FORM 10-K

                       SECURITIES AND EXCHANGE COMMISSION
                             Washington, D.C. 20549

               |X| ANNUAL REPORT PURSUANT TO SECTION 13 OR 15 (d)
                     OF THE SECURITIES EXCHANGE ACT OF 1934

                  For the fiscal year ended SEPTEMBER 28, 2002

     |_| 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

                                PHOTOWORKS, INC.
                                ----------------
             (Exact name of registrant as specified in its charter)

                Washington                               91-0964899
                ----------                               ----------
      (State or other jurisdiction            (IRS Employer Identification No.)
    of incorporation or organization)

   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 and related preferred share purchase rights.

      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 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 December 6, 2002, there were issued and outstanding 16,655,285
shares of Common Stock, par value $.01 per share. As of December 6, 2002, the
aggregate market value of the Registrant's Common Stock held by non-affiliates
of the Registrant was $2,475,551 based on the last sale price of the
Registrant's Common Stock as reported by the Over the Counter Bulletin Board
Market.

                      Documents incorporated by reference:

      Portions of the registrant's proxy statement relating to its 2002 annual
meeting of shareholders, to be held on February 4, 2003, are incorporated by
reference into Part III of this Annual Report on Form 10-K.

                                  Page 1 of 56
                            Exhibit Index at Page 51

<PAGE>

                                     PART I

ITEM 1 - BUSINESS

Description of Business

      PhotoWorks, Inc. ("PhotoWorks" or the "Company") is a leading photo
services company dedicated to providing its customers with innovative ways to
enjoy and use their photos.* In February 2000, the company name was changed from
Seattle FilmWorks to PhotoWorks to reflect the Company's corporate mission to be
the leading mail-delivered digital photo printing service. The Company offers an
array of complementary services and products primarily under the brand names
PhotoWorks(R) and Seattle FilmWorks(R).

      PhotoWorks draws upon a unique dual heritage as a top-rated photofinisher
with over twenty-four years of experience along with a tradition of innovation
and leadership in digital and online photo services. The Company provides
digital camera owners with easy ways to get professional quality digital prints
in addition to providing online image storage and management services.
PhotoWorks can also process any brand of 35mm film, Advanced Photo Systems
(24mm) film or 35mm single-use camera, and offers prints, slides, digital images
and online archiving, all from the same roll of 35mm film. The Company offers it
products and services primarily through direct mail and online channels. To a
lesser extent, the Company provides its services on a retail and wholesale
basis.

      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 PhotoWorks and the Company in this Report include PhotoWorks,
Inc., and its wholly-owned subsidiaries.

Forward-Looking Information

      This report contains forward-looking statements including, without
limitation, statements identified by an asterisk (*). These statements relate to
future events, product or service offerings or the future financial performance
of the Company. In some cases, you can identify forward-looking statements by
terminology such as "may," "will," "should," "expects," "plans," "anticipates,"
"believes," "estimates," "predicts," "potential," or "continue" or the negative
of such terms and other comparable terminology. These statements only reflect
expectations and estimates of the Company's management. Actual events or results
may 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. All forward-looking statements contained in this report reflect
the Company's expectations at the time of this report only, and the Company
disclaims any responsibility to revise or update any such forward-looking
statement except as may be required by law.

Industry Overview

      The dominant method of distributing photofinishing services and products
is through retail stores, including discount and mass merchants, drugstores,
supermarkets and camera/specialty stores. Management believes the majority of
rolls of film are sent to wholesale photofinishing laboratories for processing
or processed in-store using on-site equipment.

      Digital cameras are becoming more mainstream as quality increases and
price decreases. The Company believes that mainstream consumers using digital
cameras will benefit from the digital services offered by PhotoWorks by
providing them with easy ways to get professional quality digital prints. Online
services and increased use of personal computers provide additional channels for
direct-to-consumer marketing. Digital cameras and the Internet have created new
opportunities for people to use and share their photos.

                                       2
<PAGE>

Operating Strategy

      The principal elements of PhotoWorks operating strategy are the
introduction of convenient and easy to use digital services and products,
application of direct-to-consumer marketing techniques, and a commitment to
customer satisfaction.

      Digital Services and Products. Management believes that PhotoWorks can
distinguish itself from its online and traditional photofinishing competitors
through value-added digital services and product differentiation. The Company
endeavors 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.

      The Company has been a leader in providing digital-imaging technologies.
Some products incorporating these technologies include (i) PhotoDVD(TM) and
PhotoVHS, an animated show of personal photos on DVD or VHS; (ii) Pictures On
Disk(TM) on CD, a CD containing digital images from a roll of film or digital
camera; and, (iii) PhotoWorks, an online image management system which gives
customers a simple and convenient way to buy prints and view, share, and
organize their photos online. The Company expects to continue to introduce
products in 2003 which will provide customers with simple and convenient ways to
get professional quality prints from their digital or traditional cameras.

      Direct-to-Consumer Marketing. The Company's business model is founded on
direct-response marketing through direct mail and online channels. 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 online and mail order delivery 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. The Company's proprietary database is used to plan, personalize,
implement and evaluate marketing programs for its customers.
See "Business--Marketing."

      Commitment to Customer Satisfaction. The Company seeks to develop and
provide high-quality, and reliable photofinishing and online services and
products to enhance brand recognition for "PhotoWorks" and "Seattle FilmWorks"
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, PhotoWorks offers a 100% satisfaction guarantee and 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. See "Business--Customer Service
and Support."

Revenue Strategy

      The Company's strategy for generating revenues is to leverage the strength
of its services and products for both film-based and digital camera users. In
recent years, the Company has seen a decline in sales of traditional
photofinishing services and products and believes that the traditional
photofinishing services market will continue to decline. The Company provides
film-based camera users with the ability to digitize their images and believes
that its online archive differentiates its products and services and enhances
the services it can offer to its traditional customers.

      The Company also offers its services and products to digital camera users
and believes that it can compete effectively in this developing market by
providing digital camera owners with photo output in the form of prints,
reprints and gift items. At the current time, revenues from digital prints and
other digital related services have not been a significant source of revenue for
the Company. Management believes that the Company's future success is dependant
on its ability to increase its revenues from digital related services and
products. The Company's commitment to expanding its service and product
offerings, including enhancements to its digital-related offerings, is intended
to support this strategy.*


                                       3
<PAGE>

Marketing

      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 maintains and analyzes extensive data and
demographically segments its customers. The Company uses e-mail to communicate
with its existing online customer base to increase retention, customer
satisfaction and communication with active and inactive customers and employs a
variety of other direct-marketing techniques to acquire new customers, increase
business from existing customers and generate business from inactive customers.*

      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 its existing customer base of its
integrated array of services and products.* The Company also believes that the
online archive is a viable and economic opportunity to monetize its customer's
"personal equity" by providing image storage and management services for digital
and film based camera users and through photo output, in the form of digital
prints, reprints and gifts. The Company's commitment to expanding its service
and product offerings, is intended to support this strategy.*

      New Customers. In recent years, the Company has seen a decline in the
effectiveness of its customer acquisition programs and is currently evaluating
and testing various marketing programs that will generate new customers cost
effectively.* "See "Risk Factors." The primary method the Company has used to
acquire new customers has been low priced or free introductory offers. The
Company also promotes its products and services on its Web site
(www.photoworks.com) and has a customer referral program for online and mail
order customers which encourages existing customers to suggest family and
friends that may be interested in the Company's services and products. The
Company is currently testing and developing marketing programs to generate new
customers through cost effective marketing programs.* "See "Risk Factors."

      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. In this way, the Company's measurements allow
the Company to target its marketing effort to specific customer markets through
selected media.

      The Company also operates a small number of retail locations within
Washington to provide a "drop off" alternative to mail order delivery. Over the
past two years, the Company has closed a majority its retail stores and plans to
close certain other retail locations during fiscal year 2003. The costs
associated with store closures are not material to the operating results of the
Company.


                                       4
<PAGE>

Services and Products

      PhotoWorks has an established tradition of service and product innovations
for both traditional and digital camera users.

The following table illustrates recent service and product introductions:

<TABLE>
<CAPTION>
Service or Product                                                                 Year of Introduction
------------------                                                                 --------------------
<S>                                                                                        <C>
Mail in service for memory cards and CD's and $.19 digital print pricing .......           2002
PhotoVHS .......................................................................           2002
Year in Photos(TM)CD ...........................................................           2002
PhotoWorks(R)Designer & Custom Greeting Cards Online ...........................           2001
PhotoDVD(TM) ...................................................................           2001
Browser Uploader ...............................................................           2001
The Works: Film Processing + Pictures On Disk(TM)Bundle ........................           2001
Pocket Photo Books .............................................................           2000
Photo Framing Online ...........................................................           2000
Photo Gifts Online .............................................................           2000
PhotoWorks(R)Address Book Online ...............................................           2000
PhotoWorks(R)Scanning Service ..................................................           2000
PhotoWorks(R)Albums Online .....................................................           2000
PhotoWorks(R)UpLoader Software(R) ..............................................           2000
PhotoWorks(R) ..................................................................           1999
</TABLE>

      In April 1999, the Company launched its PhotoWorks(R) online service. This
service provides every customer who supplies an e-mail address with free
scanning of every photographic image processed with the Company and storage of
the digital images on a private customer Web site at no charge for as long as
the customer maintains an active account.* The digital images are available
online for customers to privately view, store, share, manage, post or e-mail to
family and friends.

      In 2000, the Company focused on enhancing the customer experience with
online products and services. Products such as PhotoWorks Albums Online,
PhotoWorks Scanning Service and Online Address Book gave customers the ability
to manage their images online to easily share with friends and family. Other
products such as Pocket PhotoBooks (pocket-sized printed books featuring the
photos and captions from online albums), and other photo gift products were also
introduced, giving customers the opportunity to add their favorite photographs
to a variety of gift items, including clothing, ceramics and toys.

      In 2001, the Company introduced several innovative digital and traditional
products and services. PhotoWorks PhotoDVD(TM) provides a fun way for customers
to view their photos in a multi-media, movie-like presentation, complete with a
theme, background music, credits and other professional-quality effects.
Launched in April 2001, PhotoDVD(TM) won accolades in the press and was named in
"Computer Shopper's Top 100 Products" list. Two additional products and services
were launched in April 2001. Browser Uploader enables customers to easily upload
digital images from digital cameras, scanners and computers to their PhotoWorks
online archive and "The Works" provides customers an easy way to order the most
popular PhotoWorks film processing package. It contains two sets of prints, a
Pictures On Disk(TM) CD, high resolution scanning, an index print and negatives
in a money-saving bundle. The Company also extended its line of digital photo
greeting cards by adding Designer Photo Cards and Custom Photo Cards.

      The Company continues to upgrade its digital and online services. In
January 2002, the Company introduced the Year in Photos(TM) CD. The Year In
Photos CD is an affordable and convenient way for customers to save an entire
year of their personal photos on one CD. The Company also introduced PhotoVHS, a
multi-media, movie-like presentation, complete with a theme, background music,
and other professional-quality effects.


                                       5
<PAGE>

      In June 2002, the Company launched a service to make it even easier for
digital camera owners to purchase professional-quality prints and Pictures On
Disk(TM) CDs. Customers can now mail their memory cards and CDs of their digital
images to PhotoWorks for developing. To introduce this new service, PhotoWorks
offered 19-cent 4x6" print pricing for a limited time.

      The Company offers a variety of value-added, innovative and high-quality
services through which it seeks to differentiate itself from other mail order or
online competitors.* 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 offers customers the option of
expedited delivery service for an extra charge. The PhotoWorks(R) service
improves turnaround time by offering immediate viewing and sharing of images
online with prints to follow in the mail. However, turnaround time for
traditional mail-in processing services remains a competitive disadvantage for
the Company. The Company believes that its turnaround time for digital printing
services is competitive within the marketplace.

      Net revenues generated by sales outside the United States accounted for
..7% of the Company's total net revenues in fiscal 2002, as compared to .8% in
fiscal 2001 and 1.1% in fiscal 2000.

Research and Development

      Through internal and external research and development efforts, the
Company has developed 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 2002, 2001, and 2000, the Company incurred research and development
expenses of $1,891,000, $3,966,000 and $2,924,000, respectively, primarily in
connection with development and enhancement of its online digital services and
products and PhotoWorks(R) service. See Item 7 of Part II--"Management's
Discussion and Analysis of Financial Condition and Results of Operations."

Customer Service and Support

      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 1-800-746-8696. Management believes that customer
satisfaction is critical to the Company's ongoing success. The Company has a
100% satisfaction-guarantee policy under which it will provide a full refund if
a customer's complaint cannot otherwise be resolved. As of November 30, 2002,
the Company had a customer service staff of 31. These personnel have direct
access to the Company's database and are 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) online
services.

      The Company maintains a Web site on the Internet (www.photoworks.com).
While online, customers may use the PhotoWorks(R) service to privately view,
store, share, manage, post or email their photos to friends and family and order
prints and photo gifts. Customers may also obtain the status of their orders,
access answers to frequently asked questions, order products and services, and
send email messages to customer service.

Operations

      The Company operates a single laboratory in Seattle, Washington, which is
designed to produce consistent, high-quality photofinishing. The Company's photo
processing system is designed for 24-hour in-house processing of most
photofinishing orders. Images are printed on photographic paper using
state-of-the-art equipment. Customers are notified via email when their order is
shipped and when the images are available to view online. Although much of the
photofinishing and order handling process has been automated, trained


                                       6
<PAGE>

personnel operate machinery and regularly monitor product quality with the
assistance of computerized control and measurement systems. Other vendors
fulfill most photo gift or photo related merchandise orders.

      The Company has the ability to process any type of 35mm color film,
including those manufactured by Eastman Kodak Company, Fuji Photo Film U.S.A.,
Inc., Konica U.S.A., Inc., Ferrania USA, Agfa Division of Bayer Corporation 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, 24mm format Advanced Photo
System film, and all 35mm reloadable or single-use cameras. The Company can
process and print digital images from digital memory cards, CD's or from digital
images uploaded to the Company's website.

      Management believes it has sufficient production capacity with its
existing facilities and equipment.* The Company could expand its processing
facility if necessary, to support increased production levels.*

Suppliers

      The Company obtains its conventional 35mm film from a few large
manufacturers of photographic film, including Agfa and Ferrania USA, and its
photographic paper and chemicals from a single supplier, Eastman Kodak Company.
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."

Management Information Systems and Technology

      The Company has implemented scalable technology to support customer order
processing, image archiving, and Internet accessibility. These services and
systems use a combination of proprietary technologies and commercially
available, licensed technologies. Internal development is focused on efforts for
creating and enhancing the specialized, proprietary software that is unique to
the business. The Company uses a set of applications for:

            o     Accepting and validating customer orders
            o     Archiving images
            o     Internet image viewing, ordering prints and other products
            o     Managing shipment of products to customers based on various
                  ordering criteria

      Systems have been designed based on industry standard architectures and
have been designed to reduce downtime in the event of outages or catastrophic
occurrences. The systems provide a 24-hour-a-day, seven-day-a-week availability.
The Company uses load balancing systems and redundant servers to provide for
fault tolerance.

      The market in which the Company competes is characterized by rapidly
changing technology, evolving industry standards, frequent new service and
product announcements and enhancements, and changing customer demands.
Accordingly, future success will depend on the Company's ability to:

            o     Adapt to rapidly changing technologies
            o     Adapt services to evolving industry standards
            o     Continually improve the performance, features, and reliability
                  of service in response to competitive service and product
                  offerings and evolving demands of the marketplace

      Failure to adapt to such changes would have a material adverse effect on
the Company's business, results of operations, and financial condition. In
addition, new Internet, networking or telecommunications technologies, or other
technological changes could require substantial expenditures by the Company to
modify or adapt its services or infrastructure.


