<PAGE>   1

--------------------------------------------------------------------------------
--------------------------------------------------------------------------------
                       SECURITIES AND EXCHANGE COMMISSION
                             WASHINGTON, D.C. 20549
                            ------------------------

                                   FORM 10-K
TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT
                                    OF 1934
         FOR THE TRANSITION PERIOD FROM JANUARY 1, 1999 TO JULY 3, 1999

                         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 IDENTIFICATION NO.)
       INCORPORATION OR ORGANIZATION)

        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 [ ]  No [X]

     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 20, 2000, based on the closing sale price on such date,
was approximately $30,855,782.

     The number of outstanding shares of the Registrant's classes of common
stock, $0.01 par value, as of September 20, 2000, was 12,722,205.

                      DOCUMENTS INCORPORATED BY REFERENCE

     PORTIONS OF THE REGISTRANT'S PROXY STATEMENT FOR THE 1999 ANNUAL MEETING OF
STOCKHOLDERS ARE INCORPORATED BY REFERENCE INTO PART III.
--------------------------------------------------------------------------------
--------------------------------------------------------------------------------
<PAGE>   2

                               TABLE OF CONTENTS

<TABLE>
<CAPTION>
                                                                       PAGE
                                                                       ----
<S>      <C>                                                           <C>
                               PART I
Item 1   Business....................................................    2
Item 2   Properties..................................................   14
Item 3   Legal Proceedings...........................................   14
Item 4   Submission of Matters to a Vote of Security Holders.........   15
                               PART II
Item 5   Market for Registrant's Common Equity and Related
         Stockholder Matters.........................................   15
Item 6   Selected Financial Data.....................................   16
Item 7   Management's Discussion and Analysis of Financial Condition
         and Results of Operations...................................   19
Item 7A  Quantitative and Qualitative Disclosures About Market
         Risk........................................................   24
Item 8   Financial Statements and Supplementary Data.................   25
Item 9   Changes in and Disagreements with Accountants on Accounting
         and Financial Disclosure....................................   25
                              PART III
Item 10  Directors and Executive Officers of the Registrant..........   25
Item 11  Executive Compensation......................................   25
Item 12  Security Ownership of Certain Beneficial Owners and
         Management..................................................   25
Item 13  Certain Relationships and Related Transactions..............   25
                               PART IV
Item 14  Exhibits, Financial Statement Schedules, and Reports on Form
         8-K.........................................................   25
</TABLE>

                                        1
<PAGE>   3

                                     PART I

ITEM 1.  BUSINESS

     Party City Corporation (the "Company") is incorporated in the State of
Delaware and operates retail party goods 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. As of
July 3, 1999, the Company had 215 Company-owned stores and 178 franchise stores
in its network.

SIGNIFICANT DEVELOPMENTS

  Audited Consolidated Financial Statements

     The Company was previously unable to issue audited financial statements for
the year ended December 31, 1998 and timely file its 1998 Annual Report on Form
10-K ("1998 Form 10-K") with the Securities and Exchange Commission ("SEC")
primarily because of difficulties associated with taking the year-end physical
inventories and the related reconciliation process. In September 2000, the
Company filed its 1998 Form 10-K. As a result of the failure to file the 1998
Form 10-K by March 31, 1999 the Company was in default of Nasdaq's continued
listing requirements. Trading in the Company's Common stock was halted on May 6,
1999, and the Company was delisted on July 20, 1999.

     Effective July 3, 1999, the Company changed its fiscal year end for
financial reporting from December 31 to the Saturday nearest to June 30. The
Company continues to use December 31 as its tax year end. The change to a 52-53
week calendar was made to facilitate comparable store sales computations. The
term "Fiscal Year" refers to the 52-53 weeks ending the Saturday nearest June
30, unless otherwise noted. Consolidated financial statements of the Company for
the transition period from January 1, 1999 to July 3, 1999, are included in this
Transition Report on Form 10-K.

     Financing Agreements

     On April 24, 1998, the Company refinanced and replaced its then existing
$20 million loan facility with a $60 million secured revolving line of credit
agreement with a group of banks maturing April 24, 2001 (as amended, the "Credit
Agreement"). Advances under the Credit Agreement originally bore interest, at
the Company's option, at the agent bank's base rate (the higher of the bank's
prime rate or the federal funds rate plus  1/2% per annum) or LIBOR plus an
applicable margin. The Company did not meet certain of its financial and
reporting covenants, including those relating to timely filing of consolidated
financial statements, minimum levels of profitability, net worth, liquidity,
fixed charge coverage and others. Consequently, the Company's debt under the
Credit Agreement was subject to acceleration and is classified as a current
liability in the consolidated balance sheets at December 31, 1998 and July 3,
1999. The Credit Agreement was secured by all the assets of the Company.
Additionally, the Credit Agreement restricted the payment of dividends.

     On August 16, 1999, the Company entered into agreements with its existing
bank lenders under the Credit Agreement (the "Banks"), a new group of investors
(the "Investors") and its trade vendors. The Banks and the Company entered into
a Standstill and Forbearance Agreement (the "Bank Forbearance Agreement"). Under
the Bank Forbearance Agreement, the Banks agreed not to exercise rights and
remedies based upon any existing defaults until June 30, 2000, unless a further
event of default occurred. The Company also agreed to reduce its outstanding
borrowings from $58.6 million to $15 million by October 30, 1999. The interest
rate on its bank debt was increased to 2% over the bank's prime interest rate,
and the Company paid a forbearance fee of $580,000.

     On August 17, 1999, the Company received $30 million in financing from the
Investors. The Investors purchased senior secured notes and warrants pursuant to
separate securities purchase agreements (the "Securities Purchase Agreements")
each dated as of August 16, 1999. Under these Securities Purchase Agreements,
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

                                        2
<PAGE>   4

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 $1,965,000 based on management's estimate using certain fair value
methodologies and represent an original issue discount to the C Notes and D
Notes. Up to $15 million of the Notes were secured by a first lien that was pari
pasu with the liens under the Credit Agreement. The Notes are also secured by a
junior lien on 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 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 exercise of
the Warrants. The proceeds from the $30 million in new financing were used for
the purchase of seasonal inventory, payment of amounts due under the Credit
Agreement, transaction fees and working capital.

     The Company also entered into an Investor Rights Agreement (the "Investor
Rights Agreement") with the Investors and Jack Futterman, then the chief
executive officer of the Company. In this agreement, the Company granted
registration rights with respect to shares of common stock. Under the Investor
Rights Agreement, the Investors agree that they will not, without the prior
written consent of the Board of Directors, (i) acquire or agree to acquire,
publicly offer or make any public proposal with respect to the possible
acquisition of (a) beneficial ownership of any securities of the Company, (b)
any substantial part of the Company's assets, or (c) any rights or options to
acquire any of the foregoing from any person; (ii) make or in any way
participate in any "solicitation" of "proxies" (as such terms are defined in the
rules of the Securities Exchange Act of 1934, as amended) to vote, or seek to
advise or influence any person with respect to the voting of any voting
securities of the Company; or (iii) make any public announcement with respect to
any transaction between the Company or any of its securities holders and the
Investors, including without limitation, any tender or exchange offer, merger or
other business combination of a material portion of the assets of the Company.
These standstill provisions terminate if the Company's consolidated earnings
before interest, taxes, depreciation and amortization and exclusive of special
charges ("EBITDA"), does not meet specified targets. The Company achieved its
target EBITDA for the calendar year 1999. Also, in connection with these
transactions, one outside director of the Company resigned and two
representatives of the Investors joined the Board of Directors. The Company
achieved its target EBITDA for the calendar year 1999. Also, in connection with
these transactions, one outside director of the Company resigned and two
representatives of the Investors joined the Board of Directors. The Company has
amended the restriction that prohibited the Investors from purchasing the
Company's stock to permit purchase up to an aggregate amount of $1.5 million of
the Company's common stock.

     Party City's trade vendors representing approximately $36.4 million of
trade debt also entered into an agreement with the Company. Pursuant to a Vendor
Standstill and Forbearance Agreement ("Vendor Forbearance Agreement"), these
trade vendors agreed to forbear from taking any action against Party City until
January 15, 2000. The trade vendors received promissory notes from Party City
totaling approximately $12.2 million representing one-third of their unpaid
balances as of May 1, 1999 (the "Trade Notes"). The Trade Notes bore interest at
a rate of 10% per year and were scheduled to mature on November 15, 1999.
Interest on the Trade Notes was due on January 15, 2000, unless the bank debt
was refinanced before such date. Separately, certain seasonal trade vendors
agreed to provide trade credit to the Company for 30% of purchases for the
Halloween, Thanksgiving and year-end holiday seasons. These vendors received a
shared lien on the Company's inventory for the amount of the credit.

     In order to meet the cash flow requirements of the Halloween seasonal
purchase of inventory and to meet the requirements of the Bank Forbearance
Agreement, the Company identified stores for sale to existing franchisees to
generate working capital. Eighteen stores with a net book value of approximately
$9.8 million were sold to franchisees. In order to facilitate the sale of these
stores, the Company agreed to waive royalty fees in respect of such stores for
negotiated periods up to five years. The total proceeds from the sales of these
stores was approximately $9.9 million. The net proceeds from the sale of stores
was required under the Bank Forbearance Agreement to be used to pay down the
outstanding borrowings under the Credit Agreement.

     On January 14, 2000, the Company replaced the Credit Agreement with a new
Loan and Security Agreement (the "Loan Agreement") with Congress Financial
Corporation ("Congress"), as lender. Under
                                        3
<PAGE>   5

the terms of the Loan Agreement, the Company may from time to time borrow
amounts 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 initially 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. The term of the Loan Agreement is three years, and is secured by a
lien on substantially all of the assets of the Company. At September 15, 2000,
there was $15.8 million outstanding and approximately $24.2 million was
available for borrowing under this revolving credit facility.

     On January 14, 2000, Party City also received $7 million in cash proceeds
from the sale to certain of its existing Investors (the "Investor Group") of a
new series of senior secured notes pursuant to a First Amendment (the "First
Amendment") to the Securities Purchase Agreements. Pursuant to 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. The Investor Group, together with
other existing Investors and Congress, have 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 $3,156,000 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.

     The Company used the proceeds from the sale of the E Notes and initial
amounts borrowed under the Loan Agreement (i) to pay off all amounts owed under
the Credit Agreement, (ii) to pay all amounts owed on the Trade Notes and (iii)
to pay the remaining amounts owed to various seasonal trade vendors for credit
extended for inventory purchased by the Company for the 1999 Halloween,
Thanksgiving and year-end holiday seasons. All the remaining unpaid vendor
balances that were originally due May 1, 1999, were satisfied by individual
arrangements with such vendors.

                                        4
<PAGE>   6

     The Company's unaudited pro forma consolidated balance sheet as of July 3,
1999, after giving effect to the August 16 and August 17, 1999 transactions
described above is as follows (in thousands):

<TABLE>
<CAPTION>
                                                    JULY 3,      PRO FORMA      PRO FORMA
                                                      1999      ADJUSTMENTS    JULY 3, 1999
                                                    --------    -----------    ------------
                                                                (UNAUDITED)    (UNAUDITED)
<S>                                                 <C>         <C>            <C>
                      ASSETS
Cash and cash equivalents.........................  $ 11,470     $ 25,550        $ 37,020
Merchandise inventory.............................    47,016           --          47,016
Other current assets..............................    32,887           --          32,887
                                                    --------     --------        --------
  Total current assets............................    91,373       25,550         116,923
Property and equipment............................    50,557           --          50,557
Goodwill, net.....................................    18,483           --          18,483
Other assets......................................       906          450           1,356
                                                    --------     --------        --------
          Total Assets............................  $161,319     $ 26,000        $187,319
                                                    ========     ========        ========
       LIABILITIES AND STOCKHOLDERS' EQUITY
Current liabilities
  Accounts payable................................  $ 48,386     $(12,133)       $ 36,253
  Trade Notes.....................................        --       12,133          12,133
  Accrued expenses................................    10,145           --          10,145
  Credit Agreement................................    58,550       (4,000)         54,550
  Other current liabilities.......................       986           --             986
                                                    --------     --------        --------
          Total current liabilities...............   118,067       (4,000)        114,067
Long-term Liabilities:
  Senior Secured Notes............................        --       26,844          26,844
  Other long-term liabilities.....................     7,318           --           7,318
Stockholders' equity..............................    35,934        3,156          39,090
                                                    --------     --------        --------
          Total liabilities and stockholders
            equity................................  $161,319     $ 26,000        $187,319
                                                    ========     ========        ========
</TABLE>

GENERAL

     The Company is a specialty retailer of party supplies through its network
of discount stores. At July 3, 1999, the Company owned and operated 215
Company-owned stores in the United States and its franchisees operated an
additional 178 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. Party City seeks to offer customers a
"one-stop" party store that provides a wide selection of merchandise at everyday
low prices. 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,

                                        5
<PAGE>   7

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 is estimated at $11.5 billion in sales in
1998.

     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 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 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 industries 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 is continuing 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 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 20,000 SKUs. Within its many product categories,
Party City offers 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 stimulates 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 Everyday Low Pricing.  The Company uses the buying power of its
402 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
reinforces customers' expectations of savings by prominently displaying signs
announcing its everyday low prices. The Company also maintains a lowest price
guaranty policy, to which it suggests its franchisees adhere. This policy
guarantees that Party City 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
                                        6
<PAGE>   8

provide customers with personalized shopping assistance. At Halloween, the most
important selling season for the Company, each store increases significantly 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.

     Human Resources.  Company management has made human resources one of its
key components of the Company's long-term growth strategy. During calendar 1999,
the Company hired several individuals in key management positions and reassigned
other members of management to effectively define its strategic objectives and
target significant goals for the upcoming fiscal year. While the number of
corporate personnel was decreased in 1999, key additions to the finance and
management information systems groups were made.

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 focus its efforts to create the necessary management
infrastructure and control environment to support continued growth. Over the
next few years, the Company intends to balance growth between Company-owned
stores and opening franchise stores to meet its growth objectives.

STORE LOCATIONS

     As of July 3, 1999, there were 393 Party City stores open in the United
States, Canada, Puerto Rico, Portugal and Spain. Of these, 215 were
Company-owned and 178 were operated by the Company's independent franchisees.
The following table shows the growth in the Company's network of stores.

