’s third party actuaries. These assumptions may have an effect on the amount and timing of future contributions. The plan’s trustees conduct an independent valuation of the fair value of pension plan assets. Assumptions include discount rate, expected long-term rate of return on plan assets and rate of compensation increase. The discount rate is chosen with consideration given to market rates for long-term corporate bonds, principally Moody’s Aa 30-year bond rating. The expected long-term rate of return for the Company’s pension plan assets is based on historical returns for the different asset classes, weighted based on the median of the target allocation for each asset class. The compensation rate reflects the Company’s long-term actual experience and near-term outlook. Actual results could differ from the Company’s assumptions. Such differences are accumulated and amortized over future periods in accordance with accounting principles generally accepted in the United States of America, and therefore, generally affect the Company’s recognized expense and recorded obligation in future periods.

The April 30, 2005 funded status of the Company’s pension plans is affected by April 30, 2005 assumptions. Pension expense for fiscal 2005 is based on the plan design and assumptions as of May 1, 2004. Note that the following sensitivities may be asymmetric and are specific to 2005. They also may not be additive, so the impact of changing multiple factors simultaneously cannot be calculated by combining the individual sensitivities shown. The effect of the indicated increase/(decrease) in selected factors is shown below (in thousands of dollars):

The foregoing indicates that changes in the discount rate can have a significant effect on the funded status of our pension plans, stockholders’ equity and expense. As stated above, the Company bases the discount rate assumption on investment yields available at year-end on long-term corporate bonds. The Company cannot predict these bond yields or investment returns, and therefore, cannot reasonably estimate whether adjustments to our stockholders’ equity for minimum pension liability in subsequent years will be significant.

Income Taxes – The provision for income taxes is based on reported income before income taxes. Deferred income taxes are provided for the effect of temporary differences between the amounts of assets and liabilities recognized for financial reporting purposes and amounts recognized for income tax purposes. Valuation allowances are recognized to reduce deferred tax assets when it is more likely than not that the assets will not be realized. In assessing the likelihood of realization, consideration is given to all available evidence including estimates of future taxable income and the character of income needed to realize future benefits.

Inventory Valuation – Merchandise inventories are recorded at the lower of cost (first-in, first-out) or market. The Company accounts for inventories using the full cost method which includes costs associated with acquiring and preparing inventory for distribution. Substantially all of the Company’s inventory consists of compact discs which are not substandard from a functional standpoint. Typically, the Company’s suppliers offer return privileges for excess inventory quantities. Inventory reserves are provided for the risk that exists related to the carrying value of non-returnable slow moving inventory that may exceed market value, although the effect of markdowns is minimized since the Company’s vendors generally offer some level of return allowances and price protection. On a quarterly basis, management reviews the Company’s carrying value of inventory from a lower of cost or market perspective and makes any necessary carrying value adjustments. The Company also conducts physical inventory counts on a quarterly basis.

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Long-Lived Assets – At the end of each fiscal year, the Company evaluates the carrying value and remaining estimated lives of long-lived assets for potential impairment by considering several factors, including management’s plans for future operations, recent operating results, market trends and other economic facts relating to the operation to which the assets apply. Recoverability of these assets is measured by a comparison of the carrying amount of such assets to the future undiscounted net cash flows expected to be generated by the assets. If such assets are deemed to be impaired as a result of this measurement, the impairment that would be recognized is measured by the amount by which the carrying amount of the assets exceeds the fair value of the assets.

General

During fiscal 2004, the Company sold its Anchor Bay Entertainment business unit. During fiscal 2005, the Company recorded pre-tax impairment charges of $1.1 million ($0.7 million after tax or $0.03 per diluted share), related to the sale of Anchor Bay Entertainment. Of these charges, $0.8 million was recorded in the second quarter of fiscal 2005 and represented the Company’s best estimate of amounts it expects to pay to settle certain royalty audit claims with an Anchor Bay Entertainment licensor. The remaining $0.3 million was recorded in the fourth quarter of fiscal 2005 and represented expenses associated with the termination of a royalty agreement with a certain licensor. During fiscal 2004, the Company also recorded pre-tax impairment charges of $1.8 million ($1.9 million after tax in consideration of book to tax differences, or $0.07 per diluted share), related to the sale of Anchor Bay Entertainment. Of these charges, $0.7 million was recorded in the second quarter of fiscal 2004 and included fees and legal expenses related to the sale transaction. The remaining $1.1 million was recorded in the fourth quarter of fiscal 2004 and related to the adjustment of the sale proceeds in accordance with the sale agreement. These charges, as well as the financial results of these companies, are reported separately as discontinued operations in the Company’s Consolidated Statements of Income for all periods presented since the operations and cash flows of these companies were eliminated from the ongoing operations of the Company upon completion of the sale. The Company does not have any continuing involvement in the operations of these companies after the disposal transaction.

