<PAGE>
 
                       SECURITIES AND EXCHANGE COMMISSION
                             WASHINGTON, D.C. 20549

                                   FORM 10-K
                                        
             [ X ]  ANNUAL REPORT PURSUANT TO SECTION 13 OR 15 (d)
                     OF THE SECURITIES EXCHANGE ACT OF 1934

                  For the fiscal year ended SEPTEMBER 27, 1997

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

                For the transition period from ______ to ______

                          Commission file No.  0-15338
                                        
                            SEATTLE FILMWORKS, INC.
                            -----------------------
             (Exact name of registrant as specified in its charter)
<TABLE>
<S>                                                                                <C>
                        WASHINGTON                                                                    91-0964899
                        ----------                                                                    ----------
(State or other jurisdiction of incorporation or organization)                             (IRS Employer Identification No.)
 
           1260 16TH AVENUE WEST, SEATTLE,  WA                                                          98119
           -----------------------------------                                                          -----
         (Address of principal executive offices)                                                     (Zip Code)
 
    Registrant's telephone number, including area code:                                            (206) 281-1390
                                                                                                   --------------

 Securities registered pursuant to Section 12(b) of the Act:                                             NONE
                                                                                                         ----

 Securities registered pursuant to Section 12(g) of the Act:                            COMMON STOCK, PAR VALUE $.01 PER SHARE.
                                                                                        ---------------------------------------
</TABLE>

     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 the
filing requirements for the past 90 days.  Yes:  [ X ]   No:  [   ]

     Indicate by check mark if disclosure of delinquent filers pursuant to Item
405 of Regulation S-K (Section 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.  [ X ]

     As of November 28, 1997, there were issued and outstanding 16,438,956
shares of Common Stock, par value $.01 per share.  As of November 28, 1997, the
aggregate market value of the Registrant's Common Stock held by nonaffiliates of
the Registrant was $147,454,922, based on the last sale price of the
Registrant's Common Stock as reported by the NASDAQ National Market.

                      Documents incorporated by reference:

     Portions of the registrant's proxy statement relating to its 1997 annual
meeting of shareholders, to be held on February 11, 1998, are incorporated by
reference into Part III of this Annual Report on Form 10-K.

                                  Page 1 of 53
<PAGE>
 
                                     PART I
                                        
ITEM 1 - BUSINESS

DESCRIPTION OF BUSINESS

     Seattle FilmWorks, Inc. ("Seattle FilmWorks" or the "Company") is a leading
direct-to-consumer marketer and provider of high-quality amateur photofinishing
services and products.  The Company offers an array of complementary services
and products primarily on a mail-order basis under the brand name Seattle
FilmWorks(R).

     Since 1978, the Company has been an industry leader in the introduction of
value-added photo-related services and products.  The Company offers prints,
slides and digital images, all from the same roll of 35mm film.  Seattle
FilmWorks was among the first to provide express-mail delivery, cross-referenced
data on prints and negatives, a composite photo index and a convenient reorder
system.  To a lesser extent, the Company provides photofinishing services,
products and supplies on a wholesale basis.

     Since 1994, the Company has been a pioneer in providing digital-imaging
technologies which enable photofinishing customers to creatively enhance and
share personal photographs with friends, family and business associates.
Products incorporating these technologies include (i) Pictures On Disk(TM) a
single floppy disk containing digital images from a roll of film; (ii)
PhotoWorks(R) software, which can be used to create digital photograph albums
and screen savers; (iii) PhotoMail(TM), a service which reduces turnaround time
by privately delivering digital images to customers over the Internet; (iv)
FilmWorksNet(TM), a free service which provides customers the ability to share
pictures through the creation of a private photographic home page uploaded to
the Seattle FilmWorks Web site (www.filmworks.com); and (v) most recently,
PictureWorks(TM), a digital reprint service with which customers upload digital
image files across the Internet to the Company for digital reproduction on Kodak
photographic paper. The Company is currently developing additional digital-
imaging and Internet-related services and products.

     The Company attributes its growth in photofinishing revenues in large part
to its direct-marketing programs, which are primarily based on the customer
acquisition technique of offering two rolls of film for $2.00 or less.  Direct-
marketing techniques enable the Company to target selected consumers, measure
customer response and obtain direct customer feedback to changes in marketing
strategies.  For the past three years, the Company has targeted the growing
population of personal computer users in connection with the introduction of
digital-imaging services and products.  The Company has developed comprehensive
statistical models for the design and analysis of its direct-response marketing
programs using proprietary customer data compiled over 16 years.

     The Company was incorporated in Washington State in June 1976.  The
executive offices of the Company are located at 1260 Sixteenth Avenue West,
Seattle, Washington 98119, and the Company's telephone number is (206) 281-1390.
References to Seattle FilmWorks and the Company in this Report include Seattle
FilmWorks, Inc., and its subsidiaries.  Seattle FilmWorks, Inc., reorganized its
business on September 30, 1996 by forming two wholly-owned subsidiaries, Seattle
FilmWorks Manufacturing Company and OptiColor, Inc., and transferring a portion
of its assets to each of these subsidiaries.

FORWARD-LOOKING INFORMATION

     Statements in this report concerning expectations for the future constitute
forward-looking statements which are subject to a number of known and unknown
risks, uncertainties and other factors which may cause actual results,
performance or achievements of the Company or industry trends to differ
materially from those expressed or implied by such forward-looking statements.
Relevant risks and uncertainties include, among others, those discussed in Item
1 of Part 1 under the heading "Risk Factors" and elsewhere in this Report and
those described from time to time in the Company's other filings with the
Securities and Exchange Commission, press releases and other communications.

                                       2
<PAGE>
 
PHOTOFINISHING INDUSTRY AND DIRECT-MARKETING OVERVIEW

     According to information published by the Photo Marketing Association
International ("PMAI"), domestic amateur photofinishing sales totaled
approximately $5.4 billion in 1995, having exhibited little or no growth since
1990.  The dominant method of distributing photofinishing services and products
was through retail stores, including discount and mass merchants, drugstores,
supermarkets and camera/specialty stores. Management believes the vast majority
of rolls of film are sent to wholesale photofinishing laboratories for
processing, although a growing percentage are processed in-store using on-site
equipment.

     Outside the photofinishing industry, leading users of direct marketing
include mail-order houses and catalog mailers, magazine publishers, insurance
companies, book and record clubs, financial institutions and credit card
companies. Management believes growth in the use of direct-marketing is
generally attributable to social, economic and technological changes and to the
relative cost-effectiveness of direct-marketing techniques. Management also
believes several factors have enhanced consumer responsiveness to direct
marketing as a purchasing medium, including growth in the number of people in
the most active segment of the purchasing population, growth in the number of
two-career families that have more disposable income and less time to shop, and
increased availability and use of credit cards. In the future, on-line services
and increased use of personal computers may provide additional channels for
direct-to-consumer marketing. See "Risk Factors--Dependence on Direct-Marketing
Programs; Accounting for Customer Acquisition" and "--Dependence on the Internet
and Potential Liability for Content."

OPERATING STRATEGY

     Over the past six years, Seattle FilmWorks has consistently achieved annual
and corresponding-quarter growth in net revenues and net income through the
execution of its operating strategy, the principal elements of which are the
introduction of innovative, value-added services and products, application of
direct-to-consumer marketing techniques, and a commitment to customer
satisfaction.

     Innovative, Value-Added Services and Products.  Management believes that
Seattle FilmWorks has distinguished itself from its competitors through service
and product differentiation.  The Company strives to develop and introduce
value-added photofinishing services and products based on focused research and
development efforts as well as anticipation of consumer demand by monitoring
customer feedback.  Management believes that the continuous expansion of its
array of complementary services and products promotes (i) increased acquisition
of new customers, (ii) retention of existing customers and (iii) higher average-
order sizes.  Management believes that this operating strategy has contributed
to the Company's growth at annual rates exceeding industry growth rates.

     In the late 1970s, the Company introduced Seattle FilmWorks(R) branded film
and shortly thereafter offered its customers the option of prints and/or
individually color-corrected slides from the same roll of film.  More recently,
the Company has been a leader in introducing numerous other value-added
features, including express-mail delivery, cross-referencing data on prints and
negatives, Pictures Plus(TM) Index, a convenient Easy-Order System and Professor
FilmWorks(TM) (free telephone pre-recorded mini-lessons on photography).

     In addition, the Company has been a leader in marketing photofinishing
services which employ digital technology.  These include (i) Pictures On
Disk(TM), a single floppy disk containing digital images from a roll of film
(ii) PhotoWorks(R) software, which can be used to create digital photograph
albums and screen savers; (iii) PhotoMail(TM), a service which reduces
turnaround time by privately delivering digital images to customers over the
Internet; (iv) FilmWorksNet(TM), a free service which provides customers the
ability to share pictures through the creation of a private photographic home
page uploaded to the Seattle FilmWorks Web site (www.filmworks.com); and (v)
most recently, PictureWorks(TM), a digital reprint service with which customers
upload digital image files across the Internet to the Company for digital
reproduction on Kodak(TM) photographic paper.  The Company is currently
developing additional digital-imaging and Internet-related services and
products.  See "Business Services and Products."

                                       3
<PAGE>
 
     Direct-to-Consumer Marketing.  The Company's business model is founded on
direct-response marketing.  Management believes an important advantage of its
direct-marketing strategy is the opportunity to contact a large number of
consumers who may appreciate the convenience of mail order and the Company's
array of complementary services and products.  Direct access to consumers
permits the Company to target and monitor selected potential and existing
customers, measure customer response and obtain direct customer feedback to
changes in marketing strategies.  Generally, the Company attempts to identify
prospective customers by targeting specific groups of individuals with common
characteristics.  For example, the Company has targeted the growing population
of personal computer users in connection with the introduction of its digital-
imaging services and products.  Information derived from the Company's extensive
database compiled over 16 years has been used to create statistical models to
develop targeted marketing programs and estimate future demand.  In addition,
the Company's proprietary database is used to plan, personalize, implement and
evaluate marketing programs for existing customers.  Historically, the Company
has been able to identify targeted consumer groups that, when extended the
Introductory Offer, yield economically attractive response rates.  See "Business
Marketing and Customer Acquisition."

     Commitment to Customer Satisfaction.  The Company seeks to develop and
provide high-quality, user-friendly and reliable photofinishing services and
products to enhance brand recognition for "Seattle FilmWorks" and to engender
customer loyalty.  Management believes that a significant portion of its
business comes from repeat customers.  As part of its dedication to customer
service, Seattle FilmWorks offers a 100% money-back satisfaction guarantee,
provides an Easy-Order System whereby a customer sets up a standing order, thus
avoiding the need to fill out an order form with each order, and offers
Professor FilmWorks(TM).  In addition, to achieve its customer service goals,
the Company conducts customer surveys and holds management meetings to identify
areas for service enhancement.  Moreover, through investments in automation and
state-of-the-art photofinishing equipment, as well as through the commitment of
its employees to quality control, the Company strives to deliver greater than
99.8% of its orders without loss or damage.  See "Business Customer Service and
Support.".

GROWTH STRATEGY

     The Company's strategy for growth is to continue to leverage the strength
of its services, products and marketing programs to acquire additional customers
and increase the level of business with prospective and existing customers.

     New Customers.  Historically, the Company has grown primarily through the
acquisition of new customers.  In a mail-order photofinishing environment that
has recently exhibited little or no growth, the Company has increased net
revenues at a 21% compound annual growth rate during the past five years and has
increased the total number of its customers.  The Company continuously refines
existing, and develops, tests and implements new, marketing programs to
additional groups of consumers with different demographic characteristics to
offset the potential impact of market saturation in any given target customer
group.  In addition, the Company continues to explore alternative direct-
marketing platforms in order to acquire additional customers.  To this end, the
Company has established a Web site on the Internet (www.filmworks.com) from
which customers can access answers to frequently asked questions, download
versions of Company software, create and view personal home pages, obtain the
status of their orders and send electronic messages to customer service.

     Increasing Sales to New and Existing Customers.  Management believes its
complementary value-added services and products promote customer loyalty and
increase customer demand.  The Company strives to increase both average order
size and order frequency by informing both targeted consumers and its large
existing customer base of its integrated array of services and products.  The
Company's commitment to expanding its service and product offerings, including
enhancements to its Internet-related offerings, supports this strategy.  In
addition, the Company employs a variety of other direct-marketing techniques to
increase business from existing customers and generate business from inactive
customers.

                                       4
<PAGE>
 
MARKETING AND CUSTOMER ACQUISITION

     One of the key elements of the Company's operating strategy is to generate
demand for its services and products by using its proprietary direct-marketing
techniques and extensive database to efficiently target existing and prospective
customers. The Company has used mail, print media, television, radio, telephone
and, more recently, the Internet, on-line services and retail outlets to target
groups of consumers and businesses.

     The Company makes extensive use of marketing tests in order to evaluate
which of a variety of marketing programs offers the best probable return on
investment. The Company's direct-marketing programs use coded advertisements to
monitor consumer response and to provide measurable results for each specific
marketing program. Measuring the effectiveness of marketing tests takes into
account both the response rate to advertised offers and estimates of customer
lifetime value to the Company, measured in terms of profit generated from the
estimated future stream of orders, thereby allowing for the targeting of a
marketing effort to specific market segments through selected media. During
fiscal 1997 the Company expanded its retail operations in the Pacific Northwest
to provide a drop off alternative to mail order delivery. Management believes
the Company's retail stores attract customers who might not use the Company's
mail order services. The Company uses computers to maintain and analyze
extensive data and segment markets using geographic and demographic information
about potential customers.

     Since the early 1980s, the primary method the Company has used to acquire
new film processing customers has been its introductory offer of two rolls of
film for $2.00 or less (the "Introductory Offer"). The Company regularly refines
the Introductory Offer to improve its effectiveness, but the basic concept of
sending two rolls of Seattle FilmWorks(R) branded film to targeted potential
customers has remained fairly constant. The Introductory Offer has been
nationally advertised through direct-response media, including package inserts,
newspaper supplements and magazines. The Company also has a customer referral
program in which existing customers suggest family and friends to whom the
Company mails an introductory package. The Company has further refined its
Introductory Offer program by targeting the growing population of personal
computer users. Favorable rates of return from this group led to an expansion of
the Company's customer acquisition investment. See "Risk Factors-Dependence on
Direct-Marketing Programs; Accounting for Customer Acquisition."

SERVICES AND PRODUCTS

     Seattle FilmWorks is a leader in the development and introduction of
innovative photofinishing services and products. Beginning in 1978 with the
introduction of its privately branded film and continuing with the option of
receiving both photographic prints and individually color-corrected slides from
the same roll of film, the Company established an early tradition of service and
product differentiation. The following table illustrates the Company's service
and product introductions during the past seven years:

<TABLE>
<CAPTION>
     Service or Product                                    YEAR OF INTRODUCTION
     ------------------                                    --------------------
<S>                                                        <C>
     PhotoWorks(R) Cards.................................          1997
     PictureWorks(TM)....................................          1997
     PhotoWorks(R) Composer for Windows..................          1997
     PhotoWorks(R) Plus - How to Use Every Feature(C)....          1996
     ------------------------------------------------           
     FilmWorksNet(TM)....................................          1996
     PhotoMail(TM).......................................          1995
     PhotoWorks(R) for Macintosh.........................          1995
     PhotoWorks(R) Plus for Windows......................          1994
     PhotoWorks(R) for Windows...........................          1994
     PhotoWorks(R) for MS-DOS............................          1994
     Pictures On Disk(TM)................................          1994
     Pictures Plus(TM) Index.............................          1993
     Professor FilmWorks(TM).............................          1992
     Backprinting & Referenced Negatives.................          1992
     Easy-Order System...................................          1991
     Express-Mail Delivery...............................          1991
</TABLE>

                                       5
<PAGE>
 
     In 1991, the Company began to offer mail-order photofinishing customers the
options of express-mail pickup and delivery service and the Easy-Order System,
whereby a customer sets up a standing order, thus avoiding the need to fill out
an order form with each order. This pattern of service and product innovation
continued with the introduction in early 1992 of the Company's system for
printing the date, roll identification and print number on the back of each
print and the corresponding information on each strip of negatives (known as
backprinting) and free telephone pre-recorded mini-lessons on photography from
Professor FilmWorks(TM).  In 1993, the Company introduced the Pictures Plus(TM)
Index, which offers thumbnail-size copies of images from a roll of film on a
single 4" by 6" print as a handy reference for the customer.

     In early 1994, the Company introduced Pictures On Disk(TM), which delivers
on a single floppy disk a digital version of each photograph on a roll of film.
This product was coupled with the introduction of the Company's internally
developed PhotoWorks(R) software, which enables users to create digital albums
of their photographs and to incorporate the digital images into text, slide
shows and screen savers. PhotoWorks(R) software is available in Microsoft
Windows, MS-DOS and Apple Macintosh versions and is provided at no charge with a
customer's first order of Pictures On Disk(TM). PhotoWorks(R) is also available
for free download over the Internet from the Company's Web site. A more fully
featured version, PhotoWorks(R) Plus, is sold directly to customers as an
upgrade.

