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

                                   FORM 10-K
ANNUAL REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF
                                      1934
                     FOR THE FISCAL YEAR ENDED JULY 1, 2000

                         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 2000 ANNUAL MEETING OF
STOCKHOLDERS ARE INCORPORATED BY REFERENCE INTO PART III.
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                               TABLE OF CONTENTS

<TABLE>
<CAPTION>
                                                                       PAGE
                                                                       ----
<S>      <C>                                                           <C>
                               PART I
Item 1   Business....................................................    2
Item 2   Properties..................................................   10
Item 3   Legal Proceedings...........................................   10
Item 4   Submission of Matters to a Vote of Security Holders.........   11

                               PART II
Item 5   Market for Registrant's Common Equity and Related
         Stockholder Matters.........................................   11
Item 6   Selected Financial Data.....................................   12
Item 7   Management's Discussion and Analysis of Financial Condition
         and Results of Operations...................................   15
Item 7A  Quantitative and Qualitative Disclosures About Market
         Risk........................................................   22
Item 8   Financial Statements and Supplementary Data.................   22
Item 9   Changes in and Disagreements with Accountants on Accounting
         and Financial Disclosure....................................   23

                              PART III
Item 10  Directors and Executive Officers of the Registrant..........   23
Item 11  Executive Compensation......................................   23
Item 12  Security Ownership of Certain Beneficial Owners and
         Management..................................................   23
Item 13  Certain Relationships and Related Transactions..............   23

                               PART IV
Item 14  Exhibits, Financial Statement Schedules, and Reports on Form
         8-K.........................................................   23
</TABLE>

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                                     PART I

FORWARD-LOOKING STATEMENTS

     This Form 10-K (including the information incorporated herein by reference)
contains forward-looking statements within the meaning of The Private Securities
Litigation Reform Act of 1995. The statements are made a number of times
throughout the document and may be identified by forward-looking terminology as
"estimate," "project," "expect," "believe," "may," "will," "intend" or similar
statements or variations of such terms. Such forward-looking statements 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 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 1.  BUSINESS

     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.

GENERAL

     The Company is a specialty retailer of party supplies through its network
of 425 discount stores. At September 20, 2000, the Company owns and operates 198
Company-owned stores in the United States and its franchisees operate an
additional 227 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, 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 $12.1 billion in sales in 1999.

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

BUSINESS STRATEGY

     The Company's objective is to maintain its position as a leading
category-dominant national chain of party supplies stores. The Company believes
that it has transformed the party supplies business by introducing increased
product and marketing focus and greater mass merchandising sophistication. In
order to maintain continued store growth, Company management 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 14,000 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
425 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
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 strategic plan. The Company has filled
key management positions and reassigned other members of management to meet its
strategic objectives. These hires include the current chief executive

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officer, the senior vice president of store operations, the chief information
officer and the executive vice president of merchandising.

FISCAL YEAR

     Effective July 3, 1999, the Company changed its fiscal year end for
financial reporting from December 31 to the Saturday nearest to June 30. 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.

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. During
Fiscal Year 2001, the Company intends to continue to focus its efforts to create
the necessary management infrastructure and control environment to support
continued growth. Two Company-owned stores are currently planned to be opened
during Fiscal Year 2001. The Company intends to balance growth between
Company-owned stores and opening franchise stores to meet its growth objectives.

STORE LOCATIONS

     As of July 1, 2000, there were 408 Party City stores open in the United
States, Canada, Puerto Rico, Portugal and Spain. Of these, 197 were
Company-owned and 211 were operated by the Company's independent franchisees.
The following table shows the growth in the Company's network of stores for the
years (52-53 weeks) ended on the Saturday closest to June 30.

<TABLE>
<CAPTION>
                                                                         FISCAL YEAR
                                                     ----------------------------------------------------
                                                     1994    1995    1996    1997    1998    1999    2000
                                                     ----    ----    ----    ----    ----    ----    ----
<S>                                                  <C>     <C>     <C>     <C>     <C>     <C>     <C>
COMPANY-OWNED:
  Stores open at beginning of year.................   --       1       8      20      57     148     215
  Stores opened....................................    1       7      12      31      69      63       2
  Stores closed....................................   --      --      --      --      --      --      (2)
  Stores acquired from franchisees.................   --      --      --       6      22       5      --
  Stores sold to franchisees.......................   --      --      --      --      --      (1)    (18)
                                                     ---     ---     ---     ---     ---     ---     ---
  Stores open at end of year.......................    1       8      20      57     148     215     197
FRANCHISE:
  Stores open at beginning of year.................   58      73     114     141     168     160     178
  Stores opened....................................   16      42      28      34      15      23      18
  Stores closed....................................   (1)     (1)     (1)     (1)     (1)     (1)     (3)
  Stores purchased by the Company..................   --      --      --      (6)    (22)     (5)     --
  Stores sold by the Company.......................   --      --      --      --      --       1      18
                                                     ---     ---     ---     ---     ---     ---     ---
  Stores open at end of year.......................   73     114     141     168     160     178     211
                                                     ---     ---     ---     ---     ---     ---     ---
TOTAL COMPANY AND FRANCHISE STORES.................   74     122     161     225     308     393     408
                                                     ===     ===     ===     ===     ===     ===     ===
</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, 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 when selecting
a site. The Company believes there is an extensive number of suitable locations
available for future sites.

                                        4
<PAGE>   6

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 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.

    Other Seasonal.  Customer purchases made for seasonal holiday events compose
    a significant part of Party City's business. The seasonal category includes
    products which are carried for the Super Bowl, Valentine's Day, St.
    Patrick's Day, Passover, Easter, First Communion, 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.

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

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    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 four suppliers which in the aggregate constituted
approximately 42% of the Company's purchases for the fiscal year ended July 1,
2000. 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 network (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 1999 Stock
Incentive Plan.

     Training.  Managers of Company-owned stores 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. The
Company is committed to support its franchise operations with the resources
necessary to best achieve desired results.

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<PAGE>   8

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.

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

<TABLE>
<CAPTION>
                                                      FISCAL YEAR ENDED
                                     ----------------------------------------------------
STATE                                1994    1995    1996    1997    1998    1999    2000
-----                                ----    ----    ----    ----    ----    ----    ----
<S>                                  <C>     <C>     <C>     <C>     <C>     <C>     <C>
Florida............................   1        2       4       8      14      17      16
California.........................  --        1       3      11      25      37      38
Connecticut........................  --        1       1       1       3       4       4
Illinois...........................  --        1       2       3       9      15      15
New York...........................  --        1       3      10      20      34      31
Pennsylvania.......................  --        1       1       1       5       9       8
Ohio...............................  --        1       1       2       5       7       8
Maryland...........................  --       --       1       2       4       4       3
Michigan...........................  --       --       4       7       7       7       7
Nevada.............................  --       --      --       2       2       3       3
New Jersey.........................  --       --      --       8      12      14       9
Missouri...........................  --       --      --       1       3       4       4
Indiana............................  --       --      --      --       5       5       5
Minnesota..........................  --       --      --      --       3       5       5
Texas..............................  --       --      --      --      19      22      20
Virginia...........................  --       --      --      --       3       6       6
Wisconsin..........................  --       --      --       1       1       1       1
Colorado...........................  --       --      --      --       1       2       2
North Carolina.....................  --       --      --      --       1       2      --
Tennessee..........................  --       --      --      --       3       4       1
Louisiana..........................  --       --      --      --       2       3       3
Georgia............................  --       --      --      --       1       1      --
Kentucky...........................  --       --      --      --      --       1       1
Kansas.............................  --       --      --      --      --       1      --
Massachusetts......................  --       --      --      --      --       3       3
Utah...............................  --       --      --      --      --       1       1
Washington.........................  --       --      --      --      --       3       3
                                      --      --      --     ---     ---     ---     ---
          TOTAL....................   1        8      20      57     148     215     197
                                      ==      ==      ==     ===     ===     ===     ===
</TABLE>

     Of the leases for the stores listed above, two expire in Fiscal 2001, two
expire in Fiscal 2002, nine expire in Fiscal 2003, and the balance expire in
Fiscal Year 2004 or thereafter. The Company has options to extend each of such
leases for a minimum of five years.