<TABLE>
<CAPTION>
                                                                YEAR ENDED DECEMBER 31,            SIX MONTHS
                                                          ------------------------------------       ENDED
                                                          1994    1995    1996    1997    1998    JULY 3, 1999
                                                          ----    ----    ----    ----    ----    ------------
<S>                                                       <C>     <C>     <C>     <C>     <C>     <C>
COMPANY-OWNED:
  Stores open at beginning of period                       --       7      16      36     117         207
  Stores opened                                             7       9      20      57      81           9
  Stores closed                                            --      --      --      --      --          --
  Stores acquired from franchisees                         --      --      --      24       9          --
  Stores sold to franchisees                               --      --      --      --      --          (1)
                                                          ---     ---     ---     ---     ---         ---
  Stores open at end of period                              7      16      36     117     207         215
FRANCHISE:
  Stores open at beginning of period                       58      99     132     164     158         167
  Stores opened                                            42      35      32      19      19          11
  Stores closed                                            (1)     (2)     --      (1)     (1)         (1)
  Stores purchased by the Company                          --      --      --     (24)     (9)         --
  Stores sold by the Company                               --      --      --      --      --           1
                                                          ---     ---     ---     ---     ---         ---
  Stores open at end of period                             99     132     164     158     167         178
                                                          ---     ---     ---     ---     ---         ---
TOTAL COMPANY AND FRANCHISE STORES                        106     148     200     275     374         393
                                                          ===     ===     ===     ===     ===         ===
</TABLE>

     The Company typically seeks sites for new stores that are stand-alone
buildings or 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. Often the site may be a shopping center under construction or renovation
and may be available for occupancy typically in a period ranging from three
months to one year. The Company's site selection criteria include, but are not
limited to: population density and/or 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, and the potential for future, competition in the market

                                        7
<PAGE>   9

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 15,876 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 the everyday low prices and breadth of merchandise
available. The floor plan is designed to impress the customer with the broad
selection in each product category.

     Product Categories.

     The typical Party City store offers a broad selection of merchandise
     consisting of over 14,000 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(R) 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 Company, because of the buying power of the
    Party City network, is often able to obtain supplies of the most sought
    after Halloween-related merchandise. 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, among both young children and adults, is growing significantly.

    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, Graduation, 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.

                                        8
<PAGE>   10

    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.

    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's management continuously reviews new and existing product
selections to provide the widest, most current assortment of party supplies. In
pursuit of this goal, management attends various industry trade shows including
the National Annual Halloween Trade Show in Rosemont, Illinois and the Toy Fair
in New York. In an effort to keep abreast of new and popular merchandise,
management views presentations given specifically for the Company by its major
vendors. The Company utilizes its inventory tracking system to give the
purchasing staff constant feedback on customers' preferences.

     The Company had three suppliers who in the aggregate constituted
approximately 31% and 22% of the Company's purchases for the year ended December
31, 1998 and the six months ended July 3, 1999, respectively. The loss of any of
these suppliers would adversely affect the Company's operations. The Company
considers numerous factors in supplier selection, including price, credit terms,
product offerings and quality. The Company negotiates pricing with suppliers on
behalf of all stores in the system (both Company-owned and franchise) and
believes that such buying power enables it to not only receive the most
favorable pricing terms, but, as importantly, to more readily 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

     Each Party City store is typically managed by a general manager and two
assistant managers. These managers are responsible for all aspects of the
store's day-to-day operations, including employee hiring and training, work
scheduling, inventory control, expense control, maintenance activities and
communications with central office staff. The sales and stocking staff ranges
from three to eight people, except during certain holiday selling seasons when
additional store employees are used. The Company seeks to pay its store managers
toward the higher end of the competitive pay scale in order to hire and retain
experienced and dedicated managers. In addition, managers of Company-owned
stores are eligible for stock option grants under the Company's stock option
plan.

     Training.  In Company-owned stores, corporate store managers are trained
for a minimum of two weeks prior to the opening of a store. During the store
set-up, a manager receives additional training from the Company's store set-up
team. During the first few days after the initial opening of a store, corporate
headquarters' personnel spend concentrated time in the store overseeing the
operations.

                                        9
<PAGE>   11

     In franchise locations, all franchisees go through a training program
consisting of one week in the classroom and one week in the store to learn the
fundamentals of the store's operation. During the set up of their store, the
franchisee receives additional training from the team leader of the set-up crew
that is dispatched by the Company to assist the franchisee with the store
opening. Shortly after a store opens, a representative from the Company visits
the franchisee and spends several days assisting with the day-to-day operations
of running the store. To ensure efficient operations and that the systems,
policies and processes are being followed, subsequent visits are scheduled on a
regular basis to review what was covered during the initial training.

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. To this
end, 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 a costume. This provides the sales
associates with a cross-selling opportunity to suggest various accessories and
other complementary products. Also, at Halloween the associates use two-way
radios to help stock personnel quickly fill requested items, expediting sales
and reducing 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.

                                       10
<PAGE>   12

     The Company's stores are located in the following states:

<TABLE>
<CAPTION>
                                                       DECEMBER 31,
                                           ------------------------------------    JULY 3,
STATE                                      1994    1995    1996    1997    1998     1999
-----                                      ----    ----    ----    ----    ----    -------
<S>                                        <C>     <C>     <C>     <C>     <C>     <C>
California...............................    1       2       8      21      36        37
Connecticut..............................    1       1       1       3       4         4
Florida..................................    2       3       6      11      18        17
Illinois.................................    1       1       3       8      15        15
New York.................................    1       2       7      16      33        34
Pennsylvania.............................    1       1       1       5       8         9
Maryland.................................   --       1       2       3       4         4
Michigan.................................   --       4       5       7       7         7
Ohio.....................................   --       1       1       2       7         7
Nevada...................................   --      --       1       2       3         3
New Jersey...............................   --      --       1       9      14        14
Indiana..................................   --      --      --       5       5         5
Minnesota................................   --      --      --       3       5         5
Missouri.................................   --      --      --       3       3         4
Texas....................................   --      --      --      15      22        22
Virginia.................................   --      --      --       3       5         6
Wisconsin................................   --      --      --       1       1         1
Colorado.................................   --      --      --      --       2         2
Kentucky.................................   --      --      --      --       1         1
Georgia..................................   --      --      --      --       1         1
Kansas...................................   --      --      --      --       1         1
Massachusetts............................   --      --      --      --       3         3
North Carolina...........................   --      --      --      --       2         2
Tennessee................................   --      --      --      --       4         4
Utah.....................................   --      --      --      --       1         1
Washington...............................   --      --      --      --       2         3
Louisiana................................   --      --      --      --      --         3
                                            --      --      --     ---     ---       ---
          TOTAL..........................    7      16      36     117     207       215
                                            ==      ==      ==     ===     ===       ===
</TABLE>

     Of the leases for the stores listed above, five expire in 2001, six expire
in 2002 and the balance expire in 2003 or thereafter. The Company has options to
extend each of such leases for a minimum of five years.

FRANCHISE OPERATIONS

     Until opening its first Company-owned store in January 1994, the Company
operated exclusively as a franchisor. As of July 3, 1999, the Company had 178
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.

                                       11
<PAGE>   13

     As of July 3, 1999, the Company's franchise stores are located in the
following states and foreign countries:

<TABLE>
<S>                                                      <C>
Alabama..............................................      6
Arizona..............................................      7
Arkansas.............................................      1
California...........................................     10
Colorado.............................................      1
Connecticut..........................................      4
Delaware.............................................      1
Florida..............................................     13
Georgia..............................................     16
Hawaii...............................................      1
Illinois.............................................      1
Kansas...............................................      2
Louisiana............................................      7
Maryland.............................................      4
Mississippi..........................................      1
Missouri.............................................      1
New Jersey...........................................     19
New Mexico...........................................      3
New York.............................................     10
North Carolina.......................................     12
Ohio.................................................      3
Oregon...............................................      3
Pennsylvania.........................................      7
South Carolina.......................................      4
Tennessee............................................      5
Texas................................................      8
Virginia.............................................      5
Puerto Rico..........................................      4
Canada...............................................     14
Portugal.............................................      1
Spain................................................      4
                                                         ---
          TOTAL......................................    178
</TABLE>

     The Company receives revenue from its franchisees, including an initial
one-time fee ($35,000 as of July 3, 1999) and an ongoing royalty fee (4.0% of
net sales for new franchisees, payable monthly at July 3, 1999). In addition,
each franchisee has a mandated advertising budget, which consists of a minimum
of $5,500 to promote the initial store opening and thereafter the lesser of 3.0%
of net sales or $60,000 per year for 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, signs, 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 type 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.

                                       12
<PAGE>   14

     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 and
general business operations, as well as the provision of assistance in opening
and initially promoting the store.

     As of July 3, 1999, the Company had eight territory agreements with certain
franchisees. These agreements permit the holder of the territory rights to open
a minimum of two and in some cases three or more stores within a stated time
period. The following areas are governed by territory agreements: North
Carolina; Fort Myers/Naples FL; Arkansas; Buffalo/Rochester, NY; Atlanta, GA;
Canada; Spain/Portugal; Puerto Rico.

COMPETITION

     The party supplies retailing business is highly competitive. Party City
stores compete with a variety of smaller and larger retailers, including 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 from a wholly owned subsidiary a number of
trademarks and service marks registered with the United States Patent and
Trademark Office, 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 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 regulations adopted by federal
agencies and with licensing and other regulations enforced by state and local
health, sanitation, safety, fire and other departments. Difficulties

                                       13
<PAGE>   15

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 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 July 3, 1999, the Company employed approximately 1,450 full-time and
2,650 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 September 20, 1999, the Company leased 198 stores and had signed
leases for four additional stores. The Company leases its headquarters property
in Rockaway, New Jersey. As of September 20, 1999, the Company occupied
approximately 12,600 square feet of office space for its headquarters under a
lease expiring in 2005.

ITEM 3.  LEGAL PROCEEDINGS

  Securities Litigation

     The Company has been named as a defendant in the following twelve class
action complaints: (1) Weber v. Party City Corp., Steven Mandell, and David
Lauber, Civ. Action No. 99-CV-1252; (2) Opus GT Partners LP v. Party City Corp.
and Steven Mandell, Civ. Action No. 99-CV-1327; (3) Klein and Shiffrin v. Party
City Corp., Steven Mandell and David Lauber, Civ. Action No. 99-CV-1325; (4)
Flynn v. Party City Corp., David Lauber and Steven Mandell, Civ. Action No.
99-CV-1328; (5) Catanzarite v. Party City Corp., Steven Mandell and David
Lauber, Civ. Action No. 99-CV-1317; (6) Tabbert v. Party City Corp. and Steven
Mandell, Civ. Action No. 99-CV-1353; (7) Maietta v. Steven Mandell and Party
City Corp., Civ. Action No. 99-CV-1386; (8) Barry v. Party City Corp., Steven
Mandell and David Lauber, Civ. Action No. 99-CV-1453; (9) Kurzweil v. Party City
Corp., Steven Mandell and David Lauber, Civ. Action No. 99-CV-1396; (10) Hormel
v. Party City Corp., Steven Mandell and David Lauber, Civ. Action No.
99-CV-1689; (11) Sacher v. Party City Corp., Steven Mandell and David Lauber,
Civ. Action No. 99-CV-2238; and (12) Gross v. Party City Corp., Steven Mandell
and David Lauber, Civ. Action No. 99-CV-2355. The Company's former Chief
Executive Officer and 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 complaint.

     The second amended class action 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.

                                       14
<PAGE>   16

     Defendants have moved to dismiss the second amended complaint on the ground
that it fails to state a cause of action. The Court has not yet issued a
decision with respect to the motion to dismiss. Because this case is in its
early stages, no opinion can be expressed as to its likely outcome.

  Other

     The Company was named as a defendant in a complaint filed with the Supreme
Court of the State of New York, County of New York, on January 16, 1998 (the
"Complaint"), by each of Party City of Greenbrook, Inc., Party City of Watchung,
Inc., Party City of 22, Inc., Party City of Ralph Avenue and Party City of
Jersey City, Inc., each a franchisee of the Company. Four of the plaintiffs in
the suit have existing Party City franchise stores, with the remaining plaintiff
possessing a right of first refusal to develop a Party City store in Watchung,
New Jersey.

     The Complaint stated various causes of action, including unjust enrichment,
unfair competition, fraud and misrepresentation, breach of contract,
misappropriation of information and violations of the New Jersey Franchise
Practices Act and the New York State Franchise Sales Act. The crux of the
Complaint was that the Company undertook a course of conduct intentionally
designed to adversely impact the value of the Plaintiffs' franchise stores in
order to permit the Company to purchase such stores at a substantially reduced
value. The Company settled the lawsuit on June 30, 1999, at no cost to the
Company. In connection with the settlement, the Company agreed to sell the
plaintiff one store at its fair value.

     On April 23, 1999, plaintiff Emil Asch, Inc. 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 alleges five violations of the Robinson-Patman Act, which pertains to
price discrimination, unfair competition, tortious interference with contractual
relations, and false and deceptive advertising.

     Plaintiff seeks damages of $2 million, as well as treble and/or punitive
damages for certain counts. On February 3, 2000, Emil Asch amended its Complaint
by adding Ron's: The Party Store, Inc., as an additional plaintiff to the suit.
The Amended Complaint asserts the same causes of action against the same
defendants and seeks the same damages that were sought in the original
Complaint. The Company has answered the Amended Complaint, and discovery is
proceeding. At this point, no opinion can be expressed as to the likely outcome
of the litigation.

     Although the Company's management is unable to express a view on the likely
outcome of these litigations because they are in their early stages, they could
have a material adverse effect on the Company's business and results of
operations.

     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

     Not Applicable.

                                    PART II

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

     The Company's common stock traded on the Nasdaq National Market under the
symbol "PCTY" until the Company was delisted on July 20, 1999. The common stock
now trades on the OTC Bulletin Board, an electronic quotation service for NASD
Market Makers. There can be no assurance that the Common Stock will continue to
trade on the OTC Bulletin Board. It is the Company's intention to again seek to
be listed on Nasdaq if and when the Company satisfies the requirements for
listing.

                                       15
<PAGE>   17

     The following table sets forth the high and low closing sale prices of the
common stock through July 3, 1999.

<TABLE>
<CAPTION>
                                                              HIGH       LOW
                                                              ----       ---
<S>                                                           <C>        <C>
1999
July 3, 1999................................................  $ 4 7/16   $ 2 3/4
March 31, 1999..............................................   19 1/2      2 1/8
1998
December 31, 1998...........................................   21          9 3/16
September 30, 1998..........................................   30 19/32    8 11/16
June 30, 1998...............................................   35 1/4     24 3/4
March 31, 1998..............................................   35         16 3/4
1997
December 31, 1997...........................................   21 1/2     15 15/16
September 30, 1997..........................................   20 1/16    10 3/4
June 30, 1997...............................................   11 1/8      8 7/8
March 31, 1997..............................................   11 1/8     10
</TABLE>

     At September 20, 2000, the approximate number of holders of record of the
Common Stock was approximately 5,700.

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 for 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 other factors deemed relevant
by the Company's Board of Directors. Under various agreements to which the
Company is a party, including the Credit Agreement, the Company is 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

     On August 17, 1999, the Company issued the Notes and the Warrants to the
Investors for an aggregate of $30 million. The Investors were led by Tennenbaum
& Co., LLC, a Los Angeles-based investment firm.

     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 before 5:00 p.m. (New York City time) 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
exercise of the Warrants. The private placement of the issuance and sale of the
Notes and Warrants to the Investors was exempt from the registration
requirements of the Securities Act of 1933, as amended (the "Securities Act"),
pursuant to Section 4(2) of the Securities Act.

