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                      SECURITIES AND EXCHANGE COMMISSION
                            WASHINGTON, D.C. 20549
 
                               ----------------
 
                                   FORM 10-K
 
                  FOR ANNUAL AND TRANSITION REPORTS PURSUANT
                        TO SECTIONS 13 OR 15(D) OF THE
                        SECURITIES EXCHANGE ACT OF 1934
 
  (Mark One)
 
  [X]ANNUAL REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES
     EXCHANGE ACT OF 1934
                  For the fiscal year ended December 31, 1997
 
                                      OR
 
  [_]TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES
     EXCHANGE ACT OF 1934 [NO FEE REQUIRED]
 
           For the transition period from             to
 
                        Commission file number 0-25916
 
                        YES! ENTERTAINMENT CORPORATION
            (EXACT NAME OF REGISTRANT AS SPECIFIED IN ITS CHARTER)
 
<TABLE>
<CAPTION>
                       DELAWARE                                       94-3165290
 <S>                                                    <C>
 (STATE OR OTHER JURISDICTION OF INCORPORATION OR OR-
                     GANIZATION)                         (I.R.S. EMPLOYER IDENTIFICATION NO.)
 3875 HOPYARD ROAD, SUITE 375, PLEASANTON, CALIFORNIA                   94588
       (ADDRESS OF PRINCIPAL EXECUTIVE OFFICES)                       (ZIP CODE)
 
      Registrant's telephone number, including area code: (952) 847-9444
 
       Securities registered pursuant to Section 12(b) of the Act: None
 
         Securities registered pursuant to Section 12 (g) of the Act:
 
                                                        NAME OF EACH EXCHANGE ON WHICH REGIS-
                 TITLE OF EACH CLASS                                    TERED
             Common Stock, $.01 Par Value                       Nasdaq National Market
</TABLE>
 
  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 at least 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. [_]
 
  The aggregate market value of the voting stock held by non affiliates of the
Registrant, based upon the closing sale price of the Common Stock on March 31,
1998 on the Nasdaq National Market was approximately $13,854,253.
 
  The number of shares outstanding of the Registrant's Common Stock as of
March 31, 1998 was 16,440,733.
 
                      DOCUMENTS INCORPORATED BY REFERENCE
 
  Certain sections of the Registrant's definitive Proxy Statement for the 1998
Annual Meeting of Shareholders to be held on June 3, 1998 are incorporated by
reference in Part III of this Form 10-K to the extent stated herein.
 
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                                    PART I
 
ITEM 1. BUSINESS
 
GENERAL
 
  YES! Entertainment Corporation ("YES!" or the "Company") develops,
manufactures and markets toys and other entertainment products, including a
variety of interactive products. YES! applies innovative technology available
in other industries to design products that are fun for children and build on
their natural creativity. Most of YES!'s products target children between the
ages of two and twelve, a market of over 44 million in North America alone.
 
  YES! has introduced products into several brand categories since being
founded in December 1992. A substantial portion of the Company's current
products are marketed under the YES! Gear(TM) brand. YES! Gear is principally
comprised of the Company's Yak Bak(R) Power Penz(TM), and Mega Mike(TM)
products. Yak Bak and Mega Mike, which are both children's electronic and
audio products, are designed to appeal to kids six to twelve years of age with
their high impact design and unique play activities. Power Penz is a line of
pens that incorporates toys and activities. YES! Girl(TM) was introduced in
1997, initially with Dance Studio(TM), a portable dance instructor. In 1997
the company also launched Air Vectors(TM), a line of transforming vehicles
which launch planes or missiles. The Company expanded its food activity
product line by introducing Baskin Robbins(R) Ice Cream Maker. The Company
sold its YES! Girl and Licensed Food lines in March 1998.
 
  In 1998, the Company expects to introduce a number of new products into
existing brand categories, as well as products which will be the basis for new
brand categories. In the YES! Gear brand the Company plans to introduce Yak
Live(TM), a Yak Bak combined with an LCD animated display with eight different
characters and forty-eight sound effects. Planned expansion in the Air Vectors
brand includes Air Vectors SFX(TM), a line of transforming vehicles with
integrated self- generated sound effects as well as Air Vectors Command
Center(TM), a play set designed for interactive play with all Air Vectors
vehicles. In the Power Penz brand, the Company expects to introduce
UpperCut(TM), Tattooz(TM) and Robo Penz(TM), among others. In the W-3 Wild
Water Weapons(TM) brand, YES! is currently shipping Speed Loaders(TM), a line
of self-pressurized water guns that come with their own fast refill device.
Also in 1998, YES! plans to introduce the New World of Teddy Ruxpin(R), a
video and computer compatible version of the classic talking animated bear.
 
  YES! was incorporated in California in September 1992 and began operations
in November 1992. The Company changed its state of incorporation from
California to Delaware in October 1996. The Company had net revenues of $50.9
million, $69.7 million and $55.7 million in 1997, 1996 and 1995, respectively.
The Company incurred operating losses from its inception through the quarter
ended June 30, 1995, incurred net losses of approximately $42.1 million and
$12.6 million in 1997 and 1996, respectively, reported net income of $3.5
million in 1995, and had an accumulated deficit of approximately $94.7 million
at December 31, 1997. The Company had total assets of $32.5 million as of
December 31, 1997 as compared to $61.3 million and $48.9 million in 1996 and
1995, respectively.
 
  YES!, YAK BAK, and COMES TO LIFE BOOKS are registered trademarks, YES! PRE-
SCHOOL, DISGUSTING DESIGNS, YAKKINS, PET TOONIES, GIZMO, YES! EXTREME, are
pending registered trademarks and YES! GEAR, POWER PENZ, V-LINK, T.R.A.P.S.,
RADICAL RACERS, FM ROCKER, STAMP'EMS, TATOOZ, FREE KICK, FIELD GOAL, DRUMMIN',
JAMMIN', TORPEDO BLAST, UPPERCUT, CHILLIN', LIGHTSHOW, ROBO PENZ, AIR VECTORS,
AIR VECTORS SFX, LAND VECTORS SFX, AIR VECTORS COMMAND CENTER, AIR VECTORS
SUPER COMMAND CENTER, YES! GIRL, RADICAL AIR WEAPONS, YAK BAK WARP'R, YAK BAK
SFX, YAK BAKWARDS, YAK MANIAK, YAK LIVE, YAK WAKKY, MEGA MIKE, HANDY CANDY,
MUSIC GIZMOS, INSTRUMENT GISMOS, STROBES, YAK BAK BALLS, SFX BALLS, W-3
SPEEDLOADER, W-3 WILD WATER WEAPONS, SUPER SPEED REFILLER, and FISTFUL OF
ALIENS are trademarks of YES! Entertainment
 
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Corporation. All rights reserved. MRS. FIELDS is a registered trademark of the
Mrs. Fields Development Corporation. BASKIN ROBBINS is a registered trademark
of the Baskin-Robbins USA, Co. DANCE STUDIO, CHEER LEADER and MS. MEGA MIKE
are trademarks assigned to Wham-O, Inc. TEDDY RUXPIN is a registered trademark
of and THE NEW WORLD OF TEDDY RUXPIN is a trademark of Alchemy II, Inc.
 
PRODUCTS
 
  YES!'s product lines span major markets for children's and teen products.
These include children's electronics, outdoor toys, vehicles, functional toys,
and interactive plush products. The Company has used, and plans to continue to
use, its innovative approach to product development to create new categories,
as it did with Yak Bak and Power Penz. YES! has introduced, and plans to
continue to introduce, products into existing industry categories, such as
vehicles and waterguns, where the Company believes it can compete with a
significant feature that differentiates YES! products from existing
competition and has perceived value to the consumer. The majority of the
Company's products target children ages two to twelve.
 
  The Company introduced a number of new product lines in 1997 and expects to
introduce several new product lines in 1998. The Company expects that the 1998
product lines, certain of which are technically complex, will place great
demands on management and other Company resources. There can be no assurance
that the products under development will be successfully developed or, if
successfully developed, that they will achieve market acceptance. In addition,
if the Company is not able to complete successful development, tooling,
manufacture and marketing of its 1998 product lines, the Company's operating
results and financial condition will be materially adversely affected.
 
YES! GEAR
 
  YES! Gear products are designed around the idea of combining technical
innovation in a low cost product that provides children with opportunity for
creative expression. YES! Gear is principally comprised of the Company's Yak
Bak, Power Penz and Mega Mike products.
 
  Yak Bak. The Yak Bak line of products combines solid state recording,
playback and sound effects technology in colorful, highly stylized micro-sized
recorders that permit children to record and play back their customized
messages. Designed to fit comfortably into a child's hand and pocket, each of
the Yak Bak products is available in a number of different colors. All Yak Bak
packaging is designed to achieve maximum impact in a retail store and allow
customers to test the product before purchasing it.
 
  YES! launched its YES! Gear product line in December 1994 with the
introduction of Yak Bak, a simple, highly stylized six-second record and
playback device. Since then, the Company has introduced a number of extensions
to the Yak Bak product, including Yak Bak Warp'r(TM), which includes a voice
pitch modulator, that alters the voice recording to permit the recorder to
play back the recording in new ways; Yak Wakky(TM), a more fully featured
version of the original Yak Bak, which incorporates voice modulation through a
light sensor which is adjusted by moving your hand over it; Yak Bak SFX(TM),
which incorporates built-in sound effects and extended recording features that
allow a child to create a wide variety of messages and custom recordings; and
Yak Maniak(TM) which incorporates echo, reverb, and tremelo capability to
permit kids to make new and exciting recordings. Ms Yak(TM) incorporates
sounds for girls with traditional Yak Bak play.
 
  In 1998, the Company expects to introduce Yak Live into the brand. Yak Live
combines the features of a Yak Bak with an interactive LCD screen allowing
children to give their Yak a personality. There are eight different characters
available that animate to forty-eight different sound effects and to
personalized recorded messages. There are also sixteen hidden animations for
the user to discover through extended play. Yak Live takes the Yak Bak brand
to the next level by adding LCD animation.
 
  Power Penz. In December 1995, the Company began shipping a new line of
functional toys under the Power Penz mark. Power Penz are a series of activity
toys that take form in a fully functional ball-point pen. In 1997 the Company
expanded the Power Penz line to include Radical Racers(TM), pens that
transform into cars;
 
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FM Rocker(TM) radio pens; Stamp'ems(TM) and Tatooz activity pens; Free
Kick(TM) and Field Goal(TM) sport pens; Handy Candy(TM) pens which have
refillable candy dispensers; and Drummin'(TM) and Jammin'(TM) musical pens.
 
  In 1998, the Company expects to extend the Power Penz brand to include
Torpedo Blast, which shoots foam darts; UpperCut boxing pens; Chillin'(TM) and
LightShow(TM) pens, which are a fan and flashlight respectively; and Robo
Penz, which are spring wound character pens.
 
  Mega Mike. Mega Mike is a voice amplification device that clips to the
child's belt, with a microphone into which children can speak. With the
addition of applause, booing, laughter and rim shot sound effects, Mega Mike
transforms children into one-man stand-up comedians.
 
AIRVECTORS
 
  YES! entered the vehicle category in 1997, introducing Air Vectors, a
vehicle with a unique point of differentiation. Air Vectors are wind-up
vehicles that self-transform and launch planes or missiles, and then
re:transform to their original structure and continue forward. The initial
vehicles were themed as racing cars, military vehicles, and off-road vehicles.
New styles have been added to enhance collectability for the consumer.
 
  In 1998, the Company plans to introduce brand extensions to expand into new
price points. Air Vectors SFX and Land Vectors SFX(TM) are intended to be
higher price point vehicles with integrated self-generated sound. Land Vectors
SFX will also launch motorcycles and other land-based vehicles in contrast to
missiles and planes. In addition, Air Vectors Command Center and Air Vectors
Super Command Center are expected to be play set introductions into the
category. These products are designed to promote interactive play with the Air
Vectors vehicles.
 
YES! EXTREME
 
  Strobes. In 1997 the Company introduced a line of high bounce balls with
impact activated strobing lights. Bounce the ball and the lights flash,
creating exciting day and night play. Strobes will continue as a non-promoted
line in 1998.
 
  Radical Air Weapons (R.A.W.)(TM). In 1997, the Company introduced a line of
toy guns that expel expanding foam balls. The line will continue in
international markets only in 1998.
 
  Yak Balls(TM) and SFX Balls(TM). These balls, with Yak Bak features built-
in, will not be continued in 1998.
 
LICENSED FOOD
 
  Mrs. Fields(R) Baking Factory. In 1996, the Company entered the children's
food products market with the introduction of the Mrs. Fields Baking Factory,
a toy oven that permits children to bake cookies, muffins and brownies using
recipes developed in conjunction with the Mrs. Fields Development Corporation.
 
  Baskin-Robbins Ice Cream Maker. In 1997, the Company introduced the Baskin-
Robbins Ice Cream Maker, which makes real ice cream using Baskin-Robbins
mixes.
 
  The Company sold the Licensed Food lines, as well as the YES! Girl line, to
Wham-O Corporation in March 1998.
 
YES! GIRL
 
  In 1997 the Company introduced Dance Studio, a portable dance instructor. It
expanded this category in late 1997 with the introductions of Cheer Leader and
Ms. Mega Mike.
 
 
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  The Company sold the YES! Girl line, as well as the Licensed Food line, to
Wham-O Corporation in March 1998.
 
OTHER PRODUCTS
 
  The Company's 1997 pre-school introductions of Music Gizmo(R), Pet
Toonies(R), and Yakkins(R) contributed to revenues in 1997 but will carry-
forward to 1998 in international markets only. The activity line Disgusting
Designs(R), a painting and arts design center, will not extend into 1998.
 
NEW CATEGORIES FOR 1998
 
  The Company has or is in the process of developing new categories of
products for 1998 that will expand the breadth of YES! product offerings and
have the potential for establishing brand awareness and product expansion
within that brand. The Company intends to differentiate the products within
these categories from the Company's major competitors to establish a niche.
Specifically in 1998, the Company expects to move into new categories of
products including interactive plush, water guns, and male action
collectibles.
 
  Interactive Plush. The Company plans to enter this high growth category with
the launch of a familiar, yet new and improved product at a value price point.
The New World of Teddy Ruxpin reintroduces the popular character with an
updated look, more durable construction, consumer friendly features, and
TV/Video interactivity. Teddy Ruxpin is also computer-ready with future CD-ROM
and Internet compatibility for introduction in 1999. An accessory TV/Video
pack that includes components to allow interaction with videos and television
will be offered, along with additional Book/Audio tape packs and
Book/Interactive Video packs. The books and tapes are both enjoyable and
educational, promoting reading, morality, and friendship.
 
  Waterguns. YES! entered the watergun category with W-3 SpeedLoader. The
Company shipped limited quantities of this product in the fourth quarter of
1997. The initial two styles have key differentiating features from current
products on the market. The guns are filled through the muzzle with a Super
Speed Refiller, which is connected to a hose. This allows rapid filling
without removing the water tank. The loading of the gun creates its own
pressure so that no pumping is necessary to dispense the water, allowing for
fast and continuous play. W-3 SpeedLoader shoots continuously over 30 feet and
shoots more water faster than conventional guns.
 
  Male Action/Collectible. At Toy Fair 1998, the Company introduced Fistful of
Aliens, a unique combination of collectible figures and game play. The figures
revolve around three alien races with different powers and a
Rock/Paper/Scissors game format. In addition to the figures, the Company has
developed Space Pods for game play and storage, weapons, and a Battleship
playset. Collectability will be enhanced by new figure introductions and
retirement of old figures. The Company is currently shipping to international
customers and will begin domestic shipments in June.
 
PRODUCT DESIGN AND DEVELOPMENT
 
  The Company combines the use of independent outside designers with internal
development efforts to develop new product lines.
 
  The Company continually evaluates new product ideas generated by a number of
outside independent designers with whom the Company communicates on a regular
basis. When the Company decides to develop a product based upon an idea
presented by an independent designer, the Company enters into a license
agreement with the designer. These license agreements typically provide for
the payment of royalties based on net sales of the new product. Such
arrangements exist for most of the Company's lines of products.
 
  A substantial portion of the Company's internal development efforts focus
primarily on further development of ideas originally submitted by independent
designers. Product design and development is a joint effort between the
Company's product development, marketing, sales and engineering groups.
 
 
                                       5
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  The Company tests product concepts and prototypes through consumer market
research techniques, including focus groups and in-home use tests. The Company
also meets with a number of retailers across the country to preview prototype
products, determine levels of interest and help refine details of the product
lines prior to production. In addition, the Company frequently previews
advertising plans, public relations plans, point-of-purchase displays,
packaging and other matters with retailers prior to production.
 
  In 1997, 1996 and 1995, the Company incurred research and development
expenses of approximately $5.5 million, $4.6 million and $2.8 million,
respectively. Substantially all of the Company's research and development
expense is spent on new product development.
 
MANUFACTURING, PRODUCTION AND DISTRIBUTION
 
  The Company's present strategy is to contract for substantially all of its
manufacturing requirements. Most of the Company's product lines are
manufactured overseas by unaffiliated contract manufacturers that have
facilities in Hong Kong and the People's Republic of China. Certain of the
Company's products and product components are manufactured in the United
States.
 
  The Company chooses manufacturers based on price, quality of merchandise,
reliability and ability to meet the Company's timing requirements for
delivery. Manufacturing commitments are made on a purchase order basis. The
Company generally has open terms with its customers. The Company has not
entered into any long-term contracts with any of its manufacturers.
 
  The Company has a group of employees located in California and Hong Kong who
supervise the Company's manufacturing contractors. These employees'
responsibilities include the establishment and ongoing development of close
relationships with the manufacturers, setting product and manufacturing
standards, performing production planning and quality assurance functions
including inspection at various stages, tracking costs, performing and/or
working with manufacturing engineering, and oversight of the manufacturing
processes. In order to source a variety of raw materials and components,
provide quality control, and administer contracts with manufacturers on
location, the Company established a subsidiary in Hong Kong, Entertainment
Products, Ltd.
 
  Management believes that its strategy to contract for substantially all
manufacturing requirements provides the Company with financial flexibility and
the most efficient use of its capital. However, since the Company does not
have its own manufacturing facilities, it is dependent on close working
relationships with its contract manufacturers for the supply and quality of
its products. These manufacturers are based in Hong Kong with manufacturing
facilities located in the People's Republic of China. The Company expects to
continue to use a limited number of contract manufacturers and accordingly
will continue to be highly dependent upon sources outside the Company for
timely production and quality workmanship. Given the highly seasonal nature of
the Company's business, any unusual delay or quality control problems of such
manufacturers, or delays in product deliveries, delays in locating or
providing new tooling to acceptable substitute manufacturers, or delays in
increasing the production of alternative manufacturers, would have a material
adverse effect on the Company's operating results and financial condition.
Foreign manufacturing is subject to a number of risks, including
transportation delays and interruptions, political and economic disruptions,
labor strikes, the imposition of tariffs and import and export controls,
changes in governmental policies, and fluctuations in currency exchange rates,
the occurrence of any of which could have a material adverse effect on the
Company's business. The Company is working with its manufacturers to ensure
timely delivery of the Company's product. However, there can be no assurance
that the manufacturers will be able to meet the Company's production
schedules.
 
  The Company maintains a quality control and quality assurance program and
has established process controls, inspection and test criteria for each of its
products. These methods are applied by the Company or its agents regularly to
product samples in each manufacturing location prior to shipment and each
shipment must pass quality control inspection. Once the products arrive in the
United States, samples are subject to spot inspection to ensure quality. The
Company's international distributors also maintain quality control programs,
 
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typically relying on an inspection agent who certifies the quality of the
products prior to their shipment from Hong Kong to the international
distributor.
 
  The Company has identified certain components in its products that its
contract manufacturers are allowed to purchase only from designated approved
suppliers in order to ensure quality. Each manufacturer submits samples from
early production runs to independent testing laboratories to determine whether
the manufacturer is producing to certified safety and product standards. On an
ongoing basis, random samples are drawn from each manufacturer for full-scale
testing.
 
