##### Table of Contents









SECURITIES AND EXCHANGE COMMISSION

Washington, D.C. 20549




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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 3,
2004


Commission file number 0-27826



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Party City Corporation

(Exact name of registrant as specified in its
charter)


|                                                                   |  |                                         
|------------------------------------------------------------------ |  | ----------------------------------------
|Delaware                                                           |  | 22-3033692                              
|(State or other jurisdiction of
    incorporation or organization) |  | (I.R.S. Employer
    Identification No.)
|                                                                  
|400 Commons Way, Rockaway, NJ                                      |  | 07866                                   
|(Address of principal executive
    offices)                       |  | (Zip Code)                              

Registrants telephone number, including
area code:

(973) 983-0888


Securities Registered Pursuant to
Section 12(b) of the Act:

|                    |  |                                          
|------------------- |  | -----------------------------------------
|Title of Each Class |  | Name of Each Exchange on Which Registered
|                    |  |                                          
|None                |  | None                                     

Securities Registered Pursuant to
Section 12(g) of the Act:

Common Stock, par value $0.01 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 þ          No o

Indicate
by check mark if disclosure of delinquent filers pursuant to
Item 405 of Regulation S-K is not contained herein, and
will not be contained, to the best of 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. o

Indicate
by check mark whether the registrant is an accelerated filer (as
defined in Exchange Act
Rule 12b-2).     Yes þ          No o

The
aggregate market value of voting stock held by non-affiliates of
the Registrant on December 26, 2003, based on the closing
sale price on such date, was approximately $169,191,552.

The number of outstanding shares of the
Registrants common stock, $0.01 par value, as of
August 30, 2004 was 17,103,161.

DOCUMENTS INCORPORATED BY REFERENCE

Portions
of the Registrants Proxy Statement for the 2004 Annual
Meeting of Stockholders for the fiscal year ended July 3,
2004 are incorporated by reference into Part III.



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TABLE OF CONTENTS

|                                         |  |                                                                                                                      |  |      |    | 
|---------------------------------------- |  | -------------------------------------------------------------------------------------------------------------------- |  | ---- | -- | 
|                                         |  |                                                                                                                      |  | Page
|                                         |  |                                                                                                                      |  |     
|PART I                                   |  |                                                                                                                      |  |     
|Item 1                                   |  | Business                                                                                                             |  |      | 1  | 
|Item 2                                   |  | Properties                                                                                                           |  |      | 14 | 
|Item 3                                   |  | Legal Proceedings                                                                                                    |  |      | 14 | 
|Item 4                                   |  | Submission of Matters to a
    Vote of Security Holders                                                              |  |      | 14 | 
|PART II                                  |  |                                                                                                                      |  |     
|Item 5                                   |  | Market for Registrants
    Common Equity, Related Stockholder Matters and Issuer Purchases
    of Equity Securities |  |      | 15 | 
|Item 6                                   |  | Selected Financial Data                                                                                              |  |      | 17 | 
|Item 7                                   |  | Managements Discussion
    and Analysis of Financial Condition and Results of Operations                            |  |      | 21 | 
|Item 7A                                  |  | Quantitative and Qualitative
    Disclosures About Market Risk                                                       |  |      | 32 | 
|Item 8                                   |  | Financial Statements and
    Supplementary Data                                                                      |  |      | 32 | 
|Item 9                                   |  | Changes in and Disagreements
    with Accountants on Accounting and Financial Disclosure                             |  |      | 32 | 
|Item 9A                                  |  | Controls and Procedures                                                                                              |  |      | 32 | 
|Item 9B                                  |  | Other Information                                                                                                    |  |      | 32 | 
|PART III                                 |  |                                                                                                                      |  |     
|Item 10                                  |  | Directors and Executive
    Officers of the Registrant                                                               |  |      | 33 | 
|Item 11                                  |  | Executive Compensation                                                                                               |  |      | 33 | 
|Item 12                                  |  | Security Ownership of
    Certain Beneficial Owners and Management and
    Related Stockholder Matters               |  |      | 33 | 
|Item 13                                  |  | Certain Relationships and
    Related Transactions                                                                   |  |      | 33 | 
|Item 14                                  |  | Principal Accountant Fees
    and Services                                                                           |  |      | 33 | 
|PART IV                                  |  |                                                                                                                      |  |     
|Item 15                                  |  | Exhibits, Financial
    Statement Schedules, and Reports on Form 8-K                                                 |  |      | 34 | 
|EX-23.1 CONSENT OF DELOITTE & TOUCHE LLP
|EX-31.1 CERTIFICATION                   
|EX-31.2 CERTIFICATION                   
|EX-32.1 CERTIFICATION                   
|EX-32.2 CERTIFICATION                   



References throughout this document to the
Company include Party City Corporation and its
wholly owned subsidiary. In accordance with the Securities and
Exchange Commissions Plain English guidelines,
this Annual Report on Form 10-K has been written in the
first person. In this document the words we,
our, ours and us refer only
to Party City Corporation and its wholly-owned subsidiary and
not to any other person.

Our website 
www.partycity.com  provides access, free of
charge, to our Securities and Exchange Commission
(SEC) reports as soon as reasonably practicable
after we electronically file such reports with, or furnish such
reports to, the SEC, including Annual Reports on Form 10-K,
Quarterly Reports on Form 10-Q, Current Reports on
Form 8-K and amendments to these reports.

You may also read and copy any materials we file
with the SEC at the SECs Public Reference Room at 450
Fifth Street, NW, Washington, DC 20549. You may obtain
information on the operations of the Public Reference Room by
calling the SEC at 1-800-SEC-0330. The SEC maintains a website
that contains reports, proxy and information statements and
other information regarding issuers that file electronically
with the SEC, including us, at http://www.sec.gov.

1



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PART I

Forward-Looking Statements

This Annual Report on 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 such as
estimate, project, expect,
believe, may, will,
intend or similar statements or variations of such
terms. Such forward-looking statements are based on many
assumptions that are subject to certain risks and uncertainties,
including, but not limited to: levels of sales, store traffic,
acceptance of product offerings, competitive pressures from
other party supplies retailers and other retailers, availability
of qualified personnel, availability of suitable future store
locations, schedules of store expansion plans and other factors
beyond our control. As a result of the foregoing risks and
uncertainties, actual results and performance may differ
materially from those projected or suggested herein. See
Part I, Item 1. Business  Risk
Factors beginning on page 9 for further information
on such risks and uncertainties. Furthermore, additional
information concerning other risks and uncertainties that could
cause our actual results to differ materially from those
projected or suggested may be identified from time to time in
our SEC filings and our public announcements.






|        |         
|------- | --------
|Item 1. | Business

Party City Corporation is based in Rockaway, New
Jersey and was incorporated in the State of Delaware in 1996. We
operate retail party supplies stores in the United States and we
sell franchises on an individual store and area franchise basis
throughout the United States and Puerto Rico.

General

We are a specialty retailer of party supplies
with a network of more than 500 stores. At August 30, 2004,
we owned and operated 249 stores in the United States and our
franchisees operated an additional 258 stores in the United
States, including five stores in Puerto Rico. We believe that we
are Americas largest retail party goods chain. We
authorized our first franchise store in 1989 and opened our
first Company-owned store in January 1994.

We report two segments  retail and
franchising. The retail segment generates revenue primarily
through the sale of third-party branded party goods through
Company-owned stores. The franchising segment generates revenue
through the imposition of an initial one-time franchise fee and
ongoing royalty payments based on retail sales.

We operate and franchise party supplies stores
that typically range in size from 10,000 square feet to 12,000
square feet. Our stores offer a broad selection of brand name
and private label merchandise for a wide variety of celebratory
occasions, including birthday parties, weddings and baby
showers, as well as holiday and 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. We seek to offer customers a
one-stop party store that provides a wide selection
of merchandise at a compelling value.

Our fiscal year ends the Saturday nearest to
June 30. As used herein, the term Fiscal Year
or Fiscal refers to the 52- or 53-week period, as
applicable, ending the Saturday nearest to June 30. Unless
otherwise stated, the financial results presented for the year
ended July 3, 2004 are based on a 53-week period, while the
financial results for the years ended June 28, 2003 and
June 29, 2002 are based on a 52-week period.

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Business Strategy and Initiatives

Our objective is to maintain and expand our
position as a leading national chain of party supply stores. To
that end, we have undertaken initiatives to make fundamental
improvements in the underlying components and operation of our
business, including initiatives to: develop coordinated
assortments of our product lines; increase exclusive product
offerings; enhance our product and in-store presentation through
new product packaging, in-store signage and displays, and
shorter aisles; improve customer service; strengthen our
employee base; upgrade and improve information systems; and
centralize our distribution systems. We believe these
initiatives will improve our operating efficiencies,
profitability and cash flows, which will improve shareholder
value in the long-term. Key components of our business strategy
include:

Offer a Broad Selection of Merchandise,
Including Many Exclusive Products.We
provide party-planners and party-goers with convenient one-stop
shopping for party supplies, and we offer what we believe is one
of the most extensive selections of party supplies available.
The typical Party City store offers a broad selection of brand
name and private label merchandise consisting of over 19,000
active items. We are in the process of transitioning our product
base through the development of new, coordinated assortments
within selected product categories.

Enhance Merchandise Presentation and Create an
Exciting Shopping Environment.We are
enhancing our in-store product presentation to provide a more
compelling shopping experience. We have begun to upgrade the
presentation in our stores, including cutting through long
aisles to allow customers to navigate the stores more easily and
us to merchandise more effectively by highlighting more products
around the end of each shortened aisle. We are also evaluating
our product placement in connection with our new, coordinated
assortment strategy to simplify the customers shopping
experience and to increase synergistic selling opportunities.

Establish Convenient Store Locations.Although we believe that our stores
typically are destination shopping locations, we seek to
maximize customer traffic and build quickly the visibility of
new stores by situating our stores in high traffic areas. Site
selection criteria include: population density, demographics,
traffic counts, location of complementary retailers, storefront
visibility and presence (either in a stand-alone building or in
dominant power strip shopping centers), competition, lease rates
and accessible parking. We believe there are an extensive number
of suitable domestic locations available for future stores.

Maintain Value Price Position.We use the aggregate buying power of
our more than 500 Company-owned and franchise store network
which allows us to offer a broad line of high quality
merchandise at low prices. We believe we reinforce
customers expectations of value through our advertising
media, with a balanced message of product newness, exclusivity
and savings. We also maintain a lowest price guaranty policy in
Company-owned stores, and we suggest our franchisees adhere to
such a policy. This policy guarantees that Party City stores
will meet the advertised prices of competitors products.

Provide Excellent Customer Service.We view the quality of our
customers shopping experience as critical to our continued
success, and we are committed to making shopping in our stores
an enjoyable experience. For example, at Halloween, our most
important selling season, each store significantly increases the
number of sales associates. We believe that the compensation of
our store managers and other personnel is competitive and
enables us to attract and retain well-qualified, motivated
employees who are committed to providing excellent customer
service. In Fiscal 2004, we took significant steps to improve
our customer service and to increase the ability of our in-store
employees to assist customers as party consultants. To implement
this strategy, we hired a full-time Director of Training and
launched a sales and service training program in every region.

3



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Logistics
Initiative.Through the end of Fiscal
2004, merchandise purchases were shipped directly to stores.
Starting in July 2004, we began shifting product flow for
certain products through centralized distribution centers in
order to facilitate lower freight costs through shipping
efficiencies and lower purchase prices. This will also
facilitate improved inventory management and reduce store labor
requirements. We anticipate the full transition from
direct-to-store delivery to centralized distribution to span the
next two to three years.

Expansion Plans.Our
long-term goal is to increase our market share in existing
markets and penetrate new markets to expand our position as a
leading retailer of party supplies merchandise. Our growth
strategy is based upon the opening of new Company-owned and
franchise stores. While we continuously evaluate acquisition
opportunities, we have no present commitments or agreements with
respect to material acquisitions. Franchise store growth is
subject to the ability and interest on the part of the
franchisees to open stores according to our expansion plans. To
manage continued store growth, we intend to continue to invest
in our human resources, management information systems and
supply-chain to further improve our infrastructure.

Store Counts and Locations

As of July 3, 2004 and August 30, 2004,
there were 506 and 507 Party City stores open in the United
States and Puerto Rico, respectively. Of these, 249 were
Company-owned as of July 3, 2004 and August 30, 2004,
and 257 and 258 were operated by our franchisees as of
July 3, 2004 and August 30, 2004, respectively. The
following table shows the growth in Party Citys network of
stores for the Fiscal Years 2000 through 2004.

|                                             |                                         |             |     |      |   |      |     |      |   |      |     |     |   |  |     |     |   |  |     |     |  
|-------------------------------------------- | --------------------------------------- | ----------- | --- | ---- | - | ---- | --- | ---- | - | ---- | --- | --- | - |  | --- | --- | - |  | --- | --- | -
|                                             |                                         |            
|                                             |                                         | Fiscal Year
|                                             |                                         |            
|                                             |                                         | 2004        |     | 2003 |   | 2002 |     | 2001 |   | 2000
|                                             |                                         |             |     |      |   |      |     |      |   |     
|Company-owned:                               |                                         |             |     |      |   |      |     |      |   |      |     |     |   |  |     |     |   |  |     |    
|                                             | Stores open at beginning of fiscal year |             |     | 242  |   |      |     | 209  |   |      |     | 193 |   |  |     | 197 |   |  |     | 215 |  
|                                             | Stores opened                           |             |     | 9    |   |      |     | 22   |   |      |     | 11  |   |  |     |    |   |  |     | 2   |  
|                                             | Stores closed                           |             |     | (2   | ) |      |     | (2   | ) |      |     |    |   |  |     | (2  | ) |  |     | (2  | )
|                                             | Stores acquired from franchisees        |             |     |     |   |      |     | 2    |   |      |     | 3   |   |  |     | 1   |   |  |     |    |  
|                                             | External acquisitions                   |             |     |     |   |      |     | 11   |   |      |     | 2   |   |  |     |    |   |  |     |    |  
|                                             | Stores sold to franchisees              |             |     |     |   |      |     |     |   |      |     |    |   |  |     | (3  | ) |  |     | (18 | )
|                                             |                                         |             |     |      |   |      |     |      |   |      |     |     |   |  |     |     |   |  |     |    
|                                             | Stores open at end of fiscal year       |             |     | 249  |   |      |     | 242  |   |      |     | 209 |   |  |     | 193 |   |  |     | 197 |  
|Franchise:                                   |                                         |             |     |      |   |      |     |      |   |      |     |     |   |  |     |     |   |  |     |    
|                                             | Stores open at beginning of fiscal year |             |     | 241  |   |      |     | 242  |   |      |     | 261 |   |  |     | 211 |   |  |     | 178 |  
|                                             | Stores opened                           |             |     | 18   |   |      |     | 9    |   |      |     | 19  |   |  |     | 51  |   |  |     | 18  |  
|                                             | Stores closed(a)                        |             |     | (2   | ) |      |     | (8   | ) |      |     | (35 | ) |  |     | (3  | ) |  |     | (3  | )
|                                             | Stores purchased by the Company         |             |     |     |   |      |     | (2   | ) |      |     | (3  | ) |  |     | (1  | ) |  |     |    |  
|                                             | Stores purchased by franchisees         |             |     |     |   |      |     |     |   |      |     |    |   |  |     | 3   |   |  |     | 18  |  
|                                             |                                         |             |     |      |   |      |     |      |   |      |     |     |   |  |     |     |   |  |     |    
|                                             | Stores open at end of fiscal year       |             |     | 257  |   |      |     | 241  |   |      |     | 242 |   |  |     | 261 |   |  |     | 211 |  
|                                             |                                         |             |     |      |   |      |     |      |   |      |     |     |   |  |     |     |   |  |     |    
|Total Company-owned and franchise
    stores |                                         |             | 506 |      |   |      | 483 |      |   |      | 451 |     |   |  | 454 |     |   |  | 408 |    
|                                             |                                         |             |     |      |   |      |     |      |   |      |     |     |   |  |     |     |   |  |     |    



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|    |                                                                                                                             
|--- | ----------------------------------------------------------------------------------------------------------------------------
|(a) | Our Canadian master franchisee filed for
    bankruptcy protection under Canadian law, closing 28 stores in
    fiscal 2002.

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As of July 3, 2004, Party City stores were
located in the following states and Puerto Rico:

|               |       |               |    |           |  |            |    |     |  |  |    |     | 
|-------------- | ----- | ------------- | -- | --------- |  | ---------- | -- | --- |  |  | -- | --- | 
|State          |       | Company-Owned |    | Franchise |  | Chain-Wide
|               |       |               |    |           |  |           
|Alabama        |       |               |   |           |  |            | 8  |     |  |  | 8  |    
|Arizona        |       |               |   |           |  |            | 9  |     |  |  | 9  |    
|Arkansas       |       |               |   |           |  |            | 3  |     |  |  | 3  |    
|California     |       |               | 52 |           |  |            | 13 |     |  |  | 65 |    
|Colorado       |       |               | 5  |           |  |            |   |     |  |  | 5  |    
|Connecticut    |       |               | 4  |           |  |            | 4  |     |  |  | 8  |    
|Delaware       |       |               |   |           |  |            | 1  |     |  |  | 1  |    
|Florida        |       |               | 13 |           |  |            | 39 |     |  |  | 52 |    
|Georgia        |       |               |   |           |  |            | 26 |     |  |  | 26 |    
|Hawaii         |       |               |   |           |  |            | 1  |     |  |  | 1  |    
|Illinois       |       |               | 22 |           |  |            |   |     |  |  | 22 |    
|Indiana        |       |               | 5  |           |  |            |   |     |  |  | 5  |    
|Kansas         |       |               |   |           |  |            | 4  |     |  |  | 4  |    
|Kentucky       |       |               | 1  |           |  |            |   |     |  |  | 1  |    
|Louisiana      |       |               | 3  |           |  |            | 8  |     |  |  | 11 |    
|Maryland       |       |               | 3  |           |  |            | 10 |     |  |  | 13 |    
|Massachusetts  |       |               | 5  |           |  |            |   |     |  |  | 5  |    
|Michigan       |       |               | 11 |           |  |            |   |     |  |  | 11 |    
|Minnesota      |       |               | 5  |           |  |            |   |     |  |  | 5  |    
|Mississippi    |       |               |   |           |  |            | 2  |     |  |  | 2  |    
|Missouri       |       |               | 4  |           |  |            | 1  |     |  |  | 5  |    
|Nevada         |       |               | 5  |           |  |            |   |     |  |  | 5  |    
|New Jersey     |       |               | 9  |           |  |            | 25 |     |  |  | 34 |    
|New Mexico     |       |               |   |           |  |            | 3  |     |  |  | 3  |    
|New York       |       |               | 32 |           |  |            | 17 |     |  |  | 49 |    
|North Carolina |       |               |   |           |  |            | 18 |     |  |  | 18 |    
|Ohio           |       |               | 10 |           |  |            |   |     |  |  | 10 |    
|Oregon         |       |               |   |           |  |            | 4  |     |  |  | 4  |    
|Pennsylvania   |       |               | 9  |           |  |            | 17 |     |  |  | 26 |    
|Rhode Island   |       |               |   |           |  |            | 1  |     |  |  | 1  |    
|South Carolina |       |               |   |           |  |            | 7  |     |  |  | 7  |    
|Tennessee      |       |               | 1  |           |  |            | 10 |     |  |  | 11 |    
|Texas          |       |               | 26 |           |  |            | 13 |     |  |  | 39 |    
|Utah           |       |               | 2  |           |  |            |   |     |  |  | 2  |    
|Virginia       |       |               | 6  |           |  |            | 7  |     |  |  | 13 |    
|Washington     |       |               | 15 |           |  |            | 1  |     |  |  | 16 |    
|Wisconsin      |       |               | 1  |           |  |            |   |     |  |  | 1  |    
|Puerto Rico    |       |               |   |           |  |            | 5  |     |  |  | 5  |    
|               |       |               |    |           |  |            |    |     |  |  |    |    
|               | Total |               |    | 249       |  |            |    | 257 |  |  |    | 506 | 
|               |       |               |    |           |  |            |    |     |  |  |    |    

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Merchandising

Store Layout
and Product Selection

Our stores are designed to be festive and create
a compelling shopping experience for the customer. Our stores
range in size from 6,750 to 19,800 square feet with a typical
store size between 10,000 and 12,000 square feet. The stores are
divided into various sections based upon product categories (see
below), displayed to emphasize the breadth of merchandise
available at a good value. We have begun to upgrade the
presentation in our stores, including cutting through long
aisles to allow customers to navigate the stores more easily and
to provide increased exposure for featured products. We have
also designed new packaging for many Party City products and
in-store graphics and signage that make it easier to shop.

To maintain consistency throughout our store
network, we have established a list of approved items that are
permitted to be sold in our stores. Franchise stores are
required to follow these guidelines according to the terms of
their franchise agreements. We establish a standard store
merchandise layout and presentation format to be followed by
Company-owned and franchise stores. Any layout or format changes
developed by us are communicated to the managers of stores on a
periodic basis. See Part I, Item 1.
Business  Risk Factors  An
effective franchise program is key to our successfor
limitations on our ability to control our franchisees.

Product
Categories

Although product assortment and strategies are in
transition, our general product categories remain consistent
with our historical selection. The typical Party City store
offers a broad selection of brand name and private label
merchandise consisting of over 19,000 active items. Our product
categories include the following:



| |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                              
| | ---------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
| | Halloween.The
    stores display Halloween-related merchandise throughout the year
    to position us as the customers Halloween shopping
    resource. Our Halloween merchandise is prominently displayed to
    provide an exciting and fun shopping experience for customers.
    As a key component of our sales strategy, our stores provide an
    extensive selection of Halloween products. The stores also carry
    a broad array of related decorations and accessories for the
    Halloween season. For Fiscal 2004, 2003 and 2002, our Halloween
    business represented 20%, 19% and 20% of our net sales,
    respectively.
|
| | Summer Luau.Our
    Summer Luau category includes tableware, decorations,
    accessories, toys and games, and apparel for indoor and outdoor
    summer entertainment. Sales of Summer Luau products occur
    primarily from March through July.                                                                                                                                                                                                                                                                                                                                                                                           
|
| | Other Seasonal.Customer purchases for other seasonal
    holidays and events compose a significant part of our business.
    The other seasonal category includes products for the Super
    Bowl, Valentines Day, St. Patricks Day, Fall,
    Thanksgiving, Passover, Easter, First Communion, the Fourth of
    July, Christmas, Hanukkah and New Years Eve. Some of the
    major items within this category are tableware, decorations,
    cutouts, lights and balloons tailored to the particular event.                                                                                                                            
|
| | Baby Shower.We
    maintain a baby shower department, which includes tableware,
    decorations, balloons, favors, centerpieces and garlands.                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                
|
| | Balloons.The
    balloon department 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 milestone birthdays such as first,
    sweet sixteen and 50th birthdays. Some of the
    products in this category include invitations, thank you cards,
    tableware, hats, horns, banners, cascades, balloons, novelty
    gifts, piñatas and candies.                                                                                                                                                                                                                   
|
| | Bridal/Wedding/Anniversary.This product category includes
    personalized invitations, tableware, balloons, favors, place
    setting cards, confetti, honeycomb bells and personalized
    ribbons. We also carry personalized invitation books containing
    numerous samples of customizable invitations from the leading
    invitation stationers for sale at discount prices.                                                                                                                                                                                                                                                        

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| |                                                                                                                                                                                                                                                      
| | -----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
| | Candy.The candy
    product category includes novelty and packaged candy sold to
    enhance parties or to be used as piñata fillers. Candy is
    sold both in individual units and in bulk packaging for
    customers convenience.               
|
| | Catering Supplies.Our stores offer a broad selection of
    catering supplies, including trays, platters, foil, bowls,
    warming racks and fuel.                                                                                                   
|
| | Gift Wrap.This
    product category includes a wide assortment 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.                                                                                                                                             
|
| | Party Favors.We
    offer a broad selection of packaged and bulk favors appealing to
    different age groups. The assortment includes different product
    lines varying in prices designed to offer customers a variety of
    purchasing options.
|
| | Party Basics.We
    carry a range of brand name and private label merchandise,
    including tableware, table covers, cutlery, crepe paper, cups
    and tumblers.                                                                                   

Suppliers and
Inventory

The following represents suppliers from whom we
purchased at least 5% of our merchandise:

|                        |       |                   |                    |             |  |             |    |             |   |  |    |    |   |  |    |    |  
|----------------------- | ----- | ----------------- | ------------------ | ----------- |  | ----------- | -- | ----------- | - |  | -- | -- | - |  | -- | -- | -
|Supplier                |       | Products Supplied |                    | Fiscal 2004 |  | Fiscal 2003 |    | Fiscal 2002
|                        |       |                   |                    |             |  |             |    |            
|Amscan, Inc.            |       |                   | Paper products     |             |  |             | 22 | %           |   |  | 23 | %  |   |  | 23 | % 
|Unique Industries, Inc. |       |                   | Paper products     |             |  |             | 7  |             |   |  | 8  |    |   |  | 7  |   
|Rubies Costumes Co. Inc |       |                   | Halloween costumes |             |  |             | 7  |             |   |  | 6  |    |   |  | 7  |   
|Hallmark Marketing Corp |       |                   | Paper products     |             |  |             | 6  |             |   |  | 6  |    |   |  | 6  |   
|                        |       |                   |                    |             |  |             |    |             |   |  |    |    |   |  |    |   
|                        | Total |                   |                    |             |  |             |    | 42          | % |  |    | 43 | % |  |    | 43 | %
|                        |       |                   |                    |             |  |             |    |             |   |  |    |    |   |  |    |   

The loss of any of these suppliers could
materially adversely affect our business, results of operations,
financial condition and cash flow. We consider numerous factors
in supplier selection, including, but not limited to, price,
credit terms, product offerings and quality.

We strive to maintain sufficient inventory to
enable us to provide a high level of service to our customers.
Inventory levels, accounts receivable and accounts payable
levels, payment terms and return policies are in accordance with
the general practices of the retail party supplies industry and
standard business procedures.

Through the end of Fiscal 2004, all of the
merchandise purchased by stores was shipped directly to the
stores. Pursuant to our logistics initiative to optimize
inventory management, beginning in July 2004 we have begun to
implement a centralized inventory distribution system for
Company-owned stores. We are currently receiving a portion of
our merchandise at two distribution centers, one in California
and one in Pennsylvania. Phase I of our logistics initiative,
which we believe will be completed by the end of the first
quarter of Fiscal 2005, will support the weekly scheduling of
store deliveries for merchandise being delivered to/from the
distribution centers. We believe that our logistics initiatives,
when fully implemented and operational, will reduce store labor
requirements and improve inventory accuracy while reducing
overall inventory levels. See Part I, Item 1.
Business  Risk Factors  If we
lose any of our key vendors or any of our key vendors fail to
supply us with merchandise, we may not be able to meet the
demands of our customers and our sales could decline
for risks and uncertainties related to our suppliers.

We negotiate pricing with suppliers on behalf of
all stores in our network (Company-owned and franchise). We
believe that our buying power enables us to receive favorable
pricing terms and enhances our ability to obtain high demand
merchandise.

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Franchise Operations

As of August 30, 2004, we had 258 franchise
stores throughout the United States and Puerto Rico. A Party
City store run by a franchisee utilizes our format, design
specifications, methods, standards, operating procedures,
systems and trademarks.

We receive revenue from our franchisees,
consisting of an initial, one-time fee and an ongoing royalty
fee. In addition, each franchisee has a mandated advertising
budget, which consists of a minimum initial store opening
promotion and ongoing local advertising and promotions. Further,
the franchisee must pay an additional 1% of net sales to a Party
City group advertising fund to cover common advertising
materials related to the Party City store concept. Historically
and during Fiscal 2004, to cover the expenses of fund
administration, the Company has charged the Advertising Fund a
management fee equal to 5% of the contributions. We do not offer
financing to our franchisees.

Current franchise agreements provide for an
assigned area or territory that typically equals a three-mile
radius from the franchisees store location and the right
to use the Party City logo and trademark The Discount
Party Super Store®. 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 stores.

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

We have increased our focus on the management of
our franchise operations, focusing on collaborative improvement
efforts in several key operating areas such as merchandising,
advertising and information systems.

As of August 30, 2004, we had nine territory
agreements with certain franchisees. These agreements grant the
holder of the territory the right to open one or more stores
within a stated time period.