     In October 1995, the Company introduced the private delivery of digital
photographs from its laboratory directly to customers over the Internet through
its PhotoMail(TM) delivery service. Customers requesting PhotoMail(TM) delivery
are sent an e-mail notifying them that their photographs are ready for
downloading at the Company's Web site (www.filmworks.com). Such customers can
then share their photographs with friends, family and business associates who
may view and download the photographs using a download password. Management
believes that communication with digital versions of personal photographs is a
natural extension of the rapid proliferation of e-mail and other forms of
Internet communication.

     In February 1996, the Company announced FilmWorksNet(TM), a free service
through which its customers can create and upload a private personalized
photographic home page to the Seattle FilmWorks Web site using the most recent
version of the PhotoWorks(R) software (which is available for download at no
charge). By providing the guest password to their home page, Seattle FilmWorks
customers can share their photographs with friends, family and business
associates worldwide. Both PhotoMail(TM) and FilmWorksNet(TM) provide
flexibility and creativity in this new way of sharing photographs.

     In August 1996, the Company published PhotoWorks(R) Plus - How to Use Every
Feature(C).  This 260-page reference book provides customers with detailed
information on using the Company's PhotoWorks(R) Plus software.

     In 1997 the Company introduced PhotoWorks(R) Composer, which allows
consumers to create frame-ready prints with a variety of backgrounds using
Pictures On Disk(TM) images. In addition, customers can use PhotoWorks(R)
Composer to create business reports, product sheets, e-mail attachments and
newsletters.

     In October 1997, the Company introduced PictureWorks(TM), a service that
allows customers to upload personal digitized images directly to the Company for
printing high definition digital images on photographic paper. The software for
this service is available for free download over the Internet from the Company's
Web site and is included with the Company software products PhotoWorks(R) Plus
and PhotoWorks(R) Composer.

     In November 1997, the Company introduced PhotoWorks(R) Cards, a service
which allows customers to create greeting cards using proprietary software
included on PhotoWorks(R) Plus and PhotoWorks(R) Composer. The software enables
customers to create a variety of photo greeting cards from Pictures on Disk(TM)
images, then upload these files to Seattle FilmWorks for printing on
photographic paper.

     Although mail-order photofinishing is viewed as a convenience by many
consumers, mail-order turnaround time (generally seven to ten days) is longer
than many alternative sources for photofinishing services (in some cases within
one hour). The Company has addressed this issue by offering the option of
express-mail pickup and delivery

                                       6
<PAGE>
 
service by means of the U.S. Postal Service for an extra charge and, more
recently, with an immediate delivery-after-processing option through its
PhotoMail(TM) Internet delivery service. However, turnaround time remains a
competitive disadvantage for the Company.

     Management believes that the prices for its services and products are
competitive.  The Company, however, has chosen not to compete primarily on the
basis of price, but rather by offering a variety of value-added, innovative and
high-quality services and products, thereby seeking to differentiate itself from
other photofinishers.

     The Company also provides a variety of reprint and enlargement services for
its mail-order customers, as well as selling 35mm rolled film, single-use
cameras and photofinishing supplies on a wholesale basis to photofinishing
minilabs, retail stores and commercial users of photographic film. These
products are packaged by the Company and marketed under the brand OptiColor(TM)
Film & Photo. Rolled film and single-use cameras are also marketed on a private
label basis with the customer specifying its own brand name. Although it
represents a small percentage of revenues, the Company also provides
photofinishing services on private label, retail and wholesale bases. The
Company also licenses certain digital technology, including Pictures On Disk(TM)
and PhotoWorks(R), to other photofinishers outside of the U.S.

     Net revenues generated by sales outside the United States accounted for
6.6% of the Company's total net revenues in fiscal 1997, as compared to 8.5% in
both fiscal 1996 and fiscal 1995.

RESEARCH AND DEVELOPMENT

     Through internal and external research and development efforts, the Company
has established the capability to develop innovative digital media and
photofinishing services and products. The Company seeks to identify customer
needs and shifts in consumer preferences in order to design or refine the
Company's services and products. In fiscal 1997, fiscal 1996 and fiscal 1995,
the Company incurred research and development expenses of $696,000, $732,000 and
$458,000, respectively, primarily in connection with development and enhancement
of its FilmWorksNet(TM), PhotoMail(TM), PhotoWorks(R), Pictures On Disk(TM), and
most recently, PictureWorks(TM) services and products. See Item 7 of Part II--
"Management's Discussion and Analysis of Financial Condition and Results of
Operations."

CUSTOMER SERVICE AND SUPPORT

     Management believes that customer satisfaction is critical to the Company's
ongoing success.  The Company has a 100% money-back satisfaction-guarantee
policy under which it will provide a full refund if a customer's complaint
cannot otherwise be resolved.

     The direct-to-consumer photofinishing business involves contacts with a
large number of customers. For customer convenience, the Company provides toll-
free telephone access at 1-800-FILMWORKS. As of November 22, 1997, the Company
had a customer service staff of 65, which is equipped with direct access to the
Company's extensive proprietary database and is trained to promote certain of
the Company's services and products, as well as to answer questions regarding
order status, basic photography and photofinishing and use of PhotoWorks(R)
software. On average, in a week the Company's customer support personnel respond
to approximately 40,000 telephone calls from customers, 4,000 written inquiries
and 9,000 e-mail messages. The majority of these inquiries are general
information requests and order status inquiries. In addition, the Company offers
free pre-recorded mini-lessons on photography over the telephone from Professor
FilmWorks(TM).

     The Company also maintains a Web site on the Internet (www.filmworks.com).
While on-line, customers may download Pictures On Disk(TM) orders and versions
of Company software, create and view personal home pages, access answers to
frequently asked questions, obtain the status of their orders and send
electronic messages to customer service.

                                       7
<PAGE>
 
OPERATIONS

     The Company operates a laboratory in a single facility in Seattle,
Washington, which is designed to produce consistent, high-quality
photofinishing. The system is designed for 24-hour in-house turnaround
processing of photofinishing orders. The photofinishing process begins with the
entry of each order into the Company's customer database, primarily using
information provided by the customer on the order form. Each roll received for
processing is bar-coded with an identification number which enables the tracking
of each order throughout the production process. Following order entry,
individual rolls of film are spliced together into a reel of film which is then
developed as a batch. Once the film is developed, each negative is computer
analyzed, and the color-corrected image is printed on photographic paper using
state-of-the-art equipment. Order information is then printed on the back of
customers' prints and the corresponding information is printed on a paper tab
which is attached to the sleeved negatives. After a visual quality inspection,
the orders are packaged for delivery to the customer. If a customer requests,
photographs are digitized and delivered through the mail on 3 1/2" diskettes or
via download over the Internet. Although much of the photofinishing and order
handling process has been automated, trained personnel operate machinery and
regularly monitor product quality with the assistance of computerized control
and measurement systems.

     The Company has the ability to process various types of 35mm color film,
including those manufactured by Eastman Kodak Company, Fuji Photo Film U.S.A.,
Inc., Konica U.S.A., Inc., Imation Enterprises Corp., Agfa Division of Bayer
Corporation ("Agfa") and other major producers of conventional 35mm color
negative film.  The Company also has the ability to process 35mm color negative
film manufactured by Eastman Kodak Company for professional motion picture
studios which has been packaged by the Company or others for use in 35mm still
cameras.

     Currently, the Company estimates that it is capable of processing up to
approximately 200,000 rolls of film per week with its existing facilities and
equipment.  The Company has initiated steps to expand its processing capacity.

SUPPLIERS

     The Company obtains its conventional 35mm film from a few large
manufacturers of photographic film, including Agfa and Imation Enterprises
Corp., its supply of Eastman Kodak motion picture film as surplus from motion
picture studios and television production companies, and its photographic paper
and chemicals from a single supplier, Eastman Kodak Company. The individual
cassettes into which the Company spools 35mm film for still cameras are
manufactured for the Company by foreign sources, principally in China and South
Korea. In addition, the Company obtains new and recycled single use cameras
principally from suppliers in China. Currently, substantially all of the
Company's purchases from foreign suppliers are paid for in U.S. dollars. The
Company's mail-order services and products are handled largely through the U.S.
Postal Service and other common carriers. See "Risk Factors--Reliance on Key
Vendor and Supplier Relationships; Foreign Sourcing."

MANAGEMENT INFORMATION SYSTEMS

     Management information systems ("MIS") are an essential component of the
Company's strategy to provide superior service to its customers, as well as to
effectively support internal operations.  The systems support all major aspects
of the Company's business, including mail-order operations, order entry,
production, warehousing, distribution, purchasing, inventory control and
customer service, as well as various financial systems and electronic
communication systems.  All shared data, including the Company's customer
database files, are backed up on a regular basis, with tapes stored in an off-
site secure facility.  The Company uses MIS to automate much of its
photofinishing operations.

     In fiscal 1996, the Company replaced and upgraded a portion of its systems
software and hardware.  The Company has taken a number of precautions against
certain events that could disrupt the operation of its management information
systems, including events associated with continuing software and hardware
upgrades.  However, there can be no assurance that the Company will not
experience systems failures or interruptions, which could have a material
adverse effect on its business, financial condition and operating results.  See
"Risk Factors--Dependence on Production Capabilities, Statistical Models and
Management Information Systems."

                                       8
<PAGE>
 
COMPETITION

     The market for consumer photofinishing services is characterized by intense
competition among a number of firms competing in a segment in which average
revenue per roll processed has declined during the 1990s, according to
photofinishing industry data. Many of the Company's competitors have
substantially greater financial, technical and other resources than the Company.
The Company faces competition in the consumer photofinishing market from other
direct marketers and from competitors in other distribution channels, including
much larger companies which provide photofinishing services on a wholesale basis
to independent retail outlets and, in some cases, through multiple retail
outlets owned by the photofinisher, many of which provide photofinishing service
within hours.  The largest of the wholesale photofinishers are Qualex Inc., and
Fuji TruColor, Inc.  In addition, management believes that the largest mail-
order photofinishers include Nashua Corp. (dba York Labs), District Photo Inc.
(dba Clark) and Mystic Color Lab Inc.

     Management believes that the principal competitive factors in the consumer
photofinishing industry are price, convenience, range of available services,
quality of processing, speed of service and product differentiation.  There are
no significant proprietary or other barriers to entry into the photofinishing
industry. The Company has sought to differentiate its photofinishing services by
offering a number of value-added services and products and emphasizing quality
and convenience rather than seeking to be a low-price or rapid turnaround
provider.  Although management believes the Company is a leader in developing
and marketing innovative photo-related services and products, competitors can
and do provide similar services and products.  Some of these competitors have
introduced products which compete with the Company's Pictures On Disk(TM) and
PhotoWorks(R) products.  In addition, sales of consumer photofinishing services
have experienced little or no growth since 1990.  See "Business--Photofinishing
Industry and Direct-Marketing Overview."

     In addition, the wholesale distribution market for rolled film, single use
cameras and photofinishing supplies is highly competitive and is dominated by
suppliers which manufacture what they sell and may, therefore, potentially have
lower costs of goods for these items than the Company.  Relatively few firms,
however, have the capability to produce small-production quantities of private
label rolled film.  Management believes the principal competitive factors in
this segment of the wholesale distribution market are price, ability to provide
private label products and capability to deliver small-production quantities on
short notice.

     The photography industry is characterized by evolving technology and
changing services and products. The introduction of photographic services and
products embodying new technologies could render existing services and products
obsolete. The Company's future success will depend on its ability to adapt to
new technologies and develop new or modify existing services and products to
satisfy evolving consumer needs. For example, the commercialization of filmless
digital imaging technologies may have a negative impact on the photofinishing
industry generally. Moreover, Advanced Photo System ("APS"), which includes a
new film format, has been introduced and the processing of which requires
special equipment the Company does not possess. Management believes that APS
currently constitutes an insignificant percentage of the film the Company is
asked to process, and the Company has therefore decided not to establish this
capability. However, there can be no assurance that the development of these or
other new technologies or any failure by the Company to anticipate or
successfully respond to such developments will not have a material adverse
effect on the Company's business, financial condition and operating results. See
"Risk Factors--Competition" and "--Rapid Technological Change."

PROPRIETARY TECHNOLOGY

     The Company markets its services and products under registered and common-
law trademarks and service marks, including Seattle FilmWorks(R), OptiColor(TM)
Film & Photo, Pictures On Disk(TM), PhotoMail(TM), PhotoWorks(R), Pictures 
Plus(TM) Index, Professor FilmWorks(TM), PictureWorks(TM) and FilmWorksNet(TM).
See "Risk Factors--Intellectual Property."

                                       9
<PAGE>
 
     The Company considers a large portion of its PhotoWorks(R) software, its
process for production of Pictures On Disk(TM) and certain other processes to be
proprietary. The Company has not filed any patents or patent applications, in
part to avoid disclosure of its competitive strengths. The Company, however,
does attempt to protect its proprietary rights to software through a combination
of copyright, trademark and trade secret laws and employee and third-party
nondisclosure agreements, by restricting access to certain portions of its
premises and by including contractual restrictions on use and disclosure in its
end-user licenses. Moreover, the Company's PhotoWorks(R) Plus product is shipped
in sealed packages on which notices are prominently displayed informing the end-
user that, by breaking the package seal, the end-user agrees to be bound by the
license agreement contained in the package. The legal and practical
enforceability and extent of liability for violations of license agreements that
purport to become effective upon opening a sealed package are unclear.

     This Report contains trademarks other than those of the Company.

GOVERNMENTAL REGULATION

     The Company's direct-mail operations, including its transmission of digital
images over the Internet, are subject to regulation by the U.S. Postal Service,
the Federal Trade Commission and various state, local and private consumer
protection and other regulatory authorities.  In general, these regulations
govern the manner in which orders may be solicited, the form and content of
advertisements, information which must be provided to prospective customers, the
time within which orders must be filled, obligations to customers if orders are
not shipped within a specified period of time and the time within which refunds
must be paid if the ordered merchandise is unavailable or returned.  The law
relating to the liability of on-line services companies, Internet access and/or
content providers, Web hosts and electronic publishers for information carried
on or disseminated through their systems for, among other things, infringement
of copyrighted material or trademarks, violations of personal rights of privacy
and publicity and dissemination of material legally judged to be obscene,
indecent or defamatory, is currently unclear.  Such claims have been brought,
and sometimes successfully asserted, against on-line services, including cases
against Prodigy and NETCOM.  Many states have enacted legislation which makes
the transmission of certain kinds of information, such as obscene content and
information which facilitates the commission of criminal acts, a crime.  In
addition, the Telecommunications Act of 1996 (the "Telecommunication Act")
imposes, in some circumstances, liability for or prohibits the transmission over
the Internet of certain types of information and content.  Other legislation
currently before Congress and the state legislatures could result in additional
regulation or prohibition of the transmission of certain types of content over
the Internet.  This could result in significant potential liability to the
Company, as well as additional costs and technological challenges in complying
with mandatory requirements.  See "Risk Factors--Dependence on the Internet and
Potential Liability for Content" and "--Governmental Regulation."

ENVIRONMENTAL COMPLIANCE

     The Company's photofinishing operations involve the use of several
chemicals which are subject to federal, state and local governmental regulations
relating to the storage, use, handling and disposal of such chemicals. The
Company actively monitors its compliance with applicable regulations and works
with regulatory authorities to ensure compliance. To the best of management's
knowledge, the Company has never received a significant citation or fine for
failure to comply with applicable environmental requirements. However, there can
be no assurance that changes in environmental regulations or in the kinds of
chemicals used by the Company will not impose the need for additional capital
equipment or other requirements. See "Risk Factors--Potential Adverse Impact of
Environmental Regulations."

EMPLOYEES

     As of November 22, 1997, the Company had 715 employees, of whom
approximately 537 were engaged in production operations, 74 in administration,
26 in marketing, 65 in customer service and 13 in research and development. None
of the Company's employees are covered by a collective bargaining agreement, and
the Company believes its relations with its employees are good.

                                       10
<PAGE>
 
DIRECTORS AND EXECUTIVE OFFICERS OF THE REGISTRANT

     The executive officers and directors of the Company as of November 30, 1997
were:

<TABLE>
<CAPTION>
<S>                         <C>    <C>
 
Name                          Age  Position
--------------------------    ---  -------------------------------------------------
Gary R. Christophersen         51  President, Chief Executive Officer and Director
Michael F. Lass                43  Vice President-Operations
Case H. Kuehn                  45  Vice President-Finance, Chief Financial Officer
                                     and Treasurer
Bruce A. Ericson               48  Vice President-Marketing
Annette F. Mack                40  Vice President-Human Resources
Sam Rubinstein                 80  Director
Douglas A. Swerland            52  Director
Craig E. Tall                  51  Director
Peter van Oppen                45  Director
</TABLE>

     Directors are divided into three classes, with each class as nearly equal
in number as possible.  Starting with the annual meeting of shareholders in
1998, one class will be elected each year for a three-year term.  Directors may
be removed only for cause and only by a vote of a majority of shares of the
Company's common stock entitled to vote on an election of directors.  Officers
serve at the discretion of the Board of Directors.