  The Company's products are shipped from the point of manufacture by sea and
air transport to the Company's California distribution facility and other
locations. As a result, delivery may be subject to labor disruptions,
particularly in the maritime shipping industry, as well as to limitations on
the availability of air cargo space for the shipment of items in certain
circumstances. To date, the Company has not been materially affected by any
such disruptions or constraints. In addition, extensive reliance on air
shipment is expensive and may adversely impact the Company's profitability.
 
  At the Company's California distribution facility, the Company performs
inventory planning and management, takes delivery of products, inspects,
warehouses and ships products to its retailers' distribution points. Truck
transport is used for delivery from the Company's distribution facility to the
retailers' distribution points or designated retail locations.
 
MARKETING AND SALES
 
  YES!'s marketing budget is primarily expended for television advertising and
point-of-purchase display programs. The Company has expended a majority of its
advertising for national television spots and the production of television
commercials that support the majority of YES!'s product lines. In conjunction
with television advertising and public relations and promotions programs, the
Company also uses point-of-purchase displays to serve as the final link in a
marketing chain that educates consumers and motivates them to purchase YES!
products.
 
  Additionally, many of the Company's products benefit from the strong market
identification of its licensed characters and brands. The Company has
contracts for the licensing right to use various well-known children's
characters and consumer brands and will continue to negotiate contracts for
rights for future products. Most of these character licenses provide for
advances against future royalties, minimum guaranteed payments and a royalty
based on net sales.
 
  The Company's products are sold throughout the United States by the
Company's direct sales force and independent sales representatives to toy
retailers, toy distributors, catalog showrooms, mass merchants, department
stores and discount stores. Retailers of YES! products in 1997, 1996 and 1995
included toy retailers, such as Toys "R" Us, Inc. ("TRU") and Kay Bee Toy
Stores, and general retailers, such as Wal-Mart Stores, Inc. ("Wal-Mart"),
Target Stores, K-Mart, and Hills Stores Company, Inc.
 
  The Company's ten largest customers accounted for approximately 73%, 85% and
87% of net sales for the years ending December 31, 1997, 1996 and 1995,
respectively. For the year ended December 31, 1997, the Company's two largest
customers, TRU and Wal-Mart, accounted for 21% and 13% of net sales,
respectively. For the year ended December 31, 1996, TRU and Wal-Mart accounted
for approximately 21% and 20% of net sales, respectively, and for the year
ended December 31, 1995, the same two customers each accounted for 27% of net
sales. While the Company intends to expand distribution to new accounts, the
Company expects to continue to depend on a relatively small number of
customers for a significant percentage of its sales. Significant reductions in
sales to any one or more of the Company's largest customers would have a
material adverse effect on the Company's operating results. Because orders in
the toy industry are generally cancelable at any time without penalty, there
can be no assurance that present or future customers will not terminate their
purchase arrangements with the Company or significantly change, reduce or
delay the amount of products ordered from
 
                                       7
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the Company. Any such termination of a significant customer relationship or
change, reduction or delay in significant orders could have a material adverse
effect on the Company's operating results.
 
  In connection with the introduction of new products, many companies in the
toy industry discount prices of existing products, provide for certain
advertising allowances and credits or give other sales incentives to their
customers. In addition, in order to address such issues as working capital
requirements, sales of inventory and changes in marketing trends, many toy
companies allow retailers to return slow-moving products for credit, or if the
manufacturer lowers the prices of its products, to provide price adjustments
for inventories on hand at the time the price change occurs. The Company has
made such accommodations in the past, and expects to make accommodations such
as stock balancing, returns, other allowances or price protection adjustments
in the future. Any such accommodations by the Company in the future could have
a material adverse effect on the Company's operating results. Furthermore, in
the past certain of the Company's retail customers have delayed payment beyond
the date such payment is due. There can be no assurance that retail customers
will not delay payments in the future, which would materially impact the
Company's ability to predict its cash flow, to the detriment of the Company's
business.
 
INTERNATIONAL OPERATIONS
 
  International net sales were approximately $16.3 million, $14.9 million and
$3.8 million in 1997, 1996 and 1995, respectively, and accounted for
approximately 32%, 21% and 7% of the Company's revenue in those respective
years. International net sales increased as a percentage of total sales in
1997 primarily due to weakness in the domestic sales volume. International net
sales were substantially lower in 1995 primarily as the result of weakness in
the international economy. The Company's international products are based on
the Company's products developed for the domestic market, so that
international product development costs are minimized. Certain products which
do not extend into subsequent years domestically may carry-forward on an
international basis justifying on-going production. The Company successfully
introduced Air Vectors, R.A.W. guns and Music Gizmo internationally in 1997,
and also enjoyed continued success in the on-going YES! Gear and Power Penz
lines. The Company expects in 1998 to introduced Fistful of Aliens(TM), Yak
Live, SpeedLoader, Teddy Ruxpin, and other domestic products in the
international market.
 
  The Company sells its products internationally through a network of leading
toy distributors in their local markets. The sale through distributors
generates a lower margin than direct sale to retailers. The Company believes
it has and is continuing to develop strong relationships with its key
distributors, and that such distributors have a good reputation in, and
knowledge of, the markets they serve. The Company believes that by leveraging
the distributors' local expertise, the Company is able to generate
substantially greater international retail sales than if the Company attempted
to obtain such sales directly. In addition, local market distributors absorb a
number of the costs which the Company would otherwise bear if they utilized a
direct international effort. These include payments via letter of credit which
enhances cashflow, taking delivery in Hong Kong which saves shipping costs, as
well as absorbing warehousing and promotion of the product in their local
market. This all serves to minimize the Company's risk and capital commitments
in both the manufacture of product and the staffing of operations. The Company
has engaged a sales and marketing company to coordinate sales of the Company's
products in Europe; this agency receives a commission on all sales to European
countries.
 
  Substantially all international sales are conducted through the Company's
Hong Kong subsidiary, Entertainment Products, Ltd. are denominated in U.S.
dollars and therefore the Company has not experienced any adverse impact from
currency fluctuations to date. To the extent future sales are not denominated
in US dollars, currency exchange fluctuations in the countries where the
Company does business could materially adversely affect the Company's
business, financial condition and results of operations.
 
  Although the Company's international sales division works closely with its
foreign distributors, the Company cannot directly control such distributors'
sales and marketing activities and, accordingly, cannot manage the Company's
product sales in foreign markets. While the Company believes the distributors
to whom
 
                                       8
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the Company has granted exclusive foreign market rights are highly qualified,
all of these distributors also distribute, either on behalf of themselves or
other toy manufacturers, other product lines of toys, including product lines
of toys that may be competitive with those of the Company. There can be no
assurance that these distributors will manage effectively the sale of the
Company's products worldwide or that their marketing efforts will prove
effective. In addition, although the Company attempts to structure its
international sales in U.S. dollar denominated transactions only, certain
transactions may be denominated in the local currency. Accordingly, the
Company's international sales may be disrupted by currency fluctuations or
other events beyond the Company's control, including political or regulatory
changes. In addition, the Company's international distributors are also
subject to local rules and regulations, which can substantially affect the
profitability or ability of the Company or its international distributors to
sell the Company's products internationally.
 
PATENTS AND LICENSES
 
  Certain of the Company's product lines incorporate concepts or technologies
created by outside designers, some of which are patented. In addition, many of
the Company's products incorporate other intellectual property rights, such as
characters or brand names, that are proprietary to third parties. The Company
typically enters into a license agreement to acquire the rights to the
concepts, technologies or other rights for use with the Company's products.
Substantially all of these licenses are exclusive for the children's and youth
markets. These license agreements typically provide for the retention of
ownership of the technology, concepts or other intellectual property by the
licensor and the payment of a royalty to the licensor. Such royalty payments
generally are based on the net sales of the licensed product for the duration
of the license and, depending on the revenues generated from the sale of the
licensed product, may be substantial. In addition, such agreements often
provide for an advance payment of royalties and may require the Company to
guarantee payment of a minimum level of royalties that may exceed the actual
royalties generated from net sales of the licensed product. In the event the
minimum royalty is not achieved and the product is removed from distribution
the Company would incur an expense equal to the unearned amount. Some of these
agreements have fixed terms and may need to be renewed or renegotiated prior
to their expiration in order for the Company to continue to sell the licensed
product. Certain of the Company's licenses require that minimum performance
goals be met in order for the Company to renew or extend its licenses. The
termination or non-renewal of a key license would materially adversely affect
the Company's operating results and financial condition.
 
  In addition to rights licensed from third parties, the Company also relies
on a combination of patents, copyright, trademark and trade secret protection,
non-disclosure agreements and work-for-hire arrangements to establish and
protect the proprietary rights it has in its products. There can be no
assurance that the Company's competitors will not independently develop or
acquire patented or other proprietary technologies that are substantially
equivalent or superior to those of the Company. There also can be no assurance
that the measures adopted by the Company to protect its proprietary rights
will be adequate to do so or that the Company's products do not infringe on
third party intellectual property rights, including patents. Reverse
engineering and gray market production of successful toy products is common in
the industry. The ability of the Company's competitors to acquire technologies
or other proprietary rights equivalent or superior to those of the Company or
the inability of the Company to enforce its proprietary rights would have a
material adverse effect on the Company's operating results and financial
condition.
 
  Intellectual property matters are frequently litigated on allegations that
third party proprietary rights have been infringed. Such litigation can be
expensive and time-consuming to prosecute or defend against and, if decided
adversely to the Company, may preclude the Company from enjoining competitors
from utilizing technology or designs the Company considers proprietary or
prevent the Company from selling its products or require that the Company pay
significant and unanticipated royalties. Defending such litigation is
expensive. In addition, such lawsuits could have the effect of causing the
Company's customers to delay or cancel purchase orders until they are
resolved.
 
 
                                       9
<PAGE>
 
COMPETITION
 
  The Company's product lines span major segments both within and beyond the
scope of the traditional toy industry. Accordingly, the Company's products
compete in a number of different markets with a number of different
competitors. Market leaders from which the Company faces competition include
Mattel, Inc., Hasbro, Inc., Tiger Electronics (which recently merged with
Hasbro, Inc.) and Video Technology Industries, Inc. Product innovation,
quality, product identity through marketing and promotion, and strong
distribution capabilities are all important attributes of successful companies
in the toy industry. The Company believes that it is generally competitive
with other toy companies on these factors.
 
  In recent years, leading toy retailers have gained significant market share.
They generally feature a large selection of toys, some at discount prices, and
maintain lean inventories to reduce their inventory risk. Continued
consolidation among discount-oriented retailers can be expected to require toy
companies such as the Company to keep prices competitive and to implement and
maintain production and inventory control methods permitting these toy
companies to respond quickly to changes in demand.
 
  The toy industry is highly competitive. Most of the Company's competitors
have substantially greater assets and resources than those of the Company.
Other competitors market non-promoted products that compete with the Company
on the basis of price. Some of these products are competitive with those of
the Company, which supports its sales with advertising and therefore
necessitates higher price points. The relatively low barriers to entry into
the toy industry and the limited proprietary nature of many toy products also
permit new competitors to enter the industry easily. As a result, successful
new products or product concepts often are duplicated and offered to the
Company's customers and through other channels of distribution at lower prices
than the Company may be required to charge to recapture product development
and marketing expenses. Certain companies have already introduced, and the
Company anticipates other companies will introduce toys and published products
that compete with the Company's existing and new products. Such competition
has forced in the past, and may force in the future, price reductions, which
would adversely affect the Company's operating results and financial
condition.
 
GOVERNMENT AND INDUSTRY REGULATION
 
  The Company is subject to the provisions of the Federal Hazardous Substances
Act and the Federal Consumer Product Safety Act. Those laws empower the
Consumer Product Safety Commission to protect children from hazardous toys and
other articles. The Consumer Product Safety Commission has the authority to
exclude from the market articles which are found to be hazardous and can
require a manufacturer to repurchase such toys under certain circumstances. In
the pre-production stages and periodically thereafter, the Company sends
sample toys to independent laboratories to test for compliance with the
Consumer Product Safety Commission's rules and regulations, as well as with
the voluntary product standards of the Toy Manufacturers of America. Similar
laws exist in specific jurisdictions within the United States as well as in
certain foreign countries. The Company designs its products to exceed the
highest safety standards imposed either by government or industry regulatory
authorities. In the event that the Company violates any governmental or
voluntary rule or regulation, sale of the offending product could be enjoined.
 
  Certain of the Company's products may also be subject to other government
rules and regulations. There can be no assurance that the Company may not be
required to obtain government approval for other products in the future, that
such approval can be obtained, or that seeking such approvals will not result
in delays in product introductions.
 
EMPLOYEES
 
  As of March 31, 1998, the Company had a total of 117 employees, of whom 64
were based in the United States and 53 were based in Hong Kong. The Company is
staffed in the functions necessary to operate a
 
                                      10
<PAGE>
 
successful business in the toy industry, including product development,
marketing, sales, management of outside functions and internal operations. The
Company intends to keep overhead low and utilize outside resources whenever
practical.
 
  None of the Company's employees is represented by a collective bargaining
arrangement, nor has the Company ever experienced any work stoppage. The
Company believes that its relations with its employees are good.
 
  The Company's future success will depend to a significant extent on the
efforts of the key management personnel, including Donald D. Kingsborough, the
Company's Chairman and Chief Executive Officer, and other key employees. The
loss of one or more of these employees could have a material adverse effect on
the Company's business. In addition, the Company believes that its future
success will depend in large part on its ability to attract and retain highly
qualified management, operations and sales personnel. There can be no
assurance that the Company will be able to attract and retain the employees it
needs to in order to ensure its success.
 
ITEM 2. PROPERTIES
 
  The Company leases all of its facilities, including executive offices of
17,335 square feet in Pleasanton, California, warehouse space of 84,000 square
feet in Hayward, California and a showroom of 8,300 square feet in New York,
New York. The Company's wholly-owned Hong Kong subsidiary leases approximately
4,500 square feet of office space in Kowloon, Hong Kong. The Company believes
that suitable space will be available on reasonable terms should the Company
require additional space. In 1997, the Company's total rent expense was $1.3
million. The manufacturing facility consisting of 6,700 square feet in Carson,
California was closed permanently in February 1998.
 
  The Company's management information system is based on an IBM AS400
computer and personal computers running commercially available software. The
Company believes this information system is adequate to meet the Company's
business needs for the foreseeable future, as enhanced by available
technology. See Part II, Item 7 "Impact of Year 2000."
 
ITEM 3. LEGAL PROCEEDINGS
 
  The Company is involved from time to time in litigation incidental to its
business. The Company believes that none of its pending litigation matters,
individually or in the aggregate, will have a material adverse effect on the
Company's operating results or financial condition. See also Note 13 to the
Financial Statements.
 
ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS
 
  There were no matters submitted to a vote of security holders during the
fourth quarter of fiscal 1997.
 
                                      11
<PAGE>
 
                                    PART II
 
ITEM 5.  MARKET FOR REGISTRANT'S COMMON EQUITY AND RELATED STOCKHOLDER MATTERS
 
  The Company's Common Stock is quoted on the Nasdaq National Market under the
trading symbol "YESS." The Company's Common Stock is not listed or quoted on
any other quotation system or securities exchange. The following table sets
forth the range of quarterly low, high and closing sale prices of the Common
Stock on the Nasdaq National Market for the quarter ended March 31, 1998 and
fiscal years ended 1997 and 1996. The Company has not paid cash dividends and
has no present plans to do so. At March 31, 1998, there were approximately 237
holders of record of the Company's Common Stock.
 
<TABLE>
<CAPTION>
                                                    PRICE RANGE OF
                                                     COMMON STOCK
                                                    -----------------------
                                                    LOW      HIGH     CLOSE
                                                    ---      ----     -----
   <S>                                              <C>      <C>      <C>
   Fiscal year 1998:
     First Quarter................................. $  27/32 $ 2 1/2  $   7/8
   Fiscal year 1997:
     First Quarter................................. $4 9/16  $ 7 3/16 $ 4 3/4
     Second Quarter................................ $2 5/8   $ 4 7/8  $ 4 7/64
     Third Quarter................................. $ 3      $ 5 5/8  $ 5 5/8
     Fourth Quarter................................ $1 3/16  $ 5 1/2  $ 1 27/32
   Fiscal year 1996:
     First Quarter................................. $ 6      $10 1/4  $ 9 3/8
     Second Quarter................................ $9 1/8   $16 7/8  $14 3/4
     Third Quarter................................. $9 3/8   $15 3/8  $14 1/4
     Fourth Quarter................................ $5 5/8   $ 15     $ 6 7/16
</TABLE>
 
  On March 31, 1998, the last sale price for the Common Stock reported on the
Nasdaq National Market was $0.875 per share.
 
 
                                      12
<PAGE>
 
ITEM 6. SELECTED CONSOLIDATED FINANCIAL DATA
 
  The following selected statement of operations data for each of the five
years in the period ended December 31, 1997 are derived from financial
statements of the Company.
 
<TABLE>
<CAPTION>
                                          YEAR ENDED DECEMBER 31,
                                -----------------------------------------------
                                  1997      1996     1995      1994      1993
                                --------  --------  -------  --------  --------
                                  (DOLLARS IN THOUSANDS, EXCEPT PER SHARE
                                                   DATA)
<S>                             <C>       <C>       <C>      <C>       <C>
STATEMENT OF OPERATIONS DATA:
Net sales.....................  $ 50,858  $ 69,699  $55,673  $ 36,379  $ 25,931
Operating income (loss).......   (35,852)  (11,688)   4,989   (19,920)  (20,472)
Net income (loss).............   (38,201)  (12,571)   3,478   (21,927)  (20,964)
Net income (loss) applicable
 to common shareholders.......   (42,071)  (12,571)  (3,478)  (21,927)  (20,964)
Pro forma net loss per
 share(1)(2)..................        --        --       --     (5.08)       --
Basic earnings (loss) per
 share applicable to common
 shareholders.................     (2.90)    (0.91) $  0.65        --        --
Shares used in computing pro
 forma net loss per share(1)..        --        --       --     4,319        --
Shares used in computing Basic
 earnings (loss) per share(1).    14,529    13,890    5,339        --        --
Diluted earnings (loss) per
 share........................     (2.90)    (0.91) $  0.41        --        --
Shares used in computing
 diluted earnings (loss) per
 share........................    14,529    13,890    8,534        --        --
BALANCE SHEET DATA:
Cash and cash equivalents(3)..       624     1,572    2,987     2,558     2,462
Working capital...............      (143)   25,934   25,671     5,083     8,529
Total assets..................    32,495    61,269   48,870    29,657    29,591
Convertible Debenture.........     1,741        --       --        --        --
Redeemable convertible
 preferred stock..............     8,500        --       --    49,339    30,469
Total shareholders' equity
 (deficit)....................  $  3,617  $ 30,065  $28,584  $(42,570) $(21,028)
</TABLE>
--------
(1) See Note 1 of Notes to Consolidated Financial Statements for an
    explanation of the number of shares used in computing per share amounts.
    The loss per share data in 1993 is not presented as the period was prior
    to the Company's initial public offering.
(2) The Company has not paid any cash dividends in any of the years presented.
(3) Excludes approximately $1.3 million and $5.4 million of restricted cash
    which collateralized outstanding trade letters of credit at December 31,
    1994 and 1993, respectively. At December 31, 1997, 1996 and 1995, there
    was no restricted cash collateralizing outstanding letters of credit.
 
 
                                      13
<PAGE>
 
ITEM 7.  MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND
         RESULTS OF OPERATIONS
 
  This Management's Discussion and Analysis of Financial Condition and Results
of Operations includes certain forward looking statements about the Company
that are based on current expectations. Actual results may differ materially
as a result of any one or more of the risks identified in this section, as
well as in the section captioned "Business Factors."
 
OVERVIEW
 
  YES! Entertainment Corporation was founded in September 1992 to develop,
manufacture and market a variety of toys and other children's entertainment
products, including a variety of interactive products. The Company's strategy
is to use innovative technology to design products that are fun for children
and build on their natural creativity.
 
