UNITED STATES
SECURITIES AND EXCHANGE COMMISSIONWASHINGTON,
D.C. 20549

FORM 10-K

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

FOR THE FISCAL YEAR ENDED JANUARY 31, 2009
ORTRANSITION
REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT
FOR THE TRANSITION PERIOD FROM  TO

COMMISSION FILE NUMBER: 0-14818

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|------------------------------------------------------
|TRANS
 WORLD ENTERTAINMENT CORPORATION                
|                                                      
|(Exact name of registrant as specified in its charter)

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|-------------------------------------------------------------- |  | ---------------------------------------
|New York                                                       |  | 14-1541629                             
|                                                               |  |                                        
|(State or other jurisdiction of incorporation or organization) |  | (I.R.S. Employer Identification Number)

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|38 Corporate Circle                                             
|Albany, New York 12203                                          
|                                                                
|(Address of principal executive offices, including zip code)    
|                                                                
|(518) 452-1242                                                  
|                                                                
|(Registrants telephone number, including area code)            
|                                                                
|Securities registered pursuant to Section 12(b) of the Act: None

Securities registered pursuant to Section
12(g) of the Act: Common Stock, $0.01 par value

Indicate
by check mark if the registrant is a well-known seasoned issuer, as defined in
the Rule 405 of the Securities Act. Yes o No x

Indicate by
check mark if the registrant is not required to file reports pursuant to
Section 13 or Section 15(d) of the Act. Yes o No x

Indicate by a
check mark whether the Registrant (1) has filed all reports required to be
filed by Sections 13 or 15(d) of the Securities Exchange Act of 1934 during the
preceding 12 months (or for shorter period that the Registrant was required to
file such reports), and (2) has been subject to such filing requirements for
the past 90 days.          Yes
x
No o

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 the Registrants Knowledge, in definitive proxy or information statements
incorporated by reference in Part III of this Form 10-K or an amendment to this
Form 10-K. x

Indicate by
checkmark whether the registrant is a large accelerated filer, an accelerated
filer or non-accelerated filer (as defined in Rule 12b-2 of the Act).

Large
accelerated filer o          Accelerated
filer x          Non-accelerated
filer o          Small
reporting company o

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

As of August
2, 2008, 31,269,111 shares of the Registrants Common Stock, excluding
25,102,990 shares of stock held in Treasury, were issued and outstanding. The
aggregate market value of the voting stock held by non-affiliates of the
Registrant, based upon the closing sale price of the Registrants Common Stock
on August 2, 2008 as reported on the National Market tier of The NASDAQ Stock
Market, Inc. was $55,161,961. Shares of Common Stock held by the Companys
controlling shareholder, who controlled approximately 41.4% of the outstanding
Common Stock, have been excluded for purposes of this computation. Because of
such shareholders control, shares owned by other officers, directors and 5%
shareholders have not been excluded from the computation. As of March 28, 2009,
there were 31,311,050 shares of Common Stock Issued and Outstanding.

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|Documents of Which Portions Are Incorporated by Reference                                                                                      |  | Parts of the Form 10-K into Which Portion of Documents are
Incorporated
|                                                                                                                                               |  |                                                                        
|Proxy Statement for Trans World Entertainment Corporations June 17,
 2009 Annual Meeting of Shareholders to be filed on or about May 20, 2009 |  | III                                                                    
|                                                                                                                                               |  |                                                                        

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PART I

Cautionary Statement for Purposes of the
Safe Harbor Provisions of the Private Securities Litigation Reform Act of
1995

This document
includes forward-looking statements within the meaning of the Private
Securities Litigation Reform Act of 1995. These statements relate to analyses
and other information that are based on forecasts of future results and
estimates of amounts not yet determinable. These statements also relate to the
Companys future prospects, developments and business strategies. The
statements contained in this document that are not statements of historical
fact may include forward-looking statements that involve a number of risks and
uncertainties.

We have used
the words anticipate, believe, could, estimate, expect,
intend,
may, plan, predict, project, and similar terms and phrases, including
references to assumptions, in this document to identify forward-looking statements.
These forward-looking statements are made based on managements expectations
and beliefs concerning future events and are subject to uncertainties and
factors relating to our operations and business environment, all of which are
difficult to predict and many of which are beyond the Companys control, that
could cause actual results to differ materially from those matters expressed in
or implied by these forward-looking statements. The following factors are among
those that may cause actual results to differ materially from the Companys
forward-looking statements.

| |   |                                                                       
| | - | ----------------------------------------------------------------------
| |  | highly
 competitive nature of the retail entertainment business;      
| |   |                                                                       
| |  | current
 economic conditions;                                         
| |   |                                                                       
| |  | competitive
 pricing;                                                 
| |   |                                                                       
| |  | adverse
 publicity;                                                   
| |   |                                                                       
| |  | interest
 rate fluctuations;                                          
| |   |                                                                       
| |  | dependence
 on key employees;                                         
| |   |                                                                       
| |  | accelerated
 declines in music compact disc (CD) industry sales;    
| |   |                                                                       
| |  | the
 Companys level of debt and related restrictions and limitations;
| |   |                                                                       
| |  | new product
 introductions (hit releases);                          
| |   |                                                                       
| |  | future cash
 flows;                                                   
| |   |                                                                       
| |  | availability
 of new real estate;                                     
| |   |                                                                       
| |  | new
 technology, including digital downloading; and                   
| |   |                                                                       
| |  | product
 liability claims.                                            
| |   |                                                                       
| |  | change in
 laws;                                                      

The reader
should keep in mind that any forward-looking statement made by us in this
document, or elsewhere, speaks only as of the date on which we make it. New
risks and uncertainties come up from time-to-time, and its impossible for us
to predict these events or how they may affect us. In light of these risks and
uncertainties, you should keep in mind that any forward-looking statements made
in this report or elsewhere might not occur.

In addition,
the preparation of financial statements in accordance with accounting
principles generally accepted in the United States (GAAP) requires us to make
estimates and assumptions. These estimates and assumptions affect:

| |   |                                                                        
| | - | -----------------------------------------------------------------------
| |  | the reported
 amounts and timing of revenue and expenses,              
| |   |                                                                        
| |  | the reported
 amounts and classification of assets and liabilities, and
| |   |                                                                        
| |  | the disclosure
 of contingent assets and liabilities.                  

Actual results
may vary from our estimates and assumptions. These estimates and assumptions
are based on historical results, assumptions that we make, as well as
assumptions by third-parties.

Item 1. BUSINESS

Company Background

Trans World
Entertainment Corporation, which, together with its consolidated subsidiaries,
is referred to herein as the Company, we, us and our, was incorporated
in New York in 1972. It owns 100% of the outstanding common stock of Record
Town, Inc., through which its principal operations are conducted. The Company
operates retail stores and four e-commerce sites and is one of the largest
specialty retailers of entertainment software, including music, video, and
video games and related products in the United States.

Stores and Store Concepts

At January 31,
2009, the Company operated 712 stores totaling approximately 4.6 million square
feet in the United States, the District of Columbia, the Commonwealth of Puerto
Rico and the U.S. Virgin Islands.

Mall Stores

At January 31,
2009, the Company operated 549 mall-based stores, predominantly under the
f.y.e. (For Your Entertainment) brand, including:

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| |                                                                                                                                                                                                                                                                                              
| | ---------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
| | Traditional stores.
 The traditional store averages about 5,700 square feet and carries a full
 complement of entertainment software, including music, video, video games and
 related accessories. There were 480 traditional f.y.e. mall based stores at
 the end of Fiscal 2008.          
| |                                                                                                                                                                                                                                                                                              
| | Superstores. The superstores carry the same merchandise categories as traditional
 locations, but with a much larger assortment. There were 9 f.y.e. mall
 superstores at the end of Fiscal 2008 that averaged about 24,000 square feet.                                                     
| |                                                                                                                                                                                                                                                                                              
| | Video only stores.The Company operated 60 video only stores,
 under the Suncoast Motion Pictures and Saturday Matinee brands. These stores
 specialize in the sale of video and related accessories. They are located in
 large, regional shopping malls and average about 2,400 square feet.

Freestanding
Stores

The Company
operated 163 freestanding stores as of January 31, 2009, including 9 f.y.e.
superstores, under the f.y.e. brand. They carry a full complement of
entertainment software, including music, video, video games and related
accessories and are located in freestanding, strip center and downtown
locations. The freestanding stores, excluding the superstores, average
approximately 6,600 square feet (excluding f.y.e. freestanding Superstores and
Planet Music). The freestanding f.y.e. Superstores average about 44,200 square
feet.

E-Commerce
Sites

The Company
operates four retail web sites including, www.fye.com,
www.wherehouse.com, www.secondspin.com, and www.suncoast.com. These sites offer
substantially the same complement of products as offered in the Companys
stores.

Merchandise Categories

Net sales by
merchandise category as a percentage of total net sales for Fiscal 2008, 2007
and 2006, and comparable store sales for Fiscal 2008 and 2007, were as follows:

|            |  |        |  |                         |  |        |  |                         |  |        |  |  |  |  |  | 
|----------- |  | ------ |  | ----------------------- |  | ------ |  | ----------------------- |  | ------ |  |  |  |  |  | 
|            |  |        |  |                         |  |        |  |                         |  |        | 
|            |  | 2008   |  | Comparable
 Store Sales |  | 2007   |  | Comparable
 Store Sales |  | 2006   | 
|            |  |        |  |                         |  |        |  |                         |  |        | 
|Music       |  | 35.4%  |  | (20.2%)                 |  | 39.1%  |  | (23.2%)                 |  | 46.0%  | 
|Video       |  | 41.3   |  | (3.1)                   |  | 38.8   |  | 1.1                     |  | 36.0   | 
|Video games |  | 9.1    |  | (14.3)                  |  | 9.0    |  | 8.3                     |  | 7.8    | 
|Other       |  | 14.2   |  | (0.6)                   |  | 13.1   |  | 14.2                    |  | 10.2   | 
|            |  |        |  |                         |  |        |  |                         |  |        |  |  |  |  |  | 
|Total       |  | 100.0% |  | (10.8%)                 |  | 100.0% |  | (8.5%)                  |  | 100.0% | 
|            |  |        |  |                         |  |        |  |                         |  |        |  |  |  |  |  | 

The Other
category includes electronics, accessories and trend items, none of which individually
exceeded 10% of total net sales.

Business Environment

Music, video
and video games represent an approximately $41 billion industry nationwide, and
represented approximately 86% of the Companys net sales in Fiscal 2008.

According to
statistical information from Nielsen Sound Scan (SoundScan), the total number
of music albums sold, including CD and digital albums, decreased 13% to
approximately 425 million units in 2008, representing approximately $5.4
billion in retail sales. Excluding digital albums, album sales decreased 20% to
approximately 363 million units. In 2007, the total number of music albums
sold, including CD, cassette and digital albums decreased 15% compared to 2006.
Excluding digital albums, album sales in 2007 decreased 19% compared to 2006.

According to
statistics obtained from Video Business, overall video retail sales in 2008
were $14.1 billion, a decrease of 9% from 2007. Video retail sales in 2007
decreased 3% compared to 2006.

The NPD Group,
Inc. (NPD) published that video games retail sales, including portable and
console hardware, software and accessories, were $21.3 billion in 2008, an
increase of 19% over 2007 sales. Video game sales in 2007 were $17.9 billion,
an increase of 43% over 2006.

Competition

CD sales have
suffered from the legal (e.g., iTunes) and illegal downloading of music and
specialty retailers have been impacted by the proliferation of mass merchants
(e.g., Wal-Mart and Target) and electronics superstores (e.g., Best Buy) that
offer entertainment software and, collectively, have gained a larger share of
the market. The number of specialty and independent retailers has decreased
dramatically due to their reliance on sales of CDs. The Company has taken
advantage of competitor exits from markets, made acquisitions, diversified its
products and taken other measures to position itself competitively within its
industry. The Company believes it effectively competes in the following ways:

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| |   |                                                                                                                                                                                                
| | - | -----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
| |  | Location and
 convenience: a strength of the Company is its convenient store locations that
 are often the exclusive retailer in centers offering a full complement of
 entertainment software;
| |   |                                                                                                                                                                                                
| |  | Marketing:
 the Company uses newspaper, radio and television advertising and in-store
 visual displays to market to consumers;                                                                 
| |   |                                                                                                                                                                                                
| |  | Selection
 and assortment: the Company maintains a high in-stock position in a large
 assortment of product, particularly CDs and DVDs;                                                        
| |   |                                                                                                                                                                                                
| |  | Customer
 service: the Company believes it offers personalized customer service at its
 stores;                                                                                                
| |   |                                                                                                                                                                                                
| |  | Product line
 expansion: the Company has expanded space allocations in its stores to
 support growth in electronics and trend item sales.                                                      

Seasonality

The Companys
business is seasonal, with its fourth fiscal quarter constituting the Companys
peak selling period. In Fiscal 2008, the fourth quarter accounted for
approximately 35% of annual net sales. In anticipation of increased sales
activity during these months, the Company purchases additional inventory and
hires additional temporary employees to supplement its full-time store sales
staff. If, for any reason, the Companys net sales were below seasonal norms
during the fourth quarter, the Companys operating results could be adversely
affected. Quarterly sales can also be affected by the timing of new product
releases, new store openings or closings and the performance of existing
stores.

Advertising

The Company
makes extensive use of visual displays. It uses a mass-media marketing program,
including newspaper, radio, and television advertisements. Certain vendors from
whom the Company purchases merchandise offer advertising allowances, of varying
duration and amount, to promote their merchandise.

Suppliers and Purchasing

The Company
purchases inventory from approximately 527 suppliers. In Fiscal 2008, 60% of
purchases were made from ten suppliers including EMI Music Distribution,
Sony-Bertelsmann Music Group, Warner/Electra/Atlantic Corp., Universal Music
Group, Fox Video Inc., Paramount Video, Buena Vista Video, Warner Home
Entertainment, Universal Studios Home Entertainment and Nintendo. The Company
does not have material long-term purchase contracts; rather, it purchases
products from its suppliers on an order-by-order basis. Historically, the
Company has not experienced difficulty in obtaining satisfactory sources of
supply and management believes that it will continue to have access to adequate
sources of supply.

Trade Customs and Practices

Under current
trade practices with large suppliers, retailers of music and video products are
generally entitled to return unsold merchandise they have purchased in exchange
for other titles carried by the suppliers. The four largest music suppliers
charge a related merchandise return penalty or return handling fee. Most
manufacturers and distributors of video products do not typically charge a
return penalty or handling fee. Under current trade practices with large
suppliers, retailers of video games and related products may receive markdown
support from suppliers to help clear slow turning merchandise. Merchandise return
policies and other trade practices have not changed significantly in recent
years. The Company generally adapts its purchasing policies to changes in the
policies of its largest suppliers.

Employees

As of January
31, 2009, the Company employed approximately 6,700 people, of whom
approximately 2,800 were employed on a full-time basis. Others were employed on
a part-time or temporary basis. The Company hires seasonal sales employees
during its fourth quarter peak selling season to ensure continued levels of
customer service. Store managers, district managers and regional managers are
eligible to receive incentive compensation based on the sales and/or
profitability of stores for which they are responsible. Sales support managers
are generally eligible to receive incentive compensation based on the sales and
profitability of the Company as a whole. None of the Companys employees are
covered by collective bargaining agreements and management believes that the
Company enjoys favorable relations with its employees.

4

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Information Systems

The Company
utilizes primarily IBM AS400 technology to run its management information
systems, including its merchandising, distribution and financial systems.
Management believes its systems contribute to enhanced customer service and
operational efficiency, as well as provide the ability to monitor critical
performance indicators versus plans and historical results.

Available Information

The
Companys headquarters are located at 38 Corporate Circle, Albany, New York
12203, and its telephone number is (518) 452-1242. The Companys corporate web
site address is www.twec.com. The Company makes available, free of charge, its
Exchange Act Reports (Forms 10-K, 10-Q, 8-K and any amendments thereto) on its
web site as soon as practical after the reports are filed with the Securities
and Exchange Commission (SEC). The public may read and copy any materials the
Company files with the SEC at the SECs Public Reference Room at 450 Fifth
Street, N.W., Washington, D.C. 20549. Information on the operation of the
Public Reference Room can be obtained by calling the SEC at 1-800-SEC-0330. The
SEC maintains an Internet site that contains reports, proxy and information
statements, and other information regarding issuers that file electronically
with the SEC. This information can be obtained from the site
http://www.sec.gov. The Companys Common Stock, $0.01 par value, is quoted on
the NASDAQ National Market under the trading symbol TWMC. The Companys
fiscal year end is the Saturday closest to January 31. The Fiscal 2008 (Fiscal
2008) year ended on January 31, 2009; Fiscal 2007 (Fiscal 2007) year ended
on February 2, 2008; and Fiscal 2006 (Fiscal 2006) year ended on February 3,
2007.

Item 1A. RISK FACTORS

The following is a discussion of certain factors,
which could affect the financial results of the Company.

The Companys results of operations are
affected by the availability of new products.

The Companys business is affected by the release of
hit music, video and video game titles, which can create fluctuations in
sales. It is not possible to determine the timing of these fluctuations or the
future availability of hit titles. The Company is dependent upon the major
music and movie producers to continue to produce hit products. To the extent
that new hit releases are not available, or not available at prices attractive
to consumers, or, if manufacturers fail to introduce or delay the introduction
of new products, the Companys results of operations may be adversely affected.

The Companys results of operations may
suffer if the Company does not accurately predict consumer acceptance of new
product or distribution technologies.

The entertainment industry is characterized by
changing technology, evolving format standards, frequent new and enhanced
product introductions and rapid product obsolescence. These characteristics
require that the Company respond quickly to technological changes and
understand the impact of these changes on customers preferences. If the
Company is unable to participate in new product or distribution technologies,
its results of operations may suffer. Specifically, the CD format has
experienced a continuous decline as digital forms of music content have become
more prevalent. If the Company does not timely adapt to these changing
technologies or sufficiently increase its focus on the other core categories,
operating results could significantly suffer.

Increased competition from existing retailers
and alternative distribution channels has adversely affected the Companys
results of operations.

The Company competes with a wide variety of
entertainment retailers, including deep-discount retailers, mass merchandisers,
consumer electronics outlets, internet retailers, record clubs and independent
operators, some of whom have greater financial and other resources than the
Company. The Company also expects continued growth in competing home
entertainment options. Some of these, including the ability to download music,
video and video games onto PCs or other devices, or the ability to play video
games over the Internet through consoles, could reduce retail sales of CDs,
DVDs and video games. If technological advances were to result in significant
changes in existing distribution channels for pre-recorded music, video and
video games, the Companys results of operations could be adversely affected.

In addition, the Companys success depends on our ability to positively
differentiate ourselves from other retailers. The retail business
is highly competitive. In the past the Company has been able to compete
successfully by differentiating our customer shopping experience by creating an
attractive value proposition through a careful combination of price,
merchandise assortment, convenience, customer service and marketing efforts. Customer
perceptions regarding our stores and our in-stock levels and deep assortment of
product are also factors in our ability to compete. No single competitive
factor is dominant, and actions by our competitors on any of these factors
could have an adverse effect on our sales, gross profit and expenses. If we
fail to continue to positively differentiate ourselves from our competitors,
our results of operations could be adversely affected.

The Companys business is negatively
influenced by the general economic conditions and the disruption of capital and
credit markets

The Companys performance is subject to general
economic conditions and their impact on levels of discretionary consumer
spending, which have continued to deteriorate and may remain depressed for the
foreseeable future. General economic conditions impacting discretionary

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consumer
spending include, among others, wages and employment, consumer debt, reductions
in net worth based on recent severe market declines, residential real estate
and mortgage markets, taxation, fuel and energy prices, interest rates,
consumer confidence and other macroeconomic factors.

Consumer
purchases of discretionary items, such as our merchandise, generally decline
during recessionary periods and other periods where disposable income is
adversely affected. The current downturn in the economy affects retailers
disproportionately, as consumers may prioritize reductions in discretionary
spending, which could have a direct impact on purchases of our merchandise and
adversely impact our results of operations and continued growth. In addition,
reduced consumer spending may drive us and our competitors to offer additional
products at promotional prices, which would have a negative impact on gross
profit. The Company cannot predict how long the current economic, capital and
credit market conditions will continue and what impact they will have on our
business.

Disruption of global capital and credit
markets may have a material adverse effect on the Companys liquidity and capital
resources.

The recent distress in the financial markets has
resulted in extreme volatility in security prices and diminished liquidity and
credit availability, and there can be no assurance that our liquidity will not
be affected by changes in the financial markets and the global economy or that
our capital resources will at all times be sufficient to satisfy our liquidity
needs. Although we believe that cash provided by sales of merchandise inventory
and available borrowing capacity under our credit facility, which expires on
January 6, 2011, will provide us with sufficient liquidity through the
expiration of this credit facility, a continuation of the current disruption
    in the financial markets and the general economic downturn could adversely
    impact the availability terms and/or pricing of financing if, and when, we
    need to raise additional liquidity. We would experience liquidity problems
    if we are unable to obtain additional financing as our debt becomes due or
we otherwise need additional liquidity.

The current
credit crisis is having a significant negative impact on businesses around the
world, and the impact of this crisis on our major suppliers cannot be
predicted. The inability of key suppliers to access liquidity, or the
insolvency of key suppliers, could lead to delivery delays or failures.

The
creditworthiness of many financial institutions may be closely interrelated as
a result of credit, derivative, trading, clearing or other relationships
between the institutions. As a result, concerns about, or a default or
threatened default by, one institution could lead to significant market-wide
liquidity and credit problems, losses or defaults by other institutions. This
may adversely affect the financial institutions, which we interact on a daily basis,
and therefore could adversely affect our ability to raise needed funds or
access liquidity.

Historically, we have experienced declines and we may
continue to experience, fluctuation in our level of sales results of operations and operating cash flow.

A variety of factors has historically affected,
and
will continue to affect, our comparable stores sales results and profit
margins. These factors include general regional and national economic
conditions; competition; actions taken by our competitors; consumer trends and
preferences; new product introductions and changes in our product mix; timing
and effectiveness of promotional events and weather. The Companys comparable
store sales may decline further than they did in Fiscal 2008, and they may vary
from quarter to quarter as our business is highly seasonal in nature. Our
highest sales and operating income historically occur during the fourth fiscal
quarter, which is due in part, to the holiday selling season. The fourth
quarter generated approximately 35% of our net sales for Fiscal 2008. Any
decrease in our fourth quarter sales, whether because of a slow holiday selling
season, unseasonable weather conditions, economic conditions or otherwise,
could have a material adverse effect on our business, financial condition and
operating results for the entire fiscal year. There is no assurance that we
will achieve positive levels of sales and earnings growth, and any decline in
our future growth or performance could have a material adverse effect on our
business and results of operations.

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Failure to open new stores may
limit our earnings.

Historically, the Companys growth has come from the
opening of new stores and the acquisition of stores. The Company opens new
stores if it finds desirable locations and is able to negotiate suitable lease
terms. A lack of new store growth may impact the Companys ability to increase
sales and earnings. The Company has not opened a new store in the last two
years.

A change in one or more of the Companys
vendors policies or the Companys relationship with those vendors could
adversely affect the Companys results of operations.

The Company is dependent on its vendors to supply
merchandise in a timely and efficient manner. If a vendor fails to deliver on
its commitments, whether due to financial difficulties or other reasons, the
Company could experience merchandise shortages that could lead to lost sales.

The majority
of the Companys purchases come from ten major suppliers. As is standard in its
industry, the Company does not maintain long-term contracts with its suppliers
but instead makes purchases on an order-by-order basis. If the Company fails to
maintain customary trade terms or enjoy positive vendor relations, it could
have an adverse effect on the Companys results of operations.

If the Companys vendors fail to provide
marketing and merchandising support at historical levels, the Companys results
of operations could be adversely affected.

The manufacturers of entertainment products have
typically provided retailers with significant marketing and merchandising
support for their products. As part of this support, the Company receives
cooperative advertising and other allowances from these vendors. These
allowances enable the Company to actively promote and merchandise the products
it sells at its stores and on its websites. If the Companys vendors fail to
provide this support at historical levels, the Companys results of operations
could be negatively impacted.

Loss of Key Personnel or the inability to attract,
train and retain qualified employees could adversely affect the Companys
results of operations.

The Company believes that its future prospects depend,
to a significant extent, on the services of its executive officers,
particularly, Robert J. Higgins, our Chairman and Chief Executive Officer. Our
future success will also depend on our ability to attract and retain qualified
key personnel. The loss of the services of certain of the Companys executive
officers and other key management personnel could adversely affect the
Companys results of operations. In particular, if we were to lose the services
of Robert J. Higgins, we may not able to replace his skills and experience.

In addition to
our executive officers, the Companys business is dependent on our ability to
attract, train and retain a large number of qualified team members. Many of
those team members are employed in entry-level or part-time positions with
historically high turnover rates. Our ability to meet our labor needs while
controlling our costs is subject to external factors such as unemployment
levels, health care costs and changing demographics. If we are unable to
attract and retain adequate numbers of qualified team members, our operations,
customer service levels and support functions could suffer. Those factors,
together with increased wage and benefit costs, could adversely affect our
results of operations.

Because our Chairman and Chief Executive
Officer owns approximately 42.2% of the outstanding Common Stock, he has
significant influence and control over the outcome of any vote of the Companys
Shareholders.

Robert J. Higgins serves as Chairman of the Board of
the Company and its Chief Executive Officer and owns approximately 42.2% of the
outstanding Common Stock of the Company, as of March 10, 2009. Accordingly, he
will have significant influence on the outcome of any vote of the Companys
Shareholders and on the policies and affairs of the Company. His interests may
differ from the interests of the other stockholders.

Failure to comply with legal and
regulatory requirements could adversely affect the Companys results of
operations.

The Companys business is subject to a wide array of laws and
regulations. Significant legislative changes that impact our relationship with
our workforce (none of which is represented by unions) could increase our
expenses and adversely affect our operations. Examples of possible

7

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legislative
changes impacting our relationship with our workforce include changes to an
employers obligation to recognize collective bargaining units, the process by
which collective bargaining units are negotiated or imposed, minimum wage
requirements, and health care mandates.

Our policies,
procedures and internal controls are designed to comply with all applicable laws
and regulations, including those imposed by the Securities and Exchange
Commission and the New York Stock Exchange, as well as applicable employment
laws. Additional legal and regulatory requirements, such as those arising under
the Sarbanes-Oxley Act of 2002 and various foreign laws, increase the
complexity of the regulatory environment in which we operate and the related
cost of compliance. Failure to comply with such laws and regulations may result
in damage to our reputation, financial condition and market price of our stock.

In August
2000, the Companys Board of Directors adopted a Classified Board Amendment
which together with anti-takeover provisions of New York State Law may
discourage open market purchases or a non-negotiated tender or exchange offer
for the stock of the Company. This may be adverse to the interests of certain
shareholders.

The nature of
our business involves the receipt and storage of personal information about
certain customers. If we experience a data security breach, we could be exposed
to government enforcement actions and private litigation. In addition, our
customers could lose confidence in our ability to protect their personal
information, which could cause them to discontinue usage of our customer
loyalty programs or participation in other programs. Such events could lead to
lost future sales and adversely affect our results of operations.

We could be materially and adversely affected
if either of our distribution centers is disrupted.

We operate two distribution centers, one in Albany,
New York and the other in Carson, California. We ship 71% of our merchandise
inventory through our distribution centers. If either of our distribution
centers is destroyed, or disrupted for any reason, including because of weather
or labor issues, we could incur significantly higher costs and longer lead
times associated with distributing our products to our stores during the time
it takes to reopen or replace the centers.

In addition,
our Carson, California distribution center is located in a state where
earthquakes are prevalent. Such an event could result in significant physical
damage to or closure of this center and delay distribution of merchandise from
our suppliers to our center and stores, which could adversely affect our results
of operation. We maintain business interruption insurance to protect us from
the costs relating to matters such as a shutdown, but our insurance may not be
sufficient, or the insurance proceeds may not be timely paid to us, in the
event of a shutdown.

The Companys stock price has experienced and
could continue to experience volatility and could decline further, resulting in
a substantial loss on your investment.

Our stock price has experienced, and could continue to
experience in the future, substantial volatility as a result of many factors,
including recent global economic conditions, broad market fluctuations and
public perception of the prospects for music and the home video industry.
Changes in our comparable store net sales results could also affect the price
of our Common Stock. Failure to meet market expectations, particularly with
respect to comparable store sales, net revenues, operating margins and earnings
per share, would likely result in a continued decline in the market price of
our stock.

In addition,
an active trading market for our Common Stock may not be sustained, which could
affect the ability of our stockholders to sell their shares and could depress
the market price of their shares. The stock market in general and the market
for music and home video related stocks in particular, has been highly
volatile. For example, the closing price of our Common Stock has fluctuated
between $4.69 and $0.60 from January 1, 2008 and March 31, 2009.

As a result,
the market price of our Common Stock has been and is likely to remain volatile,
and investors in our Common Stock may experience a decrease in the value of
their stock, including decreases unrelated to our operating performance or
prospects.

The failure to maintain a minimum closing
share price of $1.00 per share of our Common Stock could result in the
delisting of our shares on The NASDAQ Global Market, which would harm the
market price of the Companys Common Stock.

In order to retain our listing on The NASDAQ Global
Market we are required by NASDAQ to maintain a minimum bid price of $1.00 per
share. Our stock price is currently below $1.00 and has remained so since
January 21, 2009. However, on October 16, 2008, NASDAQ suspended enforcement of
the rules requiring a minimum $1.00 per share closing share price until January
19, 2009. On December 18, 2008 NASDAQ extended the suspension until April 19,
2009. On March 31, 2009, NASDAQ extended the suspension of continued listing
requirements regarding minimum bid price and market value of publicly held
share until July 19, 2009. A new compliance period will begin on July 20, 2009.
In the event that our stock does close below the minimum bid price of $1.00 per
share for any 30 consecutive business days following the reinstatement of the
rules on July 20, 2009, we can regain compliance if our Common Stock closes at
or above $1.00 per share for 10 consecutive days during the 180 days
immediately following. If we are unable to do so, our stock could be
delisted from The NASDAQ Global Market, transferred to a listing on The NASDAQ
Capital Market, or delisted from the NASDAQ markets altogether. The failure to
maintain our listing on The NASDAQ Global Market could harm the liquidity of
the Companys Common Stock and could have an adverse effect on the market price
of our Common Stock.

Item 1B. UNRESOLVED SEC COMMENTS

The Company
has not received within 180 days or more before January 31, 2009, written
comments from the Securities and Exchange Commission regarding its periodic or
current reports under the Securities Exchange Act of 1934, as amended.

