GOLDEN ENTERTAINMENT, INC. - Quarter Report: 2006 July (Form 10-Q)

UNITED STATES SECURITIES AND EXCHANGE COMMISSION

Washington, D.C. 20549

Form 10-Q

Commission File No. 0-24993

LAKES ENTERTAINMENT, INC.

(Exact name of registrant as specified in its charter)

(952) 449-9092

(Registrant’s telephone number, including area code)

     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 þ          No o.

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

Large Accelerated Filer o          Accelerated Filer þ          Non Accelerated Filer o

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

      As of August 3, 2006, there were 22,874,909 shares of Common Stock, $0.01 par value per share, outstanding.

LAKES ENTERTAINMENT, INC. AND SUBSIDIARIES

INDEX

LAKES ENTERTAINMENT, INC. AND SUBSIDIARIES

Condensed Consolidated Balance Sheets

July 2, 2006 and January 1, 2006

See notes to condensed consolidated financial statements

LAKES ENTERTAINMENT, INC. AND SUBSIDIARIES

Condensed Consolidated Statements of Earnings (Loss) and Comprehensive Earnings (Loss)

See notes to condensed consolidated financial statements

LAKES ENTERTAINMENT, INC. AND SUBSIDIARIES

Condensed Consolidated Statements of Shareholders’ Equity

Six months ended July 2, 2006 and July 3, 2005

See notes to condensed consolidated financial statements

LAKES ENTERTAINMENT, INC. AND SUBSIDIARIES

Condensed Consolidated Statements of Cash Flows

Six months ended July 2, 2006 and July 3, 2005

See notes to condensed consolidated financial statements

LAKES ENTERTAINMENT, INC. AND SUBSIDIARIES

Notes to Unaudited Condensed Consolidated Financial Statements

      The unaudited condensed consolidated financial statements of Lakes Entertainment, Inc., a Minnesota corporation (“Lakes” or the “Company”), have been prepared pursuant to the rules and regulations of the Securities and Exchange Commission (“SEC”) applicable to interim financial information. Accordingly, certain information normally included in the annual financial statements prepared in accordance with accounting principles generally accepted in the United States has been condensed or omitted. For further information, please refer to the annual audited consolidated financial statements of the Company, and the related notes included within the Company’s Annual Report on Form 10-K for the year ended January 1, 2006, previously filed with the SEC on March 8, 2006, from which the balance sheet information as of that date is derived.

      In the opinion of management, all adjustments considered necessary for a fair presentation have been included, consisting only of normal recurring adjustments. The results for the current interim period are not necessarily indicative of the results to be expected for the full year.

      Certain reclassifications to amounts previously reported have been made to conform to the current period presentation. These reclassifications had no effect on net earnings (loss) or shareholders’ equity as previously presented.

      Lakes’ unrestricted cash balance and short-term investments, excluding WPT Enterprises, Inc. (“WPTE”) cash and short-term investments, was approximately $45 million as of July 2, 2006. Lakes’ major use of cash over the past three years has been pre-construction financing provided to tribal partners and on-going corporate costs. While the funds provided by the $105 million credit agreement with Bank of America N.A. (“BofA”) (Note 6) allow Lakes to move forward with various casino development projects, Lakes anticipates incurring additional pre-construction costs which will require additional sources of financing during fiscal 2007 to meet operational and development needs. Therefore, Lakes will explore additional financing alternatives as needed.

      At July 2, 2006 and January 1, 2006, long-term assets related to Indian casino projects are primarily related to three separate projects for the Pokagon Band of Potawatomi Indians (“Pokagon Band”), Shingle

LAKES ENTERTAINMENT, INC. AND SUBSIDIARIES

Notes to Unaudited Condensed Consolidated Financial Statements — (Continued)

Springs Band of Miwok Indians (“Shingle Springs Tribe”) and the Jamul Indian Village (“Jamul Tribe”) as indicated in the following tables (in thousands):

      The following table provides the key assumptions used to value the notes receivable at estimated fair value (dollars in thousands):

LAKES ENTERTAINMENT, INC. AND SUBSIDIARIES

Notes to Unaudited Condensed Consolidated Financial Statements — (Continued)

     The net unrealized gain on notes receivable related to the Pokagon Band casino project was $12.4 million and $0.2 million for the three months ended July 2, 2006 and July 3, 2005, respectively, and $17.6 million and $3.0 million for the six months ended July 2, 2006 and July 3, 2005, respectively, and is included in the accompanying unaudited condensed consolidated statements of earnings (loss) and comprehensive earnings (loss).