  The Company has achieved cumulative net sales of approximately $239 million
through December 31, 1997, although it had an accumulated deficit as of
December 31, 1997 of approximately $94.7 million. In 1995, the Company was
able to secure financing to ensure that its products were introduced in time
to take advantage of the holiday selling season. In 1996, the Company's
financial results were adversely affected by a number of issues, including a
weak retail environment which caused retailers to defer orders and later than
anticipated shipment of the Company's V-Link product, compounded in part by
the voluntary suspension of V-Link shipments pending resolution of market
approval issues from the Federal Communications Commission. In 1997, the
Company's financial results were severely impacted by discounts and
allowances, and write-offs of obsolete and slow-moving inventory and royalty
advances. A large portion of these write-downs related to the V-Link and
T.R.A.P.s product lines, which were discontinued in 1997. The Company also
experienced sales shortfalls due to declining shipments in its YES! Gear
category compared to the prior year, and disappointing results in several of
its new product introductions, specifically the Pre-School and YES! Extreme
categories.
 
  The production and shipment of the Company's 1998 products is subject to a
number of risks, and there can be no assurance that the Company will be able
to complete the development, tooling, manufacture or successful marketing of
its 1998 products. This risk is compounded by the large number of new products
the Company is introducing in 1998, including Air Vectors SFX, Yak Live, and
Teddy Ruxpin, each of which is still in the developmental stage and which
involves complicated development and tooling issues. Teddy Ruxpin and Yak Live
are not expected to ship until late in the third quarter, and in the event
there is a delay in the final development, tooling, production or transport of
these products, they may not ship until even later in the year, if at all,
which could have a material adverse impact on the Company.
 
  The Company constantly evaluates the toy markets and its development and
manufacturing schedules. As the year progresses, the Company may elect to
reduce the number of products it currently plans to ship in 1998 for a variety
of reasons, which include but are not limited to more accurate evaluation of
demand, supply and manufacturing difficulties, or competitive considerations.
Similarly, the Company may add products to its 1998 line either by
accelerating development schedules or strategic acquisitions of current
product lines. Reducing or adding products from and to the Company's line may
have an impact on the Company's financial performance depending on, among
other things, the price points, advertising and promotional support for and
development, tooling and manufacturing costs of such products, relative to
products they replace or are replaced by, as the case may be, as applicable.
 
  The Company experienced a severe revenue shortfall in 1997 and was not able
to adjust its overhead to compensate for the effect of the shortfall. The
Company was also forced to take significant write-downs to recognize market
factors relating to products already shipped with slow retail sell-through, as
well as items in the Company's inventory which needed to be sold or written
down below cost. The Company also incurred write-offs relating to royalty
advances for product which it never introduced to the market or removed from
distribution prior to achieving the guaranteed minimum royalty.
 
                                      14
<PAGE>
 
RESULTS OF OPERATIONS
 
  The following table sets forth certain items from the Company's statement of
operations for the years ended December 31, 1997, 1996 and 1995, and the
relevant percentage of net sales represented by certain income and expense
items:
 
<TABLE>
<CAPTION>
                                      YEARS ENDED DECEMBER 31,
                          ------------------------------------------------------
                                1997               1996              1995
                          -----------------  -----------------  ----------------
                           AMOUNT   PERCENT   AMOUNT   PERCENT  AMOUNT   PERCENT
                          --------  -------  --------  -------  -------  -------
                                       (DOLLARS IN THOUSANDS)
<S>                       <C>       <C>      <C>       <C>      <C>      <C>
Net sales...............  $ 50,858   100.0%  $ 69,699   100.0%  $55,673   100.0%
Cost of sales...........    46,817    92.1     42,624    61.2    26,623    47.8
                          --------   -----   --------   -----   -------   -----
Gross profit............     4,041     7.9     27,075    38.8    29,050    52.2
OPERATING EXPENSES
Marketing, advertising &
 promotion..............     8,124    16.0     13,192    18.9     6,423    11.5
Selling, distribution &
 administrative.........    31,769    62.5     25,571    36.7    17,638    31.7
                          --------   -----   --------   -----   -------   -----
Total operating
 expenses...............    39,893    78.4     38,763    55.6    24,061    43.2
                          --------   -----   --------   -----   -------   -----
Operating income (loss).   (35,852)  (70.5)   (11,688)  (16.8)    4,989     9.0
Interest income.........        69     0.1        264     0.4        69     0.1
Interest expense........    (2,245)   (4.4)    (1,039)   (1.5)   (1,321)   (2.4)
Other expense, net......      (173)   (0.3)      (108)   (0.1)      (74)   (0.1)
                          --------   -----   --------   -----   -------   -----
Income (loss) before
 provision for income
 taxes..................   (38,201)  (75.1)   (12,571)  (18.0)    3,633     6.5
Provision for income
 taxes..................        --      --         --      --       185     0.3
                          --------   -----   --------   -----   -------   -----
Net income (loss).......  $(38,201)  (75.1)% $(12,571)  (18.0)% $ 3,478     6.2%
                          ========   =====   ========   =====   =======   =====
</TABLE>
 
  The Company's anticipated fourth quarter loss was negatively impacted by
significant charges of approximately $17.2 million relating to discounts and
allowances ($8.1 million), inventories ($7.4 million), and royalty advances
($1.7 million). The Company began 1997 with significant inventories, both raw
material and finished goods, related to V-Link. The Company had built its
inventory position based on anticipated sales, but experienced a sales
shortfall due to later than anticipated shipments and a sales interruption in
December 1996 due to FCC approval issues. The Company expected to re-launch
the product in the second half of 1997, but did not receive strong retail
support. A retail test of the product at Thanksgiving 1997 showed
disappointing results and the Company was forced to discount products already
in the market. The Company has written down inventory to the lower of cost or
market, and has since sold the majority of its finished goods inventory. All
V-Link raw materials have been written off. Other significant write-offs of
inventory and royalty advances are related to the Company's T.R.A.P.s product
line, which has been discontinued.
 
  The Company also did not anticipate the low level of orders in the fourth
quarter for its products that were performing well at retail. The Company
regularly relies on sell through information collected by the Company to serve
as one of a number of factors in estimating anticipated sales volumes.
Customers did not place orders in quantities which were expected based upon
sell through information available to the Company. This is indicative of
retailers' increased reliance on just-in-time inventory practices that shifts
risk of weak sales to the manufacturer, which must produce inventory prior to
actual sales results.
 
  The Company expects its business will remain highly seasonal, and difficult
to predict.
 
 
                                      15
<PAGE>
 
NET SALES
 
  The Company's worldwide net sales were $50.9 million in 1997, $69.7 million
in 1996, $55.7 million in 1995 and $36.4 million in 1994. Products introduced
in 1995 accounted for 9%, 35% and 45% of worldwide sales in 1997, 1996 and
1995, respectively. Products introduced in 1996 accounted for 38% and 54% of
worldwide sales in 1997 and 1996, respectively. Products introduced in 1997
accounted for 46% of the Company's worldwide sales in 1997. In 1997, net sales
of products introduced in 1997 were $23.4 million and net sales of products
introduced before 1997 declined from $69.7 million in 1996 to $27.5 million.
In 1996, net sales of products introduced in 1996 were $37.8 million, and
sales of products introduced before 1996 declined from $55.7 million in 1995
to $31.9 million. In 1995, net sales of products introduced in 1995 were $25.1
million and sales of products introduced before 1995 declined from $36.4
million in 1994 to $30.6 million. The Company expects that newly introduced
products will continue to account for a significant percentage of sales in the
year they are introduced as the result both of expanding sales and the decline
in sales of earlier products due to the relatively short life cycles of many
products in the toy industry.
 
  Domestic net sales were $34.6 million in 1997, compared to $54.8 million in
1996 and $51.9 million in 1995. The decrease in 1997 compared to 1996 was
attributable to the decline in the YES! Gear category as compared to prior the
year and the disappointing results of several new product categories. The
Company also experienced a significantly higher discount and allowance
percentage which serves to decrease net sales. The Company also had difficulty
in getting its full line of products into distribution at the major retailers,
which negatively impacted sales and the Company's ability to execute effective
advertising programs. The slight increase in 1996 over 1995 was attributable
to the introduction of a number of new product lines and products in 1996 and
was offset in part by lower than expected domestic sales in the fourth quarter
of 1996, and the decrease in unit sales and average selling price of the
Company's older product lines.
 
  The Company's Yak Bak and Power Penz product lines together accounted for a
significant percentage of the Company's sales in 1997, 1996 and 1995,
comprising 51%, 72% and 50% thereof, respectively. In 1997, 1996 and 1995, the
Company's Yak Bak items accounted for approximately 25%, 46% and 47% of the
Company's sales, respectively. The Company's Power Penz products accounted for
26%, 22% and 3% of the Company's sales in 1997, 1996 and 1995, respectively,
following the introduction of the Power Penz in 1995. The sales volume in
Power Penz shifted to a higher percentage of international. In addition, in
1996 the Company sold a number of Yak Bak and Power Penz products together;
these sales accounted for approximately 4% of the Company's 1996 net sales.
The Licensed Food category including Mrs. Fields and Baskin Robbins accounted
for approximately 19% and 7% of the company's sales in 1997 and 1996,
respectively. In March 1998, the Company sold the Licensed Food category and
its YES! Girls line. No other product line accounted for more than 10% of the
Company's sales in 1997 or 1996, although one product line, Comes To Life
Books(TM), accounted for 17% of the Company's sales in 1995. Although the
Company expects that its revenue base will be less concentrated on any one
line of products in 1998 as compared to previous years, the Company expects
that YES! Gear, in particular the Yak Bak items, and the Power Penz will
continue to account for a significant portion of the Company's revenues in
1998.
 
  International net sales were $16.3 million in 1997 compared with $14.9 in
1996 and $3.8 million in 1995. International sales were substantially higher
in 1997 than 1996 due to the significant growth in the European market. The
Company was successful in establishing a strong European network, as well as
diversifying its Pacific Rim distribution from its major concentration in
Japan into other Asian markets. Sales to distributors in Pacific Rim countries
comprised a substantial portion of the Company's 1997 international sales. The
Company expects that growth in 1998 will come primarily from new product
introductions. International sales represented 32% of worldwide sales in 1997,
and 21% and 7% of worldwide sales in 1996 and 1995, respectively.
 
  The Company recognizes revenue upon shipment of product and computes net
sales by concurrently deducting for sales returns and allowances, including
allowances for defective returns, price protection, mark downs and other
returns. Sales allowances may vary as a percentage of gross sales due to
changes in the Company's product mix, defective product allowances or other
sales allowances.
 
                                      16
<PAGE>
 
  The Company is dependent on a relatively small number of customers, in
particular TRU and Wal-Mart, for a significant percentage of its sales.
Significant reductions in sales to any one or more of the Company's largest
customers would have a material adverse effect on the Company's operating
results. Because orders in the toy industry are generally cancelable at any
time without penalty, there can be no assurance that present or future
customers will not terminate their purchase agreements with the Company or
significantly change, reduce or delay the amount of products ordered from the
Company. Any termination of a significant customer relationship or change,
reduction or delay in significant orders would have a material adverse effect
on the Company's operating results.
 
  The Company relies exclusively on foreign distributors to market and sell
the Company's products outside the United States. Although the Company's
international sales personnel work closely with its foreign distributors, the
Company cannot directly control such entities' sales and marketing activities
and, accordingly, cannot directly manage the Company's product sales in
foreign markets. In addition, the Company's international sales may be
disrupted by currency fluctuations or other events beyond the Company's
control, including political or regulatory changes.
 
COST OF SALES
 
  Cost of sales were approximately $46.8 million, $42.6 million and $26.6
million in 1997, 1996 and 1995, respectively. Cost of sales were approximately
92%, 61% and 48% of net sales in 1997, 1996 and 1995, respectively. The
increase in cost of sales in 1997, in absolute dollars was due primarily to
the write-down of slow moving and obsolete inventory ($7.4 million) partially
offset by the decrease in sales volume and its related impact on cost of sales
($3.8 million). The write-offs related primarily to raw materials, work-in-
progress, and finished goods for the Company's V-Link and T.R.A.P.s product
lines, which were discontinued. The increase as a percentage of sales is due
to the significant number of products sold at significant discounts during the
year and the write-off of inventories to lower of cost or market. In addition,
the higher percentage of international sales, which have lower associated
gross margins, had an impact on the overall percentage. International prices
are lower than domestic prices because the purchaser is responsible for the
cost of importing and promotion of the product.
 
  The increase in cost of sales in absolute dollars in 1996 from 1995 was
$16.0 million. The increase in cost of sales in 1996, in absolute dollars, was
the result of increased sales volume ($14.2 million), an increase in inventory
write-downs, primarily as a result of lower than expected sales in the fourth
quarter of 1996 ($2.3 million), and an increase in other costs of sales
($463,000) offset by lower product costs ($1.0 million). In addition to the
foregoing, the increase in cost of sales as a percentage of sales in 1996 from
1995 was also due to an increase in the provision for sales returns and
allowances in relation to sales as a result of lower than expected retail
sales in the fourth quarter, reduced selling prices, and a higher percentage
of international sales, which have lower associated gross margins as a result
of product prices which are lower than domestic prices due to lower operating
expenses and competitive factors.
 
FOURTH QUARTER ADJUSTMENTS
 
  During the fourth quarter of 1997, the Company recorded write-downs of
inventory of $7.4 million, and recorded additional discounts and allowances of
$8.1 million. This compares to write-downs of $2.9 million and $2.3 million
respectively in the fourth quarter of 1996. The Company also incurred write-
downs related to royalty advances of $1.7 million. The write-down in 1997
related to slow-moving inventory and lower of cost or market write-offs
regarding inventory, and increased discounts for slow retail sell-through of
the Company's product lines. Royalty advance write-downs were related to
discontinued products. The Company recognized these discounts and allowances
and write-downs in the fourth quarter when it determined that retail sell-
through was not strong enough to move the products through the retail channel
at its normal price structure, and that products would not be continued into
subsequent years.
 
 
                                      17
<PAGE>
 
OPERATING EXPENSES
 
<TABLE>
<CAPTION>
                                           YEARS ENDED DECEMBER 31,
                                -----------------------------------------------
                                     1997            1996            1995
                                --------------- --------------- ---------------
                                AMOUNT  PERCENT AMOUNT  PERCENT AMOUNT  PERCENT
                                ------- ------- ------- ------- ------- -------
<S>                             <C>     <C>     <C>     <C>     <C>     <C>
Marketing, advertising &
 promotion..................... $ 8,124  16.0%  $13,192  18.9%  $ 6,423  11.5%
Selling, distribution &
 administrative................  31,769  62.5    25,571  36.7    17,638  31.7
                                -------  ----   -------  ----   -------  ----
  Total operating expenses..... $39,893  78.4%  $38,763  55.6%  $24,061  43.2%
                                =======  ====   =======  ====   =======  ====
</TABLE>
 
  Operating expenses increased by $1.1 million in 1997 from 1996. The net
increase in 1997 was due to significantly higher selling, distribution and
administrative expenses which were offset by reduced marketing, advertising,
and promotion expenses. The increase in selling distribution and
administrative expenses was primarily due to royalty advance write-downs,
legal expenses, and increased cost of production. Operating expenses in 1996
increased by $14.7 million from 1995. The increase in 1996 was primarily the
result of higher variable expenses associated with higher sales and higher
fixed and marketing expenses required to support new product introductions and
expected higher sales volume. Operating expenses as a percentage of net sales
increased to 78% in 1997 as compared to 56% in 1996 and 43% in 1995. The
increase in 1997 as compared to 1996 was primarily the result of a significant
shortfall in expected net sales. The increase in 1996 as compared to 1995 was
primarily the result of a significant shortfall in expected net sales in the
fourth quarter of 1996.
 
  A significant portion of the Company's operating expenses are fixed and do
not vary with sales. Consequently, if sales volumes fall below expectations,
the Company's financial results are likely to be materially adversely
affected.
 
  Marketing, Advertising and Promotion. Marketing, advertising and promotional
expenses decreased $5.1 million in 1997 from 1996 to a total of $8.1 million,
due to the Company's inability to obtain full distribution of its product
lines into the major retailers. Because it was unable to achieve full
distribution, the Company reduced its spending in the areas of co-op
advertising and media. Marketing, advertising and promotional expenses
increased $6.8 million in 1996 from 1995. This increase was to promote retail
sales at expected volumes which substantially exceeded actual sales in the
fourth quarter of 1996.
 
  Selling, Distribution and Administrative. Selling, distribution and
administrative expenses increased $6.2 million in 1997 from 1996 to a total of
$31.8 million, and increased as a percentage of sales to 62.5% from 37% for
the comparable periods. The increase in absolute dollars was the result of
higher production costs, including tooling amortization, of $1.2 million;
increased royalty expense due to the write-down of royalty advances of $2.6
million; higher product development expense of $900,000; increased sales
expense due to a greater percentage of independent sales representatives and
retail sales mix of $773,000; and an increase in legal expenses, due mainly to
litigation, trademark, and licensing costs, of $766,000. The increase as a
percentage of sales was due to a significantly lower sales base, write-downs,
and the Company's fixed overhead structure not adjusting to meet the lower
sales volume.
 
  Selling, distribution and administrative expenses increased $7.9 million in
1996 from 1995 to a total of $25.6 million, and increased as a percentage of
sales to 37% from 32% for the comparable periods. The increase in absolute
dollars resulted from higher variable expenses associated with higher sales
volume, including an increase of $319,000 for outbound freight, $1.5 million
for royalty expense, and $356,000 for customer service and distribution, in
addition to higher costs required to support expected higher sales volumes,
including increases of $669,000 for operations support, $1.8 million for
product development, $1.3 million for sales expense, and $1.4 million for
general and administrative expenses. The increase in 1996 as a percentage of
sales was due to higher fixed expenses incurred in anticipation of greater
sales volume in the fourth quarter of 1996 than occurred, offset in part by
the Company's ongoing efforts to maintain low fixed expenses.
 
                                      18
<PAGE>
 
INTEREST EXPENSE
 
  The following table shows interest expense and interest income for the
applicable periods:
 
<TABLE>
<CAPTION>
                                        YEARS ENDED DECEMBER 31,
                             ----------------------------------------------------
                                  1997              1996              1995
                             ----------------  ----------------  ----------------
                             AMOUNT   PERCENT  AMOUNT   PERCENT  AMOUNT   PERCENT
                             -------  -------  -------  -------  -------  -------
                                         (DOLLARS IN THOUSANDS)
<S>                          <C>      <C>      <C>      <C>      <C>      <C>
Interest income............. $    69    0.1%   $   264    0.4%   $    69    0.1%
Interest expense............ $(2,245)  (4.4)%  $(1,039)  (1.5)%  $(1,321)  (2.4)%
</TABLE>
 
  Interest expense increased by $1.2 million in 1997 from 1996. This increase
was primarily the result of increased borrowing under the Company's credit
facility for working capital purposes, and an increase of $790,000 related to
discounts incurred on the convertible debentures issued by the Company in
March 1997, which were cancelled in exchange for convertible debentures issued
in July 1997, the aggregate principal amount of which was $1,927,000 as of
December 31, 1997. Interest expense decreased by approximately $282,000 in
1996 from 1995. This decrease was largely due to decreased borrowing under the
credit facility due to higher cash balances maintained by the Company during
the first half of 1996. The Company expects interest expense to decrease in
1998 due to decreased reliance on borrowings under the Company's credit
facility and due to the debenture discounts not recurring in 1998.
 
OTHER EXPENSE, NET
 
  The increase in other expense, net in 1997 from 1996 was $65,000 and was due
primarily to foreign currency exchange losses and administrative costs
incurred in connection with the Company's line of credit. The decrease in
other expense, net in 1996 from 1995 was $34,000.
 
