<PAGE>
 
===============================================================================
 
                                 UNITED STATES
                      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 December 31, 1998
 
                                      OR
 
[_] TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES AND
    EXCHANGE ACT OF 1934
 
            For the transition period from __________ to __________
 
                        Commission File Number 0-24363
 
                               ----------------
 
                         INTERPLAY ENTERTAINMENT CORP.
          (Exact name of the registrant as specified in its charter)
 
                               ----------------
 
                  Delaware                            33-0102707
       (State or other jurisdiction of            (I.R.S. Employer
       incorporation or organization)            Identification No.)
 
               16815 Von Karman Avenue, Irvine, California 92606
                   (Address of principal executive offices)
 
                                (949) 553-6655
             (Registrant's telephone number, including area code)
 
       Securities registered pursuant of Section 12(b) of the Act: None
 
          Securities registered pursuant of Section 12(g) of the Act:
 
                        Common Stock, $0.001 par value
 
                               ----------------
 
  Indicate by check mark whether the registrant: (1) has filed all reports
required to be filed by Section 13 or 15(d) of the Securities Exchange Act of
1934 during the preceding 12 months (or for such shorter period that the
registrant was required to file such reports), and (2) has been subject to
such filing requirements for the past 90 days. Yes [X] No [_]
 
  Indicate by check mark if disclosure of delinquent filers pursuant to Item
405 of Regulation S-K is not contained herein, and will not be contained, to
the best of registrant's knowledge, in definitive proxy or information
statements incorporated by reference in Part III of this Form 10-K or any
amendment to this Form 10-K. [X]
 
  As of March 22, 1999, 20,808,861 shares of Common Stock of the Registrant
were issued and outstanding and the aggregate market value of voting common
stock held by non-affiliates was $19,956,470.
 
                      DOCUMENTS INCORPORATED BY REFERENCE
 
  Portions of the definitive proxy statement for the Company's 1999 Annual
Meeting of Stockholders, to be held in June 1999, are incorporated by
reference into Part III.

=============================================================================== 
<PAGE>
 
                         INTERPLAY ENTERTAINMENT CORP.
 
            INDEX TO FORM 10-K FOR THE YEAR ENDED DECEMBER 31, 1998
 
<TABLE>
<CAPTION>
                                                                          Page
                                                                          ----
                                     PART I
 
 <C>      <S>                                                             <C>
 ITEM 1.  BUSINESS......................................................    4
 
 ITEM 2.  PROPERTIES....................................................   12
 
 ITEM 3.  LEGAL PROCEEDINGS.............................................   12
 
 ITEM 4.  SUBMISSION OF MATTERS 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 7A. QUANTITATIVE AND QUALITATIVE DISCLOSURE ABOUT MARKET RISK.....   36
 
 ITEM 8.  CONSOLIDATED FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA......   36
 
 ITEM 9.  CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING
           AND FINANCIAL DISCLOSURE.....................................   36
 
                                    PART III
 
 ITEM 10. DIRECTORS AND EXECUTIVE OFFICERS OF THE REGISTRANT............   37
 
 ITEM 11. EXECUTIVE COMPENSATION........................................   37
 
 ITEM 12. SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS
           AND MANAGEMENT...............................................   37
 
 ITEM 13. CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS................   37
 
                                    PART IV
 
 ITEM 14. EXHIBITS, FINANCIAL STATEMENT SCHEDULES AND REPORTS ON
           FORM 8-K.....................................................   37
 
 SIGNATURES..............................................................  38
 
 EXHIBIT INDEX...........................................................  39
</TABLE>
 
                                       2
<PAGE>
 
  This Form 10-K contains certain forward-looking statements within the
meaning of Section 27A of the Securities Act of 1933 and Section 21E of the
Securities and Exchange Act of 1934 and such forward-looking statements are
subject to the safe harbors created thereby. For this purpose, any statements
contained in this Form 10-K except for historical information may be deemed to
be forward-looking statements. Without limiting the generality of the
foregoing, words such as "may," "will," "expect," "believe," "anticipate,"
"intend," "could," "estimate" or "continue" or the negative or other
variations thereof or comparable terminology are intended to identify forward-
looking statements. In addition, any statements that refer to expectations,
projections or other characterizations of future events or circumstances are
forward-looking statements.
 
  The forward-looking statements included herein are based on current
expectations that involve a number of risks and uncertainties, as well as on
certain assumptions. For example, any statements regarding future cash flow,
financing activities, cost reduction measures, compliance with the Company's
line of credit and an extension or replacement of such line are forward-
looking statements and there can be no assurance that the Company will
generate positive cash flow in the future or that the Company will be able to
obtain financing on satisfactory terms, if at all, or that any cost reductions
effected by the Company will be sufficient to offset any negative cash flow
from operations or that the Company will remain in compliance with its line of
credit or be able to renew or replace such line. Additional risks and
uncertainties include possible delays in the completion of products, the
possible lack of consumer appeal and acceptance of products released by the
Company, fluctuations in demand, lost sales because of the rescheduling of
products launched or orders delivered, failure of the Company's markets to
continue to grow, failure of the Company's products to be and remain accepted
within their respective markets, material adverse changes in competitive
conditions within the Company's markets, failure of the Company to retain key
development and management personnel, failure of the Company to accurately
anticipate market demand, and material adverse changes in the Company's
operations or business. Additional factors that may affect future operating
results are discussed in more detail in "Management's Discussion and Analysis
of Financial Condition and Results of Operations--Factors Affecting Future
Performance". Assumptions relating to the foregoing involve judgments with
respect to, among other things, future economic, competitive and market
conditions, and future business decisions, all of which are difficult or
impossible to predict accurately and many of which are beyond the control of
the Company. Although the Company believes that the assumptions underlying the
forward-looking statements are reasonable, the business and operations of the
Company are subject to substantial risks that increase the uncertainty
inherent in the forward-looking statements, and the inclusion of such
information should not be regarded as a representation by the Company or any
other person that the objectives or plans of the Company will be achieved. In
addition, risks, uncertainties and assumptions change as events or
circumstances change. The Company disclaims any obligation to publicly release
the results of any revisions to these forward-looking statements which may be
made to reflect events or circumstances occurring subsequent to the filing of
this Form 10-K with the SEC or otherwise to revise or update any oral or
written forward-looking statement that may be made from time to time by or on
behalf of the Company.
 
  Interplay(TM), Interplay Productions(R) and certain of the Company's product
names and publishing labels referred to herein are trademarks of the Company.
This Annual Report on Form 10-K also contains trademarks of other companies.
 
                                       3
<PAGE>
 
                                    PART I
 
ITEM 1. BUSINESS
 
Overview
 
  Interplay Entertainment Corp., a Delaware corporation, (together with its
subsidiaries, the "Company" or "Interplay") is a leading developer, publisher
and distributor of interactive entertainment software for both core gamers and
the mass market. Interplay was incorporated in the State of California in 1982
and was reincorporated in the State of Delaware in May 1998. The Company,
which commenced operations in 1983, is most widely known for its titles in the
action/arcade, adventure/RPG, strategy/puzzle and sports categories. The
Company has produced titles for many of the most popular interactive
entertainment software platforms, and currently balances its development
efforts by publishing interactive entertainment software for PCs and current
generation video game consoles, such as the PlayStation and Nintendo 64.
 
  The Company seeks to publish interactive entertainment software titles that
are, or have the potential to become, franchise software titles that can be
leveraged across several releases and/or platforms, and has published many
such successful franchise titles to date. In addition, the Company secures
licenses to use popular intellectual properties, such as Star Trek, Caesars
Palace and Major League Baseball, for incorporation into certain of its
products. Of the more than 40 titles currently in development by the Company,
more than half are sequels to successful titles or incorporate licensed
intellectual properties.
 
  In February 1999, in connection with the Company's acquisition of a minority
membership interest in the parent entity of Virgin Interactive Entertainment
Limited ("Virgin"), the Company entered into an International Distribution
Agreement with Virgin (the "Virgin Distribution Agreement"). Pursuant to the
Virgin Distribution Agreement, Virgin will hire the Company's European sales
and marketing personnel and will distribute substantially all of the Company's
titles in Europe, CIS, Africa and the Middle East. See "Business--
Distribution--International" and "Management's Discussion and Analysis of
Financial Condition and Results of Operations--Factors Affecting Future
Performance--Distribution Agreement."
 
Products
 
  The Company develops, publishes and distributes interactive entertainment
software titles that provide immersive game experiences by combining advanced
technology with engaging content, vivid graphics and rich sound. The Company
utilizes the experience and judgment of the avid gamers in its product
development group to select and produce the products it publishes. This has
resulted in the publication of a wide variety of games that have received
numerous awards, including the Academy of Interactive Arts & Sciences' Best
Title, Computer Game Review's Gold and Platinum Triads and PC Entertainment's
Editor's Choice Awards.
 
  The Company's strategy is to develop products for those platforms, whether
PC or video game console, that have or will have sufficient installed bases
for such development to be economically viable. The Company currently
publishes products for multiple PC platforms, including Windows 95 and 98, and
for the current generation of video game consoles, including the PlayStation
and Nintendo 64. The Company assesses the potential acceptance and success of
emerging platforms and the anticipated continued viability of existing
platforms based on many factors, including the number of competing titles, the
ratio of software sales to hardware sales with respect to such platform, the
installed base of the platform, the change in the rate of sales of the
platform and the cost and timing of development for the platform. The Company
must continually anticipate and assess the emergence of, and market acceptance
of, new interactive entertainment software platforms well in advance of the
time the platform is introduced to consumers. Because product development
cycles are difficult to predict, the Company is required to make substantial
product development and other investments in a particular platform well in
advance of introduction of the platform. If the platforms for which the
Company develops software are not released on a timely basis or do not attain
significant market penetration, the Company's business, operating results and
financial condition could be materially adversely affected.
 
                                       4
<PAGE>
 
Alternatively, if the Company fails to develop products for a platform that
does achieve significant market penetration, then the Company's business,
operating results and financial condition could also be materially adversely
affected.
 
  The Company has entered into license agreements with Sony Computer
Entertainment and Nintendo pursuant to which the Company is granted the right
to develop, sublicense and distribute products for such platforms in specified
territories, which products are manufactured by the licensor for the Company
and the Company is currently negotiating a similar license for Sega's new
Dreamcast platform. The Company pays the licensor a royalty and/or
manufacturing fee in exchange for such license and manufacturing services.
Such agreements grant the licensor certain approval rights over the products
developed for such platforms, as well as over the packaging and marketing
materials for such products. There can be no assurance that the Company will
be able to obtain future licenses from hardware companies on acceptable terms
or that any existing or future licenses will be renewed by the licensors. The
inability of the Company to obtain such approvals could have a material
adverse effect on the Company's business, operating results and financial
condition. See "Management's Discussion and Analysis of Financial Condition
and Results of Operations--Factors Affecting Future Performance--Dependence on
Licenses from and Manufacturing by Hardware Companies."
 
Product Development
 
  The Company develops or acquires its products from a variety of sources,
including its four internal development divisions, Shiny, Interplay Europe and
publishing relationships with leading independent developers.
 
  The Development Process. The Company develops original products both
internally, using its in-house development staff, and externally, using third
party software developers working under contract with the Company. Producers
on the Company's internal staff monitor the work of both inside and third
party development teams through design review, progress evaluation, milestone
review and quality assurance. In particular, each milestone submission is
thoroughly evaluated by the Company's product development staff to ensure
compliance with the product's design specifications. The Company enters into
consulting or development agreements with third party developers which are
generally on a flat-fee, work-for-hire basis or on a royalty basis, whereby
advances are paid based on the achievement of milestones. In royalty
arrangements, the Company ultimately pays continuation royalties to developers
once the Company's advances have been recouped. In addition, in certain cases,
the Company will utilize third party developers to port products to new
platforms.
 
  The Company's products typically have short life cycles, and the Company
depends on the timely introduction of successful new products, including
enhancements of or sequels to existing products and conversions of previously
released products to additional platforms, to generate net revenues to fund
operations and to replace declining net revenues from existing products. The
development cycle of new products is difficult to predict, and involves a
number of risks. See "Management's Discussion and Analysis of Financial
Condition and Results of Operations--Factors Affecting Future Performance--
Dependence on New Product Introductions; Risk of Product Delays and Product
Defects."
 
  During the year ended December 31, 1998, the eight months ended December 31,
1997 and the fiscal years ended April 30, 1997 and 1996, the Company spent
$24.5 million, $14.3 million, $21.4 million and $15.1 million, respectively,
on product research and development activities. Those amounts represented
19.3%, 16.6%, 25.7% and 15.6%, respectively, of revenue in each of those
years.
 
Internal Product Development
 
  U.S. Product Development. The Company's U.S. internal product development
group (excluding Shiny's development group) consisted of approximately 204
people at December 31, 1998. Once a design is selected by the Company, a
production team, development schedule and budget are established. The
Company's internal development process includes initial design and concept
layout, computer graphic design, 2D and 3D artwork,
 
                                       5
<PAGE>
 
programming, prototype testing, sound engineering and quality control. The
development process for an original, internally developed product typically
takes from 12 to 24 months, and another six to 12 months for the porting of a
product to a different technology platform. The Company utilizes a variety of
advanced hardware and software development tools, including animation, sound
compression utilities, clay modeling and video compression for the production
and development of its interactive entertainment software titles. The
Company's internal development organization is divided into four divisions,
each dedicated to the production and development of products for a particular
product category. The Company also undertakes development activities through
its subsidiary, Shiny. Within each division, development teams are assigned to
a particular project. These teams are generally led by a producer or associate
producer and include game designers, software programmers, artists, product
managers and sound technicians. The Company believes that this divisional
approach promotes the creative and entrepreneurial environment necessary to
develop innovative and successful titles. In addition, the Company believes
that breaking down the development function into divisions enables it to
improve its software design capabilities, to better manage its internal and
external development processes and to create and enhance its software
development tools and techniques, thereby enabling the Company to obtain
greater efficiency and improved predictability in the software development
process.
 
  Shiny. David Perry, Shiny's President and founder, has produced a number of
highly successful interactive entertainment software titles, including
CoolSpot, Aladdin, Earthworm Jim, Earthworm Jim II and MDK. Shiny developed
Wild 9, which was released in September, 1998 for the PlayStation and
currently has three original titles under development, including Sacrifice and
Messiah. The Company will distribute Sacrifice and Messiah worldwide under the
Shiny label. Shiny's development group presently consists of approximately 28
people.
 
  International Development. The Company is building international development
resources through Interplay Europe, whose software producers manage the
efforts of local third party developers in European countries. Historically,
the Company's international product development efforts have consisted
primarily of the localization of existing Company products. The Company
currently has several original products, including Earthworm Jim 3D, under
development through Interplay Europe. Interplay Europe's development group
presently consists of approximately 10 people.
 
External Product Development
 
  In order to expand its product offerings to include hit titles created by
third party developers, and to leverage its sales and distribution
capabilities, the Company enters into publishing arrangements with third party
developers, including foreign developers and publishers who wish to utilize
the Company's sales and distribution network in North America. In February
1999, the Company entered into a Product Publishing Agreement with Virgin
Interactive Entertainment Limited pursuant to which the Company will publish
substantially all of Virgin's titles in North and South America and Japan. In
the year ended December 31, 1998, the eight months ended December 31, 1997,
and the fiscal years ended April 30, 1997 and 1996, approximately 70%, 50%,
33% and 67%, respectively, of new products released by the Company which the
Company believes are or will become franchise titles were developed by third
party developers. The Company expects that the proportion of its new products
which are developed externally may vary significantly from period to period as
different products are released. The Company's focus in obtaining publishing
products is to select titles that combine advanced technologies with creative
game design. The publishing agreements usually provide the Company with the
exclusive right to distribute a product on a worldwide basis (however, in
certain instances the agreement provides for a specified territory). The
Company typically funds external development through the payment of advances
upon the completion of milestones, which advances are credited against
royalties based on sales of the products. Further, the Company's publishing
arrangements typically provide the Company with ownership of the trademarks
relating to the product as well as exclusive rights to sequels to the product.
The Company manages the production of external development projects by
appointing a producer from one of its internal product development divisions
to oversee the product's development and work with the third party developer
to design, develop and test the game.
 
 
                                       6
<PAGE>
 
  The Company believes this strategy of cultivating relationships with
talented third party developers, such as the developers of Descent and
TombRaider, provides an excellent source of quality products, and a number of
the Company's commercially successful products have been developed under this
strategy. However, the Company's reliance on third party software developers
for the development of a significant number of its interactive software
entertainment products involves a number of risks. See "Management's
Discussion and Analysis of Financial Condition and Results of Operations--
Factors Affecting Future Performance--Dependence on Third Party Software
Developers."
 
Sales And Distribution
 
  The Company's sales and distribution efforts are designed to broaden product
distribution and to increase the penetration of the Company's products in
domestic and international markets. The Company supplements its direct
distribution efforts in North America with third party distributors and
affiliate label relationships. Over the past several years, the Company has
increased its sales and distribution efforts in international markets through
the formation of Interplay Europe, and most recently through the International
Distribution Agreement discussed below, and through licensing and third party
distribution strategies elsewhere. The Company also distributes its software
products through Interplay OEM in bundling transactions with hardware and
peripheral companies and through on-line services.
 
  North America. In North America, the Company sells its products primarily to
mass merchants, warehouse club stores, large computer and software specialty
retail chains and through catalogs. A majority of the Company's North American
retail sales are to direct accounts, and a lesser percentage are to third
party distributors. The Company's principal direct retail accounts include
CompUSA, Best Buy, Electronics Boutique, Toys "R" Us, Wal-Mart and Software
Acquisitions. The Company's principal distributors in North America include GT
Interactive, Ingram Micro, Beamscope and Merisel. The Company also distributes
product catalogs and related promotional material to end-users who can order
products by direct mail, by using a toll-free number, or by accessing the
Company's web site. See "Management's Discussion and Analysis of Financial
Condition and Results of Operations--Factors Affecting Future Performance--
Dependence on Distribution Channels; Risk of Customer Business Failures;
Product Returns."
 
  The Company sells to retailers and distributors through its North American
sales organization. The Company's North American sales force is largely
responsible for generating retail demand for the Company's products by
presenting new products to the Company's retail customers in advance of the
products' scheduled release dates, by providing technical advice with respect
to the Company's products and by working closely with retailers and
distributors to sell the Company's products. The Company typically ships its
products within a short period of time after acceptance of purchase orders
from distributors and other customers. Accordingly, the Company typically does
not have a material backlog of unfilled orders, and net sales in any quarter
are substantially dependent on orders booked in that quarter. Any significant
weakening in customer demand would therefore have a material adverse impact on
the Company's operating results and on the Company's ability to maintain
profitability. See "Management's Discussion and Analysis of Financial
Condition and Results of Operations--Factors Affecting Future Performance--
Fluctuations in Operating Results; Uncertainty of Future Results;
Seasonality."
 
  The Company seeks to extend the life cycle and financial return of many of
its products by marketing those products differently along the product's sales
life. Although the product life cycle for each title varies based on a number
of factors, including the quality of the title, the number and quality of
competing titles, and in certain instances seasonality, the Company typically
considers a title as "back catalog" six months after its initial release. The
Company utilizes marketing programs appropriate for the particular title,
which generally include progressive price reductions over time to increase the
product's longevity in the retail channel as the Company shifts its
advertising support to newer releases.
 
  The Company has acquired the right to distribute certain products on an
affiliate label basis whereby it distributes products that are produced and
published by a third party and are marketed under the third party's name with
the package bearing a notation that the product is being distributed by the
Company. The Company's
 
                                       7
<PAGE>
 
focus in obtaining affiliate label products is to select titles that
complement the Company's product families. Products that are distributed
through the Company's affiliate label program are generally purchased directly
from the third party and sold based on a distribution mark- up. These products
generally have a lower gross margin than internally and externally developed
products.
 
  The Company provides terms of sale comparable to competitors in its
industry. In addition, the Company provides technical support in North America
for its products through its customer support department and a 90-day limited
warranty to end-users that its products will be free from manufacturing
defects. While to date the Company has not experienced any material warranty
claims, there can be no assurance that the Company will not experience
material warranty claims in the future. See "Management's Discussion and
Analysis of Financial Condition and Results of Operations--Factors Affecting
Future Performance--Dependence on Distribution Channels; Risk of Customer
Business Failures; Product Returns."
 
  International. Prior to February 1999, the Company distributed its titles in
Europe through Interplay Europe, and employed approximately 21 persons
dedicated to sales and marketing in the European market. Interplay Europe had
an agreement with Infogrames U.K. and Virgin Interactive Entertainment Limited
to pool resources in order to distribute PC and video game console software to
independent software retailers in the United Kingdom, and had distribution
agreements with Acclaim Entertainment pursuant to which Acclaim Entertainment
distributes certain of the Company's titles in selected European countries.
Net revenues from such distribution agreements with Acclaim Entertainment
represented 9.6%, 7.4%, 14.9% and 7.0% of the Company's net revenues in the
year ended December 31, 1998, the eight months ended December 31, 1997 and the
fiscal years ended April 30, 1997 and 1996, respectively. On February 16,
1999, the Company completed an agreement to acquire, together with two members
of Interplay Europe management, a 49.9% membership interest in VIE Acquisition
Group LLC, the parent entity of Virgin. In connection with such acquisition,
the Company entered into the Virgin Distribution Agreement, pursuant to which
Virgin will hire Interplay Europe's sales and marketing personnel and will
distribute substantially all of the Company's titles in Europe, CIS, Africa
and the Middle East for a seven year period. Under such agreement, the Company
will pay Virgin a distribution fee for its marketing and distribution of the
Company's products, subject to a minimum amount, as well as a fixed overhead
fee that is subject to reduction in certain events. See "Management's
Discussion and Analysis of Financial Condition and Results of Operations--
Factors Affecting Future Performance--Distribution Agreement."
 
  The Company has built a distribution capability in certain of the developed
markets in Asia and the Americas utilizing third party distribution
arrangements for specified products and platforms. In 1995 the Company
established operations in Japan in order to expand its Japanese sales. In July
1997, the Company initiated a licensing strategy in Japan and terminated its
operations there. The Company has also licensed a number of its titles to Sony
Computer Entertainment to publish in Japan on the PlayStation. In Australia
and New Zealand, the Company has entered into an agreement with Roadshow
Entertainment Pty. Ltd., pursuant to which Roadshow Entertainment Pty. Ltd.
has the exclusive right to market and distribute the Company's ongoing PC and
video game console products.
 
  OEM. Interplay OEM employs approximately 13 people focused on the
distribution of interactive entertainment software in bundling transactions to
computer hardware. Under these arrangements, one or more software titles,
which are typically limited feature versions of the retail version of a game,
are bundled with hardware or peripheral devices and are sold by the OEM so
that the purchaser of the hardware device obtains the software on a discounted
basis as part of the hardware purchase. In addition, Interplay OEM has
established a development capability in order to create modified versions of
titles which support its customers' technologies. Although it is customary for
OEM customers to pay a lower per unit price on sales through OEM bundling
arrangements, such arrangements typically involve a high unit volume
commitment. OEM net revenues generally are incremental net revenues and do not
have significant additional product development or sales and marketing costs,
and accordingly have a more significant impact on the Company's operating
results. There can be no assurance, however, that OEM sales will continue to
generate consistent profits for the Company, and a decrease in OEM sales or
margins could have a material adverse effect on the Company's business,
operating results and financial condition. In addition to distributing the
Company's titles, Interplay OEM serves as an OEM distributor
 
                                       8
<PAGE>
 
for a number of interactive entertainment software publishers, including
LucasArts Entertainment Company, Take Two Interactive, Fox Interactive,
Westwood Studios and Virgin Interactive Entertainment. Interplay OEM's
hardware customers include many of the industry's largest computer and
peripheral manufacturers including IBM, Compaq, Apple Computer, 3Dfx, Diamond
Multimedia, Packard Bell, Dell and Logitech. The Company devotes five
employees to modifying existing products into suitable OEM products. Interplay
OEM also handles licensing and merchandising activities on behalf of Interplay
and Shiny including novelizations, strategy guides and other merchandise tied
to Interplay's entertainment properties.
 
  The Company's North American and international distribution channels are
characterized by continuous change, including consolidation, financial
difficulties of certain distributors and retailers, and the emergence of new
distributors and new retail channels such as warehouse chains, mass merchants,
computer superstores and Internet commerce sites. The Company is exposed to
the risk of product returns and markdown allowances with respect to its
distributors and retailers. The Company allows distributors and retailers to
return defective, shelf-worn and damaged products in accordance with
negotiated terms. The Company considers return requests on a case-by-case
basis, taking into consideration factors such as the products involved, the
customer's historical sales volume and the customer's credit status. The
Company also offers a 90-day limited warranty to its end users that its
products will be free from manufacturing defects. In addition, the Company
provides markdown allowances, which consist of credits given to customers to
lower the sales price of certain products in an effort to increase sales to
its customers to help manage its customers' inventory levels in the
distribution channel. Although the Company maintains a reserve for returns and
markdown allowances, and although the Company manages its returns and markdown
allowances through its authorization procedure, the Company could be forced to
accept substantial product returns and provide markdown allowances to maintain
its relationships with retailers and its access to distribution channels. The
Company's reserve for estimated returns, exchanges, markdowns, price
concessions, and warranty costs was $18.4 million and $14.5 million at
December 31, 1998 and 1997, respectively. Product returns and markdown
allowances that exceed the Company's reserves could have a material adverse
effect on the Company's business, operating results and financial condition.
See "Management's Discussion and Analysis of Financial Condition and Results
of Operations--Factors Affecting Future Performance--Dependence on
Distribution Channels; Risk of Customer Business Failures; Product Returns."
 