      The net unrealized gain on notes receivable related to the Shingle Springs Tribe casino project was $1.4 million and $0.1 million for the three months ended July 2, 2006 and July 3, 2005, respectively, and $2.5 million and $0.3 million for the six months ended July 2, 2006 and July 3, 2005, respectively, and is included in the accompanying unaudited condensed consolidated statements of earnings (loss) and comprehensive earnings (loss).

LAKES ENTERTAINMENT, INC. AND SUBSIDIARIES

Notes to Unaudited Condensed Consolidated Financial Statements — (Continued)

      The net unrealized gain on notes receivable related to the Jamul Tribe casino project was $0.9 million and $0.3 million for the three months ended July 2, 2006 and July 3, 2005, respectively, and $7.3 million and $0.4 million for the six months ended July 2, 2006 and July 3, 2005, respectively, and is included in the accompanying unaudited condensed consolidated statements of earnings (loss) and comprehensive earnings (loss).

      As of July 2, 2006, and January 1, 2006, Lakes has restricted cash of approximately $19.5 million and $0.2 million, respectively. Approximately $19.1 million of the restricted cash as of July 2, 2006 represents a required interest reserve to fund the first 18 months of interest payments related to the $105 million financing facility with BofA (Note 6).

      In March 2006, WPTE sold 630,000 common shares of its then 12% interest in PokerTek, Inc. (“PokerTek”) at $9.03 per share, resulting in net cash proceeds of approximately $5.7 million. As a result of the sale, WPTE realized a gain of approximately $5.7 million and its ownership interest was reduced to 450,000 shares, or 5%.

      WPTE accounts for its investment in PokerTek at fair market value and classifies it as “available for sale.”

      On February 15, 2006, Lakes closed on a $50 million financing facility with PLKS Holdings, LLC, an affiliate of Prentice Capital Management, LP (“PLKS”). An initial draw of $25 million was made under the facility. The $25 million outstanding principal balance together with accrued interest was repaid in full on June 22, 2006, as discussed below. As consideration for the PLKS financing, Lakes issued to PLKS an aggregate of 4.46 million common stock purchase warrants at an exercise price of $7.50 per share that expire in February 2013, subject to customary anti-dilution protections. As of July 2, 2006, and as a result of repaying the PLKS loan in full without any additional draws under the financing facility, certain warrants remain exercisable for 1.25 million shares of common stock and the remaining 3.21 million warrants have lapsed and

LAKES ENTERTAINMENT, INC. AND SUBSIDIARIES

Notes to Unaudited Condensed Consolidated Financial Statements — (Continued)

will not become exercisable. PLKS also has demand registration rights with respect to the Lakes common stock underlying the warrants. The holders of the warrants can require Lakes to redeem the warrants if Lakes fails to satisfy its registration obligations with respect to the Lakes common stock underlying the warrants. Lakes has agreed to pay substantially all of the costs incurred in the preparation and filing of these registration statements. The 1.25 million warrants to purchase common stock were valued at $4.7 million using a Black-Scholes pricing model and were being amortized as interest expense over the three-year life of the financing facility. The unamortized portion of the warrants were reported as an in-substance debt discount. As a result of the PLKS debt repayment, the remaining unamortized portion of the warrants ($4.3 million) as well as the unamortized closing costs ($2.5 million) were written off and reported as loss on extinguishment of debt in the accompanying unaudited condensed consolidated statement of earnings (loss) and comprehensive earnings (loss) totaled approximately $6.8 million.

      Additionally, as part of the PLKS transaction, the Lakes Board of Directors authorized the creation of a new class of Series A Convertible Preferred Stock, par value $0.01 per share. Lakes sold 4,457,751 shares of the preferred stock to PLKS for $44,578. These preferred shares have no dividend rights, had voting rights only if there was a default under the financing agreement, and become convertible into common stock of Lakes (on a fixed one-to-one basis) only if and when the warrants are cancelled in accordance with the terms of the warrants.

