<PAGE>

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

                                   FORM 10-K

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

                  For the fiscal year ended December 31, 1996

                                      OR

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

                 For the transition period         to

                        Commission File Number: 0-25916

                        YES! ENTERTAINMENT CORPORATION
            (Exact name of Registrant as specified in its charter)

<TABLE>
<S>                                            <C>
                  Delaware                                       94-3165290
              ----------------                                 --------------
       (State or other jurisdiction of                        (I.R.S. Employer
       incorporation or organization)                       (Identification No.)
</TABLE>

          3875 Hopyard Road, Suite 375, Pleasanton, California 94588
             (Address of principal executive offices and zip code)

      Registrant's telephone number, including area code: (510) 847-9444

                               ----------------

       Securities registered pursuant to Section 12(b) of the Act: None

          Securities registered pursuant to Section 12(g) of the Act:

                          Common Stock, no par value

                               (Title of Class)

  Indicate by check mark whether the Registrant (1) has filed all reports
required to be filed by Section 13 or 15(d) of the Securities Exchange Act of
1934 during the preceding 12 months (or for such shorter period that the
Registrant was required to file such reports), and (2) has been subject to
such filing requirements for the past 90 days. Yes X  No

  Indicate by check mark if disclosure of delinquent filers pursuant to Item
405 of Regulation S-K is not contained herein, and will not be contained, to
the best of Registrant's knowledge, in definitive proxy or information
statements incorporated by reference in Part III of this 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 14,
1997 on the Nasdaq National Market was approximately $42,846,228. Shares of
Common Stock held by each officer and director and by each person who owns 5%
or more of the outstanding Common Stock have been excluded in that such
persons may be deemed to be affiliates. This determination of affiliate status
is not necessarily a conclusive determination for other purposes.

  The number of shares outstanding of the Registrant's Common Stock as of
March 14, 1997 was 14,043,432.

                      DOCUMENTS INCORPORATED BY REFERENCE

  Certain sections of the Registrant's definitive Proxy Statement for the 1997
Annual Meeting of Shareholders to be held on May 20, 1997 are incorporated by
reference in Part III of this Form 10-K to the extent stated herein.
<PAGE>

                                    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 45 million in North America alone.

  YES! has introduced several lines of products since being founded in
December 1992. A substantial portion of the Company's current products are
marketed under the YES! Gear brand. YES! Gear is principally comprised of the
Company's Yak Bak, Mega and T.R.A.P.S. lines of products. These products,
which include 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. The Company also markets Power Penz, a line of pens
that incorporate toys and activities. In 1996, the Company also launched a
line of food activity products with the Mrs. Fields Baking Factory, a toy
cookie oven using mixes developed in conjunction with the Mrs. Fields
Development Corporation, and V-Link, a new line of communication products
designed to be a short-range, toll-free radiophone system that includes voice-
messaging, conference call and private conversation features.

  In 1997, the Company expects to introduce a number of new products and
product lines. These include the Baskin-Robbins Ice Cream Maker, a toy ice
cream maker with which children can prepare ice cream for their family using
delicious mixes developed in conjunction with Baskin-Robbins USA, Co., Air
Vectors, a line of small vehicles for boys that transform and launch flying
objects, such as airplanes or missiles, YES! Pre-School, a line of pre-school
products which incorporate popular features from YES!'s highly successful Yak
Bak line, YES! Girl, a line of electronic toys and activities specially for
girls, Disgusting Designs, a ghoulish new art activity center for boys, and
Radical Air, a line of toy guns that shoot foam balls that expand to three
times their original size in the air.

  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 $69.7
million, $55.7 million, $36.4 million and $25.9 million in 1996, 1995, 1994
and 1993, respectively. The Company incurred operating losses from its
inception through the quarter ended June 30, 1995, incurred a net loss of
approximately $12.6 million in 1996, and had an accumulated deficit of
approximately $52.7 million at December 31, 1996.

  The Company's initial public offering of Common Stock occurred in June 1995
at which time the Company's Common Stock and Redeemable Common Stock Purchase
Warrants issued in connection with the initial public offering ("IPO
Warrants") commenced trading on the Nasdaq SmallCap Market. The Company's
Common Stock and IPO Warrants were included on the Nasdaq National Market in
November 1995. All of the outstanding IPO Warrants were exercised in December
1995 and January 1996 at an exercise price of $4.00 per share. Pursuant to the
exercise of the IPO Warrants, the Company raised approximately $19.8 million.

  YES!, YAK BAK and COMES TO LIFE BOOKS are registered trademarks and YES!
GEAR, POWER PENZ, AIR VECTORS, YES! PRE-SCHOOL, YES! GIRL, DISGUSTING DESIGNS,
RADICAL AIR WEAPONS, T.R.A.P.S., YAK BAK WARP'R, YAK BAK SFX, YAK BAKWARDS,
YAK MANIAK, MEGA MIKE, MIGHTY MEGA MOUTH SPORTS, SECRETS, CODER, LASER SHOTS,
QUICK FLIPS, PEN PHONE, HANDY CANDY, V-LINK, MONSTER MARKER HAND, MOLDY BODY
PARTS, PET TOONIES, GIZMOS, MUSIC GIZMOS, INSTRUMENT GISMOS, DANCE STUDIO,
YES! EXTREME, STROBES, YAK BAK BALLS, SFX BALLS, YES! GAMES and SLAP TRAP are
trademarks of YES! Entertainment Corporation. All rights reserved. MRS. FIELDS
is a registered trademark of the Mrs. Fields Development Corporation. BASKIN
31 ROBBINS is a registered trademark of the Baskin-Robbins USA, Co.
NICKELODEON is a registered trademark of Nickelodeon, a programing service of
Viacom International, Inc.

                                       1
<PAGE>

PRODUCTS

  YES!'s product lines span major markets for children's and teen products.
These include educational and licensed products, children's electronics and
publishing, activity products, and electronic learning products, as well as
new product categories that YES!'s innovative approach to product development
is helping to create, such as audio recording and distortion products,
functional toys (i.e. toys that work as other types of products, such as pens)
and children's and teen communications. The majority of the Company's products
target children ages two to twelve, although the Company's V-Link product
targets consumers between the ages of ten and seventeen.

  The Company introduced a number of new product lines in 1996 and expects to
introduce several new product lines in 1997. The Company expects that the 1997
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 1997 product lines, the Company's operating
results and financial condition will be materially adversely affected.

  YES! GEAR

  The Company's current line of YES! Gear products comprises over 30 SKUs. All
of these 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, Mega and T.R.A.P.S. lines of 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 recording and
playback device. Since then, the Company has introduced a number of extensions
to the Yak Bak product, including Yak Bak Warp'r, a more fully featured
version of the original Yak Bak product, which includes a voice pitch
modulator, that alters the voice recording to permit the recorder to play back
the recording in new ways; Yak Bak SFX, 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 Bakwards, a Yak Bak device
that permits the user to play back a recorded message in reverse (thereby
creating a whole new language for children). The Company has also extended the
recordability features of the Yak Bak into other formats appealing to
children, including balls, wristwatches, motion detectors and a variety of
pens that include the Yak Warp'r, Yak Bak SFX and Yak Bakwards features.

  In 1997, the Company expects to extend the Yak Bak line further with the
introduction of Yak Maniak, a Yak Bak device that incorporates echo, reverb
and tremolo capability to permit kids to make new and exciting recordings. The
Company also expects to launch a line of Yak Bak SFX products themes for girls
under the Ms. Yak mark.

                                       2
<PAGE>

  Mega Products. In 1996, the Company introduced a line of voice amplification
products. In 1997, the Company will continue these types of products with its
Mega Mike and Mighty Mega Mouth Sports products. Mega Mike is a voice
amplification device that clips to the user's belt, attached to which is 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. Mighty Mega Mouth Sports is a high sound
volume device that let's kids blast their voice and add popular sports sound
effects sounds.