In the third quarter of fiscal 2003, the Company recorded a pre-tax impairment charge of $28.0 million ($14.1 million after tax or $0.54 per diluted share), related to the sale of its Madacy Entertainment business unit. This impairment charge was recorded as “Impairment of subsidiary assets” in the Company’s Consolidated Statements of Income and included in income from continuing operations. This impairment charge, as well as the results of operations for Madacy Entertainment, was not reported as discontinued operations since not all of the cash flows related to Madacy Entertainment will be eliminated from the ongoing operations of the Company. The Company expected to purchase, and has purchased, a similar level of product from Madacy Entertainment as was purchased prior to the sale, and in turn, has continued to sell the product at a profit margin consistent with historical performance. The Company does not have any continuing involvement in the operations of Madacy Entertainment after the disposal transaction. The sale of Madacy Entertainment allowed the Company to concentrate on its core competencies of distribution and category management.

In the third quarter of fiscal 2003, the Company also recorded a pre-tax impairment charge of $5.1 million ($3.3 million after tax or $0.13 per diluted share), related to the refocusing of its e-commerce subsidiary, Handleman Online. In an effort to better align its operations with the Company’s core competencies of distribution and category management, the Company decided to discontinue internet services such as website hosting, maintenance and support; and focus solely on consumer direct fulfillment and category management services. This impairment charge was recorded as “Impairment of subsidiary assets” in the Company’s Consolidated Statements of Income and included in income from continuing operations.

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Comparison of Fiscal 2005 with Fiscal 2004

Overview

The fiscal years ended April 30, 2005 and May 1, 2004 each consisted of 52 weeks.

Net income for fiscal 2005 was $34.2 million or $1.51 per diluted share, compared to $35.8 million or $1.45 per diluted share for fiscal 2004. Net income for fiscal years 2005 and 2004 included a loss of $0.7 million or $0.03 per diluted share and income of $1.8 million or $0.07 per diluted share, respectively, related to discontinued operations resulting from the sale of the Company’s Anchor Bay Entertainment business unit.

Results of Operations

Unless otherwise noted, the following discussion relates only to results from continuing operations.

For the fiscal year ended April 30, 2005, revenues increased to $1.26 billion from $1.22 billion for the fiscal year ended May 1, 2004. The improvement in year-over-year revenues was mainly due to increased revenues in the United Kingdom and Canada of $48.3 million and $22.2 million, respectively, over the comparable prior year period. Approximately 53% and 61% of these revenue increases in the UK and Canada, respectively, were driven by higher consumer purchases of music in mass merchant retailers. The remaining increases in these countries primarily related to strengthened local currencies in each of these markets. These increases were partially offset by a decline in revenues of $13.0 million in the Mexico operation and $10.3 million from category management and distribution operations in the United States (“U.S.”). The approximately 1% decrease in the U.S. was the result of the timing of year end shipments, which were recorded in accordance with the Company’s revenue recognition policy. Under this policy, revenues are recognized based upon delivery of product to the customer (“FOB destination” shipping terms).

Direct product costs as a percentage of revenues was 80.6% for fiscal 2005, compared to 79.4% for fiscal 2004. The increase was primarily attributable to a higher proportion of revenues from promotional products, which carry a higher direct product cost in relation to revenues than the Company’s overall direct product cost percentage. Direct product costs for fiscal 2005 and fiscal 2004 included costs associated with acquiring and preparing inventory for distribution of $15.4 million and $11.1 million, respectively.

Selling, general and administrative (“SG&A”) expenses for fiscal 2005 were $193.4 million or 15.3% of revenues, compared to $200.0 million or 16.4% of revenues for fiscal 2004. The decrease in SG&A expenses was mainly due to a reduction in stock-based compensation expense of $8.5 million, the absence of an accrual for disputed claims of $4.2 million that was recorded in fiscal 2004 and a decrease in operating expenses of $3.8 million related to the Mexico operation. These decreases in SG&A expenses were partially offset by an increase in (i) software amortization of $2.8 million resulting from the implementation of an Enterprise Resource Planning (“ERP”) suite of products; (ii) information technology related services of $2.0 million; (iii) freight expense of $1.9 million; (iv) outside consulting services of $1.5 million; and (v) outside service expenditures of $1.4 million related to the Section 404 initiative as required by the Sarbanes-Oxley Act of 2002.