INCOME TAXES
 
  The Company had no income tax provision for 1997 or 1996, as the Company had
pre-tax losses of $38.2 million and $12.6 million, respectively. The Company's
provision for income tax for 1995 of $185,000 represented an effective tax
rate of five percent and was solely attributable to federal and state and
foreign income taxes.
 
  At December 31, 1997, the Company had net operating loss carryforwards for
federal and California tax purposes of approximately $58.0 million and $27.0
million, respectively. The federal losses will expire in the years 2008 though
2013, and the state losses will expire in the years 1999 through 2003, if not
utilized. Utilization of the net operating loss carryovers may be subject to a
substantial annual limitation if it should be determined that there has been a
change in the ownership of more than 50 percent of the value of the Company's
stock, pursuant to Section 382 of the Internal Revenue Code of 1986 and
similar state provisions. The annual limitation may result in the expiration
of net operating loss carryovers before utilization. See Note 10 of Notes to
Consolidated Financial Statements.
 
SEASONALITY
 
  The Company's business continues to be highly seasonal, with a majority of
shipments to retailers occurring during the last five months of the year. The
Company's operating results have varied significantly in the past, and are
expected to vary in the future, from quarter to quarter. The Company expects
that a majority of its product will ship in the third and fourth quarters, and
a substantial portion of its accounts receivable will be collected in the
fourth and first quarters. The effect of seasonality, common in the toy
industry, has been exaggerated in the Company's case because of the
introduction of the Company's new product lines which represented a
significant portion of the Company's net sales in the third and fourth
quarters of 1997, 1996 and 1995. In 1997 and 1996, seasonality was compounded
by the poor retail environment during the respective holiday season that
caused retailers to not place reorders in the quantities expected.
 
                                      19
<PAGE>
 
  The following table shows the net sales of the Company for each of the past
twelve quarters:
 
                             NET SALES BY QUARTER
 
<TABLE>
<CAPTION>
                                              YEARS ENDED DECEMBER 31,
                                    --------------------------------------------
                                         1997           1996           1995
                                    -------------- -------------- --------------
                                    AMOUNT PERCENT AMOUNT PERCENT AMOUNT PERCENT
                                    ------ ------- ------ ------- ------ -------
                                               (DOLLARS IN THOUSANDS)
   <S>                              <C>    <C>     <C>    <C>     <C>    <C>
   March 31........................ $ 9.0     18%  $ 8.9     13%  $ 5.7     10%
   June 30.........................  12.6     25    11.6     17     4.7      9
   September 30....................  17.8     35    29.6     42    18.6     33
   December 31.....................  11.5     22    19.6     28    26.7     48
                                    -----    ---   -----    ---   -----    ---
     Total......................... $50.9    100%  $69.7    100%  $55.7    100%
                                    =====    ===   =====    ===   =====    ===
</TABLE>
 
  Because of the highly seasonal nature of the Company's business, the Company
may not be able to accurately predict retailer order trends, given that many
retailers make final reorder decisions in the fourth quarter, and often after
the date by which the Company must make manufacturing commitments to build
inventory in anticipation of retailer demand. This accounted for the
percentage decrease in fourth quarter shipments in 1997 from 1996.
 
  In addition, most of the Company's most significant customers have adopted
inventory management systems to track sales of particular products and rely on
reorders being filled rapidly by suppliers, rather than maintaining large on-
hand inventories to meet consumer demand. While these systems reduce a
retailer's investment in inventory, they increase pressure on suppliers like
the Company to fill orders promptly and shift a significant portion of
inventory risk to the supplier. The Company may also be required to incur
substantial additional expense to fill late reorders in order to ensure the
product is available at retail prior to Christmas; these may include drop-
shipment expense and higher advertising allowances which would otherwise be
born by the Company's customers.
 
LIQUIDITY AND CAPITAL RESOURCES
 
  At December 31, 1997, the Company had cash and cash equivalents of
approximately $624,000, a decrease of $1.0 million from approximately $1.6
million at December 31, 1996. This decrease in cash and cash equivalents was
due to $300,000 provided by operating activities and $3.3 million provided by
financing activities, offset by $4.5 million used in investing activities.
 
  Cash generated by operating activities was primarily the result of the
Company's net loss of $38.2 million, a decrease in inventory of $12.7 million,
a decrease in prepaid expenses, royalties, and other current assets of $4.4
million, an increase in accounts payable and accrued liabilities of $3.5
million, a decrease in accounts receivable of $13.3 million, depreciation and
amortization of $3.2 million, and advertising expenses funded by inventory of
$614,000.
 
  Cash used in investing activities was primarily for the acquisition of
tooling and other equipment of $4.6 million.
 
  Cash provided by financing activities was due primarily to the proceeds from
the issuance of preferred stock and convertible debentures in the amount, net
of cash, of approximately $9.3 million, which was offset in part by net pay
downs of approximately $6.0 million of the Company's line of credit.
 
  In March 1998, Company sold its Licensed Food line, including its Mrs.
Fields Baking Factory and Baskin-Robbins Ice Cream Maker products, and its
girls activity business unit, including its Dance Studio and Cheer Leader
products, to Wham-O, Inc. The total purchase price included $9.8 million in
cash for purchase of the lines and related inventory, a contingency payment of
up to $2.5 million to be earned based upon certain
 
                                      20
<PAGE>
 
performance criteria for the food line in the first year, royalties of up to
$5.5 million over a seven year period and an allocation of $50,000 of such
purchase price to Donald Kingsborough as compensation for his agreement to a
noncompete provision in the asset purchase agreement.
 
  Since its inception, the Company's internally generated cash flow has not
been sufficient to finance trade receivables, inventory, capital equipment
requirements and new product development, or to support operations. The
Company has met its capital requirements to date primarily through the initial
public offering of the Company, which generated net proceeds to the Company of
approximately $10.9 million, the exercise of IPO Warrants which generated
approximately $19.7 million, the private sales of approximately $50.0 million
of equity securities, borrowings of $2.0 million of long-term convertible
subordinated notes (now repaid), borrowings under short term loans from
certain stockholders, borrowings under bank loans guaranteed by certain
shareholders, borrowings under a factoring agreement with a group of banks,
borrowings under a Loan and Security Agreement with Congress Financial
Corporation Western (now repaid), and borrowings under an Accounts Receivable
Management and Security Agreement entered into with BNY Financial Corporation
in July 1995, as amended (the "ARM Agreement"). In addition, in the first
quarter of 1997, the Company raised net proceeds of approximately $9.3 million
from the sale of convertible debentures, preferred stock and warrants and
satisfied trade debt of $3.1 million by issuing common stock to several of its
vendors .
 
  To meet seasonal working capital requirements during 1998, the Company
anticipates borrowing substantial amounts under the ARM Agreement. The terms
of the ARM Agreement, as amended, provide that BNY Financial Corporation may
advance YES! up to $30 million on the basis of the Company's accounts
receivable, inventory and product being imported on a letter of credit basis.
Loans to the Company are fully secured by all of the Company's assets,
including intellectual property, and BNY acquired ownership of all of the
Company's trade receivables. The Company is required to remain in compliance
with certain financial and other covenants under the ARM Agreement. As of
December 31, 1997, the Company was required to maintain a monthly quick ratio
of 1:1 under the ARM Agreement. The ratio at December 31, 1997 was 0.5:1 and
the Company obtained a waiver for the month of December 1997 with regard to
the quick ratio requirement. Since the month ended December 31, 1997, BNY
Financial Corporation and the Company have amended the ARM Agreement to
require that a monthly quick ratio of 0.5:1 be maintained for the quarter
ending March 31, 1998, which ratio shall decrease to 0.4:1 as of June 30, 1998
and increase to 0.5:1 thereafter. As of December 31, 1997, the ARM Agreement
required that a ratio of earnings calculated before interest, taxes,
depreciation and amortization to total interest expense of 5:1 on a
retrospective rolling four quarter basis be maintained. The Company recorded a
loss before interest, taxes, depreciation and amortization for the four
quarters ended December 31, 1997. The Company has obtained a waiver from BNY
with regard to this covenant for the fourth quarter of 1997. Since the month
ended December 31, 1997, BNY Financial Corporation and the Company have
amended the ARM Agreement to require that a ratio of earnings calculated
before interest, taxes, depreciation and amortization to total interest
expense of 5:1 on a prospective rolling four quarter basis be maintained for
the year beginning January 1, 1998 and reverts back to a retrospective rolling
four quarter basis effective January 1, 1999. A tangible net worth of $32
million at December 31, 1997 was required under the ARM Agreement. As of
December 31, 1997 the Company had a tangible net worth of $3.5 million. The
Company has obtained a waiver with respect to this requirement from BNY
Financial Corporation for the fourth quarter of 1997. Since the month ended
December 31, 1997, BNY Financial Corporation and the Company have amended the
ARM Agreement to require a tangible net worth of $6.9 million at March 31,
1998, $3.8 million at June 30, 1998, and $4.3 million at September 30, 1998
and $3.0 million at December 31, 1998. The ARM Agreement also restricts the
ability of the Company to obtain working capital in the form of indebtedness,
other than indebtedness incurred in the ordinary course of the Company's
business or to grant security interests in the assets of the Company. As of
December 31, 1997, the Company had borrowings of $10.7 million under the ARM
Agreement.
 
  Primarily as the result of write-downs in the fourth quarter of 1997, the
Company's inventory decreased to $13.5 million on December 31, 1997 from $26.2
million on December 31, 1996. The Company believes that appropriate write-
downs have been taken to reduce the carrying value to the lower of cost or
market. However, there can be no assurance that the Company will be able to
market and sell the excess inventory at prices above its carrying value or
that gross margins will not be affected by a reduction in its realizable
value.
 
                                      21
<PAGE>
 
  The Company's working capital needs will depend upon numerous factors,
including the extent and timing of acceptance of the Company's products in the
market, the Company's operating results, the cost of increasing the Company's
sales and marketing activities and the status of competitive products, none of
which can be predicted with certainty. The Company has experienced severe
working capital shortfalls in the past, which have restricted the Company's
ability to conduct its business as anticipated. As a result of seasonality in
the toy industry, the timing of new product introductions and the Company's
planned growth, there can be no assurance that the Company will not require
additional funding. There can be no assurance that any additional financing
will be available to the Company on acceptable terms, if at all, when required
by the Company. The inability to obtain such financing would have a material
adverse effect on the Company's operating results.
 
                                      22
<PAGE>
 
       CAUTIONARY STATEMENT FOR PURPOSES OF THE "SAFE HARBOR" PROVISIONS
            OF THE PRIVATE SECURITIES LITIGATION REFORM ACT OF 1995
 
  The Company wishes to take advantage of the "safe harbor" provisions of the
Private Securities Litigation Reform Act of 1995 as to "forward looking"
statement in this Form 10-K which are not historical facts. The Company
cautions readers that the following important factors could affect the
Company's business and cause actual results to differ materially from those
expressed in any forward looking statement made by, or on behalf of, the
Company
 
  While management believes that its assumptions regarding these and other
factors on which forward-looking statements are based are reasonable, such
assumptions are necessarily speculative in nature, and actual outcomes can be
expected to differ to some degree. Consequently, there can be no assurance
that the results described in such forward-looking statements will, in fact,
be achieved.
 
  Because of the variety and uncertainty of the factors affecting the
Company's operating results, past financial performance and historic trends
may not be a reliable indicator of future performance. These factors, as well
as other factors affecting the Company's operating performance, and the fact
that the Company participates in a highly dynamic industry, may result in
significant volatility in the Company's common stock price. The Company's
business is subject to a number of risks and the Company's forward looking
statements should be considered in light of the business factors set forth
below.
 
  History of Losses; Accumulated Deficit. The Company incurred operating
losses of $38.2 and $12.6 million for the years ended December 31, 1997 and
1996, respectively. In 1997, the Company had a net cash outflow of $1.4
million. As a result of losses, the Company has incurred indebtedness to
finance its operations. See "Dependence on Restricted Facility." In the event
the Company continues to incur operating losses and is unable to obtain
additional financing on favorable terms, or at all, in the future, its
operating results and financial condition would be materially adversely
affected.
 
  Dependence on 1998 Products. In 1998, the Company has introduced and expects
to commence sales of a number of new product lines in new product categories,
such as the W-3 Wild Water Weapons, Air Vectors SFX, Yak Live, Fistful of
Aliens and Teddy Ruxpin. In addition, the Company also expects to expand its
existing product lines in 1996, particularly its YES! Gear line of products.
Manufacturing of certain of these items in commercial quantities has not
commenced or is just commencing. The Company expects that completing the
development and the manufacture of its 1997 product lines will place great
demands on management and other Company resources. If the Company is not able
to complete the development, tooling, manufacture and successful marketing of
its 1997 product lines, the Company's operating results and financial
condition would be materially adversely affected.
 
  Dependence on Yak Bak and Power Penz. The majority of the Company's current
product lines are sold under the YES! Gear brand and consist of Yak Bak and
Power Penz products. The Company had a significant decline in the sales of its
Yak Bak products in 1997 as compared to 1996 and, while Power Penz revenues
were stable, gross margins on its Power Penz sales declined due to a shift
from domestic to international sales. These product lines accounted for 51%
and 72% of net sales in 1997 and 1996 respectively. The Power Penz brand
accounted for 26% and 22% of net sales in 1997 and 1996 respectively. The
Company expects these brands to continue to account for a substantial
percentage of the Company's business, but there can be no assurance that they
will be able to sustain sales at the 1997 level, or at a level necessary to
maintain its overall sales and revenues. In addition, a number of toy
manufacturers have attempted to duplicate the Company's success in these areas
and there can be no assurance that the sale of these competitive products will
not impact the sale of the Yak Bak or Power Penz product lines.
 
 
                                      23
<PAGE>
 
  Just in Time Inventory; Compressed Sales Cycles. Most of the Company's most
significant customers have adopted inventory management systems to track sales
of particular products and rely on reorders being filled rapidly by suppliers,
rather than maintaining large on-hand inventories to meet consumer demand.
While these systems reduce a retailer's investment in inventory, they increase
pressure on suppliers like the Company to fill orders promptly and shift a
significant portion of inventory risk to the supplier. The limited inventory
carried by the Company's customers may also reduce or delay consumer sell-
through which in turn could impair the Company's ability to obtain reorders of
its product in quantities necessary to permit the Company to achieve planned
sales and income growth. In addition, the Company may be required to incur
substantial additional expense to fill late reorders in order to ensure the
product is available at retail prior to Christmas; these may include drop-
shipment expense and higher advertising allowances which would otherwise be
born by the Company's customers. In the event that anticipated reorders do not
materialize, the Company may incur increased inventory carrying costs.
 
  Changes in 1998 Product Line. The Company constantly evaluates the toy
markets and its development and manufacturing schedules. As the year
progresses, the Company may elect to reduce the number of products it
currently plans on shipping in 1998 for a variety of reasons, which include
but are not limited to more accurate evaluation of demand, supply and
manufacturing difficulties, or competitive considerations. Similarly, the
Company may add products to its 1998 line either by accelerating development
schedules or strategic acquisitions of current product lines. Reducing or
adding products from and to the Company's line may have an impact on the
Company's financial performance depending on, among other things, the price
points, advertising and promotional support for and development, tooling and
manufacturing costs of such products, relative to products they replace or are
replaced by, as the case may be, if applicable.
 
  Sales Concentration Risk. The Company's ten largest customers accounted for
73%, 85% and 87% of sales for the years ending December 31, 1997, 1996 and
1995, respectively. For the year ended December 31, 1997, the Company's two
largest customers, TRU and Wal-Mart, accounted for 21% and 13% of net sales,
respectively. For the year ended December 31, 1996, the same two customers
accounted for approximately 21% and 20% of net sales, respectively, and for
the year ended December 31, 1995, TRU and Wal-Mart each accounted for 27% of
net sales. While the Company intends to expand distribution to new accounts,
the Company expects to continue to depend on a relatively small number of
customers for a significant percentage of its sales. Significant reductions in
sales to any one or more of the Company's largest customers would have a
material adverse effect on the Company's operating results. Because orders in
the toy industry are generally cancelable at any time without penalty, there
can be no assurance that present or future customers will not terminate their
purchase arrangements with the Company or significantly change, reduce or
delay the amount of products ordered from the Company. Any such termination of
a significant customer relationship or change, reduction or delay in
significant orders could have a material adverse effect on the Company's
operating results.
 
  Price Protection; Stock Balancing; Reliance of Timely Payment. In connection
with the introduction of new products, many companies in the toy industry
discount prices of existing products, provide for certain advertising
allowances and credits or give other sales incentives to their customers,
particularly their most significant customers. In addition, in order to
address working capital requirements, sales of inventory, changes in marketing
trends and other issues, many companies in the toy industry allow retailers to
return slow-moving products for credit, or if the manufacturer lowers the
prices of its products, to provide price adjustments for inventories on hand
at the time the price change occurs. The Company has made such accommodations
in the past, and expects to make accommodations such as stock balancing,
returns, other allowances or price protection adjustments in the future. Any
such accommodations by the Company in the future could have a material adverse
effect on the Company's operating results. In addition, in the past certain of
the Company's retail customers have delayed payment beyond the date such
payment is due. Delays in payments from retail customers in the future could
materially impact the Company's anticipated cash flow to the detriment of the
Company's business. Delays or reductions in payment have, in the past,
increased the Company's reliance on other sources of capital, including bank
lines of credit, which has increased the Company's interest expense and, in
the case of payment reductions, reduced profitability, or increased loss, by
an amount equivalent to such reductions. Delays or reductions in payment in
the future would have the same or similar effect.
 
                                      24
<PAGE>
 
  Seasonality. Sales of toys traditionally have been highly seasonal, with a
majority of retail sales occurring during the December holiday season.
Accordingly, the Company expects that its operating results will vary
significantly from quarter to quarter, particularly in the third and fourth
quarters, when the majority of products are shipped, and the first quarter,
when a disproportionate amount of receivables are collected and trade credits
are negotiated. In addition, although indications of interest are provided by
retailers early in the year for product shipments for the December holiday
season, committed orders are not placed until later in the year and, even when
placed, such orders generally are cancelable at any time without penalty.
Accordingly, the Company generally must enter into tooling, manufacturing
media and advertising commitments prior to having firm orders. As a result,
there can be no assurance that the Company can maintain sufficient flexibility
with respect to its working capital needs or its ability to manufacture
products and obtain supplies of raw materials, tools and components to be able
to minimize the adverse effects of an unanticipated shortfall or increase in
demand. Failure to accurately predict and respond to consumer demand may cause
the Company to produce excess inventory which could materially adversely
affect the Company's operating results and financial condition. Conversely, if
a product achieves greater success than anticipated, the Company may not have
sufficient inventory to meet retail demand, which could adversely impact the
Company's relations with its customers.
 
  Short Product Cycles. Consumer preferences in the toy industry are
continuously changing and are difficult to predict. Few products achieve
market acceptance, and even when they do achieve commercial success, products
typically have short life cycles. There can be no assurance that (i) new
products introduced by the Company will achieve any significant degree of
market acceptance, (ii) acceptance, if achieved, will be sustained for any
significant amount of time, or (iii) such products' life cycles will be
sufficient to permit the Company to recover development, manufacturing,
marketing and other costs associated therewith. In addition, sales of the
Company's existing product lines are expected to decline over time, and may
decline faster than expected unless existing products are enhanced or new
product lines are introduced. Failure of new product lines to achieve or
sustain market acceptance would have a material adverse effect on the
Company's operating results and financial condition. Any or all products
within the YES! Gear and Power Penz categories, which categories account for a
majority of the Company's overall product sales, will experience relatively
short life cycles.
 
  International Business Risk. The Company will rely in 1998 principally on
foreign distributors to market and sell the Company's products outside the
United States. Although the Company's international sales personnel work
closely with its foreign distributors, the Company cannot directly control
such entities' sales and marketing activities and, accordingly, cannot
directly manage the Company's product sales in foreign markets. The percentage
of total sales constituting foreign sales for 1995, 1996 and 1997 are 7%, 21%
and 32%, respectively. In addition, the Company's international sales may be
disrupted by currency fluctuations or other events beyond the Company's
control, including political or regulatory changes. To date, substantially all
of the Company's international sales have been denominated in US dollars and
therefore the Company has not to date experienced any adverse impact from
currency fluctuations. To the extent future sales are not denominated in US
dollars, currency exchange fluctuations in the countries where the Company
does business could materially adversely affect the Company's business,
financial condition and results of operations.
 