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<PAGE>   9

FRANCHISE OPERATIONS

     Until opening its first Company-owned store in January 1994, the Company
operated exclusively as a franchisor. As of July 1, 2000, the Company had 211
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.

     The Company's franchise stores at July 1, 2000 are located in the following
states and foreign countries:

<TABLE>
<S>                                                      <C>
Alabama..............................................      5
Arizona..............................................      7
Arkansas.............................................      1
California...........................................     12
Colorado.............................................      1
Connecticut..........................................      4
Delaware.............................................      1
Florida..............................................     15
Georgia..............................................     19
Hawaii...............................................      1
Illinois.............................................      1
Kansas...............................................      3
Louisiana............................................      7
Maryland.............................................      5
Mississippi..........................................      2
Missouri.............................................      1
New Jersey...........................................     23
New Mexico...........................................      3
New York.............................................     14
North Carolina.......................................     15
Ohio.................................................      3
Oregon...............................................      3
Pennsylvania.........................................     10
South Carolina.......................................      5
Tennessee............................................      9
Texas................................................      9
Virginia.............................................      5
Puerto Rico..........................................      5
Canada...............................................     17
Portugal.............................................      1
Spain................................................      4
                                                         ---
          TOTAL......................................    211
                                                         ===
</TABLE>

     The Company receives revenue from its franchisees, including an initial
one-time fee (currently at $40,000) and an ongoing royalty fee (currently 4.0%
of net sales for new franchisees, payable monthly). In addition, each franchisee
has a mandated advertising budget, which consists of a minimum 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% 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.

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<PAGE>   10

     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.

     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 September 20, 2000, 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; and 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 a number of trademarks and service marks
registered with the United States Patent and Trademark Office from a wholly
owned subsidiary including the marks Party City(R), The Discount Party Super
Store(R) and Halloween Costume Warehouse(R).

GOVERNMENT REGULATION

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

                                        9
<PAGE>   11

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 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 September 20, 2000, the Company employs approximately 1,330 full-time
and 3,250 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 July 1, 2000, the Company leased 197 stores. The Company leases its
headquarters property in Rockaway, New Jersey. The Company occupies
approximately 26,000 square feet of office space for its headquarters under
leases expiring through 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

                                       10
<PAGE>   12

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

     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

     No matters were submitted to a vote of security holders during the fourth
quarter of the fiscal year ended July 1, 2000.

                                    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.

                                       11
<PAGE>   13

     The following table sets forth the high and low closing sale prices of the
common stock through July 1, 2000.

<TABLE>
<CAPTION>
                                                              HIGH         LOW
                                                             ------       ------
<S>                                                          <C>          <C>
QUARTER ENDED:
July 1, 2000...............................................  $ 2.70       $ 1.53
April 1, 2000..............................................    3.50         1.05
January 1, 2000............................................    2.25         0.85
October 2, 1999............................................    3.84         2.00

QUARTER ENDED:
July 3, 1999...............................................    4.44         2.75
March 31, 1999.............................................   19.50         2.13

QUARTER ENDED:
December 31, 1998..........................................   21.00        19.19
September 30, 1998.........................................   30.59         8.69
June 30, 1998..............................................   35.24        24.75
March 31, 1998.............................................   35.00        16.75
</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, 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 (hereinafter defined) and
the Warrants (hereinafter defined) to the Investors (hereinafter defined) for an
aggregate of $30 million. The Investors were led by Tennenbaum & Co., LLC, a Los
Angeles-based investment firm. See "Management's Discussion and Analysis of
Financial Condition and Results of Operations -- Financing and Related
Developments."

     The Amended Warrants (hereinafter defined) 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 Amended
Warrants represent approximately 35% of the shares of common stock outstanding
after giving effect to the exercise of the Amended Warrants. The private
placement of the issuance and sale of the Notes and Amended 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, 1995 and 1996, and the Selected Consolidated Balance Sheet Data as of
December 31, 1997 are derived from the consolidated financial statements of the
Company not included herein. The Selected Consolidated Balance Sheet data as of
December 31, 1998, July 3, 1999 and July 1, 2000, and the Selected Consolidated
Statement of Operations

                                       12
<PAGE>   14

data for the years ended December 31, 1997 and 1998, the six months ended July
3, 1999, and the year ended July 1, 2000 are derived from the consolidated
financial statements of the Company, included elsewhere in this Annual Report on
Form 10-K. The Selected Consolidated Statement of Operations Data for the year
ended July 3, 1999, is derived from the consolidated statements of operations
for the six months ended December 31, 1998, and July 3, 1999. The Consolidated
Statement of Operations for the six months ended June 30, 1998, is derived from
the unaudited consolidated statement of operations for the six months ended June
30, 1998.

     The Balance Sheets as of December 31, 1998, July 3, 1999, and July 1, 2000,
and the Consolidated Statements of Operations for the years ended December 31,
1997 and 1998, the six months ended July 3, 1999, and the year ended July 1,
2000 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
Form 10-K.

                                       13
<PAGE>   15

                            SELECTED FINANCIAL DATA

<TABLE>
<CAPTION>
                                  YEAR ENDED DECEMBER 31,                 SIX MONTHS ENDED                 YEAR ENDED
                          ---------------------------------------   ----------------------------   ---------------------------
                           1995      1996       1997       1998     JUNE 30, 1998   JULY 3, 1999   JULY 3, 1999   JULY 1, 2000
                          -------   -------   --------   --------   -------------   ------------   ------------   ------------
                                                                     (UNAUDITED)                   (UNAUDITED)
                                                    (IN THOUSANDS, EXCEPT PER SHARE AND STORE DATA)
<S>                       <C>       <C>       <C>        <C>        <C>             <C>            <C>            <C>
STATEMENT OF OPERATIONS
  DATA:
Total revenue...........  $23,120   $48,591   $141,714   $294,334      $97,272        $156,509       $353,571       $363,399
                          =======   =======   ========   ========      =======        ========       ========       ========
Company-owned stores:
  Net sales.............  $16,118   $39,144   $131,028   $282,923      $92,718        $151,349       $341,554       $349,722
  Cost of goods sold and
    occupancy costs.....   10,758    25,937     86,372    194,761       65,246         109,858        239,373        240,356
                          -------   -------   --------   --------      -------        --------       --------       --------
  Gross profit..........    5,360    13,207     44,656     88,162       27,472          41,491        102,181        109,366
  Store operating and
    selling expense.....    4,255    10,116     31,880     73,970       24,111          42,052         91,911         83,470
                          -------   -------   --------   --------      -------        --------       --------       --------
  Company-owned stores
    profit contribution
    (loss)..............    1,105     3,091     12,776     14,192        3,361            (561)        10,270         25,896
Franchise stores:
  Royalty fees..........    6,075     8,512     10,224     10,841        4,379           4,907         11,369         13,187
  Franchise fees........      927       935        462        570          175             253            648            490
                          -------   -------   --------   --------      -------        --------       --------       --------
  Total franchise
    revenues............    7,002     9,447     10,686     11,411        4,554           5,160         12,017         13,677
  Total franchise
    expense.............    2,944     3,729      3,998      4,114        1,803           1,906          4,217          4,406
                          -------   -------   --------   --------      -------        --------       --------       --------
  Franchise profit
    contribution........    4,058     5,718      6,688      7,297        2,751           3,254          7,800          9,271
General and
  administrative
  expense:
  Special charges(a)....       --        --         --         --           --           5,858          5,858          7,789
  Impairment
    provision...........       --        --         --         --           --             300            300          1,172
  Other general and
    administrative
    expenses............    3,024     3,160      7,049     15,939        5,615           9,698         20,022         21,438
                          -------   -------   --------   --------      -------        --------       --------       --------
                            3,024     3,160      7,049     15,939        5,615          15,856         26,180         30,399
                          -------   -------   --------   --------      -------        --------       --------       --------
Income (loss) before
  interest and income
  taxes.................    2,139     5,649     12,415      5,550          497         (13,163)        (8,110)         4,768
Interest expense
  (income), net.........      (23)     (476)      (212)     2,636          873           2,378          4,141          8,423
                          -------   -------   --------   --------      -------        --------       --------       --------
Income (loss) before
  income taxes..........    2,162     6,125     12,627      2,914         (376)        (15,541)       (12,251)        (3,655)
Income taxes
  (benefit).............      863     2,369      4,957      1,127         (146)         (2,125)          (852)        (4,636)(d)
                          -------   -------   --------   --------      -------        --------       --------       --------
Net income (loss).......  $ 1,299   $ 3,756   $  7,670   $  1,787      $  (230)       $(13,416)      $(11,399)      $    981
                          =======   =======   ========   ========      =======        ========       ========       ========
Basic earnings (loss)
  per share.............  $  0.16   $  0.38   $   0.65   $   0.14      $ (0.02)       $  (1.08)      $  (0.92)      $   0.08
                          =======   =======   ========   ========      =======        ========       ========       ========
Diluted earnings (loss)
  per share.............  $  0.16   $  0.38   $   0.64   $   0.14      $ (0.02)       $  (1.08)      $  (0.92)      $   0.07
                          =======   =======   ========   ========      =======        ========       ========       ========
Weighted average shares
 outstanding -- Basic...    7,984     9,802     11,749     12,411       12,376          12,455         12,450         12,611
Weighted average shares
  outstanding -- Diluted...   7,984   9,996     12,039     12,704       12,376          12,455         12,450         14,283
EBITDA(b)...............  $ 2,461   $ 6,395   $ 15,209   $ 12,148      $ 4,131        $ (1,776)      $  6,241       $ 24,486
                          =======   =======   ========   ========      =======        ========       ========       ========
</TABLE>