  T.R.A.P.S. In 1996, the Company introduced a line of remote activated pranks
and effects products marketed under the name Techno Remote Activated Pranks
(or T.R.A.P.S.). Each of the T.R.A.P.S. is activated by a radio frequency
transponder that allows the user to initiate his or her prank or effect from a
hidden or remote location. The remote control device activates all four
T.R.A.P.S., which include a squirt cannon, a water or air balloon popper, a
sound effects generator and a bug drop, which releases plastic bugs from a
ceiling location.

  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 1995, the Company introduced
four mechanical Power Penz, consisting of a dart launcher, a helicopter, a
miniature race car launcher, and a combination telescope, microscope and rear
view mirror, and two electrical Power Penz, consisting of a sound effects toy
and a mini directional amplifier. In 1996, the Company expanded the Power Penz
line to include Secrets and Coder, pens that wrote in (and illuminated with a
built-in UV light) invisible ink, Laser Shots, pens that fire and sense beams
of infrared light that allow kids to aim and fire at each other's pens, Quick
Flips, pens that house grooming and cosmetic devices for girls and spy
activities for boys that flip out of the body of the pen, and Rimshot, pens
that house a basketball hoop and launch miniature basketballs.

  The Company expects to expand the Power Penz line in 1997 to include Pen
Phone, pens that work as short range infrared walkie talkies, Handy Candy
candy dispensing pens, FM radio pens, drumming pens, and many other new and
exciting activities in a pen.

  LICENSED FOOD

  Mrs. Fields 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 for their
families and friends, using recipes developed in conjunction with the Mrs.
Fields Development Corporation. Each oven displays the familiar Mrs. Fields
red and white color scheme and logo and comes complete with a set of baking
pans and utensils. The mixes, which come with the oven and are also sold
separately, are designed to taste like the real Mrs. Fields cookies available
at any one of the hundreds of Mrs. Fields cookie outlets throughout the United
States.

  Baskin-Robbins Ice Cream Maker. In 1997, the Company expects to build on the
success of the Mrs. Fields Baking Factory when it launches the Baskin-Robbins
Ice Cream Maker, which makes real ice cream using Baskin-Robbins mixes,
including some that have been developed exclusively for YES!. Like the Mrs.
Fields Baking Factory, the Baskin-Robbins Ice Cream Maker will be sold with a
variety of mixes, and refills will be available in a number of different
flavors.

  COMMUNICATIONS

  In late 1996, the Company introduced V-Link, a new communications product
marketed principally to teens ages ten to seventeen. V-Link is designed to
permit teens to communicate with each other within up to a 1,000 foot radius
(such as in a school or at a shopping mall) without any toll or monthly
charges. V-Link also includes voice mail and messaging capabilities, together
with the ability to have private conversations or talk on a party line.

                                       3
<PAGE>

  V-Link is a complicated consumer electronics product, and the Company has
incurred substantial expense in completing the development and tooling for its
manufacture. In 1996, the Company also devoted a substantial portion of its
marketing budget to the introduction of V-Link, which occurred later than
anticipated. The Company's 1996 financial results were materially adversely
impacted as the result of delays in the introduction of V-Link, as well as in
obtaining formal regulatory approval for the sale of V-Link. If the Company is
unable to effectively market V-Link in 1997, or if V-Link is not well-received
by teen consumers in 1997, the Company will be unable to recover its
investment in the development and manufacturing of inventory of V-Link, which
may have a material adverse effect on the Company's 1997 financial results.

  NEW CATEGORIES FOR 1997

  The Company has or is in the process of developing a number of new lines of
products for 1997 that will significantly expand the breadth of YES!'s product
offerings. Specifically, the Company will move into new categories of
products, including vehicles, pre-school, girls items, foam products and
electronic games.

  Vehicles. Air Vectors is YES!'s initial foray into the popular toy vehicle
category. YES! is attempting to enter this category with a new and exciting
feature -- Air Vectors cars will race ahead, then transform and launch planes
or missiles from the vehicles superstructure, which continue their forward
motion in flight. The Company's initial vehicles will be themed as racing
cars, military vehicles and off-road vehicles. The Company is currently
developing the Air Vectors line which it expects will be shipped late in the
1997 selling season.

  YES! PreSchool. At Toy Fair 1997, the Company introduced a new line of pre-
school electronic products to address the growing three to six year old
market. These products include Yakkins, a line of molded plastic characters
into which children can record sounds and messages for playback, Pet Toonies,
a line of animals that play popular kids songs in that animal's own sounds,
and Music Gizmos and Instrument Gizmos, a line of highly stylistic devices
that play pre-set tunes and musical sounds in a variety of different ways
depending on how a child "builds" their gizmo.

  YES! Girl. The Company in 1997 expects to expand into the girls category
with a new line of YES! Girl products, themed especially for creative girls.
The Company's entree into this category is Dance Studio, a portable dance
instructor that calls out dance steps to little girls. Girls can dance to
preset routines, or create their own, and can vary the pace and beat of their
new dances.

  YES! Extreme. The Company also is creating a new category of action sports
and play activities. These will include three new product lines.

   Strobes

  In 1997, the Company expects to introduce a line of high bounce balls that
contain impact activated strobing lights. Bounce the ball and brilliant red
lights begin to flash inside, creating a whole new dynamic of day and night
ball play.

   Radical Air Weapons (R.A.W.)

  The Company is developing and expects to introduce in 1997 a line of toy
guns that shoot expanding foam balls. Unlike other foam guns, these balls
expand quickly to more than three times their compacted size as they fly
through the air.

   Yak Balls and SFX Balls

  Finally, the Company expects to extend both the recording and sound effects
features of the Yak Bak and Yak Bak SFX products into a line of miniature
baseballs and footballs under the Yak Bak Balls and SFX Balls names.


                                       4
<PAGE>

  Activities. The Company expects to introduce in 1997 Disgusting Designs, a
ghoulish new painting and arts design center for young boys. The design center
is comprised of a Zombie head and finger that incorporates all sorts of
painting activities, including paint filled brains, crayon teeth, eyeballs
that are brushes, sponge tongues and stamp and fingers. Other accessories sold
separately include a Monster Marker Hand and a Moldy Body Parts molding kit,
which lets kids mold their own creepy sculptures that they can then decorate.

  YES! Games. In 1997, the Company expects to introduce a product into the
electronic games category. Slap Trap is an electronic game module that
contains four different game plays that challenge user's memory and reaction
time. Slap Trap is designed for family fun.

PRODUCT DESIGN AND DEVELOPMENT

  The Company's product development combines the use of independent outside
designers with internal development to develop new product lines.

  INDEPENDENT DESIGNERS

  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.

  INTERNAL DEVELOPMENT

  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. Each
group brings its unique expertise, allowing the creation of ideas which
combine the latest technologies, current trends and strongest consumer and
retailer demands.

  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 1996, 1995 and 1994, the Company incurred research and development
expenses of approximately $4.6 million, $2.8 million and $4.9 million,
respectively.

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 which have
facilities in Hong Kong and the People's Republic of China. Certain of the
Company's products and components of products 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 is generally required to post a letter of credit prior to shipment.
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.

                                       5
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  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 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. In
addition, manufacturing in Hong Kong and the People's Republic of China
entails certain more specific risks, including the return of Hong Kong to
governance by the People's Republic of China in June 1997 and recent political
tensions between the People's Republic of China and the Republic of China
(Taiwan). There can be no assurance that these events will not result in
disruptions to 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,
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 which 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. 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 which support the majority of YES!'s product lines. In conjunction
with

                                       6
<PAGE>

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 primarily by
the Company's direct sales force to toy retailers, toy distributors, catalog
showrooms, mass merchants, department stores and discount stores. Retailers of
YES! products in 1996, 1995 and 1994 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, Service Merchandise
Co., Inc. and Hills Stores Company, Inc. The Company also uses sales
representative organizations typically either to address less concentrated
markets or in connection with certain of the Company's products, including V-
Link, that sell outside normal toy retail channels.