                                       7
<PAGE>

      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, the
Company could still experience systems failures or interruptions, which could
have a material adverse effect on its business, financial condition and
operating results.* See "Risk Factors". Competition

      The Company faces competition in the consumer digital and photofinishing
market from other direct marketers and in other distribution channels from much
larger companies which provide digital and 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. Management believes that the largest
mail order photofinisher is District Photo Inc. (dba York, Clark Labs, Mystic
Color Lab and Snapfish). The Company also faces competition in the online
digital market with competitors such as Ofoto (a Kodak Company), and Shutterfly.
Many of the Company's competitors have substantially greater financial,
technical, and other resources than the Company.

      Management believes that the principal competitive factors in the digital
and photofinishing industry are price, convenience, brand awareness, 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 digital or consumer photofinishing industry. The Company has sought to
differentiate its services by offering a number of value-added services and
products and by emphasizing quality and convenience. The Company also offers
very competitive prices for its digital print services. Although management
believes the Company is a leader in developing and marketing innovative online
and photo-related services and products, competitors can and do provide similar
services and products.*

      The digital and photography industry is characterized by evolving
technology and changing services and products. The introduction of photographic
services and products involving 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 is having an adverse impact on the
photofinishing industry and has among other factors, accounted for the Company's
recent decline in revenues. 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 "Risk Factors."

Proprietary Technology

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

      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 makes limited patent filings, 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, employee and third-party nondisclosure
agreements, restricting access to certain portions of its premises and
contractual restrictions on use and disclosure in its end-user licenses. The
legal and practical enforceability and extent of liability for violations of
license agreements are unclear.*

      This Report contains trademarks other than those of the Company.


                                       8
<PAGE>

Governmental Regulation

      The Company's 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 federal
government has not adopted many laws and regulations to specifically regulate
online commerce and communications. However, Congress has enacted legislation
addressing such issues as the transmission of certain materials to children,
intellectual property protection, taxation, and the transmission of sexually
explicit material. In addition, some states have enacted legislation which made
the transmission of certain kinds of information, such as obscene content and
information which facilitates the commission of criminal acts, a crime.

      The law of the Internet remains largely unsettled and it may take years to
determine whether and how existing laws such as those governing intellectual
property, privacy, libel and taxation may apply to the Internet. Legislation
enacted by Congress and the state legislatures could result in additional
regulation or prohibition of the transmission of certain types of content over
the Internet or in the imposition of taxes or fees on transactions conducted
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."

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, changes
in environmental regulations or in the kinds of chemicals used by the Company
could impose the need for additional capital equipment or other requirements.*
See "Risk Factors."

Employees

      As of November 30, 2002 the Company had 306 employees, of whom
approximately 184 were engaged in production operations, 31 in retail sales, 34
in administration, 13 in marketing and business development, 31 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.

Executive Officers of the Registrant

The executive officers of the Company as of November 30, 2002 were:

Name                          Age         Position
--------------------------------------------------------------------------------
Gary R. Christophersen        56          President/Chief  Executive  Officer,
                                          Chairman, Director
Michael F. Lass               48          Executive Vice President
Loran Cashmore Bond           45          Vice President
                                          Administration/Treasurer/Chief
                                          Accounting Officer/Corporate
                                          Secretary


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<PAGE>

      Gary R. Christophersen has been the Company's Chairman since July 2000. In
August 2001, Mr. Christophersen reassumed the role of President and Chief
Executive Officer. From August 1988 until being named as Chairman, he served as
the Company's President and Chief Executive Officer. Mr. Christophersen 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 has been the Company's Executive Vice President since
March 2001. Prior to that, Mr. Lass had served as Vice President of Operations
since September 1988. Mr. Lass 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.

      Loran Cashmore Bond became the Company's Vice President of Administration
in October 2001. She has been the Company's Chief Accounting Officer and
Treasurer since August 1999. Ms. Cashmore Bond also serves as Corporate
Secretary. Ms. Cashmore Bond joined the Company in January 1986 as Accounting
Manager, and, from 1989 to 1994 was the Controller for the Company. In 1994, Ms.
Cashmore Bond became an officer of the Company and Corporate Controller.

                                  RISK FACTORS

      In addition to the other information in this report, the following risk
factors should be carefully considered in evaluating us and our business. The
risks and uncertainties described below are not the only ones we face.
Additional risks and uncertainties not presently known to us or that we
currently deem immaterial also may impair our business operations. If any of the
following risks occur, our business, financial condition, operating results and
cash flows could be harmed.

We may require additional funding

      At the end of our 2002 fiscal year, we had cash and cash equivalents of
$1,175,000. In addition, we anticipate receiving an income tax refund in early
2003 of approximately $1,808,000. We currently have a $65,000 credit line with
Comerica Bank to support our corporate credit cards and ACH transactions. We
believe that, under our current operational and financing plans, current cash
balances and projected future cash flow from operations (including the tax
refund we expect to receive in early 2003), we will have sufficient funds for
our operations through at least the next twelve months. Although we have
significantly reduced our operating expenses, we had significant operating
losses in fiscal 2001 and 2002 and may not be able to generate sufficient cash
from operations to maintain our business as currently conducted. Our inability
to successfully generate sufficient cash flow from operations could have a
material adverse impact on our financial position and liquidity and may require
us to further reduce our expenditures or seek additional capital to continue
operations.

Declines in photofinishing industry could adversely affect our revenues

      We have experienced a significant decline in revenues during fiscal 2002,
2001 and 2000. We believe that this is primarily attributable to declines in the
mail order photofinishing market and photofinishing industry in general. Also,
our traditional direct marketing techniques have yielded lower response rates
than in past years. This may be in part due to the availability of low priced
film processing options from mass merchants such as Wal-Mart and Costco. In
addition, we believe the market shift away from traditional 35mm film and
towards digital cameras will continue due to the declining prices for and
increased availability and use of digital cameras. We may not be successful in
developing new direct marketing techniques to generate new profitable film-based
photofinishing customers. We will attempt to offset these factors by offering
film based customers online photo services such as free scanning and archiving
of all rolls processed by us for customers who provide an e-mail address. We are
developing additional products and services designed to establish us as the
choice for digital camera users for printing, archiving, sharing, viewing and
managing personal digital images. We believe that this may contribute to digital
photofinishing revenues and sales of other image-related services. However, a
number of other companies are attempting to establish this position. Competitors
in this area include Ofoto, a Kodak Company, and Shutterfly and other
traditional providers of photofinishing services. We may not be successful
against this competition. The digital print market has not been fully
established. Even if we establish a strong


                                       10
<PAGE>

position among consumers for digital services, we may not be able to generate
significant revenues from this market.

We may be adversely affected by actions of competitors

      The market for consumer photofinishing and digital imaging services is
highly competitive. Many of our competitors have substantially greater
financial, technical and other resources than we have. We face competition in
the consumer photofinishing and digital imaging services from other direct
marketers, online companies, and competitors in other distribution channels,
including much larger companies. Many of these companies provide photofinishing
services on a wholesale basis to independent retail outlets and, in some cases,
through multiple retail outlets owned by the photofinisher or online service
providers. Many of these competitors also provide photofinishing services within
hours. There are no significant proprietary or other barriers to entry into the
traditional photofinishing or digital imaging industry. Many of our competitors
offer similar photofinishing and digital imaging services and products at lower
prices and with a more rapid turnaround time than we offer. Our ability to
compete effectively depends on our ability to continue to differentiate our
services by offering a number of value-added services and products. We will
continue to emphasize professional quality, value, and convenience rather than
try to be a low-price or rapid turnaround provider. Although we believe we are a
leader in developing and marketing innovative photo-related services and
products for traditional and digital camera users, competitors can and do
provide similar services and products. There can be no assurance we will
continue to compete effectively through development of innovative services and
products or that we will respond appropriately to industry trends or to
activities of competitors.

We may be adversely affected by the outcome of litigation

      We were defendants in a claim filed by Fuji Photo Film Co., Ltd. with the
International Trade Commission. Fuji alleged that a number of companies,
including our OptiColor subsidiary, violated patents held by Fuji on single-use
cameras by bringing recycled single-use cameras into the United States for
resale. The ITC Commissioners issued a final order in June 1999 prohibiting us
and our subsidiaries from importing and selling imported recycled single-use
cameras. In July 2001, the ITC commenced enforcement and advisory opinion
proceedings against us and several other respondents, based on a new complaint
filed by Fuji with the ITC in late June 2001. This complaint alleges that we are
infringing certain claims of six of Fuji's patents on single use cameras,
through the importation and sales of certain newly manufactured reloadable
cameras. The complaint requests that the ITC determine that through these
imports and sales we are violating the ITC's previous order. It also requests
that the ITC bring an action in an appropriate U.S. District Court to seek an
injunction and civil penalties for each day in which an importation or sale
violating the order occurs in an amount up to the maximum provided by the
governing statute. In May 2002, an Administrative Law Judge of the International
Trade Commission issued an initial determination that the Company's reloadable
camera infringes certain patents owned by Fuji Photo Film Co., Ltd for
single-use cameras, and also recommended that the Commission assess a penalty of
$1.6 million for such infringement. Since that time, the Commission has upheld
the infringement determination and is currently determining what, if any,
penalty to assess and we expect the Commission's decision regarding any penalty
assessment in January 2003. Any action by the Commission is subject to further
appeal to the Federal Circuit Court of Appeals. The Company believes it has
strong arguments regarding the infringement determination and any penalty
recommendation and intends to pursue such challenges to the extent it deems
appropriate. As such, no accrual has been made at this time in the Company's
fiscal 2002 financial statements for this matter. If the penalty amount is
upheld, it would have a significantly harmful impact on our financial condition,
results of operations and liquidity.

      In April 2002, a complaint was filed against us and over and 200 other
defendants by The Massachusetts Institute of Technology and Electronics for
Imaging, Inc. claiming infringement on a patent issued in 1985 for a Color
Reproduction System. The Complaint requests injunctive relief, damages adequate
to compensate them for Defendants' infringement of the 4,500,919 patent, their
costs and prejudgment interest on their damages and reasonable attorney fees.


                                       11
<PAGE>

      The suit is in its beginning stage and we intend to contest the suit
vigorously as to the complaint's substantive allegations. Although we believe
the claim to be without merit, it is not possible to predict an outcome at this
time or the potential affect on our business or financial condition.

      In addition, 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 harm both the growth of Internet use and our
financial results. Our PhotoWorks(R) service relies on the Internet to allow
customers online access to their images. Internet, network, hardware or software
failures or damage to information stored in our online archive can cause
potential damage to our business. The federal government has not adopted many
laws and regulations to specifically regulate online commerce and
communications. However, Congress has recently enacted legislation addressing
such issues as the transmission of certain materials to children, intellectual
property protection, taxation, and the transmission of sexually explicit
material. In addition, some states have enacted legislation which made the
transmission of certain kinds of information, such as obscene content and
information which aids the commission of criminal acts, a crime. The law of the
Internet remains largely unsettled and it may take years to determine whether
and how existing laws such as those governing intellectual property, privacy,
libel and taxation may apply to the Internet.

     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 legislation could result in
significant potential liability to us for content transmitted over our Web site,
as well as additional costs and technological challenges in complying with
mandatory requirements. We do not assume responsibility to edit the content of
our customers' photographs, slides, digital images or personal home pages unless
responding to a specific complaint. Legislation which imposes potential
liability for content made available over the Internet through our Web site
could require us to implement additional measures to reduce our exposure to such
liability, which may require us to incur significant costs or discontinue
certain service or product offerings. Although we carry general liability
insurance, such insurance may not cover potential claims of this type or may not
be adequate to compensate us for the amount of these liabilities. Any costs not
covered by insurance incurred as a result of such liability or asserted
liability could harm our business, financial condition and operating results.

We may not be able to retain existing  customers or acquire new customers at a
reasonable cost

      Future revenues and profitability depends in large part on our ability to
retain our current customers and our ability to acquire new digital customers at
a reasonable cost. Historically, we used, and we continue to use,
direct-marketing programs offering low-priced or free introductory offers as our
primary customer acquisition technique. Over the past few years, the cost for
these programs has increased and we have seen a decline in customer response
rates. Our current marketing focuses on customer reactivation and retention and
opportunities to acquire new customers at a reasonable cost. Our customer
acquisition and retention efforts may not be effective. If we do not find a way
to successfully acquire new customers, retain our current customers, or market
successfully against competitors, our business, financial condition and
operating results could be harmed.

We may not be able to keep up with rapid technological change in the
photofinishing industry

      The photography industry is currently characterized by rapidly evolving
technology and changing services and products. The introduction of digital
services and products which use new technologies could render existing services
and products obsolete. Our future success will depend on our ability to adapt to
new technologies and develop new or modify existing services, products and
marketing techniques to satisfy changing consumer needs and attract new
customers. The expanded use of digital cameras has had a negative impact on
companies such as PhotoWorks which have primarily processed traditional
film-based images and slides. The development of these or other new
technologies, or failure by us to anticipate or successfully respond to such
developments, could harm our business, financial condition and operating
results.

We may be adversely affected by national events


                                       12
<PAGE>

      We rely on the United State Postal Service and other common carriers to
receive and deliver orders. Terrorist attacks and anthrax contamination have
disrupted deliveries. Additional terrorist attacks or certain proposals to
safeguard the mail through mail purification devices could cause serious harm to
our business, financial condition and operating results.

A sale or liquidation of the Company may not generate sufficient proceeds for
any distribution to the common shareholders

      The holders of the Series A Preferred Stock have a preference on the sale
or liquidation of the Company in the amount of $15,000,000. In addition, the
Company has $2,500,000 of long-term debt. If the Company were to be sold for an
amount less than the aggregate long-term debt and liquidation preference on the
Series A Preferred Stock, it is unlikely that any proceeds would be available
for distribution to the common shareholders.

Any acquisitions we make could disrupt our business and harm our financial
condition

      We may attempt to acquire other businesses that are compatible with our
business, but we have no current understanding, agreement or arrangement to make
any acquisitions. Future acquisitions could result in unforeseen operating
difficulties and expenditures and may absorb significant management attention
that would otherwise be available for ongoing development of our business. Since
we will not be able to accurately predict these difficulties and expenditures,
it is possible that these costs may outweigh the value we realize from a future
acquisition. Future acquisitions could result in issuances of equity securities
that would reduce our shareholders' ownership interest, the incurrence of debt,
contingent liabilities or amortization of expenses related to goodwill or other
intangible assets and the incurrence of large, immediate write-offs.

We could be required to collect taxes on the products we sell

      In accordance with current industry practice, we do not currently collect
sales taxes or other taxes with respect to shipments of goods into states other
than Washington. One or more states may seek to impose sales or tax collection
or other obligations on out-of-jurisdiction companies which engage in electronic
commerce as we do. In addition, states may aggressively attempt to establish
that our Company has presence (nexus) in their state which could subject our
mail order business to sales or other tax collection obligations. A successful
assertion by one or more states that we should collect sales or other taxes on
the sale of merchandise could result in substantial tax liabilities for past
sales, decrease our ability to compete with traditional retailers and otherwise
harm our business.

      Recent federal legislation limits the imposition of U.S. state and local
taxes on Internet-related sales. In 1998, Congress passed the Internet Tax
Freedom Act, which placed a three-year moratorium on state and local taxes on
Internet access, unless such tax was already imposed prior to October 1, 1998,
and on discriminatory taxes on electronic commerce. In November 2001, Congress
extended the Internet Tax Freedom Act for two years. There is a possibility that
Congress may not renew this legislation in 2003. If Congress chooses not to
renew this legislation, U.S. state and local governments would be free to impose
new taxes on electronically purchased goods. The imposition of taxes on goods
sold over the Internet by U.S. state and local governments would create
administrative burdens for us and could reduce one competitive advantage that
the purchase of goods over the Internet now possesses.

We experience fluctuations in quarterly results

      Our quarterly operating results will fluctuate for many reasons,
including:

            - seasonality of consumer photographic activity,
            - the mix of products we sell,
            - promotional activities we conduct,
            - price increases by our suppliers,


                                       13
<PAGE>

            - our introduction of new products,
            - our research and development activities,
            - our competitors' actions,
            - fluctuations in the direct-to-consumer market,
            - changes in usage of digital services and online commerce,
            - changes in the photofinishing industry and,
            - general economic influences and conditions.