8

---



Item 2. PROPERTIES

Retail Stores

At January 31,
2009, the Company operated 712 stores under operating leases, many of which
have renewal options. The majority of the leases provide for the payment of
fixed monthly rentals and expenses for maintenance, property taxes and
insurance while the others provide for the payment of monthly rentals based on
a percentage of sales. Certain leases provide for added rent based on store
sales in excess of specified levels. The following table lists the leases due
to expire as of the fiscal year-end in each of the years shown, assuming any
renewal options are not exercised:

|     |  |                |  |      |                 |                |    |    |  | 
|---- |  | -------------- |  | ---- | --------------- | -------------- | -- | -- |  | 
|Year |  | No. of
 Leases |  | Year |                 | No. of
 Leases |   
|     |  |                |  |      |                 |                |   
|    
|2009 |  | 337            |  |      |                 | 2013           |    | 25 |  | 
|     |  |                |  |      |                 |                |    |    |  | 
|2010 |  | 149            |  |      |                 | 2014           |    | 27 |  | 
|     |  |                |  |      |                 |                |    |    |  | 
|2011 |  | 81             |  |      |                 | 2015           |    | 31 |  | 
|     |  |                |  |      |                 |                |    |    |  | 
|2012 |  | 37             |  |      | 2016 and beyond |                | 25 |    | 

As leases
expire, the Company will evaluate the decision to exercise renewal rights or
obtain new leases for the same or similar locations based on store
profitability.

Corporate Offices and Distribution Center
Facilities

The Company
leases its Albany, New York, distribution facility and corporate office space
from its largest shareholder and Chairman and Chief Executive Officer under
three capital lease arrangements that extend through 2015. These leases are at
fixed rentals with provisions for biennial increases based on increases in the
Consumer Price Index. The Company incurs all property taxes, insurance and
maintenance costs. The office portion of the facility is approximately 39,800
square feet and the distribution center portion is approximately 141,500 square
feet. The Company also leases a 198,300 square foot distribution center in
Carson, California; this lease includes a five-year renewal option and expires
in December 2010.

The Company
believes that its existing distribution facilities are adequate to meet the
Companys planned business needs. Shipments from the distribution facilities to
the Companys stores provide approximately 71% of all merchandise shipment
requirements to stores. Stores are serviced by common carriers chosen on the
basis of geography and rate considerations. The balance of the stores
merchandise requirements is satisfied through direct shipments from vendors.

The Company
leases an additional 31,700 square feet of office space in Albany, New York.
The operating lease expires in June 2014 and includes two, five-year options to
renew.

Item
3. LEGAL PROCEEDINGS

The Company is subject to various legal proceedings and claims that have
arisen in the ordinary course of its business and have not been finally
adjudicated. Although there can be no assurance as to the ultimate disposition
of these matters, it is managements opinion, based upon the information
available at this time, that the expected outcome of these matters,
individually or in the aggregate, will not have a material adverse effect on
the results of operations and financial condition of the Company.

Item
4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS

No matters were submitted to a
vote of security holders during the fourth quarter of the fiscal year ended
January 31, 2009.

9

---



PART II

Item 5. MARKET FOR THE REGISTRANTS COMMON
EQUITY, RELATED STOCKHOLDER MATTERS AND ISSUER PURCHASES OF EQUITY SECURITIES

Market Information.
The Companys Common Stock trades on the NASDAQ Stock Market under the symbol
TWMC. As of March 31, 2009, there were 473 shareholders of record. The
following table sets forth high and low last reported sale prices for each
fiscal quarter during the period from February 2, 2007 through March 31, 2009.

|                      |  |                      |  |       | 
|--------------------- |  | -------------------- |  | ----- | 
|                      |  | Closing Sales Prices | 
|                      |  |                      |  |       | 
|                      |  | High                 |  | Low   | 
|                      |  |                      |  |       | 
|2007                  |  |                      |  |       | 
|1st
 Quarter          |  | $5.82                |  | $5.20 | 
|2nd
 Quarter          |  | $5.44                |  | $4.30 | 
|3rd
 Quarter          |  | $4.79                |  | $4.01 | 
|4th
 Quarter          |  | $5.76                |  | $3.83 | 
|                      |  |                      |  |       | 
|2008                  |  |                      |  |       | 
|1st
 Quarter          |  | $4.45                |  | $3.12 | 
|2nd
 Quarter          |  | $3.33                |  | $2.34 | 
|3rd
 Quarter          |  | $3.13                |  | $1.99 | 
|4th
 Quarter          |  | $2.35                |  | $0.76 | 
|                      |  |                      |  |       | 
|2009                  |  |                      |  |       | 
|1st
 Quarter (through |  | $0.89                |  | $0.52 | 
|March 31, 2009)       |  |                      |  |       | 

On March 31,
2009, the last reported sale price on the Common Stock on the NASDAQ National
Market was $0.60.

Dividend Policy: The
Company has never declared dividends on its Common Stock. The Companys
credit facility does not restrict the payment of cash dividends so long as
payment conditions per the agreement are met. Any future determination as to
the payment of dividends will depend upon capital requirements, limitations
imposed by the Companys credit facility and other factors the Companys Board
of Directors may consider.

10

---



Five-Year Performance Graph:

The following line graph
reflects a comparison of the cumulative total return of the Companys Common
Stock from January 30, 2004 through January 30, 2009 with the Nasdaq
Index (U.S. Stocks) and with the Nasdaq National Market Retail Trade Stocks
index. Because none of the Companys leading competitors has been an
independent publicly traded company over the period, the Company has elected to
compare shareholder returns with the published index of retail companies
compiled by NASDAQ. All values assume a $100 investment on January 30, 2004,
and that all dividends were reinvested.

(LINE GRAPH)

|                                      |  |      |  |      |  |      |  |      |  |      |  |      |     |  |  |  |  |     |  |  |    | 
|------------------------------------- |  | ---- |  | ---- |  | ---- |  | ---- |  | ---- |  | ---- | --- |  |  |  |  | --- |  |  | -- | 
|                                      |  | 2004 |  | 2005 |  | 2006 |  | 2007 |  | 2008 |  | 2009 |    
|                                      |  |      |  |      |  |      |  |      |  |      |  |      |    
|Trans World Entertainment Corporation |  | 100  |  | 167  |  |      |  | 70   |  |      |  |      | 75  |  |  |  |  | 57  |  |  | 10 | 
|NASDAQ (U.S. Stocks)                  |  | 100  |  | 100  |  |      |  | 113  |  |      |  |      | 121 |  |  |  |  | 116 |  |  | 58 | 
|NASDAQ Retail Trade Stocks            |  | 100  |  | 121  |  |      |  | 129  |  |      |  |      | 141 |  |  |  |  | 125 |  |  | 81 | 

11

---



Item 6. SELECTED CONSOLIDATED FINANCIAL DATA

The following
table sets forth selected Statement of Operations and Balance Sheet data for
the five fiscal years ended January 31, 2009 and is derived from the Companys
audited Consolidated Financial Statements. The fiscal year ended February 3,
2007 consisted of 53 weeks while all the other fiscal years of the Company
presented consisted of 52 weeks. This information should be read in conjunction
with the Companys audited Consolidated Financial Statements and related notes
and other financial information included herein, including Item 7,
Managements Discussion and Analysis of Financial Condition and Results of
Operations.

|                                                                                                                                                                     |  |                                                   |          |                   |  |                   |   |                   |            |                   |  |            |   |  |            |  
|-------------------------------------------------------------------------------------------------------------------------------------------------------------------- |  | ------------------------------------------------- | -------- | ----------------- |  | ----------------- | - | ----------------- | ---------- | ----------------- |  | ---------- | - |  | ---------- | -
|                                                                                                                                                                     |  | Fiscal Year Ended                                 |         
|                                                                                                                                                                     |  |                                                   |          |                   |  |                   |   |                   |            |                   |  |            |   |  |            |  
|                                                                                                                                                                     |  | January 31,
 2009                                 |          | February 2,
 2008 |  | February 3,
 2007 |   | January 28,
 2006 |            | January 29,
 2005 | 
|                                                                                                                                                                     |  |                                                   |          |                   |  |                   |   |                   |            |                   | 
|                                                                                                                                                                     |  | ($ in thousands, except per share and store data) |         
|STATEMENTS OF OPERATIONS DATA:                                                                                                                                       |  |                                                   |          |                   |  |                   |   |                   |            |                   |  |            |   |  |            |  
|                                                                                                                                                                    
|Net sales                                                                                                                                                            |  |                                                   | $987,625 |                   |  | $1,265,658        |   |                   | $1,471,157 |                   |  | $1,238,486 |   |  | $1,365,133 |  
|                                                                                                                                                                    
|Cost of sales                                                                                                                                                        |  |                                                   | 656,730  |                   |  | 819,911           |   |                   | 951,935    |                   |  | 806,873    |   |  | 869,999    |  
|                                                                                                                                                                     |  |                                                   |          |                   |  |                   |   |                   |            |                   |  |            |   |  |            |  
|Gross profit                                                                                                                                                         |  |                                                   | 330,895  |                   |  | 445,747           |   |                   | 519,222    |                   |  | 431,613    |   |  | 495,134    |  
|                                                                                                                                                                    
|Selling, general and administrative expenses                                                                                                                         |  |                                                   | 380,801  |                   |  | 470,386           |   |                   | 519,246    |                   |  | 426,854    |   |  | 450,162    |  
|                                                                                                                                                                    
|Impairment charge (1)                                                                                                                                                |  |                                                   | 15,159   |                   |  | 30,731            |   |                   |           |                   |  |           |   |  |           |  
|                                                                                                                                                                     |  |                                                   |          |                   |  |                   |   |                   |            |                   |  |            |   |  |            |  
|(Loss) income from operations                                                                                                                                        |  |                                                   | (65,065  | )                 |  | (55,370           | ) |                   | (24        | )                 |  | 4,759      |   |  | 44,972     |  
|                                                                                                                                                                    
|Interest expense                                                                                                                                                     |  |                                                   | 4,098    |                   |  | 6,519             |   |                   | 5,504      |                   |  | 2,954      |   |  | 2,444      |  
|                                                                                                                                                                    
|Other income                                                                                                                                                         |  |                                                   | (180     | )                 |  | (429              | ) |                   | (4,435     | )                 |  | (2,171     | ) |  | (1,039     | )
|                                                                                                                                                                     |  |                                                   |          |                   |  |                   |   |                   |            |                   |  |            |   |  |            |  
|(Loss) income before income taxes, extraordinary gain 
unallocated
 negative goodwill and cumulative effect of a change in accounting principle                     |  |                                                   | (68,983  | )                 |  | (61,460           | ) |                   | (1,093     | )                 |  | 3,976      |   |  | 43,567     |  
|                                                                                                                                                                    
|Income tax expense (benefit) (2)                                                                                                                                     |  |                                                   | (28      | )                 |  | 37,975            |   |                   | (2,041     | )                 |  | 1,090      |   |  | 4,892      |  
|                                                                                                                                                                     |  |                                                   |          |                   |  |                   |   |                   |            |                   |  |            |   |  |            |  
|(Loss) earnings before extraordinary gain  unallocated negative
 goodwill and cumulative effect of change in accounting principle                                   |  |                                                   | (68,955  | )                 |  | (99,435           | ) |                   | 948        |                   |  | 2,886      |   |  | 38,675     |  
|Extraordinary gain  unallocated negative goodwill, net of
income 
 taxes (3)                                                                                        |  |                                                   |         |                   |  |                  |   |                   | 10,721     |                   |  |           |   |  | 3,166      |  
|                                                                                                                                                                    
|Cumulative effect of a change in accounting principle, net of income
taxes (4)                                                                                       |  |                                                   |         |                   |  |                  |   |                   |           |                   |  | (2,277     | ) |  |           |  
|                                                                                                                                                                     |  |                                                   |          |                   |  |                   |   |                   |            |                   |  |            |   |  |            |  
|Net (loss) income                                                                                                                                                    |  |                                                   | ($68,955 | )                 |  | ($99,435          | ) |                   | $11,669    |                   |  | $609       |   |  | $41,841    |  
|                                                                                                                                                                     |  |                                                   |          |                   |  |                   |   |                   |            |                   |  |            |   |  |            |  
|Basic (loss) earnings per share:                                                                                                                                     |  |                                                   |          |                   |  |                   |   |                   |            |                   |  |            |   |  |            |  
|                                                                                                                                                                    
|(Loss) earnings per share before extraordinary gain  unallocated
 negative goodwill and cumulative effect of change in accounting principle                         |  |                                                   | ($2.21   | )                 |  | ($3.20            | ) |                   | $0.03      |                   |  | $0.09      |   |  | $1.12      |  
|                                                                                                                                                                    
|Extraordinary gain  unallocated negative goodwill                                                                                                                   |  |                                                   |         |                   |  |                  |   |                   | 0.35       |                   |  |           |   |  | 0.09       |  
|                                                                                                                                                                    
|Cumulative effect of change in accounting principle                                                                                                                  |  |                                                   |         |                   |  |                  |   |                   |           |                   |  | (0.07      | ) |  |           |  
|                                                                                                                                                                     |  |                                                   |          |                   |  |                   |   |                   |            |                   |  |            |   |  |            |  
|Basic (loss) earnings per share                                                                                                                                      |  |                                                   | ($2.21   | )                 |  | ($3.20            | ) |                   | $0.38      |                   |  | $0.02      |   |  | $1.21      |  
|                                                                                                                                                                    
|                                                                                                                                                                     |  |                                                   |          |                   |  |                   |   |                   |            |                   |  |            |   |  |            |  
|                                                                                                                                                                    
|Weighted average number of shares outstanding - basic                                                                                                                |  |                                                   | 31,223   |                   |  | 31,046            |   |                   | 30,797     |                   |  | 31,962     |   |  | 34,531     |  
|                                                                                                                                                                     |  |                                                   |          |                   |  |                   |   |                   |            |                   |  |            |   |  |            |  
|Diluted (loss) earnings per share:                                                                                                                                   |  |                                                   |          |                   |  |                   |   |                   |            |                   |  |            |   |  |            |  
|                                                                                                                                                                    
|(Loss) earnings per share before extraordinary gain  unallocated
 negative goodwill and cumulative effect of change in accounting principle                         |  |                                                   | ($2.21   | )                 |  | ($3.20            | ) |                   | $0.03      |                   |  | $0.09      |   |  | $1.06      |  
|                                                                                                                                                                    
|Extraordinary gain  unallocated negative goodwill                                                                                                                   |  |                                                   |         |                   |  |                  |   |                   | 0.33       |                   |  |           |   |  | 0.09       |  
|                                                                                                                                                                    
|Cumulative effect of change in accounting principle                                                                                                                  |  |                                                   |         |                   |  |                  |   |                   |           |                   |  | (0.07      | ) |  |           |  
|                                                                                                                                                                     |  |                                                   |          |                   |  |                   |   |                   |            |                   |  |            |   |  |            |  
|Diluted (loss) earnings per share                                                                                                                                    |  |                                                   | ($2.21   | )                 |  | ($3.20            | ) |                   | $0.36      |                   |  | $0.02      |   |  | $1.15      |  
|                                                                                                                                                                     |  |                                                   |          |                   |  |                   |   |                   |            |                   |  |            |   |  |            |  
|                                                                                                                                                                    
|Weighted average number of shares  diluted                                                                                                                          |  |                                                   | 31,223   |                   |  | 31,046            |   |                   | 31,986     |                   |  | 32,132     |   |  | 36,297     |  
|                                                                                                                                                                     |  |                                                   |          |                   |  |                   |   |                   |            |                   |  |            |   |  |            |  
|                                                                                                                                                                     |  |                                                   |          |                   |  |                   |   |                   |            |                   |  |            |   |  |            |  
|Pro forma amounts assuming new accounting principles were applied
 retroactively:                                                                                    |  |                                                   |          |                   |  |                   |   |                   |            |                   |  |            |   |  |            |  
|                                                                                                                                                                    
|(Loss) earnings before extraordinary gain  unallocated negative
 goodwill and cumulative effect of a
 change in accounting principle, as reported                   |  |                                                   | ($68,955 | )                 |  | ($99,435          | ) |                   | $948       |                   |  | $2,886     |   |  | $38,675    |  
|Pro forma (loss) earnings before extraordinary gain  unallocated
 negative goodwill and cumulative effect of a change in accounting principle                       |  |                                                   | (68,955  | )                 |  | (99,435           | ) |                   | 948        |                   |  | 2,922      |   |  | 38,946     |  
|                                                                                                                                                                    
|Pro forma net (loss) income                                                                                                                                          |  |                                                   | (68,955  | )                 |  | (99,435           | ) |                   | 11,669     |                   |  | 2,922      |   |  | 42,122     |  
|                                                                                                                                                                    
|Per share amounts:                                                                                                                                                   |  |                                                   |          |                   |  |                   |   |                   |            |                   |  |            |   |  |            |  
|Basic (loss) earnings per share before extraordinary gain 
 unallocated negative goodwill and
 cumulative effect of a change in accounting principle, as reported   |  |                                                   | ($2.21   | )                 |  | ($3.20            | ) |                   | $0.03      |                   |  | $0.09      |   |  | $1.12      |  
|Pro forma basic (loss) earnings per share before extraordinary gain

 unallocated negative goodwill and cumulative effect of a change in accounting
 principle      |  |                                                   | ($2.21   | )                 |  | ($3.20            | ) |                   | $0.03      |                   |  | $0.09      |   |  | $1.13      |  
|                                                                                                                                                                    
|Pro forma basic (loss) earnings per share                                                                                                                            |  |                                                   | ($2.21   | )                 |  | ($3.20            | ) |                   | $0.38      |                   |  | $0.09      |   |  | $1.22      |  
|Diluted (loss) earnings per share before extraordinary gain 
 unallocated negative goodwill and cumulative effect of a change in accounting
 principle, as reported |  |                                                   | ($2.21   | )                 |  | ($3.20            | ) |                   | $0.03      |                   |  | $0.09      |   |  | $1.06      |  
|Pro forma diluted (loss) earnings per share before extraordinary gain
  unallocated negative goodwill and cumulative effect of a change in
 accounting principle    |  |                                                   | ($2.21   | )                 |  | ($3.20            | ) |                   | $0.03      |                   |  | $0.09      |   |  | $1.07      |  
|                                                                                                                                                                    
|Pro forma diluted (loss) earnings per share                                                                                                                          |  |                                                   | ($2.21   | )                 |  | ($3.20            | ) |                   | $0.36      |                   |  | $0.09      |   |  | $1.16      |  

12

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|                                                                 |  |                                                   |         |                   |   |                   |    |                   |         |                   |   |         |    |   |         |  
|---------------------------------------------------------------- |  | ------------------------------------------------- | ------- | ----------------- | - | ----------------- | -- | ----------------- | ------- | ----------------- | - | ------- | -- | - | ------- | -
|                                                                 |  | Fiscal Year Ended                                 |        
|                                                                 |  |                                                   |        
|                                                                 |  | January 31,
 2009                                 |         | February 2,
 2008 |   | February 3,
 2007 |    | January 28,
 2006 |         | January 29,
 2005 |  
|                                                                 |  |                                                   |         |                   |   |                   |    |                   |         |                   |  
|                                                                 |  | ($ in thousands, except per share and store data) |        
|BALANCE SHEET DATA (at the end of the period):                   |  |                                                   |         |                   |   |                   |    |                   |         |                   |   |         |    |   |         |  
|                                                                 |  |                                                   |         |                   |   |                   |    |                   |         |                   |   |         |    |   |         |  
|Total assets                                                     |  | $                                                 | 487,036 |                   | $ | 638,993           |    | $                 | 829,690 |                   | $ | 799,657 |    | $ | 859,653 |  
|Current portion of long-term debt and
 capital lease obligations |  |                                                   | 3,748   |                   |   | 3,501             |    |                   | 3,393   |                   |   | 3,659   |    |   | 780     |  
|Long-term obligations                                            |  |                                                   | 8,844   |                   |   | 12,588            |    |                   | 16,085  |                   |   | 19,474  |    |   | 12,037  |  
|Shareholders equity                                             |  | $                                                 | 235,015 |                   | $ | 298,149           |    | $                 | 393,205 |                   | $ | 378,512 |    | $ | 404,323 |  
|                                                                 |  |                                                   |         |                   |   |                   |    |                   |         |                   |   |         |    |   |         |  
|OPERATING DATA:                                                  |  |                                                   |         |                   |   |                   |    |                   |         |                   |   |         |    |   |         |  
|Store count (open at end of period):                             |  |                                                   |         |                   |   |                   |    |                   |         |                   |   |         |    |   |         |  
|Mall stores                                                      |  |                                                   | 549     |                   |   | 610               |    |                   | 737     |                   |   | 546     |    |   | 560     |  
|Freestanding stores                                              |  |                                                   | 163     |                   |   | 203               |    |                   | 255     |                   |   | 236     |    |   | 250     |  
|Total stores                                                     |  |                                                   | 712     |                   |   | 813               |    |                   | 992     |                   |   | 782     |    |   | 810     |  
|                                                                 |  |                                                   |         |                   |   |                   |    |                   |         |                   |   |         |    |   |         |  
|Comparable store sales (decrease) / increase(5)                  |  |                                                   | (10.8   | %)                |   | (8.5              | %) |                   | (6.2    | %)                |   | (5.7    | %) |   | 0.8     | %
|                                                                 |  |                                                   |         |                   |   |                   |    |                   |         |                   |   |         |    |   |         |  
|Total square footage (in thousands)                              |  |                                                   | 4,560   |                   |   | 5,117             |    |                   | 5,950   |                   |   | 4,824   |    |   | 5,002   |  

|   |                                                                                                                                                                                                                                                                                                                                                                                                                                                               
|-- | --------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
|1. | During Fiscal 2008 and Fiscal 2007, the Company recorded
 an asset impairment charge of $15.2 million and $30.7 million, respectively,
 to write down certain long-lived assets pursuant to SFAS No. 144, Accounting
 for the Impairment or Disposal of Long-Lived Assets.                                                                                                                                                                                  
|   |                                                                                                                                                                                                                                                                                                                                                                                                                                                               
|2. | Included in income tax expense for Fiscal 2007 is deferred
 tax expense of $42.5 million, the recording of which was primarily due to the
 establishment of a full valuation allowance against the Companys net
 deferred tax assets. See Note 6 in the Notes to Consolidated Financial
 Statements for further detail.                                                                                                                                      
|   |                                                                                                                                                                                                                                                                                                                                                                                                                                                               
|3. | The Companys acquisition of substantially all of the net
 assets of Musicland Holding Corp. stores in Fiscal 2006 and of Wherehouse
 Entertainment Inc. and CD World in Fiscal 2003, resulted in extraordinary
 gains recorded in Fiscal 2006 and Fiscal 2004 in accordance with SFAS No.
 141, Business Combinations. The gains, net of tax, represented the excess
 of fair value of net assets acquired over the purchase price of the acquired
 assets.
|   |                                                                                                                                                                                                                                                                                                                                                                                                                                                               
|4. | The Company adopted FASB Interpretation No. (FIN) 47, Accounting
 for Conditional Asset Retirement Obligationsan interpretation of FASB
 Statement No. 143, effective January 28, 2006 resulting in a one-time,
 non-cash, after tax charge of $2.3 million, which was classified as a
 cumulative effect of a change in accounting principle in Fiscal 2005.                                                                                          
|   |                                                                                                                                                                                                                                                                                                                                                                                                                                                               
|5. | A store is included in comparable store sales calculations
 at the beginning of its thirteenth full month of operation. Mall stores
 relocated in the same shopping center after being open for at least thirteen
 months are considered comparable stores. Closed stores that were open for at
 least thirteen months are included in comparable store sales through the
 month immediately preceding the month of closing.                                  

13

---



Item 7. MANAGEMENTS DISCUSSION AND ANALYSIS
OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS

Overview

Managements
Discussion and Analysis of Financial Condition and Results of Operations
provides information that the Companys management believes necessary to
achieve an understanding of its financial condition and results of operations.
To the extent that such analysis contains statements which are not of a
historical nature, such statements are forward-looking statements, which
involve risks and uncertainties. These risks include, but are not limited to,
changes in the competitive environment for the Companys merchandise, including
the entry or exit of non-traditional retailers of the Companys merchandise to
or from its markets; releases by the music, video, and video game industries of
an increased or decreased number of hit releases; general economic factors in
markets where the Companys merchandise is sold; and other factors discussed in
the Companys filings with the Securities and Exchange Commission. The
following discussion and analysis of the Companys financial condition and
results of operations should be read in conjunction with Selected Consolidated
Financial Data and the Consolidated Financial Statements and related notes
included elsewhere in this report.

At January 31,
2009, the Company operated 712 stores totaling approximately 4.6 million square
feet in the United States, the District of Columbia, the Commonwealth of Puerto
Rico and the U.S. Virgin Islands. In the fiscal year ended January 31, 2009
(referred to herein as Fiscal 2008), the Companys net sales decreased as
compared to the fiscal year ended February 3, 2008, (referred to herein as
Fiscal 2007) as a result of lower average store count and a decrease in
comparable store sales. Comparable store sales decreased 10.8% during Fiscal
2008.

The Company
focuses on the following areas in its effort to improve its business:

Improving Merchandise Assortment and Product
Mix

The Company
tailors the product mix of its stores toward regional tastes in order to
optimize the productivity of its stores, seeking to serve key customer segments
within each store. We have also focused on creating a stronger value statement to our customers
to drive additional traffic across the lease line and improve conversion.
This involves tailoring the overall square footage
allocation in line with a stores trend, and increasing inventory and square
footage allocations for growth categories. As music sales have continued to
decline, the Company has been able to partially offset the impact by shifting
square footage allocations from music to other product categories. While adding inventory
in other product categories, we remain focused on improving inventory turnover.

Store Openings and Closures

During Fiscal
2008 and Fiscal 2007, the Company closed 101 and 179 stores, respectively. The
Company has not opened a new store in the last two years. The Companys real estate strategy is to reposition our store portfolio by
reducing our store base to a core group of profitable locations.

The Company
closes stores when minimum operating thresholds are not achieved or upon lease
expiration when either renewal is not available or management determines that
renewal is not in the Companys best interest. The composition of these stores
changes from time-to-time as the result of competitive changes and other
factors.

Expanding Customer Base

To strengthen customer loyalty, the Company offers its customers
    the option of signing up for a Backstage Pass card which provides an additional
    10% discount off of everyday selling prices on nearly all product in addition
    to other value added offers members receive through the program in exchange
    for an annual membership fee. The Company also co-sponsors events in many
    of its stores to provide various segments of its customers an opportunity
    to experience entertainment and shop for unique and exclusive products based
    on their particular interests.

Key Performance Indicators

Management
monitors a number of key performance indicators to evaluate its performance,
including:

Net Sales: The
Company measures the rate of comparable store net sales change. A store is
included in comparable store net sales calculations at the beginning of its
thirteenth full month of operation. Mall stores relocated in the same shopping
center after being open for at least thirteen months are considered comparable
stores. Closed stores that were open for at least thirteen months are included
in comparable store net sales through the month immediately prior to the month
of closing. The Company further analyzes net sales by store format and by
product category.

Cost of Sales and Gross Profit:
Gross profit is a function of the cost of product in relation to its retail
selling value. Changes in gross profit are impacted primarily by net sales
levels, mix of products sold, vendor discounts and allowances and distribution
costs. The Company records its distribution, freight and obsolescence expenses
in cost of sales. Distribution expenses include those costs associated with
receiving, inspecting and warehousing merchandise and costs associated with
product returns to vendors.

14

---



Selling, General and Administrative
(SG&A) expenses: Included in SG&A expenses
are payroll and related costs, occupancy charges, general operating and
overhead expenses and depreciation charges (excluding those related to
distribution operations, as discussed in Note 3 of Notes to the Consolidated
Financial Statements in this Annual Report on Form 10-K). SG&A expenses
also include fixed assets write-offs associated with store closures, if any,
and miscellaneous items, other than interest.

Balance Sheet and Ratios:
The Company views cash, net inventory investment (merchandise inventory less
accounts payable) and working capital (current assets less current liabilities)
as indicators of its financial position. See Liquidity and Capital Resources
for further discussion of these items.

Fiscal Year Ended January 31, 2009 (Fiscal
2008)
Compared to Fiscal Year Ended February 2, 2008 (Fiscal 2007)

Net Sales. The
following table sets forth a year-over-year comparison of the Companys total
net sales:

|                 |  |      |          |      |  |            |  |               |             |  |  |         | 
|---------------- |  | ---- | -------- | ---- |  | ---------- |  | ------------- | ----------- |  |  | ------- | 
|                 |  |      |          |      |  |            |  | 2008 vs. 2007 |            
|                 |  |      |          |      |  |            |  |               |            
|($ in thousands) |  | 2008 |          | 2007 |  | $          |  | %             |            
|                 |  |      |          |      |  |            |  |               |            
|Net Sales        |  |      | $987,625 |      |  | $1,265,658 |  |               | $ (278,033) |  |  | (22.0%) | 

The 22% net
sales decline from prior year is due to the comparable store net sales decline
of 11% coupled with an 18% decline in average store count. Total product units
sold in Fiscal 2008 decreased 16% and the average retail price for units sold
decreased 8%.

Net sales by
merchandise category for Fiscal 2008 and Fiscal 2007 were as follows:

|                 |  |                 |         |          |  |                 |   |          |           |                            |  |                                       |   |  |  |       |    |  |  |  |       |    | 
|---------------- |  | --------------- | ------- | -------- |  | --------------- | - | -------- | --------- | -------------------------- |  | ------------------------------------- | - |  |  | ----- | -- |  |  |  | ----- | -- | 
|                 |  |                 |         |          |  |                 |   |          |           |                            |  |                                       |   |  |  |       |    |  | 
|($ in thousands) |  | 2008
 Net Sales |         | %
 Total |  | 2007
 Net Sales |   | %
 Total |           | Total %
 Net Sales
 Change |  | Comparable
 Store % Net
 Sales Change |  
|                 |  |                 |         |          |  |                 |   |          |           |                            |  |                                       |   |  |  |       |    |  | 
|                 |  |                 |         |          |  |                 |   |          |           |                            |  |                                       |   |  |  |       |    |  | 
|Music            |  | $               | 349,737 |          |  | 35.4            | % | $        | 494,286   |                            |  | 39.1                                  | % |  |  | (29.2 | %) |  |  |  | (20.2 | %) | 
|Video            |  |                 | 407,884 |          |  | 41.3            |   |          | 491,360   |                            |  | 38.8                                  |   |  |  | (17.0 | )  |  |  |  | (3.1  | )  | 
|Video games      |  |                 | 90,233  |          |  | 9.1             |   |          | 114,431   |                            |  | 9.0                                   |   |  |  | (21.1 | )  |  |  |  | (14.3 | )  | 
|Other            |  |                 | 139,771 |          |  | 14.2            |   |          | 165,581   |                            |  | 13.1                                  |   |  |  | (15.6 | )  |  |  |  | (0.6  | )  | 
|                 |  |                 |         |          |  |                 |   |          |           |                            |  |                                       |   |  |  |       |    |  |  |  |       |    | 
|Total            |  | $               | 987,625 |          |  | 100.0           | % | $        | 1,265,658 |                            |  | 100.0                                 | % |  |  | (22.0 | %) |  |  |  | (10.8 | %) | 
|                 |  |                 |         |          |  |                 |   |          |           |                            |  |                                       |   |  |  |       |    |  |  |  |       |    | 

The Other
category includes electronics, accessories and trend items, none of which
individually exceed 10% of total net sales.