Marketing
 
  The Company's marketing department is organized into product groups aligned
with its four internal development divisions and Shiny to promote a focused
marketing strategy and brand image for each division. Integrated into these
product groups is public relations for each division. In addition, the
marketing department has four functional groups (web department, event
coordination, creative services and advertising) that support these five
product groups.
 
  The Company's marketing department develops and implements marketing
programs and campaigns for each of the Company's titles and product groups.
The Company's marketing activities in preparation for a product launch include
print advertising, game reviews in consumer and trade publications, retail in-
store promotions, attendance at trade shows and public relations. The Company
sends direct and electronic mail promotional materials to its large database
of gamers. The Company has also selectively used radio and television
advertisements in connection with the introduction of certain of its products.
The Company budgets a portion of each product's sales for cooperative
advertising and market development funds with retailers. Every title and brand
is launched with a multi-tiered marketing campaign that is developed on an
individual basis to promote product awareness and customer pre-orders. The
Company anticipates that over time, as the market for its products matures and
competition becomes more intense, it will become necessary to devote more
overall resources to marketing its products but marketing costs for its
products will remain proportional to revenues.
 
  The Company maximizes on-line marketing through web advertising and the
maintenance of several web sites. These sites provide news and information of
interest to its customers through free demonstration versions, contests,
games, tournaments and promotions. Also, to generate interest in new product
introductions, the Company provides
 
                                       9
<PAGE>
 
free demonstration versions of upcoming titles both through magazine cover
mounts and through game samples that consumers can download from the Company's
web site. In addition, marketing hosts on-line events and maintains a vast
collection of message boards to keep customers informed on shipped and
upcoming titles.
 
Competition
 
  The interactive entertainment software industry is intensely competitive and
is characterized by the frequent introduction of new hardware systems and
software products. The Company's competitors vary in size from small companies
to very large corporations with significantly greater financial, marketing and
product development resources than those of the Company. Due to these greater
resources, certain of the Company's competitors are able to undertake more
extensive marketing campaigns, adopt more aggressive pricing policies, pay
higher fees to licensors of desirable motion picture, television, sports and
character properties and pay more to third party software developers than the
Company. The Company believes that the principal competitive factors in the
interactive entertainment software industry include product features, brand
name recognition, access to distribution channels, quality, ease of use,
price, marketing support and quality of customer service.
 
  The Company competes primarily with other publishers of PC and video game
console interactive entertainment software. Significant competitors include
Electronic Arts, GT Interactive Software Corp., Mattel, Activision, Inc.,
Microsoft Corporation, LucasArts Entertainment Company, Midway Games Inc.,
Acclaim Entertainment Inc., Havas Interactive and Hasbro Inc. In addition,
integrated video game console hardware/software companies such as Sony
Computer Entertainment, Nintendo and Sega compete directly with the Company in
the development of software titles for their respective platforms. Large
diversified entertainment companies, such as The Walt Disney Company, many of
which own substantial libraries of available content and have substantially
greater financial resources than the Company, may decide to compete directly
with the Company or to enter into exclusive relationships with competitors of
the Company. The Company also believes that the overall growth in the use of
the Internet and on-line services by consumers may pose a competitive threat
if customers and potential customers spend less of their available home PC
time using interactive entertainment software and more on the Internet and on-
line services.
 
  Retailers of the Company's products typically have a limited amount of shelf
space and promotional resources, and there is intense competition among
consumer software producers, and in particular interactive entertainment
software products, for high quality retail shelf space and promotional support
from retailers. To the extent that the number of consumer software products
and computer platforms increases, competition for shelf space may intensify
and may require the Company to increase its marketing expenditures. Due to
increased competition for limited shelf space, retailers and distributors are
in an increasingly better position to negotiate favorable terms of sale,
including price discounts, price protection, marketing and display fees and
product return policies. The Company's products constitute a relatively small
percentage of any retailer's sales volume, and there can be no assurance that
retailers will continue to purchase the Company's products or to provide the
Company's products with adequate levels of shelf space and promotional
support, and a prolonged failure in this regard may have a material adverse
effect on the Company's business, operating results and financial condition.
See "Management's Discussion and Analysis of Financial Condition and Results
of Operations--Factors Affecting Future Performance--Industry Competition;
Competition for Shelf Space."
 
Manufacturing
 
  The Company's PC-based products consist primarily of CD-ROMs, user manuals
and packaging. Substantially all of the Company's CD-ROM duplication is
performed by unaffiliated third parties. Printing of the user manual and
packaging, manufacturing of related materials and assembly of completed
packages are performed to the Company's specifications by unaffiliated third
parties. To date, the Company has not experienced any material difficulties or
delays in the manufacture and assembly of its CD-ROM-based products, and has
not experienced significant returns due to manufacturing defects.
 
  Sony Computer Entertainment and Nintendo manufacture the Company's products
that are compatible with their respective video game consoles, as well as the
manuals and packaging for such products, and ship finished
 
                                      10
<PAGE>
 
products to the Company for distribution. PlayStation products consist of CD-
ROMs and are typically delivered by Sony Computer Entertainment within a
relatively short lead time. Manufacturers of Nintendo and other video game
cartridges typically deliver software to the Company within 45 to 60 days
after receipt of a purchase order. If the Company experiences unanticipated
delays in the delivery of manufactured software products, its net sales and
operating results could be materially adversely affected. Furthermore, the
long manufacturing cycle associated with video game cartridges requires that
the Company forecast retailer and consumer demands for its manufactured titles
further in advance of shipment than for PC-based products or PlayStation CD-
ROMs. See "Management's Discussion and Analysis of Financial Condition and
Results of Operations--Factors Affecting Future Performance--Dependence on
Licenses from and Manufacturing by Hardware Companies."
 
Intellectual Property And Proprietary Rights
 
  The Company holds copyrights on its products, product literature and
advertising and other materials, and holds trademark rights in the Company's
name, the Interplay logo, its "By Gamers. For Gamers.(TM)" slogan and certain
of its product names and publishing labels. The Company also holds rights
under a patent application related to the software engine for its Messiah
product. The Company has licensed certain products to third parties for
distribution in particular geographic markets or for particular platforms, and
receives royalties on such licenses. The Company also outsources some of its
product development to third party developers, contractually retaining all
intellectual property rights related to such projects. The Company also
licenses certain products developed by third parties and pays royalties on
such products. See "Management's Discussion and Analysis of Financial
Condition and Results of Operations--Product Development."
 
  The Company regards its software as proprietary and relies primarily on a
combination of patent, copyright, trademark and trade secret laws, employee
and third party nondisclosure agreements and other methods to protect its
proprietary rights. The Company owns or licenses various copyrights and
trademarks. While the Company provides "shrinkwrap" license agreements or
limitations on use with its software, the enforceability of such agreements or
limitations is uncertain. The Company is aware that unauthorized copying
occurs within the computer software industry, and if a significantly greater
amount of unauthorized copying of the Company's interactive entertainment
software products were to occur, the Company's operating results could be
materially adversely affected. While the Company does not generally copy
protect its products, it does not provide source code to third parties, unless
they have signed nondisclosure agreements with respect thereto.
 
  The Company relies on existing copyright laws to prevent unauthorized
distribution of its software. Existing copyright laws afford only limited
protection. Policing unauthorized use of the Company's products is difficult,
and software piracy can be expected to be a persistent problem, especially in
certain international markets. Further, the laws of certain countries in which
the Company's products are or may be distributed either do not protect the
Company's products and intellectual property rights to the same extent as the
laws of the U.S. or are weakly enforced. Legal protection of the Company's
rights may be ineffective in such countries, and as the Company leverages its
software products using emerging technologies, such as the Internet and on-
line services, the ability of the Company to protect its intellectual property
rights, and to avoid infringing the intellectual property rights of others,
becomes more difficult. In addition, the intellectual property laws are less
clear with respect to such emerging technologies. There can be no assurance
that existing intellectual property laws will provide adequate protection to
the Company's products in connection with such emerging technologies.
 
  As the number of software products in the interactive entertainment software
industry increases and the features and content of these products further
overlap, interactive entertainment software developers may increasingly become
subject to infringement claims. Although the Company makes reasonable efforts
to ensure that its products do not violate the intellectual property rights of
others, there can be no assurance that claims of infringement will not be
made. Any such claims, with or without merit, can be time consuming and
expensive to defend. From time to time, the Company has received communication
from third parties asserting that features or content of certain of its
products may infringe upon the intellectual property rights of such parties.
There can be no assurance that existing or future infringement claims against
the Company will not result in costly litigation
 
                                      11
<PAGE>
 
or require the Company to license the intellectual property rights of third
parties, either of which could have a material adverse effect on the Company's
business, operating results and financial condition. See "Management's
Discussion and Analysis of Financial Condition and Results of Operations--
Factors Affecting Future Performance--Protection of Proprietary Rights."
 
Employees
 
  As of December 31, 1998, the Company had 443 full time employees, including
204 in product development, 87 in sales and marketing and 57 in finance,
general and administrative. This includes 32 full time employees of Shiny, 13
full time employees of Interplay OEM and 50 full time employees of Interplay
Europe. Subsequent to year end, in connection with the signing of an
International Distribution Agreement with Virgin, the Company reduced its full
time employees of Interplay Europe to 12, 10 of whom are engaged in product
development. The Company also retains independent contractors to provide
certain services, primarily in connection with its product development
activities. The Company and its full time employees are not subject to any
collective bargaining agreements and the Company believes that its relations
with its employees are good.
 
  From time to time the Company has retained actors and/or "voice over" talent
to perform in certain of the Company's products, and the Company expects to
continue this practice in the future. These performers are typically members
of the Screen Actors Guild ("SAG") or other performers' guilds, which guilds
have established collective bargaining agreements governing their members'
participation in interactive media projects. The Company or an affiliated
entity may be required to become subject to the jurisdiction of SAG's
collective bargaining agreement, or some other applicable performers guild,
with respect to the Company's development projects in the future in order to
engage the services of performers in the development of the Company's
products.
 
ITEM 2. PROPERTIES
 
  The Company's headquarters are located in Irvine, California, where the
Company leases approximately 81,000 square feet of office space. This lease
expires in June 2006 and provides the Company with one five year option to
extend the term of the lease and expansion rights, on an "as available basis,"
to approximately double the size of the office space. Interplay Europe leases
approximately 10,000 square feet of space in Buckinghamshire, England. This
lease expires, at Interplay Europe's option, either in November 2000 or in
November 2005, and the Company is currently seeking to sublease such space.
Shiny leases approximately 4,100 square feet of space in Laguna Beach,
California, which lease expires in October 1999 and which provides Shiny with
an option to extend the term for an additional five years. The Company
believes that its facilities are adequate for its current needs and that
suitable additional or substitute space will be available in the future to
accommodate expansion of the Company's operations.
 
ITEM 3. LEGAL PROCEEDINGS
 
  The Company is occasionally involved in various legal proceedings, claims
and litigation arising in the ordinary course of business, including disputes
arising over the ownership of intellectual property rights and collection
matters. In the opinion of management, the outcome of such routine claims will
not have a material adverse effect on the Company's business, financial
condition or results of operations.
 
ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS
 
  None.
 
                                      12
<PAGE>
 
                                    PART II
 
ITEM 5. MARKET FOR REGISTRANT'S COMMON EQUITY AND RELATED STOCKHOLDER MATTERS
 
  The Common Stock is traded on The NASDAQ Stock Market National Market System
under the symbol "IPLY". As of December 31, 1998, there were approximately
2,900 holders of the Common Stock.
 
  The following table sets forth the range of high and low sales prices for
the Common Stock for each of the periods indicated during the year ended
December 31, 1998 since the Company's initial public offering in June 1998:
 
<TABLE>
<CAPTION>
     Period                                                          High   Low
     ------                                                          ----- -----
     <S>                                                             <C>   <C>
     Second Quarter................................................. $6.19 $5.75
     Third Quarter..................................................  7.50  3.19
     Fourth Quarter.................................................  3.00  1.50
</TABLE>
 
Dividend Policy
 
  The Company anticipates that all future earnings will be retained to finance
future growth, and the Company does not anticipate paying any dividends on its
Common Stock in the foreseeable future. The Company's current credit agreement
currently restricts the Company from paying cash dividends without the prior
written consent of the lender. See "Management's Discussion and Analysis of
Financial Condition and Results of Operations--Factors Affecting Future
Performance--Liquidity; Future Capital Requirements".
 
  The following is a summary of transactions by the Company during the fiscal
year ended December 31, 1998 involving sales of the Company's securities that
were not registered under the Securities Act:
 
  During the year ended December 31, 1998, the Company issued an aggregate of
451,100 nonqualified stock options to purchase Common Stock pursuant to the
Company's 1997 Stock Incentive Plan (the "1997 Plan") to officers, directors
and employees of the Company at a weighted average exercise price of $6.91.
Such options were issued but not sold, in the view of the Company, and,
therefore, registration thereof was not required. During the same period, the
Company issued an aggregate of 1,200 shares of Common Stock upon the exercise
of options under the Incentive Stock Option and Nonqualified Stock Option
Plan--1994 to one terminated employee at a purchase price of $8.50 per share.
Such shares were issued in reliance upon the exemption provided by Rule 701
promulgated under the Securities Act, as well as other exemptions. During the
period referred to above, no options issued pursuant to the 1997 Plan were
exercised. The Company issued the Company's Chairman and Chief Executive
Officer Warrants to purchase 400,000 shares of the Company's Common Stock at
an exercise price of $3.00 per share as consideration for making a personal
guarantee in the amount of $5.0 million of the Company's line of credit. Such
warrants were issued in reliance upon the exemption provided by Section 4(2)
of the Securities Act.
 
  Subsequent to the year ended December 31, 1998, the Company issued and sold
2.5 million shares of the Company's Common Stock for $10.0 million. Such
shares were issued in reliance upon the exemption provided by Section 4(2) of
the Securities Act.
 
                                      13
<PAGE>
 
ITEM 6. SELECTED FINANCIAL DATA
 
  The selected consolidated statements of operations data for the year ended
December 31, 1998, the eight months ended December 31, 1997 and the former
fiscal years ended April 30, 1997 and 1996, and the selected consolidated
balance sheets data as of December 31, 1998 and 1997 are derived from the
Company's audited consolidated financial statements included elsewhere in this
Form 10-K. The selected consolidated statements of operations data for the
former fiscal years ended April 30, 1995 and 1994, and the selected
consolidated balance sheets data as of April 30, 1997, 1996, 1995 and 1994 are
derived from the Company's audited consolidated financial statements not
included in this Form 10-K. The selected consolidated statements of operations
data for the year ended December 31, 1997 is derived from the Company's
unaudited consolidated financial statements. The Company's historical results
are not necessarily indicative of the results that may be achieved for any
other period. The following data should be read in conjunction with
"Management's Discussion and Analysis of Financial Condition and Results of
Operations" and the Consolidated Financial Statements included elsewhere in
this Form 10-K.
 
<TABLE>
<CAPTION>
                              Years Ended       Eight Months
                              December 31,         Ended          Years Ended April 30,
                          --------------------- December 31, ----------------------------------
                            1998       1997         1997       1997     1996     1995    1994
                          --------  ----------- ------------ --------  -------  ------- -------
                                    (unaudited)
                                   (Dollars in thousands, except per share amounts)
<S>                       <C>       <C>         <C>          <C>       <C>      <C>     <C>
Statements of Operations
 Data(1):
Net revenues............  $126,862   $120,053     $85,961    $ 83,262  $96,952  $79,546 $52,668
Cost of goods sold......    71,928     68,353      44,864      62,480   49,939   45,491  31,223
                          --------   --------     -------    --------  -------  ------- -------
Gross profit............    54,934     51,700      41,097      20,782   47,013   34,055  21,445
Operating expenses:
 Marketing and sales....    39,471     28,443      20,603      24,627   23,285   14,280   7,698
 General and
  administrative........    12,841     13,503       8,989       9,408    9,025    5,528   4,805
 Product development....    24,472     22,317      14,291      21,431   15,120    8,200   3,646
                          --------   --------     -------    --------  -------  ------- -------
 Total operating
  expenses..............    76,784     64,263      43,883      55,466   47,430   28,008  16,149
                          --------   --------     -------    --------  -------  ------- -------
Operating income
 (loss).................   (21,850)   (12,563)     (2,786)    (34,684)    (417)   6,047   5,296
Other income (expense)..    (4,933)    (3,640)     (2,273)     (1,600)    (807)   1,046      68
                          --------   --------     -------    --------  -------  ------- -------
Income(loss)before
 income taxes...........   (26,783)   (16,203)     (5,059)    (36,284)  (1,224)   7,093   5,364
Provision (benefit) for
 income taxes...........     1,437     (1,782)        --       (9,065)    (480)   2,844   2,161
                          --------   --------     -------    --------  -------  ------- -------
Net income (loss).......  $(28,220)  $(14,421)    $(5,059)   $(27,219) $  (744) $ 4,249 $ 3,203
                          ========   ========     =======    ========  =======  ======= =======
Net income (loss) per
 share (2):
 Basic..................  $  (1.91)  $  (1.30)    $ (0.45)   $  (2.46) $ (0.07) $  0.40 $  0.37
 Diluted................  $  (1.91)  $  (1.30)    $ (0.45)   $  (2.46) $ (0.07) $  0.35 $  0.32
                          ========   ========     =======    ========  =======  ======= =======
Selected Operating Data:
Net revenues by
 geographic region:
 North America..........  $ 73,865   $ 64,106     $51,833    $ 38,606  $54,702  $51,892 $40,094
 International..........    35,793     41,922      24,642      32,006   24,579   13,829   2,227
 OEM, royalty and
  licensing.............    17,204     14,025       9,486      12,650   17,671   13,825  10,347
Net revenues by
 platform:
 Personal computer......  $ 67,406   $ 65,922     $42,520    $ 45,192  $60,254  $36,804 $20,314
 Video game console.....    42,252     40,106      33,955      25,420   19,027   28,917  22,007
 
<CAPTION>
                              December 31,                    April 30,
                          --------------------- ---------------------------------------
                            1998       1997         1997       1996     1995     1994
                          --------  ----------- ------------ --------  -------  -------
                                            (Dollars in thousands)
<S>                       <C>       <C>         <C>          <C>       <C>      <C>     
Balance Sheets Data:
Working capital.........  $ (2,864)  $ 13,616     $ 7,890    $ 18,485  $25,227  $22,775
Total assets............    75,085     77,821      69,005      68,511   44,226   35,450
Total long-term debt
 (including current
 portion)...............    24,651     38,154      14,970         108      262      384
Stockholders' equity
 (deficit)..............     4,193     (1,267)      3,401      30,195   30,069   25,053
</TABLE>
--------
(1) Effective May 1, 1997, the Company changed its fiscal year end from April
    30 to December 31.
 
(2) See Note 8 of Notes to Consolidated Financial Statements for an
    explanation of the number of shares used in computing net income (loss)
    per share.
 
                                      14
<PAGE>
 
ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND
        RESULTS OF OPERATIONS
 
  The following discussion and analysis should be read in conjunction with the
Consolidated Financial Statements and notes thereto and other information
included or incorporated by reference herein.
 
General
 
  The Company derives net revenues primarily from direct sales of interactive
entertainment software for PCs and video game consoles to retailers and mass
merchants, from indirect sales to software distributors in North America and
internationally, from the distribution by the Company on an affiliate label
basis of titles published by third parties, and from direct sales to end-users
through the Company's catalogs and the Internet. The Company also derives
royalty-based revenues from licensing arrangements, from the sale of products
by third party distributors in international markets, and from OEM bundling
transactions.
 
  Revenues are recorded when products are delivered to customers in accordance
with Statement of Position (SOP) 97-2, Software Revenue Recognition. For those
agreements that provide the customers the right to multiple copies in exchange
for guaranteed amounts, revenue is recognized at the delivery of the product
master or the first copy. Per copy royalties on sales that exceed the
guarantee are recognized as earned. The Company is generally not contractually
obligated to accept returns, except for defective product. However, the
Company permits customers to return or exchange product and may provide price
protection on products unsold by a customer. In accordance with SFAS No. 48,
revenue is recorded net of an allowance for estimated returns, exchanges,
markdowns, price concessions, and warranty costs. Such reserves are based upon
management's evaluation of historical experience, current industry trends and
estimated costs. The amount of reserves ultimately required could differ
materially in the near term from the amounts included in the accompanying
consolidated financial statements. Postcontract customer support provided by
the Company is limited to telephone support. These costs are not material and
are charged to expenses as incurred.
 
  In order to expand the Company's distribution channels and engage in
software development in overseas markets, in 1995 the Company established
operations in the United Kingdom and in Japan. In July 1997, the Company
initiated a licensing strategy in Japan and terminated its operations there.
International net revenues accounted for approximately 28.2%, 28.7%, 38.4% and
25.4% of the Company's net revenues during the years ended December 31, 1998,
the eight months ended December 31, 1997 and the fiscal years ended April 30,
1997 and 1996, respectively.
 
  In January 1997, the Company formed a wholly owned subsidiary, Interplay
OEM, Inc. ("Interplay OEM"), which had previously operated as a division of
the Company. Interplay OEM distributes the Company's interactive entertainment
software titles, as well as those of other software publishers, to computer
hardware and peripheral device manufacturers for use in bundling arrangements.
The Company also derives net revenues from the licensing of certain of its
intellectual properties and certain of its products to third parties for
distribution in markets and through channels which are outside the Company's
primary focus. OEM, royalty and licensing net revenues accounted for 13.6%,
11.0% and 15.2% of the Company's total net revenues for the years ended
December 31, 1998, the eight months ended December 31, 1997 and the fiscal
year ended April 30, 1997, respectively. OEM, royalty and licensing net
revenues generally are incremental net revenues and do not have significant
additional product development or sales and marketing costs, and accordingly
have a more significant impact on the Company's operating results. The Company
expects that OEM, royalty and licensing net revenues may decline, both in
dollars and as a percentage of net revenues, as a larger proportion of OEM,
royalty and licensing net revenues are generated from royalty-based licensing
transactions, as opposed to the shipment of finished goods, and as the OEM
channel of distribution becomes more competitive. Cost of goods sold related
to PC and video game console net revenues represents the manufacturing and
related costs of interactive entertainment software products, including costs
of media, manuals, duplication, packaging materials, assembly, freight and
royalties paid to developers, licensors and hardware manufacturers. Cost of
goods sold related to royalty-based net revenues primarily represents third
party licensing fees and royalties paid by the Company.
 
                                      15
<PAGE>
 
Typically, cost of goods sold as a percentage of net revenues for video game
console products and affiliate label products are higher than cost of goods
sold as a percentage of net revenues for PC based products due to the
relatively higher manufacturing and royalty costs associated with these
products. Also included in the cost of goods sold is the amortization of
prepaid royalty and license fees paid to third party software developers.
Prepaid royalties are expensed over a period of six months from initial
shipment. The Company evaluates the likelihood of future realization of
prepaid royalties quarterly, on a product by product basis, and charges cost
of goods sold for any amounts that it deems unlikely to be realized through
future product sales.
 
  For the year ended December 31, 1998, the Company's net loss was $28.2
million. The Company's results from operations were adversely affected by
several factors. The Company was unable to ship two important titles, Messiah
and Earthworm Jim 3D in 1998. In addition, Baldur's Gate, the number one
selling PC game in January 1999 according to PC Data, did not ship until the
last days of 1998. The Company experienced higher product returns and markdown
allowances than usual during the year ended December 31, 1998 due to certain
title releases that did not gain broad market acceptance. Net revenues were
also negatively impacted by lower than expected OEM activity and softness in
the Asia markets. The Company has taken certain actions with the objective of
improving its operating results in the future. During 1998, the Company
reduced its headcount approximately 20% which will reduce operating expenses
in 1999. The Company is also reducing its sell-in unit quantities to limit
potential price protection and product return exposure. On February 16, 1999,
the Company announced it had completed agreements to acquire, together with
two members of Interplay Europe management, a 49.9% membership interest in VIE
Acquisition Group LLC, the parent entity of Virgin Interactive. Under the
agreements, Virgin Interactive will hire the Company's sales and marketing
personnel and distribute substantially all of the Company's titles in Europe.
In return, the Company will distribute substantially all of Virgin
Interactive's titles in North America, South America and certain other
territories, including Japan.
 
  Effective May 1, 1997, the Company changed its fiscal year end from April 30
to December 31. Accordingly, the discussion of financial results set forth
below compares the year ended December 31, 1998 to the comparable 1997 period,
the Company's previous fiscal year ended April 30, 1997 to the comparable 1996
period, and compares the eight months ending December 31, 1997 to the
comparable 1996 period.
 