                                       14
<PAGE>   16

<TABLE>
<CAPTION>
                                  YEAR ENDED DECEMBER 31,                 SIX MONTHS ENDED                 YEAR ENDED
                          ---------------------------------------   ----------------------------   ---------------------------
                           1995      1996       1997       1998     JUNE 30, 1998   JULY 3, 1999   JULY 3, 1999   JULY 1, 2000
                          -------   -------   --------   --------   -------------   ------------   ------------   ------------
                                                                     (UNAUDITED)                   (UNAUDITED)
                                                    (IN THOUSANDS, EXCEPT PER SHARE AND STORE DATA)
<S>                       <C>       <C>       <C>        <C>        <C>             <C>            <C>            <C>
OPERATING DATA:
  Number of Company-
    owned stores (end of
    period).............       16        36        117        207          148             215            215            197
  Increase in Company-
    owned same store
    sales...............     26.6%     17.9%      15.5%      11.3%        11.3%            5.1%           8.2%           3.8%
  Number of franchise
    stores (end of
    period).............      132       164        158        167          160             178            178            211
  Increase in franchise
    same store sales....     10.3%     19.5%      14.8%       6.8%         8.8%            6.6%           6.3%           7.9%
  Average sales per
    Company-owned
    store...............  $ 1,510   $ 1,662   $  1,740   $  1,684      $   681        $    706       $  1,680       $  1,810
  Depreciation and
    amortization........      322       746      2,794      6,598        3,634           5,229          8,193         10,757
BALANCE SHEET DATA:
  Working capital
    (deficiency)........  $ 1,999   $17,419   $ 13,931   $(15,039)     $40,805        $(26,694)      $(26,694)      $ 15,069
  Total assets..........   10,308    34,603     89,615    144,032      119,168         161,319        161,319        132,086
  Bank borrowings and
    other long-term
    liabilities.........       72        --      3,150         --(c)     40,182             --(c)          --(c)      29,547(c)
  Capital lease
    obligation..........       --        --      1,460      1,141        1,072             718            718            360
  Stockholders'
    equity..............    4,582    23,561     45,783     49,368       46,103          35,934         35,934         40,861
</TABLE>

---------------
(a) Special charges in Fiscal Year 1999 and Fiscal Year 2000 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) The Company's definition of EBITDA is earnings before interest, taxes,
    depreciation, amortization and impairment provision and exclusive of special
    charges.

(c) 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. The bank borrowing and other long-term liabilities at
    July 1, 2000 is net of a discount of $3.0 million.

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

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.

                                       15
<PAGE>   17

     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/CLOSED   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)
Quarter Ended:
  October 2, 1999.............................     1        --         1         (17)         215       199
  January 1, 2000.............................    --        --        --          (1)         199       198
  April 1, 2000...............................     1        --         1          (1)         198       198
  July 1, 2000................................    --        --        --          (1)         198       197
                                                  --        --        --        ----
                                                   2        --         2         (20)
</TABLE>

  Year Ended July 1, 2000 ("Fiscal 2000") Compared to Year Ended July 3, 1999
("Fiscal 1999")

     Retail.  Net sales from Company-owned stores increased 2.4% to $349.7
million in Fiscal 2000 from $341.6 million in Fiscal 1999. The Fiscal 2000
results include 215 stores which were open at the beginning of that year plus
two stores opened during the year, less 18 stores sold and two stores closed
during the year. Same store sales increased 3.8% and 8.2% in Fiscal 2000 and
Fiscal 1999, respectively. Gross profit reflects the cost of goods sold and
store occupancy costs including rent, common area maintenance, real estate
taxes, repair and maintenance, depreciation and utilities. Gross profit for
Fiscal 2000 increased 7.0% to $109.4 million compared to $102.1 million for
Fiscal 1999. The increase in Fiscal 2000 was primarily due to increased sales
volume and improvement in gross margin. Gross margin was 31.3% and 29.9% of
sales for Fiscal 2000 and Fiscal 1999, respectively. The increase in gross
margin was related primarily to a charge of $2.3 million taken in Fiscal 1999
for slow moving inventory, reduced inventory losses and increased initial mark
up in Fiscal 2000.

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

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

                                       16
<PAGE>   18

1999 recognized on 18 store openings. Franchise same store sales increases for
Fiscal 2000 and Fiscal 1999 were 7.9% and 6.3%, respectively.

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

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

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

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

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

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

  Six-Month Period Ended July 3, 1999 ("1999 Period") Compared to Six-Month
Period Ended June 30, 1998 ("1998 Period")

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

     Store operating and selling expenses increased 74.4% to $42.1 million for
the 1999 Period compared to $24.1 million for the 1998 Period. The increase in
store operating expenses is primarily attributable to the increased number of
stores operated by the Company during the 1999 Period. Store operating expenses
were 27.8% and 26.0% of sales for the 1999 Period and 1998 Period, respectively,
due to increased store operating payroll costs related to new store openings.
Company-owned store profit contribution was a negative $561,000 for the 1999
Period, compared to a profit contribution of $3.4 million for 1998 Period.
                                       17
<PAGE>   19

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

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

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

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

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

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

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

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

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

  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

                                       18
<PAGE>   20

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.

                                       19
<PAGE>   21

ACCOUNTING AND REPORTING CHANGES

     In June 1998, the Financial Accounting Standards Board ("FASB") issued
Statement of Financial Accounting Standard ("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 No. 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.

FINANCING AND RELATED DEVELOPMENTS

     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 December 31, 1998
consolidated financial statements on a timely basis was 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 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 in the following agreements with its
then 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 agreed
not to exercise rights and remedies based upon any existing defaults until June
30, 2000. 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 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 was secured by a first lien that was 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

                                       20
<PAGE>   22

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. The Company has
agreed to nominate two individuals designated by the Investors to its Board of
Directors. Under the Investor Rights Agreement, the Investors agreed 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 calendar year targets. The Company achieved its target EBITDA for
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 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
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 matured 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
the 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.

     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 2.75% per annum (subject to possible
reduction to an interest rate as low as 2.25% from and after June 30, 2001,
based on the Company's pre-tax income and excess availability) or (ii) at the
rate of  3/4% per annum above the prime rate, totaling 10.25% at July 1, 2000.
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 was available to be borrowed under the Loan
Agreement.

