GENERAL

QRS Music Technologies, Inc. (“Company”) is a Delaware Corporation which was formed in January, 1990.  During fiscal year ended June 30, 2006, Company’s primary lines of business were manufacture and sale of Pianomation® Music Instrument Digital Interface (“MIDI”), dealer preparation and sale of Story & Clark and Gulbransen pianos, sale of MIDI CDs and floppy disks, distribution of piano supply parts, manufacture and distribution of the Gulbransen Digital Hymnal, and manufacture and sale of music rolls for player pianos.  All financial statements presented are consolidated statements. The Company’s fiscal year ends each June 30, and the fiscal years ended June 30, 2005, and June 30, 2006 are referred to as “fiscal 2005” and “fiscal 2006”, respectively . The Company maintains its corporate offices and a showroom in Naples, Florida.  The Company has a warehouse, teaching facility, Pianomation® development facility and showroom in Las Vegas, Nevada, piano preparation and Pianomation® assembly and installation center and showroom facilities in Seneca, Pennsylvania, and a piano roll manufacturing and warehouse facility and software development facility in Buffalo, New York.  During Fiscal 2005 the Company leased space in Hong Kong to help with procurement and sales to the Chinese and surrounding markets.  During Fiscal 2004, the Company began utilizing space in Sydney, Australia in a building at the time owned by an affiliated company.   The Company used the space to inventory pianos and pianomation units that will be sold in the Australian market.   During Fiscal 2005 the affiliated company was sold to a non-affiliated party, and subsequently the Company moved its sales offices to another location.  (Please refer to Item 12 for additional information.)   See “Consolidated Financial Statements” for financial information.

  PIANOMATION®

The Pianomation® MIDI System is a Musical Instrument Digital Interface equipped playback system for acoustic and digital pianos.  Pianomation®, which is the Company’s flagship product, automates the Company’s own line of Story & Clark pianos, and can be retrofitted by independent installers into virtually any brand of piano. Several major piano manufacturers, have selected Pianomation® for factory installation in new instruments.

The Pianomation® product consists of an electronic processor and a mechanical assembly which drives solenoid actuators. The processor receives MIDI signals from a MIDI master controller such as a CD player, disk drive or personal computer. The signals received from the master controller are processed by the Pianomation® processor which in turn causes the mechanical solenoid actuators to “play” the piano’s keys. The MIDI signal contains, and the Pianomation® processor transmits, the information necessary to control the duration of each note and the level of expression and foot pedal operation. The Pianomation® system is unique as it is the only system currently available which not only controls the mechanical operation of a piano but synchronizes the MIDI signal with a separate track containing an audio music signal and stores both tracks in analog format on a CD. This allows the Pianomation® system to enhance the piano performance with a vocalist, symphony orchestra or other recorded music.

The ease of installation and minimal service requirements of the Pianomation® system and the software which allows the conversion of a digital signal into analog format are principal features.  A unique low profile solenoid rail actuates the keys, and can be easily regulated to the touch of the host piano to a high degree of sensitivity.  In fact, Pianomation® can actually play at volume levels below the capabilities of the human pianist for the ultimate in background music.  The sustain pedal is operated by a specially designed solenoid, or can be simulated by the system’s exclusive “Magic Pedal” feature.

Pianomation’s® flexibility and open-ended architecture allow a wide range of use and flexibility for all current and future playback formats.  With QRS CDs, Pianomation® can play unobtrusively with solo piano music or with concert-quality performances that include audio accompaniment; with QRS videos, Pianomation® can be used for group sing-alongs or karaoke; with  QRS floppies, Pianomation® can drive a general MIDI system for the MIDI enthusiast; and, with various computer programs, it can serve the working musician as a MIDI slave, interacting on a sophisticated level with all manner of MIDI equipment.  The Transcription Series and SyncAlong CDs continue to be popular items in the Pianomation CD series, and the libraries of available CDs are expanded every year.   The SyncAlong Series CDs leverage the Pianomation system advantages to allow the end-user to experience the true audio recordings of major recording artists.  The Company in fiscal 2004 introduced a download service called “NetPiano.”   This subscription service allows the consumer to log into a specified internet site and download music to play on their Pianomation system.  The Company also sells the Playola System of portable piano automation. Unlike the Pianomation® System which requires installation by a trained technician, the Playola system consists of only two components which can be easily placed on and removed from a piano by a user.  Playola is also MIDI compatible.