Competition

We operate in highly competitive markets. Our
stores compete with a variety of smaller and larger retailers,
including, but not limited to, single owner-operated party
supplies stores, specialty party supplies and paper goods
retailers (including superstores), warehouse/merchandise clubs,
designated departments in drug stores, general mass
merchandisers, supermarkets and department stores of local,
regional and national chains and catalog and Internet
merchandisers. Major chain competitors in our markets include
iParty Corp., Factory Card and Party Outlet Corp. and Party
America, Inc. In addition, other stores or Internet
merchandisers may enter the market and become significant
competitors in the future. Our stores compete, among other
things, on the basis of location and store layout, product mix,
selection, customer convenience and price. Many of our
competitors in our markets have greater financial resources than
we do.

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 classes and low prices on most items in our
stores. We believe that our significant buying power, which
results from the size of our Party City store network, is an
integral advantage.

Trademarks

We license a number of trademarks and service
marks registered with the United States Patent and Trademark
Office, including Party City®, The Discount Party Super
Store® and Halloween Costume Warehouse®.

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Government Regulation

As a franchisor, we must comply with regulations
adopted by the Federal Trade Commission, such as the Trade
Regulation Rule on Franchising, which requires us to
furnish prospective franchisees with a franchise offering
circular. We also must comply with a number of state laws that
regulate the offer and sale of our franchises and certain
substantive aspects of franchisor-franchisee relationships.
These laws vary in their application and in their regulatory
requirements. State laws that regulate the offer and sale of
franchises typically require us to, among other things, 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. In some cases, 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
and the franchisors decision to refuse to permit the
franchisee to exercise its transfer or renewal rights) by
requiring the franchisor to give advance notice to the
franchisee of the termination and give the franchisee an
opportunity to cure most defaults, and by requiring the
franchisor to repurchase the franchisees inventory or
provide other compensation upon termination. To date, those laws
have not precluded us from seeking franchisees in any given area
and have not had a material adverse effect on our operations.

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

Our stores must comply with applicable federal
and state environmental regulations, although the cost of
complying with these regulations to date 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.

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

Employees

As of August 30, 2004, we employed
approximately 1,600 full-time and 2,900 part-time employees. We
consider our relationships with our employees to be good. None
of our employees are covered by a collective bargaining
agreement.

During fiscal 2004, we filled a number of
positions that were essential for our strategic transition. This
included appointing Nancy Pedot as our permanent Chief Executive
Officer and hiring a new Chief Operating Officer, Chief
Merchandising Officer, Vice President of Finance, Creative
Director and Director of Training. We also added people in key
departments that had been understaffed, including Merchandising,
Planning and Allocation and Logistics.

Risk Factors

In addition to other matters identified or
described by us from time to time in filings with the Securities
and Exchange Commission, there are several important factors
that could cause our future results to differ materially from
historical results or trends, results anticipated or planned by
us, or results that are reflected from time to time in any
forward-looking statement that may be made by us or on our
behalf. Some of these important factors, but not necessarily all
of the important factors, are described below.

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Inability to
successfully execute our key initiatives

We have undertaken key initiatives which focus
primarily on our breadth and quality of products; product
pricing; financial, distribution and inventory systems; and
employee base.

In connection with the implementation of these
initiatives, we have generated significant initial investment
expenses that are disproportionate to our sales performance.
However, we anticipate these expenses will normalize over time.
Most importantly, these initiatives are anticipated to improve
customer experience and solidify brand recognition which we
believe will ultimately result in increased sales, reduced
expenses and, accordingly, greater net income. Should our
customers respond less favorably to our merchandise offerings,
we may need to reduce our prices resulting in a negative impact
on our net income.

An effective
franchise program is key to our success

Our growth and success depends in part upon our
ability to contract with and retain qualified franchisees, as
well as the ability of those franchisees to operate their stores
and promote and develop our store concept. Although we have
established criteria to evaluate prospective franchisees and our
franchise agreements include certain operating standards, each
franchisee operates independently. Applicable franchise laws may
delay or prevent us from terminating a franchise or withholding
consent to renew or transfer a franchise. As a franchisor, we
are subject to federal, state and international laws regulating
the offer and sale of franchises. These laws impose registration
and extensive disclosure requirements on the offer and sale of
franchises. We cannot assure you that our franchisees will
operate stores in a manner consistent with our concept and
standards, which could reduce the gross revenues of these stores
and therefore reduce our franchise revenue. The closing of
unprofitable stores or the failure of franchisees to comply with
our policies could adversely affect our reputation and could
reduce the amount of our franchise revenues. These factors could
have a material adverse effect on our revenues and operating
income.

If we are unable to attract new franchisees or to
convince existing franchisees to open additional stores, any
growth in royalties from franchised stores will depend solely
upon increases in revenues at existing franchised stores, which
could be minimal. In addition, our ability to open additional
franchise locations is limited by the territorial restrictions
in our existing franchise agreements as well as our ability to
identify additional markets in the United States that are not
currently saturated with the products we offer. If we are unable
to open additional franchise locations, we will have to sustain
additional growth externally through acquisitions and internally
by attracting new and repeat customers to our existing
locations. If we are unable to do so, our revenues and operating
income may decline significantly.



| |                                                                                                                     
| | --------------------------------------------------------------------------------------------------------------------
| | A downturn in the economy may affect
    consumer purchases of discretionary items, which could reduce
    our sales

In general, our sales represent discretionary
spending by our customers. Discretionary spending is affected by
many factors, including, among others, general business
conditions, interest rates, the availability of consumer credit,
taxation and consumer confidence in future economic conditions.
Our customers purchases of discretionary items, including
our products, could decline during periods when disposable
income is lower or during periods of actual or perceived
unfavorable economic conditions. If this occurs, our revenues
and profitability will decline. In addition, our sales could be
adversely affected by a downturn in the economic conditions in
the markets in which we operate.



| |                                                                                                                                                                                                      
| | -----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
| | If we are unable to identify and anticipate
    changes in consumer demands and preferences, or we are unable to
    respond to such consumer demands in a timely manner, our sales
    could decline

Our products appeal to a broad range of consumers
whose preferences cannot be predicted with certainty and are
subject to rapid change. Our success depends on our ability to
identify product trends as well as to anticipate and respond to
changing merchandise trends and consumer demand in a timely
manner. We cannot assure you that we will be able to continue to
offer assortments of products that appeal to our customers or
that we will satisfy changing consumer demands in the future. In
addition, consumer demand for single-use, disposable party goods
were to diminish, the party supplies and paper goods industry
and our revenues would

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be negatively affected. For example, if cost
increases in raw materials such as paper, plastic, cardboard or
petroleum were to cause our prices to increase significantly,
consumers might decide to forgo the convenience associated with
single-use, disposable products. Similarly, changes in consumer
preferences away from disposable products and in favor of
reusable products for environmental or other reasons could
reduce the demand for our products. We also sell certain
licensed products that are in great demand for short time
periods, making it difficult to project our inventory needs for
these products. Accordingly, if:




| |   |                                                                                                                    
| | - | -------------------------------------------------------------------------------------------------------------------
| |  | we are unable to identify and respond to emerging
    trends;                                                      
|
| |  | we miscalculate either the market for the
    merchandise in our stores or our customers purchasing
    habits; or
|
| |  | consumer demand dramatically shifts away from
    disposable party supplies,                                       

our business, results of operations, financial
condition and cash flow could be materially adversely affected.
In addition, we may be faced with significant excess inventory
of some products and missed opportunities for other products,
which would decrease our profitability.



| |                                                                                                                                                                                                
| | -----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
| | If we lose any of our key vendors or any of
    our key vendors fail to supply us with merchandise, we may not
    be able to meet the demands of our customers and our sales could
    decline

Our business is dependent to a significant degree
upon strong relationships with vendors and our ability to
purchase brand name and private label merchandise at competitive
prices. During Fiscal 2004, we purchased approximately 42% of
the aggregate amount of our merchandise from four vendors. The
loss of any of these key vendors could have a material adverse
effect on our business, results of operations, financial
condition and cash flow. We cannot guarantee that we will be
able to acquire such merchandise at competitive prices or on
competitive terms in the future. In this regard, certain
merchandise that is in high demand may be allocated by vendors
based upon the vendors internal criteria that are beyond
our control, and consequently we may receive less product than
we anticipated.

Many of our vendors currently provide us with
incentives like volume purchasing allowances and trade
discounts. If our vendors were to reduce or discontinue these
incentives, prices from our vendors could increase and our
profitability would be reduced. As is customary in our industry,
we generally do not have long-term contracts with any vendor and
any vendor may discontinue selling to us at any time.

In addition, we believe many of our vendors
source their products from China, Mexico and other foreign
countries. A vendor may discontinue selling products
manufactured in foreign countries at any time for reasons that
may or may not be in our control, including foreign government
regulations, political unrest, war, disruption or delays in
shipments, changes in local economic conditions and trade
issues. Our sales and profitability could decline if we are
unable to replace a vendor promptly who is unwilling or unable
to satisfy our requirements with a vendor providing equally
appealing products.

We face a
high level of competition in our markets

We operate in highly competitive markets. Our
stores compete with a variety of smaller and larger retailers,
including, but not limited to, single owner-operated party
supplies stores, specialty party supplies and paper goods
retailers (including superstores), warehouse/merchandise clubs,
designated departments in drug stores, general mass
merchandisers, supermarkets and department stores of local,
regional and national chains and catalog and Internet
merchandisers. Major chain competitors in our markets include
iParty Corp., Factory Card and Party Outlet Corp. and Party
America, Inc. In addition, other stores or Internet
merchandisers may enter the market and become significant
competitors in the future. Our stores compete, among other
things, on the basis of location and store layout, product mix,
selection, customer convenience and price. Many of our
competitors in our markets have greater financial resources than
we do.

As a result of this competition, we may need to
spend more on advertising and promotion than we anticipate. We
cannot guarantee that we will continue to be able to compete
successfully against existing or future competitors. Expansion
into markets served by our competitors, entry of new competitors
or expansion

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of existing competitors into our markets could
materially adversely affect our business, results of operations,
cash flows and financial condition.


We may need
to raise additional capital to fund our operations

Our management currently believes that the cash
generated by operations, together with the borrowing
availability under the Loan Agreement, will be sufficient to
meet our working capital needs for the next twelve months,
including investments made and expenses incurred in connection
with systems development, logistics initiatives and store
improvements. However, if we are unable to generate sufficient
cash from operations, we may be required to adopt one or more
alternatives to raise cash, such as incur indebtedness, selling
our assets, seeking to raise additional debt or equity capital
or restructuring. If adequate financing is unavailable or is
unavailable on acceptable terms, we may be unable to maintain,
develop or enhance our operations, products and services, take
advantage of future opportunities or respond to competitive
pressures.



| |                                                                                                                       
| | ----------------------------------------------------------------------------------------------------------------------
| | If we fail to protect our brand name,
    competitors may adopt tradenames that dilute the value of our
    brand name

We have invested significant resources in our
Party City brand name in order to obtain the public recognition
that we currently have. However, we may be unable or unwilling
to strictly enforce our trademark in each jurisdiction in which
we do business. Also, we may not always be able to successfully
enforce our trademark against competitors, or against challenges
by others. Our failure to successfully protect our trademark
could diminish the value and efficacy of our past and future
marketing efforts, and could cause customer confusion, which
could, in turn, adversely affect our revenues and profitability.



| |                                                                                                                                                                                                     
| | ----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
| | Our operating results are subject to
    seasonal and quarterly fluctuations, as well as the timing of
    new store openings, which could cause the market price of our
    common stock to decline

Our business is subject to substantial seasonal
variations. Historically, we have realized a significant portion
of our net sales, operating income, cash flow and net income in
the second fiscal 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. We believe this
general pattern will continue in the future. An economic
downturn during this period could adversely affect us to a
greater extent than if such downturn occurred at other times of
the year. Our results of operations and cash flows may also
fluctuate significantly as a result of a variety of other
factors, including the timing of new store openings, store
closings and timing of the acquisition and disposition of stores.

In addition, we opened nine new Company-owned
stores and closed two Company stores in Fiscal 2004. Our results
of operations and cash flows may vary significantly as a result
of the timing of new store openings, the amount and timing of
net sales contributed by new stores, the level of pre-opening
expenses associated with new stores and the relative proportion
of new stores to mature stores. Any significant decline in our
results of operations and cash flows as a result of these
variations could adversely affect our stock price.

We may be
unable to achieve our expansion plans for future
growth

During Fiscal 2004, we added nine Company-owned
stores and closed two stores. Our continued growth will depend,
in significant part, upon our ability to open such new stores in
a timely manner and to operate them profitably. Our expansion is
also dependent on the effective continuation and management of
our franchise program. Furthermore, successful expansion is
subject to various contingencies, many of which are beyond our
control. These contingencies include, among others:



| |   |                                                                                                                         
| | - | ------------------------------------------------------------------------------------------------------------------------
| |  | our ability and our franchisees ability to
    identify and secure suitable store sites on a timely basis;             
|
| |  | our ability and our franchisees ability to
    negotiate advantageous lease terms;                                     
|
| |  | our ability and our franchisees ability to
    complete any necessary construction or refurbishment of these
    sites;

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| |   |                                                                                                                                                                                           
| | - | ------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
| |  | our ability and our franchisees ability to
    adapt to different local and regional preferences and customs
    and compete against local businesses which are unfamiliar to us;
    and
|
| |  | the successful integration of new stores into
    existing operations.                                                                                                                    

As our business grows, we will need to attract
and retain additional qualified personnel in a timely manner and
develop, train and manage an increasing number of management
level and other employees. We cannot assure you that we will be
able to attract and retain personnel as needed in the future. If
we are not able to hire capable store managers and other store
level personnel, we will not be able to open new stores as
planned and our revenue growth and operating results will suffer.

We cannot give any assurances that we will be
able to continue our expansion plans successfully, that we will
be able to achieve results similar to those achieved with prior
locations, or that we will be able to continue to manage our
growth effectively. Our failure to achieve our expansion plans
could materially adversely affect our business, results of
operations and financial condition. In addition, we expect our
operating margins will be impacted by new store openings because
of the addition of pre-opening expenses and the lower sales
volume characteristic of new stores. Furthermore, the opening of
additional stores in existing markets may attract some of our
customers away from our other stores already in operation and
diminish their sales.



| |                                                                                                                                                                                                             
| | ------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
| | In the event we are unable to satisfy
    regulatory requirements relating to internal controls, or if
    these internal controls over financial reporting are not
    effective, our business could suffer

Pursuant to Section 404 of the
Sarbanes-Oxley Act of 2002, we will be required during Fiscal
2005 to perform an evaluation of our internal controls over
financial reporting and have our auditor publicly attest to such
evaluation. We have prepared an internal plan of action for
compliance, which includes a timeline and scheduled activities,
although as of the date of this filing, we have not yet
completed the evaluation. Compliance with these requirements is
expected to be expensive and time-consuming. If we fail to
timely complete this evaluation, or if our auditors cannot
timely attest to our evaluation, we could be subject to
regulatory scrutiny and a loss of public confidence in our
internal controls.

In designing and evaluating our internal controls
over financial reporting, we recognize that any internal control
or procedure, no matter how well designed and operated, can
provide only reasonable assurance of achieving desired control
objectives. For example, a companys operations may change
over time as the result of new or discontinued lines of business
and management must periodically modify a companys
internal controls and procedures to timely match these changes
in its business. In addition, management is required to apply
its judgment in evaluating the cost-benefit relationship of
possible controls and procedures and company personnel are
required to use judgment in their application. While we believe
that our internal controls over financial reporting currently
provide reasonable assurance of achieving their control
objectives, no system of internal controls can be designed to
provide absolute assurance of effectiveness. A material failure
of internal controls over financial reporting could materially
impact our reported financial results and the market price of
our stock could significantly decline. Additionally, adverse
publicity related to a material failure of internal controls
over financial reporting would have a negative impact on our
reputation and business.



| |                                                                                                                                                          
| | ---------------------------------------------------------------------------------------------------------------------------------------------------------
| | We depend on key personnel and may not be
    able to retain these employees or recruit additional qualified
    personnel, which could harm our business

Our success depends to a large extent on the
continued service of our executive management team. Departures
by our executive officers could have a negative impact on our
business, as we may not be able to find suitable management
personnel to replace departing executives on a timely basis. We
do not maintain key executive life insurance on any of our
executive officers.

As our business expands, we believe that our
future success will depend greatly on our continued ability to
attract and retain highly skilled and qualified personnel.
Although we generally have been able to meet our staffing
requirements in the past, our ability to meet our labor needs
while controlling costs is subject to external factors, such as
unemployment levels, minimum wage legislation and changing
demographics. Our

13



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inability to meet our staffing requirements in
the future at costs that are favorable to us, or at all, could
impair our ability to increase revenue, and our customers could
experience lower levels of customer care.





Item 2.     Properties

As of August 30, 2004, there were 507 Party
City stores open in the United States and Puerto Rico. Of these,
249 were Company-owned and 258 were operated by our franchisees.
See Part I, Item 1. Business-Store Counts and
Locations for additional information on the growth in
Party Citys network of stores for Fiscal 2000 through 2004
and the location of our stores as of July 3, 2004. As of
August 30, 2004, we leased all of our 249 Company-owned
stores. Our stores range in size from 6,750 to 19,800 square
feet, with a typical store size between 10,000 and 12,000 square
feet. We do not believe that any individual property is material
to our financial condition or results of operation. Of the
leases for the Company-owned stores, three expire in Fiscal
2005, twenty-one expire in Fiscal 2006, thirty expire in Fiscal
2007 and the balance expire in Fiscal 2008 or thereafter. We
have options to extend most of these leases for a minimum of
five years.

We also lease our corporate headquarters property
in Rockaway, New Jersey which will expire in December 2004. We
are in the final stages of securing space for a new corporate
office location as well as to extend the current term of our
lease for a period of months to coincide with its transition to
the new space. We plan to finalize our selection no later than
October 2004.

We believe that all of our current facilities are
in good condition and are suitable and adequate for the purposes
for which they are used.




Item 3.     Legal
Proceedings

A lawsuit was filed on September 25, 2001
against us in Los Angeles Superior Court by an assistant manager
in one of our California stores for himself and on behalf of
other members of an alleged class of Party City store managers
(the Class) who claim we misclassified the Class
members as exempt from California overtime wage and hour laws.
The Class members sought the disgorgement of overtime wages
allegedly owed by us to them but not paid and they also sought
punitive damages and statutory penalties.

On March 30, 2004, the parties reached an
agreement-in-principle to settle this lawsuit for
$5.5 million on a claims made basis, which
means that a payout to class members will only occur when claims
are actually made by Class members. Previously, we recorded a
pre-tax charge of $1.4 million related to this lawsuit. In
connection with the agreement-in-principle, we recorded an
additional pre-tax charge of $4.1 million during the third
quarter of Fiscal 2004 to fully cover the settlement payments,
attorneys fees and the estimated expenses of administering
the settlement. The settlement provided for pursuant to the
agreement-in-principle is subject to certain conditions,
including the negotiation and execution of a definitive
settlement agreement and the approval of the terms of the
definitive settlement agreement by the Superior Court after
notice to the members of the class who have the right to object.
There can be no assurance that all of these conditions will be
satisfied. If a final settlement is not consummated and the
lawsuit is continued, a class is certified, liability is found
and a judgment is entered, such judgment may adversely affect
the Company.

In addition to the foregoing, from time to time
we are involved in routine litigation incidental to the conduct
of the business, which is not, individually or in the aggregate,
material to the Company.




Item 4.     Submission
of Matters to a Vote of Security Holders

No matters were submitted to a vote of security
holders during the fourth quarter of Fiscal 2004.

14



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##### Table of Contents






PART II






| |         |                                                                                                                     
| | ------- | --------------------------------------------------------------------------------------------------------------------
| | Item 5. | Market for Registrants Common Equity,
    Related Stockholder Matters and Issuer Purchases of Equity
    Securities

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

The following table sets forth the high and low
trading prices of our common stock for each quarter of the
latest two fiscal years:

|                   |  |      |       |     |  |   |       | 
|------------------ |  | ---- | ----- | --- |  | - | ----- | 
|                   |  | High |       | Low
|                   |  |      |       |    
|Quarter Ended:     |  |      |       |     |  |   |       | 
|July 3, 2004       |  | $    | 17.32 |     |  | $ | 11.25 | 
|March 28, 2004     |  |      | 15.47 |     |  |   | 11.31 | 
|December 27, 2003  |  |      | 15.00 |     |  |   | 11.83 | 
|September 27, 2003 |  |      | 12.18 |     |  |   | 9.56  | 
|Quarter Ended:     |  |      |       |     |  |   |       | 
|June 28, 2003      |  | $    | 10.91 |     |  | $ | 8.00  | 
|March 29, 2003     |  |      | 12.70 |     |  |   | 7.17  | 
|December 28, 2002  |  |      | 14.59 |     |  |   | 9.63  | 
|September 28, 2002 |  |      | 16.98 |     |  |   | 12.73 | 

At August 30, 2004, the number of holders of
record of our common stock was approximately 415.

Dividends

We have never paid cash dividends on our capital
stock and do not intend to pay cash dividends in the foreseeable
future. We expect that earnings will be retained for the
continued growth and development of our business. Future
dividends, if any, will depend upon our earnings, financial
condition, working capital requirements, compliance with
covenants in agreements to which we are or may be subject,
future prospects and any other factors deemed relevant by our
Board of Directors. Under various agreements to which we are a
party, principally under the Loan Agreement with Wells Fargo,
there are restrictions on paying out dividends. See
Part II, Item 7. Managements Discussion
and Analysis of Financial Condition and Results of
Operations  Liquidity and Capital Resources.

Issuer Purchases of Equity
Securities

We purchased no shares of our common stock in the
fourth quarter of Fiscal 2004.

In September 2001, the Board of Directors
authorized us to repurchase up to $15 million of our
outstanding common stock. The stock repurchases are made at the
discretion of management. During Fiscal 2002, we repurchased
284,000 shares for an aggregate amount of $1.8 million, or
12.2% of the total amount authorized to be purchased. During
Fiscal 2003, we repurchased 463,000 shares for an aggregate
amount of $4.1 million, or 27.4% of total amount authorized
to be purchased. During Fiscal 2004, we purchased no shares of
company common stock. As of July 3, 2004, we have purchased
a total of 747,012 shares for an aggregate amount of
$5.9 million, or 39.6% of the total amount to be purchased.

15



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##### Table of Contents



Equity Compensation Plan Information

The following sets forth certain information as
of July 3, 2004 concerning our equity compensation plans(1):

|                                                                  |       |                      |           |                      |  |                         |       |       |  |  |           |           | 
|----------------------------------------------------------------- | ----- | -------------------- | --------- | -------------------- |  | ----------------------- | ----- | ----- |  |  | --------- | --------- | 
|                                                                  |       |                      |           |                      |  | Number of Securities   
|                                                                  |       | Number of Securities |           |                      |  | Available for Future   
|                                                                  |       | to Be Issued upon    |           | Weighted-Average     |  | Issuance under Equity  
|                                                                  |       | Exercise of          |           | Exercise Price of    |  | Compensation Plans     
|                                                                  |       | Outstanding Options, |           | Outstanding Options, |  | (Excluding Securities  
|                                                                  |       | Warrants and Rights  |           | Warrants and Rights  |  | Reflected in Column(a))
|Plan Category                                                     |       | (a)                  |           | (b)                  |  | (c)                    
|                                                                  |       |                      |           |                      |  |                        
|Equity compensation plans approved by security
    holders(2)     |       |                      | 3,044,131 | (3)                  |  | $                       | 11.36 |       |  |  | 4,615,159 | (4)      
|Equity compensation plans not approved by
    security holders(5) |       |                      | 16,012    | (6)                  |  | $                       | 8.35  |       |  |  | 276,213   |          
|                                                                  |       |                      |           |                      |  |                         |       |       |  |  |           |          
|                                                                  | Total |                      |           | 3,060,143            |  |                         | $     | 11.34 |  |  |           | 4,891,372 | 
|                                                                  |       |                      |           |                      |  |                         |       |       |  |  |           |          



---



|    |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                         
|--- | ----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
|(1) | See Note 9 to our consolidated financial
    statements included herein for a description of our equity
    compensation plans.                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                         
|   
|(2) | Consists of our Amended and Restated 1994 Stock
    Option Plan (the 1994 Plan), Amended and Restated
    1999 Stock Incentive Plan (the 1999 Plan), and
    Employee Stock Purchase Plan (the ESPP).                                                                                                                                                                                                                                                                                                                                                                                                                             
|   
|(3) | Consists of 379,662 outstanding options for our
    common stock pursuant to the 1994 Plan, 2,642,512 outstanding
    options for our common stock pursuant to the 1999 Plan and
    21,957 shares of our common stock which will be issued on
    January 1, 2005 pursuant to the ESPP. Under the ESPP, our
    employees have the opportunity to purchase shares of our common
    stock at a discount through accumulated payroll deductions. The
    Companys liability to employees in the ESPP is
    approximately $247,000. The shares which will be issued in
    January 2005 will have a purchase price of $11.36 per share.
|   
|(4) | Consists of 4,520,245 options that remain
    available for issuance pursuant to the 1999 Plan and 94,914
    shares of our common stock that remain available for issuance
    pursuant to the ESPP. Since September 4, 2000 no additional
    options may be issued under the 1994 Plan.                                                                                                                                                                                                                                                                                                                                              
|   
|(5) | Consists of our Management Stock Purchase Plan.                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                         
|   
|(6) | These shares will be issued in future periods as
    provided for in the Management Stock Purchase Plan.                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                

16



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##### Table of Contents








|        |                        
|------- | -----------------------
|Item 6. | Selected Financial Data

We have derived the selected financial data
presented below from our audited consolidated financial
statements for the Fiscal Years ended July 3, 2004,
June 28, 2003, June 29, 2002, June 30, 2001 and
July 1, 2000. Financial results for Fiscal 2004 are based
on a 53-week period, while financial results for all other
periods are based on a 52-week period. The selected financial
information presented below should be read in conjunction with
such consolidated financial statements and notes included herein.