     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
existing Warrants held by the Investors to acquire 6,880,000 shares of the
Company's
                                       21
<PAGE>   23

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 revolving credit facility (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 seasons. All the remaining unpaid vendor
balances that were originally due May 1, 1999, were satisfied by individual
arrangements with such vendors.

LIQUIDITY AND CAPITAL RESOURCES

     The Company's cash provided by operating activities was $9.3 million, in
Fiscal 2000. Included as a reduction of net cash provided by operations is a net
repayment of accounts payable of $22.4 million as a result of the Company's
refinancing activities in Fiscal 2000. Exclusive of the accounts payable
repayment, net cash from operating activities was $31.8 million in Fiscal 2000.

     Net cash of $6.2 million was provided by investing activities as a result
of proceeds from the sale of 18 stores of $10.3 million, offset in part by
capital expenditures of $4.1 million.

     Net cash used in financing activities was $23.0 million. The cash used in
financing was primarily the result of the repayment of all amounts due under the
Credit Agreement of $58.6 million, offset in part by the net proceeds from the
issuance of the Senior Notes of $34.7 million. See "Management's Discussion and
Analysis of Financial Condition and Results of Operations -- Financing and
Related Developments" for discussion of the Company's credit facilities.

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

  Impact of Inflation

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

  Seasonality

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

ITEM 7A.   QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK

     Not applicable.

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.

                                       22
<PAGE>   24

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 2000 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, 1998, and July 3, 1999, and
     July 1, 2000

     Consolidated Statements of Operations for the years ended December 31,
        1997, 1998, the six months ended June 30, 1998 (unaudited) and July 3,
        1999, and the year ended July 1, 2000.

     Consolidated Statements of Shareholders' Equity for the years ended
        December 31, 1997, 1998, the six months ended June 30, 1998 (unaudited)
        and July 3, 1999, and the year ended July 1, 2000.

     Consolidated Statements of Cash Flows for the years ended December 31, 1997
        and 1998, the six months ended June 30, 1998 (unaudited) and July 3,
        1999 and the year ended July 1, 2000.

     Notes to Consolidated Financial Statements for the years ended December 31,
        1997 and 1998, the six months ended June 30, 1998 (unaudited) and July
        3, 1999, and the year ended July 1, 2000.

     2.  Financial Statement Schedules -- Not Applicable.

     3.  List of Exhibits.

     The following exhibits are included as a part of this Annual Report on Form
10-K or 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 E Note.
  4.9(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>

                                       23
<PAGE>   25
<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>

                                       24
<PAGE>   26

<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.

    Report on Form 8-K dated June 6, 2000

                                       25
<PAGE>   27

                                   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>

                                       26
<PAGE>   28

                          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, 1998, July 3, 1999, and July 1,
2000, and the related consolidated statements of operations, stockholders'
equity, and cash flows for the years ended December 31, 1997 and 1998, the six
months ended July 3, 1999, and the year ended July 1, 2000. 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, 1998, July 3, 1999, and July 1,
2000, and the consolidated results of their operations and their cash flows for
the years ended December 31, 1997 and 1998, the six months ended July 3, 1999,
and for the year ended July 1, 2000 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>   29

                     PARTY CITY CORPORATION AND SUBSIDIARY

                          CONSOLIDATED BALANCE SHEETS
                                 (IN THOUSANDS)

<TABLE>
<CAPTION>
                                                          DECEMBER 31,
                                                              1998        JULY 3, 1999    JULY 1, 2000
                                                          ------------    ------------    ------------
<S>                                                       <C>             <C>             <C>
                                        ASSETS
Current assets:
  Cash and cash equivalents.............................    $  6,892        $ 11,470        $  3,950
  Merchandise inventory.................................      56,590          47,016          42,030
  Refundable income taxes...............................          --           6,848             764
  Advance merchandise payments..........................          --           9,439           2,419
  Other current assets..................................       9,817          16,600          19,596
                                                            --------        --------        --------
          Total current assets..........................      73,299          91,373          68,759
Property and equipment, net.............................      49,704          50,557          41,447
Goodwill, net...........................................      19,189          18,483          14,844
Other assets............................................       1,840             906           7,036
                                                            --------        --------        --------
          Total assets..................................    $144,032        $161,319        $132,086
                                                            ========        ========        ========

LIABILITIES AND STOCKHOLDERS' EQUITY
Current liabilities:
  Accounts payable......................................    $ 31,846        $ 48,386        $ 30,190
  Accrued expenses......................................       8,873          10,145          15,457
  Senior Notes, current portion.........................          --              --           5,103
  Other current liabilities.............................         819             986           2,940
  Advances under Credit Agreement.......................      46,800          58,550              --
                                                            --------        --------        --------
          Total current liabilities.....................      88,338         118,067          53,690
Long-term liabilities:
  Deferred rent.........................................       5,446           6,527           7,503
  Senior Notes..........................................          --              --          29,547
  Other long-term liabilities...........................         880             791             485

Commitments and contingencies

Stockholders' equity:
  Common stock..........................................         125             125             127
  Additional paid-in capital............................      34,042          34,024          37,968
  Retained earnings.....................................      15,201           1,785           2,766
                                                            --------        --------        --------
          Total stockholders' equity....................      49,368          35,934          40,861
                                                            --------        --------        --------
          Total liabilities and stockholders' equity....    $144,032        $161,319        $132,086
                                                            ========        ========        ========
</TABLE>

          See accompanying notes to consolidated financial statements.
                                       F-2
<PAGE>   30

                     PARTY CITY CORPORATION AND SUBSIDIARY

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

<TABLE>
<CAPTION>
                                                                        SIX MONTHS ENDED
                                         YEAR ENDED DECEMBER 31,   --------------------------
                                         -----------------------    JUNE 30,       JULY 3,       YEAR ENDED
                                            1997         1998         1998           1999       JULY 1, 2000
                                         ----------   ----------   -----------   ------------   ------------
                                                                   (UNAUDITED)
                                                                   -----------
<S>                                      <C>          <C>          <C>           <C>            <C>
Revenues:
  Net sales............................   $131,028     $282,923      $92,718       $151,349       $349,722
  Royalty fees.........................     10,224       10,841        4,379          4,907         13,187
  Franchise fees.......................        462          570          175            253            490
                                          --------     --------      -------       --------       --------
          Total revenues...............    141,714      294,334       97,272        156,509        363,399
Expenses:
  Cost of goods sold and occupancy
     costs.............................     86,372      194,761       65,246        109,858        240,356
  Company-owned stores operating and
     selling expense...................     31,880       73,970       24,111         42,052         83,470
  Franchise expense....................      3,998        4,114        1,803          1,906          4,406
  General and administrative expense...      7,049       15,939        5,615         15,856         30,399
                                          --------     --------      -------       --------       --------
          Total expenses...............    129,299      288,784       96,775        169,672        358,631
                                          --------     --------      -------       --------       --------
Income (loss) before interest and
  income taxes.........................     12,415        5,550          497        (13,163)         4,768
  Interest expense (income), net.......       (212)       2,636          873          2,378          8,423
                                          --------     --------      -------       --------       --------
Income (loss) before income taxes......     12,627        2,914         (376)       (15,541)        (3,655)
  Provision for income taxes
     (benefit).........................      4,957        1,127         (146)        (2,125)        (4,636)
                                          --------     --------      -------       --------       --------
Net income (loss)......................   $  7,670     $  1,787      $  (230)      $(13,416)      $    981
                                          ========     ========      =======       ========       ========
  Basic earnings (loss) per share......   $   0.65     $   0.14      $ (0.02)      $  (1.08)      $   0.08
                                          ========     ========      =======       ========       ========
     Weighted average shares
       outstanding -- basic............     11,749       12,411       12,376         12,455         12,611
                                          ========     ========      =======       ========       ========
  Diluted earnings (loss) per share....   $   0.64     $   0.14      $ (0.02)      $  (1.08)      $   0.07
                                          ========     ========      =======       ========       ========
     Weighted average shares
       outstanding -- diluted..........     12,039       12,704       12,376         12,455         14,283
                                          ========     ========      =======       ========       ========
</TABLE>