Music

The Companys
stores offer a wide range of new and used CDs and music DVDs across most music
genres, including new releases from current artists as well as an extensive
catalog of music from past periods and artists. The music category declined as
a percentage of total net sales and declined 20.2% on a comparable store sale
basis due to the lack of new product releases and the shift to online
downloading. The Company continues to shift square footage allocations to new
categories to compensate for the decline.

Net sales of
CDs represented approximately 95% of total net sales in the music category
during Fiscal 2008. The Companys annual CD unit sales decreased 28% in Fiscal
2008 due to lower comparable store net sales and the decrease in average store
count. According to SoundScan, total CD unit sales in the United States
declined 20% during the period corresponding with the Companys Fiscal 2008.

Video

The Company
offers DVDs in all of its stores and high definition DVDs in a majority of its
stores. The video category increased as a percentage of the Companys total net
sales due to slower comparable store sales decline in this category than the
other categories.

Total net
sales for Fiscal 2008 in the video category decreased 17% due to a comparable
store net sales decrease of 3% and the lower average store count. According to
VideoScan, total video unit sales in the United States declined 9% during the
period corresponding with the Companys Fiscal 2008.

Video games

The Company
offers video game hardware and software in 347 stores. During Fiscal 2007, the
Company discontinued the sale of video games in approximately 300 stores. The
Company has narrowed the number of stores offering video games in order to
increase average store video game sales by offering better assortment and more
product in its best game sales stores.

15

---



The negative
comparable store sales in video games was due to a lack of allocation of product
    from vendors as well as a reduction in the number of stores carrying games
    in Fiscal 2008 versus Fiscal 2007.

Other

The Other
category consists of electronics, accessories and trend items. Net sales in
this category have increased as a percentage of total net sales due to
increased store square footage allocations and slower comparable store sales
declines than music and video.

Gross Profit. The
following table sets forth a year-over-year comparison of the Companys Gross
Profit:

|                              |  |      |         |      |   |         |   |               |         |   |  |        |  
|----------------------------- |  | ---- | ------- | ---- | - | ------- | - | ------------- | ------- | - |  | ------ | -
|($ in thousands)              |  |      |         |      |   |         |   | 2008 vs. 2007
|                              |  |      |         |      |   |         |   |              
|                              |  | 2008 |         | 2007 |   | $       |   | %             |        
|                              |  |      |         |      |   |        
|Gross Profit                  |  | $    | 330,895 |      | $ | 445,747 |   | ($            | 114,852 | ) |  | (25.8% | )
|                             
|As a
 percentage of net sales |  |      | 33.5    | %    |   | 35.2    | % |               |         |   |  |        |  

The 170 basis point decline in gross profit as a percentage of net
sales was due to increased markdowns on slow moving inventory and lower vendor
allowances.

Selling, General and Administrative Expenses.
The following table sets forth a year-over-year comparison of the Companys
SG&A expenses:

|                                              |  |      |         |      |   |         |   |               |        |   |  |        |  
|--------------------------------------------- |  | ---- | ------- | ---- | - | ------- | - | ------------- | ------ | - |  | ------ | -
|($ in thousands)                              |  |      |         |      |   |         |   | 2008 vs. 2007 |       
|                                              |  |      |         |      |   |         |   |              
|                                              |  | 2008 |         | 2007 |   | $       |   | %             |       
|                                              |  |      |         |      |   |        
|Selling,
 general and administrative expenses |  | $    | 380,802 |      | $ | 470,386 |   | ($            | 89,584 | ) |  | (19.0% | )
|                                              |  |      |         |      |   |         |   |               |        |   |  |        |  
|As a
 percentage of net sales                 |  |      | 38.6    | %    |   | 37.2    | % |               |        |   |  |        |  

The $90 million decrease in SG&A expenses is due to the Company
operating an average of 18% fewer stores. Despite the decrease, SG&A as a
percentage of net sales increased to 38.6% from 37.2% due to the sales decline
of 22%.

Included in SG&A for Fiscal 2008 is a gain of approximately $3.1
million from the sale of the Canton, Ohio distribution facility.

Asset Impairment Charge.
During Fiscal 2008 and Fiscal 2007, the Company concluded, based on a
significant decline in sales and earnings during the fourth quarter, that
triggering events had occurred, pursuant to SFAS No. 144, Accounting for the Impairment or
Disposal of Long-Lived Assets (SFAS No. 144), requiring a test of
long-lived assets for impairment at its retail stores and consolidated
subsidiaries. Long-lived assets at locations where impairment was determined to
exist were written down to their estimated fair values as of the end of each period
resulting in the recording of asset impairment charges of $15.2 million and
$30.7 million in Fiscal 2008 and Fiscal 2007, respectively. Estimated fair
values for long-lived assets at these locations, including store fixtures and
equipment, leasehold improvements and certain intangible assets, were
determined based on a measure of discounted future cash flows over the
remaining lease terms at the respective locations. Future cash flows were
estimated based on store plans and were discounted at a rate approximating the
Companys cost of capital. Management believes its assumptions were reasonable
and consistently applied.

Interest Expense.
Interest expense in Fiscal 2008 was $4.1 million compared to $6.5 million in
Fiscal 2007. The increase is due to lower average borrowings on the Companys
revolving line of credit and lower interest rates.

Other Income. Other
income includes interest income, which was $0.2 million and $0.4 million in
Fiscal 2008 and 2007, respectively.

Income Tax (Benefit) Expense.The
following table sets forth a year-over-year comparison of the Companys income
tax expense (benefit):

|                              |  |      |  |      |   |               |  |   |        |    |  |  |           | 
|----------------------------- |  | ---- |  | ---- | - | ------------- |  | - | ------ | -- |  |  | --------- | 
|($ in thousands)              |  |      |  |      |   | 2008 vs. 2007
|                              |  |      |  |      |   |              
|                              |  | 2008 |  | 2007 |   | $            
|                              |  |      |  |      |   |              
|Income tax
 (benefit) expense |  |      |  | ($28 | ) |               |  | $ | 37,975 |    |  |  | ($38,003) | 
|                              |  |      |  |      |   |               |  |   |        |    |  |  |           | 
|Effective
 tax rate           |  |      |  | 0.0  | % |               |  |   | (61.8  | %) |  |  |           | 

16

---



During Fiscal
2007 the Company recorded deferred tax expense of $42.5 million, which was
primarily due to the establishment of a full valuation allowance against the
Companys net deferred tax assets. This was partially offset by a $5.7 million
federal income tax benefit recognized as the result of a net operating loss
carryback. The remaining components of income tax expense, totaling
approximately $1.2 million, include certain state and local taxes, adjustments
to the reserve for uncertain tax positions and the accrual of interest and
penalties on uncertain tax positions. See Note 6 in the Notes to Consolidated
Financial Statements for further detail.

Net Loss. The
following table sets forth a year-over-year comparison of the Companys net
loss:

|                                       |  |      |           |      |  |           |    |               |         | 
|-------------------------------------- |  | ---- | --------- | ---- |  | --------- | -- | ------------- | ------- | 
|($ in thousands)                       |  |      |           |      |  |           |    | 2008 vs. 2007 |        
|                                       |  |      |           |      |  |           |   
|                                       |  | 2008 |           | 2007 |  | $         |   
|                                       |  |      |           |      |  |           |   
|                                      
|Net loss                               |  |      | ($ 68,955 | )    |  | ($ 99,435 | )  |               | $30,480 | 
|                                       |  |      |           |      |  |           |    |               |         | 
|                                       |  |      |           |      |  |           |    |               |         | 
|Net loss as
 a percentage of net sales |  |      | (7.0      | %)   |  | (7.9      | %) |               |         | 

The Fiscal
2008 net loss of $69.0 million was due to the decline in comparable store sales
and the impairment charge of $15.2 million. The $30.5 million reduction in net
loss as compared to 2007 was due to a lower impairment charge and the $42.5
million deferred tax charge recorded in Fiscal 2007, partially offset by lower
sales and the 170 basis point decrease in gross margin.

17

---



Fiscal Year Ended February 2, 2008 (Fiscal
2007)
Compared to Fiscal Year Ended February 3, 2007 (Fiscal 2006)

Net Sales. The
following table sets forth a year-over-year comparison of the Companys total
net sales:

|                 |  |      |            |      |  |            |  |               |             |  |  |         | 
|---------------- |  | ---- | ---------- | ---- |  | ---------- |  | ------------- | ----------- |  |  | ------- | 
|($ in thousands) |  |      |            |      |  |            |  | 2007 vs. 2006 |            
|                 |  |      |            |      |  |            |  |              
|                 |  | 2007 |            | 2006 |  | $          |  | %             |            
|                 |  |      |            |      |  |           
|Net Sales        |  |      | $1,265,658 |      |  | $1,471,157 |  |               | $ (205,499) |  |  | (14.0%) | 

The 14% net
sales decline from prior year is due to the comparable store net sales decline
of 8.5% coupled with a 6.6% decline in average store count. Additionally,
Fiscal 2006 contained a 53rdweek of business which contributed
approximately $23.0 million in net sales. Total product units sold in Fiscal
2007 decreased 14.5% and the average retail price for units sold increased
1.4%.

Net sales by
merchandise category for Fiscal 2007 and Fiscal 2006 were as follows:

|                 |  |                 |           |          |  |                 |   |          |           |                            |  |                                        |   |  |  |       |    |  |  |  |       |    | 
|---------------- |  | --------------- | --------- | -------- |  | --------------- | - | -------- | --------- | -------------------------- |  | -------------------------------------- | - |  |  | ----- | -- |  |  |  | ----- | -- | 
|                 |  |                 |           |          |  |                 |   |          |           |                            |  |                                        |   |  |  |       |    |  | 
|($ in thousands) |  | 2007
 Net Sales |           | %
 Total |  | 2006
 Net Sales |   | %
 Total |           | Total %
 Net Sales
 Change |  | Comparable 
 Store % Net
 Sales Change |  
|                 |  |                 |           |          |  |                 |   |          |           |                            |  |                                        |  
|                
|Music            |  | $               | 494,286   |          |  | 39.1            | % | $        | 676,091   |                            |  | 46.0                                   | % |  |  | (26.9 | %) |  |  |  | (23.2 | %) | 
|Video            |  |                 | 491,360   |          |  | 38.8            |   |          | 529,900   |                            |  | 36.0                                   |   |  |  | (7.3  | )  |  |  |  | 1.1   |    | 
|Video games      |  |                 | 114,431   |          |  | 9.0             |   |          | 114,654   |                            |  | 7.8                                    |   |  |  | (0.2  | )  |  |  |  | 8.3   |    | 
|Other            |  |                 | 165,581   |          |  | 13.1            |   |          | 150,512   |                            |  | 10.2                                   |   |  |  | 10.0  |    |  |  |  | 14.2  |    | 
|                 |  |                 |           |          |  |                 |   |          |           |                            |  |                                        |   |  |  |       |    |  |  |  |       |    | 
|Total            |  | $               | 1,265,658 |          |  | 100.0           | % | $        | 1,471,157 |                            |  | 100.0                                  | % |  |  | (14.0 | %) |  |  |  | (8.5  | %) | 
|                 |  |                 |           |          |  |                 |   |          |           |                            |  |                                        |   |  |  |       |    |  |  |  |       |    | 

The Other
category includes electronics, accessories and trend items, none of which
individually exceed 10% of total net sales.

Music

The Companys
stores offer a wide range of new and used CDs and music DVDs across most music
genres, including new releases from current artists as well as an extensive
catalog of music from past periods and artists. The music category declined as
a percentage of total net sales and declined 23.2% on a comparable store sale
basis due to the lack of new product releases and the shift to online
downloading. The Company continues to shift square footage allocations to
growth categories to compensate for the decline.

Net sales of
CDs represented approximately 95% of total net sales in the music category
during Fiscal 2007. The Companys annual CD unit sales decreased 26% in Fiscal
2007 due to lower comparable store net sales and the decrease in average store
count. According to SoundScan, total CD unit sales in the United States
declined 19% during the period corresponding with the Companys Fiscal 2007.

Video

The Company
offers DVDs and high definition DVDs in all its stores. The video category
increased as a percentage of the Companys total net sales due to the increase
in store square footage to support the category.

Total net
sales for Fiscal 2007 in the video category decreased 7.3% despite the
comparable store net sales increase of 1.1% due to the lower average store
count. According to VideoScan, total video unit sales in the United States
declined 3% during the period corresponding with the Companys Fiscal 2007.

Video games

The Company
offers video game hardware and software in approximately half its stores.
During Fiscal 2007, the Company discontinued the sale of video games in
approximately 300 stores. The Company has narrowed the number of stores
offering video games in order to increase total video game sales by offering
better assortment and more product in its best game sales stores.

The positive
comparable store net sales in video games were due to improved hardware
allocations of Wii, PS3 and Nintendo DS Lite, as well as improved software
sales. According to NPD, industry video games sales during calendar year 2007,
including portable and console hardware, software and accessories increased 43%
over calendar year 2006 sales.

Other

The Other
category consists of electronics, accessories and trend items. Net sales in
this category have increased as a percentage of total net sales due to
increased store square footage allocations which have driven double digit
comparable store net sales growth.

18

---



Gross Profit. The
following table sets forth a year-over-year comparison of the Companys Gross
Profit:

|                              |  |      |         |      |   |         |   |               |            |  |  |         | 
|----------------------------- |  | ---- | ------- | ---- | - | ------- | - | ------------- | ---------- |  |  | ------- | 
|($ in thousands)              |  |      |         |      |   |         |   | 2007 vs. 2006 |           
|                              |  |      |         |      |   |         |   |              
|                              |  | 2007 |         | 2006 |   | $       |   | %             |           
|                              |  |      |         |      |   |        
|Gross Profit                  |  | $    | 445,747 |      | $ | 519,222 |   |               | $ (73,475) |  |  | (14.2%) | 
|As a
 percentage of net sales |  |      | 35.2    | %    |   | 35.3    | % |               |            |  |  |         | 

The 10 basis point decline in gross profit as a percentage of net sales
was due to a loss of leverage of distribution and freight costs against the net
sales decline.

Selling,
General and Administrative Expenses. The following table sets forth a
year-over-year comparison of the Companys SG&A expenses:

|                                              |  |      |         |      |   |         |   |               |            |  |  |        | 
|--------------------------------------------- |  | ---- | ------- | ---- | - | ------- | - | ------------- | ---------- |  |  | ------ | 
|($ in thousands)                              |  |      |         |      |   |         |   | 2007 vs. 2006 |           
|                                              |  |      |         |      |   |         |   |              
|                                              |  | 2007 |         | 2006 |   | $       |   | %             |           
|                                              |  |      |         |      |   |        
|Selling,
 general and administrative expenses |  | $    | 470,386 |      | $ | 519,246 |   |               | $ (48,860) |  |  | (9.4%) | 
|                                              |  |      |         |      |   |         |   |               |            |  |  |        | 
|As a
 percentage of net sales                 |  |      | 37.2    | %    |   | 35.3    | % |               |            |  |  |        | 

The $48.9
million decrease in SG&A expenses is due to the lower average store count
and the absence of approximately $7.9 million in transition costs related to
the Musicland acquisition that were incurred in Fiscal 2006. The increase in
SG&A expenses as a percentage of net sales is due to a loss of leverage on
fixed costs due to the net sales decline.

Asset Impairment Charge.
During Fiscal 2007, the Company concluded, based on a significant decline in
sales and earnings during the fourth quarter, that triggering events had
occurred, pursuant to SFAS No. 144, Accounting for the Impairment or Disposal of
Long-Lived Assets (SFAS No. 144)., requiring a test of long-lived
assets for impairment at its retail stores and consolidated subsidiaries.
Long-lived assets at locations where impairment was determined to exist were
written down to their estimated fair values as of February 2, 2008, resulting
in the recording of an asset impairment charge of $30.7 million. Estimated fair
values for long-lived assets at these locations, including store fixtures and
equipment, leasehold improvements and certain intangible assets, were
determined based on a measure of discounted future cash flows over the
remaining lease terms at the respective locations. Future cash flows were
estimated based on store operating plans and were discounted at a rate
approximating the Companys cost of capital. Management believes its
assumptions were reasonable and consistently applied.

Interest Expense.
Interest expense in Fiscal 2007 was $6.5 million compared to $5.5 million in
Fiscal 2006. The increase is due to higher average borrowings on the Companys
credit facility.

Other Income. Other
income includes interest income, which was $0.4 million and $0.9 million in
Fiscal 2007 and 2006, respectively. Fiscal 2006 other income also includes a
$3.5 million gain on the sale of an investment.

Income Tax Expense (Benefit).
The following table sets forth a year-over-year comparison of the Companys
income tax expense (benefit):

|                              |  |      |        |      |   |        |   |               |          | 
|----------------------------- |  | ---- | ------ | ---- | - | ------ | - | ------------- | -------- | 
|($ in thousands)              |  |      |        |      |   |        |   | 2007 vs. 2006 |         
|                              |  |      |        |      |   |        |   |               |         
|                              |  | 2007 |        | 2006 |   | $      |  
|                              |  |      |        |      |   |        |  
|                              |  |      |        |      |   |        |  
|Income tax
 expense (benefit) |  | $    | 37,975 |      | $ | (2,041 | ) |               | $ 40,016 | 
|                              |  |      |        |      |   |        |   |               |          | 
|Effective
 tax rate           |  |      | (61.8  | %)   |   | 186.7  | % |               |          | 

During Fiscal
2007 the Company recorded deferred tax expense of $42.5 million, which was
primarily due to the establishment of a full valuation allowance against the
Companys net deferred tax assets. This was partially offset by a $5.7 million
federal income tax benefit recognized as the result of a net operating loss
carryback. The remaining components of income tax expense, totaling
approximately $1.2 million, include certain state and local taxes, adjustments
to the reserve for uncertain tax positions and the accrual of interest and
penalties on uncertain tax positions. See Note 6 in the Notes to Consolidated
Financial Statements for further detail.

The Fiscal 2006 income tax
benefit is attributable to a tax favored gain from the sale of an investment,
which resulted in a $1.4 million reduction of the valuation allowance
attributable to losses on investments, favorable settlements of income tax
examinations ($0.9 million) and federal income tax credits ($0.3 million),
partially offset by unfavorable state tax legislation enacted during the year
and changes in managements

19

---



estimates of
the realization of state net operating losses. For a reconciliation of the
federal statutory tax rate to the Companys effective income tax rate, see Note
6 of Notes to the Consolidated Financial Statements in this Annual Report on
Form 10-K.

Extraordinary Gain.In
Fiscal 2006, the Company recorded an extraordinary gain of $10.7 million, net
of income taxes of $6.7 million, as a result of acquiring substantially all of
the net assets of Musicland Holding Corp. on March 27, 2006. The gain represented
the excess of the fair value of the net assets acquired over the purchase price
of the acquired assets.

Net (Loss) Income.
The following table sets forth a year-over-year comparison of the Companys net
(loss) income:

|                                                                                                                                  |  |      |         |      |   |                |   |   |          |  
|--------------------------------------------------------------------------------------------------------------------------------- |  | ---- | ------- | ---- | - | -------------- | - | - | -------- | -
|($ in
thousands)                                                                                                                  |  |      |         |      |   |                |   |   |          |  
|                                                                                                                                  |  |      |         |      |   | 2007 vs.
 2006 |  
|                                                                                                                                  |  |      |         |      |   |                |  
|                                                                                                                                  |  | 2007 |         | 2006 |   | $              |  
|                                                                                                                                  |  |      |         |      |   |                |  
|                                                                                                                                  |  |      |         |      |   |                |   |   |          |  
|(Loss) income before extraordinary gain 
 unallocated negative goodwill                                                          |  | $    | (99,435 | )    | $ | 948            |   | $ | (100,383 | )
|Extraordinary gain  unallocated negative
 goodwill, net of income taxes of $0 and $6,739 for Fiscal 2007 and 2006,
 respectively |  |      |        |      |   | 10,721         |   | $ | (10,721  | )
|                                                                                                                                  |  |      |         |      |   |                |   |   |          |  
|                                                                                                                                  |  |      |         |      |   |                |   |   |          |  
|Net (loss) income                                                                                                                 |  | $    | (99,435 | )    | $ | 11,669         |   | $ | (111,104 | )
|                                                                                                                                  |  |      |         |      |   |                |   |   |          |  
|                                                                                                                                  |  |      |         |      |   |                |   |   |          |  
|Net (loss) income as a percentage of net
 sales                                                                                   |  |      | (7.9    | %)   |   | 0.8            | % |   |          |  

The Fiscal
2007 net loss of $99.4 million was due, in large part, to the impairment charge
of $30.7 million and $42.5 million in deferred tax expense associated with
establishing the valuation allowance against net deferred tax assets. In addition,
the 14% net sales decline and 10 basis point gross margin decline from prior
year contributed to an approximate $73.5 million decrease in gross profit
dollars, which was partially offset by a $48.9 million decrease in SG&A
expenses. Fiscal 2006 net income also included a $3.5 million gain on the sale
of an investment.

LIQUIDITY AND CAPITAL
RESOURCES

Liquidity and Cash
Flows: The
Companys primary sources of working capital are cash provided by sales of
merchandise inventory and borrowing capacity under its revolving credit
facility. The Companys cash flows fluctuate from quarter to quarter due to
various items, including seasonality of sales and earnings, merchandise
inventory purchases and returns and the related terms on the purchases and
capital expenditures. Management believes it will have adequate resources to
fund its cash needs for the foreseeable future, including its capital spending,
its seasonal increase in merchandise inventory and other operating cash
requirements and commitments. Management has considered many initiatives as
part of the development of its operating plan for 2009 and beyond that focus on
the operation of a core base of stores, improved product selection based on
customer preferences and industry changes, as well as further streamlining of
its operations. During Fiscal 2008, management carried out certain strategic
initiatives in its efforts to reduce certain operating costs such as the
closure of the Canton, OH distribution center, reduction of headcount at the
home office and the Albany, NY distribution center, as well as the elimination
or curtailment of certain other general and administrative expenses. Also,
during the fourth quarter of Fiscal 2008, management closed 74 stores and plans
to continue its careful evaluation of store profitability of its remaining 712
stores in consideration of lease terms, conditions and expirations. As a
consequence of these further actions, the liquidation of the merchandise
inventory from closed stores and management of overall merchandise inventory
levels, management expects improvement in its operating cash flow during Fiscal
2009.

Management
anticipates any cash requirements due to a shortfall in cash from operations
will be funded by the Companys revolving credit facility, discussed hereafter.
Cash flows from investing and financing activities during Fiscal 2009 are
expected to be comparable with Fiscal 2008. The Company does not expect any
material changes in the mix (between equity and debt) or the relative cost of
capital resources. See Item 1A, Risk Factors, Disruption of the global capital
and credit markets may have a material adverse effect on the Companys
liquidity and capital resources.

20

---



The following
table sets forth a three year summary of key components of cash flow and
working capital:

|                          |  |      |         |      |    |                |   |    |         |                |  |     |    |   |          |   |    |         |   |  |      |   
|------------------------- |  | ---- | ------- | ---- | -- | -------------- | - | -- | ------- | -------------- |  | --- | -- | - | -------- | - | -- | ------- | - |  | ---- | --
|                          |  |      |         |      |    | 2008 vs.
 2007 |   |    |         | 2007 vs.
 2006 | 
|                          |  |      |         |      |    |                |   |    |         |                | 
|($ in
thousands)          |  | 2008 |         | 2007 |    | $              |   | %  |         | 2006           |  | $   |    | % |         
|                          |  |      |         |      |    |                |   |    |         |                |  |     |    |   |         
|Operating Cash Flows      |  | ($   | 37,232  | )    | ($ | 25,579         | ) | ($ | 11,653  | )              |  | (46 | %) | $ | 47,268   |   | ($ | 72,847  | ) |  | (154 | %)
|Investing Cash Flows      |  |      | (3,873  | )    |    | (15,949        | ) |    | 12,076  |                |  | 76  | %  |   | (122,871 | ) |    | 106,922 |   |  | 87   | % 
|Financing Cash Flows      |  |      | (3,495  | )    |    | (2,447         | ) |    | (1,048  | )              |  | (43 | %) |   | (2,976   | ) |    | 529     |   |  | 18   | % 
|                          |  |      |         |      |    |                |   |    |         |                |  |     |    |   |          |   |    |         |   |  |      |   
|Capital Expenditures      |  |      | (10,066 | )    |    | (15,949        | ) |    | 5,883   |                |  | 37  | %  |   | (48,289  | ) |    | 32,340  |   |  | 67   | % 
|Acquisition of Business   |  |      |        |      |    |               |   |    |        |                |  |    |    |   | (78,810  | ) |    | 78,810  |   |  | 100  | % 
|                          |  |      |         |      |    |                |   |    |         |                |  |     |    |   |          |   |    |         |   |  |      |   
|Cash and Cash Equivalents |  |      | 30,055  |      |    | 74,655         |   |    | (44,600 | )              |  | (60 | %) |   | 118,630  |   |    | (43,975 | ) |  | (37  | %)
|Merchandise Inventory     |  |      | 378,188 |      |    | 440,241        |   |    | (62,053 | )              |  | (14 | %) |   | 504,860  |   |    | (64,619 | ) |  | (13  | %)
|Working Capital           |  |      | 213,389 |      |    | 251,507        |   |    | (38,118 | )              |  | (15 | %) |   | 266,204  |   |    | (14,697 | ) |  | (6   | %)
|Inventory turns           |  |      | 1.6     |      |    | 1.7            |   |    |         |                |  |     |    |   | 1.8      |   |    |         |   |  |      |   

The $11.7
million decrease in operating cash flows was due to a loss from operations of
$49.9 million, exclusive of the $15.2 million non-cash impairment charge,
compared to a loss from operations of $26.2 million, exclusive of the $30.7
million non-cash impairment charge and $42.5 million deferred tax charge
recorded during Fiscal 2007 partially offset by fluctuation of operating assets
and liabilities, within the normal course of business, during Fiscal 2008.

The Company
monitors various statistics to measure its management of inventory, including
inventory turn (annual cost of sales divided by average merchandise inventory
balances), inventory investment per square foot and inventory leverage
(accounts payable divided by merchandise inventory). Inventory turn in Fiscal
2008 was 1.6 compared to 1.7 in Fiscal 2007. Inventory investment per square
foot was $83 per square foot at the end of Fiscal 2008 as compared to $86 per
square foot at the end of Fiscal 2007. Inventory leverage was 45% as of January
31, 2009 compared with 54% as of February 3, 2008. Management considers these
results to be consistent with historical performance.

Cash used in
investing activities was $3.9 million in Fiscal 2008, compared to $15.9 million
in Fiscal 2007. During Fiscal 2008, cash used in investing activities consisted
of capital expenditures of $10.1 million, partially offset by proceeds of $6.2
from the sale of the Companys distribution facility in Canton, Ohio. During
Fiscal 2007, cash used in investing activities consisted exclusively of capital
expenditures of $15.9 million. The Companys capital expenditures in Fiscal
2008 included approximately $6.6 million for store remodels and merchandising
projects. The remaining capital expenditures were primarily for general IT
software and equipment.

The Company
has historically financed its capital expenditures through borrowings under its
credit facility, select financing arrangements and cash generated from sales of
merchandise inventory. It may also receive landlord allowances or concessions
for store openings, relocations or improvements. The Company anticipates
capital spending of approximately $10 million in Fiscal 2009.

Cash used in
financing activities was $3.5 million in Fiscal 2008, compared to a $2.4
million in Fiscal 2007. In Fiscal 2008, the primary uses of cash were payments
of long-term debt and capital lease obligations of $0.5 million and $3.0
million. In Fiscal 2007, the primary uses of cash were payments of long-term
debt and capital lease obligations of $0.5 million and $2.9 million,
respectively, partially offset by $0.9 million in proceeds and excess tax
benefits received from the exercise of stock awards.

During Fiscal
2007, the $72.8 million decrease in operating cash flows from Fiscal 2006 was
due, in part, to a loss from operations of $24.6 million, exclusive of the $30.7
million non-cash impairment charge, compared to a loss from operations of $24
thousand during Fiscal 2006. Additionally, the change in net merchandise
inventory (merchandise inventory less accounts payable) represented a cash use
of $3.8 million in Fiscal 2007 compared to a cash source of $14.3 million in
Fiscal 2006 due to a lower inventory leverage ratio. The Company also made a
final principal and interest payment of approximately $7.4 million in
settlement of an agreement with the Internal Revenue Service (IRS) during the
second quarter of Fiscal 2007. The remaining change is due to the fluctuation
of operating assets and liabilities, within the normal course of business,
during Fiscal 2007.

In January,
2006, the Company entered into a five-year, $100 million revolving secured
credit facility with Bank of America, N.A that expires January 2011 (Credit
Facility). The revolving credit facility contains provisions governing
additional indebtedness and acquisitions and is secured by the Companys eligible
inventory, proceeds from the sale of inventory and by the stock of the
Companys subsidiaries. In March 2006, the Company and Bank of America N.A.,
entered into a First Amendment to the Credit Facility which increased the
amount available for borrowing by the Company under the Credit Facility to $130
million and in October 2006, the Company and Bank of America N.A. entered into
a Second Amendment to the Credit Facility increasing the amount available to
the Company for borrowing to $150 million. The terms and conditions under the
amendments were the same as the original Credit Facility. The availability
under the Credit Facility is subject to limitations

21

---



based on
sufficient inventory levels.

As of January
31, 2009 and February 2, 2008, the Company didnt have any borrowings under the
line of credit and no outstanding letter of credit obligations under the Credit
Facility with Bank of America, N.A. The Company had $150.0 million available
for borrowing as of January 31, 2009 and February 2, 2008. Interest expense in
Fiscal 2008 was $4.1 million, of which $1.9 million was incurred for capital
leases. Interest expense in Fiscal 2007 was $6.5 million, of which $2.0 million
was incurred for capital leases.