Income before investment income, net and income taxes (“operating income”) for the fiscal year ended April 30, 2005 was $50.8 million, compared to operating income of $51.2 million for the fiscal year ended May 1, 2004.

Investment income, net for fiscal 2005 was $2.5 million, compared to $0.6 million for fiscal 2004. Fiscal 2005 investment income, net included investment gains on assets held for the Company’s U.S. Supplemental Executive Retirement Plan of $0.7 million. Additionally, during the second quarter of fiscal 2004, the Company prepaid its outstanding debt under a senior note agreement with a group of insurance companies, in the amount of $7.1 million ($3.5 million was scheduled to mature in February 2004, with the remaining $3.6 million scheduled to mature in February 2005). As a result of the early payment in fiscal 2004, the Company incurred a pre-payment cost of $0.5 million, which is included in investment income, net in fiscal 2004. The Company would have incurred interest expense of $0.6 million had it held the

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senior note to maturity. The remaining year-over-year increase in investment income was due to higher interest income earned on cash balances within the UK.

The effective income tax rate for fiscal 2005 was 34.5%, compared to an effective income tax rate of 34.4% for fiscal 2004.

Other

Accounts receivable at April 30, 2005 was $232.4 million, compared to $216.4 million at May 1, 2004. This increase was mainly attributable to certain changes in customer payment terms during fiscal 2005.

Merchandise inventories at April 30, 2005 was $115.7 million, compared to $105.5 million at May 1, 2004. This increase was due, in part, to the Company’s necessity to maintain a wider assortment of product necessary to support its customers’ diverse needs.

Accrued and other liabilities was $31.0 million at April 30, 2005, compared to $46.5 million at May 1, 2004. This decrease was partially due to a reduction of $4.4 million in income taxes payable, the absence this year of an accrual for disputed claims of $4.2 million, as previously referred to, and a reduction in accrued compensation related items of $2.1 million.

During fiscal 2005, the Company repurchased a total of 2,250,400 shares of its common stock at a cost of $47.0 million and an average purchase price of $20.88 per share, leaving 21,445,873 shares outstanding as of April 30, 2005. On February 23, 2005, the Company announced that its Board of Directors authorized a new share repurchase program, with no expiration date, whereby the Company may repurchase up to 15% of its then outstanding common stock balance of 21,787,611 shares. This new 15% share repurchase authorization replaced the 20% authorization, which was approximately 92% completed. The Company believes the share repurchase program is an effective means of maximizing shareholder value and that the stock represents an attractive investment opportunity for the Company.

During the third quarter of fiscal 2005, the Company reached an agreement to settle its legal proceeding with Kmart relating to Kmart’s bankruptcy. The settlement did not have a material impact on the operating results of the Company for the fiscal year ended April 30, 2005. See Note 9 of Notes to Consolidated Financial Statements for a more detailed discussion of this matter. In the third quarter of fiscal 2005, a licensor of Anchor Bay Entertainment initiated legal proceedings related to certain royalty audit claims. See Note 2 of Notes to Consolidated Financial Statements for further discussion of this matter. There are no additional pending legal proceedings to which the Registrant or any of its subsidiaries is a party, other than routine legal matters which are incidental to the business and the ultimate outcome of which are not expected to be material to future results of consolidated operations, financial position and cash flows. The Company has provided for all claims and legal proceedings based on its best estimate of the amounts it expects to pay.

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Comparison of Fiscal 2004 with Fiscal 2003

Overview

The fiscal year ended May 1, 2004 consisted of 52 weeks, whereas the fiscal year ended May 3, 2003 consisted of 53 weeks.

Net income for fiscal 2004 was $35.8 million or $1.45 per diluted share, compared to $24.9 million or $0.95 per diluted share for fiscal 2003. Net income for fiscal 2003 included impairment charges related to the sale of Madacy Entertainment and the refocusing of Handleman Online of $14.1 million and $3.3 million, respectively, or a total of $0.67 per diluted share. Net income for fiscal years 2004 and 2003 also included $1.8 million or $0.07 per diluted share and $5.0 million or $0.19 per diluted share, respectively, related to discontinued operations resulting from the sale of the Company’s Anchor Bay Entertainment business unit.