          See accompanying notes to consolidated financial statements.
                                       F-3
<PAGE>   31

                     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, 1997..........  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
Issuance of common shares in
  exchange for professional
  services..........................     266,667        2           798            --         800
Tax effect of non-qualified
  options...........................          --       --           (10)           --         (10)
Issuance of warrants in connection
  with Senior Notes.................          --       --         3,156            --       3,156
Net income..........................          --       --            --           981         981
                                      ----------     ----       -------      --------    --------
Balance at July 1, 2000.............  12,722,205     $127       $37,968      $  2,766    $ 40,861
                                      ==========     ====       =======      ========    ========
</TABLE>

          See accompanying notes to consolidated financial statements.
                                       F-4
<PAGE>   32

                     PARTY CITY CORPORATION AND SUBSIDIARY

                     CONSOLIDATED STATEMENTS OF CASH FLOWS
                                 (IN THOUSANDS)

<TABLE>
<CAPTION>
                                                   YEAR ENDED
                                                  DECEMBER 31,             SIX MONTHS ENDED
                                               -------------------   ----------------------------
                                                 1997       1998     JUNE 30, 1998   JULY 3, 1999   JULY 1, 2000
                                               --------   --------   -------------   ------------   ------------
                                                                      (UNAUDITED)
<S>                                            <C>        <C>        <C>             <C>            <C>
Cash flow from operating activities:
  Net income (loss)..........................  $  7,670   $  1,787     $   (230)       $(13,416)      $    981
  Adjustments to reconcile net income (loss)
    to net cash provided by (used in)
    operating activities:
    Depreciation and amortization............     2,794      6,598        2,730           5,229         10,757
    Impairment provision.....................        --         --           --             300          1,172
    Non-cash interest and financing costs....        --         --           --              --          1,506
    Deferred rent............................     1,813      2,459        1,024           1,082            978
    Provision for doubtful accounts..........       275        127           --             204            975
    Loss on disposition and sale of stores...        99         --           --             234          1,386
    Deferred tax asset.......................      (543)      (933)          (6)         (2,338)        (6,213)
  Changes in assets and liabilities
    Merchandise inventory....................   (23,853)   (15,618)     (11,997)         11,897            186
    Refundable income taxes..................        --         --         (230)         (6,848)         6,084
    Advance merchandise payments.............        --         --           --          (9,439)         7,069
    Other current assets.....................    (5,197)    (1,201)      (4,575)         (4,047)        (2,642)
    Other assets.............................      (335)      (639)        (627)            331           (223)
    Accounts payable.........................    19,950      6,919       (2,116)         16,540        (22,417)
    Accrued expenses.........................     5,013      1,879       (2,179)            972          4,742
    Income taxes payable.....................     1,176     (3,080)      (3,080)             --             --
    Other current liabilities................       (11)      (365)        (468)            167          5,299
    Other long-term liabilities..............       197       (630)          --             (89)          (306)
                                               --------   --------     --------        --------       --------
       Net cash provided by (used in)
         operating activities................     9,048     (2,697)     (21,754)            779          9,334
  Cash flow from investment activities:
    Purchases of property and equipment,
       net...................................   (18,272)   (30,638)     (10,598)         (5,970)        (4,109)
    Proceeds from sales of stores............        --         --           --              --         10,293
    Stores acquired..........................   (21,653)    (8,456)      (2,234)         (1,963)            --
                                               --------   --------     --------        --------       --------
       Net cash provided by (used in)
         investing activities................   (39,925)   (39,094)     (12,832)         (7,933)         6,184
  Cash flow from financing activities:
    Net proceeds from sale of stock..........    14,185         --           --              --            800
    Proceeds from issuance of Senior Notes
       and warrants..........................        --         --           --              --         37,000
    Debt issue costs.........................        --         --           --              --         (2,278)
    Proceeds from exercise of stock
       options...............................       267        724          549              33             --
    Tax effect of non-qualified stock
       options...............................       100      1,074           --             (51)           (10)
    Net proceeds from (payments on) Credit
       Agreement.............................     4,610     43,650       35,891          11,750        (58,550)
                                               --------   --------     --------        --------       --------
  Net cash provided by (used in) financing
    activities...............................    19,162     45,448       36,440          11,732        (23,038)
                                               --------   --------     --------        --------       --------
  Net increase (decrease) in cash and cash
    equivalents..............................   (11,715)     3,657        1,854           4,578         (7,520)
  Cash and cash equivalents, beginning of
    period...................................    14,950      3,235        3,235           6,892         11,470
                                               --------   --------     --------        --------       --------
  Cash and cash equivalents, end of period...  $  3,235   $  6,892     $  5,089        $ 11,470       $  3,950
                                               ========   ========     ========        ========       ========
  Supplemental disclosure of cash flow
    information:
    Income taxes paid........................  $  4,219   $  3,433     $  3,207        $  2,469       $    653
    Interest paid............................       294      2,402          469           2,781          5,443
</TABLE>

          See accompanying notes to consolidated financial statements.
                                       F-5
<PAGE>   33

                     PARTY CITY CORPORATION AND SUBSIDIARY

                   NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

1.  SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES

  Consolidated Financial Statements

     Party City Corporation (the "Company") is incorporated in the State of
Delaware and operates retail party supplies stores within the continental United
States and sells franchises on an individual store and area franchise basis
throughout the United States, Puerto Rico, Spain, Portugal and Canada. At
September 20, 2000, the Company had 198 Company-owned stores and 227 franchise
stores in its network. The consolidated financial statements of the Company
include the accounts of the Company and its wholly-owned subsidiary, Party City
Michigan, Inc. All significant intercompany balances and transactions have been
eliminated.

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

  Cash and Cash Equivalents

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

  Fair Value of Financial Instruments

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

  Allowance for Doubtful Accounts

     The allowance for doubtful accounts on receivables from franchisees at
December 31, 1998, July 3, 1999, and July 1, 2000, was $166,000, $379,000 and
$917,000 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.

  Advance Merchandise Payments

     As of July 1, 2000, the Company had $2.4 million in deposits with those
vendors that required partial advanced payments prior to shipment. At July 3,
1999, the Company had $9.4 million in cash-in-advance payments. Prior to January
15, 2000, merchandise purchases were made primarily on a cash-in-advance basis
as an on-account payment and were 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.

  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%

                                       F-6
<PAGE>   34
                     PARTY CITY CORPORATION AND SUBSIDIARY

           NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED)

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 year ended December 31, 1997 and
1998, the six month periods ended June 30, 1998 (unaudited) and July 3, 1999 and
the year ended July 1, 2000, Ad Fund management fees of $210,000, $278,000,
$101,000, $139,000 and $360,000, 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, 1998, July 3, 1999 and July 1, 2000 the cost of goodwill was
$20.8 million, $20.8 million and $18.1 million, respectively.

  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.

                                       F-7
<PAGE>   35
                     PARTY CITY CORPORATION AND SUBSIDIARY

           NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED)

  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 and warrants) outstanding during the period. All
earnings per share data for the year ended December 31, 1997, have 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. Allowances
for sales returns are recorded as a component of net sales in the periods in
which the related sales are recognized.

