<PAGE>
 
================================================================================
                      SECURITIES AND EXCHANGE COMMISSION
                            WASHINGTON, D.C. 20549

                                   FORM 10-K

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

                    For the fiscal year ended June 30, 1998
OR
[_]  TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES
     EXCHANGE ACT OF 1934

                        Commission file number  0-22558

                          IWERKS ENTERTAINMENT, INC.
            (EXACT NAME OF REGISTRANT AS SPECIFIED IN ITS CHARTER)

           Delaware                                       95-4439361
(STATE OR OTHER JURISDICTION                (I.R.S. EMPLOYER IDENTIFICATION NO.)
OF INCORPORATION  OR ORGANIZATION)                           
                                           
                           4540 West Valerio Street
                        Burbank, California  91505-1046
             (ADDRESS OF PRINCIPAL EXECUTIVE OFFICES AND ZIP CODE)
                                (818) 841-7766
             (REGISTRANT'S TELEPHONE NUMBER, INCLUDING AREA CODE)

          SECURITIES REGISTERED PURSUANT TO SECTION 12(b) OF THE ACT:
                                     None
          SECURITIES REGISTERED PURSUANT TO SECTION 12(g) OF THE ACT:
                    Common stock, $.001 par value per share
                        Preferred Stock Purchase Rights
                               (Title of Class)

Indicate by check mark whether the registrant: (1) has filed all reports
required to be filed by Section 13 or 15(d) of the Securities Exchange Act of
1934 during the preceding 12 months (or for such shorter period that the
registrant was required to file such reports), and (2) has been subject to such
filing requirements for the past 90 days.
Yes  X    No ___
    ---
Indicate by check mark if disclosure of delinquent filers pursuant to Item 405
of Regulation S-K is not contained herein, and will not be contained, to the
best of Registrant's knowledge, in definitive proxy or information statements
incorporated by reference in Part III of this 10-K or any Amendment to this Form
10-K.  [_]

At September 18, 1998,  there were outstanding, 12,348,307 shares of the Common
Stock of Registrant, and the aggregate market value of the shares held on that
date by non-affiliates of Registrant, based on the closing price ($1.375 per
share) of the Registrant's Common Stock on the NASDAQ National Market System was
$14,841,266.  For purposes of this computation, it has been assumed that the
shares beneficially held by directors and executive officers of Registrant were
"held by affiliates;"  this assumption is not to be deemed to be an admission by
such persons that they are affiliates of Registrant.

                      DOCUMENTS INCORPORATED BY REFERENCE
Portions of Registrant's Proxy Statement relating to its 1998 Annual Meeting of
Stockholders are incorporated by reference in Part III of this Annual Report.

                                       1
<PAGE>
 
                          IWERKS ENTERTAINMENT, INC.

                   FISCAL YEAR 1998 FORM 10-K ANNUAL REPORT

                               TABLE OF CONTENTS
<TABLE>
<CAPTION>
                                                                                                            Page
                                                                                                            ----

PART I.
<S>                                                                                                         <C>
Item 1.   Business..........................................................................................  3

Item 2.   Properties........................................................................................  12

Item 3.   Legal Proceedings.................................................................................  12

Item 4.   Submission of Matter to a Vote of Security Holders................................................  12


PART II.

Item 5.   Market for Registrant's Common Equity and Related Stockholder Matters.............................  13

Item 6.   Selected Financial Data...........................................................................  14

Item 7.   Management's Discussion and Analysis of Financial Condition and Results of
          Operations........................................................................................  15

Item 8.   Financial Statements and Supplementary Data.......................................................  30

Item 9.   Changes and Disagreements with Accountants on Accounting and Financial
          Disclosure........................................................................................  49


PART III.

Item 10.  Directors and Executive Officers of Registrant....................................................  49

Item 11.  Executive Compensation............................................................................  49

Item 12.  Security Ownership of Certain Beneficial Owners and Management....................................  49

Item 13.  Certain Relationships and Related Transactions....................................................  49

Item 14.  Exhibits, Financial Statement Schedules, and Reports on Form 8-K..................................  50
</TABLE>

                                       2
<PAGE>
 
SPECIAL NOTE REGARDING FORWARD-LOOKING INFORMATION

       This Report contains statements that constitute "forward-looking
statements" within the meaning of Section 21E of the Exchange Act and Section
27A of the Securities Act. The words "expect", "estimate", "anticipate",
"predict", "believe" and similar expressions and variations thereof are intended
to identify forward-looking statements. Such statements appear in a number of
places in this filing and include statements regarding the intent, belief or
current expectations of Iwerks, its directors or officers with respect to, among
other things (a) trends affecting the financial condition or results of
operations of Iwerks and (b) the business and growth strategies of Iwerks. The
stockholders of Iwerks are cautioned not to put undue reliance on such forward
looking statements. Such forward-looking statements are not guarantees of future
performance and involve risks and uncertainties, and that actual results may
differ materially from those projected in this Report, for the reasons, among
others, discussed in the Sections - "Management's Discussion and Analysis of
Financial Condition and Results of Operations", and "Factors that may Affect
Future Results". Iwerks undertakes no obligation to publicly revise these
forward looking statements to reflect events or circumstances that arise after
the date hereof. Readers should carefully review the risk factors described in
other documents the Company files from time to time with the Securities and
Exchange Commission, including the Quarterly Reports on Form 10-Q to be filed by
the Company in calendar years 1998 and 1999 and any Current Reports on Form 8-K
filed by the Company.

                                    PART 1

                              BUSINESS OF IWERKS

ITEM 1.  BUSINESS.
----------------- 

GENERAL

       Iwerks Entertainment, Inc. and its subsidiaries ("Iwerks" or "the
Company") is a leading full service provider of high-tech software-based theatre
attractions for the out-of-home entertainment market and film-based software in
large format, ride simulation and specialty venue attractions.  The Company's
products combine advanced theatre systems with entertainment or educational
software to create high-impact "attractions" which immerse audiences in the
action.  The Company's products include ride simulation, giant screen, 3-D
custom film and video theatres, and various other specialty attractions.  In
addition, the Company owns and operates a fleet of 16 touring ride simulation
theatres.  The Company also produces film and video software for ride simulators
and special format theatres, and rents large format cameras and related
equipment as well as provides certain post production services to large format
filmmakers.

       Further, an important element of the Company's business strategy is the
participation in the operation of its fixed-base attractions either through
direct equity ownership or through other participation arrangements.  The
Company is currently a participant in several joint ventures to own and operate
multiple ride simulation theatres in the United States and Australia. The
Company continues to evaluate new opportunities to participate in the operation
of its fixed-based attractions.

       The primary markets for the Company's attractions are theme parks,
museums, movie theatres, various types of location-based-entertainment centers,
visitor centers and special events.  The popularity 

                                       3
<PAGE>
 
of entertainment attractions of the type sold by the Company has led to their
increasing use as the featured attraction in these locations. In addition, high-
profile retail sites and casinos are expanding their entertainment offerings to
broaden appeal, extend the visitors stay, and stimulate repeat visits. The
Company's attractions are well suited to meet this demand because, in addition
to their drawing power, they require relatively little space and can be easily
refreshed by changing the film or other software.

       Since inception in 1986 through September 18, 1998, the Company has
installed more than 250 fixed-base theatres and touring attractions in 28
countries. Of these, 119 were ride simulation theatres, which the Company
supports with a library of 41 ride simulation films, the industry's largest ride
simulation film library. The Company's ride simulation film projects include:
Escape from Dino Island, a 3D sequel to its highly successful Dino Island; Super
Speedway, a thrill ride through seven North American race tracks hosted by Craig
T. Nelson; Superstition, a haunted scream park adventure hosted by Elvira,
Mistress of the Dark; Secrets of the Lost Temple, an explorer's adventure
through a Mayan temple; Red Rock Run, a computer generated high speed ride
through a volcano; Aliens: Ride at the Speed of Fright, based on the futuristic
movie thriller of the same name; Dino Island, a fantasy based on a newly
discovered volcanic island with prehistoric reptiles; Days of Thunder: The Ride,
featuring a "200 mph race" to the checkered flag at the Daytona 500, for
Paramount Parks and RoboCop: The Ride, a futuristic fantasy ride through the
streets of Detroit with the popular movie character, "RoboCop". Fiscal 1999
releases will include Journey Through the Center of the Earth, a 3D ride to the
center of the earth and back, and Kid Koster, a roller coaster ride through a
child's room, along with other film projects to which the Company has not yet
committed. The Company has the largest installed base of film ride simulation
theatres and the largest library of ride simulation films in the world.

       The Company is a Delaware corporation with principal executive offices
located at 4540 West Valerio Street, Burbank, California 91505, telephone number
(818) 841-7766.  In addition to its principal executive offices, Iwerks has
sales offices in Sarasota, Florida and London, England.  A sales representative
maintains offices in Hong Kong and Shanghai.

BUSINESS STRATEGY

       The Company believes that there is an increasing worldwide consumer
demand for a variety of out-of-home entertainment options.  The Company's goal
is to capitalize on its position as a leader in the ride simulation attraction
business to become the leading full-service provider, not just of its hardware
systems, but also of a full range of support services and film-based software in
the ride simulation, large format and specialty venue attractions.

       The Company's current strategies to achieve its objectives include the
following:

       FULL SERVICE PROVIDER OF COMPLETE ENTERTAINMENT BUSINESS SOLUTIONS.  The
Company intends to expand its market penetration by offering its customers a
complete line of services and products to support the design, development and
operation of specialty format theater attractions.  The Company has installed
over 250 specialty format theater attractions and currently licenses film
software to over 75 installed simulation theaters.  The Company believes that
this track record of successes positions itself as a leader in terms  of
industry experience and operating expertise in the specialty format theater
market.  By focusing its services and products on solutions designed to assist
its customers in building their business, the Company believes that it will
continue to expand its own business opportunities in the 

                                       4
<PAGE>
 
future.

       EXTEND THE COMPANY'S PRODUCT LINE THROUGH INNOVATIVE USE OF ITS CURRENT
TECHNOLOGIES.  Management believes that the Company has the opportunity of
increasing its product offerings without incurring significant additional
research and development costs.  Management believes there are opportunities to
leverage the Company's existing technology to provide new, innovative products
designed to meet current market requirements.  The Company also intends to
continue to explore alliances with other companies with the objective of
developing joint incremental sales prospects taking advantage of each partner's
expertise and technological and market strengths.

       EXPAND INTO NEW MARKETS.  The Company is exploring potential new markets
for its attractions products and services.  The Company continues its expansion
efforts in South America and Europe.  In addition, the Company is exploring
market opportunities for its giant screen theaters in commercial locations, such
as movie theater multiplexes, and its ride simulation theaters in untapped
commercial settings including casinos and retail businesses.

       IDENTIFY NEW STRATEGIC PARTNERS.  Management believes that the Company
can optimize its market position and performance through the formation of
strategic alliances with companies who have complementary technologies,
manufacturing or distribution.  Management is pursuing an aggressive agenda of
forming strategic partnerships to accelerate the accomplishment of the Company's
priorities in these areas.

       OTHER.  Charles Goldwater, Chief Executive Officer of the Company, joined
the Company at the end of  February 1998.  Two of the Company's other four
senior executive officers, Jack Shishido, Senior Vice President of Worldwide
Sales and Marketing, and Dan Griesmer, Senior Vice President and General
Manager, joined the Company in June 1998 and March 1998, respectively.  The
Company and its new management team continue to examine and refine its strategic
and operating strategies. In June 1998 the Company engaged Schroder & Co. Inc.
to assist in seeking long-term strategic partners, identifying financing
opportunities for core activities such as film production, and for possible
joint ventures, and accelerating the Company's aggressive expansion in the
large-format arena.

IWERKS PRODUCTS

       FIXED-BASE RIDE SIMULATION THEATRES.  The Company's line of fixed-base
ride simulators is marketed as Iwerks TurboRide and combines high-resolution
projector film or video software, digital surround sound and moving seats to
fully involve the audience in a realistic, simulated experience.  Software
currently available includes a variety of live action and fantasy experiences
such as being chased by dinosaurs, flying at supersonic speeds, racing with Indy
cars, riding a roller coaster, white-water rafting and space and underwater
adventures.  The Company's ride simulation theatre product line is the broadest
in the industry, enabling the Company to offer its customers seat, row and
platform-based simulators in a variety of configurations and at multiple price
points. The Company derived approximately 44%, 41% and 21% of its revenues from
the sale of fixed-base ride simulation theatres in fiscal 1996, 1997 and 1998,
respectively.  The Company's ride simulators are designed to operate in theatres
which typically seat 18 to 100 people, and feature screens up to 52 feet high,
with six-channel surround sound.  In these rides, guests watch a high resolution
film with a fast action point-of-view perspective while sitting in seats that
move in synchronization with the action on the screen.  Films for the Company's
ride simulation theatres typically range between three and five minutes.  The

                                       5
<PAGE>
 
Iwerks TurboRide can be reprogrammed to create new adventures.

       PORTABLE RIDE SIMULATION THEATRES. The Company also has developed a
portable ride simulation theatre called the "Reactor", which is transported by
tractor trailers.  The trailers transform to create a theatre with a high
definition video projection system and digital surround sound.  The simulation
theatres have on-board generators which enable them to operate independent of
other power sources.  The Reactor incorporates the same ride simulation
technology as the Company's TurboRide and can accommodate up to 18 people per
show.  The Reactors can be used to exhibit the Company's ride simulation films
developed for its fixed-base ride simulation theatres as well as films developed
specifically for use in the Reactor at air shows, boat and car races, state
fairs and other special events. The Company also seeks corporate sponsors for
its touring Reactor units.  The Company derived approximately 20%, 17% and 22%
of its revenues in fiscal 1996, 1997 and 1998, respectively, from the operation
and sponsorship of portable ride simulation theatres.

       GIANT SCREEN THEATRES.  The Company's giant screen theatres are marketed
under the name Iwerks CineDome and Iwerks Theatres, and feature screens which
are much larger than standard movie screens and projection systems that  deliver
a sharper, brighter image than conventional movies.  The result is a high-
impact, immersive, sensory experience for the audience.  These theatres seat up
to 475 people, have steeply raked seating and exhibit films typically lasting
between 15 and 40 minutes.  The Company offers both 15/70 (15 perforations, 70
millimeter film) and 8/70 (8 perforations, 70 millimeter film) format systems
including its exclusive patented Linear Loop projectors.

       The Company's  giant screen theatres are available in a variety of
configurations.  Its flat screen theatres use screens as large as 81 feet high
by 110 feet wide, more than five times the size of  most movie theatre screens.
The Company's domed screen theatres use a dome-shaped screen up to 85 feet in
diameter which wraps around and above the audience filling the audience's field
of vision. The Company also offers 3D systems which use dual projectors to
create a 3D image. The Company derived approximately 9%, 12% and 8% of its
revenues from the sale of giant screen  theatres in fiscal 1996, 1997 and 1998,
respectively.

       CUSTOM AND OTHER THEATRES.  The Company offers a wide range of custom
film and video-based theatre systems utilizing 70 millimeter and 35 millimeter
film formats.  Among its offerings is the Iwerks Video 360 Theater, a video
based cylindrical theater incorporating a show control system allowing the
operator to make real time modifications to the projected image.  The Company's
custom projects range from the sale of individual projectors to complete
theatre systems.  The Company derived approximately 3%, 5% and 11% of its
revenues from the sale of custom and other theatres in fiscal 1996, 1997 and
1998, respectively.

       FILM SOFTWARE.  The Company produces film and video software for the
Company's attractions with a production strategy that is similar to that of a
movie studio, where a small core of executives hire supplemental production
talent and specialists on a project-by-project basis. This structure allows the
Company to maintain creative control of projects without incurring substantial,
continuing overhead expenses.   In addition, the Company has acquired
distribution rights for ride simulation films purchased or owned by others.  The
Company also provides executive producer and postproduction services to third
parties filming in the Company's film or video projection formats.

       The Company has a film library which includes, as of September 18, 1998,
the distribution rights to
                                       6
<PAGE>
 
41 ride simulation films, 4 giant screen films and 8 3D films. The Company's
library of ride simulation films is the largest in the industry. In addition to
the Iwerks' film library, owners of Iwerks' giant screen theatres have access to
a library of over 100 films which are generally available in the marketplace.
The Company believes that the quality and size of its film library is a
significant competitive advantage in the markets in which it competes,
particularly in the ride simulation market. Growth in the installed base of
theatres provides the Company an opportunity to increase film licensing revenue.
The Company derived approximately 11%, 14 % and 22% of its revenue in fiscal
1996, 1997 and 1998, respectively, from film license agreements.