The recent
distress in the financial markets has resulted in declines in consumer
confidence and spending, extreme volatility in securities prices, diminished
liquidity and credit availability. If the national, or global, economies or
credit market conditions in general were to deteriorate further in the future,
it is possible that such deterioration could put additional pressure
on consumer spending and further negatively affect our cash flows. Although we
have available borrowing capacity under our Credit Facility through January 6,
2011, tightening of the credit markets could also make it more difficult for us
to enter into agreements for new indebtedness or obtain funding through the
issuance of our securities. The Companys ability to obtain a new credit
facility or other financing arrangements will depend upon future performance
and financial condition, credit market conditions, and the availability of financing
which, in turn, will be subject to general economic, financial, business,
competitive legislative, regulatory and other conditions, many of which are
beyond the Companys control. The effects of these changes could also require
us to make additional changes to our current plans and strategy. Additionally,
although our levels of net cash provided by operating activities have been
negatively affected by general economic conditions, we believe that our
available cash and borrowing capacity under our Credit Facility, along with any
positive cash flow generated from operations, will provide sufficient capital needed to
fund our operations for the foreseeable future.

22

---



Contractual
Obligations and Commitments. The following table
summarizes the Companys contractual obligations as of January 31, 2009, and
the effect that such obligations are expected to have on liquidity and cash
flows in future periods.

|                                                       |  |      |        |             |   |              |  |                  |        |       |   |        |  |   |         | 
|------------------------------------------------------ |  | ---- | ------ | ----------- | - | ------------ |  | ---------------- | ------ | ----- | - | ------ |  | - | ------- | 
|ContractualObligation                                  |  | 2009 |        | 2010-
 2011 |   | 2012 -
 2013 |  | 2014 and
 Beyond |        | Total |  
|                                                       |  |      |        |             |   |              |  |                  |        |       |   |        |  |   |         | 
|$ in
thousands                                         |  |      |        |             |   |              |  |                  |        |       |   |        |  |   |         | 
|                                                      
|Operating lease and maintenance agreement
 obligations |  | $    | 80,048 |             | $ | 82,261       |  | $                | 36,887 |       | $ | 21,144 |  | $ | 220,340 | 
|Capital lease obligations                              |  |      | 4,841  |             |   | 4,936        |  |                  | 4,190  |       |   | 3,700  |  |   | 17,667  | 
|Long-term debt (principal)                             |  |      | 570    |             |   | 1,248        |  |                  | 1,408  |       |   | 330    |  |   | 3,556   | 
|Long-term debt (interest)                              |  |      | 197    |             |   | 286          |  |                  | 127    |       |   | 5      |  |   | 615     | 
|Purchase obligations (1)                               |  |      |       |             |   |             |  |                  |       |       |   |       |  |   |        | 
|Other long-term liabilities (2)                        |  |      | 2,501  |             |   | 1,489        |  |                  | 389    |       |   | 487    |  |   | 4,866   | 
|Pension benefits (3)                                   |  |      | 64     |             |   | 244          |  |                  | 2,201  |       |   | 5,683  |  |   | 8,192   | 
|                                                       |  |      |        |             |   |              |  |                  |        |       |   |        |  |   |         | 
|Total                                                  |  | $    | 88,221 |             | $ | 90,464       |  | $                | 45,202 |       | $ | 31,349 |  | $ | 255,236 | 
|                                                       |  |      |        |             |   |              |  |                  |        |       |   |        |  |   |         | 

|    |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                          
|--- | -------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
|(1) | For the
 purposes of this table, contractual obligations for purchase of goods or
 services are defined as agreements that are enforceable and legally binding
 and that specify all significant terms, including: fixed or minimum
 quantities to be purchased; fixed, minimum or variable price provisions; and
 the approximate timing of the transaction. The Companys purchase orders are
 based on its current inventory needs and are fulfilled by its suppliers
 within short time periods.                     
|    |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                          
|    |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                          
|(2) | Included in
 other long-term liabilities in the Consolidated Balance Sheet as of January
 31, 2009 are unfavorable lease valuations of $0.7 million and the long-term
 portion of deferred rent of $3.7 million which are not reflected in the table
 above as these amounts do not represent contractual obligations. Also
 included in other long-term liabilities is the long-term portion of the straight
 line rent liability of $3.6 million, which is included in operating lease
 obligations in the table above.
|    |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                          
|    | Included in
 other long-term liabilities in the table above are the estimated asset
 retirement obligations associated with the fixed assets and leasehold
 improvements at the Companys store locations that arise under the terms of
 operating leases.                                                                                                                                                                                                                                                               
|    |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                          
|(3) | In addition
 to the scheduled pension benefit payments, the Company offers a 401(k)
 Savings Plan to eligible employees (see also Note 8 of Notes to Consolidated
 Financial Statements in this Annual Report on Form 10-K). Total expense
 related to the Companys matching contribution was approximately $882,000,
 $1,042,000 and $1,003,000 in Fiscal 2008, Fiscal 2007 and Fiscal 2006
 respectively. As of February 1, 2009, the Company has postponed its matching
 contribution.                               

Related Party
Transactions.

The Company
leases its 181,300 square foot distribution center/office facility in Albany,
New York from Robert J. Higgins, its Chairman, Chief Executive Officer and
largest shareholder, under three capital leases that expire in the year 2015.
The original distribution center/office facility was occupied in 1985.

Under the
three capital leases, dated April 1, 1985, November 1, 1989 and September 1,
1998, the Company paid Mr. Higgins an annual rent of $2.1 million, $2.0 million
and $2.0 million in Fiscal 2008, 2007 and 2006 respectively. Pursuant to the
terms of the lease agreements, effective January 1, 2002 and every two years
thereafter, rental payments will increase in accordance with the biennial
increase in the Consumer Price Index. Under the terms of the lease agreements,
the Company is responsible for property taxes, insurance and other operating
costs with respect to the premises. Mr. Higgins obligation for principal and
interest on his underlying indebtedness relating to the real property is
approximately $1.1 million per year. None of the leases contain any real
property purchase options at the expiration of its term.

The Company
leases one of its retail stores from Mr. Higgins under an operating lease.
Annual rental payments under this lease were $40,000 in Fiscal 2008, 2007 and
2006. Under the terms of the lease, the Company pays property taxes,
maintenance and a contingent rental if a specified sales level is achieved.
Total additional charges for the store, including contingent rent, were
approximately $7,400, $3,800 and $4,100 in Fiscal 2008, 2007 and 2006
respectively.

The Company
occasionally utilizes privately chartered aircraft owned or partially owned by
Mr. Higgins, for Company business. The Company charters an aircraft from
Crystal Jet, a corporation wholly-owned by Mr. Higgins, for Company business.
Payments to Crystal Jet aggregated approximately $0, $0 and $11,000 in Fiscal
2008, 2007 and 2006, respectively. The Company also charters an aircraft from
Richmor Aviation Inc., an unaffiliated corporation that leases an aircraft
owned by Mr. Higgins, for Company business. Payments to Richmor Aviation Inc.,
to charter the aircraft owned by Mr. Higgins, in Fiscal 2008, 2007 and 2006
were approximately $205,000, $29,000 and $526,000, respectively.

23

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CRITICAL ACCOUNTING
POLICIES AND ESTIMATES

The
preparation of financial statements and related disclosures in conformity with
accounting principles generally accepted in the United States requires that
management apply accounting policies and make estimates and assumptions that
affect results of operations and the reported amounts of assets and liabilities
in the financial statements. Management continually evaluates its estimates and
judgments including those related to merchandise inventory and return costs,
valuation of long-lived assets, income taxes, stock-based compensation, and
accounting for gift card liability. Management bases its estimates and
judgments on historical experience and other factors that are believed to be
reasonable under the circumstances. Actual results may differ from these
estimates under different assumptions or conditions. Note 1 of the Notes to
Consolidated Financial Statements in this Annual Report on Form 10-K includes a
summary of the significant accounting policies and methods used by the Company
in the preparation of its consolidated financial statements. Management
believes that of the Companys significant accounting policies, the following
may involve a higher degree of judgment or complexity:

Merchandise Inventory
and Return Costs: Merchandise inventory is stated at
the lower of cost or market under the average cost method. The average cost
method attaches a cost to each item and is a blended average of the original
purchase price and those of subsequent purchases or other cost adjustments
throughout the life cycle of that item.

Inventory
valuation requires significant judgment and estimates, including obsolescence,
shrink and any adjustments to market value, if market value is lower than cost.
Inherent in the entertainment software industry is the risk of obsolete
inventory. Typically, newer releases generate a higher product demand. Some
vendors offer credits to reduce the cost of products that are selling more
slowly, thus allowing for a reduction in the selling price and reducing the
possibility for items to become obsolete. The Company records obsolescence and
any adjustments to market value (if lower than cost) based on current and
anticipated demand, customer preferences, and market conditions. The provision
for inventory shrink is estimated as a percentage of sales for the period from
the last date a physical inventory was performed to the end of the fiscal year.
Such estimates are based on historical results and trends and the shrink
results from the last physical inventory. Physical inventories are taken at
least annually for all stores and distribution centers throughout the year and
inventory records are adjusted accordingly.

Shrink
expense, including obsolescence was $18.0 million, $18.5 million and $14.9
million, in Fiscal 2008, 2007 and 2006 respectively. As a rate to net sales,
this equaled 1.8%, 1.5% and 1.0%, respectively. Shrink expense, including obsolescence,
as a percentage of net sales was higher in Fiscal 2008 than in prior years due
to higher shrink rates in our stores and the write down of obsolete inventory
in the Companys video game category. Presently, a 0.1% change in the rate of
shrink and obsolescence provision would equal approximately $0.6 million in
additional charge or benefit to cost of sales, based on Fiscal 2008 net sales
since the last physical inventories.

The Company is
generally entitled to return merchandise purchased from major vendors for
credit against other purchases from these vendors. Certain vendors reduce the
credit with a per unit merchandise return charge which varies depending on the
type of merchandise being returned. Certain other vendors charge a handling fee
based on units returned. The Company records merchandise return charges in cost
of sales. The Company incurred merchandise return charges in its Fiscal year
2008, Fiscal 2007 and Fiscal 2006 of $4.1 million, $2.2 million and $3.6
million, respectively.

Valuation of
Long-Lived Assets:The Company assesses the impairment
of long-lived assets to determine if any part of the carrying value may not be
recoverable. Factors that the Company considers to be important when assessing
impairment include:

| |   |                                                                                                                      
| | - | ---------------------------------------------------------------------------------------------------------------------
| |  | significant
 underperformance relative to historical or projected future operating
 results;                         
| |   |                                                                                                                      
| |  | significant
 changes in the manner of the use of acquired assets or the strategy for the
 Companys overall business;
| |   |                                                                                                                      
| |  | significant
 negative industry or economic trends;                                                                   

If the Company
determines that the carrying value of a long-lived asset may not be
recoverable, it tests for impairment to determine if an impairment charge is
needed. During Fiscal 2008 and Fiscal 2007, the Company recorded an asset
impairment charge of $15.2 million and $30.7 million, respectively, related to
the write down of certain long-lived assets at underperforming locations. There
was no asset impairment charge recorded in Fiscal 2006. Losses for store
closings in the ordinary course of business represent the write down of the net
book value of abandoned fixtures and leasehold improvements. The loss on
disposal of fixed assets related to store closings was $1.2 million, $2.5
million and $2.2 million in Fiscal 2008, 2007 and 2006, respectively, and is
included in SG&A expenses in the Consolidated Statement of Operations and
loss on disposal of fixed assets in the Consolidated Statement of Cash Flows.
Store closings usually occur at the expiration of the lease, at which time
leasehold improvements, which constitute a majority of the assets, are fully
depreciated.

Income Taxes:
Income taxes are accounted for under the asset and liability method. Deferred
tax assets and liabilities are recognized for the future tax consequences
attributable to differences between the financial statement carrying amounts of
existing assets and liabilities and their respective tax bases and tax
operating loss carryforwards. Deferred tax assets and liabilities are measured
using enacted tax rates expected to apply to taxable income in the years in
which those temporary differences are expected to be recovered or settled.
Historically, the effect on deferred tax assets and liabilities of a change in
tax rates is recognized in the results of operations in the period that
includes the enactment date.

24

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Accounting for
income taxes requires management to make estimates and judgments regarding
interpretation of various taxing jurisdictions, laws and regulations as well as
the ultimate realization of deferred tax assets. These estimates and judgments
include the generation of future taxable income, viable tax planning strategies
and support of tax filings. In assessing the propriety of deferred tax assets,
management considers whether it is more likely than not that some portion or
all of the deferred tax assets will not be realized. The ultimate realization
of deferred tax assets is dependent upon the generation of future taxable
income. Management considers the scheduled reversal of taxable temporary
differences, projected future taxable income and tax planning strategies in
making this assessment. As of February 2, 2008, the Company has incurred a
cumulative three-year loss. Based on the cumulative three-year loss and other
available objective evidence, management concluded that a full valuation
allowance should be recorded against its net deferred tax assets in accordance
with the provisions of SFAS No. 109, Accounting for Income Taxes. During Fiscal
2008 and in future years, the Company will continue to record a valuation
allowance against recorded net deferred tax assets to a level deemed
appropriate by management to ensure that any net deferred tax assets not
allowed against will ultimately be realized.

Effective
February 4, 2007, the Company adopted Financial Accounting Standards Board
(FASB) Interpretation No. 48 (FIN 48), Accounting for Uncertainty in
Income TaxesAn Interpretation of FASB Statement No. 109, which prescribes a
financial statement recognition threshold and measurement attribute for tax
positions taken or expected to be taken in a tax return. The accounting for tax
positions in accordance with FIN 48 requires management to make estimates
relative to the likelihood of realization upon ultimate settlement of uncertain
tax positions. For additional discussion regarding income taxes, refer to Note
6 in Notes to the Consolidated Financial Statements in this Annual Report on
Form 10-K.

Stock-based
Compensation:The Companys adoption of SFAS
No. 123 (revised 2004), Share-Based Payment, or SFAS 123(R), during
Fiscal 2006 required that it recognize stock-based compensation expense
associated with the vesting of share based instruments in the statement of
operations. Determining the amount of stock-based compensation to be recorded
requires the Company to develop estimates to be used in calculating the
grant-date fair value of stock options. The Company calculates the grant-date
fair values using the Black-Scholes valuation model. The Black-Scholes model
requires us to make estimates of the following assumptions:

Expected volatilityThe
estimated stock price volatility was derived based upon the Companys actual
historic stock prices over the expected life of the options, which represents
the Companys best estimate of expected volatility.

Expected option lifeThe
Companys estimate of an expected option life was calculated based on actual
historical data relating to grants, exercises and cancellations.

Risk-free interest rateThe
Company used the yield on zero-coupon U.S. Treasury securities for a period
that is commensurate with the expected life assumption as the risk-free
interest rate.

The amount of
stock-based compensation recognized during a period is based on the value of
the portion of the awards that are ultimately expected to vest. SFAS 123(R)
requires forfeitures to be estimated at the time of grant and revised, if
necessary, in subsequent periods if actual forfeitures differ from those
estimates. The term forfeitures is distinct from cancellations or
expirations and represents only the unvested portion of the surrendered
option. The Company reviewed historical forfeiture data and determined the
appropriate forfeiture rate based on that data. The Company will re-evaluate
this analysis periodically and adjust the forfeiture rate as necessary.
Ultimately, the Company will recognize the actual expense over the vesting
period only for the shares that vest.

Accounting
for Gift Card Liability:The Company sells gift cards that are redeemable only for merchandise
and have no expiration date. The Company derecognizes card liability when
either customers redeem cards, at which point the Company records revenue, or
when the Company determines it does not have a legal obligation to remit
unredeemed cards to the relevant jurisdictions and the likelihood of the cards
being redeemed becomes remote, at which point the Company records breakage as a
credit to SG&A expenses. The Companys accounting for gift cards is based
on estimating the Companys liability for future card redemptions at the end of
a reporting period. Estimated liability is equal to two years of unredeemed
cards, plus an amount for outstanding cards that may possibly be redeemed for
the cumulative look-back period, exclusive of the last two years. The Companys
ability to reasonably and reliably estimate the liability is based on
historical redemption experience with gift cards and similar types of
arrangements and the existence of a large volume of relatively homogeneous
transactions. The Companys estimate is not susceptible to significant external
factors and the circumstances around gift card sales and redemptions have not
changed significantly over time.

Recently Issued
Accounting Pronouncements.

In December
2008, the Financial Accounting Standards Board (FASB) issued FASB Staff Position
(FSP) FAS No. 132(R)-1, Employers Disclosures about Postretirement
Benefit Plan Assets (FSP FAS No. 132(R)-1) which amends SFAS
No. 132(revised 2003) Employers Disclosures about Pensions and Other
Postretirement Benefits  an Amendment of FASB Statements No. 87, 88, and
106 (SFAS No. 132(R)). FSP FAS No. 132(R)-1 requires more detailed
disclosures about the assets of a defined benefit pension or other
postretirement plan and is effective for fiscal years ending after December 15,
2009. We are in the process of evaluating FSP FAS No. 132(R)-1 and do not
expect it will have a significant impact on our Consolidated Financial
Statements.

In June 2008,
the FASB issued FSP Emerging Issues Task Force (EITF) No. 03-6-1,
Determining Whether Instruments Granted in Share-Based Payment Transactions
Are Participating Securities (FSP-EITF No. 03-6-1). Under FSP-EITF
No. 03-6-1, unvested share-based

25

---



payment awards
that contain rights to receive nonforfeitable dividends (whether paid or unpaid)
are considered participating securities and should be included in the two-class
method of computing earnings per share. FSP-EITF No. 03-6-1 is effective
for fiscal years beginning after December 15, 2008, and interim periods
within those years. The adoption of FSP-EITF No. 03-6-1 will not have any
impact on the determination or reporting of our earnings per share.

In April 2008,
the FASB issued FSP FAS No. 142-3, Determination of the Useful Life of
Intangible Assets (FSP FAS No. 142-3). FSP FAS No. 142-3 amends
the factors that should be considered in developing renewal or extension
assumptions used to determine the useful life of a recognized intangible asset
under SFAS No. 142, Goodwill and Other Intangible Assets. The objective
of FSP FAS No. 142-3 is to improve the consistency between the useful life
of a recognized intangible asset under SFAS No. 142 and the period of
expected cash flows used to measure the fair value of the asset under SFAS
No. 141 (revised 2007), Business Combinations and other U.S. GAAP. FSP FAS
No. 142-3 applies to all intangible assets, whether acquired in a business
combination or otherwise and shall be effective for financial statements issued
for fiscal years beginning after December 15, 2008, and interim periods
within those fiscal years and should be applied prospectively to intangible
assets acquired after the effective date. Early adoption is prohibited. We do
not expect the adoption of FSP FAS No. 142-3 to have a significant impact
on our Consolidated Financial Statements.

In March 2008,
the FASB issued SFAS No. 161, Disclosures about Derivative Instruments
and Hedging Activities  an Amendment of FASB Statement No. 133 (SFAS
No. 161). SFAS No. 161 seeks to improve financial reporting for
derivative instruments and hedging activities by requiring enhanced disclosures
regarding their impact on financial position, financial performance and cash
flows. To achieve this increased transparency, SFAS No. 161 requires
(1) disclosure of the fair value of derivative instruments and gains and
losses in a tabular format; (2) disclosure of derivative features that are
credit risk-related; and (3) cross-referencing within the footnotes. SFAS
No. 161 is effective prospectively for financial statements issued for fiscal
years and interim periods beginning after November 15, 2008, with early
application permitted. We do not expect adoption of SFAS No. 161 will have
an impact on our Consolidated Financial Statements.

In
December 2007, the FASB issued SFAS No. 160, Noncontrolling Interests in
Consolidated Financial Statements  an Amendment of ARB No. 51, (SFAS
No. 160). SFAS No. 160 was issued to improve the relevance,
comparability and transparency of the financial information that a reporting
entity provides in its consolidated financial statements by establishing
accounting and reporting standards for the noncontrolling interest in a
subsidiary and for the deconsolidation of a subsidiary. The provisions of SFAS
No. 160 shall be applied prospectively as of the beginning of the fiscal
year in which it is initially applied, except for the presentation and
disclosure requirements, which shall be applied retrospectively for all periods
presented. SFAS No. 160 is effective for fiscal years and interim periods
within those fiscal years, beginning on or after December 15, 2008. We do
not expect the adoption of SFAS No. 160 to have an impact on our
Consolidated Financial Statements.

In
December 2007, the FASB issued SFAS No. 141(revised 2007), Business
Combinations  (SFAS No. 141(R)). SFAS No. 141(R) establishes
principles and requirements for how the acquirer in a business combination
should recognize and measure in its financial statements the identifiable
assets acquired, the liabilities assumed and any noncontrolling interest in the
acquiree, recognize and measure the goodwill acquired in the business
combination or a gain from a bargain purchase and determine what information to
disclose to enable users of the financial statements to evaluate the nature and
financial effects of the business combination. The provisions of SFAS
No. 141(R) shall be applied prospectively to business combinations with
acquisition dates on or after the beginning of the first annual reporting
period in which it is initially applied. SFAS No. 141(R) is effective for
fiscal years and interim periods within those fiscal years, beginning on or
after December 15, 2008. We do not expect the adoption of SFAS
No. 141(R) to have an impact on our Consolidated Financial Statements.

Item 7A. QUANTITATIVE
AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK

The Company
does not hold any financial instruments that expose it to significant market
risk and does not engage in hedging activities. To the extent the Company
borrows under its revolving credit facility, the Company is subject to risk
resulting from interest rate fluctuations since interest on the Companys
borrowings under its credit facility can be variable. If interest rates on the
Companys revolving credit facility were to increase by 25 basis points, and to
the extent borrowings were outstanding, for every $1,000,000 outstanding on the
facility, income before income taxes would be reduced by $2,500 per year.
Information about the fair value of financial instruments is included in Note 1
of Notes to the Consolidated Financial Statements in this Annual Report on Form
10-K.

Item 8. FINANCIAL
STATEMENTS AND SUPPLEMENTARY DATA

The index to
the Companys Consolidated Financial Statements is included in Item 15, and the
Consolidated Financial Statements follow the signature page to this Annual
Report on Form 10-K and are incorporated herein by reference.

The quarterly
results of operations are included herein in Note 11 of Notes to the
Consolidated Financial Statements in this Annual Report on Form 10-K.

26

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Item 9. CHANGES IN
AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND FINANCIAL DISCLOSURE

None.

Item 9A. CONTROLS AND
PROCEDURES

Conclusion
Regarding the Effectiveness of Disclosure Controls and Procedures:Under the supervision
and with the participation of our management, including our principal executive
officer and principal financial officer, we conducted an evaluation of the
effectiveness of our disclosure controls and procedures, as such term is
defined under Rule 13a-15(e) promulgated under the Securities Exchange Act of
1934, as amended (the Exchange Act). Based on this evaluation, our principal
executive officer and our principal financial officer concluded that, as of the
end of the period covered by this annual report, our disclosure controls and
procedures were effective, in that they provide reasonable assurance that
information required to be disclosed by us in the reports we file or submit,
under the Exchange Act, is recorded, processed, summarized and reported within
the time period specified in the Securities and Exchange Commissions rules and
forms.

Managements Report
on Internal Control Over Financial Reporting:
Management is responsible for establishing and maintaining adequate internal
control over financial reporting (as defined in Rule 13a-15(f) and 15d 
15(f) under the Securities Exchange Act of 1934, as amended). Under the
supervision and with the participation of the Companys management, including
our principal executive officer and principal financial officer, we conducted
an evaluation of the effectiveness of our internal control over financial
reporting based on the framework set forth by the Committee of Sponsoring
Organizations of the Treadway Commission (COSO) in Internal Control-Integrated Framework.
Based on our evaluation under the framework in Internal Control- Integrated Framework,
our management concluded that our internal control over financial reporting was
effective as of January 31, 2009.

The Companys
independent registered public accounting firm, KPMG LLP, has issued an audit
report on the Companys effectiveness of internal control over financial
reporting as of January 31, 2009, which is included in Item 8 of this
Annual Report on Form 10-K and incorporated herein by reference.

Changes in Controls
and Procedures:No change in our internal control over
financial reporting occurred during the quarterly period ended January 31, 2009
that has materially affected, or is reasonably likely to materially affect, our
internal control over financial reporting.

Item 9B. Other Information

No events have
occurred which would require disclosure under this Item.

27

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PART III

Item 10. DIRECTORS,
EXECUTIVE OFFICERS AND CORPORATE GOVERNANCE

(a)
Identification of Directors

Incorporated
herein by reference is the information appearing under the captions Election
of Directors and Compensation of Directors in the Companys definitive Proxy
Statement for the Registrants 2009 Annual Meeting of Shareholders to be filed
with the Securities and Exchange Commission within 120 days after January 31,
2009.

(b)
Identification of Executive Officers

Incorporated
herein by reference is the information appearing under the caption Executive
Compensation in the Companys definitive Proxy Statement for the Registrants
2009 Annual Meeting of Shareholders to be filed with the Securities and
Exchange Commission within 120 days after January 31, 2009.

(c) Code of
Ethics

We have
adopted the Trans World Entertainment Corporation Code of Ethics that applies
to all officers, directors, employees and consultants of the Company. The Code
of Ethics is intended to comply with Item 406 of Regulation S-K of the
Securities Exchange Act of 1934 and with applicable rules of The NASDAQ Stock
Market, Inc. Our Code of Ethics is posted on our Internet website under the Corporate
page. Our Internet website address is www.twec.com. To the extent required or
permitted by the rules of the SEC and NASDAQ, we will disclose amendments and
waivers relating to our Code of Ethics in the same place as our website.

Item 11. EXECUTIVE
COMPENSATION

Incorporated
herein by reference is the information appearing under the caption Executive
Compensation in the Companys definitive Proxy Statement for the Registrants
2009 Annual Meeting of Shareholders to be filed with the Securities and
Exchange Commission within 120 days after January 31, 2009.

Item 12. SECURITY
OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT AND RELATED SHAREHOLDER
MATTERS

Incorporated
herein by reference is the information appearing under the captions Equity Ownership
of Directors and Executive Officers and Principal Shareholders in the
Companys definitive Proxy Statement for the Registrants 2009 Annual Meeting
of Shareholders to be filed with the Securities and Exchange Commission within
120 days after January 31, 2009.

Information on
Trans World Entertainment Common Stock authorized for issuance under equity
compensation plans is contained in our Proxy Statement for our 2009 Annual
Meeting of Shareholders under the caption Stock Option Plans and is incorporated
herein by reference. See Note 8 of Notes to the Consolidated Financial
Statements in this Annual Report on Form 10-K for a description of the
Companys employee stock award plans.

The following
table contains information about the Companys Common Stock that may be issued
upon the exercise of options, warrants and rights under all of the Companys
equity compensation plans as of January 31, 2009:

|                                                                      |  |                                                                                                |  |                                                                                |  |                                                                                                                                                    |      |  |  |       |  | 
|--------------------------------------------------------------------- |  | ---------------------------------------------------------------------------------------------- |  | ------------------------------------------------------------------------------ |  | -------------------------------------------------------------------------------------------------------------------------------------------------- | ---- |  |  | ----- |  | 
|                                                                      |  |                                                                                                |  |                                                                                |  |                                                                                                                                                    |     
|Plan
 Category                                                        |  | Number of
 Shares to be Issued
 upon Exercise of Outstanding
 Options, Warrants and
 Rights(1) |  | Weighted
 Average Exercise
 Price of Outstanding Options,
 Warrants and Rights |  | Number of
 Shares Remaining
 Available for Future Issuance
 Under Equity Compensation
 Plans (Excluding Outstanding
 Options, Warrants and Rights) |     
|                                                                      |  |                                                                                                |  |                                                                                |  |                                                                                                                                                    |     
|                                                                      |  |                                                                                                |  | (Shares in thousands)                                                          |  |                                                                                                                                                    |     
|Equity Compensation Plan Approved by
 Shareholders                    |  | 8,183                                                                                          |  |                                                                                |  | $                                                                                                                                                  | 7.86 |  |  | 3,857 |  | 
|Equity Compensation Plans and Agreements not Approved by
Shareholders |  |                                                                                               |  |                                                                                |  |                                                                                                                                                    |     |  |  |      |  | 

(1) Excludes
275,228 restricted stock units reserved from the Companys equity plans that
will be settled in cash.

28

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Item 13. CERTAIN
RELATIONSHIPS AND RELATED TRANSACTIONS, AND DIRECTOR INDEPENDENCE

Incorporated
herein by reference is the information appearing under the caption Related
Party Transactions in the Companys definitive Proxy Statement for the
Registrants 2009 Annual Meeting of Shareholders to be filed with the
Securities and Exchange Commission within 120 days after January 31, 2009.

Item 14. PRINCIPAL
ACCOUNTANT FEES AND SERVICES

Incorporated
herein by reference is the information appearing under the caption Other
Matters in the Companys definitive Proxy Statement for the Registrants 2009
Annual Meeting of Shareholders to be filed with the Securities and Exchange
Commission within 120 days after January 31, 2009.

29

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PART IV

Item 15.
EXHIBITS, AND FINANCIAL STATEMENT SCHEDULES

15(a) (1) Financial Statements

The
Consolidated Financial Statements and Notes are listed in the Index to
Consolidated Financial Statements on page F-1 of this report.

15(a) (2) Financial Statement Schedules

Consolidated
Financial Statement Schedules not filed herein have been omitted as they are
not applicable or the required information or equivalent information has been
included in the Consolidated Financial Statements or the notes thereto.

15(a) (3) Exhibits

Exhibits are
as set forth in the Index to Exhibits which follows the Notes to the
Consolidated Financial Statements and immediately precedes the exhibits filed.