     GARY R. CHRISTOPHERSEN, the Company's President and Chief Executive Officer
since August 1988, joined the Company in January 1982 as Vice President-
Operations and has served as a Director of the Company since 1982.  From May
1983 to August 1988, Mr. Christophersen was a Senior Vice President of the
Company and its General Manager.

     MICHAEL F. LASS, the Company's Vice President-Operations since September
1988, joined the Company in 1984 as Manager of Operations. From 1982 to 1984,
Mr. Lass was Vice President and General Manager of Breezin' Sportswear, a
manufacturer and marketer of sportswear, and, from 1980 to 1982, General Manager
and a director of Mountain Safety Research, Inc., a manufacturer of outdoor
recreational products.

     CASE H. KUEHN, has been the Company's Vice President-Finance, Chief
Financial Officer and Treasurer since February 1995. From April 1994 to February
1995, Mr. Kuehn was Chief Financial Officer of Shoe Inn, Inc., doing business as
Shoe Pavilion. From January 1992 to March 1994, Mr. Kuehn was General Manager of
Pro Mark Technologies, Inc., a manufacturer of computer/video-based inspection
equipment, and, from March 1990 to January 1992, Vice President, Commercial
Lending, at First National Bank of Chicago. From November 1985 to February 1990,
Mr. Kuehn performed business valuation consulting with Price Waterhouse.

     BRUCE A. ERICSON, the Company's Vice President-Marketing since November
1989, joined the Company in March 1985 as Director of Publishing and, from
January 1988 to October 1989, was its Director of Marketing.

     ANNETTE F. MACK, the Company's Vice President-Human Resources since January
1996, joined the Company in March 1986 as Human Resources Manager and, from
August 1988 to December 1995, was its Director of Human Resources.

     SAM RUBINSTEIN became a Director of the Company in March 1986. From June
1985 to May 1988, he was the Chairman of the Board and Chief Executive Officer
of Farwest Fisheries, Inc., a seafood processing and marketing firm. From 1974
to December 1987, Mr. Rubinstein was the Chairman of the Board and Chief
Executive Officer of Bonanza Stores, Inc., an operator of variety stores and
drugstores, and, from February 1984 to January 1986, the Chairman of the Board
and Chief Executive Officer of Whitney-Fidalgo Seafoods, Inc., a seafood
processor.

                                       11
<PAGE>
 
     DOUGLAS A. SWERLAND became a Director of the Company in October 1988.  In
December 1993, Mr. Swerland founded and became the Chairman, President and Chief
Executive Officer of SAVI, Inc., a clothing superstore retailer specializing in
men's and women's apparel and accessories.  Mr. Swerland had been employed by
Jay Jacobs, Inc., the operator of a chain of specialty retail apparel stores, in
various capacities beginning in 1969, most recently as President and a director
from 1978 to November 1993.  Jay Jacobs, Inc., filed a voluntary petition for
Chapter 11 bankruptcy protection in May 1994 and emerged therefrom in November
1995.

     CRAIG E. TALL became a Director of the Company in October 1988. Since
September 1990, Mr. Tall has been an Executive Vice President of Washington
Mutual, Inc., a bank holding company. In addition, since April 1987, Mr. Tall
has been an Executive Vice President of Washington Mutual Bank.

     PETER H. VAN OPPEN became a Director of the Company in October 1988.  Since
February 1994, Mr. van Oppen has been Chairman and Chief Executive Officer of
Advanced Digital Information Corporation ("ADIC"), a manufacturer of automated
tape data libraries for network and workstation markets.  ADIC was a wholly-
owned subsidiary of Interpoint Corporation, a diversified publicly-traded
manufacturer, until it was spun-off as a separate public company in October
1996.  Mr. van Oppen served as a Director of Interpoint from 1984 to 1996,
President and Chief Executive Officer from 1989 to 1996 and Chairman and Chief
Executive Officer from 1995 through October 1996.  Mr. van Oppen is also a
Director of ADIC.

                                 RISK FACTORS

     In addition to the other information in this Report, the following risk
factors should be carefully considered in evaluating the Company and its
business.

ABILITY TO SUSTAIN AND MANAGE GROWTH

     The Company has experienced significant growth in revenues and
profitability in recent periods. This growth has occurred despite little or no
growth in the U.S. photofinishing industry in the 1990s and an actual decline in
the number of rolls processed by the mail-order film processing portion of the
domestic photofinishing market during the same period. See "Business-
Photofinishing Industry and Direct-Marketing Overview." The continued growth of
the Company's revenues and profitability is dependent in large part on its
ability to acquire new customers at a reasonable cost. There can be no assurance
that the Company will continue to grow or to effectively manage its growth. See
"Management's Discussion and Analysis of Financial Condition and Results of
Operations" and "Business." The Company may, when and if the opportunity arises,
acquire other businesses involved in activities or having service and product
lines that are compatible with the Company's business, but the Company has no
current understanding, agreement or arrangement to make any acquisitions.
Acquisitions involve numerous risks, which could have a material adverse effect
on the Company's business, financial condition and operating results.

DEPENDENCE ON DIRECT-MARKETING PROGRAMS; ACCOUNTING FOR CUSTOMER ACQUISITION

     Management believes that a large part of the Company's growth in
photofinishing revenues is attributable to its direct-marketing programs, which
are primarily based on its customer acquisition technique of offering two rolls
of film for $2.00 or less. The Company devotes substantial resources to and
regularly tests new and modified direct-marketing programs in an effort to
improve the efficiency of its customer acquisition and retention efforts. There
can be no assurance that the Company's customer acquisition and retention
efforts will continue to be effective. A decline in the effectiveness of these
efforts or a failure to compete effectively against new or existing competitors
which use direct-marketing techniques could have a material adverse effect on
the Company's business, financial condition and operating results. See 
"Business-Marketing and Customer Acquisition" and "-Competition."

     The direct costs of the customer acquisition program, primarily the cost of
film, postage and printed materials for the Company's free or low-cost film
offers sent to prospective and existing customers, but excluding advertising
costs, are deferred and amortized over a period of up to three years as part of
customer acquisition costs.  The Company

                                       12
<PAGE>
 
establishes amortization rates for these capitalized assets based on estimates
of the timing of future roll processing volumes per customer. Rates of
amortization are compared from time to time with the actual timing of roll
processing volumes in order to assess whether the amortization rates
appropriately match the direct costs of customer acquisition with the related
revenues. If the Company were to experience a material change in the timing of
roll processing volumes, it could be required to accelerate the rate of
amortization of capitalized customer acquisition expenditures, which could have
a material adverse effect on the Company's business, financial condition and
operating results. Moreover, if the Company were to experience a significant
decline in the amount of revenues from its customers without an offsetting
decrease in direct customer acquisition costs, the Company may not be allowed to
capitalize customer acquisition costs under generally accepted accounting
principles, which could have a material adverse effect on the Company's
business, financial condition and operating results. See Item 7 of Part II-
"Management's Discussion and Analysis of Financial Condition and Results of
Operations."

RAPID TECHNOLOGICAL CHANGE

     The photography industry is characterized by evolving technology and
changing services and products. The introduction of photographic services and
products embodying new technologies could render existing services and products
obsolete. The Company's future success will depend in part on its ability to
adapt to new technologies and develop new or modify existing services and
products to satisfy evolving consumer needs. For example, the commercialization
of filmless digital imaging technologies, including mass-market filmless digital
cameras, may have a negative impact on companies such as Seattle FilmWorks,
which process traditional film-based images and slides. The development of these
or other new technologies, or any failure by the Company to anticipate or
successfully respond to such developments, could have a material adverse effect
on the Company's business, financial condition and operating results. See
"Business-Competition."

FLUCTUATIONS IN QUARTERLY RESULTS AND SEASONALITY

     The Company's quarterly operating results have fluctuated in the past and
are expected to fluctuate in the future as a result of a variety of factors,
including changes in the mix of sales, intensity and effectiveness of
promotional activities, price increases by suppliers, introductions of new
products, research and development requirements, actions by competitors, foreign
currency exchange rates, conditions in the direct-to-consumer market and the
photofinishing industry in general, national and global economic conditions and
other factors. Demand for the Company's photo-related services and products is
highly seasonal, with the highest volume of photofinishing activity occurring
during the summer months. However, seasonality of demand may be offset by the
introduction of new services and products, changes in the level or effectiveness
of customer acquisition programs, and other factors. As a result, the Company's
operating results for any period are not necessarily indicative of results for
any future period. Due to the foregoing factors, the Company's operating results
in a future period may be below the expectations of public market analysts and
investors. In such event, the price of the Common Stock may be materially
adversely affected. See Item 7 of Part II-"Management's Discussion and Analysis
of Financial Condition and Results of Operations."

COMPETITION

     The market for consumer photofinishing services is characterized by intense
competition among a number of firms competing in a segment in which average
revenue per roll processed has declined during the 1990s, according to
photofinishing industry data. Many of the Company's competitors have
substantially greater financial, technical and other resources than the Company.
The Company faces competition in the consumer photofinishing market from other
direct marketers and from competitors in other distribution channels, including
much larger companies which provide photofinishing services on a wholesale basis
to independent retail outlets and, in some cases, through multiple retail
outlets owned by the photofinisher, many of which provide photofinishing service
within hours.  There are no significant proprietary or other barriers to entry
into the photofinishing industry.  Many of the Company's competitors offer
similar photofinishing services and products at lower prices and with a more
rapid turnaround time than those offered by the Company.  However, the Company
has sought to differentiate its photofinishing services by offering a number of
value-added services and products and emphasizing quality and convenience rather
than seeking to be a

                                       13
<PAGE>
 
low-price or rapid turnaround provider. Although management believes the Company
is a leader in developing and marketing innovative photo-related services and
products, competitors can and do provide similar services and products. There
can be no assurance the Company will continue to compete effectively through
development of innovative services and products or to respond appropriately to
industry trends or to activities of competitors. In addition, the wholesale
distribution market for rolled film, single use cameras and photofinishing
supplies is highly competitive and is dominated by suppliers that manufacture
what they sell and may, therefore, potentially have lower costs of goods for
these items than the Company. There can be no assurance that the Company will be
able to compete effectively with current or future competitors or that the
competitive pressures faced by the Company will not have a material adverse
effect on the Company's business, financial condition and operating results. See
"Business-Competition."

DEPENDENCE ON KEY PERSONNEL

     The Company's success depends in large part on the abilities and continued
service of its executive officers and other key employees, in particular Gary R.
Christophersen, the Company's President and Chief Executive Officer.  These
individuals, including Mr. Christophersen, are not subject to employment
agreements that would prevent them from leaving the Company.  There can be no
assurance that the Company will be able to retain the services of such executive
officers and other key employees.  The loss of key personnel could have a
material adverse effect on the Company's business, financial condition and
operating results.  See "Management."

DEPENDENCE ON THE INTERNET AND POTENTIAL LIABILITY FOR CONTENT

     The Company offers the private delivery of digital photographs from its
laboratory directly to customers over the Internet through its PhotoMail(TM)
delivery service.  The Company also provides FilmWorksNet(TM), a free service to
its customers through which the customer can create and upload a private
personal photographic home page to the Seattle FilmWorks Web site for viewing by
friends, family and business associates to whom the customer gives a guest
password, and more recently introduced PictureWorks(TM), a service that allows
customers to upload personal digitized images directly to the Company for
printing high definition digital images on photographic paper.  Although the
Company provides its services and products through multiple distribution
channels, the Company's success may depend in part on the continued expansion of
the Internet and its network infrastructure.  Rapid growth in interest in and
use of the Internet is a recent phenomenon, and there can be no assurance that
the Company's Internet-related services will prove to be a competitive
advantage.  Moreover, critical issues concerning the commercial use of the
Internet (including security, reliability, cost, ease of use and access and
quality of service) remain unresolved and may affect both the growth of Internet
use and the Company's financial results.  The laws relating to the liability of
on-line services companies, Internet access and/or content providers, Web hosts
and electronic publishers for information carried on or disseminated through
their systems for, among other things, infringement of copyrighted material or
trademarks, violations of personal rights of privacy and publicity and
dissemination of material legally judged to be obscene, indecent or defamatory,
is currently unclear.  Such claims have been brought, and sometimes successfully
asserted, against on-line services, including cases against Prodigy and NETCOM.
Many states have enacted legislation which makes the transmission of certain
kinds of information, such as obscene content and information which facilitates
the commission of criminal acts, a crime.  In addition, the Telecommunications
Act of 1996 imposes, in some circumstances, liability for or prohibition against
the transmission over the Internet of certain types of information and content.
Other legislation currently before Congress and the state legislatures could
result in additional regulation or prohibition of the transmission of certain
types of content over the Internet.  This could result in significant potential
liability to the Company, as well as additional costs and technological
challenges in complying with mandatory requirements.  From time to time, the
Company has assisted authorities in the discovery and prosecution of child
pornography.  However, the Company does not assume responsibility to edit the
content of its customers' photographs, slides, digital images or personal home
pages unless responding to a specific complaint.  The potential liability for
content made available over the Internet through its Web site could require the
Company to implement additional measures to reduce its exposure to such
liability, which may require it to incur significant expense or to discontinue
certain service or product offerings. While the Company carries general
liability insurance, such insurance may not cover potential claims of this type
or may not be adequate to compensate the Company for any liability that may be

                                       14
<PAGE>
 
imposed for information carried on or disseminated through its systems.  Any
costs not covered by insurance incurred as a result of such liability or
asserted liability could have a material adverse effect on the Company's
business, financial condition and operating results.  See "Business-Governmental
Regulation."

RELIANCE ON KEY VENDOR AND SUPPLIER RELATIONSHIPS; FOREIGN SOURCING

     The Company obtains its conventional 35mm film from a few large
manufacturers of photographic film, including Agfa Photo Imaging Systems, a
division of Bayer ("Agfa") and Imation Enterprises, Corp., its supply of Eastman
Kodak motion picture film as surplus from motion picture studios and television
production companies, and its photographic paper and chemicals from a single
supplier, Eastman Kodak. The individual cassettes into which the Company spools
35mm film for still cameras are manufactured for the Company by foreign sources,
principally in China and South Korea. The Company obtains new and recycled
single use cameras principally from suppliers in China. In addition, the Company
acquires photofinishing equipment to maintain and increase photofinishing
production capacity. As there are relatively few suppliers of film, photographic
paper and chemicals and photofinishing equipment, the elimination of any one
supplier or failure of a supplier to deliver specified goods could cause a
material disruption in the Company's operations and could have a material
adverse effect on the Company's business, financial condition and operating
results. Other than agreements with Agfa and Eastman Kodak, which are subject to
termination under certain circumstances, the Company has no significant long-
term purchase contracts or other contractual assurance of continued supply,
pricing or access to film, paper, chemicals or cassettes. Although the Company
has experienced limited delays in the delivery of certain supplies and equipment
in the past, such delays have not had a significant impact on the Company's
operations. While management believes that alternate sources of film, paper,
chemicals, cassettes and equipment are available, there can be no assurance that
the Company will be able to continue to acquire its requirements for supplies
and equipment in sufficient quantities or on terms as favorable to the Company
as those currently available to it. Also, conversion to an alternate supplier
may cause delays, reduced quality or other problems. The Company's operations
may be adversely affected by political instability resulting in the disruption
of trade with foreign countries in which the Company's contractors and suppliers
are located and existing or potential duties, tariffs or quotas that may limit
the quantity of certain types of goods that may be imported into the United
States. Moreover, sales of the Company's services and products on a direct-to-
consumer mail-order basis are largely dependent on the U.S. Postal Service and
other common carriers for receipt of orders and delivery of processed film or
other products. Any significant changes in the operations of or prices charged
by the U.S. Postal Service or other common carriers or extended interruptions in
postal deliveries could have a material adverse effect on the Company's
business, financial condition and operating results. See "Business-Operations"
and "-Suppliers."

DEPENDENCE ON PRODUCTION CAPABILITIES, STATISTICAL MODELS AND MANAGEMENT
INFORMATION SYSTEMS

     The Company depends on its management information systems to process
orders, provide rapid response to customer inquiries, manage inventory and
accounts receivable collections, purchase, sell and ship products efficiently
and on a timely basis and maintain cost-efficient operations. In fiscal 1996,
the Company replaced and upgraded a portion of its systems software and
hardware. The Company has taken a number of precautions against certain events
that could disrupt the operation of its management information systems,
including events associated with continuing software and hardware upgrades.
However, there can be no assurance that the Company will not experience systems
failures or interruptions, which could have a material adverse effect on its
business, financial condition and operating results. See "Business-Management
Information Systems." The Company also depends on statistical models developed
to measure the effectiveness of its marketing programs and on its employees who
are knowledgeable about such models. In addition, the Company continually faces
risks regarding the availability and cost of labor, the potential need for
additional capital equipment, plant and equipment obsolescence, quality control,
excess or insufficient capacity and disruption in the Company's operations. The
loss of employees knowledgeable about the Company's statistical models or a
disruption in the Company's photofinishing or direct-marketing operations could
have a material adverse effect on the Company's business, financial condition
and operating results. See "Business-Operations" and "-Suppliers."