      On June 22, 2006, Lakes borrowed $105 million under a financing facility with BofA and certain lenders (the “Lenders”), pursuant to the terms and conditions of a Credit Agreement among Lakes, Lakes Gaming and Resorts, LLC, BofA and the Lenders. Funds drawn under the Credit Agreement bear interest at the rate of LIBOR plus 6.25% per annum, subject to adjustment or change as specified in the Credit Agreement, and are due and payable on the fourth anniversary of the closing date. A condition of the Credit Agreement requires Lakes to negotiate an interest rate swap agreement (Note 16). The notional value of the interest rate swap must be equal to 100% of the financing facility for the first 18 months and 50% of the financing facility thereafter. The interest rate swap will be used as a cash flow hedge to manage Lakes’ exposure to fluctuations in interest rates.

      Subject to certain premiums, Lakes may prepay the facility in whole or in part at any time. Approximately $25.2 million of the initial draw was used to repay in full the aforementioned loan payable to PLKS. Pursuant to the terms of the Credit Agreement, Lakes paid a closing fee of $1.5 million to BofA and an additional $0.7 million in debt issuance costs primarily consisting of legal fees. The closing fee and debt issuance costs will be amortized over the term of the Credit Agreement using the effective interest method and will be recorded as depreciation and amortization expense in the accompanying unaudited condensed consolidated statement of earnings (loss) and comprehensive earnings (loss). Lakes received net proceeds of approximately $103.9 million before the disbursements of the closing fee, debt issuance costs and repayment of the PLKS loan. The debt discount of approximately $1.1 million will also be amortized over the life of the loan using the effective interest method and will be reported as interest expense in the accompanying unaudited condensed consolidated statement of earnings (loss) and comprehensive earnings (loss). Lakes is obligated to pay a $50,000 annual administrative agent fee to BofA.

      The loan underlying the Credit Agreement is secured by substantially all of the material assets of Lakes and its subsidiaries. However, Lakes is entitled to sell up to 3 million of the approximate 12.5 million WPTE shares it owns without application of the proceeds of such sale to reduction of the amount owing under the Credit Agreement. In the event Lakes sells more than 3 million WPTE shares, the proceeds of such sale over and above the amount realized on the 3 million shares would be required to be placed in a cash collateral account securing the loan under the Credit Agreement. In addition, Lakes and certain of its subsidiaries have guaranteed the repayment of the loan under the Credit Agreement pursuant to the terms of a Continuing Guaranty dated as of June 22, 2006.

LAKES ENTERTAINMENT, INC. AND SUBSIDIARIES

Notes to Unaudited Condensed Consolidated Financial Statements — (Continued)

      The loan underlying the BofA Facility can be declared immediately due and payable upon the occurrence of an event of default that is not cured within any applicable cure period. An event of default will occur if any of the covenants contained in the Credit Agreement are violated. Management will routinely monitor all debt covenants to ensure compliance over the term of the financing facility.

      In April 2006, Lakes entered into a Letter of Settlement (“Settlement Agreement”) with the Kickapoo Traditional Tribe of Texas (“Kickapoo Tribe”) pursuant to which Lakes and the Kickapoo Tribe resolved all outstanding issues relating to the parties’ business relationship that was terminated in November 2005. During fiscal 2005, Lakes recorded a loss of approximately $6.3 million as a result of the terminated business relationship. Pursuant to the Settlement Agreement, Lakes received a cash payment of approximately $2.6 million as reimbursement in April 2006, for payments made directly by Lakes to vendors on behalf of the Kickapoo Tribe and the Kickapoo Tribe agreed to pay $0.6 million into an escrow to be released to Lakes at such time as Lakes transfers title to certain land owned by Lakes to the Kickapoo Tribe. The Company and the Kickapoo Tribe have agreed that title will transfer only after the Kickapoo Tribe assumes, settles or pays certain accounts payable to vendors related to the Kickapoo Tribe’s casino that remain on Lakes’ books, and once Lakes receives full releases for any liability thereto. During the second quarter of fiscal 2006, Lakes received releases from vendors totaling $2.8 million related to services performed in connection with the Kickapoo casino project, which have been recorded as unrealized gains in the accompanying unaudited condensed consolidated statement of earnings (loss) and comprehensive earnings (loss). Approximately $0.9 million of liabilities subject to the Settlement Agreement remain as of July 2, 2006. The Company will not recognize further gains unless and until additional releases are received from vendors. However, the Company does not have an estimate of when or if this will occur.