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

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

<TABLE>
<CAPTION>
                                                            NUMBER OF STORES
                                ------------------------------------------------------------------------
                                                YEAR ENDED
                                               DECEMBER 31,                   SIX MONTHS
                                ------------------------------------------      ENDED        YEAR ENDED
                                    1996           1997           1998       JULY 3, 1999   JULY 1, 2000
                                ------------   ------------   ------------   ------------   ------------
<S>                             <C>            <C>            <C>            <C>            <C>
Franchise stores in operation
  at beginning of the
  period......................      132            164            158            167            178
Franchise stores opened during
  the period..................       32             19             19             11             18
Franchise stores acquired
  during the period...........       --            (24)            (9)            --             --
Stores sold by the Company....       --             --             --              1             18
Franchise stores closed during
  the period..................       --             (1)            (1)            (1)            (3)
                                    ---            ---            ---            ---            ---
Franchise stores in operation
  at the end of the period....      164            158            167            178            211
                                    ===            ===            ===            ===            ===
</TABLE>

                                       F-8
<PAGE>   36
                     PARTY CITY CORPORATION AND SUBSIDIARY

           NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED)

  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 $7.0 million, $16.0 million, $4.3 million, $7.4 million and $17.2
million for the years ended December 31, 1997 and 1998, the six month periods
ended June 30, 1998 (unaudited) and July 3, 1999, and the year ended July 1,
2000, respectively.

  Effect of New Accounting Standards

     In June 1998, the Financial Accounting Standards Board ("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 No. 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,
liability for incurred but not reported medical claims and accrued workers
compensation claims.

  Concentration

     The Company had four suppliers who in the aggregate constituted
approximately 42% of the Company's purchases for the year ended July 1, 2000.
The loss of any of these suppliers would adversely affect the Company's
operations.
                                       F-9
<PAGE>   37
                     PARTY CITY CORPORATION AND SUBSIDIARY

           NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED)

  Reclassifications

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

2.  ACQUISITIONS AND DISPOSITION OF STORES

  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 and a member of the Board of Directors until
September 17, 1999. 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 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. 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 year 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
                                                              --------------------
                                                                1997        1998
                                                              --------    --------
<S>                                                           <C>         <C>
Total revenues..............................................  $174,817    $301,913
Net income..................................................     8,834       2,368
Basic earnings per share....................................  $   0.75    $   0.19
Diluted earnings per share..................................      0.73        0.19
</TABLE>

                                      F-10
<PAGE>   38
                     PARTY CITY CORPORATION AND SUBSIDIARY

           NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED)

     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.

  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. In June 1999, one store with a net book
value of approximately $400,000, was sold to a franchisee for $370,000. In the
first quarter of Fiscal Year 2000, an additional 17 stores with a net book value
of $9.4 million, were sold to franchisees for total proceeds of approximately
$9.5 million. In connection with the sales, normal royalty fees were waived for
negotiated periods up to five years. The net proceeds from the sale of stores
was required under the Bank Forbearance Agreement to be used to pay down the
outstanding borrowings under the Credit Agreement. Losses of $1.4 million and
deferred royalty income of $1.1 million were recognized on the sales of the
stores in Fiscal Year 2000. In Fiscal 2000, the Company sold an additional store
to a franchisee and recognized a gain of $75,000. The losses were included in
general and administrative expenses in the consolidated statement of operations.

3.  OTHER CURRENT ASSETS

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

<TABLE>
<CAPTION>
                                                  DECEMBER 31,
                                                      1998        JULY 3, 1999    JULY 1, 2000
                                                  ------------    ------------    ------------
<S>                                               <C>             <C>             <C>
Restricted cash from advertising fund...........     $   90         $    68         $ 1,495
Receivables from franchisees:
  Royalty fees..................................      1,201           1,124             901
  Other.........................................        795             977             706
Deferred income taxes...........................      1,284           4,225           5,976
Prepaid expenses and other current assets.......      6,447          10,206          10,518
                                                     ------         -------         -------
                                                     $9,817         $16,600         $19,596
                                                     ======         =======         =======
</TABLE>

4.  PROPERTY AND EQUIPMENT

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

<TABLE>
<CAPTION>
                                                  DECEMBER 31,
                                                      1998        JULY 3, 1999    JULY 1, 2000
                                                  ------------    ------------    ------------
<S>                                               <C>             <C>             <C>
Equipment.......................................    $22,142         $24,570         $ 26,466
Furniture.......................................     21,894          23,318           22,190
Leasehold improvements..........................     14,543          16,112           14,949
Automobiles.....................................        102             102               40
                                                    -------         -------         --------
                                                     58,681          64,102           63,645
Less: accumulated depreciation and
  amortization..................................     (8,977)        (13,545)         (22,198)
                                                    -------         -------         --------
                                                    $49,704         $50,557         $ 41,447
                                                    =======         =======         ========
</TABLE>

                                      F-11
<PAGE>   39
                     PARTY CITY CORPORATION AND SUBSIDIARY

           NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED)

5.  OTHER ASSETS

     Other assets consist of the following (in thousands):

<TABLE>
<CAPTION>
                                                  DECEMBER 31,
                                                      1998        JULY 3, 1999    JULY 1, 2000
                                                  ------------    ------------    ------------
<S>                                               <C>             <C>             <C>
Deferred income taxes...........................     $  603           $ --           $4,462
Loan commitment fees and other..................      1,237            906            2,574
                                                     ------           ----           ------
                                                     $1,840           $906           $7,036
                                                     ======           ====           ======
</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. In the
fiscal year ended July 1, 2000, the Company recorded an additional impairment
charge of $1.2 million relating to goodwill and fixed assets for seven stores.
These twelve 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,
1997 and 1998.

7.  ACCRUED EXPENSES

     Accrued expenses consist of the following (in thousands):

<TABLE>
<CAPTION>
                                                  DECEMBER 31,
                                                      1998        JULY 3, 1999    JULY 1, 2000
                                                  ------------    ------------    ------------
<S>                                               <C>             <C>             <C>
Accrued compensation............................     $1,761         $ 3,037         $ 3,422
Sales and use taxes.............................      2,204           1,741           1,402
Other...........................................      4,908           5,367          10,633
                                                     ------         -------         -------
                                                     $8,873         $10,145         $15,457
                                                     ======         =======         =======
</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 was 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 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 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.

                                      F-12
<PAGE>   40
                     PARTY CITY CORPORATION AND SUBSIDIARY

           NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED)

The bank lenders 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. 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 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
$1,9650,000 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 was secured by a first lien that was 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 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. The Company has
agreed to nominate two individuals designated by the Investors to its Board of
Directors. Under the Investor Rights Agreement, the Investors agreed 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. The Company achieved its target EBITDA for 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 have received promissory notes from Party
City representing one-third of their unpaid balances as of May 1, 1999 (the
"Trade Notes"). The Trade Notes bore interest at a rate
                                      F-13
<PAGE>   41
                     PARTY CITY CORPORATION AND SUBSIDIARY

           NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED)

of 10% per year and matured 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 the 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.

     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 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, totalling 10.25% at July 1, 2000.
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 July 1, 2000, no borrowings
were outstanding under the Loan Agreement. At September 15, 2000, there was
$15.8 million outstanding and approximately $24.2 million was available to be
borrowed under the Loan Agreement.

     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
existing 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 revolving credit facility (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 seasons. All the remaining unpaid vendor
balances that were originally due May 1, 1999, were satisfied by individual
arrangements with such vendors.

     The Company was in compliance with the financial covenants of the Loan
Agreement and the Notes at July 1, 2000.

                                      F-14
<PAGE>   42
                     PARTY CITY CORPORATION AND SUBSIDIARY

           NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED)

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>
                                                                   SIX MONTHS ENDED
                                              YEAR ENDED        -----------------------     YEAR
                                             DECEMBER 31,                                   ENDED
                                          ------------------     JUNE 30,      JULY 3,     JULY 1,
                                           1997       1998         1998          1999       2000
                                          -------    -------    -----------    --------    -------
                                                                (UNAUDITED)
<S>                                       <C>        <C>        <C>            <C>         <C>
Net income (loss).......................  $ 7,670    $ 1,787    $     (230)    $(13,416)   $   981
Average shares outstanding..............   11,749     12,411        12,376       12,455     12,611
Earnings (loss) per share -- basic......  $  0.65    $  0.14    $    (0.02)    $  (1.08)   $  0.08
Dilutive effect of stock options........      290        293            (a)          (a)        13
Dilutive effect of warrants.............       --         --            --           --      1,659
Average common and common equivalent
  shares outstanding....................   12,039     12,704        12,376       12,455     14,283
Earnings (loss) per share -- diluted....  $  0.64    $  0.14    $    (0.02)    $  (1.08)   $  0.07
</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, 134,000, 973,976, 1,026,826 and 1,150,064 common shares
    at prices ranging from $1.67 to $30.50 per share were outstanding at
    December 31, 1998, June 30, 1998, July 3, 1999, and July 1, 2000
    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.