ITEM 6.  SELECTED FINANCIAL DATA

     The following Selected Financial Data for each of the years ended December
31, 1994 and 1995 and as of December 31, 1996, are derived from the consolidated
financial statements of the Company not included herein. The Selected
Consolidated Balance Sheet data as of December 31, 1997 and 1998, and July 3,
1999, and the Selected Consolidated Statements of Operations data for the years
ended December 31, 1996, 1997 and 1998 and the six months ended July 3, 1999,
are derived from the consolidated financial statements of the Company, included
elsewhere in this Transition Report on Form 10-K. The Consolidated Statement of

                                       16
<PAGE>   18

Operations for the six months ended June 30, 1998, is derived from the
consolidated statement of operations for the six months ended June 30, 1998,
included elsewhere in this Transition Report on Form 10-K.

     The Balance Sheets as of December 31, 1997 and 1998, and July 3, 1999, and
the Consolidated Statements of Operations for the years ended December 31, 1996,
1997, 1998 and the six months ended July 3, 1999 have been audited by Deloitte &
Touche LLP, independent auditors, as stated in their report appearing elsewhere
herein. The Selected Financial Data set forth below should be read in
conjunction with "Management's Discussion and Analysis of Financial Condition
and Results of Operations" and the Consolidated Financial Statements, including
the notes thereto appearing elsewhere in this Transition Report on Form 10-K.

                            SELECTED FINANCIAL DATA
                (IN THOUSANDS, EXCEPT PER SHARE AND STORE DATA)

<TABLE>
<CAPTION>
                                        YEAR ENDED DECEMBER 31,                      SIX MONTHS ENDED
                            ------------------------------------------------   ----------------------------
                             1994     1995      1996       1997       1998     JUNE 30, 1998   JULY 3, 1999
                            ------   -------   -------   --------   --------   -------------   ------------
                                                                                (UNAUDITED)
<S>                         <C>      <C>       <C>       <C>        <C>        <C>             <C>
STATEMENT OF OPERATIONS
  DATA:
Total revenue.............  $8,853   $23,120   $48,591   $141,714   $294,334      $97,272        $156,509
                            ======   =======   =======   ========   ========      =======        ========
Company-owned stores:
  Net sales...............  $3,992   $16,118   $39,144   $131,028   $282,923      $92,718        $151,349
  Cost of goods sold and
     occupancy costs......   2,687    10,758    25,937     86,372    194,761       65,246         109,858
                            ------   -------   -------   --------   --------      -------        --------
  Gross profit............   1,305     5,360    13,207     44,656     88,162       27,472          41,491
  Store operating and
     selling expense......   1,240     4,255    10,116     31,880     73,970       24,111          42,052
                            ------   -------   -------   --------   --------      -------        --------
  Company-owned stores
     profit
     contribution.........      65     1,105     3,091     12,776     14,192        3,361            (561)
Franchise stores:
  Royalty fees............   3,836     6,075     8,512     10,224     10,841        4,379           4,907
  Franchise fees..........   1,025       927       935        462        570          175             253
                            ------   -------   -------   --------   --------      -------        --------
  Total franchise
     revenues.............   4,861     7,002     9,447     10,686     11,411        4,554           5,160
  Total franchise
     expense..............   2,050     2,944     3,729      3,998      4,114        1,803           1,906
                            ------   -------   -------   --------   --------      -------        --------
  Franchise profit
     contribution.........   2,811     4,058     5,718      6,688      7,297        2,751           3,254
General and administrative
  expense:
  Special charges(a)......      --        --        --         --         --           --           5,858
  Impairment provision....      --        --        --         --         --           --             300
  Other general and
     administrative
     expenses.............   1,930     3,024     3,160      7,049     15,939        5,615           9,698
                            ------   -------   -------   --------   --------      -------        --------
                             1,930     3,024     3,160      7,049     15,939        5,615          15,856
                            ------   -------   -------   --------   --------      -------        --------
Income (loss) before
  interest and income
  taxes...................     946     2,139     5,649     12,415      5,550          497         (13,163)
Interest expense (income),
  net.....................     (62)      (23)     (476)      (212)     2,636          873           2,378
                            ------   -------   -------   --------   --------      -------        --------
</TABLE>

                                       17
<PAGE>   19

<TABLE>
<CAPTION>
                                        YEAR ENDED DECEMBER 31,                      SIX MONTHS ENDED
                            ------------------------------------------------   ----------------------------
                             1994     1995      1996       1997       1998     JUNE 30, 1998   JULY 3, 1999
                            ------   -------   -------   --------   --------   -------------   ------------
                                                                                (UNAUDITED)
<S>                         <C>      <C>       <C>       <C>        <C>        <C>             <C>
Income (loss) before
  income taxes............   1,008     2,162     6,125     12,627      2,914         (376)        (15,541)
Income taxes (benefit)....     466       863     2,369      4,957      1,127         (146)         (2,125)
                            ------   -------   -------   --------   --------      -------        --------
Net income (loss).........  $  542   $ 1,299   $ 3,756   $  7,670   $  1,787      $  (230)       $(13,416)
                            ======   =======   =======   ========   ========      =======        ========
Basic earnings (loss) per
  share...................   (b)     $  0.16   $  0.38   $   0.65   $   0.14      $ (0.02)       $  (1.08)
                                     =======   =======   ========   ========      =======        ========
Diluted earnings (loss)
  per share...............   (b)     $  0.16   $  0.38   $   0.64   $   0.14      $ (0.02)       $  (1.08)
                                     =======   =======   ========   ========      =======        ========
Weighted average shares
  outstanding -- Basic....   7,513     7,984     9,802     11,749     12,411       12,376          12,455
Weighted average shares
 outstanding -- Diluted...   7,513     7,984     9,996     12,039     12,704       12,376          12,455
EBITDA(c).................  $1,045   $ 2,461   $ 6,395   $ 15,209   $ 12,148      $ 4,131        $ (1,776)
                            ======   =======   =======   ========   ========      =======        ========
OPERATING DATA:
  Number of Company-owned
     stores (end of
     period)..............       7        16        36        117        207          148             215
  Increase in Company-
     owned same store
     sales................      NA      26.6%     17.9%      15.5%      11.3%        11.3%            5.1%
  Number of franchise
     stores (end of
     period)..............      99       132       164        158        167          160             178
  Increase in franchise
     same store sales.....    13.1%     10.3%     19.5%      14.8%       6.8%         8.8%            6.6%
  Average sales per
     Company-owned
     store................  $  570   $ 1,510   $ 1,662   $  1,740   $  1,684      $   681        $    706
  Depreciation and
     amortization.........      99       322       746      2,794      6,598        3,634           5,229
BALANCE SHEET DATA:
  Working capital
     (deficiency).........  $2,088   $ 1,999   $17,419   $ 13,931   $(15,039)     $40,805        $(26,694)
  Total assets............   6,009    10,308    34,603     89,615    144,032      119,168         161,319
  Bank borrowings and
     other long-term
     liabilities..........      39        72        --      3,150         --(d)     40,182             --(d)
  Capital lease
     obligation...........      --        --        --      1,460      1,141        1,072             718
  Stockholders' equity....   3,232     4,582    23,561     45,783     49,368       46,103          35,934
</TABLE>

---------------
(a) Special charges in 1999 relate to consulting services, accounting fees, bank
    fees, legal fees and other expenses related to the Company's default on its
    Credit Agreement. The Company engaged the services of a crisis management
    consulting firm and numerous other professionals to advise management during
    the complex negotiations with the bank, vendors and potential investors.

(b) Until April 1994, the Company elected to be taxed as an S Corporation under
    the Internal Revenue Code. If the Company had been taxed as a C Corporation
    for the year ended December 31, 1994, pro forma income taxes, pro forma net
    income and pro forma basic and diluted earnings per share would have been
    $410,000, $598,000 and $0.08, respectively.

(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 Credit Agreement of $46.8 million and $58.6
    million included in current liabilities at December 31, 1998 and July 3,
    1999, respectively.

                                       18
<PAGE>   20

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.

     A summary of the Company's new store openings, store acquisitions and store
sales is as follows:

<TABLE>
<CAPTION>
                                                     NEW                TOTAL                          END
                                                    STORES    STORES    STORES   STORES   BEGINNING     OF
                                                    OPENED   ACQUIRED   ADDED     SOLD    OF PERIOD   PERIOD
                                                    ------   --------   ------   ------   ---------   ------
<S>                                                 <C>      <C>        <C>      <C>      <C>         <C>
Quarter Ended:
  March 31, 1997..................................     6         6        12      --          36        48
  June 30, 1997...................................     9        --         9      --          48        57
  September 30, 1997..............................    29        18        47      --          57       104
  December 31, 1997...............................    13        --        13      --         104       117
                                                      --        --        --       --
                                                      57        24        81      --
                                                      ==        ==        ==       ==
Quarter Ended:
  March 31, 1998..................................    12         1        13      --         117       130
  June 30, 1998...................................    15         3        18      --         130       148
  September 30, 1998..............................    40         5        45      --         148       193
  December 31, 1998...............................    14        --        14      --         193       207
                                                      --        --        --       --
                                                      81         9        90      --
                                                      ==        ==        ==       ==
Quarter Ended:
  March 31, 1999..................................     7        --         7      --         207       214
  July 3, 1999....................................     2        --         2       1         214       215
                                                      --        --        --       --
                                                       9        --         9       1
                                                      ==        ==        ==       ==
</TABLE>

  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 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 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 contribution was a loss of $561,000 for the 1999 Period,
compared to a profit of $3.4 million for 1998 Period.

                                       19
<PAGE>   21

     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 for calendar year 1999 compared to calendar
year 1998.

     Corporate occupancy expense 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 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 as a percentage of sales were 6.6% and 6.1% for the
1999 Period and 1998 Period, respectively.

     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 higher levels of borrowings and higher 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 loss
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.

  Year Ended December 31, 1998 Compared to Year Ended December 31, 1997

     Retail.  Net sales from Company-owned stores increased 116% to $282.9
million in the year ended December 31, 1998 from $131.0 million in the year
ended December 31, 1997. The 1998 results include 117 stores which were open at
the beginning of that year plus 81 stores opened during the year and nine stores
acquired during the year. Of the total sales increase, 48.8% is attributable to
new store openings in 1998. Same store sales increased 11.3% in 1998. 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

                                       20
<PAGE>   22

utilities. Gross profit for the year ended December 31, 1998 increased 97.4% to
$88.2 million compared to $44.7 million in 1997. The increase in 1998 was
primarily due to increased sales volume. Gross margin was 31.2% and 34.1% of
sales for the years ended December 31, 1998 and 1997, respectively. The decrease
in gross margin was related primarily to increases in the provision for
slow-moving inventory of $2.8 million and increased inventory losses of $2.1
million as compared to the loss experience in 1997. Additionally, the gross
margin percentage was effected by increased store occupancy costs of $4.0
million without a corresponding increase in sales.

     Store operating and selling expenses increased 132% to $74.0 million for
the year ended December 31, 1998 compared to $31.9 million in 1997. The increase
in store operating expenses is primarily attributable to the increased number of
stores operated by the Company during 1998. Store operating expenses were 26.1%
and 24.3% of sales for 1998 and 1997, respectively, due to increased store
operating payroll costs related to new store openings. Company-owned store
profit contribution was $14.2 million for the year ended December 31, 1998,
compared to a profit contribution of $12.8 million for 1997.

     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 6.1% to
$10.8 million in the year ended December 31, 1998 from $10.2 million in 1997.
Franchise fees, recognized on 19 store openings during the year ended December
31, 1998 increased 23.4% to $570,000 compared to $462,000 during 1997 recognized
on 19 store openings. Franchise same store sales increases for the years ended
December 31, 1998 and 1997 were 6.8% and 14.8%, respectively.

     Expenses directly related to franchise revenue increased 2.9% to $4.1
million for the year ended December 31, 1998 from $4.0 million for the year
ended December 31, 1997. 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 36.0% and 37.4% for the years ended
December 31, 1998 and 1997, respectively.

     Franchise profit contribution was increased 9.1% to $7.3 million for the
year ended December 31, 1998 compared to $6.7 million for the year ended
December 31, 1997. 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.  General and administrative expenses increased
126% to $16.0 million in the year ended December 31, 1998 compared to $7.0
million in the year ended December 31, 1997. The increase is primarily
attributable to an increase in payroll and related benefits, recruitment and
moving of new employees, professional and consulting fees, and increased travel
as a result of establishing the organizational infrastructure to allow the
Company to build the Company owned store base. As a percentage of sales, general
and administrative expenses were 5.6% and 5.4% for the years ended December 31,
1998 and 1997, respectively.

     Interest Expense.  Interest expense increased to $2.6 million for the year
ended December 31, 1998 from interest income of $212,000 in the year ended
December 31, 1997. This is attributable to additional borrowings under the
Credit Agreement outstanding during the year related to store expansion.

     Income Taxes.  Income taxes decreased 77.3% to $1.1 million for the year
ended December 31, 1998 from $5.0 million for the year ended December 31, 1997.
This decrease is related primarily to the decrease in pre-tax earnings of 76.9%
for 1998 compared to 1997.

     Net Income.  Net income decreased 76.7% to $1.8 million or $0.14 per basic
and diluted share, in the year ended December 31, 1998 as compared to net income
of $7.7 million, or $0.65 per share in the year ended December 31, 1997. All
earnings per share data have been retroactively adjusted for the three-for-two
stock split that occurred on January 16, 1998.

                                       21
<PAGE>   23

  Year Ended December 31, 1997 Compared to Year Ended December 31, 1996

     Retail.  Net sales from Company-owned stores increased 234% to $131.0
million in the year ended December 31, 1997 up from $39.1 million in the year
ended December 31, 1996. The 1997 results include 36 stores that were open at
the beginning of that year plus 57 stores opened during the year (of which 19
were opened in September, 10 in October, and three in December) and 24 stores
acquired during the year. The 1996 amount represents sales from 16 stores that
were open at the beginning of the year plus 20 stores opened during the year
(five of which were opened in September and two in October). Of the total sales
increase, 74.4% is attributable to new store openings in 1997. Same store sales
increased 15.5% in 1997. Gross profit reflects the cost of goods sold and store
occupancy costs including rent, common area maintenance, repair and maintenance,
depreciation and utilities. Gross profit for the year ended December 31, 1997
increased 238% to $44.7 million, compared to $13.2 million for the year ended
December 31, 1996. The increase in 1997 was due to increased sales volume. Gross
margin was 34.1% and 33.7% of sales for the years ended December 31, 1997 and
1996, respectively.

     Store operating and selling expenses increased 216% to $31.9 million for
the year ended December 31, 1997 compared to $10.1 million for 1996. The
increase in store operating expenses is attributable to the increased number of
stores operated by the Company during 1997. Store operating expenses were 24.3%
and 25.8% of sales for the years ended December 31, 1997 and 1996, respectively.
Company-owned store profit contribution increased 313% to $12.8 million for the
year ended December 31, 1997, compared to a profit contribution of $3.1 million
for the comparable 1996 period.