       The Company's recent ride simulation films include Escape from Dino
Island, a 3D sequel to its highly successful film Dino Island;  Super Speedway,
a thrill ride through seven North American race tracks hosted by Craig T.
Nelson; Superstition,  a haunted scream park adventure hosted by Elvira -
Mistress of the Dark; Mad Racers, Iwerks first ride simulation 3D film; Secrets
of the Lost Temple, based on an explorer's adventure through a Mayan temple;
Aliens Ride at the Speed of Fright, based on the futuristic movie thriller of
the same name; Dino Island, a fantasy ride through a dinosaur-inhabited island;
Moon Raid Alpha, a space chase adventure fantasy; a film for Time Warner Six
Flags theme parks called The Right Stuff; a film for the Iwerks Reactor called
Fly With The Blue Angels featuring the Blue Angels flight team; a film for
Paramount theme parks based on the motion picture Days of Thunder and a film
based on the motion picture RoboCop. Fiscal 1999 releases will include Journey
to the Center of the Earth, a 3D ride to the center of the earth and back and
Kid Koster, a roller coaster ride through a child's room. The Company continues
to look at additional projects which may increase the number of films released
in fiscal 1999. Many of the Company's ride simulation and other productions have
received industry recognition. For the second year in a row, the Company won the
prestigious Image Award for Best Overall Presentation at the November 1997
International Association of Amusement Parks and Attractions (IAAPA) convention
in Orlando. The dramatic Iwerks TurboRide 3D! took first honors for best New
Entertainment Technology at the November 1996 IAAPA convention in New Orleans.
Secrets of the Lost Temple, premiered at IAAPA 1996, also received an award in
the Best New Product category. Dino Island was rated the best new attraction at
IAAPA convention, 1994.

       The Company also produces and distributes large format and specialty
films to theme parks.  In fiscal 1999, the Company is scheduled to release
"Encounter in the Third Dimension" a large format 3D film based on the history
and technology of 3D effects.  This film will be available in 15/70 and 8/70
formats to the existing network of approximately 40 large format 3D theaters.  A
shortened version of this film will also be available for specialty theater
exhibition.

       Typically, a film produced for exhibition on a theatre system is sold or
licensed to a customer as part of the sale of the theatre system.  When sold,
the customer  pays all or most of the production cost; the Company attempts to
retain limited distribution rights beyond an exclusive exhibition territory
retained by the customer.  When licensed, the Company typically licenses the
film for a one-year period for a flat fee which varies based upon the film.  In
limited cases, the Company  will accept its fees as a percentage of the ticket
sales.  Film rentals vary according to the quality of the film, the initial
price paid for the theatre systems and other factors.

CAMERAS AND OTHER PRODUCTION SERVICES

       The Company owns four 8/70 large format cameras and related equipment,
including lenses and 

                                       7
<PAGE>
 
accessories, which it rents on a short-term basis, generally from several days
to several months.

       In fiscal 1998, the Company contracted with a third party to develop and
manufacture three 15/70 large format cameras, and a 3D rig for both 15/70 and
8/70 cameras,  which are expected to be completed in fiscal 1999.  The Company
intends to rent these cameras to third party film producers.  The Company also
provides technical and post-production services to third party producers for a
fee and maintains a 15/70 projection room at its Burbank facilities for rent to
giant screen film makers for use in the post-production process.


MARKETING AND CUSTOMERS

       The Company distributes its theatre systems, software and services
through multiple distribution channels including a direct sales and marketing
force as well as independent sales representatives in selected areas.  The sales
and marketing staff consists of 19 employees.  A sales representative maintains
foreign sales offices in Hong Kong and Shanghai which provide support to the
Company's Asian marketing programs and assist in customer service.  A satellite
sales office was established in London, England in May 1997 to support the
European and Middle East marketplaces.  In addition, the Company has sales
professionals located in Burbank, California and Sarasota, Florida.   Itochu
Corporation, also a stockholder, has a non-exclusive distribution agreement to
sell the Company's product in Asia.

       The Company markets its attractions, including theatre systems and film
software, mainly to theme parks, museums, movie theaters, visitor centers,
casinos, world expositions, location-based-entertainment centers and special
event venues.  The Company's theatre systems include projection and audio
equipment, show control systems and film handling equipment.  The Company also
provides ride simulation systems; these include motion bases, film projection
and audio equipment, show control and other effects.  The customer supplies its
own theatre space and other necessary site improvements to operate the theatre.
The Company provides installation, training, design, maintenance and other
support services.

       A primary market for the Company's 3D and 2D ride simulation theatres has
been the worldwide amusement and theme park industry.  Continuing sales will
come from previously existing parks looking for new attractions, parks under
development looking for an array of attractions and the expanding location-
based-entertainment industry.  Most new park development is occurring outside of
the United States and management believes that international operators will
continue as important customers for this product.  The Company has also
developed customers in the family entertainment center, movie theater,
institutional and casino markets as well as tourist, vacation, destination
shopping and convention locations for its ride simulation theatres.  The Company
sells its ride simulation theatres at prices which are separately negotiated,
depending upon the product, the number of motion bases, the configuration of the
theatre space, optional components selected and the level of design service
provided.  The Company licenses its ride simulation films for a range of prices
depending on the film and the license term.

       The Company tours its Reactor units at a variety of special events,
primarily air shows, boat and car races, state fairs, trade shows and other
outdoor events.  Revenue is generated through admission tickets of between $3
and $6 per person or through lease of the system to corporate sponsors who may
use the system for promotional campaigns in connection with new product
introductions and other promotional purposes.

                                       8
<PAGE>
 
       The primary markets for the Company's giant screen 2D and 3D theatres
have been museums, visitor destination centers, world expositions and other
institutional exhibition facilities frequented by large numbers of visitors.
Increasingly, commercial movie theatre operators are also viewing giant screen
theatres as a new entertainment option for their guests. The Company sells its
giant screen and custom and video theatres at prices which are separately
negotiated.

       No single customer accounted for more than 10% of revenues in fiscal
1996, 1997 and 1998.

       The Company's sales typically are made pursuant to written contracts, and
are denominated in United States dollars. International hardware sales are
generally backed by letters of credit. Consequently, the Company's operations
have not historically been subject to risks related to currency fluctuations.
During fiscal 1996, 1997 and 1998, 49%, 55% and 46% of the Company's revenues,
respectively, were derived from sales outside the United States. The Company's
sales contracts typically provide for progress payments which are timed to match
related expenditures by the Company. The customer generally has the right to
terminate the contract before completion by paying Iwerks its nonrecoverable
costs plus a termination fee. The Company offers a warranty on sales of its
products, generally for a period of 12 months. The Company believes that its
material contract terms are consistent with industry practices.

ENABLING TECHNOLOGIES

       With limited exceptions, the underlying technologies employed by the
Company are in the public domain and generally available in the marketplace.
However, the Company possesses substantial expertise in the design, modification
and engineering of projection, film-handling, camera and audio technologies
which it believes to be an important competitive factor.

       IMAGING SYSTEMS.    The Company offers a variety of technologically
advanced imaging systems.
 
       Iwerks Quatro is a projection system designed to offer small ride
simulation venues high-clarity film quality in locations which were previously
limited to video systems.  The Iwerks Quatro houses four ride simulation films
on one reel. Two 35mm frames are placed side by side on the 70mm film with two
films operating in the forward direction and two in the reverse direction.  This
eliminates the need for a film storage system while providing fast cycle times.
All claims have been allowed on the Company's patent application on certain
features of the Quatro projection system and the Quatro is now a patented
proprietary projection technology.

       The Company's  8/70 is an eight perforation, 70-millimeter film system
that operates at 30 frames per second.  By comparison, most motion picture
theatres use four perforation, 35-millimeter film that runs at 24 frames per
second and standard 70-millimeter film is five perforation which also runs at 24
frames per second.  The larger frame size and faster speed gives the Company's
8/70 a brighter and sharper image without the flicker and stroboscopic effects
common with conventional 35- and 70-millimeter film systems.  The Company's
8/70 is used in the Company's array of ride simulation systems and destination
theatres common to museums and visitor centers where screen sizes smaller than
60' high and 80' wide or dome screens of 75' or less in diameter are suitable.

       The Company's 15/70 is a fifteen perforation, 70-millimeter rolling loop
projection system 

                                       9
<PAGE>
 
which handles the largest commercially available film size. This system projects
an image area more than nine times that of conventional 35-millimeter film and
300% larger than standard 70-millimeter film. The Company's 15/70 is capable of
achieving screen sizes up to 81' high and 110' wide and dome screens up to 85'
in diameter that are generally found in high capacity theatres at world
expositions and larger museums and visitor centers. Iwerks 8/70 and 15/70 are
used in the Iwerks Dome and Giant Screen Theatres.
 
       In fiscal 1997, the Company acquired Pioneer Technology Corporation and
the proprietary Linear-Loop Projection ("LLP") Technology to offer the expanding
giant screen market a genuine alternative to existing projection techniques.
The LLP gently pushes film through the projector on a column of air unlike most
projection systems that use levers to pull film through.  The LLP is designed to
produce an image that is brighter and more stable than other projectors
available.

       The Company offers high resolution digital video imaging systems that
utilize a laser disc source and produce a high quality video image.  This
imaging system is ideal for Iwerks Reactors and small ride simulation theatre
systems.  In the Iwerks Video 360  theatre, the video imaging and show control
systems allow real-time manipulation of the projected image to allow a variety
of special effects.

       MOTION BASES.  The Company's  ride simulation theatres utilize seat-based
ride simulation technologies with per-base capacities ranging from two to eight.
The Turbo Tour is a compact and highly responsive three-axis system, allowing a
multitude of combinations of pitch (tilt from front to rear), vertical (move up
and down) and roll (tilt from side to side) movements, which keep passengers in
constant motion with the image.  Each motion base is a self-contained system,
requiring only electronic communications and electrical power connections. The
Transporter is a two- and four-seat, six-axis motion base capable of producing
the most realistic ride simulation available.  These six-axis systems permit
pitch, roll, vertical, sway, yaw (a turning motion), and surge (forward and
back), all the motions available within a given motion envelope.  Iwerks is
developing an electro-magnetic 8-seat six-axis motion base offering the same
quality as the Transporter with greater seat capacity.

       FILM STORAGE.  The Company's  film-based systems are offered with
specially designed film loop cabinets.  These cabinets allow the film to be
spliced into an endless loop, more fully automating the projection system and
providing the fastest possible recycle time for maximum theatre throughput.  The
loop cabinet also includes other important features:  the film is housed in a
dust-free humidity-controlled environment; the film is cleaned twice on each
trip through the system so that dust picked up during projection doesn't
accumulate; and the film picture area never rubs on itself or any other surface,
eliminating degradation common on reel to reel and platter systems.

MANUFACTURING

       The Company manufactures and assembles its theatre systems at its
facilities in Burbank, California.  A majority of the components for these
theatre systems are purchased from outside vendors.  The Company's manufacturing
operations consist of assembly, testing, quality control and system integration
of its theatre system components, subassemblies and final assemblies, including
modifications and the programming of the show-control and motion-control
components, and installation of the completed theatre systems.
 
       The Company is the exclusive distributor of 15/70-format giant screen
projection systems, manufactured by Cinema Technologies, Inc.. This distribution
agreement expires in September, 2003.

                                       10
<PAGE>
 
In order to maintain its exclusive rights under the agreement, Iwerks is
required to meet certain minimum purchase and other requirements. As of the date
of this report, Iwerks had satisfied all such requirements.
 
       The Company's manufacturing operations utilize a wide variety of
electrical and mechanical components, raw materials and other supplies and
services.  The Company has developed multiple commercial sources for most
components and materials, but it does use single sources for a limited number of
standard and custom components.  While delays in delivery of such single source
components could cause delay in shipments of certain products by Iwerks, at this
time, the Company has no reason to believe that any of the single-source vendors
present a serious risk.  Consistent with industry practice, the Company
generally purchases components of its theatre systems upon receipt of an order.
Certain components used by Iwerks, including lenses, hydraulic power sources and
motion bases must be ordered up to four months in advance to assure timely
delivery.  The Company maintains an inventory of these items as it deems
appropriate to service  forecasted demand.  Research and development costs are
incurred in the design, construction and testing of prototype systems and are
charged to expense as incurred.  The research and development expenses were
$358,000, $726,000 and $766,000 for the years ended June 30, 1996, 1997 and
1998, respectively.  Of the expenses, 32%, 23% and 66% in 1996, 1997 and 1998,
respectively, were for improvements to existing products and the remainder was
for development of new products.   

       In fiscal 1997, the Company acquired the technology and patents to
produce the Linear Loop Projector ("LLP") which is a new technology in film
handling and projection.  The Company utilizes LLP not only in its Giant Screen
Theatres, but also as its projector of choice in larger ride simulation
installations.  Since the acquisition of this technology in 1997, the Company
has continued to make modifications and enhancements to the LLP and has not
begun to produce the projectors in large quantity. The LLP is not an upgrade or
rework of existing vendored products.  The technology is unique, patented and
has a distinctive advantage compared to "geneva" driven models that preceded it.
The Company is exploring with several vendors the possibility of the vendor
manufacturing and distributing the projector for a royalty payment.

       The Company acquires certain other projectors from third party suppliers.
The Company makes modifications to the projectors to fit the Company's  use.
Lenses and lamphouses incorporated in the projection systems are supplied to the
Company by third parties.
 
       The Company and Vickers Incorporated, a manufacturer of hydraulic
components, jointly developed the hydraulically actuated seats which are used in
the Turbo Tour ride simulation theatre.  Under the agreement pursuant to which
the hydraulically actuated seats were developed,  the Company owns all rights in
and to the seats.  Vickers continues as the sole manufacturer of these motion
bases on behalf of the Company; however, the Company has the right under its
agreement with Vickers to secure alternate sources of manufacturing at any time.
The Company also purchases other products from Vickers.


EMPLOYEES

       At September 18, 1998, the Company employed 123  persons, of whom 31 were
employed in management, finance and administration, 19 were employed in sales
and marketing, and 73 were 

                                       11
<PAGE>
 
employed in operations (including 38 employees working in the field on the
Company's touring units). None of the Company's employees are represented by a
collective bargaining agreement. The Company believes that its relations with
its employees are satisfactory.


ITEM 2. PROPERTIES.
-------------------

       The Company maintains its principal facility in Burbank, California where
it leases space under four separate leases on adjacent facilities consisting of
36,000, 23,460, 7,596 and 5,184  square feet each, expiring between September
30, 1999 and September 30, 2001.  The Company leases the space for an aggregate
lease payment of approximately $42,400 per month.  The Company believes that its
current facilities are adequate to meet its needs for the immediate future;
however is evaluating the possibility of a facility reduction in light of its
efforts to reduce ongoing costs.


ITEM 3.  LEGAL PROCEEDINGS.
---------------------------

       The Company is a party to various other actions arising in the ordinary
course of business which, in the opinion of management, will not have a material
adverse impact on the Company's financial condition; however, there can be no
assurance that the Company will not become a party to other lawsuits in the
future, and such lawsuits could potentially have a material adverse effect on
the Company's financial condition and results of operations.


ITEM 4.  SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS.
-------------------------------------------------------------

       During the last quarter of the Registrant's fiscal year ended June 30,
1998, no matter was submitted to a vote of the security holders of the
Registrant.

                                       12
<PAGE>
 
                                    PART II

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

       The Company's  Common Stock is listed for quotation on The NASDAQ
National Market.  The table below sets forth, for the calendar quarters
indicated, the high and low closing sales prices per share as reported on The
NASDAQ National Market for the Iwerks Common Stock.
<TABLE>
<CAPTION>

                                            High        Low
                                           -------   ---------
<S>                                        <C>       <C>
Year Ended June 30, 1997
-------------------------------------
First Quarter                              $10 3/8   $ 6 3/8
Second Quarter                               7 1/4     4 5/8
Third Quarter                                6         4 1/4
Fourth Quarter                               5 1/4     3 11/16
 
Year Ended June 30, 1998
-------------------------------------
First Quarter                              $ 5 5/8   $ 3 1/2
Second Quarter                               4 3/8     2 1/4
Third Quarter                                3 1/4     2 1/4
Fourth Quarter                               3 5/16    1 5/6
 
Year Ended June 30, 1999
-------------------------------------
First Quarter  (through September 18,      $ 2 5/8   $ 1 1/4
 1998)
</TABLE>

       As of September 18, 1998, Iwerks had approximately 953 holders of record.
No dividends have been declared or paid since incorporation. Iwerks currently
intends to retain earnings for use in its business and does not anticipate
paying any cash dividends on its common stock in the foreseeable future.