  The Company's operating results have fluctuated significantly in the past
and will likely fluctuate significantly in the future, both on a quarterly and
an annual basis. A number of factors may cause or contribute to such
fluctuations, and many of such factors are beyond the Company's control. There
can be no assurance that the Company will be profitable in any particular
period. It is likely that the Company's operating results in one or more
future periods will fail to meet or exceed the expectations of securities
analysts or investors. See "Management's Discussion and Analysis of Financial
Condition and Results of Operations--Factors Affecting Future Performance--
Fluctuations in Operating Results; Uncertainty of Future Results; Seasonality.
 
                                      16
<PAGE>
 
Results of Operations
 
  The following table sets forth certain consolidated statements of operations
data and segment and platform data for the periods indicated expressed as a
percentage of net revenues:
 
<TABLE>
<CAPTION>
                                                Eight Months
                             Years Ended           Ended          Years Ended
                            December 31,        December 31,       April 30,
                          ------------------- ------------------  -------------
                          1998       1997     1997       1996     1997    1996
                          -----   ----------- -----   ----------  -----   -----
                                  (unaudited)         (unaudited)
<S>                       <C>     <C>         <C>     <C>         <C>     <C>
Statements of Operations
 Data:
Net revenues............  100.0 %    100.0 %  100.0 %   100.0 %   100.0 % 100.0 %
Cost of goods sold......   56.7       56.9     52.2      70.9      75.0    51.5
                          -----      -----    -----     -----     -----   -----
Gross profit............   43.3       43.1     47.8      29.1      25.0    48.5
Operating expenses:
  Marketing and sales...   31.1       23.7     24.0      31.3      29.6    24.0
  General and
   administrative.......   10.1       11.2     10.5      17.3      11.3     9.3
  Product development...   19.3       18.6     16.6      24.8      25.7    15.6
                          -----      -----    -----     -----     -----   -----
  Total operating
   expenses.............   60.5       53.5     51.1      73.4      66.6    48.9
                          -----      -----    -----     -----     -----   -----
Operating income
 (loss).................  (17.2)     (10.4)    (3.3)    (44.3)    (41.6)   (0.4)
Other income (expense)..   (3.9)      (3.0)    (2.6)     (2.2)     (1.9)   (0.9)
                          -----      -----    -----     -----     -----   -----
Loss before income
 taxes..................  (21.1)     (13.4)    (5.9)    (46.5)    (43.5)   (1.3)
Provision (benefit) for
 income taxes...........    1.1       (1.5)      --     (11.8)    (10.9)   (0.5)
                          -----      -----    -----     -----     -----   -----
Net loss................  (22.2)%    (11.9)%   (5.9)%   (34.7)%   (32.6)%  (0.8)%
                          =====      =====    =====     =====     =====   =====
Selected Operating Data:
Net revenues by segment:
  North America.........   58.2 %     53.4 %   60.3 %    55.1 %    46.4 %  56.4 %
  International.........   28.2       34.9     28.7      27.7      38.4    25.4
  OEM, royalty and
   licensing............   13.6       11.7     11.0      17.2      15.2    18.2
                          -----      -----    -----     -----     -----   -----
                          100.0 %    100.0 %  100.0 %   100.0 %   100.0 % 100.0 %
                          =====      =====    =====     =====     =====   =====
Net revenues by
 platform:
  Personal computer.....   53.1       54.9     49.5      50.9      54.3    62.2
  Video game console....   33.3       33.4     39.5      31.9      30.5    19.6
  OEM, royalty and
   licensing............   13.6       11.7     11.0      17.2      15.2    18.2
                          -----      -----    -----     -----     -----   -----
                          100.0 %    100.0 %  100.0 %   100.0 %   100.0 % 100.0 %
                          =====      =====    =====     =====     =====   =====
</TABLE>
 
Year Ended December 31, 1998 Compared To The Year Ended December 31, 1997
 
 Net Revenues
 
  Net revenues for the twelve months ended December 31, 1998 increased 5.7% to
$126.9 million from $120.1 million in the comparable 1997 period. North
American net revenues increased to $73.9 million from $64.1 million in the
1997 period, and international net revenues decreased to $35.8 million from
$41.9 million in the 1997 period. OEM, royalty and licensing net revenues
increased to 13.6% of net revenues in the 1998 period from 11.7% in the 1997
period.
 
  The increase in net revenues for the twelve months ended December 31, 1998
was primarily due to increased title releases across multiple platforms and
resulting increases in unit sales volume in the 1998 period, offset in part by
a high level of product returns and markdowns due to certain title releases
that did not gain broad market acceptance. Significant title releases in 1998
included Baldur's Gate (PC), Caesars Palace II
 
                                      17
<PAGE>
 
(PlayStation), Crime Killer (PlayStation), Die By The Sword (PC), Descent:
Freespace The Great War (PC), Fallout 2 (PC), Heart of Darkness (PlayStation),
VR Sports Powerboat Racing (PC and PlayStation), Redneck Deer Huntin' (PC),
Redneck Rides Again (PC), VR Baseball 99 (PlayStation), and Wild 9
(PlayStation). The decrease in international net revenues was due primarily to
decreased net revenues in Europe due to a decrease in the number of titles
that achieved broad market acceptance and an increase in product returns
during 1998, as well as decreased sales in Asia due to unfavorable economic
conditions in that market. The Company expects that OEM, royalty and licensing
net revenues may decline, both in dollars and as a percentage of net revenues
during future periods as a larger proportion of OEM, royalty and licensing net
revenues are generated from royalty-based licensing transactions, as opposed
to the shipment of finished goods, and as such distribution channels become
more competitive.
 
 Cost of Goods Sold; Gross Profit
 
  Cost of goods sold increased 5.2% to $71.9 million, or 56.7% of net revenues
in the twelve months ended December 31, 1998, from $68.4 million, or 56.9% of
net revenues, in the comparable 1997 period. Gross profit as a percentage of
net revenue remained consistent, increasing slightly to 43.3% in the 1998
period from 43.1% in the 1997 period.
 
  Gross profits in both periods were adversely impacted by the effects of
additional write-offs of prepaid royalties relating to titles or platform
versions of titles which had been canceled or which were expected to achieve
lower unit sales than were originally anticipated.
 
 Operating Expenses
 
  Total operating expenses increased 19.5% to $76.8 million, or 60.5% of net
revenues, in the twelve months ended December 31, 1998 from $64.3 million, or
53.5% of net revenues, for the comparable 1997 period. In an effort to reduce
operating expenses, during 1998 the Company cut its workforce by approximately
20%.
 
  Marketing and Sales. Marketing and sales expenses primarily include
advertising and retail marketing support, sales commissions, marketing and
sales personnel, customer support services, fulfillment and other costs.
Marketing and sales expenses increased 38.8% to $39.5 million, or 31.1% of net
revenues, for the twelve months ended December 31, 1998 from $28.4 million, or
23.7% of net revenues, for the comparable 1997 period. The increase was
primarily due to increases in advertising and other marketing costs associated
with the increase in major titles launched and products sold, including
increased cooperative advertising and marketing development funds, increased
advertising and commissions on product releases in the U.S. and the European
markets during the 1998 period as well as television advertising for Wild 9
and Heart of Darkness, two titles launched during the 1998 period. In February
1999, the Company entered into agreements with Virgin Interactive
Entertainment Limited and its parent entity, pursuant to which Virgin
Interactive will hire the Company's European sales and marketing personnel and
will distribute substantially all of the Company's titles in Europe, CIS,
Africa and the Middle East. The Company expects that marketing and sales
expenses will decrease in 1999, both in absolute dollars and as a percentage
of net revenues, due to the actions discussed above.
 
  General and Administrative. General and administrative expenses primarily
include administrative personnel expenses, facilities costs, professional
expenses and other overhead charges. General and administrative expenses
decreased 4.9% to $12.8 million, or 10.1% of net revenues, in the twelve
months ended December 31, 1998 from $13.5 million, or 11.2% of net revenues,
in the comparable 1997 period. The decrease in the twelve months ended
December 31, 1998 was primarily attributable to lower overhead costs offset in
part by a $0.8 million provision for uncollectible amounts owed to the Company
by Engage Games Online, which is majority-owned by the company's Chairman and
Chief Executive Officer. The Company may in the future be required to make
additional payments of approximately $0.5 million in the aggregate under a
lease of equipment originally utilized by Engage, and the Company is
attempting to mitigate this potential expense by using or subleasing a portion
of the equipment. The Company expects that general and administrative expenses
will decrease slightly in 1999 due to the cost reduction efforts discussed
above, but will increase in absolute dollars and vary as a percentage of net
revenues in future periods.
 
                                      18
<PAGE>
 
  Product Development. Product development expenses, which primarily include
personnel and support costs, are charged to operations in the period incurred.
Product development expenses increased 9.7% to $24.5 million, or 19.3% of net
revenues, in the twelve months ended December 31, 1998 from $22.3 million, or
18.6% of net revenues, in the comparable 1997 period. The increase was
primarily due to an increase in the number of products under development,
offset in part by cost efficiencies achieved as a result of the reorganization
of the development process. The increase as a percentage of net revenues in
the twelve months ended December 31, 1998 was primarily due to higher labor
and operations costs combined with a less than expected increase in net
revenues base. The Company expects that product development expenses will
remain relatively consistent in 1999 in absolute dollars, but will increase in
absolute dollars and vary as a percentage of net revenues in future periods.
 
 Other Income (Expense)
 
  Other expense increased to $4.9 million in the twelve months ended December
31, 1998 from $3.6 million in the comparable 1997 period. The increase in the
twelve months ended December 31, 1998 was primarily due to increased
borrowings under the Company's line of credit to support increased working
capital requirements prior to the completion of the IPO in June 1998 and
interest on the Subordinated Secured Promissory Notes. The Company used the
proceeds of the IPO to repay those Subordinated Secured Promissory Notes that
were not converted into Common Stock and to pay down the bank line of credit,
both of which resulted in lower interest expense in the second half of 1998.
 
 Provision (Benefit) for Income Taxes
 
  The Company recorded a tax provision of $1.4 million in the twelve months
ended December 31, 1998, as compared with a tax benefit of $1.8 million in the
comparable 1997 period. The $1.4 million tax provision for 1998 consists
primarily of an increase in the deferred tax valuation of $2.0 million, offset
by a foreign tax benefit of $0.6 million.
 
Eight Months Ended December 31, 1997 Compared To The Eight Months Ended
December 31, 1996
 
 Net Revenues
 
  Net revenues for the eight months ended December 31, 1997 increased 70.7% to
$86.0 million from $50.4 million in the comparable 1996 period. North American
net revenues increased to $51.8 million from $27.7 million in the 1996 period,
and international net revenues increased to $24.6 million from $14.0 million
in the 1996 period. The increase in net revenues in the 1997 period was
primarily due to increased title releases across multiple platforms in the
eight months ended December 31, 1997 as compared with the eight months ended
December 31, 1996, including significant title releases, such as Clay Fighter
63 1/3 and Star Trek: Starfleet Academy, in the calendar fourth quarter of
1997, and a higher than expected level of product returns and markdowns
recorded during the 1996 period. OEM, royalty and licensing net revenues
decreased to 11.0% of net revenues in the 1997 period from 17.2% in the 1996
period.
 
 Cost of Goods Sold; Gross Profit
 
  Cost of goods sold increased 25.6% in the eight months ended December 31,
1997 to $44.9 million, or 52.2% of net revenues, from $35.7 million, or 70.9%
of net revenues, in the comparable 1996 period. Gross profit as a percentage
of net revenue increased to 47.8% in the 1997 period from 29.1% in the 1996
period. The increase in gross profit was primarily due to reductions in sales
by the Company on an affiliate label basis of titles published by third
parties, reductions in OEM royalty expenses as a percentage of net revenues,
and changes in the product mix of externally developed products released
during the periods, offset in part by greater manufacturing costs attributable
to an increased number of video game console products released during the 1997
period. The 1996 period also included the effects of additional write-offs of
prepaid royalties relating to titles or platform versions of titles which had
been canceled or which were expected to achieve lower unit sales than were
originally forecast.
 
                                      19
<PAGE>
 
 Operating Expenses
 
  Total operating expenses increased 18.8% to $43.9 million, or 51.1% of net
revenues, in the eight months ended December 31, 1997 from $36.9 million, or
73.4% of net revenues, for the comparable 1996 period.
 
  Marketing and Sales. Marketing and sales expenses increased 30.8% to $20.6
million, or 24.0% of net revenues, for the eight months ended December 31,
1997 from $15.7 million, or 31.3% of net revenues, for the comparable 1996
period. The increase in absolute dollars was primarily due to advertising and
other marketing costs associated with the increase in products launched during
the period. The decrease as a percentage of net revenues was primarily
attributable to operating efficiencies gained as a result of an increased net
revenues base.
 
  General and Administrative. General and administrative expenses increased
3.0% to $9.0 million, or 10.5% of net revenues, in the eight months ended
December 31, 1997 from $8.7 million, or 17.3% of net revenues, in the
comparable 1996 period. The increase in absolute dollars was primarily
attributable to increased personnel and operations and facilities costs both
in North America and Europe in support of increased net revenues. The decrease
as a percentage of net revenues was primarily attributable to operating
efficiencies gained as a result of an increased net revenues base.
 
  Product Development. Product development expenses increased 14.7% to $14.3
million, or 16.6% of net revenues, in the eight months ended December 31, 1997
from $12.5 million, or 24.8% of net revenues, in the comparable 1996 period.
The increase in absolute dollars was primarily due to the addition of
personnel in the Company's product development group, an increase in the
number of products under development and the initiation of European and OEM
product development in the 1997 period. The decrease as a percentage of net
revenues primarily reflected operating efficiencies gained as a result of
increased net revenues.
 
 Other Income (Expense)
 
  Other expense increased to $2.3 million in the eight months ended December
31, 1997 from $1.1 million in the comparable 1996 period. This increase was
primarily due to increased borrowings under the Company's line of credit to
support increased working capital requirements in the 1997 period and interest
on the Subordinated Secured Promissory Notes, which were issued from October
1996 through February 1997 and were outstanding throughout the 1997 period.
 
 Provision (Benefit) for Income Taxes
 
  The Company recorded no tax provision in the eight months ended December 31,
1997, compared to a tax benefit of $5.9 million in the comparable 1996 period.
No tax benefit was recorded in the 1997 period due to the uncertainty of
realization in future periods.
 
Year Ended April 30, 1997 Compared To The Year Ended April 30, 1996
 
  The Company's net loss for the former fiscal year ended April 30, 1997
increased to $27.2 million from $0.7 million in the comparable 1996 period.
The Company's results of operations for the former fiscal year ended April 30,
1997 were adversely affected by a number of factors, including delays in the
completion of certain products, which led the Company to release alternative
titles developed by third parties which did not achieve broad market
acceptance, and a sharp decline in the market for titles for the Macintosh and
Sega Saturn platforms, both of which resulted in a higher than expected level
of product returns and markdown allowances. The Company increased its reserves
by approximately $5.4 million during fiscal 1997 in response to these
increased returns and markdown allowances. Operating results for the period
were also negatively affected by (i) the Company's decision to write-off $5.9
million in prepayments to third party developers relating to titles or
platform versions of titles which had been canceled or which were expected to
achieve lower unit sales than were originally forecast, (ii) an excessive
reliance on development projects utilizing new technologies in the face of
increasing development costs (total development costs were $21.4 million in
fiscal 1997 as compared with $15.1 million in fiscal 1996) , (iii) slower than
expected growth in sales in the Japanese market, and (iv) investments in new
product lines in the sports and edutainment categories.
 
                                      20
<PAGE>
 
 Net Revenues
 
  Net revenues in the year ended April 30, 1997 decreased 14.1% to $83.3
million from $97.0 million in the comparable 1996 period. North American net
revenues decreased to $38.6 million in the 1997 period from $54.7 million in
the 1996 period and international net revenues increased to $32.0 million in
the 1997 period from $24.6 million in the 1996 period. OEM, royalty and
licensing net revenues accounted for 15.2% of total net revenues for the 1997
period, compared to 18.2% for the 1996 period. The decrease in net revenues
for the 1997 period was primarily due to a decreased number of title releases
resulting from certain product delays across multiple platforms, lower unit
sales of the titles released during the period and a higher than expected
level of product returns and markdowns recorded during the period.
 
 Cost of Goods Sold; Gross Profit
 
  Cost of goods sold increased 25.1% to $62.5 million, or 75.0% of net
revenues, in the year ended April 30, 1997 from $49.9 million, or 51.5% of net
revenues, in the comparable 1996 period. Gross profit as a percentage of net
revenue decreased to 25.0% in the 1997 period from 48.5% in the 1996 period.
The decrease in gross profit in the 1997 period was primarily due to an
increase in royalty expenses attributable to the write-off of $5.9 million in
prepaid royalties relating to titles or platform versions of titles which had
been canceled or which were expected to achieve lower unit sales than
originally forecast, increased sales of video game console titles and
affiliate label products and disproportionate returns and markdowns in the
1997 period, offset in part by increased OEM volumes.
 
 Operating Expenses
 
  Total operating expenses increased 16.9% to $55.5 million, or 66.6% of net
revenues, in the year ended April 30, 1997 from $47.4 million, or 48.9% of net
revenues, in the comparable 1996 period.
 
  Marketing and Sales. Marketing and sales expenses increased 5.8% to $24.6
million, or 29.6% of net revenues, in the 1997 period from $23.3 million, or
24.0% of net revenues, in the 1996 period. The increase in absolute dollars
was primarily due to increased commissions expense on European sales offset in
part by lower marketing and advertising expenses due to a decrease in titles
released during the period.
 
  General and Administrative. General and administrative expenses increased
4.2% to $9.4 million, or 11.3% of net revenues, in the 1997 period from $9.0
million, or 9.3% of net revenues, in the 1996 period. The increase in absolute
dollars was primarily attributable to increased personnel and facilities costs
in North America, Europe and Japan.
 
  Product Development. Product development expenses increased 41.7% to $21.4
million, or 25.7% of net revenues, in the 1997 period from $15.1 million, or
15.6% of net revenues, in the 1996 period. The increase in absolute dollars
was primarily attributable to an increase in the number of products under
development, the inclusion of a full year of operations of Shiny, an
interactive entertainment software developer in which the Company acquired a
91% interest in 1995, localization and development costs in Japan, initiation
of European and OEM product development and increased product development
personnel and facilities costs.
 
 Other Income (Expense)
 
  Other expense increased to $1.6 million in the 1997 period from $0.8 million
in the 1996 period. The increase was primarily due to interest expense related
to borrowings under the Company's bank line of credit to support increased
working capital requirements and interest on the Subordinated Secured
Promissory Notes which were issued from October 1996 through February 1997.
 
 Provision (Benefit) for Income Taxes
 
  The Company's income tax benefit in the 1997 period was $9.1 million,
compared to an income tax benefit of $0.5 million in the 1996 period. The
benefit for income taxes as a percentage of pre-tax income declined from 39.2%
to 25.0% due to the recording of a valuation allowance of $2.9 million in the
1997 period.
 
                                      21
<PAGE>
 
Liquidity and Capital Resources
 
  The Company has funded its operations to date primarily through the use of
lines of credit and equipment leases, through cash generated by the private
sale of securities and the initial public offering and from operations. As of
December 31, 1998 the Company's principal sources of liquidity included cash
and short term investments of approximately $614,000 and the Company's line of
credit bearing interest at the London Interbank Offered Rate plus 4.87%
(10.49% as of December 31, 1998), expiring May 31, 1999. The line of credit
also provides for a personal guarantee by the Company's Chairman and Chief
Executive Officer, Brian Fargo, in the amount of $5.0 million secured by
certain of Mr. Fargo's personal assets. As consideration for making such
guarantee, the Company issued Mr. Fargo Warrants to purchase 400,000 shares of
the Company's Common Stock at an exercise price of $3.00 per share. The
Warrants have a three year term and include a cashless exercise provision. In
addition, the Warrants are not exercisable in the event the Company enters
into an agreement to merge or combine the Company prior to May 1999. The
shares issuable upon exercise of the Warrants are subject to the twelve month
lockup agreement Mr. Fargo entered into in connection with the Company's
initial public offering. In connection with the issuance of the Warrants, the
Company was required to record an expense equal to the fair market value of
the Warrants, which is estimated to be approximately $316,000, with such
expense being amortized as additional interest expense over the term of the
guarantee. In addition, the issuance of such Warrants by the Company may
result in dilution to stockholders. As of December 31, 1998, the Company's
balance on the line of credit was $24.5 million with stand-by letters of
credit outstanding totaling $4.6 million.
 
  In March 1999, the Company amended its credit agreement to extend its
current line of credit through January 1, 2000 and thereafter, on a year to
year basis, unless either party gives 30 day notice prior to expiration of the
current term, based on qualifying receivables and inventory. Under the terms
of the Amendment the Company's credit limit will be $37.5 million through
November 29, 1999, $30.0 million through December 30, 1999 and $25.0 million
thereafter. Within the total credit limit, the Company may borrow up to $14.0
million in excess of its borrowing base through July 30, 1999, $10.0 million
in excess through September 29, 1999, $7.0 million through November 29, 1999
and $5.0 million in excess thereafter. Under the amended line of credit the
Company is required to place a cash collateral deposit of $0.5 million on
April 15, 1999. In addition, the Company is required to maintain certain
borrowing limitations beginning July 30, 1999 where actual borrowings are
limited to $35.0 million with various month end limitations, generally
decreasing to $25.0 million at December 31, 1999 and the $5.0 million personal
guarantee by Mr. Fargo must remain in place throughout the term. All other
terms and conditions remain in full force and effect. As consideration for the
extension of Mr. Fargo's guaranty through January 1, 2000, the Company has
agreed to assume Mr. Fargo's obligations under an agreement between Mr. Fargo
and Christopher J. Kilpatrick, the Company's President, pursuant to which
Mr. Fargo granted certain put rights to Mr. Kilpatrick with respect to the
271,528 common stock options held by Mr. Kilpatrick. The amount of the
obligation assumed is presently unknown, but will be between zero and
$1.0 million, with such expense to be amortized as additional interest expense
over the extended term of Mr. Fargo's guaranty. The Company is currently in
compliance with all terms of its amended credit agreement.
 
  The Company's primary capital needs have historically been to fund working
capital requirements necessitated by its net losses, its sales growth, the
development and introduction of products and related technologies and the
acquisition or lease of equipment and other assets used in the product
development process. The Company's operating activities used cash of $18.8
million during the year ended December 31, 1998, primarily attributable to
increased prepaid licenses and royalties and the net loss for the year, offset
in part by an increase in accounts payable. Cash provided by financing
activities of $19.4 million for the year ended December 31, 1998 consisted
primarily of the proceeds from the Company's initial public offering, offset
partially by the payoff of the Subordinated Secured Promissory Notes and
Warrants. On June 24, 1998 the Company completed its initial public offering
of 5,000,000 shares of Common Stock at $5.50 per share which raised
approximately $24.3 million, net of expenses. In connection with the offering,
$8.7 million of Notes and Warrants were converted to Common Stock and $6.3
million were repaid in cash. Cash used in investing activities of $1.7 million
for the year ended December 31, 1998 consisted of capital expenditures,
primarily for office and computer equipment used in Company operations. The
Company does not currently have any material commitments with respect to any
capital expenditures.
 
                                      22
<PAGE>
 
  On February 10, 1999, the Company entered into an agreement to acquire,
together with two members of Interplay Europe management, a 49.9% membership
interest in VIE Acquisition Group LLC, the parent entity of Virgin
Interactive. Under the terms of an International Distribution Agreement
entered into between the Company and Virgin Interactive in connection with the
acquisition of that interest, the Company must pay a fixed monthly overhead
fee, subject to reduction in certain events, and a distribution fee for the
marketing and distribution of the Company's products based on net sales,
subject to a minimum annual payment. See "Management's Discussion and Analysis
of Financial Condition and Results of Operations--Factors Affecting Future
Performance--Distribution Agreement".
 
  To reduce the Company's working capital needs, the Company has implemented
certain measures including an approximately 20% reduction of personnel, a
significant reduction of fixed overhead commitments, a decrease in management
compensation and the delay, cancellation or scale back of certain product
development and marketing programs. In addition, in February 1999 the Company
executed an International Distribution Agreement which the Company believes
will reduce its international costs and expenses in future periods ( see
"Notes to Consolidated Financial Statements--Subsequent Events"). The Company
is pursuing various alternatives, including further expense reductions, in an
effort to continue to reduce operating expenses. There can be no assurance
that the Company will be able to undertake such measures, or that such
measures would not materially and adversely affect the Company's ability to
publish commercially viable titles, or that such measures would be sufficient
to generate operating profits. In addition, the Company's long term liquidity
will be materially dependent on its ability to develop and market successful
titles for the hardware platforms that dominate the interactive entertainment
market.
 