Selected Financial Data

|                                                  |                                          |                                                 |         |          |  |          |         |          |  |         |         |         |  |   |         |         |  |   |         |         | 
|------------------------------------------------- | ---------------------------------------- | ----------------------------------------------- | ------- | -------- |  | -------- | ------- | -------- |  | ------- | ------- | ------- |  | - | ------- | ------- |  | - | ------- | ------- | 
|                                                  |                                          |                                                
|                                                  |                                          | Year Ended                                     
|                                                  |                                          |                                                
|                                                  |                                          | July 3,                                         |         | June 28, |  | June 29, |         | June 30, |  | July 1,
|                                                  |                                          | 2004(a)                                         |         | 2003     |  | 2002     |         | 2001     |  | 2000   
|                                                  |                                          |                                                 |         |          |  |          |         |          |  |        
|                                                  |                                          |                                                
|                                                  |                                          | (In thousands, except per share and store data)
|Statement of Operations Data:                     |                                          |                                                 |         |          |  |          |         |          |  |         |         |         |  |   |         |         |  |   |         |        
|Total revenues                                    |                                          | $                                               | 516,267 |          |  | $        | 482,620 |          |  | $       | 423,510 |         |  | $ | 395,900 |         |  | $ | 363,399 |        
|                                                  |                                          |                                                 |         |          |  |          |         |          |  |         |         |         |  |   |         |         |  |   |         |        
|Company-owned stores:                             |                                          |                                                 |         |          |  |          |         |          |  |         |         |         |  |   |         |         |  |   |         |        
|                                                  | Net sales                                |                                                 | $       | 496,138  |  |          | $       | 464,258  |  |         | $       | 405,821 |  |   | $       | 380,671 |  |   | $       | 349,722 | 
|                                                  | Cost of goods sold and occupancy costs   |                                                 |         | 332,311  |  |          |         | 311,170  |  |         |         | 263,980 |  |   |         | 252,320 |  |   |         | 240,356 | 
|                                                  |                                          |                                                 |         |          |  |          |         |          |  |         |         |         |  |   |         |         |  |   |         |        
|                                                  | Gross profit                             |                                                 |         | 163,827  |  |          |         | 153,088  |  |         |         | 141,841 |  |   |         | 128,351 |  |   |         | 109,366 | 
|                                                  | Store operating and selling expense      |                                                 |         | 113,292  |  |          |         | 108,294  |  |         |         | 91,576  |  |   |         | 88,128  |  |   |         | 83,470  | 
|                                                  |                                          |                                                 |         |          |  |          |         |          |  |         |         |         |  |   |         |         |  |   |         |        
|                                                  | Company-owned stores profit contribution |                                                 |         | 50,535   |  |          |         | 44,794   |  |         |         | 50,265  |  |   |         | 40,223  |  |   |         | 25,896  | 
|                                                  | General and administrative expense       |                                                 |         | 39,637   |  |          |         | 32,475   |  |         |         | 27,086  |  |   |         | 26,603  |  |   |         | 30,399  | 
|                                                  |                                          |                                                 |         |          |  |          |         |          |  |         |         |         |  |   |         |         |  |   |         |        
|Retail profit (loss) contribution                 |                                          |                                                 | 10,898  |          |  |          | 12,319  |          |  |         | 23,179  |         |  |   | 13,620  |         |  |   | (4,503  | )      
|                                                  |                                          |                                                 |         |          |  |          |         |          |  |         |         |         |  |   |         |         |  |   |         |        
|Franchise stores:                                 |                                          |                                                 |         |          |  |          |         |          |  |         |         |         |  |   |         |         |  |   |         |        
|                                                  | Royalty fees                             |                                                 |         | 19,521   |  |          |         | 18,007   |  |         |         | 17,048  |  |   |         | 14,604  |  |   |         | 13,187  | 
|                                                  | Franchise fees                           |                                                 |         | 608      |  |          |         | 355      |  |         |         | 641     |  |   |         | 625     |  |   |         | 490     | 
|                                                  |                                          |                                                 |         |          |  |          |         |          |  |         |         |         |  |   |         |         |  |   |         |        
|                                                  | Total franchise revenues                 |                                                 |         | 20,129   |  |          |         | 18,362   |  |         |         | 17,689  |  |   |         | 15,229  |  |   |         | 13,677  | 
|                                                  | Total franchise expense                  |                                                 |         | 7,184    |  |          |         | 6,538    |  |         |         | 6,563   |  |   |         | 4,937   |  |   |         | 4,406   | 
|                                                  |                                          |                                                 |         |          |  |          |         |          |  |         |         |         |  |   |         |         |  |   |         |        
|                                                  | Franchise profit contribution            |                                                 |         | 12,945   |  |          |         | 11,824   |  |         |         | 11,126  |  |   |         | 10,292  |  |   |         | 9,271   | 
|                                                  |                                          |                                                 |         |          |  |          |         |          |  |         |         |         |  |   |         |         |  |   |         |        
|Operating income                                  |                                          |                                                 | 23,843  |          |  |          | 24,143  |          |  |         | 34,305  |         |  |   | 23,912  |         |  |   | 4,768   |        
|Interest expense, net                             |                                          |                                                 | 471     |          |  |          | 3,990   |          |  |         | 5,610   |         |  |   | 7,949   |         |  |   | 8,423   |        
|                                                  |                                          |                                                 |         |          |  |          |         |          |  |         |         |         |  |   |         |         |  |   |         |        
|Income (loss) before income taxes                 |                                          |                                                 | 23,372  |          |  |          | 20,153  |          |  |         | 28,695  |         |  |   | 15,963  |         |  |   | (3,655  | )      
|Provision (benefit) for income taxes(b)           |                                          |                                                 | 9,466   |          |  |          | 8,061   |          |  |         | 11,503  |         |  |   | 6,002   |         |  |   | (4,636  | )      
|                                                  |                                          |                                                 |         |          |  |          |         |          |  |         |         |         |  |   |         |         |  |   |         |        
|Net income                                        |                                          | $                                               | 13,906  |          |  | $        | 12,092  |          |  | $       | 17,192  |         |  | $ | 9,961   |         |  | $ | 981     |        
|                                                  |                                          |                                                 |         |          |  |          |         |          |  |         |         |         |  |   |         |         |  |   |         |        
|Basic earnings per share                          |                                          | $                                               | 0.82    |          |  | $        | 0.73    |          |  | $       | 1.32    |         |  | $ | 0.78    |         |  | $ | 0.08    |        
|                                                  |                                          |                                                 |         |          |  |          |         |          |  |         |         |         |  |   |         |         |  |   |         |        
|Diluted earnings per share                        |                                          | $                                               | 0.71    |          |  | $        | 0.62    |          |  | $       | 0.89    |         |  | $ | 0.56    |         |  | $ | 0.07    |        
|                                                  |                                          |                                                 |         |          |  |          |         |          |  |         |         |         |  |   |         |         |  |   |         |        
|Weighted average shares outstanding 
    basic   |                                          |                                                 | 16,880  |          |  |          | 16,602  |          |  |         | 13,068  |         |  |   | 12,723  |         |  |   | 12,611  |        
|                                                  |                                          |                                                 |         |          |  |          |         |          |  |         |         |         |  |   |         |         |  |   |         |        
|Weighted average shares outstanding 
    diluted |                                          |                                                 | 19,651  |          |  |          | 19,646  |          |  |         | 19,313  |         |  |   | 17,819  |         |  |   | 14,283  |        
|                                                  |                                          |                                                 |         |          |  |          |         |          |  |         |         |         |  |   |         |         |  |   |         |        

17



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|                                 |                                              |                                                 |                                             |          |   |          |   |          |   |         |   |         |   |        |   |         |   |        |   |         |   |       | 
|-------------------------------- | -------------------------------------------- | ----------------------------------------------- | ------------------------------------------- | -------- | - | -------- | - | -------- | - | ------- | - | ------- | - | ------ | - | ------- | - | ------ | - | ------- | - | ----- | 
|                                 |                                              |                                                
|                                 |                                              | Year Ended                                     
|                                 |                                              |                                                
|                                 |                                              | July 3,                                         |                                             | June 28, |   | June 29, |   | June 30, |   | July 1,
|                                 |                                              | 2004(a)                                         |                                             | 2003     |   | 2002     |   | 2001     |   | 2000   
|                                 |                                              |                                                 |                                             |          |   |          |   |          |   |        
|                                 |                                              |                                                
|                                 |                                              | (In thousands, except per share and store data)
|Operating Data:                  |                                              |                                                 |                                             |          |   |          |   |          |   |         |   |         |   |        |   |         |   |        |   |        
|                                 | Number of Company-owned stores (end of year) |                                                 |                                             | 249      |   |          |   | 242      |   |         |   | 209     |   |        |   | 193     |   |        |   | 197     |  
|                                 |                                              |                                                 |                                             |          |   |          |   |          |   |         |   |         |   |        |   |         |   |        |   |        
|                                 | Increase in Company-owned same store sales   |                                                 |                                             | 0.6      | % |          |   | 2.2      | % |         |   | 4.9     | % |        |   | 10.3    | % |        |   | 3.8     | %
|                                 |                                              |                                                 |                                             |          |   |          |   |          |   |         |   |         |   |        |   |         |   |        |   |        
|                                 | Number of franchise stores (end of year)     |                                                 |                                             | 257      |   |          |   | 241      |   |         |   | 242     |   |        |   | 261     |   |        |   | 211     |  
|                                 |                                              |                                                 |                                             |          |   |          |   |          |   |         |   |         |   |        |   |         |   |        |   |        
|                                 | Increase in franchise same store sales       |                                                 |                                             | 3.0      | % |          |   | 3.7      | % |         |   | 4.5     | % |        |   | 4.3     | % |        |   | 7.9     | %
|                                 |                                              |                                                 |                                             |          |   |          |   |          |   |         |   |         |   |        |   |         |   |        |   |        
|                                 | Average sales per Company-owned store        |                                                 | $                                           | 2,009    |   |          | $ | 2,090    |   |         | $ | 2,044   |   |        | $ | 1,961   |   |        | $ | 1,810   |  
|                                 |                                              |                                                 |                                             |          |   |          |   |          |   |         |   |         |   |        |   |         |   |        |   |        
|Other Information:               |                                              |                                                 |                                             |          |   |          |   |          |   |         |   |         |   |        |   |         |   |        |   |        
|                                 | Depreciation and amortization                |                                                 | $                                           | 17,601   |   |          | $ | 16,229   |   |         | $ | 12,156  |   |        | $ | 10,431  |   |        | $ | 10,757  |  
|                                 |                                              |                                                 |                                             |          |   |          |   |          |   |         |   |         |   |        |   |         |   |        |   |        
|Cash flow (used in) provided by: |                                              |                                                 |                                             |          |   |          |   |          |   |         |   |         |   |        |   |         |   |        |   |        
|                                 | Investing activities                         |                                                 | $                                           | (13,484  | ) |          | $ | (22,234  | ) |         | $ | (20,008 | ) |        | $ | (15,664 | ) |        | $ | 6,184   |  
|                                 |                                              |                                                 |                                             |          |   |          |   |          |   |         |   |         |   |        |   |         |   |        |   |        
|                                 | Financing activities                         |                                                 |                                             | (13,642  | ) |          |   | (949     | ) |         |   | (17,409 | ) |        |   | (12,320 | ) |        |   | (18,845 | )
|                                 |                                              |                                                 |                                             |          |   |          |   |          |   |         |   |         |   |        |   |         |   |        |   |        
|Balance Sheet Data:              |                                              |                                                 |                                             |          |   |          |   |          |   |         |   |         |   |        |   |         |   |        |   |        
|                                 | Working capital                              |                                                 | $                                           | 34,818   |   |          | $ | 12,867   |   |         | $ | 14,707  |   |        | $ | 8,784   |   |        | $ | 15,069  |  
|                                 |                                              |                                                 |                                             |          |   |          |   |          |   |         |   |         |   |        |   |         |   |        |   |        
|                                 | Total assets                                 |                                                 |                                             | 177,417  |   |          |   | 167,999  |   |         |   | 149,054 |   |        |   | 141,342 |   |        |   | 132,086 |  
|                                 |                                              |                                                 |                                             |          |   |          |   |          |   |         |   |         |   |        |   |         |   |        |   |        
|                                 | Bank borrowings(c)                           |                                                 |                                             |         |   |          |   | 11,229   |   |         |   | 8,915   |   |        |   | 16,006  |   |        |   | 29,547  |  
|                                 |                                              |                                                 |                                             |          |   |          |   |          |   |         |   |         |   |        |   |         |   |        |   |        
|                                 | Stockholders equity                         |                                                 |                                             | 96,838   |   |          |   | 79,422   |   |         |   | 67,599  |   |        |   | 51,090  |   |        |   | 40,861  |  
|                                 |                                              |                                                 |                                             |          |   |          |   |          |   |         |   |         |   |        |   |         |   |        |   |        
|EBITDA:                          |                                              |                                                 |                                             |          |   |          |   |          |   |         |   |         |   |        |   |         |   |        |   |        
|                                 | EBITDA(d)                                    |                                                 | $                                           | 41,444   |   |          | $ | 40,372   |   |         | $ | 46,461  |   |        | $ | 34,343  |   |        | $ | 15,525  |  
|                                 |                                              |                                                 |                                             |          |   |          |   |          |   |         |   |         |   |        |   |         |   |        |   |        
|                                 |                                              | Most directly comparable GAAP
    measures:     |                                             |          |   |          |   |          |   |         |   |         |   |        |   |         |   |        |   |         |   |      
|                                 |                                              |                                                 | Net income                                  |          | $ | 13,906   |   |          | $ | 12,092  |   |         | $ | 17,192 |   |         | $ | 9,961  |   |         | $ | 981   | 
|                                 |                                              |                                                 |                                             |          |   |          |   |          |   |         |   |         |   |        |   |         |   |        |   |        
|                                 |                                              |                                                 | Cash flows provided by operating activities |          | $ | 51,599   |   |          | $ | 23,088  |   |         | $ | 31,042 |   |         | $ | 33,876 |   |         | $ | 5,141 | 
|                                 |                                              |                                                 |                                             |          |   |          |   |          |   |         |   |         |   |        |   |         |   |        |   |        



---



|    |  |                                                                                                                                                                                                                                                                                                                                                          
|--- |  | ---------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
|(a) |  | The figures provided for the fiscal year ended
    July 3, 2004 reflect a 53-week year.                                                                                                                                                                                                                                                                  
|   
|(b) |  | The fiscal year ended July 1, 2000 includes
    $3.7 million benefit related to the reversal of a valuation
    reserve on deferred tax assets established in the six months
    ended July 3, 1999 due to the uncertainty at that time that
    our net operating loss carryforwards would be realized.                                                 
|   
|(c) |  | Bank borrowings and other long-term liabilities
    at June 29, 2002, June 30, 2001 and July 1, 2000
    is net of an unamortized debt discount of $1.3 million,
    $1.9 million and $3.0 million, respectively.                                                                                                                                        
|   
|(d) |  | Our definition of EBITDA is earnings before
    interest, taxes, depreciation and amortization. EBITDA is not a
    measurement defined by GAAP and has limitations as an analytical
    tool, and you should not consider it in isolation, or as a
    substitute for analysis of our results as reported under GAAP.
    Some of these limitations are:



| |   |                                                                                                                                    
| | - | -----------------------------------------------------------------------------------------------------------------------------------
| |  | EBITDA does not reflect our cash expenditures, or
    future requirements, for capital expenditures or contractual
    commitments;

18



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##### Table of Contents





| |   |                                                                                                                                                                                                                                           
| | - | ------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
| |  | EBITDA does not reflect changes in, or cash
    requirements for, our working capital needs;                                                                                                                                              
|
| |  | EBITDA does not reflect the interest expense, or
    the cash requirements necessary to service interest or principal
    payments, on any debts we may have;                                                                             
|
| |  | Although depreciation and amortization are
    non-cash charges, the assets being depreciated and amortized
    will often have to be replaced in the future, and EBITDA does
    not reflect any cash requirements for such replacements;
|
| |  | EBITDA does not reflect the impact of earnings or
    charges resulting from matters we consider not to be indicative
    of our ongoing operations; and                                                                                  
|
| |  | Other companies in our industry may calculate
    EBITDA differently than we do, limiting its usefulness as a
    comparative measure.                                                                                                    



| |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                             
| | ------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
| | Because of these limitations, EBITDA should not
    be considered as a measure of discretionary cash available to us
    to invest in the growth of our business. We compensate for these
    limitations by relying primarily on our GAAP results and using
    EBITDA only supplementally.                                                                                                                                                                                                                                                                
|
| | We have presented EBITDA, however, because we
    believe it is an indicative measure of, and it is commonly used
    by certain investors and analysts to analyze and compare
    companies on the basis of operating performance and a
    companys ability to service and/or incur debt.
    Furthermore, our executive compensation plans base incentive
    compensation payments on our EBITDA performance measured against
    budget. EBITDA is also widely used by us and others in our
    industry to evaluate and price potential acquisitions.
|
| | Our computation of EBITDA may not be comparable
    to similarly titled measures of other companies.                                                                                                                                                                                                                                                                                                                                                                                                                                                        

Because we consider EBITDA useful as an operating
measure, we present a reconciliation of EBITDA to net income for
the periods indicated:

|                                     |  |                |         |          |  |          |         |          |  |         |         |   |  |   |         |   |  |   |         |  
|------------------------------------ |  | -------------- | ------- | -------- |  | -------- | ------- | -------- |  | ------- | ------- | - |  | - | ------- | - |  | - | ------- | -
|                                     |  |               
|                                     |  | Year Ended    
|                                     |  |               
|                                     |  | July 3,        |         | June 28, |  | June 29, |         | June 30, |  | July 1,
|                                     |  | 2004(a)        |         | 2003     |  | 2002     |         | 2001     |  | 2000   
|                                     |  |                |         |          |  |          |         |          |  |        
|                                     |  |               
|                                     |  | (In thousands)
|EBITDA                               |  | $              | 41,444  |          |  | $        | 40,372  |          |  | $       | 46,461  |   |  | $ | 34,343  |   |  | $ | 15,525  |  
|Depreciation and amortization        |  |                | (17,601 | )        |  |          | (16,229 | )        |  |         | (12,156 | ) |  |   | (10,431 | ) |  |   | (10,757 | )
|Interest expense, net                |  |                | (471    | )        |  |          | (3,990  | )        |  |         | (5,610  | ) |  |   | (7,949  | ) |  |   | (8,423  | )
|(Provision) benefit for income taxes |  |                | (9,466  | )        |  |          | (8,061  | )        |  |         | (11,503 | ) |  |   | (6,002  | ) |  |   | 4,636   |  
|                                     |  |                |         |          |  |          |         |          |  |         |         |   |  |   |         |   |  |   |         |  
|Net income                           |  | $              | 13,906  |          |  | $        | 12,092  |          |  | $       | 17,192  |   |  | $ | 9,961   |   |  | $ | 981     |  
|                                     |  |                |         |          |  |          |         |          |  |         |         |   |  |   |         |   |  |   |         |  

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Because we also consider EBITDA useful as a
liquidity measure, we present a reconciliation of EBITDA to our
cash flow provided by operating activities for the periods
indicated:

|                                                   |                                                                      |                                           |        |          |        |          |        |          |        |         |         |        |        |   |        |        |        |   |        |        |       | 
|-------------------------------------------------- | -------------------------------------------------------------------- | ----------------------------------------- | ------ | -------- | ------ | -------- | ------ | -------- | ------ | ------- | ------- | ------ | ------ | - | ------ | ------ | ------ | - | ------ | ------ | ----- | 
|                                                   |                                                                      |                                          
|                                                   |                                                                      | Year Ended                               
|                                                   |                                                                      |                                          
|                                                   |                                                                      | July 3,                                   |        | June 28, |        | June 29, |        | June 30, |        | July 1,
|                                                   |                                                                      | 2004(a)                                   |        | 2003     |        | 2002     |        | 2001     |        | 2000   
|                                                   |                                                                      |                                           |        |          |        |          |        |          |        |        
|                                                   |                                                                      |                                          
|                                                   |                                                                      | (In thousands)                           
|EBITDA                                             |                                                                      | $                                         | 41,444 |          |        | $        | 40,372 |          |        | $       | 46,461  |        |        | $ | 34,343 |        |        | $ | 15,525 |       
|Interest expense, net                              |                                                                      |                                           | (471   | )        |        |          | (3,990 | )        |        |         | (5,610  | )      |        |   | (7,949 | )      |        |   | (8,423 | )     
|(Provision) benefit for income taxes               |                                                                      |                                           | (9,466 | )        |        |          | (8,061 | )        |        |         | (11,503 | )      |        |   | (6,002 | )      |        |   | 4,636  |       
|Non-cash interest                                  |                                                                      |                                           | 163    |          |        |          | 1,624  |          |        |         | 1,395   |        |        |   | 1,815  |        |        |   | 1,506  |       
|Deferred taxes                                     |                                                                      |                                           | (1,051 | )        |        |          | (2,131 | )        |        |         | 819     |        |        |   | 1,543  |        |        |   | (6,213 | )     
|Deferred rent                                      |                                                                      |                                           | (608   | )        |        |          | 556    |          |        |         | 765     |        |        |   | 1,148  |        |        |   | 978    |       
|Stock based compensation                           |                                                                      |                                           | 102    |          |        |          | 342    |          |        |         | 463     |        |        |   | 264    |        |        |   |       |       
|(Provision for) benefit from doubtful accounts     |                                                                      |                                           | (141   | )        |        |          | (498   | )        |        |         | (67     | )      |        |   | (65    | )      |        |   | 975    |       
|Tax effect of non-qualified stock options          |                                                                      |                                           | 1,110  |          |        |          | 556    |          |        |         | 37      |        |        |   |       |        |        |   |       |       
|Impairment charge                                  |                                                                      |                                           |       |          |        |          | 1,505  |          |        |         |        |        |        |   | 2,275  |        |        |   | 1,172  |       
|Loss (gain) on dispositions and sale of
    stores |                                                                      |                                           | 72     |          |        |          | 162    |          |        |         |        |        |        |   | (131   | )      |        |   | 1,386  |       
|Changes in assets and liabilities:                 |                                                                      |                                           |        |          |        |          |        |          |        |         |         |        |        |   |        |        |        |   |        |       
|                                                   | Accounts payable, accrued expenses and other
    current liabilities |                                           |        | 8,592    |        |          |        | 3,608    |        |         |         | 4,894  |        |   |        | 11,522 |        |   |        | (3,416 | )    
|                                                   | Merchandise inventory                                                |                                           |        | 8,551    |        |          |        | (9,634   | )      |         |         | (7,310 | )      |   |        | (6,606 | )      |   |        | 186    |      
|                                                   | Other long-term liabilities                                          |                                           |        | (41      | )      |          |        | 121      |        |         |         | 833    |        |   |        | (326   | )      |   |        | (306   | )    
|                                                   | Other current assets and other assets                                |                                           |        | 3,343    |        |          |        | (1,444   | )      |         |         | (135   | )      |   |        | 2,045  |        |   |        | (2,865 | )    
|                                                   |                                                                      |                                           |        |          |        |          |        |          |        |         |         |        |        |   |        |        |        |   |        |       
|                                                   |                                                                      | Net cash provided by operating activities |        | $        | 51,599 |          |        | $        | 23,088 |         |         | $      | 31,042 |   |        | $      | 33,876 |   |        | $      | 5,141 | 
|                                                   |                                                                      |                                           |        |          |        |          |        |          |        |         |         |        |        |   |        |        |        |   |        |       

20



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|        |                                                                                          
|------- | -----------------------------------------------------------------------------------------
|Item 7. | Managements Discussion and Analysis
    of Financial Condition and Results of Operations

Overview

We operate retail party supplies stores within
the continental United States and we sell franchises on an
individual store and area franchise basis throughout the
United States and Puerto Rico. At July 3, 2004,
our network consisted of 506 stores, with 249 stores
owned by us and 257 stores owned by franchisees. We report
two segments  retail and franchising. The retail
segment generates revenue primarily through the sale of
third-party branded party goods through Company-owned stores.
The franchising segment generates revenue through the imposition
of an initial one-time franchise fee and ongoing royalty
payments based on retail sales.

Currently, the retail party supplies business has
been fragmented, with consumers purchasing party-related
products from single owner-operated and regional party supplies
stores and designated departments in drug stores, general mass
merchandisers, supermarkets and department stores of local,
regional and national chains. We offer customers a
one-stop party store that provides a wide selection
of merchandise at a compelling value and in sufficient
quantities to satisfy customer needs for parties of virtually
all sizes and types.

We continually strive to improve customer
satisfaction and strengthen our financial condition. We have
recently undertaken various initiatives to make fundamental
improvements in our business, profitability and cash flows.
These initiatives have primarily focused on our: breadth and
quality of products; product pricing; financial, distribution
and inventory systems; and employee base.

With respect to our products, we are developing
proprietary processes to evaluate and select our product
assortments more efficiently and effectively. We are also
reconfiguring our in-store product layout to better align
product themes and facilitate an easier shopping experience for
our customers.

Additionally, we continue to make advances in our
inventory reduction initiative which is designed to reduce
overall inventory levels while increasing inventory availability
to stores. Our item reduction, vendor rationalization and
product allocation strategies have facilitated an average per
store inventory reduction of 15% from June 28, 2003 to
July 3, 2004 and are a significant reason for the increase
in our cash and cash equivalents from $3.4 million at
June 28, 2003 to $27.8 million at July 3, 2004.
This inventory reduction has also resulted in an increase of
inventory turnover. We believe these strategies will continue to
provide us with the flexibility to provide fresh merchandise
choices to our customers and still maintain a sufficient variety
and quantity of products to satisfy customer needs.

Phase I of the logistics initiative, which
will be completed in the first quarter of Fiscal 2005, will
support weekly scheduling of store deliveries, thereby reducing
store labor requirements and improving inventory accuracy. We
are now able to receive and distribute our products for our
Company-owned stores from two distribution centers 
one in California and one in Pennsylvania, and also initiated a
Preferred Carrier Process earlier this fiscal year resulting in
lower negotiated transportation rates, better visibility on
deliveries and higher service levels.

We have also focused on enhancing our enterprise
systems, with the upgrade of our store and corporate systems
fully implemented. The investment in our enterprise systems has
improved certain store processes, and will provide the systemic
foundation for our logistics initiative. Working with our vendor
partners and third-party logistics providers, we are embarking
on enhancements that will further drive product in-stock
positions and lower our supply-chain network costs.

Underlying these and other important initiatives
are key investments we have made in our employee base, including
the implementation of training programs related to customer
service. During Fiscal 2004, we filled a number of positions
that were essential for our strategic transition. This included
appointing Nancy Pedot as our permanent Chief Executive Officer,
and hiring a new Chief Operating Officer, Chief Merchandising
Officer, Vice President of Finance, Creative Director and
Director of Training. We also added people in key departments
that had been understaffed, including Merchandising, Planning
and Allocation and Logistics.

In connection with the implementation of these
initiatives, we have incurred significant initial expenses that
are disproportionate to our sales performance. However, we
anticipate these initial expenses will diminish

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over time. Most importantly, these investment
initiatives are anticipated to improve customer experience and
solidify brand recognition which we believe will ultimately
result in increased sales, reduced expenses and, accordingly,
greater net income.


Key Performance Indicators and
Statistics

We use a number of key indicators of financial
condition and operating results to evaluate the performance of
our business, including the following:

|                                                                                          |  |            |         |          |  |          |         |   |  |   |         |  
|----------------------------------------------------------------------------------------- |  | ---------- | ------- | -------- |  | -------- | ------- | - |  | - | ------- | -
|                                                                                          |  |           
|                                                                                          |  | Year Ended
|                                                                                          |  |           
|                                                                                          |  | July 3,    |         | June 28, |  | June 29,
|                                                                                          |  | 2004       |         | 2003     |  | 2002    
|                                                                                          |  |            |         |          |  |         
|Net sales (in thousands)                                                                  |  | $          | 496,138 |          |  | $        | 464,258 |   |  | $ | 405,821 |  
|Total Company-owned store count                                                           |  |            | 249     |          |  |          | 242     |   |  |   | 209     |  
|Average net same store sales per Company-owned
    stores  current period (in thousands) |  | $          | 2,034   |          |  | $        | 2,101   |   |  | $ | 2,055   |  
|Same store average net sale per retail
    transaction(a)                                 |  | $          | 18.92   |          |  | $        | 18.70   |   |  | $ | 18.00   |  
|Same store net sales growth                                                               |  |            | 0.6     | %        |  |          | 2.2     | % |  |   | 4.9     | %
|Gross profit as a percent of net sales                                                    |  |            | 33.0    | %        |  |          | 33.0    | % |  |   | 35.0    | %
|Store profit contribution as a percent of net
    sales                                   |  |            | 10.2    | %        |  |          | 9.6     | % |  |   | 12.4    | %
|Diluted earnings per share                                                                |  | $          | 0.71    |          |  | $        | 0.62    |   |  | $ | 0.89    |  
|EBITDA(b) (in thousands)                                                                  |  | $          | 41,444  |          |  | $        | 40,372  |   |  | $ | 46,461  |  



---



|    |  |                                                                                                                                                                   
|--- |  | ------------------------------------------------------------------------------------------------------------------------------------------------------------------
|(a) |  | Same store sales divided by same store retail
    transactions. Retail transactions represent each time a customer
    makes a purchase or return at the register.
|   
|(b) |  | See EBITDA discussion on page 18.                                                                                                                                 

For further discussion of these key indicators,
see Part II, Item 7. Results of Operations
beginning on page 24.

Critical Accounting Policies and
Estimates

The preparation of financial statements in
conformity with accounting principles generally accepted in the
United States of America requires the appropriate application of
certain accounting policies, many of which require estimates and
assumptions about future events and their impact on amounts
reported in the financial statements and related notes. Since
future events and their impact cannot be determined with
certainty, the actual results will inevitably differ from our
estimates. Such differences could be material to the
consolidated financial statements.

We believe our application of accounting
policies, and the estimates inherently required by the policies,
are reasonable. These accounting policies and estimates are
constantly reevaluated and adjustments are made when facts and
circumstances dictate a change. Historically, we have found the
application of accounting policies to be appropriate, and actual
results generally do not differ materially from those determined
using necessary estimates.

Our accounting policies are more fully described
in Note 1 to the consolidated financial statements included
herein. We have identified certain critical accounting policies
that are described below.

Merchandise
inventory.Inventory is valued using
the cost method which values inventory at the lower of the
actual cost or market, at the individual item level. Cost is
determined using the weighted average method. Inventory levels
are reviewed to identify slow-moving and closeout merchandise
that will no longer be carried. Market is determined by the
estimated net realizable value, based upon the merchandise
selling price. We also estimate amounts of current inventories
that will ultimately become obsolete due to changes in fashion
and style, based on the following factors: (i) supply on
hand, (ii) historical experience and (iii) our
expectations as to future sales.

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Finite long-lived
assets.In the evaluation of the fair
value and future benefits of finite long-lived assets, we
perform an analysis by store of the anticipated undiscounted
future net cash flows of the related finite long-lived assets.
If the carrying value of the related asset exceeds the
undiscounted cash flows, the carrying value is reduced to its
fair value. Various factors including future sales growth and
profit margins are included in this analysis. To the extent
these future projections or strategies change, the conclusion
regarding impairment may differ from the current estimates.

