<PAGE>   1

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                       SECURITIES AND EXCHANGE COMMISSION
                             WASHINGTON, D.C. 20549

                             ---------------------

                                   FORM 10-K

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

                    FOR THE FISCAL YEAR ENDED JUNE 30, 2001

                         COMMISSION FILE NUMBER 0-27826

                             ---------------------

                             PARTY CITY CORPORATION
             (Exact name of registrant as specified in its charter)

<Table>
<S>                                            <C>
                   DELAWARE                                      22-3033692
       (State or other jurisdiction of                        (I.R.S. Employer
        incorporation or organization)                      Identification No.)

        400 COMMONS WAY, ROCKAWAY, NJ                              07866
   (Address of principal executive offices)                      (Zip Code)
</Table>

              REGISTRANT'S TELEPHONE NUMBER, INCLUDING AREA CODE:
                                 (973) 983-0888

          SECURITIES REGISTERED PURSUANT TO SECTION 12(b) OF THE ACT:

<Table>
<Caption>
             TITLE OF EACH CLASS                 NAME OF EACH EXCHANGE ON WHICH REGISTERED
             -------------------                 -----------------------------------------
<S>                                            <C>
                     None                                           None
</Table>

          SECURITIES REGISTERED PURSUANT TO SECTION 12(g) OF THE ACT:
                     COMMON STOCK, PAR VALUE $.01 PER SHARE

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

     Indicate by check mark if disclosure of delinquent filers pursuant to Item
405 of Regulation S-K is not contained herein, and will not be contained, to the
best of Registrant's knowledge, in definitive proxy or information statements
incorporated by reference in Part III of this Form 10-K or any amendment to this
Form 10-K. [ ]

     The aggregate market value of voting stock held by non-affiliates of the
Registrant on September 17, 2001, based on the closing sale price on such date,
was approximately $60,683,758.

     The number of outstanding shares of the Registrant's classes of common
stock, $0.01 par value, as of September 17, 2001 was 12,755,205.

                      DOCUMENTS INCORPORATED BY REFERENCE

     PORTIONS OF THE REGISTRANT'S PROXY STATEMENT FOR THE 2001 ANNUAL MEETING OF
STOCKHOLDERS ARE INCORPORATED BY REFERENCE INTO PART III.
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                               TABLE OF CONTENTS

<Table>
<Caption>
                                                                       PAGE
                                                                       ----
<S>      <C>                                                           <C>
                                  PART I
Item 1   Business....................................................    2
Item 2   Properties..................................................    9
Item 3   Legal Proceedings...........................................    9
Item 4   Submission of Matters to a Vote of Security Holders.........   10

                                  PART II
Item 5   Market for Registrant's Common Equity and Related
         Stockholder Matters.........................................   11
Item 6   Selected Financial Data.....................................   12
Item 7   Management's Discussion and Analysis of Financial Condition
         and Results of Operations...................................   14
Item 7A  Quantitative and Qualitative Disclosures About Market
         Risk........................................................   20
Item 8   Financial Statements and Supplementary Data.................   21
Item 9   Changes in and Disagreements with Accountants on Accounting
         and Financial Disclosure....................................   21

                                 PART III
Item 10  Directors and Executive Officers of the Registrant..........   21
Item 11  Executive Compensation......................................   21
Item 12  Security Ownership of Certain Beneficial Owners and
         Management..................................................   21
Item 13  Certain Relationships and Related Transactions..............   21

                                  PART IV
Item 14  Exhibits, Financial Statement Schedules, and Reports on Form
         8-K.........................................................   21
</Table>

                                        1
<PAGE>   3

                                        2

                                     PART I

FORWARD-LOOKING STATEMENTS

     This Form 10-K (including the information incorporated herein by reference)
contains forward-looking statements within the meaning of The Private Securities
Litigation Reform Act of 1995. The statements are made a number of times
throughout the document and may be identified by forward-looking terminology as
"estimate," "project," "expect," "believe," "may," "will," "intend" or similar
statements or variations of such terms. Such forward-looking statements are
based on many assumptions that are subject to certain risks and uncertainties,
and include among others, the following: levels of sales, store traffic,
acceptance of product offerings, competitive pressures from other party supplies
and other retailers, availability of qualified personnel, availability of
suitable future store locations, schedules of store expansion plans, and other
factors beyond the control of Party City Corporation (the "Company"). As a
result of the foregoing risks and uncertainties, actual results and performance
may differ materially from that projected or suggested herein. Additional
information concerning certain risks and uncertainties that could cause actual
results to differ materially from that projected or suggested may be identified
from time to time in the Company's Securities and Exchange Commission filings
and the Company's public announcements.

ITEM 1.  BUSINESS

     The Company is incorporated in the State of Delaware and operates retail
party supplies stores within the continental United States and sells franchises
on an individual store and area franchise basis throughout the United States,
Puerto Rico, Spain, Portugal and Canada.

GENERAL

     The Company is a specialty retailer of party supplies through its network
of 470 discount stores. At September 17, 2001, the Company owns and operates 198
Company-owned stores in the United States and its franchisees operate an
additional 272 stores in the United States, Puerto Rico, Canada, Portugal and
Spain. The Company, based in Rockaway, New Jersey, believes it is one of the
largest party supplies specialty chains. The Company authorized the first
franchise store in 1989 and opened its first Company-owned store in January
1994.

     The Company operates and franchises party supplies stores that generally
range in size from 10,000 square feet to 12,000 square feet. These stores offer
a broad selection of merchandise (brand name as well as private label) for a
wide variety of celebratory occasions, including birthday parties, weddings and
baby showers, as well as seasonal events such as Halloween, Christmas, New
Year's Eve, Graduation, Easter, Valentine's Day, Thanksgiving, St. Patrick's
Day, the Super Bowl and the Fourth of July. The Company seeks to offer customers
a "one-stop" party store that provides a wide selection of merchandise at a
compelling value. A key element of delivering customer satisfaction is stocking
inventory in sufficient quantities to satisfy customer needs for parties of
virtually all sizes and types.

INDUSTRY OVERVIEW

     The retail party supplies business has traditionally been fragmented, with
consumers purchasing party-related products from single owner-operated party
supplies stores and designated departments in drug stores, general mass
merchandisers, supermarkets, and department stores of local, regional and
national chains. According to industry sources, the market for party and special
occasion merchandise, comprised of party supplies, greeting cards, gift wrap and
related items was estimated at $12.1 billion in sales in 2000.

     The Company believes that the increasing breadth of party supplies
merchandise produced by manufacturers over the past few years has been a driving
factor in the marketplace's acceptance of the party supplies store concept.
Further, the Company believes that the significant revenues experienced by its
Company-owned and franchise stores in the fourth calendar quarter of recent
years can be attributed, to a large extent, to the growth in the number of
persons celebrating Halloween and the increased demand for costumes and party
supplies utilized in such celebrations. The Company has noted the marketplace's
acceptance of other types of
                                        3
<PAGE>   4

superstores and mega-retailers in various categories such as food, home
furnishings and pet supplies, among others. The success of such superstores and
mega-retailers in other types of products has prompted the Company to expand its
product lines to include a wider breadth of merchandise in order to make its
stores attractive destination shopping locations for party supplies. In
addition, Company management believes that the increased breadth of related and
integrated merchandise available to customers in superstores and mega-retailers
influences consumers to increase the number of purchases in a given trip to a
retailer. As such, the Company believes that the broad selection, and relatively
low price points, of merchandise offered by its stores often stimulates
customers to purchase additional items on impulse.

BUSINESS STRATEGY

     The Company's objective is to maintain its position as a leading
category-dominant national chain of party supplies stores. The Company believes
that it has transformed the party supplies business by introducing increased
product and marketing focus and greater mass merchandising sophistication. In
order to maintain continued store growth, Company management intends to continue
to invest in its human resources and management information systems to further
improve the infrastructure necessary to manage continued growth. Key components
of the Company's current strategy are:

     Offer the Broadest Selection of Merchandise in an Exciting Shopping
Environment.  The Company tries to provide party-planners and party-goers with
convenient one-stop shopping for party supplies and offers what it believes is
one of the most extensive selections of party supplies. A typical Party City
store contains approximately 16,000 SKUs. Within its many product categories,
Party City stores offer a wide variety of patterns, colors and styles. The
Company has been expanding the range of items which it offers in order to create
consumer loyalty and generate repeat business by striving to maintain a new and
exciting product selection. Further, the Company believes that its broad
selection of merchandise and relatively low price points often stimulate
consumers to purchase additional party supplies on impulse.

     Establish Convenient Store Locations.  While the Company believes that its
stores typically are destination shopping locations, it seeks to maximize
customer traffic and quickly build the visibility of new stores by situating its
stores in high traffic areas. Site selection criteria include: population
density; demographics; traffic counts; complementary retailers; storefront
visibility and presence (either in a stand-alone building or in a strip or power
shopping center); competition; lease rates; and accessible parking. The Company
believes there is an extensive number of suitable locations available for future
stores.

     Maintain Value Price Position.  The Company uses the aggregate buying power
of its 470 Company-owned and franchise stores network to attempt to obtain
volume discounts from its vendors on most products, allowing the stores to offer
a broad line of high quality merchandise at competitive prices. The Company
believes it reinforces customers' expectations of savings by prominently
displaying signs announcing its value pricing and savings opportunities. The
Company also maintains a lowest price guaranty policy, to which it suggests its
franchisees adhere. This policy guarantees that Party City stores will meet and
discount the advertised prices of a competitor's products. The Company believes
that this policy has helped foster the Company's image of offering consumers
exceptional value for their money.

     Provide Excellent Customer Service.  The Company views the quality of its
customers' shopping experience as critical to its continued success. The Company
is committed to making shopping in its stores an enjoyable experience through
the employment of friendly, knowledgeable and energetic sales associates who
provide customers with personalized shopping assistance. At Halloween, the most
important selling season for the Company, each store significantly increases the
number of sales associates to ensure prompt service. Sales associates assist
customers in selecting or finding a certain item, which provides the sales
associates with a cross-selling opportunity to suggest accessories or other
complementary products. The Company believes that the compensation of its store
managers and other personnel is competitive and enables the Company to attract
and retain well-qualified, motivated employees who are committed to providing
excellent customer service.

                                        3
<PAGE>   5

FISCAL YEAR

     Effective July 3, 1999, the Company changed its fiscal year end for
financial reporting from December 31 to the Saturday nearest to June 30. As used
herein, the term "Fiscal Year" refers to the 52 or 53 weeks, as applicable,
ending the Saturday nearest to June 30, unless otherwise noted.

EXPANSION PLANS

     The Company's long-term goal regarding expansion is to increase its market
share in existing markets and penetrate new markets with a goal of expanding its
position as a category-dominant retailer of party supplies merchandise. The
Company intends to balance growth between Company-owned stores and opening
franchise stores to meet its growth objectives. In addition, the Company
continuously reviews acquisition possibilities. It intends to utilize its
improved financial circumstances to pursue all growth alternatives. Ten to
fifteen Company-owned stores are currently planned to be opened during Fiscal
Year 2002.

STORE LOCATIONS

     As of June 30, 2001, there were 454 Party City stores open in the United
States, Canada, Puerto Rico, Portugal and Spain. Of these, 193 were
Company-owned and 261 were operated by the Company's independent franchisees.
The following table shows the growth in the Company's network of stores for the
Fiscal Years ended on the Saturday closest to June 30, 1996 to 2001.

<Table>
<Caption>
                                                               FISCAL YEAR
                                                 ---------------------------------------
                                                 1996   1997   1998   1999   2000   2001
                                                 ----   ----   ----   ----   ----   ----
<S>                                              <C>    <C>    <C>    <C>    <C>    <C>
COMPANY-OWNED:
  Stores open at beginning of year.............    8     20     57    148    215    197
  Stores opened................................   12     31     69     63      2     --
  Stores closed................................   --     --     --     --     (2)    (2)
  Stores acquired from franchisees.............   --      6     22      5     --      1
  Stores sold to franchisees...................   --     --     --     (1)   (18)    (3)
                                                 ---    ---    ---    ---    ---    ---
  Stores open at end of year...................   20     57    148    215    197    193
FRANCHISE:
  Stores open at beginning of year.............  114    141    168    160    178    211
  Stores opened................................   28     34     15     23     18     51
  Stores closed................................   (1)    (1)    (1)    (1)    (3)    (3)
  Stores purchased by the Company..............   --     (6)   (22)    (5)    --     (1)
  Stores sold by the Company...................   --     --     --      1     18      3
                                                 ---    ---    ---    ---    ---    ---
  Stores open at end of year...................  141    168    160    178    211    261
                                                 ---    ---    ---    ---    ---    ---
TOTAL COMPANY AND FRANCHISE STORES.............  161    225    308    393    408    454
                                                 ===    ===    ===    ===    ===    ===
</Table>

     The Company-owned stores are located in the following states:

<Table>
<Caption>
                                                            FISCAL YEAR ENDED
                                                 ---------------------------------------
STATE                                            1996   1997   1998   1999   2000   2001
-----                                            ----   ----   ----   ----   ----   ----
<S>                                              <C>    <C>    <C>    <C>    <C>    <C>
Florida........................................    4      8     14     17     16     12
California.....................................    3     11     25     37     38     38
Connecticut....................................    1      1      3      4      4      4
Illinois.......................................    2      3      9     15     15     16
New York.......................................    3     10     20     34     31     31
Pennsylvania...................................    1      1      5      9      8      8
Ohio...........................................    1      2      5      7      8      8
</Table>

                                        4
<PAGE>   6

<Table>
<Caption>
                                                            FISCAL YEAR ENDED
                                                 ---------------------------------------
STATE                                            1996   1997   1998   1999   2000   2001
-----                                            ----   ----   ----   ----   ----   ----
<S>                                              <C>    <C>    <C>    <C>    <C>    <C>
Maryland.......................................    1      2      4      4      3      3
Michigan.......................................    4      7      7      7      7      7
Nevada.........................................   --      2      2      3      3      3
New Jersey.....................................   --      8     12     14      9      9
Missouri.......................................   --      1      3      4      4      4
Indiana........................................   --     --      5      5      5      5
Minnesota......................................   --     --      3      5      5      5
Texas..........................................   --     --     19     22     20     20
Virginia.......................................   --     --      3      6      6      6
Wisconsin......................................   --      1      1      1      1      1
Colorado.......................................   --     --      1      2      2      2
North Carolina.................................   --     --      1      2     --     --
Tennessee......................................   --     --      3      4      1      1
Louisiana......................................   --     --      2      3      3      3
Georgia........................................   --     --      1      1     --     --
Kentucky.......................................   --     --     --      1      1      1
Kansas.........................................   --     --     --      1     --     --
Massachusetts..................................   --     --     --      3      3      3
Utah...........................................   --     --     --      1      1      1
Washington.....................................   --     --     --      3      3      2
                                                  --     --    ---    ---    ---    ---
          TOTAL................................   20     57    148    215    197    193
                                                  ==     ==    ===    ===    ===    ===
</Table>

     Of the leases for the stores listed above, one expires in Fiscal Year 2002,
nine expire in Fiscal Year 2003, five expire in Fiscal Year 2004, and the
balance expire in Fiscal Year 2005 or thereafter. The Company has options to
extend each of such leases for a minimum of five years.

     The Company typically seeks sites for new stores that are located in a
strip or power shopping center near high traffic routes. The Company seeks to
lease sites rather than own the real estate. The Company's site selection
criteria include, but are not limited to: population density, demographics,
traffic count, complementary retailers, storefront visibility and presence,
competition, lease rates, and accessible parking. In addition, the Company
carefully considers the presence of existing competition in the market when
selecting a site. The Company believes there is an extensive number of suitable
locations available for future sites.

MERCHANDISING

  STORE LAYOUT.

     Party City stores are designed to give the shopper a feeling of excitement
and create a festive atmosphere. The Company's goal is for the customer to be
pleasantly surprised by his or her shopping experience. The Company's strategy
to achieve this goal is to maintain an in-stock position of a wide selection of
party supplies. Party City stores range in size from 6,750 to 15,560 square feet
with a typical store size between 10,000 and 12,000 square feet. The stores are
divided into various sections of different categories of party supplies,
displayed to emphasize value pricing and breadth of merchandise available. The
floor plan is designed to impress the customer with the broad selection in each
product category.

                                        5
<PAGE>   7

  PRODUCT CATEGORIES.

     The typical Party City store offers a broad selection of merchandise
consisting of over 16,000 SKUs divided into the following categories:

          Halloween.  As a key component of its sales strategy, Party City
     stores provide an extensive selection of costumes for Halloween through its
     "Halloween Costume Warehouse(R)" department. The stores also carry a broad
     array of decorations and accessories for the Halloween season. The
     Halloween merchandise is prominently displayed to provide an exciting and
     fun shopping experience for customers. The stores display Halloween-related
     merchandise throughout the year to position the Company as the customer's
     Halloween shopping resource. The Company believes that the importance of
     Halloween is growing significantly among both young children and adults.