Results of Operations

Unless otherwise noted, the following discussion relates only to results from continuing operations.

For the fiscal year ended May 1, 2004, revenues decreased to $1.22 billion from $1.28 billion for the fiscal year ended May 3, 2003. Approximately 44% of the decrease in revenues for fiscal 2004 resulted from the absence of Madacy Entertainment revenues, due to the sale of that business unit in the third quarter of fiscal 2003, with the remaining decrease in revenues predominately due to lower revenues from category management and distribution operations.

Revenues from category management and distribution operations decreased to $1.21 billion for fiscal 2004 from $1.25 billion for fiscal 2003. This decline was mainly due to a decline in revenues within the U.S. operation of $112.0 million. The decrease in U.S. revenues was primarily attributable to lower year-over-year shipments on a comparable store basis to a key customer in the amount of $116.7 million; in addition, the U.S. serviced fewer stores during fiscal 2004 accounting for an additional $85.5 million of decreased revenues. These declines were offset, in part, by incremental revenues generated from a test program for potential new business. The decrease in U.S. revenues was also partially offset by increased revenues within the UK and Canadian operations of $55.1 million and $21.8 million, respectively, over fiscal 2003. Approximately 40% and 71% of the increased revenues in the UK and Canada, respectively, resulted from stronger local currencies in both countries.

Consolidated direct product costs as a percentage of revenues was 79.4% for fiscal 2004, compared to 79.5% for fiscal 2003. Consolidated direct product costs for fiscal 2004 and fiscal 2003 included costs associated with acquiring and preparing inventory for distribution of $11.1 million and $10.9 million, respectively.

Consolidated selling, general and administrative expenses for fiscal 2004 were $200.0 million or 16.4% of revenues, compared to $205.7 million or 16.1% of revenues for fiscal 2003. The lower SG&A expenses during fiscal 2004 were mainly attributable to the absence of expenses at Madacy Entertainment, which incurred $11.2 million in SG&A expenses in fiscal 2003; a decrease in expenses at Handleman Online of $7.8 million resulting from the refocusing of its operations; and a reduction in SG&A expenses of $4.1 million related to the capitalization of internal labor costs associated with the development of computer software principally related to the Company’s implementation of an integrated ERP solution. These reductions in SG&A expenses were partially offset by a year-over-year increase in stock-based compensation expense of $6.6 million; costs in fiscal 2004 associated with new business initiatives in the amount of $5.5 million; and an accrual recorded in fiscal 2004 for disputed claims in the amount of $4.2 million.

Consolidated operating income for fiscal 2004 increased to $51.2 million from $23.9 million for fiscal 2003. This year-over-year improvement in consolidated operating income was primarily due to the $28.0 million of impairment charges recorded in the third quarter of fiscal 2003 related to the sale of Madacy Entertainment, as discussed earlier.

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The U.S. category management and distribution operating income in fiscal 2004 decreased by $34.5 million from fiscal 2003, predominately due to lower net sales, as previously discussed. This decrease in U.S. operating income was partially offset by (i) a reduction in operating loss of $12.9 million at Handleman Online (of which $5.1 million resulted from impairment charges recorded in fiscal 2003 related to the refocusing of that business unit); (ii) improvements in operating income in the UK and Canadian operations of $12.8 million and $5.1 million, respectively, predominantly due to lower direct product costs as a percentage of revenues in those countries; and (iii) a $3.5 million improvement in operating income related to the Mexican operation, chiefly due to lower direct product costs.

Investment income, net increased to $0.6 million for fiscal 2004 from $0.2 million for fiscal 2003. The improvement for the twelve-month period was due to lower borrowing levels in fiscal 2004 compared to fiscal 2003, due primarily to proceeds generated from the sale of subsidiary companies and cash generated from operating activities. During the second quarter of fiscal 2004, the Company prepaid its outstanding debt under a senior note agreement with a group of insurance companies, in the amount of $7.1 million ($3.5 million was scheduled to mature in February 2004, with the remaining $3.6 million scheduled to mature in February 2005). As a result of the early payment, the Company incurred a pre-payment cost of $0.5 million, which was included in investment income, net in fiscal 2004.