  The Company's ten largest customers accounted for approximately 85%, 87% and
68% of sales for the years ending December 31, 1996, 1995 and 1994,
respectively. For the year ended December 31, 1996, the Company's two largest
customers, TRU and Wal-Mart, accounted for 21% and 20% of net sales,
respectively. For the year ended December 31, 1995, TRU and Wal-Mart each
accounted for approximately 27% of net sales and for the year ended December
31, 1994, the same two customers accounted for 14% and 21% of net sales,
respectively. 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.

  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, often to the detriment of the
Company's business.

INTERNATIONAL OPERATIONS

  International net sales were approximately $14.9 million, $3.8 million and
$10.4 million in 1996, 1995 and 1994, respectively, and accounted for
approximately 21%, 7% and 29% of the Company's revenue in those respective
years. International net sales were substantially lower in 1995 primarily as
the result of weakness in the international economy.

                                       7
<PAGE>

  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. In 1996, the Company introduced the YES! Gear line of
products internationally, where they were well-received, particularly in
Japan. In 1997, the Company expects to introduce all of its domestic 1996 and
early 1997 products internationally, with a particular emphasis on expanding
European sales.

  The Company sells its products internationally through a network of leading
toy distributors in their local markets. 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, because local market distributors typically pay for the Company's
products on a letter of credit and take delivery of such product in Hong Kong,
and because the distributors are responsible for the warehousing and promotion
of the Company's products in the local market, the Company is able to minimize
risks associated with a direct international effort as well as the Company's
capital commitments in advance of manufacture of the product, and can maintain
a leaner staff requiring fewer resources to support the Company's
international operations. The Company also 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. and are denominated in U.S.
dollars.

  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 the Company has granted 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 also 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. 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 certain 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.

                                       8
<PAGE>

  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 grey 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. The Company has defended two such
lawsuits and, although the Company prevailed in each instance, each lawsuit
was expensive and time-consuming to defend. In addition, such lawsuits could
have the effect of causing the Company's customers to delay or cancel purchase
orders until they are resolved.

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., Tyco Toys, Inc. (which recently merged with
Mattel, Inc.), Tiger Electronics 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. Many 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 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.

                                       9
<PAGE>

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 such rule or
regulation, sale of the offending product could be enjoined. To date, the
Company has not experienced any material governmental or voluntary safety
compliance problems with respect to its products. In the event that the
Company violates any such 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. For instance, the Company's V-Link product is subject
to Federal Communications Commission ("FCC") rules and regulations. In
December 1997, the Company voluntarily ceased shipments of its V-Link products
pending receipt of final marketing approval from the FCC to sell V-Link, which
the Company had inadvertently not obtained prior to commencing V-Link sales.
While the Company did obtain such approval, the Company was required to pay a
$31,000 fine to the FCC as a result of its failure to obtain FCC marketing
approval and take certain other remedial steps to help ensure that the Company
meets its FCC obligations in the future. 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 February 28, 1997, the Company had a total of 123 employees, of whom
74 were based in the United States and 49 were based in Hong Kong. The Company
is staffed in the functions necessary to operate a 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.

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, manufacturing facilities of 6,700 square feet in
Carson, 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 1996, the Company's total rent expense was $1.2
million.

  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.

                                      10
<PAGE>

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.

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 1996.

                                      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 SmallCap Stock Market from the Company's initial public
offering on June 7, 1995 until November 1995, and as quoted on the Nasdaq
National Market since November 1995. The Company has not paid cash dividends
and has no present plans to do so. At March 14, 1997, there were approximately
230 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 1997:
  First quarter (through March 14, 1997).............. $4 5/8 $7 3/16   $5 7/16
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
Fiscal year 1995:
  Second Quarter (from June 7, 1995)..................   5     5 1/4      5
  Third Quarter.......................................   5     6 1/4     5 7/8
  Fourth Quarter......................................  5 3/4  6 5/8     6 5/8
</TABLE>

  On March 14, 1997, the last sale price for the Common Stock reported on the
Nasdaq National Market was $5 7/16 per share.

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, 1996 are derived from financial
statements of the Company.

<TABLE>
<CAPTION>
                              YEAR ENDED DECEMBER 31,             PERIOD FROM
                         -----------------------------------  SEPTEMBER 14, 1992
                                                              (INCEPTION) THROUGH
                          1996     1995     1994      1993     DECEMBER 31, 1992
                         -------  ------- --------  --------  -------------------
                             (DOLLARS IN THOUSANDS, EXCEPT PER SHARE DATA)
<S>                      <C>      <C>     <C>       <C>       <C>
STATEMENT OF OPERATIONS
 DATA:
  Net sales............. $69,699  $55,673 $ 36,379  $ 25,931         $  --
  Operating income
   (loss)............... (11,688)   4,989  (19,920)  (20,472)         (674)
  Net income (loss)..... (12,571)   3,478  (21,927)  (20,964)         (672)
  Pro forma net loss per
   share(1)(2)..........      --       -- $  (5.08)       --            --
  Net income (loss) per
   share(1)(2)..........   (0.91) $  0.41       --        --
  Shares used in comput-
   ing pro forma net
   loss per share(1)....      --       --    4,319        --            --
  Shares used in comput-
   ing net income (loss)
   per share(1).........  13,890    8,534       --        --            --
BALANCE SHEET DATA:
  Cash and cash equiva-
   lents(3)............. $ 1,572  $ 2,987 $  2,558  $  2,462         $   6
  Working capital.......  25,934   25,671    5,083     8,529          (438)
  Total assets..........  61,451   48,870   29,657    29,591           725
  Redeemable convertible
   preferred stock......      --       --   49,339    30,469            --
  Total shareholders'
   equity (deficit)..... $30,065  $28,584 $(42,570) $(21,028)          (79)
</TABLE>

                                      12
<PAGE>

--------
(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 and 1992 is not presented as the periods
    were 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, 1996 and 1995, there was no
    restricted cash collateralizing outstanding letters of credit.

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 $188 million
through December 31, 1996, although it had an accumulated deficit as of
December 31, 1996 of approximately $52.7 million. Management believes that
delays in obtaining financing in 1993 and 1994 resulted in lost sales
opportunities, including opportunities for reorders, and also required the
Company to incur higher than normal shipment and advertising expenses to
expedite product delivery and create consumer demand in a shortened holiday
selling period. 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 a delivery delay in 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 FCC.

  The production and shipment of the Company's 1997 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 1997 products. This risk is compounded by the large number of new products
the Company is introducing in 1997, including many additions to the YES! Gear
line of products (such as Yak Maniak and several new Power Penz), the Baskin-
Robbins Ice Cream Maker, Air Vectors and R.A.W., each of which is still in the
developmental stage and which also involve complicated development and tooling
issues. Air Vectors and R.A.W. 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.

  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 1997 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 1997 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 at all.

                                      13
<PAGE>

  In 1995, the Company adopted a financial strategy to maintain a low break-
even point and to focus on profitability rather than sales growth. Management
believes that this financial strategy was instrumental in achieving
profitability in 1995. While the Company attempted to maintain this strategy
in 1996, the revenue shortfall realized in 1996 was much more significant than
the Company had expected. The Company expects to continue to focus on
controlling fixed expenses in 1997, although there is no guarantee that a
revenue shortfall in 1997 would not materially adversely affect the Company's
financial performance.

  The Company also expects to consider opportunities to enhance revenue growth
as well as profitability through acquisitions or other strategic business
relationships in 1997.