                                       13
<PAGE>
 








<TABLE> 
<CAPTION> 

ITEM 6. SELECTED FINANCIAL DATA
-------------------------------

                                                                                    Fiscal Year Ended June 30,
                                                              ---------------------------------------------------------------
                                                                1994(1)         1995          1996        1997(2)     1998(3)
                                                              ----------    ----------    ----------    ---------   ---------
                                                                          (in Thousands Except Per Share Information)

OPERATIONS:
<S>                                                           <C>            <C>           <C>          <C>           <C>  
Total revenue                                                 $ 36,625       $ 44,975      $ 48,516     $ 39,584      $ 25,073
Income (loss) from operations                                   (8,522)       (13,893)        2,464      (10,573)      (12,132)
Net income (loss)                                             $ (8,055)      $(13,473)     $  3,099     $ (9,956)     $(11,560)

Net income (loss) per share - basic                           $  (1.05)      $  (1.32)     $   0.28     $  (0.84)     $  (0.95)
Net income (loss) per share - diluted                         $  (1.05)      $  (1.32)     $   0.26     $  (0.84)     $  (0.95)
Weighted average shares outstanding -
  basic                                                          7,666         10,210        10,945        11,855       12,212
Weighted average shares outstanding -
  diluted                                                        7,666         10,210        12,144        11,855       12,212

FINANCIAL POSITION (AT PERIOD END):
Cash, cash equivalents and short-term
  investments                                                 $ 26,526       $ 20,586      $ 25,281     $  19,067      $10,464

Total assets                                                    81,235         71,626        72,926        64,529       50,803

Capital lease obligations and long-term
  debt                                                           3,349          2,130         2,732         1,827        1,082

Stockholders' equity                                            62,335         50,374        56,665        48,386       36,834

Total liabilities and stockholders' equity                     $81,235       $ 71,626      $ 72,926     $  64,529     $ 50,803

PER SHARE DATA (AT END OF PERIOD):
Net book value per common share                                $  6.25       $   4.76      $   4.89     $   3.97       $  2.98
Common shares outstanding                                        9,968         10,592        11,588       12,160        12,345
</TABLE>

(1)  Selected financial data includes Omni Films International, Inc. since the
     acquisition date of May 18, 1994.

(2)  Net loss for 1997 includes the write down of $5.6 million ($0.47 loss per
     share) for the asset impairment of long lived assets for the portable
     ride simulation business and other fixed assets.

(3)  Net loss for 1998 includes approximately $1.6 million of severance costs
     associated with a company-wide layoff and termination of certain officers,
     and an additional $1.6 million for merger related costs associated with the
     failed merger.


                                      14
<PAGE>
 
ITEM 7.  MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND
------------------------------------------------------------------------
RESULTS OF OPERATIONS
--------------------- 

GENERAL
-------

     The Company is engaged in the business of designing, engineering,
manufacturing, marketing and servicing specialty theatre systems which employ a
variety of projection, show control, ride simulation and software technologies.
The Company is currently in the business of: (a) selling and installing ride
simulation attractions in specialty theatres, (b) selling and installing giant
screen theatres (generally such theatres require projection technology which
utilizes film sizes ranging between five perforations per frame by 70
millimeters (5/70) and fifteen perforations per frame by 70 millimeter (15/70)),
(c) licensing and distributing the films in its library to ride simulation
theatres, (d) producing films in the 5/70, 8/70 and 15/70 film format for its
film library as well as producing films in these formats for third parties, (e)
investing in joint ventures by contributing its ride simulation technology,
design and equipment and participating in the theatre profits, (f) operating a
fleet of 16 mobile ride simulation attractions which it owns and (g) renting
facilities, cameras and related equipment to large format film makers. The
selling and installation of both ride simulation theatres and large screen
theatres includes providing all or part of the design of such theatres, sale of
the projector screens, show control systems, motion simulators and sound
systems.

     The Company's operating results in fiscal 1997 through fiscal 1998 have
been adversely impacted by several trends and other developments.  Revenues
attributable to sales in Asia declined from $17.3 million in fiscal 1996
(representing 35.7% of the Company's revenues) to $5.7 million in fiscal 1998
(representing 22.6% of the Company's revenues).  In addition, the Company did
not enter into a new hardware sales contract for delivery in Asia during the
fiscal year 1998.  This decline in revenues primarily resulted from the
continuing impact of the economic downturn and deflationary environment recently
experienced throughout most of the Asia Pacific Region.

     In addition, the Company experienced a significant decline in sponsorship
revenues during this period primarily resulting from the termination of a single
contract with a major telecommunications company (AT&T Corp).  The Company
derived $6.6 million, $3.3 million and $1.4 million of revenues in fiscal 1996,
1997 and 1998, respectively, from sponsorship of its fleet of touring motion
simulators.  Sponsorship revenues prior to January 1996 were primarily derived
from the Company's advertising contract with AT&T Corp, which had sponsored the
Company's touring motion simulators from March 1994 through September 1996.  The
Company currently has only limited sponsorship contracts and the Company has
been unsuccessful in securing sponsorship arrangements that approach the levels
enjoyed prior to fiscal 1997.  In fiscal 1997, the Company sold one touring unit
and continues to explore other strategic alternatives for the touring
operations.

     Results were also impacted by certain one-time charges.  In the fourth
quarter of fiscal 1997, the Company took approximately $8.4 million in charges,
including a loss on impairment of assets, legal and dispute reserves, additional
film amortization expense and an increase in bad debt reserve.  In  fiscal 1998
results were adversely impacted by nonrecurring expenses related to a proposed
merger between Iwerks and Showscan which did not receive the required
shareholder vote in March 1998.  In addition, in light of reduced revenues and
earnings in fiscal 1997 and 1998, during fiscal 1998, Iwerks reduced its
workforce by approximately 10 percent in order to more closely align staffing
levels with expected revenues going forward. In an unrelated event, effective
February 23,

                                       15
<PAGE>
 
1998, Charles Goldwater was appointed Chairman of the Board, Chief Executive
Officer and President succeeding Roy A. Wright. 


RESULTS OF OPERATIONS
---------------------

     The Company derives its revenues primarily from three sources: sales of
hardware systems, owned and operated (primarily portable simulation theatres),
and licensing of films.   To a lesser extent, revenues are also earned from
service to existing theatre owners, rental of facilities and camera equipment
and production of films for third parties.

Revenues for the fiscal year ended June 30, 1996, 1997 and 1998 are analyzed in
the following table (in thousands):

<TABLE>
<CAPTION>

 
                                                   Fiscal Year Ended June 30
                                        ------------------------------------------------

                                          1996      %      1997      %      1998      %
                                        -------   ----   -------   ----   -------   ----

        <S>                             <C>       <C>    <C>       <C>    <C>       <C>
        Hardware sales & service        $27,998    58%   $25,829    65%   $12,132    48%
        Owned and operated               13,469    28%     8,072    20%     6,871    28%
        Film licensing                    4,800    10%     5,358    14%     5,521    22%
        Film production and other         2,249     4%       325     1%       549     2%
                                        -------   ---    -------   ---    -------   ---
                                        $48,516   100%   $39,584   100%   $25,073   100%
                                        =======   ===    =======   ===    =======   ===
</TABLE>
                                                                                
     Revenues on sales of theatre systems are recognized on the percentage-of-
completion method, measured by the ratio of percentage of labor hours incurred
to-date to estimated total labor hours for each fixed-price contract, over the
life of the contract. Accordingly, the timing of shipment schedules as dictated
by the customer can result in variability of quarterly revenues and earnings.
Likewise, the cash received and used for the contract can vary from quarter-to-
quarter with the revenue and cost recognition on the contract. The gross margin
for each contract varies based upon pricing strategies, competitive conditions
and product mix.

     Revenues from owned and operated (O & O) consist of portable ride
simulation theatre revenues derived primarily from ticket sales at state fairs,
air shows, and similar events, as well as revenues derived from fixed site joint
venture revenues which includes Iwerks' contractual share of the sites' revenues
or profits as applicable. Admission revenues from the portable ride simulation
theatres are subject to variability due to the seasonal nature of these events
and are higher during the summer months. In addition, revenues from O&O for
fiscal 1996 and fiscal 1997 were benefited by significant corporate
sponsorships. Sponsorship revenues for the portable theatres are recognized
ratably over the term of the contract. Sponsorship revenues recognized in fiscal
1998 were significantly lower than the fiscal 1996 and 1997 levels.

     The Company typically licenses its film software under one year film
license agreements. Revenues and related expenses are recognized at the
beginning of the license period at which time the customer is billed the license
fee and film is delivered to the customer.

     The Company recognizes revenues and costs associated with the production of
custom films at the 

                                       16
<PAGE>
 
time of completion and acceptance by the customer. Accordingly, the timing of
completion of custom films can result in substantial variability of quarterly
revenues and gross margin. The Company typically realizes a smaller margin from
the sale of custom films in comparison to its theatre system sales.

     A significant portion of the Company's sales are made to customers located
outside of the United States, primarily in Asia, South America, Europe and
Canada. Revenues for the fiscal years ended June 30, 1996, 1997 and 1998
attributable to sales to these areas are summarized in the following table (in
thousands):

<TABLE> 
<CAPTION> 

                                                    1996                           1997                           1998
                                     ---------------------------       -------------------------       ------------------------
                                                    Percentage of                   Percentage of                 Percentage of
                                       Amount       Total Revenue        Amount     Total Revenue       Amount    Total Revenue
                                     ---------     --------------      ---------   -------------       --------   ------------- 
<S>                                  <C>            <C>                <C>           <C>                <C>           <C> 
Asia                                   $17,311           35.7%          $13,682         34.6%           $5,660        22.6%
South America                              972            2.0%            5,375         13.6%            2,493         9.9%
  (including Mexico) 
Europe                                   4,409            9.1%            2,085          5.3%            1,672         6.7%
Canada                                   1,131            2.3%              516          1.3%            1,596         6.4%
                                     ---------      ---------         ---------     --------          --------    -------- 
       Total Export Revenues           $23,823           49.1%          $21,658         54.7%          $11,421        45.6%
                                     =========      =========         =========     ========          ========    ========
</TABLE> 
 
     The Company maintained an office in Hong Kong and in June 1998 closed this
office to affiliate with a sales representative that has offices in Hong Kong
and Shanghai to support sales to Asia. The Company also maintains a satellite
office in London, England to support its European sales. South American sales
are supported out of the Sarasota, Florida office. International operations and
sales may be subject to political and economic risks, including political
instability, currency fluctuations, changes in import/export regulations, tariff
and freight rates. In addition, various forms of protectionist trade legislation
have been proposed in the United States and in certain other countries. Any
resulting change in current tariff structures or other trade and monetary
policies could adversely affect Iwerks' international operations. Political and
economic factors have been identified by the Company with respect to certain
markets in which it competes. There can be no assurance that these factors will
not result in customers of the Company defaulting on payments owed to Iwerks, or
in the reduction of potential purchases of the Company's products. Recent
turmoil in the economies of the countries in Asia have had a material adverse
affect on the Company's revenues and results of operations. Revenues
attributable to sales in Asia declined from $17.3 million for fiscal 1996
(representing 35.7% of the Company's revenues) to $5.7 million in fiscal 1998
(representing 22.6% of the Company's revenues). In addition, the Company did not
enter into a new hardware sales contract for delivery in Asia during the fiscal
year ended June 30, 1998. Subsequent to June 30, 1998, however, the Company
finalized two sales contracts totaling $3.4 million with Chinese customers and
an additional two contracts totaling $1.4 million with customers in Japan. If
recent economic problems experienced in Asia, Russia, and Eastern Europe were to
spread to Europe, South America or the United States, it could have a material
adverse affect upon the Company's revenues and results of operations. The
Company is not able to predict to what extent, or for what period, these
economic trends may adversely affect the sales of its products. Typically, sales
outside the United States are denominated in United States dollars and are
backed by bank letters of credit, which reduce the risks related to
international sales.

                                       17
<PAGE>
 
COMPARISON OF YEAR ENDED JUNE 30, 1998 TO YEAR ENDED JUNE 30, 1997
------------------------------------------------------------------

     REVENUES

     Revenue for the fiscal year ended June 30, 1998 decreased $14.5 million or
37% from the fiscal year 1997 revenue. Hardware sales and service decreased by
$13.7 million or 53% from the prior fiscal year. Most severely impacted were
hardware sales in the Asia-Pacific region, which decreased $8.1 million due to
the continued economic downturn in that part of the world. North American and
South American hardware sales declined in 1998 by $6.0 million primarily as a
result of timing of projects. However, North American hardware bookings were
higher in fiscal 1998 as compared to fiscal 1997.
                                                                               
     Owned and operated revenue decreased $1.2 million or 15%, primarily from
the Company's 16 touring ride simulators (Reactors), due primarily to the loss
of a major sponsor (AT&T Corp.) during fiscal year 1997. In addition, there was
one less Reactor in 1998 as it was sold in June of 1997. The loss of AT&T
Corporation accounted for $1.4 million in lower revenues, however the general
admission portion of this business increased by $570,000. The Company continues
to actively seek other sponsors as well as other alternatives to increase the
utilization of the 16 Reactors.

     Film licensing revenue increased 3% from fiscal 1997 to fiscal 1998 due
primarily to a net increase in the number of theatres which license films
partially offset by pricing declines. The increase in film production and other
was primarily due to additional revenue generated for theatre and equipment
rentals.

     COST OF SALES

     Cost of sales primarily includes costs of theatre systems sold, expenses
associated with operating portable ride simulation theatres, and costs
associated with film production and licensing fees. The cost of theatre systems
include the cost of components, customization, engineering, project management,
assembly, system integration and installation. Also included in cost of sales
are royalties payable to a former joint venture partner and estimated warranty
expenses. The costs associated with film license fees primarily reflect
amortization of film production costs over the lives of certain films and
royalties paid to third parties. The cost of sales associated with operating
portable ride simulation theatres include costs for personnel, depreciation and
amortization, event fees, fuel, insurance and maintenance.

     Cost of sales as a percentage of sales was 73% and 78% for the fiscal years
ended June 30, 1997 and 1998, respectively. The increase in cost of sales, in
1998 compared with 1997, as a percentage of sales was primarily due to the
absorption of certain fixed overhead charges which did not decrease as revenues
decreased.

     SELLING, GENERAL AND ADMINISTRATIVE EXPENSES

     Selling, general and administrative expenses (SG&A) include personnel
costs, trade shows and other promotional expenses, sales commissions, travel
expenses, public relations costs, amortization of goodwill, professional fees,
research and development costs and divisional administrative costs.

     Selling, general and administrative expenses were $15.4 million and $16.0
million, for the years ended June 30, 1997 and 1998, respectively.

                                       18
<PAGE>
 
     The $600,000 increase in selling, general and administrative expenses
between fiscal 1997 and 1998 was due primarily to a $1.6 million charge for
severance payments made to employees, including the former Chief Executive
Officer and other officers, partially offset by a 10 percent decrease in
employee related expenses. This decrease in employee related expenses was due
primarily to lower overall staffing levels than that of the prior year as a
result of work force reductions made in fiscal 1998.

     MERGER RELATED EXPENSES
                                                                                
     The Company incurred a total of $1.8 million of non-recurring expenses
related to the proposed merger with Showscan which did not receive the required
shareholder vote in March 1998. These costs were primarily professional legal,
accounting and investment banking fees of which $1.6 million was expensed in
fiscal 1998 and $250,000 expensed in fiscal 1997.

     INTEREST INCOME & EXPENSE

     Interest income for fiscal 1997 and 1998 was $1.1 million and $0.8 million,
respectively. The decrease from 1997 to 1998 resulted primarily from a reduction
in the invested cash balances during the 1998 fiscal year.

     Interest expense for fiscal 1997 and 1998 was $391,000 and $247,000,
respectively. This decrease resulted primarily from the scheduled maturity of
notes payable in fiscal 1998.

     INCOME TAXES

     The provisions for income taxes were $117,000 and $23,000 to the years
ended June 30, 1997 and 1998, respectively. As the Company has significant net
losses, the income tax provisions are primarily for foreign taxes and minimum
state taxes.