30

---



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.

|                      |                                       
|--------------------- | --------------------------------------
|                      | TRANS WORLD
 ENTERTAINMENT CORPORATION
|                      |                                       
|                      |                                       
|Date: April
 16, 2009 | By: /s/ ROBERT J. HIGGINS             
|                      |                                       
|                      | Robert J. Higgins                     
|                      | Chairman and Chief 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          
|                         
|/s/ ROBERT
 J. HIGGINS    |  | Chairman and
 Chief Executive Officer
 (Principal Executive Officer)                                                    |  | April 16, 2009
|                          |  |                                                                                                                         | 
|(Robert J. Higgins)       |  |                                                                                                                         | 
|                          |  |                                                                                                                         |  |               
|/s/ JOHN J.
 SULLIVAN     |  | Executive
 Vice President and Chief Financial Officer (Principal Financial and Chief
 Accounting Officer) and Secretary |  | April 16, 2009
|                          |  |                                                                                                                         | 
|(John J.
 Sullivan)       |  |                                                                                                                         | 
|                          |  |                                                                                                                         |  |               
|/s/ ISAAC
 KAUFMAN        |  | Director                                                                                                                |  | April 16, 2009
|                          |  |                                                                                                                         |  |               
|(Isaac
 Kaufman)          |  |                                                                                                                         |  |               
|                          |  |                                                                                                                         |  |               
|/s/ DR.
 JOSEPH G. MORONE |  | Director                                                                                                                |  | April 16, 2009
|                          |  |                                                                                                                         |  |               
|(Dr. Joseph
 G. Morone)   |  |                                                                                                                         |  |               
|                          |  |                                                                                                                         |  |               
|/s/ BRYANT
 RILEY         |  | Director                                                                                                                |  | April 16, 2009
|                          |  |                                                                                                                         |  |               
|(Bryant
 Riley)           |  |                                                                                                                         |  |               
|                          |  |                                                                                                                         |  |               
|/s/ MICHAEL
 B. SOLOW     |  | Director                                                                                                                |  | April 16, 2009
|                          |  |                                                                                                                         |  |               
|(Michael B.
 Solow)       |  |                                                                                                                         |  |               

31

---



TRANS WORLD ENTERTAINMENT CORPORATION
INDEX TO CONSOLIDATED FINANCIAL STATEMENTS

|                                                                                                                                                                |  |                    
|--------------------------------------------------------------------------------------------------------------------------------------------------------------- |  | -------------------
|                                                                                                                                                                |  | Form 10-K
 Page No.
|                                                                                                                                                                |  |                    
|Reports of Independent Registered Public Accounting Firm                                                                                                        |  | F-2                
|                                                                                                                                                                |  |                    
|Consolidated Financial Statements                                                                                                                               |  |                    
|                                                                                                                                                                |  |                    
|Consolidated Balance Sheets at January 31, 2009 and February 2, 2008                                                                                            |  | F-4                
|                                                                                                                                                                |  |                    
|Consolidated
 Statements of Operations - Fiscal years endedJanuary 31, 2009, February 2, 2008, and
 February 3, 2007                                            |  | F-5                
|                                                                                                                                                                |  |                    
|Consolidated
 Statements of Shareholders Equity and Comprehensive
 Income (Loss) - Fiscal years endedJanuary 31, 2009, February 2, 2008, and
 February 3, 2007 |  | F-6                
|                                                                                                                                                                |  |                    
|Consolidated
Statements of Cash Flows - Fiscal years endedJanuary 31, 2009, February 2, 2008, and
 February 3, 2007                                             |  | F-7                
|                                                                                                                                                                |  |                    
|Notes to Consolidated Financial Statements                                                                                                                      |  | F-8                

F-1

---



Report of
Independent Registered Public Accounting Firm

The Board of
Directors and Shareholders
Trans World Entertainment Corporation:

We have
audited the accompanying consolidated balance sheets of Trans World
Entertainment Corporation and subsidiaries (the Company) as of January 31,
2009 and February 2, 2008, and the related consolidated statements of
operations, shareholders equity and comprehensive income (loss), and cash
flows for each of the fiscal years in the three-year period ended January 31,
2009. These consolidated financial statements are the responsibility of the
Companys management. Our responsibility is to express an opinion on these
consolidated financial statements based on our audits.

We conducted
our audits in accordance with the standards of the Public Company Accounting
Oversight Board (United States). Those standards require that we plan and
perform the audit to obtain reasonable assurance about whether the financial
statements are free of material misstatement. An audit 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 financial position of Trans World
Entertainment Corporation and subsidiaries as of January 31, 2009 and February
2, 2008, and the results of their operations and their cash flows for each of
the fiscal years in the three-year period ended January 31, 2009, in conformity
with U.S. generally accepted accounting principles.

As discussed
in Note 1 to the consolidated financial statements, effective February 4, 2007,
the Company adopted Financial Accounting Standards Board Interpretation No. 48,
Accounting for Uncertainty in Income Taxes. Effective February 3, 2007, the
Company adopted Statement of Financial Accounting Standards No. 158,
Employers Accounting for Defined Benefit Pension and Other Postretirement
Plans.

We also have
audited, in accordance with the standards of Public Company Accounting
Oversight Board (United States), the Companys internal control over financial
reporting as of January 31, 2009, based on criteria established in Internal
Control  Integrated Framework issued by the Committee of Sponsoring
Organizations of the Treadway Commission, and our report dated April 16, 2009
expressed an unqualified opinion on the effectiveness of the Companys internal
control over financial reporting.

/s/ KPMG LLP

Albany, New
York
April 16, 2009

F-2

---



Report
of Independent Registered Public Accounting Firm

The Board of
Directors and Shareholders
of Trans World Entertainment Corporation:

We have
audited Trans World Entertainment Corporation and subsidiaries (the
Company), internal control over financial reporting as of January 31, 2009,
based on criteria established in Internal Control  Integrated Framework
issued by the Committee of Sponsoring Organizations of the Treadway Commission
(COSO). The Companys management is responsible for maintaining effective
internal control over financial reporting, and for its assessment of the
effectiveness of internal control over financial reporting, included in the
accompanying Management Report. Our responsibility is to express an opinion on
the Companys internal control over financial reporting based on our audit.

We conducted
our audit in accordance with the standards of the Public Company Accounting
Oversight Board (United States). Those standards require that we plan and
perform the audit to obtain reasonable assurance about whether effective
internal control over financial reporting was maintained in all material
respects. Our audit included obtaining an understanding of internal control
over financial reporting, assessing the risk that a material weakness exists,
and testing and evaluating the design and operating effectiveness of control
based on the assessed risk. Our audit also included performing such other
procedures as we considered necessary in the circumstances. We believe that our
audit provides a reasonable basis for our opinion.

A companys
internal control over financial reporting is a process designed to provide a
reasonable assurance regarding the reliability of financial reporting and the
preparation of financial statements for external purposes in accordance with
generally accepted accounting principles. A companys internal control over
financial reporting includes those policies and procedures that (1) pertain to
the maintenance of records that, in reasonable detail, accurately and fairly
reflect the transactions and dispositions of the assets of the company; (2)
provide reasonable assurance that transactions are recorded as necessary to
permit preparation of financial statements in accordance with generally
accepted accounting principles, and that receipts and expenditures of the
company are being made only in accordance with authorizations of management and
directors of the company; and (3) provide reasonable assurance regarding
prevention or timely detection of unauthorized acquisition, use, or disposition
of the companys assets that could have a material effect on the financial
statements.

Because of its
inherent limitations, internal control over financial reporting may not prevent
or detect misstatements. Also, projections of any evaluation of effectiveness
to future periods are subject to the risk that controls may become inadequate
because of changes in conditions, or that the degree of compliance with the
policies or procedures may deteriorate.

In our
opinion, the Company maintained, in all material respects, effective internal
control over financial reporting as of January 31, 2009, based on criteria
established in Internal Control  Integrated Framework issued by COSO.

We also have
audited in accordance with the standards of the Public Company Accounting
Oversight Board (United States), the consolidated balance sheets of Trans World
Entertainment Corporation and subsidiaries as of January 31, 2009 and February
2, 2008, and the related consolidated statements of operations, shareholders
equity and comprehensive income (loss), and cash flows for each of the years in
the three-year period ended January 31, 2009, and our report dated April 16,
2009 expressed an unqualified opinion on those consolidated financial
statements.

/s/ KPMG LLP

Albany, New
York
April 16, 2009

F-3

---



TRANS WORLD ENTERTAINMENT CORPORATION AND
SUBSIDIARIESCONSOLIDATED BALANCE SHEETS
($ in thousands)

|                                                                                                                              |  |                   |          |                   |   |          |  
|----------------------------------------------------------------------------------------------------------------------------- |  | ----------------- | -------- | ----------------- | - | -------- | -
|                                                                                                                              |  | January 31,
 2009 |          | February 2,
 2008 |  
|                                                                                                                              |  |                   |          |                   |  
|ASSETS                                                                                                                        |  |                   |          |                   |   |          |  
|CURRENT
 ASSETS                                                                                                               |  |                   |          |                   |   |          |  
|Cash and cash equivalents                                                                                                     |  | $                 | 30,055   |                   | $ | 74,655   |  
|Accounts receivable                                                                                                           |  |                   | 7,559    |                   |   | 8,632    |  
|Merchandise inventory                                                                                                         |  |                   | 378,188  |                   |   | 440,241  |  
|Income taxes receivable, net                                                                                                  |  |                   |         |                   |   | 5,216    |  
|Prepaid expenses and other                                                                                                    |  |                   | 13,817   |                   |   | 17,578   |  
|                                                                                                                              |  |                   |          |                   |   |          |  
|Total current assets                                                                                                          |  |                   | 429,619  |                   |   | 546,322  |  
|                                                                                                                              |  |                   |          |                   |   |          |  
|                                                                                                                              |  |                   |          |                   |   |          |  
|FIXED
 ASSETS, net                                                                                                            |  |                   | 50,437   |                   |   | 82,248   |  
|OTHER ASSETS                                                                                                                  |  |                   | 6,980    |                   |   | 10,423   |  
|                                                                                                                              |  |                   |          |                   |   |          |  
|TOTAL ASSETS                                                                                                                  |  | $                 | 487,036  |                   | $ | 638,993  |  
|                                                                                                                              |  |                   |          |                   |   |          |  
|                                                                                                                              |  |                   |          |                   |   |          |  
|LIABILITIES                                                                                                                   |  |                   |          |                   |   |          |  
|CURRENT
 LIABILITIES                                                                                                          |  |                   |          |                   |   |          |  
|Accounts payable                                                                                                              |  | $                 | 170,302  |                   | $ | 237,774  |  
|Accrued expenses and other current
 liabilities                                                                               |  |                   | 42,180   |                   |   | 53,540   |  
|Current portion of long-term debt                                                                                             |  |                   | 570      |                   |   | 537      |  
|Current portion of capital lease
 obligations                                                                                 |  |                   | 3,178    |                   |   | 2,964    |  
|                                                                                                                              |  |                   |          |                   |   |          |  
|Total current liabilities                                                                                                     |  |                   | 216,230  |                   |   | 294,815  |  
|                                                                                                                              |  |                   |          |                   |   |          |  
|                                                                                                                              |  |                   |          |                   |   |          |  
|LONG TERM
 DEBT, less current portion                                                                                        |  |                   | 2,986    |                   |   | 3,552    |  
|CAPITAL
 LEASE OBLIGATIONS, less current portion                                                                              |  |                   | 5,858    |                   |   | 9,036    |  
|OTHER
 LONG-TERM LIABILITIES                                                                                                  |  |                   | 26,947   |                   |   | 33,441   |  
|                                                                                                                              |  |                   |          |                   |   |          |  
|TOTAL LIABILITIES                                                                                                             |  |                   | 252,021  |                   |   | 340,844  |  
|                                                                                                                              |  |                   |          |                   |   |          |  
|                                                                                                                              |  |                   |          |                   |   |          |  
|SHAREHOLDERS EQUITY                                                                                                          |  |                   |          |                   |   |          |  
|Preferred stock ($0.01 par value; 5,000,000
 shares authorized; none issued)                                                  |  |                   |         |                   |   |         |  
|Common stock ($0.01 par value; 200,000,000
 shares authorized; 56,372,101 shares and 56,288,637 shares issued,
 respectively) |  |                   | 564      |                   |   | 563      |  
|Additional paid-in capital                                                                                                    |  |                   | 306,159  |                   |   | 303,998  |  
|Treasury stock at cost (25,102,990 and
 25,102,990 shares, respectively)                                                      |  |                   | (217,555 | )                 |   | (217,555 | )
|Accumulated other comprehensive income
 (loss)                                                                                |  |                   | 2,396    |                   |   | (1,625   | )
|Retained earnings                                                                                                             |  |                   | 143,451  |                   |   | 212,768  |  
|                                                                                                                              |  |                   |          |                   |   |          |  
|TOTAL SHAREHOLDERS EQUITY                                                                                                    |  |                   | 235,015  |                   |   | 298,149  |  
|                                                                                                                              |  |                   |          |                   |   |          |  
|TOTAL LIABILITIES AND SHAREHOLDERS
EQUITY                                                                                    |  | $                 | 487,036  |                   | $ | 638,993  |  
|                                                                                                                              |  |                   |          |                   |   |          |  

See Accompanying Notes to Consolidated
Financial Statements.

F-4

---



TRANS WORLD ENTERTAINMENT CORPORATION AND
SUBSIDIARIESCONSOLIDATED STATEMENTS OF OPERATIONS
($ in thousands, except per share amounts)

|                                                                                            |  |                    |          |                    |  |                    |   |  |            |  
|------------------------------------------------------------------------------------------- |  | ------------------ | -------- | ------------------ |  | ------------------ | - |  | ---------- | -
|                                                                                            |  | Fiscal
 Year Ended
|                                                                                            |  |                    |          |                    |  |                    |  
|                                                                                            |  | January
 31,
 2009 |          | February
 2,
 2008 |  | February
 3,
 2007 |  
|                                                                                            |  |                    |          |                    |  |                    |  
|                                                                                            |  |                    |          |                    |  |                    |   |  |            |  
|                                                                                            |  |                    |          |                    |  |                    |   |  |            |  
|Net sales                                                                                   |  |                    | $987,625 |                    |  | $1,265,658         |   |  | $1,471,157 |  
|Cost of sales                                                                               |  |                    | 656,730  |                    |  | 819,911            |   |  | 951,935    |  
|                                                                                            |  |                    |          |                    |  |                    |   |  |            |  
|Gross profit                                                                                |  |                    | 330,895  |                    |  | 445,747            |   |  | 519,222    |  
|Selling, general and administrative
 expenses                                               |  |                    | 380,802  |                    |  | 470,386            |   |  | 519,246    |  
|Asset impairment charges                                                                    |  |                    | 15,158   |                    |  | 30,731             |   |  |           |  
|                                                                                            |  |                    |          |                    |  |                    |   |  |            |  
|Loss from operations                                                                        |  |                    | (65,065  | )                  |  | (55,370            | ) |  | (24        | )
|Interest expense                                                                            |  |                    | 4,098    |                    |  | 6,519              |   |  | 5,504      |  
|Other income                                                                                |  |                    | (180     | )                  |  | (429               | ) |  | (4,435     | )
|                                                                                            |  |                    |          |                    |  |                    |   |  |            |  
|Loss before income taxes, extraordinary
 gain  unallocated negative goodwill               |  |                    | (68,983  | )                  |  | (61,460            | ) |  | (1,093     | )
|Income tax (benefit) expense                                                                |  |                    | (28      | )                  |  | 37,975             |   |  | (2,041     | )
|                                                                                            |  |                    |          |                    |  |                    |   |  |            |  
|(Loss) income before extraordinary gain 
 unallocated negative goodwill                    |  |                    | (68,955  | )                  |  | (99,435            | ) |  | 948        |  
|Extraordinary gain  unallocated negative
 goodwill, net of income taxes of
 $6,739 in 2006 |  |                    |         |                    |  |                   |   |  | 10,721     |  
|                                                                                            |  |                    |          |                    |  |                    |   |  |            |  
|NET (LOSS) INCOME                                                                           |  |                    | ($68,955 | )                  |  | ($99,435           | ) |  | $11,669    |  
|                                                                                            |  |                    |          |                    |  |                    |   |  |            |  
|BASIC (LOSS) EARNINGS PER SHARE:                                                            |  |                    |          |                    |  |                    |   |  |            |  
|(Loss) earnings per share before
 extraordinary gain  unallocated
 negative goodwill       |  |                    | ($2.21   | )                  |  | ($3.20             | ) |  | $0.03      |  
|Extraordinary gain  unallocated negative
 goodwill                                         |  |                    |         |                    |  |                   |   |  | 0.35       |  
|                                                                                            |  |                    |          |                    |  |                    |   |  |            |  
|Basic (loss) earnings per share                                                             |  |                    | ($2.21   | )                  |  | ($3.20             | ) |  | $0.38      |  
|                                                                                            |  |                    |          |                    |  |                    |   |  |            |  
|                                                                                            |  |                    |          |                    |  |                    |   |  |            |  
|Weighted average number of common shares
 outstanding  basic                               |  |                    | 31,223   |                    |  | 31,046             |   |  | 30,797     |  
|                                                                                            |  |                    |          |                    |  |                    |   |  |            |  
|                                                                                            |  |                    |          |                    |  |                    |   |  |            |  
|DILUTED (LOSS) EARNINGS PER SHARE:                                                          |  |                    |          |                    |  |                    |   |  |            |  
|(Loss) earnings per share before
 extraordinary gain  unallocated
 negative goodwill       |  |                    | ($2.21   | )                  |  | ($3.20             | ) |  | $0.03      |  
|Extraordinary gain  unallocated negative
 goodwill                                         |  |                    |         |                    |  |                   |   |  | 0.33       |  
|                                                                                            |  |                    |          |                    |  |                    |   |  |            |  
|Diluted (loss) earnings per share                                                           |  |                    | ($2.21   | )                  |  | ($3.20             | ) |  | $0.36      |  
|                                                                                            |  |                    |          |                    |  |                    |   |  |            |  
|                                                                                            |  |                    |          |                    |  |                    |   |  |            |  
|Weighted average number of common shares 
 diluted                                         |  |                    | 31,223   |                    |  | 31,046             |   |  | 31,986     |  
|                                                                                            |  |                    |          |                    |  |                    |   |  |            |  

See Accompanying Notes to Consolidated Financial
Statements.

F-5

---



TRANS WORLD ENTERTAINMENT CORPORATION AND
SUBSIDIARIESCONSOLIDATED STATEMENTS OF SHAREHOLDERS EQUITY AND
COMPREHENSIVE INCOME(LOSS)
(Shares and $ in thousands)

|                                                                                                   |  |                |  |               |      |                              |  |                                           |   |                  |        |                          |         |                                                  |  |                    |   |                       |         |   |  |          |   |  |          |  
|-------------------------------------------------------------------------------------------------- |  | -------------- |  | ------------- | ---- | ---------------------------- |  | ----------------------------------------- | - | ---------------- | ------ | ------------------------ | ------- | ------------------------------------------------ |  | ------------------ | - | --------------------- | ------- | - |  | -------- | - |  | -------- | -
|                                                                                                   |  | Common
 Shares |  | Common
 Stock |      | Additional
 Paid-in
 Capital |  | Unearned
 Compensation
 Restricted
 Stock |   | Treasury
 Shares |        | Treasury
 Stock
 At Cost |         | Accumulated
 Other
 Comprehensive
 Income (Loss) |  | Retained
 Earnings |   | Shareholders
 Equity |        
|                                                                                                   |  |                |  |               |      |                              |  |                                           |   |                  |        |                          |         |                                                  |  |                    |   |                       |         |   |  |          |   |  |          |  
|Balance as of January 28, 2006                                                                     |  | 55,728         |  |               | $557 |                              |  | $298,699                                  |   |                  | ($30   | )                        | (25,105 | )                                                |  | ($217,564          | ) |                       | ($2,048 | ) |  | $298,898 |   |  | $378,512 |  
|Comprehensive income:                                                                              |  |                |  |               |      |                              |  |                                           |   |                  |        |                          |         |                                                  |  |                    |   |                       |         |   |  |          |   |  |          |  
|Net income                                                                                         |  |               |  |               |     |                              |  |                                          |   |                  |       |                          |        |                                                  |  |                   |   |                       |        |   |  | 11,669   |   |  | 11,669   |  
|                                                                                                  
|Additional pension liability adjustment, net of
income taxes of $1,771                             |  |               |  |               |     |                              |  |                                          |   |                  |       |                          |        |                                                  |  |                   |   |                       | 2,445   |   |  |         |   |  | 2,445    |  
|                                                                                                   |  |                |  |               |      |                              |  |                                           |   |                  |        |                          |         |                                                  |  |                    |   |                       |         |   |  |          |   |  |          |  
|                                                                                                  
|Total comprehensive income                                                                         |  |                |  |               |      |                              |  |                                           |   |                  |        |                          |         |                                                  |  |                    |   |                       |         |   |  |          |   |  | 14,114   |  
|                                                                                                   |  |                |  |               |      |                              |  |                                           |   |                  |        |                          |         |                                                  |  |                    |   |                       |         |   |  |          |   |  |          |  
|Adjustment to initially applySFAS 158, net of income
taxes of $1,623                               |  |               |  |               |     |                              |  |                                          |   |                  |       |                          |        |                                                  |  |                   |   |                       | (2,285  | ) |  |         |   |  | (2,285   | )
|Issuance of treasury stock under incentive stock programs                                          |  |               |  |               |     |                              |  | 2                                         |   |                  |       |                          | 1       |                                                  |  | 4                  |   |                       |        |   |  |         |   |  | 6        |  
|Stock compensation and related tax benefit                                                         |  | 270            |  |               | 3    |                              |  | 2,842                                     |   |                  |       |                          |        |                                                  |  |                   |   |                       |        |   |  |         |   |  | 2,845    |  
|                                                                                                  
|Reclassification of unearned compensation upon adoption
of SFAS 123(R)                             |  |               |  |               |     |                              |  | (30                                       | ) |                  | 30     |                          |        |                                                  |  |                   |   |                       |        |   |  |         |   |  |         |  
|Amortization of unearned compensation  restricted
stock                                           |  |               |  |               |     |                              |  | 13                                        |   |                  |       |                          |        |                                                  |  |                   |   |                       |        |   |  |         |   |  | 13       |  
|Balance as of February 3, 2007                                                                     |  | 55,998         |  |               | $560 |                              |  | $301,526                                  |   |                  | $     |                          | (25,104 | )                                                |  | ($217,560          | ) |                       | ($1,888 | ) |  | $310,567 |   |  | $393,205 |  
|                                                                                                   |  |                |  |               |      |                              |  |                                           |   |                  |        |                          |         |                                                  |  |                    |   |                       |         |   |  |          |   |  |          |  
|Comprehensive loss:                                                                                |  |                |  |               |      |                              |  |                                           |   |                  |        |                          |         |                                                  |  |                    |   |                       |         |   |  |          |   |  |          |  
|                                                                                                  
|Net loss                                                                                           |  |               |  |               |     |                              |  |                                          |   |                  |       |                          |        |                                                  |  |                   |   |                       |        |   |  | (99,435  | ) |  | (99,435  | )
|                                                                                                  
|Additional pension liability adjustment, net of
income taxes of $107                               |  |               |  |               |     |                              |  |                                          |   |                  |       |                          |        |                                                  |  |                   |   |                       | 263     |   |  |         |   |  | 263      |  
|                                                                                                   |  |                |  |               |      |                              |  |                                           |   |                  |        |                          |         |                                                  |  |                    |   |                       |         |   |  |          |   |  |          |  
|                                                                                                  
|Total comprehensive loss                                                                           |  |                |  |               |      |                              |  |                                           |   |                  |        |                          |         |                                                  |  |                    |   |                       |         |   |  |          |   |  | (99,172  | )
|                                                                                                   |  |                |  |               |      |                              |  |                                           |   |                  |        |                          |         |                                                  |  |                    |   |                       |         |   |  |          |   |  |          |  
|                                                                                                  
|Adjustment to initially apply FIN 48                                                               |  |               |  |               |     |                              |  |                                          |   |                  |       |                          |        |                                                  |  |                   |   |                       |        |   |  | 1,636    |   |  | 1,636    |  
|Issuance of treasury stock under incentive stock programs                                          |  |               |  |               |     |                              |  | 1                                         |   |                  |       |                          | 1       |                                                  |  | 5                  |   |                       |        |   |  |         |   |  | 6        |  
|Stock compensation and related tax benefit                                                         |  | 291            |  |               | 3    |                              |  | 2,532                                     |   |                  |       |                          |        |                                                  |  |                   |   |                       |        |   |  |         |   |  | 2,535    |  
|                                                                                                  
|Unearned compensation  restricted stock                                                           |  |               |  |               |     |                              |  | (125                                      | ) |                  |       |                          |        |                                                  |  |                   |   |                       |        |   |  |         |   |  | (125     | )
|                                                                                                  
|Amortization of unearned compensation  restricted
stock                                           |  |               |  |               |     |                              |  | 54                                        |   |                  |       |                          |        |                                                  |  |                   |   |                       |        |   |  |         |   |  | 54       |  
|Reversal of unearned compensation  restricted stock associated
with
 termination of a participant |  |               |  |               |     |                              |  | 10                                        |   |                  |       |                          |        |                                                  |  |                   |   |                       |        |   |  |         |   |  | 10       |  
|                                                                                                   |  |                |  |               |      |                              |  |                                           |   |                  |        |                          |         |                                                  |  |                    |   |                       |         |   |  |          |   |  |          |  
|Balance as of February 2, 2008                                                                     |  | 56,289         |  |               | $563 |                              |  | $303,998                                  |   |                  | $     |                          | (25,103 | )                                                |  | ($217,555          | ) |                       | ($1,625 | ) |  | $212,768 |   |  | $298,149 |  
|                                                                                                  
|Comprehensive loss:                                                                                |  |                |  |               |      |                              |  |                                           |   |                  |        |                          |         |                                                  |  |                    |   |                       |         |   |  |          |   |  |          |  
|                                                                                                  
|Net loss                                                                                           |  |               |  |               |     |                              |  |                                          |   |                  |       |                          |        |                                                  |  |                   |   |                       |        |   |  | (68,955  | ) |  | (68,955  | )
|                                                                                                  
|Additional pension liability adjustment                                                            |  |               |  |               |     |                              |  |                                          |   |                  |       |                          |        |                                                  |  |                   |   |                       | 4,021   |   |  |         |   |  | 4,021    |  
|                                                                                                   |  |                |  |               |      |                              |  |                                           |   |                  |        |                          |         |                                                  |  |                    |   |                       |         |   |  |          |   |  |          |  
|Total comprehensive loss                                                                           |  |                |  |               |      |                              |  |                                           |   |                  |        |                          |         |                                                  |  |                    |   |                       |         |   |  |          |   |  | (64,934  | )
|                                                                                                   |  |                |  |               |      |                              |  |                                           |   |                  |        |                          |         |                                                  |  |                    |   |                       |         |   |  |          |   |  |          |  
|Adjustment upon adoption of measurement date provision of FAS
158                                  |  |               |  |               |     |                              |  |                                          |   |                  |       |                          |        |                                                  |  |                   |   |                       |        |   |  | (362     | ) |  | (362     | )
|Stock compensation                                                                                 |  | 1              |  |               |     |                              |  | 1,380                                     |   |                  |       |                          |        |                                                  |  |                   |   |                       |        |   |  |         |   |  | 1,380    |  
|                                                                                                  
|Issuance of stock to Directors                                                                     |  | 82             |  |               | 1    |                              |  | 719                                       |   |                  |       |                          |        |                                                  |  |                   |   |                       |        |   |  |         |   |  | 720      |  
|                                                                                                  
|Amortization of unearned compensation  restricted
stock                                           |  |               |  |               |     |                              |  | 62                                        |   |                  |       |                          |        |                                                  |  |                   |   |                       |        |   |  |         |   |  | 62       |  
|                                                                                                   |  |                |  |               |      |                              |  |                                           |   |                  |        |                          |         |                                                  |  |                    |   |                       |         |   |  |          |   |  |          |  
|Balance as of January 31, 2009                                                                     |  | 56,372         |  |               | $564 |                              |  | $306,159                                  |   |                  | $     |                          | (25,103 | )                                                |  | ($217,555          | ) |                       | $2,396  |   |  | $143,451 |   |  | $235,015 |  
|                                                                                                   |  |                |  |               |      |                              |  |                                           |   |                  |        |                          |         |                                                  |  |                    |   |                       |         |   |  |          |   |  |          |  

See Accompanying Notes to Consolidated
Financial Statements.