      Demand for our photo-related services and products is seasonal, with the
highest volume of photofinishing activity generally occurring during the summer
months. As a result, our operating results for any period do not necessarily
indicate the results that can be expected for any future period. Our operating
results in a future period may be below the expectations of public market
analysts and investors which may cause the price of our common stock to decline.

The loss of key personnel could negatively affect our business

      We depend on the abilities and continued service of our executive officers
and other key employees, including Gary Christophersen, our Chief Executive
Officer. These individuals, including Mr. Christophersen, are not subject to
employment agreements that would prevent them from leaving us. There can be no
assurance that we will be able to retain the services of our executive officers
and other key employees. The loss of key personnel could harm our business,
financial condition and operating results.

We rely on key vendors, suppliers and foreign sourcing

      We obtain our conventional 35mm film from a few large manufacturers of
photographic film, including Agfa Photo Imaging Systems, a division of Bayer,
and Ferrania USA, and our photographic paper and chemicals from a single
supplier, Eastman Kodak. In addition, we acquire photofinishing equipment to
maintain and increase production capacity from various vendors. 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 our
operations and could harm our business, financial condition and operating
results.

      Our agreement with Eastman Kodak is subject to termination under certain
circumstances. We have no other significant long-term purchase contracts or
agreements to ensure continued supply, pricing or access to film, paper or
chemicals. While we believe that alternate sources of film, paper, chemicals and
equipment are available, it is possible that we will not be able to continue to
meet our requirements for supplies and equipment, or purchase supplies and
equipment in sufficient quantities or on terms as favorable to us as those
currently available. Also, changing to an alternate supplier may cause delays,
reduced quality or other problems. Our operations may be harmed by political
instability causing disruption of trade with foreign countries in which our
contractors and suppliers may be located. Existing or potential duties, tariffs
or quotas may limit the quantity of certain types of goods that may be imported
into the United States. Sales of our services and products on a
direct-to-consumer mail-order basis largely depend 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 harm our business, financial condition
and operating results.

Our production capabilities, statistical models, management information systems
and technology may not be viable

      We depend on our management information systems and technology systems to
process orders, provide rapid response to customer inquiries, manage inventory,
and purchase, sell and ship products efficiently. We periodically replace and
upgrade certain portions of our systems software and hardware. We take a number
of precautions against certain events that could disrupt our management
information systems, including events


                                       14
<PAGE>

associated with continuing software and hardware upgrades. Any damages or
failures to our computer equipment, technology systems and the information
stored in our data center could harm our business, financial condition, and
operating results.

      We also depend on marketing models developed to measure the effectiveness
of our marketing programs and on employees who are knowledgeable about such
models. We continually face 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
our operations. The loss of employees knowledgeable about our marketing models
or a disruption in our online or photofinishing services could harm our
business, financial condition and operating results.
Governmental regulation could harm our business

      Our operations, including our 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 federal
government has not adopted many laws and regulations to specifically regulate
online commerce and communications. However, Congress has enacted legislation
addressing such issues as the transmission of certain materials to children,
intellectual property protection, taxation, and the transmission of sexually
explicit material. In addition, some states have enacted legislation which made
the transmission of certain kinds of information, such as obscene content and
information which facilitates the commission of criminal acts, a crime. The law
of the Internet remains largely unsettled and it may take years to determine
whether and how existing laws such as those governing intellectual property,
privacy, libel and taxation may apply to the Internet. Legislation enacted by
Congress and the state legislatures could result in additional regulation or
prohibition of the transmission of certain types of content over the Internet or
in the imposition of taxes or fees on transactions conducted over the Internet.
This could result in significant potential liability to us as well as additional
costs and technological challenges in complying with mandatory requirements.

Environmental regulations could harm our business

      Our photofinishing operations involve the use of several chemicals which
are subject to federal, state and local governmental regulations relating to
their storage, use, handling and disposal. We actively monitor our compliance
with applicable regulations and work with regulatory authorities to ensure
compliance. Changes in environmental regulations or in the kinds of chemicals
used by us may impose the need for additional capital equipment or other
requirements. Any failure by us to control the use or adequately restrict the
discharge of hazardous substances under present or future regulations could
subject us to substantial liability or cause suspension of our operations. Such
liability or suspension of operations could harm our business, financial
condition and operating results.

ITEM 2 - PROPERTIES

      The Company's headquarters are located in Seattle, Washington. This 60,000
square foot building which houses the Company's photofinishing and mail order
operations, is occupied under a lease which expires in September 2005, with an
option to extend for an additional five years.


                                       15
<PAGE>

      The Company has a lease agreement for 51,000 square feet of office and
production space adjoining the Company's headquarters. This lease expires in
September 2005, with an option to extend for an additional five years. In
September 2001, the Company vacated a portion of the office space and relocated
employees to the headquarters location. The Company is evaluating any available
opportunities regarding the vacated office space of the building.

      The Company had a lease agreement to September 2005 for 8,700 square feet
of office space that was occupied by the Company's customer service department.
In September 2001, the Company moved its customer service department back to its
main headquarter location. In fiscal 2002 the Company negotiated an early
termination of the lease with the landlord to exit the lease as of August 1,
2002, pursuant to which the Company paid a termination fee of $185,000.

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

ITEM 3 - LEGAL PROCEEDINGS

      Fuji Photo Film Co., Ltd - The Company is a defendant in a claim filed by
Fuji Photo Film Co., Ltd. with the International Trade Commission. Fuji alleged
that a number of companies, including the Company's OptiColor subsidiary,
violated patents held by Fuji on single-use cameras by bringing recycled
single-use cameras into the United States for resale. The ITC Commissioners
issued a final order in June 1999 prohibiting the Company and its subsidiaries
from importing and selling imported recycled single-use cameras. The Company
appealed the ITC Commissioners' order to the Federal Circuit Court of Appeals
and that Court issued a decision in November 2001, upholding the order against
the Company. In July 2001, the ITC commenced enforcement and advisory opinion
proceedings against the Company and several other respondents, based on a new
complaint filed by Fuji with the ITC in late June 2001. This complaint alleges
that the Company is infringing certain claims of six of Fuji's patents on single
use cameras, through the importation and sales of certain newly manufactured
reloadable cameras. The complaint requests that the ITC determine that through
these imports and sales we are violating the ITC's previous order. It also
requests that the ITC bring an action in an appropriate U.S. District Court to
seek an injunction and civil penalties for each day in which an importation or
sale violating the order occurs in an amount up to the maximum provided by the
governing statute. In May 2002, an Administrative Law Judge of the International
Trade Commission issued an initial determination that the Company's reloadable
camera infringes three patents owned by Fuji Photo Film Co., Ltd for single-use
cameras, and also recommended that the Commission assess a penalty of $1.6
million for such infringement. Since that time, the Commission has upheld the
infringement determination and is currently determining what, if any, penalty to
assess. The Company expects the Commission's decision regarding any penalty
assessment in January 2003. Any action by the Commission is subject to further
appeal to the Federal Circuit Court of Appeals. The Company believes it has
strong arguments regarding the infringement determination and any penalty
recommendation and intends to pursue such challenges to the extent it deems
appropriate. As such, no accrual has been made at this time in the Company's
fiscal 2002 financial statements for this matter. If the penalty amount is
upheld, it would have a significantly harmful impact on the Company's financial
condition, results of operations and liquidity.

      Washington Department of Revenue - The Company has an outstanding tax
issue with the Washington State Department of Revenue related to use taxes owed
as a result of advertising materials (including order forms) mailed to
out-of-state customers. The Company is seeking resolution of the issues
involved, primarily related to future periods, as this is an ongoing issue for
the Company for tax reporting periods after January 1, 1998. That is, it is
reasonable that a future routine audit by the Department of Revenue will result
in a further use tax assessment unless the issue can be resolved in a manner
favorable to the Company prior to such audit assessment. The Company believes
its accrual of approximately $150,000 is adequate for possible assessments
related to the outstanding issue.


                                       16
<PAGE>

      Massachusetts Institute of Technology - On April 25, 2002, a Complaint was
filed against the Company and over 200 other defendants by The Massachusetts
Institute of Technology and Electronics for Imaging, Inc. claiming infringement
on a patent issued in 1985 for a Color Reproduction System. The Complaint
requests injunctive relief, damages adequate to compensate them for Defendants'
infringement of the 4,500,919 patent, their costs and prejudgment interest on
their damages and reasonable attorney fees.

      The suit is in an early stage and management of the Company intends to
contest the suit vigorously as to the complaint's substantive allegations.
Although the Company believes the claim to be without merit, it is not possible
to predict an outcome at this time or the potential affect on its business or
financial condition.

      Although the Company believes it has a reasonable position relative to the
claims listed above, it is not possible to predict an outcome at this time or
the potential affect on its business or financial condition. The Company's
defense of these claims will cause it to incur additional legal expenses.

      The Company is also involved in various routine legal proceedings in the
ordinary course of its business.

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.

                                     PART II

ITEM 5 - MARKET PRICES AND DIVIDENDS ON COMMON STOCK

      The Company's common stock traded on the Nasdaq Stock Market until August
2001. The Nasdaq delisted the Company's stock after it failed to comply with
required listing standards of the Nasdaq Stock Market. Since August 2001, the
Company's common stock is traded on the Over the Counter Bulletin Board (OTCBB)
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 and OTCBB.

                                                     High          Low
                                                     ----          ---
      Fiscal Year Ended September 28, 2002
         First Quarter..........................     $.20         $.05
         Second Quarter.........................      .54          .12
         Third Quarter..........................      .34          .18
         Fourth Quarter.........................      .21          .15

      Fiscal Year Ended September 29, 2001
         First Quarter..........................    $3.13         $.50
         Second Quarter.........................     1.84          .50
         Third Quarter..........................     1.13          .56
         Fourth Quarter.........................      .95          .09

      On December 6, 2002, the last sale price reported for the Company's common
stock was $.17 per share and as of that date, the common stock was held by an
estimated 5,100 shareholders with approximately 472 holders of record.

      The Company has never declared or paid cash dividends on its common stock
and does not anticipate paying any dividends in the foreseeable future. The
Company is restricted under the covenants of a bank agreement from declaring any
dividends on shares of its capital stock without the bank's prior consent. The
Company currently intends to retain its earnings, if any, for developing its
business.


                                       17
<PAGE>

ITEM 6 - SELECTED FINANCIAL DATA

      The selected financial data set forth below with respect to the Company's
consolidated statements of operations for the years ended September 28, 2002,
September 29, 2001 and September 30, 2000 and the Company's consolidated balance
sheets at September 28, 2002 and September 29, 2001 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 statement of operations data for the years ended
September 25, 1999 and September 26, 1998 and selected balance sheet data at
September 30, 2000, September 25, 1999 and September 26, 1998 are derived from
audited consolidated financial statements which are not included in this report.

                                PHOTOWORKS, INC.
                           SELECTED FINANCIAL DATA
               (in thousands, except per share and share data)

<TABLE>
<CAPTION>
                                                                                     Fiscal Years
                                                  ----------------------------------------------------------------------------------
                                                      2002               2001            2000            1999               1998
====================================================================================================================================
<S>                                               <C>                <C>             <C>             <C>                <C>
Consolidated Statement of Operations Data:

Net revenues ..................................   $     42,093       $     56,690    $     82,061    $     89,613       $     96,716

Gross profit ..................................         10,474             12,496          21,858          32,645             41,389

Operating expenses ............................         12,351             24,584          57,323          48,940             31,202

Net income (loss) .............................          3,581(**)        (12,122)        (34,794)        (10,127)             7,575

Net income (loss) attributable to
    common shareholders .......................   $      3,581       $    (12,122)   $    (37,817)   $    (10,127)      $      7,575
                                                  ============       ============    ============    ============       ============

Diluted earnings (loss) per share .............   $        .21       $       (.73)   $      (2.12)   $       (.62)      $        .43
                                                  ============       ============    ============    ============       ============
Diluted earnings (loss) per share
    attributable to common shareholders .......   $        .21       $       (.73)   $      (2.31)   $       (.62)      $        .43
                                                  ============       ============    ============    ============       ============

Weighted average shares and
   equivalents outstanding - diluted ..........     17,043,000         16,563,000      16,389,000      16,299,000         17,474,000
                                                  ============       ============    ============    ============       ============

Consolidated Balance Sheet Data:

Capitalized customer acquisition
   expenditures ...............................   $          0       $          0    $          0    $          0(*)    $     16,800

Total assets ..................................         11,822             12,381          24,662          41,100(*)          55,116

Long-term obligations .........................          2,500              2,594           1,523             521                706

Shareholders' equity ..........................   $      4,638       $      1,045    $     13,004    $     32,321       $     43,701
                                                  ============       ============    ============    ============       ============
</TABLE>

See notes to consolidated financial statements.

(*) During fiscal 1999, the Company fully amortized $16,800,000 of previously
capitalized customer acquisition costs in addition to current period marketing
costs.

(**) During fiscal 2002, the Company realized $5,673,000 of income tax benefits.


                                       18
<PAGE>

ITEM 7 - MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS
OF OPERATIONS

Forward-Looking Information

      This report contains forward-looking statements including, without
limitation, statements identified by an asterisk (*). These statements relate to
future events, product or service offerings or the future financial performance
of the Company. In some cases, you can identify forward-looking statements by
terminology such as "may," "will," "should," "expects," "plans," "anticipates,"
"believes," "estimates," "predicts," "potential," or "continue" or the negative
of such terms and other comparable terminology. These statements only reflect
expectations and estimates of the Company's management. Actual events or results
may 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. All forward-looking statements contained in this report reflect
the Company's expectations at the time of this report only, and the Company
disclaims any responsibility to revise or update any such forward-looking
statement except as may be required by law.

Controls and Procedures

      Within the 90-day period prior to filing this report, as part of our
annual audit, we carried out an evaluation, under the supervision and with the
participation of the Company's management, including our Chief Executive Officer
and Chief Accounting Officer, of the effectiveness of the design and operation
of our disclosure controls and procedures pursuant to Exchange Act Rule 13a-14
and 15d-14. Based upon that evaluation, the Chief Executive Officer and the
Chief Accounting Officer concluded that our disclosure controls and procedures
are effective to timely alert them to any material information relating to the
Company (including its consolidated subsidiaries) that must be included in our
periodic SEC filings. There have been no significant changes in the Company's
internal controls or in other factors that could significantly affect internal
controls subsequent to their evaluation.

      We intend to review and evaluate the design and effectiveness of our
disclosure controls and procedures on an ongoing basis and to improve our
controls and procedures over time and to correct any deficiencies that we may
discover in the future. Our goal is to ensure that our senior management has
timely access to all material financial and non-financial information concerning
our business. While we believe the present design of our disclosure controls and
procedures is effective to achieve our goal, future events affecting our
business may cause us to modify our disclosure controls and procedures.

Overview

      PhotoWorks, Inc. ("PhotoWorks" or the "Company") is a leading online,
direct mail and retail photo services company dedicated to providing its
customers with innovative ways to create and tell the stories of their lives
through photos.* In February 2000, the company name was changed from Seattle
FilmWorks to PhotoWorks to reflect the Company's corporate mission to be the
leading mail-delivered digital photo printing service. The Company offers an
array of complementary services and products primarily under the brand names
PhotoWorks(R) and Seattle FilmWorks(R).

      To promote its service and products, the Company relies primarily on
direct marketing and online email programs. 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 its existing customer base of its
integrated array of services and products.* The Company also believes that the
online archive provides an opportunity to monetize its customer's "personal
equity" through photo output, in the form of prints, reprints, and gifts for
traditional and digital camera users.* The Company's commitment to


                                       19
<PAGE>

expanding its digital service and product offerings, is intended to support this
strategy.* The Company uses email and other direct-marketing media to
effectively communicate with both its existing and inactive customers.