The effective income tax rate for fiscal 2004 was 34.4%, compared to an effective income tax rate of 19.4% for fiscal 2003. The lower tax rate in fiscal 2003 primarily resulted from the sale of Madacy Entertainment, including the recognition of a tax benefit in the amount of $2.6 million related to the utilization of a capital loss carryforward.

During fiscal 2004, the Company repurchased a total of 2,632,900 shares of its common stock at a cost of $51.2 million (average purchase price of $19.43 per share), leaving 23,455,330 shares outstanding as of May 1, 2004.

Liquidity and Capital Resources

The Company has an unsecured $150.0 million line of credit arrangement with a consortium of banks, which was amended twice during fiscal 2005. The amendments extended the facility through August 2007 and clarified certain covenants. At April 30, 2005, borrowings available under the credit agreement were $146.6 million after $3.4 million of outstanding letters of credit. The Company had no borrowings under its revolving credit agreement as of April 30, 2005. The borrowing base under the revolving credit agreement is limited to the lesser of (a) $150.0 million, (b) 80% of the net accounts receivable balances plus 100% of the cash balances of the United States companies, Handleman Canada and Handleman UK; however, Handleman Canada and Handleman UK balances are included only to the extent of their intercompany balances, or (c) $150.0 million less amounts outstanding under its subsidiary credit facilities.

Management believes that the revolving credit agreement, along with cash provided from operations, will provide sufficient liquidity to fund the Company’s day-to-day operations, including seasonal increases in working capital, as well as payments of cash dividends and repurchases of common stock under the Company’s share repurchase program.

For the fiscal year ended April 30, 2005, a total of $0.30 per share or $6.7 million in cash dividends were paid to shareholders, compared to a total of $0.21 per share or $5.1 million for the fiscal year ended May 1, 2004. The Company initiated the payment of cash dividends beginning in the second quarter of fiscal 2004.

Working capital at April 30, 2005 was $227.5 million, compared to $232.9 million at May 1, 2004. The working capital ratio was 2.4 to 1 at April 30, 2005, compared to 2.3 to 1 at May 1, 2004.

Net cash provided from operating activities included in the Consolidated Statements of Cash Flows decreased to $21.2 million for fiscal 2005 from $39.1 million for fiscal 2004. This decrease in cash flows from operating activities was primarily related to an unfavorable year-over-year change in other operating assets and liability balances of $30.8 million, a decrease of $17.1 million in non-cash charges compared to the same period last year (principally recoupment/amortization of acquired rights and stock-based

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compensation expense) and an unfavorable year-over-year change in inventory balances of $14.3 million, offset, in part, by favorable year-over-year changes in accounts payable and accounts receivable balances of $25.5 million and $20.4 million, respectively.

Net cash used by investing activities was $6.4 million for fiscal 2005, compared to net cash provided from investing activities of $27.5 million for fiscal 2004. This decrease in cash flows from investing activities was mainly due to proceeds received last year of $58.7 million from the sale of the Company’s Anchor Bay Entertainment business unit. This change was partially offset by a favorable year-over-year change in auction rate security investment balances of $11.6 million; the absence, this year, of additions to acquired rights related to Anchor Bay Entertainment (the Company incurred $6.5 million in additions to acquired rights last year); and a year-over-year reduction in additions to property and equipment of $6.3 million, primarily related to the Company’s ERP computer system, which was substantially implemented in the Company’s U.S. operation this fiscal year.

Net cash used by financing activities decreased to $51.1 million for fiscal 2005 from $59.5 million used by financing activities for fiscal 2004. This decrease in cash used by financing activities was primarily due to a favorable year-over-year change in revolving credit agreement balances of $7.1 million and lower repurchases of the Company’s common stock of $4.0 million, offset, in part, by lower cash proceeds from stock-based compensation plans of $2.0 million and an increase of $1.6 million in cash dividends paid.

The following table summarizes the Company’s contractual cash obligations and commitments as of April 30, 2005 along with their expected effects on its liquidity and cash flows in future periods (in thousands of dollars):

Operating leases represented non-cancelable operating leases entered into by the Company, primarily related to buildings and other equipment. Purchase obligations were those entered into through the normal course of business, principally related to the purchase of inventory. Other obligations included contractual commitments with information technology related services.