      In March 2006, Lakes received notification from the National Indian Gaming Commission (“NIGC”) that it has approved Lakes’ management agreement with the Pokagon Band to develop and manage the Four Winds Casino Resort on the Pokagon Band’s land in New Buffalo Township, Michigan (“Pokagon Casino”). On June 22, 2006 the Pokagon Band closed on a $305 million senior note financing in addition to a $75 million commitment for furniture, fixtures and equipment (“FF&E”) to fund the Four Winds Casino project. Amounts owed to Lakes under the management and development agreements are subordinated to the senior note financing.

      The closing of third-party financing by the Pokagon Band during the second quarter of fiscal 2006 triggered a retroactive interest rate adjustment on the Company’s notes receivable, which required the recalculation of interest cost as if a fixed rate had been in effect for the entire period the loans were outstanding. The interest rate used in this calculation is prime rate plus one percentage point as of June 22, 2006 (approximately 9.0%). The advances Lakes makes to the tribes are accounted for as structured notes in accordance with the guidance contained in Emerging Issues Task Force (EITF) Consensus No. 96-12 Recognition of Interest Income and Balance Sheet Classification of Structured Notes (EITF No. 96-12). Accordingly, pursuant to the guidance in EITF No. 96-12, Lakes records its advances to tribes at estimated fair value and therefore, this fixed interest rate has been included as part of the fair value calculation related to the notes receivable from the Pokagon Band as of July 2, 2006. (Note 3)

LAKES ENTERTAINMENT, INC. AND SUBSIDIARIES

Notes to Unaudited Condensed Consolidated Financial Statements — (Continued)

      In April 2006, Lakes received notification from the NIGC that it has approved Lakes’ management agreement with the Iowa Tribe of Oklahoma (“Iowa Tribe”) to refurbish and manage the Cimarron Casino project on the Iowa Tribe’s land in Perkins, Oklahoma.

      Effective March 30, 2006, Lakes entered into a development financing and services agreement with the Jamul Tribe. As part of the agreement, Lakes will use its best efforts to obtain financing, from which advances will be made to the Jamul Tribe of up to $350 million to pay for the design and construction of the project. There can be no assurance that third party financing will be available with acceptable terms. If Lakes is unable to obtain the appropriate amount of financing for this project, the project may not be completed as planned. This agreement will help assist the Jamul Tribe in developing a casino with related amenities/services (“Jamul Casino”) on its existing six-acre reservation which the Jamul Tribe will manage.

      Lakes will receive a flat fee of $15 million for its development design services, and a flat fee of $15 million for its construction oversight services, payable evenly over the first five years after the opening date of the Jamul Casino. In connection with Lakes’ financing of the Jamul Casino, the Jamul Tribe will pay interest over a ten-year period on sums advanced by Lakes equal to the rate charged to Lakes for obtaining the funds necessary plus 5%. Amounts previously advanced by Lakes to the Jamul Tribe in connection with the Jamul Tribe’s proposed casino resort are included in the development financing and services agreement financing amount.

      As of March 17, 2006, Lakes entered into a Settlement Agreement with Deephaven Capital Management LLC (“Deephaven”) pursuant to which Deephaven paid Lakes approximately $2.8 million as repayment of short-swing profits under Section 16(b) of the Securities Exchange Act of 1934, as amended, relating to or in connection with one or more funds managed by Deephaven trading in shares of Lakes’ common stock prior to February 14, 2006. The payment has been recorded as an increase in additional paid-in capital.

      Lakes has a Stock Option and Compensation Plan and a Director Stock Option Plan, which were carried forward from Lakes’ predecessor Grand Casinos, Inc. (“Grand Casinos”). All options granted under these plans were carried forward with the original terms and vesting and expiration dates.

      Additionally, Lakes has a 1998 Stock Option and Compensation Plan and a 1998 Director Stock Option Plan (the “1998 Plans”), which upon resolution of the Compensation Committee, are approved to grant up to an aggregate of 5.0 million shares and 0.5 million shares, respectively, of incentive and non-qualified stock options to officers, directors, and employees. Stock options granted under the 1998 Plans vest in equal installments over four-year and five-year periods, beginning on the first anniversary of the date of each grant and continue on each subsequent anniversary date until the option is fully vested. The employee must be employed by Lakes on the anniversary date in order to vest in any shares that year. Vested options are exercisable for ten years from the date of grant; however, if the employee is terminated (voluntarily or involuntarily), any unvested options as of the date of termination will be forfeited.