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 12,452,369, 12,455,538 and 12,722,205
at December 31, 1998, July 3, 1999 and July 1, 2000 respectively.

     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 have been retroactively
adjusted for the stock split.

     On October 19, 1999, the Company's board of directors adopted the Company's
1999 Stock Incentive Plan ("1999 Plan"). This adoption was approved by the
company's stockholders on November 15, 1999. A total of 500,000 shares of the
Company's common stock were reserved for issuance under the 1999 Plan. Pursuant
to agreement into which the Company entered in connection with the issuance of
the Senior Notes, the Company may not grant options to purchase more than
500,000 shares of common stock at an exercise price of less than $10 per share.

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

     The 1999 Plan provides for the grants of options and restricted stock and
other stock-based awards as the compensation committee of the board of directors
may from time to time deem appropriate. Such awards

                                      F-15
<PAGE>   43
                     PARTY CITY CORPORATION AND SUBSIDIARY

           NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED)

include stock appreciation rights, phantom stock awards, bargain purchase of
stock and stock bonuses. Vesting and other terms of stock options awarded are
set out in the agreements between the Company and the individuals receiving such
awards. The exercise price of the options is determined by the compensation
committee at the time of grant and will not be less than the fair market value
of the Company's common stock on the date of grant. Options granted under the
1999 Plan vest over four years from date of grant, and expire in ten years.

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

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

<TABLE>
<CAPTION>
                                                                                WEIGHTED
                                                                            AVERAGE EXERCISE
                                                        NUMBER OF SHARES         PRICE
                                                        ----------------    ----------------
<S>                                                     <C>                 <C>
Balance at January 1, 1997............................       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
Granted...............................................       780,250               2.28
Canceled..............................................      (285,950)             12.23
                                                           ---------
Balance at July 1, 2000...............................     1,521,126               7.29
                                                           =========
Options Exercisable at:
December 31, 1997.....................................       244,650
December 31, 1998.....................................       352,251
July 3, 1999..........................................       448,701
July 1, 2000..........................................       559,123
</TABLE>

                                      F-16
<PAGE>   44
                     PARTY CITY CORPORATION AND SUBSIDIARY

           NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED)

<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 1, 2000       LIFE         PRICE        AT JULY 1, 2000     PRICE
------------------------        ---------------    -----------    --------      ---------------    --------
<S>                             <C>                <C>            <C>           <C>                <C>
$1.67                                 50,000          9.84         $ 1.67                --         $ 0.00
$1.71 to $2.00                       476,500          9.44           1.99                --           0.00
$2.25 to $6.67                       355,150          8.77           3.78           123,650           5.30
$8.83 to $10.17                      314,250          6.47           9.96           233,750           9.97
$10.25 to $32.50                     325,226          7.41          17.17           201,723          16.71
-----------------------------------------------------------------------------------------------------------
$1.67 to $32.50                    1,521,126          8.25         $ 7.29           559,123         $11.37
</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 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
                           ----------------------    -----------------------------     YEAR ENDED
                             1997         1998       JUNE 30, 1998    JULY 3, 1999    JULY 1, 2000
                           ---------    ---------    -------------    ------------    ------------
                                                      (UNAUDITED)
<S>                        <C>          <C>          <C>              <C>             <C>
Expected volatility......     40%         100%           100%            120%            137%
Expected lives...........  4.3 years    5.0 years      5.0 years      5.0 years       5.0 years
Risk-free interest
  rate...................    5.7%         5.2%           5.2%            5.5%            6.2%
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
                                      ---------------   ----------------------------    YEAR ENDED
                                       1997     1998    JUNE 30, 1998   JULY 3, 1999   JULY 1, 2000
                                      ------   ------   -------------   ------------   ------------
                                                         (UNAUDITED)
<S>                                   <C>      <C>      <C>             <C>            <C>
Net income (loss):
  As reported.......................  $7,670   $1,787      $ (230)        $(13,416)      $   981
  Pro-forma.........................   6,944      174        (963)        $(14,252)         (383)
Basic earnings (loss) per share:
  As reported.......................  $ 0.65   $ 0.14      $(0.02)        $  (1.08)      $  0.08
  Pro-forma.........................    0.59     0.01       (0.08)        $  (1.14)        (0.03)
Diluted earnings (loss) per share:
  As reported.......................  $ 0.64   $ 0.14      $(0.02)        $  (1.08)      $  0.07
  Pro-forma.........................    0.58     0.01       (0.08)        $  (1.14)        (0.03)
</TABLE>

                                      F-17
<PAGE>   45
                     PARTY CITY CORPORATION AND SUBSIDIARY

           NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED)

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
                                      ---------------   ----------------------------    YEAR ENDED
                                       1997     1998    JUNE 30, 1998   JULY 3, 1999   JULY 1, 2000
                                      ------   ------   -------------   ------------   ------------
                                                         (UNAUDITED)
<S>                                   <C>      <C>      <C>             <C>            <C>
Current:
  Federal...........................  $4,519   $1,721       $(127)        $   310        $ 1,575
  State.............................     981      339         (13)            (97)             2
                                      ------   ------       -----         -------        -------
                                       5,500    2,060        (140)            213          1,577
Deferred:
  Federal...........................    (464)    (796)         (6)         (2,642)        (4,787)
  State.............................     (79)    (137)         --             304         (1,426)
                                      ------   ------       -----         -------        -------
                                        (543)    (933)         (6)         (2,338)        (6,213)
                                      ------   ------       -----         -------        -------
                                      $4,957   $1,127       $(146)        $(2,125)       $(4,636)
                                      ======   ======       =====         =======        =======
</TABLE>

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

     The Company 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.

                                      F-18
<PAGE>   46
                     PARTY CITY CORPORATION AND SUBSIDIARY

           NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED)

     Significant components of the net deferred tax asset at December 31, 1998,
July 3, 1999 and July 1, 2000 are as follows (in thousands):

<TABLE>
<CAPTION>
                                                  DECEMBER 31,
                                                      1998        JULY 3, 1999    JULY 1, 2000
                                                  ------------    ------------    ------------
<S>                                               <C>             <C>             <C>
Current:
  Inventory.....................................    $ 1,030          $1,218          $2,813
  Vacation pay accrual..........................        158             183             188
  Reserves not currently deductible.............         --             401             608
  Amortization of goodwill......................         --             220             115
  Part year federal net operating loss..........         --           4,225           3,012
  Deferred state taxes..........................         --             184            (760)
  Valuation allowance...........................         --          (2,206)             --
  Other.........................................         96              --              --
                                                    -------          ------          ------
     Net current deferred tax asset.............    $ 1,284          $4,225          $5,976
                                                    =======          ======          ======
Non-current:
  Deferred rent.................................    $ 2,261          $2,525          $2,991
  Start-up costs................................       (381)           (404)           (294)
  Property and equipment........................     (1,798)         (2,187)         (2,005)
  Deferred state taxes..........................         84            (184)            298
  Foreign tax credit............................         --              --             202
  Miscellaneous reserves........................         --              --             438
  Part year federal and state net operating
     loss.......................................         --           1,640           2,525
  AMT credit....................................        437             347             509
  Valuation allowance...........................         --          (1,737)           (202)
                                                    -------          ------          ------
     Non-current deferred tax asset.............    $   603          $   --          $4,462
                                                    =======          ======          ======
</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
                                      -------------    ----------------------------     YEAR ENDED
                                      1997    1998     JUNE 30, 1998   JULY 3, 1999    JULY 1, 2000
                                      -----   -----    -------------   ------------    ------------
                                                        (UNAUDITED)
<S>                                   <C>     <C>      <C>             <C>             <C>
Federal statutory rate/(benefit)....  35.0%   34.0%        (34.0%)        (34.0%)          (34.0%)
State income taxes net of federal
  benefit...........................   4.7     5.4          (3.6)          (3.6)             4.0
Valuation allowance.................    --      --            --           25.4           (102.4)
Foreign tax.........................    --      --            --             --              1.9
Other...............................  (0.4)   (0.7)         (1.2)           1.5              3.7
                                      ----    ----         -----          -----           ------
Effective tax rate/(benefit)........  39.3%   38.7%        (38.8%)        (13.7%)         (126.8%)
                                      ====    ====         =====          =====           ======
</TABLE>

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, 1997 and 1998, the six months ended June
30, 1998 (unaudited) and July 3, 1999, and the year ended July 1, 2000, matching
contributions of $65,000, $121,000, $50,000, $107,000 and $232,000,
respectively, were expensed under the 401(k) Plan.