  Dependence on Manufacturing Facilities Based in People's Republic of
China. The Company contracts for the manufacture of substantially all of its
products with entities based in Hong Kong whose manufacturing facilities are
located in the People's Republic of China. In 1998, Hong Kong became a
sovereign territory of the People's Republic of China. While the People's
Republic of China has provided assurances that Hong Kong will be allowed to
maintain critical economic and tax policies, there can be no assurance that
political or social tensions will not develop in Hong Kong that would disrupt
this process. In addition, tensions between the Peoples Republic of China and
the Republic of China (Taiwan), and the United States' involvement therein,
could result either in a disruption in manufacturing in the China mainland or
in the imposition of tariffs or duties on Chinese manufactured goods. Either
event would have an adverse impact on the Company's ability to obtain its
products or on the cost of these products, respectively, such that its
operating results and financial condition would be materially adversely
affected.
 
 
                                      25
<PAGE>
 
  Dependence on Restrictive Facility. The Company is dependent on the ARM
Agreement with BNY Financial Corporation to meet its financial needs during
1998, due in large part to the seasonality of the Company's business whereby
the Company is required to finance the manufacture of a substantial portion of
its products in the summer and autumn but does not collect on the sale of
these products until the fourth quarter of that year and the first quarter of
the following year. Under the terms of the ARM Agreement, BNY Financial
Corporation has taken a first priority security interest in substantially all
of the Company's assets, including its intellectual property. The ARM
Agreement also contains a number of restrictive covenants and events of
default, including a provision specifying that it shall be an event of default
if Donald Kingsborough, the Company's Chief Executive Officer, is not active
in the management of the Company and is not replaced within ninety (90) days
with a suitable individual of comparable experience and capability. In the
event the Company falls out of compliance with the ARM Agreement, and BNY
Financial Corporation does not provide financing, the Company would not be
able to finance its operations as contemplated, and its operating results and
financial condition would be materially adversely affected.
 
  Dependence on Key Personnel. The Company's future success will depend to a
significant extent on the efforts of the key management personnel, including
Donald D. Kingsborough, the Company's Chairman and Chief Executive Officer,
Mark Shepherd, the Company's Chief Operating and Financial Officer and other
key employees. The loss of one or more of these employees could have a
material adverse effect on the Company's business. In addition, the Company
believes that its future success will depend in large part on its ability to
attract and retain highly qualified management, operations and sales
personnel. There can be no assurance that the Company will be able to attract
and retain the employees it needs to in order to ensure its success.
 
  Impact of Year 2000. The Company in the process of evaluating and updating
its internal management information systems so that they will have the
capability to manage and manipulate data involving the transition of dates
from 1999 to 2000 without functional or data abnormality and without
inaccurate results relating to such dates. The Company expects to complete the
updating of its current systems before 2000. Any new systems implemented by
the Company would be Year 2000 compliant. Other participants in the Company's
industry may also experience functional or data abnormality. Any failures on
the part of the Company or the Company's manufacturers, lending institutions
and key customers to ensure their respective software complies with Year 2000
requirements, could have a material adverse effect on the financial condition
and results of operation of the Company.
 
ITEM 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA
 
  The Company's Financial Statements and Notes thereto appear beginning at
page F-1 of this report.
 
ITEM 9.  CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND
         FINANCIAL DISCLOSURE
 
  None.
 
 
                                      26
<PAGE>
 
                                   PART III
 
  Certain information required in Part III of this Report is incorporated by
reference to the Registrant's Proxy Statement in connection with the
Registrant's 1998 Annual Meeting to be filed in accordance with Regulation 14A
under the Securities Exchange Act of 1934, as amended.
 
ITEM 10. EXECUTIVE OFFICERS OF THE REGISTRANT
 
EXECUTIVE OFFICERS OF THE COMPANY
 
  The following sets forth certain information regarding the executive
officers of the Company, who are elected by and serve at the discretion of the
Board of Directors:
 
<TABLE>
<CAPTION>
   NAME                   AGE POSITION
   ----                   --- --------
   <S>                    <C> <C>
   Donald Kingsborough... 51  Chairman of the Board and Chief Executive Officer
   Mark Shepherd......... 42  Chief Operating Officer, Chief Financial Officer
   Sharon Duncan......... 46  Executive Vice President, International
   Tom Fritz............. 39  Executive Vice President, Marketing
   Leonard Ciciretto..... 41  Executive Vice President, Sales
   William Radin......... 67  Executive Vice President, Operations
</TABLE>
 
  The Company's executive officers are appointed annually by, and serve at the
discretion of, the Board of Directors. Each executive officer is a full time
employee of the Company. There is no family relationship between any executive
officer or director of the Company.
 
  Donald Kingsborough founded the Company in September 1992 and has served as
Chairman of the Board and Chief Executive Officer since that time. From May
1989 to November 1992, Mr. Kingsborough was Chief Executive Officer of
Intelligy Corporation, a developer of educational and child development
products, including software. In February 1985, Mr. Kingsborough founded
Worlds of Wonder, Inc., and served as its Chief Executive Officer until April
1988.
 
  Mark Shepherd joined the Company in October 1997 as Chief Operating Officer
and was named Chief Financial Officer in April 1998. From 1992 to 1995 he
served as Senior Vice President and Chief Financial Officer for Galoob Toys,
Inc., a toy company. Prior to joining the Company, Mr. Shepherd was most
recently the Senior Vice President-Finance for Einstein/Noah Bagel Corp. a 500
store bagel retailer.
 
  Sharon Duncan joined the Company in July 1996 as Executive Vice President,
International. From January 1990 to January 1992, she was Director of
International Sales and Marketing for Galoob Toys, Inc., a toy company. She
was promoted to Vice President, International Sales and Marketing for Galoob
in January of 1992 and held that position through June 1996.
 
  Tom Fritz joined the Company in November 1993 as Director of Marketing and
was promoted to Executive Vice President, Marketing in September 1995. From
1991 until he joined the Company, Mr. Fritz was employed by Nestle Beverage
Corporation, most recently as Business Director, Nestea.
 
  Leonard Ciciretto joined the Company in January 1998 as Executive Vice
President, Sales. From 1990 until he joined the Company, Mr. Ciciretto was
with Sega of America, most recently as Group Vice President of Sales. Prior to
that title he held various sales management positions with Sega.
 
  William Radin joined the Company in June 1993 as Senior Vice President, R&D,
and was promoted to Executive Vice President, Operations in July 1994. From
January 1990 to December 1992, he was Vice President and Managing Director of
Galco, the Hong Kong division of Lewis Galoob Toys, Inc., a toy manufacturer,
and from December 1992 to April 1993, he was Managing Director of Arco, Ltd.,
the Hong Kong division of Mattel,
 
                                      27
<PAGE>
 
Inc., a toy manufacturer. From June 1983 to December 1990, Mr. Radin was Vice
President and Managing Director for Tonka Kenner Parker Far East, a toy
manufacturer.
 
  The information required by this Item regarding the directors of the Company
is incorporated by reference to the information set forth in the section
entitled "Proposal No. 1: Election of Directors" in the Company's Proxy
Statement for the 1998 Annual Meeting of Stockholders to be filed with the
Securities and Exchange Commission within 120 days after the end of the
Company's fiscal year ended December 31, 1997.
 
ITEM 11. EXECUTIVE COMPENSATION
 
  The information required in Item 11 of Part III of this Report is
incorporated by reference to the Registrant's Proxy Statement in connection
with the Registrant's 1998 Annual Meeting to be filed in accordance with
Regulation 14A under the Securities Exchange Act of 1934, as amended.
 
ITEM 12. SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT
 
  The information required in Item 12 of Part III of this Report is
incorporated by reference to the Registrant's Proxy Statement in connection
with the Registrant's 1998 Annual Meeting to be filed in accordance with
Regulation 14A under the Securities Exchange Act of 1934, as amended.
 
ITEM 13. CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS
 
  The information required in Item 13 of Part III of this Report is
incorporated by reference to the Registrant's Proxy Statement in connection
with the Registrant's 1998 Annual Meeting to be filed in accordance with
Regulation 14A under the Securities Exchange Act of 1934, as amended.
 
 
                                      28
<PAGE>
 
                                    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) Index to Consolidated Financial Statements and Report of Ernst & Young,
      LLP, Independent Auditors.
 
  The consolidated financial statements required by this item are submitted in
a separate section beginning on page F-1 of this report.
 
<TABLE>
<CAPTION>
                                                                            PAGE
                                                                            ----
     <S>                                                                    <C>
     Report of Ernst & Young LLP, Independent Auditors..................... F-1
     Consolidated Balance Sheets........................................... F-2
     Consolidated Statements of Operations................................. F-3
     Consolidated Statements of Stockholders' Equity (Deficit)............. F-4
     Consolidated Statements of Cash Flows................................. F-5
     Notes to Consolidated Financial Statements............................ F-6
</TABLE>
 
  (2) Financial Statement Schedules.
 
  The following financial statement schedule of the Company is filed as part
of this report and should be read in conjunction with the consolidated
financial statements, and related notes thereto, of the Company.
 
<TABLE>
<CAPTION>
                                                                           PAGE
                                                                           ----
     <S>                                                                   <C>
     Schedule II -- Valuation and Qualifying Accounts.....................  S-1
</TABLE>
 
  Schedules not listed above have been omitted because the information
required to be set forth therein is not applicable or is included in the
financial statements or notes thereto.
 
  (3) Exhibits.
 
<TABLE>
<CAPTION>
     EXHIBIT
     NUMBER     DESCRIPTION
     -------    -----------
     <C>        <S>
      3.1(1)    Certificate of Incorporation of Registrant, as amended.
      3.2(1)    Bylaws of Registrant.
      4.1(1)    Form of Registrant's Common Stock Certificate.
      4.2(1)    Form of Debenture dated July 25, 1997.
      4.3(1)    Form of Warrant dated March 18, 1997.
      4.4(1)    Certificate of Designation of the Series B Convertible
                Preferred Stock.
     10.1(1)(2) Form of Indemnification Agreement entered into by Registrant
                with each of its directors and executive officers.
     10.2(1)(2) 1992 Stock Option Plan and related agreements.
     10.3(1)(2) 1995 Profit Sharing Plan.
     10.4(1)(2) 1995 Stock Option Plan and related agreements.
     10.5(1)(2) 1995 Director Option Plan.
     10.6(1)    Acquisition Agreement dated as of December 31, 1992 by and
                between the Registrant and Intelligy Corporation.
     10.7(1)    Amendment to Acquisition Agreement dated as of December 31,
                1992 by and between the Registrant and Intelligy Corporation
                dated as of January 21, 1993.
     10.8(1)    Series B Stock Purchase Agreement dated as of January 27,
                1993 by and among the Registrant and the Purchasers (as
                defined therein).
</TABLE>
 
                                      29
<PAGE>
 
<TABLE>
<CAPTION>
     EXHIBIT
     NUMBER      DESCRIPTION
     -------     -----------
     <C>         <S>
     10.9(1)     Amendment to Series B Stock Purchase Agreement dated as of
                 January 27, 1993 by and among the Registrant and the
                 Purchasers (as defined therein) dated as of February 5,
                 1993.
     10.10(1)    Note and Warrant Purchase Agreement dated as of June 4, 1993
                 by and among the Registrant and the Purchasers (as defined
                 therein).
     10.11(1)    Amended and Restated Registration Rights Agreement dated as
                 of June 17, 1994 by and among the Registrant and Holders (as
                 defined therein).
     10.12(1)(3) Asset Purchase Agreement dated as of December 18, 1992
                 between the Registrant and Microsonics International, Inc.
     10.13(1)(3) License Agreement dated as of May 11, 1994 between the
                 Registrant and the Disney Publishing Group.
     10.14(1)(3) Product Development Agreement dated as of June 28, 1994 by
                 and among the Registrant and the Licensors (as defined
                 therein).
     10.15(1)    Lease Agreement between the Registrant and Chawin Property,
                 Inc., dated as of March 1, 1993, for the facility located at
                 3875 Hopyard Road, Pleasanton, California.
     10.16(1)    Lease Agreement between the Registrant and Lincoln Hayward
                 VI, dated as of May 17, 1993, for the facility located at
                 1039-1055 Whipple Road, Hayward, California.
     10.17(1)    License Agreement dated as of January 13, 1993 by and
                 between the Registrant and Shoot the Moon Products, Inc.
     10.18(1)    Second Amendment to Lease between the Registrant and Chawin
                 Property, Inc., dated as of May 1, 1995, for the facility
                 located at 2875 Hopyard Road, Pleasanton, California.
     10.19(1)(3) License Agreement dated as of April 26, 1995 by and between
                 the Registrant and Machina, Inc.
     10.20(1)(2) Employment Agreement by and between the Registrant and
                 William Radin.
     10.21(3)    Product Development and License Agreement by and between
                 Registrant and Machina, Inc. dated September 7, 1995.
     10.22(3)    Development and License Agreement by and between Registrant
                 and Machina, Inc. dated April 26, 1995.
     10.23(3)    Product Development and License Agreement by and between
                 Registrant and Machina, Inc. dated June 16, 1995, as
                 amended.
     10.24(3)    Product Development and License Agreement by and between
                 Registrant and Machina, Inc. dated June 27, 1995.
     10.25(1)    Accounts Receivable Management and Security Agreement by and
                 between Registrant and BNY Financial Corporation dated July
                 31, 1995.
     10.26       First Amendment to Accounts Receivable Management and
                 Security Agreement by and between Registrant and BNY
                 Financial Corporation dated July 31, 1995.
     10.27       Second Amendment to Accounts Receivable Management and
                 Security Agreement by and between Registrant and BNY
                 Financial Corporation dated July 31, 1995.
     10.28       Third Amendment to Accounts Receivable Management and
                 Security Agreement by and between Registrant and BNY
                 Financial Corporation dated July 31, 1995.
     10.29(3)    Product Development and License Agreement by and between
                 Registrant and Machina, Inc. dated August 31, 1995.
     10.30(3)    License Agreement by and between Registrant and Mrs. Fields
                 Development Corporation dated September 30, 1995.
     10.31(3)    License Agreement by and among Registrant, Kiscom, Inc., and
                 Greg Hyman Associates dated November 18, 1995.
</TABLE>
 
                                       30
<PAGE>
 
<TABLE>
<CAPTION>
     EXHIBIT
     NUMBER   DESCRIPTION
     -------  -----------
     <C>      <S>
     10.32(3) Royalty Agreement by and between Registrant and Shoot The Moon,
              Inc., dated December 27, 1995.
     10.33(2) 1996 Profit Sharing Plan.
     10.34(2) 1996 Executive Profit Sharing Plan.
     10.35(1) Third Amendment to Lease Agreement between Registrant and
              Lincoln Hayward VI dated May 17, 1996 for the facility located
              at 1006 Whipple Road, Hayward, California.
     10.36(1) Third Amendment to Lease Agreement between Registrant and
              Chawin Property, Inc. dated May 1, 1996 for the facility
              located at 3875 Hopyard Road, Pleasanton, California.
     10.37(1) Amended and Restated Securities Purchase Agreement dated July
              25, 1997 among Infinity Investors Limited, Fairway Capital
              Limited, Cappello & Laffer Capital Corp. and Registrant.
     10.38(1) Amended and Restated Registration Rights Agreement dated July
              25, 1997 among Infinity Investors Limited, Fairway Capital
              Limited, Cappello & Laffer Capital Corp. and Registrant.
     21.1(1)  Subsidiaries of the Registrant.
     23.1     Consent of Ernst & Young LLP, Independent Auditors.
     27.1     Financial Data Schedule for the year ended December 31, 1997.
</TABLE>
--------
(1) Incorporated by reference to Exhibits filed with the following:
    Registration Statement on Form S-1 (File No. 33-91408), which became
    effective on June 7, 1995; Quarterly Report on Form 10-Q for the quarter
    ended June 30, 1995, filed with the Securities and Exchange Commission on
    August 15, 1995; Quarterly Report on Form 10-Q for the quarter ended
    September 30, 1995, filed with the Securities and Exchange Commission on
    October 31, 1995; Annual Report on Form 10-K for the year ended on
    December 31, 1995; Quarterly Report on Form 10-Q for the quarter ended
    June 30, 1996, filed with the Securities and Exchange Commission on August
    2, 1996; Registration Statement on Form 8-B, filed with the Securities and
    Exchange Commission on October 31, 1996, which became effective on
    November 5, 1996; Post-Effective Amendment No. 4 on Form S-3 to the
    Registration Statement on Form S-1 (File No. 33-91408), which became
    effective on November 20, 1996; Quarterly Report on Form 10-Q/A for the
    quarter ended June 30, 1997, filed October 23, 1997; Current Report on
    Form 8-K filed with the Securities and Exchange Commission on April 1,
    1998; Current Report on Form 8-K filed with the Securities and Exchange
    Commission on August 4, 1997.
(2) Indicates management compensatory plan, contract or arrangement.
(3) Confidential treatment has been previously granted for certain portions of
    these exhibits.
(b) The Registrant filed no reports on Form 8-K in the third quarter of 1997.
(c) See Exhibits listed under Item 14 (a) (3).
(d) The financial statement schedules required by this item are listed under
    14 (a) (2).
 
 
                                      31
<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 on Form 10-K
to be signed on its behalf by the undersigned, thereunto duly authorized, in
the City of Pleasanton, State of California, on this 15th day of April 1998.
 
                                          YES! ENTERTAINMENT CORPORATION
 
                                          By: /s/ Donald D. Kingsborough
                                            -----------------------------------
                                            Name: Donald D. Kingsborough
                                            Title: Chief Executive Officer
 
                               POWER OF ATTORNEY
 
  KNOW ALL THESE PERSONS BY THESE PRESENTS, that each person whose signature
appears below constitutes and appoints Donald D. Kingsborough and Mark C.
Shepherd and each of them, jointly and severally, his attorneys-in-fact, each
with full power of substitution, for him in any and all capacities, to sign
any and all amendments to this Form 10-K, and to file the same, with exhibits
thereto and other documents in connection therewith, with the Securities and
Exchange Commission, hereby ratifying and confirming all that each said
attorneys-in-fact or his substitute or substitutes, may do or cause to be done
by virtue hereof.
Pursuant to the requirements of the Securities Exchange Act of 1934, this 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/ Donald D. Kingsborough        Chairman of the Board and       April 15, 1998
____________________________________ Chief Executive Officer
       Donald D. Kingsborough        (Principal Executive
                                     Officer)
 
      /s/ Mark C. Shepherd           Chief Financial Officer         April 15, 1998
____________________________________ (Principal Financial and
          Mark C. Shepherd           Accounting Officer)
 
      /s/ David C. Costine           Director                        April 15, 1998
____________________________________
          David C. Costine
 
       /s/ Esmond T. Goei            Director                        April 15, 1998
____________________________________
           Esmond T. Goei
 
</TABLE>
 
 
                                      32
<PAGE>
 
 
                                            CONSOLIDATED FINANCIAL STATEMENTS
 
                                             YES! ENTERTAINMENT CORPORATION
 
                                            Years ended December 31, 1997 and
                                             1996 with Report of Independent
                                                         Auditors
<PAGE>
 
                         YES! ENTERTAINMENT CORPORATION
 
                       CONSOLIDATED FINANCIAL STATEMENTS
 
                     YEARS ENDED DECEMBER 31, 1997 AND 1996
 
                                    CONTENTS
 
<TABLE>
<S>                                                                          <C>
Report of Independent Auditors..............................................   1
 
Consolidated Financial Statements
 
Consolidated Balance Sheets.................................................   2
Consolidated Statements of Operations.......................................   3
Consolidated Statements of Stockholders' Equity (Deficit)...................   4
Consolidated Statements of Cash Flows.......................................   5
Notes to Consolidated Financial Statements..................................   6
</TABLE>
<PAGE>
 
                        REPORT OF INDEPENDENT AUDITORS
 
The Board of Directors and Stockholders
YES! Entertainment Corporation
 
  We have audited the accompanying consolidated balance sheets of YES!
Entertainment Corporation as of December 31, 1997 and 1996, and the related
consolidated statements of operations, stockholders' equity (deficit), and
cash flows for each of the three years in the period ended December 31, 1997.
Our audits also included the financial statement schedule listed in the index
at Item 14(a). These financial statements and schedule are the responsibility
of the Company's management. Our responsibility is to express an opinion on
these financial statements and schedule based on our audits.
 