Pianomation® Manufacturer

The components of the Pianomation® MIDI System and Playola system are manufactured for the Company by a number of different suppliers. With the exception of a number of small pieces, the Company has located more than one supplier for each component. It maintains an inventory of components which it believes would be sufficient to continue its business if the single source vendor of small pieces should cease to adequately supply ordered parts. The Company assembles some of the Pianomation® System and Playola components in its Pennsylvania facility. The Company also has installations centers in its Pennsylvania, Florida and Nevada locations, enabling music stores and dealers to send their pianos for factory installations of a Pianomation system.  In large part, the Pianomation® System is shipped in kit form for installation by a technician into an acoustic piano. The Company believes there to be ample sources and quantities of raw materials for the manufacture of all components.  As technology advances, the Company continues to develop and introduce new user-interface devices (“front ends”) that can be utilized to play the Pianomation system.   In Fiscal 2005 the Company debuted the Ancho, Petine and Q-Touch interfaces as the music industry’s annual trade show in January in Anaheim, CA.   Each front end has unique properties that leverage the advantages of current technology to enhance and benefit the Pianomation player system.   The introduction of new front ends, and discontinuation of older models also enables the Company to address conditions of supply of electronic components.

Pianomation® Distribution

The Company distributes the Pianomation® system as an option on its Story & Clark pianos, through approximately 500 independent piano retailers and independent piano technicians who install the system on virtually any piano initially sold by the retailer or as a retrofit on pianos owned by customers. The Company also distributes through OEM sales to piano manufacturers and other distributors who private label the system. Playola is distributed though the same network of independent piano retailers.

STORY & CLARK PIANOS

The Company imports and sells pianos under the Story & Clark trademark, and manufactures a select number of specialty pianos bearing the Story & Clark trademark.  The Story & Clark line includes reproducing player pianos, grand pianos, console and studio pianos, nickelodeons, custom leaded glass panel pianos, roll players, and various piano accessories such as piano benches and lamps. The term player piano is used to describe any acoustic piano that has been modified to play itself.    A nickelodeon is a piano that plays itself, and has additional instruments (such as drums, xylophone, castanets, etc.) that are mounted on or near the piano and are also played by the same solenoid system.

All Story & Clark pianos, including imported pianos, at the option of the dealer, are thoroughly serviced and prepared by factory piano technicians prior to sale. All Story & Clark pianos are pre-slotted to allow for easy later installation of the Pianomation® system.

The Company purchased the Gulbransen name and the Digital Hymnal in 2003.   As a requirement of that purchase, the company is obligated to supply audited statements of the product sold.  Currently the Company is involved in discussions as to the format of that audit.  The Gulbransen name is an established name in the piano industry. In September 2004 the Company introduced a new commercial line of pianos marketed under the Gulbransen brand name.  The Gulbransen brand of pianos is offered through different sales channels as well as several traditional dealer accounts.  The primary focus of the Gulbransen line is direct sales through the Internet as well as catalog sales.   The Gulbransen line increases exposure to QRS’s unique line of products from venue specific Grand Pianos to Nickelodeons and Violins.  QRS Music’s Pianomation ® technology is  available on the Gulbransen line of pianos

Piano Manufacture

A majority of the Company’s line of pianos are imported from the Peoples Republic of China.  Specialty pianos and all piano prep services are performed at the Company’s 46,000 square foot facility in Seneca, Pennsylvania. The Company believes that there is an adequate supply of all materials used to build its specialty pianos in Pennsylvania. The Company also believes there are other sources of imported pianos if current supply were interrupted.

The name Story & Clark is used on pianos imported from various piano manufacturers located in the People’s Republic of China.  For Fiscal 2006 and Fiscal 2005 combined imported piano sales represented 39.90% and 38.41% of overall sales respectively.

Piano Distribution

The Company distributes its pianos and technology products through a network of approximately 240 independent

piano stores around the country.  The Company also retails its pianos through its own showrooms in Las Vegas and Seneca, and during various special promotions and sales.

The Company may enter into an agreement with a financing company when the dealer (purchaser) desires to finance his purchases.  For the year ended June 30, 2006, approximately 24.08% of the Company sales were subject to these financing agreements. Under these agreements, the entire sale is financed. There were no material costs incurred by the Company due to repurchasing of repossessed merchandise for the year ended June 30, 2006.

PLAYER PIANO ROLLS

The Company is the only major manufacturer in the world of paper player piano rolls.  The Company has master recording data for over 5,000 music titles for player piano rolls and maintains an inventory of over 45,000 music rolls at its Buffalo facility. The Company contracts with copyright owners for nonexclusive rights to produce various musical selections and then with artists who actually perform the musical selection. The Company has master rolls representing the only player piano performance of Liberace and one of only a few of the performances of Scott Joplin, Fats Waller, George Gershwin and other famous pianists.  Celebrity performances are recorded on a specially equipped piano called a marking piano.  Each key on the marking piano is connected pneumatically to a metal stylus on unit sitting next to the piano.   There is a blank roll of piano roll paper that passes over a drum equipped with a piece of carbon paper.   As a key is depressed on the piano, the metal stylus descends against the piano roll paper, and a carbon mark is made on the underside of the paper.   As long as the key is depressed, the stylus stays down.   Once the key is released, the stylus raises. Once the performance is complete, the roll with the carbon marks is taken out, and the carbon lines are cut out with an exacto knife.   This becomes the pattern for the piano rolls that will be mass-produced.  Celebrity performances are recorded on the marking piano because it requires no knowledge of player piano roll arranging by the performer.  The artist is only required to sit at the piano and play as they normally would.  Upon completion of the performance there is a pattern of the exact performance that can then be reproduced in the form of a perforated piano roll.   When the completed roll is played on a customer’s piano, the original artist’s performance will be duplicated exactly.  For fiscal year ended June 30, 2006 and 2005 player piano roll and related items sales represented 1.90% and 3.38% of total overall sales respectively. Non-celebrity performances are done on a digital keyboard or computer.  All raw materials for the rolls are readily available from multiple sources. The Company also sells player piano accessories.