F-6

---



TRANS WORLD ENTERTAINMENT CORPORATION AND
SUBSIDIARIESCONSOLIDATED STATEMENTS OF CASH FLOWS
($ in thousands)

|                                                                                                     |  |                    |          |                  |  |                  |   |  |          |  
|---------------------------------------------------------------------------------------------------- |  | ------------------ | -------- | ---------------- |  | ---------------- | - |  | -------- | -
|                                                                                                     |  | Fiscal
 Year Ended
|                                                                                                     |  |                   
|                                                                                                     |  | January
 31,2009   |          | February
 2,2008 |  | February
 3,2007 |  
|                                                                                                     |  |                    |          |                  |  |                  |  
|OPERATING
 ACTIVITIES:                                                                               |  |                    |          |                  |  |                  |   |  |          |  
|Net (loss)
 income                                                                                   |  |                    | ($68,955 | )                |  | ($99,435         | ) |  | $11,669  |  
|Adjustments
 to reconcile net (loss) income to net cash (used by) provided by operating
 activities: |  |                    |          |                  |  |                  |   |  |          |  
|Depreciation and amortization of fixed
 assets                                                       |  |                    | 23,614   |                  |  | 39,900           |   |  | 40,099   |  
|Asset impairment charges                                                                             |  |                    | 15,158   |                  |  | 30,731           |   |  |         |  
|Amortization of intangible assets                                                                    |  |                    | 94       |                  |  | 297              |   |  | 263      |  
|Amortization of lease valuations, net                                                                |  |                    | (350     | )                |  | (1,146           | ) |  | (3,150   | )
|Stock compensation                                                                                   |  |                    | 1,930    |                  |  | 1,906            |   |  | 2,191    |  
|Loss on disposal of fixed assets                                                                     |  |                    | 1,219    |                  |  | 2,535            |   |  | 2,243    |  
|Gain on sale of assets                                                                               |  |                    | (3,070   | )                |  |                 |   |  |         |  
|Gain on sale of available for sale
 securities and other investments                                 |  |                    |         |                  |  |                 |   |  | (3,528   | )
|Deferred tax expense (benefit)                                                                       |  |                    |         |                  |  | 42,475           |   |  | (4,387   | )
|Decrease (increase) in cash surrender
value                                                          |  |                    | 1,585    |                  |  | (130             | ) |  | 641      |  
|Extraordinary gain on acquisition of
 businesses, net of income taxes                                |  |                    |         |                  |  |                 |   |  | (10,721  | )
|Changes in
 operating assets and liabilities, net of effects of acquisition:                         |  |                    |          |                  |  |                  |   |  |          |  
|Accounts receivable                                                                                  |  |                    | 1,073    |                  |  | (758             | ) |  | 819      |  
|Merchandise inventory                                                                                |  |                    | 62,053   |                  |  | 64,619           |   |  | 10,520   |  
|Prepaid expenses and other                                                                           |  |                    | 3,761    |                  |  | (11,625          | ) |  | 146      |  
|Other assets                                                                                         |  |                    | 186      |                  |  | 177              |   |  | (1,131   | )
|Accounts payable                                                                                     |  |                    | (66,753  | )                |  | (68,444          | ) |  | 3,804    |  
|Income taxes receivable/payable                                                                      |  |                    | 5,708    |                  |  | (17,280          | ) |  | 2,247    |  
|Accrued expenses and other current
 liabilities                                                      |  |                    | (8,321   | )                |  | (3,457           | ) |  | (3,305   | )
|Other long-term liabilities                                                                          |  |                    | (6,164   | )                |  | (5,944           | ) |  | (1,152   | )
|                                                                                                     |  |                    |          |                  |  |                  |   |  |          |  
|Net cash
 (used by) provided by operating activities                                                 |  |                    | (37,232  | )                |  | (25,579          | ) |  | 47,268   |  
|                                                                                                     |  |                    |          |                  |  |                  |   |  |          |  
|                                                                                                     |  |                    |          |                  |  |                  |   |  |          |  
|INVESTING
 ACTIVITIES:                                                                               |  |                    |          |                  |  |                  |   |  |          |  
|Purchases of fixed assets                                                                            |  |                    | (10,066  | )                |  | (15,949          | ) |  | (48,289  | )
|Acquisition of businesses                                                                            |  |                    |         |                  |  |                 |   |  | (78,810  | )
|Net proceeds from sale of distribution
 facility                                                     |  |                    | 6,193    |                  |  |                 |   |  |         |  
|Proceeds from sale of available-for-sale
 securities and other investments                           |  |                    |         |                  |  |                 |   |  | 4,228    |  
|                                                                                                     |  |                    |          |                  |  |                  |   |  |          |  
|Net cash
 used by investing activities                                                               |  |                    | (3,873   | )                |  | (15,949          | ) |  | (122,871 | )
|                                                                                                     |  |                    |          |                  |  |                  |   |  |          |  
|                                                                                                     |  |                    |          |                  |  |                  |   |  |          |  
|FINANCING
 ACTIVITIES:                                                                               |  |                    |          |                  |  |                  |   |  |          |  
|Payments of long-term debt                                                                           |  |                    | (533     | )                |  | (502             | ) |  | (473     | )
|Payments of capital lease obligations                                                                |  |                    | (2,964   | )                |  | (2,887           | ) |  | (3,182   | )
|Excess tax benefit from stock award
 exercises                                                       |  |                    |         |                  |  | 3                |   |  | 36       |  
|Proceeds from exercise of stock awards                                                               |  |                    | 2        |                  |  | 939              |   |  | 643      |  
|                                                                                                     |  |                    |          |                  |  |                  |   |  |          |  
|Net cash
 used by financing activities                                                               |  |                    | (3,495   | )                |  | (2,447           | ) |  | (2,976   | )
|                                                                                                     |  |                    |          |                  |  |                  |   |  |          |  
|                                                                                                     |  |                    |          |                  |  |                  |   |  |          |  
|Net decrease
 in cash and cash equivalents                                                           |  |                    | (44,600  | )                |  | (43,975          | ) |  | (78,579  | )
|Cash and
 cash equivalents, beginning of year                                                        |  |                    | 74,655   |                  |  | 118,630          |   |  | 197,209  |  
|                                                                                                     |  |                    |          |                  |  |                  |   |  |          |  
|Cash and
 cash equivalents, end of year                                                              |  |                    | $30,055  |                  |  | $74,655          |   |  | $118,630 |  
|                                                                                                     |  |                    |          |                  |  |                  |   |  |          |  
|Supplemental
 disclosures and non-cash investing and financing activities:                           |  |                    |          |                  |  |                  |   |  |          |  
|Interest paid                                                                                        |  |                    | $4,164   |                  |  | $5,529           |   |  | $2,901   |  
|Issuance of treasury stock under incentive
 stock programs                                           |  |                    |         |                  |  | 6                |   |  | 6        |  
|Issuance of deferred / restricted shares
 under deferred / restricted stock plans                    |  |                    |         |                  |  | 160              |   |  | 105      |  

See Accompanying Notes to Consolidated
Financial Statements.

F-7

---



TRANS WORLD
ENTERTAINMENT CORPORATION AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

Note 1. Nature of Operations and Summary of
Significant Accounting Policies

Nature of Operations:
Trans World Entertainment Corporation and subsidiaries (the Company) is one
of the largest specialty retailers of entertainment software, including music,
video, video games and related products in the United States. The Company
operates a chain of retail entertainment stores and e-commerce sites, www.fye.com, www.wherehouse.com, www.secondspin.com
and www.suncoast.com in a single
industry segment. As of January 31, 2009, the Company operated 712 stores
totaling approximately 4.6 million square feet in the United States, the
District of Columbia, the Commonwealth of Puerto Rico and the U.S. Virgin
Islands. The Companys business is seasonal in nature, with the peak selling
period being the holiday season in the Companys fourth fiscal quarter.

Liquidity: The Companys primary sources of
working capital are cash provided by sales of merchandise inventory and
borrowing capacity under its revolving credit facility. The Companys cash
flows fluctuate from quarter to quarter due to various items, including
seasonality of sales and earnings, merchandise inventory purchases and returns
and the related terms on the purchases and capital expenditures. Management
believes it will have adequate resources to fund its cash needs for the
foreseeable future, including its capital spending, its seasonal increase in
merchandise inventory and other operating cash requirements and commitments.
Management has considered many initiatives as part of the development of its
operating plan for 2009 and beyond that focus on the operation of a core base
of stores, improved product selection based on customer preferences and
industry changes, as well as further streamlining of its operations. During
Fiscal 2008, management carried out certain strategic initiatives in its
efforts to reduce certain operating costs such as the closure of the Canton, OH
distribution center, reduction of headcount at the home office and the Albany,
NY distribution center, as well as the elimination or curtailment of certain
other general and administrative expenses. Also, during the fourth quarter of
Fiscal 2008, management closed 74 stores and plans to continue its careful
evaluation of store profitability of its remaining 712 stores in consideration
of lease terms, conditions and expirations. As a consequence of these further
actions, the liquidation of the merchandise inventory from closed stores and
management of overall merchandise inventory levels, management expects
improvement in its operating cash flow during Fiscal 2009.

Management anticipates any cash requirements
due to a shortfall in cash from operations will be funded by the Companys
revolving credit facility, as discussed further within note 5. Cash flows from investing and
financing activities during Fiscal 2009 are expected to be comparable with
Fiscal 2008.

Basis of Presentation:
The consolidated financial statements consist of Trans World Entertainment
Corporation, its wholly-owned subsidiary, Record Town, Inc. (Record Town),
and Record Towns subsidiaries, all of which are wholly-owned. All significant
intercompany accounts and transactions have been eliminated. The preparation of
financial statements in conformity with accounting principles generally
accepted in the United States of America requires management to make estimates
and assumptions that affect the reported amounts of assets and liabilities and
disclosure of contingent assets and liabilities at the date of the financial
statements, and the reported amounts of revenues and expenses during the
reporting period. Actual results could differ from those estimates.

Items Affecting Comparability:
The Companys fiscal year is a 52 or 53-week period ending the Saturday nearest
to January 31. Fiscal 2008, 2007, and 2006 ended January 31, 2009, February 2,
2008, and February 3, 2007, respectively. Fiscal 2006 had 53 weeks and 2008 and
2007 had 52 weeks. The 53rd week of business in Fiscal 2006
contributed approximately $23.0 million in net sales.

Effective
February 4, 2007, the Company adopted Financial Accounting Standards Board
(FASB) Interpretation No. 48 (FIN 48), Accounting
for Uncertainty in Income TaxesAn Interpretation of FASB Statement No. 109,
which prescribes a financial statement recognition threshold and measurement
attribute for tax positions taken or expected to be taken in a tax return. In
particular, FIN 48 requires uncertain tax positions to be recognized only if
they are more-likely-than-not to be upheld based on their technical merits.
Additionally, the measurement of a tax position will be based on the largest
amount that is determined to have greater than a 50% likelihood of realization
upon ultimate settlement. Any resulting cumulative effect of adopting the
provisions of FIN 48 are to be reported as an adjustment to the beginning
balance of retained earnings in the period of adoption. As a result of adopting
FIN 48, the Company recorded a $1.6 million decrease in its reserve for
uncertain tax positions as an adjustment to retained earnings. See Note 6 in
the Notes to Consolidated Financial Statements for detailed discussion.

The Company
adopted the FASBs Statement of Financial Accounting Standards (SFAS) No. 158, Employers Accounting for Defined Benefit
and Other Postretirement Plans  an amendment of FASB Statements No. 87, 88,
106 and 132(R), effective February 3, 2007. In accordance with SFAS
No. 158, the Company recorded a liability equal to the underfunded status of
the Company sponsored Supplemental Executive Retirement Plan (SERP) and
Director Retirement Plan as of the November 1, 2007 measurement date. See
Note 8 in the Notes to Consolidated Financial Statements for detailed
discussion.

Effective
February 3, 2008, the Company adopted Statement of Financial Accounting
Standards No. 157, Fair Value Measurements. This Statement defines fair value
as used in numerous accounting pronouncements, establishes a framework for
measuring fair value under US GAAP and expands disclosure related to the use of
fair value measures in financial statements. SFAS No. 157 does not expand the
use of fair

F-8

---



value measures
in financial statements, but standardizes its definition and guidance in GAAP.
SFAS No. 157 establishes a fair value hierarchy with observable market data as
the highest level and fair value based on an entitys own fair value
assumptions as the lowest level. The adoption of SFAS No. 157 did not have a
material impact on the Companys consolidated financial statements. In February
2008, the FASB delayed the effective date of SFAS No. 157 for all nonrecurring
fair value measurements of nonfinancial assets and liabilities. The adoption of
SFAS No. 157 as it relates to nonfinancial assets and liabilities is not
expected to have a material impact on the Companys consolidated financial
statements.

Effective
February 3, 2008, the Company adopted SFAS No. 159, The Fair Value Option for
Financial Assets and Financial Liabilities, which permits entities to choose to
measure certain financial assets and liabilities at fair value, with changes in
fair value reported in operations. The Company did not choose the fair value
option for any financial instruments upon the adoption of this statement.

Concentration of Business Risks:
The Company purchases merchandise inventory for its stores from approximately
527 suppliers, with approximately 60% of purchases being made from ten
suppliers including EMI Music Distribution, Sony-Bertelsmann Music Group,
Warner/Electra/Atlantic Corp., Universal Music Group, Fox Video Inc., Paramount
Video, Buena Vista Video, Warner Home Entertainment, Universal Studios Home
Entertainment and Nintendo. Historically, the Company has not experienced
difficulty in obtaining satisfactory sources of supply, and management believes
that it will retain access to adequate sources of supply. However, a loss of a
major supplier could cause a loss of sales, which would have an adverse effect
on operating results.

Cash and Cash Equivalents:
The Company considers all highly liquid investments purchased with an original
maturity of three months or less to be cash equivalents.

Concentration of Credit Risks:
The Company maintains centralized cash management and investment programs
whereby excess cash balances are invested in short-term money market funds and
instruments considered to be cash equivalents. The Companys investment
portfolio is diversified and consists of short-term investment grade securities
consistent with its investment guidelines. These guidelines include the
provision that sufficient liquidity will be maintained to meet anticipated cash
flow needs. The Company maintains investments with various financial
institutions. These amounts often exceed the FDIC insurance limits. The Company
limits the amount of credit exposure with any one financial institution and
believes that no significant concentration of credit risk exists with respect
to cash investments.

Accounts Receivable:
Accounts receivable are comprised of receivables and unbilled revenues from
advertising services performed for third parties, and amounts due under
operating or service agreements with unaffiliated entities, loans to related
business ventures, and other, individually insignificant amounts. There are no
provisions for uncollectible amounts from retail sales of merchandise inventory
since payment is received at the time of sale.

Merchandise Inventory and Return Costs:
Merchandise inventory is stated at the lower of cost or market under the
average cost method. Inventory valuation requires significant judgment and
estimates, including obsolescence, shrink and any adjustments to market value,
if market value is lower than cost. The Company records obsolescence and any
adjustments to market value (if lower than cost) based on current and
anticipated demand, customer preferences and market conditions. The provision
for inventory shrink is estimated as a percentage of sales for the period from
the last date a physical inventory was performed to the end of the fiscal year.
Such estimates are based on historical results and trends, and the shrink
results from the last physical inventory. Physical inventories are taken at
least annually for all stores and distribution centers throughout the year, and
inventory records are adjusted accordingly.

The Company is
generally entitled to return merchandise purchased from major music vendors for
credit against other purchases from these vendors. Certain vendors reduce the
credit with a merchandise return charge which varies depending on the type of
merchandise being returned. Certain other vendors charge a handling fee based
on units returned. The Company records merchandise return charges in cost of
sales.

Fixed Assets and Depreciation:
Fixed assets are recorded at cost and depreciated or amortized over the
estimated useful life of the asset using the straight-line method. The
estimated useful lives are as follows:

|                            |                                                                
|--------------------------- | ---------------------------------------------------------------
|Leasehold
 improvements     | Lesser of
 estimated useful life of the asset or the lease term
|Fixtures and
 equipment     | 3-7 years                                                      
|Buildings
 and improvements | 10-30 years                                                    

Major
improvements and betterments to existing facilities and equipment are
capitalized. Expenditures for maintenance and repairs are expensed as incurred.
Amortization of capital lease assets is included in depreciation and
amortization expense.

Impairment of Long-Lived Assets:
Long-lived assets are reviewed for impairment whenever events or changes in
circumstances indicate that the carrying amount of an asset may not be
recoverable. Recoverability of assets to be held and used is measured by a
comparison of the carrying amount of an asset to undiscounted future net cash
flows expected to be generated by the asset over its remaining useful life. If
the carrying amount of an asset exceeds its estimated future cash flows, an
impairment charge is recognized by the amount by which the carrying amount of
the assets exceeds the fair value of the assets. Fair value is generally
measured based on discounted estimated future cash flows. Assets to be disposed
of would be separately presented in the Consolidated Balance Sheets and reported
at the lower of the carrying amount or

F-9

---



fair value
less disposition costs.

During Fiscal
2008 and Fiscal 2007, the Company recorded an asset impairment charge of $15.2
million and $30.7 million, respectively, related to the write down of certain long-lived
assets at underperforming locations. Losses for store closings in the ordinary
course of business represent the write down of the net book value of abandoned
fixtures and leasehold improvements. The loss on disposal of fixed assets
related to store closings was $1.2 million, $2.5 million and $2.2 million in
Fiscal 2008, 2007 and 2006, respectively, and is included in selling, general
and administrative (SG&A) expenses in the Consolidated Statements of
Operations and loss on disposal of fixed assets in the Consolidated Statements
of Cash Flows. Store closings usually occur at the expiration of the lease, at
which time leasehold improvements, which constitute a majority of the abandoned
assets, are fully depreciated.

Conditional Asset Retirement Obligations:
The Company records the fair value of an asset retirement obligation (ARO) as
a liability in the period in which it incurs a legal obligation associated with
the retirement of tangible long-lived assets that result from the acquisition,
construction, development, and/or normal use of the asset. The Company also
records a corresponding asset that is depreciated over the life of the asset.
Subsequent to the initial measurement of the ARO, the ARO is adjusted at the
end of each period to reflect the passage of time and changes in the estimated
future cash flows underlying the obligation.

Commitments and ContingenciesThe Company is subject to legal proceedings and claims
that have arisen in the ordinary course of its business and have not been finally
adjudicated. Although there can be no assurance as to the ultimate disposition
of these matters, it is managements opinion, based upon the information
available at this time, that the expected outcome of these matters,
individually or in the aggregate, will not have a material adverse effect on
the results of operations and financial condition of the Company.

Revenue Recognition:
The Companys revenue is primarily from retail sales of merchandise inventory.
Revenue is recognized at the point-of-sale. Internet sales are recognized as
revenue upon shipment. Shipping and handling fee income from the Companys
Internet operations is recognized as net sales. Loyalty card revenue is
amortized straight-line over the life of the membership period. Net sales are
recorded net of estimated amounts for sales returns and other allowances. The
Company records shipping and handling costs in cost of goods sold. Net sales
are recorded net of applicable sales taxes.

Cost of Sales: In
addition to the cost of product, the Company includes in cost of sales those
costs associated with purchasing, receiving, shipping, inspecting and
warehousing product. Also included are costs associated with the return of
product to vendors. Cost of sales further includes the cost of inventory shrink
and obsolescence and the benefit of vendor allowances and discounts.

Selling, General and Administrative
(SG&A) Expenses: Included in SG&A expenses
are payroll and related costs, store operating costs, occupancy charges,
professional and service fees, general operating and overhead expenses and
depreciation charges (excluding those related to distribution operations, as
discussed in Note 3 of Notes to the Consolidated Financial Statements in this
Annual Report on Form 10-K). Selling, general and administrative expenses also
include fixed asset write offs associated with store closures, if any, and
miscellaneous items, other than interest.

Advertising Costs and Vendor Allowances:
The Company often receives allowances from its vendors to fund in-store
displays, print, radio and television advertising, and other promotional
events. The Company accounts for vendor allowances in accordance with the
provisions of the Financial Accounting Standards Boards (FASBs) Emerging
Issues Task Force (EITF) Statement No. 02-16, Accounting by a Customer
(Including a Reseller) for Certain Consideration Received from a Vendor.
Vendor advertising allowances which exceed specific, incremental and
identifiable costs incurred in relation to the advertising and promotions
offered by the Company to its vendors are classified as a reduction in the
purchase price of merchandise inventory. Accordingly, advertising and sales
promotion costs are charged to operations, offset by direct vendor
reimbursements, as incurred. Total advertising expense, excluding vendor
allowances, was $23.2 million, $29.7 million, and $29.7 million in Fiscal 2008,
2007, and 2006, respectively. In the aggregate, vendor allowances supporting
the Companys advertising and promotion included as a reduction of SG&A
expenses, as reimbursements of such costs in accordance with EITF No. 02-16,
were $14.7 million, $15.9 million, and $10.7 million in Fiscal 2008, 2007, and
2006, respectively.

Lease Accounting:
The Companys calculation of straight-line rent expense includes the impact of
escalating rents for periods in which it is reasonably assured of exercising
lease options and includes in the lease term any period during which the
Company is not obligated to pay rent while the store is being constructed
(rent holiday). The Company accounts for step rent provisions, escalation
clauses and other lease concessions by recognizing these amounts on a straight
line basis over the initial lease term. The Company capitalizes leasehold
improvements funded by tenant improvement allowances, depreciating them over
the lives of the related leases. The tenant improvement allowances are recorded
as deferred rent within other long-term liabilities in the Consolidated Balance
Sheet and are amortized as a reduction in rent expense over the life of the
related leases.

Store Closing Costs:
Management periodically considers the closing of underperforming stores.
Reserves are established at the time a liability is incurred for the present
value of any remaining lease obligations, net of estimated sublease income, and
other exit costs, as prescribed by SFAS No. 146, Accounting for Costs Associated with Exit or Disposal Activities.

F-10

---



Gift Cards: The
Company offers gift cards for sale. A deferred income account, which is
included in accrued expenses and other current liabilities in the Consolidated
Balance Sheets, is established for gift cards issued. The deferred income
balance related to gift cards was $13.1 million and $18.3 million at the end of
Fiscal 2008 and 2007, respectively. When gift cards are redeemed at the store
level, revenue is recorded and the related liability is reduced. Breakage is
estimated based on the historical relationship of the redemption of gift cards
redeemed to gift cards sold, over a certain period of time. The Company has the
ability to reasonably and reliably estimate gift card liability based on
historical experience with redemption rates associated with a large volume of
homogeneous transactions, from a period of more than ten years. The Companys
estimate is not susceptible to significant external factors and the
circumstances around purchases and redemptions have not changed significantly
over time. The Company recorded breakage on its gift cards for Fiscal 2008,
2007 and 2006 in the amount of $4.1 million, $3.4 million and $3.6 million,
respectively. Gift card breakage is recorded as a reduction of SG&A
expenses.

Income Taxes: Income
taxes are accounted for under the asset and liability method. Deferred tax
assets and liabilities are recognized for the future tax consequences
attributable to differences between the financial statement carrying amounts of
existing assets and liabilities and their respective tax bases and operating
loss and tax credit carryforwards. Deferred tax assets and liabilities are
measured using enacted tax rates expected to apply to taxable income in the
years in which those temporary differences are expected to be recovered or
settled. The effect on deferred tax assets and liabilities of a change in tax
rates is recognized in income in the period that includes the enactment date.
Deferred tax assets are subject to valuation allowances based upon managements
estimates of realizability.

Beginning with
the adoption of FASB Interpretation No. 48, Accounting for Uncertainty in
Income Taxes as of February 4, 2007, the Company recognizes the effect of
income tax positions only if those positions are more likely than not of being
sustained. Recognized income tax positions are measured at the largest amount
that is greater than 50% likely of being realized. Changes in recognition or
measurement are reflected in the period in which the change in judgment occurs.
Prior to the adoption of FIN 48, the Company recognized the effect of income
tax positions only if such positions were probable of being sustained. It is
the Companys practice to recognize interest and penalties related to income
tax matters in income tax expense (benefit) in the consolidated statements of
operations.

Stock-Based Compensation:
Stock-based compensation represents the cost related to stock-based awards
granted to employees and directors. The Company measures stock-based
compensation cost at grant date, based on the estimated fair value of the
award, and recognizes the cost as expense on a straight-line basis (net of
estimated forfeitures) over the options requisite service period. The Company
recognizes compensation expense based on estimated grant date fair value using
the Black-Scholes option-pricing model. Tax benefits resulting from tax deductions
in excess of the compensation cost recognized for those options are to be
classified and reported as both an operating cash outflow and financing cash
inflow.

Total
stock-based compensation expense recognized in the Consolidated Statements of
Operations for Fiscal 2008, Fiscal 2007 and Fiscal 2006 was $1.9 million, $1.9
million and $2.2 million. For Fiscal 2008 the related total deferred tax
expense was $0.1 million. The related total deferred tax benefit was
approximately $0.8 million and $0.9 million in 2007 and 2006, respectively. As
of January 31, 2009, there was $2.3 million of unrecognized compensation cost
related to stock option awards that is expected to be recognized as expense
over a weighted average period of 1.4 years.

The fair
values of the options granted have been estimated at the date of grant using
the Black - Scholes option pricing model with the following assumptions:

|                                                                          |  |                   |               |      |  |               |  |  |               | 
|------------------------------------------------------------------------- |  | ----------------- | ------------- | ---- |  | ------------- |  |  | ------------- | 
|                                                                          |  | Stock Option Plan |              
|                                                                          |  |                   |              
|                                                                          |  | 2008              |               | 2007 |  | 2006          | 
|                                                                          |  |                   |               |      |  |               | 
|Dividend yield                                                            |  |                   | 0%            |      |  | 0%            |  |  | 0%            | 
|Expected volatility                                                       |  |                   | 52.8% - 56.3% |      |  | 65.1% - 68.7% |  |  | 65.9% - 71.2% | 
|Risk-free interest rate                                                   |  |                   | 1.42% - 3.41% |      |  | 3.57% - 4.94% |  |  | 4.64% - 5.04% | 
|Expected option life in years                                             |  |                   | 4.87  5.69   |      |  | 4.70  7.30   |  |  | 4.93  7.12   | 
|Weighted average fair value per share of
 options granted during the year |  |                   | $1.34         |      |  | $3.39         |  |  | $3.42         | 

In the fourth
quarter of 2005, the Companys Board of Directors approved the acceleration of
vesting of previously granted unvested options awarded annually to employees
and officers under the Companys Stock Option Plans which had exercise prices
greater than $10.00 per share. Options to purchase 2,273,057 shares of the
Companys common stock, representing approximately 24% of the total options
outstanding, became immediately vested and exercisable as a result of this
action. The number of shares and exercise prices of the options subject to the
acceleration remained unchanged. Also, all of the other terms of the options
remain the same. Based upon an analysis performed, the acceleration of vesting
of these stock options resulted in compensation expense of $5.9 million. The
decision to accelerate vesting of these stock options was made primarily to
avoid recognizing compensation expense in the Consolidated Statements of
Operations in future financial statements upon the adoption of SFAS No.123 (R),
Share-Based Payment, which the Company adopted on January 29, 2006. The
acceleration of the vesting of these stock options reduced the amounts
recognized by the Company as share-based compensation expense, net of income
taxes, by approximately

F-11

---



$1.9 million
in Fiscal 2007 and by approximately $1.2 million in Fiscal 2008, and will
reduce compensation expense by approximately $0.4 million in Fiscal 2009. The
accelerated options included 1,355,000 options held by executive officers and
918,057 options held by other employees. Based on the Companys closing stock
price of $6.25 per share on the date of accelerated vesting, the exercise
prices of all of the options were above the closing market price.

(Loss) Earnings Per Share:
Basic (loss) earnings per share is calculated by dividing net income by the
weighted average common shares outstanding for the period. Diluted (loss)
earnings per share is calculated by dividing net income by the sum of the
weighted average shares outstanding and additional common shares that would
have been outstanding if the dilutive potential common shares had been issued
for the Companys common stock awards from the Companys Stock Award Plans.

The following
is a reconciliation of the basic weighted average number of shares outstanding
to the diluted weighted average number of shares outstanding:

|                                                      |  |             |        |      |  |        |  |  |        | 
|----------------------------------------------------- |  | ----------- | ------ | ---- |  | ------ |  |  | ------ | 
|                                                      |  | Fiscal Year |       
|                                                      |  |             |       
|                                                      |  | 2008        |        | 2007 |  | 2006   | 
|                                                      |  |             |        |      |  |        | 
|                                                      |  |             |        |      |  |        |  |  |        | 
|Weighted
 average common shares outstanding  basic   |  |             | 31,223 |      |  | 31,046 |  |  | 30,797 | 
|Dilutive
 effect of outstanding stock awards          |  |             |       |      |  |       |  |  | 1,189  | 
|                                                      |  |             |        |      |  |        |  |  |        | 
|Weighted
 average common shares outstanding  diluted |  |             | 31,223 |      |  | 31,046 |  |  | 31,986 | 
|                                                      |  |             |        |      |  |        |  |  |        | 
|                                                      |  |             |        |      |  |        |  |  |        | 
|Antidilutive
 stock awards                            |  |             | 6,651  |      |  | 6,413  |  |  | 7,290  | 
|                                                      |  |             |        |      |  |        |  |  |        | 

As the Company
recorded a net loss during Fiscal 2008 and 2007, the impact of all outstanding
stock awards was not considered as such impact would be antidilutive. Certain
stock awards outstanding were excluded from the computation of diluted earnings
per share for Fiscal 2006 because the exercise price of the options was greater
than the average market price of the common shares during the period.

Fair Value of Financial Instruments:
The carrying amounts reported in the Consolidated Balance Sheets for cash and
cash equivalents, accounts receivable, accounts payable and other current
liabilities approximate fair value because of the immediate or short-term
maturity of these financial instruments. The carrying value of life insurance
policies included in other assets approximates fair value based on estimates
received from insurance companies. The carrying value of the Companys
long-term debt including current portion, approximates fair value based on
estimated discounted future cash flows for remaining maturities and rates
currently offered to the Company for similar debt instruments. The Company had
no outstanding product import letters of credit as of January 31, 2009 and
February 2, 2008.

Segment Information:
The Company has one reportable segment in accordance with the requirements of
SFAS No. 131, Disclosures about Segments of
an Enterprise and Related Information. The following table shows net
sales by merchandise category:

|            |  |                  |         |      |   |           |  |   |           | 
|----------- |  | ---------------- | ------- | ---- | - | --------- |  | - | --------- | 
|            |  |                  |        
|            |  | Fiscal year      |        
|           
|            |  | 2008             |         | 2007 |   | 2006      | 
|            |  |                  |         |      |   |           | 
|            |  | ($ in thousands) |        
|Music       |  | $                | 349,737 |      | $ | 494,286   |  | $ | 676,091   | 
|Video       |  |                  | 407,884 |      |   | 491,360   |  |   | 529,900   | 
|Video games |  |                  | 90,233  |      |   | 114,431   |  |   | 114,654   | 
|Other       |  |                  | 139,771 |      |   | 165,581   |  |   | 150,512   | 
|            |  |                  |         |      |   |           |  |   |           | 
|Total       |  | $                | 987,625 |      | $ | 1,265,658 |  | $ | 1,471,157 | 
|            |  |                  |         |      |   |           |  |   |           | 

The Other
category includes electronics, accessories and trend items, none of which
individually exceeds 10% of total net sales.

Note 2. Business Combinations

On March 27,
2006, the Company acquired substantially all the net assets of Musicland
Holding Corp. (Musicland). Under the terms of the Asset Purchase Agreement
(APA), the Company acquired 335 of Musiclands 400 stores, with the remainder
of the stores being liquidated under an agency agreement with Hilco Merchant
Resources LLC. Musicland, which operated retail stores and websites, filed a
voluntary petition to restructure under Chapter 11 of the United States
Bankruptcy Code in January 2006. The acquisition was accounted for using the
purchase method of accounting. The Consolidated Statement of Operations for
Fiscal 2006 includes the results of Musicland beginning March 27, 2006.

From March 27,
2006 to February 3, 2007, the Company allocated the purchase price in
accordance with the provisions of SFAS No. 141, Business Combinations,
resulting in an extraordinary gain  unallocated negative goodwill of $10.7
million, net of income taxes of $6.7 million. The extraordinary gain represents
the excess of the fair value of net assets acquired over the purchase price.
The purchase price was

F-12

---



allocated on a
preliminary basis during the thirteen weeks ended April 29, 2006 using
information available at the time. The extraordinary gain recorded as of April
29, 2006 was $0.9 million, which was net of income taxes of $0.7 million. In
accordance with SFAS No.141, the allocation of the purchase price to the assets
and liabilities acquired must be finalized within twelve months following the
date of acquisition. Accordingly, the purchase price allocation was adjusted
between April 26, 2006 and February 3, 2007, resulting in an adjustment to the
extraordinary gain of $9.8 million, which is net of income taxes of $6.0
million. The pre-tax increase in the extraordinary gain from April 29, 2006 to
February 2, 2008 represented adjustments to the value of acquired inventory
($1.9 million), an adjustment to customer liabilities related to the former
Musicland loyalty program ($3.4 million), an adjustment to customer liabilities
related to gift cards based on the redemption experience since acquisition
($6.1 million), an adjustment to occupancy related expenses ($1.5 million) and
an adjustment to the cash purchase price ($2.9 million).