      Net income for fiscal 2002 was $3,581,000, compared to a net loss for
fiscal 2001 of $12,122,000 and net loss of $34,794,000 for fiscal 2000. Net
income for fiscal 2002 was primarily due to income tax benefits of $5,673,000 as
a result of the "Job Creation and Worker Assistance Act enacted by Congress in
March 2002. The bill provided for an economic stimulus package of temporary
business tax incentives. The Company benefited from a business tax incentive
contained in the bill, which allows a business to extend the net operating loss
carry-back period to five years (previously two years) for net operating losses
arising in taxable years ending in 2001 and 2002 (See Note F of Notes to
Consolidated Financial Statements). In fiscal 2002, the Company had lower net
revenues as compared to fiscal 2001, which were partially offset by lower
operating expenses. The net loss for fiscal 2001 as compared to the net loss for
fiscal 2000 was lower primarily due to a substantial decrease in operating
expenses, primarily marketing expenses. Operating results will fluctuate in the
future due to a number of factors including lower sales, the level and nature of
marketing activities, price increases by suppliers, introductions of new
products, research and development requirements, actions by competitors,
economic conditions, and conditions in the online and direct-to-consumer market
and the digital imaging and photofinishing industry in general.*

      Cost of goods and services consist of labor, postage, supplies and fixed
operating costs related to the Company's services and products. Marketing
expenses include costs associated with customer acquisition and retention,
building brand awareness, and testing of new marketing programs. Research and
development expenses consist primarily of costs incurred in developing
computerized online image management concepts, developing online photo archiving
and photo sharing services, other digital related services, and creating
equipment necessary to provide customers with new computer-related photographic
services and products. General and administrative expenses consist of costs
related to management information systems, computer operations, human resource
functions, finance, legal, accounting, investor relations, and general corporate
activities.

      Demand for the Company's services and products is generally seasonal.
However, seasonality of demand may be offset by changes in the effectiveness of
marketing programs, the introduction of new services and products, actions by
competitors, production difficulties and other factors. 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.

Critical Accounting Policies

      Management's Discussion and Analysis of Financial Condition and Results of
Operations discusses the Company's consolidated financial statements, which have
been prepared in accordance with accounting principles generally accepted in the
United States. The preparation of these financial statements requires management
to make estimates and judgments that affect the reported amounts of assets,
liabilities, net revenue, and expenses. Management's estimates and judgments are
based upon the Company's historical experience, knowledge of economic and market
factors, and various other factors that are believed to be relevant given the
circumstances. Significant policies, methodologies, estimates, and the factors
used therein, are reviewed on at least a quarterly basis with the Company's
Audit Committee. Actual results may differ from these estimates.

      The following is a discussion of the estimates included in the Company's
financial statements that encompass matters of uncertainty, whereby different
estimates could have reasonably been made or changes in such estimates could
have a material impact on the financial statements of the Company.

      Allowance for Doubtful Accounts


                                       20
<PAGE>

      The allowance for doubtful accounts is based on the Company's historical
loss percentage for bad debts as a percentage of sales with consideration given
to the aging of the receivables. Additionally, we review customers with large
past due balances on at least a monthly basis. Based on our assessment of the
financial condition of such customers, their past payment history, and other
circumstances, we record a specific allowance for those accounts that we
determine may be uncollectible. We are unable to predict changes in the
financial condition of our customers or general economic conditions. If
circumstances related to either of these change, our estimate of an appropriate
allowance for doubtful accounts could be materially affected and we may be
required to record additional allowances.

      Reserve for Obsolete Inventory

      Management regularly assesses the valuation of the Company's inventory and
writes down those inventories which are obsolete or in excess of forecasted
usage to their estimated realizable value. A reserve for obsolesence is recorded
against inventory for any film or paper inventories that are nearing their
expiration dates. Additional reserves are recorded for slow-moving or
discontinued stock to the extent it is estimated the materials may go unused
based on historical inventory turnover, planned changes in marketing promotions
or other anticipated changes in product mix over the next year, seasonality, or
other factors. Estimates of future usage are based on estimates of future sales
and product mix. If actual sales or product mix differs from management's
estimates, the Company may need to record additional reserves for obsolete
inventory.

      Deferred Revenues

      The Company defers revenues related primarily to a Frequent Customer
Program, which the Company began testing during the second quarter of fiscal
2002. Under this program, after processing a certain number of rolls of film
within a stated period of time, a customer receives free processing on their
next roll of film. For each roll of film for which the processing is paid under
this program, the Company defers a portion of the revenue received and
recognizes the revenue upon processing of the free roll, so that revenue from
customers in this program is recognized ratably over all film rolls processed.
Although management believes it is unlikely that all customers in this program
will process the requisite number of rolls that entitle them to the free
processing, because this program is new, management does not believe it has
adequate historical data on which to estimate a percentage of customers that
will not achieve this benefit and has, accordingly, deferred the maximum amount
of revenue. As more information is obtained, management may be able to determine
this percentage within a reasonable range and reduce its deferral of revenues
under this program accordingly. Such a reduction may have a material impact on
the reported deferred revenues of the Company.

      Deferred Tax Assets

      The Company has deferred tax assets totaling $12,719,000, comprised
primarily of net operating loss carryforwards. Due to its recent history of
operating losses, the uncertainty of future profits, and limitations on the
utilization of net operating loss carryforwards under IRC Section 382,
management has recorded a valuation allowance against its net deferred tax
assets.

      Contingencies

      The Company is subject to various legal proceedings and claims (see Item 3
- Legal Proceedings), the outcomes of which are subject to significant
uncertainty. SFAS 5, Accounting for Contingencies, requires that an estimated
loss from a contingency should be recorded if it is probable that a liability
has been incurred and the amount of the loss can be reasonably estimated.
Disclosure of a contingency is required if there is at least a reasonable
possibility that a loss may have been incurred. The Company evaluates, among
other factors, the degree of probability of an unfavorable outcome and the
ability to make a reasonable estimate of the amount of loss.


                                       21
<PAGE>

      The Company is a defendant in a claim filed by Fuji Photo Film Co., Ltd.
with the International Trade Commission. In May 2002, an Administrative Law
Judge of the International Trade Commission issued an initial determination that
the Company's reloadable camera infringes three patents owned by Fuji Photo Film
Co., Ltd for single-use cameras, and also recommended that the Commission assess
a penalty of $1.6 million for such infringement. Since that time, the Commission
has upheld the infringement determination and is currently determining what, if
any, penalty to assess. The Company expects the Commission's decision regarding
any penalty assessment in January 2003. Management believes it has strong
arguments regarding the infringement determination, and any penalty
recommendation, and intends to pursue such challenges to the extent it deems
appropriate. As such, no accrual has been made in the Company's fiscal 2002
financial statements for this matter. If the Company is assessed a significant
penalty by the International Trade Commission, it could materially impact the
Company's financial position or its results of operations.

Results of Operations

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

                                                  Fiscal Years Ended
                                      ------------------------------------------
                                      September 28,  September 29,  September 30
                                          2002           2001           2000
================================================================================
Net revenues                             100.0%         100.0%         100.0%
Cost of goods and services                75.1           77.9           73.4
                                        ------         ------         ------
GROSS PROFIT                              24.9           22.1           26.6

Operating expenses:
   Marketing                              10.9           19.5           57.7
   Research and development                4.5            7.0            3.5
   General and administrative             14.0           13.4            8.6
Lawsuit settlement                          --            1.9             --
   Accrued lease obligations                --            1.6             --
                                        ------         ------         ------
     Total operating expenses             29.4           43.4           69.8
                                        ------         ------         ------

LOSS FROM OPERATIONS                      (4.5)         (21.3)         (43.2)

Total other income (expense)               (.5)           (.1)           1.3
                                        ------         ------         ------

NET LOSS BEFORE INCOME TAXES              (5.0)         (21.4)         (41.9)
Benefit (provision) for income taxes      13.5             --            (.5)
                                        ------         ------         ------

NET INCOME (LOSS)                          8.5%         (21.4)%        (42.4)%
                                        ======         ======         ======

      Net revenues decreased 25.7% to $42,093,000 in fiscal 2002 compared to
$56,690,000 in fiscal 2001. Net revenues decreased 30.9% to $56,690,000 in
fiscal 2001 from $82,061,000 in fiscal 2000. The decreases in net revenues for
fiscal years 2002 and 2001 were primarily due to declines in film-based
processing volumes which management attributes to increased competition,
primarily mass merchants, and declines in the effectiveness of its customer
acquisition programs. During fiscal 2002, net revenues from digital-based
processing increased to approximately 3% of total net revenues compared to
approximately 1.5% in fiscal year 2001. The Company's marketing expenditures in
fiscal 2002 and 2001 declined significantly as compared to fiscal 2000, which
contributed to the decline in processing volumes. In addition, the
photofinishing industry is experiencing lower sales, which the Company believes
may be due to general economic conditions and changes in the photofinishing
industry in general. Net revenues are expected to decline further in fiscal year
2003.* Net revenues from ancillary businesses declined approximately $600,000 in
fiscal 2002 as compared to fiscal 2001. In fiscal 2001, net revenues from
ancillary businesses declined approximately $2,300,000 as compared to fiscal
2000. The decline in fiscal 2002 was primarily due to lower sales of the
Company's reloadable camera. During fiscal 2002, the Company exited this
business due to issues related to its camera design (see Note K - Contingencies
in Notes to Consolidated


                                       22
<PAGE>

Financial Statements). The decline in net revenues from ancillary businesses in
fiscal 2001 was primarily due to declines in sales of wholesale film, which the
Company phased out in September 2000.

      Gross profit as a percentage of net revenues for fiscal 2002 increased to
24.9%, compared to 22.1% for fiscal 2001 and 26.6% for fiscal 2000. The increase
in gross profit in fiscal 2002 was primarily due to an overall increase in net
revenue per roll combined with expense reductions in overhead areas. The
decrease in gross profit in fiscal 2001 was primarily due to lower net revenues
per roll in the first half of fiscal 2001 and lower processing volumes. Gross
profit fluctuates due to the seasonal nature of revenues and revenues per roll,
combined with fixed operating costs associated with equipment, facilities and
fixed overhead costs related to the Company's products and services.*

      Total operating expenses as a percentage of net revenues for fiscal 2002
were 29.4% compared to 43.4% for fiscal 2001 and 69.8% for fiscal 2000. The
decrease in operating costs as a percentage of net revenues for fiscal 2002, was
primarily due to a significant reduction in marketing expenses and lower costs
for research and development. In addition, fiscal 2001 operating expenses
included $1,094,000 for costs related to the settlement of a class action
lawsuit and $908,000 for estimated costs related to unused facility costs and
store closure reserve. The decrease in operating expenses as a percentage of net
revenues in fiscal 2001 as compared to fiscal 2000 was primarily due to
substantial decreases in marketing expenses, partially offset by increased costs
for research and development, general and administrative costs and other accrued
costs. Future periods may reflect increased or decreased operating expenses due
to the timing and magnitude of marketing activities as well as expenditures
related to develop its digital services and products.*

      Marketing expenses in fiscal 2002 decreased as a percentage of net
revenues to 10.9% compared to 19.5% in fiscal 2001. Marketing expenses in fiscal
2001 decreased as a percentage of net revenues to 19.5% compared to 57.7% in
fiscal 2000. The notable decreases in marketing expenses in fiscal 2002 and
fiscal 2001 were primarily due to a shift in the Company's marketing strategy to
target the Company's customer base through retention and reactivation marketing
programs. The Company is currently testing and evaluating marketing programs
that focus on a more immediate return on investment. In fiscal 2000, marketing
expenditures were heavily focused on customer acquisition and establishing its
leadership position in the online photo space. In addition, the Company incurred
marketing costs related to the rebranding and renaming the company from Seattle
FilmWorks to PhotoWorks. The increased marketing expenses in fiscal 2000
included a national brand advertising campaign to promote brand awareness
combined with a major direct mail and Internet campaign to acquire new customers
interested in its online and digital services and products. The Company does not
anticipate an increase in the level of marketing expenditures in fiscal 2003.*

      Research and development expenses in fiscal 2002 were $1,891,000 compared
to $3,966,000 in fiscal 2001. Research and development expenses in fiscal 2001
were $3,966,000 compared to $2,924,000 for fiscal 2000. The decrease in research
and development expenditures in fiscal 2002 was primarily due to reductions in
staff and related overhead costs. The increase in research and development
expenses in fiscal 2001 compared to fiscal 2000 was primarily due to increased
investment in the Company's online and digital services and products. The
Company does not anticipate substantial increases in the level of research and
development expenditures in fiscal 2003.*

      General and administrative expenses decreased to $5,893,000 compared to
$7,583,000 in fiscal 2001. General and administrative expenses increased to
$7,583,000 in fiscal 2001 compared to $7,061,000 in fiscal 2000. General and
administrative costs decreased in fiscal 2002 primarily due to reductions in
staff and related overhead costs, which was partially offset by increased legal
fees. General and administrative costs increased in fiscal 2001 primarily as a
result of increases in information technology systems to support the Company's
expanding computer based and Internet related operations in addition to
increased costs associated with wages, recruiting, legal fees, and shareholder
relations. General and administrative expenses will include ongoing legal
expenses.*


                                       23
<PAGE>

      Other operating expenses for fiscal 2001 included costs related to the
settlement of a class action lawsuit (see Note K - Contingencies). In addition,
fiscal 2001 operating expenses included $908,000 for estimated costs related to
unused facility costs and a store closure reserve. During the fourth quarter of
fiscal 2001, the Company consolidated its facilities. The $908,000 includes a
write-off of leasehold improvements related to the unused facilities, estimated
lease obligations and a reserve for estimated costs related to planned closure
of certain retail locations.

      Other expense in fiscal 2002 was $215,000 compared to $34,000 in fiscal
2001. Other expense in fiscal 2001 was $34,000, compared to other income of
$1,099,000 in fiscal 2000. Other expense for fiscal 2002 consists primarily of
interest expense. Other expense for fiscal 2001 consists primarily of interest
expense and losses on disposals of assets, partially offset by a negotiated
vendor discount from a fiscal 2000 expenditure. Other income in fiscal 2000
included higher interest income from higher cash and short-term investment
balances following the sale of Series A Preferred Stock in February 2000.

      On March 8, 2002, Congress enacted the "Job Creation and Worker Assistance
Act". The Company benefited from a business tax incentive contained in the bill,
which allows a business to extend the net operating loss carryback period to
five years (from two years) for net operating losses arising in taxable years
ending in 2001 and 2002. As a result, the Company recorded tax benefits of
$5,673,000 related to net operating loss carrybacks for fiscal years 2001 and
2002. In July 2002, the Company received a tax refund in the amount of
$3,865,000 for its 2001 tax loss and expects to receive a tax refund of
approximately $1,808,000 for its 2002 tax loss in early 2003.

      Net income in fiscal 2002 was $3,581,000 compared to a net loss in fiscal
2001 of $12,122,000. Net income in fiscal 2002 was primarily due to the income
tax benefits discussed above. In addition, net income for fiscal 2002 was
impacted by the reductions in operating costs partially offset by a decline in
net revenues. The net loss in fiscal 2001 decreased to $12,122,000 compared to a
net loss of $34,794,000 in fiscal 2000. The fiscal 2001 decrease in the net loss
as compared to fiscal 2000 was primarily due to decreased operating expenses,
primarily marketing expenses, which offset the decrease in revenues and gross
profit.

Liquidity and Capital Resources

      Net cash generated from operating activities in fiscal 2002 was $1,445,000
compared to net cash used in operating activities in fiscal 2001 of $4,596,000
and $25,107,000 in fiscal 2000. In fiscal 2002, the Company generated cash from
operations due to a decrease in operating costs as compared to fiscal 2001,
combined with the tax benefits discussed above. In fiscal 2001, the Company
incurred a net loss of $12,122,000 that was partially offset by non-cash charges
related to depreciation and various other operating expense accruals.

      Net cash used in investing activities was $583,000 in fiscal 2002 compared
to net cash generated from investing activities of $842,000 in fiscal 2001 and
net cash used of $3,574,000 in fiscal 2000. In fiscal 2002, the Company
purchased additional equipment to support its digital strategy. The increase in
net cash generated from investing activities for fiscal 2001 was primarily due
to sales of available-for-sale securities and decreased purchases of furniture,
fixtures and equipment compared to fiscal year 2000.