                                       15
<PAGE>
 
GOVERNMENTAL REGULATION

     The Company's direct-mail operations are subject to regulation by the U.S.
Postal Service, the Federal Trade Commission and various state, local and
private consumer protection and other regulatory authorities.  In general, these
regulations govern the manner in which orders may be solicited, the form and
content of advertisements, information which must be provided to prospective
customers, the time within which orders must be filled, obligations to customers
if orders are not shipped within a specified period of time and the time within
which refunds must be paid if the ordered merchandise is unavailable or
returned.  From time to time the Company has modified its methods of doing
business and its marketing operations in response to inquiries and requests from
regulatory authorities.  To date, such changes have not had an adverse effect on
the Company's business.  There can be no assurance, however, that future
regulatory requirements or actions will not have a material adverse effect on
the Company's business, financial condition and operating results.  See
"Business-Governmental Regulation."

POTENTIAL ADVERSE IMPACT OF ENVIRONMENTAL REGULATIONS

     The Company's photofinishing operations involve the use of several
chemicals which are subject to federal, state and local governmental regulations
relating to the storage, use, handling and disposal of such chemicals. The
Company actively monitors its compliance with applicable regulations and works
with regulatory authorities to ensure compliance. However, there can be no
assurance that changes in environmental regulations or in the kinds of chemicals
used by the Company will not impose the need for additional capital equipment or
other requirements. Any failure by the Company to control the use of, or
adequately restrict the discharge of, hazardous substances under present or
future regulations could subject it to substantial liability or could cause its
operations to be suspended. Such liability or suspension of operations could
have a material adverse effect on the Company's business, financial condition
and operating results. See "Business-Environmental Compliance."

STATE SALES TAX

     Many states impose taxes on the sale or use of products and the sale of
certain services within the taxing state's borders. To the extent a seller of
taxable products or services is subject to the jurisdiction of a taxing state,
the state may impose a sales tax directly on the seller or may impose a duty on
the seller to collect a sales or use tax from the seller's customers. A seller
is generally considered subject to the jurisdiction of a taxing state for sales
or use tax purposes when the seller has an in-state presence that is beyond de
minimis. An in-state presence can include solicitation of orders for sales in
the taxing state either in-person or through an employee or other agent. The
Company currently collects and pays sales tax only with respect to shipments to
the state of Washington. The Company has structured its operations in a manner
designed to minimize the likelihood that it has more than a de minimis physical
presence in any state other than Washington. However, if a state taxing
authority determines that the Company has established more than a de minimis
physical presence in that particular state, the Company could be obligated to
collect a sales or use tax (or pay a sales tax in states that impose a tax on
the seller) on some sales of its services and products. Should the Company be
found liable by a state taxing authority for unpaid historic sales and use
taxes, such liabilities could have a material adverse effect on the Company's
business, financial condition and operating results. From time to time,
legislation has been introduced in the U.S. Congress that, if enacted into law,
would impose a state sales or use tax collection obligation on out-of-state 
mail-order companies such as the Company. Enactment of any such legislation
could have a material adverse effect on the Company's business, financial
condition and operating results.

                                       16
<PAGE>
 
INTELLECTUAL PROPERTY

     The Company considers a large portion of its PhotoWorks(R) software, its
process for production of Pictures On Disk(TM) and certain other processes to be
proprietary. The Company has not filed any patents or patent applications, in
part to avoid disclosure of its competitive strengths. Moreover, the Company's
PhotoWorks(R) Plus product is shipped in sealed packages on which notices are
prominently displayed informing the end-user that, by breaking the package seal,
the end-user agrees to be bound by the license agreement contained in the
package. The legal and practical enforceability and extent of liability for
violations of license agreements that purport to become effective upon opening a
sealed package are unclear. See "Business-Proprietary Technology."

POSSIBLE VOLATILITY OF STOCK PRICE

     The market price of the Common Stock has been, and is likely to continue to
be, volatile. There can be no assurance that the market price of the Common
Stock will not fluctuate significantly from its current level. The market price
of the Common Stock could be subject to significant fluctuations in response to
a number of factors, such as actual or anticipated variations in the Company's
quarterly operating results, the introduction of new services or products by the
Company or its competitors, changes in other conditions or trends in the
Company's industry, changes in governmental regulations, changes in securities
analysts' estimates of the Company's, or its competitors' or industry's, future
performance or general market conditions. See Item 7 of Part II-"Management's
Discussion and Analysis of Financial Condition and Results of Operations." In
addition, stock markets have experienced extreme price and volume volatility in
recent years, and this volatility has had a substantial effect on the market
prices of securities of many smaller public companies for reasons frequently
unrelated to the operating performance of such companies. These broad market
fluctuations may adversely affect the market price of the Common Stock. See
"Price Range of Common Stock."

ANTITAKEOVER CONSIDERATIONS

     The Company's Board of Directors has the authority, without shareholder
approval, to issue up to 2,000,000 shares of Preferred Stock and to fix the
rights and preferences thereof. This authority, together with certain provisions
of the Articles, including those providing for a classified board and removal of
directors only for cause, and the Washington Business Corporation Act, may
discourage takeover attempts or tender offers that could result in shareholders
receiving a premium over the market price for the Common Stock or that
shareholders may otherwise consider to be in their best interests.

ITEM 2 - PROPERTIES

     The Company's headquarters are located in Seattle, Washington. This
building also houses the Company's photofinishing and mail-order operations. The
building's square footage was expanded in fiscal 1996 to approximately 60,000
square feet to accommodate increased levels of production. The building is
occupied under a lease which expires in September 2000.

     During fiscal 1997, the Company signed a lease agreement for office and
warehouse space adjoining the Company's headquarters. This space is primarily
utilized for office space and certain photofinishing and mail order operations.
The lease commenced on April 1, 1997, for a term of forty-two months and
includes 46,317 of total square feet, including 7,700 square feet of mezzanine
office space.

     The Company also occupies 80,000 square feet in a building that is used as
a warehouse storage and limited production facility. This building, located in
Seattle, Washington, is occupied under a three-year lease expiring January 31,
1999, with options to extend the lease for two additional one-year periods to
January 31, 2001.

     The Company has various leases for its retail store locations with lease
terms generally ranging from three to five years.

                                       17
<PAGE>
 
ITEM 3 - LEGAL PROCEEDINGS

     The Company is involved in various routine legal proceedings incident to
the ordinary course of its business. Management believes that the outcome of all
pending legal proceedings in the aggregate will not have a material adverse
effect on the Company's business, financial condition or operating results.

ITEM 4 - SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS

     No matters were submitted to a vote of shareholders during the fourth
quarter of the Company's fiscal year.

                                       18
<PAGE>
 
                                 PART II

ITEM 5 - MARKET PRICES AND DIVIDENDS ON COMMON STOCK

     The Company's Common Stock trades on the NASDAQ National Market tier of The
NASDAQ Stock Market under the symbol "FOTO." The following table sets forth, for
the periods indicated, the high and low sale prices of the Common Stock as
reported on NASDAQ, as adjusted for stock splits.

<TABLE>
<CAPTION>
                                                  HIGH        LOW
------------------------------------              ----        ---
<S>                                               <C>         <C>
Fiscal Year Ended September 27, 1997
  First Quarter.......................            $15.00      $11.67
  Second Quarter......................            13.67         9.83
  Third Quarter.......................            12.88         9.50
  Fourth Quarter......................            14.56        11.00
Fiscal Year Ended September 28, 1996
  First Quarter.......................           $10.55       $ 8.00
  Second Quarter......................            13.67         8.89
  Third Quarter.......................            14.50        10.67
  Fourth Quarter......................            14.67         9.67
</TABLE>

     On November 28, 1997, the last sale price reported on NASDAQ for the Common
Stock was $9.875 per share and was held by an estimated 9,500 shareholders with
approximately 534 holders of record.

     The Company has never declared or paid cash dividends on the Common Stock
and does not anticipate paying any dividends in the foreseeable future. The
Company currently intends to retain its earnings, if any, for the development of
its business.

ITEM 6 - SELECTED FINANCIAL DATA

     The selected financial data set forth below with respect to the Company's
consolidated statements of income for the years ended September 27, 1997,
September 28, 1996 and September 30, 1995 and the Company's consolidated balance
sheets at September 27, 1997 and September 28, 1996 are derived from the audited
consolidated financial statements included elsewhere in this report and should
be read in conjunction with those consolidated financial statements and their
related footnotes. The selected income statement data for the years ended
September 24, 1994 and September 25, 1993 and selected balance sheet data at
September 30, 1995, September 24, 1994 and September 25, 1993 are derived from
audited consolidated financial statements which are not included in this report.

                                       19
<PAGE>
 
                            SEATTLE FILMWORKS, INC.
                            SELECTED FINANCIAL DATA
                (In thousands, except per share and share data)

<TABLE>
<CAPTION>
                                                              Fiscal Years
                                      ---------------------------------------------------------------------
                                            1997          1996           1995          1994          1993
=========================================================================================================== 
<S>
CONSOLIDATED INCOME STATEMENT DATA:    <C>             <C>            <C>           <C>           <C>
-------------------------------------

Net revenues                           $   101,189     $  84,152      $  62,185     $  49,753     $  42,728

Gross profit                                42,565        34,993         24,057        18,907        17,269

Operating expenses                          27,752        23,084         15,729        12,709        12,284

Net income                             $    10,145   $     8,017    $     5,682   $     4,438   $     3,570
                                       ===========   ===========    ===========   ===========   ===========

Income as a percent of revenues               10.0%          9.5%           9.1%          8.9%          8.4%

Earnings per share*                    $       .57   $       .45    $       .32   $       .24   $       .19
                                       ===========   ===========    ===========   ===========   ===========

Weighted average shares outstanding*    17,775,000    17,808,000     17,598,000    18,592,000    18,537,000
                                       ===========   ===========    ===========   ===========   ===========

CONSOLIDATED BALANCE SHEET DATA:
--------------------------------

Capitalized customer acquisition
  expenditures                         $    13,882   $    11,334    $     7,356   $     4,458   $     3,832

Total assets                                51,366        37,826         28,244        18,835**      19,632

Long-term obligations                            0             0              0             0             0

Shareholders' equity                   $    37,601   $    26,675    $    17,932   $    11,347**  $   13,376
                                       ===========   ===========    ===========   ===========    ==========
 
</TABLE>

See notes to consolidated financial statements.

* All share and per share data are retroactively adjusted to reflect a three for
two stock split distributed February 26, 1993, a two for one stock split
distributed March 16, 1994, a three for two stock split distributed March 15,
1995, a three for two stock split distributed March 15, 1996 and a three for two
stock split distributed March 17, 1997.

** Reflects the impact of repurchasing 1,687,500 shares of common stock for
$6,643,000 during the fourth quarter of fiscal 1994.

                                       20
<PAGE>
 
ITEM 7 - MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND
RESULTS OF OPERATIONS

FORWARD-LOOKING INFORMATION

     Statements in this report concerning expectations for the future constitute
forward-looking statements which are subject to a number of known and unknown
risks, uncertainties and other factors which may cause actual results,
performance or achievements of the Company or industry trends to differ
materially from those expressed or implied by such forward-looking statements.
Relevant risks and uncertainties include, among others, those discussed in Item
1 of Part I under the heading "Risk Factors" and elsewhere in this Report and
those described from time to time in the Company's other filings with the
Securities and Exchange Commission, press releases and other communications.

OVERVIEW

     Seattle FilmWorks, Inc. (the "Company") is a leading direct-to-consumer
marketer and provider of high-quality amateur photofinishing services and
products. The Company offers an array of complementary services and products
primarily on a mail-order basis under the brand name Seattle FilmWorks(R). The
Company has experienced an increase in net revenues in each year since 1990.
Management believes this growth is attributable principally to its direct-
marketing programs, including the customer acquisition technique of offering two
rolls of film for $2.00 or less (the "Introductory Offer"). The Introductory
Offer has been nationally advertised in package inserts, newspaper supplements
and magazines and through various other direct-response media.

     Beginning in fiscal 1995, the Company shifted the focus of, and
substantially expanded, its customer acquisition programs. Management believes
that these steps are the primary reasons for the acceleration in growth of net
revenues and net income during fiscal 1997, fiscal 1996 and fiscal 1995. In
addition, management believes its core photofinishing business has benefited
from the introduction of new products, such as the January 1994 introduction of
Pictures On Disk(TM) and PhotoWorks(R).

     Customer acquisition costs are comprised of the costs of generating a lead
and the amortization of direct costs associated with the Company's promotional
offers sent to prospective and existing customers. The costs of generating a
lead include all direct-response media, advertising and other costs associated
with developing target customer lists. These costs-per-lead have declined during
each of the last three fiscal years. The direct costs of customer acquisition
include film, postage and printed material costs associated with mailings to
prospective and existing customers.

     The direct costs of customer acquisition programs are capitalized as an
asset on the Company's consolidated balance sheet under "capitalized customer
acquisition expenditures." Capitalized customer acquisition expenditures
relating to prospective customers are amortized over three years, and
capitalized customer acquisition expenditures relating to certain marketing
activities to groups of existing customers are amortized over six months. These
amortization rates are based on estimates of the timing of future roll
processing volumes per customer. The proportion of capitalized customer
acquisition expenditures to be amortized over three years relative to those to
be amortized over six months will vary from period to period based on the timing
and mix of promotional activities. Rates of amortization are compared from time
to time with the actual timing of roll processing volumes in order to assess
whether the amortization rates appropriately match the direct costs of customer
acquisition with the related revenues. If the Company were to experience a
material change in the timing of roll processing volumes, it could be required
to accelerate the rate of amortization of capitalized customer acquisition
expenditures, which could have a material adverse effect on the Company's
business, financial condition and operating results.

     Customer acquisition costs as a percentage of net revenues increased to
15.6% in fiscal 1997 as compared to 14.2% in fiscal 1996 and 13.8% in fiscal
1995. Management believes this increase in customer acquisition costs as a
percentage of net revenues is due primarily to expansion of the Company's
customer acquisition programs. Future periods may reflect increased or decreased
customer acquisition costs due to timing of the amortization of capitalized
expenditures or the development and initiation of additional marketing programs.
For tax purposes, customer

                                       21
<PAGE>
 
acquisition expenditures are expensed as incurred, thereby reducing current
federal income tax liabilities and increasing deferred federal income tax
liabilities. See Note F of Notes to Consolidated Financial Statements.

     Net income as a percentage of net revenues has improved from 9.1% in fiscal
1995 to 10.0% in fiscal 1997 primarily due to the relationship between changes
in costs of goods sold, customer acquisition costs and other selling expenses
which in turn are primarily driven by changes in sales mix and the Company's
customer acquisition strategy. Operating results will fluctuate in the future
due to changes in the mix of sales, intensity and effectiveness of promotional
activities, price increases by suppliers, introductions of new products,
research and development requirements, actions by competitors, foreign currency
exchange rates, conditions in the direct-to-consumer market and the
photofinishing industry in general, national and global economic conditions and
other factors.

     Cost of goods and services consist of labor, postage and supplies related
to the Company's services and products. Other selling expenses include marketing
costs associated with building brand awareness, testing new marketing strategies
and marketing to existing customers, as well as certain costs associated with
acquiring new customers. Research and development expenses consist primarily of
costs incurred in researching new computerized digital imaging concepts,
developing computer software products and creating equipment necessary to
provide customers with new computer-related photographic services and products.
General and administrative expenses consist of costs related to computer
operations, human resource functions, finance, accounting, investor relations
and general corporate activities.

     Demand for the Company's photo-related services and products is highly
seasonal, with the highest volume of photofinishing activity occurring during
the summer months. However, seasonality of demand may be offset by the
introduction of new services and products, changes in the level of effectiveness
of customer acquisition programs and other factors. This seasonality, when
combined with the general growth of the Company's photofinishing business, has
produced greater photofinishing net revenues during the last half of the
Company's fiscal year (April through September), with a peak occurring in the
fourth fiscal quarter. Net income is affected by the seasonality of the
Company's net revenues due to the fixed nature of a portion of the Company's
operating expenses, seasonal variation in sales mix and the Company's practice
of relatively higher marketing program expenditures prior to the summer months.

                                       22
<PAGE>
 
RESULTS OF OPERATIONS

     The following table presents information from the Company's statements of
income, expressed as a percentage of net revenues for the periods indicated.