     NET INCOME (LOSS)

     The Company recorded net loss of $9,956,000 in 1997, compared to a net loss
of $11,560,000 in 1998 due to the reasons mentioned above.
                                                                                
COMPARISON OF YEAR ENDED JUNE 30, 1997 TO YEAR ENDED JUNE 30, 1996
------------------------------------------------------------------

     REVENUES
                                                                                
     Revenue for the fiscal year ended June 30, 1997 decreased $8.9 million or
18% from the fiscal year 1996 revenue. Owned and operated revenue decreased $5.4
million or 40%, primarily from the Company's 17 Reactors, due primarily to the
loss of a major sponsor (AT&T Corp.) in the first quarter of fiscal 1997. In
addition, fiscal 1996 revenue included a $2.5 million cancellation settlement
for an event which was to be held at World Expo in Tokyo, Japan and there were
no such cancellation revenue in fiscal 1997. During the remaining portion of the
fiscal year the Company aggressively pursued new sponsorship opportunities and
looked at other options to replace these revenues. The loss of the major
sponsor, that utilized 5 of the Reactors throughout fiscal 1996, resulted in
excess capacity between early

                                       19
<PAGE>
 
Fall and late Spring of fiscal 1997. In June, 1997 one of the Reactors was sold
to a customer in Korea.

     The $2.2 million reduction in hardware sales and service resulted from a
reduced number of hardware contracts in fiscal 1997 compared with fiscal 1996.
Film licensing revenue increased 12% from fiscal 1996 to fiscal 1997 due
primarily to an increase in the number of theatres which license films. The
decrease in film production and other was due to no films produced in fiscal
1997 compared to two films produced in fiscal 1996.

     COST OF SALES

     Cost of sales as a percentage of sales was 59% and 73% for the fiscal years
ended June 30, 1996 and 1997, respectively.
                                                                               
     One of the primary reasons for the decrease in the gross margins between
fiscal 1997 and 1996 was due to $1.5 million of charges to cost of sales made in
the fourth quarter of fiscal 1997 due to changes in accounting estimates. These
included additional film amortization expense on films which have not achieved
their projected revenue ($746,000), additional reserve disputes ($450,000),
increased warranty reserve ($147,000) due to increased work performance on a
contract, and a reduction of previously recognized earnings by $205,000 in
connection with the cancellation of a contract. In addition, the costs related
to the revenue received from the cancellation settlement of the Tokyo World Expo
in 1996 were nominal resulting in an unusually high margin in fiscal 1996 which
did not occur in fiscal 1997.

     SELLING GENERAL AND ADMINISTRATIVE EXPENSES

     Selling General and Administrative Expenses were $17.4 million and $15.4
million for the fiscal years ended June 30, 1996 and 1997, respectively.
                                                                               
     The $2.0 million reduction in Selling, General and Administrative expenses
between fiscal 1997 and 1996 was due primarily to reduced employee related
compensation ($2.3 million), legal and accounting expenses ($0.6 million) and
travel and entertainment expenses ($0.6 million). These reductions were
partially offset by an increase in the provision for doubtful accounts ($0.8
million), increased research and development expenditures ($0.4 million) and
increased accrued expenses related to a regulatory audit ($0.3 million).

     LOSS ON IMPAIRMENT OF ASSETS
                                                                                
     Due to the Company being unable to replace the major sponsorship revenue
from AT&T Corp. for its portable simulation theatre business and the resulting
excess capacity this generated during the winter months as described above in
the "Revenues" section, the Company recognized a non-cash charge of $5.6 million
in fiscal 1997 primarily for its portable simulation theatres in accordance with
Financial Accounting Standards Board (FASB) release Number 121, "Accounting for
the Impairment of Long-Lived Assets and for Long-Lived Assets to be Disposed
Of". The loss was calculated as the excess of the carrying value of the portable
simulation theatre assets over the estimated future discounted cash flow from
these theatres during the next six fiscal years. (See Note 12 of Notes to
Consolidated Financial Statements). The impairment occurred in the fourth
quarter of fiscal 1997 as a result of disappointing results and an under
utilization of Reactors during the quarter, sponsorship and general admission
events below expectations, and the lack of significant sponsorship backlog as of
June 30,

                                       20
<PAGE>
 
1997.

     INTEREST INCOME AND EXPENSE

     Interest income for fiscal 1996 and 1997 was $1.2 million and $1.1 million,
respectively. This decrease resulted primarily from changes in the invested cash
balances during the respective periods.

     Interest expense for fiscal 1996 and 1997 was $380,000 and $391,000
resulted primarily from financing costs on the portable ride simulation
theatres.

     INCOME TAXES

     The provisions for income taxes were $149,000 and $117,000 for the years
ended June 30, 1996 and 1997, respectively. As the Company had significant net
operating loss carry forwards, the income tax provisions are primarily for
foreign taxes and state taxes.

     NET INCOME (LOSS)

     The Company recorded a net income of $3,099,000 in 1996, compared to net
loss of $9,956,000 in 1997 due to the reasons mentioned above.

SEASONALITY AND FLUCTUATING QUARTERLY RESULTS
---------------------------------------------

     The following tables set forth unaudited data regarding operations for each
quarter of fiscal 1997 and 1998 and the percentage of the Company's revenue and
expenses represented by each item of the respective quarter. This quarterly
information has been prepared on the same basis as the annual consolidated
financial statements and, in management's opinion, contains all adjustments
necessary to fairly state the information set forth herein. The operating
results for any quarter are not necessarily indicative of results for any future
period.


<TABLE> 
<CAPTION> 
  
                                              Fiscal 1997                                      Fiscal 1998
                                 -------------------------------------      ----------------------------------------- 
                                  First       Second     Third     Fourth       First     Second     Third     Fourth
(Dollars in thousands)            Quarter    Quarter    Quarter   Quarter       Quarter   Quarter    Quarter   Quarter
----------------------           --------   --------    -------   -------    ----------  --------   --------  --------
<S>                              <C>        <C>         <C>       <C>         <C>         <C>       <C>         <C> 

Revenue                           $9,594     $10,023    $11,042    $ 8,925    $ 8,052    $ 5,989    $ 4,483    $ 6,549
Cost of Sales                      6,236       6,955      7,335      8,422      4,789      5,168      4,195      5,501
                                  ------     -------     -------   -------    -------    -------    -------    -------
Gross Margin                       3,358      3,068       3,707        503      3,263        821        288      1,048
Selling, general and
   administrative                  3,381      3,322       3,582      5,088      3,605      4,311      4,637      3,446
Merger related expenses               --         --          --        250        313        218        888        134
Loss on impairment of assets          --         --          --      5,586         --         --         --         --  
Interest (income) expense, net      (197)      (197)       (145)      (195)      (149)      (208)      (160)       (78)
                                  ------     ------     -------   --------    -------    -------    -------    -------
Income (loss) before provision
  for taxes                          174        (57)        270    (10,226)      (506)    (3,500)    (5,077)    (2,454)   
Provision for taxes                   --         --         --         117         --         --         --         23
                                  ------     ------     -------   --------    -------    -------    -------    -------
Net income (loss)                 $  174     $  (57)    $   270   $(10,343)   $  (506)   $(3,500)   $(5,077)   $(2,477)   
                                  ======     ======     =======   ========    =======    =======    =======    =======
</TABLE> 

                                       21

<PAGE>
 
     The Company's operating results fluctuate from quarter to quarter as a
result of the timing of theatre system shipments, the mix of theatre system
contracts, the completion of custom film contracts and the amount of revenues
from portable simulation theatre and film licensing agreements. Hardware sales
will likely continue to experience inexplicable quarterly fluctuations as they
are substantially dependent on the customers' varying delivery and installation
requirements.

     A significant portion of the Company's operating expenses are relatively
fixed, and planned expenditures are primarily based upon revenue forecasts. The
decline in revenue, as shown in the above chart, is primarily from hardware
sales which were significantly lower from customers in the Asia-Pacific region.
The sales cycle for the sale of a single attraction by the Company typically
ranges between six and eighteen months. The Company has little control over the
timing of customer purchases. Although revenue decreased in fiscal 1998, backlog
orders for new hardware contracts was higher at June 30, 1998 than on the same
date in 1997. In fiscal 1997, the fourth quarter net income was impacted by the
charge for the asset impairments of $5.6 million as well as cost of sales
expenses totaling $1.5 million for additional film amortization expense on films
which have not achieved their projected revenue, additional reserve for
disputes, increased warranty reserve and a reduction of previously recognized
earnings in connection with the cancellation of a contract. Also Selling,
General and Administrative expenses were higher in the fourth quarter of fiscal
1997 due to an increase to the allowance for doubtful accounts due to
receivables which were deemed uncollectable, a legal reserve that first arose in
the fourth quarter and increased accrual due to a regulatory audit. In the
second and third quarters of fiscal 1998, the Company's selling, general and
administrative expenses increased due to severance costs associated with a
Company wide layoff and termination of certain others, including the Chief
Executive Officer, as well as recruitment costs for new management and
directors. Also as a result of this downsizing, the Company's selling, general
and administrative expenses were lower in the fourth quarter of fiscal 1998.

     The seasonal fluctuations in earnings also may cause volatility in the
stock prices of the Company. While a significant portion of the Company's
expense levels are relatively fixed, the timing of increases in expense levels
is based in large part on the Company's forecasts of future sales. If net sales
are below expectations in any given period, the adverse impact on results of
operations may be magnified by the Company's inability to adjust spending
quickly enough to compensate for the sales shortfall. The Company may also
choose to reduce prices or increase spending in response to market conditions,
which may have a material adverse effect on the Company's results of operations.

LIQUIDITY AND CAPITAL RESOURCES
-------------------------------

     Since 1994, the Company has financed its operations primarily from net
proceeds of $47 million from an initial public offering of the Company's Common
Stock in fiscal 1994 and cash flow from operations. The Company has also
received cash in the amount of $5 million for the sale of certain distribution
rights during the three fiscal years ending June 30, 1996 and proceeds from the
financing of certain equipment purchases.
 
     In fiscal 1998, approximately $1.3 million in cash was used in operating
activities. Iwerks' major investing activities included the sale of debt
securities partially offset by purchases of property and equipment and additions
to the film library. During fiscal 1998, the major financing activities were the
scheduled payments of capital leases and notes payable.

                                       22
<PAGE>
 
     In fiscal 1997, approximately $1.0 million was provided by operating
activities. The Company's major investing activities included investments in
joint ventures for $1.2 million, additions to film library of approximately $2.5
million, acquisition of Pioneer (see Note 2 of Notes to Consolidated Financial
Statements) and related patent for $1.09 million, and purchase of property and
equipment for $1.2 million. Financing activities included repayment of notes
payable and capital leases of $2.1 million.

     At June 30, 1998 the Company had cash and short-term investments of
approximately $10.5 million compared to $19.1 million at June 30, 1997 and $25.3
million (including long-term investments of approximately $5.8 million) at June
30, 1996. In addition, the Company maintained an unsecured $5 million bank line
of credit. The Company's cash and short-term investment balances have continued
to decline since June 30, 1998 and the Company expects to experience further
declining balances during the remainder of fiscal 1999. In addition, the history
of losses and negative cash flow resulted in the Company's bank terminating the
Company's line of credit. Management believes that its existing cash balances
and short-term investments, combined with anticipated cash flow from operations,
will continue to decline, however they will be sufficient to meet its cash
requirements through the end of fiscal 1999. However, if the Company is unable
to achieve its projected cash flow from operations, the Company may experience
significantly reduced cash and short-term investments, which could result in the
Company not being able to meet its operating needs. Recent operating losses, the
Company's declining cash balances, the ongoing financial turmoil in Asia
(historically the Company's largest market and a significant source of operating
revenues), the Company's historical stock performance, and a general decrease in
investor interest in the Company's industry, may make it difficult for the
Company to attract equity investments on terms that are deemed to be favorable
to the Company. In addition, the losses in fiscal 1997 and fiscal 1998 make it
more difficult for the Company to attract significant debt financing. Although
the Company anticipates that its cash balances will decrease during fiscal 1999,
management is in the process of implementing a plan which it believes will
facilitate a return to profitability and increase the cash flow beyond fiscal
1999. This plan includes, among other things, changes to senior management,
expansion of the Board of Directors, developing and marketing new products,
seeking new markets for the Company's simulation and film capabilities, the
establishment of new strategic vendor and customer partnerships and aggressively
reducing expenses. In the event that cash flow from operations is less than that
anticipated, in order to preserve cash, the Company would be required to reduce
expenditures for capital projects (including new films) and research and
development, or effect further reductions in its corporate infrastructure, any
of which could have a material adverse affect on the Company's future
operations. At June 30, 1998 the Company was committed to approximately $3.1
million of capital expenditures to be made in fiscal 1999.

IMPACT OF YEAR 2000
-------------------

     Some of the Company's older computer programs were written using two digits
rather than four to define the applicable year. As a result, those computer
programs have time-sensitive software that recognize a date using "00" as the
year 1900 rather than the year 2000. This could cause a system failure or
miscalculations causing disruptions of operations, including among other things,
a temporary inability to process transactions, send invoices, or engage in
similar normal business activities.

     The Company with the assistance of consultants, has completed its initial
assessment of its existing internal computer systems and after reviewing various
factors, one of which being the year 2000 issue, has determined that
modifications or upgrades to or replacements of certain software and hardware 

                                       23
<PAGE>
 
is required. The Company's most critical software systems are its assembly and
financial software systems. The Company has determined that these systems will
require replacement. The Company's initial estimate of the cost of such
replacement is $400,000, which includes approximately $350,000 for the purchase
and implementation of new software and hardware (which will be capitalized and
amortized over their respective useful lives) and approximately $50,000 of which
will be expenses in the period incurred. The Company has not yet completed the
process of selecting its preferred systems or vendors and consequently the
Company's estimates may change depending upon the systems but does not believe
they will be material. At June 30, 1998, the Company had incurred approximately
$25,000 in connection with this project.

     The Company believes that the required changes to its existing computer
systems will be installed and tested by June 30, 1999, which is prior to any
anticipated impact on its operating systems. Although the Company believes that
with these changes, the year 2000 issue will not pose significant operational
problems for the Company, there can be no assurances that the Company will not
experience serious unanticipated negative consequences and/or material
additional costs caused by an undetected error or defect in the technology used
in its internal systems which are purchased from third parties.

     The costs of the project and the date on which the Company believes it will
complete the conversion are based on management's best estimates, which were
derived utilizing numerous assumptions of future events, including the continued
availability of certain resources and other factors. However, there can be no
guarantee that these estimates will be achieved and actual results could differ
materially from those anticipated.

     The Company's engineers have reviewed all of the Company's significant
products and do not believe there is any date sensitive software included in
products sold by the Company since 1994. Some products sold by Omni
Entertainment, a company acquired in 1994, may have date-sensitive computers
which may result in incorrect date displays. The Company is in the process of
notifying these customers of this concern and is providing the necessary tools
to test their equipment. The Company does not expect to incur a material cost to
test or correct products initially sold by the Company.

     The Company is also in the process of surveying key vendors to insure they
are year 2000 compliant. As of September 18, 1998 the Company is unaware of any
key vendors who are not compliant, however such survey is not yet complete.


FACTORS THAT MAY AFFECT FUTURE RESULTS
--------------------------------------

     HISTORY OF OPERATING LOSSES; FLUCTUATING PERIODIC OPERATING RESULTS AND
     CASH FLOW

     The Company has sustained substantial operating losses in four of its last
five fiscal years. The Company's revenues in fiscal 1998 decreased by $14.5
million or 37% from fiscal year 1997 revenues. Although the Company expects to
sustain a loss in the first quarter of fiscal 1999, revenues will be higher than
in the prior three quarters. For all of fiscal 1999, the Company will not be
able to achieve profitable operations unless revenues significantly increase to
pre-1998 levels or above, or unless expenses are substantially decreased.
Management believes that the fiscal 1999 revenues from hardware sales will
exceed the fiscal 1998 level because the revenue to be recognized from the
hardware sales backlog (defined as a signed sales contract with a customer
deposit) at September 18, 1998 will exceed

                                       24
<PAGE>
 
the hardware revenue recognized in all of fiscal 1998. Additionally, while the
Company took measures in fiscal 1998 to decrease the level of its SG&A expenses,
management continues to examine its operations to achieve greater operating
efficiencies and increase its revenues. However, there can be no assurance that
the Company will be able to achieve profitable operations in fiscal 1999.
 