     Franchising.  Franchise revenue is composed of the initial franchise fees
that 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 20.1% to
$10.2 million in the year ended December 31, 1997, up from $8.5 million in the
comparable 1996 period. The increase was attributable primarily to sales
increases in stores opened as of December 31, 1996. Franchise same store sales
increases for the years ended December 31, 1997 and 1996 were 14.8% and 19.5%,
respectively. Franchise fees, recognized on 19 store openings during the year
ended December 31, 1997 were $462,000 compared to $935,000 representing 32 store
openings during 1996. The reduction in franchise fees attributed to fewer store
openings was partially offset by the increase in such fees from $30,000 to
$35,000 per store with respect to franchise agreements signed after January 1,
1996.

     Expenses directly related to franchise revenue increased 7.2% to $4.0
million for the year ended December 31, 1997 from $3.7 million for the year
ended December 31, 1996. As a percentage of franchise revenue, franchise
expenses were 37.4% and 39.5% for the years ended December 31, 1997 and 1996,
respectively.

     Franchise profit contribution was increased 17.0% to $6.7 million for the
year ended December 31, 1997, compared to $5.7 million for the year ended
December 31, 1996. The increase in franchise profit contribution is due to the
increase in royalty fees offset by a decrease in franchise fees and increase in
franchise expenses as discussed above.

     General and Administrative Expense.  General and administrative expenses
increased 123% to $7.0 million in the year ended December 31, 1997, compared
with $3.1 million in the year ended December 31, 1996. The increase is primarily
attributable to an increase in payroll and related benefits of approximately
$1.8 million as a consequence of establishing the necessary organizational
infrastructure to allow the Company to build its Company-owned store base,
professional fees increases of approximately $226,000 due primarily to increases
in legal and accounting fees and travel expense increases of approximately
$730,000 which increased primarily due to the increase in the number of stores.
In addition, the Company had other increases in general and administrative
expenses related to insurance, investor relations expenditures and general
corporate expenses. As a percentage of sales, general and administrative
expenses were 5.4% and 8.1% for the years ended December 31, 1997 and 1996,
respectively. This decrease as a percentage of revenue resulted from increased
leverage of general and administrative expenses over a larger sales base.

                                       22
<PAGE>   24

     Interest Income.  Interest income decreased 55.5% to $212,000 during the
year ended December 31, 1997, as compared to $476,000 during the year ended
December 31, 1996. This decrease related primarily to the decrease in average
funds available for investment during the period.

     Income Taxes.  The provision for income tax expense increased 109% to $5.0
million during for the year ended December 31, 1997 as compared to the $2.4
million recorded in 1996. This increase related primarily to the increase in
pre-tax earnings of 106% for the 1997 period over 1996.

     Net Income.  As a result of the foregoing factors, net income increased
104% to $7.7 million, or $0.65 per basic share and $0.64 per diluted share, in
the year ended December 31, 1997 compared with $3.8 million, or $0.38 per basic
and diluted share in the year ended December 31, 1996.

ACCOUNTING AND REPORTING CHANGES

     In June 1997, the Financial Accounting Standards Board ("FASB") issued
Statement of Financial Accounting Standard ("SFAS") No. 130 "Reporting
Comprehensive Income," which establishes standards for the reporting and display
of comprehensive income and its components (revenues, expenses, gains and
losses) in a full set of general-purpose financial statements. This statement
requires that all items that are required to be recognized under accounting
standards as components of comprehensive income be reported in a financial
statement that is displayed with the same prominence as other financial
statements. Comprehensive income is equivalent to the Company's reported net
income. The adoption of this statement had no impact on the consolidated
financial statements.

     Effective January 1, 1998, the Company adopted AICPA Statement of Position
(the "SOP") 98-1, "Accounting for the Costs of Computer Software Developed or
Obtained for Internal Use," which requires the Company to capitalize certain
software development costs. Generally, once the capitalization criteria of the
SOP have been met, external direct costs of materials and services used in
development of internal-use software, payroll and payroll-related costs for
employees directly involved in the development of internal-use software and
interest costs incurred when developing software for internal use are to be
capitalized. The adoption of the SOP had no impact on the consolidated financial
statements because the SOP requires the change to be implemented prospectively.

     Effective January 1, 1999, the Company adopted SFAS No. 131, "Disclosures
about Segments of an Enterprise and Related Information." SFAS No. 131
establishes standards for the way that business enterprises report information
about operating segments in financial statements and related disclosures about
products and services, geographical areas and major customers. The Company has
adopted this statement and expanded its disclosure of its retail and franchise
segments.

     In June 1998, the FASB issued SFAS No. 133, "Accounting for Derivative
Instruments and Hedging Activities" ("SFAS No. 133"). SFAS No. 133 establishes
accounting and reporting standards for derivative instruments and hedging
activities. SFAS No. 133 requires an entity to recognize all derivatives as
either assets or liabilities in the statement of financial position and to
measure those instruments at fair value. For fiscal year 2001, the Company is
required to adopt SFAS No. 133. The Company has determined that the application
of SFAS No. 133 will not have a material impact on its financial position or
results of operations.

     In November 1999, the SEC issued Staff Accounting Bulletin 101, "Revenue
Recognition." This bulletin sets forth the SEC Staff's position regarding the
point at which it is appropriate for a Registrant to recognize revenue. The
Staff believes that revenue is realizable and earned when all of the following
criteria are met: persuasive evidence of an arrangement exists; delivery has
occurred or service has been rendered; the seller's price to the buyer is fixed
or determinable; and collectibility is reasonably assured. The Company uses the
above criteria to determine whether revenue can be recognized, and therefore
believes that the issuance of this bulletin does not have a material impact on
its financial statements.

LIQUIDITY AND CAPITAL RESOURCES

     The Company's cash provided by operating activities was $779,000 in the
1999 Period, compared to cash used in operating activities of $21.8 million in
the 1998 Period. The decrease in cash provided by operating
                                       23
<PAGE>   25

activities in the 1999 Period compared to 1998 Period was primarily the result
of decreased operating contribution for the increased number of stores in
operation during the 1999 Period and the significant special changes incurred
during the 1999 Period.

     Cash used in investing activities was $7.9 million in the 1999 Period. The
increase in cash used in investing activities in 1997 compared to 1996 and in
the 1999 Period as compared to 1997 was attributable to increased purchases of
property and equipment and store acquisitions. Cash used in investing activities
in the 1998 period was $12.8 million. This decrease in cash used in investing
activities is due to the reduced store growth during the 1999 Period.

     Cash provided by financing activities was $11.7 million and $36.4 for the
1999 Period and 1998 Period, respectively. The cash provided by financing
activities in the 1999 Period was primarily attributable to the proceeds from
borrowings under the revolving credit agreement. See "Business -- Significant
Developments" for discussion of the resolution of the Company's liquidity
shortfall during the 1999 period and subsequent periods.

     Management currently believes that the cash generated by operations,
together with projected availability under the Congress Loan Agreement will be
sufficient to meet the Company's working capital needs for the next 12 months.

  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, store closings and store sales.

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 involve
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 retailers, availability of qualified personnel,
availability of suitable future store locations, schedules of store expansion
plans and year 2000 readiness issues relating to the Company's internal systems
and those of third parties, the ability of the Company to refinance its existing
debt on terms acceptable to it and other factors. 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 7A.  QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK

     Not applicable.

                                       24
<PAGE>   26

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 1999 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 December 31, 1997 and 1998, and July 3,
     1999
     Consolidated Statements of Operations for the years ended December 31,
        1996, 1997 and 1998, and the six months ended June 30, 1998 (unaudited)
        and July 3, 1999.
     Consolidated Statements of Shareholders' Equity for the years ended
        December 31, 1996, 1997 and 1998, and the six months ended June 30, 1998
        (unaudited) and July 3, 1999.
     Consolidated Statements of Cash Flows for the years ended December 31,
        1996, 1997 and 1998, and the six months ended June 30, 1998 (unaudited)
        and July 3, 1999.
     Notes to Consolidated Financial Statements for the years ended December 31,
        1996, 1997 and 1998, and the six months ended June 30, 1998 (unaudited)
        and July 3, 1999.

     2.  Financial Statement Schedules -- Not Applicable.

     3.  List of Exhibits.

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

<TABLE>
<C>       <S>  <C>
  3.1(1)  --   Certificate of Incorporation of the Company.
  3.2(1)  --   Bylaws of the Company.
  4.1(1)  --   Specimen stock certificate evidencing the Common Stock.
  4.2(2)  --   Form of Revolving Credit Note.
  4.3(3)  --   Form of Warrant.
  4.4(3)  --   Form of A Note.
  4.5(3)  --   Form of B Note.
  4.6(3)  --   Form of C Note.
  4.7(3)  --   Form of D Note.
  4.8(3)  --   Form of Securities Purchase Agreement, dated as of August
               16, 1999, by and between the Company and each of the
               Investors.
 10.1(1)  --   Form of Unit Franchise Agreement entered into by the Company
               and franchisees.
</TABLE>

                                       25
<PAGE>   27
<TABLE>
<C>       <S>  <C>
 10.2(1)  --   Employment Agreement, dated as of January 1, 1994 and
               amended as of January 16, 1996, by and between the Company
               and Steve Mandell.
 10.3(4)  --   Amendment to Employment Agreement, dated as of March 5,
               1997, by and between the Company and Steven Mandell.
 10.4(1)  --   Employment Agreement, dated as of January 1, 1994 and
               amended as of January 16, 1996, by and between the Company
               and Perry Kaplan.
 10.5(1)  --   Employment Agreement of David Lauber, dated as of June 12,
               1995, by and between the Company and David Lauber.
 10.6(1)  --   Employment Agreement of Lawrence Fine, dated as of October
               13, 1995, by and between the Company and Lawrence Fine.
 10.7(5)  --   Amended Stock Option Plan of the Company.
 10.8(5)  --   Amended and Restated 1994 Stock Option Plan of the Company.
 10.9(1)  --   Loan and Security Agreement, dated as of August 15, 1995 and
               amended as of October 6, 1995, by and between the Company
               and Midlantic Bank, N.A.
10.10(4)  --   Commitment Letter between PNC Bank and the Company.
10.11(6)  --   Asset Purchase Agreement dated as of September 2, 1997 by
               and among the Company and Hammond Retailing of Mesquite,
               L.C., Hammond Retailing of West Plano, L.C., Hammond
               Retailing of Richardson, L.C., Hammond Retailing of
               Arlington, L.C., Hammond Retailing of Carrollton, L.C.,
               Hammond Retailing of Irving, L.C., Hammond Retailing of
               Medallion, L.C., Hammond Retailing of Red Bird LLC, Hammond
               Retailing of Vista Ridge, LLC, Hammond Retailing of Pleasant
               Grove, LLC, Hammond Retailing of White Rock, LLC, Hammond
               Communications, Inc. and Mr. Geoffrey Hammond (without
               exhibits or schedules).
10.12(6)  --   Letter Agreement by and between the Company and Hammond
               Retailing of Plano East, LLC, dated as of July 7, 1997.
10.13(6)  --   Third Amendment to Loan and Security Agreement, dated as of
               June 16, 1997, by and between the Company and PNC Bank,
               National Association.
10.14(7)  --   Fourth Amendment to the Loan and Security Agreement, dated
               as of March 10, 1998, by and between the Company and PNC
               Bank, National Association.
10.15(7)  --   $60,000,000 credit facility Commitment Letter, dated as of
               March 9, 1998, by and between the Company and PNC Bank N.A.,
               as agent, for the Banks.
10.16(7)  --   Employment Agreement of David Lauber, dated as of September
               23, 1997, by and between the Company and David Lauber.
10.17(2)  --   Revolving Credit Facility Credit Agreement, dated as of
               April 24, 1998, by and among the Company, the Banks and PNC
               Bank, National Association, as Agent.
10.18(8)  --   Option Agreement, dated as of June 8, 1999, between Steven
               Mandell and Jack Futterman.
10.19(8)  --   Stock Pledge Agreement, dated as of June 8, 1999, between
               Steven Mandell and Jack Futterman.
10.20(8)  --   Employment Agreement, dated as of June 8, 1999, between the
               Company and Jack Futterman.
10.21(3)  --   Investor Rights Agreement, dated as of August 16, 1999, by
               and among the Company, the Investors and Jack Futterman.
10.22(3)  --   Standstill and Forbearance Agreement, dated as of August 16,
               1999, by and among the Company, PNC Bank, National
               Association, as Agent, and the Banks.
10.23(3)  --   Vendor Forbearance and Standstill Agreement, dated as of
               August 16, 1999, by and among the Company and the Trade
               Vendors.
</TABLE>

                                       26
<PAGE>   28
<TABLE>
<C>       <S>  <C>
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      --   Independent Auditors' Consent.
27.1      --   Financial Data Schedule.
</TABLE>

---------------
Notes

(1) Incorporated by reference to the Company's Registration Statement as amended
    on Form S-1 Number 333-350 as filed with the Commission on January 18, 1996.

(2) Incorporated by reference to the Company's Quarterly Report on Form 10-Q as
    filed with the Commission on May 15, 1998.

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

(4) Incorporated by reference to the Company's Registration Statement on Form
    S-1 as filed with the Commission on March 6, 1997.

(5) Incorporated by reference to the Company's Registration Statement on Form
    S-8 as filed with the Commission on January 9, 1997.

(6) Incorporated by reference to the Company's Current Report on Form 8-K as
    filed with the Commission on September 12, 1997, as amended November 10,
    1997.

(7) Incorporated by reference to the Company's Annual Report on Form 10-K as
    filed with the Commission on March 31, 1998.

(8) Incorporated by reference to Amendment No. 1 to Schedule 13D as filed with
    the Commission on June 30, 1999.
---------------

(b) Reports on Form 8-K.

    None.

                                       27
<PAGE>   29

                                   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 27, 2000.

                                          PARTY CITY CORPORATION

                                          By:        /s/ JAMES SHEA
                                            ------------------------------------
                                                         James Shea
                                                  Chief Executive Officer

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

                                          By:      /s/ LINDA M. SILUK
                                            ------------------------------------
                                                       Linda M. Siluk
                                                  Chief Accounting Officer

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

<TABLE>
<CAPTION>
                       NAME                                      TITLE                      DATE
                       ----                                      -----                      ----
<S>                                                    <C>                           <C>

               By: /s/ RALPH DILLION                   Non-Executive,                September 27, 2000
   ---------------------------------------------         Chairman of the Board
                   Ralph Dillion                         and Director

              By: /s/ JACK FUTTERMAN                   Director                      September 27, 2000
   ---------------------------------------------
                  Jack Futterman

             By: /s/ L.R. JALENAK, JR.                 Director                      September 27, 2000
   ---------------------------------------------
                 L.R. Jalenak, Jr.