Roll Distribution .

Player piano rolls and player piano accessories are primarily sold though mail order catalog.  The Company maintains a prospect list of over 89,000 qualified buyers.  The Company also sells player piano rolls and accessories on its internet web site and through a few independent dealers.

MIDI CDS, FLOPPY DISKS and NETPIANO

The Company has an inventory of over 2,000 musical data files in MIDI format which it sells in CD, DVD and floppy disk format and as downloads on its internet web site. The CDs are primarily used for electronic player devices such as Pianomation®.  The web downloads are part of a new online service called NetPiano. Total music sales for Pianomation (including CD, floppy and downloadable format) for fiscal year ended June 30, 2006 and 2005 were 5.32% and 4.86% of total overall sales respectively.

COMPETITION

Pianomation® has two major competitors, Yamaha Music and PianoDisc.  During Fiscal 2006, one new company exhibited a player system at the Industry NAMM Show in January.   It is too soon to know the level of competition that company will exhibit. The Yamaha Disklavier system is only available as a factory installed option on Yamaha pianos. The PianoDisc system, and the new system introduced in January are retrofitable.  Principal competitive factors are reliability, features, system flexibility and ease of installation. The Company believes it competes well as a result of the reliability of its system, ease of installation, and its strong library of live recorded background music including vocals as well as piano signal on one CD.

The quality of the software offered for use on the Pianomation System continues to be one of the strongest selling points of the system.   The Sync Along Series of CDs, available exclusively in the QRS Library, is a deciding factor in many consumers choice of player systems.

Story & Clark competes with very large (Steinway Pianos, Samick Pianos, Young Chang Pianos, and Kawai Music) and several other offshore piano manufacturers and has a very small portion of the market. Principal competitive factors are distribution channels, trademark and value added features. While it is one of only a handful of domestic piano distributors and manufacturers, the Company competes by filling niche markets including player pianos and nickelodeons rather than competing in the mass distribution market for standard home-use and commercial-use pianos.

Currently no other company sells new player piano rolls.  Although several small companies do specialty recuts and small runs of unique rolls. Used player piano rolls are sold by numerous individuals.

PIANOMATION AND OTHER PIANO SALES

For Fiscal 2005 and Fiscal 2006, perforated paper roll players represented less than one percent of piano sales.  Total piano sales for fiscal year ended June 30, 2006 and 2005 represented 39.90% and 38.72% of total overall sales respectively.   Sales of technology related products for fiscal year ended June 30, 2006 and 2005 represented 50.81% and 50.72% of overall sales respectively. Approximately 52.21% of Story & Clark pianos sold were retrofitted with the Pianomation® system in fiscal year 2006 and approximately 61.7% in fiscal year 2005.

EMPLOYEES

The Company employs 60 full-time employees, one seasonal worker and one part-time worker.

RESEARCH AND DEVELOPMENT

The Company is involved in several research and development projects both in the area of Pianomation products and pianos.  The expenditures for fiscal year 2006 were $769,000 and for fiscal 2005 they were $684,000. All research and development expenses were borne directly by the Company. Other than new products discussed elsewhere herein, all other publicly announced new products are in the research and development stage. The Company is undertaking several large projects as it works to maintain its leading edge in technology for the music industry.   As these projects progress in their development cycle more funds are required to bring them to fruition.  Development for the Petine and Ancho user interfaces for the Pianomation player system were completed in fiscal 2006, and these interfaces were introduced and are now a part of the QRS product line of technology devices.

PATENTS TRADEMARKS AND LICENSES

The Company has 10 United States Trademark registrations: Registration No. 658,518 (QRS logo), Registration No. 2,190,286 (QRS), Registration No. 2,562,052 (Hobart M. Cable), Registration No. 2,490,762 (Story & Clark), Registration No. 2,227,035 (Pianomation), Registration No 744,841 (Gulbransen), Registration No. 830,313 (PNOBar), Registration No. 830,340 (PNOScan), Registration No 830,442 (PNO) and Registration No. 830,751 (PNOVision).

The Company also holds and or has rights (some exclusive) to ten patents related to both existing product offerings, such as NetPiano, and the Gulbransen Digital Hymnal and several other products currently under development.

QRS obtains rights to use the music for both the Pianomation library and music roll library from the appropriate copyright holders.   In some cases those rights are administered by an agency, and sometimes by the copyright holder themselves.