<TABLE>
<CAPTION>
 
                                              Fiscal Years Ended
                               -------------------------------------------------
                               September 27,     September 28,     September 30,
                                   1997              1996              1995
                               =============     =============     =============
<S>                            <C>               <C>               <C>
 
Net revenues                       100.0%            100.0%            100.0%
 
Cost of goods and services          57.9              58.4              61.3
                                   -----             -----             -----
 
GROSS PROFIT                        42.1              41.6              38.7
 
Operating expenses:
  Customer acquisition costs        15.6              14.2              13.8
  Other selling expenses             7.7               8.2               6.5
  Research and development           0.7               0.9               0.7
  General and administrative         3.5               4.2               4.3
                                   ------            -----             -----
    Total operating expenses        27.5              27.5              25.3
                                   -----             -----             -----
 
INCOME FROM OPERATIONS              14.6              14.1              13.4
 
Total other income                   0.6               0.4               0.4
                                   -----             -----             -----
 
INCOME BEFORE INCOME TAXES          15.2              14.5              13.8
 
Provision for income taxes           5.2               5.0               4.7
                                   -----             -----             -----
 
NET INCOME                          10.0%              9.5%              9.1%
                                   =====             =====             =====
 
</TABLE>

     Net revenues increased 20.2% to $101,189,000 in fiscal 1997 from
$84,152,000 in fiscal 1996. Net revenues in fiscal 1996 increased 35.3% to
$84,152,000 from $62,185,000 in fiscal 1995. The increases were primarily due to
expanded customer acquisition activities and marketing to existing customers
during fiscal year 1997 and fiscal year 1996 which have resulted in increased
net revenues from photofinishing services and products. Management also believes
that its Seattle FilmWorks(R) branded business has benefited from the Company's
entry into the personal computer market with its PhotoWorks(R) and Pictures On
Disk(TM) products, which were introduced in January 1994. The rate of growth in
net revenues for fiscal 1997 has been affected by lower-than-expected
photofinishing volume during and since the United Parcel Service strike of
August 1997. In addition, management attributes lower volumes to increased
delivery times during the third and fourth quarters of fiscal 1997 due to
production problems experienced in the third quarter and by a planned reduction
in the Company's wholesale photofinishing and mail-order photography course
operations, both of which will be phased out.

     Gross profit as a percentage of net revenues for fiscal 1997, fiscal 1996
and fiscal 1995 was 42.1%, 41.6% and 38.7%, respectively. The increase in gross
profit percentage in fiscal 1997 and fiscal 1996 as compared to fiscal 1995 was
primarily due to a product mix containing a higher percentage of Seattle
FilmWorks(R) branded products, which carry a higher gross profit margin than the
Company's other services and products. In addition, gross profit was negatively
affected during fiscal 1997 due to higher labor costs as a result of incremental
overtime incurred as a result of production problems during the third quarter
and increased overhead expenses as a percentage of net revenues 

                                       23
<PAGE>
 
resulting from increased customer service costs. Fluctuations in gross profit
will occur in future periods due to the seasonal nature of revenues, mix of
product sales, intensity and effectiveness of promotional activities and other
factors.

     Total operating expenses as a percentage of net revenues for fiscal 1997,
fiscal 1996 and fiscal 1995 were 27.5%, 27.5% and 25.3%, respectively. The
increase in total operating expenses in fiscal 1997 and fiscal 1996 as compared
to fiscal 1995 was due primarily to an increase in customer acquisition and
other selling activities, which affect revenues in current and future periods.
The Company's principal technique for acquiring new customers is its
Introductory Offer of two rolls of 35 mm film for $2.00 or less. Effective as of
the beginning of the second quarter of fiscal 1996 the Company reduced from
twelve to six months the amortization period for certain marketing activities to
specific groups of existing customers. This change in accounting estimate
resulted in incremental amortization of $127,000 in fiscal year 1996 of
previously deferred customer acquisition costs. The Company capitalized
$17,271,000 of customer acquisition expenditures during fiscal 1997 compared to
$14,750,000 in fiscal 1996 and $9,187,000 in fiscal 1995. Capitalized customer
acquisition expenditures as of September 27, 1997 increased to $13,882,000 as
compared to $11,334,000 as of September 28, 1996. The Company's increased
investment in customer acquisition combined with new service and product
introductions are the primary reasons for the increase in photofinishing related
revenues. Each year the Company prepares detailed plans for its various
marketing activities, including the mix between customer acquisition
expenditures and other selling expenses. However, the Company occasionally
changes both the mix and total marketing expenditures between periods to take
advantage of marketing opportunities as they become available. Future periods
may reflect increased customer acquisition costs due to the timing of the
amortization of capitalized expenditures or the development and initiation of
additional marketing programs.

     Other selling expenses in fiscal 1997 decreased to 7.7% of net revenues
compared to 8.2% in fiscal 1996. Other selling expenses for fiscal 1996
increased to 8.2% of net revenues as compared to 6.5% in fiscal 1995. The
increase in fiscal 1996 was primarily due to increased marketing activities
associated with expanded promotional activities to new and existing customers
compared to fiscal 1995. Fiscal year 1996 selling expenses also included
additional expense as a result of an increase in amortization of a non-compete
agreement due to a change in the estimated life from ten years to five years and
expense related to securing rights to the PhotoWorks(R) mark claimed by a third
party.

     Research and development expenses during fiscal 1997, fiscal 1996 and
fiscal 1995 were $696,000, $732,000 and $458,000, respectively. The decrease in
fiscal 1997 as compared to fiscal 1996 was due primarily to lower contract
service costs. The increase in fiscal 1996 as compared to fiscal 1995 was
primarily related to the Company's continuing development of digital services
and products.

     General and administrative expenses increased to $3,503,000 in fiscal 1997
as compared to $3,460,000 in fiscal 1996 and $2,657,000 in fiscal 1995. The
increase in fiscal 1997 as compared to fiscal 1996 was due primarily to
increased costs related to the Company's management information systems and
increased legal and accounting costs. The fiscal year 1997 increases were
partially offset by a decrease in costs related to shareholders relations.
Fiscal year 1996 expenses increased over fiscal 1995 expenses primarily due to
increased compensation expenses based on the Company's profitability and
increased legal, accounting and consulting costs. General and administrative
expenses as a percent of net revenues decreased to 3.5% for fiscal 1997 as
compared to 4.2% in fiscal 1996 and 4.3% in fiscal 1995.

     Total other income in fiscal 1997 was $574,000 as compared to $328,000 in
fiscal 1996 and $252,000 in fiscal 1995. The increases in total other income in
fiscal 1997 and fiscal 1996 resulted primarily from higher interest income due
to higher levels of cash generated by operations during fiscal 1997 and fiscal
1996.

     The income tax rate for fiscal 1997 was 34.1% as compared to 34.5% for
fiscal 1996 and 33.8% for fiscal 1995. The decrease in the effective tax rate
for fiscal 1997 as compared to fiscal 1996 was due primarily to an increase in
tax exempt interest income and a higher federal research and development tax
credit. The increase for fiscal 1996 as compared to fiscal 1995 was primarily
due to an increase in the marginal federal corporate tax rate due to income
levels and the expiration of the federal research and development tax credit for
the first three quarters of the 1996 fiscal year.

                                       24
<PAGE>
 
     Net income increased to $0.57 per share in fiscal 1997 as compared to $0.45
per share in fiscal 1996 and $0.32 per share in fiscal 1995. The increases in
the fiscal 1997 and fiscal 1996 periods were primarily attributable to the
increases in net revenues and gross profit.

LIQUIDITY AND CAPITAL RESOURCES

     Net cash provided by operating activities was $9,493,000, $4,554,000 and
$6,908,000 in fiscal 1997, fiscal 1996 and fiscal 1995, respectively. The
increase in cash provided by operating activities in fiscal 1997 as compared to
fiscal 1996 was primarily due to additional cash from increases in net income,
adjusted for depreciation and amortization and amortization of customer
acquisition expenditures. The decrease in cash provided by operating activities
in fiscal 1996 as compared to fiscal 1995 was primarily due to a net increase in
customer acquisition expenditures, an increase in inventories and accounts
receivable and a decrease in accounts payable, partially offset by increases in
net income, depreciation and amortization and deferred taxes.

     Net cash used in investing activities was $5,282,000, $7,281,000 and
$1,629,000 in fiscal 1997, fiscal 1996 and fiscal 1995, respectively. Net cash
used in investing activities during fiscal 1997 decreased as compared to fiscal
1996 primarily due to the net decrease in purchases of securities available-for-
sale, partially offset by an increase in purchases of furniture, fixtures and
equipment. Net cash used in investing activities during fiscal 1996 increased as
compared to fiscal 1995 primarily due to increases in purchases of furniture,
fixtures and equipment and securities-available-for sale.

     Net cash used in financing activities was $94,000 in fiscal 1997 as
compared to $302,000 provided from financing activities in fiscal 1996. The
decrease was primarily due to the repurchase of shares of its Common Stock,
partially offset by increases in the level of stock options exercised. On
January 22, 1997, the Company announced that it may repurchase shares of its
Common Stock, either through open market purchases at prevailing market prices,
through block purchases or in privately negotiated transactions. Repurchases may
be commenced or discontinued at any time. Although the number of shares to be
repurchased is uncertain, any repurchased shares will to some degree offset the
dilutive effect on earnings per share of shares of Common Stock issued under the
Company's stock option and stock purchase plans. As of September 27, 1997, the
Company had purchased a total of 80,000 shares for a total of $824,000. Net cash
provided by financing activities in fiscal 1996 was $302,000 as compared to
$570,000 for fiscal year 1995. The decrease was primarily attributable to lower
proceeds from stock option exercise activity.

     As of November 28, 1997, the Company's principal sources of liquidity
included $19,286,000 in cash and short-term investments together with an unused
operating line of credit of $6,000,000. The ratio of current assets to current
liabilities for the Company was 3.1 to 1 at the end of fiscal 1997, which
reflects an increase from the current ratio of 2.7 to 1 at the end of fiscal
1996. During fiscal 1997 the Company increased its cash and cash equivalents by
$4,117,000 primarily due to the increase in net income. In addition, the Company
increased its inventory levels by $2,421,000 to accommodate expanded marketing
plans and support increased photofinishing volume and increased accounts
receivable by $1,700,000 primarily due to the timing of wholesale film shipments
during the fourth quarter of fiscal year 1997. These increases were partially
offset by an increase in income taxes payable of $1,478,000.

      Capital expenditures during fiscal 1997 totaled $4,779,000 including
equipment for expanding the capacity of photofinishing operations and leasehold
improvements. In fiscal 1996, the Company made capital expenditures of
$4,067,000 relating to photofinishing equipment, data processing equipment and
for expanding the capacity of photofinishing operations. The Company has plans
to expend approximately $7,000,000 in fiscal 1998, principally for additional
photofinishing processing equipment, data storage equipment and for leasehold
improvements, although at this time it has no binding commitments to do so.

     The Company currently anticipates that existing funds together with
anticipated cash flow from operations and the Company's available line of credit
of $6,000,000 will be sufficient to finance its operations, including planned
capital expenditures, and to service its indebtedness for the foreseeable
future. However, if the Company does not generate sufficient cash from
operations to satisfy its ongoing expenses, the Company will be required to seek
external
                                       25
<PAGE>
 
sources of financing or refinance its obligations. Possible sources of financing
include the sale of equity securities or additional bank borrowings. There can
be no assurance that the Company will be able to obtain adequate financing in
the future. See Item 1 of Part I-"Risk Factors."

INFLATION

     The results of the Company's operations have not been significantly
affected by inflation during any of the last three fiscal years. Although the
Company has incurred moderately increased costs for labor, materials, postage
and overhead, it has been able to offset the impact of such increases primarily
through enhanced operating efficiencies.

ADOPTION OF ACCOUNTING STANDARDS

     In October 1995, the Financial Accounting Standards Board issued Statement
No. 123, "Accounting for Stock-Based Compensation." This pronouncement
establishes accounting and reporting standards for stock-based employee
compensation plans, including stock purchase plans, stock options and stock
appreciation rights. This standard defines a fair value-based method of
accounting for these equity instruments, which method measures compensation cost
based on the value of the award and recognizes that cost over the service
period. Companies may elect to adopt this standard or to continue accounting for
these types of equity instruments under current guidance, Accounting Principles
Board ("APB") Opinion No. 25, "Accounting for Stock Issued to Employees." The
Company has elected to follow APB Opinion No. 25 and related interpretations in
accounting for its employee stock options.

ITEM 8 - FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA

     See pages 27 through 39.

                                       26
<PAGE>
 
                          REPORT OF ERNST & YOUNG LLP

                             INDEPENDENT AUDITORS

Shareholders and Board of Directors
SEATTLE FILMWORKS, INC.

     We have audited the accompanying consolidated balance sheets of SEATTLE
FILMWORKS, INC. as of September 27, 1997 and September 28, 1996, and the related
consolidated statements of income, consolidated shareholders' equity, and
consolidated cash flows for each of the three years in the period ended
September 27, 1997. We have also audited the consolidated financial statement
schedule listed in the Index at Item 14(a). These consolidated financial
statements and schedule are the responsibility of the Company's management. Our
responsibility is to express an opinion on these consolidated financial
statements and schedule based on our audits.

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

     In our opinion, the consolidated financial statements referred to above
present fairly, in all material respects, the financial position of SEATTLE
FILMWORKS, INC. at September 27, 1997 and September 28, 1996, and the results of
its operations and its cash flows for each of the three years in the period
ended September 27, 1997, in conformity with generally accepted accounting
principles. Also in our opinion, the related consolidated financial statement
schedule, when considered in relation to the basic consolidated financial
statements taken as a whole, presents fairly in all material respects the
information set forth therein.

Seattle, Washington
November 7, 1997

                                       27
<PAGE>
 
                            SEATTLE FILMWORKS, INC.
                          CONSOLIDATED BALANCE SHEETS
                (in thousands, except per share and share data)

                                    ASSETS
<TABLE>
<CAPTION>
                                                                September 27,     September 28,
                                                                    1997              1996
                                                                -------------     -------------
<S>                                                             <C>               <C>
CURRENT ASSETS
  Cash and cash equivalents                                      $10,252           $ 6,135
  Securities available-for-sale                                    5,062             4,559
  Accounts receivable, net of allowance for doubtful accounts
    of $240 and $287 in 1997 and 1996, respectively                3,680             1,980
  Inventories                                                      8,998             6,577
  Capitalized promotional expenditures                               211               238
  Prepaid expenses and other                                         743               351
  Deferred income taxes                                              313               311
                                                                 -------           -------
    TOTAL CURRENT ASSETS                                          29,259            20,151
 
FURNITURE, FIXTURES, AND EQUIPMENT,
  at cost, less accumulated depreciation (Note C)                  7,564             5,337
 
CAPITALIZED CUSTOMER ACQUISITION EXPENDITURES                     13,882            11,334
 
DEPOSITS AND OTHER ASSETS                                            285               253
 
NONCOMPETE AGREEMENT (Note B)                                        376               751
                                                                 -------           -------
 
TOTAL ASSETS                                                     $51,366           $37,826
                                                                 =======           =======

                       LIABILITIES AND SHAREHOLDERS' EQUITY
CURRENT LIABILITIES
  Accounts payable                                               $ 3,588           $ 3,490
  Accrued expenses                                                 1,402             1,086
  Accrued compensation                                             1,931             2,001
  Income taxes payable                                             2,450               972
                                                                 -------           -------
    TOTAL CURRENT LIABILITIES                                      9,371             7,549
 
DEFERRED INCOME TAXES                                              4,394             3,602
                                                                 -------           -------
 
TOTAL LIABILITIES                                                 13,765            11,151
 
SHAREHOLDERS' EQUITY (Notes G and H)
  Preferred Stock, $.01 par value, authorized 2,000,000 
    shares, none issued
  Common Stock, $.01 par value, authorized 101,250,000 
    shares, issued and outstanding 16,436,258 and 
    16,231,846 in 1997 and 1996, respectively                        164               162
  Additional paid-in capital                                       2,459             1,680
  Retained earnings                                               34,978            24,833
                                                                 -------           -------
    TOTAL SHAREHOLDERS' EQUITY                                    37,601            26,675
                                                                 -------           -------
 
TOTAL LIABILITIES AND SHAREHOLDERS' EQUITY                       $51,366           $37,826
                                                                 =======           =======
</TABLE>

See notes to consolidated financial statements.

                                       28
<PAGE>
 
                            SEATTLE FILMWORKS, INC.
                       CONSOLIDATED STATEMENTS OF INCOME
                (in thousands, except per share and share data)
<TABLE>
<CAPTION>
                                                      Fiscal Years Ended
                                       -------------------------------------------------
                                       September 27,     September 28,     September 30,
                                           1997              1996              1995
========================================================================================
<S>                                    <C>               <C>               <C>
 
Net revenues                            $   101,189       $    84,152       $    62,185
 
Cost of goods and services                   58,624            49,159            38,128
                                        -----------       -----------       -----------
 
GROSS PROFIT                                 42,565            34,993            24,057
 
Operating expenses:
  Customer acquisition costs                 15,764            11,981             8,579
  Other selling expenses                      7,789             6,911             4,035
  Research and development                      696               732               458
  General and administrative                  3,503             3,460             2,657
                                        -----------       -----------       -----------
    Total operating expenses                 27,752            23,084            15,729
                                        -----------       -----------       -----------
 
INCOME FROM OPERATIONS                       14,813            11,909             8,328
 
Other income (expense):
  Interest income                               561               449               276
  Nonoperating income (expense), net             13              (121)              (24)
                                        -----------       -----------       -----------
    Total other income                          574               328               252
                                        -----------       -----------       -----------
 
INCOME BEFORE INCOME TAXES                   15,387            12,237             8,580
 
Provision for income taxes (Note F)           5,242             4,220             2,898
                                        -----------       -----------       -----------
 
NET INCOME                              $    10,145       $     8,017       $     5,682
                                        ===========       ===========       ===========
 
EARNINGS PER SHARE                      $       .57       $       .45       $       .32
                                        ===========       ===========       ===========
 
WEIGHTED AVERAGE SHARES AND
  EQUIVALENTS OUTSTANDING                17,775,000        17,808,000        17,598,000
                                        ===========       ===========       ===========
 
</TABLE>

See notes to consolidated financial statements.