             By: /s/ HOWARD LEVKOWITZ                  Director                      September 27, 2000
   ---------------------------------------------
                 Howard Levkowitz

              By: /s/ DUAYNE WEINGER                   Director                      September 27, 2000
   ---------------------------------------------
                  Duayne Weinger
</TABLE>

                                       28
<PAGE>   30

                          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 December 31, 1997 and 1998, and July 3, 1999,
and the related consolidated statements of operations, stockholders' equity, and
cash flows for the years ended December 31, 1996, 1997, 1998, and the six months
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 of December 31, 1997 and 1998, and July 3, 1999,
and the consolidated results of their operations and their cash flows for the
years ended December 31, 1996, 1997, 1998, and for the six months ended July 3,
1999 in conformity with accounting principles generally accepted in the United
States of America.

DELOITTE & TOUCHE LLP

PARSIPPANY, NEW JERSEY
SEPTEMBER 27, 2000

                                       F-1
<PAGE>   31

                     PARTY CITY CORPORATION AND SUBSIDIARY

                          CONSOLIDATED BALANCE SHEETS
                                 (IN THOUSANDS)

<TABLE>
<CAPTION>
                                                                 DECEMBER 31,
                                                         ----------------------------
                                                               1997            1998      JULY 3, 1999
                                                         -----------------   --------    ------------
<S>                                                      <C>                 <C>         <C>
                                       ASSETS
Current assets:
  Cash and cash equivalents............................       $ 3,235        $  6,892      $ 11,470
  Merchandise inventory................................        39,041          56,590        47,016
  Refundable income taxes..............................            --              --         6,848
  Advance merchandise payments.........................            --              --         9,439
  Other current assets.................................         7,840           9,817        16,600
                                                              -------        --------      --------
          Total current assets.........................        50,116          73,299        91,373
Property and equipment, net............................        24,199          49,704        50,557
Goodwill, net..........................................        14,130          19,189        18,483
Other assets...........................................         1,170           1,840           906
                                                              -------        --------      --------
          Total assets.................................       $89,615        $144,032      $161,319
                                                              =======        ========      ========

LIABILITIES AND STOCKHOLDERS' EQUITY
Current liabilities:
  Accounts payable.....................................       $24,927        $ 31,846      $ 48,386
  Accrued expenses.....................................         6,994           8,873        10,145
  Advances under credit agreement......................            --          46,800        58,550
  Income taxes payable.................................         3,080              --            --
  Other current liabilities............................         1,184             819           986
                                                              -------        --------      --------
          Total current liabilities....................        36,185          88,338       118,067
Long-term liabilities:
  Revolving credit agreement...........................         3,150              --            --
  Deferred rent........................................         2,987           5,446         6,527
  Other long-term liabilities..........................         1,510             880           791

Commitments and contingencies

Stockholders' equity:
  Common stock.........................................           123             125           125
  Additional paid-in capital...........................        32,246          34,042        34,024
  Retained earnings....................................        13,414          15,201         1,785
                                                              -------        --------      --------
          Total stockholders' equity...................        45,783          49,368        35,934
                                                              -------        --------      --------
          Total liabilities and stockholders' equity...       $89,615        $144,032      $161,319
                                                              =======        ========      ========
</TABLE>

          See accompanying notes to consolidated financial statements.
                                       F-2
<PAGE>   32

                     PARTY CITY CORPORATION AND SUBSIDIARY

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

<TABLE>
<CAPTION>
                                        YEAR ENDED DECEMBER 31,              SIX MONTHS ENDED
                                    -------------------------------    -----------------------------
                                     1996        1997        1998      JUNE 30, 1998    JULY 3, 1999
                                    -------    --------    --------    -------------    ------------
                                                                        (UNAUDITED)
<S>                                 <C>        <C>         <C>         <C>              <C>
Revenues:
  Net sales.......................  $39,144    $131,028    $282,923       $92,718         $151,349
  Royalty fees....................    8,512      10,224      10,841         4,379            4,907
  Franchise fees..................      935         462         570           175              253
                                    -------    --------    --------       -------         --------
          Total revenues..........   48,591     141,714     294,334        97,272          156,509
Expenses:
  Cost of goods sold and occupancy
     costs........................   25,937      86,372     194,761        65,246          109,858
  Company-owned stores operating
     and selling expense..........   10,116      31,880      73,970        24,111           42,052
  Franchise expense...............    3,729       3,998       4,114         1,803            1,906
  General and administrative
     expense......................    3,160       7,049      15,939         5,615           15,856
                                    -------    --------    --------       -------         --------
          Total expenses..........   42,942     129,299     288,784        96,775          169,672
                                    -------    --------    --------       -------         --------
Income (loss) before interest and
  income taxes....................    5,649      12,415       5,550           497          (13,163)
  Interest expense (income),
     net..........................     (476)       (212)      2,636           873            2,378
                                    -------    --------    --------       -------         --------
Income (loss) before income
  taxes...........................    6,125      12,627       2,914          (376)         (15,541)
  Provision for income taxes
     (benefit)....................    2,369       4,957       1,127          (146)          (2,125)
                                    -------    --------    --------       -------         --------
Net income (loss).................  $ 3,756    $  7,670    $  1,787       $  (230)        $(13,416)
                                    =======    ========    ========       =======         ========
  Basic earnings (loss) per
     share........................  $  0.38    $   0.65    $   0.14       $ (0.02)        $  (1.08)
                                    =======    ========    ========       =======         ========
     Weighted average shares
       outstanding -- basic.......    9,802      11,749      12,411        12,376           12,455
                                    =======    ========    ========       =======         ========
  Diluted earnings (loss) per
     share........................  $  0.38    $   0.64    $   0.14       $ (0.02)        $  (1.08)
                                    =======    ========    ========       =======         ========
     Weighted average shares
       outstanding -- diluted.....    9,996      12,039      12,704        12,376           12,455
                                    =======    ========    ========       =======         ========
</TABLE>

          See accompanying notes to consolidated financial statements.
                                       F-3
<PAGE>   33

                     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, 1996..........   7,836,000     $ 78       $ 2,515      $  1,988    $  4,581
Sale of common shares...............   2,550,000       25        16,975            --      17,000
Expenses incurred on sale of common
  shares............................          --       --        (1,990)           --      (1,990)
Exercise of stock options...........      55,001        1           174            --         175
Tax effect of non-qualified
  options...........................          --       --            39            --          39
Net income..........................          --       --            --         3,756       3,756
                                      ----------     ----       -------      --------    --------
Balance at December 31, 1996........  10,441,001      104        17,713         5,744      23,561
Sale of common shares...............   1,800,000       18        15,582            --      15,600
Expenses incurred on sale of common
  shares............................          --       --        (1,415)           --      (1,415)
Exercise of stock options...........      59,094        1           266            --         267
Tax effect of non-qualified
  options...........................          --       --           100            --         100
Net income..........................          --       --            --         7,670       7,670
                                      ----------     ----       -------      --------    --------
Balance at December 31, 1997........  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
                                      ==========     ====       =======      ========    ========
</TABLE>

          See accompanying notes to consolidated financial statements.
                                       F-4
<PAGE>   34

                     PARTY CITY CORPORATION AND SUBSIDIARY

                     CONSOLIDATED STATEMENTS OF CASH FLOWS
                                 (IN THOUSANDS)

<TABLE>
<CAPTION>
                                               YEAR ENDED DECEMBER 31,            SIX MONTHS ENDED
                                            -----------------------------   ----------------------------
                                             1996       1997       1998     JUNE 30, 1998   JULY 3, 1999
                                            -------   --------   --------   -------------   ------------
                                                                             (UNAUDITED)
<S>                                         <C>       <C>        <C>        <C>             <C>
Cash flow from operating activities:
  Net income (loss).......................  $ 3,756   $  7,670   $  1,787     $   (230)       $(13,416)
  Adjustments to reconcile net income
     (loss) to net cash provided by (used
     in) operating activities:
     Depreciation and amortization........      746      2,794      6,598        2,730           5,229
     Impairment provision.................       --         --         --           --             300
     Deferred rent........................      706      1,813      2,459        1,024           1,082
     Provision for doubtful accounts......        6        275        127           --             204
     Loss on disposition of assets........       11         99         --           --             234
     Deferred tax asset...................     (152)      (543)      (933)          (6)         (2,338)
  Changes in assets and liabilities
     Merchandise inventory................   (5,464)   (23,853)   (15,618)     (11,997)         11,897
     Refundable income taxes..............       --         --         --         (230)         (6,848)
     Advance merchandise payments.........       --         --         --           --          (9,439)
     Other current assets.................   (1,170)    (5,197)    (1,201)      (4,575)         (4,047)
     Other assets.........................       (5)      (335)      (639)        (627)            331
     Accounts payable.....................    3,016     19,950      6,919       (2,116)         16,540
     Accrued expenses.....................      755      5,013      1,879       (2,179)            972
     Income taxes payable.................    1,390      1,176     (3,080)      (3,080)             --
     Other current liabilities............      (37)       (11)      (365)        (468)            167
     Other long-term liabilities..........       --        197       (630)          --             (89)
                                            -------   --------   --------     --------        --------
       Net cash provided by (used in)
          operating activities............    3,558      9,048     (2,697)     (21,754)            779
  Cash flow from investment activities:
     Purchases of property and
       equipment..........................   (4,872)   (18,272)   (30,638)     (10,598)         (5.970)
     Stores acquired......................       --    (21,653)    (8,456)      (2,234)         (1,963)
                                            -------   --------   --------     --------        --------
       Net cash used in investing
          activities......................   (4,872)   (39,925)   (39,094)     (12,832)         (7,933)
  Cash flow from financing activities:
     Net proceeds from sale of stock......   15,010     14,185         --           --
     Proceeds from exercise of stock
       options............................      174        267        724          549              33
     Tax effect of non-qualified stock
       options............................       39        100      1,074           --             (51)
     Net proceeds from Credit Agreement...      (72)     4,610     43,650       35,891          11,750
                                            -------   --------   --------     --------        --------
  Net cash provided by financing
     activities...........................   15,151     19,162     45,448       36,440          11,732
                                            -------   --------   --------     --------        --------
  Net increase (decrease) in cash and cash
     equivalents..........................   13,837    (11,715)     3,657        1,854           4,578
  Cash and cash equivalents, beginning of
     period...............................    1,113     14,950      3,235        3,235           6,892
                                            -------   --------   --------     --------        --------
  Cash and cash equivalents, end of
     period...............................  $14,950   $  3,235   $  6,892     $  5,089        $ 11,470
                                            =======   ========   ========     ========        ========
  Supplemental disclosure of cash flow
     information:
     Income taxes paid....................  $ 1,148   $  4,219   $  3,433     $  3,207        $  2,469
     Interest paid........................       41        294      2,402          469           2,781
</TABLE>

          See accompanying notes to consolidated financial statements.
                                       F-5
<PAGE>   35

                     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. As of
July 3, 1999, the Company had 215 Company-owned stores and 178 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 was delayed in issuing its audited financial statements for the
year ended December 31, 1998 and was unable to timely file its 1998 Annual
Report on Form 10-K ("1998 Form 10-K") with the Securities and Exchange
Commission ("SEC") primarily because of difficulties associated with taking the
year-end physical inventories and the related reconciliation process. The
Company took a complete physical inventory as of July 3, 1999 and completed the
related reconciliation process necessary to prepare consolidated financial
statements for the year ended December 31, 1998. In September 2000 the Company
filed its 1998 Form 10-K. As a result of the failure to file the Form 10-K by
March 31, 1999, the Company was in default of Nasdaq's continued listing
requirements. Trading in the Company's common stock was halted on May 6, 1999,
and the Company was delisted on July 20, 1999.

     Effective July 3, 1999, the Company changed its fiscal year end for
financial reporting from December 31 to the Saturday nearest to June 30. The
Company continues to use December 31 as its tax year end. The change to a 52-53
week calendar was made to facilitate comparable store sales computations. The
term "Fiscal Year" refers to the 52-53 weeks ending the Saturday nearest June
30, unless otherwise noted. Consolidated financial statements of the Company for
the transition period from July 1, 1999 to July 3, 1999, are included in this
Transition Report on Form 10-K.

  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.

  Allowance for Doubtful Accounts

     The allowance for doubtful accounts on receivables from franchisees at
December 31, 1997 and 1998, and July 3, 1999 was $48,000, $166,000 and $379,000
respectively.

  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.

                                       F-6
<PAGE>   36
                     PARTY CITY CORPORATION AND SUBSIDIARY

           NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED)

  Advance Merchandise Payments

     In order to continue shipments of merchandise from suppliers while the
Company was in arrears on its trade payables, merchandise purchases was being
made primarily on a cash-in-advance basis as an on-account payment and
classified in current assets. As merchandise inventory attributable to these
on-account payments was received in the stores, an adjustment was made in the
Company's accounting records to reflect the purchase in merchandise inventory
and reduce the advance merchandise payments account. At July 3, 1999, the
Company had approximately $9.4 million in advance merchandise payments.

  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"). These amounts are restricted in their use for advertising on behalf
of the franchisees. Receipts and disbursements are not recorded as income or
expense since the Company does not have full discretion over the use of the
funds. The Company also contributes 1% of net sales of its owned stores into the
Ad Fund. 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 years ended December 31, 1996, 1997, 1998, and the six month periods
ended June 30, 1998 (unaudited) and July 3, 1999, Ad Fund management fees of
$134,000, $210,000, $278,000, $101,000, and $139,000, 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 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, see Note 6. 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 December 31, 1997 and 1998, and July 3, 1999 the cost of goodwill was $14.6
million, $20.8 million and $20.8, respectively.

                                       F-7
<PAGE>   37
                     PARTY CITY CORPORATION AND SUBSIDIARY

           NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED)

  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, "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) outstanding during the period. All earnings per
share data for the years ended December 31, 1996, 1997 and 1998, has been
retroactively adjusted for the three-for-two common stock split that occurred on
January 16, 1998.

  Revenue Recognition

     The Company operates predominately as a retailer through its Company owned
stores. The retail segment recognizes revenue at the point of sale.

     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

                                       F-8
<PAGE>   38
                     PARTY CITY CORPORATION AND SUBSIDIARY

           NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED)

obligations to the franchisee and the store is opened, the Company recognizes
the deposit as revenue. Information regarding franchise activity follows:

<TABLE>
<CAPTION>
                                                                NUMBER OF STORES
                                                      ------------------------------------
                                                          YEAR ENDED
                                                         DECEMBER 31,        SIX MONTHS
                                                      ------------------        ENDED
                                                      1996   1997   1998   TO JULY 3, 1999
                                                      ----   ----   ----   ---------------
<S>                                                   <C>    <C>    <C>    <C>
Franchise stores in operation at beginning of the
  period............................................  132    164    158          167
Franchise stores opened.............................   32     19     19           11
Franchise stores acquired...........................   --    (24)    (9)          --
Stores sold by the Company..........................   --     --     --            1
Franchise stores closed.............................   --     (1)    (1)          (1)
                                                      ---    ---    ---          ---
Franchise stores in operation at the end of the
  period............................................  164    158    167          178
                                                      ===    ===    ===          ===
</TABLE>

  Store Opening and Closing Costs

     New store opening costs are expensed as incurred. In the event a store is
closed before its lease expires, the estimated lease obligation, less any
sublease rental income, is provided in the period of closing.