          Graduation.  Customer purchases for graduation parties in the United
     States primarily occur during April, May and June. These purchases include
     decorations and tableware related to the graduation.

          Other Seasonal.  Customer purchases made for seasonal holiday events
     compose a significant part of Party City's business. The seasonal category
     includes products which are carried for the Super Bowl, Valentine's Day,
     St. Patrick's Day, Passover, Easter, First Communion, the Fourth of July,
     Christmas, Hanukkah and New Year's Eve. Some of the major items within this
     category are tableware, decorations, cutouts, lights and balloons tailored
     to the particular event.

          Baby Shower.  The Company maintains a baby shower department, which
     includes tableware, decorations, balloons, favors, centerpieces and
     garlands.

          Balloons.  The Company maintains a balloon department, which carries a
     wide selection of basic and decorative latex balloons in various sizes,
     qualities, colors and package sizes. The balloon department also carries
     Mylar balloons in numerous sizes, shapes and designs relating to birthday,
     seasonal, anniversary and other themes.

          Birthdays.  The birthday product category includes a wide assortment
     of merchandise to fulfill customer needs for celebrating birthdays,
     including special ones such as "first," "sweet sixteen" and other milestone
     birthdays such as 40th and 50th birthdays. Some of the products in this
     category include invitations, thank you cards, tableware, hats, horns,
     banners, cascades, balloons, novelty gifts, pinatas and candies.

          Bridal/Wedding/Anniversary.  This product category includes
     personalized invitations, tableware, balloons, favors, place setting cards,
     confetti, honeycomb bells and personalized ribbons. Personalized invitation
     books containing numerous samples of customizable event invitations are
     carried from the leading invitation stationers at discounted prices.

          Candy.  The candy product category includes novelty and packaged candy
     sold to enhance children's parties or to be used as pinata fillers. Candy
     is sold both in individual units and in bulk packaging for customers'
     convenience.

          Catering Supplies.  Party City stores offer a broad selection of
     catering supplies that consists of trays, platters, foil, bowls, warming
     racks and fuel.

          Gift Wrap.  This product category includes wide assortments of gift
     bags, bows, tissue paper, ribbons, printed bags and wrapping paper.

          Greeting Cards.  This product category includes greeting cards from
     quality national card vendors at discount prices.

          Party Favors.  The Company maintains a party favors department that
     includes a broad selection of packaged and bulk favors appealing to
     different age groups. The assortment includes different product lines
     varying in price points designed to offer customers a variety of purchasing
     options.

                                        6
<PAGE>   8

          General.  The Company carries a range of other products, including
     tableware, table covers, cutlery, crepe paper, cups and tumblers. Party
     City stores carry private label items, as well as brand name merchandise.

  PRODUCT SELECTION, PURCHASING AND SUPPLIERS.

     The Company has three suppliers which in the aggregate constituted
approximately 38% of the Company's purchases for the Fiscal Year 2001. The loss
of any of these suppliers would adversely affect the Company's operations. The
Company considers numerous factors in supplier selection, including, but not
limited to, price, credit terms, product offerings and quality. The Company
negotiates pricing with suppliers on behalf of all stores in the network (both
Company-owned and franchise) and believes that such buying power enables it to
not only receive the most favorable pricing terms, but, more importantly, to
enhance its ability to obtain high demand merchandise, especially popular
Halloween costumes.

     In order to maintain consistency throughout its store network, the Company
has established an approved list of items that are permitted to be sold in Party
City stores. Franchise stores must adhere to these guidelines according to the
terms of their franchise agreements. The Company establishes a standard store
merchandise layout and presentation format to be followed by Company-owned and
franchise stores. Any layout or format changes developed by the Company are
communicated to the managers of stores on a periodic basis. All of the
merchandise purchased by stores is shipped directly from suppliers to the
stores.

STORE OPERATIONS

     Customer Service.  Customer service and shopping convenience are integral
components of Party City's one-stop shopping concept. The Company views the
quality of its customers' shopping experience as critical to its continued
success. Therefore, the Company seeks to employ friendly, knowledgeable and
energetic sales associates who provide customers with personalized shopping
assistance. For example, at Halloween, the most important selling season for the
Company, each store increases significantly the number of sales associates in
the store. These employees assist customers in selecting costumes, which
provides the sales associates with cross-selling opportunities to suggest
various accessories and other complementary products. Also, at Halloween the
associates use two-way radios to help stock personnel quickly fill in-demand
items, which the Company believes expedites sales and reduces lost business
caused by slow service.

     Company management believes that the compensation of its store managers and
other personnel is competitive and enables the Company to attract and retain
well-qualified, highly motivated employees who are committed to providing
excellent customer service.

FRANCHISE OPERATIONS

     As of June 30, 2001, the Company had 261 franchise stores throughout the
United States, Puerto Rico, Canada, Portugal and Spain. A Party City store run
by a franchisee utilizes the Company's format, design specifications, methods,
standards, operating procedures, systems and trademarks. During Fiscal Year
2001, the Company added 51 franchise stores.

     The Company's franchise stores at June 30, 2001 are located in the
following states and geographic regions:

<Table>
<S>                   <C>
Alabama..............   6
Arizona..............   7
Arkansas.............   2
California...........  12
Colorado.............   1
Connecticut..........   5
Delaware.............   1
Florida..............  37
Georgia..............  21
Hawaii...............   1
Kansas...............   3
Louisiana............   7
Maryland.............   7
Mississippi..........   2
Missouri.............   1
New Jersey...........  22
New Mexico...........   3
New York.............  14
North Carolina.......  15
Ohio.................   3
Oregon...............   3
Pennsylvania.........  17
Rhode Island.........   1
South Carolina.......   6
Tennessee............   9
Texas................  10
Virginia.............   6
Puerto Rico..........   5
Canada...............  27
Portugal.............   2
Spain................   5
  TOTAL.............. 261
</Table>

                                        7
<PAGE>   9

     The Company receives revenue from its franchisees, including an initial
one-time fee (currently $40,000) and an ongoing royalty fee (currently 4.0% of
net sales for new franchisees, payable monthly). In addition, each franchisee
has a mandated advertising budget, which consists of a minimum initial store
opening promotion and ongoing local advertising and promotions. Further, the
franchisee must pay an additional 1.0% of net sales to a Party City group
advertising fund to cover common advertising materials related to the Party City
store concept. The Company does not offer financing for a franchisee's initial
investment. A franchisee's start-up costs include the franchise fee, rent,
leasehold improvements, equipment and furniture, initial inventory, opening
promotion, signage, other deposits, insurance, training expenses and
professional fees.

     Current franchise agreements provide for an assigned area or territory that
typically equals a three-mile radius from the franchisee's store location and
the right to use the Party City logo and trademark "The Discount Party Super
Store(R)." In most stores, the franchisee or the majority shareholder of a
corporate franchisee devotes full time to the management, operation and
on-premises supervision of the franchise.

     Although such locations are generally obtained and secured by the
franchisee, pursuant to the franchise agreement entered into with franchisees,
the Company must approve all site locations. As franchisor, Party City also
supplies valuable and proprietary information pertaining to the operation of the
Party City store business, as well as advice regarding location, improvements
and promotion. The Company also supplies consultation in the areas of
purchasing, inventory control, pricing, marketing, merchandising, hiring,
training, improvements and new developments in the franchisee's business
operations, as well as the provision of assistance in opening and initially
promoting the store.

     The Company has recently added staff and increased its focus on the
management of its franchise operations. Additionally, franchisees have been
represented on several key operating committees, addressing issues such as
merchandising, advertising and information systems initiatives.

     As of September 17, 2001, the Company had twelve territory agreements with
certain franchisees. These agreements grant the holder of the territory the
right to open one or more stores within a stated time period.

COMPETITION

     The party supplies retailing business is highly competitive. Party City
stores compete with a variety of smaller and larger retailers, including, but
not limited to single owner-operated party supplies stores, specialty party
supplies retailers (including superstores), designated departments in drug
stores, general mass merchandisers, supermarkets and department stores of local,
regional and national chains and catalog and Internet stores. Many of these
competitors have substantially greater financial resources than the Company.

     Management believes that Party City stores maintain a leading position in
the party supplies business by offering a wider breadth of merchandise, greater
selection within merchandise class and discount prices offered on most items in
the stores. The Company believes that the significant buying power resulting
from the size of the Party City store network is an integral advantage.

TRADEMARKS

     The Company has licensed a number of trademarks and service marks
registered with the United States Patent and Trademark Office from its wholly
owned subsidiary, including the marks Party City(R), The Discount Party Super
Store(R) and Halloween Costume Warehouse(R).

GOVERNMENT REGULATION

     As a franchisor, the Company must comply with regulations adopted by the
Federal Trade Commission (the "FTC") and with several state laws that regulate
the offer and sale of franchises. The Company also must comply with a number of
state laws that regulate certain substantive aspects of the
franchisor-franchisee relationship. The FTC's Trade Regulation Rule on
Franchising (the "FTC Rule") requires that the Company furnish prospective
franchisees with a franchise offering circular containing information prescribed
by the FTC

                                        8
<PAGE>   10

Rule. State laws that regulate the offer and sale of franchises require the
Company to register before the offer and sale of a franchise can be made in that
state.

     State laws that regulate the franchisor-franchisee relationship presently
exist in a substantial number of states. Those laws regulate the franchise
relationship, for example, by requiring the franchisor to deal with its
franchisees in good faith, by prohibiting interference with the right of free
association among franchisees and by regulating discrimination among franchisees
with regard to charges, royalties or fees. Those laws also restrict a
franchisor's rights with regard to the termination of a franchise agreement (for
example, by requiring "good cause" to exist as a basis for the termination) by
requiring the franchisor to give advance notice to the franchisee of the
termination and give the franchisee an opportunity to cure any default, and by
requiring the franchisor to repurchase the franchisee's inventory or provide
other compensation. To date, those laws have not precluded the Company from
seeking franchisees in any given area and have not had a material adverse effect
on the Company's operations.

     Each Party City store must comply with applicable regulations adopted by
federal agencies and with licensing and other regulations enforced by state and
local health, sanitation, safety, fire and other departments. Difficulties or
failures in obtaining the required licenses or approvals can delay and sometimes
prevent the opening of a new store.

     Party City stores must comply with applicable federal and state
environmental regulations, but the cost of complying with those regulations has
not been material. More stringent and varied requirements of local governmental
bodies with respect to zoning, land use, and environmental factors can delay,
and sometimes prevent, development of new stores in particular locations.

     The Company and its franchisees must comply with the Fair Labor Standards
Act and various state laws governing various matters such as minimum wages,
overtime and other working conditions. The Company and its franchisees also must
comply with the provisions of the Americans with Disabilities Act. The Act
requires that employers provide reasonable accommodation for employees with
disabilities and that stores be accessible to customers with disabilities.

EMPLOYEES

     As of September 17, 2001, the Company employed approximately 1,350
full-time and 3,600 part-time employees. The Company considers its relationships
with its employees to be good. None of the Company's employees is covered by a
collective bargaining agreement.

ITEM 2.  PROPERTIES

     As of June 30, 2001, the Company leased 193 stores. The Company also leases
its headquarters property in Rockaway, New Jersey. The Company occupies
approximately 31,000 square feet of office space for its headquarters under
leases expiring in 2004.

ITEM 3.  LEGAL PROCEEDINGS

SECURITIES LITIGATION

     The Company has been named as a defendant in twelve class action
complaints. The Company's former Chief Executive Officer and the former Chief
Financial Officer and Executive Vice President of Operations have also been
named as defendants. The complaints have all been filed in the United States
District Court for the District of New Jersey. The complaints were filed as
class actions on behalf of persons who purchased or acquired Party City common
stock during various time periods between February 1998 and March 19, 1999. In
October 1999, plaintiffs filed an amended class action complaint and in February
2000, plaintiffs filed a second amended class action complaint.

     The second amended complaint alleges, among other things, violations of
sections 10(b) and 20(a) of the Securities Exchange Act of 1934 and Rule 10b-5
promulgated thereunder, and seeks unspecified damages. The plaintiffs allege
that defendants issued a series of false and misleading statements and failed to
disclose

                                        9
<PAGE>   11

material facts concerning, among other things, the Company's financial
condition, adequacy of internal controls and compliance with certain loan
covenants. The plaintiffs further allege that because of the issuance of a
series of false and misleading statements and/or failure to disclose material
facts, the price of Party City common stock was artificially inflated.

     In early 2000, defendants moved to dismiss the second amended complaint on
the ground that it failed to state a cause of action. On May 29, 2001 the
District Court issued an Opinion and Order dismissing the Complaint against all
defendants with prejudice. On June 27, 2001 plaintiffs filed a Notice of Appeal
to the United States Court of Appeals for the Third Circuit. Because this case
is in the early stages of the appeal process, no opinion can be expressed as to
its likely final outcome.

OTHER

     On April 23, 1999, plaintiff Emil Asch, Inc. ("Emil Asch") filed a
complaint in the United States District Court for the Eastern District of New
York against the Company and co-defendants Amscan, Inc., Hallmark, Inc., and
Rubie's Costume. The complaint alleged violations of the Robinson-Patman Act
(price discrimination), unfair competition, tortious interference with
contractual relations, and false and deceptive advertising. Plaintiff sought
damages of $2 million, as well as treble and punitive damages for certain
counts. On February 3, 2000, Emil Asch amended its complaint by adding an
additional plaintiff to the suit. The Company has settled the case and, in May
2001, the court approved a stipulation entered into by the plaintiffs and the
Company dismissing the case.

     In addition to the foregoing, the Company is from time to time involved in
routine litigation incidental to the conduct of its business. The Company is
aware of no other material existing or threatened litigation to which it is or
may be a party.

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 June 30, 2001.

                                        10
<PAGE>   12

                                    PART II

ITEM 5.  MARKET FOR REGISTRANT'S COMMON EQUITY AND RELATED STOCKHOLDER MATTERS

     The Company's common stock has traded on the Nasdaq National Market under
the symbol "PCTY" since its re-listing in July 2001. From July 1999 until its
re-listing on the Nasdaq National Market, the common stock was traded on the OTC
Bulletin Board, an electronic quotation service for NASD Market Makers. From
March 1996 until July 1999 the Company's common stock was traded on the Nasdaq
National Market.

     The following table sets forth the high and low closing sale prices of the
common stock through June 30, 2001.

<Table>
<Caption>
                                                              HIGH     LOW
                                                              -----   -----
<S>                                                           <C>     <C>
QUARTER ENDED:
June 30, 2001...............................................  $6.00   $3.26
March 31, 2001..............................................   3.73    2.90
December 30, 2000...........................................   4.50    3.05
September 30, 2000..........................................   4.00    2.40
QUARTER ENDED:
July 1, 2000................................................   2.70    1.53
April 1, 2000...............................................   3.50    1.05
January 1, 2000.............................................   2.25    0.85
October 2, 1999.............................................   3.84    2.00
</Table>

     At September 17, 2001, the approximate number of holders of record of the
common stock was approximately 2,900.

DIVIDENDS

     Except for the S Corporation distribution of a portion of previously
undistributed earnings to the Company's stockholders in 1994 upon the Company's
election to be taxed as a C Corporation, the Company has never paid cash
dividends on its capital stock and does not intend to pay cash dividends in the
foreseeable future. The Company expects that earnings will be retained for the
continued growth and development of the Company's business. Future dividends, if
any, will depend upon the Company's earnings, financial condition, working
capital requirements, compliance with covenants in agreements to which the
Company is or may be subject, future prospects and any other factors deemed
relevant by the Company's Board of Directors. Under various agreements to which
the Company is a party, the Company is currently not permitted to pay any
dividends. See "Management's Discussion and Analysis of Financial Condition and
Results of Operations -- Liquidity and Capital Resources."

UNREGISTERED SECURITIES

     Pursuant to separate Securities Purchase Agreements, each dated as of
August 16, 1999 (the "Purchase Agreements"), the Company issued the Notes and
the Warrants (each as defined below) to the investors set forth therein (the
"Investors") for an aggregate purchase price of $30 million. Under the terms of
an amendment to the Securities Purchase Agreements, dated as of January 14, 2000
(the "First Amendment"), the Amended Warrants are exercisable for an aggregate
of 6,880,000 shares of common stock at an exercise price of $1.07 per share and
may be exercised at any time through August 16, 2006. The shares of common stock
reserved for issuance under the Amended Warrants represent approximately 35% of
the shares of common stock outstanding after giving effect to the full exercise
of the Amended Warrants. The private placement of the issuance and sale of the
Notes and the Amended Warrants to the Investors was exempt from the registration
requirements of the Securities Act of 1933, as amended, pursuant to Section 4(2)
of such Act. See "Management's Discussion and Analysis of Financial Condition
and Results of Operations -- Liquidity and Capital Resources."

                                        11
<PAGE>   13

ITEM 6.  SELECTED FINANCIAL DATA

     The selected financial information presented below has been derived from
the Company's audited Consolidated Financial Statements for the fiscal years
ended December 31, 1996, 1997, 1998, July 1, 2000 and June 30, 2001 and the six
months ended July 3, 1999. The selected financial information presented below
should be read in conjunction with such financial statements and notes thereto.
The year ended July 3, 1999 and the six months ended June 30, 1998 are unaudited
and presented for comparative purposes.