  There can be no assurance that the Company's operating expenses or current
obligations will not materially exceed cash flows available from the Company's
operations in fiscal 1999 and beyond, that the increased line of credit will
be sufficient to finance any negative cash flow from operations or that such
line of credit will be renewed or replaced on reasonable terms, if at all. In
addition, no assurance can be given that the cost reduction measures
undertaken by the Company will not materially adversely affect the Company's
ability to develop and publish commercially viable titles, or that such
measures, whether alone or in conjunction with increased net revenues, if any,
will be sufficient to generate operating profits in fiscal 1999 and beyond.
Certain of such measures may require third party consents or approvals,
including the Company's financial institution, and there can be no such
assurance that such consents or approvals can be obtained. See "Management's
Discussion and Analysis of Financial Condition and Results of Operations--
Factors Affecting Future Performance--Liquidity; Future Capital Requirements".
 
  To provide working capital to support the Company's future operations, the
Company took several actions during 1998, including entering into certain
product licensing and distribution agreements which in the aggregate provided
approximately $10.8 million in advance cash payments. In addition, in March
1999, the Company extended the expiration of its line of credit to January 1,
2000 and entered into a Stock Purchase Agreement with an investor which
provides for the issuance of 2.5 million shares of the Company's Common Stock
for $10 million. Under the terms of the Stock Purchase Agreement up to 2.5
million additional shares of the Company's common stock may be issued without
additional consideration based on the average closing price per share of the
Company's Common Stock as of certain specified future dates; provided,
however, the investor will not be issued a total number of shares equaling or
exceeding 20% of the Company's current outstanding Common Stock without the
approval of the Company's stockholders.
 
  The Company believes that funds available under its line of credit, amounts
to be received under various product license and distribution agreements and
anticipated funds from operations will be sufficient to satisfy the Company's
projected working capital and capital expenditure needs and debt obligations
in the normal course of business at least through the expiration of its line
of credit on January 1, 2000. Based upon certain assumptions, including
without limitation, the Company's ability to achieve anticipated operating
results, the Company believes that it will be able to renew its line of credit
or obtain alternate financing on reasonable terms. However, there can be no
assurance that the assumptions relied on by the Company will prove correct or
that the Company will be able to renew or replace its line of credit on
satisfactory terms, if at all. Further, there can be no assurance
 
                                      23
<PAGE>
 
that the Company will not be required to raise additional working capital
through debt or equity financing during such period. If the Company is
required to raise additional working capital, there can be no assurance that
the Company will be able to raise such additional working capital on
acceptable terms, if at all. In the event the Company is unable to raise
additional working capital, further measures would be necessary including,
without limitation, the sale or consolidation of certain operations, the
delay, cancellation or scale back of product development and marketing
programs and other actions. No assurance can be given that such measures would
not materially adversely affect the Company's ability to develop and publish
commercially viable titles, or that such measures would be sufficient to
generate operating profits in fiscal 1999 and beyond. Certain of such measures
may require third party consents or approvals, including the Company's
financial institution, and there can be no such assurance that such consents
or approvals can be obtained. See "Management's Discussion and Analysis of
Financial Condition and Results of Operations--Factors Affecting Future
Performance--Liquidity; Future Capital Requirements".
 
Year 2000 Issue
 
  Many existing computer systems and applications, and other control devices,
use only two digits to identify a year in the date field, without considering
the impact of the upcoming change in the century. Therefore, they do not
properly recognize a year that begins with "20" rather than "19". Others do
not correctly process "leap year" dates. As a result, such systems and
applications could fail or create erroneous results unless corrected so that
they can correctly process data related to the year 2000 and beyond. The
Company relies on its systems and applications in operating and monitoring all
major aspects of its business, including financial systems (such as general
ledger, accounts payable and payroll modules), customer services, networks and
telecommunications systems equipment and end products. The Company also
relies, directly and indirectly, on external systems of suppliers for the
management and control of product development and of business enterprises such
as developers, customers, suppliers, creditors, financial organizations, and
governmental entities, both domestic and international, for accurate exchange
of data. The Company could be affected through disruptions in the operation of
the enterprises with which the Company interacts or from general widespread
problems or an economic crisis resulting from non-compliant Year 2000 systems.
Despite the Company's efforts to address the Year 2000 impact on its internal
systems and business operations, there can be no assurance that such impact
will not result in a material disruption of its business or have a material
adverse effect on the Company's business, operating results and financial
condition.
 
  The Company is currently in the process of assessing the potential impact of
the Year 2000 issue on its business and the related foreseeable expenses that
may be incurred in attempting to remedy such impact. The Company is employing
a combination of internal resources and outside consultants to evaluate and
address Year 2000 issues. The Company's Year 2000 plan includes (i)
Assessment: Conducting an evaluation of the Company's computer based systems,
facilities and products (and those of significant dealers, vendors and other
third parties with which the Company does business) to determine their Year
2000 compliance, (ii) Remediation: Coordinating the replacement and/or upgrade
of non-compliant systems, as necessary, and (iii) Test and Implement:
Developing and overseeing the implementation of all of the initiatives in the
Company's Year 2000 compliance plan. For example, the Company is in the
process of upgrading its internal accounting software and expects such upgrade
to be completed prior to the commencement of the 3rd quarter in 1999. Although
the Company has identified certain systems and applications that are not Year
2000 compliant and the Company is in the process of upgrading its software to
address the Year 2000 issue, there can be no assurance that such upgrades will
be completed on a timely basis at reasonable costs, or that such upgrades will
be able to anticipate all of the problems triggered by the actual impact of
the year 2000. In addition, the inability of any internal system to achieve
Year 2000 compliance could result in material disruption to the Company's
operations. With respect to customers, developers, suppliers and other
enterprises upon which the Company relies, even where assurances are received
from such third parties, there remains a risk that failure of systems and
applications of such third parties could have a material adverse effect on the
Company.
 
  The Company is currently assessing its products for Year 2000 compliance and
anticipates such assessment to be complete prior to the end of the 3rd quarter
in 1999. However, there can be no assurance that any of the
 
                                      24
<PAGE>
 
Company's products are or will be Year 2000 compliant. The failure of any of
the Company's products to achieve Year 2000 compliance would result in
increased warranty costs, customer satisfaction issues, potential lawsuits and
other material costs and liabilities. In addition, if the computer systems on
which the consumers use the Company's products are not Year 2000 compliant,
such non compliance could adversely affect the consumers ability to use such
products.
 
  The Company believes that it will substantially complete the implementation
of its Year 2000 plan prior to the commencement of the 3rd quarter in 1999.
However, if the Company does not complete its Year 2000 plan prior to the
commencement of the year 2000, or if the Company fails to identify and
remediate all critical Year 2000 problems or if major suppliers, developers or
customers experience material Year 2000 problems, the Company's results of
operations or financial condition could be materially adversely effected.
 
  The Company has estimated that the total cost of Year 2000 compliance will
be less than $500,000, $36,000 of which had been spent. The costs of
compliance have been included in the Company's 1999 budget. The Company
currently does not have a formal contingency plan in the event that an area of
its operations does not become Year 2000 compliant. The Company will consider
adopting a formal plan upon completion of the Year 2000 assessment or if,
pending such completion, it becomes more evident that there will be an area of
non-compliance in its systems or at a critical third party.
 
  The foregoing statements are based upon management's best estimates at the
present time, which were derived utilizing numerous assumptions of future
events, including the continued availability of certain resources, third party
modification plans and other factors. There can be no assurance that these
estimates will be achieved and actual results could differ materially from
those anticipated. Specific factors that might cause such material differences
include, but are not limited to, the availability and cost of personnel
trained in this area, the ability to locate and correct all relevant computer
codes, the nature and amount of programming required to upgrade or replace
each of the affected programs, the rate and magnitude of related labor and
consulting costs and the success of the Company's external customers,
developers and suppliers in addressing the Year 2000 issue. The Company's
evaluation is ongoing and it expects that new and different information will
become available to it as the evaluation continues. Consequently, there can be
no assurance that all material elements will be Year 2000 compliant in time.
 
FACTORS AFFECTING FUTURE PERFORMANCE
 
  Future operating results of the Company depend upon many factors and are
subject to various risks and uncertainties. Some of the risks and
uncertainties which may cause the Company's operating results to vary from
anticipated results or which may materially and adversely affect its operating
results are as follows:
 
Liquidity; Future Capital Requirements
 
  The Company used net cash in operations of $18.8 million and $15.3 million,
respectively, in the year ended December 31, 1998 and the eight months ended
December 31, 1997. There can be no assurance that the Company will ever
generate positive cash flow from operations. The Company's ability to fund its
capital requirements out of available cash, its line of credit and cash
generated from operations will depend on numerous factors, including the
progress of the Company's product development programs, the rate of growth of
the Company's business, and the commercial success of the Company's products.
The Company may be required to seek additional funds through debt or equity
financings, product licensing or distribution transactions or some other
source of financing in order to provide sufficient working capital for the
Company. The issuance of additional equity securities by the Company could
result in substantial dilution to stockholders. If the Company is required to
raise additional working capital, there can be no assurance that the Company
will be able to raise such additional working capital on acceptable terms, if
at all. In the event the Company is unable to raise additional working
capital, further cost reduction measures would be necessary including, without
limitation, the
 
                                      25
<PAGE>
 
sale or consolidation of certain operations, the delay, cancellation or scale
back of product development and marketing programs and other actions. No
assurance can be given that such measures would not materially adversely
affect the Company's ability to publish commercially viable titles, or that
such measures would be sufficient to generate operating profits. Certain of
such measures may require third party approvals, including the Company's
financial institution, and there can be no assurance that such consents or
approvals can be obtained.
 
Fluctuations in Operating Results; Uncertainty of Future Results; Seasonality
 
  The Company's operating results have fluctuated significantly in the past
and will likely fluctuate significantly in the future, both on a quarterly and
an annual basis. A number of factors may cause or contribute to such
fluctuations, and many of such factors are beyond the Company's control. Such
factors include, but are not limited to, delays in shipment, demand for the
Company's and its competitors' products, the size and rate of growth of the
market for interactive entertainment software, changes in computing platforms,
the number of new products and product enhancements released by the Company
and its competitors during the period, changes in product mix, product
returns, the timing of orders placed by distributors and dealers, delays in
shipment, the timing of development and marketing expenditures, price
competition and the level of the Company's international and OEM, royalty and
licensing net revenues. The uncertainties associated with the interactive
entertainment software development process, lengthy manufacturing lead times
for Nintendo-compatible products, possible production delays, and the approval
process for products compatible with the Sony Computer Entertainment, Nintendo
and Sega video game consoles, as well as approvals required from other
licensors, make it difficult to accurately predict the quarter in which
shipments will occur. Because of the limited number of products introduced by
the Company in any particular quarter, a delay in the introduction of a
product may materially adversely affect the Company's operating results for
that quarter and may not be recaptured in subsequent quarters. A significant
portion of the Company's operating expenses is relatively fixed, and planned
expenditures are based primarily on sales forecasts. If net revenues do not
meet the Company's expectations in any given quarter, operating results may be
materially adversely affected. The interactive entertainment software industry
is highly seasonal, with the highest levels of consumer demand occurring
during the year-end holiday buying season, followed by demand during the first
calendar quarter. As a result, net revenues, gross profits and operating
income for the Company have historically been highest during the fourth and
the following first calendar quarters, and have declined from those levels in
subsequent second and third calendar quarters.
 
  The failure or inability of the Company to introduce products on a timely
basis to meet such seasonal increases in demand may have a material adverse
effect on the Company's business, operating results and financial condition.
The Company may over time become increasingly affected by the industry's
seasonal patterns. Although the Company seeks to reduce the effect of such
seasonal patterns on its business by distributing its product release dates
more evenly throughout the year, there can be no assurance that such efforts
will be successful. There can be no assurance that the Company will be
profitable in any particular period given the uncertainties associated with
software development, manufacturing, distribution and the impact of the
industry's seasonal patterns on the Company's net revenues.
 
  As a result of the foregoing factors and the other factors discussed in
"Management's Discussion and Analysis of Financial Condition and Results of
Operations--Factors Affecting Future Performance," it is likely that the
Company's operating results in one or more future periods will fail to meet or
exceed the expectations of securities analysts or investors. In such event,
the trading price of the Common Stock would likely be materially adversely
affected.
 
Significant Recent Losses
 
  The Company has experienced significant losses in recent periods, including
losses of $28.2 million, $5.1 million and $27.2 million, respectively, in the
years ended December 31, 1998, the eight months ended December 31, 1997 and in
the fiscal year ended April 30, 1997. The losses for the year ended December
31, 1998 resulted primarily from delays in the completion of certain products,
a higher than expected level of product
 
                                      26
<PAGE>
 
returns and markdowns on products released during the year and lower than
expected worldwide sales of certain releases, as well as from operating
expense levels that were higher than appropriate for the Company's revenue
level. There can be no assurance that the Company will not experience similar
problems in current or future periods or that the Company will be able to
generate sufficient net revenues or adequate working capital, or bring its
costs into line with revenues, so as to attain or sustain profitability in the
future.
 
Dependence on New Product Introductions; Risk of Product Delays and Product
Defects
 
  The Company's products typically have short life cycles, and the Company
depends on the timely introduction of successful new products, including
enhancements of or sequels to existing products and conversions of previously
released products to additional platforms, to generate net revenues to fund
operations and to replace declining net revenues from older products. In the
year ended December 31, 1998, the Company's results of operations were
adversely affected by a number of factors, including delays in the completion
of certain new products including Messiah, Earthworm Jim 3D and Baldur's Gate.
If in the future for any reason net revenues from new products were to fail to
replace declining net revenues from existing products, the Company's business,
operating results and financial condition could be materially adversely
affected. The timing and success of new interactive entertainment software
product releases remains unpredictable due to the complexity of product
development, including the uncertainty associated with new technology. The
development cycle of new products is difficult to predict but typically ranges
from 12 to 24 months and another six to 12 months for the porting of a product
to a different technology platform. In the past, the Company has frequently
experienced significant delays in the introduction of new products, including
certain products currently under development. Because net revenues associated
with the initial shipments of a new product generally constitute a high
percentage of the total net revenues associated with a product, any delay in
the introduction of, or the presence of a defect in, one or more new products
expected in a period could have a material adverse effect on the ultimate
success of such products and on the Company's business, operating results and
financial condition. The costs of developing and marketing new interactive
entertainment software have increased in recent years due to such factors as
the increasing complexity and content of interactive entertainment software,
increasing sophistication of hardware technology and consumer tastes and
increasing costs of obtaining licenses for intellectual properties, and the
Company expects this trend to continue. There can be no assurance that new
products will be introduced on schedule, if at all, or that, if introduced,
they will achieve significant market acceptance or generate significant net
revenues. In addition, software products as complex as those offered by the
Company may contain undetected errors when first introduced or when new
versions are released. There can be no assurance that, despite testing by the
Company, errors will not be found in new products or releases after
commencement of commercial shipments, resulting in loss of or delay in market
acceptance, which could have a material adverse effect on the Company's
business, operating results and financial condition.
 
Uncertainty of Market Acceptance; Dependence on Hit Titles
 
  Consumer preferences for interactive entertainment software are continually
changing and are extremely difficult to predict. Historically, few interactive
entertainment software products have achieved sustained market acceptance.
Rather, a limited number of releases have become "hits" and have accounted for
a substantial portion of revenues in the industry. Further, publishers with a
history of producing hit tittles have enjoyed a significant marketing
advantage because of their heightened brand recognition and consumer loyalty.
The Company expects the importance of introducing hit titles to increase in
the future. There can be no assurance that new products introduced by the
Company will achieve significant market acceptance, that such acceptance, if
achieved, will be sustainable for any significant period, or that product life
cycles will be sufficient to permit the Company to recover development and
other associated costs. Most of the Company's products have a relatively short
life cycle and sell for a limited period of time after their initial release,
usually less than one year. The Company believes that these trends will
continue and that the Company's future revenue will continue to be dependent
on the successful production of hit titles on a continuous basis. Because the
Company introduces a relatively limited number of new products in a given
period, the failure of one or more of such products to achieve market
acceptance could have a material adverse effect on the Company's business,
operating results
 
                                      27
<PAGE>
 
and financial condition. Further, if market acceptance is not achieved, the
Company could be forced to accept substantial product returns or grant
significant markdown allowances to maintain its relationship with retailers
and its access to distribution channels. For example, the Company had higher
than expected product returns and markdowns in the year ended December 31,
1998 and there can be no assurance that higher than expected product returns
and markdowns will not continue in the future. In the event that the Company
is forced to accept significant product returns or grant significant markdown
allowances, its business, operating results and financial condition could be
materially adversely affected.
 
Continued Listing on the NASDAQ National Market
 
  The Company's Common Stock is currently quoted on the NASDAQ National Market
under the symbol "IPLY." For continued inclusion on the NASDAQ National
Market, a company must meet certain tests, such as a minimum bid price of
$1.00 and net tangible assets of at least $2.0 million. As of December 31,
1998 the Company had net tangible assets of approximately $2.5 million. In the
event that the Company fails to satisfy the listing standards on a continuous
basis, the Company's Common Stock may be removed from listing on the NASDAQ
National Market. If the Company's Common Stock is delisted from the NASDAQ
National Market, trading of the Company's Common Stock, if any, would be
conducted in the over-the-counter market in the so-called "pink sheets" or, if
available, the NASD's "Electronic Bulletin Board." In such event, investors
could find it more difficult to dispose of, or to obtain accurate quotations
as to the value of, the Company's Common Stock and the trading price per share
would most likely be reduced as a result.
 
Distribution Agreement
 
  In February 1999 in connection with the Company's acquisition, together with
two members of Interplay Europe management, of a 49.9% membership interest in
Virgin's parent entity, the Company signed an International Distribution
Agreement with Virgin. Under this Agreement, the Company appointed Virgin as
the exclusive distributor for substantially all of the Company's products in
Europe, CIS, Africa and the Middle East, subject to certain reserved rights,
for a seven year period. Because of the exclusive nature of the Agreement, if
Virgin were to experience problems with its business, or were to fail to
perform as expected, the Company's business, operating results and financial
condition could be materially and adversely affected. In connection with this
Agreement, Virgin will hire the Company's European sales and marketing
personnel, and the Company will pay Virgin a distribution fee for its
marketing and distribution of the Company's products, subject to a minimum
amount, as well as a fixed overhead fee, subject to reduction in certain
events. Because of the minimum distribution fee, in the event the Company's
European sales are lower than expected, the Company may effectively pay a
higher distribution fee on the units sold, which could have a material adverse
effect on the Company's business, operating results and financial condition.
In addition, due to the fixed nature of the overhead fee, the Company will not
be able to reduce its European sales and marketing expenses in response to
downturns in the Company's sales in Europe, which could have a material
adverse effect on the Company's business, operating results and financial
condition.
 
Dependence on Third Party Software Developers
 
  The Company relies on third party interactive entertainment software
developers for the development of a significant number of its interactive
entertainment software products. As reputable and competent third party
developers continue to be in high demand, there can be no assurance that third
party software developers that have developed products for the Company in the
past will continue to be available to develop products for the Company in the
future. Many third party software developers have limited financial resources,
which could expose the Company to the risk that such developers may go out of
business prior to completing a project. In addition, due to the limited
control that the Company exercises over third party software developers, there
can be no assurance that such developers will complete products for the
Company on a timely basis or within acceptable quality standards, if at all.
Increased competition for skilled third party software developers has required
the Company to enter into agreements with licensors of intellectual property
and developers of games that involved advance payments by the Company of
royalties and guaranteed minimum royalty payments, and
 
                                      28
<PAGE>
 
the Company expects to continue to enter into such arrangements. If the sales
volumes of products subject to such arrangements are not sufficient to recover
such royalty advances and guarantees, the Company would be required to write-
off unrecovered portions of such payments, which could have a material adverse
effect on its business, operating results and financial condition. Further,
there can be no assurance that third party developers will not demand
renegotiation of their arrangements with the Company.
 
Rapidly Changing Technology; Platform Risks
 
  The interactive entertainment software industry is subject to rapid
technological change. The introduction of new technologies, including
operating systems such as Microsoft Windows 95 and 98, technologies that
support multi-player games, new media formats such as on-line delivery and
digital video disks ("DVDs") and as yet unreleased video game platforms could
render the Company's current products or products in development obsolete or
unmarketable. The Company must continually anticipate and assess the emergence
of, and market acceptance of, new interactive entertainment software platforms
well in advance of the time the platform is introduced to consumers. Because
product development cycles are difficult to predict, the Company is required
to make substantial product development and other investments in a particular
platform well in advance of introduction of the platform. If the platforms for
which the Company develops software are not released on a timely basis or do
not attain significant market penetration, the Company's business, operating
results and financial condition could be materially adversely affected.
Alternatively, if the Company fails to develop products for a platform that
does achieve significant market penetration, then the Company's business,
operating results and financial condition could also be materially adversely
affected.
 
  The emergence of new interactive entertainment software platforms and
technologies and the increased popularity of new products and technologies may
materially and adversely affect the demand for products based on older
technologies. In this regard, the Company's results of operations in its
former fiscal year ended April 30, 1997 were adversely affected by a sharp
decline in the market for titles for the Macintosh and Sega Saturn platforms,
which declines resulted in a high level of product returns and markdown
allowances. The broad range of competing and incompatible emerging
technologies may lead consumers to postpone buying decisions with respect to
products until one or more of such technologies gain widespread acceptance.
Such postponement could have a material adverse effect on the Company's
business, operating results and financial condition. The Company is currently
actively developing products for the Microsoft Windows 95 and 98, PlayStation
and Nintendo 64 platforms, as well as for the Sega Dreamcast platform
scheduled for release in Fall 1999. The Company's success will depend in part
on its ability to anticipate technological changes and to adapt its products
to emerging game platforms. There can be no assurance that the Company will be
able to anticipate future technological changes, to obtain licenses to develop
products for those platforms on terms favorable to the Company or to create
software for those new platforms, and any failure to do so could have a
material adverse effect on the Company's business, operating results and
financial condition.
 
Industry Competition; Competition for Shelf Space
 
  The interactive entertainment software industry is intensely competitive and
is characterized by the frequent introduction of new interactive entertainment
software platforms and software platforms. The Company's competitors vary in
size from small companies to very large corporations with significantly
greater financial, marketing and product development resources than those of
the Company. Due to these greater resources, certain of the Company's
competitors are able to undertake more extensive marketing campaigns, adopt
more aggressive pricing policies, pay higher fees to licensors of desirable
motion picture, television, sports and character properties and pay more to
third party software developers than the Company. The Company believes that
the principal competitive factors in the interactive entertainment software
industry include product features, brand name recognition, access to
distribution channels, quality, ease of use, price, marketing support and
quality of customer service.
 
  The Company competes primarily with other publishers of PC and video game
console interactive entertainment software. Significant competitors include
Electronic Arts, GT Interactive Software Corp., Mattel, Activision, Inc.,
Microsoft Corporation, LucasArts Entertainment Company, Midway Games Inc.,
Acclaim Entertainment Inc., Havas
 
                                      29
<PAGE>
 
Interactive and Hasbro Inc. In addition, integrated video game console
hardware/software companies such as Sony Computer Entertainment, Nintendo and
Sega compete directly with the Company in the development of software titles
for their respective platforms. Large diversified entertainment companies,
such as The Walt Disney Company, many of which own substantial libraries of
available content and have substantially greater financial resources than the
Company, may decide to compete directly with the Company or to enter into
exclusive relationships with competitors of the Company. The Company also
believes that the overall growth in the use of the Internet and on-line
services by consumers may pose a competitive threat if customers and potential
customers spend less of their available home PC time using interactive
entertainment software and more on the Internet and on-line services.
 
  Retailers of the Company's products typically have a limited amount of shelf
space and promotional resources, and there is intense competition among
consumer software producers, and in particular interactive entertainment
software products, for high quality retail shelf space and promotional support
from retailers. To the extent that the number of consumer software products
and computer platforms increases, competition for shelf space may intensify
and may require the Company to increase its marketing expenditures. Due to
increased competition for limited shelf space, retailers and distributors are
in an increasingly better position to negotiate favorable terms of sale,
including price discounts, price protection, marketing and display fees and
product return policies. The Company's products constitute a relatively small
percentage of any retailer's sale volume, and there can be no assurance that
retailers will continue to purchase the Company's products or to provide the
Company's products with adequate levels of shelf space and promotional
support, and a prolonged failure in this regard may have a material adverse
effect on the Company's business, operating results and financial condition.
 
Dependence on Distribution Channels; Risk of Customer Business Failures;
Product Returns
 
  The Company currently sells its products directly through its own sales
force to mass merchants, warehouse club stores, large computer and software
specialty chains and through catalogs in the U.S. and Canada, as well as to
certain distributors. Outside North America, the Company generally sells to
third party distributors. The Company's sales are made primarily on a purchase
order basis, without long-term agreements. The loss of, or significant
reduction in sales to, any of the Company's principal retail customers or
distributors could materially adversely affect the Company's business,
operating results and financial condition.
 