RESULTS OF OPERATIONS

  The following table sets forth certain items from the Company's statement of
operations for the years ended December 31, 1996, 1995 and 1994, and the
relevant percentage of net sales represented by certain income and expense
items:

<TABLE>
<CAPTION>
                                      YEARS ENDED DECEMBER 31,
                          -------------------------------------------------------
                                1996               1995               1994
                          -----------------   ----------------  -----------------
                           AMOUNT   PERCENT   AMOUNT   PERCENT   AMOUNT   PERCENT
                          --------  -------   -------  -------  --------  -------
                                       (DOLLARS IN THOUSANDS)
<S>                       <C>       <C>       <C>      <C>      <C>       <C>
Net sales...............  $ 69,699  100.0%    $55,673  100.0%   $ 36,379   100.0%
Cost of sales...........    42,624    61.2     26,623    47.8     25,012    68.8
                          --------  ------    -------  ------   --------   -----
Gross profit............    27,075    38.8     29,050    52.2     11,367    31.2
Operating expenses
  Marketing, advertising
   & promotion..........    13,192    18.9      6,423    11.5     11,013    30.3
  Selling, distribution
   & administrative.....    25,571    36.7     17,638    31.7     20,274    55.7
                          --------  ------    -------  ------   --------   -----
    Total operating ex-
     penses.............    38,763    55.6     24,061    43.2     31,287    86.0
                          ========  ======    =======  ======   ========   =====
Operating income (loss).   (11,688)  (16.8)     4,989     9.0    (19,920)  (54.8)
Interest income.........       264     0.4         69     0.1        129     0.4
Interest expense........  $ (1,039)   (1.5)    (1,321)   (2.4)      (785)   (2.2)
Other expense, net......  $   (108)   (0.1)       (74)   (0.1)    (1,351)   (3.7)
                          --------  ------    -------  ------   --------   -----
Income (loss) before
 provision of income
 taxes..................  $(12,571)  (18.0)     3,633     6.5    (21,927)  (60.3)
Provision for income
 taxes..................  $     --      --        185     0.3         --      --
                          --------  ------    -------  ------   --------   -----
  Net income (loss).....  $(12,571)  (18.0)%  $ 3,478    6.2%   $(21,927)  (60.3)%
                          ========  ======    =======  ======   ========   =====
</TABLE>

NET SALES

  The Company's worldwide net sales were $69.7 million in 1996, $55.7 million
in 1995 and $36.4 million in 1994. Products introduced in 1994 accounted for
9%, 35% and 38% of worldwide sales in 1996, 1995 and 1994, respectively.
Products introduced in 1995 accounted for 35% and 45% of worldwide sales in
1996 and 1995, respectively. Products introduced in 1996 accounted for 54% of
the Company's worldwide sales in 1996. 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 $54.8 million in 1996, compared to $51.9 million in
1995 and $26.0 million in 1994. The slight increase in 1996 over 1995 was
attributable to the introduction of a number of new product lines in 1996,
including the Mrs. Fields Baking Factory and V-Link, together with the
addition of a number of new products to the Company's YES! Gear and Power Penz
categories. This increase 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

                                      14
<PAGE>

price of the Company's older product lines. The increase in 1995 domestic net
sales over 1994 was primarily the result of the introduction of Yak Bak and
Nickelodeon products in 1995.

  The Company's Yak Bak and Power Penz product lines together accounted for a
significant percentage of the Company's sales in 1996 and 1995, comprising 72%
and 50% thereof, respectively. Yak Bak accounted for 4% of the Company's 1994
net sales, the year in which Yak Bak was first shipped. In 1996 and 1995, the
Company's Yak Bak items accounted for approximately 46% and 47% of the
Company's sales, respectively. The Company's Power Penz products accounted for
22% and 3% of the Company's sales in 1996 and 1995, respectively, following
the introduction of the Power Penz in 1995. 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. No other
product line accounted for more than 10% of the Company's sales in 1996,
although one product line, Comes To Life Books, accounted for 17% and 47% of
the Company's sales in 1995 and 1994, respectively. Although the Company
expects that its revenue base will be less concentrated on any one line of
products in 1997 as compared to previous years, the Company expects that YES!
Gear, in particular the Yak Bak items, and the Power Penz and Mrs. Fields
lines of product will continue to account for a substantial portion of the
Company's revenues in 1997.

  International net sales were $14.9 million in 1996 compared with $3.8 in
1995 and $10.4 million in 1994. International sales were substantially higher
in 1996 than 1995 due to the increased emphasis the Company placed on
expanding international sales in conjunction with the introduction of the
Company's YES! Gear line of product internationally beginning in 1996. Sales
to distributors in Pacific Rim countries comprised a substantial portion of
the Company's 1996 international sales, although the Company expects that
sales to Europe will expand substantially in 1997. International net sales in
1995 were lower than in 1994 primarily as the result of weakness in the
international economy. International sales represented 21% of worldwide sales
in 1996, and 7% and 29% of worldwide sales in 1995 and 1994, respectively.

  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.

  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 61%, 48% and 69% of net sales in 1996, 1995
and 1994, respectively. The increase in cost of sales as a percentage of sales
in 1996 from 1995 was primarily the result of a substantial increase in the
relative mix of international sales, which typically have lower associated
gross margins, in 1996 compared to 1995 and an increase in returns and
allowances and inventory provisions in 1996 as compared to

                                      15
<PAGE>

1995. The decline in cost of sales as a percentage of net sales in 1995 from
1994 was primarily the result of favorable changes in product mix and was also
due to an increase in inventory write downs and a relative increase in higher
margin domestic sales. In absolute dollars, cost of sales increased $16.0
million from 1995 to 1996 and $1.6 million from 1994 to 1995 as the result of
higher overall sales and the factors enumerated above.

OPERATING EXPENSES

<TABLE>
<CAPTION>
                                            YEARS ENDED DECEMBER 31,
                                 -----------------------------------------------
                                      1996            1995            1994
                                 --------------- --------------- ---------------
                                 AMOUNT  PERCENT AMOUNT  PERCENT AMOUNT  PERCENT
                                 ------- ------- ------- ------- ------- -------
                                             (DOLLARS IN THOUSANDS)
<S>                              <C>     <C>     <C>     <C>     <C>     <C>
Marketing, advertising & promo-
 tion..........................  $13,192  18.9%  $ 6,423  11.5%  $11,013  30.3%
Selling, distribution & admin-
 istrative.....................   25,571  36.7    17,638  31.7    20,274  55.7
                                 -------  ----   -------  ----   -------  ----
Total operating expenses.......  $38,763  55.6%  $24,061  43.2%  $31,287  86.0%
</TABLE>

  Operating expenses increased by $14.7 million in 1996 from 1995. Operating
expenses in 1995 decreased by $7.2 million from 1994. 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 56% in 1996 from 43% in 1995, but were
less than the 86% for 1994. The increase in 1996 was primarily the result of a
significant shortfall in expected net sales in the fourth quarter of 1996. The
decrease in 1995 in operating expenses both in absolute terms and as a
percentage of sales as compared to 1994 was primarily the result of the
Company's strategy to maintain a low break-even level.

  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, particularly where, as in 1996, this shortfall is not anticipated
until late in the fourth quarter. The Company expects that fixed expenses will
increase in 1997.

  MARKETING, ADVERTISING AND PROMOTION. Marketing, advertising and promotional
expenses increased $6.8 million in 1996 from 1995 to a total of $13.2 million,
to promote retail sales of the Company's products at expected volumes that
substantially exceeded actual sales in the fourth quarter. In order to obtain
the most competitive prices, advertising commitments, in particular for fourth
quarter advertising, must be made in advance and cannot be canceled in the
event of product shipment delays, as occurred with V-Link. Marketing,
advertising and promotional expenses decreased $4.6 million in 1995 from 1994.
This decrease resulted primarily from a reduction in advertising expense,
which was occasioned in part by the need for additional advertising in late
1994 to compensate for late delivery of product.