Note 3. Fixed Assets

Fixed assets consist of the following:

|                                              |  |                   |          |                   |   |          |  
|--------------------------------------------- |  | ----------------- | -------- | ----------------- | - | -------- | -
|                                              |  | January 31,
 2009 |          | February 2,
 2008 |  
|                                              |  |                   |          |                   |  
|                                              |  | ($ in thousands)  |         
|Buildings
 and improvements                   |  | $                 | 17,288   |                   | $ | 26,513   |  
|Fixtures and
 equipment                       |  |                   | 136,896  |                   |   | 173,414  |  
|Leasehold
 improvements                       |  |                   | 48,240   |                   |   | 76,274   |  
|                                              |  |                   |          |                   |   |          |  
|                                              |  |                   | 202,424  |                   |   | 276,201  |  
|Allowances
 for depreciation and amortization |  |                   | (151,987 | )                 |   | (193,953 | )
|                                              |  |                   |          |                   |   |          |  
|                                              |  | $                 | 50,437   |                   | $ | 82,248   |  
|                                              |  |                   |          |                   |   |          |  

Depreciation
and amortization of fixed assets is included in the Consolidated Statements of
Operations as follows:

|                                              |  |                  |        |      |   |        |  |   |        | 
|--------------------------------------------- |  | ---------------- | ------ | ---- | - | ------ |  | - | ------ | 
|                                              |  | Fiscal Year      |       
|                                              |  |                  |       
|                                              |  | 2008             |        | 2007 |   | 2006   | 
|                                              |  |                  |        |      |   |        | 
|                                              |  | ($ in thousands) |       
|Cost of
 sales                                |  | $                | 1,563  |      | $ | 2,670  |  | $ | 3,108  | 
|Selling,
 general and administrative expenses |  |                  | 22,051 |      |   | 37,230 |  |   | 36,991 | 
|                                              |  |                  |        |      |   |        |  |   |        | 
|Total                                         |  | $                | 23,614 |      | $ | 39,900 |  | $ | 40,099 | 
|                                              |  |                  |        |      |   |        |  |   |        | 

Depreciation
and amortization expense related to the Companys distribution center facility
and equipment is included in cost of sales. All other depreciation and
amortization of fixed assets is included in SG&A expenses.

Note 4. Impairment of Long-Lived Assets

During Fiscal 2008 and Fiscal 2007, the Company
concluded, based on a significant decline in sales and earnings during the
fourth quarter, that triggering events had occurred, pursuant to SFAS No. 144, Accounting for the Impairment or Disposal of
Long-Lived Assets (SFAS No. 144), requiring a test of long-lived
assets for impairment at its retail stores and consolidated subsidiaries.
Long-lived assets at locations where impairment was determined to exist were
written down to their estimated fair values as of the end of the period,
resulting in the recording of an asset impairment charges of $15.2 million and
$30.7 million in Fiscal 2008 and Fiscal 2007, respectively. Estimated fair
values for long-lived assets at these locations, including store fixtures and
equipment, leasehold improvements and certain intangible assets, were
determined based on a measure of discounted future cash flows over the
remaining lease terms at the respective locations. Future cash flows were
estimated based on store operating plans and were discounted at a rate
approximating the Companys cost of capital. Management believes its
assumptions were reasonable and consistently applied.

Note 5. Debt

On January 5, 2006, the Company entered into a five
year, $100 million revolving secured credit facility agreement (Credit
Facility) with Bank of America, N.A. At the election of the Company, loans
under the Credit Facility bear interest on the principal amount at a rate equal
to either the Prime Rate or Adjusted LIBOR plus 0.75%. The principal amount of
all outstanding loans under the Credit Facility together with any accrued but
unpaid interest, are due and payable on January 6, 2011, unless otherwise paid
earlier pursuant to the terms of the Credit Facility. Payments of amounts due
under the Credit Facility are secured by the assets of the Company.

The Credit
Facility includes customary provisions, including affirmative and negative
covenants, which include representations, warranties and restrictions on
additional indebtedness and acquisitions. The Credit Facility also includes
customary events of default, including, among other things, a material adverse effect, bankruptcy, and
certain changes of control. The Company was in compliance with terms and
conditions of the Credit Facility as of January 31, 2009.

F-13

---



On March 23,
2006, the Company entered into a First Amendment of the Credit Facility with
Bank of America, N.A. which increased the maximum amount available for
borrowing under the revolving secured credit facility to $130 million, under
the same terms and conditions.

On October 20,
2006, the Company entered into a Second Amendment of the Credit Facility with
Bank of America, N.A. which increased the maximum amount available for
borrowing under the revolving secured credit facility to $150 million, under
the same terms and conditions. The availability under the Credit Facility is subject to
limitations based on sufficient inventory levels.

During Fiscal
2008, 2007 and 2006, the highest aggregate balances outstanding under the
revolving credit facility were $97.6 million, $111.5 million and $107.5
million, respectively. As of January 31, 2009 and February 2, 2008, the Company
had no outstanding letter of credit obligations under the Credit Facility with
Bank of America, N.A. The Company had $150 million available for borrowing as
of January 31, 2009 and February 3, 2008.

During Fiscal
2004, the Company borrowed $5.8 million under a mortgage loan to finance the
purchase of real estate. The mortgage loan is repayable in monthly installments
of $64,000 over 10 years with a fixed interest rate of 6.0% and is
collateralized by the real estate. As of January 31, 2009, the outstanding
balance on the loan was $3.6 million. The following table presents principal
cash payments of long-term debt by expected maturity dates as of January 31,
2009:

|                           |  |                  |        | 
|-------------------------- |  | ---------------- | ------ | 
|                           |  | Long-term debt   |       
|                           |  |                  |       
|                           |  | ($ in thousands) |       
|2009                       |  |                  | $570   | 
|2010                       |  |                  | 605    | 
|2011                       |  |                  | 643    | 
|2012                       |  |                  | 683    | 
|2013                       |  |                  | 725    | 
|Thereafter                 |  |                  | 330    | 
|                           |  |                  |        | 
|Total                      |  |                  | 3,556  | 
|Less: current portion      |  |                  | 570    | 
|                           |  |                  |        | 
|Long term debt obligation |  |                  | $2,986 | 
|                           |  |                  |        | 

Note 6. Income Taxes

Income tax
expense (benefit) consists of the following:

|                   |  |                  |       |      |  |         |   |  |         |  
|------------------ |  | ---------------- | ----- | ---- |  | ------- | - |  | ------- | -
|                   |  | Fiscal Year      |      
|                   |  |                  |      
|                   |  | 2008             |       | 2007 |  | 2006    |  
|                   |  |                  |       |      |  |         |  
|                   |  | ($ in thousands) |      
|Federal 
 current |  |                  | ($455 | )    |  | ($4,864 | ) |  | $2,090  |  
|State 
 current   |  |                  | 427   |      |  | 364     |   |  | 256     |  
|Deferred           |  |                  |      |      |  | 42,475  |   |  | (4,387  | )
|                   |  |                  |       |      |  |         |   |  |         |  
|                   |  |                  | ($28  | )    |  | $37,975 |   |  | ($2,041 | )
|                   |  |                  |       |      |  |         |   |  |         |  

F-14

---



A reconciliation of the Companys effective
income tax rate with the Federal statutory rate is as follows:

|                                                       |  |             |       |      |  |       |    |  |       |   
|------------------------------------------------------ |  | ----------- | ----- | ---- |  | ----- | -- |  | ----- | --
|                                                       |  | Fiscal Year |      
|                                                       |  |            
|                                                       |  | 2008        |       | 2007 |  | 2006  |   
|                                                       |  |             |       |      |  |       |   
|Federal statutory rate                                 |  |             | 35.0  | %    |  | 35.0  | %  |  | 35.0  | % 
|State income taxes, net of federal tax effect          |  |             | (0.2  | %)   |  | (15.9 | %) |  | 17.9  | % 
|Change in valuation allowance                          |  |             | (32.1 | %)   |  | (78.1 | %) |  | 99.3  | % 
|Corporate-owned life insurance payment settlement, net |  |             |      |      |  | (0.4  | %) |  | (21.4 | %)
|Cash surrender value  insurance/ benefit programs     |  |             | (1.0  | %)   |  | (0.1  | %) |  | 10.7  | % 
|Executive compensation                                 |  |             | (0.2  | %)   |  | (0.2  | %) |  | (13.1 | %)
|Tax exempt income                                      |  |             |      |      |  |      |    |  | 17.7  | % 
|Closing of tax periods                                 |  |             |      |      |  |      |    |  | 18.1  | % 
|Tax credits                                            |  |             | (0.1  | %)   |  | (0.1  | %) |  | 27.6  | % 
|Other                                                  |  |             | (1.4  | %)   |  | (2.0  | %) |  | (5.1  | %)
|                                                       |  |             |       |      |  |       |    |  |       |   
|Effective income tax rate                              |  |             | 0.0   | %    |  | (61.8 | %) |  | 186.7 | % 
|                                                       |  |             |       |      |  |       |    |  |       |   

Under the final payment
terms of a 2003 agreement between the Company and the IRS regarding an earlier
audit, the Company made a final principal payment of $7.1 million in 2007. The other category
is comprised of various items, including the impacts of non deductible meals, dues,
penalties, amortization, uncertain tax positions, tax attribute, carryback limitations
and graduate tax brackets.

Significant components of
the Companys deferred tax assets are as follows:

|                                                               |  |                   |         |                   |   |         |  
|-------------------------------------------------------------- |  | ----------------- | ------- | ----------------- | - | ------- | -
|                                                               |  | January 31,
 2009 |         | February 2,
 2008 |  
|                                                               |  |                   |         |                   |  
|                                                               |  | ($ in
thousands)  |        
|DEFERRED TAX ASSETS                                            |  |                   |         |                   |   |         |  
|Accrued expenses                                               |  | $                 | 1,581   |                   | $ | 1,643   |  
|Inventory                                                      |  |                   | 2,582   |                   |   | 4,690   |  
|Retirement and
 compensation related accruals                  |  |                   | 7,009   |                   |   | 8,033   |  
|Fixed assets                                                   |  |                   | 19,402  |                   |   | 18,949  |  
|Federal and state net
 operating loss and credit carryforwards |  |                   | 46,895  |                   |   | 19,011  |  
|Real estate leases,
 including deferred rent                   |  |                   | 7,671   |                   |   | 9,799   |  
|Losses on investments                                          |  |                   | 2,013   |                   |   | 1,683   |  
|Goodwill                                                       |  |                   | 4,579   |                   |   | 5,525   |  
|Other                                                          |  |                   | 1,009   |                   |   | 1,263   |  
|                                                               |  |                   |         |                   |   |         |  
|Gross deferred tax assets
 before valuation allowance          |  |                   | 92,741  |                   |   | 70,596  |  
|Less: valuation allowance                                      |  |                   | (92,741 | )                 |   | (70,596 | )
|                                                               |  |                   |         |                   |   |         |  
|Total deferred tax assets                                      |  | $                 |        |                   | $ |        |  
|                                                               |  |                   |         |                   |   |         |  
|                                                               |  |                   |         |                   |   |         |  
|DEFERRED TAX LIABILITIES                                       |  |                   |        |                   |   |        |  
|                                                               |  |                   |         |                   |   |         |  
|                                                               |  |                   |         |                   |   |         |  
|NET DEFERRED TAX ASSET                                         |  | $                 |        |                   | $ |        |  
|                                                               |  |                   |         |                   |   |         |  

The Company has a net
operating loss carryforward of $88.7 million for federal income tax purposes
and approximately $210 million for state income tax purposes as of the end of
Fiscal 2008 that expire at various times through 2025 and are subject to
certain limitations and statutory expiration periods. The state net operating
loss carryforwards are subject to various business apportionment factors and
multiple jurisdictional requirements when utilized. The Company has federal tax
credit carryforwards of $0.9 million, of which $0.2 million will expire in
2026, with the remainder available indefinitely. The Company has state tax
credit carryforwards of $1.1 million, of which $0.3 million will expire in
2027.

In assessing the
realizability of deferred tax assets, management considers whether it is more
likely than not that some portion or all of the deferred tax assets will not be
realized. The ultimate realization of deferred tax assets is dependent upon the
generation of future taxable income. Management considers the scheduled
reversal of taxable temporary differences, projected future taxable income and
tax planning strategies in

F-15

---



making this assessment. As
of January 31, 2009, the Company has incurred a cumulative three-year loss.
Based on the cumulative three-year loss and other available objective evidence,
management concluded that a full valuation allowance should be recorded against
its deferred tax assets. As of January 31, 2009, the valuation allowance
increased to $92.7 million from $70.6 million at February 3, 2008; because
management believes that it is more likely than not that the tax benefit will
not be realized. The increase in the valuation allowance equals the increase in
gross deferred tax assets and is consistent with the Companys decision to
record a full valuation allowance against deferred tax assets that have been
recorded in the normal course of business, as described above.

During Fiscal 2008, the
Company paid income taxes of approximately $0.2 million and received income tax
refunds of approximately $6.0 million. For Fiscal 2007, the Company paid income
taxes, net of refunds, of approximately $12.4 million. For Fiscal 2006, the Company
received a net income tax refund of approximately $0.1 million.

On February 4, 2007, the
Company adopted Financial Interpretation No. 48 (FIN 48), Accounting for Uncertainties in Income Taxes  An
Interpretation of FASB Statement No. 109, which prescribes a
recognition threshold and measurement attribute for financial statement
recognition and measurement of tax positions taken or expected to be taken in a
tax return. Under FIN 48, the tax benefit from an uncertain tax position may be
recognized only if it is more likely than not that the tax position will be
sustained, based on its technical merits, on examination by taxing authorities.
The amount of the tax benefit recognized is measured as the largest amount that
is determined to have a greater than 50% likelihood of realization upon
ultimate settlement. Upon adoption of FIN 48 on February 4, 2007, the Company
reduced the total reserve for uncertain tax positions by $1.6 million, with a
corresponding increase to retained earnings.

A reconciliation of the
beginning and ending amounts of unrecognized tax benefits is provided below.
Amounts presented excluded interest and penalties, where applicable, on
unrecognized tax benefits:

|                                               |  |   |       |  
|---------------------------------------------- |  | - | ----- | -
|(Amounts in thousands)                         |  |   |       |  
|Unrecognized tax benefits
 at February 4, 2008 |  | $ | 3,157 |  
|Increases in tax positions
 from prior years   |  |   | 132   |  
|Decreases in tax positions
 from prior years   |  |   | (10   | )
|Increases in tax positions
 for current year   |  |   |      |  
|Settlements                                    |  |   |      |  
|Lapse of applicable
 statute of limitations    |  |   | (899  | )
|                                               |  |   |       |  
|                                               |  |   |       |  
|Unrecognized tax benefits
 at January 31, 2009 |  | $ | 2,380 |  

As of January 31, 2009, the
Company had $2.4 million of gross unrecognized tax benefits, $1.7 million of
which would affect the Companys tax rate if recognized. While it is reasonably
possible that the amount of unrecognized tax benefits will increase or decrease
within the next twelve months, the Company does not expect the change to have a
significant impact on its results of operations or financial position.

The Company is subject to
U.S. federal income tax as well as income tax of multiple state jurisdictions.
The Company has substantially concluded all federal income tax matters through
Fiscal 2007 and all material state and local income tax matters through Fiscal
2003.

The Companys practice is to
recognize interest and penalties associated with its unrecognized tax benefits
as a component of income tax expense in the Companys Consolidated Statement
of Operations. During Fiscal 2008, the Company accrued a provision for interest
and penalties of $0.5 million. As of January 31, 2009, the
liability for uncertain tax positions reflected in the Companys Consolidated
Balance Sheets was $2.2 million, including accrued interest of $1.2 million.

F-16

---



Note 7. Leases

Leases—lessee

As more fully discussed in
Note 10 in the Notes to Consolidated Financial Statements, the Company leases
its Albany, NY distribution center and administrative offices under three
capital lease arrangements with its Chief Executive Officer and largest
shareholder.

Fixed assets recorded under
capital leases, which are included in fixed assets on the accompanying
Consolidated Balance Sheets, are as follows:

|                                              |  |                   |         |                   |   |         |  
|--------------------------------------------- |  | ----------------- | ------- | ----------------- | - | ------- | -
|                                              |  | January 31,
 2009 |         | February 2,
 2008 |  
|                                              |  |                   |         |                   |  
|                                              |  | ($ in thousands)  |        
|Buildings                                     |  | $                 | 9,342   |                   | $ | 9,342   |  
|Fixtures and equipment                        |  |                   | 12,824  |                   |   | 12,824  |  
|                                              |  |                   |         |                   |   |         |  
|                                              |  |                   | 22,166  |                   |   | 22,166  |  
|                                             
|Allowances for
 depreciation and amortization |  |                   | (15,926 | )                 |   | (13,120 | )
|                                              |  |                   |         |                   |   |         |  
|                                              |  | $                 | 6,240   |                   | $ | 11,841  |  
|                                              |  |                   |         |                   |   |         |  

At January 31, 2009, the
Company leased 712 stores under operating leases, many of which contain renewal
options, for periods ranging from one to twenty-five years. Most leases also
provide for payment of operating expenses and real estate taxes. Some also
provide for additional rent based on a percentage of sales.

Net rental expense was as
follows:

|                   |  |                  |         |      |   |         |  |   |         | 
|------------------ |  | ---------------- | ------- | ---- | - | ------- |  | - | ------- | 
|                   |  | Fiscal Year      |        
|                   |  |                  |        
|                   |  | 2008             |         | 2007 |   | 2006    | 
|                   |  |                  |         |      |   |         | 
|                   |  | ($ in thousands) |        
|Minimum rentals    |  | $                | 102,647 |      | $ | 123,303 |  | $ | 130,802 | 
|Contingent rentals |  |                  | 581     |      |   | 849     |  |   | 1,453   | 
|                   |  |                  |         |      |   |         |  |   |         | 
|                   |  | $                | 103,228 |      | $ | 124,152 |  | $ | 132,255 | 
|                   |  |                  |         |      |   |         |  |   |         | 

Future minimum rental
payments required under all leases that have initial or remaining
non-cancelable lease terms at January 31, 2009 are as follows:

|                                         |  |                   |         |                 |   |        | 
|---------------------------------------- |  | ----------------- | ------- | --------------- | - | ------ | 
|                                         |  | Operating
 Leases |         | Capital
 Leases |  
|                                         |  |                   |         |                 |  
|                                         |  | ($ in thousands)  |        
|2009                                     |  | $                 | 80,048  |                 | $ | 4,841  | 
|2010                                     |  |                   | 50,365  |                 |   | 2,841  | 
|2011                                     |  |                   | 31,895  |                 |   | 2,095  | 
|2012                                     |  |                   | 21,719  |                 |   | 2,095  | 
|2013                                     |  |                   | 15,168  |                 |   | 2,095  | 
|Thereafter                               |  |                   | 21,144  |                 |   | 3,700  | 
|                                         |  |                   |         |                 |   |        | 
|Total
 minimum payments required         |  | $                 | 220,339 |                 |   | 17,667 | 
|                                         |  |                   |         |                 |   |        | 
|Less:
 amounts representing
 interest    |  |                   |         |                 |   | 8,631  | 
|                                         |  |                   |         |                 |   |        | 
|Present
 value of minimum lease payments |  |                   |         |                 |   | 9,036  | 
|Less:
 current portion                   |  |                   |         |                 |   | 3,178  | 
|                                         |  |                   |         |                 |   |        | 
|Long-term
 capital lease obligations     |  |                   |         |                 | $ | 5,858  | 
|                                         |  |                   |         |                 |   |        | 

In addition to the
obligations in the table above, a significant number of the Companys stores
have leases which have rent payments based on the stores sales volume in lieu
of fixed minimum rent payments. During Fiscal 2008, minimum rent payments based
on a stores sales volume were $8.4 million.

Interest rates on capital
leases were between 5.65% and 33.2% per annum.

F-17

---



Leases—lessor

The Company, as lessor,
entered into a 60 year lease, which is effective April 2009, covering the real
property owned by the Company in Miami, Florida. Under the provisions of the
lease, the Company receives minimum monthly rent payments as follows:

|                        |  |                      |       |                 |   |         | 
|----------------------- |  | -------------------- | ----- | --------------- | - | ------- | 
|                        |  | Annual Rent
 Payment |       | Total
 Payments |  
|                        |  |                      |       |                 |  
|                        |  | ($ in thousands)     |      
|April 2009  March 2029 |  | $                    | 1,620 |                 | $ | 32,400  | 
|April 2029  March 2039 |  |                      | 1,782 |                 |   | 17,820  | 
|April 2039  March 2049 |  |                      | 1,960 |                 |   | 19,602  | 
|April 2049  March 2059 |  |                      | 2,156 |                 |   | 21,560  | 
|April 2059  March 2069 |  |                      | 2,372 |                 |   | 23,718  | 
|                        |  |                      |       |                 |   |         | 
|Total future payments   |  |                      |       |                 | $ | 115,100 | 

The lease allows for the
tenant to terminate the lease after the twenty fifth year and every five years
thereafter. Total guaranteed rent payments due to the Company are $41.3
million. The Company didnt record any rental income on the lease in 2008.

Note 8. Benefit Plans

401(k) Savings Plan

The Company offers a 401(k)
Savings Plan to eligible employees meeting certain age and service
requirements. This plan permits participants to contribute up to 80% of their
salary, including bonuses, up to the maximum allowable by IRS regulations.
Participants are immediately vested in their voluntary contributions plus
actual earnings thereon. Participant vesting of the Companys matching and
profit sharing contribution is based on the years of service completed by the
participant. Participants are fully vested upon the completion of four years of
service. All participant forfeitures of non-vested benefits are used to reduce
the Companys contributions in future years. Total expense related to the Plan
was approximately $882,000, $1,042,000 and $1,003,000 in Fiscal 2008, 2007 and
2006, respectively. As of February 1, 2009, the Company has postponed its
matching contribution.

Stock Award Plans

The Company has five
employee stock award plans, the 1994 Stock Option Plan, the 1998 Stock Option
Plan, the 1999 Stock Option Plan and the 2002 Stock Option Plan (the Old
Plans); and the 2005 Long Term Incentive Share Plan (the New Plan).
Additionally, the Company has a stock award plan for non-employee directors
(the 1990 Plan). The Company no longer issues stock options under the Old
Plans. Under the New Plan, the Company generally issues Stock-Settled
Appreciation Rights (SSARS) that become exercisable in 50% increments commencing
three years from the date of grant and have a maximum term of ten years from
issuance. Under the 1990 Plan, awards generally become exercisable commencing
one year from the date of grant in increments of 25% per year with a maximum
term of ten years. In addition, directors of the Company receive annual grants
of deferred shares of Common Stock (Deferred Shares) issued under the 1990
Plan which vest equally in three years from date of grant.

Stock options and SSARS
authorized for issuance under the Old Plans, New Plan and 1990 Plan total 20.6
million. As of January 31, 2009, of the awards authorized for issuance under
the Old Plans, New Plan and 1990 Plan, 8.5 million were granted and are
outstanding, 6.7 million of which were vested and exercisable. Options
available for future grants at January 31, 2009 and February 3, 2008 were 3.2
million and 3.3 million, respectively.

During Fiscal 2008, the
Company issued 275,000 restricted stock units. Restricted stock units vest 50%
after two years and 50% after three years and will be settled in cash upon
vesting. During Fiscal 2008, the Company recognized $17,000 in expenses related
to the grant of restricted stock units.

F-18

---



The following table
summarizes information about the stock awards outstanding under the Old Plans,
New Plan and 1990 Plan as of January 31, 2009:

|                      |  |             |           |                          |  |                                    |  |                             |       |        |  |                                    |  |                             |           |  |   |       |  |  |        | 
|--------------------- |  | ----------- | --------- | ------------------------ |  | ---------------------------------- |  | --------------------------- | ----- | ------ |  | ---------------------------------- |  | --------------------------- | --------- |  | - | ----- |  |  | ------ | 
|                      |  |             |           |                          | 
|                      |  | Outstanding |           | Exercisable              | 
|                      |  |             |           |                          | 
|Exercise
 Price Range |  | Shares      |           | Average
 Remaining
 Life |  | Weighted
 Average
 Exercise
 Price |  | Aggregate
 Intrinsic
 Value |       | Shares |  | Weighted
 Average
 Exercise
 Price |  | Aggregate
 Intrinsic
 Value |          
|                      |  |             |           |                          |  |                                    |  |                             |       |        |  |                                    |  |                             |          
|$0.00-$2.66           |  |             | 510,191   |                          |  | 8.1                                |  | $                           | 0.02  |        |  | 373,868                            |  |                             | 77,526    |  | $ | 0.00  |  |  | 56,811 | 
|2.67-5.33             |  |             | 2,376,615 |                          |  | 5.1                                |  |                             | 4.06  |        |  |                                   |  |                             | 1,610,215 |  |   | 3.50  |  |  |       | 
|5.34-8.00             |  |             | 788,775   |                          |  | 7.2                                |  |                             | 6.25  |        |  |                                   |  |                             | 187,500   |  |   | 7.11  |  |  |       | 
|8.01-10.00            |  |             | 1,760,169 |                          |  | 2.6                                |  |                             | 8.46  |        |  |                                   |  |                             | 1,760,169 |  |   | 8.46  |  |  |       | 
|10.01-13.33           |  |             | 1,891,425 |                          |  | 3.0                                |  |                             | 10.86 |        |  |                                   |  |                             | 1,891,425 |  |   | 10.86 |  |  |       | 
|13.34-16.00           |  |             | 1,131,290 |                          |  | 4.4                                |  |                             | 14.57 |        |  |                                   |  |                             | 1,131,290 |  |   | 14.57 |  |  |       | 
|                      |  |             |           |                          |  |                                    |  |                             |       |        |  |                                    |  |                             |           |  |   |       |  |  |        | 
|Total                 |  |             | 8,458,465 |                          |  | 4.4                                |  | $                           | 7.86  |        |  | 373,868                            |  |                             | 6,658,125 |  | $ | 8.84  |  |  | 56,811 | 
|                      |  |             |           |                          |  |                                    |  |                             |       |        |  |                                    |  |                             |           |  |   |       |  |  |        | 

The aggregate intrinsic
value in the preceding table represents the total pretax intrinsic value based
on the Companys closing stock price of $0.76 as of January 30, 2009, which
would have been received by the award holders had all award holders under the
Old Plans, New Plan and 1990 Plan exercised their awards as of that date. There
were no in-the-money awards exercisable as of January 31, 2009.

F-19

---



The following table
summarizes activity under the Stock Award Plans:

|                         |  |                                         |            |                                                 |  |                                   |  |   |       | 
|------------------------ |  | --------------------------------------- | ---------- | ----------------------------------------------- |  | --------------------------------- |  | - | ----- | 
|                         |  | Employee and Director Stock Award Plans |           
|                         |  |                                         |           
|                         |  | Number of
 Shares Subject
 To Option    |            | Stock Award
 Exercise Price
 Range Per Share(1) |  | Weighted
 Average
 Exercise Price | 
|                         |  |                                         |            |                                                 |  |                                   | 
|Balance January 28, 2006 |  |                                         | 9,859,812  |                                                 |  | $1.58-$23.75                      |  | $ | 8.94  | 
|Granted                  |  |                                         | 1,092,675  |                                                 |  | 5.32-7.29                         |  |   | 4.86  | 
|Exercised                |  |                                         | (267,262   | )                                               |  | 1.58-3.96                         |  |   | 2.40  | 
|Canceled*                |  |                                         | (626,371   | )                                               |  | 2.80-17.79                        |  |   | 8.58  | 
|                         |  |                                         |            |                                                 |  |                                   |  |   |       | 
|Balance February 3, 2007 |  |                                         | 10,058,854 |                                                 |  | $3.16-$23.75                      |  | $ | 8.70  | 
|Granted                  |  |                                         | 654,716    |                                                 |  | 4.80-5.50                         |  |   | 4.43  | 
|Exercised                |  |                                         | (272,802   | )                                               |  | 3.16-3.96                         |  |   | 3.45  | 
|Forfeited                |  |                                         | (900,000   | )                                               |  | 11.20                             |  |   | 11.20 | 
|Canceled                 |  |                                         | (520,373   | )                                               |  | 3.50-23.75                        |  |   | 5.01  | 
|                         |  |                                         |            |                                                 |  |                                   |  |   |       | 
|Balance February 2, 2008 |  |                                         | 9,020,395  |                                                 |  | $3.50-$17.79                      |  | $ | 8.26  | 
|Granted                  |  |                                         | 431,728    |                                                 |  | 1.16-2.91                         |  |   | 2.66  | 
|Exercised                |  |                                         | (94,825    | )                                               |  | 3.50                              |  |   | 3.50  | 
|Forfeited                |  |                                         | (569,371   | )                                               |  | 3.50-17.79                        |  |   | 12.47 | 
|Canceled                 |  |                                         | (329,462   | )                                               |  | 3.50-13.28                        |  |   | 2.93  | 
|                         |  |                                         |            |                                                 |  |                                   |  |   |       | 
|Balance January 31, 2009 |  |                                         | 8,458,465  |                                                 |  | $1.16-$15.25                      |  | $ | 7.86  | 
|                         |  |                                         |            |                                                 |  |                                   |  |   |       | 

|    |                                                                                                                                                            
|--- | -----------------------------------------------------------------------------------------------------------------------------------------------------------
|(1) | Exercise price ranges do not include the impact of
 deferred or restricted shares and restricted stock units that were granted at
 an exercise price of $0.

During Fiscal 2008, 2007 and
2006, the Company recognized expenses of approximately $213,000, $526,000 and
$477,000, respectively, for deferred shares issued to non-employee directors at
an exercise price below the closing stock price on the date of grant.

Restricted Stock Plan

Under the 1990 Restricted
Stock Plan, the Compensation Committee of the Board of Directors is authorized
to grant awards for up to 900,000 restricted shares of Common Stock to
executive officers and other key employees of the Company. The shares are issued
as restricted stock and are held in the custody of the Company until all
vesting restrictions are satisfied. If conditions or terms under which an award
is granted are not satisfied, the shares are forfeited. Shares vest under these
grants over a period of two to five years, with vesting criteria that includes
continuous employment until applicable vesting dates have expired. As of
January 31, 2009, a total of 330,000 shares have been granted, of which 240,000
shares have vested and 90,000 shares had been forfeited. Unearned compensation
is recorded at the date of award, based on the market value of the shares, and
is amortized over the applicable vesting period. The amount amortized to
expense in Fiscal 2008, 2007 and 2006, net of the impact of forfeitures, was
approximately $62,000, $54,000 and $13,000, respectively. As of January 31,
2009, there were no outstanding awards and shares available for grant totaled
660,000.