Outlook

For fiscal 2006, the Company expects its customers to continue to increase their market share within the music industry resulting in higher revenues, in percentage terms in the mid-single digits, as a percent, for the Company compared to fiscal 2005. Direct product costs as a percentage of revenues is anticipated to be higher than fiscal 2005 as a result of continuing changes in revenue mix. A greater percentage of revenues is expected to be from promotional products, non-serviced revenues and international revenues, all of which carry a higher direct product cost as a percentage of revenues than the Company’s overall direct product cost percentage. Selling, general and administrative expenses as a percentage of revenues is forecasted to decrease based on the Company’s continued focus on productivity and cost control. Net income for fiscal 2006 is expected to be slightly ahead of fiscal 2005 results. The Company expects to continue acquiring shares of its common stock under the new 15% stock repurchase authorization, which will result in fewer shares outstanding and an increase, in percentage terms in the mid-single digits, in the Company’s fully-diluted earnings per share compared to fiscal 2005 results.

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New Accounting Pronouncements

In November 2004, Statement of Financial Accounting Standards (“SFAS”) No. 151, “Inventory Costs, an amendment of ARB No. 43, Chapter 4” was issued by the Financial Accounting Standards Board (“FASB”). SFAS No. 151 requires that items such as idle facility expense, excessive spoilage, double freight and re-handling costs be recognized as charges in the current period. This Statement also requires that the allocation of fixed production overheads to the costs of conversion be based on the normal capacity of the production facilities. The Company has evaluated SFAS No. 151 and does not expect that this Statement will have an impact on its operating results.

In December 2004, SFAS No. 123R, “Share-Based Payment (revised 2004),” was issued by the FASB. SFAS No. 123R requires public companies to measure the cost of employee services received in exchange for an award of equity instruments based on the grant-date fair value of the award; this cost will be recognized over the period during which an employee is required to provide service in exchange for the award, usually the vesting period. Since the Company adopted SFAS No. 123, “Accounting for Stock-Based Compensation,” effective May 4, 2003, all stock-based awards issued after May 3, 2003 are being expensed over the vesting period using the fair value method. The Company is currently evaluating the new requirements under SFAS No. 123R and will adopt the provisions of this Statement at the beginning of its fiscal year 2007, as required.

In May 2005, SFAS No. 154, “Accounting Changes and Error Corrections, a replacement of APB Opinion No. 20 and FASB Statement No. 3,” was issued by the FASB. SFAS No. 154 requires that a voluntary change in accounting principle be applied retrospectively with all prior period financial statements presented on the new accounting principle, unless it is impracticable to do so. SFAS No. 154 also provides that (1) a change in method of depreciating or amortizing a long-lived nonfinancial asset be accounted for as a change in estimate (prospectively) that was effected by a change in accounting principle, and (2) correction of errors in previously issued financial statements should be termed a “restatement.” The new standard is effective for accounting changes and correction of errors made in fiscal years beginning after December 15, 2005. The Company will adopt the provisions of this Statement at the beginning of its fiscal year 2007, as necessary.

Other Information

The Company has no significant investments that are accounted for under the equity method in accordance with accounting principles generally accepted in the United States of America. Accordingly, there are no liabilities associated with investments accounted for under the equity method that would be considered material to the Company.

The Company’s financial statements have reported amounts based on historical costs, which represent dollars of varying purchasing power and do not measure the effects of inflation. If the financial statements had been restated for inflation, net income would have been lower because depreciation expense would have to be increased to reflect the most current costs.

Management does not believe that inflation within the economies in which the Company does business has had a material effect on the Company’s results of operations.

The Company has not engaged in any related party transactions which would have had a material effect on the Company’s financial position, results of operations or cash flows.

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* * * * * * * * * *

This document contains forward-looking statements, which are not historical facts. These statements involve risks and uncertainties and are made pursuant to the safe harbor provisions of the Private Securities Litigation Reform Act of 1995. Actual results, events and performance could differ materially from those contemplated by these forward-looking statements including, without limitation, risks associated with changes in the music industry, continuation of satisfactory relationships with existing customers and suppliers, establishing satisfactory relationships with new customers and suppliers, effects of electronic commerce inclusive of digital music distribution, dependency on technology, ability to control costs, relationships with the Company’s lenders, pricing and competitive pressures, dependence on third-party carriers to deliver products to customers, the ability to secure funding or generate sufficient cash required to build and grow new businesses, the occurrence of catastrophic events or acts of terrorism, certain global and regional economic conditions, and other factors discussed in this Form 10-K and those detailed from time to time in the Company’s other filings with the Securities and Exchange Commission. Handleman Company notes that the preceding conditions are not a complete list of risks and uncertainties. The Company undertakes no obligation to update any forward-looking statement to reflect events or circumstances after the date of this document.