  SELLING, DISTRIBUTION AND ADMINISTRATIVE. 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, higher royalty expenses
associated with the increase in revenue, and higher costs in operations
support, product development, and general and administrative expenses required
to support expected higher sales volumes. The increase 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. Selling,
distribution and administrative expenses decreased $2.6 million in 1995 from
1994, and decreased as a percentage of net sales to 32% in 1995 from 56% in
1994. This decrease resulted from reduced headcount in operations support and
product development and from significantly reduced spending in product
development, operations support, administration, and sales activities.

                                      16
<PAGE>

INTEREST EXPENSE

  The following table shows interest expense and interest income for the
applicable periods:

<TABLE>
<CAPTION>
                                          YEARS ENDED DECEMBER 31,
                               ---------------------------------------------------
                                    1996              1995              1994
                               ----------------  ----------------  ---------------
                               AMOUNT   PERCENT  AMOUNT   PERCENT  AMOUNT  PERCENT
                               -------  -------  -------  -------  ------  -------
                                           (DOLLARS IN THOUSANDS)
<S>                            <C>      <C>      <C>      <C>      <C>     <C>
Interest income............... $   264    0.4%   $    69    0.1%   $ 129     0.4%
Interest expense.............. $(1,039)  (1.5)%  $(1,321)  (2.4)%  $(785)   (2.2)%
</TABLE>

  Interest expense decreased by $282,000 in 1996 from 1995. This decrease was
primarily the result of decreased borrowing under the Company's credit
facility for working capital purposes, due in part to the higher cash balance
the Company maintained during the first half of 1996. Interest expense
increased by approximately $536,000 in 1995 from 1994. This increase was
largely due to higher borrowings against the Company's credit facilities as
the result of increasing sales volume and purchase commitments. The Company
expects interest expense to increase in 1997 due to increased reliance on
borrowings under the Company's credit facility and the issuance in March 1997
of convertible debentures in the aggregate principal amount of $1,566,000. As
part of the March 1997 transaction, the Company also issued 85,000 shares of
convertible Series A Preferred Stock. This preferred stock has a cumulative
semi-annual dividend of 6.5% per annum, which will not be accounted for as
interest expense, and which may be paid either in common stock or cash, at the
Company's option.

OTHER EXPENSE, NET

  The decrease in other expense, net in 1995 and 1996 from 1994 was primarily
the result of a charge against earnings taken in 1994 for unreconciled
intercompany balances, offset in part by miscellaneous income. The Company has
implemented procedures to ensure that future intercompany accounts are
promptly cleared.

INCOME TAXES

  The Company had no income tax provision for 1996 as the Company had a pre-
tax loss of $12.6 million. The Company's provision for income tax for 1995 of
$185,000 represented an effective tax rate of five percent and, due to the
utilization of net operating loss carryforwards, was solely attributable to
federal and state minimum taxes and foreign income taxes. There was no
provision for income taxes in 1994 as the Company had a pre-tax losses of $22
million. The Company anticipates that its effective tax rate will increase in
1997 due, in part, to anticipated taxable income, offset in part by potential
restrictions on the utilization of net operating loss carryforwards, discussed
below.

  At December 31, 1996, the Company had net operating loss carryforwards for
federal and California tax purposes of approximately $36.5 million and $17.0
million, respectively. The federal losses will expire in the years 2007 though
2011, and the state losses will expire in the years 1999 through 2001, 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 11 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

                                      17
<PAGE>

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 1996, 1995 and 1994. In 1996,
seasonality was compounded by the poor retail environment during the 1996
holiday season that caused retailers to not place reorders in the quantities
expected.

  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,
                                    --------------------------------------------
                                         1996           1995           1994
                                    -------------- -------------- --------------
                                    AMOUNT PERCENT AMOUNT PERCENT AMOUNT PERCENT
                                    ------ ------- ------ ------- ------ -------
                                               (DOLLARS IN THOUSANDS)
<S>                                 <C>    <C>     <C>    <C>     <C>    <C>
March 31........................... $ 8.9     13%  $ 5.7     10%  $ 2.3      6%
June 30............................  11.6     17     4.7      9     4.5     12
September 30.......................  29.6     42    18.6     33    16.3     45
December 31........................  19.6     28    26.7     48    13.3     37
                                    -----    ---   -----    ---   -----    ---
  Total............................ $69.7    100%  $55.7    100%  $36.4    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 1996 from 1995.

  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, 1996, the Company had cash and cash equivalents of
approximately $1.6 million, a decrease of $1.4 from approximately $3.0 million
at December 31, 1995. This decrease was attributable primarily to the
Company's net loss, net of depreciation and amortization, of $10.1 million,
cash used in other operating activities of $6.1 million, the acquisition of
property and equipment (primarily tooling) of approximately $3.5 million, and
the repayment of notes in the principal amount of $2.0 million, offset in part
by the proceeds primarily from issuance of common stock upon the exercise of
warrants in January 1996, net of costs, of $13.0 million, proceeds from the
collection of shareholder notes of $800,000, and net proceeds from bank loans
of $6.6 million.

  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

                                      18
<PAGE>

shareholders, borrowings under a factoring agreement with a group of banks,
borrowings under a Loan and Security Agreement with Congress Financial
Corporation (Western), 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 $9.5 million from the
sale of convertible debentures, preferred stock and warrants.

  To meet seasonal working capital requirements during the balance of 1997,
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.
The Company was not in compliance with the quick ratio and profitability
covenants at December 31, 1996, but has obtained a waiver from BNY with regard
to those covenants. 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, to
grant security interests in the assets of the Company or to pay dividends on
the Company's securities. As of December 31, 1996, the Company had borrowings
of $16.7 million under the ARM Agreement.

  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.

BUSINESS FACTORS

  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.

  Limited Operating History; History of Losses; Accumulated Deficit. The
Company has a short operating history, having commenced operation in November
1992 and shipped its first product in July 1993. Although the Company has
achieved approximately $188 million in cumulative net sales through December
31, 1996, the Company incurred substantial operating losses in 1993 and 1994,
and again in 1996, and at December 31, 1996 had an accumulated deficit of
approximately $53 million. Future profitability is dependent upon the
Company's ability to successfully and timely introduce, finance and
manufacture its new products, successfully market its existing products and
collect trade receivables in a timely manner.

  Dependence on 1997 Products. In 1997, the Company has introduced and expects
to commence sales of a number of new product lines in new product categories,
such as the Baskin-Robbins Ice Cream Maker, Air Vectors, YES! Extreme, YES!
Games, and YES! PreSchool. In addition, the Company also expects to expand its
existing product lines in 1996, particularly its YES! Gear and Power Penz 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

                                      19
<PAGE>

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 YES! Gear and Power Penz. The majority of the Company's
current product lines are sold under the YES! Gear and Power Penz brands,
which together accounted for 83% and 58% of the Company's sales in 1996 and
1995, respectively. The Company expects YES! Gear, and in particular the Yak
Bak, and the Power Penz product lines to continue to account for a substantial
percentage of the Company's business. In addition, the Company is aware that a
number of toy manufacturers have attempted to duplicate the Company's success
in this area of product by introducing similar lines of products in 1996 and
for 1997. While the Company believes it will compete favorably with these new
products on the basis of styling, quality, product depth and promotional
support, there can be no assurance that the sale of these competitive products
will not impact the sale of the YES! Gear or Power Penz product lines,
particularly on the basis of price.

  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 1997 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 1997 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 1997 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 at all.

  Sales Concentration Risk. The Company's ten largest customers accounted for
approximately 85%, 87% and 68% of sales for the years ending December 31,
1996, 1995 and 1994, respectively. For the year ended December 31, 1996, the
Company's two largest customers, TRU and Wal-Mart, accounted for 21% and 20%
of net sales, respectively. For the year ended December 31, 1995, the same two
customers each accounted for approximately 27% of net sales and for the year
ended December 31, 1994, TRU and Wal-Mart accounted for 14% and 21% of net
sales, respectively. 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

                                      20
<PAGE>

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.