LAKES ENTERTAINMENT, INC. AND SUBSIDIARIES

Notes to Unaudited Condensed Consolidated Financial Statements — (Continued)

      WPTE has adopted the board-approved 2004 Stock Incentive Plan (the “2004 Plan”) that is authorized to grant stock awards to purchase up to 3,120,000 shares of common stock, including the options to purchase up to 1,120,000 shares of common stock issued to employees and consultants that were previously outstanding under a previous stock incentive plan at the time of conversion to a publicly-traded company. On May 31, 2006, WPTE shareholders approved an amendment to the 2004 Plan to increase the number of shares of common stock reserved for issuance from 3,120,000 shares to 4,200,000 shares. Under the 2004 Plan, the options vest in equal installments over three-year and five-year periods beginning on the first anniversary of the date of each grant and continue on each subsequent anniversary date until the option is fully vested. The employee must be employed with WPTE on the anniversary date in order to vest in any shares that year. Vested options are exercisable for ten years from the date of grant; however, if the employee is terminated (voluntarily or involuntarily), any unvested options as of the date of termination will be forfeited.

      Lakes and WPTE issue new shares of common stock upon exercise of options.

      On January 2, 2006, the Company adopted Statement of Financial Accounting Standards (SFAS) No. 123(R), Share-Based Payment-Revised 2004, which requires the measurement and recognition of compensation expense for all share-based payment awards made to employees and directors including employee stock options and employee stock purchases based on estimated fair values.

      SFAS 123(R) requires companies to estimate the fair value of share-based payment awards on the date of grant using an option-pricing model. The value of the portion of the award that is ultimately expected to vest is recognized as expense over the requisite service periods in the Company’s unaudited condensed consolidated statement of earnings (loss) and comprehensive earnings (loss). SFAS 123(R) supersedes the Company’s previous accounting for employee stock-based compensation for options granted prior to January 2, 2006, in accordance with Accounting Principles Board Opinion (APB) No. 25, Accounting for Stock Issued to Employees and related interpretations (APB 25). Accordingly, no accounting recognition was given in prior years to stock options granted at fair market value until they were exercised. Upon exercise, net proceeds, including tax benefits realized, were recorded in equity.

LAKES ENTERTAINMENT, INC. AND SUBSIDIARIES

Notes to Unaudited Condensed Consolidated Financial Statements — (Continued)

      The Company adopted SFAS 123(R) using the “modified prospective transition method,” which requires the application of the accounting standard as of January 2, 2006, the first day of the Company’s fiscal year 2006. In accordance with the modified prospective transition method, the Company’s condensed consolidated financial statements for prior periods have not been restated to reflect, and do not include, the impact of SFAS 123(R). The effect of the change from APB 25 to SFAS 123(R) was to decrease net earnings for the three months and six months ended July 2, 2006 by $1.4 million and $3.6 million, respectively, and basic and diluted earnings per share by $0.06 and $0.06, and $0.16 and $0.15, respectively. There was no share-based compensation expense related to employee stock options and employee stock purchases recognized in the Company’s unaudited condensed consolidated financial statements during the three months and six months ended July 3, 2005. The following table summarizes the consolidated share-based compensation expense related to employee stock options and stock purchases and non-vested shares under SFAS 123(R) for the three months and six months ended July 2, 2006, which was allocated as follows:

      For the three months and six months ended July 2, 2006, no income tax benefit was recognized in the Company’s unaudited condensed consolidated statement of earnings (loss) and comprehensive earnings (loss) for share-based compensation arrangements. Management assessed the likelihood that deferred tax assets relating to future tax deductions from share-based compensation will be recovered from future taxable income and determined that a valuation allowance was required due to uncertainty of realization.

      The Company uses a Black-Scholes option-pricing model to value stock options, which requires the consideration of historical employee exercise behavior data and the use of a number of assumptions including volatility of the Company’s stock price, the weighted-average risk-free interest rate, and the weighted-average expected life of the options. As the Company does not pay dividends, the dividend rate variable in the Black-Scholes model is zero. The following values for the indicated variables were used to value options granted during the three months and six months ended July 2, 2006, and we expect the assumptions used for grants in future quarters of fiscal 2006 to approximate these values.

      The volatility assumption is based on the historical weekly price data of Lakes’ stock over a two-year period. Management evaluated whether there were factors during that period which were unusual and which would distort the volatility figure if used to estimate future volatility and concluded that there were no such factors.