Insurance accruals.Our consolidated balance sheets include liabilities with respect
to self-insured workers compensation and general liability
claims. We estimated the required liability of such claims dated
July 3, 2004, utilizing an actuarial method based upon
various assumptions, which include, but are not limited to, our
historical loss experience, projected loss development factors,
actual payroll and other data. The required liability is also
subject to adjustment in the future based upon the changes in
claims experience, including changes in the number of incidents
(frequency) and changes in the ultimate cost per incident
(severity).

Goodwill.All of our
goodwill is associated with our retail segment. We evaluate
goodwill annually or whenever events and changes in
circumstances suggest that the carrying amount may not be
recoverable from its estimated future cash flows. In making this
assessment, management relies on a number of factors including
operating results, business plans, economic projections,
anticipated future cash flows and marketplace data. A change in
these underlying assumptions may cause a change in the results
of the tests and, as such, could cause fair value to be less
than the carrying value. In such event, we would then be
required to record a charge, which would impact earnings.

Sales Returns.We
estimate future sales returns and, when material, record a
provision in the period that the related sales are recorded
based on historical information. Should actual returns differ
from our estimates, we would be required to revise estimated
sales returns.

Store Closure Costs.We record estimated store closure costs, estimated lease
commitment costs net of estimated sublease income and other
miscellaneous store closing costs, when the liability is
incurred. Such estimates, including sublease income, may be
subject to change.

Income Taxes.Temporary differences arising from differing treatment of income
and expense items for tax and financial reporting purposes
result in deferred tax assets and liabilities that are recorded
on the balance sheet. These balances, as well as income tax
expense, are determined through managements estimations,
interpretation of tax law for multiple jurisdictions and tax
planning. If our actual results differ from estimated results
due to changes in tax laws, new store locations or tax planning,
our effective tax rate and tax balances could be affected.

General Definitions for Operating
Results

Net Sales.Net sales
include same store net sales and new store net sales. Same store
net sales include net sales for those stores that were in
operation for a full period in both the current month and the
corresponding month for the prior year. New store net sales
include net sales in the current fiscal year from stores opened
during the previous fiscal year before they are considered same
stores and new stores opened in the current fiscal year.

Cost of goods sold and occupancy
costs.Cost of goods sold and
occupancy costs includes the cost of merchandise, freight to the
stores and store occupancy costs. Store occupancy costs include
rent, common area maintenance, real estate taxes, repairs and
maintenance, depreciation, insurance and utilities.

Gross profit.Gross
profit is net sales minus cost of goods sold and occupancy costs.

Store operating and selling
expenses.Store operating and selling
expenses consist of selling and store management payroll,
employee benefits, medical insurance, employment taxes,
advertising and other store level expenses and pre-opening
expenses which are expensed when incurred.

Company-owned store profit
contribution.Company-owned store
profit contribution is gross profit minus store operating and
selling expenses.

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General and administrative
expenses.General and administrative
expenses include payroll and employee benefits, employment
taxes, management information systems, marketing, insurance,
legal and other corporate level expenses. Corporate level
expenses are primarily attributable to our corporate office in
Rockaway, New Jersey as well as district and regional offices
throughout the country.

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. Franchise expenses include direct and indirect expenses.
The direct expenses include salaries, travel and other direct
expenses of the franchise operations department in addition to
legal fees, bad debt expense, insurance expense and other
miscellaneous charges. The indirect expenses include pro-rata
allocations of corporate expenses for salaries, including
bonuses, occupancy and depreciation, based on time spent on
franchise support.

Franchise profit
contribution.Franchise profit
contribution is franchise revenue minus franchise expenses.

Interest expense.Interest expense includes interest relating to our senior notes
and credit facility. Interest also includes amortization of
financing intangibles, bank service charges and interest on
capital lease obligations.

Results of Operations

Our revenues and earnings are generated primarily
from our two business segments  Retail and
Franchising. See Part I, Item 6. Selected
Financial Data  for a summary of our financial
performance.



| |                                                                                                       
| | ------------------------------------------------------------------------------------------------------
| | Year Ended July 3, 2004 (Fiscal
    2004) Compared with Year Ended June 28, 2003
    (Fiscal 2003)

Unless otherwise stated, the financial results
presented for Fiscal 2004 Compared with Fiscal 2003
are based on a 53-week period for the year ended July 3,
2004, and on a 52-week period for the year ended June 28,
2003.

Retail.Net sales
from Company-owned stores increased 6.9% to $496.1 million
for Fiscal 2004 from $464.3 million for the same period
last year. The 6.9% increase in net sales resulted from an
increase of 6.3% related to stores that have not been open for
one year and an increase in same store net sales of 0.6%. For
purposes of understanding the effect of the additional week in
fiscal 2004, our net sales for the last week of Fiscal 2004 were
approximately $8.2 million. The customer count in
Company-owned stores, on a same store basis, decreased 1.5%, and
the average net sale increased 2.1%. With 31 stores joining the
same store sales group during Fiscal 2004, same store net sales
increased 1.9% in the western region, 1.4% in the eastern region
and decreased 1.1% in the central region. We opened nine new
stores and closed two store during Fiscal 2004 and opened 35
stores (including an acquisition of eleven stores from a third
party and two stores from a franchisee) and closed two store
during the same period last year.

Gross profit increased 7.0% to
$163.8 million in Fiscal 2004 from $153.1 million in
the same period last year. The increase was primarily due to
increased sales volume. Gross margin as a percent of net sales
was 33.0% for Fiscal 2004, relatively flat with last fiscal
year. The chart below shows the components of the
$10.7 million increase in gross profit (in millions):

|                          |       |                         |      |                                      |  |                                                  | 
|------------------------- | ----- | ----------------------- | ---- | ------------------------------------ |  | ------------------------------------------------ | 
|                          |       | Portion of Total Change |      |                                     
|Component                 |       | Increase /(Decrease)    |      | Impact of Component on Gross Profit:
|                          |       |                         |      |                                     
|Net sales                 |       | $                       | 10.5 |                                      |  | Due to increase in total sales.                 
|Merchandise margins       |       |                         | 2.1  |                                      |  | Due to improved product cost and pricing.       
|Occupancy and other costs |       |                         | (1.9 | )                                    |  | Due to fixed expenses deleveraged against sales.
|                          |       |                         |      |                                      |  |                                                 
|                          | Total |                         | $    | 10.7                                 |  |                                                  | 
|                          |       |                         |      |                                      |  |                                                 

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Store operating and selling expenses increased
4.6% to $113.3 million for Fiscal 2004 from
$108.3 million in the same period last year. The increase
in store operating and selling expenses is attributable to
increased expenses related to the new stores opened in Fiscal
2004. Pre-opening expenses incurred in Fiscal 2004, which
included payroll and fringe benefits and other operating costs,
for the stores opened in Fiscal 2004 and stores to be opened in
Fiscal 2005 amounted to $552,000 compared with $1.6 million
incurred in Fiscal 2003 For stores opened in Fiscal 2003 and
stores to be opened in Fiscal 2004. Store operating and selling
expenses were 22.8% and 23.3% of sales for Fiscal 2004 and
Fiscal 2003, respectively. The decrease as a percent of net
sales is due mainly to a decrease in physical inventory fees as
a result of lower inventory and a decrease in advertising
expenses. The chart below shows the components of the
$5.0 million increase in store operating and selling
expenses (in millions):

|                                                 |       |                         |      |                                         |  |                                                                                                | 
|------------------------------------------------ | ----- | ----------------------- | ---- | --------------------------------------- |  | ---------------------------------------------------------------------------------------------- | 
|                                                 |       | Portion of Total Change |      | Impact of Components on Store Operating
|Component                                        |       | Increase /(Decrease)    |      | and Selling Expenses:                  
|                                                 |       |                         |      |                                        
|Net sales                                        |       | $                       | 7.4  |                                         |  | Due to increase in total sales.                                                               
|Payroll and fringe benefits                      |       |                         | (0.2 | )                                       |  | Due to store labor efficiencies.                                                              
|Advertising                                      |       |                         | (0.4 | )                                       |  | Due to reduced grand opening charges.                                                         
|Credit card, bank fees and other operating costs |       |                         | (1.8 | )                                       |  | Due primarily to reduced inventory levels and
    corresponding physical inventory count fees.
|                                                 |       |                         |      |                                         |  |                                                                                               
|                                                 | Total |                         | $    | 5.0                                     |  |                                                                                                | 
|                                                 |       |                         |      |                                         |  |                                                                                               

Company-owned store profit contribution was
$50.5 million for Fiscal 2004 compared with
$44.8 million for the same period last year. The
improvement from Fiscal 2003 is primarily the result of the
increase in same store net sales and the number of stores. New
store contribution made up 61% of the increase over last year.
New stores include locations opened during Fiscal 2004 and 2003
before they are considered same stores. Store profit
contribution as a percent of net sales was 10.2% for Fiscal 2004
compared with 9.6% of net sales in the same period last year due
to the increase in gross margin and the decrease in store
operating and selling expenses as described above.

General and administrative expenses increased
22.1% to $39.6 million in Fiscal 2004 from
$32.5 million in the same period last year. General and
administrative expenses were 8.0% and 7.0% of net sales for
Fiscal 2004 and Fiscal 2003, respectively. This 22.1% increase
is primarily due to a charge taken in connection with the
settlement in principle of the employment class action in
California, as well as increased corporate staffing, and our
information systems, logistics and Sarbanes-Oxley compliance
initiatives, partially offset by the $1.5 million decrease
in impairment charges. During the third quarter of Fiscal 2004,
we recorded a pre-tax charge of $4.1 million related to the
settlement payments, attorneys fees and estimated expenses
of administering the settlement in principle. See Note 14
in the consolidated financial statements included herein for a
further description of the class action. The chart below shows
the components of the $7.2 million increase in general and
administrative expenses (in millions):

|                               |       |                  |      |                                     |  |                                                                                       | 
|------------------------------ | ----- | ---------------- | ---- | ----------------------------------- |  | ------------------------------------------------------------------------------------- | 
|                               |       | Portion of Total |      |                                    
|                               |       | Change Increase  |      | Impact of Components on General and
|Component                      |       | /(Decrease)      |      | Administrative Expenses:           
|                               |       |                  |      |                                    
|Litigation settlement          |       | $                | 4.1  |                                     |  | Due to California class action settlement.                                           
|Corporate payroll              |       |                  | 2.8  |                                     |  | Due to increased corporate staffing.                                                 
|Professional fees and training |       |                  | 0.9  |                                     |  | Due to information systems, logistics, and
    Sarbanes-Oxley compliance initiatives.
|Other                          |       |                  | 0.9  |                                     |  | Due to store closing expenditures.                                                   
|Impairment                     |       |                  | (1.5 | )                                   |  | Due to asset and goodwill impairment charges in
    Fiscal 2003.                     
|                               |       |                  |      |                                     |  |                                                                                      
|                               | Total |                  | $    | 7.2                                 |  |                                                                                       | 
|                               |       |                  |      |                                     |  |                                                                                      

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##### Table of Contents



Franchising.Franchise fees recognized on 18 store openings were $608,000 for
Fiscal 2004 as compared with $355,000 for nine store openings in
the same period last year. Royalty fees increased 8.4% to
$19.5 million in Fiscal 2004 from $18.0 million in the
same period last year. This was primarily due to an increased
franchise store base and a same store sales increase of 3.0% for
the franchise stores in Fiscal 2004.

Expenses attributable to the franchise segment
for Fiscal 2004 increased 9.9% to $7.2 million from
$6.5 million for the same period last year. As a percentage
of franchise revenue, franchise expenses were 35.7% in Fiscal
2004 as compared with 35.6% for Fiscal 2003. This increase is
primarily due to a larger corporate expense allocation, which is
primarily based on corporate salaries.

Franchise profit contribution increased 9.5% to
$12.9 million for Fiscal 2004 from $11.8 million in
the same period last year. The increase in franchise profit
contribution is due to the increase in royalty and franchise
fees, partially offset by an increase in franchise expenses.

Interest Expense.Net interest expense decreased to $471,000 for Fiscal 2004 from
$4.0 million in the same period last year. This decrease in
interest expense is due to the repurchase of all of the
outstanding senior notes during the first six months of Fiscal
2003. The repurchase of these notes was completed using working
capital and borrowings under our asset-based revolving credit
agreement.

Income Taxes.An
income tax expense of $9.5 million, or 40.5% of pre-tax
income, and $8.1 million, or 40.0% of pre-tax income, was
recorded in Fiscal 2004 and Fiscal 2003, respectively. The
change in tax rate from 40.0% to 40.5% is due to an increase in
the overall state tax rate.

Net Income.As a
result of the above factors, net income increased to
$13.9 million, or $0.71 per diluted share, for Fiscal
2004 as compared with $12.1 million, or $0.62 per
diluted share, in the same period last year. Weighted average
diluted shares outstanding remained flat at 19.65 million
shares for Fiscal 2004 when compared to last year.



| |                                                                                                      
| | -----------------------------------------------------------------------------------------------------
| | Year Ended June 28, 2003 (Fiscal
    2003) Compared to Year Ended June 29, 2002
    (Fiscal 2002)

Retail.Net sales
from Company-owned stores increased 14.4% to $464.3 million
in Fiscal 2003 from $405.8 million in Fiscal 2002. The
Fiscal 2003 results include 209 stores that were open at the
beginning of that year, plus 13 stores acquired during the year,
22 stores opened during the year and two stores closed during
the year. Same store sales increased 2.2% in Fiscal 2003 and the
remaining 12.2% increase in sales relates to the stores that
have been open for less than one year. The customer count in
company-owned stores, on a same store basis, decreased 1.2%, and
the average sale, on a same store basis, increased 3.4%. With
nine stores joining the same store sales group during Fiscal
2003, same store sales increased 2.8% in the eastern region,
2.1% in the central region and 1.4% in the western region.

Gross profit, which is net sales minus cost of
goods sold and occupancy costs, increased 7.9% to
$153.1 million in Fiscal 2003 from $141.8 million in
Fiscal 2002. The increase in gross profit of $11.3 million
is due to increases in gross profit from new stores of
$12.0 million and an increase in gross profit in mature
stores (i.e., stores open for 24 months or longer) of
$1.7 million offset by $2.4 million of markdown
charges. This $12.0 million increase in gross profit from
35 new stores was produced at a reduced gross profit rate due to
the higher occupancy costs ratio in new stores, including stores
acquired in the Seattle market which were opened in early Fiscal
2003. The new store gross margin rate for Fiscal 2003 was 23.5%
compared to the mature store gross margin rate for Fiscal 2003
of 34.4%. In addition, we increased promotional efforts to clear
slower moving merchandise which caused us to recognize markdown
charges of approximately $2.4 million related to products
identified for clearance. As a percent of sales, these markdown
charges decreased gross profit by approximately 0.6%. Gross
profit as a percentage of sales was 33.0% and 35.0% for Fiscal
2003 and Fiscal 2002, respectively.

Store operating and selling expenses increased
18.3% to $108.3 million for Fiscal 2003 from
$91.6 million in Fiscal 2002. The increase in store
operating expenses of $16.7 million is primarily
attributable to increased expenses of $16.4 million related
to 35 new stores, including $4.2 million of additional
advertising expense and $12.2 million of new store
operating expenses. Store operating expenses were 23.3% of sales
for Fiscal 2003 compared with 22.6% of sales in Fiscal 2002 due
to the impact of new stores not having achieved mature store

26



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sales levels. For Fiscal 2003, operating expenses
as a percent of sales were 22.2% for mature stores compared to
32.3% for our stores open for less than 24 months,
including stores acquired in the Seattle market.


Pre-opening expenses of $1.6 million were
recorded in Fiscal 2003 for 22 new stores opened during the year
and for eight stores scheduled to open in the first quarter of
Fiscal 2004. Pre-opening expenses of $753,000 were recorded in
Fiscal 2002 for 13 new stores opened during the year and for
eight stores scheduled to open in the first quarter of Fiscal
2003.

Company-owned store profit contribution, which is
gross profit minus store operating and selling expenses,
decreased to $44.8 million in Fiscal 2003 compared with
$50.3 million in Fiscal 2002 for the reasons set forth
above.

General and administrative expenses increased
19.9% to $32.5 million in Fiscal 2003, compared with
$27.1 million in Fiscal 2002. The increase of
$5.4 million is primarily attributable to an increased
store base which required investments in new systems and new
logistics initiatives and related consulting services. Our
investments resulted in additional depreciation of approximately
$1.0 million, and we incurred $1.4 million of
professional and consulting fees related to the implementation
of these systems and logistics initiatives. Furthermore, we
recorded fixed asset and goodwill impairment charges of
approximately $1.5 million associated with five
under-performing stores, and executive severance and other
payroll charges of $700,000.

Retail profit contribution, which is store profit
contribution minus general and administrative expenses,
decreased by 46.9% to $12.3 million in Fiscal 2003,
compared with $23.2 million in Fiscal 2002. Retail profit
contribution as a percent of sales was 2.7% in Fiscal 2003
compared with 5.7% in Fiscal 2002 for the reasons set forth
above.

Franchising.Royalty
fees increased 5.6% to $18.0 million in Fiscal 2003
compared with $17.0 million in Fiscal 2002. Franchise fees,
recognized on nine store openings during Fiscal 2003, decreased
44.6% to $355,000 compared with $641,000 during Fiscal 2002
recognized on 19 store openings. Franchise same store sales
increased 3.7% in Fiscal 2003 as compared with a 4.5% increase
in Fiscal 2002.

Expenses related to franchise revenue decreased
0.4% to $6.5 million in Fiscal 2003 from $6.6 million
in Fiscal 2002. As a percentage of franchise revenue, franchise
expenses were 35.6% and 37.1% for Fiscal 2003 and Fiscal 2002,
respectively. Franchise expenses include direct and indirect
expenses. The direct expenses include salaries, travel and other
direct expenses of the franchise operations department in
addition to legal fees, bad debt expense, insurance expense and
other miscellaneous charges. The indirect expenses include
pro-rata allocations of corporate expenses for salaries,
including bonuses, occupancy and depreciation based on time
spent on franchise support.

Franchise profit contribution, which is franchise
revenue minus expenses related to franchise revenue, increased
6.3% to $11.8 million in Fiscal 2003 from
$11.1 million in Fiscal 2002. The increase in franchise
profit contribution is due to the increase in royalty fees along
with a decrease in franchise expenses, offset in part by a
decrease in franchise fee income, as discussed above.

Interest Expense.Interest expense decreased 28.9% to $4.0 million for Fiscal
2003 from $5.6 million in Fiscal 2002. This decrease in
interest expense is due to the repurchase of outstanding senior
notes during the later part of the second quarter that had an
effective interest rate of 29%, with a cash interest rate of
18.5%. The repurchase of these notes was completed using cash
from operations and borrowings under the credit agreement at
significantly lower interest costs. The repurchase of the notes
resulted in a pre-tax charge of $2.2 million related to a
pre-payment premium. As a result of the cash needed to
repurchase the notes, the average borrowings under the Credit
Agreement in Fiscal 2003 were $12.2 million compared with
average borrowings under the Credit Agreement of
$3.4 million in Fiscal 2002.

Income Taxes.Income
taxes of $8.1 million, or 40.0% of pre-tax income, were
provided in Fiscal 2003 compared to income taxes of
$11.5 million, or 40.1% of pre-tax income recorded in
Fiscal 2002.

Net Income.As a
result of the above factors, net income decreased to
$12.1 million or $0.73 per basic share and
$0.62 per diluted share in Fiscal 2003, as compared to net
income of $17.2 million, or $1.32 per basic share and
$0.89 per diluted share in Fiscal 2002. Weighted average
basic shares outstanding increased

27



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##### Table of Contents



from 13.1 million in Fiscal 2002 to
16.6 million in Fiscal 2003 due to the exercise of 672,459
warrants during Fiscal 2003. Weighted average diluted shares
increased from 19.3 million in Fiscal 2002 to
19.6 million in Fiscal 2003.


Liquidity and Capital Resources

Our cash requirements are primarily for working
capital, the opening of new stores, investment in human capital,
the improvement and expansion of existing facilities and the
improvement of information systems. Historically, these cash
requirements have been met through cash flow from operations and
borrowings under our credit facilities. At July 3, 2004,
working capital was $34.8 million compared to
$12.9 million in the same period last year.

Our current priorities for the use of cash are
primarily for investments in value added capital projects
including, in particular, investments in technology to improve
merchandising and distribution, reduce costs, improve
efficiencies and assist each store to better serve its
customers. Key initiatives include:



| |   |                                                                                                                             
| | - | ----------------------------------------------------------------------------------------------------------------------------
| |  | our logistics initiative, pursuant to which we
    are implementing centralized warehousing and distribution
    facilities;
|
| |  | executing our store information systems roll-out;                                                                           
|
| |  | revitalizing our brand and retail environment;                                                                              
|
| |  | evaluating our current and future store locations;                                                                          
|
| |  | improving customer service at the stores; and                                                                               
|
| |  | enhancing franchise growth.                                                                                                 

We currently believe that the cash generated by
operations, together with the borrowing availability under the
Loan Agreement, will be sufficient to meet our working capital
needs for the next twelve months, including investments made and
expenses incurred in connection with systems development,
logistics initiatives and store improvements.

We are currently free of debt, which permits us
to consider a wide variety of corporate initiatives intended to
improve shareholder value, although there is no assurance that
any specific initiative will be pursued or consummated.

28



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##### Table of Contents



Key Indicators of Liquidity and Capital
Resources

The following table sets forth key indicators of
our liquidity and capital resources (in thousands):

|                                  |                               |                                        |   |          |        |  |   |         |     |  
|--------------------------------- | ----------------------------- | -------------------------------------- | - | -------- | ------ |  | - | ------- | --- | -
|                                  |                               |                                       
|                                  |                               | Year Ended                            
|                                  |                               |                                       
|                                  |                               | July 3,                                |   | June 28,
|                                  |                               | 2004                                   |   | 2003    
|                                  |                               |                                        |   |         
|Balance Sheet Data:               |                               |                                        |   |          |        |  |   |        
|                                  | Cash and cash equivalents     |                                        | $ | 27,845   |        |  | $ | 3,372   |    
|                                  | Working capital               |                                        |   | 34,818   |        |  |   | 12,867  |    
|                                  | Total assets                  |                                        |   | 177,417  |        |  |   | 167,999 |    
|                                  | Borrowings                    |                                        |   |         |        |  |   | 11,229  |    
|                                  | Stockholders equity          |                                        |   | 96,838   |        |  |   | 79,422  |    
|Other Information:                |                               |                                        |   |          |        |  |   |        
|                                  | Depreciation and amortization |                                        | $ | 17,601   |        |  | $ | 16,229  |    
|Cash Flows Provided by (used in): |                               |                                        |   |          |        |  |   |        
|                                  | Operating activities          |                                        | $ | 51,599   |        |  | $ | 23,088  |    
|                                  | Investing activities          |                                        |   | (13,484  | )      |  |   | (22,234 | )  
|                                  | Financing activities          |                                        |   | (13,642  | )      |  |   | (949    | )  
|                                  |                               |                                        |   |          |        |  |   |        
|                                  |                               | Total cash flows provided by (used in) |   | $        | 24,473 |  |   | $       | (95 | )
|                                  |                               |                                        |   |          |        |  |   |        

Operating
Activities.For Fiscal 2004, cash
provided by operating activities was $51.6 million compared
with $23.1 million for the same period last year. The
increase in cash provided by operating activities was primarily
attributable to a decrease in inventory of $8.6 million.
The decrease in average inventory level per store of 15.4% from
the same period last year, due to managements inventory
reduction initiatives, enabled us to focus on product
assortment, merchandise presentation and identify and
discontinue slower moving items. Our accounts payable have
increased slightly due to the purchase of new merchandise while
the decrease in inventory is attributed to the reduction of old
discontinued merchandise. The increase was also a result of
higher accrued expenses and other current liabilities as a
result of timing.

Investing
Activities.Cash used in investing
activities for Fiscal 2004 was $13.5 million compared with
$22.2 million for the same period last year. The decrease
in cash used in investing activities was primarily attributable
to the opening of nine Company-owned stores this year compared
with the opening of 35 Company-owned stores (including an
acquisition of eleven stores from a third party and two stores
from a franchisee) during the same period last year. This
decrease was partially offset by our investments in the
information systems and logistics initiatives.

Financing
Activities.Cash used in financing
activities was $13.6 million in Fiscal 2004 compared with
$0.9 million for the same period last year. Cash generated
from operating activities during Fiscal 2004 was used to pay
down our revolving credit facility during the fiscal year. We
also received proceeds of $1.7 million from the exercise of
stock options and warrants in Fiscal 2004 compared with
$1.6 million in Fiscal 2003.

Loan Agreement.Under the terms of the Loan Agreement, we may from time to time
borrow amounts based on a percentage of our eligible inventory
and credit card receivables, up to a maximum of $65 million
at any time, subject to certain borrowing conditions and
customary sub-limits, reserves and other limitations. Interest
on each advance is charged, at our option, (i) at the
adjusted Eurodollar rate per annum, plus the applicable margin
which is currently at 1.25% or (ii) at the prime rate per
annum, less the applicable margin which is currently
0.25% per annum (totaling 4.00% at July 3, 2004). The
term of the Loan Agreement is through April 30, 2006, and
borrowings are secured by a lien on substantially all of our
assets. On July 3, 2004 and August 30, 2004, we had no
borrowings outstanding under the Loan Agreement. Based on a
percentage of current eligible inventory and credit card
receivables, we had $33.0 million available to be borrowed
under the Loan Agreement at August 30, 2004.

Stock Repurchase.In
September 2001, the Board of Directors authorized us to
repurchase up to $15 million of our outstanding common
stock. The stock repurchases are made at the discretion of
management. During Fiscal 2002, we repurchased
284,000 shares for an aggregate amount of
$1.8 million, or 12.2% of the total amount authorized to be
purchased. During Fiscal 2003, we repurchased
463,012 shares for an aggregate amount of
$4.1 million, or 27.4% of total amount authorized to be
purchased. During Fiscal 2004,

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we purchased no shares of our common stock. As of
July 3, 2004, we have purchased a total of
747,012 shares for an aggregate amount of
$5.9 million, or 39.6% of the total amount to be purchased.


Warrants.In Fiscal
2003, 688,000 warrants to purchase our common stock were
exercised. This included an exercise of 458,667 warrants for
which proceeds of $490,774 were received and a cashless exercise
of the remaining 229,333 warrants for which the warrant holders
received 213,792 shares of common stock. The remaining
15,541 shares were surrendered in connection with this
exercise. These 15,541 shares of our common stock had a
market value of $245,386 at the time of surrender. There was no
warrant activity in Fiscal 2004. Warrants to
purchase 2,496,000 common shares at $1.07 per share
were outstanding at July 3, 2004 and are currently
exercisable.

In August, 1999, we received $30 million in
financing from certain investors (the Investors),
who purchased senior secured notes and warrants pursuant to a
Securities Purchase Agreement. Pursuant to the First Amendment,
on January 14, 2000, we received an additional
$7 million in cash proceeds from the sale to certain of the
Investors of a new series of senior secured notes. In
consideration for waivers and forbearances granted by the
Investors to various defaults under the terms of our various
classes of senior secured notes, we agreed to amend and restate
the terms of the warrants acquired by the Investors in August
1999. The amended and restated 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.

We repaid $10.2 million and
$19.3 million of the senior secured notes in Fiscal 2003
and 2002, respectively, and repaid the remaining amounts in
previous fiscal years. The Fiscal 2003 repurchase resulted in an
additional payment of $1.4 million, comprised of interest
and an incentive premium, and resulted in an after-tax charge of
$1.3 million, or $0.07 per diluted share.

Contractual Obligations and Commercial
Commitments

The Company leases real estate in connection with
the operation of Company-owned retail stores as well as its
corporate office. The store leases are for properties ranging in
size from 6,750 to 19,800 square feet. The terms range from
five years to twenty years. Of the leases for the Company-owned
stores, three expire in Fiscal 2005, twenty-one expire in Fiscal
2006, thirty expire in Fiscal 2007 and the balance expire in
Fiscal 2008 or thereafter. The leases contain escalation
clauses, renewal options from five years to ten years and
obligations for reimbursement of common area maintenance and
real estate taxes. Certain leases contain contingent rent based
upon specified sales volume. The Company paid $14,000 and
$26,000 for contingent rent for Fiscal 2004 and 2003,
respectively. There was no contingent rent in Fiscal 2002.

Logistics initiative obligations include a
commitment for the purchase of selected equipment and services
associated with the operation of the distribution centers.

At July 3, 2004, the Company leased
thirty-eight motor vehicles, primarily for its district managers
and regional management. The terms are for 36 months and
expire through December 2007.