  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.

  International Business Risk. The Company will rely in 1997 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. 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.

  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 1997, Hong Kong will become 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, recent 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.

  Dependence on Restrictive Facility. The Company is dependent on the ARM
Agreement with BNY Financial Corporation to meet its financial needs during
1997, 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, including covenants
concerning the requirement that Donald Kingsborough and Sol Kershner, the
Company's Chief Executive Officer and Chief Financial Officer, respectively,
remain active in the management of the Company. 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.


                                      21
<PAGE>

ITEM 8.FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA

  The following consolidated financial statements of the YES! Entertainment
Corporation are filed as a part of this report:

<TABLE>
<CAPTION>
                                                                           PAGE
                                                                           ----
<S>                                                                        <C>
Report of Ernst & Young LLP, Independent Auditors......................... F-1
Consolidated Balance Sheets at December 31, 1996 and December 31, 1995.... F-2
Consolidated Statements of Operations for the three years ended December
 31, 1996................................................................. F-3
Consolidated Statements of Stockholders' Equity (Deficit) for the three
 years ended December 31, 1996............................................ F-4
Consolidated Statements of Cash Flows for the three years ended December
 31, 1996................................................................. F-5
Notes to Consolidated Financial Statements................................ F-6
</TABLE>

ITEM 9. CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND
        FINANCIAL DISCLOSURE

  None.

                                      22
<PAGE>

                                   PART III

  Certain information required by Part III is omitted from this Report in that
the Company will have filed a definitive proxy statement pursuant to
Regulation 14A (the "Proxy Statement") for its 1996 Annual Meeting of
Shareholders with 120 days after the end of the fiscal year covered by this
Report, and certain information included therein is incorporated herein by
reference.

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
 ----                               ---                 --------
 <C>                                <C> <S>
 Donald Kingsborough..............   50 Chairman of the Board and Chief
                                        Executive Officer
 Tim Bender.......................   36 Senior Vice President, Sales
 Bruce Bower......................   35 Executive Vice President, Business
                                        Development, General Counsel and
                                        Secretary
 Sharon Duncan....................   45 Executive Vice President, International
 Tom Fritz........................   37 Vice President, Marketing
                                        Chief Financial and Chief Operating
 Sol Kershner.....................   68 Officer
 William Radin....................   66 Executive Vice President, Operations
                                        Executive Vice President, Product
 Patricia Root....................   38 Development
</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.

  Tim Bender joined the Company in October 1994 as National Accounts Manager.
Mr. Bender was promoted to Senior Vice President, Sales in February 1997. From
1984 until he joined the Company, Mr. Bender was employed by Lego Systems
Inc., a toy manufacturer, most recently as Senior National Accounts Manager.

  Bruce Bower joined the Company in March 1994 as Executive Vice President,
General Counsel and Secretary. In January 1996, Mr. Bower was also named
Executive Vice President, Business Development. From November 1989 until March
1994, Mr. Bower was associated with the law firm of Wilson Sonsini Goodrich &
Rosati in Palo Alto, California.

  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 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.

                                      23
<PAGE>

  Sol Kershner was appointed Chief Financial Officer and Chief Operating
Officer in July 1995. Mr. Kershner served as the Company's first Chief
Financial Officer and was a founder of the Company. From September 1994 until
July 1995, Mr. Kershner consulted with the Company on a full-time basis. From
1989 to 1992 Mr. Kershner was Executive Vice President and Chief Financial
Officer of Intelligy Corporation, a children's educational products company.
From 1987 to 1989, Mr. Kershner served as the Chief Financial Officer of
Centigram Corporation, a telecommunications company.

  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, 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.

  Patricia Root joined the Company at inception as Executive Vice President,
Product Development. From June 1989 to September 1992, Ms. Root was Director
of Product Development of Intelligy Corporation, a developer of educational
and child development products, including software.

  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 1997 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, 1996.

ITEM 11.EXECUTIVE COMPENSATION

  The information required by this item regarding executive compensation is
incorporated by reference to the information set forth in the section entitled
"Executive Officer Compensation" in the Company's Proxy Statement for the 1997
Annual Meeting of Stockholders to be filed with the Commission within 120 days
after the end of the Company's fiscal year ended December 31, 1996.

ITEM 12.SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT

  The information required by this item regarding security ownership of
certain beneficial owners and management is incorporated by reference to the
information set forth in the section entitled "Other Information--Share
Ownership by Principal Stockholders and Management" in the Company's Proxy
Statement for the 1997 Annual Meeting of Stockholders to be filed with the
Commission within 120 days after the end of the Company's fiscal year ended
December 31, 1996.

ITEM 13.CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS

  The information required by this item regarding certain relationships and
related transactions is incorporated by reference to the information set forth
in the section entitled "Certain Transactions" in the Company's Proxy
Statement for the 1997 Annual Meeting of Stockholders to be filed with the
Commission within 120 days after the end of the Company's fiscal year ended
December 31, 1996.

                                      24
<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) Consolidated Financial Statements. The consolidated
        financial statements of YES! Entertainment Corporation are
        listed at Item 8 and attached hereto beginning at page F-1.

    (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
       Schedules not listed above have been omitted because the informa-
       tion required to be set forth therein is not applicable or is in-
       cluded in the financial statements or notes thereto.
</TABLE>

    (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 Convertible Subordinated Debenture dated March 18, 1997.
  4.3(1)    Form of Warrant dated March 18, 1997.
 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)(2) Form of Founder Stock Purchase Agreement dated as of December 21,
            1992 by and between the Registrant and each Purchaser (as defined
            therein).
 10.7(1)    Acquisition Agreement dated as of December 31, 1992 by and between
            the Registrant and Intelligy Corporation.
 10.8(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.
 10.9(1)    Series B Stock Purchase Agreement dated as of January 27, 1993 by
            and among the Registrant and the Purchasers (as defined therein).
 10.10(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.
 10.11(1)   Preferred Stock Purchase Agreement dated as of March 29, 1993 by
            and between the Registrant and Capital Cities Capital, Inc.
 10.12(1)   Note and Warrant Purchase Agreement dated as of June 4, 1993 by and
            among the Registrant and the Purchasers (as defined therein).
 10.13(1)   Series D Stock Purchase Agreement dated as of July 16, 1993 by and
            among the Registrant and the Purchasers (as defined therein).
 10.14(1)   Series D. Stock Purchase Agreement dated as of July 16, 1993 by and
            among the Registrant and the Purchasers (as defined therein), as
            amended through October 4, 1993.
 10.15(1)   Convertible Subordinated Note Purchase Agreement dated as of
            September 30, 1993 by and among the Registrant and the Purchasers
            (as defined therein).
</TABLE>