     DEPENDENCE ON PRODUCTION OF FILM SOFTWARE; FINANCIAL RISKS OF FILM
     PRODUCTION

     The Company's ability to implement its business strategy depends in large
part upon its ability to successfully create, produce and market entertainment
and educational film software for exhibition in its theatre systems. The size
and quality of the Company's library of film software titles is a material
factor in competing for sales of the Company's attractions and developing the
Company's base of recurring revenue.  The Company  has invested $0.8 million,
$2.5 million and $3.9 million in film software during fiscal 1996, 1997 and
1998, respectively.   The Company has commitments to  invest approximately $0.7
million in film software in fiscal 1999.  The Company's recent operating losses
and declining cash balance have caused it to decrease the level of its
investments in film software, which may have an adverse affect on revenues on
future periods.

     The Company generally produces and develops specialty films and videos for
its library with production budgets ranging from approximately $100,000 to $2.0
million. While the Company may enter into participation, licensing or other
financing arrangements with third parties in order to minimize its financial
involvement in production, the Company generally is subject to substantial
financial risks relating to the production and development of new entertainment
and educational software. The Company typically is required to pay for the
production of software during the production period prior to release and
typically is unable to recoup these costs from revenues from exhibition licenses
prior to 24 to 36 months following release. There can be no assurance that
Iwerks will be able to create and produce additional software for its library
which will be perceived by its customers to be of high quality or high
entertainment value.

     At June 30, 1998, the Company had recorded on its balance sheet $5.3
million in film library costs. The Company periodically reviews the net
realizable value of its film inventory and makes adjustments to its carrying
value when appropriate. While the current carrying value of the Company's film
inventory reflects management's belief that it will realize the net amount
recorded on its balance sheet, there can be no assurance that it will be able to
do so.

     INTENSE COMPETITION; UNPREDICTABILITY OF CONSUMER TASTES
 
     Competition in each of the markets in which the Company competes is
intense. The principal direct competition for customers comes from manufacturers
of competing movie-based attractions, and in the case of amusement and theme
parks, manufacturers of traditional amusement park attractions. In addition to
direct competitors, there is also competition from systems integrators and some
amusement and theme parks developing and constructing their own attractions.
Many of the Company's competitors have better name recognition, and
substantially greater financial and other resources than the Company.

     In the large screen, special format motion picture business, Iwerks' main
competitor is Imax. The 15 perforation 70 millimeter ("15/70") film format is
the most predominant large film format due primarily to the large number of
films that have been available in that format. Imax is by far the dominant
company in this market. Increasingly, large format films are being made
available in the 8/70 format,

                                       25
<PAGE>
 
such as "Everest" and others. The Company also sells 8/70 systems that can
benefit from this trend.

     Additionally, the out-of-home entertainment industry in general is
undergoing significant changes, primarily due to technological developments as
well as changing consumer tastes. Numerous companies are developing and are
expected to develop new entertainment products or concepts for the out-of-home
entertainment industry in response to these developments that are or may be
directly competitive with existing products. There is severe competition for
financial, creative and technological resources in the industry and there can be
no assurance that existing products will continue to compete effectively or that
products under development will ever be competitive. Further, the commercial
success of products is ultimately dependent upon audience reaction. Audience
reaction will to a large extent be influenced by the audience's perception of
how the Company's products compare with other available entertainment options
out of the home. There can be no assurance that new developments in out-of-home
entertainment will not result in changes in consumer tastes that will make the
Company's products less competitive.

NEW PRODUCT DEVELOPMENT

     The Company operates in a technology driven segment of the entertainment
business. As such the Company must continually improve its products to increase
their entertainment value while also facing pressure to continually reduce the
price of its products to respond to competitive pressures. The Company intends
to extend the current product line through innovative use of its current
technologies. This also can be accomplished with the Company's effort to
identify new strategic partners (see "Business Strategy" section). The Company's
recent operating losses and declining cash balances have caused it to consider
reducing the level of its capital expenditures and research and development
efforts. The inability of the Company to develop new products and to respond to
technological developments of its competitors could have a materially adverse
effect on its business, operations and financial condition.

INTERNATIONAL OPERATIONS

     A significant portion of the Company's sales and film licensing are made to
customers located outside of the United States, primarily, in the Far East,
Europe, South America and Canada. During fiscal 1996, 1997 and 1998, 49%, 55%
and 46% of the Company's revenues, respectively, were derived from sales outside
the United States. During fiscal 1998, no country (other than the United States)
accounted for more than 10% of the Company's revenues. During fiscal 1997, China
accounted for approximately 14% of the Company's revenues and in fiscal 1996
Japan accounted for approximately 11% of the Company's revenues. The Company
expects a significant portion (between 40% and 60%) of the Company's sales in
fiscal 1999 and 2000 will be to customers outside of the United States, similar
to the percentage experienced in the past three years. International operations
and sales of the Company may be subject to political and economic risks,
including political instability, currency controls, exchange rate fluctuations
(which, in the event of a decrease in value of foreign currency to the dollar
can significantly affect the affordability of the Company's products overseas),
changes in import/export regulations, tariff and freight rates, longer accounts
receivable collection patterns, changes in regional or worldwide economic or
political conditions and natural disasters. In addition, various forms of
protectionist trade legislation have been proposed in the United States and
certain other countries. Any resulting changes in current tariff structures or
other trade and monetary policies could adversely affect the Company's
international operations. Political and economic factors have been identified by
the

                                       26
<PAGE>
 
Company with respect to certain markets in which it competes. There can be no
assurance that these factors will not result in customers of the Company
defaulting on payments due to it, or in the reduction of potential purchases of
their products. The Company does not engage in any hedging programs.

CURRENT TRENDS IN THE GLOBAL ECONOMY

     The Company's revenues and profitability are dependent on the strength of
the national and international economies. In a recessionary or deflationary
environment, sales of the Company's products and products of other entertainment
companies may be adversely affected. Theme parks and other out-of-home
entertainment venues may also experience a downturn in sales which could reduce
the funds available for capital improvements and film licensing, resulting in
price and other concessions and discounts by the Company in order to maintain
sales activity. Recent turmoil in the economies of the countries in Asia have
had a material adverse affect on the Company's revenues and results of
operations. Revenues attributable to sales in Asia declined from $17.3 million
for fiscal 1996 (representing 35.7% of the Company's revenues) to $5.7 million
in fiscal 1998 (representing 22.6% of the Company's revenues). In addition, the
Company did not enter into a new hardware sales contract for delivery in Asia
during the fiscal year ended June 30, 1998. Subsequent to June 30, 1998 however,
the Company finalized two sales contracts totaling $3.4 million with Chinese
customers and an additional two contracts totaling $1.4 million with customers
in Japan. If recent economic problems experienced in Asia, Russia, and Eastern
Europe were to spread to Europe, South America or the United States, it could
have a material adverse affect upon the Company's revenues and results of
operations. The Company is not able to predict to what extent, or for what
period, these economic trends may adversely affect the sales of its products.

DEPENDENCE ON DIRECTORS AND SENIOR MANAGEMENT; RECENT CHANGES TO KEY PERSONNEL

     During fiscal 1998, many of the Company's executive officers including its
CEO have changed. Current executive officers are Charles Goldwater, Chairman of
the Board and Chief Executive Officer, Bruce C. Hinckley, Executive Vice
President, Chief Financial Officer and Secretary, Jack Shishido, Senior Vice
President of Worldwide Sales and Marketing, Jon Corfino, Senior Vice President
Film Development and Distribution and Dan Griesmer, Senior Vice President and
General Manager. Further, during fiscal 1998 and the first two months of fiscal
1999, as a result of downsizing and voluntary resignations, the Company has
experienced a reorganization in its sales, marketing, human resources, film
distribution, engineering, project management and assembly staffs. Between March
6, 1997, and June 30, 1998 three members of the Board of Directors have resigned
and since February 1998 three new Board members have joined the Company. The
Company continues to search for one additional Board member which will bring the
total members of the Board to seven.
 
     The recruitment, retention and motivation of skilled directors, executives,
sales, technical and creative personnel and other employees are important to the
operations of the Company. The Company's turnover in management personnel has
placed, and could continue to place, a significant strain on Iwerks' management
and other resources. In addition, there is competition for management and
creative personnel in the industries in which the Company operates. Also, the
recruitment and retention of qualified employees is restricted because as of
September 18, 1998 the Company has less than 25,000 shares available for future
stock option grants under its existing stock option plans. There can be no
assurance that the Company will not encounter difficulties in recruiting and
retaining qualified personnel in the future. Should any key executive officer
cease to be affiliated with the Company before a qualified

                                       27
<PAGE>
 
replacement is found, the Company's business could be materially adversely
affected.

VOLATILITY OF STOCK PRICE

     The Company's stock price has been, and could continue to be, highly
volatile. The market price of the Company's Common Stock has fluctuated
substantially in recent periods. During fiscal 1998 and through September 18,
1998, the Company's market price has ranged from a low of $1.25, to a high of
$5.625 per share. Future announcements concerning the Company or its
competitors, quarterly variations in operating results, introduction of new
products or changes in product pricing policies by the Company or its
competitors and acquisition or loss of significant customers may affect or be
perceived to affect the Company's operations, or changes in earnings estimates
by analysts, among other factors, could cause the market price of the Company's
Common Stock to fluctuate substantially. In addition, stock markets have
experienced extreme price and volume volatility in recent years. This volatility
has had a substantial effect on the market prices of securities of many smaller
public companies for reasons frequently unrelated to the operating performance
of the specific companies. These broad market fluctuations may adversely affect
the market price of the Company's Common Stock.

ENVIRONMENTAL MATTERS AND OTHER GOVERNMENTAL REGULATIONS

     Under various Federal, state and local environmental laws and regulations,
a current or previous owner or occupant of real property may become liable for
the costs of removal or remediation of hazardous substances at such real
property. Such laws and regulations often impose liability without regard to
fault. The Company leases its corporate headquarters and manufacturing
facilities. The Company could be held liable for the costs of remedial actions
with respect to hazardous substances on such properties under the terms of the
governing lease and/or governing law. Although the Company has not been notified
of, and is not otherwise aware of, any current environmental liability, claim or
non-compliance, there can be no assurance that the Company will not be required
to incur remediation or other costs in the future in connection with its leased
properties. In addition, the Company's subcontractors and other third parties,
with which it has contractual relations, are similarly subject to such laws.

EFFECT OF ANTI-TAKEOVER PROVISIONS

     The Company's Board has the authority to issue up to 1,000,000 shares of
preferred stock and to determine the price, rights, preferences and privileges
of those shares without any further vote or action by the Company's
stockholders. The rights of the holders of the Common Stock will be subject to,
and may be adversely affected by, the rights of the holders of preferred stock.
While the Company has no present intention to issue shares of preferred stock,
such issuance, while providing desirable flexibility in connection with the
possible acquisitions and other corporate purposes, could have the effect of
delaying, deferring or preventing a change in control of the Company and
entrenching existing management. In addition, such preferred stock may have
other rights, including economic rights senior to the Company's Common Stock,
and, as a result, the issuance thereof could have a material adverse effect on
the market value of the Company's Common Stock.

     A number of provisions of the Company's Certificate of Incorporation and
By-Laws and the

                                       28
<PAGE>
 
Delaware General Corporation Law ("DGCL") and regulations relating to matters of
corporate governance, certain rights of Directors and the issuance of preferred
stock without stockholder approval, may be deemed to have and may have the
effect of making more difficult, and thereby discouraging, a merger, tender
offer, proxy contest or assumption of control and change of incumbent
management, even when stockholders other than Iwerks' principal stockholders
consider such a transaction to be in their best interest.

     In addition, the Company has adopted a Stockholder Rights Plan (the "Rights
Agreement"). Pursuant to the Rights Agreement each outstanding share of the
Company's Common Stock has received one right entitling the holder to purchase
1/100th of a share of Series A Preferred Stock of the Company's for each share
of the Company's Common Stock then held by such holder. Each right becomes
exercisable upon certain triggering events related to an unsolicited takeover
attempt of the Company.

PATENTS AND TRADEMARKS

     The Company has several United States and selected other countries' patents
on various processes and elements related to film projection and ride
simulation. The Company has registered its principal trademarks in the United
States and selected other countries. While the Company's patents have not been
challenged and the Company believes that its patents are valid, third parties
could still challenge the patents and a court could determine that one or more
of them are invalid. Declarations of invalidity, particularly of key patents,
could adversely affect the marketability of the Company's products and services.

                                       29
<PAGE>
 
ITEM 8.  FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA.
---------------------------------------------------- 

                        REPORT OF INDEPENDENT AUDITORS

The Board of Directors
Iwerks Entertainment, Inc.

We have audited the accompanying consolidated balance sheets of Iwerks
Entertainment, Inc. as of June 30, 1997 and 1998, and the related consolidated
statements of operations, stockholders' equity, and cash flows for each of the
three years in the period ended June 30, 1998. Our audits also included the
financial statement schedule listed in the Index at Item 14(a). These financial
statements and schedule are the responsibility of the Company's management. Our
responsibility is to express an opinion on these financial statements and 
schedule based on our audits.

We conducted our audits in accordance with generally accepted auditing
standards. Those standards require that we plan and perform the audit to obtain
reasonable assurance about whether the financial statements are free of material
misstatement. An audit includes examining, on a test basis, evidence supporting
the amounts and disclosures in the financial statements. An audit also includes
assessing the accounting principles used and significant estimates made by
management, as well as evaluating the overall financial statement presentation.
We believe that our audits provide a reasonable basis for our opinion.
 
In our opinion, the consolidated financial statements referred to above present
fairly, in all material respects, the consolidated financial position of Iwerks
Entertainment, Inc. at June 30, 1997 and 1998 and the consolidated results of
its operations and its cash flows for each of the three years in the period
ended June 30, 1998, in conformity with generally accepted accounting
principles. Also, in our opinion, the related financial statement schedule, when
considered in relation to the basic financial statements taken as a whole,
present fairly in all material respects the information set forth therein.



Los Angeles, California                         Ernst & Young LLP
August 5, 1998

                                       30
<PAGE>
 
                     Iwerks Entertainment, Inc.
 
                    Consolidated Balance Sheets
 
                               Assets
 
                           (in Thousands)
<TABLE>
<CAPTION>
                                                                   June 30,
                                                               -----------------
                                                                 1997      1998
                                                               -------   -------
<S>                                                            <C>       <C>
Current assets:
 
  Cash and cash equivalents                                    $ 3,608   $ 7,542
 
  Short-term investments (Note 3)                               15,459     2,922
 
  Trade accounts receivable, net of allowance for doubtful
    accounts (Note 1)                                            5,447     3,521
 
  Costs and estimated earnings in excess of billings on
    uncompleted contracts (Note 4)                               6,339     1,574
 
  Inventories                                                    3,835     3,366
 
  Other current assets                                             567       706
                                                               -------   -------
 
      Total current assets                                      35,255    19,631
 
Portable simulation theatres at cost, net of
  accumulated depreciation                                       4,018     3,413
 
Property and equipment at cost, net of
  accumulated depreciation and amortization (Note 6)             2,920     4,329
 
Film inventory at cost, net of amortization (Note 1)             3,439     5,308
 
Goodwill, net of amortization (Notes 1 and 2)                   15,367    14,742
 
Other assets                                                     3,530     3,380
                                                               -------   -------
 
      Total assets                                             $64,529   $50,803
                                                               =======   =======
</TABLE>


                            See accompanying notes.

                                       31
<PAGE>
 
                          Iwerks Entertainment, Inc.
 
 
                          Consolidated Balance Sheets
                     Liabilities and Stockholders' Equity
 
                     (in Thousands, Except Share Amounts)
<TABLE> 
<CAPTION> 
                                                                  June 30,
                                                           ---------------------
                                                             1997        1998
                                                           --------    ---------
<S>                                                        <C>         <C>
Current liabilities:
  Accounts payable                                         $  3,435    $  1,982
 
  Accrued expenses                                            8,793       6,823
 
  Notes payable, current portion                                 81           -
 
  Billings in excess of costs and estimated
    earnings on uncompleted contracts (Note 4)                  990       2,971
 
  Deferred revenue                                              278         308
 
  Capital leases, current portion (Note 10)                     739         803

                                                           --------    --------  
      Total current liabilities                              14,316      12,887
 
Capital lease obligations, excluding
  current portion (Note 10)                                   1,827       1,082

                                                           --------    --------  
      Total liabilities                                      16,143      13,969
 
Commitments and contingencies (Note 10)
 
Stockholder's' equity (Note 9):
 
  Preferred stock, $0.01 par value, 1,000,000                     -           -
    authorized, none issued and outstanding
 
  Common stock, $.001 par value,  50,000,000 shares              57          57
    authorized; 12,160,102 (1997) and 12,344,807 (1998)
    issued and outstanding
 
Paid-in capital                                              78,016      78,024
Deficit                                                     (29,687)    (41,247)
                                                           --------    --------  
      Total stockholders' equity                             48,386      36,834
                                                           --------    --------  
        Total liabilities and stockholders' equity         $ 64,529    $ 50,803
                                                           ========    ======== 
</TABLE>
                                                                                
                            See accompanying notes.