  The distribution channels through which consumer software products are sold
are characterized by continuous change, including consolidation, financial
difficulties of certain distributors and retailers, and the emergence of new
distributors and new retailers such as warehouse chains, mass merchants and
computer superstores. As more consumers own PCs, the distribution channels for
interactive entertainment software have changed are expected to continue to
change. Mass merchants have become the most important distribution channels
for retail sales of interactive entertainment software. A number of these mass
merchants, including Wal-Mart, have entered into exclusive buying arrangements
with other software developers or distributors, which arrangements prevent the
Company from selling certain of its products directly to that mass merchant.
If the number of mass merchants entering into exclusive buying arrangements
with software distributors other than the Company were to increase, the
Company's ability to sell to such merchants would be restricted to selling
through the exclusive distributor. Because sales to distributors typically
have a lower gross profit than sales to retailers, this would have the effect
of lowering the Company's gross profit. In addition, this trend could increase
the material adverse impact on the Company's business, operating results and
financial condition. In addition, emerging methods of distribution, such as
the Internet and on-line services, may become more important in the future,
and it will be important for the Company to maintain access to these channels
of distribution. There can be no assurance that the Company will maintain such
access or that the Company's access will allow the Company to maintain its
historical levels of sales volume.
 
  Distributors and retailers in the computer industry have from time to time
experienced significant fluctuations in their businesses, and there have been
a number of business failures among these entities. The insolvency or business
failure of any significant distributor or retailer of the Company's products
could have a material adverse effect on the Company's business, operating
results and financial condition. Sales are typically
 
                                      30
<PAGE>
 
made on unsecured credit, with terms that vary depending upon the customer and
the nature of the product. Although the Company has obtained insolvency risk
insurance to protect against any bankruptcy, insolvency or liquidation that
may occur involving its customers, such insurance contains a significant
deductible and a co-payment obligation, and the policy does not cover all
instances of non-payment. In addition, while the Company maintains a reserve
for uncollectible receivables, the actual reserve may not be sufficient in
every circumstance. As a result, a payment default by a significant customer
could have a material adverse effect on the Company's business, operating
results and financial condition.
 
  The Company is exposed to the risk of product returns and markdown
allowances with respect to its distributors and retailers. The Company allows
distributors and retailers to return defective, shelf-worn and damaged
products in accordance with negotiated terms, and also offers a 90-day limited
warranty to its end users that its products will be free from manufacturing
defects. In addition, the Company provides markdown allowances to its
customers to manage its customers' inventory levels in the distribution
channel. Although the Company maintains a reserve for returns and markdown
allowances, and although the Company's agreements with certain of its
customers place certain limits on product returns and markdown allowances, the
Company could be forced to accept substantial product returns and provide
markdown allowances to maintain its relationships with retailers and its
access to distribution channels. Product return and markdown allowances that
exceed the Company's reserves could have a material adverse effect on the
Company's business, operating results and financial condition. In this regard,
the Company's results of operations for the fiscal year ended December 31,
1998 were adversely affected by a higher than expected level of product
returns and markdown allowances and consequently reduced net revenues. There
can be no assurance that the Company will not continue to experience such high
levels of product returns and markdown allowances in future periods, which
could have a material adverse effect on the Company's business, operating
results and financial condition.
 
Dilution; Shares Eligible for Future Sale
 
  In March 1999, the Company entered into a Stock Purchase Agreement with
Titus Interactive S.A. ("Titus"), pursuant to which Titus purchased from the
Company 2.5 million shares of the Company's Common Stock for an aggregate
purchase price of $10 million. Pursuant to such Agreement, the Company may
become obligated to issue additional shares of Common Stock to Titus without
additional consideration in certain events (see Note 15 to the Company's
Consolidated Financial Statements). Such issuance could result in material
dilution to the Company's stockholders.
 
  In addition, the Company has agreed to register all of the shares held by
Titus (up to 9,658,216 shares if Titus exercises its option to acquire the
shares owned by Universal and the maximum number of additional shares are
issued) for resale under the Securities Act of 1933, as amended. Such
registration could temporarily impair the Company's ability to raise capital
through the sale of its equity securities, and, if such registered shares are
sold, could have a material adverse effect on the market price of the
Company's Common Stock.
 
Dependence Upon Third Party Licenses
 
  Many of the Company's products, such as its Star Trek, Major League Baseball
and Caesars Palace titles, are based on original ideas or intellectual
properties licensed from third parties. There can be no assurance that the
Company will be able to obtain new licenses, or renew existing licenses, on
commercially reasonable terms, if at all. For example, Paramount has granted
the Star Trek license to a third party upon the expiration of the Company's
rights. Should the Company be unable to obtain licenses for the underlying
content that it believes offers the greatest consumer appeal, the Company
would either have to seek alternative, potentially less appealing licenses, or
release the products without the desired underlying content, either of which
events could have a material adverse effect on the Company's business,
operating results and financial condition. There can be no assurance that
acquired properties will enhance the market acceptance of the Company's
products based on such properties, that the Company's new product offerings
will generate net revenues in excess of their costs of development and
marketing or minimum royalty obligations, or that net revenues from new
product sales will meet or exceed net revenues from existing product sales.
 
                                      31
<PAGE>
 
Dependence on Licenses from and Manufacturing by Hardware Companies
 
  The Company is required to obtain a license to develop and distribute
software for each of the video game console platforms for which the Company
develops products, including a separate license for each of North America,
Japan and Europe. The Company has obtained licenses to develop software for
the PlayStation in North America and is currently negotiating agreements
covering additional territories. In addition, the Company has obtained a
license to develop software for the Nintendo 64 in North America, Europe and
Australia and is currently negotiating with Nintendo for licenses covering
additional territories. There can be no assurance that the Company will be
able to obtain licenses from hardware companies on acceptable terms or that
any existing or future licenses will be renewed by the licensors. In addition,
each of Sony Computer Entertainment, Nintendo and Sega have the right to
approve the technical functionality and content of the Company's products for
such platform prior to distribution. Due to the nature of the approval
process, the Company must make significant product development expenditures on
a particular product prior to the time it seeks such approvals. The inability
of the Company to obtain such approvals could have a material adverse effect
on the Company's business, operating results and financial condition.
 
  Hardware companies such as Sony Computer Entertainment, Nintendo and Sega
may impose upon their licensees a restrictive selection and product approval
process, such that licensees are restricted in the number of titles that will
be approved for distribution on the particular platform. While the Company has
prepared its future product release plans taking this competitive approval
process into consideration, if the Company has incorrectly predicted the
impact of this restrictive approval process, and as a result the Company fails
to obtain approvals for all products in the Company's development plans, such
failure could have a material adverse effect on the Company's business,
operating results and financial condition. The Company depends upon Sony
Computer Entertainment and Nintendo for the manufacture of the Company's
products that are compatible with their respective video game consoles. As a
result, Sony and Nintendo have the ability to raise prices for supplying such
products at any time and effectively control the timing of the Company's
release of new titles for those platforms. PlayStation products consist of CD-
ROMs and are typically delivered by Sony Computer Entertainment within a
relatively short lead time. Manufacturers of Nintendo and other video game
cartridges typically deliver software to the Company within 45 to 60 days
after receipt of a purchase order. If the Company experiences unanticipated
delays in the delivery of video game console products from Sony Computer
Entertainment or Nintendo, or if actual retailer and consumer demand for its
interactive entertainment software differs from that forecast by the Company,
its business, operating results and financial condition could be materially
adversely affected.
 
Dependence on Key Personnel
 
  The Company's success depends to a significant extent on the continued
service of its key product design, development, sales, marketing and
management personnel, and in particular on the leadership, strategic vision
and industry reputation of its founder and Chief Executive Officer, Brian
Fargo. The Company's future success will also depend upon the Company's
ability to continue to attract, motivate and retain highly qualified employees
and contractors, particularly key software design and development personnel.
Competition for highly skilled employees is intense, and there can be no
assurance that the Company will be successful in attracting and retaining such
personnel. Specifically, the Company may experience increased costs in order
to attract and retain skilled employees. The Company's failure to retain the
services of Brian Fargo or its other key personnel or to attract and retain
additional qualified employees could have a material adverse effect on the
Company's business, operating results and financial condition.
 
Risks Associated with International Operations; Currency Fluctuations
 
  International net revenues accounted for 28.2%, 28.7%, 38.4% and 25.4% of
the Company's total net revenues in the year ended December 31, 1998, the
eight months ended December 31, 1997 and the fiscal years ended April 30, 1997
and 1996, respectively. Additionally, in February 1999, the Company entered
into an International Distribution Agreement with Virgin for the exclusive
distribution of its products in selected international territories (see
Note 15 to the Consolidated Financial Statements). The Company intends to
continue to expand its direct and
 
                                      32
<PAGE>
 
indirect sales, marketing and product localization activities worldwide. Such
expansion will require significant management time and attention and financial
resources in order to develop improved international sales and support
channels. There can be no assurance, however, that the Company will be able to
maintain or increase international market demand for its products.
International sales and operations are subject to a number of inherent risks,
including the impact of possible recessionary environments in economies
outside the U.S., the time and financial costs associated with translating and
localizing products for foreign markets, longer accounts receivable collection
periods and greater difficulty in accounts receivable collection, unexpected
changes in regulatory requirements, difficulties and costs of staffing and
managing foreign operations, and political and economic instability. For
example, the Company has recently experienced difficulties selling products in
certain Asian countries as a result of economic instability in such countries,
and there can be no assurance that such difficulties will not continue or
occur in other countries in the future. There can be no assurance that the
foregoing factors will not have a material adverse effect on the Company's
future international net revenues and, consequently, on the Company's
business, operating results and financial condition. The Company currently
does not engage in currency hedging activities. Although exposure to currency
fluctuations to date has been insignificant, there can be no assurance that
fluctuations in currency exchange rates in the future will not have a material
adverse effect on net revenues from international sales and licensing, and
thus on the Company's business, operating results and financial condition.
 
Risks Associated with New European Currency
 
  On January 1, 1999, eleven of the fifteen member countries of the European
Union ("Participating Countries") established fixed conversion rates between
their existing sovereign currencies and a new European currency, the "euro".
The euro was adopted by the Participating Countries as the common legal
currency on that date. A significant portion of the Company's sales are made
to Participating Countries and consequently, the Company anticipates that the
euro conversion will, among other things, create technical challenges to adapt
information technology and other systems to accommodate euro-denominated
transactions and limit the Company's ability to charge different prices for
its producers in different markets. While the Company anticipates that the
conversion will not cause material disruption of its business, there can be no
assurance that the conversion will not have a material effect on the Company's
business or financial condition.
 
Protection of Proprietary Rights
 
  The Company regards its software as proprietary and relies on a combination
of patent, copyright, trademark and trade secret laws, employee and third
party nondisclosure agreements and other methods to protect its proprietary
rights. The Company owns or licenses various copyrights and trademarks, and
holds the rights to one patent application related to the software engine for
its Messiah title. While the Company provides "shrinkwrap" license agreements
or limitations on use with its software, the enforceability of such agreements
or limitations is uncertain. The Company is aware that unauthorized copying
occurs within the computer software industry, and if a significantly greater
amount of unauthorized copying of the Company's interactive entertainment
software products were to occur, the Company's operating results could be
materially adversely affected. While the Company does not generally copy
protect its products, it does not provide source code to third parties unless
they have signed nondisclosure agreements with respect thereto.
 
  The Company relies on existing copyright laws to prevent unauthorized
distribution of its software. Existing copyright laws afford only limited
protection. Policing unauthorized use of the Company's products is difficult,
and software piracy can be expected to be a persistent problem, especially in
certain international markets. Further, the laws of certain countries in which
the Company's products are or may be distributed either do not protect the
Company's products and intellectual property rights to the same extent as the
laws of the U.S. or are weakly enforced. Legal protection of the Company's
rights may be ineffective in such counties, and as the Company leverages its
software products using emerging technologies, such as the Internet and on-
line services, the ability of the Company to protect its intellectual property
rights, and to avoid infringing the intellectual property rights of others,
becomes more difficult. There can be no assurance that existing intellectual
property laws will provide adequate protection to the Company's products in
connection with such emerging technologies.
 
 
                                      33
<PAGE>
 
  As the number of interactive entertainment software products in the industry
increases and the features and content of these products further overlap,
software developers may increasingly become subject to infringement claims.
Although the Company makes reasonable efforts to ensure that its products do
not violate the intellectual property rights of others, there can be no
assurance that claims of infringement will not be made. Any such claims, with
or without merit, can be time consuming and expensive to defend. From time to
time, the Company has received communications from third parties of such
parties. There can be no assurance that existing or future infringement claims
against the Company will not result in costly litigation or require the
Company to license the intellectual property rights of third parties, either
of which could have a material adverse effect on the Company's business,
operating results and financial condition.
 
Entertainment Software Rating System; Governmental Restrictions
 
  Legislation is periodically introduced at the state and federal levels in
the U.S. and in foreign countries to establish a system for providing
consumers with information about graphic violence and sexually explicit
material contained in interactive entertainment software products. Such a
system would include procedures with which interactive entertainment software
publishers would be expected to comply by identifying particular products
within defined rating categories and communicating such ratings to consumers
through appropriate package labeling and through advertising and marketing
presentations consistent with each products' rating. In addition, many foreign
countries have laws which permit governmental entities to censor the content
of certain works, including interactive entertainment software. In certain
instances, the Company may be required to modify its products to comply with
the requirements of such governmental entities, which could delay the release
of those products in such countries. Such delays could have a material adverse
effect on the Company's business, operating results and financial condition.
While the Company currently voluntarily submits its products to industry-
created review boards and publishes their ratings on its game packaging, the
Company believes that mandatory government-run integrative entertainment
software products rating systems eventually will be adopted in many countries
which represent significant markets or potential markets for the Company. Due
to the uncertainties inherent in the implementation of such a rating system,
confusion in the marketplace may occur, and the Company is unable to predict
what effect, if any, such a rating system would have on the Company's
business. In addition to such regulations, certain retailers have in the past
declined to stock certain of the Company's products because they believed that
the content of the packaging artwork or the products would be offensive to the
retailer's customer base. While to date such actions have not had a material
adverse effect on the Company's business, operating results or financial
condition, there can be no assurance that similar actions by the Company's
distributors or retailers in the future would not have a material adverse
effect on the Company's business, operating results and financial condition.
 
Control by Directors and Officers
 
  The Company's directors and executive officers and Universal Studios, Inc.
("Universal"), which currently has two representatives on the Company's Board
of Directors, beneficially own, in the aggregate, approximately 52.5% of the
Company's outstanding Common Stock. In addition, Titus beneficially owns
approximately 12.1% of the Company's outstanding Common Stock, and may be
issued additional shares in certain events (see Note 15 to the Company's
Consolidated Financial Statements). Titus also holds an option to purchase the
4,658,216 shares of Common Stock held by Universal, which would increase its
ownership percentage to approximately 34.5%. These stockholders, if acting
together, would be able to control substantially all matters requiring
approval by the stockholders of the Company, including the election of
directors (subject to the cumulative voting rights of the Company's
stockholders) and the approval of mergers or other business combination
transactions. Such concentration of ownership could discourage or prevent a
change in control of the Company.
 
 
                                      34
<PAGE>
 
Year 2000 Compliance
 
  Many existing computer systems and applications, and other control devices,
use only two digits to identify a year in the date field, without considering
the impact of the upcoming change in the century. Therefore, they do not
properly recognize a year that begins with "20" rather than "19". Others do
not correctly process "leap year" dates. As a result, such systems and
applications could fail or create erroneous results unless corrected so that
they can correctly process data related to the year 2000 and beyond. The
Company relies on its systems and applications in operating and monitoring all
major aspects of its business, including financial systems (such as general
ledger, accounts payable and payroll modules), customer services, networks and
telecommunications systems equipment and end products. The Company also
relies, directly and indirectly, on external systems of suppliers for the
management and control of product development and of business enterprises such
as developers, customers, suppliers, creditors, financial organizations, and
governmental entities, both domestic and international, for accurate exchange
of data. The Company could be affected through disruptions in the operation of
the enterprises with which the Company interacts or from general widespread
problems or an economic crisis resulting from non-compliant Year 2000 systems.
Despite the Company's efforts to address the Year 2000 impact on its internal
systems and business operations, there can be no assurance that such impact
will not result in a material disruption of its business or have a material
adverse effect on the Company's business, operating results and financial
condition.
 
  The Company is currently in the process of assessing the potential impact of
the Year 2000 issue on its business and the related foreseeable expenses that
may be incurred in attempting to remedy such impact. Although the Company has
identified certain systems and applications that are not Year 2000 compliant
and the Company is in the process of upgrading its software to address the
Year 2000 issue, there can be no assurance that such upgrades will be
completed on a timely basis at reasonable costs, or that such upgrades will be
able to anticipate all of the problems triggered by the actual impact of the
year 2000. In addition, the inability of any internal system to achieve Year
2000 compliance could result in material disruption to the Company's
operations. With respect to customers, developers, suppliers and other
enterprises upon which the Company relies, even where assurances are received
from such third parties, there remains a risk that failure of systems and
applications of such third parties could have a material adverse effect on the
Company.
 
Development of Internet/On-Line Services or Products
 
  The Company seeks to establish an on-line presence by creating and
supporting sites on the Internet. The Company's future plans envision
conducting and supporting on-line product offerings through these sites or
others. The ability of the Company to successfully establish an on-line
presence and to offer on-line products will depend on several factors that are
outside the Company's control, including the emergence of a robust on-line
industry and infrastructure and the development and implementation of
technological advancements to the Internet to increase bandwidth and the speed
of responsiveness to the point that will allow the Company to conduct and
support on-line product offerings. Because global commerce and the exchange of
information on the Internet and other similar open, wide area networks are
relatively new and evolving, there can be no assurance that a viable
commercial marketplace on the Internet will emerge from the developing
industry infrastructure, that the appropriate complementary products for
providing and carrying Internet traffic and commerce will be developed, that
the Company will be able to create or develop a sustainable or profitable
on-line presence or that the Company will be able to generate any significant
revenue from on-line product offerings in the near future, it at all. If the
Internet does not become a viable commercial marketplace, or if such
development occurs but is insufficient to meet the Company's needs or if such
development is delayed beyond the point where the Company plans to have
established an on-line service, the Company's business, operating results and
financial condition could be materially adversely affected.
 
Risks Associated with Acquisitions
 
  As part of its strategy to enhance distribution and product development
capabilities, the Company intends to review potential acquisitions of
complementary businesses, products and technologies. Some of these
acquisitions could be material in size and scope. While the Company will
continue to search for appropriate
 
                                      35
<PAGE>
 
acquisition opportunities, there can be no assurance that the Company will be
successful in identifying suitable acquisition opportunities. If any potential
acquisition opportunity is identified, there can be no assurance that the
Company will consummate such acquisition, and if such acquisition does occur,
there can be no assurance that it will be successful in enhancing the
Company's business or will be accretive to the Company's earnings. As the
interactive entertainment software industry continues to consolidate, the
Company may face increased competition for acquisition opportunities, which
may inhibit its ability to complete suitable transactions or increase the cost
thereof. Future acquisitions could also divert substantial management time,
could result in short term reductions in earnings or special transaction or
other charges and may be difficult to integrate with existing operations or
assets.
 
  The Company may, in the future, issue additional shares of Common Stock in
connection with one or more acquisitions, which may dilute its stockholders.
Additionally, with respect to future acquisitions, the Company's stockholders
may not have an opportunity to review the financial statements of the entity
being acquired or to vote on such acquisitions.
 
Anti-Takeover Effects; Delaware Law and Certain Charter and Bylaw Provisions
 
  The Company's Certificate of Incorporation and Bylaws, as well as Delaware
corporate law, contain certain provisions that could have the effect of
delaying, deferring or preventing a change in control of the Company and could
materially adversely affect the prevailing market price of the Common Stock.
Certain of such provisions impose various procedural and other requirements
that could make it more difficult for stockholders to effect certain corporate
actions.
 
Stock Price Volatility
 
  The trading price of the Company's Common Stock has been and could continue
to be subject to wide fluctuations in response to quarter to quarter
variations in results of operations, announcements of new products by the
Company or its competitors, product development or release schedule, general
conditions in the computer, software, entertainment, media or electronics
industries, changes in earnings estimates or buy/sell recommendations by
analysts, investor perceptions and expectations regarding the products, plans
and strategic position of the Company, its competitors and its customers, or
other events or factors. In addition, the public stock markets have
experienced extreme price and trading volume volatility, particularly in high
technology sectors of the market. This volatility has significantly affected
the market prices of securities of many technology 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.
 
ITEM 7A. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK
 
  The Company does not have any derivative financial instruments as of
December 31, 1998. Further, the Company is not exposed to interest rate risk
as the Company's revolving line of credit agreement has a variable interest
rate. Therefore, the fair value of these instruments are not affected by
changes in market interest rates. The Company believes that the market risk
arising from holdings of its financial instruments is not material.
 
ITEM 8. CONSOLIDATED FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA
 
  The Company's Consolidated Financial Statements begin on page F-1 of this
report.
 
ITEM 9. CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND
        FINANCIAL DISCLOSURE
 
  None.
 
                                      36
<PAGE>
 
                                   PART III
 
  Certain information required by Part III is omitted from this report, as the
Company will file a definitive proxy statement (the "Proxy Statement") within
120 days after the end of its fiscal year pursuant to Regulation 14A of the
Securities Exchange Act of 1934 for its Annual Meeting of Shareholders to be
held in June 1999 and the information included therein is incorporated herein
by reference.
 
ITEM 10. DIRECTORS AND EXECUTIVE OFFICERS OF THE REGISTRANT
 
  Information regarding directors appears under the caption "Election of
Directors" in the Proxy Statement and is incorporated herein by reference.
Information regarding executive officers appears under the caption "Executive
Officers Who Are Not Directors" in the Proxy Statement and is incorporated
herein by reference.
 
ITEM 11. EXECUTIVE COMPENSATION
 
  Information regarding executive compensation appears under the caption
"Compensation of Executive Officers" in the Proxy Statement and is
incorporated herein by reference.
 
ITEM 12. SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT
 
  Information regarding security ownership of certain beneficial owners and
management appears under the caption "Security Ownership of Management
Directors and Nominees" in the Proxy Statement and is incorporated herein by
reference.
 
ITEM 13. CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS
 
  Information regarding certain relationships and related transactions appears
under the caption "Certain Transactions Between Management and the Company or
its Subsidiaries" in the Proxy Statement and is incorporated herein by
reference.
 
                                    PART IV
 
ITEM 14. EXHIBITS, FINANCIAL STATEMENT SCHEDULES AND REPORTS ON FORM 8-K
 
  (a) The following documents are filed as part of this report:
 
  (1) Financial Statements
 
  The list of financial statements contained in the accompanying Index to
Consolidated Financial Statements covered by the Report of Independent
Auditors is herein incorporated by reference.
 
  (2) Financial Statement Schedules
 
  The list of financial statement schedules contained in the accompanying
Index to Consolidated Financial Statements covered by the Report of
Independent Auditors is herein incorporated by reference.
 
  All other schedules are omitted because they are not applicable or the
required information is included in the Consolidated Financial Statements or
the Notes thereto.
 
  (3) Exhibits
 
  The list of exhibits on the accompanying Exhibit Index is herein
incorporated by reference.
 
  (b) Reports on Form 8-K.
 
  The Company filed a Report on Form 8-K on January 2, 1999, which reported
that the Company announced its acceptance of the resignation of David Dukes as
a Director of the Company. The Report also stated that Mr. Dukes' resignation
was not due to any disagreement with the Company on any matter relating to the
Company's operations, policies or practices.
 
                                      37
<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, thereto duly authorized, at Irvine,
California this 30th day of March, 1999.
 
                                          INTERPLAY ENTERTAINMENT CORP.
 
                                                    /s/ Brian Fargo
                                          By: _________________________________
                                                        Brian Fargo
                                              Chairman of the Board and Chief
                                                Executive Officer (Principal
                                                     Executive Officer)
 
                               POWER OF ATTORNEY
 
  The undersigned directors and officers of Interplay Entertainment Corp. do
hereby constitute and appoint Brian Fargo and James C. Wilson, or either of
them, with full power of substitution and resubstitution, as their true and
lawful attorneys and agents, to do any and all acts and things in our name and
behalf in our capacities as directors and officers and to execute any and all
instruments for us and in our names in the capacities indicated below, which
said attorney and agent, may deem necessary or advisable to enable said
corporation to comply with the Securities Exchange Act of 1934, as amended and
any rules, regulations and requirements of the Securities and Exchange
Commission, in connection with this Annual Report on Form 10-K, including
specifically but without limitation, power and authority to sign for us or any
of us in our names in the capacities indicated below, any and all amendments
(including post-effective amendments) hereto, and we do hereby ratify and
confirm all that said attorneys and agents, or either of them, shall do or
cause to be done by virtue hereof.
 
  Pursuant to the requirements of the Securities Exchange Act of 1934, as
amended, this Annual Report and Form 10-K has been signed below by the
following persons on behalf of the Registrant and in the capacities and on the
dates indicated.
 