                            SELECTED FINANCIAL DATA

<Table>
<Caption>
                                            YEAR ENDED DECEMBER 31                       YEAR ENDED
                                         -----------------------------   -------------------------------------------
                                          1996       1997       1998     JULY 3, 1999   JULY 1, 2000   JUNE 30, 2001
                                         -------   --------   --------   ------------   ------------   -------------
                                                                         (UNAUDITED)
                                                       (IN THOUSANDS, EXCEPT PER SHARE AND STORE DATA)
<S>                                      <C>       <C>        <C>        <C>            <C>            <C>
STATEMENT OF OPERATIONS DATA:
Total revenue..........................  $48,591   $141,714   $294,334     $353,571       $363,399       $395,900
                                         =======   ========   ========     ========       ========       ========
Company-owned stores:
  Net sales............................  $39,144   $131,028   $282,923     $341,554       $349,722       $380,671
  Cost of goods sold and occupancy
    costs..............................   25,937     86,372    194,761      239,373        240,356        252,320
                                         -------   --------   --------     --------       --------       --------
  Gross profit.........................   13,207     44,656     88,162      102,181        109,366        128,351
  Store operating and selling
    expense............................   10,116     31,880     73,970       91,911         83,470         88,128
                                         -------   --------   --------     --------       --------       --------
  Company-owned stores profit
    contribution.......................    3,091     12,776     14,192       10,270         25,896         40,223
Franchise stores:
  Royalty fees.........................    8,512     10,224     10,841       11,369         13,187         14,604
  Franchise fees.......................      935        462        570          648            490            625
                                         -------   --------   --------     --------       --------       --------
  Total franchise revenues.............    9,447     10,686     11,411       12,017         13,677         15,229
  Total franchise expense..............    3,729      3,998      4,114        4,217          4,406          4,937
                                         -------   --------   --------     --------       --------       --------
  Franchise profit contribution........    5,718      6,688      7,297        7,800          9,271         10,292
General and administrative expense:
  Impairment charge....................       --         --         --          300          1,172          2,275
  Special charges(a)...................       --         --         --        5,858          7,789             --
  Other general and administrative
    expenses...........................    3,160      7,049     15,939       20,022         21,438         24,328
                                         -------   --------   --------     --------       --------       --------
                                           3,160      7,049     15,939       26,180         30,399         26,603
                                         -------   --------   --------     --------       --------       --------
Income (loss) before interest and
  income taxes.........................    5,649     12,415      5,550       (8,110)         4,768         23,912
Interest expense (income), net.........     (476)      (212)     2,636        4,141          8,423          7,949
                                         -------   --------   --------     --------       --------       --------
Income (loss) before income taxes......    6,125     12,627      2,914      (12,251)        (3,655)        15,963
Income tax provision (benefit)(b)......    2,369      4,957      1,127         (852)        (4,636)         6,002
                                         -------   --------   --------     --------       --------       --------
Net income (loss)......................  $ 3,756   $  7,670   $  1,787     $(11,399)      $    981       $  9,961
                                         =======   ========   ========     ========       ========       ========
Basic earnings (loss) per share........  $  0.38   $   0.65   $   0.14     $  (0.92)      $   0.08       $   0.78
                                         =======   ========   ========     ========       ========       ========
Diluted earnings (loss) per share......  $  0.38   $   0.64   $   0.14     $  (0.92)      $   0.07       $   0.56
                                         =======   ========   ========     ========       ========       ========
Weighted average shares
  outstanding -- basic.................    9,802     11,749     12,411       12,450         12,611         12,723
                                         =======   ========   ========     ========       ========       ========
Weighted average shares outstanding --
  diluted..............................    9,996     12,039     12,704       12,450         14,283         17,819
                                         =======   ========   ========     ========       ========       ========
EBITDA(c)..............................  $ 6,395   $ 15,209   $ 12,148     $  6,241       $ 24,486       $ 36,618
                                         =======   ========   ========     ========       ========       ========
</Table>

                                        12
<PAGE>   14

<Table>
<Caption>
                                            YEAR ENDED DECEMBER 31                       YEAR ENDED
                                         -----------------------------   -------------------------------------------
                                          1996       1997       1998     JULY 3, 1999   JULY 1, 2000   JUNE 30, 2001
                                         -------   --------   --------   ------------   ------------   -------------
                                                                         (UNAUDITED)
                                                       (IN THOUSANDS, EXCEPT PER SHARE AND STORE DATA)
<S>                                      <C>       <C>        <C>        <C>            <C>            <C>
OPERATING DATA:
  Number of Company-owned stores (end
    of year)...........................       36        117        207          215            197            193
                                         =======   ========   ========     ========       ========       ========
  Increase in Company-owned same store
    sales..............................     17.9%      15.5%      11.3%         8.2%           3.8%          10.3%
                                         =======   ========   ========     ========       ========       ========
  Number of franchise stores (end of
    year)..............................      164        158        167          178            211            261
                                         =======   ========   ========     ========       ========       ========
  Increase in franchise same store
    sales..............................     19.5%      14.8%       6.8%         6.3%           7.9%           4.3%
                                         =======   ========   ========     ========       ========       ========
  Average sales per Company-owned
    store..............................  $ 1,662   $  1,740   $  1,684     $  1,680       $  1,810       $  1,961
                                         =======   ========   ========     ========       ========       ========
  Depreciation and amortization........      746      2,794      6,598        8,193         10,757         10,431
                                         =======   ========   ========     ========       ========       ========
BALANCE SHEET DATA:
  Working capital (deficiency).........  $17,419   $ 13,931   $(15,039)    $(26,694)      $ 15,069       $  8,285
                                         =======   ========   ========     ========       ========       ========
  Total assets.........................   34,603     89,615    144,032      161,319        132,086        141,342
                                         =======   ========   ========     ========       ========       ========
  Bank borrowings and other long-term
    liabilities(d).....................       --      3,150         --           --         29,547         16,006
                                         =======   ========   ========     ========       ========       ========
  Capital lease obligation.............       --      1,460      1,141          718            360             54
                                         =======   ========   ========     ========       ========       ========
  Stockholders' equity.................   23,561     45,783     49,368       35,934         40,861         51,090
                                         =======   ========   ========     ========       ========       ========
</Table>

<Table>
<Caption>
                                                                    SIX MONTHS ENDED
                                                              ----------------------------
                                                              JUNE 30, 1998   JULY 3, 1999
                                                              -------------   ------------
                                                               (UNAUDITED)
<S>                                                           <C>             <C>
STATEMENT OF OPERATIONS DATA:
Total revenue...............................................    $ 97,272        $156,509
                                                                ========        ========
Company-owned stores:
  Net sales.................................................    $ 92,718        $151,349
  Cost of goods sold and occupancy costs....................      65,246         109,858
                                                                --------        --------
  Gross profit..............................................      27,472          41,491
  Store operating and selling expense.......................      24,111          42,052
                                                                --------        --------
  Company-owned stores profit contribution (loss)...........       3,361            (561)
Franchise stores:
  Royalty fees..............................................       4,379           4,907
  Franchise fees............................................         175             253
                                                                --------        --------
  Total franchise revenues..................................       4,554           5,160
  Total franchise expense...................................       1,803           1,906
                                                                --------        --------
  Franchise profit contribution.............................       2,751           3,254
General and administrative expense:
  Special charges(a)........................................          --           5,858
  Impairment charge.........................................          --             300
  Other general and administrative expenses.................       5,615           9,698
                                                                --------        --------
                                                                   5,615          15,856
                                                                --------        --------
Income (loss) before interest and income taxes..............         497         (13,163)
Interest expense, net.......................................         873           2,378
                                                                --------        --------
</Table>

                                        13
<PAGE>   15

<Table>
<Caption>
                                                                    SIX MONTHS ENDED
                                                              ----------------------------
                                                              JUNE 30, 1998   JULY 3, 1999
                                                              -------------   ------------
                                                               (UNAUDITED)
<S>                                                           <C>             <C>
Loss before income taxes....................................        (376)        (15,541)
Income tax benefit..........................................        (146)         (2,125)
                                                                --------        --------
Net loss....................................................    $   (230)       $(13,416)
                                                                ========        ========
Basic loss per share........................................    $  (0.02)       $  (1.08)
                                                                ========        ========
Diluted loss per share......................................    $  (0.02)       $  (1.08)
                                                                ========        ========
Weighted average shares outstanding -- basic................      12,376          12,455
                                                                ========        ========
Weighted average share outstanding -- diluted...............      12,376          12,455
                                                                ========        ========
EBITDA(c)...................................................    $  4,131        $ (1,776)
                                                                ========        ========
BALANCE SHEET DATA:
  Working capital (deficiency)..............................    $ 40,805        $(26,694)
                                                                ========        ========
  Total assets..............................................     119,168         161,319
                                                                ========        ========
  Bank borrowings and other long-term liabilities(d)........      40,182              --
                                                                ========        ========
  Capital lease obligation..................................       1,072             718
                                                                ========        ========
  Stockholders' equity......................................      46,103          35,934
                                                                ========        ========
</Table>

---------------

(a) Special charges relate to consulting services, accounting fees, bank fees,
    legal fees and other expenses related to the Company's financial
    restructuring.

(b) The year ended July 1, 2000 includes $3.7 million of benefit related to the
    reversal of valuation reserves on deferred tax assets established in the
    year ended July 3, 1999 due to the uncertainty at that time that the
    Company's net operating loss carryforwards would be realized.

(c) The Company's definition of EBITDA is earnings before interest, taxes,
    depreciation, amortization and impairment provision and exclusive of special
    charges.

(d) Excludes borrowings under the Company's previous Credit Agreement of $46.8
    million and $58.6 million included in current liabilities at December 31,
    1998 and July 3, 1999, respectively. The bank borrowing and other long-term
    liabilities at July 1, 2000 and June 30, 2001 is net of an unamortized debt
    discount of $3.0 million and $1.9 million, respectively.

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

RESULTS OF OPERATIONS

     The Company's revenues and earnings are generated primarily from its two
business segments -- Retail and Franchising.

 YEAR ENDED JUNE 30, 2001 ("FISCAL 2001") COMPARED TO YEAR ENDED JULY 1, 2000
 ("FISCAL 2000")

     Retail.  Net sales from Company-owned stores increased 8.8% to $380.7
million in Fiscal 2001 from $349.7 million in Fiscal 2000. The Fiscal 2001
results include 197 stores which were open at the beginning of that year plus
one store acquired during the year, less three stores sold and two stores closed
during the year. Same store sales increased 10.3% and 3.8% in Fiscal 2001 and
Fiscal 2000, respectively. Gross profit reflects the cost of goods sold and
store occupancy costs including rent, common area maintenance, real estate
taxes, repair and maintenance, depreciation and utilities. Gross profit for
Fiscal 2001 increased 17.4% to $128.4 million compared to $109.4 million for
Fiscal 2000. The increase in Fiscal 2001 was primarily due to increased sales
volume and improvement in gross margin. Gross margin was 33.7% and 31.3% of
sales for Fiscal 2001 and Fiscal 2000, respectively. The increase in gross
margin was related primarily to stronger controls over inventory resulting in
reduced inventory loss and improved buying.

                                        14
<PAGE>   16

     Store operating and selling expenses increased 5.6% to $88.1 million for
Fiscal 2001, compared to $83.5 million in Fiscal 2000. The increase in store
operating expenses is primarily attributable to an increase in sales. Store
operating expenses were 23.2% and 23.9% of sales for Fiscal 2001 and Fiscal
2000, respectively, due to efficiencies occurring in staffing and advertising
resulting from an increase in average store sales. Company-owned store profit
contribution increased to $40.2 million for Fiscal 2001, compared to $25.9
million for Fiscal 2000.

     Pre-opening expenses of $78,000 were recorded in Fiscal 2001 for four
stores scheduled to open in the first quarter of Fiscal 2002. The Company
expenses pre-opening costs when incurred. No pre-opening expenses were recorded
in Fiscal 2000.

     Franchising.  Franchise revenue is composed of the initial franchise fees
which are recorded as revenue when a franchise store opens, and ongoing royalty
fees, generally 4.0% of the store's net sales. Royalty fees increased 10.7% to
$14.6 million in Fiscal 2001 from $13.2 million in Fiscal 2000. Franchise fees
recognized on 51 store openings during Fiscal 2001 increased 27.6% to $625,000
compared to $490,000 during Fiscal 2000 recognized on 23 store openings.
Franchise same store sales increases for Fiscal 2001 and Fiscal 2000 were 4.3%
and 7.9%, respectively.

     Expenses directly related to franchise revenue increased 12.1% to $4.9
million for Fiscal 2001 from $4.4 million for Fiscal 2000. This increase is
primarily attributable to additional franchise personnel required to operate
this portion of the Company's business and the infrastructure to support such
employees. As a percentage of franchise revenue, franchise expenses were 32.4%
and 32.2% for Fiscal 2001 and Fiscal 2000, respectively.

     Franchise profit contribution was increased 11.0% to $10.3 million for
Fiscal 2001 compared to $9.3 million for Fiscal 2000. The increase in franchise
profit contribution is due to the increase in royalty and franchise fees offset
in part by an increase in franchise expenses, as discussed above.

     General and Administrative.  General and administrative expenses decreased
12.5% to $26.6 million in Fiscal 2001, compared to $30.4 million in Fiscal 2000.
The decrease is primarily attributable to $7.8 million in special charges,
relating to consulting, accounting, banking and other expenses resulting from
the Company's refinancing arrangements in Fiscal 2000, with no comparable
special charges in Fiscal 2001. An impairment charge of $2.3 million related to
store registers replaced in the Company's information system initiative was
recorded in Fiscal 2001, compared to an impairment charge of $1.2 million in
Fiscal 2000 related to long-lived assets in certain underperforming stores.
Excluding special charges and impairment, general and administrative expenses
increased 13.5% to $24.3 million in Fiscal 2001 compared to $21.4 million in
Fiscal 2000. Payroll and benefits increased $1.9 million or 19.1%, to $12.0
million in Fiscal 2001 from $10.1 million in Fiscal 2000 as a result of
additional headquarters personnel and increased bonus payments. Exclusive of
special charges and the impairment charge, discussed above, general and
administrative expenses were 6.4% and 6.1% of sales in Fiscal 2001 and Fiscal
2000, respectively.

     Interest Expense.  Interest expense decreased to $7.9 million for Fiscal
2001 from $8.4 million in Fiscal 2000. This is attributable to a reduction in
principal balance with a scheduled payment of $5.1 million made in January 2001.
The Company expensed approximately $100,000 in the write-off of debt-issue
costs, included in interest expense, related to an additional prepayment of $3.0
million made in June 2001.

     Income Taxes.  Income taxes of $6.0 million, or 37.6% of pre-tax income,
were provided in Fiscal 2001. Tax benefits of $4.6 million related primarily to
deferred tax valuation allowance reversals were recognized in Fiscal 2000.

     Net Income.  As a result of the above factors, net income increased to
$10.0 million or $0.78 per basic share and $0.56 per diluted share in Fiscal
2001, as compared to net income of $981,000, or $0.08 per basic share and $0.07
per diluted share in Fiscal 2000.

 YEAR ENDED JULY 1, 2000 ("FISCAL 2000") COMPARED TO YEAR ENDED JULY 3, 1999
 ("FISCAL 1999")

     Retail.  Net sales from Company-owned stores increased 2.4% to $349.7
million in Fiscal 2000 from $341.6 million in Fiscal 1999. The Fiscal 2000
results include 215 stores which were open at the beginning of

                                        15
<PAGE>   17

that year plus two stores opened during the year, less 18 stores sold and two
stores closed during the year. Same store sales increased 3.8% and 8.2% in
Fiscal 2000 and Fiscal 1999, respectively. Gross profit reflects the cost of
goods sold and store occupancy costs including rent, common area maintenance,
real estate taxes, repair and maintenance, depreciation and utilities. Gross
profit for Fiscal 2000 increased 7.0% to $109.4 million compared to $102.1
million for Fiscal 1999. The increase in Fiscal 2000 was primarily due to
increased sales volume and improvement in gross margin. Gross margin was 31.3%
and 29.9% of sales for Fiscal 2000 and Fiscal 1999, respectively. The increase
in gross margin was related primarily to a charge of $2.3 million taken in
Fiscal 1999 for slow moving inventory, reduced inventory losses and increased
initial mark up in Fiscal 2000.

     Store operating and selling expenses decreased 9.2% to $83.5 million for
Fiscal 2000 compared to $91.9 million in Fiscal 1999. The decrease in store
operating expenses is primarily attributable to a reduction in the number of
stores and improved operating efficiencies due to increased sales. Store
operating expenses were 23.9% and 26.9% of sales for Fiscal 2000 and Fiscal
1999, respectively, due to efficiencies occurring in staffing and advertising
resulting from an increase in average store sales. Company-owned store profit
contribution was $25.9 million for Fiscal 2000, compared to $10.3 million for
Fiscal 1999.