      Net cash used in financing activities was $2,548,000 compared to net cash
from financing activities of $4,620,000 in fiscal 2001 and $15,253,000 in fiscal
2000. In fiscal 2002, the Company paid off its bank loan of $2,350,000. In
fiscal 2001, net cash from financing activities included proceeds from a bank
loan and issuance of Subordinated Convertible Debentures. Net cash from
financing activities in fiscal 2000 was primarily due to the sales of Series A
Preferred shares in February 2000.

      The ratio of current assets to current liabilities for the Company was
1.81 to 1 at the end of fiscal 2002 compared to .67 to 1 at the end of fiscal
2001. The increase is primarily due to an increase in income tax


                                       24
<PAGE>

receivable and prepaid expenses, partially offset by decreases in inventory,
accounts payable, and bank loan payable.

      Net capital expenditures during fiscal 2002 totaled $668,000 compared to
$187,000 in fiscal 2001. The expenditures related primarily to the purchase of
additional digital processing equipment. Net capital expenditures during fiscal
2000 totaled $7,234,000 principally for photofinishing equipment, data storage
equipment and computer network equipment to support the Company's digital and
online archive and image management services. The Company has plans for capital
expenditures as needed, although at this time it has no binding commitments.*

     As of December 13, 2002, the Company's principal sources of liquidity
included approximately $2,167,000 in cash and cash equivalents. In addition, in
September 2002 the Company made certain prepaid expenditures of approximately
$3,500,000, primarily for prepayment of postage amounts, which will be utilized
in fiscal 2003.* The Company currently anticipates that existing cash and cash
equivalents, the $1,808,000 tax refund and projected future cash flows from
operations will be sufficient to fund its operations, including any capital
expenditures, and to service its indebtedness through at least September 30,
2003.* However, if the Company does not generate sufficient cash from operations
to satisfy its ongoing expenses, the Company may be required to seek external
sources of financing or refinance its obligations. Possible sources of financing
include the sale of equity securities or 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.

ITEM 7A - QUANTITATIVE AND QUALITATIVE DISCLOSURE ABOUT MARKET RISK

      Not material.

ITEM 8 - FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA

      See pages 26 through 42.


                                       25
<PAGE>

                Report of Ernst & Young LLP, Independent Auditors

Shareholders and Board of Directors
PhotoWorks, Inc.

      We have audited the accompanying consolidated balance sheets of
PhotoWorks, Inc. (the Company) as of September 28, 2002 and September 29, 2001
and the related consolidated statements of operations, shareholders' equity, and
cash flows for each of the three years in the period ended September 28, 2002.
Our audits also included the financial statement schedule listed in the Index at
Item 14(a). These financial statements and schedule are the responsibility of
the Company's management. Our responsibility is to express an opinion on these
financial statements and schedule based on our audits.

      We conducted our audits in accordance with auditing standards generally
accepted in the United States. 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 financial statements. An audit also includes assessing the accounting
principles used and significant estimates made by management, as well as
evaluating the overall 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 consolidated financial position of
PhotoWorks, Inc. at September 28, 2002 and September 29, 2001, and the results
of its operations and its cash flows for each of the three years in the period
ended September 28, 2002, in conformity with accounting principles generally
accepted in the United States. Also, in our opinion, the related financial
statement schedule, when considered in relation to the basic financial
statements taken as a whole, presents fairly in all material respects the
information set forth therein.

                                                /s/ ERNST & YOUNG LLP

Seattle, Washington
November 8, 2002,
Except for Note F, as to which the date is
December 20, 2002


                                       26
<PAGE>

                                PHOTOWORKS, INC.
                           CONSOLIDATED BALANCE SHEETS
                 (in thousands, except per share and share data)

<TABLE>
<CAPTION>
                                                                                  September 28,    September 29,
                                                                                      2002              2001
                                                                                    --------          --------
<S>                                                                                 <C>               <C>
                                     ASSETS

CURRENT ASSETS
    Cash and cash equivalents                                                       $  1,175          $  2,861
    Accounts receivable, net of allowance for doubtful accounts
       of $28 and $45 in 2002 and 2001, respectively                                     548               406
    Income taxes receivable                                                            1,808                --
    Inventories                                                                          934             2,203
    Prepaid expenses                                                                   4,011               382
                                                                                    --------          --------
       TOTAL CURRENT ASSETS                                                            8,476             5,852

Furniture, fixtures, and equipment,
    at cost, less accumulated depreciation (Note D)                                    3,346             6,529
                                                                                    --------          --------

TOTAL ASSETS                                                                        $ 11,822          $ 12,381
                                                                                    ========          ========

                      LIABILITIES AND SHAREHOLDERS' EQUITY

CURRENT LIABILITIES
    Bank note payable                                                               $     --          $  2,350
    Note payable - other                                                                  --                38
    Accounts payable                                                                   2,024             2,872
    Accrued compensation                                                               1,392             1,141
    Accrued taxes                                                                        150               325
    Accrued lawsuit settlement (Note K)                                                   --               705
    Other accrued expenses                                                               495             1,014
    Current portion of capital lease obligation                                           94               198
    Deferred revenues                                                                    529                99
                                                                                    --------          --------
      TOTAL CURRENT LIABILITIES                                                        4,684             8,742

Subordinated convertible debentures (Note E)                                           2,500             2,500
Capital lease obligations, net of current portion (Note C)                                --                94
                                                                                    --------          --------

TOTAL LIABILITIES                                                                      7,184            11,336

SHAREHOLDERS' EQUITY (Notes G and I)
    Preferred Stock, $.01 par value; authorized 2,000,000 shares;
      15,000 shares Series A Convertible Preferred Stock authorized,
      issued and outstanding in 2002 and 2001
      36,830 shares Series B Convertible Preferred Stock authorized,
      none issued or outstanding in 2002 and 2001                                         --                --
    Common Stock, $.01 par value, authorized 101,250,000 shares, issued and
      outstanding 16,655,285 and 16,655,971 in 2002 and 2001, respectively               167               167
    Additional paid-in capital                                                        15,802            15,790
    Retained deficit                                                                 (11,331)          (14,912)
                                                                                    --------          --------
      TOTAL SHAREHOLDERS' EQUITY                                                       4,638             1,045
                                                                                    --------          --------

TOTAL LIABILITIES AND SHAREHOLDERS' EQUITY                                          $ 11,822          $ 12,381
                                                                                    ========          ========
</TABLE>

See notes to consolidated financial statements.


                                       27
<PAGE>

                                PHOTOWORKS, INC.
                      CONSOLIDATED STATEMENTS OF OPERATIONS
                 (in thousands, except per share and share data)

<TABLE>
<CAPTION>
                                                                 Fiscal Years Ended
                                                -----------------------------------------------------
                                                September 28,       September 29,       September 30,
                                                    2002                2001                2000
=====================================================================================================
<S>                                             <C>                 <C>                 <C>
Net revenues                                    $     42,093        $     56,690        $     82,061
Cost of goods and services                            31,619              44,194              60,203
                                                ------------        ------------        ------------

GROSS PROFIT                                          10,474              12,496              21,858

Operating expenses:
   Marketing                                           4,567              11,033              47,338
   Research and development                            1,891               3,966               2,924
   General and administrative                          5,893               7,583               7,061
   Lawsuit settlement (Note K)                            --               1,094                  --
   Accrued lease obligations (Note C)                     --                 908                  --
                                                ------------        ------------        ------------
Total operating expenses                              12,351              24,584              57,323
                                                ------------        ------------        ------------

LOSS FROM OPERATIONS                                  (1,877)            (12,088)            (35,465)

Other income (expense):
   Interest income                                        43                  89               1,177
   Interest expense                                     (286)               (539)                (68)
   Other income (expense), net                            28                 416                 (10)
                                                ------------        ------------        ------------
     Total other income (expense)                       (215)                (34)              1,099
                                                ------------        ------------        ------------

LOSS BEFORE INCOME TAXES                              (2,092)            (12,122)            (34,366)

Benefit (provision) for income taxes (Note F)          5,673                  --                (428)
                                                ------------        ------------        ------------

NET INCOME (LOSS)                                      3,581             (12,122)            (34,794)

Preferred stock accretion (Note G & H)                    --                  --              (3,023)
                                                ------------        ------------        ------------

NET INCOME (LOSS) ATTRIBUTABLE
   TO COMMON SHAREHOLDERS                       $      3,581        $    (12,122)       $    (37,817)
                                                ============        ============        ============

Diluted earnings (loss) per share               $        .21        $       (.73)       $      (2.12)
                                                ============        ============        ============
Basic earnings (loss) per share                 $        .22        $       (.73)       $      (2.12)
                                                ============        ============        ============

Diluted earnings (loss) per common share        $        .21        $       (.73)       $      (2.31)
                                                ============        ============        ============
Basic earnings (loss) per common share          $        .22        $       (.73)       $      (2.31)
                                                ============        ============        ============

Weighted average shares - diluted                 17,043,000          16,563,000          16,389,000
                                                ============        ============        ============
Weighted average shares - basic                   16,655,000          16,563,000          16,389,000
                                                ============        ============        ============
</TABLE>

See notes to consolidated financial statements.


                                       28
<PAGE>

                                PHOTOWORKS, INC.
                 CONSOLIDATED STATEMENTS OF SHAREHOLDERS' EQUITY
                        (in thousands, except share data)

<TABLE>
<CAPTION>
                                                   Preferred Stock          Common Stock
                                                   ---------------          ------------                    Retained
                                                   Shares      Par        Shares        Par     Paid-In     Earnings
                                                 Outstanding  Value     Outstanding    Value    Capital     (Deficit)       Total
====================================================================================================================================
<S>                                              <C>          <C>       <C>            <C>      <C>         <C>            <C>
BALANCE AS OF SEPTEMBER 25, 1999                        --    $ --      16,303,460      $163     $   154     $ 32,004      $ 32,321

   Issuance of preferred stock                      15,000      --              --        --      14,936           --        14,936
   Stock options exercised                              --      --         122,262         1         318           --           319
   Employee stock purchase plan                         --      --          79,937         1         221           --           222
   Net loss                                             --      --              --        --          --      (34,794)      (34,794)
                                                    ------    ----      ----------      ----     -------     --------      --------

BALANCE AS OF SEPTEMBER 30, 2000                    15,000      --      16,505,659       165      15,629       (2,790)       13,004

   Warrants issued                                      --      --              --        --          83           --            83
   Purchase of Storycatcher.com                         --      --          86,500         1          59           --            60
   Employee stock purchase plan                         --      --          63,812         1          19           --            20
   Net loss                                             --      --              --        --          --      (12,122)      (12,122)
                                                    ------    ----      ----------      ----     -------     --------      --------

BALANCE AS OF SEPTEMBER 29, 2001                    15,000      --      16,655,971       167      15,790      (14,912)        1,045

   Warrants issued                                      --      --              --        --          12           --            12
   Employee stock purchase plan                         --      --            (686)       --          --           --            --
   Net income                                           --                      --        --          --        3,581         3,581
                                                    ------    ----      ----------      ----     -------     --------      --------

BALANCE AS OF SEPTEMBER 28, 2002                    15,000    $ --      16,655,285      $167     $15,802     $(11,331)     $  4,638
                                                    ======    ====      ==========      ====     =======     ========      ========
</TABLE>

See notes to consolidated financial statements.


                                       29
<PAGE>

                                PHOTOWORKS, INC.
                      CONSOLIDATED STATEMENTS OF CASH FLOWS
                                (in thousands)

<TABLE>
<CAPTION>
                                                                                 Fiscal Years Ended
                                                                  ------------------------------------------------
                                                                  September 28,     September 29,    September 30,
                                                                      2002              2001             2000
==================================================================================================================
<S>                                                               <C>              <C>             <C>
OPERATING ACTIVITIES:
Net income (loss)                                                    $ 3,581          $(12,122)       $(34,794)
 Charges to income not affecting cash:
    Depreciation                                                       3,711             5,361           5,042
    Deferred revenues                                                    430                 5             (83)
    Loss on disposal of furniture, fixtures, and equipment                55               277             116
    Accrued lease obligations                                             --               908              --
    Lawsuit settlement                                                    --               705              --
    Deferred income taxes                                                 --                --           1,334
 Net change in receivables, inventories, payables and other           (4,524)             (700)          3,278
 Income taxes receivable                                              (1,808)              970              --
                                                                     -------          --------        --------
NET CASH FROM (USED IN) OPERATING ACTIVITIES                           1,445            (4,596)        (25,107)

INVESTING ACTIVITIES:
 Purchase of furniture, fixtures, and equipment                         (668)             (187)         (7,234)
 Proceeds from sales of furniture, fixtures, and equipment                85                 7             169
 Purchases of securities available-for-sale                               --                --         (13,740)
 Sales of securities available-for-sale                                   --             1,022          17,231
                                                                     -------          --------        --------
NET CASH FROM (USED IN) INVESTING ACTIVITIES                            (583)              842          (3,574)

FINANCING ACTIVITIES:
 Repayment of bank note payable                                       (2,350)               --              --
 Payment on capital lease obligations                                   (198)             (250)           (224)
 Proceeds from issuance of Common Stock                                   --                20             541
 Proceeds from bank note payable                                          --             2,350              --
 Proceeds from Subordinated Convertible Debentures                        --             2,500              --
 Proceeds from issuance of preferred stock                                --                --          14,936
                                                                     -------          --------        --------
NET CASH FROM (USED) IN FINANCING ACTIVITIES                          (2,548)            4,620          15,253
                                                                     -------          --------        --------

INCREASE (DECREASE) IN CASH AND
 CASH EQUIVALENTS                                                     (1,686)              866         (13,428)

Cash and cash equivalents at beginning of year                         2,861             1,995          15,423
                                                                     -------          --------        --------

CASH AND CASH EQUIVALENTS
 AT END OF YEAR                                                      $ 1,175          $  2,861        $  1,995
                                                                     =======          ========        ========
Supplemental cash flow information:
 Cash paid for interest                                              $   261          $    356        $     43
 Cash received from income tax refund                                $ 3,865          $     --        $     --

Supplemental non-cash financing and investing activity:
  Stock warrants issued for bank financing                           $    12          $     83        $     --
  Purchase of StoryCatcher.com                                       $    --          $     98        $     --
  Capital lease obligation incurred                                  $    --          $     --        $     59
  Conversion of accounts payable to notes payable                    $    --          $     --        $  2,052
</TABLE>

   See notes to consolidated financial statements


                                       30
<PAGE>

                                PHOTOWORKS, INC.
                   NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

NOTE A -- OPERATIONS AND SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES

PHOTOWORKS, INC: ("PhotoWorks" or the "Company") is a leading photo services
company, dedicated to providing its customers with innovative ways to enjoy and
use their photos, primarily through online and mail-order channels. The Company,
formerly Seattle FilmWorks, Inc., changed its corporate name to PhotoWorks, Inc.
on February 1, 2000. The PhotoWorks service provides film and image processing
and online image storage and management services to both traditional and digital
camera users, primarily in the United States, providing customers the easiest
way to store and organize photos online, share them with friends and family, and
order reprints, photo albums, and photo related products. The Company also
offers an array of complementary products and services, primarily under the
brand names PhotoWorks(R) and Seattle FilmWorks(R).

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

SEGMENT REPORTING: The Company currently operates in one business segment.

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

OTHER FINANCIAL INSTRUMENTS: The carrying values 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 includes amounts due from
wholesale customers from the sale of single-use cameras. An allowance for
doubtful accounts is established based on the Company's historical loss
percentage for bad debts as a percentage of sales with consideration given the
aging of the receivables.

INVENTORIES: Inventories are stated at the lower of cost (using the first-in,
first-out method) or market. Inventories consist primarily of film, and
photofinishing supplies. An inventory reserve is established based on the
valuation of the Company's inventory, and those inventories which are obsolete
or in excess of forecasted usage or estimated net realizable value.