<TABLE>
<CAPTION>
             Signature                            Title                   Date
             ---------                            -----                   ----
 
<S>                                  <C>                             <C>
        /s/ Brian Fargo              Chairman of the Board of        March 30, 1999
____________________________________  Directors and Chief Executive
            Brian Fargo               Officer (Principal Executive
                                      Officer)
 
                                     President and Director          March 30, 1999
____________________________________
     Christopher J. Kilpatrick
 
      /s/ James C. Wilson            Chief Financial Officer         March 30, 1999
____________________________________  (Principal Financial and
          James C. Wilson             Accounting Officer)
 
   /s/ Richard S.F. Lehrberg         Executive Vice President and    March 30, 1999
____________________________________  Director
       Richard S.F. Lehrberg
 
       /s/ Mark Pinkerton            Director                        March 30, 1999
____________________________________
           Mark Pinkerton
 
      /s/ Charles S. Paul            Director                        March 30, 1999
____________________________________
          Charles S. Paul
 
       /s/ Kenneth J. Kay            Director                        March 30, 1999
____________________________________
           Kenneth J. Kay
</TABLE>
 
                                      38
<PAGE>
 
                                 EXHIBIT INDEX
 
<TABLE>
<CAPTION>
 Exhibit
   No.                                 Description
 -------                               -----------
 <C>     <S>
  2.1    Agreement and Plan of Reorganization and Merger, dated May 29, 1998,
          between the Company and Interplay Productions. (incorporated herein
          by reference to Exhibit 2.1 to the Company's Registration Statement
          on Form S-1, No. 333-48473 (the "Form S-1"))
  3.1    Amended and Restated Certificate of Incorporation of the Company.
          (incorporated herein by reference to Exhibit 3.1 to the Form S-1)
  3.2    Amended and Restated Bylaws of the Company. (incorporated herein by
          reference to Exhibit 3.2 to the Form S-1)
  4.1    Specimen form of stock certificate for Common Stock. (incorporated
          herein by reference to Exhibit 4.1 to the Form S-1)
  4.2    Shareholders' Agreement among MCA Inc., the Company, and Brian Fargo,
          dated March 30, 1994, as amended. (incorporated herein by reference
          to Exhibit 4.2 to the Form S-1)
  4.3    Investors' Rights Agreement dated October 10, 1996, as amended, among
          the Company and holders of its Subordinated Secured Promissory Notes
          and Warrants to purchase Common Stock. (incorporated herein by
          reference to Exhibit 4.3 to the Form S-1)
 10.1    Amended and Restated 1997 Stock Incentive Plan (the "1997 Plan").
          (incorporated herein by reference to Exhibit 10.1 to the Form S-1)
 10.2    Form of Stock Option Agreement pertaining to the 1997 Plan.
          (incorporated herein by reference to Exhibit 10.2 to the Form S-1)
 10.3    Form of Restricted Stock Purchase Agreement pertaining to the 1997
          Plan. (incorporated herein by reference to Exhibit 10.3 to the Form
          S-1)
 10.4    Incentive Stock Option and Nonqualified Stock Option Plan--1994, as
          amended (the "1994 Plan"). (incorporated herein by reference to
          Exhibit 10.4 to the Form S-1)
 10.5    Form of Nonqualified Stock Option Agreement pertaining to the 1994
          Plan. (incorporated herein by reference to Exhibit 10.5 to the Form
          S-1)
 10.6    Incentive Stock Option, Nonqualified Stock Option and Restricted Stock
          Purchase Plan--1991, as amended (the "1991 Plan"). (incorporated
          herein by reference to Exhibit 10.6 to the Form S-1)
 10.7    Form of Incentive Stock Option Agreement pertaining to the 1991 Plan.
          (incorporated herein by reference to Exhibit 10.7 to the Form S-1)
 10.8    Form of Nonqualified Stock Option Agreement pertaining to the 1991
          Plan. (incorporated herein by reference to Exhibit 10.8 to the Form
          S-1)
 10.9    Employee Stock Purchase Plan. (incorporated herein by reference to
          Exhibit 10.10 to the Form S-1)
 10.10   Form of Indemnification Agreement for Officers and Directors of the
          Company. (incorporated herein by reference to Exhibit 10.11 to the
          Form S-1)
 10.11   Von Karman Corporate Center Office Building Lease between the Company
          and Aetna Life Insurance Company of Illinois, dated September 8,
          1995, together with amendments thereto. (incorporated herein by
          reference to Exhibit 10.14 to the Form S-1)
 10.12   Loan and Security Agreement among Greyrock Business Credit, a Division
          of NationsCredit Commercial Corporation ("Greyrock"), the Company,
          and Interplay OEM, Inc. ("Interplay OEM"), dated June 16, 1997, as
          amended, with Schedules. (incorporated herein by reference to Exhibit
          10.15 to the Form S-1)
 10.13   Letter of Credit Agreement among Greyrock, the Company and Interplay
          OEM, dated September 10, 1997. (incorporated herein by reference to
          Exhibit 10.18 to the Form S-1)
 10.14   Letter of Credit Agreement among Greyrock, the Company and Interplay
          OEM, dated September 24, 1997. (incorporated herein by reference to
          Exhibit 10.19 to the Form S-1)
</TABLE>
 
                                       39
<PAGE>
 
<TABLE>
<CAPTION>
 Exhibit
   No.                                 Description
 -------                               -----------
 <C>     <S>
 10.15   Master Equipment Lease between Brentwood Credit Corporation and the
          Company, dated March 28, 1996, with Schedules. (incorporated herein
          by reference to Exhibit 10.20 to the Form S-1)
 10.16   Master Equipment Lease Agreement between General Electric Capital
          Computer Leasing Corporation and the Company, dated December 14,
          1994, as amended, with Schedules. (incorporated herein by reference
          to Exhibit 10.22 to the Form S-1)
 10.17   Confidential License Agreement for Nintendo 64 Video Game System,
          between the Company and Nintendo of America, Inc., dated October 7,
          1997. (Portions omitted pursuant to a request for confidential
          treatment.) (incorporated herein by reference to Exhibit 10.23 to the
          Form S-1)
 10.18   PlayStation License Agreement, between Sony Computer Entertainment of
          America and the Company, dated February 16, 1995. (Portions omitted
          pursuant to a request for confidential treatment.) (incorporated
          herein by reference to Exhibit 10.24 to the Form S-1)
 10.19   Master Merchandising License Agreement between Paramount Pictures
          Corporation and the Company, dated as of June 16, 1992. (Portions
          omitted pursuant to a request for confidential treatment.)
          (incorporated herein by reference to Exhibit 10.25 to the Form S-1)
 10.20   Employment Agreement between the Company and Brian Fargo, dated March
          28, 1994, as amended. (incorporated herein by reference to Exhibit
          10.26 to the Form S-1)
 10.21   Employment Agreement between the Company and Christopher J.
          Kilpatrick, dated May 1, 1994, as amended. (incorporated herein by
          reference to Exhibit 10.27 to the Form S-1)
 10.22   Employment Agreement between the Company and Richard S.F. Lehrberg,
          dated March 28, 1994, as amended. (incorporated herein by reference
          to Exhibit 10.28 to the Form S-1)
 10.23   Heads of Agreement concerning Sales and Distribution between the
          Company and Activision, Inc., dated November 19, 1998, as amended.
          (Portions omitted pursuant to a request for confidential treatment.)
 
 10.24   Stock Purchase Agreement between the Company and Titus Interactive SA,
          dated March 18, 1999.
 10.25   Second Amendment to Employment Agreement between the Company and Brian
          Fargo, dated March 18, 1999.
 10.26   International Distribution Agreement between the Company and Virgin
          Interactive Entertainment Limited, dated February 10, 1999. (Portions
          omitted pursuant to a request for confidential treatment.)
 10.27   Termination Agreement among the Company, Virgin Interactive
          Entertainment Limited, VIE Acquisition Group, LLC and VIE Acquisition
          Holdings, LLC, dated February 10, 1999. (Portions omitted pursuant to
          a request for confidential treatment.)
 10.28   Amendment to Loan Documents among the Company, Interplay OEM, Inc. and
          Greyrock, dated March 18, 1999.
 10.29   Fifth Amendment to Lease for Von Karman Corporate Center Office
          Building between the Company and Arden Realty Finance IV, L.L.C.,
          dated December 4, 1998.
 21.1    Subsidiaries of the Company. (incorporated herein by reference to
          Exhibit 21.1. to the Form S-1)
 23.1    Consent of Arthur Andersen LLP.
 24.1    Power of Attorney (included as page 37 to this Form 10-K).
 27.1    Financial Data Schedule.
</TABLE>
 
                                       40
<PAGE>
 
                   INDEX TO CONSOLIDATED FINANCIAL STATEMENTS
 
                 INTERPLAY ENTERTAINMENT CORP. AND SUBSIDIARIES
 
                       CONSOLIDATED FINANCIAL STATEMENTS
                  AND REPORT OF INDEPENDENT PUBLIC ACCOUNTANTS
 
<TABLE>
<CAPTION>
                                                                           Page
                                                                           ----
<S>                                                                        <C>
REPORT OF INDEPENDENT PUBLIC ACCOUNTANTS.................................. F-2
CONSOLIDATED FINANCIAL STATEMENTS:
  Consolidated Balance Sheets at December 31, 1998 and 1997............... F-3
  Consolidated Statements of Operations for the year ended December 31,
   1998, the eight months ended December 31, 1997 and the fiscal years
   ended April 30, 1997 and 1996.......................................... F-4
  Consolidated Statements of Changes in Stockholders' Equity (Deficit) or
   the year ended December 31, 1998, the eight months ended December 31,
   1997 and the fiscal years ended April 30, 1997 and 1996................ F-5
  Consolidated Statements of Cash Flows for the year ended December 31,
   1998, the eight months ended December 31, 1997 and the fiscal years
   ended April 30, 1997 and 1996.......................................... F-6
  Notes to Consolidated Financial Statements.............................. F-7
</TABLE>
 
                                      F-1
<PAGE>
 
                   REPORT OF INDEPENDENT PUBLIC ACCOUNTANTS
 
To Interplay Entertainment Corp.:
 
  We have audited the accompanying consolidated balance sheets of INTERPLAY
ENTERTAINMENT CORP. (a Delaware corporation) and subsidiaries as of December
31, 1998 and 1997, and the related consolidated statements of operations,
stockholders' equity (deficit) and cash flows for the year ended December 31,
1998, the eight months ended December 31, 1997, and the fiscal years ended
April 30, 1997 and 1996. These financial statements are the responsibility of
the Company's management. Our responsibility is to express an opinion on these
financial statements 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 financial statements referred to above present fairly,
in all material respects, the financial position of Interplay Entertainment
Corp. and subsidiaries as of December 31, 1998 and 1997, and the related
consolidated statements of operations, stockholders' equity (deficit) and cash
flows for the year ended December 31, 1998, the eight months ended December
31, 1997 and the fiscal years ended April 30, 1997 and 1996, in conformity
with generally accepted accounting principles.
 
                                          /s/ Arthur Andersen LLP
 
Orange County, California
March 29, 1999
 
                                      F-2
<PAGE>
 
                 INTERPLAY ENTERTAINMENT CORP. AND SUBSIDIARIES
 
                          CONSOLIDATED BALANCE SHEETS
 
<TABLE>
<CAPTION>
                                                              December 31,
                                                            ------------------
                                                              1998      1997
                                                            --------  --------
                                                               (Dollars in
                                                               thousands)
<S>                                                         <C>       <C>
                          ASSETS
                          ------
 
Current Assets:
  Cash and cash equivalents................................ $    614  $  1,536
  Trade receivables, net of allowances of $18,431 and
   $14,461, respectively...................................   33,991    34,684
  Inventories..............................................    6,303     6,338
  Prepaid licenses and royalties...........................   18,128    12,628
  Income taxes receivable..................................      --      1,427
  Deferred income taxes....................................    5,477     7,792
  Other....................................................    3,101     4,218
                                                            --------  --------
    Total current assets...................................   67,614    68,623
Property and Equipment, net................................    5,679     7,026
Other Assets...............................................    1,792     2,172
                                                            --------  --------
                                                            $ 75,085  $ 77,821
                                                            ========  ========
 
      LIABILITIES AND STOCKHOLDERS' EQUITY (DEFICIT)
      ----------------------------------------------
 
Current Liabilities:
  Accounts payable......................................... $ 23,403  $ 17,121
  Accrued liabilities......................................   22,300    22,549
  Current portion of long-term debt........................   24,521    14,767
  Income taxes payable.....................................      254       570
                                                            --------  --------
    Total current liabilities..............................   70,478    55,007
Long-Term Debt, net of current portion.....................      130    23,387
Deferred Income Taxes......................................      141       434
Minority Interest..........................................      143       260
 
Commitments and Contingencies
 
Stockholders' Equity (Deficit):
  Preferred stock, no par value, authorized 5,000,000
   shares; issued and outstanding, none
  Common stock, $.001 par value, authorized 50,000,000
   shares; issued and outstanding 18,292,431 shares in 1998
   and 10,951,828 shares in 1997...........................       18        11
  Paid-in capital..........................................   51,918    18,408
  Retained earnings (accumulated deficit)..................  (48,097)  (19,877)
  Foreign currency translation adjustments.................      354       191
                                                            --------  --------
    Total stockholders' equity (deficit)...................    4,193    (1,267)
                                                            --------  --------
                                                            $ 75,085  $ 77,821
                                                            ========  ========
</TABLE>
 
  The accompanying notes are an integral part of these consolidated financial
                                  statements.
 
                                      F-3
<PAGE>
 
                 INTERPLAY ENTERTAINMENT CORP. AND SUBSIDIARIES
 
                     CONSOLIDATED STATEMENTS OF OPERATIONS
 
<TABLE>
<CAPTION>
                                          Eight Months
                              Year Ended     Ended     Years Ended April 30,
                             December 31, December 31, ----------------------
                                 1998         1997        1997        1996
                             ------------ ------------ ----------  ----------
                                 (Dollars in thousands, except per share
                                                amounts)
 
<S>                          <C>          <C>          <C>         <C>
Net revenues................  $  126,862   $   85,961  $   83,262  $   96,952
Cost of goods sold..........      71,928       44,864      62,480      49,939
                              ----------   ----------  ----------  ----------
Gross profit................      54,934       41,097      20,782      47,013
 
Operating expenses:
  Marketing and sales.......      39,471       20,603      24,627      23,285
  General and
   administrative...........      12,841        8,989       9,408       9,025
  Product development.......      24,472       14,291      21,431      15,120
                              ----------   ----------  ----------  ----------
    Total operating
     expenses...............      76,784       43,883      55,466      47,430
                              ----------   ----------  ----------  ----------
    Operating loss..........     (21,850)      (2,786)    (34,684)       (417)
 
Other income (expense):
  Interest income...........           6           92         190         102
  Interest expense..........      (4,620)      (3,009)     (1,907)       (531)
  Other.....................        (319)         644         117        (378)
                              ----------   ----------  ----------  ----------
    Total other income
     (expense)..............      (4,933)      (2,273)     (1,600)       (807)
 
Loss before provision
 (benefit) for income
 taxes......................     (26,783)      (5,059)    (36,284)     (1,224)
Provision (benefit) for
 income taxes...............       1,437          --       (9,065)       (480)
                              ----------   ----------  ----------  ----------
Net loss....................  $  (28,220)  $   (5,059) $  (27,219) $     (744)
                              ==========   ==========  ==========  ==========
 
Net loss per share:
  Basic/Diluted.............  $    (1.91)  $    (0.45) $    (2.46) $    (0.07)
 
Weighted average number of
 common shares outstanding:
  Basic/Diluted.............  14,762,644   11,123,327  11,085,632  10,661,944
</TABLE>
 
 
 
  The accompanying notes are an integral part of these consolidated financial
                                  statements.
 
                                      F-4
<PAGE>
 
                 INTERPLAY ENTERTAINMENT CORP. AND SUBSIDIARIES
 
           CONSOLIDATED STATEMENTS OF STOCKHOLDERS' EQUITY (DEFICIT)
 
<TABLE>
<CAPTION>
                                                                 Accumulated
                           Common Stock              Retained       Other
                         ------------------ Paid-in  Earnings   Comprehensive Comprehensive
                           Shares    Amount Capital  (Deficit)     Income         Loss
                         ----------  ------ -------  ---------  ------------- -------------
                                             (Dollars in thousands)
 
<S>                      <C>         <C>    <C>      <C>        <C>           <C>
Balance, April 30,
 1995................... 10,741,899   $ 11  $16,913  $ 13,145       $ --
 Exercise of stock
  options...............    177,104    --       140       --          --
 Repurchase of common
  stock.................    (89,222)   --       --        --          --
 Tax benefit from
  exercise of stock
  options...............        --     --       424       --          --
 Compensation for stock
  options granted.......        --     --       306       --          --
 Net loss...............        --     --       --       (744)        --        $   (744)
 Other comprehensive
  income, net of income
  taxes:
 Foreign currency
  translation
  adjustment............        --     --       --        --          --             --
                                                                                --------
  Other comprehensive
   income...............        --     --       --        --          --             --
                         ----------   ----  -------  --------       -----       --------
   Comprehensive loss...        --     --       --        --          --        $   (744)
                         ----------   ----  -------  --------       -----       ========
Balance, April 30,
 1996................... 10,829,781     11   17,783    12,401         --
 Exercise of stock
  options...............    313,403    --        58       --          --
 Repurchase of common
  stock.................    (29,124)   --      (275)      --          --
 Proceeds from
  warrants..............        --     --       148       --          --
 Compensation for stock
  options granted.......        --     --       306       --          --
 Net loss...............        --     --       --    (27,219)        --        $(27,219)
 Other comprehensive
  income, net of income
  taxes:
 Foreign currency
  translation
  adjustment............        --     --       --        --          --             188
                                                                                --------
  Other comprehensive
   income...............        --     --       --        --          188            188
                                                                                --------
   Comprehensive loss...        --     --       --        --          --        $(27,031)
                         ----------   ----  -------  --------       -----       ========
Balance, April 30,
 1997................... 11,114,060     11   18,020   (14,818)        188
 Issuance of common
  stock.................     16,362    --       184       --          --
 Repurchase of common
  stock.................   (178,594)   --       --        --          --
 Compensation for stock
  options granted.......        --     --       204       --          --
 Net loss...............        --     --       --     (5,059)        --        $ (5,059)
 Other comprehensive
  income, net of income
  taxes:
 Foreign currency
  translation
  adjustment............        --     --       --        --          --               3
                                                                                --------
  Other comprehensive
   income...............        --     --       --        --            3              3
                                                                                --------
   Comprehensive loss...        --     --       --        --          --        $ (5,056)
                         ----------   ----  -------  --------       -----       ========
Balance, December 31,
 1997................... 10,951,828     11   18,408   (19,877)        191
 Issuance of common
  stock, net of issuance
  costs.................  5,056,102      5   24,390       --          --
 Issuance of warrants...        --     --       316       --          --
 Exercise of warrants...  2,272,417      2    8,599       --          --
 Exercise of stock
  options...............     12,084    --        15       --          --
 Compensation for stock
  options granted.......        --     --       190       --          --
 Net loss...............        --     --       --    (28,220)        --        $(28,220)
 Other comprehensive
  income, net of income
  taxes:
 Foreign currency
  translation
  adjustment............        --     --       --        --          --             163
                                                                                --------
  Other comprehensive
   income...............        --     --       --        --          163            163
                                                                                --------
   Comprehensive loss...        --     --       --        --          --        $(28,057)
                         ----------   ----  -------  --------       -----       ========
Balance, December 31,
 1998................... 18,292,431   $ 18  $51,918  $(48,097)      $ 354
                         ==========   ====  =======  ========       =====
</TABLE>
 
 
  The accompanying notes are an integral part of these consolidated financial
                                  statements.
 
                                      F-5
<PAGE>
 
                 INTERPLAY ENTERTAINMENT CORP. AND SUBSIDIARIES
 
                     CONSOLIDATED STATEMENTS OF CASH FLOWS
 
<TABLE>
<CAPTION>
                                                 Eight Months   Years Ended
                                     Year Ended     Ended        April 30,
                                    December 31, December 31, -----------------
                                        1998         1997       1997     1996
                                    ------------ ------------ --------  -------
                                              (Dollars in thousands)
<S>                                 <C>          <C>          <C>       <C>
Cash flows from operating
 activities:
 Net loss.........................    $(28,220)    $ (5,059)  $(27,219) $  (744)
 Adjustments to reconcile net loss
  to the cash provided by (used
  in) operating activities--
  Depreciation and amortization...       3,415        2,138      3,172    1,985
  Gain on sale of property and
   equipment......................         --           --         --       (21)
  Noncash expense for stock
   options........................         190          204        306      306
  Noncash interest expense........          68          184        --       --
  Write-off of non-current
   assets.........................         --           --         250      388
  Deferred income taxes...........       2,022          128     (6,649)    (335)
  Minority interest in earnings
   (loss) of subsidiary...........        (117)         (66)        28       25
  Changes in assets and
   liabilities:
  Trade receivables...............         693      (12,338)     3,926   (3,229)
  Inventories.....................          35        1,066     (1,508)  (2,193)
  Income taxes receivable.........       1,427          174       (176)  (1,403)
  Other current assets............       1,657       (1,864)     5,732   (2,232)
  Other assets....................          (3)         543      5,610     (467)
  Prepaid licenses and royalties..      (5,501)      (1,714)    (4,102)  (5,966)
  Accounts payable................       6,282          146     (1,999)   7,589
  Accrued liabilities.............        (166)       1,449      5,618    9,223
  Income taxes payable............        (607)        (310)       --      (467)
                                      --------     --------   --------  -------
   Net cash provided by (used in)
    operating activities..........     (18,825)     (15,319)   (17,011)   2,459
Cash flows from investing
 activities:
 Purchase of property and
  equipment.......................      (1,684)        (792)    (3,451)  (4,585)
 Proceeds from sales of property
  and equipment...................         --           --         --        14
 Acquisitions of subsidiary, net
  of cash acquired of $119........         --           --         --    (3,196)
 Proceeds from sale of investment
  in affiliate....................         --           --         --       200
 Proceeds from sale of marketable
  securities......................         --           --         --        69
                                      --------     --------   --------  -------
   Net cash used in investing
    activities....................      (1,684)        (792)    (3,451)  (7,498)
Cash flows from financing
 activities:
 Net borrowings on line of
  credit..........................       1,229       12,296      5,900    5,050
 Issuances (payments) of
  subordinated secured promissory
  notes and warrants..............      (6,054)         --      14,803      --
 Repayments on notes payable......         (76)         (62)       (75)    (117)
 Net proceeds from issuance of
  common stock....................      24,310          --         --       --
 Proceeds from exercise of stock
  options.........................          15          --          58      140
 Tax benefit from stock option
  exercise........................         --           --         --       424
 Other financing activities.......         --           --         --       (11)
                                      --------     --------   --------  -------
   Net cash provided by financing
    activities....................      19,424       12,234     20,686    5,486
                                      --------     --------   --------  -------
Effect of exchange rate changes on
 cash and cash equivalents........         163            3        263      (58)
                                      --------     --------   --------  -------
Net increase (decrease) in cash
 and cash equivalents.............        (922)      (3,874)       487      389
Cash and cash equivalents,
 beginning of year................       1,536        5,410      4,923    4,534
                                      --------     --------   --------  -------
Cash and cash equivalents, end of
 year.............................    $    614     $  1,536   $  5,410  $ 4,923
                                      ========     ========   ========  =======
Supplemental cash flow
 information:
 Cash paid during the year for:
  Interest........................    $  4,671     $  2,936   $  1,638  $   480
  Income taxes....................         --           --         --       526
</TABLE>
 
  The accompanying notes are an integral part of these consolidated financial
                                  statements.
 
                                      F-6
<PAGE>
 
                INTERPLAY ENTERTAINMENT CORP. AND SUBSIDIARIES
 
                  NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
               (Dollars in thousands, except per share amounts)
 
1. Line of Business; Risk Factors
 
  Interplay Entertainment Corp., a Delaware corporation, and its subsidiaries
(collectively with Interplay Productions, a California corporation, the
"Company"), develop, publish, and distribute interactive entertainment
software. In addition, the Company distributes certain titles to hardware or
peripheral device manufacturers for use in bundling arrangements. The
Company's software is developed for use on various interactive entertainment
software platforms, including personal computers and current generation video
game consoles, such as the PlayStation and Nintendo 64.
 
  For the year ended December 31, 1998 the Company incurred a net loss of
$28.2 million and used cash in operating activities of $18.8 million.
Partially because of these losses, the Company's liquidity significantly
deteriorated during the second half of 1998. At December 31, 1998, the Company
had negative working capital of $2.9 million, although the Company did have
borrowing availability under its line of credit (See Note 5).
 
  To provide working capital to support the Company's future operations, the
Company took several actions during 1998, including entering into certain
product licensing and distribution agreements which in the aggregate provided
approximately $10.8 million in advance cash payments. In addition, in March
1999, the Company extended the expiration of its line of credit to January 1,
2000, in connection with which the Company's Chief Executive Officer
personally guaranteed $5 million of the Company's obligations under such line
of credit. Further, the Company entered into a Stock Purchase Agreement with
an investor which provides for the issuance of 2.5 million shares of the
Company's Common Stock for $10 million. Under the terms of the Stock Purchase
Agreement up to 2.5 million additional shares of the Company's common stock
may be issued without additional consideration based on the average closing
price per share of the Company's Common Stock as of certain specified future
dates; provided, however, the investor will not be issued a total number of
shares equaling or exceeding 20% of the Company's current outstanding Common
Stock without the approval of the Company's stockholders. Additional steps
taken by Management include reductions in personnel, reductions in management
compensation, cutbacks in overhead costs and modifications in product
development plans to preserve cash resources.
 