     Franchising.  Franchise revenue is composed of the initial franchise fees
which are recorded as revenue when a franchise store opens, and ongoing royalty
fees, generally 4.0% of the store's net sales. Royalty fees increased 16.0% to
$13.2 million in Fiscal 2000 from $11.4 million in Fiscal 1999. Franchise fees
recognized on 23 store openings during Fiscal 2000 decreased 24.4% to $490,000
compared to $648,000 during Fiscal 1999 recognized on 18 store openings.
Franchise same store sales increases for Fiscal 2000 and Fiscal 1999 were 7.9%
and 6.3%, respectively.

     Expenses directly related to franchise revenue increased 4.5% to $4.4
million for Fiscal 2000 from $4.2 million for Fiscal 1999. This increase is
primarily attributable to additional franchise personnel required to operate
this portion of the Company's business and the necessary infrastructure to
support such employees. As a percentage of franchise revenue, franchise expenses
were 32.2% and 35.1% for Fiscal 2000 and Fiscal 1999, respectively.

     Franchise profit contribution was increased 18.9% to $9.3 million for
Fiscal 2000 compared to $7.8 million for Fiscal 1999. The increase in franchise
profit contribution is due to the increase in royalty fees offset in part by an
increase in franchise expenses, as discussed above.

     General and Administrative.  General and administrative expenses increased
16.1% to $30.4 million in Fiscal 2000 compared to $26.2 million in Fiscal 1999.
The increase is primarily attributable to $7.8 million in special charges,
relating to consulting, accounting, banking and other expenses resulting from
the Company's refinancing arrangements in Fiscal 2000, compared to $5.9 million
in Fiscal 1999 and an increase in the impairment provision to $1.2 million in
Fiscal 2000 compared to $300,000 in Fiscal 1999. Payroll and benefits decreased
$151,000, or 1.5%, to $10.1 million in Fiscal 2000 from $10.2 million in Fiscal
1999. Professional fees, exclusive of special charges, decreased 28% to $2.5
million in Fiscal 2000 from $3.2 million in Fiscal 1999. Exclusive of special
charges and the impairment provision, discussed above, general and
administrative expenses were 6.0% and 5.9% of sales in Fiscal 2000 and Fiscal
1999, respectively.

     Interest Expense.  Interest expense increased to $8.4 million for Fiscal
2000 from $4.1 million in Fiscal 1999. This is attributable to additional
borrowings under the Company's previous Credit Agreement, the Senior Notes and
the Loan Agreement hereinafter defined.

     Income Taxes.  Income taxes decreased 444% to a benefit of $4.6 million for
Fiscal 2000 compared to a benefit of $852,000 in Fiscal 1999. This increase in
benefit relates primarily to the reversal of previously established deferred tax
valuation allowances of $3.7 million in Fiscal 2000.

     Net Income.  As a result of the above factors, net income increased to
$981,000 or $0.08 per basic share and $0.07 per diluted share in Fiscal 2000, as
compared to a net loss of $11.4 million, or $(0.92) per basic and diluted share
in Fiscal 1999.

                                        16
<PAGE>   18

 SIX-MONTH PERIOD ENDED JULY 3, 1999 ("1999 PERIOD") COMPARED TO SIX-MONTH
 PERIOD ENDED JUNE 30, 1998 ("1998 PERIOD")

     Retail.  Net sales from Company-owned stores increased 63.2% to $151.3
million for the 1999 Period, from $92.7 million for the 1998 Period. The 1999
Period results include 207 stores which were open at the beginning of that
period plus eight (net) stores opened during the period. The 1998 Period amount
represents net sales from 117 stores which were open at the beginning of the
period, plus 31 stores opened during the period. Of the total sales increase,
26.7% is attributable to an additional 67 new store openings after the 1998
Period. Same store sales increased 5.1% and 11.3% in the 1999 Period and the
1998 Period, respectively. Gross profit reflects the cost of goods sold and
store occupancy costs including rent, common area maintenance, real estate
taxes, repairs and maintenance, depreciation and utilities. Gross profit
increased 51.0% to $41.5 million for the 1999 Period compared to $27.5 million
for the 1998 Period. The increase for the 1999 Period was primarily due to
increased sales volume. Gross margin was 27.4% and 29.6% of sales for the 1999
Period and 1998 Period, respectively. The decrease in gross margin was related
primarily to the recognition of inventory losses from physical inventories taken
as of July 3, 1999 and increases in store occupancy costs.

     Store operating and selling expenses increased 74.4% to $42.1 million for
the 1999 Period compared to $24.1 million for the 1998 Period. The increase in
store operating expenses is primarily attributable to the increased number of
stores operated by the Company during the 1999 Period. Store operating expenses
were 27.8% and 26.0% of sales for the 1999 Period and 1998 Period, respectively,
due to increased store operating payroll costs related to new store openings.
Company-owned store profit contribution was a negative $561,000 for the 1999
Period, compared to a profit contribution of $3.4 million for 1998 Period.

     Franchising.  Franchise revenue is composed of the initial franchise fees,
which are recorded as revenue when a franchise store opens, and ongoing royalty
fees, generally 4.0% of the store's net sales. Royalty fees increased 12.1% to
$4.9 million for the 1999 Period from $4.4 million for the 1998 Period.
Franchise fees recognized on 11 store openings during the 1999 Period, increased
44.6% to $253,000 compared to $175,000 during the 1998 Period, which represents
eight store openings. Franchise same store sales increased by 8.8% and 6.6% for
the 1999 Period and the 1998 Period, respectively.

     Expenses directly related to franchise revenue increased 5.7% to $1.9
million for the 1999 Period from $1.8 million for the 1998 Period. This increase
is primarily attributable to additional franchise personnel required to operate
this portion of the Company's business and the necessary infrastructure to
support such employees. As a percentage of franchise revenue, franchise expenses
were 36.9% and 39.6% for the 1999 Period and 1998 Period, respectively.

     Franchise profit contribution increased 18.3% to $3.3 million for the 1999
Period, compared to $2.8 million for the 1998 Period. The increase in franchise
profit contribution is due to the increase in royalty fees and franchise fees
offset in part by an increase in franchise expenses, as discussed above.

     General and Administrative Expenses.  The Company's general and
administrative expenses increased 182% to $15.9 million during the 1999 Period,
compared to $5.6 million during the 1998 Period. The increase is attributable in
part to $5.9 million in special charges relating to consulting, accounting,
banking and other expenses resulting from the Company's refinancing
arrangements. In addition, during the 1999 Period, there was an increase in
payroll and related benefits due to a higher overhead structure intended to
support a planned 50-store increase in calendar year 1999 compared to the
calendar year 1998.

     Corporate occupancy increased 236% to $1.4 million for the 1999 Period from
$410,000 in the 1998 Period, primarily as a result of additional depreciation
expense for computer hardware and software. Also, professional fees, exclusive
of special charges of $5.9 million, increased 94.4% to $1.3 million in the 1999
Period from $674,000 million in the 1998 Period, primarily related to
information systems expenses for Year 2000 systems remediation and new systems
consulting, design and implementation. Due to reductions in planned growth, the
number of corporate staff members decreased by 21% in May 1999 in order to bring
administrative costs in line with reduced growth objectives.

     Exclusive of the $5.9 million in special charges discussed above, general
and administrative expenses were 6.4% and 6.1% of sales for the 1999 Period and
1998 Period, respectively.
                                        17
<PAGE>   19

     Interest Expense.  Interest expense increased 172% to $2.4 million during
the 1999 Period as compared to the $874,000 in the comparable 1998 Period. This
increase related primarily to an increase in interest rates due to provisions of
the bank's standstill agreements in effect during the quarter ended July 3,
1999.

     Income Taxes.  The income tax benefit was $2.1 million during the 1999
Period compared with $146,000 during the 1998 Period. This increase related to
the pre-tax loss in the 1999 Period of $15.5 million compared to $376,000
million in the 1998 Period. The benefit recorded in the 1999 Period is net of
recording a $3.9 million valuation allowance against deferred tax assets.

     Net Loss.  As a result of the above factors, net loss was $13.4 million, or
$(1.08) per basic and diluted share, in the 1999 Period as compared to a net
loss of $230,000, or $(0.02) per basic and diluted share, in the comparable 1998
Period.

LIQUIDITY AND CAPITAL RESOURCES

     The Company's cash provided by operating activities was $29.7 million, in
Fiscal 2001 compared to $9.3 million in Fiscal 2000. The increase is primarily
due to net income in Fiscal 2001 of $10.0 million and changes in deferred tax
and tax receivable accounts, and reduced accounts payable repayments.

     Net cash of $15.7 million was used in investing activities as a result of
investments in new systems and additions to fixed assets of $16.9 offset by
proceeds of $1.2 million from the sale of stores.

     Net cash used in financing activities was $8.1 million. The cash used in
financing was primarily the result of the scheduled repayment of $5.1 million of
Senior Notes in January 2001 and the prepayment of $3.0 million of Senior Notes
in June 2001.

     As of June 30, 2001, the Company had no balance outstanding under its Loan
and Security Agreement dated January 14, 2000 (the "Loan Agreement"), with
Congress Financial Corporation. Under the terms of the Loan Agreement, the
Company may from time to time borrow, based on a percentage of its eligible
inventory, up to a maximum of $40 million at any time outstanding. Advances bear
interest, at the Company's option, (i) at the adjusted Eurodollar rate plus the
applicable margin, which was 2.75% per annum (subject to possible reduction to
an interest rate as low as 2.25% from and after June 30, 2001, based on the
Company's pre-tax income and excess availability) or (ii) at the rate of 3/4%
per annum above the prime rate, totaling 7.75% at June 30, 2001. The term of the
Loan Agreement is three years with yearly renewals thereafter and is secured by
a lien on substantially all of the assets of the Company. At September 17, 2001,
there was $4.4 million outstanding and $35.6 million available to be borrowed
under the Loan Agreement.

     On August 17, 1999, the Company received $30 million in financing from the
Investors, who purchased senior secured notes and warrants pursuant to the
Securities Purchase Agreement. Under the Purchase Agreement, the Company issued
(i) $10 million of its 12.5% Secured Notes due 2003 (the "A Notes"); (ii) $5
million of its 13.0% Secured Notes due 2003 (the "B Notes"); (iii) $5 million of
its 13.0% Secured Notes due 2002 (the "C Notes"); (iv) $10 million of its 14.0%
Secured Notes due 2004 (the "D Notes" and, together with the A Notes, the B
Notes and the C Notes, the "Notes"); and (v) warrants (the "Warrants") to
purchase 6,880,000 shares of the Company's common stock at an initial exercise
price of $3.00 per share. The Warrants were valued at $2.0 million based on
management's estimate using certain fair value methodologies and represent an
original issue discount to the C Notes and D Notes. The Notes are secured by a
junior lien on substantially all of the Company's assets. The Company issued the
Warrants in connection with the sale of the C Notes and the D Notes. The
Warrants may be exercised on or before the close of business on August 16, 2006.
The shares of common stock reserved for issuance under the Warrants represent
approximately 35% of the shares of common stock outstanding after giving effect
to the full exercise of the Warrants. The proceeds from the $30 million in new
financing were used for the purchase of seasonal inventory, the payment of
amounts due under the Company's previous Credit Agreement, certain transaction
fees and working capital.

     Pursuant to the First Amendment, on January 14, 2000, the Company received
$7 million in cash proceeds from the sale to certain of the Investors (the
"Investor Group") of a new series of senior secured notes. Under the First
Amendment, the Company issued $7 million in aggregate principal amount of its
14.0%
                                        18
<PAGE>   20

Secured Notes due 2002 (the "E Notes"). The E Notes are secured by a lien on
substantially all of the Company's assets. Under the terms of the First
Amendment, the interest rate on the A Notes, the B Notes, the C Notes and the D
Notes was increased by 4.5%. The Investor Group, together with the Investors and
Congress, entered into an intercreditor agreement. In consideration for waivers
and forbearances granted by the Investors to various defaults under the terms of
the Company's A Notes, B Notes, C Notes and D Notes, the Company also agreed to
amend and restate the terms of the Warrants held by the Investors to acquire
6,880,000 shares of the Company's common stock. The amended and restated
warrants (the "Amended Warrants") provide for an exercise price of $1.07 per
share and were issued upon surrender of the Warrants, which had an exercise
price of $3.00 per share. The Amended Warrants were valued at $3.2 million based
on management's estimate using certain fair value methodologies and represent an
original issue discount to the C Notes and D Notes. This discount is being
amortized using the effective interest method. The effective yield is 28.6% and
28.9% on the C Notes and D Notes, respectively.

     As of June 30, 2001, the Company had approximately $29.5 million in notes
payable to investors. The Company made a required payment of $5.1 million due on
these notes in January 2001. An additional $3.0 million (due in January 2002)
was prepaid in June 2001. The Company expensed approximately $100,000 in the
write-off of debt-issue costs, included in interest expense related to this
prepayment.

     The Company was in violation of a covenant under the Securities Purchase
Agreements (as amended) related to the amount of capital expenditures during the
fiscal year ended June 30, 2001. The Company exceeded the capital expenditures
limit primarily because of additional costs related to expanded functionality in
the merchandise management system to be implemented in Fiscal Year 2002. The
Company received a waiver from the Investors for this violation.

     The Company's Board of Directors has authorized the repurchase of up to $15
million of the Company's common stock. Shares of the Company's common stock will
be repurchased in the open market at times and prices considered appropriate by
the Company. The timing of any repurchases and the exact number of shares to be
purchased will be dependent on market conditions.

     Company management currently believes that the cash generated by
operations, together with the borrowing availability under the Loan Agreement,
will be sufficient to meet the Company's working capital needs for the next
twelve months, including the scheduled repayment of $11.7 million of Senior
Notes, due in January 2002.

ACCOUNTING AND REPORTING CHANGES

     Emerging Issues Task Force Issue 00-10, "Accounting for Shipping and
Handling Fees and Costs" requires that all amounts billed to a customer in a
sale transaction related to shipping and handling, if any, should be classified
as revenue. The adoption of this statement does not have an impact on the
consolidated financial statements.

     In June 2001, the Financial Accounting Standards Board ("FASB") issued two
new pronouncements: Statement of Financial Accounting Standards ("SFAS") No.
141, Business Combinations, and SFAS No. 142, Goodwill and Other Intangible
Assets.

     SFAS No. 141 addresses financial accounting and reporting for business
combinations and supersedes APB No. 16 "Business Combinations" and FASB
Statement No. 38, "Accounting for Preacquisition Contingencies of Purchased
Enterprises". All business combinations in the scope of this Statement are to be
accounted for using one method, the purchase method. SFAS 141 is effective as
follows: a) use of the pooling-of-interest method is prohibited for business
combinations initiated after June 30, 2001; and b) the provisions of SFAS 141
also apply to all business combinations accounted for by the purchase method
that are completed after June 30, 2001 (that is, the date of the acquisition is
July 2001 or later). The Company believes that the adoption of this statement
will not have an impact on the consolidated financial statements.

     SFAS No. 142 addresses financial accounting and reporting for acquired
goodwill and other intangible assets and supersedes APB No. 17, "Intangible
Assets". It changes the accounting for goodwill from an amortization method to
an impairment only approach. SFAS 142 is effective for fiscal years beginning
after December 15, 2001 to all goodwill and other intangible assets recognized
in an entity's statement of financial position at that date, regardless of when
those assets were initially recognized. The Company is evaluating the

                                        19
<PAGE>   21

impact of adopting these pronouncements on the consolidated financial
statements. For the year ended June 2001, the Company's amortization of goodwill
charged to operations was $1.2 million.

 IMPACT OF INFLATION

     The Company believes that inflation did not have a material impact on its
operations for the periods reported. Significant increases in cost of
merchandise purchased, labor, employee benefits and other operating expenses
could have a material adverse effect on the Company's performance.

 SEASONALITY

     The Company's business is subject to substantial seasonal variations.
Historically, the Company has realized a significant portion of its net sales
and substantially all of its cash flow and net income for the year during the
fourth calendar quarter of the year, principally due to the sales in October for
the Halloween season and, to a lesser extent, due to holiday sales for end of
year holidays. The Company's results of operations may also fluctuate
significantly as a result of a variety of other factors, including the timing of
new store openings.

ITEM 7A.  QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK

     The Company, in the normal course of doing business, is theoretically
exposed to interest rate change market risk. As borrowing patterns are cyclical,
the Company is not dependent on borrowing throughout the year. Therefore, a
sudden increase in interest rates (which under the Loan Agreement is dependent
on the prime rate) may, during peak borrowing, have a negative impact on
short-term results.

                                        20
<PAGE>   22

ITEM 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA

     The response to this item is submitted as a separate section of this Report
commencing on page F-1.

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

     None.

                                    PART III

     In accordance with general instruction G(3) of Form 10-K, the information
called for by Items 10, 11, 12 and 13 of Part III is incorporated by reference
to the Company's definitive Proxy Statement for its 2001 Annual Meeting of
Stockholders.