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

INCOME TAXES: The benefit or provision for federal income taxes is generally
computed based on pretax income. However, the benefit or provision may differ
from income taxes currently payable or receivable, because certain items of
income and expense are recognized in different periods for financial reporting
purposes than they are for federal income tax purposes. As more fully described
in Note F, net operating losses for both book and tax purposes exceed amounts
available for operating loss carryback. Due to the uncertainty of the
recoverability of most of these deferred assets, a valuation allowance has been
recorded. Amounts available for operating loss carryback are recorded as income
taxes receivable.


                                       31
<PAGE>

                                PHOTOWORKS, INC.
             NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued)

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

STOCK-BASED COMPENSATION: The Company has adopted the disclosure-only provisions
of Statement of Financial Accounting Standards (SFAS) No. 123, "Accounting for
Stock-Based Compensation" 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 diluted earnings per share under SFAS 123 is provided in Note I to the
consolidated financial statements.

REVENUE RECOGNITION: The Company recognizes revenue when products are shipped or
services are delivered. The Company provides its customers with a 100%
satisfaction guarantee. The majority of the Company's products and services will
not be returned but customers can request a refund if not satisfied. During
fiscal year 2002 refunds were less than 1% of net revenues. An allowance is
recorded for expected future returns.

DEFERRED REVENUES: The Company defers revenue related primarily to a Frequent
Customer Program, which the Company began testing during the second quarter of
fiscal 2002. Under this program, after processing a certain number of rolls of
film within a stated period of time, a customer receives free processing on
their next roll of film. For each roll of film for which the processing is paid
under this program, the Company defers a portion of the revenue received and
recognizes this upon processing of the free roll, so that revenue from customers
in this program is recognized ratably over all film rolls processed.

EARNINGS (LOSS) PER SHARE: - The Company calculates earnings per share based on
the weighted average number of shares and dilutive Common Stock equivalents
outstanding during the period. Net loss per share is based on the weighted
average number of common shares outstanding during the period. See Notes H and
I.

SHIPPING AND HANDLING COSTS: These costs are included in the cost of goods and
services.

ADVERTISING COSTS: Advertising costs are recorded as expenses when incurred.
Direct mail promotional costs of printed promotional materials are recorded as
expenses during the period in which they are mailed or otherwise disseminated to
customers.

USE OF ESTIMATES: The preparation of financial statements in conformity with
accounting principles generally accepted in the United States 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 amounts have been reclassified to conform
to the current year's presentation.

NOTE B -- LIQUIDITY

The Company has experienced significant revenue declines and has incurred
operating losses in recent years. Cash flows from operations were positive in
fiscal 2002, unlike the previous three fiscal years, but were impacted
significantly by a $3,865,000 tax refund for the carryback of a taxable loss.
With the additional carryback of $1,808,000 for fiscal 2002, the Company has
fully utilized its carryback potential.


                                       32
<PAGE>

                                PHOTOWORKS, INC.
             NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued)

NOTE B -- LIQUIDITY (Continued)

Working capital at September 28, 2002 was $3,792,000 compared to a deficiency of
$2,890,000 at September 29, 2001. While the Company has yet to return to
profitability, management believes that its current cash balances and its
projected cash flows from operations will be sufficient to fund operations for
at least the next 12 months.

NOTE C -- PROPERTY AND LEASES

The Company has operating leases related to its main operating facilities,
totaling approximately 100,000 square feet. These leases expire in September
2005, with five-year options to extend through September 2010. Rental payments
under these leases total approximately $840,000 for each of the next three
years. The Company also has various operating leases for its retail stores, with
lease terms generally ranging from one to three years.

The Company leases the majority of the equipment needed to archive and retrieve
customers' digital images under three-year operating leases. These leases
commenced on the in-service date of the particular equipment and generally
expire during fiscal 2005. Total payments under these equipment leases are
approximately $394,000 annually.

At September 28, 2002, future minimum payments under capital leases and
non-cancelable operating leases are as follows:

                                                 Capital            Operating
                                                  Lease              Leases
================================================================================
                                                       (in thousands)
Fiscal 2003                                        $96               $1,410
Fiscal 2004                                         --                1,335
Fiscal 2005                                         --                1,042
Fiscal 2006                                         --                   16
                                                   ---               ------
                                                    96               $3,803
                                                                     ======
Amounts representing interest                       (2)
                                                   ---
Present value of net minimum lease payments        $94
                                                   ===

Rental expense relating to facilities operating leases for fiscal years 2002,
2001, and 2000, was $1,303,000, $1,910,000, and $1,580,000, respectively. Rental
expense relating to equipment operating leases for fiscal years 2002, 2001, and
2000 was $778,000, $1,132,000, and $614,000, respectively. Interest expense
relating to the capital lease was $13,000, $28,000, and $43,000 for fiscal years
2002, 2001 and 2000, respectively.

During the fourth quarter of fiscal 2001, the Company consolidated its
operations and moved out of two buildings under lease. Leasehold improvements
for these buildings, with a net book value of $403,000 were written down and
remaining lease obligations, net of estimated future sublease revenue, were
accrued, totaling $275,000. Also, the Company accrued $230,000 in fiscal 2001
for estimated costs related to planned retail store closures. These costs were
paid during fiscal 2002.


                                       33
<PAGE>

                                PHOTOWORKS, INC.
             NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued)

NOTE D -- FURNITURE, FIXTURES, AND EQUIPMENT

Furniture, fixtures, and equipment, at cost, consist of the following:

                                                   September 28,   September 29,
                                                       2002            2001
================================================================================
                                                          (in thousands)

Furniture, fixtures, and equipment                   $ 21,347        $ 23,480
Equipment under capital lease                           1,028           1,028
Leasehold improvements                                  4,313           4,656
                                                     --------        --------
                                                       26,688          29,164
Less accumulated depreciation and amortization        (23,342)        (22,635)
                                                     --------        --------

                                                     $  3,346        $  6,529
                                                     ========        ========

NOTE E -- CONVERTIBLE DEBENTURES

In April 2001, the Company issued $2,500,000 of convertible debentures carrying
a 7% interest rate and convertible, at the discretion of the holders, into
Series B Preferred Stock at a conversion price of $75.00 per share, one year
after closing. Each share of Series B Preferred Stock is convertible, at the
option of the holder, at any time into 100 shares of Common Stock (Series B
conversion to common stock results in $.75 per common share). If not previously
converted, the debentures are required to be repaid five years from closing. In
July 2002, the Company filed a registration statement with the SEC for common
shares attributable to Series A and Series B preferred shares.

NOTE F -- INCOME TAXES

Principal items comprising cumulative deferred income taxes are as follows:

                                                         2002            2001
================================================================================
                                                             (in thousands)
Deferred tax assets:
   Net operating loss carryforward                     $ 10,622        $ 15,089
   Depreciation and amortization                          1,155           1,204
   Tax credit carryforwards                                 482             332
   Accrued expenses                                         213           1,091
   Other                                                    247              84
   Non-compete agreement                                     --             251
                                                       --------        --------
Total deferred tax assets                                12,719          18,051
                                                       --------        --------

Deferred tax liabilities:
   Prepaid expenses                                      (1,339)            (64)
   Other liabilities                                         (4)             (8)
                                                       --------        --------
Total deferred tax liabilities                           (1,343)            (72)
                                                       --------        --------

Valuation Allowance                                     (11,376)        (17,979)
                                                       --------        --------

Net deferred tax liability                             $      0        $      0
                                                       ========        ========


                                       34
<PAGE>

                               PHOTOWORKS, INC.
            NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued)

NOTE F -- INCOME TAXES (Continued)

Due to the uncertainty of the recoverability of net deferred tax assets, a
valuation allowance has been recorded. The Company's net operating loss
carryforwards are subject to limitation under Internal Revenu Code (IRC) Section
382. On Decmeber 20, 2002, the Company completed a final study and analysis of
IRC Section 382 and its impact on limitations of the Company's net operating
loss carryforwards. As a result, the Company reduced the valuation allowance on
net deferred tax assets to $11,376,000.

In March 2002, Congress enacted changes in the tax law that allowed the Company
to carryback additional tax losses that resulted in a tax refund of $3,865,000.
Also as a result of this legislation, the Company is able to carryback up to
$1,808,000 of tax losses from the current year, which is recorded as income
taxes receivable.

The benefit (provision) for income taxes is as follows (in thousands):

                                                   2002      2001         2000
================================================================================
Benefit (provision) for income taxes:
      Current                                     $5,673     $   0      $   906
      Deferred                                        --         0       (1,334)
                                                  ------     -----      -------
                                                  $5,673     $   0      $  (428)
                                                  ======     =====      =======

A reconciliation of the federal statutory tax rates to the effective tax rates
is as follows:

                                                   2002      2001         2000
===============================================================================
Statutory tax rate                                 34.0%     34.0%        35.0%
Research and development tax credits                3.1        .7           .4
Other, net                                          (.1)       .2           .3
Valuation allowance                               234.2     (34.9)       (36.9)
                                                 ------     -----      -------
                                                  271.2%      0.0%        (1.2%)
                                                 ======     =====      =======

The net operating loss carry forward begins expiring in 2020. Tax credit carry
forwards of $207,000 relate to minimum tax credits and have no expiration date.
The remaining tax credit carry forwards are related to research and development
and charitable contributions. These credits and the net operating loss
carryforward expire as follows:

                                                        NOL         Tax Credit
                                                   Carryforward    Carryforwards
==============================================================================
                                                          (in thousands)
         Fiscal 2020                                 $ 30,389        $    111
         Fiscal 2021                                       --              75
         Fiscal 2022                                      851              49
         Thereafter                                        --              40
                                                     --------        --------
                                                     $ 31,240        $    275
                                                     ========        ========


                                       35
<PAGE>

                                PHOTOWORKS, INC.
             NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued)

NOTE G -- SHAREHOLDERS' EQUITY

Convertible Preferred Stock

In February 2000, the Company completed a private offering of 15,000 shares of
Series A convertible preferred stock for $14,936,000, net of offering costs of
$65,000. The shares of Series A preferred stock have a conversion price of $4.75
and include warrants to purchase common stock at an exercise price of $6.00 per
share.

The difference between the conversion price of $4.75 and the market value of the
common stock on the date of closing and the fair value of the warrants was
recorded as a $3,023,000 discount to paid in capital and was accreted over the
six-month holding period prior to eligible conversion of the Series A preferred
stock. The preferred stock accretion is a deduction of amounts available to
common shareholders in earnings per share calculations.

The shares of Series A preferred stock are convertible into a total of 3,157,895
shares of common stock and the warrants are exercisable to purchase a total of
789,474 shares of common stock which are reserved for issuance. The shares are
convertible at the holder's option at any time and may be redeemed by the
Company for $4.75 per share any time after February 14, 2003. Under the
anti-dilution provisions of the Series A rights agreement, upon conversion by
Subordinated Convertible Debenture holders to Series B Preferred Stock, the
conversion price of Common stock will be reduced to $4.25 per share and the
exercise price for warrants will be reduced to $5.37 per share.

The holders of the Series A Preferred Stock have a preference on the sale or
liquidation of the Company. The aggregate amount of the liquidation preference
is $15,000,000. The holders of Series A preferred stock also have preferential
rights to receive dividends at the rate of 6% but only when and if declared by
the Company's Board of Directors. The holders are entitled to the number of
votes equal to the number of shares of common stock into which the preferred
stock could be converted.

Warrants

In addition to the warrants issued to the Series A preferred shareholders, the
Company issued warrants in conjunction with its bank note payable as follows:

Issue date               Warrants issued     Exercise price   Expiration Date
--------------------------------------------------------------------------------
December 20, 2000             72,727             $1.00        December 20, 2010
July 23, 2001                 50,000             $ .66        July 23, 2011
October 11, 2001             150,000             $ .20        October 11, 2011

The Company amortized the fair value of the warrants as interest expense over
the applicable loan periods.

Dividends

The Company has never declared or paid cash dividends on its common stock and
does not anticipate paying any dividends in the foreseeable future. The Company
is restricted under the covenants of a bank agreement from declaring any
dividends on shares of its capital stock without the bank's prior consent. The
Company currently intends to retain earnings, if any, for developing its
business.


                                       36
<PAGE>

                                PHOTOWORKS, INC.
             NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued)

NOTE H -- EARNINGS (LOSS) PER COMMON SHARE

The following table sets forth the computation of earnings (loss) per common
share:

<TABLE>
<CAPTION>
                                                                 2002               2001                2000
=================================================================================================================
<S>                                                         <C>                <C>                 <C>
    Numerator for earnings (loss) per common share:
     Net income (loss)                                      $   3,581,000      $ (12,122,000)      $ (34,794,000)
    Preferred stock accretion                                          --                 --          (3,023,000)
                                                            -------------      -------------       -------------
      Net income (loss) attributable to common
       shareholders                                         $   3,581,000      $ (12,122,000)      $ (37,817,000)
                                                            =============      =============       =============

    Denominator for basic earnings (loss) per share:
         Weighted-average number
         of common shares                                      16,655,000         16,563,000          16,389,000

    Effect of dilutive securities:
       Stock options                                              388,000                 --                  --
     Warrants                                                          --                 --                  --
                                                            -------------      -------------       -------------

   Denominator for diluted earnings (loss)
        per common share                                       17,043,000         16,563,000          16,389,000
                                                            =============      =============       =============

Basic earnings (loss) per share                             $         .22      $        (.73)      $       (2.12)
                                                            =============      =============       =============
Diluted earnings (loss) per share                           $         .21      $        (.73)      $       (2.12)
                                                            =============      =============       =============

Basic earnings (loss) per common share                      $         .22      $        (.73)      $       (2.31)
                                                            =============      =============       =============
Diluted earnings (loss) per common share                    $         .21      $        (.73)      $       (2.31)
                                                            =============      =============       =============
</TABLE>

Excluded from the computation of diluted earnings per common share for the year
ended September 28, 2002 are options to acquire 1,443,176 shares of common stock
with a weighted average exercise price of $3.73, common shares of 3,157,895
related to convertible preferred stock with an exercise price of $4.75, 789,474
common stock warrants with an exercise prices of $6.00, 72, 727 common stock
warrants with an exercise price of $1.00, 50,000 common stock warrants with an
exercise price of $.66 and 150,000 common stock warrants with an exercise price
of $.20.

Excluded from the computation of diluted loss per common share for the year
ended September 29, 2001 are options to acquire 1,712,162 shares of common stock
with a weighted average exercise price of $4.37, common shares of 3,157,895
related to convertible preferred stock with an exercise price of $4.75, 789,474
common stock warrants with an exercise price of $6.00, 72,727 common stock
warrants with an exercise price of $1.00, and 50,000 common stock warrants with
an exercise price of $.66.

Excluded from the computation of diluted loss per common share for the year
ended September 30, 2000 are options to acquire 2,026,682 shares of common stock
with a weighted average exercise price of $5.05, common

shares of 3,157,895 related to convertible preferred stock with an exercise
price of $4.75, and 789,474 common stock warrants with an exercise price of
$6.00.

The impact of these options, convertible preferred shares and warrants were
excluded from the computation of diluted earnings (loss) per common share in
fiscal 2001 and 2000 because their effects would be antidilutive.


                                       37
<PAGE>

                                PHOTOWORKS, INC.
             NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued)

NOTE I -- STOCK-BASED COMPENSATION

Pursuant to 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.

On October 20, 1999 the Board of Directors adopted the PhotoWorks, Inc. 1999
Employee Stock Option Plan. Employees, consultants, independent contractors,
advisors and agents are eligible to participate in this plan. Officers and
directors are not eligible to participate. Pursuant to this plan, options may be
granted to purchase up to 800,000 shares of Common Stock at prices equal to the
fair market value of the shares at the time the options are granted.

In February 2000, shareholders approved the 1999 Stock Incentive Compensation
Plan. Officers, directors, employees, consultants, independent contractors,
advisors and agents are eligible to participate in this plan. Pursuant to this
plan, options may be granted to purchase up to 800,000 shares of Common Stock at
prices equal to the fair market value of the shares at the time the options are
granted. In February 2001, shareholders approved an amendment to increase the
number of shares reserved for issuance to 1,300,000.