                                       25
<PAGE>

<TABLE>
<CAPTION>
 EXHIBIT
 NUMBER                                  DESCRIPTION
 -------     ------------------------------------------------------------------
 <C>         <S>
 10.16(1)    Congress Financial Guarantee Financing and Warrant Agreement dated
             as of August 15, 1994 by and among the Registrant and the
             Investors (as defined therein).
 10.17(1)    Series F Preferred Stock Purchase Agreement dated as of September
             16, 1994 by and among the Registrant and the Purchasers (as
             defined therein).
 10.18(1)    Amended and Restated Registration Rights Agreement dated as of
             June 17, 1994 by and among the Registrant and Holders (as defined
             therein).
 10.19(1)    Amended Shareholders Agreement dated as of June 17, 1994 by and
             among the Registrant and the Purchasers (as defined therein).
 10.20(1)    Loan and Security Agreement dated as of June 15, 1994 by and
             between Congress Financial Corporation (Western) and the
             Registrant (the "Loan and Security Agreement").
 10.21(1)    First Amendment to the Loan and Security Agreement dated as of
             August 15, 1994.
 10.22(1)    Second Amendment to the Loan and Security Agreement dated as of
             December 1994.
 10.23(1)    Third Amendment to the Loan and Security Agreement dated as of
             January 27, 1995.
 10.24(1)    Fourth amendment to the Loan and Security Agreement dated as of
             March 31, 1995.
 10.25(1)    Bank Guarantee, Note Financing and Warrant Agreement dated as of
             February 18, 1994 by and among the Registrant and the Investors
             (as defined therein).
 10.26(1)    Form of Reimbursement Agreement for Letters of Guarantee dated as
             of February 18, 1994 by and between the Registrant and each
             Guarantor (as defined therein).
 10.27(1)(3) Asset Purchase Agreement dated as of December 18, 1992 between the
             Registrant and Microsonics International, Inc.
 10.28(1)(3) License Agreement dated as of May 11, 1994 between the Registrant
             and the Disney Publishing Group.
 10.29(1)(3) Product Development Agreement dated as of June 28, 1994 by and
             among the Registrant and the Licensors (as defined therein).
 10.30(1)(3) Agreement dated as of January 31, 1994 between the Registrant and
             Liu Concept Designs & Associates.
 10.31(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.
 10.32(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.
 10.33(1)    Guarantee Conversion Agreement dated as of March 31, 1995 by and
             among the Registrant and the Guarantors (as defined therein), as
             amended.
 10.34(1)    Form of Subscription Documents dated as of April 1995 by and
             between the Registrant and each Investor (as defined therein).
 10.35(1)    License Agreement dated as of January 13, 1993 by and between the
             Registrant and Shoot the Moon Products, Inc.
 10.36(1)(3) Nickelodeon Merchandise License Agreement dated as of April 26,
             1995 by and between the Registrant and MTV Networks.
 10.37(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.
 10.38(1)    Form of Bridge Note issued in the Registrant's April 1995 Bridge
             Financing.
 10.39(1)    Accounts Receivable Management and Security Agreement by and
             between the Registrant and BNY Financial Corporation.
 10.40(1)(3) License Agreement dated as of April 26, 1995 by and between the
             Registrant and Machina, Inc.
 10.41(1)(2) Employment Agreement by and between the Registrant and Sol
             Kershner.
 10.42(1)(2) Employment Agreement by and between the Registrant and William
             Radin.
 10.43(3)    Product Development and License Agreement by and between
             Registrant and Machina, Inc. dated September 7, 1995.
 10.44(3)    Development and License Agreement by and between Registrant and
             Machina, Inc. dated April 26, 1995.
</TABLE>

                                       26
<PAGE>

<TABLE>
<CAPTION>
 EXHIBIT
 NUMBER                                 DESCRIPTION
 -------    -------------------------------------------------------------------
 <C>        <S>
 10.45(3)   Product Development and License Agreement by and between Registrant
            and Machina, Inc. dated June 16,1995, as amended.
 10.46(3)   Product Development and License Agreement by and between Registrant
            and Machina, Inc. dated June 27, 1995.
 10.47(3)   Accounts Receivable Management and Security Agreement by and
            between Registrant and BNY Financial Corporation dated July 31,
            1995.
 10.48(3)   Product Development and License Agreement by and between Registrant
            and Machina, Inc. dated August 31, 1995.
 10.49(3)   License Agreement by and between Registrant and Skyline Products,
            Inc. dated September 27, 1995.
 10.50(3)   License Agreement by and between Registrant and Mrs. Fields
            Development Corporation dated September 30, 1995.
 10.51(3)   License Agreement by and among Registrant, Kiscom, Inc., and Greg
            Hyman Associates dated November 18, 1995.
 10.52(3)   Royalty Agreement by and between Registrant and Shoot The Moon,
            Inc. dated December 27, 1995.
 10.53(2)   1996 Profit Sharing Plan.
 10.54(2)   1996 Executive Profit Sharing Plan.
 10.55(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.
 10.56(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, Califonia.
 10.57(1)   Amended and Restated Convertible Debenture and Convertible
            Preferred Stock Purchase Agreement dated as of March 18, 1997 among
            Infinity Investors Limited, Fairway Capital Limited and Registrant.
 10.58(1)   Amended and Restated Registration Rights Agreement dated as of
            March 18, 1997 among Infinity Investors Limited, Fairway Capital
            Limited and Registrant.
 11.1       Statement of computation of earnings per share.
 21.1(1)    Subsidiaries of the Registrant.
 23.1       Consent of Ernest & Young LLP, Independent Auditors.
 24.1       Power of Attorney (see page 29).
 27.1       Financial Data Schedule for the year ended December 31, 1996.
</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 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; Current Report on Form 8-K filed with the
    Securities and Exchange Commission on February 11, 1997; Current Report on
    Form 8-K filed with the Securities and Exchange Commmission on March 25,
    1997; Registration Statement on Form S-3 (File No. 33-91408 ), which
    became effective on March 25, 1997.
(2) Indicates management compensatory plan, contract or arrangement.
(3) Confidential treatment has been previously granted for certain portions of
    these exhibits.

                                      27
<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 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 28th day of March 1997.

                                          YES! Entertainment Corporation

                                          By: /s/Bruce D. Bower
                                            -----------------------------------
                                            Bruce D. Bower
                                            Executive Vice President, General
                                            Counsel and Secretary

                               POWER OF ATTORNEY

  KNOW ALL THESE PERSONS BY THESE PRESENTS, that each person whose signature
appears below constitutes and appoints Donald D. Kingsborough and Bruce D.
Bower 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       March 28, 1997
____________________________________ Chief Executive Officer
 Donald D. Kingsborough               (Principal Executive
                                     Officer)
/s/ Sol Kershner                     Chief Financial Officer         March 28, 1997
____________________________________ (Principal Financial and
 Sol Kershner                         Accounting Officer)

/s/ David C. Costine                 Director                        March 28, 1997
____________________________________
 David C. Costine

/s/ Esmond T. Goei                   Vice Chairman and Director      March 28, 1997
____________________________________
 Esmond T. Goei

/s/ Michael J. Marocco               Director                        March 28, 1997
____________________________________
 Michael J. Marocco

/s/ Gary L. Nemetz                   Director                        March 28, 1997
____________________________________
Gary L. Nemetz
</TABLE>

                                      28
<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, 1996 and 1995, 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, 1996.
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, 1996 and 1995, and the
consolidated results of its operations and its cash flows for each of the
three years in the period ended December 31, 1996, 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.

                                                          /s/ ERNST & YOUNG LLP

February 26, 1997,
except as to Note 16,
as to which the date is
March 18, 1997

                                      F-1
<PAGE>

                         YES! ENTERTAINMENT CORPORATION

                          CONSOLIDATED BALANCE SHEETS
                                 (IN THOUSANDS)