To facilitate an understanding of our contractual
obligations and commercial commitments, the following data is
provided as of July 3, 2004 (in thousands):

|                             |  |       |         |                  |  |             |         |             |  |   |       |  |  |   |     | 
|---------------------------- |  | ----- | ------- | ---------------- |  | ----------- | ------- | ----------- |  | - | ----- |  |  | - | --- | 
|                             |  |       |         |                  |  | Logistics   |         |            
|                             |  |       |         |                  |  | Initiative  |         |            
|                             |  | Total |         | Operating Leases |  | Obligations |         | Auto Leases
|                             |  |       |         |                  |  |             |         |            
|Fiscal year ending:          |  |       |         |                  |  |             |         |             |  |   |       |  |  |   |     | 
|2005                         |  | $     | 81,987  |                  |  | $           | 79,389  |             |  | $ | 2,500 |  |  | $ | 98  | 
|2006                         |  |       | 45,256  |                  |  |             | 42,666  |             |  |   | 2,500 |  |  |   | 90  | 
|2007                         |  |       | 37,941  |                  |  |             | 35,324  |             |  |   | 2,500 |  |  |   | 117 | 
|2008                         |  |       | 24,295  |                  |  |             | 24,279  |             |  |   |      |  |  |   | 16  | 
|2009                         |  |       | 23,450  |                  |  |             | 23,450  |             |  |   |      |  |  |   |    | 
|Thereafter                   |  |       | 30,202  |                  |  |             | 30,202  |             |  |   |      |  |  |   |    | 
|                             |  |       |         |                  |  |             |         |             |  |   |       |  |  |   |     | 
|Total minimum lease payments |  | $     | 243,131 |                  |  | $           | 235,310 |             |  | $ | 7,500 |  |  | $ | 321 | 
|                             |  |       |         |                  |  |             |         |             |  |   |       |  |  |   |     | 

Our rent expense under operating leases provides
for step rent provisions, escalation clauses, capital
improvement funding and other lease concessions as applicable in
each lease. The minimum lease payments are recognized on a
straight-line basis over the term of each individual underlying
lease.

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The Company is also obligated for guarantees,
subleases or assigned lease obligations for 23 of its
franchisees through 2011. The majority of the guarantees were
given when the Company sold stores in 1999 as part of its
restructuring. The guarantees continue until the leases expire.
The maximum amount of the guarantees may vary, but is limited to
the sum of the total amount due under the lease. As of
July 3, 2004, the maximum amount of the guarantees was
approximately $16.1 million.

We enter into arrangements to purchase
merchandise up to eight months in advance of expected delivery.
These purchase orders do not contain any significant termination
payments or other penalties if cancelled.

As of July 3, 2004, we had a contingent
liability related to severance payments to 15 employees which
ranged from zero to approximately $2.1 million. As of
August 30, 2004, we had a liability related to severance
payments for one employee for up to approximately $120,000 and a
contingent liability related to severance payment to 14
employees which ranged from zero to approximately
$2.0 million. As of July 3, 2004 and August 30,
2004, we had a standby letter of credit of $3.7 million
pursuant to the Loan Agreement. This standby letter of credit
relates to general liability and workers compensation insurance.

Off-Balance Sheet Arrangements

We have not created, and are not party to, any
special-purpose or off-balance sheet entities for the purpose of
raising capital, incurring debt or operating our business. We do
not have any off-balance sheet arrangements or relationships
with entities that are not consolidated into our financial
statements that have or are reasonably likely have a material
current or future effect on our financial condition, changes in
financial condition, revenues, expenses, results of operations,
liquidity, capital expenditures or capital resources.

Recent Accounting Pronouncements

In June 2004, the Financial Accounting Standards
Board FASB issued an interpretation of FASB
No. 143, Accounting for Asset Retirement Obligations
(FASB No. 143). This interpretation clarifies
the scope and timing of liability recognition for conditional
asset retirement obligations under FASB No. 143 and is
effective no later than the end of Fiscal 2005. We have
determined that this interpretation, and the adoption of FASB
No. 143, will not have a material impact on our
consolidated results of operations, financial position or cash
flows.

In March 2004, the FASB published an Exposure
Draft, Share-Based Payment, an amendment of FASB
Statements No. 123 and No. 95. Under this FASB
proposal, all forms of share-based payment to employees,
including employee stock options, would be treated as
compensation and recognized in the income statement. This
proposed statement, if adopted, would be effective beginning in
Fiscal 2005. The Company currently accounts for stock options
under APB No. 25. The pro-forma impact of expensing options
is disclosed in Note 1 to our consolidated financial
statements included herein.

In December 2003, FASB issued Interpretation
46R FIN 46R, a revision to Interpretation 46
FIN 46, Consolidation of Variable Interest
Entities. FIN 46R clarifies some of the provisions of
FIN 46 and exempts certain entities from its requirements.
FIN 46R is effective at the end of the first interim period
ending after March 15, 2004. Entities that have adopted
FIN 46 prior to this effective date can continue to apply
the provisions of FIN 46 until the effective date of
FIN 46R or elect early adoption of FIN 46R. The
adoption of FIN 46 and FIN 46R did not have a material
impact on our financial statements.



| |                    
| | -------------------
| | Impact of Inflation

We believe that inflation did not have a material
impact on our 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 our results of operations, cash flows and
financial condition.



| |            
| | -----------
| | Seasonality

Our business is subject to substantial seasonal
variations. Historically, we have realized a significant portion
of our net sales, cash flow and net income in the second fiscal
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. We expect that this general
pattern will continue.

Our results of operations and cash flows may also
fluctuate significantly as a result of a variety of other
factors, including the timing of new store openings and store
closings and the timing of the acquisition and disposition of
stores.

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Item 7A.Quantitative
and Qualitative Disclosures about Market Risk

In the normal course of doing business, we are
exposed to interest rate change and market risk. We generally
borrow only during certain times of the year as our borrowing
patterns are cyclical. Therefore, a sudden increase in interest
rates (which under the Loan Agreement is dependent on, at our
option, (i) at the adjusted Eurodollar rate per annum, plus
the applicable margin which is currently 1.25% or (ii) at
the prime rate per annum, less the applicable margin which is
currently 0.25% totaling (4.00% at July 3, 2004)) may,
during peak borrowing, have a negative impact on short-term
results. We believe that our interest rate risk is minimal as a
hypothetical 1.0% increase or decrease in interest rates in the
associated debts variable rate would not materially affect
our results of operations or cash flows.






|        |                                                
|------- | -----------------------------------------------
|Item 8. | Financial Statements and Supplementary
    Data

The response to this item is submitted as a
separate section of this Annual Report on Form 10-K,
commencing on page F-1.






|        |                                                                                         
|------- | ----------------------------------------------------------------------------------------
|Item 9. | Changes in and Disagreements with
    Accountants on Accounting and Financial Disclosure

None.






|         |                        
|-------- | -----------------------
|Item 9A. | Controls and Procedures

We maintain disclosure controls and procedures
that are designed to ensure that information required to be
disclosed in our Exchange Act reports is recorded, processed,
summarized and reported within the time periods specified in the
Securities and Exchange Commissions (the SEC)
rules and forms and that such information is accumulated and
communicated to our management, including our Chief Executive
Officer and Chief Financial Officer, as appropriate, to allow
for timely decisions regarding required disclosure. In designing
and evaluating the disclosure controls and procedures,
management recognizes that any controls and procedures, no
matter how well designed and operated, can provide only
reasonable assurance of achieving the desired control
objectives, and management is required to apply its judgment in
evaluating the cost-benefit relationship of possible controls
and procedures.

We regularly evaluate our internal control over
financial reporting and discuss these matters with our
independent accountants, Deloitte & Touche LLP, and our
audit committee. We concluded in May 2004 that there was a
reportable condition (as defined under standards
established by the American Institute of Certified Public
Accountants) in our internal control over financial reporting
relating to the classification of a financing activity on the
cash flow statement. Although the dollar amounts relating to the
reportable condition were immaterial to our results of
operations, financial condition and liquidity, our management,
the audit committee and our independent accountants reviewed and
analyzed our internal controls, procedures and policies in
response to this reportable condition. As a result, we enhanced
our internal controls over financial reporting, including hiring
additional financing and accounting staff, enhancing the
training of our finance and accounting staff and requiring
periodic review of a wider variety of current technical
accounting literature. Based on these enhancements, the
reportable condition was remediated and we have no reportable
conditions.

As required by Rule 13a-15(b) under the
Exchange Act, we conducted an evaluation, under the supervision
and with the participation of our management, including our
Chief Executive Officer and our Chief Financial Officer, of the
effectiveness of the design and operation of our disclosure
controls and procedures as of the end of the period covered by
this report. Based on the foregoing, our management, including
our Chief Executive Officer and Chief Financial Officer,
concluded that our disclosure controls and procedures were
effective at the reasonable assurance level as of the end of the
period covered by this report.

Other than as described above, there has been no
change in our internal control over financial reporting during
the fourth quarter ended July 3, 2004 that has materially
affected, or is reasonably likely to materially affect, our
internal control over financial reporting. In addition, other
than as described above, since the most recent evaluation date,
there have been no significant changes in our internal control
structure, policies and procedures or in other areas that could
significantly affect our internal control over financial
reporting.




Item 9B. Other Information

None.

32



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##### Table of Contents






PART III






|         |                                                       
|-------- | ------------------------------------------------------
|Item 10. | Directors and Executive Officers of the
    Registrant

The information required by this item is set
forth in our definitive Proxy Statement for our 2004 Annual
Meeting of Stockholders to be held on November 11, 2004
(the Proxy Statement) under the subheadings
Election of Directors, Executive
Officers and Security Ownership of Certain
Beneficial Owners and Management  Section 16(a)
Beneficial Ownership Reporting Compliance and is
incorporated herein by reference.

Code of Business Conduct and Ethics

We have adopted a Code of Business Conduct and
Ethics (the Code) that applies to our officers,
directors and employees. This Code, the charters of the Audit,
Compensation and Nominating and Corporate Governance committees
and other related corporate governance information are posted on
our website at www.partycity.com. We intend to post any
amendments to or waivers from the Code on our website.






|         |                       
|-------- | ----------------------
|Item 11. | Executive Compensation

The information required by this item is set
forth under subheadings Executive Compensation,
Option Grants, Option Exercises and Option
Values and Executive Agreements and is
incorporated herein by reference.






|         |                                                                                                       
|-------- | ------------------------------------------------------------------------------------------------------
|Item 12. | Security Ownership of Certain Beneficial
    Owners and Management and Related Stockholder
    Matters

The information required by this item is set
forth under subheading Ownership of Securities and
is incorporated herein by reference.






|         |                                                   
|-------- | --------------------------------------------------
|Item 13. | Certain Relationships and Related
    Transactions

The information required by this item is set
forth under subheading Certain Relationships and Related
Transactions and is incorporated herein by reference.






|         |                                           
|-------- | ------------------------------------------
|Item 14. | Principal Accountant Fees and
    Services

The information required by this item is set
forth under subheading Independent Registered Public
Accountants and is incorporated herein by reference.

33



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##### Table of Contents






PART IV






|         |                                                                     
|-------- | --------------------------------------------------------------------
|Item 15. | 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 listed below are filed as a separate section of this
    Report commencing on page F-1:



| |                                                                                                                           
| | --------------------------------------------------------------------------------------------------------------------------
| | Report of Independent Registered Public
    Accounting Firm  Deloitte & Touche LLP.                                      
|
| | Consolidated Balance Sheets as of July 3,
    2004 and June 28, 2003.                                                     
|
| | Consolidated Statements of Income for the years
    ended July 3, 2004, June 28, 2003 and June 29,
    2002.              
|
| | Consolidated Statements of Stockholders
    Equity for the years ended July 3, 2004, June 28, 2003
    and June 29, 2002.
|
| | Consolidated Statements of Cash Flows for the
    years ended July 3, 2004, June 28, 2003 and
    June 29, 2002.          
|
| | Notes to Consolidated Financial Statements for
    the years ended July 3, 2004, June 28, 2003 and
    June 29, 2002.     



| |                                                                                                           
| | ----------------------------------------------------------------------------------------------------------
| | 2. Financial Statement Schedule for the
    years ended July 3, 2004, June 28, 2003 and
    June 29, 2002.
|
| | 3. See (c) below for a list of Exhibits.                                                                  

(b) Reports on Form 8-K.



| |                                                                                                                                            
| | -------------------------------------------------------------------------------------------------------------------------------------------
| | 1. On April 9, 2004, we filed a Current
    Report on Form 8-K announcing our sales results for the
    third quarter ended March 27, 2004.
|
| | 2. On May 14, 2004, we filed a Current
    Report on Form 8-K announcing the following:                                                    



| |                                                                                                                                                                                                   
| | --------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
| | On May 11, 2004, we issued a press release
    to remind the public about the investor/analyst presentation to
    be held that morning and to announce certain sales and margin
    expectations.
|
| | On May 7, 2004, we announced our operating
    results for the three and nine months ended March 27, 2004.                                                                                        

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

EXHIBIT INDEX

|            |     |  |  |                                                                                                                                                                                                                                                  
|----------- | --- |  |  | -------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
|Exhibit No. |     | 
|            |     | 
|            | 3.1 |  |  | Amended and Restated Certificate of Incorporation
    of the Company, incorporated by reference from the
    Companys Quarterly Report on Form 10-Q as filed with
    the Commission on May 17, 2004 (the S-1).                               
|            | 3.2 |  |  | Bylaws of the Company as amended, incorporated by
    reference from the Companys Quarterly Report on
    Form 10-Q as filed with the Commission on November 12,
    2003 (the November 2003 10-Q).                                           
|            | 4.1 |  |  | Specimen stock certificate evidencing the Common
    Stock, incorporated by reference from the Companys
    Registration Statement as amended on Form S-1
    Number 333-00350 as filed with the Commission on
    January 18, 1996 (the S-1).

34



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##### Table of Contents



|            |       |  |  |                                                                                                                                                                                                                                                                                                     
|----------- | ----- |  |  | ----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
|Exhibit No. |       | 
|            |       | 
|            | 4.2   |  |  | Form of Amended and Restated Warrant,
    incorporated by reference from the Companys Current Report
    on Form 8-K as filed with the Commission on
    January 19, 2000 (the January 2000 8-K).                                                                                                
|            | 4.3   |  |  | Form of Securities Purchase Agreement, dated as
    of August 16, 1999, by and between the Company and each of
    the Investors, incorporated by reference from the Companys
    Current Report on Form 8-K as filed with the Commission on
    August 25, 1999 (the August 1999 8-K).          
|            | 4.4   |  |  | First Amendment to Securities Purchase Agreement,
    dated as of January 14, 2000, by and between the Company
    and each of the Investors, incorporated by reference from the
    January 2000 8-K.                                                                                              
|            | 4.5   |  |  | Second Amendment to Securities Purchase
    Agreement, dated as of April 1, 2001, by and among the
    Company and each of the Investors, incorporated by reference
    from the Companys Quarterly Report on Form 10-Q as
    filed with the Commission on May 15, 2001 (the May
    2001 10-Q).
|            | 10.1  |  |  | Form of Unit Franchise Agreement entered into by
    the Company and franchisees, incorporated by reference from the
    S-1.                                                                                                                                                                       
|            | 10.2  |  |  | Option Agreement, dated as of June 8, 1999,
    between Steven Mandell and Jack Futterman, incorporated by
    reference from Amendment No. 1 to Schedule 13D as
    filed by Jack Futterman with the Commission on June 17,
    1999 (Futtermans 13D).                                          
|            | 10.3  |  |  | Stock Pledge Agreement, dated as of June 8,
    1999, between Steven Mandell and Jack Futterman, incorporated by
    reference from Futtermans 13D.                                                                                                                                                
|            | 10.4  |  |  | Amended and Restated Investor Rights Agreement,
    dated as of August 18, 2003, by and among the Company and
    the Investors, incorporated by reference from the Companys
    Annual Report on Form 10-K as filed with the Commission on
    September 26, 2003 (the September 2003 10-K).    
|            | 10.5  |  |  | Description of oral consulting agreement between
    the Company and Ralph Dillon, incorporated by reference from the
    Companys Quarterly Report on Form 10-Q as filed with
    the Commission on February 13, 2001.                                                                            
|            | 10.6  |  |  | General Release and Severance Agreement of James
    Shea, dated as of May 28, 2003, by and between the Company
    and James Shea, incorporated by reference from the September
    2003 10-K.                                                                                                     
|            | 10.7  |  |  | Separation Agreement of Andrew Bailen, dated as
    of July 14, 2003, by and between the Company and Andrew
    Bailen, incorporated by reference from the September 2003 10-K.                                                                                                                     
|            | 10.8  |  |  | Separation Agreement of Thomas Larson, dated as
    of August 26, 2002, by and between the Company and Thomas
    Larson, incorporated by reference from the September 2003 10-K.                                                                                                                   
|            | 10.9  |  |  | Employment Agreement of Steven Skiba, dated as of
    November 29, 2002, by and between the Company and Steven
    Skiba, incorporated by reference from the September 2003 10-K.                                                                                                                   
|            | 10.10 |  |  | Employment Agreement of Linda Siluk, dated as of
    November 7, 2003, by and between the Company and Linda M.
    Siluk, incorporated by reference from the November 2003 10-Q.                                                                                                                    
|            | 10.11 |  |  | Employment Agreement of Warren Jeffrey, dated as
    of November 7, 2003, by and between the Company and Warren
    Jeffery, incorporated by reference from the November 2003 10-Q.                                                                                                                 
|            | 10.12 |  |  | Employment Agreement of Gregg A. Melnick,
    dated as of September 7, 2004, by and between the Company
    and Gregg A. Melnick incorporated by reference from the
    Companys Current Report on Form 8-K as filed on
    September 9, 2004.                                                     
|            | 10.13 |  |  | Employment Agreement of Richard H. Griner dated
    as of January 12, 2004, by and between the Company and
    Richard H. Griner, incorporated by reference from the February
    2004 10-Q.                                                                                                        
|            | 10.14 |  |  | Management Stock Purchase Plan of the Company,
    incorporated by reference from the Registration of Form S-8
    as filed with the Commission on July 23, 2001.                                                                                                                                   
|            | 10.15 |  |  | Employee Stock Purchase Plan of the Company,
    incorporated by reference from the Companys Definitive
    Proxy Statement for the 2001 Annual Meeting of Stockholders,
    included within Form 14-A as filed with the Commission on
    October 18, 2001.                                       

35



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##### Table of Contents



|            |       |  |  |                                                                                                                                                                                                                                                                                                                                                                                                                                  
|----------- | ----- |  |  | ---------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
|Exhibit No. |       | 
|            |       | 
|            | 10.16 |  |  | Amended and Restated 1994 Stock Option Plan,
    incorporated by reference from the Registration of Form S-8
    as filed with the Commission on January 9, 1997.                                                                                                                                                                                                                                                                
|            | 10.17 |  |  | 1999 Stock Incentive Plan (Amended and Restated
    as of October 17, 2003), incorporated by reference from the
    Companys Definitive Proxy Statement for the 2003 Annual
    Meeting of Stockholders included within Form 14-A as filed
    with the Commission on October 20, 2003.                                                                                                                                         
|            | 10.18 |  |  | Loan and Security Agreement (the Loan
    Agreement), dated January 9, 2003, by and between the
    Company and Wells Fargo Retail Finance, LLC (WFRF),
    as the arranger, collateral agent and administrative agent, and
    Fleet Retail Finance, Inc., as the documentation agent,
    incorporated by reference from the Companys Current Report
    on Form 8-K as filed with the Commission on
    January 10, 2003.
|            | 10.19 |  |  | Stock Pledge Agreement, dated January 9,
    2003, by and among the Company, Party City Michigan, Inc.
    (PCMI) and WFRF, as the arranger, collateral agent
    and administrative agent for the lender group under the Loan
    Agreement, incorporated by reference from the September 2003
    10-K.                                                                                                                      
|            | 10.20 |  |  | Trademark Security Agreement, dated
    January 9, 2003, by and between the Company and WFRF, as
    the arranger, collateral agent and administrative agent for the
    lender group under the Loan Agreement, incorporated by reference
    from the September 2003 10-K.                                                                                                                                                      
|            | 10.21 |  |  | Copyright Security Agreement, dated
    January 9, 2003, by and between the Company and WFRF, as
    the arranger, collateral agent and administrative agent for the
    lender group under the Loan Agreement, incorporated by reference
    from the September 2003 10-K.                                                                                                                                                      
|            | 10.22 |  |  | Guaranty and Security Agreement, dated
    January 9, 2003, by and between PCMI and WFRF, as the
    arranger, collateral agent and administrative agent for the
    lender group under the Loan Agreement, incorporated by reference
    from the September 2003 10-K.                                                                                                                                                          
|            | 21.1  |  |  | Subsidiaries, incorporated by reference from the
    September 2003 10-K.                                                                                                                                                                                                                                                                                                                                                        
|            | *23.1 |  |  | Consent of Deloitte & Touche LLP.                                                                                                                                                                                                                                                                                                                                                                                                
|            | *31.1 |  |  | Certification of Chief Executive Officer pursuant
    to 18 U.S.C. Section 1350, as adopted pursuant to
    Section 302 of the Sarbanes-Oxley Act of 2002.                                                                                                                                                                                                                                                                       
|            | *31.2 |  |  | Certification of Chief Financial Officer pursuant
    to 18 U.S.C. Section 1350, as adopted pursuant to
    Section 302 of the Sarbanes-Oxley Act of 2002.                                                                                                                                                                                                                                                                       
|            | *32.1 |  |  | Certification of Chief Executive Officer pursuant
    to 18 U.S.C. Section 1350, as adopted pursuant to
    Section 906 of the Sarbanes-Oxley Act of 2002.                                                                                                                                                                                                                                                                       
|            | *32.2 |  |  | Certification of Chief Financial Officer pursuant
    to 18 U.S.C. Section 1350, as adopted pursuant to
    Section 906 of the Sarbanes-Oxley Act of 2002.                                                                                                                                                                                                                                                                       



---



|  |                
|- | ---------------
|* | Included herein

36



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##### Table of Contents



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 14,
2004.



| |                       
| | ----------------------
| | PARTY CITY CORPORATION



| |     |                   
| | --- | ------------------
| | By: | /s/ LINDA M. SILUK

| |                        
| | -----------------------
| |                        
| | Linda M. Siluk         
| | Chief Financial Officer

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

|     |  |                                                |  |                                                      |  |                   
|---- |  | ---------------------------------------------- |  | ---------------------------------------------------- |  | ------------------
|     |  |                                                |  |                                                     
|Name |  | Title                                          |  | Date                                                
|     |  |                                                |  |                                                     
|By:  |  | /s/ RALPH D. DILLONRalph D. Dillon             |  | Non-Executive Chairman of the
    Board and Director |  | September 14, 2004
|    
|By:  |  | /s/ MICHAEL E. TENNENBAUMMichael E. Tennenbaum |  | Vice Chairman and Director                           |  | September 14, 2004
|    
|By:  |  | /s/ L.R. JALENAK, JR.L.R. Jalenak, Jr.         |  | Director                                             |  | September 14, 2004
|    
|By:  |  | /s/ FRANKLIN R. JOHNSONFranklin R. Johnson     |  | Director                                             |  | September 14, 2004
|    
|By:  |  | /s/ HOWARD LEVKOWITZHoward Levkowitz           |  | Director                                             |  | September 14, 2004
|    
|By:  |  | /s/ WALTER SALMONWalter Salmon                 |  | Director                                             |  | September 14, 2004
|    
|By:  |  | /s/ NANCY PEDOTNancy Pedot                     |  | Chief Executive Officer and Director                 |  | September 14, 2004
|    
|By:  |  | /s/ LINDA M. SILUKLinda M. Siluk               |  | Chief Financial Officer                              |  | September 14, 2004

37



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##### Table of Contents



REPORT OF INDEPENDENT REGISTERED PUBLIC
ACCOUNTING FIRM

To the Board of Directors and Stockholders of

Party City Corporation


Rockaway, New Jersey


We have audited the accompanying consolidated
balance sheets of Party City Corporation and subsidiary as of
July 3, 2004 and June 28, 2003, and the related
consolidated statements of income, stockholders equity,
and cash flows for each of the three fiscal years in the period
ended July 3, 2004. Our audits also included the
consolidated financial statement schedule listed in the Index at
Item 15. These consolidated financial statements and
consolidated financial statement schedule are the responsibility
of the Companys management. Our responsibility is to
express an opinion on these consolidated financial statements
and consolidated financial statement schedule based on our
audits.

We conducted our audits in accordance with
standards of the Public Company Accounting Oversight Board
(United States). Those standards require that we plan and
perform the audit to obtain reasonable assurance about whether
the financial statements are free of material misstatement. An
audit includes examining, on a test basis, evidence supporting
the amounts and disclosures in the financial statements. An
audit also includes assessing the accounting principles used and
significant estimates made by management, as well as evaluating
the overall financial statement presentation. We believe that
our audits provide a reasonable basis for our opinion.

In our opinion, such consolidated financial
statements referred to above present fairly, in all material
respects, the financial position of Party City Corporation and
subsidiary as of July 3, 2004 and June 28, 2003, and
the results of their operations and their cash flows for each of
the three fiscal years in the period ended July 3, 2004 in
conformity with accounting principles generally accepted in the
United States of America. Also, in our opinion such consolidated
financial statement schedule, when considered in relation to the
basic consolidated financial statements taken as a whole,
presents fairly, in all material respects, the information set
forth therein.



| |                      
| | ---------------------
| | DELOITTE & TOUCHE LLP

Parsippany, New Jersey

September 7, 2004


F-1



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##### Table of Contents



PARTY CITY CORPORATION AND
SUBSIDIARY

CONSOLIDATED BALANCE SHEETS

|                                         |                                                |                                                                                                                                                                                                                                                                                                         |                                            |          |     |         |        |        |     |         | 
|---------------------------------------- | ---------------------------------------------- | ------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------- | ------------------------------------------ | -------- | --- | ------- | ------ | ------ | --- | ------- | 
|                                         |                                                |                                                                                                                                                                                                                                                                                                        
|                                         |                                                | As of                                                                                                                                                                                                                                                                                                  
|                                         |                                                |                                                                                                                                                                                                                                                                                                        
|                                         |                                                | July 3,                                                                                                                                                                                                                                                                                                 |                                            | June 28,
|                                         |                                                | 2004                                                                                                                                                                                                                                                                                                    |                                            | 2003    
|                                         |                                                |                                                                                                                                                                                                                                                                                                         |                                            |         
|                                         |                                                |                                                                                                                                                                                                                                                                                                        
|                                         |                                                | (In thousands, except                                                                                                                                                                                                                                                                                  
|                                         |                                                | share data)                                                                                                                                                                                                                                                                                            
|ASSETS                                  
|Current assets:                          |                                                |                                                                                                                                                                                                                                                                                                         |                                            |          |     |         |        |       
|                                         | Cash and cash equivalents                      |                                                                                                                                                                                                                                                                                                         | $                                          | 27,845   |     |         | $      | 3,372  |    
|                                         | Merchandise inventory                          |                                                                                                                                                                                                                                                                                                         |                                            | 57,357   |     |         |        | 65,908 |    
|                                         | Other current assets, net                      |                                                                                                                                                                                                                                                                                                         |                                            | 20,669   |     |         |        | 21,900 |    
|                                         |                                                |                                                                                                                                                                                                                                                                                                         |                                            |          |     |         |        |       
|                                         |                                                |                                                                                                                                                                                                                                                                                                         | Total current assets                       |          |     | 105,871 |        |        |     | 91,180  | 
|Property and equipment, net              |                                                |                                                                                                                                                                                                                                                                                                         | 48,762                                     |          |     |         | 52,819 |       
|Goodwill                                 |                                                |                                                                                                                                                                                                                                                                                                         | 18,614                                     |          |     |         | 18,614 |       
|Other assets                             |                                                |                                                                                                                                                                                                                                                                                                         | 4,170                                      |          |     |         | 5,386  |       
|                                         |                                                |                                                                                                                                                                                                                                                                                                         |                                            |          |     |         |        |       
|                                         |                                                |                                                                                                                                                                                                                                                                                                         | Total assets                               |          | $   | 177,417 |        |        | $   | 167,999 | 
|                                         |                                                |                                                                                                                                                                                                                                                                                                         |                                            |          |     |         |        |       
|LIABILITIES AND STOCKHOLDERS
    EQUITY
|Current liabilities:                     |                                                |                                                                                                                                                                                                                                                                                                         |                                            |          |     |         |        |       
|                                         | Accounts payable                               |                                                                                                                                                                                                                                                                                                         | $                                          | 38,364   |     |         | $      | 37,960 |    
|                                         | Accrued expenses and other current liabilities |                                                                                                                                                                                                                                                                                                         |                                            | 32,689   |     |         |        | 24,998 |    
|                                         | Cash overdraft                                 |                                                                                                                                                                                                                                                                                                         |                                            |         |     |         |        | 4,126  |    
|                                         | Advances under Loan Agreement                  |                                                                                                                                                                                                                                                                                                         |                                            |         |     |         |        | 11,229 |    
|                                         |                                                |                                                                                                                                                                                                                                                                                                         |                                            |          |     |         |        |       
|                                         |                                                |                                                                                                                                                                                                                                                                                                         | Total current liabilities                  |          |     | 71,053  |        |        |     | 78,313  | 
|Long-term liabilities:                   |                                                |                                                                                                                                                                                                                                                                                                         |                                            |          |     |         |        |       
|                                         | Deferred rent and other long-term liabilities  |                                                                                                                                                                                                                                                                                                         |                                            | 9,526    |     |         |        | 10,264 |    
|Commitments and contingencies            |                                                |                                                                                                                                                                                                                                                                                                         |                                            |          |     |         |        |       
|                                         | Stockholders equity:                          |                                                                                                                                                                                                                                                                                                         |                                            |          |     |         |        |        |    
|                                         |                                                | Common stock, $0.01 par value, 40,000,000
    and 25,000,000 shares authorized at July 3, 2004 and
    June 28, 2003, respectively; 17,835,778 shares issued
    and 17,088,766 shares outstanding at July 3, 2004;
    17,296,807 shares issued and 16,549,795 shares
    outstanding at June 28, 2003 |                                            |          | 178 |         |        |        | 173 |        
|                                         | Additional paid-in capital                     |                                                                                                                                                                                                                                                                                                         |                                            | 46,683   |     |         |        | 43,178 |    
|                                         | Retained earnings                              |                                                                                                                                                                                                                                                                                                         |                                            | 55,917   |     |         |        | 42,011 |    
|                                         | Treasury shares, at cost (747,012 shares)      |                                                                                                                                                                                                                                                                                                         |                                            | (5,940   | )   |         |        | (5,940 | )  
|                                         |                                                |                                                                                                                                                                                                                                                                                                         |                                            |          |     |         |        |       
|                                         |                                                |                                                                                                                                                                                                                                                                                                         | Total stockholders equity                 |          |     | 96,838  |        |        |     | 79,422  | 
|                                         |                                                |                                                                                                                                                                                                                                                                                                         |                                            |          |     |         |        |       
|                                         |                                                |                                                                                                                                                                                                                                                                                                         | Total liabilities and stockholders equity |          | $   | 177,417 |        |        | $   | 167,999 | 
|                                         |                                                |                                                                                                                                                                                                                                                                                                         |                                            |          |     |         |        |       

See accompanying notes to consolidated financial
statements.