  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 $2.3 million, $7.0 million, $16.0 million, $4.3 million and $7.4
million for the years ended December 31, 1996, 1997, 1998, and the six month
periods ended June 30, 1998 (unaudited) and July 3, 1999, respectively.

  Effect of New Accounting Standards

     In June 1997, the Financial Accounting Standards Board ("FASB") issued SFAS
No. 130 "Reporting Comprehensive Income," which establishes standards for the
reporting and display of comprehensive income and its components (revenues,
expenses, gains and losses) in a full set of general-purpose financial
statements. This statement requires that all items that are required to be
recognized under accounting standards as components of comprehensive income be
reported in a financial statement that is displayed with the same prominence as
other financial statements. Comprehensive income is equivalent to the Company's
reported net income. The adoption of this statement had no impact on the
consolidated financial statements.

     Effective January 1, 1998, the Company adopted AICPA Statement of Position
98-1 (the "SOP"), "Accounting for the Costs of Computer Software Developed or
Obtained for Internal Use," which requires the Company to capitalize certain
software development costs. Generally, once the capitalization criteria of the
SOP have been met, external direct costs of materials and services used in
development of internal-use software, payroll and payroll-related costs for
employees directly involved in the development of internal-use software and
interest costs incurred when developing software for internal use are to be
capitalized. The adoption of the SOP had no impact on the consolidated financial
statements because the SOP requires the change to be implemented prospectively.

     Effective January 1, 1999, the Company adopted SFAS No. 131, "Disclosures
about Segments of an Enterprise and Related Information." SFAS No. 131
establishes standards for the way that business enterprises report information
about operating segments in financial statements and related disclosures about
products and services, geographical areas and major customers. The Company has
adopted this statement and expanded its disclosure of its retail and franchise
segments.

                                       F-9
<PAGE>   39
                     PARTY CITY CORPORATION AND SUBSIDIARY

           NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED)

     In June 1998, the FASB issued SFAS No. 133, "Accounting for Derivatives
Instruments and Hedging Activities ("SFAS No. 133")." SFAS No. 133 establishes
accounting and reporting standards for derivative instruments and hedging
activities. SFAS No. 133 requires an entity to recognize all derivatives as
either assets or liabilities in the statement of financial position and to
measure those instruments at fair value. For fiscal year 2001, the Company is
required to adopt SFAS No. 133. The Company has determined that the application
of SFAS No. 133 will not have a material impact on its financial position or
results of operations.

     In November 1999, the SEC issued Staff Accounting Bulletin 101, "Revenue
Recognition." This bulletin sets forth the SEC Staff's position regarding the
point at which it is appropriate for a registrant to recognize revenue. The
Staff believes that revenue is realizable and earned when all of the following
criteria are met: persuasive evidence of an arrangement exists; delivery has
occurred or service has been rendered; the seller's price to the buyer is fixed
or determinable; and collectibility is reasonably assured. The Company uses the
above criteria to determine whether revenue can be recognized, and therefore
believes that the issuance of this bulletin does not have a material impact on
its financial statements.

  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 and
a liability for incurred but not reported medical claims.

  Concentration

     The Company had three suppliers who in the aggregate constituted
approximately 31% and 22% of the Company's purchases for the year ended December
31, 1998 and the six months ended July 3, 1999, respectively. 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

  1997 Acquisitions

     On February 28, 1997, the Company acquired six franchise stores. Four of
the stores acquired were owned by Steven Mandell, then the Company's Chairman
and President through May 1999, a member of the Board of Directors until
September 17, 1999 and a significant stockholder of the Company. Such stores
were acquired for an aggregate purchase price of $5.2 million. The remaining two
stores were owned by Perry Kaplan, a former executive officer and Director of
the Company. Such stores were acquired for an aggregate

                                      F-10
<PAGE>   40
                     PARTY CITY CORPORATION AND SUBSIDIARY

           NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED)

purchase price of $1.3 million. On August 1, 1997, the Company acquired three
franchise stores; two stores in the Southern California market and one store in
Staten Island, New York. Through these transactions, the Company acquired
certain development rights to the Southern California and Staten Island, New
York markets. The aggregate purchase price of these transactions was
approximately $3.3 million. On August 27, 1997 the Company acquired two
franchise stores in the Chicago market and on September 12, 1997 the Company
acquired two franchise stores in Virginia. The aggregate purchase price of these
transactions was approximately $3.9 million. On September 2, 1997, the Company
acquired 11 franchise stores in the Dallas/Fort Worth market. The purchase price
of this transaction was approximately $8.2 million. Additionally, the
acquisition agreement provides that the Company acquired the rights for any
future development in the Dallas/Fort Worth market.

  1998 Acquisitions

     On March 27, 1998, the Company acquired one franchise store in the Miami,
Florida market. The purchase price of this transaction was approximately $0.3
million. On June 28, 1998, the Company acquired three franchise stores in the
Memphis, Tennessee market. The purchase price of this transaction was
approximately $1.9 million. As discussed in Note 19, in order to meet cash flow
requirements, the Company sold the three Memphis stores to a franchisee in
August 1999. On August 31, 1998, the Company acquired four franchise stores in
the Chicago market from Duayne Weinger, a director of the Company. The purchase
price of this transaction was $3.9 million. On September 23, 1998, the Company
acquired one franchise store in the Houston market. The purchase price of this
store was approximately $0.5 million.

     The acquisitions have been accounted for under the purchase method of
accounting. The results of operations of the acquired stores are included in the
financial statements from the date of acquisition. Goodwill of $14.6 million in
1997 and $6.2 million in 1998 was recorded in connection with these acquisitions
and is being amortized on a straight-line basis over 15 years.

     Assuming the stores acquired during the years ended December 31, 1997 and
1998, were acquired on January 1, 1997, the pro forma results would have been as
follows (in thousands, except per share amounts) (unaudited):

<TABLE>
<CAPTION>
                                                                YEAR ENDED DECEMBER 31,
                                                                ------------------------
                                                                   1997          1998
                                                                ----------    ----------
<S>                                                             <C>           <C>
Total Revenues..............................................     $174,817      $301,913
Net Income..................................................        8,834         2,368
Basic EPS...................................................     $   0.75      $   0.19
Diluted EPS.................................................         0.73          0.19
</TABLE>

     The pro forma results are not necessarily indicative of the results of
operations that would have occurred had the transactions been consummated as
indicated nor are they intended to indicate results that may occur in the
future.

                                      F-11
<PAGE>   41
                     PARTY CITY CORPORATION AND SUBSIDIARY

           NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED)

3.  OTHER CURRENT ASSETS

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

<TABLE>
<CAPTION>
                                                            DECEMBER 31,
                                                          ----------------    JULY 3,
                                                           1997      1998      1999
                                                          ------    ------    -------
<S>                                                       <C>       <C>       <C>
Restricted cash from advertising fund...................  $  290    $   90    $    68
Receivables from franchisees:
  Royalty fees..........................................   1,069     1,201      1,124
  Other.................................................     386       795        977
Deferred income taxes...................................     382     1,284      4,225
Prepaid expenses and other current assets...............   5,713     6,447     10,206
                                                          ------    ------    -------
                                                          $7,840    $9,817    $16,600
                                                          ======    ======    =======
</TABLE>

4.  PROPERTY AND EQUIPMENT

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

<TABLE>
<CAPTION>
                                                          DECEMBER 31,
                                                       ------------------    JULY 3,
                                                        1997       1998        1999
                                                       -------    -------    --------
<S>                                                    <C>        <C>        <C>
Equipment............................................  $ 9,041    $22,142    $ 24,570
Furniture............................................   10,974     21,894      23,318
Leasehold improvements...............................    7,550     14,543      16,112
Automobiles..........................................      118        102         102
                                                       -------    -------    --------
                                                        27,683     58,681      64,102
Less: accumulated depreciation and amortization......   (3,484)    (8,977)    (13,545)
                                                       -------    -------    --------
                                                       $24,199    $49,704    $ 50,557
                                                       =======    =======    ========
</TABLE>

5.  OTHER ASSETS

     Other assets consist of the following (in thousands):

<TABLE>
<CAPTION>
                                                              DECEMBER 31,
                                                            ----------------    JULY 3,
                                                             1997      1998      1999
                                                            ------    ------    -------
<S>                                                         <C>       <C>       <C>
Deferred income taxes.....................................  $  572    $  603     $ --
Other.....................................................     598     1,237      906
                                                            ------    ------     ----
                                                            $1,170    $1,840     $906
                                                            ======    ======     ====
</TABLE>

6.  IMPAIRMENT OF LONG-LIVED ASSETS

     For the six months ended July 3, 1999, the Company recorded an impairment
charge of $300,000 relating to goodwill and fixed assets for five stores. These
stores have not achieved expected sales and earnings. The Company determined
that each store's projected cash flow could not support future amortization of
the remaining goodwill and fixed assets and an impairment charge was warranted.
The amount of impairment was measured on the basis of projected discounted cash
flows using a discount rate indicative of the Company's average cost of funds.
The Company will continually assess the recoverability of goodwill and fixed
asset balances of all long-lived assets and intangibles. The impairment charge
is applicable to the Company's retail segment and is included in general and
administrative expense in the consolidated statement of operations. No
impairment charge was incurred in the years ended December 31, 1996, 1997 and
1998.

                                      F-12
<PAGE>   42
                     PARTY CITY CORPORATION AND SUBSIDIARY

           NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED)

7.  ACCRUED EXPENSES

     Accrued expenses consist of the following (in thousands):

<TABLE>
<CAPTION>
                                                            DECEMBER 31,
                                                          ----------------    JULY 3,
                                                           1997      1998      1999
                                                          ------    ------    -------
<S>                                                       <C>       <C>       <C>
Accrued compensation....................................  $2,228    $1,761    $ 3,037
Sales and use taxes.....................................   1,709     2,204      1,741
Other...................................................   3,057     4,908      5,367
                                                          ------    ------    -------
                                                          $6,994    $8,873    $10,145
                                                          ======    ======    =======
</TABLE>

8.  FINANCING AGREEMENTS

     On April 24, 1998, the Company refinanced and replaced its then existing
$20 million loan facility with a $60 million secured revolving line of credit
agreement with a group of banks maturing April 24, 2001 (as amended, the "Credit
Agreement"). Advances under the Credit Agreement originally bore interest, at
the Company's option, at the agent bank's base rate (the higher of the bank's
prime rate or the federal funds rate plus  1/2% per annum) or LIBOR plus an
applicable margin. The Company's failure to issue its consolidated financial
statements on a timely basis is a default under the Credit Agreement. In
addition to this default, the Company did not meet certain of its financial
covenants, including those relating to minimum levels of profitability, net
worth, liquidity, fixed charge coverage and others. Consequently, the Company's
debt was subject to acceleration and was classified as a current liability in
the consolidated balance sheet at July 3, 1999. The Credit Agreement was secured
by all the assets of the Company. Additionally, the Credit Agreement restricted
the payment of dividends. See additional discussion in Note 19 to the
consolidated financial statements.

9.  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>
                                                 YEAR ENDED              SIX MONTHS ENDED
                                                DECEMBER 31,          ----------------------
                                         --------------------------    JUNE 30,     JULY 3,
                                          1996     1997      1998        1998         1999
                                         ------   -------   -------   -----------   --------
                                                                      (UNAUDITED)
<S>                                      <C>      <C>       <C>       <C>           <C>
Net income (loss)......................  $3,756   $ 7,670   $ 1,787   $     (230)   $(13,416)
Average shares outstanding.............   9,802    11,749    12,411       12,376      12,455
Earnings (loss) per share -- basic.....  $ 0.38   $  0.65   $  0.14   $    (0.02)   $  (1.08)
Dilutive effect of stock options.......     194       290       293           (a)         (a)
Average common and common equivalent
  shares outstanding...................   9,996    12,039    12,704       12,376      12,455
Earnings (loss) per share -- diluted...  $ 0.38   $  0.64   $  0.14   $    (0.02)   $  (1.08)
</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, 119,250, 134,000, 973,976 and 1,026,826 common shares
    at prices ranging from $3.84 to $34.44 per share were outstanding at
    December 31, 1996 and July 3, 1999, respectively, 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.

                                      F-13
<PAGE>   43
                     PARTY CITY CORPORATION AND SUBSIDIARY

           NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED)

10.  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 12,300,095, 12,452,369 and 12,455,538
at December 31, 1997 and 1998 and July 3, 1999, respectively.

     On March 27, 1996, the Company completed an initial public offering ("IPO")
of 2,550,000 shares of common stock, $.01 par value, issued by the Company, at
an IPO price of $6.67 per share. Proceeds to the Company, net of offering
expenses of $1,990,000, were $15,010,000.

     On May 8, 1997, the Company completed a secondary public offering of its
common stock. The total offering was for 3,360,000 shares of common stock, of
which 1,800,000 shares were offered by the Company and 1,560,000 were offered by
certain selling stockholders. The offering price was $8.67 per share. Proceeds
to the Company net of offering expenses were $14,185,000. On December 18, 1997,
the Board of Directors declared a three-for-two common stock split effective
January 16, 1998. All common stock and per share data has been retroactively
adjusted for the stock split.

     The Company maintains the Amended and Restated 1994 Stock Option Plan (the
"1994 Plan") pursuant to which options may be granted to employees, directors
and consultants for the purchase of the common stock of the Company. On March 6,
1998, the Board of Directors of the Company amended the 1994 Option Plan to
increase the number of shares available for the grant of options under the 1994
Plan from 900,000 shares to 1,800,000 shares. This amendment was ratified by the
Company's stockholders on June 22, 1998.

     The 1994 Plan, as amended, permits the Company to grant incentive and
non-qualified stock options to purchase an aggregate of 1,800,000 shares of the
Company's common stock, as adjusted for the three-for-two common stock split
that occurred on January 16, 1998. Such options may be incentive stock options
or non-qualified options. Any employee of the Company or any subsidiary of the
Company is eligible to receive incentive stock options and non-qualified stock
options under the 1994 Plan. Non-qualified stock options may be granted to
employees as well as non-employee directors and consultants of the Company under
the 1994 Plan as determined by the Board or the Compensation Committee.

     The term of an option is determined by the Compensation Committee of the
Board. The exercise price of the shares covered by an incentive stock option may
not be less than the fair value of the shares at the time of grant. The exercise
price of the shares covered by a non-qualified option need not be equal to the
fair value of the stock at the date of grant, but may be granted with an
exercise price as determined by the Compensation Committee. The options granted
prior to November 1997 vest one-third each year, over a period of three years.
Options granted after November 1997 vest over four-year and five-year periods,
vesting ratably starting in the second year after the date of grant.