                                       29
<PAGE>
 
                            SEATTLE FILMWORKS, INC.
                CONSOLIDATED STATEMENTS OF SHAREHOLDERS' EQUITY
                       (in thousands, except share data)
<TABLE>
<CAPTION>
                                                Common Stock
                                            --------------------
                                               Shares       Par     Paid-In    Retained
                                             Outstanding   Value    Capital    Earnings    Total
===================================================================================================
<S>                                         <C>            <C>      <C>        <C>         <C>
BALANCE AS OF SEPTEMBER 24, 1994             15,765,969     $158     $   53     $11,134     $11,345
 
  Stock options exercised                       173,922        1        274                     275
  Income tax benefit of stock options                                   333                     333
  Employee stock purchase plan                  141,918        1        348                     349
  Purchase and retirement of Common Stock        (8,325)                (54)                    (54)
  Net income                                                                      5,682       5,682
                                             ----------     ----     ------     -------     -------

BALANCE AS OF SEPTEMBER 30, 1995             16,073,484      160        954      16,816      17,930
 
  Stock options exercised                       155,902        2        350                     352
  Income tax benefit of stock options                                   424                     424
  Employee stock purchase plan                   20,172                 162                     162
  Purchase and retirement of Common Stock       (17,712)               (210)                   (210)
  Net income                                                                      8,017       8,017
                                             ----------     ----     ------      ------      ------

BALANCE AS OF SEPTEMBER 28, 1996             16,231,846      162      1,680      24,833      26,675
 
 Stock options exercised                        247,002        2        358                     360
 Income tax benefit of stock options                                    875                     875
 Employee stock purchase plan                    37,410        1        369                     370
 Purchase and retirement of Common Stock        (80,000)      (1)      (823)                   (824)
 Net income                                                                      10,145      10,145
                                             ----------     ----     ------      ------      ------

BALANCE AS OF SEPTEMBER 27, 1997             16,436,258     $164     $2,459     $34,978     $37,601
                                             ==========     ====     ======     =======     =======
</TABLE>

See notes to consolidated financial statements.

                                       30
<PAGE>
 
                            SEATTLE FILMWORKS, INC.
                     CONSOLIDATED STATEMENTS OF CASH FLOWS
                                (in thousands)
<TABLE>
<CAPTION>
 
                                                                     Fiscal Years Ended
                                                     --------------------------------------------------
                                                      September 27,     September 28,     September 30,
                                                          1997              1996              1995
=======================================================================================================
<S>                                                   <C>               <C>              <C>
OPERATING ACTIVITIES:
---------------------
  Net income                                           $ 10,145          $  8,017         $ 5,682
  Charges to income not affecting cash:
    Depreciation and amortization                         2,864             2,018           1,608
    Amortization of capitalized customer
      acquisition expenditures                           14,723            10,772           6,289
    Deferred income taxes                                   790             1,379             830
  Net change in receivables, inventories,
    payables, and other                                  (1,785)           (2,802)          1,456
  Capitalized promotional expenditures, net                  27               (80)            230
  Additions to capitalized customer
    acquisition expenditures                            (17,271)          (14,750)         (9,187)
                                                        -------           -------         -------
 
NET CASH FROM OPERATING ACTIVITIES                        9,493             4,554           6,908
 
INVESTING ACTIVITIES:
---------------------
  Purchase of furniture, fixtures, and equipment         (4,779)           (4,067)         (1,614)
  Purchases of securities available-for-sale             (9,642)           (7,409)         (1,356)
  Sales of securities available-for-sale                  9,139             4,195           1,341
                                                        -------           -------         -------
 
NET CASH USED IN INVESTING ACTIVITIES                    (5,282)           (7,281)         (1,629)
 
FINANCING ACTIVITIES:
---------------------
  Proceeds from issuance of Common Stock                    730               512             624
  Payment on purchase of Common Stock                      (824)             (210)            (54)
                                                        -------           -------         -------
NET CASH FROM (USED IN) FINANCING ACTIVITIES                (94)              302             570
                                                        -------           -------         -------
 
INCREASE (DECREASE) IN CASH AND  CASH EQUIVALENTS         4,117            (2,425)          5,849
 
Cash and cash equivalents at beginning of year            6,135             8,560           2,711
                                                        -------           -------         -------
 
CASH AND CASH EQUIVALENTS  AT END OF YEAR               $10,252          $  6,135         $ 8,560
                                                        =======          ========         =======
 
</TABLE>

See notes to consolidated financial statements.

                                       31
<PAGE>
 
                            SEATTLE FILMWORKS, INC.
                  NOTES TO CONSOLIDATED FINANCIAL STATEMENTS


NOTE  A --  OPERATIONS AND SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES

SEATTLE FILMWORKS, INC. and subsidiaries (the "Company") is a leading direct-to-
consumer marketer and provider of high-quality amateur photofinishing services
and products. The Company offers an array of complementary services and
products, primarily on a mail-order basis, under the brand name
SeattleFilm Works(R). To a lesser extent, the Company provides services, 
products and photofinishing supplies on a wholesale basis to a variety of 
commercial customers.

PRINCIPLES OF CONSOLIDATION: The consolidated financial statements include
Seattle FilmWorks, Inc. and its subsidiaries, all of which are wholly-owned.
Significant intercompany accounts and transactions have been eliminated in
consolidation.

CASH AND CASH EQUIVALENTS: Cash and cash equivalents include cash on hand and
highly liquid short-term investments with a maturity of three months or less on
the date of purchase.

SECURITIES AVAILABLE-FOR-SALE: Securities available-for-sale consist primarily
of bankers' acceptances, commercial paper, and government securities issued by
financial institutions with high credit ratings. Company policy limits the
amount of credit exposure with any one financial institution. The fiscal 1997
and fiscal 1996 balance consisted primarily of government securities. Securities
available-for-sale are carried at amortized cost, which approximates market.

OTHER FINANCIAL INSTRUMENTS: At September 27, 1997 the carrying value of
financial instruments such as trade receivables and payables approximate their
fair values, based on the short-term maturities of these instruments.

ACCOUNTS RECEIVABLE: Accounts receivable primarily include amounts due from 
mail-order customers from the sale of related photographic products and amounts
due from wholesale customers from the sale of film and single-use cameras. An
allowance for doubtful accounts is established for an estimate of bad debts.

INVENTORIES: Inventories are stated at the lower of cost (determined using the
first-in, first-out method) or market. Inventories consist primarily of film and
photofinishing supplies.

CAPITALIZED PROMOTIONAL EXPENDITURES: The Company's promotional programs run for
periods of one to six months. Promotional expenditures primarily consist of
advertising and media costs related to generating consumer interest in the
Company's photofinishing services. The Company capitalizes these costs as
capitalized promotional expenditures and expenses them the first time the
promotion is run. Advertising expense was $3,582,000, $2,989,000, and $1,882,000
in fiscal years 1997, 1996, and 1995 respectively.

DEPRECIATION AND AMORTIZATION: Furniture, fixtures, and equipment are
depreciated using the straight-line and accelerated methods based on the
estimated useful asset lives ranging from three to five years. Expenditures for
major remodeling and improvements are capitalized as leasehold improvements.
Leasehold improvements are amortized over the shorter of the life of the lease
or the life of the asset.

                                       32
<PAGE>
 
                            SEATTLE FILMWORKS, INC.
            NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)

NOTE A -- OPERATIONS AND SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES (CONTINUED)

CAPITALIZED CUSTOMER ACQUISITION EXPENDITURES: The Company's principal technique
for acquiring new customers is its Introductory Offer of two rolls of 35mm film
for $2.00 or less. Customer acquisition costs are comprised of the costs of
generating a lead and the amortization of direct costs associated with the
Company's promotional offers sent to prospective and existing customers. The
costs of generating a lead, which are expensed when the promotion is run,
include all direct-response media, advertising and other costs associated with
developing target customer lists. The direct costs of customer acquisition
include film, postage and printed material costs associated with mailings to
prospective and existing customers.

     The direct costs of customer acquisition are capitalized as an asset on the
Company's consolidated balance sheet under "capitalized customer acquisition
expenditures." Capitalized customer acquisition expenditures relating to
prospective customers are amortized over three years, and capitalized customer
acquisition expenditures relating to certain marketing activities to groups of
existing customers are amortized over six months. These amortization rates are
based on the estimates of timing of future roll processing volumes per customer.
Based on the historical pattern of roll processing volumes and the estimate of
orders to be processed in the future, estimated amortization of capitalized
customer acquisition expenditures as of September 27, 1997 will be $9,174,297,
$3,842,331 and $865,262 in fiscal years 1998, 1999, and 2000 respectively.

INCOME TAXES: The provision for federal income taxes is computed based on pretax
income reported in the consolidated financial statements. Research and
development tax credits are recorded as a reduction of the provision for federal
income taxes in the year realized. The provision for income taxes differs from
income taxes currently payable because certain items of income and expense are
recognized in different periods for financial reporting purposes than they are
for federal income tax purposes. Deferred income taxes have been recorded in
recognition of these temporary differences.

EARNINGS PER SHARE: Earnings per share is based on the weighted average number
of shares and dilutive Common Stock equivalents outstanding during the fiscal
year. Common Stock equivalents consist of stock options. In February 1997, the
Financial Accounting Standards Boards issued Statement No. 128, Earnings per
Share, which shall be effective for all financial statements for both interim
and annual periods ending after December 15, 1997. At that time, the Company
will be required to change the method currently used to compute earnings per
share and to restate all prior periods. Under the new requirements for
calculating primary (basic) earnings per share, the dilutive effect of stock
options will be excluded, but included in the computation of diluted earnings
per share. The impact is expected to result in an increase in primary (basic)
earnings per share for fiscal years 1997 and 1996 of $.05 per share, and fiscal
year 1995 of $.03 per share. The impact of Statement No. 128 on the calculation
of fully diluted (diluted) earnings per share for these same periods is not
expected to be material.

STOCK-BASED COMPENSATION: In October 1995, the Financial Accounting Standards
Board issued Statement of Financial Accounting Standards No. 123, "Accounting
for Stock-Based Compensation" (Statement 123). The Company has adopted the
disclosure-only provisions of Statement 123, and applies Accounting Principles
Board Opinion No 25 (APB 25) and related Interpretations in accounting for its
stock option plans. Accordingly, the Company's stock-based compensation expense
is recognized based on the intrinsic value of the option on the date of grant.
Pro forma disclosure of earnings per share under Statement 123 is provided in
Note G to the consolidated financial statements.

                                       33
<PAGE>
 
                            SEATTLE FILMWORKS, INC.
            NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)

NOTE A -- OPERATIONS AND SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES (CONTINUED)

REVENUE RECOGNITION: The Company recognizes revenue when products are shipped or
services are delivered.

USE OF ESTIMATES: The preparation of financial statements in conformity with
generally accepted accounting principles requires management to make estimates
and assumptions that affect the amounts reported in the consolidated financial
statements and accompanying notes. Actual results could differ from those
estimates.

RECLASSIFICATIONS: Certain prior year balances have been reclassified to conform
to the current year's presentation.

NOTE  B --  ACQUISITION OF PRIVATE LABEL FILM BUSINESS

     On December 30, 1993, the Company acquired certain assets of Private Label
Film, Inc. for approximately $1,637,000. The assets relate to the manufacture
and sale of private-label film and related products to retailers and commercial
users. This acquisition has been accounted for using the purchase method. The
purchase price was recorded as follows: equipment $100,000; and other assets of
$1,536,830 related to noncompete agreements which includes capitalized legal and
accounting expenses. Noncompete agreement is being amortized as other selling
expenses on a straight-line basis over five years.

NOTE  C --  FURNITURE, FIXTURES, AND EQUIPMENT

Furniture, fixtures, and equipment consist of the following:

<TABLE>
<CAPTION>
 
                                                  September 27,   September 28,
                                                       1997            1996
                                                  =============   ============= 
                                                          (in thousands)
<S>                                               <C>             <C>
 
Furniture, fixtures, and equipment                   $ 15,389        $12,558
Leasehold improvements                                  2,949          2,294
                                                     --------        -------
                                                       18,338         14,852
Less accumulated depreciation and amortization        (10,774)        (9,515)
                                                     --------        -------
                                                                            
                                                     $  7,564        $ 5,337
                                                     ========        ======= 
</TABLE>
 
NOTE  D --  CREDIT AGREEMENT

     At September 27, 1997, the Company had a $6,000,000 available line of
credit. At the option of the Company, the interest rate on borrowings under the
agreement may be at the lending bank's prime rate or at a rate of 0.75% above
the London Interbank Offered Rate. There were no borrowings outstanding at the
end of fiscal 1997 or fiscal 1996 under the line of credit.

                                       34
<PAGE>
 
                            SEATTLE FILMWORKS, INC.
            NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)

NOTE  E --  PROPERTY AND LEASES

     The Company's primary leases relate to its main operating facilities. These
leases expire in September 2000. The Company has a lease agreement for
additional warehouse and production space, which expires in January 1999 with an
option to extend the lease for two one-year periods. The Company also has
various leases for its retail stores, with lease terms generally ranging from
three to five years. At September 27, 1997 future minimum payments under
noncancelable operating leases for fiscal years 1998 through 2001 are $947,000,
$780,000, $637,000 and $6,800, respectively. Rental expense relating to
operating leases for fiscal years 1997, 1996 and 1995 was $792,000, $481,000,
and $353,000, respectively.

NOTE  F --  INCOME TAXES

<TABLE>
<CAPTION>
The provision for income taxes is as follows:
                                                                                             (in thousands)
                                                                  1997       1996       1995
                                                                 ------    -------    -------
                   <S>                                          <C>        <C>        <C>
                   Provision for income taxes:
                     Current..................................   $4,452     $2,841     $2,068
                     Deferred.................................      790      1,379        830
                                                                 ------     ------     ------
                                                                 $5,242     $4,220     $2,898
                                                                 ======     ======     ======


A reconciliation of the federal statutory tax rates to the effective tax rates is as follows:
 
                                                                   1997       1996       1995
                                                                   ----       ----       ----
                    Statutory tax rate........................     35.0%      35.0%      34.0%
                    Research and development tax credits......      (.3)       (.1)       (.4)
                    Other, net................................      (.6)       (.4)        .2
                                                                   ----       ----       ----
                                                                   34.1%      34.5%      33.8%
                                                                  ======     ======     ======

Principal items comprising the cumulative deferred income taxes are as follows:

                                                                  1997      1996
                                                                 ------    ------
                   Deferred tax liabilities:
                     Customer acquisition expenditures........   $4,859    $3,899
                     Other liabilities........................      300       212
                                                                 ------    ------
                   Total deferred tax liabilities.............    5,159     4,111

                   Deferred tax assets:
                     Accrued expenses.........................      614       524
                     Depreciation and amortization............      464       296
                                                                 ------    ------
                   Total deferred tax assets..................    1,078       820
                                                                 ------    ------

                   Net deferred tax liabilities...............   $4,081    $3,291
                                                                 ======    ======
</TABLE>

Taxes paid in 1997, 1996, and 1995 were $2,095,000, $2,300,000, and $2,020,000,
respectively.

                                       35
<PAGE>
 
                            SEATTLE FILMWORKS, INC.

             NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)


NOTE  G --  STOCK-BASED COMPENSATION

STOCK OPTIONS

     Pursuant to the Company's Stock Option Plans adopted in 1982 and 1987,
options may be granted to purchase up to 6,904,688 shares of Common Stock at
prices equal to the fair market value of the shares at the time the options are
granted.  Options generally vest over four years and become exercisable
commencing one year after the date of grant and expiring five years after the
date of grant.