F-2



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##### Table of Contents



PARTY CITY CORPORATION AND
SUBSIDIARY

CONSOLIDATED STATEMENTS OF INCOME

|                           |                                                    |                                                   |        |               |         |               |        |         |         |   |        |         |         | 
|-------------------------- | -------------------------------------------------- | ------------------------------------------------- | ------ | ------------- | ------- | ------------- | ------ | ------- | ------- | - | ------ | ------- | ------- | 
|                           |                                                    |                                                  
|                           |                                                    | Year Ended                                       
|                           |                                                    |                                                  
|                           |                                                    | July 3, 2004                                      |        | June 28, 2003 |         | June 29, 2002
|                           |                                                    |                                                   |        |               |         |              
|                           |                                                    |                                                  
|                           |                                                    | (In thousands, except per share data)            
|Revenues:                  |                                                    |                                                   |        |               |         |               |        |         |         |   |        |        
|                           | Net sales                                          |                                                   | $      | 496,138       |         |               | $      | 464,258 |         |   | $      | 405,821 |        
|                           | Royalty fees                                       |                                                   |        | 19,521        |         |               |        | 18,007  |         |   |        | 17,048  |        
|                           | Franchise fees                                     |                                                   |        | 608           |         |               |        | 355     |         |   |        | 641     |        
|                           |                                                    |                                                   |        |               |         |               |        |         |         |   |        |        
|                           |                                                    | Total revenues                                    |        |               | 516,267 |               |        |         | 482,620 |   |        |         | 423,510 | 
|Expenses:                  |                                                    |                                                   |        |               |         |               |        |         |         |   |        |        
|                           | Cost of goods sold and occupancy costs             |                                                   |        | 332,311       |         |               |        | 311,170 |         |   |        | 263,980 |        
|                           | Company-owned stores operating and selling expense |                                                   |        | 113,292       |         |               |        | 108,294 |         |   |        | 91,576  |        
|                           | Franchise expense                                  |                                                   |        | 7,184         |         |               |        | 6,538   |         |   |        | 6,563   |        
|                           | General and administrative expense                 |                                                   |        | 39,637        |         |               |        | 32,475  |         |   |        | 27,086  |        
|                           |                                                    |                                                   |        |               |         |               |        |         |         |   |        |        
|                           |                                                    | Total expenses                                    |        |               | 492,424 |               |        |         | 458,477 |   |        |         | 389,205 | 
|                           |                                                    |                                                   |        |               |         |               |        |         |         |   |        |        
|Operating income           |                                                    |                                                   | 23,843 |               |         |               | 24,143 |         |         |   | 34,305 |        
|                           | Interest income                                    |                                                   |        | (92           | )       |               |        | (175    | )       |   |        | (176    | )      
|                           | Interest expense                                   |                                                   |        | 563           |         |               |        | 4,165   |         |   |        | 5,786   |        
|                           |                                                    |                                                   |        |               |         |               |        |         |         |   |        |        
|                           | Interest expense, net                              |                                                   |        | 471           |         |               |        | 3,990   |         |   |        | 5,610   |        
|                           |                                                    |                                                   |        |               |         |               |        |         |         |   |        |        
|Income before income taxes |                                                    |                                                   | 23,372 |               |         |               | 20,153 |         |         |   | 28,695 |        
|                           | Provision for income taxes                         |                                                   |        | 9,466         |         |               |        | 8,061   |         |   |        | 11,503  |        
|                           |                                                    |                                                   |        |               |         |               |        |         |         |   |        |        
|Net income                 |                                                    | $                                                 | 13,906 |               |         | $             | 12,092 |         |         | $ | 17,192 |        
|                           |                                                    |                                                   |        |               |         |               |        |         |         |   |        |        
|                           | Basic earnings per share                           |                                                   | $      | 0.82          |         |               | $      | 0.73    |         |   | $      | 1.32    |        
|                           |                                                    |                                                   |        |               |         |               |        |         |         |   |        |        
|                           |                                                    | Weighted average shares outstanding 
    basic   |        |               | 16,880  |               |        |         | 16,602  |   |        |         | 13,068  | 
|                           |                                                    |                                                   |        |               |         |               |        |         |         |   |        |        
|                           | Diluted earnings per share                         |                                                   | $      | 0.71          |         |               | $      | 0.62    |         |   | $      | 0.89    |        
|                           |                                                    |                                                   |        |               |         |               |        |         |         |   |        |        
|                           |                                                    | Weighted average shares outstanding 
    diluted |        |               | 19,651  |               |        |         | 19,646  |   |        |         | 19,313  | 
|                           |                                                    |                                                   |        |               |         |               |        |         |         |   |        |        

See accompanying notes to consolidated financial
statements.

F-3



---



##### Table of Contents



PARTY CITY CORPORATION AND
SUBSIDIARY

CONSOLIDATED STATEMENTS OF STOCKHOLDERS
EQUITY

|                                                         |  |                                   |            |            |  |          |     |          |  |      |        |       |  |   |        |  |  |   |        |   |  |   |        |  
|-------------------------------------------------------- |  | --------------------------------- | ---------- | ---------- |  | -------- | --- | -------- |  | ---- | ------ | ----- |  | - | ------ |  |  | - | ------ | - |  | - | ------ | -
|                                                         |  |                                   |            |            |  |          |     |          |  |     
|                                                         |  | Common Stock                      |            | Additional |  |          |     | Treasury |  |     
|                                                         |  |                                   |            | Paid-In-   |  | Retained |     | Stock at |  |     
|                                                         |  | Shares                            |            | Amounts    |  | Capital  |     | Earnings |  | Cost |        | Total
|                                                         |  |                                   |            |            |  |          |     |          |  |      |        |      
|                                                         |  |                                  
|                                                         |  | (In thousands, except share data)
|Balance at June 30, 2001                                 |  |                                   | 12,723,455 |            |  | $        | 127 |          |  | $    | 38,236 |       |  | $ | 12,727 |  |  |   |       |   |  | $ | 51,090 |  
|Warrant exercise                                         |  |                                   | 3,381,624  |            |  |          | 34  |          |  |      | (34    | )     |  |   |       |  |  |   |       |   |  |   |       |  
|Equity compensation                                      |  |                                   |           |            |  |          |    |          |  |      | 463    |       |  |   |       |  |  |   |       |   |  |   | 463    |  
|Tax effect of non-qualified options                      |  |                                   |           |            |  |          |    |          |  |      | 37     |       |  |   |       |  |  |   |       |   |  |   | 37     |  
|Exercise of stock options                                |  |                                   | 134,002    |            |  |          | 1   |          |  |      | 645    |       |  |   |       |  |  |   |       |   |  |   | 646    |  
|Repurchase of common shares (284,000 shares)             |  |                                   |           |            |  |          |    |          |  |      |       |       |  |   |       |  |  |   | (1,829 | ) |  |   | (1,829 | )
|Net income                                               |  |                                   |           |            |  |          |    |          |  |      |       |       |  |   | 17,192 |  |  |   |       |   |  |   | 17,192 |  
|                                                         |  |                                   |            |            |  |          |     |          |  |      |        |       |  |   |        |  |  |   |        |   |  |   |        |  
|Balance at June 29, 2002                                 |  |                                   | 16,239,081 |            |  |          | 162 |          |  |      | 39,347 |       |  |   | 29,919 |  |  |   | (1,829 | ) |  |   | 67,599 |  
|Warrant exercise                                         |  |                                   | 672,459    |            |  |          | 7   |          |  |      | 484    |       |  |   |       |  |  |   |       |   |  |   | 491    |  
|Equity compensation                                      |  |                                   |           |            |  |          |    |          |  |      | 342    |       |  |   |       |  |  |   |       |   |  |   | 342    |  
|Tax effect of non-qualified options                      |  |                                   |           |            |  |          |    |          |  |      | 556    |       |  |   |       |  |  |   |       |   |  |   | 556    |  
|Exercise of stock options                                |  |                                   | 213,486    |            |  |          | 2   |          |  |      | 1,130  |       |  |   |       |  |  |   |       |   |  |   | 1,132  |  
|Issuance of shares of Management Stock Purchase
    Plan |  |                                   | 95,511     |            |  |          | 1   |          |  |      | 707    |       |  |   |       |  |  |   |       |   |  |   | 708    |  
|Issuance of shares of Employee Stock Purchase Plan       |  |                                   | 76,270     |            |  |          | 1   |          |  |      | 612    |       |  |   |       |  |  |   |       |   |  |   | 613    |  
|Repurchase of common shares (463,012 shares)             |  |                                   |           |            |  |          |    |          |  |      |       |       |  |   |       |  |  |   | (4,111 | ) |  |   | (4,111 | )
|Net income                                               |  |                                   |           |            |  |          |    |          |  |      |       |       |  |   | 12,092 |  |  |   |       |   |  |   | 12,092 |  
|                                                         |  |                                   |            |            |  |          |     |          |  |      |        |       |  |   |        |  |  |   |        |   |  |   |        |  
|Balance at June 28, 2003                                 |  |                                   | 17,296,807 |            |  |          | 173 |          |  |      | 43,178 |       |  |   | 42,011 |  |  |   | (5,940 | ) |  |   | 79,422 |  
|Equity compensation                                      |  |                                   |           |            |  |          |    |          |  |      | 102    |       |  |   |       |  |  |   |       |   |  |   | 102    |  
|Tax effect on non-qualified option                       |  |                                   |           |            |  |          |    |          |  |      | 1,110  |       |  |   |       |  |  |   |       |   |  |   | 1,110  |  
|Exercise of stock options                                |  |                                   | 471,220    |            |  |          | 4   |          |  |      | 1,709  |       |  |   |       |  |  |   |       |   |  |   | 1,713  |  
|Issuance of shares of Management Stock Purchase
    Plan |  |                                   | 10,880     |            |  |          |    |          |  |      | 87     |       |  |   |       |  |  |   |       |   |  |   | 87     |  
|Issuance of shares of Employee Stock Purchase Plan       |  |                                   | 56,871     |            |  |          | 1   |          |  |      | 497    |       |  |   |       |  |  |   |       |   |  |   | 498    |  
|Net income                                               |  |                                   |           |            |  |          |    |          |  |      |       |       |  |   | 13,906 |  |  |   |       |   |  |   | 13,906 |  
|                                                         |  |                                   |            |            |  |          |     |          |  |      |        |       |  |   |        |  |  |   |        |   |  |   |        |  
|Balance at July 3, 2004                                  |  |                                   | 17,835,778 |            |  | $        | 178 |          |  | $    | 46,683 |       |  | $ | 55,917 |  |  | $ | (5,940 | ) |  | $ | 96,838 |  
|                                                         |  |                                   |            |            |  |          |     |          |  |      |        |       |  |   |        |  |  |   |        |   |  |   |        |  

See accompanying notes to consolidated financial
statements.

F-4



---



##### Table of Contents



PARTY CITY CORPORATION AND
SUBSIDIARY

CONSOLIDATED STATEMENTS OF CASH
FLOWS

|                                                            |                                                                                       |                                                                      |                                           |               |        |               |       |         |        |         |        |         |        |         |  
|----------------------------------------------------------- | ------------------------------------------------------------------------------------- | -------------------------------------------------------------------- | ----------------------------------------- | ------------- | ------ | ------------- | ----- | ------- | ------ | ------- | ------ | ------- | ------ | ------- | -
|                                                            |                                                                                       |                                                                     
|                                                            |                                                                                       | Year Ended                                                          
|                                                            |                                                                                       |                                                                     
|                                                            |                                                                                       | July 3, 2004                                                         |                                           | June 28, 2003 |        | June 29, 2002
|                                                            |                                                                                       |                                                                      |                                           |               |        |              
|                                                            |                                                                                       |                                                                     
|                                                            |                                                                                       | (In thousands)                                                      
|Cash flow from operating activities:                        |                                                                                       |                                                                      |                                           |               |        |               |       |         |        |         |        |        
|                                                            | Net income                                                                            |                                                                      | $                                         | 13,906        |        |               | $     | 12,092  |        |         | $      | 17,192  |       
|                                                            | Adjustments to reconcile net income to net cash
    provided by operating activities: |                                                                      |                                           |               |        |               |       |         |        |         |        |         |       
|                                                            |                                                                                       | Depreciation and amortization                                        |                                           |               | 17,601 |               |       |         | 16,229 |         |        |         | 12,156 |        
|                                                            |                                                                                       | Non-cash interest and financing costs                                |                                           |               | 163    |               |       |         | 1,624  |         |        |         | 1,395  |        
|                                                            |                                                                                       | Deferred taxes                                                       |                                           |               | (1,051 | )             |       |         | (2,131 | )       |        |         | 819    |        
|                                                            |                                                                                       | Deferred rent                                                        |                                           |               | (608   | )             |       |         | 556    |         |        |         | 765    |        
|                                                            |                                                                                       | Stock based compensation                                             |                                           |               | 102    |               |       |         | 342    |         |        |         | 463    |        
|                                                            |                                                                                       | Provision for doubtful accounts                                      |                                           |               | (141   | )             |       |         | (498   | )       |        |         | (67    | )      
|                                                            |                                                                                       | Tax effect of non-qualified stock options                            |                                           |               | 1,110  |               |       |         | 556    |         |        |         | 37     |        
|                                                            |                                                                                       | Impairment charge                                                    |                                           |               |       |               |       |         | 1,505  |         |        |         |       |        
|                                                            |                                                                                       | Other                                                                |                                           |               | 72     |               |       |         | 162    |         |        |         |       |        
|                                                            | Changes in assets and liabilities:                                                    |                                                                      |                                           |               |        |               |       |         |        |         |        |         |       
|                                                            |                                                                                       | Accounts payable, accrued expenses and other
    current liabilities |                                           |               | 8,592  |               |       |         | 3,608  |         |        |         | 4,894  |        
|                                                            |                                                                                       | Merchandise inventory                                                |                                           |               | 8,551  |               |       |         | (9,634 | )       |        |         | (7,310 | )      
|                                                            |                                                                                       | Other long-term liabilities                                          |                                           |               | (41    | )             |       |         | 121    |         |        |         | 833    |        
|                                                            |                                                                                       | Other current assets and other assets                                |                                           |               | 3,343  |               |       |         | (1,444 | )       |        |         | (135   | )      
|                                                            |                                                                                       |                                                                      |                                           |               |        |               |       |         |        |         |        |        
|                                                            |                                                                                       |                                                                      | Net cash provided by operating activities |               |        | 51,599        |       |         |        | 23,088  |        |         |        | 31,042  |  
|Cash flow from investing activities:                        |                                                                                       |                                                                      |                                           |               |        |               |       |         |        |         |        |        
|                                                            | Purchases of property and equipment                                                   |                                                                      |                                           | (13,484       | )      |               |       | (20,476 | )      |         |        | (14,085 | )     
|                                                            | Stores acquired                                                                       |                                                                      |                                           |              |        |               |       | (1,758  | )      |         |        | (5,923  | )     
|                                                            |                                                                                       |                                                                      |                                           |               |        |               |       |         |        |         |        |        
|                                                            |                                                                                       |                                                                      | Net cash used in investing activities     |               |        | (13,484       | )     |         |        | (22,234 | )      |         |        | (20,008 | )
|Cash flow from financing activities:                        |                                                                                       |                                                                      |                                           |               |        |               |       |         |        |         |        |        
|                                                            | Net (repayment of) proceeds from Loan Agreement                                       |                                                                      |                                           | (11,229       | )      |               |       | 11,229  |        |         |        |        |       
|                                                            | Cash overdrafts                                                                       |                                                                      |                                           | (4,126        | )      |               |       | 1,041   |        |         |        | 3,085   |       
|                                                            | Proceeds from exercise of stock options and
    warrants                              |                                                                      |                                           | 1,713         |        |               |       | 1,623   |        |         |        | 646     |       
|                                                            | Payments on Senior Notes                                                              |                                                                      |                                           |              |        |               |       | (10,207 | )      |         |        | (19,311 | )     
|                                                            | Purchase of treasury shares                                                           |                                                                      |                                           |              |        |               |       | (4,111  | )      |         |        | (1,829  | )     
|                                                            | Payment of financing costs                                                            |                                                                      |                                           |              |        |               |       | (524    | )      |         |        |        |       
|                                                            |                                                                                       |                                                                      |                                           |               |        |               |       |         |        |         |        |        
|                                                            |                                                                                       |                                                                      | Net cash used in financing activities     |               |        | (13,642       | )     |         |        | (949    | )      |         |        | (17,409 | )
|                                                            |                                                                                       |                                                                      |                                           |               |        |               |       |         |        |         |        |        
|Net increase (decrease) in cash and cash
    equivalents    |                                                                                       |                                                                      | 24,473                                    |               |        |               | (95   | )       |        |         | (6,375 | )      
|Cash and cash equivalents, beginning of year                |                                                                                       |                                                                      | 3,372                                     |               |        |               | 3,467 |         |        |         | 9,842  |        
|                                                            |                                                                                       |                                                                      |                                           |               |        |               |       |         |        |         |        |        
|Cash and cash equivalents, end of year                      |                                                                                       | $                                                                    | 27,845                                    |               |        | $             | 3,372 |         |        | $       | 3,467  |        
|                                                            |                                                                                       |                                                                      |                                           |               |        |               |       |         |        |         |        |        
|Supplemental disclosure of cash flow information:           |                                                                                       |                                                                      |                                           |               |        |               |       |         |        |         |        |        
|                                                            | Income taxes paid                                                                     |                                                                      | $                                         | 8,531         |        |               | $     | 9,895   |        |         | $      | 9,990   |       
|                                                            | Interest paid                                                                         |                                                                      | $                                         | 401           |        |               | $     | 2,978   |        |         | $      | 5,283   |       
|Supplemental disclosure of non-cash financing
    activity: |                                                                                       |                                                                      |                                           |               |        |               |       |         |        |         |        |        
|                                                            | Issuance of shares under employee stock purchase
    plan                             |                                                                      | $                                         | 497           |        |               | $     | 613     |        |         | $      |        |       
|                                                            | Issuance of shares under management stock
    purchase plan                           |                                                                      | $                                         | 87            |        |               | $     | 708     |        |         | $      |        |       
|                                                            | Issuance of warrants                                                                  |                                                                      | $                                         |              |        |               | $     | 245     |        |         | $      | 3,955   |       

See accompanying notes to consolidated financial
statements.

F-5



---



##### Table of Contents



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 United States and sells
franchises on an individual store and area franchise basis
throughout the United States and Puerto Rico. At July 3,
2004, the Company had 249 Company-owned stores and
257 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.

Our fiscal year ends the Saturday nearest to
June 30. As used herein, the term Fiscal Year
or Fiscal refers to the 52- or 53-week period, as
applicable, ending the Saturday nearest to June 30. Unless
otherwise stated, the financial results presented for the year
ended July 3, 2004 are based on a 53-week period, while the
financial results for the years ended June 28, 2003 and
June 29, 2002 are based on a 52-week period.



| |                 
| | ----------------
| | 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 use assumptions that affect the reported amounts of assets
and liabilities and disclosure of contingent 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.

The most significant estimates made by management
include those made in the areas of inventory; deferred taxes;
contingencies; the assessment of the recoverability of goodwill;
self insurance reserves; litigation reserves; and sales returns
and allowances.

Management periodically evaluates estimates used
in the preparation of the consolidated financial statements for
continued reasonableness. Appropriate adjustments, if any, to
the estimates used are made prospectively based on such periodic
evaluations.



| |                          
| | -------------------------
| | Cash and Cash Equivalents

The Company considers its highly liquid
investments purchased, with an original maturity of three months
or less, 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 advances
under the Loan Agreement. The carrying amounts reported in the
balance sheets of such financial instruments approximate their
fair market values due to their short-term maturities.

The estimated fair values of financial
instruments that are presented herein have been determined by
the Company using available market information and appropriate
valuation methodologies. However, considerable judgment is
required in interpreting market data to develop estimates of
fair value. Accordingly, the estimates presented herein are not
necessarily indicative of amounts the Company could realize in a
current market exchange.



| |                      
| | ---------------------
| | Merchandise Inventory

Inventory is valued using the cost method which
values inventory at the lower of the actual cost or market, at
the individual item level. Cost is determined using the weighted
average method. Inventory levels are reviewed to identify
slow-moving and closeout merchandise that will no longer be
carried. Market is

F-6



---



##### Table of Contents



PARTY CITY CORPORATION AND
SUBSIDIARY


NOTES TO CONSOLIDATED FINANCIAL
STATEMENTS  (Continued)

determined by the estimated net realizable value,
based upon the merchandise selling price. We also estimate
amounts of current inventories that will ultimately become
obsolete due to changes in fashion and style, based on the
following factors: (i) supply on hand, (ii) historical
experience and (iii) our expectations as to future sales.



| |                  
| | -----------------
| | Vendor Allowances

The Company and certain vendors have arrangements
whereby the vendors provide merchandise allowances based on
purchases. Generally, these arrangements provide for a fixed
percentage discount to be provided to the Company. Because the
arrangements provide for concessions to be based on the level of
purchases from the vendor, the Company accounts for the
allowances from the vendor as a reduction of inventory cost.
This is applied consistently regardless if the vendor
merchandise allowance is provided up-front or received after the
selling season.

The Company also receives vendor allowances as
reimbursement for advertising. Advertising allowances are
recorded as reductions to advertising expense as they do not
affect inventory or gross margin. These allowances represent
reimbursements of specific, incremental, identifiable costs
incurred by the Company in selling the vendors product and
therefore are characterized as a reduction of that cost when
recognized in the income statement. The Company has not
historically received cash consideration in excess of the cost
being incurred.

All allowances received from our vendors are a
result of either our buying relationship or a reimbursed cost of
specific advertising. The Companys accounting methodology
with respect to vendor merchandise allowances reflects this
viewpoint, and appropriately captures the substance of the
vendor consideration.



| |           
| | ----------
| | Litigation

The Company is subject to litigation in the
ordinary course of business and also to certain other
litigation-related contingencies (see Note 14). Legal fees
and other expenses related to litigation and contingencies are
recorded as incurred. The Company, in consultation with its
counsel, assesses the need to record a liability for litigation
and contingencies on a case-by-case basis. Accruals are recorded
when the Company determines that a loss related to a matter is
both probable and reasonably estimable.



| |               
| | --------------
| | Self-Insurance

The Company maintains self-insured workers
compensation and general liability programs. The Company
estimates the required liability of such claims utilizing an
actuarial method and based upon various assumptions, which
include, but are not limited to, historical loss experience,
projected loss development factors, actual payroll and other
data. The required liability is also subject to adjustment in
the future based upon the changes in claims experience,
including changes in the number of incidents
(frequency) and changes in the ultimate cost per incident
(severity).



| |                  
| | -----------------
| | Advertising Costs

Advertising costs, including print and other
media advertising, are expensed as incurred and were
$23.5 million, $22.4 million and $16.7 million
for Fiscal 2004, Fiscal 2003 and Fiscal 2002, respectively.



| |                 
| | ----------------
| | Advertising Fund

Pursuant to its franchise agreements, the Company
collects 1% of the net sales of its franchise stores for
contribution into the Advertising Fund (the Ad
Fund). The Company also contributes 1% of net sales of
Company-owned stores into the Ad Fund. These amounts are
restricted to be used for advertising. To cover the expenses of
fund administration, the Company charges the Ad Fund a
management fee equal to 5% of the

F-7



---



##### Table of Contents



PARTY CITY CORPORATION AND
SUBSIDIARY


NOTES TO CONSOLIDATED FINANCIAL
STATEMENTS  (Continued)

contributions. For the fiscal years ended
July 3, 2004, June 28, 2003, June 29, 2002, Ad
Fund management fees of $508,000, $484,000 and $439,000,
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.
Depreciation begins in the year the assets are 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 Finite-Lived
    Assets

The Company evaluates Finite-Lived Assets in
accordance with Statement of Financial Accounting Standards
(SFAS) No. 144, Accounting for the
Impairment or Disposal of Long-lived Assets
(SFAS No. 144). This statement supersedes
SFAS No. 121, Accounting for Impairment of
Long-lived Assets and for Long-lived Assets to Be Disposed
of. Finite-lived assets are evaluated for recoverability
in accordance with SFAS No. 144 whenever events or
changes in circumstances indicate that an asset may have been
impaired. In evaluating an asset for recoverability, the Company
estimates the future cash flows expected to result from the use
of the asset and eventual disposition. If the sum of the
expected future cash flows (undiscounted and without interest
charges) is less than the carrying amount of the asset, an
impairment loss, equal to the excess of the carrying amount over
the fair market value of the asset is recognized. The Company
evaluated its finite-lived assets during Fiscal 2004 and Fiscal
2003. Based on current and projected performance, the Company
determined that there were no fixed asset impairment in Fiscal
2004. In Fiscal 2003, the Company impaired fixed assets for four
stores in the Seattle market and one other store recording a
pre-tax charge of $946,000 in Fiscal 2003. After adjusting for
this impairment charge, management believes the carrying value
and useful lives are appropriate.



| |                      
| | ---------------------
| | Non-Compete Agreement

The Company has two non-compete agreements. One
is with a franchise owner and the other is with Paper Warehouse,
Inc. The Company also has trademark license agreements. These
agreements are included in other assets and are being amortized
using the straight-line method over the life of the agreement.
Amortization expense for other intangibles was $134,000,
$131,000 and $33,000 for the fiscal years ended July 3,
2004, June 28, 2003 and June 29, 2002, respectively.
The following chart shows the amortization expense of these
intangibles by year until they are fully amortized:

|                           |  |                      |     | 
|-------------------------- |  | -------------------- | --- | 
|Fiscal year ending:        |  | Amortization Expense
|                           |  |                     
|                           |  | (In thousands)      
|2005                       |  | $                    | 82  | 
|2006                       |  |                      | 82  | 
|2007                       |  |                      | 82  | 
|2008                       |  |                      | 82  | 
|2009                       |  |                      | 20  | 
|Thereafter                 |  |                      | 14  | 
|                           |  |                      |     | 
|Total amortization expense |  | $                    | 362 | 
|                           |  |                      |     | 

F-8



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##### Table of Contents



PARTY CITY CORPORATION AND
SUBSIDIARY


NOTES TO CONSOLIDATED FINANCIAL
STATEMENTS  (Continued)



| |         
| | --------
| | Goodwill

The Company adopted SFAS No. 142,
Goodwill and Other Intangible Assets
(SFAS No. 142) effective July 1,
2001. It changes the accounting for goodwill from an
amortization method to an impairment only approach.
Under SFAS No. 142, goodwill is no longer amortized
but reviewed for impairment annually or more frequently if
certain indicators arise. The Company evaluates the goodwill
associated with its acquisitions and this evaluation is based on
current and projected performance. In Fiscal 2004, the Company
determined there was no impairment of goodwill. In Fiscal 2003,
the Company determined that the goodwill associated with one
acquisition was impaired and a charge for $558,000 was recorded.
Management believes the carrying value of its goodwill is
appropriate. All of the Companys recorded goodwill is
associated with its retail segment.



| |             
| | ------------
| | Income Taxes

The Company files a consolidated Federal income
tax return. Separate state income tax returns are filed with
each state in which the Company conducts business. The Company
accounts for its income taxes using the asset and liability
method. Deferred tax assets and liabilities are recognized for
the future tax consequences attributable to the differences
between the financial statement carrying amounts of existing
assets and liabilities and their respective tax bases and
operating loss and tax credit carryforwards. Deferred tax assets
and liabilities are measured using enacted tax rates expected to
apply to taxable income in the year in which those temporary
differences are expected to be recovered or settled. The effect
on deferred tax assets and liabilities of a change in tax rates
is recognized in earnings in the period that includes the
enactment date.



| |                         
| | ------------------------
| | Stock-Based Compensation

In accordance with SFAS No. 123,
Accounting for Stock-Based Compensation,
(SFAS No. 123) 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:

|                        |  |            |            |          |  |          |           |  |  |  |           | 
|----------------------- |  | ---------- | ---------- | -------- |  | -------- | --------- |  |  |  | --------- | 
|                        |  |           
|                        |  | Year Ended
|                        |  |           
|                        |  | July 3,    |            | June 28, |  | June 29,
|                        |  | 2004       |            | 2003     |  | 2002    
|                        |  |            |            |          |  |         
|Expected volatility     |  |            | 55%        |          |  |          | 55%       |  |  |  | 50%       | 
|Expected lives          |  |            | 4.0  years |          |  |          | 5.4 years |  |  |  | 4.7 years | 
|Risk-free interest rate |  |            | 2.5%       |          |  |          | 2.3%      |  |  |  | 3.3%      | 
|Expected dividend yield |  |            | 0.0%       |          |  |          | 0.0%      |  |  |  | 0.0%      | 

The weighted average fair value of options
granted during the fiscal years 2004, 2003 and 2002 were $5.75,
$7.47 and $2.53 respectively.