                                      F-14
<PAGE>   44
                     PARTY CITY CORPORATION AND SUBSIDIARY

           NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED)

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

<TABLE>
<CAPTION>
                                                                                WEIGHTED
                                                                            AVERAGE EXERCISE
                                                        NUMBER OF SHARES         PRICE
                                                        ----------------    ----------------
<S>                                                     <C>                 <C>
Balance at January 1, 1996............................       255,000             $ 2.69
Granted...............................................       422,250               9.59
Exercised.............................................       (54,999)              3.18
Canceled..............................................       (88,001)              6.00
                                                           ---------
Balance at December 31, 1996..........................       534,250               7.54
Granted...............................................       583,625              12.66
Exercised.............................................       (56,600)              4.62
Canceled..............................................       (64,250)             10.59
                                                           ---------
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
                                                           =========
Options Exercisable at:
December 31, 1996.....................................       142,500
December 31, 1997.....................................       244,650
December 31, 1998.....................................       352,251
July 3, 1999..........................................       448,701
</TABLE>

<TABLE>
<CAPTION>
                                           OPTIONS OUTSTANDING                      OPTIONS EXERCISABLE
                                ------------------------------------------      ---------------------------
                                                    WEIGHTED
                                                     AVERAGE      WEIGHTED                         WEIGHTED
                                    NUMBER          REMAINING     AVERAGE           NUMBER         AVERAGE
                                  OUTSTANDING      CONTRACTUAL    EXERCISE        EXERCISABLE      EXERCISE
RANGE OF EXERCISE PRICES        AT JULY 3, 1999       LIFE         PRICE        AT JULY 3, 1999     PRICE
------------------------        ---------------    -----------    --------      ---------------    --------
<S>                             <C>                <C>            <C>           <C>                <C>
$3.84 to $9.50                       183,650          8.31         $ 6.28            89,150         $ 7.00
$9.68 to $10.00                      212,750          7.53          10.00           124,500          10.00
$10.17 to $11.00                     228,076          7.92          10.60           129,201          10.37
$11.56 to $16.00                     225,600          8.38          13.64            69,850          13.99
$16.33 to $34.44                     176,750          8.62          22.78            36,000          22.21
-----------------------------------------------------------------------------------------------------------
$3.84 to $34.44                    1,026,826          8.13         $12.47           448,701         $11.11
</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
for Stock-Based Compensation," the fair value of each option grant is estimated
on the date of

                                      F-15
<PAGE>   45
                     PARTY CITY CORPORATION AND SUBSIDIARY

           NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED)

grant using the Black-Scholes option-pricing model using the following
assumptions for grants in the respective periods:

<TABLE>
<CAPTION>
                                 YEAR ENDED DECEMBER 31,                SIX MONTHS ENDED
                           -----------------------------------    -----------------------------
                             1996         1997         1998       JUNE 30, 1998    JULY 3, 1999
                           ---------    ---------    ---------    -------------    ------------
<S>                        <C>          <C>          <C>          <C>              <C>
Expected volatility......     35%          40%         100%          100%             120%
Expected lives...........  6.0 years    4.3 years    5.0 years     5.0 years       5.0 years
Risk-free interest
  rate...................    6.50%        5.7%         5.2%          5.2%             5.5%
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 were
recognized in accordance with the provisions of SFAS No. 123 (in thousands,
except per share data):

<TABLE>
<CAPTION>
                                         YEAR ENDED DECEMBER 31,          SIX MONTHS ENDED
                                         ------------------------   ----------------------------
                                          1996     1997     1998    JUNE 30, 1998   JULY 3, 1999
                                         ------   ------   ------   -------------   ------------
                                                                     (UNAUDITED)
<S>                                      <C>      <C>      <C>      <C>             <C>
Net income (loss):
  As reported..........................  $3,756   $7,670   $1,787      $ (230)        $(13,416)
  Pro-forma............................   3,345    6,944      174        (963)         (14,252)
Basic earnings (loss) per share:
  As reported..........................  $ 0.38   $ 0.65   $ 0.14      $(0.02)        $  (1.08)
  Pro-forma............................    0.34     0.59     0.01       (0.08)           (1.14)
Diluted earnings (loss) per share:
  As reported..........................  $ 0.38   $ 0.64   $ 0.14      $(0.02)        $  (1.08)
  Pro-forma............................    0.33     0.58   $ 0.01       (0.08)           (1.14)
</TABLE>

11.  INCOME TAXES

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

<TABLE>
<CAPTION>
                                         YEAR ENDED DECEMBER 31,          SIX MONTHS ENDED
                                         ------------------------   ----------------------------
                                          1996     1997     1998    JUNE 30, 1998   JULY 3, 1999
                                         ------   ------   ------   -------------   ------------
                                                                     (UNAUDITED)
<S>                                      <C>      <C>      <C>      <C>             <C>
Current:
  Federal..............................  $1,963   $4,519   $1,721      $  (127)       $   310
  State................................     558      981      339          (13)           (97)
                                         ------   ------   ------      -------        -------
                                          2,521    5,500    2,060         (140)           213
Deferred:
  Federal..............................    (128)    (464)    (796)          (6)        (2,642)
  State................................     (24)     (79)    (137)           -            304
                                         ------   ------   ------      -------        -------
                                           (152)    (543)    (933)          (6)        (2,338)
                                         ------   ------   ------      -------        -------
                                         $2,369   $4,957   $1,127      $  (146)       $(2,125)
                                         ======   ======   ======      =======        =======
</TABLE>

                                      F-16
<PAGE>   46
                     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 eighteen-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. Since it is presently uncertain
when the Company would generate sufficient taxable income, the Company
determined it was more likely than not that such deferred tax assets could not
be recovered.

     The Company has changed its year end for financial reporting to the 52-53
week year ending closest to June 30 effective the period ended July 3, 1999. The
tax year end remains December 31. The estimated tax loss for the six months
ended July 3, 1999, will be included in the tax year ended December 31, 1999. If
such a loss exists for the tax year ending December 31, 1999, its can be carried
back two years and forward 20 years.

     Significant components of the net deferred tax asset at December 31, 1997
and 1998 and July 3, 1999 are as follows (in thousands):

<TABLE>
<CAPTION>
                                                          DECEMBER 31,
                                                        -----------------
                                                         1997      1998      JULY 3, 1999
                                                        -------   -------    ------------
<S>                                                     <C>       <C>        <C>
Current:
  Inventory...........................................  $   274   $ 1,030       $1,218
  Vacation pay accrual................................       94       158          183
  Reserves not currently deductible...................        -         -          401
  Amortization of goodwill............................        -         -          220
  Part year federal net operating loss................        -         -        4,225
  Deferred state taxes................................        -         -          184
  Valuation allowance.................................        -         -       (2,206)
  Other...............................................       14        96            -
                                                        -------   -------       ------
     Net current deferred tax asset...................  $   382   $ 1,284       $4,225
                                                        =======   =======       ======
Non-current:
  Deferred rent.......................................  $ 1,259   $ 2,261       $2,525
  Start-up costs......................................       20      (381)        (404)
  Property and equipment..............................     (672)   (1,798)      (2,187)
  Deferred state taxes................................      (35)       84         (184)
  Part year federal and state net operating loss......       --        --        1,640
  AMT credit..........................................       --       437          347
  Valuation allowance.................................       --        --       (1,737)
                                                        -------   -------       ------
     Non-current deferred tax asset...................  $   572   $   603       $   --
                                                        =======   =======       ======
</TABLE>

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

<TABLE>
<CAPTION>
                                                DECEMBER 31,             SIX MONTHS ENDED
                                             ------------------    ----------------------------
                                             1996   1997   1998    JUNE 30, 1998   JULY 3, 1999
                                             ----   ----   ----    -------------   ------------
                                                                    (UNAUDITED)
<S>                                          <C>    <C>    <C>     <C>             <C>
Federal statutory rate/(benefit)...........  34.0%  35.0%  34.0%       (34.0%)        (34.0%)
State income taxes net of federal
  benefit..................................   5.6    4.7    5.4         (3.6)          (3.6)
Valuation allowance........................    --     --     --           --           25.4
Other......................................  (0.9)  (0.4)  (0.7)        (1.2)           1.5
                                             ----   ----   ----        -----          -----
Effective tax rate/(benefit)...............  38.7%  39.3%  38.7%       (38.8%)        (13.7%)
                                             ====   ====   ====        =====          =====
</TABLE>

                                      F-17
<PAGE>   47
                     PARTY CITY CORPORATION AND SUBSIDIARY

           NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED)

12.  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 years ended December 31, 1996, 1997 and 1998, and the six months
ended June 30, 1998 (unaudited) and July 3, 1999, $45,000, $65,000, $121,000,
$50,000 and $107,000, respectively were expensed under the 401(k) Plan.

13.  RELATED PARTY TRANSACTIONS

     Steven Mandell, the former president of the Company and a major
stockholder, owned all of the outstanding shares of two party supplies stores
for which no royalty fees were charged. Steven Mandell was also the majority
owner of two additional franchise stores and was a 50% owner of one franchise
through 1995. The Company received royalty fees based on 3.0% of net sales from
the majority owned stores. In addition, a former director of the Company owned
two franchises and was a 50% owner of one franchise through 1995, for which the
franchisee paid royalty fees of 2.0% of net sales. On February 28, 1997, the
Company acquired six of these franchise stores.

     Furthermore, another former officer of the Company owned two franchises. On
August 1, 1997, the Company acquired one of these stores. The Company charged
the officer approximately $0 and $19,000 for rent for the years ended December
31, 1996 and 1997. As of December 31, 1998, a current executive of the Company
owned one franchise store.

     Royalty fees of $208,000, $24,000, $58,000, $23,000 and $26,000 relating to
the above are included in the accompanying consolidated financial statements for
the years ended December 31, 1996, 1997 and 1998 and the six months ended June
30, 1998 (unaudited) and July 3, 1999, respectively.

     The Company provided bookkeeping and office services for certain of these
related parties. The Company charged such parties approximately $94,000, $14,000
and $15,000 for the years ended December 31, 1996, 1997, and 1998, respectively.
As of July 3, 1999, all such services were terminated. Personnel and office
costs allocated to the affiliate were based the percentage of time individuals
devoted to services for the affiliate stores and square footage occupied.

     On August 31, 1998, the Company acquired four franchise stores in the
Chicago market from a director of the Company at a purchase price of $3.9
million.

     In June 1999, a major shareholder and director of the Company granted an
option to acquire 1,000,000 shares of the shareholder's common stock to the
current chief executive officer. 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.

14.  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 15,900 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 years
ended December 31, 1996, 1997 and 1998, and the six months ended June 30, 1998
(unaudited) and July 3, 1999, no such contingent rent was paid.

                                      F-18
<PAGE>   48
                     PARTY CITY CORPORATION AND SUBSIDIARY

           NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED)

     At July 3, 1999, the Company leases 29 motor vehicles. The terms range from
24 to 36 months, and expire by March 2002.

     In August 1997, 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 and software is included in
property and equipment at a net book value of approximately $1.3 million at July
3, 1999.

     Future minimum lease payments under outstanding leases at July 3, 1999, are
as follows (in thousands):

<TABLE>
<CAPTION>
                                                                               OPERATING
                                                              CAPITAL LEASE     LEASES
                                                              -------------    ---------
<S>                                                           <C>              <C>
Fiscal year ending:
2000........................................................     $  366        $ 33,611
2001........................................................        366          33,741
2002........................................................        366          33,929
2003........................................................         --          33,938
2004........................................................         --          34,071
Thereafter..................................................         --         130,603
                                                                 ------        --------
Total minimum lease payments................................      1,096        $299,893
                                                                               ========
Less amount representing interest...........................        (61)
                                                                 ------
Present value of net minimum lease payments.................      1,037
Less current maturities, included in other liabilities......        319
                                                                 ------
Long-term obligation........................................     $  718
                                                                 ======
</TABLE>

     Rent expense for all operating leases was $3.8 million, $12.0 million,
$27.3 million, $11.1 million, and $19.3 million, for the years ended December
31, 1996, 1997 and 1998, and the six months ended June 30, 1998 (unaudited) and
July 3, 1999, respectively. The Company is obligated for guarantees, subleases
or assigned lease obligations for eight of its franchisees through 2011. The
aggregate future minimum payments under these leases are approximately $14.2
million.

15.  COMMITMENTS AND CONTINGENCIES

  Securities Litigation

     The Company has been named as a defendant in the following twelve class
action complaints: (1) Weber v. Party City Corp., Steven Mandell, and David
Lauber, Civ. Action No. 99-CV-1252; (2) Opus GT Partners LP v. Party City Corp.
and Steven Mandell, Civ. Action No. 99-CV-1327; (3) Klein and Shiffrin v. Party
City Corp., Steven Mandell and David Lauber, Civ. Action No. 99-CV-1325; (4)
Flynn v. Party City Corp., David Lauber and Steven Mandell, Civ. Action No.
99-CV-1328; (5) Catanzarite v. Party City Corp., Steven Mandell and David
Lauber, Civ. Action No. 99-CV-1317; (6) Tabbert v. Party City Corp. and Steven
Mandell, Civ. Action No. 99-CV-1353; (7) Maietta v. Steven Mandell and Party
City Corp., Civ. Action No. 99-CV-1386; (8) Barry v. Party City Corp., Steven
Mandell and David Lauber, Civ. Action No. 99-CV-1453; (9) Kurzweil v. Party City
Corp., Steven Mandell and David Lauber, Civ. Action No. 99-CV-1396; (10) Hormel
v. Party City Corp., Steven Mandell and David Lauber, Civ. Action No.
99-CV-1689; (11) Sacher v. Party City Corp., Steven Mandell and David Lauber,
Civ. Action No. 99-CV-2238; and (12) Gross v. Party City Corp., Steven Mandell
and David Lauber, Civ. Action No. 99-CV-2355. The Company's former Chief
Executive Officer and former Chief Financial Officer and Executive Vice
President of Operations have also been named as defendants. The complaints have
all been

                                      F-19
<PAGE>   49
                     PARTY CITY CORPORATION AND SUBSIDIARY

           NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED)


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
complaint.



     The second amended class action 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.



     Defendants have moved to dismiss the second amended complaint on the ground
that it fails to state a cause of action. The Court has not yet issued a
decision with respect to the motion to dismiss. Because this case is in its
early stages, no opinion can be expressed as to its likely outcome.



  Other



     The Company was named as a defendant in a complaint filed with the Supreme
Court of the State of New York, County of New York, on January 16, 1998 (the
"Complaint"), by each of Party City of Greenbrook, Inc., Party City of Watchung,
Inc., Party City of 22, Inc., Party City of Ralph Avenue and Party City of
Jersey City, Inc., each a franchisee of the Company. Four of the plaintiffs in
the suit have existing Party City franchise stores, with the remaining plaintiff
possessing a right of first refusal to develop a Party City store in Watchung,
New Jersey.



     The Complaint stated various causes of action, including unjust enrichment,
unfair competition, fraud and misrepresentation, breach of contract,
misappropriation of information and violations of the New Jersey Franchise
Practices Act and the New York State Franchise Sales Act. The crux of the
Complaint was that the Company undertook a course of conduct intentionally
designed to adversely impact the value of the Plaintiffs' franchise stores in
order to permit the Company to purchase such stores at a substantially reduced
value. The Company settled the lawsuit on June 30, 1999, at no cost to the
Company. In connection with the settlement, the Company agreed to sell the
plaintiff one store at its fair value.