     The following schedule summarizes stock option activity for fiscal years
1995, 1996, and 1997.
<TABLE>
<CAPTION>
                                     Number      Price Per     Weighted Average
                                   of Shares       Share        Exercise Price
                                   =========   ==============  ================
<S>                                <C>         <C>             <C> 
  Balance at September 24, 1994    1,925,010   $0.17 -  $5.41       $ 1.25
    Granted during 1995              228,488   $4.78 -  $9.44       $ 5.66
    Canceled during 1995             (31,644)  $2.07 -  $4.96       $ 2.33
    Exercised during 1995           (173,922)  $0.17 -  $4.37       $ 1.57
                                   ---------
                                                                    
  Balance at September 30, 1995    1,947,932   $0.19 -  $9.44       $ 1.72
    Granted during 1996              213,075   $8.55 - $13.67       $11.37
    Canceled during 1996             (28,886)  $2.07 -  $9.44       $ 4.68
    Exercised during 1996           (155,902)  $0.19 -  $6.78       $ 2.24
                                   ---------
A                                                                    
  Balance at September 28, 1996    1,976,219   $0.21 - $13.67       $ 2.67
    Granted during 1997              194,100   $9.63 - $14.67       $12.04
    Canceled during 1997             (25,679)  $2.07 - $14.67       $ 5.48
    Exercised during 1997           (247,002)  $0.21 - $11.72       $ 1.45
                                   ---------   --------------       ------
                                                                    
  Balance at September 27, 1997    1,897,638   $0.21 - $14.67       $ 3.75
                                   =========   ==============       ======
</TABLE>

  The following schedule summarizes weighted-average remaining contractual life
and weighted-average exercise price of options outstanding and options
exercisable as of September 27, 1997.
<TABLE>
<CAPTION>
                            Options Outstanding           Options Exercisable
                   ------------------------------------   ---------------------
                                  Remaining
Range of             Options     Contractual   Exercise     Options    Exercise
Exercise Prices    Outstanding   Life (Years)    Price    Exercisable   Price
---------------    -----------   ------------  --------   -----------  --------
<S>                <C>           <C>           <C>        <C>          <C>
                              
$0.21 -  $ 2.00      892,486        1.4         $ 0.34       892,486     $ 0.34
$ 2.01 - $ 5.00      479,590        2.1         $ 2.95       437,134     $ 2.79
$ 5.01 - $10.00      144,025        4.6         $ 6.25        96,101     $ 5.99
$10.01 - $14.67      381,537        3.9         $11.81       127,332     $11.75
                   ---------        ---         ------     ---------     ------
                   1,897,638        2.3         $ 3.75     1,553,053     $ 2.31
                   =========        ===         ======     =========     ======
</TABLE>

     Options considered fully vested as of September 27, 1997 and September 28,
1996 were 1,553,053 and 1,562,568, respectively, at weighted average exercise
prices of $2.31 and $1.60, respectively.  Shares of Common Stock reserved for
issuance under these stock option plans totaled 2,283,132 at September 27, 1997,
of which 385,494 shares were available for options to be granted in the future.

                                       36
<PAGE>
 
                            SEATTLE FILMWORKS, INC.

             NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)


NOTE  G --  STOCK-BASED COMPENSATION
(CONTINUED)

     The weighted average fair value of options granted during fiscal 1997 was
$5.90 per option and $5.49 per option for fiscal 1996.

     Pro forma information regarding net income and earnings per share required
by Statement No. 123 has been determined as if the Company had accounted for its
employee stock options under the fair value method of that Statement. The fair
value for the options was estimated at the date of grant using a Black-Scholes
option pricing model with the following weighted-average assumptions on the
option grant date: Risk free interest rate of 6.39% for fiscal year 1997 and
5.74% for fiscal year 1996, expected volatility of 46.75%, expected option life
of 4.99 years, and a dividend yield of 0.0%.

     Under Statement No. 123, if the Company had elected to recognize the
compensation cost based upon the fair value of the options granted at grant
date, net income would have been reduced as follows:
<TABLE>
<CAPTION>
                                  September 27,       September 28,
                                       1997               1996
                                ------------------  -----------------
                                (in thousands, except per share data)
<S>                             <C>                 <C>
Net income:          
  As reported..................      $10,145             $8,017
  Pro forma....................      $ 9,687             $7,706
Earnings per share:                   
  As reported..................      $   .57             $  .45
  Pro forma....................      $   .54             $  .43
</TABLE>

     The pro forma effects on net income for fiscal year 1997 and 1996 are not
indicative of pro forma effects in future years because SFAS No. 123 does not
apply to grants prior to fiscal 1996 and additional grants in future years are
anticipated.

EMPLOYEE STOCK PURCHASE PLAN

     Effective September 22, 1993, the Company adopted an Employee Stock
Purchase Plan under which substantially all employees have the option to
purchase 506,250 shares of Common Stock.  Under the Plan, eligible employees may
purchase shares of the Company's Common Stock at six-month intervals at 85% of
the fair market value on the first or last day of the six-month offering period,
whichever is lower.  Employees may purchase shares having a value not exceeding
10% of their gross compensation during the purchase period.  During fiscal 1997
and 1996, shares totaling 37,410 and 20,172 were issued under the Plan at an
average price of $9.891 and $8.028 per share, respectively.  At September 27,
1997, 266,874 shares were reserved for future issuance.

                                       37
<PAGE>
 
                            SEATTLE FILMWORKS, INC.

             NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)


NOTE  H --  SHAREHOLDERS' EQUITY

STOCK SPLITS

     All share data, per share data and related accounts in the accompanying
consolidated financial statements and these notes reflect a retroactive
adjustment for a three-for-two stock split effective March 15, 1995, a three-
for-two split effective March 15, 1996 and a three-for-two stock split effective
March 17, 1997.

SHARE REPURCHASES

     In January 1997, the Board of Directors authorized the repurchase of the
Company's Common Stock, either through open market purchases at prevailing
market prices, through block purchases or in privately negotiated transactions.
Repurchases may be commenced or discontinued at any time.  Although the number
of shares to be repurchased is uncertain, any repurchased shares will to some
degree offset the dilutive effect on earnings per share of shares of Common
Stock issued under the Company's stock option and stock purchase plans.

     As of September 27, 1997, the Company had purchased a total of 80,000
shares for a total of $824,000.  In addition, in November 1997, the Company
purchased a total of 267,300 shares for a total of $2,637,000.

NOTE  I --  RETIREMENT AND PROFIT SHARING PLAN

     The Company maintains a 401(k) Plan for substantially all employees.  The
Company's contributions are based on matching a percentage of up to 2% of
voluntary employee contributions and discretionary profit sharing contribution
determined by the Board of Directors.  The Company's contributions were
$547,000, $488,000, and $366,000 for  fiscal years 1997, 1996, and 1995,
respectively.

NOTE J  --  CONTINGENCIES

The Company is involved in various routine legal proceedings incident to the
ordinary course of its business.  Management believes that the outcome of all
pending legal proceedings in the aggregate will not have a material adverse
effect on the Company's business, financial condition or operating results.

                                       38
<PAGE>
 
                            SEATTLE FILMWORKS, INC.

             NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)


NOTE  K  --  SELECTED QUARTERLY FINANCIAL DATA (Unaudited)

     The following table sets forth summary financial data for the Company by
quarter for fiscal years 1997 and 1996 (in thousands, except per share data).
<TABLE>
<CAPTION>
                                         Quarters
                           -----------------------------------
                            First    Second    Third   Fourth
                           --------  -------  -------  -------
<S>                        <C>       <C>      <C>      <C>
Fiscal 1997
-----------
     Net revenue            $21,236  $21,657  $25,553  $32,743
     Gross profit             8,254    8,895   11,576   13,840
     Net income               1,357    1,146    2,792    4,850
     Earnings per share         .07      .06      .16      .27
 
Fiscal 1996
-----------
     Net revenue            $16,689  $17,821  $22,509  $27,133
     Gross profit             6,292    7,311    8,927   12,463
     Net income                 951      503    2,242    4,321
     Earnings per share         .05      .03      .13      .24
</TABLE>

     The sum of quarterly earnings per share will not necessarily equal the
earnings per share reported for the entire year since the weighted average
shares outstanding used in the earnings per share computation changes throughout
the year.  All earnings per share data presented above have been adjusted to
reflect stock splits.  See Note H.


ITEM 9 - CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND
FINANCIAL DISCLOSURE

     None.

                                       39
<PAGE>
 
                                    PART III


ITEM 10 -- DIRECTORS AND EXECUTIVE OFFICERS OF THE REGISTRANT

     See "Directors and Executive Officers of the Registrant" under Item 1 -
Part 1 above.

     Information concerning compliance with Section 16 of the Securities
Exchange Act is incorporated herein by reference to information appearing in the
Company's Proxy Statement for its annual meeting of shareholders to be held on
February 11, 1998, which information appears under the caption "Section 16(a)
Beneficial Ownership Reporting Compliance".  Such Proxy Statement will be filed
within 120 days of the Company's last fiscal year-end, September 27, 1997.


ITEMS 11, 12, AND 13

     The information called for by Part III (Items 11, 12, and 13) is included
in the Company's Proxy Statement relating to the Company's annual meeting of
shareholders to be held on February 11, 1998 and is incorporated herein by
reference.  The information appears in the Proxy Statement under the captions
"Election of Directors", and "Remuneration of Executive Officers," "Voting
Securities and Principal Holders," "Compensation Committee Report on Executive
Compensation" and "Stock Price Performance Graph".  Such Proxy Statement will be
filed within 120 days of the Company's last fiscal year-end, September 27, 1997.


                                    PART IV

ITEM 14 -- EXHIBITS, FINANCIAL STATEMENT SCHEDULES, AND REPORTS ON FORM 8-K

A. INDEX TO CONSOLIDATED FINANCIAL STATEMENTS AND CONSOLIDATED FINANCIAL
   ---------------------------------------------------------------------
   STATEMENT SCHEDULES
   -------------------
<TABLE>
<CAPTION>
(1)    Consolidated Financial Statements                                                Page
       ---------------------------------                                                ----
<S>    <C>                                                                              <C>
       Report of Ernst & Young LLP, Independent Auditors                                 27
 
       Consolidated Balance Sheets as of September 27, 1997 and September 28, 1996       28
 
       Consolidated Statements of Income for the years ended September 27, 1997,
       September 28, 1996, and September 30, 1995                                        29
 
       Consolidated Statements of Shareholders' Equity for the years ended
       September 27, 1997, September 28, 1996, and September 30, 1995                    30
 
       Consolidated Statements of Cash Flows for the years ended September 27, 1997,
       September 28, 1996, and September 30, 1995                                        31
 
       Notes to Consolidated Financial Statements                                       32-39
</TABLE>

     Supplemental Consolidated Financial Statement Schedule.  The following
additional information should be read in conjunction with the Consolidated
Financial Statements of the Company included in Part II, Item 8.

                                       40
<PAGE>
 
<TABLE>
<CAPTION>
(2)    Schedule                                                                        Page
       --------                                                                        ----
<S>    <C>                                                                              <C>
       II - Valuation and Qualifying Accounts                                            45
</TABLE> 

     All other schedules have been omitted because the required information is
included in the consolidated financial statements or the notes thereto, or is
not applicable or required.

B. REPORTS ON FORM 8-K
   -------------------

     None.

C. EXHIBITS
   --------

     The following list is a subset of the exhibits set forth below and contains
all compensatory plans, contracts, or arrangements in which any director or
executive officer of the Company is a participant, unless the method of
allocation of benefits thereunder is the same for management and non-management
participants:

     (1)  The Company's Incentive Stock Option Plan, as amended and restated as
          of April 1, 1996. See Exhibit 10.4
 
     (2)  The Company's 1987 Stock Option Plan, as amended and restated as of
          April 1, 1996. See Exhibit 10.6

<TABLE> 
<CAPTION> 
Exhibit
Number                       Exhibit Description
-------                      -------------------
<S>      <C>                 
3.1      Articles of Incorporation of the Company, as amended through February
         23, 1989. (Incorporated by reference to Exhibit 3.1 filed with the
         Company's Annual Report on Form 10-K for the year ended September 30,
         1989.)
 
3.2      Bylaws of the Company, as amended and restated on November 13, 1996.
         (Incorporated by reference to Exhibit 3.2 filed with the Company's
         Annual Report on Form 10-K for the year ended September 28, 1996.)

3.3      Articles of Amendment to Articles of Incorporation dated March 2, 1994.
         (Incorporated by reference to Exhibit 3.4 filed with the Company's
         Annual Report on Form 10-K for the year ended September 24, 1994.)

3.4      Articles of Amendment to Articles of Incorporation dated February 16,
         1995. (Incorporated by reference to Exhibit 3.4 filed with the
         Company's Annual Report on Form 10-Q for the year ended March 25,
         1995.)

3.5      Second Restated Articles of Incorporation of Seattle FilmWorks, Inc.
         dated March 5, 1996. (Incorporated by reference to Exhibit 3.0 filed
         with the Company's Quarterly Report on Form 10-Q for the quarter ended
         March 30, 1996.)

3.6      Articles of Amendment to Articles of Incorporation dated February 13,
         1997. (Incorporated by reference to Exhibit 3.0 filed with the
         Company's Quarterly Report on Form 10-Q for the quarter ended March 29,
         1997.)

</TABLE> 

                                       41
<PAGE>
 
<TABLE> 
<S>      <C>                 
10.1     Lease Agreement dated September 10, 1985 between Gilbert Scherer and
         Marlyn Friedlander, Lessors, and the Company with respect to certain
         office and plant facilities in Seattle, Washington. (Incorporated by
         reference to the exhibit with a corresponding number filed with the
         Company's registration statement on Form S-1 (file no. 33-4388.)

10.2     First Amendment to Facility Lease Agreement dated April 29, 1989, with
         Gilbert Scherer and Marlyn Friedlander, Lessors. (Incorporated by
         reference to Exhibit 10.48 filed with the Company's Annual Report on
         Form 10-K for the year ended September 30, 1989.)

10.3     Consent to Sublease dated September 30, 1996, between Gilbert Scherer
         and Marlyn Friedlander and Seattle FilmWorks, Inc. (Incorporated by
         reference to Exhibit 10.3 filed with the Company's Annual Report on
         Form 10-K for the year ended September 28, 1996.)

10.4     Incentive Stock Option Plan, as amended and restated as of April 1,
         1996. (Incorporated by reference to Exhibit 10.1 filed with the
         Company's Quarterly Report on Form 10-Q for the quarter ended June 29,
         1996.)

10.5     Form of Incentive Stock Option Agreement. (Incorporated by reference to
         Exhibit 10.2 filed with the Company's Registration Statement on Form S-
         8, file no. 33-24107.)

10.6     1987 Stock Option Plan, as amended and restated as of April 1, 1996.
         (Incorporated by reference to Exhibit 10.2 filed with the Company's
         Quarterly Report on Form 10-Q for the quarter ended June 29, 1996.)

10.7     Form of Stock Option Agreement. (Incorporated by reference to Exhibit
         10.4 filed with the Company's Registration Statement on Form S-8, file
         no. 33-24107.)

10.8     1993 Employee Stock Purchase Plan as amended and restated as of May 31,
         1995. (Incorporated by reference to Exhibit 10.58 filed with the
         Company's Annual Report on Form 10-K for the year ended September 30,
         1995.)

10.9     Purchase and Sale Agreement dated as of December 16, 1993 and related
         Amendment to Purchase and Sale Agreement dated December 30, 1993 among
         Seattle FilmWorks, Inc., Private Label Film, Inc. and certain
         shareholders of Private Label Film, Inc. (Incorporated by reference to
         Exhibits 2.1 and 2.2 filed with the Company's Report on Form 10-Q dated
         February 7, 1994.)

10.10    Business Loan Agreement with First Interstate Bank of Washington N.A.
         as amended and restated on March 31, 1994. (Incorporated by reference
         to Exhibit 10.60 filed with the Company's Annual Report on Form 10-K
         for the year ended September 24, 1994.)

10.11    Business Loan Agreement with First Interstate Bank of Washington N.A.
         as amended and restated on February 28, 1995. (Incorporated by
         reference to Exhibit 10.0 filed with the Company's Quarterly Report on
         Form 10-Q for the quarter ended March 25, 1995.)

10.12    Business Loan Agreement with First Interstate Bank of Washington N.A.
         as amended and restated on January 31, 1996. (Incorporated by reference
         to Exhibit 10.1 filed with the Company's Quarterly Report on Form 10-Q
         for the quarter ended March 30, 1996.)

</TABLE> 

                                       42
<PAGE>
 
<TABLE> 
<S>      <C>                 
10.13    Business Loan Agreement with Wells Fargo Bank, National Association as
         amended and restated on December 13, 1996. (Incorporated by reference
         to Exhibit 10.13 filed with the Company's Annual Report on Form 10-K
         for the year ended September 28, 1996.)

10.14    Credit Agreement with Wells Fargo Bank, National Association as of
         March 1, 1997. (Incorporated by reference to Exhibit 10.1 filed with
         the Company's Quarterly Report on Form 10-Q for the quarter ended June
         28, 1997.)
 
10.15    Stock Redemption Agreement dated July 20,1994 between the Company and
         Sam Rubinstein and related promissory note. (Incorporated by reference
         to Exhibits 5.1 and 5.2 filed with the Company's Report on Form 8-K
         dated July 22, 1994.)
 
10.16    Lease Agreement dated September 22, 1995 between the United States of
         America, Lessors, and the Company with respect to certain plant and
         warehouse facilities in Seattle, Washington. (Incorporated by reference
         to Exhibit 10.63 filed with the Company's Annual Report on Form 10-K
         for the year ended September 30, 1995.)
 
10.17    Addendum to Lease Agreement dated January 1, 1996 between the United
         States of America, Lessors, and the Company. (Incorporated by reference
         to Exhibit 10.3 filed with the Company's Quarterly Report on Form 10-Q
         for the quarter ended March 30, 1996.)
 