  The Company believes that funds available under its line of credit, funds
received from the sale of equity securities, amounts to be received under
various product license and distribution agreements and anticipated funds from
operations, will be sufficient to satisfy the Company's projected working
capital and capital expenditure needs and debt obligations in the normal
course of business at least through the expiration of its line of credit on
January 1, 2000 (see Note 15). Based upon the Company's estimates, including
the Company's ability to achieve anticipated operating results, the Company
believes that it will be able to renew its line of credit or obtain alternate
financing on reasonable terms.
 
                                      F-7
<PAGE>
 
                INTERPLAY ENTERTAINMENT CORP. AND SUBSIDIARIES
 
            NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(Continued)
               (Dollars in thousands, except per share amounts)
 
  In addition to the risks related to the Company's liquidity discussed above,
the Company also faces numerous other risks associated with its industry.
These risks include dependence on new product introductions, product delays,
rapidly changing technology, intense competition, dependence on distribution
channels and risk of customer returns. Certain additional risks are discussed
on pages 25-36 of the Company's Annual Report on Form 10-K for the year ended
December 31, 1998.
 
  The Company's consolidated financial statements have been presented on the
basis that it is a going concern, which contemplates the realization of assets
and the satisfaction of liabilities in the normal course of business.
Accordingly, the consolidated financial statements do not include any
adjustments relating to the recoverability and classification of recorded
asset amounts or the amounts and classification of liabilities or any other
adjustments that might result should the Company be unable to continue as a
going concern.
 
2. Summary of Significant Accounting Policies
 
 Consolidation
 
  The accompanying consolidated financial statements include the accounts of
Interplay Entertainment Corp. and its wholly-owned subsidiaries, Interplay
Productions Limited (U.K.), Interplay OEM, Inc., Interplay Productions Pty Ltd
(Australia), Interplay Co., Ltd., (Japan) and its 91 percent-owned subsidiary
Shiny Entertainment, Inc. All significant intercompany accounts and
transactions have been eliminated.
 
 Change of Fiscal Year End
 
  Effective May 1, 1997, the Company changed its fiscal year end from April 30
to December 31.
 
 Reincorporation
 
  On March 2, 1998, the Board of Directors of Interplay Productions approved a
reincorporation plan. Under the reincorporation plan Interplay Productions
formed a new entity in Delaware into which Interplay Productions was merged on
May 29, 1998.
 
 Use of Estimates
 
  The preparation of financial statements in conformity with generally
accepted accounting principles requires management to make estimates and
assumptions that affect the reported amounts of assets and liabilities and
disclosure of contingent assets and liabilities at the date of the financial
statements and the reported amounts of revenues and expenses during the
reporting period. Actual results could differ from those estimates.
 
 Cash and Cash Equivalents and Noncash Activities
 
  The Company considers all highly liquid investments with original maturities
of three months or less to be cash equivalents.
 
  During the fiscal year ended April 30, 1997, in a noncash financing
transaction, the Company acquired 29,124 shares of common stock in exchange
for a $275 note payable.
 
 Inventories
 
  Inventories consist of CD-ROMs, video game console cartridges (cartridges),
manuals, packaging materials, supplies and packaged software ready for
shipment and are valued at the lower of cost (first-in, first-out) or market.
 
                                      F-8
<PAGE>
 
                INTERPLAY ENTERTAINMENT CORP. AND SUBSIDIARIES
 
            NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(Continued)
               (Dollars in thousands, except per share amounts)
 
 
 Prepaid Licenses and Royalties
 
  Prepaid licenses and royalties consist of payments for intellectual property
rights, payments to celebrities and sports leagues and advanced royalty
payments to outside developers. In addition such costs include certain other
outside production costs generally consisting of film cost and amounts paid
for digitized motion data with alternative future uses. Payments to developers
represent contractual advanced payments made for future royalties. These
payments are contingent upon the successful completion of milestones, which
generally represent specific deliverables. Royalty advances are recoupable
against future sales based upon the contractual royalty rate. The Company
amortizes the cost of licenses, prepaid royalties and other outside production
costs to cost of sales over six months commencing with the initial shipment of
the title at a rate based upon the number of units shipped. Management
evaluates the future realization of such costs quarterly and charges to cost
of goods sold any amounts that management deems unlikely to be fully realized
through future sales. Such costs are classified as current and noncurrent
assets based upon estimated net product sales.
 
 Property and Equipment
 
  Property and equipment are stated at cost. Depreciation of computers,
equipment and furniture and fixtures is provided using the straight-line
method over a five year period. Leasehold improvements are amortized on a
straight line basis over the lesser of the estimated useful life or the
remaining lease term.
 
 Other Non-current Assets
 
  Other non-current assets consist primarily of goodwill which the Company is
amortizing on a straight-line basis over seven years (see Note 3). Accumulated
amortization as of December 31, 1998 and 1997 was $1,300 and $1,000,
respectively.
 
 Long-lived Assets
 
  As prescribed by Statement of Financial Accounting Standards (SFAS) No. 121,
"Accounting for the Impairment of Long-lived Assets and for Long-lived Assets
to be Disposed of," the Company assesses the recoverability of its long-lived
assets (including goodwill) by determining whether the asset balance can be
recovered over the remaining depreciation or amortization period through
projected undiscounted future cash flows. Cash flow projections, although
subject to a degree of uncertainty, are based on trends of historical
performance and management's estimate of future performance, giving
consideration to existing and anticipated competitive and economic conditions.
 
 Fair Value of Financial Instruments
 
  The carrying value of cash and cash equivalents, accounts receivable,
accounts payable and notes payable approximates the fair value. In addition,
the carrying value of all borrowings approximate fair value based on interest
rates currently available to the Company.
 
 Revenue Recognition
 
  Revenues are recorded when products are delivered to customers in accordance
with Statement of Position (SOP) 97-2, Software Revenue Recognition. For those
agreements that provide the customers the right to multiple copies in exchange
for guaranteed amounts, revenue is recognized at the delivery of the product
master or the first copy. Per copy royalties on sales that exceed the
guarantee are recognized as earned. The Company is generally not contractually
obligated to accept returns, except for defective product. However, the
Company
 
                                      F-9
<PAGE>
 
                INTERPLAY ENTERTAINMENT CORP. AND SUBSIDIARIES
 
            NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(Continued)
               (Dollars in thousands, except per share amounts)
 
permits customers to return or exchange product and may provide price
protection on products unsold by a customer. In accordance with SFAS No. 48,
revenue is recorded net of an allowance for estimated returns, exchanges,
markdowns, price concessions, and warranty costs. Such reserves are based upon
management's evaluation of historical experience, current industry trends and
estimated costs. The amount of reserves ultimately required could differ
materially in the near term from the amounts included in the accompanying
consolidated financial statements. Postcontract customer support provided by
the Company is limited to telephone support. These costs are not material and
are charged to expenses as incurred.
 
 Product Development
 
  Product development expenses are charged to operations in the period
incurred and consist primarily of payroll and payroll related costs.
 
 Advertising Costs
 
  The Company generally expenses advertising costs as incurred, except for
production costs associated with media campaigns which are deferred and
charged to expense at the first run of the ad. Cooperative advertising with
distributors and retailers is accrued when revenue is recognized. Cooperative
advertising credits are reimbursed when qualifying claims are submitted.
 
 Income Taxes
 
  The Company accounts for income taxes using the liability method as
prescribed by the SFAS No. 109, "Accounting for Income Taxes." The statement
requires an asset and liability approach for financial accounting and
reporting of income taxes. Deferred income taxes are provided for temporary
differences in the recognition of certain income and expense items for
financial reporting and tax purposes given the provisions of the enacted tax
laws.
 
 Foreign Currency Translation
 
  The Company follows the principles of SFAS No. 52, "Foreign Currency
Translation," using the local currency of its operating subsidiaries as the
functional currency. Accordingly, all assets and liabilities outside the
United States are translated into U.S. dollars at the rate of exchange in
effect at the balance sheet date. Income and expense items are translated at
the weighted average exchange rate prevailing during the period. Gains or
losses arising from the translation of the foreign subsidiaries' financial
statements are included in the accompanying consolidated balance sheets as a
separate component of stockholders' equity (deficit). (Losses) gains resulting
from foreign currency transactions amounted to ($288), $246, $364 and $325
during the year ended December 31, 1998, the eight months ended December 31,
1997 and the fiscal years ended April 30, 1997 and 1996, respectively, and are
included in other income (expense) in the consolidated statements of
operations.
 
 Net Loss Per Share
 
  The Company accounts for net loss per share in accordance with SFAS No. 128
"Earnings Per Share" and SFAS No. 129, "Disclosure of Information about
Capital Structure." Basic net loss per share is computed by dividing loss
attributable to common stockholders by the weighted average number of common
shares outstanding. Diluted net loss per share is computed by dividing loss
attributable to common stockholders by the weighted average number of common
shares outstanding plus the effect of any dilutive stock options and common
stock warrants.
 
 
                                     F-10
<PAGE>
 
                INTERPLAY ENTERTAINMENT CORP. AND SUBSIDIARIES
 
            NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(Continued)
               (Dollars in thousands, except per share amounts)
 
  For year ended December 31, 1998, the eight months ended December 31, 1997
and the years ended April 30, 1997 and 1996, all options and warrants to
purchase common stock were excluded from the diluted loss per share
calculation as the effect of such inclusion would be antidilutive (see Note
8).
 
 Stock-Based Compensation
 
  As permitted under generally accepted accounting principles, the Company
accounts for employee stock options in accordance with the Accounting
Principles Board Opinion No. 25 and makes the necessary pro forma disclosures
mandated by SFAS No. 123 (see Note 11).
 
 Recent Accounting Pronouncements
 
  In June 1997, the Financial Accounting Standards Board ("FASB") issued
Statement of Financial Accounting Standards ("SFAS") No. 130, "Reporting
Comprehensive Income" and SFAS No. 131, "Disclosures about Segments of an
Enterprise and Related Information". In addition, in November 1997, the
American Institute of Certified Public Accountants (AICPA) issued Statement of
Position ("SOP") 97-2, "Software Revenue Recognition". SFAS Nos. 130 and 131
and certain provisions of SOP 97-2 became effective for fiscal years beginning
after December 15, 1997. The adoption of these standards did not have a
material impact on the Company's results of operations.
 
  In April 1998, the AICPA issued SOP 98-1, "Accounting for the Costs of
Computer Software Developed or Obtained for Internal Use". SOP 98-1 is
effective for fiscal years beginning after December 15, 1998. Additionally,
the AICPA issued SOP 98-4, "Deferral of the Effective Date of SOP 97-2,
Software Revenue Recognition", and SOP 98-9, "Modification of SOP 97-2,
Software Revenue Recognition", which effectively modified and delayed the
application of certain provisions of SOP 97-2 until fiscal years beginning
after March 15, 1999. The Company does not believe that adoption of these
standards will have a material impact on the Company's results of operations.
 
3. Acquisition
 
  Effective June 24, 1995, the Company acquired a 91 percent interest in Shiny
Entertainment, Inc. (Shiny) for $3,624 in cash and stock. The acquisition was
accounted for using the purchase method. The allocation of purchase price is
summarized as follows:
 
<TABLE>
     <S>                                                                 <C>
     Cash and cash equivalents.......................................... $  119
     Receivables........................................................    107
     Other current assets...............................................      6
     Property and equipment.............................................    417
     Goodwill...........................................................  3,057
     Accounts payable and accrued liabilities...........................    (82)
                                                                         ------
       Total purchase price............................................. $3,624
                                                                         ======
</TABLE>
 
  The purchase agreement requires the Company to pay the former owner of Shiny
additional cash payments of up to $5,625 upon the delivery and acceptance of
five future Shiny interactive entertainment software titles, as defined. As of
December 31, 1998, the Company had not been required to make any additional
payments.
 
                                     F-11
<PAGE>
 
                 INTERPLAY ENTERTAINMENT CORP. AND SUBSIDIARIES
 
            NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(Continued)
                (Dollars in thousands, except per share amounts)
 
 
4. Detail of Selected Balance Sheet Accounts
 
 Inventories
 
  Inventories consist of the following:
 
<TABLE>
<CAPTION>
                                                                  December 31,
                                                                  -------------
                                                                   1998   1997
                                                                  ------ ------
     <S>                                                          <C>    <C>
     Packaged software........................................... $4,070 $4,171
     CD-ROMs, cartridges, manuals, packaging
      and supplies...............................................  2,233  2,167
                                                                  ------ ------
                                                                  $6,303 $6,338
                                                                  ====== ======
</TABLE>
 
 Other Current Assets
 
  Other current assets consist of the following:
 
<TABLE>
<CAPTION>
                                                                   December 31,
                                                                   -------------
                                                                    1998   1997
                                                                   ------ ------
     <S>                                                           <C>    <C>
     Prepaid expenses............................................. $  639 $1,640
     Royalties receivables........................................    --   1,644
     Deposits.....................................................     46    162
     Other receivables............................................  2,416    772
                                                                   ------ ------
                                                                   $3,101 $4,218
                                                                   ====== ======
</TABLE>
 
 Property and Equipment
 
  Property and equipment consists of the following:
 
<TABLE>
<CAPTION>
                                                                December 31,
                                                               ----------------
                                                                1998     1997
                                                               -------  -------
     <S>                                                       <C>      <C>
     Computers and equipment.................................. $13,944  $12,383
     Furniture and fixtures...................................     588      474
     Leasehold improvements...................................   1,135    1,125
                                                               -------  -------
                                                                15,667   13,982
     Less: accumulated depreciation and amortization..........  (9,988)  (6,956)
                                                               -------  -------
                                                               $ 5,679  $ 7,026
                                                               =======  =======
</TABLE>
 
 Accrued Liabilities
 
  Accrued liabilities consist of the following:
 
<TABLE>
<CAPTION>
                                                                 December 31,
                                                                ---------------
                                                                 1998    1997
                                                                ------- -------
     <S>                                                        <C>     <C>
     Royalties payable......................................... $ 6,758 $ 6,901
     Accrued payroll...........................................   2,552   2,707
     Payable to distributor....................................     216   4,240
     Accrued bundling and affiliate costs......................   1,409   2,923
     Deferred income...........................................   9,786   3,442
     Other.....................................................   1,579   2,336
                                                                ------- -------
                                                                $22,300 $22,549
                                                                ======= =======
</TABLE>
 
  Included in deferred income for the year ended December 31, 1998 is $9,000
related to distribution and other advances on future products.
 
                                      F-12
<PAGE>
 
                INTERPLAY ENTERTAINMENT CORP. AND SUBSIDIARIES
 
            NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(Continued)
               (Dollars in thousands, except per share amounts)
 
 
5. Long-term Debt
 
  Long-term debt consists of the following:
 
<TABLE>
<CAPTION>
                                                               December 31,
                                                             ------------------
                                                               1998      1997
                                                             --------  --------
     <S>                                                     <C>       <C>
     Subordinated Secured Promissory Notes.................. $    --   $ 14,655
     Loan Agreement.........................................   24,475    23,246
     Other..................................................      176       253
                                                             --------  --------
                                                               24,651    38,154
     Less--current portion..................................  (24,521)  (14,767)
                                                             --------  --------
                                                             $    130  $ 23,387
                                                             ========  ========
</TABLE>
 
 Subordinated Secured Promissory Notes
 
  From October 1996 through February 1997, the Company issued $14,800 in
Subordinated Secured Promissory Notes ("Notes") and nondetachable Warrants to
purchase Common Stock, of which employees, officers, and directors of the
Company held $2,600 of the total Notes outstanding. The principal amount of
the Notes was $14,700 and the purchase price of the Warrants was $148. The
amount paid for the Warrants approximates management's estimate of the fair
market value of the Warrants at the date of issuance and is included in paid-
in capital in the accompanying consolidated balance sheets.
 
  The Notes provided for interest at a rate of 12.0 percent per year, payable
quarterly, beginning May 1, 1997. Interest expense related to the Notes was
$863, $1,200 and $856 for the year ended December 31, 1998, the eight months
ended December 31, 1997 and the fiscal year ended April 30, 1997,
respectively.
 
  Each Warrant holder had the right to purchase from the Company the number of
shares of Common Stock equal to the investor's aggregate investment (including
Notes and Warrants) divided by the product of 0.70 multiplied by the initial
public offering ("IPO") price per share.
 
  Total interest due on the Notes at May 1, 1997 was $856. The Company offered
to pay the interest in cash or offered to issue one share of common stock for
each $11.25 of interest due (management's estimate of fair value of the
Company's common stock at the time). Interest of $672 was paid in cash and
$184 of interest was paid with 16,362 shares of common stock.
 
  In accordance with the terms of the Notes, the Company requested that each
holder elect to either convert the outstanding principal amount to Common
Stock upon the closing of the IPO or receive full payment in cash from the
proceeds of the IPO. At the IPO completion, the holders of approximately
$8,700 of Notes and Warrants elected to exercise their Warrants by converting
their Notes to Common Stock. The remaining Note holders with a balance of
approximately $6,300 requested payment in cash inclusive of interest of $277.
This amount was paid by the Company in July 1998.
 
 Loan Agreement
 
  In June 1997, the Company entered into a Loan and Security Agreement ("Loan
Agreement") with a financial institution which was amended in February 1998.
Borrowings under the Loan Agreement bear interest at LIBOR (5.62 percent at
December 31, 1998 and 5.72 percent at December 31, 1997) plus 4.87 percent
(10.49 percent at December 31, 1998 and 10.59 percent at December 31, 1997).
The agreement provides for a line of
 
                                     F-13
<PAGE>
 
                INTERPLAY ENTERTAINMENT CORP. AND SUBSIDIARIES
 
            NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(Continued)
               (Dollars in thousands, except per share amounts)
 
credit based in part on qualified receivables and inventory. Borrowings under
this Loan Agreement were to up to a maximum of $35,000 through August 30,
1998; $30,000 from August 31 to December 30, 1998; and $25,000 thereafter.
Within the total credit limits, the Company may borrow up to $10,000 in excess
of its borrowing base through August 1998 and up to $5,000 in excess of its
borrowing base thereafter through December 30, 1998. The line of credit is
secured by cash, accounts receivable and inventory and by a security interest
in certain of the Company's assets and was to expire on May 31, 1999.
 
  In November 1998, the Company further amended the Loan Agreement to provide
for a $37,500 maximum credit limit through May 31, 1999, based in part on
qualifying receivables and inventory. The amended line of credit also provides
for a personal guarantee by the Company's Chairman and Chief Executive Officer
in the amount of $5,000 secured by certain personal assets. As consideration
for making such guarantee, the employee received warrants to purchase 400,000
shares of the Company's Common Stock at an exercise price of $3.00 per share
(see Note 10). Subsequent to year end, on March 18, 1999, the Company entered
into amendments to the Loan Agreement which, among other things, extended the
expiration date to January 1, 2000 (see Note 15). The Company is in compliance
with the terms of the Loan Agreement.
 
6. Income Taxes
 
  The Company files a consolidated U.S. Federal income tax return which
includes substantially all of its domestic operations. The Company files
separate tax returns for each of its foreign subsidiaries in the countries in
which they reside.
 
  Loss before provision (benefit) for income taxes consists of the following:
 
<TABLE>
<CAPTION>
                                                 Eight Months   Years Ended
                                     Year Ended     Ended        April 30,
                                    December 31, December 31, -----------------
                                        1998         1997       1997     1996
                                    ------------ ------------ --------  -------
   <S>                              <C>          <C>          <C>       <C>
   Domestic........................   $(25,038)    $(2,784)   $(32,888) $(1,890)
   Foreign.........................     (1,745)     (2,275)     (3,396)     666
                                      --------     -------    --------  -------
   Total...........................   $(26,783)    $(5,059)   $(36,284) $(1,224)
                                      ========     =======    ========  =======
</TABLE>
 
  The provision (benefit) for income taxes is comprised of the following:
 
<TABLE>
<CAPTION>
                                                    Eight Months  Years Ended
                                        Year Ended     Ended       April 30,
                                       December 31, December 31, --------------
                                           1998         1997      1997    1996
                                       ------------ ------------ -------  -----
   <S>                                 <C>          <C>          <C>      <C>
   Current:
     Federal..........................    $  --        $(179)    $(1,689) $(275)
     State............................         8         --          --      10
     Foreign..........................      (571)         51         153    456
                                          ------       -----     -------  -----
                                            (563)       (128)     (1,536)   191
   Deferred:
     Federal..........................     2,000         128      (7,303)  (653)
     State............................       --          --         (226)   (18)
                                          ------       -----     -------  -----
                                           2,000         128      (7,529)  (671)
                                          ------       -----     -------  -----
                                          $1,437       $ --      $(9,065) $(480)
                                          ======       =====     =======  =====
</TABLE>
 
 
                                     F-14
<PAGE>
 
                INTERPLAY ENTERTAINMENT CORP. AND SUBSIDIARIES
 
            NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(Continued)
               (Dollars in thousands, except per share amounts)
 
  The Company's available net operating loss (NOL) carryforward for federal
tax reporting purposes approximates $46,400 and may be subject to certain
limitations as defined under Section 382 of the Internal Revenue Code. The
federal NOL carryforwards expire through the year 2018. The Company's NOL's
for state tax reporting purposes approximate $27,900 and expire through the
year 2003.
 
  A reconciliation of the statutory federal income tax rate and the effective
tax rate as a percentage of pretax loss is as follows:
 
<TABLE>
<CAPTION>
                                                   Eight Months Years Ended
                                       Year Ended     Ended      April 30,
                                      December 31, December 31, -------------
                                          1998         1997     1997    1996
                                      ------------ ------------ -----   -----
   <S>                                <C>          <C>          <C>     <C>
   Statutory income tax rate.........    (34.0)%      (34.0)%   (34.0)% (34.0)%
   State and local income taxes, net
    of
    federal income tax benefit.......     (3.0)        (3.0)     (3.0)   (3.0)
   Valuation allowance...............     39.8         39.7       8.0     --
   Other.............................      2.6         (2.7)      4.0    (2.2)
                                         -----        -----     -----   -----
                                           5.4 %        --  %   (25.0)% (39.2)%
                                         =====        =====     =====   =====
</TABLE>
 
  The components of the Company's net deferred income tax asset (liability)
are as follows:
 
<TABLE>
<CAPTION>
                                                               December 31,
                                                             -----------------
                                                               1998     1997
                                                             --------  -------
   <S>                                                       <C>       <C>
   Current deferred tax asset (liability):
     Prepaid royalties...................................... $ (5,621) $(2,760)
   Nondeductible reserves...................................    5,013    5,603
     Accrued expenses.......................................      853    1,015
     Foreign loss and credit carryforward...................    1,962    1,008
     Federal and state net operating losses.................   17,796    6,668
     Research and development credit carryforward...........      831      831
     Other..................................................      461      330
                                                             --------  -------
                                                               21,295   12,695
   Valuation allowance......................................  (15,818)  (4,903)
                                                             --------  -------
                                                             $  5,477  $ 7,792
                                                             ========  =======
   Non-current deferred tax asset (liability):
     Depreciation expense................................... $   (342) $  (625)
     Nondeductible reserves.................................      223      191
     Other..................................................      (22)     --
                                                             --------  -------
                                                             $  (141)  $  (434)
                                                             ========  =======
</TABLE>
 
  The valuation allowance relates primarily to net operating loss and tax
credit carryforward. Due to the uncertainty surrounding the realization of the
favorable tax attributes in future years, the Company has placed a valuation
allowance against its net deferred tax assets.
 
 
                                     F-15
<PAGE>
 
                INTERPLAY ENTERTAINMENT CORP. AND SUBSIDIARIES
 
            NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(Continued)
               (Dollars in thousands, except per share amounts)
 
7. Commitments and Contingencies
 
 Leases
 
  The Company leases office space in Irvine, California for its corporate
offices. The lease expires in June 2006 with one five-year option to extend
the term of the lease. The Company has also entered into various computer
equipment operating leases. Future minimum lease payments under noncancelable
operating leases are as follows:
 
<TABLE>
       <S>                                                               <C>
       Year ending December 31:
         1999........................................................... $ 2,132
         2000...........................................................   1,531
         2001...........................................................   1,318
         2002...........................................................   1,322
         2003...........................................................   1,332
         Thereafter.....................................................   3,649
                                                                         -------
                                                                         $11,284
                                                                         =======
</TABLE>
 
  Total rent expense was $2,400, $1,300, $2,100 and $697 for the year ended
December 31, 1998, the eight months ended December 31, 1997, and the years
ended April 30, 1997 and 1996, respectively.
 