Shares of Common Stock reserved for issuance under stock option plans totaled
3,186,840 at September 28, 2002, of which 451,527 shares were available for
options to be granted in the future. Options generally vest over three to 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 2000,
2001, and 2002.

<TABLE>
<CAPTION>
                                        Number             Price Per       Weighted Average
                                       of Shares             Share          Exercise Price
===========================================================================================
<S>                                    <C>               <C>               <C>
Balance at September 25, 1999          1,063,539         $0.67 - $13.06        $5.69
    Granted during 2000                1,388,900         $2.78 - $12.00        $4.41
    Canceled during 2000                (303,495)        $3.06 - $12.00        $5.36
    Exercised during 2000               (122,262)        $0.67 - $ 6.30        $2.61
                                      ----------

Balance at September 30, 2000          2,026,682         $1.00 - $13.06        $5.14
    Granted during 2001                1,370,950         $ .16 - $ 2.38        $ .78
    Canceled during 2001              (1,685,470)        $ .66 - $12.00        $3.67
    Exercised during 2001                     --         $ .00 - $  .00        $ .00
                                     -----------

Balance at September 29, 2001          1,712,162         $ .16 - $13.06        $4.37
    Granted during 2002                1,468,500         $ .12 - $  .26        $ .12
    Canceled during 2002                (445,349)        $ .12 - $13.06        $4.75
    Exercised during 2002                     --         $ .00 - $  .00        $ .00
                                     -----------

Balance at September 28, 2002          2,735,313         $ .12 - $12.00        $2.03
</TABLE>

Options considered fully vested as of September 28, 2002, September 29, 2001,
and September 30, 2000, were 970,749, 912,767, and 633,395, respectively, at
weighted average exercise prices of $4.55, $4.88, and $6.38, respectively. The
following schedule summarizes the weighted-average remaining contractual life
and weighted-average exercise price of options outstanding and options
exercisable as of September 28, 2002.


                                       38
<PAGE>

                                PHOTOWORKS, INC.
             NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued)

NOTE I -- STOCK-BASED COMPENSATION (Continued)

<TABLE>
<CAPTION>
                                       Options Outstanding                        Options Exercisable
                         ---------------------------------------------        ---------------------------
                                            Remaining        Wtd. Avg.                          Wtd. Avg.
Range of                   Options         Contractual       Exercise           Options         Exercise
Exercise Prices          Outstanding       Life (Years)        Price          Exercisable         Price
---------------          -----------       ------------        -----          -----------         -----
<C>                      <C>               <C>               <C>              <C>               <C>
$  0.00 - $ 1.46          1,696,986             4.0           $   .23           148,880          $   .75
$  1.47 - $ 2.93             75,000             2.2           $  2.64            74,709          $  2.64
$  2.94 - $ 4.40            527,871             1.8           $  3.33           388,182          $  3.34
$  4.41 - $ 5.86            195,700             2.6           $  4.72           129,837          $  4.68
$  5.87 - $ 7.33             48,706             2.4           $  6.04            38,091          $  6.04
$  7.34 - $ 8.80             34,150             2.4           $  7.51            34,150          $  7.51
$  8.81 - $10.26             56,900             0.4           $  9.07            56,900          $  9.07
$ 10.27 - $11.73                 --             0.0           $   .00                --          $   .00
$ 11.74 - $13.20            100,000             2.8           $ 12.00           100,000          $ 12.00
                          ---------                                             -------
                          2,735,313             3.3           $  2.03           970,749          $  4.55
</TABLE>

The per share weighted average fair value of stock options granted during fiscal
years 2002, 2001, and 2000 was $.10, $.77 and $2.81 respectively.

Pro forma information regarding net income (loss) and diluted earnings (loss)
per share has been determined as if the Company had accounted for its employee
stock options under the fair value method of SFAS No. 123. 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:

                             Fiscal 2002        Fiscal 2001        Fiscal 2000
================================================================================
Risk free interest rate         2.68%              3.81%              5.85%
Expected volatility           134.95%            314.64%            127.64%
Expected option life            3.00 years         2.70 years         3.22 years
Dividend yield                  0.00%              0.00%              0.00%

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 28,  September 29,  September 30,
                                                                     2002           2001           2000
                                                                 -------------------------------------------
                                                                    (in thousands, except per share data)
<S>                                                              <C>            <C>            <C>
Net income (loss):
    As reported ..............................................      $  3,581      $(12,122)      $(34,794)
    Pro forma ................................................      $  3,037      $(12,742)      $(36,798)
Net income (loss) attributable to common shareholders:
    As reported ..............................................      $  3,581      $(12,122)      $(37,817)
    Pro forma ................................................      $  3,037      $(12,742)      $(39,821)
Diluted earnings (loss) per share:
     As reported .............................................      $    .21      $   (.73)      $  (2.12)
     Pro forma ...............................................      $    .18      $   (.77)      $  (2.25)
Earnings (loss) per share attributable to common shareholders:
    As reported ..............................................      $    .21      $   (.73)      $  (2.31)
    Pro forma ................................................      $    .18      $   (.77)      $  (2.43)
</TABLE>


                                       39
<PAGE>

                                PHOTOWORKS, INC.
             NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued)

NOTE I -- STOCK-BASED COMPENSATION (Continued)

The pro forma effects on net income for fiscal years 2002, 2001, and 2000 are
not indicative of pro forma effects in future years because additional grants in
future years are anticipated.

The Company has a total of 48,750 stock options subject to variable accounting,
which are measured quarterly against the Company's July 3, 2000 stock price of
$3.06. The difference, to the extent that it exceeds $3.06, will be recognized
as non-cash compensation expense for the period then ended. No compensation
expense was required to be recorded during fiscal 2002, 2001 or 2000.

Employee Stock Purchase Plan

The Company had an Employee Stock Purchase Plan under which substantially all
employees had the option to purchase a total of 506,250 shares of Common Stock.
Under the Plan, eligible employees could purchase shares of the Company's Common
Stock at six-month intervals at 85% of its fair market value on the first or
last day of the six-month offering period, whichever is lower. Employees could
elect to contribute up to 10% of their gross compensation during the purchase
period. As of September 30, 2001, substantially all shares allocated to the plan
had been issued and the Plan was discontinued effective October 1, 2001. During
fiscal 2001 and 2000, shares totaling 63,812 and 79,937 were issued under the
Plan at an average price of $.31 and $2.78 per share, respectively.

NOTE J -- 401(K) RETIREMENT PLAN

The Company maintains a 401(k) Plan for substantially all employees. Prior to
fiscal 2001, the Company's contributions were based on matching a percentage of
up to 2% of voluntary employee contributions, plus a discretionary profit
sharing contribution determined by the Board of Directors. Beginning in fiscal
year 2001, the Company increased the matching contribution to 4% of voluntary
contributions. No profit sharing contributions were made for fiscal 2002, 2001
or 2000. The Company's contributions totaled $269,000, $401,000, and $193,000
for fiscal years 2002, 2001, and 2000, respectively.

NOTE K -- CONTINGENCIES

Fuji Photo Film Co., Ltd - The Company is a defendant in a claim filed by Fuji
Photo Film Co., Ltd. with the International Trade Commission. Fuji alleged that
a number of companies, including the Company's OptiColor subsidiary, violated
patents held by Fuji on single-use cameras by bringing recycled single-use
cameras into the United States for resale. The ITC Commissioners issued a final
order in June 1999 prohibiting the Company and its subsidiaries from importing
and selling imported recycled single-use cameras. The Company appealed the ITC
Commissioners' order to the Federal Circuit Court of Appeals and that Court
issued a decision in November 2001, upholding the order against the Company. In
July 2001, the ITC commenced enforcement and advisory opinion proceedings
against the Company and several other respondents, based on a new complaint
filed by Fuji with the ITC in late June 2001. This complaint alleges that the
Company is infringing certain claims of six of Fuji's patents on single use
cameras, through the importation and sales of certain newly manufactured
reloadable cameras. The complaints requests that the ITC determine that through
these imports and sales we are violating the ITC's previous order. It also
requests that the ITC bring an action in an appropriate U.S. District Court to
seek an injunction and civil penalties for each day in which an importation or
sale violating the order occurs in an amount up to the maximum provided by the
governing statute. In May 2002, an Administrative Law Judge of the International
Trade Commission issued an initial determination that the Company's reloadable
camera infringes three patents owned by Fuji Photo Film Co., Ltd for single-use
cameras, and also recommended that the Commission assess a penalty of $1.6
million for such infringement.


                                       40
<PAGE>

                                PHOTOWORKS, INC.
             NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued)

NOTE K -- CONTINGENCIES (Continued)

Since that time, the Commission has upheld the infringement determination and is
currently determining what, if any, penalty to assess. The Company expects the
Commission's decision regarding any penalty assessment in January 2003. Any
action by the Commission is subject to further appeal to the Federal Circuit
Court of Appeals. The Company believes it has strong arguments regarding the
infringement determination and any penalty recommendation and intends to pursue
such challenges to the extent it deems appropriate. As such, no accrual has been
made at this time in the Company's fiscal 2002 financial statements for this
matter. If the penalty amount is upheld, it would have a significantly negative
impact on the financial condition, results of operations, and liquidity of the
Company.

Washington Department of Revenue - The Company has an outstanding tax issue with
the Washington State Department of Revenue related to use taxes owed as a result
of advertising materials (including order forms) mailed to out-of-state
customers. The Company is seeking resolution of the issues involved, primarily
related to future periods, as this is an ongoing issue for the Company for tax
reporting periods after January 1, 1998. That is, it is reasonable that a future
routine audit by the Department of Revenue will result in a further use tax
assessment unless the issue can be resolved in a manner favorable to the Company
prior to such audit assessment. The Company believes its accrual of
approximately $150,000 is adequate for possible assessments related to the
outstanding issue.

Massachusetts Institute of Technology - On April 25, 2002, a Complaint was filed
against the Company and over 200 other defendants by The Massachusetts Institute
of Technology and Electronics for Imaging, Inc. claiming infringement on a
patent issued in 1985 for a Color Reproduction System. The Complaint requests
injunctive relief, damages adequate to compensate them for Defendants'
infringement of the 4,500,919 patent, their costs and prejudgment interest on
their damages and reasonable attorney fees.

The suit is at an early stage and management of the Company intends to contest
the suit vigorously as to the complaint's substantive allegations. Although the
Company believes the claim to be without merit, it is not possible to predict an
outcome at this time or the potential affect on its business or financial
condition.

Sharon Drinkard, et al vs. PhotoWorks, Inc. - A complaint was filed in March
2000, alleging that the Company had engaged in unfair and deceptive practices by
allegedly misrepresenting that film received from the Company, must be processed
only by the Company and that replacement film is "free". Without admitting
wrongdoing or liability, and for the sole purpose of compromising disputed
claims and avoiding costs and risks of further litigation, PhotoWorks and the
plaintiffs, who represented the Class, agreed to a settlement which was approved
by the Court in July 2001. In fiscal 2001, the Company accrued a total of
$675,000 related to the future distribution of 900,000 rolls of film pursuant to
the terms of the final settlement. As of September 28, 2002, the Company had
distributed approximately $675,000 of film fully discharging its liability under
the settlement terms.

Although the Company believes it has a reasonable position relative to the
claims listed above, it is not possible to predict an outcome at this time or
the potential affect on its business or financial condition. The Company's
defense of these claims will cause it to incur additional legal expenses.

The Company is also involved in various routine legal proceedings in the
ordinary course of its business.


                                       41
<PAGE>

                                PHOTOWORKS, INC.
             NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued)

NOTE L -- SELECTED QUARTERLY FINANCIAL DATA (Unaudited)

The Company's fiscal year consists of four 13-week quarters. The following table
sets forth summary financial data for the Company by quarter for fiscal years
2002 and 2001 (in thousands, except per share data).

                                                     Quarters
                                    --------------------------------------------
                                      First     Second       Third      Fourth
--------------------------------------------------------------------------------
Fiscal 2002
Net revenue                         $ 11,063    $ 9,269    $ 10,514    $ 11,247
Gross profit                           2,573      1,834       2,857       3,210
Pretax loss                             (167)      (917)       (925)        (83)
Tax benefit                               --      3,758         484       1,431
Net income (loss)                       (167)     2,841        (441)      1,348
Earnings (loss) per share               (.01)       .17        (.03)        .08

                                                     Quarters
                                    --------------------------------------------
                                      First     Second       Third      Fourth
--------------------------------------------------------------------------------
Fiscal 2001
Net revenue                         $ 14,985    $12,690    $ 14,365    $ 14,650
Gross profit                           2,687      1,743       3,439       4,627
Net income (loss)                     (3,033)    (6,896)     (3,046)        853
Earnings (loss) per share               (.18)      (.42)       (.18)        .05

The significant tax benefits recognized in the second, third and fourth quarters
of fiscal 2002 result from benefits of loss carrybacks under the "Job Creation
and Workers Assistance Act" and the utilization of net operating loss
carryforwards to the extent they are no longer restricted under IRC Section 382.

The sum of quarterly loss per share will not necessarily equal the loss per
share reported for the entire year since the weighted average shares outstanding
used in the loss per share computation changes throughout the year.

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

      None.


                                       42
<PAGE>

                                    PART III

ITEM 10 -- DIRECTORS AND EXECUTIVE OFFICERS OF THE REGISTRANT

      See "Directors and Executive Officers of the Registrant" under Item 1 -
Part I 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 4, 2003, 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 28, 2002.

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 4, 2003, 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". Such Proxy Statement will be filed within 120
days of the Company's last fiscal year-end, September 28, 2002.

                                     PART IV

ITEM 14 -- CONTROLS AND PROCEDURES

      See "Management's Discussion and Analysis of Financial Condition and
Results of Operation - Controls and Procedures."

ITEM 15 -- EXHIBITS, FINANCIAL STATEMENT SCHEDULES, AND REPORTS ON FORM 8-K

a. Index to Consolidated Financial Statements and Consolidated Financial
Statement Schedules

 (1)  Consolidated Financial Statements                                   Page
                                                                          ----

      Report of Ernst & Young LLP, Independent Auditors                    26

      Consolidated Balance Sheets as of September 28, 2002 and
      September 29, 2001                                                   27

      Consolidated Statements of Operations for the years ended
      September 28, 2002, September 29, 2001, and September 30, 2000       28

      Consolidated Statements of Shareholders' Equity for the years
      ended September 28, 2002, September 29, 2001, and
      September 30, 2000                                                   29

      Consolidated  Statements of Cash Flows for the years ended
      September 28, 2002, September 29, 2001, and September 30, 2000       30

      Notes to Consolidated Financial Statements                          31-42


                                       43
<PAGE>

      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.

 (2)  Schedule                                                        Page
                                                                      ----

      II - Valuation and Qualifying Accounts                           47

      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

Exhibit
Number      Exhibit Description
------      -------------------

3.1         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.)

3.2         Articles of Amendment to Articles of Incorporation of PhotoWorks,
            Inc. dated February 9, 2000. (Incorporated by reference to Exhibit
            3.1 filed with the Company's Form 8-K filed February 16, 2000.)

3.3         Articles of Amendment to Articles of Incorporation of PhotoWorks,
            Inc. dated April 24, 2001. (Incorporated by reference to Exhibit 3.1
            filed with the Company's 8-K filed April 27, 2001.)

3.4         Articles of Correction to Articles of Incorporation of PhotoWorks,
            Inc dated April 25, 2001. (Incorporated by reference to Exhibit 3.2
            filed with the Company's 8-K filed April 27, 2001.)

3.5         Form of Certificate of Designation Preferences and Rights of Series
            RP Preferred Stock (Incorporated by reference to Exhibit 3.4 to the
            Company's Annual Report on Form 10-K for the year ended September
            25, 1999).

4.1         Rights Agreement dated December 16, 1999 between the Registrant and
            Chase Mellon Shareholder Services L.L.C., as Rights Agent
            (Incorporated by reference to Exhibit 4.1 to the current report on
            Form 8-K filed with the Commission on December 17, 1999.)