                                    PART IV

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

     (a) List of Documents filed as part of this Annual Report on Form 10-K.

     1. The following consolidated financial statements of the Company are filed
as a separate section of this Report commencing on page F-1.

     Independent Auditors' Report -- Deloitte & Touche LLP

     Consolidated Balance Sheets as of July 1, 2000 and June 30, 2001.

     Consolidated Statements of Operations for the year ended December 31, 1998,
      the six months ended June 30, 1998 (unaudited) and July 3, 1999, and the
      years ended July 1, 2000 and June 30, 2001.

     Consolidated Statements of Shareholders' Equity for the year ended December
      31, 1998, the six months ended July 3, 1999, and the years ended July 1,
      2000 and June 30, 2001.

     Consolidated Statements of Cash Flows for the year ended December 31, 1998,
      the six months ended June 30, 1998 (unaudited) and July 3, 1999 and the
      years ended July 1, 2000 and June 30, 2001.

     Notes to Consolidated Financial Statements for the year ended December 31,
      1998, the six months ended June 30, 1998 (unaudited) and July 3, 1999, and
      the years ended July 1, 2000 and June 30, 2001.

     2. Financial Statement Schedules -- Not Applicable.

     3. List of Exhibits.

     The following exhibits are included as a part of this Annual Report on Form
10-K or, where indicated, are incorporated herein by reference.

<Table>
<C>         <C>  <S>
  3.1(1)     --  Certificate of Incorporation of the Company.
  3.2(4)     --  Bylaws of the Company, as amended.
  4.1(1)     --  Specimen stock certificate evidencing the Common Stock.
  4.2(5)     --  Form of Amended and Restated Warrant.
  4.3(2)     --  Form of A Note.
  4.4(2)     --  Form of B Note.
  4.5(2)     --  Form of C Note.
  4.6(2)     --  Form of D Note.
  4.7(5)     --  Form of E Note.
  4.8(2)     --  Form of Securities Purchase Agreement, dated as of August
                 16, 1999, by and between the Company and each of the
                 Investors.
  4.9(5)     --  First Amendment to Securities Purchase Agreement, dated as
                 of January 14, 2000, by and between the Company and each of
                 the Investors.
</Table>

                                        21
<PAGE>   23

<Table>
<S>          <C>        <C>
    4.10(7)         --  Second Amendment to Securities Purchase Agreement, dated as of April 1, 2001, by and among
                        the Company and each of the Investors.
   10.1(1)          --  Form of Unit Franchise Agreement entered into by the Company and franchisees.
   10.2(6)          --  Amended and Restated 1999 Stock Incentive Plan of the Company.
   10.3(3)          --  Option Agreement, dated as of June 8, 1999, between Steven Mandell and Jack Futterman.
   10.4(3)          --  Stock Pledge Agreement, dated as of June 8, 1999, between Steven Mandell and Jack
                        Futterman.
   10.5(3)          --  Employment Agreement, dated as of June 8, 1999, between the Company and Jack Futterman.
   10.6(2)          --  Investor Rights Agreement, dated as of August 16, 1999, by and among the Company, the
                        Investors and Jack Futterman.
   10.7(2)          --  Standstill and Forbearance Agreement, dated as of August 16, 1999, by and among the
                        Company, PNC Bank, National Association, as Agent, and the Banks.
   10.8(2)          --  Vendor Forbearance and Standstill Agreement, dated as of August 16, 1999, by and among the
                        Company and the Trade Vendors.
   10.9(7)          --  First Amendment to Investor Rights Agreement, dated as of October 11, 2000, by and among
                        the Company, the Investors and Jack Futterman.
   10.10(7)         --  Second Amendment to Investor Rights Agreement, dated as of November 20, 2000, by and among
                        the Company, the Investors and Jack Futterman.
   10.11(5)         --  Loan and Security Agreement, dated January 14, 2000, by and between the Company and
                        Congress Financial Corporation.
   10.12(6)         --  Description of oral consulting agreement between the Company and Ralph Dillon.
   10.13(6)         --  Employment Agreement of James Shea, dated as of December 10, 1999, by and between the
                        Company and James Shea.
   10.14(6)         --  Employment Agreement of Andrew Bailen, dated as of August 7, 2000, by and between the
                        Company and Andrew Bailen.
   10.15(6)         --  Employment Agreement of Thomas Larson, dated as of June 18, 1999, by and between the
                        Company and Thomas Larson.
   10.16(8)         --  Management Stock Purchase Plan of the Company
   21.1             --  Subsidiaries. The wholly owned subsidiary of the Company is Party City Michigan, Inc.
                        incorporated on October 23, 1997, in the State of Delaware. This subsidiary does business
                        under the name Party City Michigan, Inc.
   23.1             --  Consent of Deloitte & Touche LLP.
</Table>

---------------

Notes

(1) Incorporated by reference to the Company's Registration Statement as amended
    on Form S-1 Number 333-00350 as filed with the Commission on January 18,
    1996.

(2) Incorporated by reference to the Company's Current Report on Form 8-K as
    filed with the Commission on August 25, 1999.

(3) Incorporated by reference to Amendment No. 1 to Schedule 13D as filed by
    Jack Futterman with the Commission on June 17, 1999.

(4) Incorporated by reference to the Company's Current Report on Form 8-K as
    filed with the Commission on June 8, 2000.

(5) Incorporated by reference to the Company's Current Report on Form 8-K as
    filed with the Commission on January 19, 2000.

                                        22
<PAGE>   24

(6) Incorporated by reference to the Company's Quarterly Report on Form 10-Q as
    filed with the Commission on February 13, 2001.

(7) Incorporated by reference to the Company's Quarterly Report on Form 10-Q as
    filed with the Commission on May 15, 2001.

(8) Incorporated by reference to the Registration of Form S-8 as filed with the
    Commission on July 23, 2001.

     (b) Reports on Form 8-K.

     No reports on Form 8-K have been filed during the fourth quarter.

                                        23
<PAGE>   25

                                   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, on September 25, 2001.

                                          PARTY CITY CORPORATION

                                          By:     /s/ THOMAS E. LARSON
                                            ------------------------------------
                                                      Thomas E. Larson
                                                  Chief Financial Officer

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

<Table>
<Caption>
                           NAME                                    TITLE                     DATE
                           ----                                    -----                     ----
<S>  <C>                                                <C>                           <C>

By:                  /s/ RALPH DILLON                   Non-Executive, Chairman of    September 25, 2001
        -----------------------------------------         the Board and Director
                       Ralph Dillon


By:                 /s/ JACK FUTTERMAN                           Director             September 25, 2001
        -----------------------------------------
                      Jack Futterman


By:                 /s/ MICHAEL GATTO                            Director             September 25, 2001
        -----------------------------------------
                      Michael Gatto


By:               /s/ L.R. JALENAK, JR.                          Director             September 25, 2001
        -----------------------------------------
                    L.R. Jalenak, Jr.


By:                /s/ HOWARD LEVKOWITZ                          Director             September 25, 2001
        -----------------------------------------
                     Howard Levkowitz


By:                  /s/ NANCY PEDOT                             Director             September 25, 2001
        -----------------------------------------
                       Nancy Pedot


By:                 /s/ WALTER SALMON                            Director             September 25, 2001
        -----------------------------------------
                      Walter Salmon


By:               /s/ MICHAEL TENNENBAUM                         Director             September 25, 2001
        -----------------------------------------
                    Michael Tennenbaum


By:                   /s/ JAMES SHEA                      Chief Executive Officer     September 25, 2001
        -----------------------------------------
                        James Shea


By:                /s/ THOMAS E. LARSON                   Chief Financial Officer     September 25, 2001
        -----------------------------------------
                     Thomas E. Larson


By:                 /s/ LINDA M. SILUK                   Chief Accounting Officer     September 25, 2001
        -----------------------------------------
                      Linda M. Siluk
</Table>

                                        24
<PAGE>   26

                          INDEPENDENT AUDITORS' REPORT

To the Board of Directors and Stockholders of
Party City Corporation
Rockaway, New Jersey

     We have audited the accompanying consolidated balance sheets of Party City
Corporation and subsidiary as of July 1, 2000 and June 30, 2001, and the related
consolidated statements of operations, stockholders' equity, and cash flows for
each of the three fiscal years ended December 31, 1998, July 1, 2000 and June
30, 2001 and the six month period ended July 3, 1999. 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 auditing standards generally
accepted in the United States of America. 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 Party City
Corporation and subsidiary as July 1, 2000 and June 30, 2001, and the
consolidated results of their operations and their cash flows for each of the
fiscal years ended December 31, 1998, July 1, 2000 and June 30, 2001 and the six
month period ended July 3, 1999 in conformity with accounting principles
generally accepted in the United States of America.

                                          DELOITTE & TOUCHE LLP

Parsippany, New Jersey
August 29, 2001

                                       F-1
<PAGE>   27

                     PARTY CITY CORPORATION AND SUBSIDIARY

                          CONSOLIDATED BALANCE SHEETS
                                 (IN THOUSANDS)

<Table>
<Caption>
                                                              JULY 1,    JUNE 30,
                                                                2000       2001
                                                              --------   --------
<S>                                                           <C>        <C>
                                     ASSETS
Current assets:
  Cash and cash equivalents.................................  $  3,950   $  9,842
  Merchandise inventory.....................................    42,030     48,034
  Deferred income taxes.....................................     5,976      3,798
  Advance merchandise payments..............................     2,419        623
  Other current assets, net.................................    14,384     11,533
                                                              --------   --------
          Total current assets..............................    68,759     73,830
Property and equipment, net.................................    41,447     46,351
Goodwill, net...............................................    14,844     13,647
Other assets................................................     7,036      7,514
                                                              --------   --------
          Total assets......................................  $132,086   $141,342
                                                              ========   ========
                      LIABILITIES AND STOCKHOLDERS' EQUITY
Current liabilities:
  Accounts payable..........................................  $ 30,190   $ 27,905
  Accrued expenses and other current liabilities............    18,397     26,274
  Senior Notes, current portion.............................     5,103     11,366
  Advances under Loan Agreement.............................        --         --
                                                              --------   --------
          Total current liabilities.........................    53,690     65,545
Long-term liabilities:
  Deferred rent and other long-term liabilities.............     7,988      8,701
  Senior Notes..............................................    29,547     16,006
Commitments and contingencies
Stockholders' equity:
  Common stock..............................................       127        127
  Additional paid-in capital................................    37,968     38,236
  Retained earnings.........................................     2,766     12,727
                                                              --------   --------
          Total stockholders' equity........................    40,861     51,090
                                                              --------   --------
          Total liabilities and stockholders' equity........  $132,086   $141,342
                                                              ========   ========
</Table>

          See accompanying notes to consolidated financial statements.

                                       F-2
<PAGE>   28

                     PARTY CITY CORPORATION AND SUBSIDIARY

                     CONSOLIDATED STATEMENTS OF OPERATIONS
                     (IN THOUSANDS, EXCEPT PER SHARE DATA)

<Table>
<Caption>
                                                             SIX MONTHS ENDED                  YEAR ENDED
                                      YEAR ENDED       ----------------------------   ----------------------------
                                   DECEMBER 31, 1998   JUNE 30, 1998   JULY 3, 1999   JULY 1, 2000   JUNE 30, 2001
                                   -----------------   -------------   ------------   ------------   -------------
                                                        (UNAUDITED)
<S>                                <C>                 <C>             <C>            <C>            <C>
Revenues:
  Net sales......................      $282,923           $92,718        $151,349       $349,722       $380,671
  Royalty fees...................        10,841             4,379           4,907         13,187         14,604
  Franchise fees.................           570               175             253            490            625
                                       --------           -------        --------       --------       --------
          Total revenues.........       294,334            97,272         156,509        363,399        395,900
Expenses:
  Cost of goods sold and
     occupancy costs.............       194,761            65,246         109,858        240,356        252,320
  Company-owned stores operating
     and selling expense.........        73,970            24,111          42,052         83,470         88,128
  Franchise expense..............         4,114             1,803           1,906          4,406          4,937
  General and administrative
     expense.....................        15,939             5,615          15,856         30,399         26,603
                                       --------           -------        --------       --------       --------
          Total expenses.........       288,784            96,775         169,672        358,631        371,988
                                       --------           -------        --------       --------       --------
Income (loss) before interest and
  income taxes...................         5,550               497         (13,163)         4,768         23,912
  Interest expense, net..........         2,636               873           2,378          8,423          7,949
                                       --------           -------        --------       --------       --------
Income (loss) before income
  taxes..........................         2,914              (376)        (15,541)        (3,655)        15,963
  Provision (benefit) for income
     taxes.......................         1,127              (146)         (2,125)        (4,636)         6,002
                                       --------           -------        --------       --------       --------
Net income (loss)................      $  1,787           $  (230)       $(13,416)      $    981       $  9,961
                                       ========           =======        ========       ========       ========
  Basic earnings (loss) per
     share.......................      $   0.14           $ (0.02)       $  (1.08)      $   0.08       $   0.78
                                       ========           =======        ========       ========       ========
     Weighted average shares
       outstanding -- basic......        12,411            12,376          12,455         12,611         12,723
                                       ========           =======        ========       ========       ========
  Diluted earnings (loss) per
     share.......................      $   0.14           $ (0.02)       $  (1.08)      $   0.07       $   0.56
                                       ========           =======        ========       ========       ========
     Weighted average shares
       outstanding -- diluted....        12,704            12,376          12,455         14,283         17,819
                                       ========           =======        ========       ========       ========
</Table>

          See accompanying notes to consolidated financial statements.

                                       F-3
<PAGE>   29

                     PARTY CITY CORPORATION AND SUBSIDIARY

                CONSOLIDATED STATEMENTS OF STOCKHOLDERS' EQUITY
                    (IN THOUSANDS, EXCEPT NUMBER OF SHARES)

<Table>
<Caption>
                                              COMMON STOCK       ADDITIONAL
                                          --------------------    PAID-IN-    RETAINED
                                            SHARES     AMOUNTS    CAPITAL     EARNINGS    TOTAL
                                          ----------   -------   ----------   --------   --------
<S>                                       <C>          <C>       <C>          <C>        <C>
Balance at January 1, 1998..............  12,300,095    $123      $32,246     $ 13,414   $ 45,783
Exercise of stock options...............     152,274       2          722           --        724
Tax effect of non-qualified options.....          --      --        1,074           --      1,074
Net income..............................          --      --           --        1,787      1,787
                                          ----------    ----      -------     --------   --------
Balance at December 31, 1998............  12,452,369     125       34,042       15,201     49,368
Exercise of stock options...............       3,169      --           33           --         33
Tax effect of non-qualified options.....          --      --          (51)          --        (51)
Net loss................................          --      --           --      (13,416)   (13,416)
                                          ----------    ----      -------     --------   --------
Balance at July 3, 1999.................  12,455,538     125       34,024        1,785     35,934
Issuance of common shares in exchange
  for professional services.............     266,667       2          798           --        800
Tax effect of non-qualified options.....          --      --          (10)          --        (10)
Issuance of warrants in connection with
  Senior Notes..........................          --      --        3,156           --      3,156
Net income..............................          --      --           --          981        981
                                          ----------    ----      -------     --------   --------
Balance at July 1, 2000.................  12,722,205     127       37,968        2,766     40,861
Exercise of stock options...............       1,250      --            4           --          4
Issuance of options as compensation.....          --      --          264           --        264
Net income..............................          --      --                     9,961      9,961
                                          ----------    ----      -------     --------   --------
Balance at June 30, 2001................  12,723,455    $127      $38,236     $ 12,727   $ 51,090
                                          ==========    ====      =======     ========   ========
</Table>

          See accompanying notes to consolidated financial statements.