                                       32
<PAGE>
 
                          Iwerks Entertainment, Inc.
 
                     Consolidated Statements of Operations
 
                   (in Thousands, Except Per Share Amounts)

<TABLE> 
<CAPTION> 
 
                                                           Years ended June 30,
                                                   ----------------------------------
                                                     1996         1997         1998
                                                   --------     --------     --------
<S>                                                <C>          <C>          <C>      
Revenue                                            $48,516      $ 39,584     $ 25,073 
                                                                                      
Cost of sales                                       28,675        28,948       19,653 
                                                   -------      --------     -------- 

Gross margin                                        19,841        10,636        5,420 
                                                                                      
Selling, general and administrative expenses        17,377        15,373       15,999 
                                                                                      
Merger related expenses                                  -           250        1,553 
                                                                                      
Loss on impairment of assets                             -         5,586            - 
                                                   -------      --------     -------- 
                                                                                      
Income (loss) from operations                        2,464       (10,573)     (12,132)
                                                                                      
Interest income                                      1,164         1,125          842 
                                                                                      
Interest expense                                      (380)         (391)        (247)
                                                   -------      --------     -------- 
                                                                                      
Income (loss) before provision for income taxes      3,248        (9,839)     (11,537)
                                                                                      
Provision for income taxes (Note 8)                    149           117           23 
                                                   -------      --------     -------- 
                                                                                      
Net income (loss)                                  $ 3,099      $ (9,956)    $(11,560)
                                                   =======      ========     ======== 

Basic income (loss) per common share (Note 5)      $   .28      $   (.84)    $   (.95)
                                                   =======      ========     ======== 
                                                                                      
Diluted income (loss) per common share (Note 5)    $   .26      $   (.84)    $   (.95)
                                                   =======      ========     ======== 
                                                                                      
Weighted average shares outstanding - Basic         10,945        11,855       12,212 
                                                   =======      ========     ======== 
                                                                                      
Weighted average shares outstanding - Diluted       12,144        11,855       12,212  
                                                   =======      ========     ======== 
</TABLE> 
 
 
                            See accompanying notes.

                                       33
<PAGE>
 
                          Iwerks Entertainment, Inc.
 
                Consolidated Statements of Stockholders' Equity
 
                                (in Thousands)
<TABLE> 
<CAPTION> 
 
                                                                                                         
                                                           Common Stock                                 Retained
                                                           ----------------   Paid    Unearned stock    Earnings
                                                           Shares   Amount   capital   compensation     (deficit)   Total
                                                           ------   -------  -------  --------------   ----------  ------
<S>                                                        <C>      <C>      <C>       <C>               <C>         <C>

Balance at June 30, 1995                                   10,592   $   55   $73,411   $         (263)   $(22,830)   $ 50,373
                                                           ------   -------  -------   --------------    --------    -------- 
Issuance of common stock in connection with the                75        -     1,600                -           -       1,600
class action settlement (Note 15)
 
Common stock options and warrants exercised (Note 9)          961        1     1,579                -           -       1,580
 
Retirement of common stock                                    (40)       -      (250)               -           -        (250)
 
Amortization of unearned stock compensation                     -        -         -              263           -         263
 
Net income                                                      -        -         -                -       3,099       3,099
                                                           ------   -------  -------   --------------    --------    -------- 
Balance at June 30, 1996                                   11,588       56    76,340                -     (19,731)     56,665
                                                           ------   ------   -------   --------------    --------    --------
 
Common stock issued in connection with the Purchase of        299        1     1,200                -           -       1,201
Pioneer (Note 2)
 
Common stock options and warrants exercised (Note 9)          273        -       476                -           -         476
Net loss                                                        -        -         -                -      (9,956)     (9,956)
                                                           ------   -------  -------   --------------    --------    -------- 
Balance at June 30, 1997                                   12,160       57    78,016                -     (29,687)     48,386
                                                           ------   -------  -------   --------------    --------    -------- 
 
Common stock options and warrants exercised (Note 9)           25        -         8                -           -           8
 
Issuance of common stock issued in connection with the
class action settlement (Note 15)                             160        -         -                -           -           -
 
Net loss                                                        -        -         -                -     (11,560)    (11,560)
                                                           ------   -------  -------   --------------    --------    -------- 
 
Balance at June 30,  1998                                  12,345   $   57   $78,024   $            -    $(41,247)   $ 36,834
                                                           ======   ======   =======   ==============    ========    ========
</TABLE> 
 
 
                            See accompanying notes.

                                       34
<PAGE>
 
                          Iwerks Entertainment, Inc.
 
                     Consolidated Statements of Cash Flows
 
                                (in Thousands)
<TABLE> 
<CAPTION> 
                                                                       Year ended June 30,
                                                                --------------------------------
                                                                 1996        1997         1998
OPERATING ACTIVITIES                                            -------     -------     --------
<S>                                                             <C>         <C>         <C>
Net (loss) income                                               $ 3,099     $(9,956)    $(11,560)
Adjustments to reconcile net (loss) income
  to net cash provided by (used in) operating activities:
    Depreciation and amortization                                 6,438       6,279        4,628
    Write-down of assets to net realizable value                      -       5,587            -
    Changes in operating assets and liabilities:
       Trade accounts receivable, net                             1,282        (639)       1,926
       Costs and estimated earnings in excess of
         billings on uncompleted contracts                       (2,772)       (637)       4,765
       Inventories                                                 (656)     (1,012)         469
       Other current assets                                         412        (152)        (139)
       Accounts payable and accrued expenses                       (775)      1,389       (3,423)
       Billings in excess of costs and estimated
         earnings on uncompleted contracts                       (1,424)       (116)       1,981
       Deferred revenue                                          (1,873)        217           30
                                                                -------     -------     --------
         Net cash provided by (used in) operating activities      3,731         960       (1,323)
 
INVESTING ACTIVITIES
Investment in limited partnership and joint ventures                  -      (1,162)        (426)
Investment in portable simulation theatres and patents             (184)       (108)         (46)
Purchases of property and equipment                                (312)     (1,247)      (2,333)
Additions to film inventory                                        (790)     (2,548)      (3,917)
Investment in debt securities                                     2,247      (2,851)      12,537
Purchase of Pioneer and acquisition of related patent
  net of cash acquired and stock issued                               -      (1,088)           -
Proceeds from sale of portable simulation unit                        -       1,184            -
                                                                -------     -------     -------- 
         Net cash provided by (used in) investing activities        961      (7,820)       5,815

FINANCING ACTIVITIES
Proceeds from capital lease                                       3,000           -            -
Repayment of notes payable to related parties                      (372)       (875)           -
Repayment of notes payable                                       (1,819)       (571)         (81)
Payments on capital leases                                         (129)       (700)        (681)
Exercise of stock options and warrants                            1,580         476            8
Retirement of common stock                                         (250)          -            -
Other                                                               241        (536)         196
                                                                -------     -------     --------
         Net cash provided by (used in) financing activities      2,251      (2,206)        (558)
                                                                -------     -------     --------
Net increase (decrease) in cash                                   6,943      (9,066)       3,934
Cash and cash equivalents at beginning of year                    5,731      12,674        3,608
                                                                -------     -------     --------
Cash and cash equivalents at end of year                        $12,674     $ 3,608     $  7,542
                                                                =======     =======     ========
</TABLE>

                                       35
<PAGE>
 
SUPPLEMENTAL INFORMATION TO CONSOLIDATED STATEMENTS OF CASH FLOWS

<TABLE> 
<CAPTION> 
                                               Year ended June 30,
                                            ------------------------
                                             1996     1997     1998
                                            ------   ------   ------
<S>                                         <C>      <C>      <C> 
Cash paid during the year for:
  Interest, net of amount capitalized       $  419   $  411   $  244
                                            ======   ======   ======
  Income taxes                              $   61   $   65   $   23
                                            ======   ======   ======
</TABLE> 


Supplemental disclosures of non-cash  investing and financing activities:

     In 1997, the Company purchased patents, other assets and all the
     outstanding common stock of the Pioneer related entities for cash and
     Iwerks common stock. The Common Stock issued was valued at $1.2 million
     (see Note 2).
 
     In 1996, $1,600,000 was recorded to stockholders' equity from accrued
     expenses due to the issuance of common stock and warrants in connection
     with the class action settlement (see Note 15).
 
     Capital lease obligations increased by $3,000,000, in 1996, due to the
     purchase of portable simulation theatres.


                            See accompanying notes.

                                       36
<PAGE>
 
                          IWERKS ENTERTAINMENT, INC.
                  NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
 
1.   SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES
 
     CONSOLIDATION AND BASIS OF PRESENTATION - Iwerks is a Delaware corporation.
Iwerks designs, manufactures, installs and services high resolution, proprietary
motion picture theatre attractions. Iwerks' attractions are built around a
variety of theatre systems, including fixed and portable simulators, giant
screen theatres, 3D theatres and the licensing of the related software.
 
     Iwerks operates in one business segment, the manufacture, distribution and
operation of entertainment and educational hardware and software.
 
     The financial statements consolidate the accounts of Iwerks and its wholly
owned subsidiaries. All significant intercompany amounts and transactions have
been eliminated in consolidation.
 
     Certain reclassifications were made to the financial statements for the
year ended June 30, 1997 and 1996 in order to conform to the fiscal 1998
presentation.
 
     REVENUE AND COST RECOGNITION - Revenue from fixed-price-contracts are
recognized on the percentage-of-completion method, measured by the ratio of
percentage of labor hours incurred to date to estimated total labor hours for
each contract. Management considers expended labor hours to be the best
available measure of progress on such contracts. A contract is considered
substantially complete upon delivery and acceptance of the product by the
customer. These contracts average six to eighteen months in duration.
 
     Contract costs include direct materials, direct labor cost and indirect
costs related to contract performance, such as indirect labor, supplies and
tools. Costs and estimated earnings in excess of billings on uncompleted
contracts represents costs incurred and gross profit recognized in excess of
amounts billed. Billings in excess of costs and estimated earnings on
uncompleted contracts represents billings in excess of costs incurred and gross
profit recognized. Billings to customers are in accordance with the terms of the
contract and generally follow a payment schedule.
 
     Iwerks performs a quarterly review of uncompleted contracts. Changes in
estimates are reflected in the period of the change. Provisions for estimated
losses on uncompleted contracts are made in the period in which such losses are
determined.
 
     Iwerks provides a warranty for contracts generally for a period of twelve
months. Such warranty costs are included in cost of sales. The warranty accrual
as of June 30, 1997 and 1998 was $1,205,000, and $1,014,000, respectively, and
are included in accrued expenses in the accompanying consolidated balance sheet.
 
     Iwerks also earns revenues for the production of films for outside parties.
Iwerks recognizes revenue from such projects when the film is complete and has
been accepted by the customer.
 
     Iwerks generally licenses films at agreed-upon minimum amounts. Revenues
from film licenses are recognized when the license period begins and the
programming is available pursuant to the terms of the license agreement.

                                       37
<PAGE>
 
     Revenues from portable simulation theatres ticket sales are recorded at the
time collected and fees from leasing of these simulators are recognized over the
related lease periods.
 
     TRADE ACCOUNTS RECEIVABLE primarily consists of amounts due on contracts 
and film licenses. Allowance for doubtful accounts was $1,111,000 in 1997 and
$1,893,000 in 1998.
 
     INVENTORIES consist primarily of simulation system equipment components and
are stated at the lower of cost or market on an average cost basis.
 
     FILM INVENTORY consists of production and print costs and are stated at the
lower of cost or net realizable value. The individual film forecast method is
used to amortize film costs. Costs accumulated in the production of a film are
amortized in the proportion that gross revenues realized bear to management's
estimate of total gross revenues expected to be received. Revenue estimates on a
film-by-film basis are reviewed quarterly by management and are revised, if
warranted, based upon management's appraisal of current market conditions.
Unamortized film costs are written down to net realizable value based on this
appraisal, where applicable. Estimated liabilities for royalties and
participation are accrued and expensed in the same manner as film costs are
amortized.
 
     Film inventory is comprised of the following (in thousands):
 
<TABLE> 
<CAPTION>
                                                  June 30,
                                            --------------------- 
                                              1997         1998
                                            --------     --------
        <S>                                 <C>          <C> 
        Films released                      $ 15,204     $ 19,968
        Films in process and development       1,639          792
                                            --------     --------
          Total                               16,843       20,760
        Less accumulated amortization        (13,404)     (15,452)
                                            --------     --------
                                            $  3,439     $  5,308
                                            ========     ========
</TABLE> 
                                                                               
     The Company estimates that approximately 84% of unamortized film costs at
June 30, 1998 will be amortized over the next three fiscal years. Many of the
Company's films that have been fully amortized continue to generate revenues.
 
     PORTABLE SIMULATION THEATRES - Sixteen portable simulation theatres are in
operation at June 30, 1998. Depreciation on the portable simulation theatres is
computed using the straight line method over the estimated useful lives of the
related assets, which range from seven to ten years. Accumulated depreciation
was $4,327,000 in 1997 and $ 4,977,000 in 1998 (see Note 12).
 
     DEPRECIATION AND AMORTIZATION OF PROPERTY AND EQUIPMENT is computed using
the straight line method over the estimated useful lives of the assets, which
range from three to ten years. Leasehold improvements are amortized over five
years or the term of the lease, whichever is shorter.
 
     GOODWILL (excess purchase price and liabilities assumed over the fair
market value of assets acquired) primarily resulted from the acquisition of Omni
and is being amortized over thirty years using the straight line method. The
remaining goodwill relates to the acquisition of Pioneer Marketing Corporation
and a related company (collectively referred to as "Pioneer") (see Note 2)and
prior acquisitions and is being amortized over 16 to 25 years. Goodwill is
reviewed periodically to determine if the facts and circumstances suggest that
it may be impaired. If this review indicates that goodwill will not be
recoverable, as determined based upon discounted cash flows of the acquired
business over the remaining amortization period, then the carrying value of the
related goodwill will be reduced by the estimated shortfalls of cash flows.
Accumulated

                                       38
<PAGE>
 
amortization was $2,737,000 in 1997 and $ 3,421,000 in 1998.
 
     OTHER ASSETS - Patents are stated at cost, and are being amortized using
the straight line method between 10 and 25 years. Iwerks acquired a patent in
fiscal 1997 in connection with the Pioneer acquisition in the amount of
$1,094,000, and a covenant not to compete in the amount of $50,000 (see Note 2).
Accumulated amortization was $329,000 in 1997 and $278,000 in 1998. The Company
has entered into joint venture arrangements whereby the Company contributes ride
simulation theatre equipment and the joint venture partner contributes site
improvements. The Company retains title to the assets it contributes to certain
joint ventures, and therefore its investment in joint ventures is carried at
historical cost and depreciated over 5 years. The Company receives film
licensing fees and cash flow income is split between the joint venture partners.
 
     ACCRUED EXPENSES - The Company provides for commission and applicable
royalties on revenue recognized in connection with certain agreements. The
commission accrual as of June 30, 1997 and 1998 was $1,683,000 and $427,000,
respectively, and the royalty accrual as of June 30, 1997 and 1998 was
$2,285,000 and $2,847,000, respectively. These amounts are included in accrued
expenses in the accompanying consolidated balance sheets.
 
     The Company had legal accruals as of June 30, 1997 and 1998 in the amounts
of $671,000 and $584,000, respectively. The Company also had compensation
accruals in the amount of $250,000 and $215,000 as of June 30, 1997 and 1998,
respectively. These amounts are included in accrued expenses in the accompanying
consolidated balance sheets.
 
     DEFERRED REVENUE represents advance payments received for rental of
portable theatre systems and theatre service contracts and are recognized as
revenue over the life of the respective agreements.
 
     RESEARCH AND DEVELOPMENT COSTS are incurred in the design, construction and
testing of prototype systems and are charged to expense when incurred. The
research and development expenses amounted to $358,000, $726,000 and $766,000
for the years ended June 30, 1996, 1997 and 1998, respectively.
 