LAKES ENTERTAINMENT, INC. AND SUBSIDIARIES

Notes to Unaudited Condensed Consolidated Financial Statements — (Continued)

      The risk-free interest rate assumption is based upon the interpolation of various U.S. Treasury rates determined at the date of option grant.

      The expected term of employee stock options represents the weighted-average period that the stock options are expected to remain outstanding. It is based upon an analysis of the historical behavior of option holders during the period from September 1995 to July 2, 2006. Management believes historical data is representative of future exercise behavior.

      As share-based compensation expense recognized in the unaudited condensed consolidated statement of earnings (loss) and comprehensive earnings (loss) pursuant to SFAS 123(R) is based on awards ultimately expected to vest, expense for grants beginning upon adoption of SFAS 123(R) on January 2, 2006 will be reduced for estimated forfeitures. SFAS 123(R) requires forfeitures to be estimated at the time of grant and revised, if necessary, in subsequent periods if actual forfeitures differ from those estimates. The Company has reviewed the historical forfeitures which are minimal and as such will amortize the grants to the end of the vesting period and will adjust for forfeitures at the end of the term. Estimated forfeitures are based partially on historical experience.

      WPTE uses a Black-Scholes option-pricing model to estimate the fair value and compensation cost associated with employee incentive stock options in accordance with SFAS 123(R). The bases for the key assumptions included in the model are as follows:

LAKES ENTERTAINMENT, INC. AND SUBSIDIARIES

Notes to Unaudited Condensed Consolidated Financial Statements — (Continued)

      The following table summarizes Lakes’ stock option activity through the three months and six months ended July 2, 2006 and July 3, 2005:

LAKES ENTERTAINMENT, INC. AND SUBSIDIARIES

Notes to Unaudited Condensed Consolidated Financial Statements — (Continued)

      The following table summarizes significant ranges of Lakes’ outstanding and exercisable options as of July 2, 2006:

      The aggregate intrinsic value in the preceding table represents the total pre-tax intrinsic value, based on Lakes’ closing stock price of $12.09 June 30, 2006, which would have been received by the option holders had all option holders exercised their options as of that date. The total intrinsic value of options exercised during the three months and six months ended July 2, 2006 was $0.2 million and $2.2 million, respectively. As of July 2, 2006, Lakes’ unrecognized share-based compensation related to stock options was approximately $4.6 million. This cost is expected to be expensed over a weighted-average period of 2.0 years.

LAKES ENTERTAINMENT, INC. AND SUBSIDIARIES

Notes to Unaudited Condensed Consolidated Financial Statements — (Continued)

      The following table summarizes WPTE stock option activity through the three months and six months ended July 2, 2006 and July 3, 2005:

      The following table summarizes significant ranges of WPTE outstanding and exercisable options as of July 2, 2006:

LAKES ENTERTAINMENT, INC. AND SUBSIDIARIES

Notes to Unaudited Condensed Consolidated Financial Statements — (Continued)

     The aggregate intrinsic value in the preceding table represents the total pre-tax intrinsic value, based on WPTE’s closing stock price of 6.02 on June 30, 2006, which would have been received by the option holders had all option holders exercised their options as of that date. As of July 2, 2006, the total number of “in-the-money” options exercisable was 225,000. The total intrinsic value of options exercised during the first six months ended July 2, 2006 was $1.4 million.

      For the six months ended July 2, 2006, total compensation cost related to SFAS 123(R) was approximately $2.3 million, of which $92,000 relates to the total fair value of the shares vested during the period. As of July 2, 2006, total compensation cost related to non-vested share-based options not yet recognized was $5.7 million, which is expected to be recognized over the next 33 months on a weighted-average basis.

      The following table illustrates the consolidated pro forma effect on net loss and net loss per share if the Company had retroactively applied the fair value recognition provisions of SFAS 123 for the 2005 periods presented.

      For all periods, basic earnings (loss) per share is calculated by dividing earnings (loss) by the weighted average number of common shares outstanding. For the three months and six months ended July 2, 2006, diluted earnings per share reflects the effect of all potentially dilutive common shares outstanding by dividing net earnings by the weighted-average of all common and potentially dilutive shares outstanding. The effects of stock options and warrants have not been included in diluted loss per share for the three months and six months ended July 3, 2005 as the effect would have been anti-dilutive as a result of losses.