                                       F-4
<PAGE>   30

                     PARTY CITY CORPORATION AND SUBSIDIARY

                     CONSOLIDATED STATEMENTS OF CASH FLOWS
                                 (IN THOUSANDS)

<Table>
<Caption>
                                                                       SIX MONTHS ENDED
                                                YEAR ENDED       ----------------------------
                                             DECEMBER 31, 1998   JUNE 30, 1998   JULY 3, 1999   JULY 1, 2000   JUNE 30, 2001
                                             -----------------   -------------   ------------   ------------   -------------
                                                                  (UNAUDITED)
<S>                                          <C>                 <C>             <C>            <C>            <C>
Cash flow from operating activities:
  Net income (loss)........................      $  1,787          $   (230)       $(13,416)      $    981       $  9,961
  Adjustments to reconcile net income
    (loss) to net cash provided by (used
    in) operating activities:
    Depreciation and amortization..........         6,598             2,730           5,229         10,757         10,431
    Impairment provision...................            --                --             300          1,172          2,275
    Non-cash interest and financing
      costs................................            --                --              --          1,506          1,815
    Deferred rent..........................         2,459             1,024           1,082            978          1,148
    Provision for doubtful accounts........           127                --             204            975            (65)
    Loss (gain) on disposition and sale of
      stores...............................            --                --             234          1,386           (131)
    Deferred tax asset.....................          (933)               (6)         (2,338)        (6,213)         1,543
    Issuance of options as compensation....            --                --              --             --            264
  Changes in assets and liabilities
    Merchandise inventory..................       (15,618)          (11,997)         11,897            186         (6,606)
    Refundable income taxes................            --              (230)         (6,848)         6,084           (702)
    Advance merchandise payments...........            --                --          (9,439)         7,069          1,796
    Other current assets...................        (1,201)           (4,575)         (4,047)        (2,642)         3,580
    Other assets...........................          (639)             (627)            331           (223)          (833)
    Accounts payable.......................         6,919            (2,116)         16,540        (22,417)        (2,284)
    Accrued expenses.......................         1,879            (2,179)            972          4,742          7,965
    Income taxes payable...................        (3,080)           (3,080)             --             --             --
    Other current liabilities..............          (365)             (468)            167          5,299           (176)
    Other long-term liabilities............          (630)               --             (89)          (306)          (326)
                                                 --------          --------        --------       --------       --------
      Net cash provided by (used in)
        operating activities...............        (2,697)          (21,754)            779          9,334         29,655
Cash flow from investment activities:
  Purchases of property and equipment......       (30,638)          (10,598)         (5,970)        (4,109)       (16,305)
  Proceeds from sales of stores............            --                --              --         10,293          1,157
  Stores acquired..........................        (8,456)           (2,234)         (1,963)            --           (516)
                                                 --------          --------        --------       --------       --------
      Net cash provided by (used in)
        investing activities...............       (39,094)          (12,832)         (7,933)         6,184        (15,664)
Cash flow from financing activities:
  Net proceeds from sale of stock..........            --                --              --            800             --
  Proceeds from issuance of (payments on)
    Senior Notes and warrants..............            --                --              --         37,000         (8,103)
  Debt issue costs.........................            --                --              --         (2,278)            --
  Proceeds from exercise of stock
    options................................           724               549              33             --              4
  Tax effect of non-qualified stock
    options................................         1,074                --             (51)           (10)            --
  Net proceeds from (payments on) Credit
    Agreement..............................        43,650            35,891          11,750        (58,550)            --
                                                 --------          --------        --------       --------       --------
Net cash provided by (used in) financing
  activities...............................        45,448            36,440          11,732        (23,038)        (8,099)
                                                 --------          --------        --------       --------       --------
Net increase (decrease) in cash and cash
  equivalents..............................         3,657             1,854           4,578         (7,520)         5,892
Cash and cash equivalents, beginning of
  period...................................         3,235             3,235           6,892         11,470          3,950
                                                 --------          --------        --------       --------       --------
Cash and cash equivalents, end of period...      $  6,892          $  5,089        $ 11,470       $  3,950       $  9,842
                                                 ========          ========        ========       ========       ========
Supplemental disclosure of cash flow
  information:
  Income taxes paid........................      $  3,433          $  3,207        $  2,469       $    653       $  5,315
  Interest paid............................         2,402               469           2,781          5,443          6,648
</Table>

          See accompanying notes to consolidated financial statements.
                                       F-5
<PAGE>   31

                     PARTY CITY CORPORATION AND SUBSIDIARY

                   NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

1.  SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES

  CONSOLIDATED FINANCIAL STATEMENTS

     Party City Corporation (the "Company") is incorporated in the State of
Delaware and operates retail party supplies stores within the continental United
States and sells franchises on an individual store and area franchise basis
throughout the United States, Puerto Rico, Spain, Portugal and Canada. At
September 17, 2001, the Company had 198 Company-owned stores and 272 franchise
stores in its network. The consolidated financial statements of the Company
include the accounts of the Company and its wholly-owned subsidiary, Party City
Michigan, Inc. All significant intercompany balances and transactions have been
eliminated.

     The Company's fiscal year ends on the Saturday nearest June 30. As used
herein, the term "Fiscal Year" refers to the 52 or 53 weeks ending the Saturday
nearest to June 30, unless otherwise noted.

  CASH AND CASH EQUIVALENTS

     The Company considers its highly liquid investments purchased as part of
daily cash management activities to be cash equivalents.

  FAIR VALUE OF FINANCIAL INSTRUMENTS

     Financial instruments consist of cash equivalents, accounts receivable,
accounts payable and debt obligations. The carrying amounts reported in the
balance sheets of such financial instruments approximate their fair market
values due to their short-term maturity.

  MERCHANDISE INVENTORY

     The Company values its inventory at the lower of average cost (which
approximates FIFO) or market. Provision for slow moving inventory is charged to
operations in the period in which such estimates are determined by management.

  ADVANCE MERCHANDISE PAYMENTS

     As of June 30, 2001, the Company had $623,000 in deposits with those
vendors who required partial advanced payments prior to shipment. At July 1,
2000, the Company had $2.4 million in cash-in-advance payments to facilitate the
ordering process for vendors providing limited credit.

  ADVERTISING FUND

     Pursuant to its franchise agreements, the Company collects 1% of the net
sales of its franchise stores for contribution into the Advertising Fund (the
"Ad Fund"). The Company also contributes 1% of net sales of its owned stores
into the Ad Fund. These amounts are restricted in their use for advertising.
Receipts and disbursements are not recorded as income or expense since the
Company does not have full discretion over the use of the funds. To cover the
expenses of fund administration, the Company charges the Ad Fund a management
fee equal to 5% of the funds contributed by franchisees. For the year ended
December 31, 1998, the six month periods ended June 30, 1998 (unaudited) and
July 3, 1999, and the years ended July 1, 2000 and June 30, 2001, Ad Fund
management fees of $278,000, $101,000, $139,000, $360,000 and $401,000,
respectively, were collected by the Company and credited to general and
administrative expense.

  PROPERTY AND EQUIPMENT

     Property and equipment are recorded at cost. Depreciation and amortization
are provided using the straight-line method over the estimated useful lives of
the assets or, where applicable, the terms of the

                                       F-6
<PAGE>   32
                     PARTY CITY CORPORATION AND SUBSIDIARY

           NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED)

respective leases, whichever is shorter. The Company uses estimated useful lives
of five to seven years for furniture, fixtures and equipment. Capitalized
software costs are amortized on a straight-line basis over their estimated lives
of three to five years, beginning in the year the assets were placed into
service.

     Maintenance and repairs are charged directly to expense as incurred. Major
renewals or replacements of fixed assets are capitalized after making the
necessary adjustments to the asset and accumulated depreciation of the items
renewed or replaced.

  IMPAIRMENT OF LONG-LIVED ASSETS AND INTANGIBLES

     The Company follows Statement of Financial Accounting Standards ("SFAS")
No. 121, Accounting for the Impairment of Long-Lived Assets and for Long-Lived
Assets to Be Disposed Of, which requires impairment losses to be recorded on
long-lived assets used in operations when indicators of impairment are present
and the undiscounted cash flows estimated to be generated by those assets are
less than the assets' carrying amount. In evaluating the fair value and future
benefits of long-lived assets, the Company performs an analysis of the
anticipated undiscounted future net cash flows of the related long-lived assets
and reduces their carrying value by the excess, if any, of the result of such
calculation. In fiscal 2001, the Company recorded an impairment charge of $2.3
million related to store registers replaced in the Company's information system
initiative. In fiscal 2000 and the 1999 period, the Company recorded an
impairment charge of $1.2 million and $300,000 related to long-lived assets in
certain underperforming stores, respectively. Management believes at this time
that the carrying value and useful life of goodwill and fixed assets continue to
be appropriate.

  INTANGIBLES

     Trademarks, which are included in other assets, consist primarily of
capitalized legal costs and are being amortized using the straight-line method
over the estimated useful lives of the assets. The excess of purchase price over
the fair value of the net assets acquired in connection with the purchase of
stores ("goodwill") is being amortized on a straight-line basis over 15 years.
At July 1, 2000 and June 30, 2001 the cost of goodwill was $18.1 million.

  DEFERRED RENT

     The Company accounts for scheduled rent increases contained in its leases
on a straight-line basis over the noncancelable lease term.

  INCOME TAXES

     The Company files a consolidated Federal income tax return. Separate state
income tax returns are filed with each state in which the Company conducts
business. The Company accounts for its income taxes using the asset and
liability method. Deferred tax assets and liabilities are recognized for the
future tax consequences attributable to the 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 year 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 earnings in the period
that includes the enactment date.

  STOCK OPTIONS

     As permitted under SFAS No. 123, "Accounting for Stock-Based Compensation,"
the Company has elected not to adopt the fair value based method of accounting
for its stock-based compensation plans. The Company will continue to apply the
provisions of Accounting Principles Board ("APB") Opinion No. 25,

                                       F-7
<PAGE>   33
                     PARTY CITY CORPORATION AND SUBSIDIARY

           NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED)

"Accounting for Stock Issued to Employees." The Company has complied with the
disclosure requirements of SFAS No. 123.

  EARNINGS PER SHARE

     Basic earnings per share is computed by dividing net income by the
weighted-average number of common shares outstanding for the period. Diluted
earnings per common share also includes the dilutive effect of potential common
shares (dilutive stock options and warrants) outstanding during the period.

  REVENUE RECOGNITION

     The Company operates predominately as a retailer through its Company owned
stores. The retail segment recognizes revenue at the point of sale. Allowances
for sales returns are recorded as a component of net sales in the periods in
which the related sales are recognized.

     The Company's franchise segment generates revenues through franchise fees
and royalties. Revenue from individual franchise sales, recorded as franchise
fees, is recognized by the Company upon completion of certain initial services,
which normally coincide with the opening of the franchisee's store. The Company
is obligated in accordance with the terms of each franchisee's respective
agreement to provide the following initial services: advice on site location,
store design and layout, training and pre-opening assistance. On an ongoing
basis, the Company provides assistance regarding sources of supply, pricing,
advertising and promotion programs and other defined assistance. Royalty fees
are recorded on a monthly basis as a percentage of the franchisee's net sales.

     Area franchise sales represent agreements with franchisees to open a
specified number of franchises within defined geographic areas and development
periods. The Company's policy is to receive a deposit in advance for each of the
potential stores, based on its standard initial franchise fee at the time the
contract is signed. Upon receipt, the deposit is recorded as deferred revenue.
When the Company satisfies its initial obligations to the franchisee and the
store is opened, the Company recognizes the deposit as revenue. The Company has
opened 261 and 211 franchise stores at June 30, 2001 and July 1, 2000,
respectively.

  STORE OPENING COSTS

     New store opening costs are expensed as incurred.

  ADVERTISING COSTS

     The costs associated with store advertising are expensed in the period in
which the related promotion and sales occur. Advertising expense was
approximately $16.0 million, $4.3 million, $7.4 million, $17.2 million and $17.8
million for the year ended December 31, 1998, the six month periods ended June
30, 1998 (unaudited) and July 3, 1999, and the year ended July 1, 2000 and June
30, 2001, respectively.

  EFFECT OF NEW ACCOUNTING STANDARDS

     Emerging Issues Task Force Issue 00-10, "Accounting for Shipping and
Handling Fees and Costs" requires that all amounts billed to a customer in a
sale transaction related to shipping and handling, if any, should be classified
as revenue. The adoption of this statement does not have an impact on the
consolidated financial statements.

                                       F-8
<PAGE>   34
                     PARTY CITY CORPORATION AND SUBSIDIARY

           NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED)

     In June 2001, the Financial Accounting Standards Board ("FASB") issued two
new pronouncements: Statement of Financial Accounting Standards ("SFAS") No.
141, Business Combinations, and SFAS No. 142, Goodwill and Other Intangible
Assets.

     SFAS No. 141 addresses financial accounting and reporting for business
combinations and supersedes APB No. 16 "Business Combinations" and FASB
Statement No. 38, "Accounting for Preacquisition Contingencies of Purchased
Enterprises". All business combinations in the scope of this Statement are to be
accounted for using one method, the purchase method. SFAS 141 is effective as
follows: a) use of the pooling-of-interest method is prohibited for business
combinations initiated after June 30, 2001; and b) the provisions of SFAS 141
also apply to all business combinations accounted for by the purchase method
that are completed after June 30, 2001 (that is, the date of the acquisition is
July 2001 or later). The Company believes that the adoption of this statement
will not have an impact on the consolidated financial statements.

     SFAS No. 142 addresses financial accounting and reporting for acquired
goodwill and other intangible assets and supersedes APB No. 17, "Intangible
Assets". It changes the accounting for goodwill from an amortization method to
an impairment only approach. SFAS 142 is effective for fiscal years beginning
after December 15, 2001 to all goodwill and other intangible assets recognized
in an entity's statement of financial position at that date, regardless of when
those assets were initially recognized. The Company is evaluating the impact of
adopting these pronouncements on the consolidated financial statements. The
amortization of goodwill for the year ended June 30, 2001 was $1.2 million.

  SEASONALITY

     The Company's business is subject to substantial seasonal variations.
Historically, the Company has realized a significant portion of its net sales
during the fourth calendar quarter of the year, principally due to the sales in
October for the Halloween season and, to a lesser extent, due to sales for end
of year holidays. The Company's results of operations may also fluctuate
significantly as a result of a variety of other factors, including the timing of
new store openings, store closings and store sales. The Company believes this
general pattern will continue in the future.

  USE OF ESTIMATES

     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. Significant estimates include provision for slow-moving inventory,
liability for incurred but not reported medical claims and accrued workers
compensation claims.

  CONCENTRATION

     The Company has three suppliers who in the aggregate constituted
approximately 38% of the Company's purchases for the year ended June 30, 2001.
The loss of any of these suppliers would adversely affect the Company's
operations.

  RECLASSIFICATIONS

     Certain reclassifications have been made to the consolidated financial
statements in prior periods to conform to the current period presentation.

2.  ACQUISITIONS AND DISPOSITION OF STORES

     In June 1999, one store with a net book value of approximately $400,000,
was sold to a franchisee for $370,000. In the first quarter of Fiscal Year 2000,
an additional 17 stores with a net book value of $9.4 million,

                                       F-9
<PAGE>   35
                     PARTY CITY CORPORATION AND SUBSIDIARY

           NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED)

were sold to franchisees for total proceeds of approximately $9.5 million. In
connection with the sales, normal royalty fees were waived for negotiated
periods up to five years. The net proceeds from the sale of stores was used to
pay down the outstanding borrowings under the Credit Agreement. Losses of $1.4
million and deferred royalty income of $1.1 million were recognized on the sales
of the stores in Fiscal Year 2000. In Fiscal 2000, the Company sold an
additional store to a franchisee and recognized a gain of $75,000. The losses
were included in general and administrative expenses in the consolidated
statement of operations. See Note 12 -- Related Party Transactions. In October
2000, the Company signed an agreement with The Party Supermarket, Inc. ("Party
Supermarket") whereby Party Supermarket would become a franchisee. Under that
agreement, Party Supermarket purchased three stores in Florida from the Company
for approximately $1.2 million. A gain of $131,000 was recorded by the Company
on this sale.

3.  OTHER CURRENT ASSETS, NET

     Other current assets consist of the following (in thousands):

<Table>
<Caption>
                                                              JULY 1,   JUNE 30,
                                                               2000       2001
                                                              -------   --------
<S>                                                           <C>       <C>
Restricted cash from advertising fund.......................  $ 1,495   $ 1,476
Receivables from franchisees:
  Royalty fees..............................................    1,818     1,934
  Other.....................................................      706       316
Prepaid expenses and other current assets...................   11,282     8,659
                                                              -------   -------
                                                               15,301    12,385
Less: Allowance for doubtful accounts.......................     (917)     (852)
                                                              -------   -------
                                                              $14,384   $11,533
                                                              =======   =======
</Table>

4.  PROPERTY AND EQUIPMENT

     Property and equipment consists of the following (in thousands):

<Table>
<Caption>
                                                              JULY 1,    JUNE 30,
                                                                2000       2001
                                                              --------   --------
<S>                                                           <C>        <C>
Equipment...................................................  $ 26,506   $ 35,852
Furniture...................................................    22,190     22,060
Leasehold improvements......................................    14,949     16,689
                                                              --------   --------
                                                                63,645     74,601
Less: accumulated depreciation..............................   (22,198)   (28,250)
                                                              --------   --------
                                                              $ 41,447   $ 46,351
                                                              ========   ========
</Table>

5.  OTHER ASSETS

     Other assets consist of the following (in thousands):

<Table>
<Caption>
                                                              JULY 1,   JUNE 30,
                                                               2000       2001
                                                              -------   --------
<S>                                                           <C>       <C>
Deferred income taxes.......................................  $4,462     $5,097
Loan commitment fees and other..............................   2,574      2,417
                                                              ------     ------
                                                              $7,036     $7,514
                                                              ======     ======
</Table>

                                       F-10
<PAGE>   36
                     PARTY CITY CORPORATION AND SUBSIDIARY

           NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED)

6.  ACCRUED EXPENSES AND OTHER CURRENT LIABILITIES

     Accrued expenses and other current liabilities consist of the following (in
thousands):

<Table>
<Caption>
                                                              JULY 1,   JUNE 30,
                                                               2000       2001
                                                              -------   --------
<S>                                                           <C>       <C>
Accrued compensation........................................  $ 3,422   $ 6,896
Sales and use taxes.........................................    1,402     1,681
Other.......................................................   13,573    17,697
                                                              -------   -------
                                                              $18,397   $26,274
                                                              =======   =======
</Table>

7.  FINANCING AGREEMENTS

     As of June 30, 2001, the Company had no balance outstanding under its Loan
and Security Agreement dated January 14, 2000 (the "Loan Agreement"), with
Congress Financial Corporation. Under the terms of the Loan Agreement, the
Company may from time to time borrow, based on a percentage of its eligible
inventory, up to a maximum of $40 million at any time outstanding. Advances bear
interest, at the Company's option, (i) at the adjusted Eurodollar rate plus the
applicable margin, which was 2.75% per annum (subject to possible reduction to
an interest rate as low as 2.25% from and after June 30, 2001, based on the
Company's pre-tax income and excess availability) or (ii) at the rate of 3/4%
per annum above the prime rate, totaling 7.75% at June 30, 2001. The term of the
Loan Agreement is three years with yearly renewals thereafter and is secured by
a lien on substantially all of the assets of the Company. At September 17, 2001,
there was $4.4 million outstanding and $35.6 million available to be borrowed
under the Loan Agreement.