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.)


                                       44
<PAGE>

10.3        Second Amendment to Facility Lease Agreement dated November 2, 1998,
            with Gilbert Scherer and Marlyn Friedlander, Lessors. (Incorporated
            by reference to Exhibit 10.3 filed with the Company's Annual Report
            on Form 10-K for the year ended September 26, 1998.)

10.4        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.)

10.5        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.)

10.6        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.)

10.7        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.)

10.8        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.)

10.9        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.)

10.10       1999 Employee Stock Option Plan dated October 20, 1999.
            (Incorporated by reference to Exhibit 10.10 filed with the Company's
            Annual Report on Form 10-K for the year ended September 25, 1999.)

10.11       PhotoWorks, Inc. 1999 Stock Incentive Compensation Plan
            (Incorporated by reference to Form S-8 Filing dated May 24, 2000,
            File # 333-37698.)

10.12       PhotoWorks, Inc. 1999 Stock Incentive Compensation Plan as amended
            and PhotoWorks, Inc. Individual Nonqualified Option Agreements.
            (Incorporated by reference to the Form S-8 filing dated May 16,
            2001, File #333-61048.)

10.13       Loan and Security Agreement, Form of Warrant with Imperial Bank.
            (Incorporated by reference to Exhibit 10.2 filed with the Company's
            Quarterly Report on Form 10-Q for the quarter ended December 30,
            2000.)

10.14       First Amendment to Loan and Security Agreement, Form of Warrant with
            Comerica Bank (formerly Imperial Bank) dated July 23, 2001.
            (Incorporated by reference to Exhibit 10.18 filed with the Company's
            Annual Report on Form 10-K for the year ended September 29. 2001.)

10.15       Second Amendment to Loan and Security Agreement, Form of Warrant
            with Comerica Bank dated October 11, 2001. (Incorporated by
            reference to Exhibit 10.19 filed with the Company's Annual Report on
            Form 10-K for the year ended September 29, 2001.)

10.16       Loan & Security Agreement dated January 3, 2002 with Comerica Bank,
            Inc. (Incorporated by reference to Exhibit 10.1 filed with the
            Company's Quarterly Report on Form 10-Q for the quarter ended
            December 29, 2001.)

10.17       Fourth Amendment to Loan and Security Agreement with Comerica Bank,
            Inc. (Incorporated by reference to Exhibit 10.1 filed with the
            Company Quarterly Report on Form 10-Q for the quarter ended June 29,
            2002.)


                                       45
<PAGE>

10.18       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.)

10.19       Second amendment to lease agreement dated June 14, 2000 between
            Smith Cove Partnership and the Company. (Incorporated by reference
            to Exhibit 10.23 filed with Company's Annual Report on Form 10-K for
            the year ended September 30, 2000.)

10.20       Lease agreement dated February 3, 2000 between Interbay One, LLC.
            and the Company. (Incorporated by reference to Exhibit 10.2 filed
            with the Company's Quarterly Report on Form 10-Q for the quarter
            ended March 25, 2000.)

10.21*      Eastman Kodak Supply Agreement effective November 1, 2000.
            (Incorporated by reference to Exhibit 10.1 filed with the Company's
            Quarterly Report on Form 10-Q for the quarter ended December 30,
            2000.)

10.22       Employment Agreement with Gary Christophersen dated August 16, 2000.
            (Incorporated by reference to Exhibit 10.35 filed with the Company's
            Annual Report on Form 10-K for the year ended September 30, 2000.)

10.23       Change in Control Agreement with Michael F. Lass and Loran Cashmore
            Bond dated April 25, 2001. (Incorporated by reference to Exhibit
            10.33 filed with the Company's Annual Report on Form 10-K for the
            year ended September 29, 2001.)

21**        PhotoWorks, Inc. Subsidiaries

23**        Consent of Ernst & Young LLP, Independent Auditors

99**        Certification pursuant to 18 U.S.C. Section 1350 as adopted pursuant
            to Section 906 of the Sarbanes-Oxley Act of 2002

   *  Exhibit for which confidential treatment has been granted.
  **  Filed herewith.


                                       46
<PAGE>

                                PHOTOWORKS, INC.

                                   SCHEDULE II

                        VALUATION AND QUALIFYING ACCOUNTS
                                 (in thousands)

<TABLE>
<CAPTION>
                                                             Additions
                                                    --------------------------
                                                      Charged
                                        Balance at   (Credited)     Charged to                 Balance
                                        Beginning   to 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, 2000

Allowance for doubtful accounts           $123           $ 10          $  0         $ 54         $ 79

FOR THE YEAR ENDED
SEPTEMBER 29, 2001

Allowance for doubtful accounts           $ 79           $  0          $  0         $ 34         $ 45

FOR THE YEAR ENDED
SEPTEMBER 28, 2002

Allowance for doubtful accounts           $ 45           $(12)         $  0         $  5         $ 28
</TABLE>


                                       47
<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.

                                                    PHOTOWORKS, INC.
                                                      (REGISTRANT)

DATED:  December 20, 2002                    By: /s/ Gary R. Christophersen
                                                 --------------------------
                                                 Gary R. Christophersen
                                          Chairman 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.

NAME                                TITLE                      DATE

By: /s/ Gary R. Christophersen      Chairman and               December 20, 2002
   ------------------------------   Chief Executive Officer
    Gary R. Christophersen
    Director
    (Principal Executive Officer)

By: /s/ Ross K. Chapin              Director                   December 20, 2002
    -----------------------------
    Ross K. Chapin

By: /s/ Paul B. Goodrich            Director                   December 20, 2002
    -----------------------------
    Paul B. Goodrich

By: /s/ Matthew A. Kursh            Director                   December 20, 2002
    -----------------------------
    Matthew A. Kursh

By: /s/ Douglas A. Swerland         Director                   December 20, 2002
    -----------------------------
    Douglas A. Swerland

By: /s/ Douglas M. Rowan            Director                   December 20, 2002
    -----------------------------
    Douglas M. Rowan

By: /s/ Loran Cashmore Bond         Chief Accounting Officer   December 20, 2002
    -----------------------------
    Loran Cashmore Bond


                                       48
<PAGE>

                                 CERTIFICATIONS

I, Gary R. Christophersen, certify that:

      1)    I have reviewed this annual report on Form 10-K of PhotoWorks, Inc.

      2)    Based on my knowledge, this annual report does not contain any
            untrue statement of a material fact or omit to state a material fact
            necessary to make the statements made, in light of the circumstances
            under which such statements were made, not misleading with respect
            to the period covered by this annual report;

      3)    Based on my knowledge, the financial statements, and other financial
            information included in this annual report, fairly present in all
            material respects the financial condition, results of operations and
            cash flows of the registrant as of, and for, the periods presented
            in this annual report;

      4)    The registrant's other certifying officer and I are responsible for
            establishing and maintaining disclosure controls and procedures (as
            defined in Exchange Act Rules 13a-14 and 15d-14) for the registrant
            and have:

                  a)    designed such disclosure controls and procedures to
                        ensure that material information relating to the
                        registrant, including its consolidated subsidiaries, is
                        made known to us by others within those entities,
                        particularly during the period in which this annual
                        report is being prepared;

                  b)    evaluated the effectiveness of the registrant's
                        disclosure controls and procedures as of a date within
                        90 days prior to the filing date of this annual report
                        (the "Evaluation Date"); and

                  c)    presented in this annual report our conclusions about
                        the effectiveness of the disclosure controls and
                        procedures based on our evaluation as of the Evaluation
                        Date;

      5)    The registrant's other certifying officer and I have disclosed,
            based on our most recent evaluation, to the registrant's auditors
            and the audit committee of registrant's board of directors (or
            persons performing the equivalent functions):

                  a)    all significant deficiencies in the design or operation
                        of internal controls which could adversely affect the
                        registrant's ability to record, process, summarize and
                        report financial data and have identified for the
                        registrant's auditors any material weaknesses in
                        internal controls; and

                  b)    any fraud, whether or not material, that involves
                        management or other employees who have a significant
                        role in the registrant's internal controls; and

      6)    The registrant's other certifying officer and I have indicated in
            this annual report whether there were significant changes in
            internal controls or in other factors that could significantly
            affect internal controls subsequent to the date of our most recent
            evaluation, including any corrective actions with regard to
            significant deficiencies and material weaknesses.

                  /s/ GARY R. CHRISTOPERSEN
            ------------------------------------
                  Gary R. Christophersen
                  Chief Executive Officer and President


                                       49
<PAGE>

                                 CERTIFICATIONS

I, Loran Cashmore Bond, certify that:

      1)    I have reviewed this annual report on Form 10-K of PhotoWorks, Inc.

      2)    Based on my knowledge, this annual report does not contain any
            untrue statement of a material fact or omit to state a material fact
            necessary to make the statements made, in light of the circumstances
            under which such statements were made, not misleading with respect
            to the period covered by this annual report;

      3)    Based on my knowledge, the financial statements, and other financial
            information included in this annual report, fairly present in all
            material respects the financial condition, results of operations and
            cash flows of the registrant as of, and for, the periods presented
            in this annual report;

      4)    The registrant's other certifying officer and I are responsible for
            establishing and maintaining disclosure controls and procedures (as
            defined in Exchange Act Rules 13a-14 and 15d-14) for the registrant
            and have:

                  a)    designed such disclosure controls and procedures to
                        ensure that material information relating to the
                        registrant, including its consolidated subsidiaries, is
                        made known to us by others within those entities,
                        particularly during the period in which this annual
                        report is being prepared;

                  b)    evaluated the effectiveness of the registrant's
                        disclosure controls and procedures as of a date within
                        90 days prior to the filing date of this annual report
                        (the "Evaluation Date"); and

                  c)    presented in this annual report our conclusions about
                        the effectiveness of the disclosure controls and
                        procedures based on our evaluation as of the Evaluation
                        Date;

      5)    The registrant's other certifying officer and I have disclosed,
            based on our most recent evaluation, to the registrant's auditors
            and the audit committee of registrant's board of directors (or
            persons performing the equivalent functions):

                  a)    all significant deficiencies in the design or operation
                        of internal controls which could adversely affect the
                        registrant's ability to record, process, summarize and
                        report financial data and have identified for the
                        registrant's auditors any material weaknesses in
                        internal controls; and

                  b)    any fraud, whether or not material, that involves
                        management or other employees who have a significant
                        role in the registrant's internal controls; and

      6)    The registrant's other certifying officer and I have indicated in
            this annual report whether there were significant changes in
            internal controls or in other factors that could significantly
            affect internal controls subsequent to the date of our most recent
            evaluation, including any corrective actions with regard to
            significant deficiencies and material weaknesses.

                  /s/ LORAN CASHMORE BOND
            ------------------------------
                  Loran Cashmore Bond
                  Acting Chief Financial Officer


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<PAGE>

                                  EXHIBIT INDEX

                           Annual Report on Form 10-K
                      For The Year Ended September 28, 2002

Exhibit
Number      Exhibit Description
------      -------------------

3.1         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.)

3.2         Articles of Amendment to Articles of Incorporation of PhotoWorks,
            Inc. dated February 9, 2000. (Incorporated by reference to Exhibit
            3.1 filed with the Company's Form 8-K filed February 16, 2000.)

3.3         Articles of Amendment to Articles of Incorporation of PhotoWorks,
            Inc. dated April 24, 2001. (Incorporated by reference to Exhibit 3.1
            filed with the Company's 8-K filed April 27, 2001.)

3.4         Articles of Correction to Articles of Incorporation of PhotoWorks,
            Inc dated April 25, 2001. (Incorporated by reference to Exhibit 3.2
            filed with the Company's 8-K filed April 27, 2001.)

3.5         Form of Certificate of Designation Preferences and Rights of Series
            RP Preferred Stock (Incorporated by reference to Exhibit 3.4 to the
            Company's Annual Report on Form 10-K for the year ended September
            25, 1999).

4.1         Rights Agreement dated December 16, 1999 between the Registrant and
            Chase Mellon Shareholder Services L.L.C., as Rights Agent
            (Incorporated by reference to Exhibit 4.1 to the current report on
            Form 8-K filed with the Commission on December 17, 1999.)

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        Second Amendment to Facility Lease Agreement dated November 2, 1998,
            with Gilbert Scherer and Marlyn Friedlander, Lessors. (Incorporated
            by reference to Exhibit 10.3 filed with the Company's Annual Report
            on Form 10-K for the year ended September 26, 1998.)

10.4        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.)

10.5        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.)

10.6        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.)


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<PAGE>

10.7        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.)

10.8        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.)

10.9        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.)

10.10       1999 Employee Stock Option Plan dated October 20, 1999.
            (Incorporated by reference to Exhibit 10.10 filed with the Company's
            Annual Report on Form 10-K for the year ended September 25, 1999.)

10.11       PhotoWorks, Inc. 1999 Stock Incentive Compensation Plan
            (Incorporated by reference to Form S-8 Filing dated May 24, 2000,
            File # 333-37698.)

10.12       PhotoWorks, Inc. 1999 Stock Incentive Compensation Plan as amended
            and PhotoWorks, Inc. Individual Nonqualified Option Agreements.
            (Incorporated by reference to the Form S-8 filing dated May 16,
            2001, File #333-61048.)

10.13       Loan and Security Agreement, Form of Warrant with Imperial Bank.
            (Incorporated by reference to Exhibit 10.2 filed with the Company's
            Quarterly Report on Form 10-Q for the quarter ended December 30,
            2000.)

10.14       First Amendment to Loan and Security Agreement, Form of Warrant with
            Comerica Bank (formerly Imperial Bank) dated July 23, 2001.
            (Incorporated by reference to Exhibit 10.18 filed with the Company's
            Annual Report on Form 10-K for the year ended September 29. 2001.)

10.15       Second Amendment to Loan and Security Agreement, Form of Warrant
            with Comerica Bank dated October 11, 2001. (Incorporated by
            reference to Exhibit 10.19 filed with the Company's Annual Report on
            Form 10-K for the year ended September 29, 2001.)

10.16       Loan & Security Agreement dated January 3, 2002 with Comerica Bank,
            Inc. (Incorporated by reference to Exhibit 10.1 filed with the
            Company's Quarterly Report on Form 10-Q for the quarter ended
            December 29, 2001.)

10.17       Fourth Amendment to Loan and Security Agreement with Comerica Bank,
            Inc. (Incorporated by reference to Exhibit 10.1 filed with the
            Company Quarterly Report on Form 10-Q for the quarter ended June 29,
            2002.)

10.18       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.)

10.19       Second amendment to lease agreement dated June 14, 2000 between
            Smith Cove Partnership and the Company. (Incorporated by reference
            to Exhibit 10.23 filed with Company's Annual Report on Form 10-K for
            the year ended September 30, 2000.)

10.20       Lease agreement dated February 3, 2000 between Interbay One, LLC.
            and the Company. (Incorporated by reference to Exhibit 10.2 filed
            with the Company's Quarterly Report on Form 10-Q for the quarter
            ended March 25, 2000.)


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<PAGE>

10.21*      Eastman Kodak Supply Agreement effective November 1, 2000.
            (Incorporated by reference to Exhibit 10.1 filed with the Company's
            Quarterly Report on Form 10-Q for the quarter ended December 30,
            2000.)

10.22       Employment Agreement with Gary Christophersen dated August 16, 2000.
            (Incorporated by reference to Exhibit 10.35 filed with the Company's
            Annual Report on Form 10-K for the year ended September 30, 2000.)

10.23       Change in Control Agreement with Michael F. Lass and Loran Cashmore
            Bond dated April 25, 2001. (Incorporated by reference to Exhibit
            10.33 filed with the Company's Annual Report on Form 10-K for the
            year ended September 29, 2001.)

21**        PhotoWorks, Inc. Subsidiaries

23**        Consent of Ernst & Young LLP, Independent Auditors

99**        Certification pursuant to 18 U.S.C. Section 1350 as adopted pursuant
            to Section 906 of the Sarbanes-Oxley Act of 2002

   *  Exhibit for which confidential treatment has been granted.
  **  Filed herewith.


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