10.18    Supplemental Lease Agreement dated October 21, 1996 between the United
         States of America, Lessors, and the Company. (Incorporated by reference
         to Exhibit 10.17 filed with the Company's Annual Report on Form 10-K
         for the year ended September 28, 1996.)

10.19    Lease agreement dated March 4, 1997 between Smith Cove Partnership and
         the Company. (Incorporated by reference to Exhibit 10.3 filed with the
         Company's Quarterly Report on Form 10-Q for the quarter ended March 29,
         1997.)
 
10.20*   Sales contract dated August 18, 1995 between the Company and Agfa
         Division of Miles, Inc. with respect to the purchase of certain
         products. (Incorporated by reference to Exhibit 10.64 filed with the
         Company's Quarterly Report on Form 10-Q for the quarter ended March 30,
         1996.)

10.21*   Supplement to sales contract with Agfa Division of Miles, Inc. dated
         March 29, 1996. (Incorporated by reference to Exhibit 10.2 filed with
         the Company's Quarterly Report on Form 10-Q for the quarter ended March
         30, 1996.)

10.22*   Agfa Sales Contract and Sales Contract Addendum dated May 21, 1997.
         (Incorporated by reference to Exhibit 10.2 filed with the Company's
         Quarterly Report on Form 10-Q for the quarter ended June 28, 1997.)

10.23*   Supply Agreement effective January 1, 1997 with Fuji Photo Film U.S.A.,
         Inc. (Incorporated by reference to Exhibit 10.1 filed with the
         Company's Quarterly Report on Form 10-Q for the quarter ended March 29,
         1997.)
 
10.24*   Kodak Agreement dated May 13, 1997. (Incorporated by reference to
         Exhibit 10.3 filed with the Company's Quarterly Report on Form 10-Q for
         the quarter ended June 28, 1997.)
 
10.25*   AT&T Agreement dated March 5, 1997. (Incorporated by reference to
         Exhibit 10.2 filed with the Company's Quarterly Report on Form 10-Q for
         the quarter ended March 29, 1997.)

</TABLE> 

                                       43
<PAGE>
 
<TABLE> 
<S>      <C>                 
10.26     Warehouse Sublease between Seattle FilmWorks, Inc. and OptiColor, Inc.
          dated September 30, 1996. (Incorporated by reference to Exhibit 10.20
          filed with the Company's Annual Report on Form 10-K for the year ended
          September 28, 1996.)

10.27     Warehouse Sublease between Seattle FilmWorks, Inc. and Seattle
          FilmWorks Manufacturing Company dated September 30, 1996.
          (Incorporated by reference to Exhibit 10.21 filed with the Company's
          Annual Report on Form 10-K for the year ended September 28, 1996.)

10.28     1260 16th Avenue West Sublease between Seattle FilmWorks, Inc. and
          OptiColor Inc. dated September 30, 1996. (Incorporated by reference to
          Exhibit 10.22 filed with the Company's Annual Report on Form 10-K for
          the year ended September 28, 1996.)

10.29     1260 16th Avenue West Sublease between Seattle FilmWorks, Inc. and
          Seattle FilmWorks Manufacturing Company dated September 30, 1996.
          (Incorporated by reference to Exhibit 10.23 filed with the Company's
          Annual Report on Form 10-K for the year ended September 28, 1996.)

10.30     General Assignment between Seattle FilmWorks, Inc., Seattle FilmWorks
          Manufacturing Company and OptiColor, Inc. dated September 30, 1996.
          (Incorporated by reference to Exhibit 10.24 filed with the Company's
          Annual Report on Form 10-K for the year ended September 28, 1996.)

11        Computation of Earnings Per Share

21        Seattle FilmWorks, Inc. Subsidiaries

23        Consent of Ernst & Young LLP, Independent Auditors

27        Financial Data Schedule

</TABLE> 

     * Exhibit for which confidential treatment has been granted.

                                       44
<PAGE>
 
                            SEATTLE FILMWORKS, INC.

                                  SCHEDULE  II

                       VALUATION AND QUALIFYING ACCOUNTS
                                 (in thousands)
<TABLE>
<CAPTION>
                                                           Additions
                                               ---------------------------------
                                   Balance at  Charged to  Charged to               Balance
                                   Beginning   Costs and     Other                  at End
           Description              of Year     Expenses    Accounts   Deductions  of Period
           ===========             ==========  ==========  ==========  ==========  =========
<S>                                <C>         <C>         <C>         <C>         <C>
FOR THE YEAR ENDED
SEPTEMBER 30, 1995
 
Allowance for doubtful accounts       $461        $639          $0         $554       $546
Allowance for returns                 $105        $272          $0         $280       $ 97
                                      
FOR THE YEAR ENDED                    
SEPTEMBER 28, 1996                    
                                      
Allowance for doubtful accounts       $546        $158          $0         $417       $287
Allowance for returns                 $ 97        $130          $0         $182       $ 45
                                      
FOR THE YEAR ENDED                    
SEPTEMBER 27, 1997                    
                                      
Allowance for doubtful accounts       $287        $ 97          $0         $144       $240
Allowance for returns                 $ 45        $155          $0         $147       $ 53
</TABLE>

                                       45
<PAGE>
 
                                   SIGNATURES

Pursuant to the requirements of Section 13 or 15 (d) of the Securities Exchange
Act of 1934, the Registrant has duly caused this report to be signed on its
behalf by the undersigned, thereunto duly authorized.

                                       SEATTLE FILMWORKS,  INC.
                                             (REGISTRANT)

DATED:  December 19, 1997              By: /s/ Gary R. Christophersen
                                           -------------------------------------
                                               Gary R. Christophersen
                                           President and Chief Executive Officer
                                               (Principal Executive Officer)


Pursuant to the requirements of the Securities Exchange Act of 1934, this report
has been signed below by the following persons on behalf of the Registrant and
in the capacities and on the dates indicated.

<TABLE>
<CAPTION>
             NAME                                     TITLE                    DATE
             ----                                     -----                    ----
<S>                                      <C>                            <C>
By: /s/ Gary R. Christophersen    President                      December 19, 1997
    ---------------------------   Chief Executive Officer
    Gary R. Christophersen        Director  
                                  (Principal Executive Officer)

By: /s/ Sam Rubinstein            Director                       December 19, 1997
    ---------------------------
    Sam Rubinstein

By: /s/ Douglas A. Swerland       Director                       December 19, 1997
    ---------------------------
    Douglas A. Swerland

By: /s/ Craig E. Tall             Director                       December 19, 1997
    ---------------------------
    Craig E. Tall

By: /s/ Peter H. van Oppen        Director                       December 19, 1997
    ---------------------------
    Peter H. van Oppen

By: /s/ Case H. Kuehn             Vice President-Finance         December 19, 1997
    ---------------------------   Chief Financial Officer
    Case H. Kuehn                 (Principal Financial and        
                                  Accounting Officer)
</TABLE>

                                       46
<PAGE>
 
                                 EXHIBIT INDEX
                                 -------------

                           Annual Report on Form 10-K
                     For The Year Ended September 27, 1997

<TABLE> 
<CAPTION> 
Exhibit                                                                       Page
Number                    Exhibit Description                                Number
-------                   -------------------                                ------
<S>       <C>                                                                <C> 
3.1       Articles of Incorporation of the Company, as amended through
          February 23, 1989. (Incorporated by reference to Exhibit 3.1
          filed with the Company's Annual Report on Form 10-K for the
          year ended September 30, 1989.)

3.2       Bylaws of the Company, as amended and restated on November 13,
          1996. (Incorporated by reference to Exhibit 3.2 filed with
          the Company's Annual Report on Form 10-K for the year ended
          September 28, 1996.)

3.3       Articles of Amendment to Articles of Incorporation dated
          March 2, 1994. (Incorporated by reference to Exhibit 3.4
          filed with the Company's Annual Report on Form 10-K for the
          year ended September 24, 1994.)

3.4       Articles of Amendment to Articles of Incorporation dated
          February 16, 1995. (Incorporated by reference to Exhibit 3.4
          filed with the Company's Annual Report on Form 10-Q for the
          year ended March 25, 1995.)

3.5       Second Restated Articles of Incorporation of Seattle
          FilmWorks, Inc. dated March 5, 1996. (Incorporated by
          reference to Exhibit 3.0 filed with the Company's Quarterly
          Report on Form 10-Q for the quarter ended March 30, 1996.)

3.6       Articles of Amendment to Articles of Incorporation dated
          February 13, 1997. (Incorporated by reference to Exhibit 3.0
          filed with the Company's Quarterly Report on Form 10-Q for
          the quarter ended March 29, 1997.)

10.1      Lease Agreement dated September 10, 1985 between Gilbert
          Scherer and Marlyn Friedlander, Lessors, and the Company with
          respect to certain office and plant facilities in Seattle,
          Washington. (Incorporated by reference to the exhibit with a
          corresponding number filed with the Company's registration
          statement on Form S-1 (file no. 33-4388.)

10.2      First Amendment to Facility Lease Agreement dated April
          29, 1989, with Gilbert Scherer and Marlyn Friedlander,
          Lessors. (Incorporated by reference to Exhibit 10.48 filed
          with the Company's Annual Report on Form 10-K for the year
          ended September 30, 1989.)

10.3      Consent to Sublease dated September 30, 1996, between
          Gilbert Scherer and Marlyn Friedlander and Seattle
          FilmWorks, Inc. (Incorporated by reference to Exhibit 10.3
          filed with the Company's Annual Report on Form 10-K for the
          year ended September 28, 1996.)

10.4      Incentive Stock Option Plan, as amended and restated as
          of April 1, 1996. (Incorporated by reference to Exhibit 10.1
          filed with the Company's Quarterly Report on Form 10-Q for
          the quarter ended June 29, 1996.)

10.5      Form of Incentive Stock Option Agreement. (Incorporated
          by reference to Exhibit 10.2 filed with the Company's
          Registration Statement on Form S-8, file no. 33-24107.)
</TABLE> 

                                       47
<PAGE>
 
<TABLE> 
<S>       <C>
10.6      1987 Stock Option Plan, as amended and restated as of
          April 1, 1996. (Incorporated by reference to Exhibit 10.2
          filed with the Company's Quarterly Report on Form 10-Q for
          the quarter ended June 29, 1996.)

10.7      Form of Stock Option Agreement. (Incorporated by
          reference to Exhibit 10.4 filed with the Company's
          Registration Statement on Form S-8, file no. 33-24107.)

10.8      1993 Employee Stock Purchase Plan as amended and
          restated as of May 31, 1995. (Incorporated by reference to
          Exhibit 10.58 filed with the Company's Annual Report on Form
          10-K for the year ended September 30, 1995.)

10.9      Purchase and Sale Agreement dated as of December 16,
          1993 and related Amendment to Purchase and Sale Agreement
          dated December 30, 1993 among Seattle FilmWorks, Inc.,
          Private Label Film, Inc. and certain shareholders of Private
          Label Film, Inc. (Incorporated by reference to Exhibits 2.1
          and 2.2 filed with the Company's Report on Form 10-Q dated
          February 7, 1994.)

10.10     Business Loan Agreement with First Interstate Bank of
          Washington N.A. as amended and restated on March 31, 1994.
          (Incorporated by reference to Exhibit 10.60 filed with the
          Company's Annual Report on Form 10-K for the year ended
          September 24, 1994.)

10.11     Business Loan Agreement with First Interstate Bank of
          Washington N.A. as amended and restated on February 28,
          1995. (Incorporated by reference to Exhibit 10.0 filed with
          the Company's Quarterly Report on Form 10-Q for the quarter
          ended March 25, 1995.)

10.12     Business Loan Agreement with First Interstate Bank of
          Washington N.A. as amended and restated on January 31, 1996.
          (Incorporated by reference to Exhibit 10.1 filed with the
          Company's Quarterly Report on Form 10-Q for the quarter
          ended March 30, 1996.)

10.13     Business Loan Agreement with Wells Fargo Bank, National
          Association as amended and restated on December 13, 1996.
          (Incorporated by reference to Exhibit 10.13 filed with the
          Company's Annual Report on Form 10-K for the year ended
          September 28, 1996.)

10.14     Credit Agreement with Wells Fargo Bank, National Association
          as of March 1, 1997. (Incorporated by reference to Exhibit
          10.1 filed with the Company's Quarterly Report on Form 10-Q
          for the quarter ended June 28, 1997.)
 
10.15     Stock Redemption Agreement dated July 20,1994 between
          the Company and Sam Rubinstein and related promissory note.
          (Incorporated by reference to Exhibits 5.1 and 5.2 filed
          with the Company's Report on Form 8-K dated July 22, 1994.)
 
10.16     Lease Agreement dated September 22, 1995 between the
          United States of America, Lessors, and the Company with
          respect to certain plant and warehouse facilities in
          Seattle, Washington. (Incorporated by reference to Exhibit
          10.63 filed with the Company's Annual Report on Form 10-K
          for the year ended September 30, 1995.)
 
10.17     Addendum to Lease Agreement dated January 1, 1996 between
          the United States of America, Lessors, and the Company.
          (Incorporated by reference to Exhibit 10.3 filed with the
          Company's Quarterly Report on Form 10-Q for the quarter
          ended March 30, 1996.)
</TABLE> 

                                       48
<PAGE>
 
<TABLE> 
<S>       <C>
10.18     Supplemental Lease Agreement dated October 21, 1996
          between the United States of America, Lessors, and the
          Company. (Incorporated by reference to Exhibit 10.17 filed
          with the Company's Annual Report on Form 10-K for the year
          ended September 28, 1996.)

10.19     Lease agreement dated March 4, 1997 between Smith Cove
          Partnership and the Company. (Incorporated by reference to
          Exhibit 10.3 filed with the Company's Quarterly Report on
          Form 10-Q for the quarter ended March 29, 1997.)
 
10.20*    Sales contract dated August 18, 1995 between the Company
          and Agfa Division of Miles, Inc. with respect to the purchase
          of certain products. (Incorporated by reference to Exhibit
          10.64 filed with the Company's Quarterly Report on Form 10-Q
          for the quarter ended March 30, 1996.)

10.21*    Supplement to sales contract with Agfa Division of Miles,
          Inc. dated March 29, 1996. (Incorporated by reference to
          Exhibit 10.2 filed with the Company's Quarterly Report on Form
          10-Q for the quarter ended March 30, 1996.)

10.22*    Agfa Sales Contract and Sales Contract Addendum dated May 21,
          1997. (Incorporated by reference to Exhibit 10.2 filed with
          the Company's Quarterly Report on Form 10-Q for the quarter
          ended June 28, 1997.)

10.23*    Supply Agreement effective January 1, 1997 with Fuji Photo
          Film U.S.A., Inc. (Incorporated by reference to Exhibit 10.1
          filed with the Company's Quarterly Report on Form 10-Q for
          the quarter ended March 29, 1997.)
 
10.24*    Kodak Agreement dated May 13, 1997. (Incorporated by
          reference to Exhibit 10.3 filed with the Company's Quarterly
          Report on Form 10-Q for the quarter ended June 28, 1997.)
 
10.25*    AT&T Agreement dated March 5, 1997. (Incorporated by
          reference to Exhibit 10.2 filed with the Company's Quarterly
          Report on Form 10-Q for the quarter ended March 29, 1997.)

10.26     Warehouse Sublease between Seattle FilmWorks, Inc. and
          OptiColor, Inc. dated September 30, 1996. (Incorporated by
          reference to Exhibit 10.20 filed with the Company's Annual
          Report on Form 10-K for the year ended September 28, 1996.)

10.27     Warehouse Sublease between Seattle FilmWorks, Inc. and
          Seattle FilmWorks Manufacturing Company dated September 30,
          1996. (Incorporated by reference to Exhibit 10.21 filed with
          the Company's Annual Report on Form 10-K for the year ended
          September 28, 1996.)

10.28     1260 16th Avenue West Sublease between Seattle
          FilmWorks, Inc. and OptiColor Inc. dated September 30, 1996.
          (Incorporated by reference to Exhibit 10.22 filed with the
          Company's Annual Report on Form 10-K for the year ended
          September 28, 1996.)

10.29     1260 16th Avenue West Sublease between Seattle
          FilmWorks, Inc. and Seattle FilmWorks Manufacturing Company
          dated September 30, 1996. (Incorporated by reference to
          Exhibit 10.23 filed with the Company's Annual Report on Form
          10-K for the year ended September 28, 1996.)

</TABLE> 

                                       49
<PAGE>
 
<TABLE> 
<S>       <C>
10.30     General Assignment between Seattle FilmWorks, Inc., Seattle
          FilmWorks Manufacturing Company and OptiColor, Inc. dated
          September 30, 1996. (Incorporated by reference to Exhibit
          10.24 filed with the Company's Annual Report on Form 10-K
          for the year ended September 28, 1996.)

11        Computation of Earnings Per Share

21        Seattle FilmWorks, Inc. Subsidiaries

23        Consent of Ernst & Young LLP, Independent Auditors

27        Financial Data Schedule

</TABLE> 

     * Exhibit for which confidential treatment has been granted.

                                       50