     INCOME TAXES - The Company has applied Statement of Financial Accounting
Standards No. 109, (Accounting for Income Taxes), which utilizes the liability
method. Deferred income taxes under the liability method arise primarily from
the difference between the timing of recognition of certain revenue and expense
items for financial reporting and income tax purposes.
 
     CASH AND CASH EQUIVALENTS - The Company places its temporary cash
investments with one high quality financial institution. The investments mature
within 30 to 90 days and therefore are subject to limited risk.
 
     CONCENTRATION OF CREDIT RISK - The Company conducts credit evaluations of
customers and believes the credit risk from its customers is minimal.
 
     QUALIFIED 401K PLAN - The Company has a Defined Contribution 401k Plan
("Plan") for all of its eligible employees. Under the Plan, each employee who
has attained the age of eighteen and who has completed three months of service
with the Company is eligible to become a participant. Under the Plan, each
participant is permitted to make tax deferred voluntary contributions of an
amount not to exceed the lesser of 15% of his or her respective compensation and
the applicable statutory limitation. Effective July 1997, the Company began
making matching contributions not to exceed 3% of participants salaries to the
Plan, and has consequently recorded an expense of

                                       39
<PAGE>
 
approximately $109,000 in fiscal 1998.
 
     USE OF ESTIMATES - The preparation of financial statements in conformity
with generally accepted accounting principles requires management to make
estimates and assumptions that effect the amounts reported in the financial
statements and accompanying notes. Actual results could differ from these
estimates.
 
     FAIR VALUE OF FINANCIAL INSTRUMENTS - The Company's financial instruments,
other than cash, accounts receivable and accounts payable, consist primarily of
investments in debt securities. The fair value of investments in debt securities
is based on quoted market prices.
 
2.   ACQUISITION OF PIONEER
 
     On March 4, 1997 two newly formed wholly-owned subsidiaries of the Company
acquired all the stock of Pioneer (a manufacturer of motion picture projectors)
in exchange for 299,101 shares of Iwerks Common Stock. Concurrently, the Company
purchased a patent from a partnership related to Pioneer for approximately
$1,114,000 in cash. These transactions were accounted for as a purchase with an
aggregate purchase price of approximately $2,784,000 including acquisition
costs. The aggregate purchase price of Pioneer in excess of the fair value of
the identifiable assets of Pioneer at the date of acquisition was $1,536,000
which has been allocated to goodwill. The operations of Pioneer have been
consolidated with the operations of the Company from March 4, 1997.
 
3.   SHORT-TERM INVESTMENTS
 
     The carrying amounts of the Company's investments in debt securities at
June 30, 1997 and 1998 (maturing October, 1998) are as follows (in thousands):
<TABLE> 
<CAPTION>  
                                              Carrying Amount
                                            -------------------
        Security                              1997        1998
        --------                            -------     -------
        <S>                                 <C>         <C> 
        U.S. Treasury Notes                 $ 8,542     $     -
        FNMA Discount Notes                   1,532           -
        Banker's Acceptances                  5,385           -
        Commercial Paper                          -       2,922
                                            -------     -------
        Total Short-Term Investments        $15,459     $ 2,922
                                            =======     =======
</TABLE> 
 
     The principal amount, cost and fair value are not materially different than
the carrying amount as shown above. There were no sales of available for sale
securities for the fiscal year ended 1998 and $5,369,000 of proceeds for the
fiscal year ended June 30, 1997. Realized gains or losses from debt securities
sold during the year ended June 30, 1997 were not material. The basis on which
cost was determined on calculating gains and losses was the specific
identification method.
 
     Investments in debt securities at June 30, 1997 and 1998 are classified as
available-for-sale, and the unrealized gains and losses, net of tax, were not
material for any year presented.
 

                                       40
<PAGE>
 
4.   BILLINGS IN EXCESS OF COSTS AND ESTIMATED EARNINGS ON UNCOMPLETED CONTRACTS
 
     Billings in excess of costs and estimated earnings on uncompleted contracts
at June 30, 1997 and 1998 consist of the following (in thousands):
 
                                                        1997         1998
                                                      --------     --------
        Costs incurred on uncompleted contracts       $ 17,684     $ 14,486
        Estimated earnings                              15,513       13,228
                                                      --------     --------
                                                        33,197       27,714
        Less billings to date                          (27,848)     (29,111)
                                                      --------     --------
                                                      $  5,349     $ (1,397)
                                                      ========     ========
                                                                               
     Such costs are included in the accompanying balance sheets at June 30, 1997
and 1998 under the following captions (in thousands):
<TABLE> 
<CAPTION>  
                                                             1997        1998
                                                           -------     -------
        <S>                                                <C>         <C> 
        Costs and estimated earnings in excess of
         billings on uncompleted contracts                 $ 6,339     $ 1,574
        Billings in excess of costs and estimated 
         earnings on uncompleted contracts                    (990)     (2,971)
                                                           -------     -------
                                                           $ 5,349     $(1,397)
                                                           =======     =======
</TABLE> 

5.   NET (LOSS) INCOME PER COMMON SHARE
 
     In February 1997, the Financial Accounting Standards Board ("FASB") issued
SFAS No. 128, Earnings Per Share, which is effective for annual and interim
financial statements issued for periods ending after December 15, 1997. The
statement requires restatement of prior years' earnings (loss) per share
("EPS"). SFAS No. 128 was issued to simplify the standards for calculating EPS
previously found in APB No. 15, Earnings Per Share. SFAS 128 replaces the
presentation of primary EPS with a presentation of basic EPS. Basic EPS excludes
the dilutive effects of stock options and warrants. Diluted EPS reflects all
potential dilutive securities.
 
     The reconciliation of fiscal 1996 weighted average shares outstanding is as
follows (in Thousands):
<TABLE> 
<CAPTION> 

        <S>                                                <C>  
        Weighted average shares outstanding - Basic        10,945
        Effect of dilutive securities:
          Options                                             867
          Warrants                                            332
                                                           ------
        Weighted average shares outstanding - Diluted      12,144
                                                           ======
</TABLE> 
                                                                               
     Options and warrants to purchase 425,430 and 109,162 shares of common stock
during the years ended June 30, 1997 and 1998, respectively were not included in
the computation of diluted loss per common share as the effect would be
antidilutive.

                                       41
<PAGE>
 
  6.   PROPERTY AND EQUIPMENT
 
       Property and equipment, at cost, are summarized as follows at June 30,
  1997, and 1998 (in thousands):
 

<TABLE> 
<CAPTION> 

                                                                1997         1998
                                                              ------        ------
<S>                                                           <C>           <C>   

         Office equipment, furniture and fixtures             $2,120        $2,247
         Operating equipment                                   1,147         1,226
         Film production equipment                             2,616         4,012
         Demonstration theatres                                2,878         3,548
         Leasehold improvements                                1,279         1,279 
                                                              ------        ------                           
               Total                                          10,040        12,312
         Less accumulated depreciation                        (7,120)       (7,983)
                                                              ------        ------                         
                                                              $2,920        $4,329
                                                              ======        ======
</TABLE>            

       Certain transportation equipment aggregating $3,711,000 at June 30, 1997
  and 1998  were recorded under capital lease agreements.  Accumulated
  depreciation on this equipment was $1,018,000 and $ 1,307,293 at June 30, 1997
  and 1998, respectively.
 
       Depreciation expense amounted to $3,113,000, $2,750,00 and $1,797,000 for
  the years ended June 30, 1996, 1997 and 1998, respectively, including amounts
  related to assets under capital leases.
 
  7.   RELATED PARTY TRANSACTIONS
 
  During 1993, Itochu Corporation ("Itochu"), a stockholder, agreed to pay the
  Company $5 million primarily for the right to become the Company's exclusive
  distributor for a three year term in Asia for its Cinetropolis concept.
  Cinetropolis is a location based entertainment attraction utilizing multiple
  Iwerks products combined with food and beverage, retail and other
  entertainment in a stand-alone 35,000 to 60,000 square foot facility.  The $5
  million was recorded in deferred revenue and has been amortized over the three
  year exclusivity period.  In addition, Itochu became a nonexclusive agent for
  Iwerks' other products for seven years.  Itochu earns sales commissions on
  collections from customers on any theatre systems and related software sold by
  Itochu or its agents.    During  the  years  ended   June 30,  1996,   1997
  and  1998,  $610,000,  $489,000,   and  $291,000 respectively, was paid to
  Itochu in connection with this arrangement.

                                       42
<PAGE>
 
 
 
8.      INCOME TAXES


       Provision for income taxes for the three years ended June 30 consists of
  (in thousands):

<TABLE>
<CAPTION>
  
                                                                      1996       1997         1998
                                                                     -----       -----        -----
<S>                                                                 <C>          <C>         <C>
Current:                                                                             
 Federal                                                             $  47      $  40        $  -
 State                                                                  25         24           8
 Foreign                                                                77         53          15
                                                                     -----      -----       -----
                                                                       149        117          23
Deferred:                                                                                  
 Federal                                                                 -          -           -
 State                                                                   -          -           -
                                                                     -----      -----       -----
                                                                     $ 149      $ 117       $  23
                                                                     =====      =====       =====              
                                                                                           
 Reconciliation of effective rate of income taxes:                                         

<CAPTION>                                                                                  
 
                                                                     1996       1997        1998
                                                                   --------   ---------   --------
<S>                                                                <C>        <C>         <C>
Provision for income taxes at statutory
 federal rate of 35%                                               $ 1,137     $(3,444)   $(3,828)
State and local taxes                                                   25          24          8
Foreign taxes                                                           77          53         15
Nondeductible items and
 nontaxable items                                                      399       1,019        266
NOL benefit                                                         (1,489)          -          -
Benefit of net operating loss
 not currently recognized                                                -       2,465      3,562
                                                                   -------     -------    -------
                                                                   $   149     $   117    $    23
                                                                   =======     =======    =======
<CAPTION> 
 
The deferred tax asset at June 30 consists of (in thousands):
 
                                                                                 1997      1998
                                                                                ------     ------
<S>                                                                            <C>         <C>  
Net operating loss                                                             $ 7,461     $ 8,160
Reserves                                                                          (405)       (450)
Asset impairment reserve                                                        (1,507)     (1,507)
Deferred revenues                                                                  (62)        (74)
Film cost amortization                                                             785         542
Other                                                                                8           9
                                                                               -------     -------
                                                                                 6,280       6,680
 Valuation allowance                                                            (6,280)     (6,680)
                                                                               -------     -------
                                                                               $     -     $     -
                                                                               =======     ======= 
</TABLE> 
 
       At June 30, 1998, Iwerks had available federal and state tax net
  operating loss carryforwards of approximately $ 20,400,000 and $ 9,200,000,
  respectively, expiring through 2013.

                                       43
<PAGE>
 
  9. STOCK OPTIONS AND WARRANTS
 
       The Company has elected to follow Accounting Principles Board Opinion No.
  25, "Accounting for Stock Issued to Employees" (APB 25) and related
  Interpretations in accounting for its employee stock options because, as
  discussed below, the alternative fair value accounting provided for under FASB
  Statement No. 123, "Accounting for Stock-Based Compensation," requires use of
  option valuation models that were not developed for use in valuing employee
  stock options.  Under APB 25, because the exercise price of Iwerks' employee
  stock options equals the market price of the underlying stock on the date of
  grant, no compensation expense is recognized.
 
       The Company has three stock incentive plans adopted in 1987, 1993, and
  1994, respectively, (the "Plans") which provide for the granting to officers,
  directors, employees and consultants options to purchase shares of Iwerks
  Common Stock.  In aggregate, 3,250,000 shares of Iwerks Common Stock are
  reserved for issuance under the Plans.  In addition the Company has granted
  other options to purchase 100,000 shares of Iwerks Common Stock to certain
  officers outside of the Plans.  Options generally vest over a four-year period
  and expire in ten years.
 
       Terminated employees have 90 days to exercise options, however certain
  officers, having separation agreements, have as long as 36 months to exercise
  options.  At June 30, 1998, there were 876,500 vested options outstanding
  relating to four terminated officers which expire at varying dates until May,
  2001.
 
       Pro forma information regarding net income and earnings per share is
  required by Statement 123, and has been determined as if the Company had
  accounted for its employee stock options under the fair value method of that
  Statement. The fair value for these options was estimated at the date of grant
  using a Black-Scholes option pricing model with the following weighted-average
  assumptions for fiscal year 1996, 1997 and 1998, respectively: risk-free
  interest rates of 5.74%, 6.36% and 5.55%; weighted-average expected life of
  the option of 4.64 years, 4.19 years and 4.75 years; zero dividend yields; and
  a volatility factor of the expected market price of Iwerks' Common Stock of
  51%, 51% and 57.5%.
 
       The Black-Scholes option valuation model was developed for use in
  estimating the fair value of traded options which have no vesting restrictions
  and are fully transferable.  In addition, option valuation models require the
  input of highly subjective assumptions including the expected stock price
  volatility.  Because the Company's employee stock options have characteristics
  significantly different from those of traded options, and because changes in
  the subjective input assumptions can materially affect the fair value
  estimate, in management's opinion, the existing models do not necessarily
  provide a reliable single measure of the fair value of its employee stock
  options.
 
       For purposes of pro forma disclosures, the estimated fair value of the
  options is amortized to expense over the options' vesting period.  Given this
  method of amortization, the initial impact of applying FAS 123 on pro forma
  net income (loss) and pro forma earnings (loss) per share is not
  representative of the potential impact on pro forma amounts in future years
  when the effect of amortization from multiple awards would be reflected. The
  Company's pro forma information follows (in thousands except for per share
  information):

 
 
 

                                       44
<PAGE>

<TABLE> 
<CAPTION> 

                                         1996        1997          1998
                                        ------     --------      --------
<S>                                     <C>        <C>           <C> 
Pro Forma net income (loss)             $2,717     $(10,685)     $(12,483)

Pro Forma net income (loss) per share   $ 0.23     $  (0.90)     $  (1.02)
</TABLE> 

       A summary of the Company's stock option activities and related
  information for the years ended June 30 are as follows:
 
<TABLE>
<CAPTION>
 
                                                                         Number of Shares              Weighted Average
                                                                          (in thousands)                Exercise Price
                                                                          --------------                --------------
 
<S>                                                                        <C>                            <C>
 
Options outstanding July 1, 1995                                               1,708                          $3.54
Options granted                                                                  877                           5.23
Options exercised                                                               (385)                          1.64
Options terminated                                                              (274)                          6.46
Options exercisable at June 30, 1996                                             604                          $3.07
 
Options outstanding July 1, 1996                                               1,926                          $4.26
Options granted                                                                  660                           5.54
Options exercised                                                               (260)                          1.82
Options terminated                                                              (425)                          4.96
Options exercisable at June 30, 1997                                             696                          $4.30

                                                                                    
Options outstanding July 1, 1997                                               1,901                          $4.88
Options granted                                                                  464                           2.90
Options exercised                                                                (24)                           .35
Options terminated                                                              (159)                          5.33
</TABLE>
                                        
The weighted-average fair value of options granted was $1.45 in fiscal year
1998, $2.64 in fiscal year 1997 and $2.57 in fiscal year 1996.
                                        
                                        
                                        

                                       45
<PAGE>
 
     The following table summarizes information about stock options outstanding
at June 30, 1998:

<TABLE>
<CAPTION>
                                  Options Outstanding                                Options
                                   Weighted  Average                               Exercisable   
                        --------------------------------------               -----------------------
                                       Weighted   
                                        Average    
                     Outstanding       Remaining                                         
                         at           Contractual       Weighted         Exercisable at         Weighted
   Range of         June 30, 1998        Life            Average          June 30, 1998         Average
Exercise Prices     in Thousands       in Years       Exercise Price      in Thousands       Exercise Price
---------------     -------------     -----------     --------------     --------------      --------------
<S>                 <C>               <C>             <C>                <C>                 <C> 
  $  .10-.74               71             3.4              $ .46                71                 $ .46
  $2.25-3.28              435             8.3              $2.68               152                 $2.71
  $3.38-5.02            1,158             4.3              $4.71               906                 $4.82
  $5.19-7.56              488              7               $5.79               265                 $5.77
  $9.00-9.75               30              7               $9.38                20                 $9.29
                        -----                                                -----
                        2,182                                                1,414
                        =====                                                =====
</TABLE>
 
     As of June 30, 1996, 1997 and 1998 the Company had 580,593, 364,582 and
23,099 shares available for future grants under the Plans. As of June 30, 1998
Iwerks has reserved 2,205,446 shares of unissued Iwerks Common Stock for
issuance upon exercise of options granted under the Plans and outside the Plans.
                                        
     At June 30, 1998 the Company had 470,494 warrants exercisable at $8.78 per
share and expiring July 2, 1999 and 8,000 warrants exercisable at $7.30 per
share expiring April, 2003. (See Note 15).
                                        
10.  COMMITMENTS AND CONTINGENCIES
                                        
     The Company leases facilities under operating leases that expire through
2001. Leases that expire are expected to be renewed or replaced. Rental expense
for the years ended June 30, 1996, 1997 and 1998 was approximately $617,000,
$641,000 and $641,000, respectively.
                                        
     Future minimum lease payments under capital and operating leases at June
30, 1998 are as follows (in thousands):
<TABLE>
<CAPTION>
                                          Capital    Operating
                                           leases     leases
                                          --------   ---------
   <S>                                    <C>        <C>
   1999                                    $   963        $435
   2000                                        867         240
   2001                                        294          60
   2002                                          -           -
   2003                                          -           -
                                           -------        ----
   Total minimum lease payments              2,124        $735
                                                          ====
   Less amount representing interest          (239)
                                           -------
                                           $ 1,885
                                           =======
</TABLE> 
 
     The Company has also from time to time, provided standby letters of credit
to customers as performance bonds. The customers may draw on the letters of
credit should Iwerks fail to perform under the terms of the contracts. There
were no standby letters of credit outstanding as of June 30,


                                       46
<PAGE>
 
1998.
 