  We conducted our audits in accordance with generally accepted auditing
standards. Those standards require that we plan and perform the audit to
obtain reasonable assurance about whether the financial statements are free of
material misstatement. An audit includes examining, on a test basis, evidence
supporting the amounts and disclosures in the financial statements. An audit
also includes assessing the accounting principles used and significant
estimates made by management, as well as evaluating the overall financial
statement presentation. We believe that our audits provide a reasonable basis
for our opinion.
 
  In our opinion, the consolidated financial statements referred to above
present fairly, in all material respects, the consolidated financial position
of YES! Entertainment Corporation at December 31, 1997 and 1996, and the
consolidated results of its operations and its cash flows for each of the
three years in the period ended December 31, 1997, in conformity with
generally accepted accounting principles. Also, in our opinion, the related
financial statement schedule, when considered in relation to the basic
financial statements taken as a whole, presents fairly in all material
respects the information set forth therein.
 
February 27, 1998,
except for paragraph 4
of Note 5 and Note 16,
as to which the date is
March 26, 1998
 
                                      F-1
<PAGE>
 
                         YES! ENTERTAINMENT CORPORATION
 
                          CONSOLIDATED BALANCE SHEETS
                                 (IN THOUSANDS)
 
<TABLE>
<CAPTION>
                                                                DECEMBER 31
                                                             ------------------
                                                               1997      1996
                                                             --------  --------
<S>                                                          <C>       <C>
ASSETS
Current assets:
  Cash and cash equivalents................................. $    624  $  1,572
  Accounts receivable, net of allowance for doubtful
   accounts of $137 in 1997 and $465 in 1996................    8,659    21,956
  Inventories...............................................   13,513    26,194
  Prepaid royalties.........................................      955     4,045
  Prepaid expenses..........................................    1,254     1,868
  Other current assets......................................    1,989     1,489
                                                             --------  --------
Total current assets........................................   26,994    57,124
Property and equipment, net.................................    5,345     3,869
Intangibles and deposits, net...............................      156       276
                                                             --------  --------
Total assets................................................ $ 32,495  $ 61,269
                                                             ========  ========
 
LIABILITIES AND STOCKHOLDERS' EQUITY
Current liabilities:
  Loans payable............................................. $ 10,709  $ 16,712
  Accounts payable..........................................   11,716    12,565
  Accrued royalties.........................................    2,406     1,018
  Accrued liabilities.......................................    2,178       879
  Dividends payable.........................................      123        --
  Capital lease obligations.................................        5        16
                                                             --------  --------
Total current liabilities...................................   27,137    31,190
Capital lease obligations...................................       --        14
Convertible debentures......................................    1,741        --
Stockholders' equity:
  Convertible preferred stock, $0.001 par value:
   Authorized shares--2,000,000; issued and outstanding
    Series B--387,770 in 1997, none issued at December 31,
    1996; aggregate liquidation preference of $9,694,000....    8,500        --
  Common stock, $0.001 par value:
   Authorized shares--48,000,000 at December 31, 1997
   Issued and outstanding shares--15,537,159 in 1997 and
    14,044,422 in 1996......................................       16        14
  Additional paid-in capital................................   90,434    82,707
  Deferred compensation.....................................     (606)       --
  Accumulated deficit.......................................  (94,727)  (52,656)
                                                             --------  --------
  Total stockholders' equity................................    3,617    30,065
                                                             --------  --------
  Total liabilities and stockholders' equity................ $ 32,495  $ 61,269
                                                             ========  ========
</TABLE>
 
See accompanying notes.
 
                                      F-2
<PAGE>
 
                         YES! ENTERTAINMENT CORPORATION
 
                     CONSOLIDATED STATEMENTS OF OPERATIONS
                    (IN THOUSANDS, EXCEPT PER SHARE AMOUNTS)
 
<TABLE>
<CAPTION>
                                                   YEARS ENDED DECEMBER 31
                                                  -----------------------------
                                                    1997       1996      1995
                                                  --------   --------   -------
<S>                                               <C>        <C>        <C>
Net sales.......................................  $ 50,858   $ 69,699   $55,673
Cost of sales...................................    46,817     42,624    26,623
                                                  --------   --------   -------
Gross profit....................................     4,041     27,075    29,050
Operating expenses:
  Marketing, advertising, and promotion.........     8,124     13,192     6,423
  Selling, distribution, and administrative.....    31,769     25,571    17,638
Total operating expenses........................    39,893     38,763    24,061
                                                  --------   --------   -------
Operating (loss) income.........................   (35,852)   (11,688)    4,989
Interest income.................................        69        264        69
Interest expense................................    (2,245)    (1,039)   (1,321)
Other expense, net..............................      (173)      (108)      (74)
                                                  --------   --------   -------
(Loss) income before provision for income taxes.   (38,201)   (12,571)    3,663
Provision for income taxes......................        --         --      (185)
                                                  --------   --------   -------
Net (loss) income...............................   (38,201)   (12,571)    3,478
Non-cash dividends and discount on preferred
 stock..........................................    (3,870)        --        --
                                                  --------   --------   -------
Net (loss) income applicable to common
 stockholders...................................  $(42,071)  $(12,571)  $ 3,478
                                                  ========   ========   =======
Basic (loss) earnings per share applicable to
 common shareholders............................   $ (2.90)   $ (0.91)   $ 0.65
                                                  ========   ========   =======
Shares used in computing basic (loss) earnings
 per share......................................    14,529     13,890     5,339
                                                  ========   ========   =======
Diluted (loss) earnings per share...............   $ (2.90)   $ (0.91)   $ 0.41
                                                  ========   ========   =======
Shares used in computing diluted (loss) earnings
 per share......................................    14,529     13,890     8,534
                                                  ========   ========   =======
</TABLE>
 
See accompanying notes.
 
                                      F-3
<PAGE>
 
                        YES! ENTERTAINMENT CORPORATION
 
           CONSOLIDATED STATEMENTS OF STOCKHOLDERS' EQUITY (DEFICIT)
                                (IN THOUSANDS)
 
<TABLE>
<CAPTION>
                          CONVERTIBLE                                                         NOTES AND
                           PREFERRED                                                           AMOUNTS        TOTAL
                             STOCK        COMMON STOCK   ADDITIONAL                           RECEIVABLE  STOCKHOLDERS'
                         --------------  --------------   PAID-IN   ACCUMULATED   DEFERRED       FROM         EQUITY
                         SHARES  AMOUNT  SHARES AMOUNT    CAPITAL     DEFICIT   COMPENSATION STOCKHOLDERS   (DEFICIT)
                         ------  ------  ------ -------  ---------- ----------- ------------ ------------ -------------
<S>                      <C>     <C>     <C>    <C>      <C>        <C>         <C>          <C>          <C>
Balance at December 31,
1994...................   1,800  $  594     400 $   399   $    --    $(43,563)     $  --         $ --       $(42,570)
 Exercise of stock
 options...............      --      --      19      33        --          --         --           --             33
 Issuance of common
 stock.................      --      --   3,196  12,015        --          --         --           --         12,015
 Issuance of common
 stock warrants........      --      --      --     320        --          --         --           --            320
 Exercise of common
 stock warrants........      --      --   1,703   6,812        --          --         --         (842)         5,970
 Conversion of Series A
 convertible preferred
 stock to common stock.  (1,800)   (594)    120     594        --          --         --           --             --
 Conversion of
 redeemable convertible
 preferred stock to
 common stock..........      --      --   5,301  49,338        --          --         --           --         49,338
 Net income............      --      --      --      --        --       3,478         --           --          3,478
                         ------  ------  ------ -------   -------    --------      -----         ----       --------
Balance at December 31,
1995...................      --      --  10,739  69,511        --     (40,085)        --         (842)        28,584
 Reincorporation in the
 state of Delaware.....      --      --      -- (69,500)   69,500          --         --           --             --
 Exercise of stock
 options...............      --      --      47      --       160          --         --           --            160
 Exercise of common
 stock warrant.........      --      --   3,242       3    12,883          --         --           --         12,886
 Issuance of common
 stock related to
 Company's 401(k) plan.      --      --      16      --       164          --         --           --            164
 Payments of
 stockholder notes
 receivable............      --      --      --      --        --          --         --          842            842
 Net loss..............      --      --      --      --        --     (12,571)        --           --        (12,571)
                         ------  ------  ------ -------   -------    --------      -----         ----       --------
Balance at December 31,
1996...................      --      --  14,044      14    82,707     (52,656)        --           --         30,065
 Exercise of stock
 options...............      --      --      16      --        33          --         --           --             33
 Issuance of common
 stock related to
 Company's 401(k) plan.      --      --      40      --       145          --         --           --            145
 Issuance of common
 stock to vendors......      --      --     831       1     3,115          --         --           --          3,116
 Issuance of preferred
 stock, Series A.......      85   8,500      --      --        --          --         --           --          8,500
 Discount on preferred
 stock.................      --   1,487      --      --        --      (3,239)        --           --         (1,752)
 Issuance of common
 stock warrants........      --    (705)     --             1,131          --         --           --            426
 Amortization of
 warrants..............      --     230      --      --        --        (230)        --           --             --
 Cancellation of Series
 A preferred stock.....     (85) (8,500)     --      --        --          --         --           --         (8,500)
 Issuance of preferred
 stock, Series B.......     391   9,175      --      --        --          --         --           --          9,175
 Amortization of
 discount on issuance
 of preferred stock and
 debentures............      --  (1,487)     --      --     1,465          --         --           --            (22)
 Issuance of common
 stock due to preferred
 stock and debenture
 conversions...........     (16)   (408)    606       1     1,232          --         --           --            825
 Dividends on preferred
 stock.................      13     208      --      --        --        (401)        --           --           (193)
 Deferred compensation.      --      --      --      --       606          --       (606)          --             --
 Net loss..............      --      --      --      --        --     (38,201)        --           --        (38,201)
                         ------  ------  ------ -------   -------    --------      -----         ----       --------
Balance at December 31,
1997...................     388  $8,500  15,537 $    16   $90,434    $(94,727)     $(606)        $ --       $  3,617
                         ======  ======  ====== =======   =======    ========      =====         ====       ========
</TABLE>
 
See accompanying notes.
 
                                      F-4
<PAGE>
 
                         YES! ENTERTAINMENT CORPORATION
 
                     CONSOLIDATED STATEMENTS OF CASH FLOWS
                                 (IN THOUSANDS)
 
<TABLE>
<CAPTION>
                                                    YEARS ENDED DECEMBER 31
                                                   ----------------------------
                                                     1997      1996      1995
                                                   --------  --------  --------
<S>                                                <C>       <C>       <C>
OPERATING ACTIVITIES
Net (loss) income................................  $(38,201) $(12,571) $  3,478
Adjustments to reconcile net (loss) income to net
 cash provided by (used in) operating activities:
  Depreciation...................................     3,092     2,370     2,127
  Amortization...................................        77        87        56
  Debt discount and warrant amortization.........       709        --        --
  Advertising expenses funded by inventory.......       614     1,022       893
  Employer contribution to 401(k) plan funded
   with common stock.............................       145       164        --
  Changes in operating assets and liabilities:
   Accounts receivable...........................    13,297     4,304   (17,744)
   Inventories...................................    12,681   (15,166)      333
   Prepaid royalties, expenses and other current
    assets.......................................     4,371    (3,050)   (4,320)
   Accounts payable..............................       705     7,081    (5,463)
   Accrued royalties and liabilities.............     2,810      (382)      158
   Income taxes payable..........................        --        (3)       --
   Other long-term liabilities...................        --       (97)       58
                                                   --------  --------  --------
Net cash provided by (used in) operating
 activities......................................       300   (16,241)  (20,424)
INVESTING ACTIVITIES
Acquisition of property and equipment............    (4,568)   (3,470)   (1,397)
Decrease (increase) in intangibles and deposits..        55       (93)       18
                                                   --------  --------  --------
Net cash used in investing activities............    (4,513)   (3,563)   (1,379)
Financing activities
Decrease in restricted cash......................        --        --     1,251
Principle payments on convertible notes payable..        --    (2,000)       --
Net proceeds from loans payable..................    (6,003)    6,587     4,121
Principal payments on capital lease obligations..       (25)      (86)      (77)
Proceeds from issuance of convertible debentures.     1,385        --        --
Proceeds from issuance of redeemable convertible
 preferred stock, net of issuance costs..........     7,875        --        --
Proceeds from exercise of common stock options
 and common stock warrants, net of issuance
 costs...........................................        33    13,046    16,937
Proceeds from stockholders' notes receivable.....        --       842        --
                                                   --------  --------  --------
Net cash provided by financing activities........     3,265    18,389    22,232
                                                   --------  --------  --------
Net (decrease) increase in cash and cash
 equivalents.....................................      (948)   (1,415)      429
Cash and cash equivalents at beginning at period.     1,572     2,987     2,558
                                                   --------  --------  --------
Cash and cash equivalents at end of period.......  $    624  $  1,572  $  2,987
                                                   ========  ========  ========
SUPPLEMENTAL DISCLOSURES OF CASH FLOW INFORMATION
Interest paid....................................  $  1,540  $  1,105  $  1,404
SUPPLEMENTAL DISCLOSURES OF NONCASH INVESTING AND
 FINANCING ACTIVITIES
Common stock issued in exchange for
 extinguishment of trade accounts payable........     3,116        --        --
Conversion of debentures and preferred stock into
 common stock....................................     1,233        --        --
Amounts receivable from stockholders upon
 exercise of warrants............................        --        --       842
Conversion of notes payable into common stock....        --        --     1,400
</TABLE>
 
See accompanying notes.
 
                                      F-5
<PAGE>
 
                        YES! ENTERTAINMENT CORPORATION
 
                  NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
 
                               DECEMBER 31, 1997
 
1. ORGANIZATION AND SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES
 
 Organization
 
  YES! Entertainment Corporation (the Company) develops, manufactures, and
markets a variety of toys and other children's products, including a variety
of interactive products. The Company markets its products through domestic and
international retailers and distributors.
 
  As of December 31, 1997, the Company had an accumulated deficit of
$96,505,000, and for the year then ended incurred a net loss of $38,201,000.
Management believes that the proceeds from the sale of two product lines (see
Note 16), the Company's line of credit, and cash from operations will support
the Company's planned activities through the end of 1998. If the Company
experiences unanticipated cash requirements during 1998, it could be required
to reduce cash disbursements, reduce operating expenses, or seek additional
financing. There can be no assurance that such additional financing would be
available or that such financing would be available on acceptable terms.
 
 Basis of Presentation
 
  The accompanying consolidated financial statements include the accounts of
the Company and its wholly owned subsidiaries. All significant intercompany
accounts and transactions have been eliminated.
 
 Use of Estimates
 
  The preparation of the financial statements in conformity with generally
accepted accounting principles requires management to make estimates and
assumptions that affect the amounts reported in the financial statements and
accompanying notes. Actual results could differ from those estimates.
 
 Reclassifications
 
  Certain amounts in the 1996 financial statements have been reclassified to
conform to the 1997 presentation.
 
 Revenue Recognition
 
  The Company recognizes revenue upon shipment of product and computes net
sales by concurrently deducting a provision for sales returns and allowances,
including allowances for defective returns, price protection, mark downs, and
other returns. Sales allowances may vary as a percentage of gross sales due to
changes in the Company's product mix, defective product allowances, or other
sales allowances. Actual amounts for returns and allowances may differ from
the Company's estimate and such differences could be material to the financial
statements. Revenue from licensing and royalties is recognized at the time
payment for the same is received. Revenue from licensing and royalties has
not, to date, constituted a significant portion of the Company's total
revenues.
 
 Advertising Expense
 
  The cost of production related to advertising is expensed upon the first
showing of the advertising and the cost associated with media time is expensed
as incurred. The Company incurred approximately $6,481,000, $10,033,000, and
$3,295,000 in advertising costs during 1997, 1996, and 1995, respectively. At
December 31, 1997 and 1996, the Company had $2,105,000 and $2,583,000,
respectively, of prepaid advertising related to future advertising.
 
                                      F-6
<PAGE>
 
                        YES! ENTERTAINMENT CORPORATION
 
            NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(CONTINUED)
 
                               DECEMBER 31, 1997
 
 
 Research and Development
 
  Research and development expenses of approximately $5,483,000, $4,586,000,
and $2,768,000 for the years ended December 31, 1997, 1996, and 1995,
respectively, have been included in general and administrative expenses for
financial statement purposes.
 
 Cash and Cash Equivalents
 
  The Company considers all highly liquid investments with original maturities
of three months or less at the time of purchase to be cash equivalents.
 
 Inventories
 
  Inventories are stated at the lower of cost (first-in, first-out) or market.
Inventories are as follows:
 
<TABLE>
<CAPTION>
                                                                   DECEMBER 31
                                                                 ---------------
                                                                  1997    1996
                                                                 ------- -------
                                                                 (IN THOUSANDS)
   <S>                                                           <C>     <C>
   Raw materials................................................ $   496 $ 2,940
   Work-in-process..............................................     600     974
   Finished goods...............................................  12,417  22,280
                                                                 ------- -------
                                                                 $13,513 $26,194
                                                                 ======= =======
</TABLE>
 
  The Company's inventory valuation process is done on a part-by-part basis.
Lower of cost or market adjustments, specifically identified on a part-by-part
basis, reduce the carrying value of the related inventory and take into
consideration reductions in sales prices, excess inventory levels, and
obsolete inventory. Once established, these adjustments are considered
permanent and are not reversed until the related inventory is sold or
disposed.
 
 Property and Equipment
 
  Property and equipment are stated at cost. Depreciation is computed on a
straight-line basis over the assets' estimated useful lives of one to five
years. Equipment under capital leases and leasehold improvements are amortized
over the shorter of the estimated useful lives or the lease term.
 
<TABLE>
<CAPTION>
                                                                  DECEMBER 31
                                                                ---------------
                                                                 1997    1996
                                                                ------- -------
                                                                (IN THOUSANDS)
   <S>                                                          <C>     <C>
   Equipment................................................... $ 1,883 $ 1,766
   Tooling.....................................................  10,158   6,169
   Furniture and fixtures......................................   2,389   2,113
   Leasehold improvements......................................     390     332
   Film........................................................     489     412
   Software....................................................     530     479
                                                                ------- -------
                                                                 15,839  11,271
   Accumulated depreciation....................................  10,494   7,402
                                                                ------- -------
                                                                $ 5,345 $ 3,869
                                                                ======= =======
</TABLE>
 
 
                                      F-7
<PAGE>
 
                        YES! ENTERTAINMENT CORPORATION
 
            NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(CONTINUED)
 
                               DECEMBER 31, 1997
 
 Intangible Assets
 
  Intangible assets of $156,000 and $276,000 at December 31, 1997 and 1996,
respectively, consist primarily of product technology rights, patents, and
trademarks. Intangibles are amortized on a straight-line basis over the
estimated lives of the related assets of two to six years. Accumulated
amortization as of December 31, 1997 and 1996 was $314,000 and $249,000,
respectively.
 
 Earnings Per Share
 
  In 1997, the Financial Accounting Standards Board issued Statement No. 128,
"Earnings Per share." Statement No. 128 replaced the calculation of primary
and fully diluted earnings per share with basic and diluted earnings per
share. Unlike primary earnings per share, basic earnings per share excludes
any dilutive effects of options, warrants, and convertible securities. Diluted
earnings per share is very similar to the previously reported fully diluted
earnings per share. All earnings per share amounts for all periods have been
presented, and where appropriate, restated to conform to the Statement No. 128
requirements.
 