Defined Benefit Plans

The Company maintains a
non-qualified Supplemental Executive Retirement Plan (SERP) for certain
Executive Officers of the Company. The SERP, which is unfunded, provides
eligible executives defined pension benefits that supplement benefits under
other retirement arrangements. The annual benefit amount is based on salary and
bonus at the time of retirement and number of years of service.

The Company provides the
Board of Directors with a noncontributory, unfunded retirement plan (Director
Retirement Plan) that pays a retired director an annual retirement benefit
equal to 60% of the annual retainer at the time of retirement plus a 3% annual
increase through the final payment. Payments begin at age 62 or retirement,
whichever is later, and continue for 10 years or the life of the director and
his or her spouse, whichever period is shorter. Partial vesting in the
retirement plan begins after six years of continuous service. Participants
become fully vested after 12 years of continuous service on the Board. After
June 1, 2003, new directors were not covered by the Director Retirement Plan.
Directors who were not yet vested in their retirement benefits as of June 1,
2003 had the present value of benefits already accrued as of the effective date
converted to Deferred Shares under the 1990 Plan. Directors that were fully or
partially vested in their retirement benefits were given a one time election to
continue to participate in the current retirement program or convert the
present value of benefits already accrued to Deferred Shares under the 1990
Plan as of the effective date.

The Company accounts for the
SERP and the Director Retirement Plan in accordance with SFAS No. 158, Employers Accounting
for Defined Benefit and Other Postretirement Plans  an amendment of FASB
Statements No. 87, 88, 106 and 132(R). SFAS No. 158 requires that the funded
status of defined benefit pension plans, or the difference between the fair value
of plan assets and the projected benefit obligation, be recognized in the Consolidated
Balance Sheets. This differs from the accounting under SFAS No. 87, which required
the difference between the

F-20

---



fair value of plan assets
and the accumulated benefit obligation to be recorded in the Consolidated
Balance Sheets. SFAS No. 158 also requires that defined benefit plan assets and
obligations be measured as of the date of the employers fiscal year-end
statement of financial position; however, this requirement of the statement is
effective for fiscal years ending after December 15, 2008. Accordingly, the
Company adjusted its measurement date for Fiscal 2008 to January 31, 2009. For
Fiscal 2007, the measurement date for the plans was November 1.

For Fiscal 2008, Fiscal 2007
and Fiscal 2006, net periodic benefit cost recognized under both plans totaled
approximately $1.4 million, $1.3 million, and $2.2 million, respectively. The
accrued pension liability for both plans was approximately $11.9 million and
$14.2 million at January 31, 2009 and February 2, 2008, respectively, and is
recorded within Other long term liabilities. The accumulated benefit obligation
for both plans was approximately $9.7 million and $13.5 million as of January
31, 2009 and February 2, 2008, respectively.

The following is a summary
of the Companys defined benefit pension plans as of the most recent actuarial
calculations:

Obligation and Funded Status:

|                                                                   |  |                   |                  |                   |    |         |  
|------------------------------------------------------------------ |  | ----------------- | ---------------- | ----------------- | -- | ------- | -
|                                                                   |  |                   |                  |                   |   
|                                                                   |  | January 31,
 2009 |                  | February 2,
 2008 |   
|                                                                   |  |                   |                  |                   |   
|                                                                   |  | ($ in thousands)  |                 
|Change in Projected
 Benefit Obligation:                           |  |                   |                  |                   |    |         |  
|Benefit obligation at
 beginning of year                           |  | $                 | 14,175           |                   | $  | 13,276  |  
|Service cost                                                       |  |                   | 273              |                   |    | 216     |  
|Interest cost                                                      |  |                   | 1,114            |                   |    | 763     |  
|Actuarial gain                                                     |  |                   | (3,597           | )                 |    | (30     | )
|Benefits paid                                                      |  |                   | (52              | )                 |    | (50     | )
|                                                                   |  |                   |                  |                   |    |         |  
|Projected Benefit obligation at end of
year                        |  | $                 | 11,913           |                   | $  | 14,175  |  
|                                                                   |  |                   |                  |                   |    |         |  
|                                                                   |  |                   |                  |                   |    |         |  
|Fair value of plan assets
 at end of year                          |  | $                 |                 |                   | $  |        |  
|                                                                   |  |                   |                  |                   |    |         |  
|                                                                   |  |                   |                  |                   |    |         |  
|Reconciliation of Funded
 Status:                                  |  |                   |                  |                   |    |         |  
|Funded status                                                      |  | ($                | 11,913           | )                 | ($ | 14,175  | )
|Unrecognized prior service
 cost                                   |  |                   | 2,630            |                   |    | 3,058   |  
|Unrecognized net actuarial
 gain                                   |  |                   | (3,793           | )                 |    | (199    | )
|                                                                   |  |                   |                  |                   |    |         |  
|Accrued benefit cost                                               |  |                   | (13,076          | )                 |    | (11,316 | )
|Decrease (increase) in
 liability                                  |  |                   | 1,163            |                   |    | (2,859  | )
|                                                                   |  |                   |                  |                   |    |         |  
|Accrued pension liability                                          |  | ($                | 11,913           | )                 | ($ | 14,175  | )
|                                                                   |  |                   |                  |                   |    |         |  
|                                                                   |  |                   |                  |                   |    |         |  
|Amounts
 recognized in the Consolidated Balance Sheets consist of: |  |                   |                  |                   |    |         |  
|                                                                   |  |                   |                  |                   |    |         |  
|                                                                   |  |                   |                  |                   |   
|                                                                   |  | January 31,
 2009 |                  | February 2,
 2008 |   
|                                                                   |  |                   |                  |                   |   
|                                                                   |  |                   | ($ in
thousands) |                  
|                                                                   |  |                   |                  |                   |    |         |  
|Accrued pension liability                                          |  | ($                | 11,913           | )                 | ($ | 14,175  | )
|Accumulated other
 comprehensive (income) loss                     |  |                   | (1,163           | )                 |    | 1,625   |  
|Deferred tax asset                                                 |  |                   | 1,234            |                   |    | 1,234   |  
|                                                                   |  |                   |                  |                   |    |         |  
|Net amount recognized                                              |  | ($                | 11,842           | )                 | ($ | 11,316  | )
|                                                                   |  |                   |                  |                   |    |         |  

F-21

---



|                                                                                                            |  |             |         |      |  |        |   |  |        |  | 
|----------------------------------------------------------------------------------------------------------- |  | ----------- | ------- | ---- |  | ------ | - |  | ------ |  | 
|Components of Net Periodic Benefit Cost and
 Other Amounts Recognized in Other Comprehensive (Income) Loss:
|($ in thousands)                                                                                           
|                                                                                                            |  |             |        
|Net
 Periodic Benefit Cost:                                                                                
|                                                                                                            |  |             |        
|                                                                                                            |  |             |        
|                                                                                                            |  | Fiscal Year |        
|                                                                                                            |  | 2008        |         | 2007 |  | 2006   |  
|                                                                                                            |  |             |         |      |  |        |  
|Service cost                                                                                                |  |             | $218    |      |  | $216   |   |  | $679   | 
|Interest
 cost                                                                                              |  |             | 891     |      |  | 763    |   |  | 885    | 
|Amortization
 of prior service cost                                                                         |  |             | 342     |      |  | 342    |   |  | 343    | 
|Amortization
 of net (gain) loss                                                                            |  |             | (2      | )    |  | (2     | ) |  | 275    | 
|                                                                                                            |  |             |         |      |  |        |   |  |        | 
|Net periodic benefit cost                                                                                   |  |             | $1,449  |      |  | $1,319 |   |  | $2,182 | 
|                                                                                                            |  |             |         |      |  |        |   |  |        | 
|                                                                                                           
|Other Changes in Benefit Obligations
 Recognized in Other Comprehensive (Income) Loss:                      | 
|                                                                                                           
|Net prior
 service cost recognized as a component of net periodic benefit cost                              |  |             | ($427   | )    |  | ($342  | ) |  |        |  | 
|Net
 actuarial gain (loss) recognized as a component of net periodic benefit cost                           |  |             | 3       |      |  | 2      |   |  |        |  | 
|Net
 actuarial (gain) loss arising during the period                                                        |  |             | (3,597  | )    |  | (30    | ) |  |        |  | 
|                                                                                                            |  |             |         |      |  |        |   |  |        |  | 
|                                                                                                            |  |             | (4,021  | )    |  | (370   | ) |  |        |  | 
|Income tax
 effect                                                                                          |  |             |        |      |  | 107    |   |  |        |  | 
|                                                                                                            |  |             |         |      |  |        |   |  |        |  | 
|Total
 recognized in other comprehensive (income) loss                                                      |  |             | ($4,021 | )    |  | ($263  | ) |  |        |  | 
|                                                                                                            |  |             |         |      |  |        |   |  |        |  | 
|Total recognized in net periodic benefit
 cost and other comprehensive (income) loss                        |  |             | ($2,604 | )    |  | $1,056 |   |  |        |  | 
|                                                                                                            |  |             |         |      |  |        |   |  |        |  | 

The pre-tax components of
accumulated other comprehensive loss (income), which have not yet been
recognized as components of net periodic benefit cost as of January 31, 2009
and February 2, 2008 are summarized below.

|                                               |  |                   |         |                   |  |        |  
|---------------------------------------------- |  | ----------------- | ------- | ----------------- |  | ------ | -
|($ in thousands)                               |  | January 31,
 2009 |         | February 2,
 2008 | 
|                                               |  |                   |         |                   | 
|Net
 unrecognized actuarial gain               |  |                   | ($3,734 | )                 |  | ($199  | )
|Net
 unrecognized prior service cost           |  |                   | 2,631   |                   |  | 3,058  |  
|                                               |  |                   |         |                   |  |        |  
|Accumulated
 other comprehensive loss (income) |  |                   | ($1,103 | )                 |  | $2,859 |  
|                                               |  |                   |         |                   |  |        |  

In Fiscal 2008, approximately
$342,000 of net unrecognized prior service cost and approximately $3,000 of the
net unrecognized actuarial gain, recorded as components of accumulated other
comprehensive loss at January 31, 2009, will be recognized as components of net
periodic benefit cost.

Assumptions:

|                                                                           |  |              |       |             |  |       |  |  |       | 
|-------------------------------------------------------------------------- |  | ------------ | ----- | ----------- |  | ----- |  |  | ----- | 
|                                                                           |  |              |       |             |  |      
|                                                                           |  | Fiscal Year  |       |             |  |      
|                                                                           |  |              |       |             |  |      
|                                                                           |  | 2008         |       | 2007        |  |       |  | 
|                                                                           |  |              |       |             |  |       |  | 
|Weighted-average assumptions used to
 determine benefit obligation:        |  |              |       |             |  |       |  |  |       | 
|Discount rate                                                              |  |              | 6.75% |             |  | 6.25% |  |  |       | 
|Salary increase rate                                                       |  |              | 4.00% |             |  | 4.00% |  |  |       | 
|Measurement date                                                           |  | Jan 31, 2009 |       | Nov 1, 2007 |  |       |  | 
|                                                                           |  |              |       |             |  |       |  | 
|                                                                           |  |              |      
|                                                                           |  | Fiscal Year 
|                                                                           |  | 2008         |       | 2007        |  | 2006  | 
|                                                                           |  |              |       |             |  |       | 
|Weighted-average assumptions used to
 determine net periodic benefit cost: |  |              |       |             |  |       |  |  |       | 
|Discount rate                                                              |  |              | 6.75% |             |  | 6.25% |  |  | 5.75% | 
|Salary increase rate                                                       |  |              | 4.00% |             |  | 4.00% |  |  | 4.00% | 

The discount rate
is based on the rates implicit in high-quality fixed-income investments
currently available as of the measurement date. The Citigroup Pension Discount
Curve (CPDC) rates are intended to represent the spot rates implied by the high
quality corporate bond market in the U.S. The projected benefit payments
attributed to the projected benefit obligation have been discounted using the
CPDC mid-year rates and the discount rate is the single constant rate that
produces the same total present value.

The following
benefit payments, which reflect expected future service, as appropriate, are
expected to be paid:

F-22

---



|                     |  |                  |       | 
|-------------------- |  | ---------------- | ----- | 
|                     |  |                  |      
|Year                 |  | Pension Benefits |      
|                     |  |                  |      
|                     |  | ($ in thousands) |      
|                     |  |                  |       | 
|2009                 |  | $                | 64    | 
|2010                 |  |                  | 101   | 
|2011                 |  |                  | 143   | 
|2012                 |  |                  | 1,100 | 
|2013                 |  |                  | 1,101 | 
|2014 and
 thereafter |  |                  | 5,683 | 

Note 9. Shareholders
Equity

The Company
has never declared dividends on its Common Stock and does not plan to pay cash
dividends on its Common Stock in the foreseeable future. The Companys Credit
Facility does not restrict the payment of cash dividends so long as payment
conditions per the agreement are met. Any future determination as to the
payment of dividends will depend upon capital requirements, limitations imposed
by the Companys Credit Facility (see Note 5 to the Consolidated Financial
Statements) and other factors the Companys Board of Directors may consider.

Note 10. Related
Party Transactions

The Company
leases its 181,300 square foot distribution center/office facility in Albany,
New York from Robert J. Higgins, its Chairman, Chief Executive Officer and
largest shareholder, under three capital leases that expire in the year 2015.
The original distribution center/office facility was occupied in 1985.

Under the
three capital leases, dated April 1, 1985, November 1, 1989 and September 1,
1998, the Company paid Mr. Higgins an annual rent of $2.1 million, $2.0 million
and $2.0 million in Fiscal 2008, 2007 and 2006 respectively. Pursuant to the
terms of the lease agreements, effective January 1, 2002 and every two years
thereafter, rental payments will increase in accordance with the biennial
increase in the Consumer Price Index. Under the terms of the lease agreements,
the Company is responsible for property taxes, insurance and other operating
costs with respect to the premises. Mr. Higgins obligation for principal and
interest on his underlying indebtedness relating to the real property is
approximately $1.1 million per year. None of the leases contain any real
property purchase options at the expiration of its term.

The Company
leases one of its retail stores from Mr. Higgins under an operating lease.
Annual rental payments under this lease were $40,000 in Fiscal 2008, 2007 and
2006. Under the terms of the lease, the Company pays property taxes,
maintenance and a contingent rental if a specified sales level is achieved.
Total additional charges for the store, including contingent rent, were
approximately $7,400, $3,800 and $4,100 in Fiscal 2008, 2007 and 2006
respectively.

The Company
occasionally utilizes privately chartered aircraft owned or partially owned by
Mr. Higgins, for Company business. The Company charters an aircraft from
Crystal Jet, a corporation wholly-owned by Mr. Higgins, for Company business.
Payments to Crystal Jet aggregated approximately $0, $0 and $11,000 in Fiscal
2008, 2007 and 2006, respectively. The Company also charters an aircraft from
Richmor Aviation Inc., an unaffiliated corporation that leases an aircraft
owned by Mr. Higgins, for Company business. Payments to Richmor Aviation Inc.,
to charter the aircraft owned by Mr. Higgins, in Fiscal 2008, 2007 and 2006
were approximately $205,000, $29,000 and $526,000, respectively.

F-23

---



Note 11. Quarterly
Financial Information (Unaudited)

|                                  |  |                                                |          |                   |  |                   |   |                 |          |              |  |          |   |  |          |  
|--------------------------------- |  | ---------------------------------------------- | -------- | ----------------- |  | ----------------- | - | --------------- | -------- | ------------ |  | -------- | - |  | -------- | -
|                                  |  | Fiscal
 2008 Quarter Ended                     |         
|                                  |  |                                                |          |                   |  |                   |   |                 |          |              | 
|                                  |  | 2008                                           |          | January 31,
 2009 |  | November 1,
 2008 |   | August 2,
 2008 |          | May 3,
 2008 | 
|                                  |  |                                                |          |                   |  |                   |   |                 |          |              | 
|                                  |  | ($ in thousands, except for per share amounts) |         
|Net sales                         |  |                                                | $987,625 |                   |  | $344,655          |   |                 | $195,193 |              |  | $215,226 |   |  | $232,551 |  
|Gross profit                      |  |                                                | 330,895  |                   |  | 106,626           |   |                 | 65,411   |              |  | 75,870   |   |  | 82,988   |  
|                                  |  |                                                |          |                   |  |                   |   |                 |          |              |  |          |   |  |          |  
|Net loss                          |  |                                                | ($68,955 | )                 |  | ($9,457           | ) |                 | ($28,442 | )            |  | ($19,230 | ) |  | ($11,826 | )
|                                  |  |                                                |          |                   |  |                   |   |                 |          |              |  |          |   |  |          |  
|Basic and
 diluted loss per share |  |                                                | ($2.21   | )                 |  | ($0.30            | ) |                 | ($0.91   | )            |  | ($0.62   | ) |  | ($0.38   | )
|                                  |  |                                                |          |                   |  |                   |   |                 |          |              |  |          |   |  |          |  

During the fourth quarter of
Fiscal 2008, the Company recorded an asset impairment charge of $15.2 million
related to the write down of certain long-lived assets at underperforming
locations. See Note 4 in the Notes to Consolidated Financial Statements for
further detail regarding the impairment charge.

|                                  |  |                                                |            |                   |  |                   |   |                 |          |              |  |          |   |  |          |  
|--------------------------------- |  | ---------------------------------------------- | ---------- | ----------------- |  | ----------------- | - | --------------- | -------- | ------------ |  | -------- | - |  | -------- | -
|                                  |  | Fiscal
 2007 Quarter Ended                     |           
|                                  |  |                                                |           
|                                  |  | 2007                                           |            | February 2,
 2008 |  | November 3,
 2007 |   | August 4,
 2007 |          | May 5,
 2007 | 
|                                  |  |                                                |            |                   |  |                   |   |                 |          |              | 
|                                  |  | ($ in thousands, except for per share amounts) |           
|Net sales                         |  |                                                | $1,265,658 |                   |  | $451,476          |   |                 | $260,570 |              |  | $267,305 |   |  | $286,307 |  
|Gross profit                      |  |                                                | 445,747    |                   |  | 152,072           |   |                 | 91,332   |              |  | 97,962   |   |  | 104,381  |  
|                                  |  |                                                |            |                   |  |                   |   |                 |          |              |  |          |   |  |          |  
|Net loss                          |  |                                                | ($99,435   | )                 |  | ($66,029          | ) |                 | ($14,263 | )            |  | ($10,074 | ) |  | ($9,069  | )
|                                  |  |                                                |            |                   |  |                   |   |                 |          |              |  |          |   |  |          |  
|                                  |  |                                                |            |                   |  |                   |   |                 |          |              |  |          |   |  |          |  
|Basic and
 diluted loss per share |  |                                                | ($3.20     | )                 |  | ($2.12            | ) |                 | ($0.46   | )            |  | ($0.32   | ) |  | ($0.29   | )
|                                  |  |                                                |            |                   |  |                   |   |                 |          |              |  |          |   |  |          |  

During the
fourth quarter of Fiscal 2007, the Company recorded an asset impairment charge
of $30.7 million related to the write down of certain long-lived assets at
underperforming locations. In addition, during the fourth quarter, the Company
recorded a charge of $42.5 million to provide a full valuation allowance
against its net deferred tax assets. See Note 4 and Note 6, respectively in the
Notes to Consolidated Financial Statements for further detail regarding the
impairment charge and valuation allowance.

F-24

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|                                |                                                                                                                                                                                                                                                                                                                                                                            
|------------------------------- | ---------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
|Index to Exhibits              
|Document Number and Description
|                               
|Exhibit No.                    
|3.1                             | Restated Certificate
 of Incorporation  incorporated herein by reference to Exhibit 3.1 to the
 Companys Annual Report on Form 10-K for the year ended January 29, 1994.
 Commission File No. 0-14818.                                                                                                                                                                   
|                                |                                                                                                                                                                                                                                                                                                                                                                            
|3.2                             | Certificate
 of Amendment to the Certificate of Incorporation  incorporated herein by
 reference to Exhibit 3.1 to the Companys Quarterly Report on Form 10-Q for
 the fiscal quarter ended October 29, 1994. Commission File No. 0-14818.                                                                                                                               
|                                |                                                                                                                                                                                                                                                                                                                                                                            
|3.3                             | Certificate
 of Amendment to the Certificate of Incorporation  incorporated herein by
 reference to Exhibit 3.4 to the Companys Annual Report on Form 10-K for the
 year ended January 31, 1998. Commission File No. 0-14818.                                                                                                                                            
|                                |                                                                                                                                                                                                                                                                                                                                                                            
|3.4                             | Amended
 By-Laws  incorporated herein by reference to Exhibit 3.4 to the Companys
 Annual Report on Form 10-K for the year ended January 29, 2000. Commission
 File No. 0-14818.                                                                                                                                                                                         
|                                |                                                                                                                                                                                                                                                                                                                                                                            
|3.5                             | Certificate
 of Amendment to the Certificate of Incorporationincorporated herein by
 reference to Exhibit 3.5 to the Companys Registration Statement on Form S-4,
 No. 333-75231.                                                                                                                                                                                        
|                                |                                                                                                                                                                                                                                                                                                                                                                            
|3.6                             | Certificate
 of Amendment to the Certificate of Incorporationincorporated herein by
 reference to Exhibit 3.6 to the Companys Registration Statement on Form S-4,
 No. 333-75231.                                                                                                                                                                                        
|                                |                                                                                                                                                                                                                                                                                                                                                                            
|3.7                             | Certificate
 of Amendment to the Certificate of Incorporationincorporated herein by
 reference to Exhibit 4.2 to the Companys Current Report on Form 8-K filed
 August 15, 2000. Commission File No. 0-14818.                                                                                                                                                            
|                                |                                                                                                                                                                                                                                                                                                                                                                            
|3.8                             | Certificate
 of Amendment to the Certificate of Incorporation of - incorporated herein by
 reference to Exhibit 2 to the Companys Current Report on Form 8-A filed
 August 15, 2000. Commission File No. 0-14818.                                                                                                                                                         
|                                |                                                                                                                                                                                                                                                                                                                                                                            
|4.1                             | Credit
 Agreement dated January 5, 2006, between Trans World Entertainment
 Corporation and Bank of America N.A. - incorporated by reference to Exhibit
 99.2 to the Companys Current Report on Form 8-K filed January 10, 2006.
 Commission File No. 0-14818.                                                                                                            
|                                |                                                                                                                                                                                                                                                                                                                                                                            
|4.2                             | First
 Amendment to Credit Agreement between Trans World Entertainment Corporation
 and Bank of America N.A  incorporated by reference to Exhibit 4.1 to the
 Companys Current Report on Form 8-K filed March 29, 2006. Commission File
 No. 0-14818.                                                                                                                    
|                                |                                                                                                                                                                                                                                                                                                                                                                            
|4.3                             | Second
 Amendment to Credit Agreement between Trans World Entertainment Corporation
 and Bank of America N.A  incorporated by reference to Exhibit 4.1 to the
 Companys Current Report on Form 8-K filed October 23, 2006. Commission File
 No. 0-14818.                                                                                                                 
|                                |                                                                                                                                                                                                                                                                                                                                                                            
|4.4                             | Rights
 Agreement, between Trans World Entertainment Corporation and ChaseMellon
 Shareholder Services, L.L.C., as Rights Agent  incorporated herein by
 reference to Exhibit 1 to the Companys Current Report on Form 8-A filed
 August 15, 2000. Commission File No. 0-14818.                                                                                          
|                                |                                                                                                                                                                                                                                                                                                                                                                            
|4.5                             | Amendment
 No. 1 to the Rights Agreement, dated as of August 11, 2000, between Trans
 World Entertainment Corporation and Mellon Investor Services LLC (as
 successor in interest to ChaseMellon Shareholder Services, L.L.C.) 
 incorporated herein by reference to Exhibit 4.2 to the Companys Form
 8-A12G/A filed November 27, 2007. Commission File No. 0-14818.    
|                                |                                                                                                                                                                                                                                                                                                                                                                            
|10.1                            | Lease, dated
 April 1, 1985, between Robert J. Higgins, as Landlord, and Record Town, Inc.
 and Trans World Music Corporation, as Tenant and Amendment thereto dated
 April 28, 1986  incorporated herein by reference to Exhibit 10.3 to the
 Companys Registration Statement on Form S-1, No. 33-6449.                                                                 
|                                |                                                                                                                                                                                                                                                                                                                                                                            
|10.2                            | Second
 Addendum, dated as of November 30, 1989, to Lease, dated April 1, 1985, among
 Robert J. Higgins, and Trans World Music Corporation, and Record Town, Inc.,
 exercising five year renewal option  incorporated herein by reference to
 Exhibit 10.2 to the Companys Annual Report on Form 10-K for the year ended
 February 3, 1990. Commission File No. 0-14818.
|                                |                                                                                                                                                                                                                                                                                                                                                                            
|10.3                            | Lease, dated
 November 1, 1989, between Robert J. Higgins, as Landlord, and Record Town,
 Inc. and Trans World Music Corporation, as Tenant  incorporated herein by
 reference to Exhibit 10.3 to the Companys Annual Report on Form 10-K for the
 year ended February 2, 1991. Commission File No. 0-14818.                                                             

F-25

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|                       |                                                                                                                                                                                                                                                                                                                                                                                 
|---------------------- | --------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
|10.5                   | Lease dated
 September 1, 1998, between Robert J. Higgins, as Landlord, and Record Town,
 Inc. and Trans World Music Corporation, as Tenant, for additional office
 space at 38 Corporate Circle  incorporated herein by reference to Exhibit
 10.1 to the Companys Quarterly Report on Form 10-Q for the fiscal quarter
 ended October 31, 1998. Commission File No. 0-14818.
|                       |                                                                                                                                                                                                                                                                                                                                                                                 
|10.6                   | Trans World
 Music Corporation 1990 Stock Option Plan for Non-Employee Directors, as
 amended and restated  incorporated herein by reference to Annex A to Trans
 Worlds Definitive Proxy Statement on Form 14A filed as of May 19, 2000.
 Commission File No. 0-14818.                                                                                                       
|                       |                                                                                                                                                                                                                                                                                                                                                                                 
|10.7                   | Trans World
 Entertainment Corporation Amended 1990 Restricted Stock Plan  incorporated
 herein by reference to Annex B to Trans Worlds Definitive Proxy Statement on
 Form 14A filed as of May 19, 1999. Commission File No. 0-14818.                                                                                                                                        
|                       |                                                                                                                                                                                                                                                                                                                                                                                 
|10.8                   | Trans World
 Entertainment Corporation 1994 Stock Option Plan  incorporated herein by
 reference to Exhibit 10.1 to the Companys Quarterly Report on Form 10-Q for
 the fiscal quarter ended July 30, 1994. Commission File No. 0-14818.                                                                                                                                      
|                       |                                                                                                                                                                                                                                                                                                                                                                                 
|10.9                   | Trans World
 Entertainment Corporation 1998 Stock Option Plan  incorporated herein by
 reference to Annex B to Trans Worlds Definitive Proxy Statement on Form 14A
 filed as of May 7, 1998. Commission File No. 0-14818.                                                                                                                                                     
|                       |                                                                                                                                                                                                                                                                                                                                                                                 
|10.10                  | Trans World
 Entertainment Corporation 1999 Stock Option Plan  incorporated herein by
 reference to Annex A to Trans Worlds Definitive Proxy Statement on Form 14A
 filed as of May 7, 1998. Commission File No. 0-14818.                                                                                                                                                     
|                       |                                                                                                                                                                                                                                                                                                                                                                                 
|10.11                  | Form of
 Indemnification Agreement dated May 1, 1995 between the Company and its
 officers and directors incorporated herein by reference to Exhibit 10.2 to
 the Companys Quarterly Report on Form 10-Q for the fiscal quarter ended
 April 29, 1995. Commission File No. 0-14818.                                                                                            
|                       |                                                                                                                                                                                                                                                                                                                                                                                 
|10.12                  | Trans World
 Entertainment Corporation Supplemental Executive Retirement Plan, as amended
  incorporated herein by reference to Exhibit 10.1 to the Companys Form 8-K
 filed on December 19, 2008. Commission File No. 0-14818.                                                                                                                                               
|                       |                                                                                                                                                                                                                                                                                                                                                                                 
|10.13                  | Employment
 Agreement, dated as of December 26, 2008, between the Company and Robert J.
 Higgins. Incorporated herein by reference to Exhibit 10.1 to the Companys
 Form 8-K filed on December 29, 2008. Commission File No. 0-14818.                                                                                                                                          
|                       |                                                                                                                                                                                                                                                                                                                                                                                 
|10.15                  | Trans World
 Entertainment Corporation 2005 Long Term Incentive and Share Award Plan
 incorporated herein by reference to Appendix A to Trans World Entertainment
 Corporations Definitive Proxy Statement on Form 14A filed as of May 11,
 2005. Commission File No. 0-14818.                                                                                                 
|                       |                                                                                                                                                                                                                                                                                                                                                                                 
|* 21                   | Significant
 Subsidiaries of the Registrant.                                                                                                                                                                                                                                                                                                                                    
|                       |                                                                                                                                                                                                                                                                                                                                                                                 
|* 23                   | Consent of
 KPMG LLP.                                                                                                                                                                                                                                                                                                                                                           
|                       |                                                                                                                                                                                                                                                                                                                                                                                 
|*31.1                  | Certification
 of Chief Executive Officer dated April 16, 2009, relating to the Registrants
 Annual Report on Form 10-K for the year ended January 31, 2009, pursuant to
 Rule 13a-14(a) or Rule 15a-14(a).                                                                                                                                                                    
|                       |                                                                                                                                                                                                                                                                                                                                                                                 
|*31.2                  | Certification
 of Chief Financial Officer dated April 16, 2009, relating to the Registrants
 Annual Report on Form 10-K for the year ended January 31, 2009, pursuant to
 Rule 13a-14(a) or Rule 15a-14(a).                                                                                                                                                                    
|                       |                                                                                                                                                                                                                                                                                                                                                                                 
|**32                   | Certification
 of Chief Executive Officer and Chief Financial Officer of Registrant, dated
 April 16, 2009, pursuant to 18 U.S.C. Section 1350, as adopted Pursuant to
 Section 906 of the Sarbanes-Oxley Act of 2002 relating to the Registrants
 Annual Report on Form 10-K for the year ended January 31, 2009.                                                             
|                       |                                                                                                                                                                                                                                                                                                                                                                                 
|* Filed
 herewith     
|                       |                                                                                                                                                                                                                                                                                                                                                                                 
|** Furnished
 herewith

F-26

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