     On August 17, 1999, the Company received $30 million in financing from the
Investors, who purchased senior secured notes and warrants pursuant to the
Securities Purchase Agreement. Under the Purchase Agreement, the Company issued
(i) $10 million of its 12.5% Secured Notes due 2003 (the "A Notes"); (ii) $5
million of its 13.0% Secured Notes due 2003 (the "B Notes"); (iii) $5 million of
its 13.0% Secured Notes due 2002 (the "C Notes"); (iv) $10 million of its 14.0%
Secured Notes due 2004 (the "D Notes" and, together with the A Notes, the B
Notes and the C Notes, the "Notes"); and (v) warrants (the "Warrants") to
purchase 6,880,000 shares of the Company's common stock at an initial exercise
price of $3.00 per share. The Warrants were valued at $2.0 million based on
management's estimate using certain fair value methodologies and represent an
original issue discount to the C Notes and D Notes. The Notes are secured by a
junior lien on substantially all of the Company's assets. The Company issued the
Warrants in connection with the sale of the C Notes and the D Notes. The
Warrants may be exercised on or before the close of business on August 16, 2006.
The shares of common stock reserved for issuance under the Warrants represented
approximately 35% of the shares of common stock outstanding at the time of
issuance after giving effect to the full exercise of the Warrants. The proceeds
from the $30 million in new financing were used for the purchase of seasonal
inventory, the payment of amounts due under the Company's previous Credit
Agreement, certain transaction fees and working capital.

     Pursuant to the First Amendment, on January 14, 2000, the Company received
$7 million in cash proceeds from the sale to certain of the Investors (the
"Investor Group") of a new series of senior secured notes. Under the First
Amendment, the Company issued $7 million in aggregate principal amount of its
14.0% Secured Notes due 2002 (the "E Notes"). The E Notes are secured by a lien
on substantially all of the Company's assets. Under the terms of the First
Amendment, the interest rate on the A Notes, the B Notes, the C Notes and the D
Notes was increased by 4.5%. The Investor Group, together with the Investors and
Congress, entered into an intercreditor agreement. In consideration for waivers
and forbearances granted by the Investors to various defaults under the terms of
the Company's A Notes, B Notes, C Notes and D Notes, the Company also agreed to
amend and restate the terms of the Warrants held by the Investors to acquire
6,880,000 shares of the Company's common stock. The amended and restated
warrants (the "Amended Warrants") provide for an exercise price of $1.07 per
share and were issued upon surrender of the Warrants,

                                       F-11
<PAGE>   37
                     PARTY CITY CORPORATION AND SUBSIDIARY

           NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED)

which had an exercise price of $3.00 per share. The Amended Warrants were valued
at $3.2 million based on management's estimate using certain fair value
methodologies and represent an original issue discount to the C Notes and D
Notes. This discount is being amortized using the effective interest method. The
effective yield is 28.6% and 28.9% on the C Notes and D Notes, respectively.

     As of June 30, 2001, the Company had approximately $29.5 million in notes
payable to investors. The Company made a required payment of $5.1 million due on
these notes in January 2001. An additional $3.0 million (due in January 2002)
was prepaid in June 2001. The Company expensed approximately $100,000 in the
write-off of debt-issue costs, included in interest expense, related to this
prepayment.

     The Company was in violation of a covenant under the Securities Purchase
Agreements (as amended) related to the amount of capital expenditures during the
fiscal year ended June 30, 2001. The Company exceeded the capital expenditures
limit primarily because of additional costs related to expanded functionality in
the merchandise management system to be implemented in Fiscal Year 2002. The
Company received a waiver from the Investors for this violation.

     The amounts of each Note outstanding are as follows:

<Table>
<Caption>
                                                                     JULY 1,   JUNE 30,
NOTE                                       DESCRIPTION                2000       2001
----                           -----------------------------------   -------   --------
<S>                            <C>                                   <C>       <C>
Series A                       12.5% Secured Notes due 2003          $10,207   $  5,104
Series B                       13.0% Secured Notes due 2003            5,103      5,103
Series C                       13.0% Secured Notes due 2002            5,103      5,103
Series D                       14.0% Secured Notes due 2004           10,207     10,207
Series E                       14.0% Senior Secured Notes due 2002     7,000      4,000
                                                                     -------   --------
                                                                      37,620     29,517
                               Unamortized debt discount              (2,970)    (2,145)
                               Less: Current portion, net of debt
                               discount                               (5,103)   (11,366)
                                                                     -------   --------
                                                                     $29,547   $ 16,006
                                                                     =======   ========
</Table>

     As of June 30, 2001, the aggregate maturities of Senior Notes are due as
follows:

<Table>
<Caption>

<S>                                                           <C>
January 2002................................................  $11,655
January 2003................................................    7,655
January 2004................................................   10,207
                                                              -------
                                                               29,517
Less: Unamortized debt discount.............................   (2,145)
                                                              -------
                                                              $27,372
                                                              =======
</Table>

                                       F-12
<PAGE>   38
                     PARTY CITY CORPORATION AND SUBSIDIARY

           NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED)

8.  EARNINGS PER SHARE

     The following table sets forth the computations of basic and diluted
earnings per share (in thousands, except per share amounts):

<Table>
<Caption>
                                                        SIX MONTHS ENDED            YEAR ENDED
                                      YEAR ENDED    ------------------------   ---------------------
                                     DECEMBER 31,    JUNE 30,      JULY 3,      JULY 1,     JUNE 30,
                                         1998          1998          1999         2000        2001
                                     ------------   -----------   ----------   ----------   --------
                                                    (UNAUDITED)
<S>                                  <C>            <C>           <C>          <C>          <C>
Net income (loss)..................    $  1,787      $   (230)    $  (13,416)  $      981   $  9,961
Average shares outstanding.........      12,411        12,376         12,455       12,611     12,723
Earnings (loss) per
  share -- basic...................    $   0.14      $  (0.02)    $    (1.08)  $     0.08   $   0.78
Dilutive effect of stock options...         293            (a)            (a)          13        244
Dilutive effect of warrants........          --            --             --        1,659      4,852
Average common and common
  equivalent shares outstanding....      12,704        12,376         12,455       14,283     17,819
Earnings (loss) per
  share -- diluted.................    $   0.14      $  (0.02)    $    (1.08)  $     0.07   $   0.56
Options excluded from dilutive
  calculation......................     134,000       973,976      1,026,826    1,150,064    907,794
</Table>

---------------

(a) In periods with losses, options were excluded from the computation of
    diluted earnings per share because they would be antidilutive.

     Options to purchase common shares at prices ranging from $1.67 to $30.50
per share were outstanding but were not included in the computation of dilutive
earnings per share because to do so would have been anti-dilutive for the
periods presented.

9.  STOCKHOLDERS' EQUITY AND STOCK OPTIONS

     The Company has 25,000,000 shares authorized of its $.01 par value common
stock. Shares issued and outstanding were 12,722,205, and 12,723,455 at July 1,
2000 and June 30, 2001, respectively.

     On October 19, 1999, the Company's board of directors adopted the Company's
1999 Stock Incentive Plan ("1999 Plan"). This adoption was approved by the
company's stockholders on November 15, 1999. A total of 500,000 shares of the
Company's common stock were reserved for issuance under the 1999 Plan.

     On October 5, 2000, the Board approved an amendment and restatement of the
1999 Plan, increasing the number of shares of common stock reserved for issuance
thereunder from 500,000 to 2,000,000. This adoption was approved by the
Company's stockholders on November 15, 2000. A total of 2,000,000 shares are
reserved for issuance under the 1999 Plan.

     The purpose of the 1999 Plan is to promote the long-term financial success
of the Company by enhancing the ability of the Company to attract, retain and
reward individuals who can and do contribute to such success and to further
align the interest of the Company's key personnel with its stockholders. Key
employees, directors and consultants of the Company and its subsidiary are
eligible to receive options under 1999 Plan.

     The 1999 Plan provides for the grants of options and restricted stock and
other stock-based awards as the compensation committee of the board of directors
may from time to time deem appropriate. Such awards include stock appreciation
rights, phantom stock awards, bargain purchase of stock and stock bonuses.
Vesting and other terms of stock options awarded are set out in the agreements
between the Company and the individuals receiving such awards. The exercise
price of the options is determined by the compensation committee at the time of
grant and will not be less than the fair market value of the Company's common
stock

                                       F-13
<PAGE>   39
                     PARTY CITY CORPORATION AND SUBSIDIARY

           NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED)

on the date of grant. Options granted under the 1999 Plan vest over four to
seven years from date of grant, and expire in ten years.

     The Company also maintains the Amended and Restated 1994 Stock Option Plan
("1994 Plan") pursuant to which options were granted to employees, directors and
consultants for the purchase of common stock of the company. The 1994 Plan, as
amended, permitted the Company to grant incentive and non-qualified stock
options to purchase a total of 1,800,000 shares of the company's common stock.
The exercise price was not less than the fair value at date of grant. On
September 4, 2000, the 1994 Plan terminated. From that time forward, no
additional grants of options under the 1994 Plan are permitted. The original
terms of the agreements between the Company and the individuals receiving the
grants under the 1994 Plan with respect to vesting, expiration and exercise
price remain unchanged.

     During Fiscal 2001, the Company established a Management Stock Purchase
Plan ("MSPP"). The MSPP is designed to provide a means through which the Company
may attract highly qualified persons to enter into and remain in the employ of
the Company. In addition, the MSPP provides a means whereby employees of the
Company can defer a portion of their compensation to be used to acquire and
maintain ownership of the Company's common stock, thereby strengthening their
commitment to the welfare of the Company and promoting an identity of interest
among Company stockholders and these employees. The amount deferred by the
individual is held in restricted stock units. These restricted stock units are
purchased at a discount of 20% or 25% depending on the amount of the individual
deferral from the average price of Company's common stock on the determination
date. Such discounts vest at the end of three years after the determination
date. The amortization of the discount is charged to compensation expense over
the three-year period. There was no compensation expense attributable to fiscal
2001 for the MSPP.

     During Fiscal 2001, the Company established an Employee Stock Purchase Plan
("ESPP"). The ESPP provides employees of the Company with an opportunity to
purchase shares of the Company's commons stock at a discount of 15% through
accumulated payroll deductions. It is the intention of the Company to have this
plan qualify as an " Employee Stock Purchase Plan" under Section 423 of the
Code.

                                       F-14
<PAGE>   40
                     PARTY CITY CORPORATION AND SUBSIDIARY

           NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED)

     The following tables summarize information about stock option transactions
for the 1999 and 1994 Plan:

<Table>
<Caption>
                                                                             WEIGHTED
                                                              NUMBER     AVERAGE EXERCISE
                                                             OF SHARES        PRICE
                                                             ---------   ----------------
<S>                                                          <C>         <C>
Balance at December 31, 1997...............................    997,025        $10.51
Granted....................................................    453,000         19.73
Exercised..................................................   (152,274)         4.75
Canceled...................................................   (203,000)        20.37
                                                             ---------        ------
Balance at December 31, 1998...............................  1,094,751         13.30
Granted....................................................     74,500          5.38
Exercised..................................................     (3,175)        10.41
Canceled...................................................   (139,250)        15.25
                                                             ---------
Balance at July 3, 1999....................................  1,026,826         12.47
Granted....................................................    780,250          2.28
Canceled...................................................   (285,950)        12.23
                                                             ---------
Balance at July 1, 2000....................................  1,521,126          7.29
Granted....................................................    398,000          4.14
Exercised..................................................     (1,250)         3.00
Canceled...................................................   (266,500)         8.62
                                                             ---------
Balance at June 30, 2001...................................  1,651,376          6.29
                                                             =========
Options Exercisable at:
December 31, 1997..........................................    244,650          7.82
December 31, 1998..........................................    352,251         10.55
July 3, 1999...............................................    448,701         11.10
July 1, 2000...............................................    559,123         11.34
June 30, 2001..............................................    839,316          8.49
</Table>

<Table>
<Caption>
                                                 OPTIONS OUTSTANDING
                                       ---------------------------------------      OPTIONS EXERCISABLE
                                                         WEIGHTED                -------------------------
                                                          AVERAGE     WEIGHTED                    WEIGHTED
                                           NUMBER        REMAINING    AVERAGE        NUMBER       AVERAGE
                                       OUTSTANDING AT   CONTRACTUAL   EXERCISE   EXERCISABLE AT   EXERCISE
RANGE OF EXERCISE PRICES               JUNE 30, 2001       LIFE        PRICE     JULY 30, 2001     PRICE
------------------------               --------------   -----------   --------   --------------   --------
<S>                                    <C>              <C>           <C>        <C>              <C>
$1.71 to $2.00                             476,000         8.45        $ 1.99       174,832        $ 1.99
$2.25 to $3.40                             359,875         8.86          3.14        64,194          3.05
$3.49 to $9.94                             357,150         8.31          5.43       231,358          6.02
$10.00 to $13.94                           303,976         5.72         10.58       232,976         10.49
14.33 to $32.50                            154,375         6.60         20.45       135,956         20.21
                                         ---------         ----        ------       -------        ------
$1.71 to $32.50                          1,651,376         7.83        $ 6.29       839,316        $ 8.49
</Table>

     The Company measures compensation cost under APB No. 25, "Accounting for
Stock Issued to Employees." Accordingly, no compensation cost has been
recognized in connection with the 1999 and 1994 Plan in the accompanying
consolidated financial statements. In accordance with SFAS No. 123, "Accounting

                                       F-15
<PAGE>   41
                     PARTY CITY CORPORATION AND SUBSIDIARY

           NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED)

for Stock-Based Compensation," the fair value of each option grant is estimated
on the date of grant using the Black-Scholes option-pricing model using the
following assumptions for grants in the respective periods:

<Table>
<Caption>
                                                          SIX MONTHS ENDED            YEAR ENDED
                                         YEAR ENDED    -----------------------   ---------------------
                                        DECEMBER 31,    JUNE 30,      JULY 3,     JULY 1,    JUNE 30,
                                            1998          1998         1999        2000        2001
                                        ------------   -----------   ---------   ---------   ---------
                                                       (UNAUDITED)
<S>                                     <C>            <C>           <C>         <C>         <C>
Expected volatility...................        100%           100%         120%        137%         97%
Expected lives........................   5.0 years      5.0 years    5.0 years   5.0 years   4.0 years
Risk-free interest rate...............        5.2%           5.2%         5.5%        6.2%        4.3%
Expected dividend yield...............          0%             0%           0%          0%          0%
</Table>

     Set forth below are the Company's net income (loss) and earnings (loss) per
share presented "as reported" and pro forma as if compensation cost had been
recognized in accordance with the provisions of SFAS No. 123 (in thousands,
except per share data):

<Table>
<Caption>
                                                             SIX MONTHS ENDED          YEAR ENDED
                                            YEAR ENDED    ----------------------   ------------------
                                           DECEMBER 31,    JUNE 30,     JULY 3,    JULY 1,   JUNE 30,
                                               1998          1998         1999      2000       2001
                                           ------------   -----------   --------   -------   --------
                                                          (UNAUDITED)
<S>                                        <C>            <C>           <C>        <C>       <C>
Net income (loss):
  As reported............................     $1,787        $ (230)     $(13,416)  $  981     $9,961
  Pro-forma..............................        174          (963)      (14,252)    (383)     8,895
Basic earnings (loss) per share:
  As reported............................     $ 0.14        $(0.02)     $  (1.08)  $ 0.08     $ 0.78
  Pro-forma..............................       0.01         (0.08)        (1.14)   (0.03)      0.70
Diluted earnings (loss) per share:
  As reported............................     $ 0.14        $(0.02)     $  (1.08)  $ 0.07     $ 0.56
  Pro-forma..............................       0.01         (0.08)        (1.14)   (0.03)      0.50
</Table>

10.  INCOME TAXES

     The provision for income tax expense (benefit) consists of the following
(in thousands):

<Table>
<Caption>
                                                            SIX MONTHS ENDED          YEAR ENDED
                                            YEAR ENDED    ---------------------   ------------------
                                           DECEMBER 31,    JUNE 30,     JULY 3,   JULY 1,   JUNE 30,
                                               1998          1998        1999      2000       2001
                                           ------------   -----------   -------   -------   --------
                                                          (UNAUDITED)
<S>                                        <C>            <C>           <C>       <C>       <C>
Current:
  Federal................................     $1,721         $(127)     $   310   $ 1,575    $3,720
  State..................................        339           (13)         (97)        2       470
  Foreign................................         --            --           --        --       269
                                              ------         -----      -------   -------    ------
                                               2,060          (140)         213     1,577     4,459
Deferred:
  Federal................................       (796)           (6)      (2,642)   (4,787)    1,154
  State..................................       (137)           --          304    (1,426)      389
                                              ------         -----      -------   -------    ------
                                                (933)           (6)      (2,338)   (6,213)    1,543
                                              ------         -----      -------   -------    ------
                                              $1,127         $(146)     $(2,125)  $(4,636)   $6,002
                                              ======         =====      =======   =======    ======
</Table>

                                       F-16
<PAGE>   42
                     PARTY CITY CORPORATION AND SUBSIDIARY

           NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED)

     Deferred income taxes reflect the net tax effects of temporary differences
between the carrying value of assets and liabilities for financial reporting
purposes and amounts used for income tax purposes. In the six month period ended
July 3, 1999, the Company recorded a valuation allowance on certain of the
Company's deferred tax assets due to uncertainties associated with generating
taxable income needed to recover such assets. As of July 1, 2000, the Company
recognized $3.7 million related to the reversal of such valuation reserves
because the Company believed it was more likely than not that such deferred tax
assets would be recognized.