2. PREPAID ADVERTISING
 
  During 1997 and 1996, the Company entered into various transactions whereby
it exchanged $0 and $987,000 of inventory, respectively, for advertising
credits to be used toward the purchase of media time. These transactions are
reported at the estimated fair market value of the inventory exchanged, which
approximated cost. The agreements allow the Company to use the advertising
credits in lieu of up to 25% of the cost of media purchased. The credits
expire in August 2000. During 1997 and 1996, the Company utilized $614,000 and
$1,022,000, respectively, of these credits for advertising.
 
  At December 31, 1997 and 1996, the Company had advertising credits in the
amount of $1,254,000 and $1,868,000, respectively, which were included in
prepaid assets.
 
3. CONCENTRATIONS OF CREDIT RISK
 
  Financial instruments that subject the Company to concentrations of credit
risk are cash equivalents and trade receivables. Cash equivalents consist
principally of short-term money market funds and certificates of deposit.
These instruments are short-term in nature and bear minimal risk. To date, the
Company has not experienced losses on these investments.
 
  The Company manufactures and sells its products primarily to major toy
retailers in the United States. Credit is extended based on an evaluation of
the customers' financial condition, and generally collateral is not required.
Credit losses are provided for in the consolidated financial statements and,
to date, have been within management's expectations. Reserves are maintained
for potential credit losses.
 
4. CERTAIN OTHER RISKS
 
 Stock Balancing, Price Protection, and Advertising Allowances
 
  Many companies in the toy industry allow retailers to return slow-moving
products for credit/replacement (referred to as stock balancing), discount
prices of existing products, provide for certain advertising allowances and
credits, or give other sales incentives to customers. The Company has made
such accommodations in the
 
                                      F-8
<PAGE>
 
                        YES! ENTERTAINMENT CORPORATION
 
            NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(CONTINUED)
 
                               DECEMBER 31, 1997
 
past, including significant accommodations in fiscal 1997 with regard to slow-
moving products. Due to the nature of the industry, including the volatility
of consumer acceptance of product introductions, there can be no assurance
that the Company will not make such accommodations in the future. Such
accommodations could have a material adverse effect on the Company's operating
results and financial condition.
 
 Seasonally of Sales
 
  Sales of toys have historically been highly seasonal with a majority of the
sales occurring late in the fiscal year. Failure to accurately predict and
respond to consumer demand may cause the Company to produce excess inventory
which could materially adversely affect the Company's operating results and
financial condition. Conversely, if a product achieves greater success than
anticipated, the Company may not have sufficient inventory to meet retail
demand, which could adversely impact the Company's relations with its
customers.
 
 Off-Shore Manufacturing
 
  As the Company does not have its own manufacturing facilities, it is
dependent on close working relationships with its contract manufacturers for
the supply and quality of its product. These manufacturers are based in Hong
Kong with manufacturing facilities in the People's Republic of China. The
Company expects to continue to use a limited number of contract manufacturers
and, accordingly, will continue to be highly dependent upon sources outside
the Company for timely production. Given the highly seasonal nature of the
Company's business, any unusual delays or quality control problems could have
a material adverse effect on the Company's operating results and financial
condition.
 
 Customer Concentration
 
  A limited number of customers historically have accounted for a substantial
portion of the Company's revenues.
 
  The Company's sales to significant customers as a percent of net sales were
as follows:
 
<TABLE>
<CAPTION>
                                                                   YEARS ENDED
                                                                   DECEMBER 31
                                                                  ----------------
                                                                  1997  1996  1995
                                                                  ----  ----  ----
   <S>                                                            <C>   <C>   <C>
   Toys R Us.....................................................  21%   21%   27%
   Wal-Mart......................................................  13%   20%   27%
   Tomy..........................................................   *    11%    *
   Kmart.........................................................   *    11%    *
   Kay-Bee.......................................................   *     *    12%
</TABLE>
--------
* Sales to these customers were less than 10% of net sales in the years
  indicated.
 
  The Company expects to continue to depend on a relatively small number of
customers for a significant percentage of its sales. Significant reductions in
sales to any one or more of the Company's largest customers would have a
material adverse effect on the Company's operating results and financial
condition. Because orders in the toy industry are generally cancelable at any
time without penalty, there can be no assurance that present or future
customers will not terminate their purchase arrangements with the Company or
significantly change, reduce, or delay the amount of products ordered from the
Company. With respect to its larger customers, any such termination of a
customer relationship or change, reduction, or delay in orders could have a
material adverse effect on the Company's operating results and financial
condition.
 
 
                                      F-9
<PAGE>
 
                        YES! ENTERTAINMENT CORPORATION
 
            NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(CONTINUED)
 
                               DECEMBER 31, 1997
 
 Dependence on New Product Introductions
 
  The Company has introduced and expects to commence sales of new product
lines during the current year. The Company expects that the new product lines
will place great demands on management and other Company resources. There can
be no assurance that the products under development by the Company will be
successfully developed or, if they are successfully developed, that they will
achieve market acceptance. If the Company is not able to complete development,
tooling, manufacture, and successful marketing of these product lines, the
Company's operating results and financial condition could be materially
adversely affected.
 
 Dependence on Key Personnel
 
  The Company believes its success will depend, to a significant extent, on
the efforts and abilities of certain of its senior management. Additionally,
the Company's line of credit agreement required employment of certain key
personnel. The Company has entered into employment agreements with these
individuals; however, the loss of such key personnel could have a material
adverse effect on the Company's operating results and financial condition.
 
5. NOTES PAYABLE AND FINANCING ARRANGEMENTS
 
  The Company has $30,000,000 available under the Accounts Receivable
Management and Security Agreement (the "Agreement") that expires September 3,
2001. Borrowings under the Agreement are based on 50% of defined eligible
accounts receivable and 40% of defined eligible inventories up to a maximum of
$6,000,000. Borrowings under the line of credit can be applied to the issuance
of letters of credit up to $16,000,000. Borrowings are collateralized by
substantially all of the Company's assets, and the Company is subject to
significant charges for early termination of the Agreement.
 
  At December 31, 1997 and 1996, borrowings were $10,709,000 and $16,712,000,
respectively, and the Company had approximately $132,000 of letters of credit
outstanding. The amount available under the line of credit at December 31,
1997 was approximately $13,254,000. Borrowings bear interest at 3% above the
institution's reference rate (the higher of the prime rate or the Federal
Funds Rate plus 1/2%). The interest rate was 11.50% and 11.25% at December 31,
1997 and 1996, respectively. In addition, the Agreement entered into with BNY
Financial Corporation limits the Company's ability to pay dividends without
the lender's consent.
 
  The Agreement contains covenants that require the Company to maintain a
minimum tangible net worth and meet certain other financial ratios. The
Company was not in compliance with the tangible net worth, quick ratio and
profitability covenants at December 31, 1997 and has obtained a waiver from
the financial institution with regard to these covenants for the year ended
December 31, 1997.
 
  On March 26, 1998, the Company entered into an agreement with BNY Financial
Corporation amending the covenants. The Company believes it will be in
compliance with the amended covenants throughout 1998.
 
  In September 1997, the Company issued 150,000 warrants to purchase shares of
the Company's common stock at an exercise price of $5 per share to BNY in
connection with an amendment of the Agreement. The warrants expire five years
from issuance and were valued at $231,000 using the Black-Scholes pricing
model. The amount is being amortized over the life of the warrant as a
deferred loan cost which is included in other current assets.
 
 
                                     F-10
<PAGE>
 
                        YES! ENTERTAINMENT CORPORATION
 
            NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(CONTINUED)
 
                               DECEMBER 31, 1997
 
6. CONVERTIBLE DEBENTURES AND PREFERRED STOCK
 
  During March 1997, the Company issued $1,566,667 in convertible debentures
and 85,000 shares of Series A convertible preferred stock at a par value of
$0.001 per share for $100 per share to two investors for $8,500,000
(collectively the "March Securities"). In April 1997, approximately $696,000
of the convertible preferred stock, including accrued dividends, were
converted to common stock. Effective April 30, 1997, the remaining March
Securities plus accrued dividends and interest were cancelled in favor of
$1,956,021 in convertible debentures and 390,846 shares of Series B
convertible preferred stock at a par value of $0.001 per share for $25 per
share for an aggregate value of $11,727,167 to the two investors and an
investment bank.
 
  Holders of the Series B preferred stock are entitled to receive, when and as
declared by the Board of Directors out of legally available funds, cumulative
dividends at a rate of $1.28 per annum, payable in shares of Series B
convertible preferred stock, quarterly. The Series B convertible preferred
stock has no voting rights, has a liquidation preference of $25 per share plus
all accrued but unpaid dividends, subject to adjustment, and is convertible at
the option of the holder into shares of common stock at a discount to the fair
market value of the Company's common stock near the time of conversion. The
discount increases monthly from 11.75% beginning in November 1997 increasing
to 18.75% in April 1998. The Series B convertible preferred stock is
redeemable at any time in cash, at the option of the Company. Any redemption
payments must be approved by BNY, the financial institution with which the
Company has its current Accounts Receivable Management and Security Agreement.
Any amount of the Series B convertible preferred stock remaining after five
years will convert at the then-prevailing conversion price.
 
  The convertible debentures earn interest at 5% per annum, are due April 30,
2002, and are convertible any time after the earlier of (a) November 1, 1997
or (b) such time as the price of the Company's common stock exceeds a volume-
weighted average price above $10 per share for 20 consecutive trading days
after August 1, 1997, at the option of the holder, at a conversion price
similar to that of the Series B convertible preferred stock. The convertible
debentures are subordinated to the bank financing agreements. The debentures
can be repaid at any time in cash, at the option of the Company.
 
  The discount resulting from the conversion feature of the Series B preferred
stock has been accounted for as a dividend that is recognized as a return to
the preferred shareholders. The discount resulting from the conversion of
convertible debentures has been treated as an additional interest expense that
is amortized over the discount period.
 
  The Company is not permitted by NASDAQ rules to issue in the aggregate more
than 20% of its outstanding common stock as the result of the conversion of
the Series B convertible preferred stock and convertible debentures and the
exercise of the warrants without first obtaining stockholder approval. If the
Company has not obtained stockholder approval and the investors seek to
convert the outstanding Series B convertible preferred stock and convertible
debentures into a number of common stock which exceeds 20% of the outstanding
common stock, the Company could be required to redeem the outstanding Series B
convertible preferred stock and repay the convertible debentures.
 
  In connection with the issuance of convertible debt and preferred stock, the
Company issued warrants for the purchase of 300,000 shares of common stock at
an exercise price per share of $3.55. The warrants expire March 18, 2002. The
warrants were valued at $900,000 using the Black-Scholes pricing model and
have been included in additional paid-in capital.
 
                                     F-11
<PAGE>
 
                         YES! ENTERTAINMENT CORPORATION
 
            NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(CONTINUED)
 
                               DECEMBER 31, 1997
 
 
7.  ROYALTIES
 
  The Company has acquired certain product rights and technologies from product
designers and developers as well as the rights to certain well-known children's
characters. These agreements generally provide for an advance royalty payment
and subsequent royalty payments based on net sales of products utilizing the
related technology or characters. Royalty expense under these agreements
totaled $7,184,000, $4,586,000, and $3,065,000 in 1997, 1996 and 1995,
respectively. Future minimum royalty commitments under these agreements are
approximately $857,000 at December 31, 1997.
 
  The Company has a license agreement with Shoot the Moon Products, Inc. (STM)
pursuant to which the Company pays royalties for the use of the technology
incorporated in one of the Company's products, T.V. Teddy. Prior to founding
the Company, Donald D. Kingsborough, the Company's Chairman and Chief Executive
Officer, was a shareholder of STM. In consideration of Mr. Kingsborough's
contribution to the capital of STM of all of his shares, STM entered into an
agreement with Mr. Kingsborough pursuant to which he is entitled to receive 15%
of the royalties received by STM for three products, including T.V. Teddy. The
amount to be paid to Mr. Kingsborough is based upon royalties paid on sales of
the T.V. Teddy hardware and excludes sales of the encoded videotapes. During
1997, 1996, and 1995, royalty payments to STM for sales of T.V. Teddy hardware
approximated $0, $7,700, and $335,000, respectively.
 
8. CAPITAL LEASE OBLIGATIONS
 
  The Company leases certain equipment under noncancelable lease agreements
that are accounted for as capital leases. As of December 31, 1997 and 1996,
equipment under capital lease arrangements included in property and equipment,
aggregated approximately $303,000 and $348,000 at December 31, 1997 and 1996,
respectively. Accumulated amortization totaled $297,000 and $319,000 at
December 31, 1997, and 1996, respectively.
 
  Future minimum lease payments under capital lease obligations at December 31,
1997, are $5,000 for 1998.
 
9. OPERATING LEASE COMMITMENTS
 
  The Company leases its operating facilities under noncancelable operating
leases expiring at various dates through 2000. The lease agreements contained
scheduled rent increases over the terms of the lease, and rental expense is
charged to operations on a straight-line basis over the lease term. The leases
are secured by deposits of $156,000 and $210,000 at December 31, 1997 and 1996,
respectively, which are included in other assets.
 
  Future minimum operating lease payments, net of sublease income, at December
31, 1997 are as follows (in thousands):
 
<TABLE>
   <S>                                                                  <C>
   1998................................................................  $1,486
   1999................................................................   1,444
   2000................................................................     757
   2001................................................................     757
   2002................................................................     757
   Thereafter..........................................................     228
                                                                        -------
                                                                         $5,429
                                                                        =======
</TABLE>
 
                                      F-12
<PAGE>
 
                        YES! ENTERTAINMENT CORPORATION
 
            NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(CONTINUED)
 
                               DECEMBER 31, 1997
 
 
  Total rental expense was approximately $1,313,000, $1,187,000, and
$1,345,000, in 1997, 1996, and 1995, respectively. The Company subleased a
portion of its Hong Kong subsidiary's facility under a noncancelable operating
lease that expired in 1995. As such, the 1995 rental expense was offset by
approximately $186,000 of sublease income.
 
10. INCOME TAXES
 
  There was no provision for income taxes in either 1997 or 1996, as the
Company incurred pre-tax book losses of approximately $38,201,000 and
$12,571,000, respectively. The Company's provision for income taxes of
$185,000 for 1995 is solely attributable to federal and state minimum taxes
and foreign income taxes.
 
  The total provision for income taxes differs from the amount computed by
applying the federal statutory income tax rate (34%) to income (loss) before
taxes as follows (in thousands):
 
<TABLE>
<CAPTION>
                                                    YEARS ENDED DECEMBER 31
                                                    --------------------------
                                                      1997     1996     1995
                                                    --------  -------  -------
   <S>                                              <C>       <C>      <C>
   Income tax (benefit) computed at the federal
    statutory rate................................. $(12,988) $(4,274) $ 1,294
   State taxes.....................................       --       --       25
   Foreign taxes...................................       --       --       50
   Temporary differences and net operating losses
    with no current tax benefit (benefited)........   12,988    4,274   (1,184)
                                                    --------  -------  -------
   Provision for income taxes...................... $     --  $    --  $   185
                                                    ========  =======  =======
</TABLE>
 
  Deferred income taxes reflect the net tax effects of temporary differences
between the carrying amounts of assets and liabilities for financial reporting
purposes and the amounts used for income tax purposes. Significant components
of the Company's deferred tax assets are as follows (in thousands):
 
<TABLE>
<CAPTION>
                                                                DECEMBER 31
                                                             ------------------
                                                               1997      1996
                                                             --------  --------
   <S>                                                       <C>       <C>
   Deferred tax assets:
     Tax benefit of net operating loss carryforwards........ $ 21,611  $ 13,453
     Allowance for returns..................................    2,949     1,807
     Inventory reserves.....................................    2,937     2,177
     Capitalized research and development...................    2,027     2,505
     Reserves and accrued expenses..........................    3,323      (331)
                                                             --------  --------
   Total deferred tax assets................................   32,847    19,611
   Valuation allowance......................................  (32,847)  (19,611)
                                                             --------  --------
   Net deferred tax assets.................................. $     --  $     --
                                                             ========  ========
</TABLE>
 
  Realization of deferred tax assets is dependent on future earnings, the
amount and timing of which are uncertain. Accordingly, a valuation allowance,
in an amount equal to the net deferred tax assets as of December 31, 1997 and
1996 has been established to reflect these uncertainties. The change in the
valuation allowance was an increase of $13,236,000 and $4,484,000 in 1997 and
1996, respectively, and a decrease of $993,000 in 1995.
 
  At December 31, 1997, the Company had net operating loss carryforwards for
federal and California tax purposes of approximately $58,000,000 and
$27,000,000, respectively. The federal losses will expire in the years
 
                                     F-13
<PAGE>
 
                        YES! ENTERTAINMENT CORPORATION
 
            NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(CONTINUED)
 
                               DECEMBER 31, 1997
 
2008 through 2013, and the state losses will expire in the years 1999 through
2003, if not utilized. Utilization of the net operating loss carryovers may be
subject to a substantial annual limitation if it should be determined that
there has been a change in the ownership of more than 50% of the value of the
Company's stock, pursuant to Section 382 of the Internal Revenue Code of 1986
and similar state provisions. The annual limitation may result in the
expiration of net operating loss carryovers before utilization.
 
11. STOCKHOLDERS' EQUITY
 
 Common Stock
 
  In August 1997, the Company entered into agreements with certain vendors to
satisfy indebtedness in an aggregate amount of approximately $3,116,000 with
the issuance of 831,000 shares of its common stock.
 
 Warrants
 
  In April and May 1995, in connection with the bridge notes described in Note
6, the Company issued warrants to purchase an aggregate of 1,500,000 shares of
the Company's common stock. The warrants are exercisable for a five-year
period from the date of grant at $4.00 per share.
 
  In connection with the Company's initial public offering in June 1995, the
Company issued redeemable common stock purchase warrants (IPO Warrants) at
$0.10 per share. In addition, the Company issued to the underwriter of the
initial public offering an option to purchase an additional 250,000 shares of
common stock and an option to purchase 250,000 warrants. Each IPO Warrant
entitles the holder to purchase one share of common stock for $4.00 during the
five-year period beginning June 7, 1995. Additionally, the Company issued
320,729 IPO Warrants in connection with the conversion of approximately
$1,400,000 of convertible subordinated promissory notes.
 
  All IPO Warrants, the warrants issued in April and May 1995 in connection
with the bridge notes, and any warrants issued upon the exercise of the
underwriter's purchase option were redeemable by the Company at a price of
$0.01 per warrant if the last price of the common stock had been at least
$6.50 per share for twenty consecutive trading days. The warrants became
redeemable on December 14, 1995, and the Company called all warrants for
redemption at which point various warrants were exercised.
 
  In addition to the warrants described above, the Company has the following
additional warrants outstanding to purchase common stock at December 31, 1997:
 
<TABLE>
<CAPTION>
                                                                          EXPIRATION
             NUMBER OF SHARES           PRICE PER SHARE                      DATE
             ----------------           ---------------                 --------------
             <S>                        <C>                             <C>
               37,252                       $16.32                      November 1998
               35,990                       $12.60                      December 1998
              348,729                       $15.30                      July 1998
              217,265                       $16.32                      February 1999
              454,852                       $ 7.50                      August 1999
              150,000                       $ 5.00                      September 2000
              300,000                       $ 3.55                      March 2002
</TABLE>
 
 
                                     F-14
<PAGE>
 
                        YES! ENTERTAINMENT CORPORATION
 
            NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(CONTINUED)
 
                               DECEMBER 31, 1997
 
 Stock Option Plans
 
  Under the Company's 1992 Stock Option Plan (1992 Plan), the Board of
Directors may grant incentive stock options to employees, directors, and
consultants to purchase up to 500,000 shares of common stock.
 