     On April 23, 1999, plaintiff Emil Asch, Inc. 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 alleges five violations of the Robinson-Patman Act, which pertains to
price discrimination, unfair competition, tortious interference with contractual
relations, and false and deceptive advertising.



     Plaintiff seeks damages of $2 million, as well as treble and/or punitive
damages for certain counts. On February 3, 2000, Emil Asch amended its Complaint
by adding Ron's: The Party Store, Inc., as an additional plaintiff to the suit.
The Amended Complaint asserts the same causes of action against the same
defendants and seeks the same damages that were sought in the original
Complaint. The Company has answered the Amended Complaint, and discovery is
proceeding. At this point, no opinion can be expressed as to the likely outcome
of the litigation.



     Although the Company's management is unable to express a view on the likely
outcome of these litigations because they are in their early stages, they could
have a material adverse effect on the Company's business and results of
operations.


                                      F-20
<PAGE>   50
                     PARTY CITY CORPORATION AND SUBSIDIARY

           NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED)

     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.

  Employment Agreements

     The Company has entered into employment agreements with Jack Futterman,
then its chief executive officer and the chief financial officer, each for a
period of three years. Such agreements expire May and June 2002, respectively.
Under the agreements, the executives are entitled to specified salaries over the
contract periods and guaranteed bonuses for fiscal year 2000. Future bonuses are
provided contingent upon certain Company and individual performance criteria
devised by the Company for each period. Severance payments are due in the event
the executives are terminated by the Company. The Company's minimum commitment
under these agreements is approximately $3.0 million.

16.  SEGMENT INFORMATION

     The Company owns, operates and franchises party supplies stores in the
United States 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.

                                      F-21
<PAGE>   51
                     PARTY CITY CORPORATION AND SUBSIDIARY

           NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED)

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

<TABLE>
<CAPTION>
                                                                         SIX MONTHS ENDED
                                         YEAR ENDED DECEMBER 31,      ----------------------
                                      -----------------------------    JUNE 30,     JULY 3,
                                       1996       1997       1998        1998         1999
                                      -------   --------   --------   -----------   --------
                                                                      (UNAUDITED)
<S>                                   <C>       <C>        <C>        <C>           <C>
RETAIL:
Net revenue.........................  $39,144   $131,028   $282,923    $ 92,718     $151,349
Operating earnings (loss)...........    3,091     12,776     14,192       3,361         (561)
Identifiable assets.................   32,441     84,939    133,435     112,727      150,232
Depreciation/amortization...........      563      2,433      5,721       2,368        3,771
Capital expenditures................    4,356     37,200     32,845      10,924        6,623
FRANCHISING:
Net revenue.........................  $ 9,447   $ 10,686   $ 11,411    $  4,554     $  5,160
Operating earnings..................    5,718      6,688      7,297       2,751        3,254
Identifiable assets.................    1,193      1,455      1,996       1,674        2,101
Depreciation/amortization...........       --         --         --          --           --
Capital expenditures................       --         --         --          --           --
CORPORATE/OTHER:
Net revenue.........................  $    --   $     --   $     --    $     --     $     --
Operating expense...................   (3,160)    (7,049)   (15,939)     (5,615)     (15,856)
Identifiable assets.................      969      3,221      8,601       4,767        8,986
Depreciation/amortization...........      183        361        877         362        1,458
Capital expenditures................      516      2,725      6,249       1,908        1,310
CONSOLIDATED TOTALS:
Net revenue.........................  $48,591   $141,714   $294,334    $ 97,272     $156,509
Operating earnings (loss)...........    5,649     12,415      5,550         497      (13,163)
Interest expense (income), net......     (476)      (212)     2,636         874        2,378
                                      -------   --------   --------    --------     --------
Income (loss) before income taxes
  (benefit).........................    6,125     12,627      2,914        (376)     (15,541)
Income taxes (benefit)..............    2,369      4,957      1,127        (146)      (2,125)
                                      -------   --------   --------    --------     --------
Net income (loss)...................  $ 3,756   $  7,670   $  1,787    $   (230)    $(13,416)
                                      =======   ========   ========    ========     ========
Identifiable assets.................  $34,603   $ 89,615   $144,032    $119,168     $161,319
Depreciation/amortization...........      746      2,794      6,598       2,730        5,229
Capital expenditures................    4,872     39,925     39,094      12,832        7,933
</TABLE>

17.  SPECIAL CHARGES AND GENERAL AND ADMINISTRATIVE EXPENSE

     As a result of the liquidity issues the Company faced in 1999, the Company
incurred substantial expenses which management believes to be nonrecurring in
nature.

     April 1999, the Company engaged the services of a crisis management firm,
and several law firms, accounting firms and consultants to assist Company
management with such tasks as: (1) preparing required projections, (2)
contacting additional financing sources, (3) negotiating with and monitoring
efforts by a vendor steering committee, (4) negotiating with representatives of
the bank group, and (5) other nonrecurring consulting services. Included in
general and administrative expense is approximately $5.9 million for these
services incurred between March 1999 and July 3, 1999.

     Company management believes these costs to be unusual both in scope of
services and magnitude and has incurred similar expenses to further resolve its
financing issues. Such expenses will be recognized as the related services are
performed.

                                      F-22
<PAGE>   52
                     PARTY CITY CORPORATION AND SUBSIDIARY

           NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED)

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

<TABLE>
<CAPTION>
                                                                   QUARTER ENDED
                                                 -------------------------------------------------
                                                 MARCH 31   JUNE 30    SEPTEMBER 30    DECEMBER 31
                                                 --------   --------   -------------   -----------
<S>                                              <C>        <C>        <C>             <C>
1996
Total revenues.................................  $  5,981   $  8,286     $  9,908       $ 24,416
Cost of goods sold and occupancy costs.........     3,334      4,363        5,340         12,900
Net income (loss)..............................      (167)       499          346          3,078
Basic earnings (loss) per share................     (0.02)      0.05         0.03           0.30
Diluted earnings (loss) per share..............     (0.02)      0.05         0.03           0.29

1997
Total revenues.................................  $ 14,612   $ 22,455     $ 28,016       $ 76,631
Cost of goods sold and occupancy costs.........     9,383     13,756       18,152         45,081
Net income (loss)..............................      (288)       897         (244)         7,305
Basic earnings (loss) per share................      (.03)       .07         (.02)          0.59
Diluted earnings (loss) per share..............      (.03)       .07         (.02)          0.57

1998
Total revenues.................................  $ 40,714   $ 56,558     $ 58,374       $138,688
Cost of goods sold and occupancy costs.........    28,548     36,698       39,512         90,003
Net income (loss)..............................    (1,271)     1,041       (2,161)         4,178
Basis earnings (loss) per share................     (0.10)      0.08        (0.17)          0.34
Diluted earnings (loss) per share..............     (0.10)      0.08        (0.17)          0.33
</TABLE>

<TABLE>
<CAPTION>
                                                    QUARTER ENDED
                                                 -------------------
                                                 MARCH 31    JULY 3
                                                 --------   --------
<S>                                              <C>        <C>        <C>             <C>
1999
Total revenues.................................  $ 72,722   $ 83,787
Cost of goods sold and occupancy costs.........    51,479     58,379
Net income (loss)..............................    (5,406)    (8,010)
Basic earnings (loss) per share................     (0.43)     (0.64)
Diluted earnings (loss) per share..............     (0.43)     (0.64)
</TABLE>

19.  SUBSEQUENT EVENTS

     On August 16, 1999 the Company entered in the following agreements with its
existing bank lenders under the Credit Agreement (the "Banks"), a new group of
investors (the "Investors") and its trade vendors. The bank lenders and the
Company entered into a Standstill and Forbearance Agreement (the "Bank
Forbearance Agreement"). Under the Bank Forbearance Agreement, the Banks have
agreed not to exercise rights and remedies based upon any existing defaults
until June 30, 2000 unless a further event of default occurred. The Company also
agreed to reduce its outstanding bank borrowings from the $58.6 million
outstanding at July 3, 1999, to $15 million by October 30, 1999, to increase the
interest rate on its bank debt to 2% over the bank's prime interest rate and to
pay a forbearance fee of $580,000.

     On August 17, 1999, the Company received $30 million in financing from the
Investors. The Investors purchased senior secured notes and warrants pursuant to
separate securities purchase agreements (the "Securities Purchase Agreements")
each dated as of August 16, 1999. Under these Securities Purchase Agreements,
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
                                      F-23
<PAGE>   53
                     PARTY CITY CORPORATION AND SUBSIDIARY

           NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED)

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 $1,965,000 based on management's estimate using certain fair value
methodologies and represent an original issue discount to the C Notes and D
Notes. Up to $15 million of the Notes is secured by a first lien that is pari
pasu with the liens under the Credit Agreement. The Notes are secured by a
junior lien on 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 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 exercise of
the Warrants.

     The Company also entered into an Investor Rights Agreement (the "Investor
Rights Agreement") with the Investors and Jack Futterman, then the chief
executive officer of the Company. In this agreement, the Company granted
registration rights with respect to shares of common stock. The Company has
agreed to nominate two individuals designated by the Investors to its Board of
Directors. Under the Investor Rights Agreement, the Investors agree that they
will not, without the prior written consent of the Board of Directors, (i)
acquire or agree to acquire, publicly offer or make any public proposal with
respect to the possible acquisition of (a) beneficial ownership of any
securities of the Company, (b) any substantial part of the Company's assets, or
(c) any rights or options to acquire any of the foregoing from any person; (ii)
make or in any way participate in any "solicitation" of "proxies" (as such terms
are defined in the rules of the Securities Exchange Act of 1934, as amended) to
vote, or seek to advise or influence any person with respect to the voting of
any voting securities of the Company; or (iii) make any public announcement with
respect to any transaction between the Company or any of its securities holders
and the Investors, including without limitation, any tender or exchange offer,
merger or other business combination of a material portion of the assets of the
Company. These standstill provisions terminate if the Company's consolidated
earnings before interest, taxes, depreciation and amortization and exclusive of
special charges, as defined in the Investor Rights Agreement, do not meet
specified targets.

     Party City's trade vendors representing approximately $36.4 million of
trade debt also entered into an agreement with the Company. Pursuant to a Vendor
Standstill and Forbearance Agreement ("Vendor Forbearance Agreement"), these
trade vendors agreed to forbear from taking any action against Party City until
January 15, 2000. The trade vendors received promissory notes from Party City
totaling approximately $12.2 million representing one-third of their unpaid
balances as of May 1, 1999 (the "Trade Notes"). The Trade Notes bore interest at
a rate of 10% per year and were scheduled to mature on November 15, 1999.
Interest on the Trade Notes was due on January 15, 2000, unless the bank debt
was refinanced before such date. Separately, certain seasonal trade vendors
agreed to provide trade credit to the Company for 30% of purchases for the
Halloween, Thanksgiving and year-end holiday seasons. These vendors received a
shared lien on the Company's inventory for the amount of the credit.

     In order to meet the cash flow requirements of the Halloween seasonal
purchase of inventory and to meet the requirements of the Bank Forbearance
Agreement, the Company identified stores for sale to existing franchisees to
generate working capital. Eighteen stores with a net book value of approximately
$9.8 million were sold to franchisees. In order to facilitate the sale of these
stores, royalty fees were negotiated at lower than normal rates for specific
periods. The total proceeds from the sales of these stores was approximately
$9.9 million. The net proceeds from the sale of stores was required under the
Bank Forbearance Agreement to be used to pay down the outstanding borrowings
under the Credit Agreement.

     On January 14, 2000, the Company replaced the Credit Agreement with a new
Loan and Security Agreement (the "Loan Agreement") with Congress Financial
Corporation ("Congress"), as lender. Under the terms of the Loan Agreement, the
Company may from time to time borrow amounts 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

                                      F-24
<PAGE>   54
                     PARTY CITY CORPORATION AND SUBSIDIARY

           NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED)

initially 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. The term of the Loan Agreement is three years, and is secured by a lien on
substantially all of the assets of the Company. At September 15, 2000, there was
$15.8 million outstanding and $24.2 million was available for borrowing under
this revolving credit facility.

     The Company's unaudited pro forma consolidated balance sheet as of July 3,
1999, after giving effect to the August 16 and August 17, 1999 transactions
described above, is as follows (in thousands):

<TABLE>
<CAPTION>
                                                    JULY 3,      PRO FORMA      PRO FORMA
                                                      1999      ADJUSTMENTS    JULY 3, 1999
                                                    --------    -----------    ------------
                                                                (UNAUDITED)    (UNAUDITED)
<S>                                                 <C>         <C>            <C>
                      ASSETS
Cash and cash equivalents.........................  $ 11,470     $ 25,550        $ 37,020
Merchandise inventory.............................    47,016           --          47,016
Other current assets..............................    32,887           --          32,887
                                                    --------     --------        --------
  Total current assets............................    91,373       25,550         116,923
Property and equipment............................    50,557           --          50,557
Goodwill, net.....................................    18,483           --          18,483
Other assets......................................       906          450           1,356
                                                    --------     --------        --------
          Total Assets............................  $161,319     $ 26,000        $187,319
                                                    ========     ========        ========
       LIABILITIES AND STOCKHOLDERS' EQUITY
Current liabilities
  Accounts payable................................  $ 48,386     $(12,133)       $ 36,253
  Trade Notes.....................................        --       12,133          12,133
  Accrued expenses................................    10,145           --          10,145
  Credit Agreement................................    58,550       (4,000)         54,550
  Other current liabilities.......................       986           --             986
                                                    --------     --------        --------
          Total current liabilities...............   118,067       (4,000)        114,067
Long-term Liabilities:
  Senior Secured Notes............................        --       26,844          26,844
  Other long-term liabilities.....................     7,318           --           7,318
Stockholders' equity..............................    35,934        3,156          39,090
                                                    --------     --------        --------
          Total liabilities and stockholders
            equity................................  $161,319     $ 26,000        $187,319
                                                    ========     ========        ========
</TABLE>

  Sales of Company-Owned Stores

     In order to meet the cash flow requirements of the Halloween seasonal
purchase of inventory and to meet the requirements of the Bank Forbearance
Agreement, the Company began a program to identify stores for sale to existing
franchisees to generate working capital. Eighteen stores with a net book value
of approximately $9.2 million were sold to franchisees, of which seventeen
stores with a net book value of approximately $8.8 million were sold subsequent
to July 3, 1999. In connection with the sales, normal franchise fees were waived
for negotiated periods up to five years. The total proceeds from the sales of
these stores were approximately $9.9 million, of which $9.7 million was received
subsequent to July 3, 1999. The net proceeds from the sale of stores was
required under the Bank Forbearance Agreement to be used to pay down the
outstanding borrowings under the Credit Agreement.

                                      F-25