      Management has evaluated its ability to utilize deferred tax assets arising from net operating loss carry forwards, deferred tax assets and other ordinary items and determined that a valuation allowance was appropriate at July 2, 2006 and January 1, 2006. Management evaluated all evidence and determined net losses generated over the past three years outweighed the current positive evidence that the Company believes exists surrounding its ability to generate significant income from its long-term assets in Indian casino projects. Therefore, the Company recorded a 100% valuation allowance against these items at July 2, 2006 and January 1, 2006. However, the Company has recognized deferred tax assets related to capital losses incurred during 2001 through 2005. The realization of these benefits is dependant on the generation of capital gains. The Company owns approximately 12.5 million shares of WPTE common stock valued at approximately

LAKES ENTERTAINMENT, INC. AND SUBSIDIARIES

Notes to Unaudited Condensed Consolidated Financial Statements — (Continued)

$46.4 million as of August 4, 2006 based upon the closing stock price as reported by the Nasdaq Global Market on August 4, 2006 of $3.72. Therefore, it is expected that these capital losses could be offset by future capital gains associated with Lakes’ WPTE common stock. However, Lakes does not currently intend to sell shares of WPTE common stock and has determined that a deferred tax asset in the approximate amount of $0.3 million related to capital losses may expire before it can be utilized at the end of 2006, since it may not be possible to generate sufficient capital gains during the remainder of 2006. Therefore, a valuation allowance has been recorded against this item as of July 2, 2006.

      The Company is currently under examination for income and franchise tax matters (Note 14).

      The Company leases an airplane under a non-cancelable operating lease. The airplane lease was amended on May 1, 2005, which allows for a base term of one year and two one-year renewal terms. Under the lease agreement, the Company has the option of renewing the lease, purchasing the airplane at amounts which range from approximately $5.2 million to $5.8 million or facilitating the sale of the aircraft at the end of each term included in the up to three-year lease term; however at the conclusion of the lease, the Company is required to either purchase the airplane or facilitate the sale of the airplane. The Company’s airplane lease contains a residual value guarantee of $5.2 million at the end of the three-year lease term.

      The Company is under audit by the Internal Revenue Service (“IRS”) for the fiscal years ended 2001 and 2000. The IRS is challenging the treatment of income categorized as a capital gain. If the Company is unsuccessful in sustaining its position, the Company may be required to pay up to approximately $3.2 million plus accrued interest related to tax on ordinary income. The Company originally carried back capital losses to offset the capital gain. If the Company is unsuccessful in sustaining its capital gain position, it could use the capital losses in the future to offset future capital gains, if any, prior to their expiration. The Company owns approximately 12.5 million shares of WPTE common stock valued at approximately $46.4 million as of August 4, 2006 based upon the closing stock price as reported by the Nasdaq Global Market on August 4, 2006 of $3.72. However, Lakes does not currently intend to sell shares of WPTE common stock. Therefore, if reinstated during 2006, these capital loss items could expire before they could be utilized at the end of 2006, due to insufficient capital gains. As a result, Lakes has recorded a liability related to this matter of approximately $2.6 million, including interest, due to the possibility that if reinstated, these capital loss items may expire before they could be utilized.

      In connection with the establishment of Lakes as a public corporation on December 31, 1998, via a distribution of its common stock to the shareholders of Grand Casinos, the Company and Grand Casinos entered into an agreement governing the sharing or allocation of tax benefits accruing to Grand Casinos and certain affiliated companies of Grand Casinos. Lakes asserted claims against Grand Casinos for amounts to which Lakes believed it was entitled under the tax sharing agreement. On December 1, 2004, Lakes entered into a settlement agreement with Grand Casinos and its parent company, Park Place Entertainment Corporation (now known as “Harrah’s Entertainment, Inc.” or “Harrah’s”), pursuant to which Lakes received $11.3 million in December 2004 in satisfaction of its prior claim and its future rights to the tax benefits that were the subject of the dispute. Lakes will be required to provide reimbursement for its share of the disallowed benefits. This settlement income was recorded as other income in the accompanying unaudited

LAKES ENTERTAINMENT, INC. AND SUBSIDIARIES

Notes to Unaudited Condensed Consolidated Financial Statements — (Continued)

condensed consolidated statement of earnings (loss) in fiscal 2005. Lakes has not recorded any tax related to the settlement payment of $11.3 million, as Lakes believes this settlement is not taxable to Lakes.

      The Company’s management, development, consulting and financing contracts with its tribal partners require the Company provide financial support related to project development in the form of loans.

Tribal Casino Development Advances/ Commitments

As of July 2, 2006