  In July 1995, the Board of Directors adopted the 1995 Stock Option Plan
(1995 Plan) and reserved 500,000 shares of common stock for issuance
thereunder. In October 1995, the Board of Directors increased the total number
of shares reserved for issuance to 1,000,000. In July 1996, the Board of
Directors increased the total number of shares reserved for issuance under the
1995 Stock Option Plan by 1,500,000 shares.
 
  The 1992 Plan and the 1995 Plan provide for the granting of incentive stock
options and nonstatutory stock options to employees, directors, and
consultants of the Company at prices ranging from 85% to 110% (depending on
the type of grant) of the fair market value of the common stock on the date of
grant as determined by the Board of Directors. The options generally vest at a
rate of 25% after one year from the date of grant and 1/48 each month
thereafter. The vesting and exercise provisions of the option grants are
determined by the Board of Directors, and the options are nontransferable. The
Company may offer to repurchase the outstanding options at any time under
terms and conditions to be determined by the Board of Directors.
 
  In July 1995, the Company adopted the 1995 Director Option Plan (Director
Plan) and reserved 120,000 shares of common stock for issuance thereunder.
Under the Director Plan, automatic option grants are made upon appointment as
a director and on each anniversary date thereafter to eligible nonemployee
members of the Board of Directors. One hundred percent of the shares subject
to the initial option granted to each director become fully vested one year
after the date of the grant. One forty-eighth of the shares subject to
subsequent options granted to each director become exercisable each month
after the option grant.
 
  In August 1997, the Board of Directors approved the repricing of options
granted to employees in 1996 as such options were in excess of the prevailing
price of the Company's common stock. In order to restore incentives to these
employees, the holders of the options were given the right to cancel their
1996 options in their entirety in consideration of the issue of new stock
options for the same number of shares at an exercise price of $3.75 per share.
The difference between the exercise price and the fair market value of the
Company's common stock at the date of issue of the stock options, totaling
approximately $606,000 has been recorded as deferred compensation and a
component of stockholders' equity. The deferred compensation amount will be
recognized as an expense as the shares and options vest over a period of four
years.
 
                                     F-15
<PAGE>
 
                        YES! ENTERTAINMENT CORPORATION
 
            NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(CONTINUED)
 
                               DECEMBER 31, 1997
 
 
  Stock option activity under the 1992 Plan and 1995 Plan was as follows: (in
thousands, except per share data)
 
<TABLE>
<CAPTION>
                                                         OPTIONS OUTSTANDING
                                                      --------------------------
                                                                        WEIGHTED
                                                                        AVERAGE
                                                                NUMBER   PRICE
                                                      AVAILABLE   OF      PER
                                                      FOR GRANT SHARES   SHARE
                                                      --------- ------  --------
   <S>                                                <C>       <C>     <C>
   Balance at December 31, 1994......................      60      156   $1.90
     Options authorized..............................   1,404       --      --
     Granted.........................................  (1,243)   1,243    4.86
     Exercised.......................................      --      (19)   1.84
     Canceled........................................      71      (71)   2.02
                                                       ------   ------   -----
   Balance at December 31, 1995......................     292    1,309    4.70
     Options authorized..............................   1,500       --      --
     Granted.........................................  (1,218)   1,218   13.07
     Exercised.......................................      --      (47)   3.40
     Canceled........................................      64      (64)   6.45
                                                       ------   ------   -----
   Balance at December 31, 1996......................     638    2,416    9.11
     Options authorized .............................      --       --      --
     Granted.........................................  (1,693)   1,693    3.70
     Exercised.......................................      --      (16)   2.06
     Canceled........................................   1,461   (1,461)  10.54
                                                       ------   ------   -----
   Balance at December 31, 1997......................     406    2,632   $4.87
                                                       ======   ======   =====
</TABLE>
 
  At December 31, 1997 and 1996, approximately 757,000 and 554,000 options,
respectively, were exercisable under the plans.
 
  At December 31, 1997, options outstanding were as follows:
 
<TABLE>
<CAPTION>
                                           OUTSTANDING OPTIONS EXERCISABLE
                                      ------------------------------------------
                            NUMBER     WEIGHTED               NUMBER
                         OUTSTANDING    AVERAGE   WEIGHTED EXERCISABLE  WEIGHTED
                            AS OF      REMAINING  AVERAGE     AS OF     AVERAGE
                         DECEMBER 31, CONTRACTUAL EXERCISE DECEMBER 31, EXERCISE
       EXERCISE PRICES       1997        LIFE      PRICE       1997      PRICE
       ---------------   ------------ ----------- -------- ------------ --------
       <S>               <C>          <C>         <C>      <C>          <C>
       $ 1.50 --  2.25      816,422      $6.78     $2.17     264,958     $ 2.02
         5.25 --  6.00    1,280,344       9.00      3.91     440,797       3.93
         6.13 --  9.13      410,858       7.94      6.56       7,010       6.93
        10.69 -- 13.88      123,214       8.62     12.92      43,976      12.83
       ---------------    ---------      -----     -----     -------     ------
       $ 1.50 --$13.88    2,630,838      $8.13     $4.20     756,741     $ 3.80
       ===============    =========      =====     =====     =======     ======
</TABLE>
 
  The Company has elected to follow Accounting Principle Board Opinion No. 25,
"Accounting for Stock Issued to Employees" (APB Opinion No. 25) and related
Interpretations in accounting for its employee stock options because, as
discussed below, the alternative fair value accounting provided for under the
Statement of Financial Accounting Standards No. 123, "Accounting for Stock-
Based Compensation" (FAS 123), requires use of option valuation models that
were not developed for use in valuing employee stock options. Under APB
Opinion No. 25, because the exercise price of the Company's employee stock
options equals the market price of the underlying stock on the date of grant,
no compensation expense is recognized.
 
 
                                     F-16
<PAGE>
 
                        YES! ENTERTAINMENT CORPORATION
 
            NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(CONTINUED)
 
                               DECEMBER 31, 1997
 
 
  Pro forma information regarding net income (loss) and earnings (loss) per
share is required by FAS 123, and has been determined as if the Company had
accounted for its employee stock options under the fair value method of FAS
123. For options granted prior to the initial public offering in June 1995,
the fair value for these options was estimated at the date of grant using the
Minimum Value option pricing method with the following assumption for 1995: a
risk-free interest rate of 6.37%; a dividend yield of 0%; and an expected life
of options of five years. For options granted subsequent to the initial public
offering, the fair value for these options was estimated at the date of grant
using the Black-Scholes option pricing model with the following weighted
average assumptions: a risk-free interest rate of 5.77% to 6.76% for 1997 and
6.23% for 1996; a dividend yield of 0%; a volatility factor of the expected
market price of the Company's common stock of .679 and .342 for 1997 and 1996,
respectively; and a weighted average expected life of the option of five
years. The weighted average fair value of these options granted were $3.70 and
$1.84 for 1997 and 1996, respectively.
 
  The Minimum Value option valuation method may be used by nonpublic companies
to value an award. The Black-Scholes option valuation model was developed for
use in estimating the fair value of traded options which have no vesting
restrictions and are fully transferable. In addition, option valuation models
require the input of highly subjective assumptions, including expected stock
price volatility. Because the Company's employee stock options have
characteristics significantly different from those of traded options and
because changes in the subjective input assumptions can materially affect the
fair value estimate, in management's opinion, the existing models do not
necessarily provide a reliable single measure of the fair value of its
employee stock options.
 
  Had compensation costs for the Company's stock-based compensation plans been
determined on the fair value at the grant dates for awards under those plans
consistent with the method of FAS 123, the Company's net (loss) income and
(loss) earnings per share would have been the pro forma amounts indicated
below:
 
<TABLE>
<CAPTION>
                                                YEAR ENDED DECEMBER 31
                                         --------------------------------------
                                             1997          1996         1995
                                         ------------  ------------  ----------
<S>                                      <C>           <C>           <C>
Net (loss) income....................... $(42,071,000) $(12,571,000) $3,478,000
Pro forma net (loss) income............. $(42,453,000) $(13,477,000) $3,314,000
Net (loss) earnings per share:
 Basic.................................. $      (2.90) $      (0.91) $     0.65
 Diluted................................ $      (2.90) $      (0.91) $     0.41
Pro forma (loss) earnings per share:
 Basic.................................. $      (2.92) $      (0.97) $     0.62
 Diluted................................ $      (2.92) $      (0.97) $     0.39
</TABLE>
 
 Preferred Stock
 
  The Board of Directors may issue up to 2,000,000 shares of undesignated
preferred stock in one or more series and may fix the rights, privileges and
restrictions granted to or imposed upon any wholly unissued series of
undesignated preferred stock, as well as to fix the number of shares
constituting any series and designations of such series, without any further
voter action by the stockholders.
 
  In 1997, the Company issued 390,846 shares of Series B preferred stock in
connection with a financing transaction. See Note 6.
 
                                     F-17
<PAGE>
 
                        YES! ENTERTAINMENT CORPORATION
 
            NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(CONTINUED)
 
                               DECEMBER 31, 1997
 
 
 Common Stock Reserved for Future Issuance
 
  Authorized shares of common stock reserved, are as follows (in thousands):
 
<TABLE>
<CAPTION>
                                                                     DECEMBER 31
                                                                     -----------
                                                                     1997  1996
                                                                     ----- -----
<S>                                                                  <C>   <C>
Stock option plans, including the 1992 Stock Option Plan,
 the 1995 Stock Option Plan, and the 1995 Director Option Plans..... 3,038 3,054
Issued and outstanding warrants..................................... 1,544 1,354
Undesignated preferred stock........................................ 1,609 2,000
                                                                     ----- -----
Total common stock reserved for future issuance..................... 6,189 6,408
                                                                     ===== =====
</TABLE>
 
12. INDUSTRY AND GEOGRAPHIC INFORMATION
 
  The Company operates in a single industry segment. The Company markets its
products in the United States and in foreign countries through its sales
personnel, independent sales representatives, and distributors.
 
  The Company's geographic sales as a percent of net product sales were as
follows:
 
<TABLE>
<CAPTION>
                                                     YEARS ENDED DECEMBER 31
                                                     ---------------------------
                                                      1997      1996      1995
                                                     -------   -------   -------
<S>                                                  <C>       <C>       <C>
United States.......................................      68%       79%       93%
Export:
Europe..............................................      16         3         2
Far East............................................       9        11         2
Other...............................................       7         7         3
                                                     -------   -------   -------
                                                         100%      100%      100%
                                                     =======   =======   =======
</TABLE>
 
13. LITIGATION
 
  The Company is defending several shareholder lawsuits, as follows:
 
 The State Securities Class Actions
 
  Two class actions have been filed against the Company, Donald D.
Kingsborough, Sol Kershner and Bruce D. Bower in the California Superior court
of the County of Alameda: Wang v. YES! Entertainment Corporation et al., filed
on April 15, 1997; and Miller v. YES! Entertainment Corporation et al., filed
on July 3, 1997. In Miller , Gary L. Nemetz, a former director of the Company,
is also named as a defendant.
 
  The Wang lawsuit is purportedly brought on behalf of purchasers of the
Company's common stock between October 23, 1996 and December 12, 1996,
inclusive. It challenges certain statements made by defendants regarding the
Company's V-Link product, as well as its impact on the Company's sales and
profitability. The Wang lawsuit alleges that these statements violated
Corporations Code Section 25400 and 25500, which provides a remedy to
California residents against persons who make false or misleading statements
while engaged in "market activity"; constituted "unfair competition" in
violation of California Business & Professions Code Section 17200; and
constituted common law fraud pursuant to California Civil Code Section 1709-
1711.
 
                                     F-18
<PAGE>
 
                        YES! ENTERTAINMENT CORPORATION
 
            NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(CONTINUED)
 
                               DECEMBER 31, 1997
 
 
  The Miller lawsuit is based on the same facts as the Wang lawsuit, alleges a
longer class period of March 29, 1996 to December 12, 1996, and challenges
certain additional statements made by defendants. The Miller first amended
complaint states only one count, which is for violation of (S)(S)25400 and
25500 of the California Corporations Code.
 
  In July 1997, a demurrer filed by defendants in the Wang action was
sustained with leave to amend. Plaintiffs filed an amended complaint on
September 29, 1997. On January 8, 1998, the court sustained without leave to
amend defendant's demurrer to the causes of action for violations of Sections
25400 and 25500 of the California Corporations Code, and Section 17200 of the
Business and Professions Code in the amended complaint. On January 19, 1998,
the plaintiff filed a second amended complaint alleging only one count for
violation of California Civil Code Section, 1709, 1711 and 1717. Defendants
filed a demurrer to the second amended complaint which was sustained with ten
days leave to amend on March 31, 1998. Plaintiff has not yet filed their
amended complaint.
 
  On January 7, 1998, the defendants' demurrer to the first amended complaint
of the Miller action was sustained with leave to amend. On January 19, 1998,
plaintiff filed a second amended complaint. Defendants filed a demurrer to the
second amended complaint which is scheduled to be heard in May 1998. In
addition, the plaintiffs have served on the Company two separate requests for
production of documents and have noticed the deposition of Donald D.
Kingsborough with a request for the production of documents. A date for the
deposition and production of documents has not yet been agreed upon.
 
 The Federal Securities Class Actions
 
  Three class actions were filed against the Company and Messrs. Kingsborough
and Kershner in the United States District Court for the Northern District of
California: Harrow v. YES! Entertainment Corporation et al., filed on April
17, 1997; Takats v. YES! Entertainment Corporation et al., filed on June 11,
1997; and Siegel v. YES! Entertainment Corporation et al., filed on June 27,
1997. On August 6, 1997, the three Federal actions were consolidated for pre-
trial proceedings and captioned In re YES! Entertainment Corp. Securities
Litigation, Civil Action No. C-97-1388 MHP. On December 4, 1997, the action
was referred to the Northern District of California. On August 18, 1997, all
defendants filed a motion to dismiss the consolidated action. In response, on
November 8, 1997, plaintiffs filed a first amended consolidated complaint for
violation of the Securities Exchange Act of 1934. Defendants filed a motion to
dismiss the consolidated complaint on January 5, 1998. The hearing date for
the motion is set for May 22, 1998. The Federal class actions are based upon
claims under the federal securities laws, which impose liability on persons
who make false or misleading statements in connection with the sale or
purchase of securities.
 
  The State and Federal securities class action lawsuits have been tendered to
the applicable directors and officers insurance carriers who have responded
with a reservation of rights pending a final determination of coverage.
Directors and officers insurance coverage totals $5 million. The primary
insurance policy is subject to certain deductible and retention provisions.
 
                                     F-19
<PAGE>
 
                        YES! ENTERTAINMENT CORPORATION
 
            NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(CONTINUED)
 
                               DECEMBER 31, 1997
 
 
  The Company believes that it has meritorious defenses to these lawsuits and
intends to vigorously defend them. However, no assurance can be given as to
the outcome of the lawsuits. The Company believes it will incur substantial
time and expense to defend these lawsuits, and an adverse result in any of the
lawsuits would have a material effect on the Company's operating results and
financial condition. The State and Federal actions seek compensatory and
punitive damages, interest, attorneys' fees and other costs, as well as
equitable relief to preserve defendants' assets. The inability of the Company
to prevail in the lawsuits could have a material adverse effect on the
Company's business, financial condition, and results of operations.
 
  The Company is involved from time to time in other litigation matters
incidental to its business.
 
14. EMPLOYEE BENEFIT PLAN
 
  In July 1996, the Company restated the YES! Entertainment 401(k) Savings
Plan (the Plan) to accommodate a matching contribution in the form of employer
stock. As allowed under Section 401(k) of the Internal Revenue Code, the Plan
provides tax deferred salary deductions for eligible employees. Eligible
employees include persons employed by YES! Entertainment Corporation on a
substantially full-time basis for a period of at least one month. Participants
in the Plan may make deferrals not less than 1% and not more than 20% of their
annual compensation, limited by the maximum dollar amount allowed by the
Internal Revenue Code. The Company, at its discretion, may elect to make
contributions to the Plan on behalf of its eligible participants. If the
Company elects to do so, it will match 50% of employee contributions at the
end of each quarter in the form of company stock. During 1997 and 1996, the
Company made contributions in the form of company stock in the amount of
$145,000 and $164,000, respectively.
 
15. EARNINGS PER SHARE
 
  The following table sets forth the computation of basic and diluted earnings
per share:
 
<TABLE>
<CAPTION>
                                                       1997      1996     1995
                                                     --------  --------  ------
<S>                                                  <C>       <C>       <C>
Numerator:
 Net (loss) income.................................. $(38,201) $(12,571) $3,478
 Non-cash dividends and discount on preferred stock.   (3,870)       --      --
                                                     --------  --------  ------
 Numerator for basic (loss) earnings per share-
  income available to common shareholders........... $(42,071) $(12,571) $3,478
                                                     ========  ========  ======
Denominator:
 Denominator for basic (loss) earnings per share-
  weighted average shares...........................   14,529    13,890   5,339
 Effect of dilutive securities:
  Employee stock options............................       --        --     574
  Preferred stock...................................       --        --   2,259
  Other dilutive securities.........................       --        --     362
                                                     --------  --------  ------
 Denominator for diluted earnings per share:
  Weighted average common shares and dilutive
   securities outstanding...........................   14,529    13,890   8,534
                                                     ========  ========  ======
Basic (loss) earnings per share..................... $  (2.90) $  (0.91) $ 0.65
                                                     ========  ========  ======
Diluted earnings per share.......................... $  (2.90) $  (0.91) $ 0.41
                                                     ========  ========  ======
</TABLE>
 
                                     F-20
<PAGE>
 
                        YES! ENTERTAINMENT CORPORATION
 
            NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(CONTINUED)
 
                               DECEMBER 31, 1997
 
 
16. SUBSEQUENT EVENT
 
  In March 1998, the Company entered into a definitive agreement for Wham-O,
Inc. to purchase the assets of YES!'s Food and Girls Activity product lines.
The total purchase price includes approximately $9.8 million in cash for the
purchase of the lines and related inventories, a $2.5 million contingency
payment to be earned based upon certain performance criteria for the Food line
in the first year, and royalties of up to $5.5 million over a seven year
period.
 
  Sales from these product lines were $15.7 million, $5.1 million and $0 for
1997, 1996 and 1995.
 
  Gross margin from these product lines were $9.5 million, $2.8 million and $0
for 1997, 1996 and 1995.
 
                                     F-21
<PAGE>
 
                                                                     Schedule II
 
                         YES! ENTERTAINMENT CORPORATION
                       VALUATION AND QUALIFYING ACCOUNTS
                                 (IN THOUSANDS)
 
<TABLE>
<CAPTION>
                                     BALANCE AT CHARGED TO             BALANCE
                                     BEGINNING  COSTS AND              AT END
                                     OF PERIOD   EXPENSES  DEDUCTIONS OF PERIOD
                                     ---------- ---------- ---------- ---------
<S>                                  <C>        <C>        <C>        <C>
Year ended December 31, 1995:
 Allowance for doubtful accounts....  $   259    $   232    $    59    $   432
 Allowance for sales returns and al-
  lowances..........................    7,658      6,523     11,575      2,606
                                      -------    -------    -------    -------
                                      $ 7,917    $ 6,755    $11,634    $ 3,038
                                      =======    =======    =======    =======
Year ended December 31, 1996:
 Allowance for doubtful accounts....  $   432    $   192    $   159    $   465
 Allowance for sales returns and al-
  lowances..........................    2,606      9,939      7,365      5,180
                                      -------    -------    -------    -------
                                      $ 3,038    $10,131    $ 7,524    $ 5,645
                                      =======    =======    =======    =======
Year ended December 31, 1997:
 Allowance for doubtful accounts....  $   465    $   (70)   $   258    $   137
 Allowance for sales returns and al-
  lowances..........................    5,180     14,121      6,554     12,747
                                      -------    -------    -------    -------
                                      $ 5,645    $14,051    $ 6,812    $12,884
                                      =======    =======    =======    =======
</TABLE>
 
                                      S-1