     During the year, the Company has entered into employment contracts with
four key officers including the CEO. In aggregate, these contracts provide for
minimum annual compensation of $740,000. The contracts provide for annual
salaries, annual rate increases between 4% and 5%, bonus compensation based on
performance and stock options. These contracts have a term of two and three
years and provide for termination benefits of a minimum of 15 months annual
salary in the event of termination without cause or change of control.
 
     The Company has guaranteed the debt of a customer in connection with the
purchase of a hardware system. The total amount of this debt at June 30, 1998
was approximately $355,000. Subsequent to June 30, 1998, this debt became due
and the customer is in default. The Company believes that no material amounts
will become payable under its guarantee.
 
11.  SIGNIFICANT CUSTOMERS AND GEOGRAPHIC INFORMATION
 
     In 1996, 1997 and 1998 Iwerks had no customers who accounted for more than
10% of consolidated revenue.
 
     Export revenue by geographic area for the years ended June 30 consist of
(in thousands):

<TABLE> 
<CAPTION> 

                                    1996         1997         1998
                                  --------     --------     --------
        <S>                       <C>          <C>          <C> 
        Asia                      $ 17,311     $ 13,682     $  5,660
        South America                  972        5,375        2,493
        Europe                       4,409        2,085        1,672
        Canada                       1,131          516        1,596
                                  --------     --------     --------
        Total export revenue      $ 23,823     $ 21,658     $ 11,421
                                  ========     ========     ========
</TABLE> 

12.  ASSET IMPAIRMENT IN FISCAL 1997

     The fourth quarter of fiscal 1997 includes a non-cash charge of $5.6
million to record the impact of the adoption of SFAS No. 121, "Accounting for
the Impairment of Long-Lived Assets and for Long-Lived Assets to be disposed
of." This charge consisted primarily of a reduction in the carrying value of the
portable simulation business (touring) to the net present value of the future
cash flows expected from these assets. Of the charge, $1.8 million reduced
Goodwill, and the balance reduced Iwerks' fixed assets. The Company lost AT&T as
a major sponsor of the Reactor' fleet in the first quarter of fiscal 1997. The
loss of the major sponsor that utilized five of the Reactors throughout fiscal
1996 resulted in excess capacity between early fall and late spring of fiscal
1997. Since that time, and through the fourth quarter of fiscal 1997, the
Company aggressively pursued new sponsorship opportunities and other options to
replace those revenues. The failure to consummate those opportunities prior to
the end of fiscal 1997 and the lack of sponsorship backlog as of June 30, 1997
prompted the Company to take the charge under SFAS 121.
 
 
                                       47
<PAGE>
 
13.  FOURTH QUARTER ADJUSTMENTS IN FISCAL 1997

     In the fourth quarter of fiscal 1997, certain events occurred which
resulted in changes in accounting estimates. These include additional film
amortization of $746,000 due to changes in revenue estimates; increased bad debt
reserve by $557,000 due to an account which was deemed uncollectable,
established a legal and dispute reserve of $850,000 for disputes that first
arose in the fourth quarter of fiscal 1997; increase the warranty reserve by
$147,000 due to increase work performed on a contract, increased accrued
expenses by $320,000 due to a regulatory audit and reduced previously recognized
earnings by $205,000 in connection with the cancellation of a contract.

14.  STOCKHOLDERS RIGHTS PLAN
 
     The Company has adopted a Stockholder Rights Plan (the "Agreement").
Pursuant to the Agreement each outstanding share of Iwerks' Common Stock has
received one right entitling the holder to purchase 1/100th of a share of Series
A Preferred Stock of Iwerks for each share of Iwerks Common Stock then held by
such holder. Each right becomes exercisable upon certain triggering events
related to an unsolicited takeover attempt of Iwerks.
 
15.  LITIGATION
 
     In the fourth quarter of fiscal year ended 1996, the Company reached an
agreement with the plaintiffs to settle all pending shareholder class action
suits against the Company and certain of its officers and directors in the
United States District Court of the Central District of California. In
accordance with the principal terms of the agreement, $1.75 million was paid by
the Company's insurance carrier (with unclaimed amounts being returned to the
carrier). In fiscal 1996 and 1998 an aggregate of 235,246 shares of Iwerks'
Common Stock and 470,494 warrants to purchase Iwerks' Common Stock were issued
by the Company to the plaintiffs and their attorneys. The warrants are
exercisable through July 2, 1999, and the exercise price is $8.78. The Company
will receive the proceeds from the exercise of the warrants if and when they are
exercised. The Company took a charge against earnings of $1.7 million in the
fourth quarter of fiscal 1995 to reflect the anticipated costs of the
settlement. Further, there can be no assurance that others not included in the
settlement will not file similar claims in the future.
 
     Fred Hollingsworth III, a former director of the Company and former chief
executive officer and founder of Omni Films International, Inc., filed suit in
1996 against the Company and seven of its current or former officers and
directors. In February, 1997 the Company and Mr. Hollingsworth reached an 
out-of-court settlement. The Company made a cash payment to Mr. Hollingsworth
which the Company was reimbursed by its insurance carrier in the quarter ended
June 30, 1997.
 
     There are no material legal proceedings to which the Company is a party
other than ordinary routine litigation in the course of business. In the opinion
of management, resolution of these matters will not have a material adverse
impact on the Company's financial position or results of operations.
 

                                       48
<PAGE>
 
ITEM 9.   CHANGES AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND FINANCIAL
--------------------------------------------------------------------------------
DISCLOSURE.
---------- 

        None.

                                   PART III

ITEM 10.  DIRECTORS AND EXECUTIVE OFFICERS OF REGISTRANT.
-------------------------------------------------------- 

     On February 21, 1998 Charles Goldwater was appointed Chairman of the Board,
Chief Executive Officer and President replacing Roy A. Wright.  Mr. Goldwater
was formerly the Chief Executive Officer and President of Mann Theatres
(Cinemerica Theatres L.P.)

     In March, 1998 Daniel Griesmer was appointed Senior Vice President and
General Manager overseeing all areas of product development, touring ride
simulation business, manufacturing, project design and field operations.

     In June, 1998 Jack Shishido was appointed Senior Vice President Worldwide
Sales and Marketing.

     On June 8, 1998 the Company announced the appointment of two new outside
members to its Board of Directors bringing the number of outside Directors to
six. The two new directors were Bruce A. Beda, Chief Executive of Orion Partners
and Peter Hanelt, Chief Operating Officer of Natural Wonders.

     Information regarding directors and executive officers of the Company will
appear in the Proxy Statement for the 1998 Annual Meeting of Stockholders, and
is incorporated herein by this reference.

ITEM 11.  EXECUTIVE COMPENSATION.
-------------------------------- 

     Information regarding executive compensation will appear in the Proxy
Statement for the 1998 Annual Meeting of Stockholders, and is incorporated
herein by this reference.

ITEM 12.  SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT.
------------------------------------------------------------------------ 

     Information regarding security ownership of certain beneficial owners and
management of the Company will appear in the Proxy Statement for the 1998 Annual
Meeting of Stockholders, and is incorporated herein by this reference.

ITEM 13.  CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS.
-------------------------------------------------------- 

     Information regarding certain relationships and related transactions will
appear in the Proxy Statement for the 1998 Annual Meeting of Stockholders, and
is incorporated herein by this reference.

                                       49
<PAGE>
 
ITEM 14.  EXHIBITS, FINANCIAL STATEMENT SCHEDULES, AND REPORTS ON FORM 8-K.
---------------------------------------------------------------------------
<TABLE> 
<CAPTION> 

(a)  FINANCIAL STATEMENTS:                                           PAGE NUMBER
                                                                     -----------
<S>                                                                  <C>
     Report of Independent Auditors                                     30
 
     Consolidated Balance Sheets                                        31-32
     June 30, 1997 and 1998
 
     Consolidated Statements of Operations                              33
     Years Ended June 30, 1996, 1997 and 1998
 
     Consolidated Statements of Stockholders' Equity                    34
     Years Ended June 30, 1996, 1997 and 1998
 
     Consolidated Statements of Cash Flows                              35-36
     Years Ended June 30, 1996, 1997 and 1998
 
     Notes to Consolidated Financial Statements                         37-48
</TABLE>

          FINANCIAL STATEMENT SCHEDULES:

     Schedule II - Valuation and Qualifying Accounts for the years ended June
     30, 1996, 1997 and 1998.
 
     All other schedules for which provision is made in the applicable
     accounting regulation of the Securities and Exchange Commission are not
     required under the related instructions or are inapplicable, and therefore
     have been omitted.

(b)  EXHIBITS:  See Exhibit List attached to this Annual Report on Form 10-K.

(c)  REPORTS ON FORM 8-K:

     (i)  Report on Form 8-K, filed on April 2, 1998 with respect to an event
          occurring on March 31, 1998 - Item 5.
 
     (ii) Report on Form 8-K, filed on June 18, 1998 with respect to an event
          occurring on June 15, 1998 - Item 5.
 

                                       50
<PAGE>
 
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.

                                    IWERKS ENTERTAINMENT, INC.
                                          (Registrant)

                                     By: /s/ Charles Goldwater
                                         ---------------------
                                         Charles Goldwater
                                         Chief Executive Officer

                                     Date:   September 24, 1998

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

<TABLE>
<CAPTION>
           Signature                               Title                             Date
           ---------                               -----                             ----
<S>                               <C>                                       <C>
/s/ Charles Goldwater                   Chairman, President and CEO           September 24, 1998
-------------------------------        (Principal Executive Officer)
Charles Goldwater
 
                                         Executive Vice President             September 24, 1998
/s/ Bruce C. Hinckley                     Chief Financial Officer
-------------------------------         (Principal Finance Officer)
Bruce C. Hinckley
 
 
/s/ Jeffrey M. Dahl                     Vice President /Controller            September 24, 1998
-------------------------------       (Principal Accounting Officer)
Jeffrey M. Dahl
 
 
/s/ Donald W. Iwerks                    Vice Chairman of the Board            September 24, 1998
-------------------------------
Donald W. Iwerks
 
 
/s/ Dag Tellefsen                                Director                     September 24, 1998
-------------------------------
Dag Tellefsen
 
 /s/ Gary J. Matus                               Director                     September 24, 1998
-------------------------------
Gary J. Matus
 
/s/ Bruce Beda                                   Director                     September 24, 1998
-------------------------------
Bruce Beda
 
/s/ Peter Hanelt                                 Director                     September 24, 1998
-------------------------------
Peter Hanelt
</TABLE>

                                       51
<PAGE>
 
                                                                     SCHEDULE II
                                                                                
                          IWERKS ENTERTAINMENT, INC.
                       VALUATION AND QUALIFYING ACCOUNTS
               FOR THE YEARS ENDED JUNE 30, 1996, 1997 AND 1998
<TABLE>
<CAPTION>
                                        Balance at
                                         beginning                                     Balance at
Classification                           of year        Additions      Write-Offs      end of year
--------------                          ----------     -----------     -----------     -----------
<S>                                     <C>            <C>             <C>             <C>
FOR THE YEAR ENDED JUNE 30, 1996
  Allowance for doubtful accounts         $932,255               -        $639,265        $292,990
 
FOR THE YEAR ENDED JUNE 30, 1997
  Allowance for doubtful accounts         $292,990        $843,495         $25,171      $1,111,315

FOR THE YEAR ENDED JUNE 30, 1998
  Allowance for doubtful accounts       $1,111,315      $1,808,250      $1,026,333      $1,893,232
</TABLE>

                                       52
<PAGE>
 
                                 EXHIBIT INDEX


<TABLE>

<C>     <S>
  3.1   Certificate of Amendment of Certificate of Incorporation dated August 1,
        1997. ***
  3.2   Bylaws of Iwerks. **
  4.1   Specimen Certificate evidencing Common Stock of Iwerks.*
  4.3   Warrant Agreement, dated April 30, 1993, by and between Iwerks and
        Richard King International.*
 10.1   Form of Indemnification Agreement and schedule of indemnified parties.*
 10.2   Purchase Agreement dated January 23, 1991, by and between Iwerks and
        Ride and Show Engineering, Inc.*
 10.3   Amended and Restated 1987 Stock Option, Purchase and Appreciation Rights
        Plan of Iwerks.*
 10.6   1993 Stock Incentive Plan of Iwerks.*
 10.7   Lease for 4540 W. Valerio Street, Burbank, California 91505, dated May
        15, 1990, by and between Iwerks as lessee and Sheldon Plutsky as
        lessor.*
 10.8   Lease for 4520 Valerio Street, Burbank, California 91505, dated
        September 1, 1992, and the Amendment thereto, dated September 22, 1992,
        by and between Iwerks as lessee and James E. McGraw as lessor.*
 10.9   Lease for 4535 W. Valerio Street, Burbank, California 91505, dated
        September 11, 1991, by and between Iwerks as lessee and R.C. Associates
        as lessor.*
10.10   Lease for 4525 W. Valerio Street, Burbank, California 91505, dated March
        23, 1994 by and between Iwerks as lessee and the Penney Family Trust as
        lessor.***
10.12   1994 Stock Incentive Plan of Iwerks Entertainment, Inc.**
10.15   Lease Agreement - Matrix Funding Corporation***
10.16   Separation Agreement dated October 31, 1997 between the Company and Roy
        A. Wright *****
10.17   Separation Agreement dated October 31, 1997 between the Company and
        Bruce Hinckley *****
10.18   Separation Agreement dated October 31, 1997 between the Company and
        William J. Battison III *****
10.22   Employment Agreement dated February 21, 1998 between the Company and
        Charles Goldwater ******
10.23   Employment Agreement dated March 2, 1998 between the Company and Dan
        Griesmer *******
10.24   Employment Agreement dated August 3, 1998 between the Company and Jack
        Shishido.
22.1    Subsidiary List.**
23.1    Consent of Independent Auditors - Ernst & Young LLP
</TABLE> 

                                       53
<PAGE>

<TABLE> 

<C>    <S>  
27.1   Exhibit 27.1 - Schedule of Financial Information
</TABLE> 
______________
      *  Incorporated by reference from Iwerks' Registration Statement on Form 
         S-1, SEC File No. 68022 declared effective on October 19, 1993.
 
     **  Incorporated by reference from Registrants Annual Report on Form 10-K
         for the year ended June 30, 1995.
 
    ***  Incorporated by reference from Registrants Annual Report on Form 10-K
         for the year ended June 30, 1996.

   ****  Incorporated by reference from Registrants Annual Report on Form 10-K
         for the year ended June 30, 1997.

  *****  Incorporated by reference from Registrants Quarterly Report on Form 
         10-Q for the quarter and six months ended December 31, 1997.

 ******  Incorporated by reference from Registrants Registration Statement on
         Form S-4 filed on March 4, 1998.

*******  Incorporated by reference from Registrants Quarterly Report on Form
         10-Q for the quarter and nine months ended March 31, 1998.


                                       54