The Company periodically grants stock options to
employees. Pursuant to Accounting Principles Board Opinion
No. 25, Accounting for Stock Issued to
Employees, the Company accounts for stock-based employee
compensation arrangements using the intrinsic value method. If
the options are granted to employees below fair market value,
compensation expense is recognized. The Company has adopted the
disclosure only provisions SFAS No. 123 as amended by
SFAS No. 148, Accounting for Stock Based
Compensation  Transition and Disclosure, an Amendment
of SFAS No. 123. If compensation cost for the

F-9



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##### Table of Contents



PARTY CITY CORPORATION AND
SUBSIDIARY


NOTES TO CONSOLIDATED FINANCIAL
STATEMENTS  (Continued)

Companys stock option plans had been
determined in accordance with the fair value method prescribed
by SFAS No. 148, the Companys net income would
have been (in thousands, except per share data):

|                            |                                                                                                                    |                                       |        |          |   |          |        |        |   |   |        |        |  
|--------------------------- | ------------------------------------------------------------------------------------------------------------------ | ------------------------------------- | ------ | -------- | - | -------- | ------ | ------ | - | - | ------ | ------ | -
|                            |                                                                                                                    |                                      
|                            |                                                                                                                    | Year Ended                           
|                            |                                                                                                                    |                                      
|                            |                                                                                                                    | July 3,                               |        | June 28, |   | June 29,
|                            |                                                                                                                    | 2004                                  |        | 2003     |   | 2002    
|                            |                                                                                                                    |                                       |        |          |   |         
|                            |                                                                                                                    |                                      
|                            |                                                                                                                    | (In thousands, except per share data)
|Net income as reported      |                                                                                                                    | $                                     | 13,906 |          |   | $        | 12,092 |        |   | $ | 17,192 |       
|                            | Add: Stock-based employee compensation expense
    determined under APB 25, net of taxes                           |                                       |        | 73       |   |          |        | 205    |   |   |        | 278    |  
|                            | Deduct: Total stock based employee compensation
    expense determined under fair value based method, net of taxes |                                       |        | (1,816   | ) |          |        | (1,247 | ) |   |        | (2,423 | )
|                            |                                                                                                                    |                                       |        |          |   |          |        |        |   |   |        |       
|                            | Pro-forma net income                                                                                               |                                       | $      | 12,163   |   |          | $      | 11,050 |   |   | $      | 15,047 |  
|                            |                                                                                                                    |                                       |        |          |   |          |        |        |   |   |        |       
|Basic earnings per share:   |                                                                                                                    |                                       |        |          |   |          |        |        |   |   |        |       
|                            | As reported                                                                                                        |                                       | $      | 0.82     |   |          | $      | 0.73   |   |   | $      | 1.32   |  
|                            | Pro-forma                                                                                                          |                                       |        | 0.72     |   |          |        | 0.67   |   |   |        | 1.16   |  
|Diluted earnings per share: |                                                                                                                    |                                       |        |          |   |          |        |        |   |   |        |       
|                            | As reported                                                                                                        |                                       | $      | 0.71     |   |          | $      | 0.62   |   |   | $      | 0.89   |  
|                            | Pro-forma                                                                                                          |                                       |        | 0.62     |   |          |        | 0.56   |   |   |        | 0.78   |  



| |                   
| | ------------------
| | Earnings Per Share

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



| |                    
| | -------------------
| | Revenue Recognition

The Company operates predominately as a retailer
through its Company-owned stores. The retail segment recognizes
revenue at the point of sale. Allowances for sales returns are
estimated as a component of net sales in the periods in which
the related sales are recognized. The Company estimates the
amount of allowances based on historical information. Sales
discounts, coupons and other similar incentives are recorded as
a reduction of net sales in the period when the related sales
are recorded.

The Companys franchise segment generates
revenues through one-time franchise fees and ongoing royalties.
Revenue from the sale of individual franchises, recorded as
franchise fees, is recognized by the Company upon completion of
certain initial services, which normally coincides with the
opening of the franchisees store. Royalty fees are
recorded on a monthly basis as a percentage of the
franchisees net sales. 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.

Area franchise agreements represent arrangements
with franchisees to open a specified number of franchises within
defined geographic areas and development periods. The
Companys policy is to receive a deposit in advance for
each of the potential stores, based on its standard initial
franchise fee at the time the contract is signed. Upon receipt,
the deposit is recorded as deferred revenue. When the Company
satisfies its initial obligations to the franchisee and the
store is opened, the Company recognizes the deposit as revenue.
The Company had 257 and 241 franchise stores at July 3,
2004 and June 28, 2003, respectively.

F-10



---



##### Table of Contents



PARTY CITY CORPORATION AND
SUBSIDIARY


NOTES TO CONSOLIDATED FINANCIAL
STATEMENTS  (Continued)



| |                 
| | ----------------
| | Operating Leases

The Companys rent expense under operating
leases provides for step rent provisions, escalation clauses,
capital improvement funding and other lease concessions as
applicable in each lease. The minimum lease payments are
recognized on a straight-line basis over the term of each
individual underlying lease.



| |                                    
| | -----------------------------------
| | Store Opening and Closing
    Costs

New store opening costs are expensed as incurred.
Closed store costs, such as future rent and real estate taxes
net of expected sublease recovery, are accrued when an agreement
is entered or when the store is closed.



| |                                     
| | ------------------------------------
| | Recent Accounting
    Pronouncements

In June 2004, the FASB issued an
interpretation of FASB No. 143, Accounting for Asset
Retirement Obligations (FASB No. 143). This
interpretation clarifies the scope and timing of liability
recognition for conditional asset retirement obligations under
FASB No. 143 and is effective no later than the end of
Fiscal 2005. We have determined that this interpretation, and
the adoption of FASB No. 143, will not have a material
impact on our consolidated results of operations, financial
position or cash flows.

In March 2004, the FASB published an Exposure
Draft, Share-Based Payment, an amendment of FASB
Statements No. 123 and No. 95. Under this FASB
proposal, all forms of share-based payment to employees,
including employee stock options, would be treated as
compensation and recognized in the income statement. This
proposed statement, if adopted, would be effective beginning in
Fiscal 2005. The Company currently accounts for stock options
under APB No. 25. The pro-forma impact of expensing options
is disclosed above to our consolidated financial statements
included herein.

In December 2003, the FASB issued
Interpretation 46R FIN 46R, a revision to
Interpretation 46 FIN 46, Consolidation of
Variable Interest Entities. FIN 46R clarifies some of
the provisions of FIN 46 and exempts certain entities from
its requirements. FIN 46R is effective at the end of the
first interim period ending after March 15, 2004. Entities
that have adopted FIN 46 prior to this effective date can
continue to apply the provisions of FIN 46 until the
effective date of FIN 46R or elect early adoption of
FIN 46R. The adoption of FIN 46 and FIN 46R did
not have a material impact on our financial statements.



| |            
| | -----------
| | Seasonality

Our business is subject to substantial seasonal
variations. Historically, we have realized a significant portion
of our net sales, cash flow and net income in the second fiscal
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. We expect that this general
pattern will continue.

Our results of operations and cash flows may also
fluctuate significantly as a result of a variety of other
factors, including the timing of new store openings and store
closings and the timing of the acquisition and disposition of
stores.



| |              
| | -------------
| | Concentration

The Company has four suppliers, who each
represented over 5%, and who in the aggregate constituted
approximately 42%, of the Companys purchases for each of
the three fiscal years ended July 3, 2004. The loss of any
of these suppliers could adversely affect the Companys
operations.

F-11



---



##### Table of Contents



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 of Stores

The Company acquired 13 stores in the Seattle,
Washington market from Paper Warehouse, Inc. in the fourth
quarter of Fiscal 2002. The conversion of these locations to the
Party City store format was completed and all stores were opened
in the first quarter of Fiscal 2003. The aggregate consideration
paid in connection with the Fiscal 2002 acquisitions was
$5.9 million. The consolidated balance sheets include
allocations of the purchase prices relating to these
acquisitions, which resulted in the recording of approximately
$4.4 million in goodwill, $523,000 in inventory and
$1.0 million in fixed assets. During Fiscal 2003, $558,000
of goodwill was impaired relating to the acquisition of one
store in Texas.

In Fiscal 2003, the Company acquired two stores
from a franchisee. The aggregate consideration paid in
connection with this acquisition was $1.6 million. The
consolidated balance sheets include an allocation of the
purchase price related to this transaction resulting in the
recording of approximately $1.0 million in goodwill,
$407,000 in inventory and $195,000 in fixed assets.

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 the stores were opened. The favorable real estate
locations and market share obtained in the aforementioned
transactions resulted in goodwill premiums paid. Such items
continue to provide sufficient return on the premium invested.

The purchase price of these acquisitions was
determined by applying a multiple to the acquired
businesss proforma earnings before depreciation,
amortization, and taxes. The range of multiples the Company uses
has generally resulted in an acceptable return on our investment
compared to the opening of a new site as the customer and sales
base is already established.

Assuming the stores acquired during Fiscal 2002
and 2003 were acquired on June 30, 2001, the first day of
Fiscal 2002, the pro forma results would have been as follows
(in thousands, except per share amounts) (unaudited):

|                           |  |            |         |          |  |          |         |  |  |   |         | 
|-------------------------- |  | ---------- | ------- | -------- |  | -------- | ------- |  |  | - | ------- | 
|                           |  |           
|                           |  | Year Ended
|                           |  |           
|                           |  | July 3,    |         | June 28, |  | June 29,
|                           |  | 2004       |         | 2003     |  | 2002    
|                           |  |            |         |          |  |         
|Net sales                  |  | $          | 516,267 |          |  | $        | 484,068 |  |  | $ | 439,989 | 
|Net income                 |  |            | 13,096  |          |  |          | 12,168  |  |  |   | 17,618  | 
|Basic earnings per share   |  | $          | 0.82    |          |  | $        | 0.73    |  |  | $ | 1.35    | 
|Diluted earnings per share |  | $          | 0.71    |          |  | $        | 0.62    |  |  | $ | 0.91    | 

All of the Companys recorded goodwill is
associated with its retail segment. The changes in the carrying
amount of goodwill for Fiscal 2004 and 2003 are as follows (in
thousands):

|                            |                                       |   |        |       |  
|--------------------------- | ------------------------------------- | - | ------ | ----- | -
|Balance as of June 29, 2002 |                                       | $ | 18,016 |      
|                            | Goodwill acquired during the period   |   |        | 1,156 |  
|                            | Goodwill impairment during the period |   |        | (558  | )
|                            |                                       |   |        |      
|Balance as of June 28, 2003 |                                       |   | 18,614 |      
|                            | Activity in Fiscal 2004               |   |        |      |  
|                            |                                       |   |        |      
|Balance as of July 3, 2004  |                                       | $ | 18,614 |      
|                            |                                       |   |        |      

F-12



---



##### Table of Contents



PARTY CITY CORPORATION AND
SUBSIDIARY


NOTES TO CONSOLIDATED FINANCIAL
STATEMENTS  (Continued)



|   |                     
|-- | --------------------
|3. | Other Current Assets

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

|                                          |  |         |        |          |  |   |        |  
|----------------------------------------- |  | ------- | ------ | -------- |  | - | ------ | -
|                                          |  | July 3, |        | June 28,
|                                          |  | 2004    |        | 2003    
|                                          |  |         |        |         
|Deferred taxes                            |  | $       | 9,298  |          |  | $ | 7,428  |  
|Prepaid expenses and other current assets |  |         | 3,984  |          |  |   | 4,764  |  
|Prepaid rent                              |  |         | 3,794  |          |  |   | 4,722  |  
|Receivables from franchisees              |  |         | 2,354  |          |  |   | 2,454  |  
|Restricted cash from Advertising Fund     |  |         | 792    |          |  |   | 1,307  |  
|Advance merchandise payments              |  |         | 595    |          |  |   | 1,513  |  
|                                          |  |         |        |          |  |   |        |  
|                                          |  |         | 20,817 |          |  |   | 22,188 |  
|Less: Allowance for doubtful accounts     |  |         | (148   | )        |  |   | (288   | )
|                                          |  |         |        |          |  |   |        |  
|                                          |  | $       | 20,669 |          |  | $ | 21,900 |  
|                                          |  |         |        |          |  |   |        |  



|   |                       
|-- | ----------------------
|4. | Property and Equipment

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

|                               |  |         |         |          |  |   |         |  
|------------------------------ |  | ------- | ------- | -------- |  | - | ------- | -
|                               |  | July 3, |         | June 28,
|                               |  | 2004    |         | 2003    
|                               |  |         |         |         
|Equipment                      |  | $       | 52,998  |          |  | $ | 48,647  |  
|Furniture                      |  |         | 36,025  |          |  |   | 34,147  |  
|Leasehold improvements         |  |         | 27,558  |          |  |   | 25,426  |  
|                               |  |         |         |          |  |   |         |  
|                               |  |         | 116,581 |          |  |   | 108,220 |  
|Less: accumulated depreciation |  |         | (67,819 | )        |  |   | (55,401 | )
|                               |  |         |         |          |  |   |         |  
|                               |  | $       | 48,762  |          |  | $ | 52,819  |  
|                               |  |         |         |          |  |   |         |  

Depreciation expense of $17.5 million,
$16.1 million and $12.1 million was recorded in Fiscal
2004, 2003 and 2002, respectively, on equipment, furniture and
leasehold improvements.



|   |             
|-- | ------------
|5. | Other Assets

Other assets consist of the following (in
thousands):

|                               |  |         |       |          |  |   |       | 
|------------------------------ |  | ------- | ----- | -------- |  | - | ----- | 
|                               |  | July 3, |       | June 28,
|                               |  | 2004    |       | 2003    
|                               |  |         |       |         
|Deferred income taxes          |  | $       | 1,960 |          |  | $ | 2,779 | 
|Securities deposits            |  |         | 1,557 |          |  |   | 1,660 | 
|Non-compete agreement          |  |         | 362   |          |  |   | 493   | 
|Loan commitment fees and other |  |         | 291   |          |  |   | 454   | 
|                               |  |         |       |          |  |   |       | 
|                               |  | $       | 4,170 |          |  | $ | 5,386 | 
|                               |  |         |       |          |  |   |       | 

F-13



---



##### Table of Contents



PARTY CITY CORPORATION AND
SUBSIDIARY


NOTES TO CONSOLIDATED FINANCIAL
STATEMENTS  (Continued)



|   |                                                   
|-- | --------------------------------------------------
|6. | Accrued Expenses and Other Current
    Liabilities

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

|                                        |  |         |        |          |  |   |        | 
|--------------------------------------- |  | ------- | ------ | -------- |  | - | ------ | 
|                                        |  | July 3, |        | June 28,
|                                        |  | 2004    |        | 2003    
|                                        |  |         |        |         
|Accrued compensation                    |  | $       | 7,812  |          |  | $ | 5,649  | 
|Accrued legal settlement and legal fees |  |         | 5,980  |          |  |   | 1,823  | 
|Accrued insurance                       |  |         | 4,529  |          |  |   | 3,500  | 
|Sales and use taxes                     |  |         | 1,929  |          |  |   | 1,749  | 
|Other                                   |  |         | 12,439 |          |  |   | 12,277 | 
|                                        |  |         |        |          |  |   |        | 
|                                        |  | $       | 32,689 |          |  | $ | 24,998 | 
|                                        |  |         |        |          |  |   |        | 



|   |                     
|-- | --------------------
|7. | Financing Agreements

In January 2003, the Company entered into a
$65 million revolving credit facility (Loan
Agreement) with Wells Fargo Retail Finance, LLC, as the
arranger, collateral agent and administrative agent, and Fleet
Retail Finance, Inc., as the documentation agent. Under the
terms of the Loan Agreement, the Company may borrow amounts
based on a percentage of its eligible inventory and credit card
receivables, subject to certain borrowing conditions and
customary sub-limits, reserves and other limitations. Interest
on each advance is charged, at the Companys option,
(i) at the adjusted Eurodollar rate per annum, plus the
applicable margin which is currently 1.25% or (ii) at the
prime rate per annum, less the applicable margin which is
currently 0.25% (totaling 4.00% at July 3, 2004). The term
of the Loan Agreement is through April 30, 2006 and is
secured by a lien on substantially all of the Companys
assets. Pursuant to the terms of the Loan Agreement, the Company
has a standby letter of credit of $3.7 million outstanding
at July 3, 2004. At July 3, 2004 and June 28,
2003, the Company had $0 and $11.2 million in borrowings
outstanding under the Loan Agreement, respectively.

In August, 1999, we received $30 million in
financing from certain investors (the Investors),
who purchased senior secured notes and warrants pursuant to a
Securities Purchase Agreement. Pursuant to the First Amendment,
on January 14, 2000, we received an additional
$7 million in cash proceeds from the sale to certain of the
Investors of a new series of senior secured notes.

In consideration for waivers and forbearances
granted by the Investors to various defaults under the terms of
our various classes of senior secured notes, we agreed to amend
and restate the terms of the warrants acquired by the Investors
in August 1999. The amended and restated 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.

We repaid $10.2 million and
$19.3 million of the senior secured notes in Fiscal 2003
and 2002, respectively, and repaid the remaining amounts in
previous fiscal years. The Fiscal 2003 repurchase resulted in an
additional payment of $1.4 million, comprised of interest
and an incentive premium, and resulted in an after-tax charge of
$1.3 million, or $0.07 per diluted share.

F-14



---



##### Table of Contents



PARTY CITY CORPORATION AND
SUBSIDIARY


NOTES TO CONSOLIDATED FINANCIAL
STATEMENTS  (Continued)



|   |                   
|-- | ------------------
|8. | Earnings Per Share

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

|                                                                                      |  |            |         |          |  |          |         |  |  |   |         | 
|------------------------------------------------------------------------------------- |  | ---------- | ------- | -------- |  | -------- | ------- |  |  | - | ------- | 
|                                                                                      |  |           
|                                                                                      |  | Year Ended
|                                                                                      |  |           
|                                                                                      |  | July 3,    |         | June 28, |  | June 29,
|                                                                                      |  | 2004       |         | 2003     |  | 2002    
|                                                                                      |  |            |         |          |  |         
|Net income                                                                            |  | $          | 13,906  |          |  | $        | 12,092  |  |  | $ | 17,192  | 
|Earnings per share  basic                                                            |  | $          | 0.82    |          |  | $        | 0.73    |  |  | $ | 1.32    | 
|Earnings per share  diluted                                                          |  | $          | 0.71    |          |  | $        | 0.62    |  |  | $ | 0.89    | 
|Weighted average common shares outstanding                                            |  |            | 16,880  |          |  |          | 16,602  |  |  |   | 13,068  | 
|Dilutive effect of stock options                                                      |  |            | 460     |          |  |          | 637     |  |  |   | 650     | 
|Dilutive effect of warrants                                                           |  |            | 2,293   |          |  |          | 2,323   |  |  |   | 5,531   | 
|Restricted stock units                                                                |  |            | 18      |          |  |          | 84      |  |  |   | 64      | 
|                                                                                      |  |            |         |          |  |          |         |  |  |   |         | 
|Weighted average common shares and potentially
    dilutive common shares outstanding |  |            | 19,651  |          |  |          | 19,646  |  |  |   | 19,313  | 
|                                                                                      |  |            |         |          |  |          |         |  |  |   |         | 
|Options excluded from dilutive calculation                                            |  |            | 744,123 |          |  |          | 686,285 |  |  |   | 260,555 | 
|                                                                                      |  |            |         |          |  |          |         |  |  |   |         | 

Options to purchase common shares at prices
ranging from $13.42 to $32.50 per share were outstanding
but were not included in the computation of dilutive earnings
per share because to do so would have been anti-dilutive for the
periods presented.



|   |                                           
|-- | ------------------------------------------
|9. | Stockholders Equity and Stock
    Options

Shares
Outstanding

The Companys authorized capital stock at
July 3, 2004 and June 28, 2003 was
40,000,000 shares and 25,000,000 shares of its common
stock, respectively, $0.01 par value per share. At
July 3, 2004 and June 28, 2003 there were
17,835,778 shares and 17,296,807 shares, respectively,
of the Companys common stock issued. At July 3, 2004
and June 28, 2003, there were 747,012 shares of the
Companys common stock held as treasury stock. At
July 3, 2004 and June 28, 2003, there were
17,088,766 shares and 16,549,795 shares, respectively,
of the Companys common stock outstanding.

Stock
Repurchase

In September 2001, the Board of Directors
authorized the Company to repurchase up to $15 million of
its outstanding common stock. The stock repurchases are made at
the discretion of management. During Fiscal 2002, the Company
repurchased 284,000 shares for an aggregate amount of
$1.8 million, or 12.2% of the total amount authorized to be
purchased. During Fiscal 2003, the Company repurchased
463,012 shares for an aggregate amount of $4.1 million
or 27.4% of the total amount authorized to be purchased. There
were no shares purchased in Fiscal 2004 under the stock
repurchase plan. As of July 3, 2004, the Company had
purchased 747,012 shares for an aggregate amount of
$5.9 million or 39.6% of the total amount authorized to be
purchased.

Warrants

In Fiscal 2003, 688,000 warrants to purchase the
Companys common stock were exercised. This included an
exercise of 458,667 warrants for which proceeds of $490,774 were
received and a cashless exercise of the remaining 229,333
warrants, in which the warrant holders received
213,792 shares of common stock. The remaining
15,541 shares were surrendered in connection with this
exercise. These 15,541 shares of the

F-15



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##### Table of Contents



PARTY CITY CORPORATION AND
SUBSIDIARY


NOTES TO CONSOLIDATED FINANCIAL
STATEMENTS  (Continued)

Companys common stock had a market value of
$245,386 at the time of surrender. There was no warrant activity
during Fiscal 2004. Warrants to purchase 2,496,000 common
shares at $1.07 per share were outstanding at July 3,
2004 and are currently exercisable.

Stock
Options

On October 19, 1999, the Companys
Board of Directors adopted the Companys 1999 Stock
Incentive Plan (1999 Plan). This adoption was
approved by the Companys stockholders on November 15,
1999. A total of 500,000 shares of the Companys
common stock were reserved for issuance under the 1999 Plan.

On October 5, 2000, the Board approved an
amendment and restatement of the 1999 Plan, increasing the
number of shares of common stock reserved for issuance
thereunder from 500,000 to 2,000,000. This adoption was approved
by the Companys stockholders on November 15, 2000. On
October 17, 2003, the Board approved an amendment and
restatement of the 1999 Plan, increasing the number of shares of
common stock reserved for issuance under the Plan from 2,000,000
to 7,500,000, and increasing the limit on the number of shares
of the Companys common stock which may be subject to
options or stock appreciation rights granted to a single
participant in any given year from 400,000 to 750,000. This
adoption was approved by the shareholders on November 12,
2003. A total of 7,500,000 are reserved for issuance under the
1999 Plan. There have been 3,313,217 options issued of which
337,243 have been exercised and 2,642,512 are outstanding. There
have been cancellations of 333,462 options, therefore there are
4,520,245 options remaining to issue.

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
the 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 may 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 may 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 to seven
years from date of grant, and expire in ten years.

The Company also maintains the Amended and
Restated 1994 Stock Option Plan (1994 Plan) pursuant
to which options were granted to employees, directors and
consultants for the purchase of common stock of the Company. The
1994 Plan, as amended, permitted the Company to grant incentive
and non-qualified stock options to purchase a total of up to
1,800,000 shares of the Companys common stock at an
exercise price not less than fair value at date of grant. No
additional grants of options under the 1994 Plan are permitted.
There were 2,330,875 options issued of which 749,576 have been
exercised, 1,201,637 have been cancelled and 379,662 remain
outstanding. The original terms of the agreements between the
Company and the individuals receiving the grants under the 1994
Plan with respect to vesting, expiration and exercise price
remain unchanged.

During June 2001, the Company established a
Management Stock Purchase Plan (MSPP). The MSPP is
designed to provide a means by which the Company may attract
highly qualified persons to enter into and remain in the
employment of the Company. In addition, the MSPP provides a
means whereby employees of the Company can defer a portion of
their compensation to be used to acquire and maintain ownership
of the Companys common stock, thereby strengthening their
commitment to the welfare of the Company and promoting an
identity of interest among Company stockholders and these
employees. The amount deferred by the individual is held in
restricted stock units. These restricted stock units are
purchased at a discount of 20%

F-16



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##### Table of Contents



PARTY CITY CORPORATION AND
SUBSIDIARY


NOTES TO CONSOLIDATED FINANCIAL
STATEMENTS  (Continued)

or 25% depending on the amount of the individual
deferral from the average price of Companys common stock
on the determination date. Such discounts vest at the end of
three years or seven years, selected by the participant, after
the determination date. The amortization of the discount is
charged to compensation expense over the three-year period or
seven year period. The compensation expense attributable to the
MSPP for Fiscal 2004, 2003 and 2002, was $22,000, $188,000 and
$33,000, respectively.

In June 2001, the Company established an Employee
Stock Purchase Plan (ESPP). The ESPP provides
employees of the Company with an opportunity to purchase shares
of the Companys common stock at a discount of
15% through accumulated payroll deductions. This plan
qualifies as an Employee Stock Purchase Plan under
Section 423 of the Code. Contributions to the plan during
Fiscal 2004 and 2003 were $490,000 and $593,000, resulting in
the obligation to issue 51,029 and 62,234 shares of common
stock, respectively. At the end of Fiscal 2004, the
Companys obligation to employees in the ESPP is
approximately $247,000.