     Significant components of the net deferred tax asset at July 1, 2000 and
June 30, 2001 are as follows (in thousands):

<Table>
<Caption>
                                                              JULY 1,   JUNE 30,
                                                               2000       2001
                                                              -------   --------
<S>                                                           <C>       <C>
Current:
  Inventory.................................................  $ 2,813   $ 2,861
  Vacation pay accrual......................................      188       457
  Reserves not currently deductible.........................      608       797
  Amortization of goodwill..................................      115        --
  Part year federal net operating loss......................    3,012        --
  Deferred state taxes......................................     (760)     (317)
                                                              -------   -------
     Net current deferred tax asset.........................  $ 5,976   $ 3,798
                                                              =======   =======
Non-current:
  Deferred rent.............................................  $ 2,991   $ 3,307
  Start-up costs............................................     (294)     (348)
  Property and equipment....................................   (2,005)   (2,023)
  Deferred state taxes......................................      298        --
  Foreign tax credit........................................      202       440
  Other liabilities.........................................      438     1,790
  Part year federal and state net operating loss............    2,525     1,309
  AMT credit................................................      509       622
  Valuation allowance.......................................     (202)       --
                                                              -------   -------
     Non-current deferred tax asset.........................  $ 4,462   $ 5,097
                                                              =======   =======
</Table>

                                       F-17
<PAGE>   43
                     PARTY CITY CORPORATION AND SUBSIDIARY

           NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED)

     The following table reconciles the statutory Federal income tax rate with
the effective rate of the Company for the periods ended:

<Table>
<Caption>
                                                               SIX MONTHS ENDED          YEAR ENDED
                                               YEAR ENDED    ---------------------   ------------------
                                              DECEMBER 30,    JUNE 30,     JULY 3,   JULY 1,   JUNE 30,
                                                  1998          1998        1999      2000       2001
                                              ------------   -----------   -------   -------   --------
                                                             (UNAUDITED)
<S>                                           <C>            <C>           <C>       <C>       <C>
Federal statutory rate/(benefit)............     34.0%          (34.0)%     (34.0)%   (34.0)%    34.0%
State income taxes net of federal benefit...       5.4           (3.6)       (3.6)      4.0       3.6
Valuation allowance.........................        --             --        25.4    (102.4)     (1.3)
Foreign tax.................................        --             --          --       1.9        --
Other.......................................      (0.7)          (1.2)       (1.5)      3.7       1.3
                                                  ----          -----       -----    ------      ----
Effective tax rate/(benefit)................     38.7%          (38.8)%     (13.7)%  (126.8)%    37.6%
                                                  ====          =====       =====    ======      ====
</Table>

11.  EMPLOYEE BENEFIT PLANS

     The Company has a defined contribution 401(k) savings plan (the "401(k)
Plan") covering all eligible employees. Participants may defer between 1% and
15% of annual pre-tax compensation subject to statutory limitations. The Company
contributes an amount as determined by the Board of Directors. Such amount has
been established as 50% of the employee's contribution up to $1,000.

     For the year ended December 31, 1998, the six months ended June 30, 1998
(unaudited) and July 3, 1999, and the years ended July 1, 2000 and June 30,
2001, matching contributions of $121,000, $50,000, $107,000, $232,000 and
$300,000, respectively, were expensed under the 401(k) Plan.

12.  RELATED PARTY TRANSACTIONS

     In June 1999, Steven Mandell, the former president of the Company and a
major stockholder granted an option to acquire 1,000,000 shares of the
shareholder's common stock to Jack Futterman, then the Company's chief executive
officer and current member of the Board of Directors. The option vested
immediately and has an exercise price of $3.00 a share, the fair value of the
common stock at date of grant. The option expires in June 2004.

     On November 2, 1999, the Company's non-executive chairman of the board
purchased $167,000 of the Company's 13.0% Secured Notes due 2002, $333,000 of
the Company's 14.0% Secured Notes due 2004, and Warrants to purchase 229,333
shares of the Company's stock from one of the Investors for a total purchase
price of $498,000. For the years ended July 1, 2000 and June 30, 2001, the
Company paid $72,000 and $93,000 of interest related to these Notes,
respectively.

     As of July 3, 1999, Erik Mandell, an officer of the Company and the son of
Steven Mandell, owned one franchise store. During the year ended July 1, 2000,
Steven Mandell acquired this store from Erik Mandell. On July 27, 2000, the
Company purchased this store from Steven Mandell. Total consideration for the
purchase was $516,000. Neither Steven Mandell nor Erik Mandell owns any other
Party City franchise stores.

     On June 22, 2001, the Company granted options on 90,000 shares of the
Company's common stock to Ralph Dillon's (the Company's non-executive chairman
of the board of directors) in compensation for his services to the Company.
These options were granted at $6.25 per share and vested immediately. In
addition, future grants of 50,000 shares will be made in January 2002, July 2002
and January 2003 at the fair market value of the Company's common stock on the
date of grant. All options will be vested at grant date. These grants will be
made providing that Mr. Dillon remains the non-executive chairman of the board
of directors of the Company and certain other requirements are met. For the year
ended June 30, 2001, $264,000 was charged to operations as compensation expense.

                                       F-18
<PAGE>   44
                     PARTY CITY CORPORATION AND SUBSIDIARY

           NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED)

13.  LEASE COMMITMENTS

  LEASES

     The Company leases real estate in connection with the operation of
corporate retail stores as well as its corporate office. The store leases are
for properties ranging in size from 6,750 to 15,560 square feet. The terms range
from five years to twenty years, and expire by 2016. The leases contain
escalation clauses, renewal options from five years to ten years and obligations
for reimbursement of common area maintenance and real estate taxes. Certain
leases contain contingent rent based upon specified sales volume. For the year
ended December 31, 1998 the six months ended June 30, 1998 (unaudited) and July
3, 1999, and the years ended July 1, 2000 and June 30, 2001, no such contingent
rent was paid.

     At June 30, 2001, the Company leased 31 motor vehicles, primarily for its
district managers and regional management. The terms range from 24 to 36 months,
and expire through June 2004.

     The Company entered into a five-year capital lease with a present value of
approximately $1.6 million for computer hardware and software. The Company has
the option to purchase the equipment for a nominal cost at the termination of
the lease. The leased hardware is included in property and equipment at a net
book value of approximately $420,000 at June 30, 2001. The leased software has
been fully depreciated.

     Future minimum lease payments under outstanding leases at June 30, 2001,
are as follows (in thousands):

<Table>
<Caption>
                                                              CAPITAL   OPERATING
                                                               LEASE     LEASES
                                                              -------   ---------
<S>                                                           <C>       <C>
Fiscal year ending:
2002........................................................   $369     $ 36,060
2003........................................................     34       34,924
2004........................................................     22       33,984
2005........................................................     --       32,688
2006........................................................     --       31,337
Thereafter..................................................     --       66,252
                                                               ----     --------
Total minimum lease payments................................    425     $235,245
                                                                        ========
Less amount representing interest...........................    (11)
                                                               ----
Present value of net minimum lease payments.................    414
Less current maturities, included in other current
  liabilities...............................................    360
                                                               ----
Long-term obligation........................................   $ 54
                                                               ====
</Table>

     Rent expense for all operating leases was $27.3 million, $11.1 million,
$19.3 million, $35.0 million, and $35.1 million for the year ended December 31,
1998, the six months ended June 30, 1998 (unaudited) and July 3, 1999, and the
years ended July 1, 2000, and June 30, 2001, respectively. The Company is
obligated for guarantees, subleases or assigned lease obligations for 29 of its
franchisees through 2011. The aggregate future minimum payments under these
leases are approximately $34.4 million.

14.  COMMITMENTS AND CONTINGENCIES

  SECURITIES LITIGATION

     The Company has been named as a defendant in twelve class action
complaints. The Company's former Chief Executive Officer and the former Chief
Financial Officer and Executive Vice President of Operations have also been
named as defendants. The complaints have all been filed in the United States
District Court for

                                       F-19
<PAGE>   45
                     PARTY CITY CORPORATION AND SUBSIDIARY

           NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED)

the District of New Jersey. The complaints were filed as class actions on behalf
of persons who purchased or acquired Party City common stock during various time
periods between February 1998 and March 19, 1999. In October 1999, plaintiffs
filed an amended class action complaint and in February 2000, plaintiffs filed a
second amended class action complaint.

     The second amended complaint alleges, among other things, violations of
sections 10(b) and 20(a) of the Securities Exchange Act of 1934 and Rule 10b-5
promulgated thereunder, and seeks unspecified damages. The plaintiffs allege
that defendants issued a series of false and misleading statements and failed to
disclose material facts concerning, among other things, the Company's financial
condition, adequacy of internal controls and compliance with certain loan
covenants. The plaintiffs further allege that because of the issuance of a
series of false and misleading statements and/or failure to disclose material
facts, the price of Party City common stock was artificially inflated.

     In early 2000, defendants moved to dismiss the second amended complaint on
the ground that it failed to state a cause of action. On May 29, 2001 the
District Court issued an Opinion and Order dismissing the Complaint against all
defendants with prejudice. On June 27, 2001 plaintiffs filed a Notice of Appeal
to the United States Court of Appeals for the Third Circuit. Because this case
is in the early stages of the appeal process, no opinion can be expressed as to
its likely final outcome.

  OTHER

     On April 23, 1999, plaintiff Emil Asch, Inc. ("Emil Asch") filed a
complaint in the United States District Court for the Eastern District of New
York against the Company and co-defendants Amscan, Inc., Hallmark, Inc., and
Rubie's Costume. The complaint alleged violations of the Robinson-Patman Act
(price discrimination), unfair competition, tortious interference with
contractual relations, and false and deceptive advertising. Plaintiff sought
damages of $2 million, as well as treble and punitive damages for certain
counts. On February 3, 2000, Emil Asch amended its complaint by adding an
additional plaintiff to the suit. The Company has settled the case and, in May
2001, the court approved a stipulation entered into by the plaintiffs and the
Company dismissing the case.

     In addition to the foregoing, the Company is from time to time involved in
routine litigation incidental to the conduct of its business. The Company is
aware of no other material existing or threatened litigation to which it is or
may be a party.

                                       F-20
<PAGE>   46
                     PARTY CITY CORPORATION AND SUBSIDIARY

           NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED)

15.  SEGMENT INFORMATION

     The Company owns, operates and franchises party supplies stores in North
America and, to a limited extent in Europe. The Company's management reporting
system evaluates performance based on a number of factors; however, the primary
measure of performance is the pre-tax operating profit of each segment.
Accordingly, the Company reports two segments -- retail and franchising. The
retail segment generates revenue through the sale of primarily third-party
branded party goods through Company-owned stores. The franchising segment
generates revenue through the charge for initial franchise fees and a royalty on
retail sales. The accounting policies are described in the summary of
significant accounting policies. The Company has no intersegment sales. No
single customer accounts for 10% or more of total revenues. Revenues from Europe
were not significant in all periods presented. All assets of the Company are
located in North America.

     The following table contains key financial information of the Company's
business segments (in thousands):

<Table>
<Caption>
                                       YEAR ENDED             SIX MONTHS ENDED                  YEAR ENDED
                                    -----------------   ----------------------------   ----------------------------
                                    DECEMBER 31, 1998   JUNE 30, 1998   JULY 3, 1999   JULY 1, 2000   JUNE 30, 2001
                                    -----------------   -------------   ------------   ------------   -------------
                                                         (UNAUDITED)
<S>                                 <C>                 <C>             <C>            <C>            <C>
RETAIL:
Net revenue.......................      $282,923          $ 92,718        $151,349       $349,722       $380,671
Operating earnings (loss).........        14,192             3,361            (561)        25,896         40,223
Identifiable assets...............       133,435           112,727         150,232        121,190        122,804
Depreciation/amortization.........         5,721             2,368           3,771          8,351          8,086
Capital expenditures..............        32,845            10,924           6,623          1,728          6,597
FRANCHISING:
Net revenue.......................      $ 11,411          $  4,554        $  5,160       $ 13,677       $ 15,229
Operating earnings................         7,297             2,751           3,254          9,271         10,292
Identifiable assets...............         1,996             1,674           2,101          1,607          1,398
Depreciation/amortization.........            --                --              --             --             --
Capital expenditures..............            --                --              --             --             --
CORPORATE/OTHER:
Net revenue.......................      $     --          $     --        $     --       $     --       $     --
Operating expense.................       (15,939)           (5,615)        (15,856)       (30,399)       (26,603)
Identifiable assets...............         8,601             4,767           8,986          9,289         17,140
Depreciation/amortization.........           877               362           1,458          2,406          2,345
Capital expenditures..............         6,249             1,908           1,310          2,589         10,121
CONSOLIDATED TOTALS:
Net revenue.......................      $294,334          $ 97,272        $156,509       $363,399       $395,900
Operating earnings (loss).........         5,550               497         (13,163)         4,768         23,912
Interest expense, net.............         2,636               873           2,378          8,423          7,949
                                        --------          --------        --------       --------       --------
Income (loss) before income taxes
  (benefit).......................         2,914              (376)        (15,541)        (3,655)        15,963
Income taxes (benefit)............         1,127              (146)         (2,125)        (4,636)         6,002
                                        --------          --------        --------       --------       --------
Net income (loss).................      $  1,787          $   (230)       $(13,416)      $    981       $  9,961
                                        ========          ========        ========       ========       ========
Identifiable assets...............      $144,032          $119,168        $161,319       $132,086       $141,342
Depreciation/amortization.........         6,598             2,730           5,229         10,757         10,431
Capital expenditures..............        39,094            12,832           7,933          4,317         16,718
</Table>

                                       F-21
<PAGE>   47
                     PARTY CITY CORPORATION AND SUBSIDIARY

           NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED)

16.  SELECTED QUARTERLY INFORMATION (UNAUDITED) (IN THOUSANDS, EXCEPT PER SHARE
DATA)

<Table>
<Caption>
                                                                    QUARTER ENDED
                                                       ----------------------------------------
                                                       SEPTEMBER   DECEMBER    MARCH     JUNE
                                                       ---------   --------   -------   -------
<S>                                                    <C>         <C>        <C>       <C>
YEAR ENDED JULY 1, 2000
Total revenues.......................................   $70,451    $136,046   $68,872   $88,030
Cost of goods sold and occupancy costs...............    50,717      79,733    49,669    60,237
Net income (loss)....................................   (12,259)     21,238    (8,624)      626
Basic earnings (loss) per share......................     (0.98)       1.69     (0.68)     0.05
Diluted earnings (loss) per share....................     (0.98)       1.69     (0.68)     0.04
YEAR ENDED JUNE 30, 2001
Total revenues.......................................   $80,088    $143,682   $77,209   $94,921
Cost of goods sold and occupancy costs...............    55,462      83,428    53,364    60,066
Net income (loss)....................................    (2,351)     13,911    (3,527)    1,928
Basic earnings (loss) per share......................     (0.18)       1.09     (0.28)     0.15
Diluted earnings (loss) per share....................     (0.18)       0.78     (0.28)     0.11
</Table>

                                       F-22