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The Company has no market risk from derivative instruments that would have a material effect on the Company’s financial position, results of operations or cash flows.

The following financial statements and supplementary data are filed as a part of this report:

Report of Independent Registered Public Accounting Firm

Consolidated Balance Sheets As of April 30, 2005 and May 1, 2004

Consolidated Statements of Income – For the Years Ended April 30, 2005, May 1, 2004 and May 3, 2003

Consolidated Statements of Shareholders’ Equity – For the Years Ended April 30, 2005, May 1, 2004 and May 3, 2003

Consolidated Statements of Cash Flows – For the Years Ended April 30, 2005, May 1, 2004 and May 3, 2003

Notes to Consolidated Financial Statements

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Report of Independent Registered Public Accounting Firm

To the Board of Directors and Shareholders of Handleman Company:

We have completed an integrated audit of Handleman Company’s April 30, 2005 consolidated financial statements and of its internal control over financial reporting as of April 30, 2005 and audits of its May 1, 2004 and May 3, 2003 consolidated financial statements in accordance with the standards of the Public Company Accounting Oversight Board (United States). Our opinions, based on our audits, are presented below.

Consolidated Financial Statements and Financial Statement Schedules

In our opinion, the consolidated financial statements listed in the accompanying index appearing under Item 15(a)(1) present fairly in all material respects, the financial position of Handleman Company and its subsidiaries at April 30, 2005 and May 1, 2004 and the results of their operations and their cash flows for each of the three years in the period ended April 30, 2005 in conformity with accounting principles generally accepted in the United States of America. In addition, in our opinion, the financial statement schedule listed in the index appearing under Item 15(a)(2) presents fairly, in all material respects, the information set forth therein when read in conjunction with the related consolidated financial statements. These financial statements and financial statement schedule are the responsibility of the Company’s management. Our responsibility is to express an opinion on these financial statements and financial statement schedule based on our audits. We conducted our audits of these statements 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 of financial statements includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements, assessing the accounting principles used and significant estimates made by management, and evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for our opinion.

As discussed in Note 1 to the consolidated financial statements, effective May 4, 2003, the Company adopted the fair value recognition provisions of Statement of Financial Accounting Standards (“SFAS”) No. 123, “Accounting for Stock-Based Compensation:” and selected the prospective transition method, as defined in SFAS No. 148, “Accounting for Stock-Based Compensation – Transition and Disclosure,” an amendment SFAS No. 123.

Internal Control Over Financial Reporting

Also, in our opinion, management’s assessment, included in Management’s Report on Internal Control Over Financial Reporting appearing under Item 9A, that the Company maintained effective internal control over financial reporting as of April 30, 2005 based on criteria established in Internal Control – Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission (COSO), is fairly stated, in all material respects, based on those criteria. Furthermore, in our opinion, the Company maintained, in all material respects, effective internal control over financial reporting as of April 30, 2005 based on criteria established in Internal Control – Integrated Framework issued by the COSO. The Company’s

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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 opinions on management’s assessment and on the effectiveness of the Company’s internal control over financial reporting based on our audit. We conducted our audit of internal control over financial reporting 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. An audit of internal control over financial reporting includes 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 consider 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 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 (i) pertain to the maintenance of records that, in reasonable detail, accurately and fairly reflect the transactions and dispositions of the assets of the company; (ii) 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 (iii) 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 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 that the degree of compliance with the policies or procedures may deteriorate.

PricewaterhouseCoopers LLP

Detroit, Michigan

June 28, 2005

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HANDLEMAN COMPANY

CONSOLIDATED BALANCE SHEETS

AS OF APRIL 30, 2005 and MAY 1, 2004

(in thousands of dollars except share data)

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

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HANDLEMAN COMPANY

CONSOLIDATED STATEMENTS OF INCOME

FOR THE YEARS ENDED APRIL 30, 2005, MAY 1, 2004 and MAY 3, 2003

(in thousands of dollars except per share data)

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

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HANDLEMAN COMPANY

CONSOLIDATED STATEMENTS OF SHAREHOLDERS’ EQUITY

FOR THE YEARS ENDED APRIL 30, 2005, MAY 1, 2004 and MAY 3, 2003

(in thousands of dollars)