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

|                         |  |           |           |          |  |   |       | 
|------------------------ |  | --------- | --------- | -------- |  | - | ----- | 
|                         |  |           |           | Weighted
|                         |  |           |           | Average 
|                         |  | Number of |           | Exercise
|                         |  | Shares    |           | Price   
|                         |  |           |           |         
|Balance at June 30, 2001 |  |           | 1,651,376 |          |  | $ | 6.29  | 
|Granted                  |  |           | 591,750   |          |  |   | 8.03  | 
|Exercised                |  |           | (134,002  | )        |  |   | 4.82  | 
|Canceled                 |  |           | (104,248  | )        |  |   | 10.72 | 
|                         |  |           |           |          |  |   |       | 
|Balance at June 29, 2002 |  |           | 2,004,876 |          |  |   | 6.59  | 
|Granted                  |  |           | 638,000   |          |  |   | 14.85 | 
|Exercised                |  |           | (212,486  | )        |  |   | 5.28  | 
|Canceled                 |  |           | (208,901  | )        |  |   | 9.71  | 
|                         |  |           |           |          |  |   |       | 
|Balance at June 28, 2003 |  |           | 2,221,489 |          |  |   | 8.78  | 
|Granted                  |  |           | 1,447,217 |          |  |   | 12.90 | 
|Exercised                |  |           | (471,033  | )        |  |   | 3.96  | 
|Canceled                 |  |           | (175,499  | )        |  |   | 11.21 | 
|                         |  |           |           |          |  |   |       | 
|Balance at July 3, 2004  |  |           | 3,022,174 |          |  | $ | 11.36 | 
|                         |  |           |           |          |  |   |       | 
|Options Exercisable at:  |  |           |           |          |  |   |       | 
|June 29, 2002            |  |           | 1,076,631 |          |  |   | 7.41  | 
|June 28, 2003            |  |           | 1,399,241 |          |  |   | 7.94  | 
|July 3, 2004             |  |           | 1,485,978 |          |  |   | 10.42 | 

F-17



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##### Table of Contents



PARTY CITY CORPORATION AND
SUBSIDIARY


NOTES TO CONSOLIDATED FINANCIAL
STATEMENTS  (Continued)

|                         |  |                     |           |                     |  |          |      |             |  |          |       |  |  |  |           |  |  |   |       | 
|------------------------ |  | ------------------- | --------- | ------------------- |  | -------- | ---- | ----------- |  | -------- | ----- |  |  |  | --------- |  |  | - | ----- | 
|                         |  |                     |           |                    
|                         |  | Options Outstanding |           | Options Exercisable
|                         |  |                     |           |                    
|                         |  |                     |           | Weighted            |  |          |      |            
|                         |  | Number              |           | Average             |  | Weighted |      | Number      |  | Weighted
|                         |  | Outstanding         |           | Remaining           |  | Average  |      | Exercisable |  | Average 
|                         |  | at July 3,          |           | Contractual         |  | Exercise |      | at July 3,  |  | Exercise
|Range of Exercise Prices |  | 2004                |           | Life                |  | Price    |      | 2004        |  | Price   
|                         |  |                     |           |                     |  |          |      |             |  |         
|$ 1.71 to $ 7.38         |  |                     | 609,385   |                     |  |          | 6.27 |             |  | $        | 4.44  |  |  |  | 498,977   |  |  | $ | 3.72  | 
|$ 7.39 to $12.16         |  |                     | 684,593   |                     |  |          | 7.60 |             |  |          | 10.63 |  |  |  | 302,209   |  |  |   | 9.86  | 
|$12.17 to $12.34         |  |                     | 792,000   |                     |  |          | 8.30 |             |  |          | 12.34 |  |  |  | 170,500   |  |  |   | 12.33 | 
|$12.35 to $16.41         |  |                     | 605,938   |                     |  |          | 7.96 |             |  |          | 14.40 |  |  |  | 310,042   |  |  |   | 14.23 | 
|$16.42 to $32.50         |  |                     | 330,258   |                     |  |          | 8.23 |             |  |          | 17.77 |  |  |  | 204,250   |  |  |   | 18.24 | 
|                         |  |                     |           |                     |  |          |      |             |  |          |       |  |  |  |           |  |  |   |       | 
|                         |  |                     | 3,022,174 |                     |  |          | 7.66 |             |  | $        | 11.36 |  |  |  | 1,485,978 |  |  | $ | 10.42 | 
|                         |  |                     |           |                     |  |          |      |             |  |          |       |  |  |  |           |  |  |   |       | 



|    |             
|--- | ------------
|10. | Income Taxes

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

|          |         |            |        |          |   |          |        |        |   |   |        |       |  
|--------- | ------- | ---------- | ------ | -------- | - | -------- | ------ | ------ | - | - | ------ | ----- | -
|          |         |           
|          |         | Year Ended
|          |         |           
|          |         | July 3,    |        | June 28, |   | June 29,
|          |         | 2004       |        | 2003     |   | 2002    
|          |         |            |        |          |   |         
|Current:  |         |            |        |          |   |          |        |        |   |   |        |      
|          | Federal |            | $      | 8,163    |   |          | $      | 8,036  |   |   | $      | 7,760 |  
|          | State   |            |        | 2,108    |   |          |        | 1,925  |   |   |        | 2,673 |  
|          | Foreign |            |        | 246      |   |          |        | 232    |   |   |        | 251   |  
|          |         |            |        |          |   |          |        |        |   |   |        |      
|          |         |            | 10,517 |          |   |          | 10,193 |        |   |   | 10,684 |      
|Deferred: |         |            |        |          |   |          |        |        |   |   |        |      
|          | Federal |            |        | (854     | ) |          |        | (1,730 | ) |   |        | 1,329 |  
|          | State   |            |        | (197     | ) |          |        | (401   | ) |   |        | (510  | )
|          |         |            |        |          |   |          |        |        |   |   |        |      
|          |         |            | (1,051 | )        |   |          | (2,131 | )      |   |   | 819    |      
|          |         |            |        |          |   |          |        |        |   |   |        |      
|          |         | $          | 9,466  |          |   | $        | 8,062  |        |   | $ | 11,503 |      
|          |         |            |        |          |   |          |        |        |   |   |        |      

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.

F-18



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##### Table of Contents



PARTY CITY CORPORATION AND
SUBSIDIARY


NOTES TO CONSOLIDATED FINANCIAL
STATEMENTS  (Continued)

Significant components of the net deferred tax
asset at July 3, 2004 and June 28, 2003 are as follows
(in thousands):

|             |                                   |                                |   |          |       |  |   |        |       | 
|------------ | --------------------------------- | ------------------------------ | - | -------- | ----- |  | - | ------ | ----- | 
|             |                                   | July 3,                        |   | June 28,
|             |                                   | 2004                           |   | 2003    
|             |                                   |                                |   |         
|Current:     |                                   |                                |   |          |       |  |   |       
|             | Inventory                         |                                | $ | 5,216    |       |  | $ | 6,484  |      
|             | Vacation pay accrual              |                                |   | 810      |       |  |   | 467    |      
|             | Reserves not currently deductible |                                |   | 1,046    |       |  |   | 1,030  |      
|             | Bonus accrual                     |                                |   | 32       |       |  |   | 94     |      
|             | Litigation accrual                |                                |   | 2,194    |       |  |   |       |      
|             | Deferred state taxes              |                                |   |         |       |  |   | (647   | )    
|             |                                   |                                |   |          |       |  |   |       
|             |                                   | Net current deferred tax asset |   | $        | 9,298 |  |   | $      | 7,428 | 
|             |                                   |                                |   |          |       |  |   |       
|Non-current: |                                   |                                |   |          |       |  |   |       
|             | Deferred rent                     |                                | $ | 3,686    |       |  | $ | 4,188  |      
|             | Start-up costs                    |                                |   | (303     | )     |  |   | (456   | )    
|             | Property and equipment            |                                |   | 198      |       |  |   | (1,394 | )    
|             | Amortization of goodwill          |                                |   | (2,287   | )     |  |   | (1,470 | )    
|             | Other liabilities                 |                                |   | 667      |       |  |   | 1,911  |      
|             |                                   |                                |   |          |       |  |   |       
|             |                                   | Non-current deferred tax asset |   | $        | 1,961 |  |   | $      | 2,779 | 
|             |                                   |                                |   |          |       |  |   |       

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

|                                                         |  |            |      |          |  |          |      |   |  |  |      |  
|-------------------------------------------------------- |  | ---------- | ---- | -------- |  | -------- | ---- | - |  |  | ---- | -
|                                                         |  |           
|                                                         |  | Year Ended
|                                                         |  |           
|                                                         |  | July 3,    |      | June 28, |  | June 29,
|                                                         |  | 2004       |      | 2003     |  | 2002    
|                                                         |  |            |      |          |  |         
|Federal statutory rate                                   |  |            | 35.0 | %        |  |          | 35.0 | % |  |  | 35.0 | %
|State income taxes net of Federal income tax
    benefit |  |            | 5.3  |          |  |          | 4.9  |   |  |  | 4.9  |  
|Other                                                    |  |            | 0.2  |          |  |          | 0.1  |   |  |  | 0.2  |  
|                                                         |  |            |      |          |  |          |      |   |  |  |      |  
|Effective tax rate                                       |  |            | 40.5 | %        |  |          | 40.0 | % |  |  | 40.1 | %
|                                                         |  |            |      |          |  |          |      |   |  |  |      |  



|    |                       
|--- | ----------------------
|11. | Employee Benefit Plans

The Company has a defined contribution 401(k)
savings plan (the 401(k) Plan) covering all eligible
employees. Participants may defer between 1% and 15% of annual
pre-tax compensation subject to statutory limitations. The
Company contributes an amount as determined by the Board of
Directors. Such amount has been established as 50% of the first
4% of the employees contribution up to $1,000.

For the fiscal years ended July 3, 2004,
June 28, 2003 and June 29, 2002, matching
contributions of $321,000, $301,000, and $309,000, respectively,
were made by the Company under the 401(k) Plan.



|    |                           
|--- | --------------------------
|12. | Related Party Transactions

In June 1999, Steven Mandell, the former
president of the Company and a major stockholder granted an
option to acquire 1,000,000 shares of the
shareholders common stock to Jack Futterman, then the
Companys chief executive officer and a member of the Board
of Directors. The option vested immediately and has an

F-19



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##### Table of Contents



PARTY CITY CORPORATION AND
SUBSIDIARY


NOTES TO CONSOLIDATED FINANCIAL
STATEMENTS  (Continued)

exercise price of $3.00 a share, the fair value
of the common stock at date of grant. The option was exercised
in Fiscal 2004 prior to its expiration date of June 2004.

On August 16, 1999, Special Value Bond
Fund II, LLC, (SVBF II) purchased
$10.0 million in aggregate principal amount of the
Companys 12.5% Secured Notes due 2003 (the A
Notes) and $5.0 million in aggregate principal amount
of the Companys 13.0% Secured Notes due 2003 (the
B Notes). Subsequently on November 20,
2000, SVBF II sold $5.0 million in aggregate principal
amount of the A Notes and $2.5 million in aggregate
principal amount of the B Notes to other Company investors.
In addition, on August 16, 1999, Tennenbaum & Co.,
LLC (TCO) purchased $2,250,000 in aggregate
principal amount of the Companys 13.0% Secured Notes due
2002, $4.5 million in aggregate principal amount of the
Companys 14.0% Secured Notes due 2004 and Warrants to
purchase 3,096,000 shares of the Companys stock.
TCO then transferred all of these Secured Notes and the Warrants
to Special Value Bond Fund, LLC (SVBF) effective as
of September 1, 1999. Then on January 14, 2000, SVBF
purchased $3,250,000 in aggregate principal amount of the
Companys 14.0% Secured Notes due 2002. The managing member
of SVBF II is SVIM/ MSM II, LLC (SVIM/
MSM II) and the managing member of SVIM/ MSM II
is TCO. The managing member of SVBF is SVIM/ MSM, LLC
(SVIM/ MSM) and the managing member of SVIM/ MSM is
TCO. The managing member of TCO is Michael E. Tennenbaum, the
Companys Vice Chairman of the Board of Directors. During
Fiscal 2003 and Fiscal 2002, Secured Notes totaling
$3.9 million and $9.3 million were repaid,
respectively. For the fiscal years ended June 28, 2003 and
June 29, 2002, the Company paid $1.0 million and
$2.3 million of interest related to these Notes,
respectively.

On November 2, 1999, Ralph Dillon, the
Companys non-executive chairman of the board of directors,
purchased $167,000 in aggregate principal amount of the
Companys 13.0% Secured Notes due 2002, $333,000 in
aggregate principal amount 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. During Fiscal 2003 and Fiscal 2002, the Secured Notes
totaling $333,000 and $167,000 were repaid, respectively. In
Fiscal 2003 and Fiscal 2002, the Company paid $78,000 and
$80,000 of interest related to these Notes, respectively.

On June 22, 2001, the Company granted
options for 90,000 shares of the Companys common
stock to Ralph Dillon as compensation for his services to the
Company. These options were granted at $6.25 per share and
vested upon issuance. In addition, on each of January 12,
2002, July 12, 2002 and January 12, 2003 additional
grants of options for 50,000 shares of the Companys
common stock were made to Mr. Dillon, which options had an
exercise price of $9.38, $17.00 and $17.00, respectively. An
additional grant of 50,000 options for shares were made to
Mr. Dillon on July 12, 2004 with an exercise price of
$17.00. All of these options vest upon issuance. Compensation
expensed was recorded for all grants. Compensation expense
included in the statement of income for Fiscal 2004, 2003 and
2002 was $101,000, $154,000 and $430,000, respectively.



|    |                                                  
|--- | -------------------------------------------------
|13. | Lease Commitments and Contractual
    Obligations

The Company leases real estate in connection with
the operation of Company-owned retail stores as well as its
corporate office. The store leases are for properties ranging in
size from 6,750 to 19,800 square feet. The terms range from
five years to twenty years. Of the leases for the Company-owned
stores, three expire in Fiscal 2005, twenty-one expire in Fiscal
2006, thirty expire in Fiscal 2007 and the balance expire in
Fiscal 2008 or thereafter. The leases contain escalation
clauses, renewal options from five years to ten years and
obligations for reimbursement of common area maintenance and
real estate taxes. Certain leases contain contingent rent based
upon specified sales volume. The Company paid $14,000 and
$26,000 for contingent rent for Fiscal 2004 and 2003,
respectively. There was no contingent rent in Fiscal 2002.

Logistics initiative obligations include a
commitment for selected equipment and services associated with
the operation of the distribution centers.

At July 3, 2004, the Company leased
thirty-eight motor vehicles, primarily for its district managers
and regional management. The terms are for 36 months and
expire through December 2007.

F-20



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##### Table of Contents



PARTY CITY CORPORATION AND
SUBSIDIARY


NOTES TO CONSOLIDATED FINANCIAL
STATEMENTS  (Continued)

Future minimum lease payments under outstanding
leases at July 3, 2004, are as follows (in thousands):

|                             |  |       |         |           |  |             |         |             |  |   |       |  |  |   |     | 
|---------------------------- |  | ----- | ------- | --------- |  | ----------- | ------- | ----------- |  | - | ----- |  |  | - | --- | 
|                             |  |       |         |           |  | Logistics   |         |            
|                             |  |       |         | Operating |  | Initiative  |         |            
|                             |  | Total |         | Leases    |  | Obligations |         | Auto Leases
|                             |  |       |         |           |  |             |         |            
|Fiscal year ending:          |  |       |         |           |  |             |         |             |  |   |       |  |  |   |     | 
|2005                         |  | $     | 81,987  |           |  | $           | 79,389  |             |  | $ | 2,500 |  |  | $ | 98  | 
|2006                         |  |       | 45,256  |           |  |             | 42,666  |             |  |   | 2,500 |  |  |   | 90  | 
|2007                         |  |       | 37,941  |           |  |             | 35,324  |             |  |   | 2,500 |  |  |   | 117 | 
|2008                         |  |       | 24,295  |           |  |             | 24,279  |             |  |   |      |  |  |   | 16  | 
|2009                         |  |       | 23,450  |           |  |             | 23,450  |             |  |   |      |  |  |   |    | 
|Thereafter                   |  |       | 30,202  |           |  |             | 30,202  |             |  |   |      |  |  |   |    | 
|                             |  |       |         |           |  |             |         |             |  |   |       |  |  |   |     | 
|Total minimum lease payments |  | $     | 243,131 |           |  | $           | 235,310 |             |  | $ | 7,500 |  |  | $ | 321 | 
|                             |  |       |         |           |  |             |         |             |  |   |       |  |  |   |     | 

Our rent expense under operating leases provides
for step rent provisions, escalation clauses, capital
improvement funding and other lease concessions as applicable in
each lease. The minimum lease payments are recognized on a
straight-line basis over the term of each individual underlying
lease.

Rent expense for all operating leases was
$46.4 million, $43.4 million and $35.9 million
for the fiscal years ended July 3, 2004, June 28, 2003
and June 29, 2002, respectively.

The Company is obligated for guarantees,
subleases or assigned lease obligations for 23 of its
franchisees through 2011. The majority of the guarantees were
given when the Company sold stores in 1999 as part of its
restructuring. The guarantees continue until the leases expire.
The maximum amount of the guarantees may vary, but is limited to
the sum of the total amount due under the lease. As of
July 3, 2004, the maximum amount of the guarantees was
approximately $16.1 million.

As of July 3, 2004, we had a contingent
liability related to severance payments to 15 employees which
ranged from zero to approximately $2.1 million. As of
August 30, 2004, we had a liability related to severance
payments for one employee for up to approximately $120,000 and a
contingent liability related to severance payment to 14
employees which ranged from zero to approximately
$2.0 million. As of July 3, 2004 and August 30,
2004, we had a standby letter of credit of $3.7 million
pursuant to the Loan Agreement. This standby letter of credit
relates to general liability and workers compensation insurance.

We enter into arrangements to purchase
merchandise up to eight months in advance of expected delivery.
These purchase orders do not contain any significant termination
payments or other penalties if cancelled.



|    |                                    
|--- | -----------------------------------
|14. | Other Commitments and Contingencies



| |                  
| | -----------------
| | Legal Proceedings

A lawsuit was filed on September 25, 2001
against Party City Corporation in Los Angeles Superior Court by
an assistant manager in one of the Companys California
stores for himself and on behalf of other members of an alleged
class of Party City store managers (the Class) who
claim the Company misclassified the Class members as exempt from
California overtime wage and hour laws. The Class members sought
the disgorgement of overtime wages allegedly owed by the Company
to them but not paid and they also sought punitive damages and
statutory penalties.

On March 30, 2004, the parties reached an
agreement-in-principle to settle this lawsuit for
$5.5 million on a claims made basis, which
means that a payout to class members will only occur when claims
are actually made by Class members. Previously, the Company
recorded a pre-tax charge of $1.4 million related to this
lawsuit. In connection with the agreement-in-principle, the
Company recorded an additional pre-tax charge of
$4.1 million during the third quarter of Fiscal 2004 to
fully cover the settlement payments, attorneys

F-21



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##### Table of Contents



PARTY CITY CORPORATION AND
SUBSIDIARY


NOTES TO CONSOLIDATED FINANCIAL
STATEMENTS  (Continued)

fees and the estimated expenses of administering
the settlement. The settlement provided for pursuant to the
agreement-in-principle is subject to certain conditions,
including the negotiation and execution of a definitive
settlement agreement and the approval of the terms of the
definitive settlement agreement by the Superior Court after
notice to the members of the class who have the right to object.
There can be no assurance that all of these conditions will be
satisfied. If a final settlement is not consummated and the
lawsuit is continued, a class is certified, liability is found
and a judgment is entered, such judgment may adversely affect
the Company.

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



|    |                    
|--- | -------------------
|15. | Segment Information

The Company owns, operates and franchises party
supplies stores in the United States. 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 imposition of an initial one-time franchise fee and
ongoing royalty payments based on retail sales. The accounting
policies are described in the summary of significant accounting
policies. The Company has no intersegment sales. No single
customer accounts for 10% or more of total revenues. All assets
of the Company are located in the United States, including
Puerto Rico.

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##### Table of Contents



PARTY CITY CORPORATION AND
SUBSIDIARY


NOTES TO CONSOLIDATED FINANCIAL
STATEMENTS  (Continued)

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

|                                         |  |                                 |         |          |  |          |         |  |  |   |         | 
|---------------------------------------- |  | ------------------------------- | ------- | -------- |  | -------- | ------- |  |  | - | ------- | 
|                                         |  |                                
|                                         |  | Year Ended                     
|                                         |  |                                
|                                         |  | July 3,                         |         | June 28, |  | June 29,
|                                         |  | 2004                            |         | 2003     |  | 2002    
|                                         |  |                                 |         |          |  |         
|                                         |  |                                
|                                         |  | (In thousands, except per share
|Retail:                                  |  |                                 |         |          |  |          |         |  |  |   |         | 
|Net sales                                |  | $                               | 496,138 |          |  | $        | 464,258 |  |  | $ | 405,821 | 
|Cost of goods sold and occupancy costs   |  |                                 | 332,311 |          |  |          | 311,170 |  |  |   | 263,980 | 
|                                         |  |                                 |         |          |  |          |         |  |  |   |         | 
|Gross profit                             |  |                                 | 163,827 |          |  |          | 153,088 |  |  |   | 141,841 | 
|Store operating and selling expense      |  |                                 | 113,292 |          |  |          | 108,294 |  |  |   | 91,576  | 
|                                         |  |                                 |         |          |  |          |         |  |  |   |         | 
|Company-owned stores profit contribution |  |                                 | 50,535  |          |  |          | 44,794  |  |  |   | 50,265  | 
|General and administrative expense       |  |                                 | 39,637  |          |  |          | 32,475  |  |  |   | 27,086  | 
|                                         |  |                                 |         |          |  |          |         |  |  |   |         | 
|Retail profit contribution               |  | $                               | 10,898  |          |  | $        | 12,319  |  |  | $ | 23,179  | 
|                                         |  |                                 |         |          |  |          |         |  |  |   |         | 
|Identifiable assets                      |  | $                               | 175,211 |          |  | $        | 165,833 |  |  | $ | 147,277 | 
|Depreciation/amortization                |  | $                               | 17,601  |          |  | $        | 16,229  |  |  | $ | 12,156  | 
|Capital expenditures                     |  | $                               | 13,484  |          |  | $        | 22,234  |  |  | $ | 14,085  | 
|Franchise:                               |  |                                 |         |          |  |          |         |  |  |   |         | 
|Royalty fees                             |  | $                               | 19,521  |          |  | $        | 18,007  |  |  | $ | 17,048  | 
|Franchise fees                           |  |                                 | 608     |          |  |          | 355     |  |  |   | 641     | 
|                                         |  |                                 |         |          |  |          |         |  |  |   |         | 
|Total franchise revenues                 |  |                                 | 20,129  |          |  |          | 18,362  |  |  |   | 17,689  | 
|Total franchise expense                  |  |                                 | 7,184   |          |  |          | 6,538   |  |  |   | 6,563   | 
|                                         |  |                                 |         |          |  |          |         |  |  |   |         | 
|Franchise profit contribution            |  |                                 | 12,945  |          |  |          | 11,824  |  |  |   | 11,126  | 
|                                         |  |                                 |         |          |  |          |         |  |  |   |         | 
|Identifiable assets                      |  | $                               | 2,206   |          |  | $        | 2,166   |  |  | $ | 1,777   | 
|Depreciation/amortization                |  | $                               |        |          |  | $        |        |  |  | $ |        | 
|Capital expenditures                     |  | $                               |        |          |  | $        |        |  |  | $ |        | 
|Operating income                         |  |                                 | 23,843  |          |  |          | 24,143  |  |  |   | 34,305  | 
|Interest expense, net                    |  |                                 | 471     |          |  |          | 3,990   |  |  |   | 5,610   | 
|                                         |  |                                 |         |          |  |          |         |  |  |   |         | 
|Income before income taxes               |  |                                 | 23,372  |          |  |          | 20,153  |  |  |   | 28,695  | 
|Provision for income taxes               |  |                                 | 9,466   |          |  |          | 8,061   |  |  |   | 11,503  | 
|                                         |  |                                 |         |          |  |          |         |  |  |   |         | 
|Net income                               |  | $                               | 13,906  |          |  | $        | 12,092  |  |  | $ | 17,192  | 
|                                         |  |                                 |         |          |  |          |         |  |  |   |         | 

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##### Table of Contents



PARTY CITY CORPORATION AND
SUBSIDIARY


NOTES TO CONSOLIDATED FINANCIAL
STATEMENTS  (Continued)



|    |                                                                                     
|--- | ------------------------------------------------------------------------------------
|16. | Selected Quarterly Information (Unaudited) (in
    thousands, except per share data)

|                                       |  |               |         |          |  |       |         |      |  |   |         |   |  |   |         | 
|-------------------------------------- |  | ------------- | ------- | -------- |  | ----- | ------- | ---- |  | - | ------- | - |  | - | ------- | 
|                                       |  |              
|                                       |  | Quarter Ended
|                                       |  |              
|                                       |  | September     |         | December |  | March |         | June
|                                       |  |               |         |          |  |       |         |     
|Year Ended July 3, 2004                |  |               |         |          |  |       |         |      |  |   |         |   |  |   |         | 
|Total revenues                         |  | $             | 106,975 |          |  | $     | 182,559 |      |  | $ | 101,549 |   |  | $ | 125,184 | 
|Cost of goods sold and occupancy costs |  |               | 74,328  |          |  |       | 104,705 |      |  |   | 71,432  |   |  |   | 81,846  | 
|Net (loss) income                      |  |               | (1,950  | )        |  |       | 19,290  |      |  |   | (5,561  | ) |  |   | 2,127   | 
|Basic (loss) earnings per share        |  |               | (0.12   | )        |  |       | 1.14    |      |  |   | (0.33   | ) |  |   | 0.12    | 
|Diluted (loss) earnings per share      |  |               | (0.12   | )        |  |       | 0.98    |      |  |   | (0.33   | ) |  |   | 0.11    | 
|Year Ended June 28, 2003               |  |               |         |          |  |       |         |      |  |   |         |   |  |   |         | 
|Total revenues                         |  | $             | 95,006  |          |  | $     | 168,191 |      |  | $ | 99,533  |   |  | $ | 119,890 | 
|Cost of goods sold and occupancy costs |  |               | 64,425  |          |  |       | 95,974  |      |  |   | 70,164  |   |  |   | 80,607  | 
|Net (loss) income                      |  |               | (1,736  | )        |  |       | 15,050  |      |  |   | (1,808  | ) |  |   | 586     | 
|Basic (loss) earnings per share        |  | $             | (0.11   | )        |  | $     | 0.90    |      |  | $ | (0.11   | ) |  | $ | 0.04    | 
|Diluted (loss) earnings per share      |  |               | (0.11   | )        |  |       | 0.76    |      |  |   | (0.11   | ) |  |   | 0.03    | 

The per share amounts are calculated
independently for each quarter. The sum of the quarters may not
equal the full year per share amounts.

F-24



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##### Table of Contents



PARTY CITY CORPORATION

SCHEDULE II

VALUATION AND QUALIFYING ACCOUNTS

|                                 |  |           |     |                 |  |            |        |         |  |   |         |   |  |   |     | 
|-------------------------------- |  | --------- | --- | --------------- |  | ---------- | ------ | ------- |  | - | ------- | - |  | - | --- | 
|                                 |  | Balance   |     | Amounts         |  | Write-offs |        | Balance
|                                 |  | Beginning |     | Charged to Cost |  | Against    |        | End of 
|                                 |  | of Year   |     | and Expenses    |  | Reserve    |        | Year   
|                                 |  |           |     |                 |  |            |        |        
|                                 |  |           |     |                 |  |           
|                                 |  |           |     | (In thousands)  |  |           
|Allowance for Doubtful Accounts: |  |           |     |                 |  |            |        |         |  |   |         |   |  |   |     | 
|Year Ended July 3, 2004          |  | $         | 287 |                 |  | $          | (117   | )       |  | $ | (22     | ) |  | $ | 148 | 
|Year Ended June 28, 2003         |  |           | 785 |                 |  |            | 50     |         |  |   | (548    | ) |  |   | 287 | 
|Year Ended June 29, 2002         |  |           | 852 |                 |  |            | 366    |         |  |   | (433    | ) |  |   | 785 | 
|Reserve for Returns:             |  |           |     |                 |  |            |        |         |  |   |         |   |  |   |     | 
|Year Ended July 3, 2004          |  | $         | 673 |                 |  | $          | 17,365 |         |  | $ | (17,404 | ) |  | $ | 634 | 
|Year Ended June 28, 2003         |  |           | 547 |                 |  |            | 16,249 |         |  |   | (16,123 | ) |  |   | 673 | 
|Year Ended June 29, 2002         |  |           | 253 |                 |  |            | 14,204 |         |  |   | (13,910 | ) |  |   | 547 | 

F-25