 Pending Internal Revenue Service Examination
 
  The Internal Revenue Service (the IRS) is currently examining the Company's
consolidated federal income tax returns for the years ended April 30, 1992
through 1997. The IRS has challenged the timing of certain tax deductions
taken by the Company, and has asserted that an additional tax liability is
due. The Company disagrees with and is currently contesting such challenges.
The potential losses to the Company, as a result of these challenges are not
reasonably estimable. Accordingly, no reserve has been established in the
accompanying financial statements. Any losses which might be suffered by the
Company as a result of this examination could impact the Company's future
profitability.
 
 Litigation
 
  The Company is involved in litigation arising from the normal course of
business. Management believes that the final outcome of all legal matters will
not have a material adverse effect on the Company's financial position or
results of operations.
 
 Employment Agreements
 
  The Company has entered into employment agreements with three of its
officers providing for, among other things, salary, bonuses and the right to
participate in certain incentive compensation and other employee benefit plans
established by the Company. Under these agreements, upon termination without
cause or resignation for good reason, as defined, the employees are entitled
to 150 percent of their annual salary and 75 percent of the imputed bonus, as
defined. These agreements expire in 1999.
 
 New European Currency
 
  On January 1, 1999, eleven of the fifteen member countries of the European
Union ("Participating Countries") established fixed conversion rates between
their existing sovereign currencies and a new European
 
                                     F-16
<PAGE>
 
                INTERPLAY ENTERTAINMENT CORP. AND SUBSIDIARIES
 
            NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(Continued)
               (Dollars in thousands, except per share amounts)
 
currency, the "euro". The euro was adopted by the Participating Countries as
the common legal currency on that date. A significant portion of the Company's
sales are made to Participating Countries and consequently, the Company
anticipates that the euro conversion will, among other things, create
technical challenges to adapt information technology and other systems to
accommodate euro-denominated transactions and limit the Company's ability to
charge different prices for its producers in different markets. While the
Company believes that the conversion will not cause material disruption of its
business, there can be no assurance that the conversion will not have a
material effect on the Company's business or financial condition.
 
8. Loss Per Share
 
  Basic loss per share is calculated by dividing net loss available to common
stockholders by the weighted average number of common shares outstanding and
does not include the impact of any potentially dilutive common stock
equivalents. Diluted loss per share is arrived at by dividing the weighted
average number of shares outstanding, adjusted for the dilutive effect of
outstanding stock options.
 
  The following table sets forth the computation of basic and diluted loss per
share:
 
<TABLE>
<CAPTION>
                                          Eight Months      Years Ended
                              Year Ended     Ended           April 30,
                             December 31, December 31, ----------------------
                                 1998         1997        1997        1996
                             ------------ ------------ ----------  ----------
<S>                          <C>          <C>          <C>         <C>
BASIC
Net loss....................  $  (28,220)  $   (5,059) $  (27,219) $     (744)
Average common shares
 outstanding................  14,762,644   11,123,327  11,085,632  10,661,944
                              ----------   ----------  ----------  ----------
Net loss per common share--
 basic......................  $    (1.91)  $    (0.45) $    (2.46) $    (0.07)
                              ==========   ==========  ==========  ==========
DILUTED
Net loss....................  $  (28,220)  $   (5,059) $  (27,219) $     (744)
Average common shares
 outstanding................  14,762,644   11,123,327  11,085,632  10,661,944
Stock option adjustment.....         --           --          --          --
                              ----------   ----------  ----------  ----------
Average common shares
 outstanding................  14,762,644   11,123,327  11,085,632  10,661,944
                              ----------   ----------  ----------  ----------
Net loss per common share--
 diluted....................  $    (1.91)  $    (0.45) $    (2.46) $    (0.07)
                              ==========   ==========  ==========  ==========
</TABLE>
 
  Options to purchase 2,132,738, 1,838,972, 1,627,522 and 1,824,025 shares of
common stock at December 31, 1998, December 31, 1997, April 30, 1997 and April
30, 1996, respectively, were not included in the computation of diluted
earnings per share as the effect would be antidilutive. The weighted average
exercise price at December 31, 1998, December 31, 1997, April 30, 1997 and
April 30, 1996 was $4.73, $5.31, $4.57 and $3.16, respectively, for the
options outstanding.
 
9. Comprehensive Income
 
  As of January 1, 1998 the Company adopted SFAS No. 130, "Reporting
Comprehensive Income". SFAS No. 130 establishes new rules for the reporting
and display of comprehensive income and its components; however, the adoption
of this Statement had no impact on the Company's net income or stockholders
equity. SFAS No. 130 requires unrealized gains or losses on the Company's
foreign currency translations adjustments which, prior to adoption, were
reported separately in stockholders, equity to be included in other
comprehensive income. Prior year financial statements have been reclassified
to conform to the requirements of SFAS No. 130.
 
 
                                     F-17
<PAGE>
 
                INTERPLAY ENTERTAINMENT CORP. AND SUBSIDIARIES
 
            NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(Continued)
               (Dollars in thousands, except per share amounts)
 
  For the year ended December 31, 1998, the eight months ended December 31,
1998 and the fiscal years ended April 30, 1997 and 1996, the Company had pre-
tax increase in foreign currency translations of $172, $3, $141 and $0,
respectively.
 
10. Stockholders' Equity (Deficit)
 
 Common Stock
 
  On February 1, 1997, the Company repurchased 29,124 shares of common stock
from an employee in exchange for a $275 note payable. The note bears interest
at 7 percent and is payable over 36 months.
 
  On September 12, 1997, the Company entered into a Separation and Release
Agreement with a former employee whereby 178,594 shares of common stock were
canceled and the former employee's remaining shares of 149,500 shares were
retained by the former employee.
 
  In connection with the amendment of the Company's line of credit agreement
in November 1998 (see Note 5), the Company issued its Chairman and Chief
Executive Officer, 400,000 warrants to purchase the Company's Common Stock
(the "Warrants") at an exercise price of $3.00 per share exercisable after May
20, 1999. The Warrants have a three year term, have no registration rights and
the Warrants are canceled in the event the Company enters into an agreement to
merge or combine the Company within six months after the issuance date of the
Warrants. The shares issuable upon exercise of the warrants are subject to the
twelve month lockup agreement the employee entered into in connection with the
Company's IPO. In connection with the issuance of the Warrants, the Company
recorded an expense equal to the fair market value of the Warrants, which is
approximately $316, with such expense being amortized as additional debt cost
over the term of the guarantee.
 
  Subsequent to year end, the Company entered into a Stock Purchase Agreement
with an investor which provides for the issuance of up to 5 million shares of
the Company's Common Stock for $10,000 (see Note 15). This transaction closed
and the Company received the proceeds from the sale on March 19, 1999.
 
 Employee Stock Purchase Plan.
 
  The Company's Employee Stock Purchase Plan (the "Purchase Plan"), covering
an aggregate of 200,000 shares of Common Stock, was adopted by the Board of
Directors and approved by the Company's stockholders in March 1998. The
Purchase Plan, which is intended to qualify as an "employee stock purchase
plan" under Section 423 of the Internal Revenue Code of 1986, as amended (the
"Code"), will be implemented by twelve-month offerings with purchases
occurring at six-month intervals commencing on the date of this Prospectus.
The Purchase Plan will be administered by the Board of Directors. The Purchase
Plan permits eligible employees to purchase Common Stock through payroll
deductions, which may not exceed 15% of an employee's compensation. The price
of stock purchased under the Purchase Plan will be 85% of the lower of the
fair market value of the Common Stock at the beginning of the offering period
or on the applicable purchase date. On December 31, 1998, the Purchase Plan
acquired 56,102 shares of the Company's common stock at $1.51 per share.
 
 Initial Public Offering
 
  On June 18, 1998, the Company effected a registration with the Securities
and Exchange Commission on Form S-1, Registration No. 333-48473 (the
"Registration Statement"), whereby the Company registered up to 5,750,000
shares of its Common Stock. On June 24, 1998, the Company completed its
initial public offering of 5,000,000 shares of Common Stock, at $5.50 per
share, that raised approximately $24,310, net of expenses of $3,200. In
addition, in connection with the offering, 750,000 shares of Common Stock of
the Company were sold by a selling stockholder at $5.50 per share, for which
the company received no proceeds.
 
                                     F-18
<PAGE>
 
                INTERPLAY ENTERTAINMENT CORP. AND SUBSIDIARIES
 
            NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(Continued)
               (Dollars in thousands, except per share amounts)
 
 
11. Employee Benefit Plans
 
 Stock Option Plans
 
  The Company has three stock option plans. Under the Incentive Stock Option,
Nonqualified Stock Option and Restricted Stock Purchase Plan--1991 (1991
Plan), the Company may grant options to its employees to purchase up to
2,250,000 shares of common stock. Under the Incentive Stock Option and
Nonqualified Stock Option Plan--1994 (1994 Plan), the Company may grant
options to its employees to purchase up to 808,300 shares of common stock.
Under the 1997 Stock Incentive Plan the Company may grant options to its
employees, consultants and directors to purchase up to 700,000 shares of
common stock.
 
  Options under all three plans generally vest over five years. Holders of
options under the 1991 Plan and the 1994 Plan shall be deemed 100 percent
vested in the event of a merger in which the Company is not the surviving
entity, a sale of substantially all of the assets of the Company, or a sale of
all shares of common stock of the Company. The Company has treated the
difference, if any, between the exercise price and the estimated fair market
value, as determined by the board of directors on the date of grant, as
compensation expense for financial reporting purposes. Compensation expense
for the vested portion aggregated $190, $204, $306 and $306 for the year ended
December 31, 1998, the eight months ended December 31, 1997, and the fiscal
years ended April 30, 1997 and 1996.
 
  Effective February 9, 1998, the Company repriced substantially all
outstanding options with exercise prices greater than $8 per share and
subsequently reissued these options with exercise prices equal to $8 per
share, management's estimate of the fair value of the Company's common stock
as of the date of reissuance. These options were accounted for as new grants.
Effective March 2, 1998, the 1991 Plan and the 1994 Plan were terminated for
purposes of future grants. On February 23, 1998, the Company granted 240,100
stock options with an exercise price equal to the estimated fair market value
of $8 per share.
 
  The following is a summary of option activity pursuant to the Company's
stock option plans:
 
<TABLE>
<CAPTION>
                          December 31, 1998   December 31, 1997     April 30, 1997      April 30, 1996
                          ------------------- ------------------- ------------------- -------------------
                                     Weighted            Weighted            Weighted            Weighted
                                     Average             Average             Average             Average
                                     Exercise            Exercise            Exercise            Exercise
                           Shares     Price    Shares     Price    Shares     Price    Shares     Price
                          ---------  -------- ---------  -------- ---------  -------- ---------  --------
<S>                       <C>        <C>      <C>        <C>      <C>        <C>      <C>        <C>
Options outstanding at
 beginning of year......  1,838,972   $5.29   1,630,022   $ 4.59  1,824,025   $ 3.16  1,665,479   $1.69
 Granted................    451,100    6.91     263,750    11.25    136,800    14.08    418,050    8.79
 Exercised..............    (12,084)   1.27         --       --    (313,403)    0.18   (177,104)   0.79
 Canceled...............   (139,750)   8.44     (54,800)   12.50    (17,400)    8.50    (82,400)   7.16
 Rescinded..............     (5,500)   8.00         --       --         --       --         --      --
                          ---------   -----   ---------   ------  ---------   ------  ---------   -----
Options outstanding at
 end of year............  2,132,738   $4.73   1,838,972   $ 5.29  1,630,022   $ 4.59  1,824,025   $3.16
                          =========   =====   =========   ======  =========   ======  =========   =====
 Options exercisable....  1,448,143           1,324,132           1,218,102           1,434,775
                          =========           =========           =========           =========
</TABLE>
 
  The following outlines the significant assumptions used to calculate the
fair value information presented utilizing the Black-Scholes Single Option
approach with ratable amortization:
 
<TABLE>
<CAPTION>
                                    December 31,              April 30,
                                ----------------------  ----------------------
                                   1998        1997        1997        1996
                                ----------  ----------  ----------  ----------
   <S>                          <C>         <C>         <C>         <C>
   Risk free rate.............         5.1%        6.1%        6.1%        6.1%
   Expected life..............  7.74 years  8.02 years  7.13 years  7.12 years
   Expected volatility........        0.70         --          --          --
   Expected dividends.........         --          --          --          --
   Weighted-average grant-date
    fair value of
    options granted...........  $     2.95  $     3.61  $     3.68  $     2.34
</TABLE>
 
                                     F-19
<PAGE>
 
                INTERPLAY ENTERTAINMENT CORP. AND SUBSIDIARIES
 
            NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(Continued)
               (Dollars in thousands, except per share amounts)
 
 
  A detail of the options outstanding and exercisable as of December 31, 1998
is as follows:
 
<TABLE>
<CAPTION>
                              Options Outstanding            Options Exercisable
                   ----------------------------------------- --------------------
                                        Weighted    Weighted             Weighted
      Range of                           Average    Average              Average
      Exercise                          Remaining   Exercise   Number    Exercise
       Prices      Number Outstanding Contract Life  Price   Outstanding  Price
      --------     ------------------ ------------- -------- ----------- --------
   <S>             <C>                <C>           <C>      <C>         <C>
   $0.15 - $ 0.47        572,874          3.24       $0.15      572,874   $0.15
   $2.00 - $ 4.44        367,814          4.78       $2.72      367,814   $2.72
   $4.50 - $ 6.66        237,000          8.25       $5.08       84,700   $5.37
   $7.00 - $10.00        955,050          7.50       $8.16      422,755   $8.22
                       ---------          ----       -----    ---------   -----
   $0.15 - $10.00      2,132,738          5.97       $4.73    1,448,143   $3.46
                       =========          ====       =====    =========   =====
</TABLE>
 
  The following table shows pro forma net loss as if the fair value based
accounting method prescribed by SFAS No. 123 had been used to account for
stock based compensation cost:
 
<TABLE>
<CAPTION>
                                                 Eight Months   Years Ended
                                     Year Ended     Ended        April 30,
                                    December 31, December 31, ----------------
                                        1998         1997       1997     1996
                                    ------------ ------------ --------  ------
   <S>                              <C>          <C>          <C>       <C>
   Net loss as reported...........    $(28,220)    $(5,059)   $(27,219) $ (744)
   Pro forma compensation
    expense.......................      (1,011)       (276)       (348)   (121)
                                      --------     -------    --------  ------
   Pro forma net loss.............    $(29,231)    $(5,335)   $(27,567) $ (865)
                                      ========     =======    ========  ======
   Basic and diluted net loss as
    reported......................    $  (1.91)    $ (0.45)   $  (2.46) $(0.07)
   Basic and diluted pro forma net
    loss..........................    $  (1.98)    $ (0.48)   $  (2.49) $(0.08)
</TABLE>
 
 Profit Sharing 401(k) Plan
 
  The Company sponsors a 401(k) plan (the Plan) for most full-time employees.
The Company matches 50 percent of the participant's contributions up to the
first six percent of the participant's salary deferral. The profit sharing
contribution amount is at the sole discretion of the Company's board of
directors. Participants vest at a rate of 20 percent per year after the first
year of service for profit sharing contributions and 20 percent per year after
the first two years of service for matching contributions. Participants become
100 percent vested upon death, permanent disability or termination of the
Plan. Benefit expense for the year ended December 31, 1998, for the eight
months ended December 31, 1997 and for the years ended April 30, 1997 and 1996
was $256, $178, $229 and $160, respectively.
 
12. Related Parties
 
  The Company has amounts due from a business controlled by the Chairman and
CEO of the Company. Net amounts due, prior to reserves, at December 31, 1998
and 1997 were $2,000 and $1,500, respectively. Such amounts at December 31,
1998 and 1997 are fully reserved. Through December 1997, the Company rented
office space from the Chairman and CEO of the Company. Rent expense paid to
the Chairman and CEO was $160, $191 and $248 for the eight months ended
December 31, 1997 and for the years ended April 30, 1997 and 1996,
respectively.
 
  In connection with the amendment of the Company's line of credit agreement
in November 1998 (see Note 5), the Company's Chairman and Chief Executive
Officer, Brian Fargo, provided a personal guarantee in the amount of $5.0
million secured by certain of Mr. Fargo's personal assets. As consideration
for making such guarantee, Mr. Fargo received warrants to purchase 400,000
shares of the Company's Common Stock at an exercise price of $3.00 per share
exercisable after May 20, 1999 (see Note 10).
 
                                     F-20
<PAGE>
 
                INTERPLAY ENTERTAINMENT CORP. AND SUBSIDIARIES
 
            NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(Continued)
               (Dollars in thousands, except per share amounts)
 
 
13. Concentration of Credit Risk
 
  The Company extends credit to various companies in the retail and mass
merchandising industry. Collection of trade receivables may be affected by
changes in economic or other industry conditions and may, accordingly, impact
the Company's overall credit risk. Although the Company generally does not
require collateral, the Company performs ongoing credit evaluations of its
customers and reserves for potential credit losses are maintained.
 
  For the year ended April 30, 1997 one customer accounted for approximately
15 percent of net revenues. No single customer accounted for ten percent or
more of net revenues in the year ended December 31, 1998, the eight months
ended December 31, 1997 or the year ended April 30, 1996.
 
14. Segment and Geographical Information
 
  The Company operates in three principal business segments. Information about
the Company's operations in the United States and foreign areas is presented
below:
 
<TABLE>
<CAPTION>
                                                Eight Months   Years Ended
                                    Year Ended     Ended        April 30,
                                   December 31, December 31, -----------------
                                       1998         1997       1997     1996
                                   ------------ ------------ --------  -------
   <S>                             <C>          <C>          <C>       <C>
   Net revenues:
     United States...............    $ 94,727     $65,199    $ 54,469  $78,823
     United Kingdom..............      32,135      20,689      27,867   18,127
     Other.......................         --           73         926        2
                                     --------     -------    --------  -------
       Consolidated net
        revenues.................    $126,862     $85,961    $ 83,262  $96,952
                                     ========     =======    ========  =======
   Income (loss) from operations:
     United States...............    $(20,315)    $   298    $(30,764) $(1,410)
     United Kingdom..............      (1,535)     (2,666)     (3,871)   1,853
     Other.......................         --         (418)        (49)    (860)
                                     --------     -------    --------  -------
       Consolidated loss from
        operations...............    $(21,850)    $(2,786)   $(34,684) $  (417)
                                     ========     =======    ========  =======
 
  Expenditures made for the acquisition
       of long-lived assets:
 
     United States...............    $  1,067     $   459    $  2,741  $ 3,859
     United Kingdom..............         422         175         382      149
     Other.......................         195         158         328      577
                                     --------     -------    --------  -------
       Total expenditures for
        long-lived assets........    $  1,684     $   792    $  3,451  $ 4,585
                                     ========     =======    ========  =======
</TABLE>
 
  Net revenues were made in geographic regions as follows:
 
<TABLE>
<CAPTION>
                            Year Ended     Eight Months        Years Ended April 30,
                           December 31,   Ended December  -------------------------------
                               1998          31, 1997          1997            1996
                         ---------------- --------------- --------------- ---------------
                          Amount  Percent Amount  Percent Amount  Percent Amount  Percent
                         -------- ------- ------- ------- ------- ------- ------- -------
<S>                      <C>      <C>     <C>     <C>     <C>     <C>     <C>     <C>
North America........... $ 73,865   58.2% $51,833   60.3% $38,606   46.4% $54,702   56.4%
Europe..................   28,777   22.7   19,941   23.2   26,752   32.1   17,683   18.3
Rest of World...........    7,016    5.5    4,701    5.5    5,254    6.3    6,896    7.1
OEM, royalty and
 licensing..............   17,204   13.6    9,486   11.0   12,650   15.2   17,671   18.2
                         --------  -----  -------  -----  -------  -----  -------  -----
                         $126,862  100.0% $85,961  100.0% $83,262  100.0% $96,952  100.0%
                         ========  =====  =======  =====  =======  =====  =======  =====
</TABLE>
 
                                     F-21
<PAGE>
 
                INTERPLAY ENTERTAINMENT CORP. AND SUBSIDIARIES
 
            NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(Continued)
               (Dollars in thousands, except per share amounts)
 
 
  Long-lived assets by geographic regions, net:
 
<TABLE>
<CAPTION>
                          December 31,   December 31,
                              1998           1997      April 30, 1997  April 30, 1996
                         -------------- -------------- --------------- --------------
                         Amount Percent Amount Percent Amount  Percent Amount Percent
                         ------ ------- ------ ------- ------- ------- ------ -------
<S>                      <C>    <C>     <C>    <C>     <C>     <C>     <C>    <C>
North America........... $6,621   89.6% $8,380   91.9% $ 9,578   91.5% $7,149   91.2%
Europe..................    723    9.8     685    7.5      616    5.9     480    6.1
Rest of World...........    --     0.0     --     0.0      220    2.1     209    2.7
OEM, royalty and
 licensing..............     44    0.6      53    0.6       50    0.5     --     0.0
                         ------  -----  ------  -----  -------  -----  ------  -----
                         $7,388  100.0% $9,118  100.0% $10,464  100.0% $7,838  100.0%
                         ======  =====  ======  =====  =======  =====  ======  =====
</TABLE>
 
15. Subsequent Events
 
 Distribution Agreement
 
  On February 10, 1999 the Company signed an International Distribution
Agreement with Virgin Interactive Entertainment Limited ("Virgin") which
provides for the exclusive distribution of substantially all of the Company's
products in Europe, CIS, Africa and the Middle East for a seven year period,
cancelable under certain conditions, subject to termination penalties and
costs. Under the Agreement, the Company will pay Virgin a monthly overhead fee
and a distribution fee based on net sales, subject to a minimum annual
payment, and Virgin will provide certain market preparation, warehousing,
sales and fulfillment services on behalf of the Company. In connection with
this arrangement and the associated reduction in the Company's European
operations, the Company anticipates recording an asset valuation and
restructuring charge of approximately $650 in the first quarter of 1999. In
connection with the International Distribution Agreement the Company has also
executed a Product Publishing Agreement which provides the Company with an
exclusive license to publish and distribute substantially all of Virgin's
products within North America, Latin America and South America for a royalty
based on net sales. The Company has also executed an Operating Agreement, in
connection with the above agreements, which provides the Company, together
with two members of Interplay Europe's management, a 49.9% equity interest in
VIE Acquisition Group LLC, the parent entity of Virgin. The Company is not
obligated to make any other contributions to the working capital of Virgin.
 
 Sale of Common Stock
 
  On March 18, 1999, the Company entered into a Stock Purchase Agreement with
an investor which provides for the issuance of 2.5 million shares of the
Company's Common Stock for $10,000. Under the terms of the Stock Purchase
Agreement up to 2.5 million additional shares of the Company's common stock
may be issued without additional consideration based on the average closing
share price per share of the Company's Common Stock as of certain specified
future dates; provided, however, the investor will not be issued a total
number of shares equaling or exceeding 20% of the Company's current
outstanding Common Stock without the approval of the Company's stockholders.
 
 Amendment to Credit Facility
 
  On March 18, 1999 the Company amended its line of credit with a financial
institution to extend its current line of credit through January 1, 2000 and
thereafter, based on qualifying receivables and inventory. Under the terms of
the Amendment the $37,500 maximum credit line will continue through November
29, 1999, $30,000 through December 30, 1999 and $25,000 thereafter. Within the
total credit limit, the Company may borrow up to $14,000 in excess of its
borrowing base through July 30, 1999, $10,000 in excess through September 29,
1999, $7,000 through November 29, 1999 and $5,000 in excess thereafter. Under
the amended line of credit the Company is required to place a cash collateral
deposit of $1,000 on February 15, 1999 and March 15, 1999 and $500 on April
15, 1999. In addition, the Company is required to maintain certain borrowing
limitations beginning July 30, 1999 where actual borrowings are limited to
$35,000 with various month end limitations, generally decreasing to $25,000 at
December 31, 1999 and the $5,000 personal guarantee by the Company's Chairman
and Chief Executive Officer will remain in place throughout the term. All
other terms and conditions remain in full force and effect.
 
                                     F-22
<PAGE>
 
                 INTERPLAY ENTERTAINMENT CORP. AND SUBSIDIARIES
 
                 SCHEDULE II--VALUATION AND QUALIFYING ACCOUNTS
                             (Amounts in Thousands)
 
<TABLE>
<CAPTION>
                                        Trade Receivables Allowances
                              ------------------------------------------------
                              Balance at Provisions for             Balance at
                              Beginning   Returns and   Returns and   End of
   Period                     of Period    Discounts     Discounts    Period
   ------                     ---------- -------------- ----------- ----------
   <S>                        <C>        <C>            <C>         <C>
   Year ended April 30,
    1996.....................  $ 5,032      $26,882      $(22,814)   $ 9,100
                               =======      =======      ========    =======
   Year ended April 30,
    1997.....................  $ 9,100      $34,424      $(28,630)   $14,894
                               =======      =======      ========    =======
   Eight months ended
    December 31, 1997........  $14,894      $21,915      $(22,348)   $14,461
                               =======      =======      ========    =======
   Year ended December 31,
    1998.....................  $14,461      $43,596      $(39,626)   $18,431
                               =======      =======      ========    =======
</TABLE>
 
                                      F-23