                                      F-19
<PAGE>   47
                     PARTY CITY CORPORATION AND SUBSIDIARY

           NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED)

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 $24,000, $58,000, $22,000 and $26,000 relating to the above
are included in the accompanying consolidated financial statements for the years
ended December 31, 1997 and 1998, and the six months ended June 30, 1998 and
July 1, 1999, respectively.

     The Company provided bookkeeping 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. Office expenses allocated
from the affiliate to the Company were based upon the square footage occupied by
the Company. Personnel costs allocated to the affiliate were based upon an
analysis of the percentage of time individuals devoted to services for the
affiliate stores. Management believes that both allocation methods are
reasonable to determine the appropriate expenses to be allocated.

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

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

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

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

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

                                      F-20
<PAGE>   48
                     PARTY CITY CORPORATION AND SUBSIDIARY

           NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED)

estate taxes. Certain leases contain contingent rent based upon specified sales
volume. For the years ended December 31, 1997 and 1998, and the six months ended
June 30, 1998 (unaudited) and July 3, 1999, and the year ended July 1, 2000, no
such contingent rent was paid.

     At July 1, 2000, the Company leased 23 motor vehicles. The terms range from
24 to 36 months, and expire through 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 is included in property and
equipment at a net book value of approximately $580,000 at July 1, 2000. The
leased software has been fully depreciated.

     Future minimum lease payments under outstanding leases at July 1, 2000, are
as follows (in thousands):

<TABLE>
<CAPTION>
                                                                               OPERATING
                                                              CAPITAL LEASE     LEASES
                                                              -------------    ---------
<S>                                                           <C>              <C>
Fiscal year ending:
2001........................................................     $  366        $ 35,839
2002........................................................        366          35,512
2003........................................................         --          34,350
2004........................................................         --          33,416
2005........................................................         --          32,085
Thereafter..................................................         --          93,340
                                                                 ------        --------
Total minimum lease payments................................        732        $264,542
                                                                               ========
Less amount representing interest...........................        (23)
                                                                 ------
Present value of net minimum lease payments.................        709
Less current maturities, included in other current
  liabilities...............................................        349
                                                                 ------
Long-term obligation........................................     $  360
                                                                 ======
</TABLE>

     Rent expense for all operating leases was $12.0 million, $27.3 million,
$11.1 million, $19.3 million, and $35 million for the years ended December 31,
1997 and 1998, the six months ended June 30, 1998 (unaudited) and July 3, 1999,
and the year ended July 1, 2000, respectively. The Company is obligated for
guarantees, subleases or assigned lease obligations for 27 of its franchisees
through 2011, including the 17 stores sold in the first quarter of Fiscal Year
2000. The aggregate future minimum payments under these leases are approximately
$36.7 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

                                      F-21
<PAGE>   49
                     PARTY CITY CORPORATION AND SUBSIDIARY

           NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED)

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.

     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

     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.

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

                                      F-22
<PAGE>   50
                     PARTY CITY CORPORATION AND SUBSIDIARY

           NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED)

has no intersegment sales. No single customer accounts for 10% or more of total
revenues. Revenues from Europe were not significant in all periods presented.
All assets of the Company are located in North America.

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

<TABLE>
<CAPTION>
                                                                SIX MONTHS ENDED
                                  YEAR ENDED DECEMBER 31,    ----------------------
                                  ------------------------    JUNE 30,     JULY 3,     YEAR ENDED
                                     1997          1998         1998         1999     JULY 1, 2000
                                  ----------    ----------   -----------   --------   ------------
                                                            (UNAUDITED)
<S>                               <C>           <C>          <C>           <C>        <C>
RETAIL:
Net revenue.....................   $131,028      $282,923     $ 92,718     $151,349     $349,722
Operating earnings (loss).......     12,776        14,192        3,361         (561)      25,896
Identifiable assets.............     84,939       133,435      112,727      150,232      121,190
Depreciation/ amortization......      2,433         5,721        2,368        3,771        8,351
Capital expenditures............     37,200        32,845       10,924        6,623        1,728
FRANCHISING:
Net revenue.....................   $ 10,686      $ 11,411     $  4,554     $  5,160     $ 13,677
Operating earnings..............      6,688         7,297        2,751        3,254        9,271
Identifiable assets.............      1,455         1,996        1,674        2,101        1,607
Depreciation/ amortization......         --            --           --           --           --
Capital expenditures............         --            --           --           --           --
CORPORATE/OTHER:
Net revenue.....................   $     --      $     --     $     --     $     --     $     --
Operating expense...............     (7,049)      (15,939)      (5,615)     (15,856)     (30,399)
Identifiable assets.............      3,221         8,601        4,767        8,986        9,289
Depreciation/ amortization......        361           877          362        1,458        2,406
Capital expenditures............      2,725         6,249        1,908        1,310        2,589
CONSOLIDATED TOTALS:
Net revenue.....................   $141,714      $294,334     $ 97,272     $156,509     $363,399
Operating earnings (loss).......     12,415         5,550          497      (13,163)       4,768
Interest expense (income),
  net...........................       (212)        2,636          874        2,378        8,423
                                   --------      --------     --------     --------     --------
Income (loss) before income
  taxes (benefit)...............     12,627         2,914         (376)     (15,541)      (3,655)
Income taxes (benefit)..........      4,957         1,127         (146)      (2,125)      (4,636)
                                   --------      --------     --------     --------     --------
Net income (loss)...............   $  7,670      $  1,787     $   (230)    $(13,416)    $    981
                                   ========      ========     ========     ========     ========
Identifiable assets.............   $ 89,615      $144,032     $119,168     $161,319     $132,086
Depreciation/ amortization......      2,794         6,598        2,730        5,229       10,757
Capital expenditures............     39,925        39,094       12,832        7,933        4,317
</TABLE>

                                      F-23
<PAGE>   51
                     PARTY CITY CORPORATION AND SUBSIDIARY

           NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED)

17.  SPECIAL CHARGES AND GENERAL AND ADMINISTRATIVE EXPENSE

     As a result of the liquidity issues the Company faced in 1999 and 2000, the
Company incurred substantial expenses which management believes to be
nonrecurring in nature.

     In 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 during the six months ended July 3, 1999 and $9.0 million for
the year ended July 1, 2000.

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

<TABLE>
<CAPTION>
                                                                   QUARTER ENDED
                                                     -----------------------------------------
                                                      FIRST      SECOND     THIRD      FOURTH
                                                     --------   --------   --------   --------
<S>                                                  <C>        <C>        <C>        <C>
YEAR ENDED DECEMBER 31, 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

YEAR ENDED DECEMBER 31, 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

SIX MONTHS ENDED JULY 3, 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)

YEAR ENDED JULY 1, 2000
Total revenues.....................................  $ 70,451   $136,046   $ 68,872   $ 88,030
Cost of goods sold and occupancy costs.............    50,717     79,733     49,669     60,237
Net income (loss)..................................   (12,259)    21,238     (8,624)       626
Basic earnings (loss) per share....................     (0.98)      1.69      (0.68)      0.05
Diluted earnings (loss) per share..................     (0.98)      1.69      (0.68)      0.04
</TABLE>

                                      F-24