<TABLE>
<CAPTION>
                                                                DECEMBER 31,
                                                               ----------------
                                                                1996     1995
                                                               -------  -------
<S>                                                            <C>      <C>
                            ASSETS
Current assets:
  Cash and cash equivalents................................... $ 1,572  $ 2,987
  Accounts receivable, net of allowance for doubtful accounts
   of $465 in 1996 and $432 in 1995...........................  21,956   26,260
  Inventories.................................................  26,194   12,050
  Prepaid royalties...........................................   4,045    2,071
  Prepaid expenses............................................   1,868    1,903
  Other current assets........................................   1,671      560
                                                               -------  -------
Total current assets..........................................  57,306   45,831
Property and equipment, net...................................   3,869    2,769
Intangibles and deposits, net.................................     276      270
                                                               -------  -------
Total assets.................................................. $61,451  $48,870
                                                               =======  =======
             LIABILITIES AND STOCKHOLDERS' EQUITY
Current liabilities:
  Convertible notes payable................................... $    --  $ 2,000
  Loans payable...............................................  16,712   10,125
  Accounts payable............................................  12,565    5,484
  Accrued royalties...........................................   1,018    1,267
  Accrued liabilities.........................................     879    1,012
  Capital lease obligations due within one year...............      16       87
  Income taxes payable........................................     182      185
                                                               -------  -------
Total current liabilities.....................................  31,372   20,160
Capital lease obligations.....................................      14       29
Other liabilities.............................................      --       97
Stockholders' equity:
  Undesignated preferred stock, $0.001 par value:
    Authorized shares--2,000,000 at December 31, 1996 and
     1995.....................................................
    Issued and outstanding shares--none issued at December 31,
     1996 and 1995............................................      --       --
  Common stock, $0.001 par value:
    Authorized shares--48,000,000 at December 31, 1996
    Issued and outstanding shares--14,044,422 in 1996 and
     10,738,710 in 1995                                             14   69,511
  Additional paid-in capital..................................  82,707       --
  Accumulated deficit......................................... (52,656) (40,085)
  Less amounts receivable from stockholders...................      --     (842)
                                                               -------  -------
Total stockholders' equity....................................  30,065   28,584
                                                               -------  -------
Total liabilities and stockholders' equity.................... $61,451  $48,870
                                                               =======  =======
</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,
                                                   ---------------------------
                                                     1996     1995      1994
                                                   --------  -------  --------
<S>                                                <C>       <C>      <C>
Net sales......................................... $ 69,699  $55,673  $ 36,379
Cost of sales.....................................   42,624   26,623    25,012
                                                   --------  -------  --------
Gross profit......................................   27,075   29,050    11,367
Operating expenses:
  Marketing, advertising, and promotion...........   13,192    6,423    11,013
  Selling, distribution, and administrative.......   25,571   17,638    20,274
                                                   --------  -------  --------
Total operating expenses..........................   38,763   24,061    31,287
                                                   --------  -------  --------
Operating income (loss)...........................  (11,688)   4,989   (19,920)
Interest income...................................      264       69       129
Interest expense..................................   (1,039)  (1,321)     (785)
Other expense, net................................     (108)     (74)   (1,351)
                                                   --------  -------  --------
Income (loss) before provision for income taxes...  (12,571)   3,663   (21,927)
Provision for income taxes........................       --      185        --
                                                   --------  -------  --------
Net income (loss)................................. $(12,571) $ 3,478  $(21,927)
                                                   ========  =======  ========
Net income (loss) per share....................... $  (0.91) $  0.41  $     --
                                                   ========  =======  ========
Shares used in computing net income (loss) per
 share............................................   13,890    8,534        --
                                                   ========  =======  ========
Pro forma net loss per share......................                    $  (5.08)
                                                                      ========
Shares used in computing pro forma net loss per
 share............................................                       4,319
                                                                      ========
</TABLE>



                            See accompanying notes.

                                      F-3
<PAGE>

                         YES! ENTERTAINMENT CORPORATION

           CONSOLIDATED STATEMENTS OF STOCKHOLDERS' EQUITY (DEFICIT)
                                 (IN THOUSANDS)

<TABLE>
<CAPTION>
                              SERIES A                                              NOTES AND
                            CONVERTIBLE                                              AMOUNTS        TOTAL
                          PREFERRED STOCK   COMMON STOCK    ADDITIONAL              RECEIVABLE  STOCKHOLDERS'
                          ---------------- ----------------  PAID-IN   ACCUMULATED     FROM        EQUITY
                           SHARES  AMOUNT  SHARES   AMOUNT   CAPITAL     DEFICIT   STOCKHOLDERS   (DEFICIT)
                          -------- ------- ------  -------- ---------- ----------- ------------ -------------
<S>                       <C>      <C>     <C>     <C>      <C>        <C>         <C>          <C>
Balance at December 31,
 1993...................     1,800 $   594    380  $     57  $    --    $(21,636)     $ (43)      $(21,028)
 Repurchase of common
  stock.................        --      --     (1)       --       --          --         --             --
 Common stock issued for
  services..............        --      --     21       342       --          --         --            342
 Repayment of notes
  receivable............        --      --     --        --       --          --         43             43
 Net loss...............        --      --     --        --       --     (21,927)        --        (21,927)
                          -------- ------- ------  --------  -------    --------      -----       --------
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 warrants........        --      --  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
                          ======== ======= ======  ========  =======    ========      =====       ========
</TABLE>


                            See accompanying notes.

                                      F-4
<PAGE>

                         YES! ENTERTAINMENT CORPORATION

                     CONSOLIDATED STATEMENTS OF CASH FLOWS
                                 (IN THOUSANDS)

<TABLE>
<CAPTION>
                                                    YEARS ENDED DECEMBER 31,
                                                    ---------------------------
                                                      1996     1995      1994
                                                    --------  -------  --------
<S>                                                 <C>       <C>      <C>
OPERATING ACTIVITIES
Net income (loss).................................  $(12,571) $ 3,478  $(21,927)
Adjustments to reconcile net income (loss) to net
 cash used in operating activities:
  Depreciation....................................     2,370    2,127     2,078
  Amortization....................................        87       56        59
  Advertising expense funded by issuance of re-
   deemable preferred stock.......................        --       --     2,741
  Advertising expenses funded by inventory........     1,022      893        --
  Employer contribution to 401(k) plan funded with
   common stock...................................       164       --        --
  Changes in operating assets and liabilities:
    Accounts receivable...........................     4,304  (17,744)      467
    Inventories...................................   (15,166)     333    (4,673)
    Prepaid expenses and other current assets.....    (3,050)  (4,320)        9
    Accounts payable..............................     7,081   (5,463)   (3,860)
    Accrued liabilities...........................      (382)     158      (364)
    Income taxes payable..........................        (3)      --        --
    Other long-term liabilities...................       (97)      58       (45)
                                                    --------  -------  --------
Net cash used in operating activities.............   (16,241) (20,424)  (25,515)
INVESTING ACTIVITIES
Acquisition of property and equipment.............    (3,470)  (1,397)   (2,798)
Decrease (increase) in intangibles and deposits...       (93)      18       (21)
                                                    --------  -------  --------
Net cash used in investing activities.............    (3,563)  (1,379)   (2,819)
FINANCING ACTIVITIES
Decrease (increase) in restricted cash............        --    1,251     4,168
Principle payments on convertible notes payable...    (2,000)      --        --
Net proceeds from loans payable...................     6,587    4,121     7,403
Principal payments on capital lease obligations...       (86)     (77)      (54)
Proceeds from bridge loans........................        --       --     2,092
Proceeds from issuance of redeemable convertible
 preferred stock, net of issuance costs...........        --       --    14,778
Proceeds from issuance of common stock and common
 warrants, net of issuance costs..................    13,046   16,937        --
Proceeds from stockholders' notes receivable......       842       --        43
                                                    --------  -------  --------
Net cash provided by financing activities.........    18,389   22,232    28,430
                                                    --------  -------  --------
Net increase (decrease) in cash and cash equiva-
 lents............................................    (1,415)     429        96
Cash and cash equivalents at beginning at period..     2,987    2,558     2,462
                                                    --------  -------  --------
Cash and cash equivalents at end of period........  $  1,572  $ 2,987  $  2,558
                                                    ========  =======  ========
SUPPLEMENTAL DISCLOSURES OF CASH FLOW INFORMATION
Interest paid.....................................  $  1,105    1,404  $    685
SUPPLEMENTAL DISCLOSURES OF NONCASH INVESTING AND
 FINANCING ACTIVITIES
Series C and F redeemable convertible preferred
 stock issued in exchange for advertising.........        --       --  $  2,000
Series F redeemable convertible preferred stock
 issued in exchange for bridge loans..............        --       --     2,092
Equipment acquired under capital lease financings.        --       --         7
Common stock issued in exchange for extinguishment
 of trade accounts payable........................        --       --  $    342
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, 1996

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.

 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. During 1996, the Company
reincorporated in the state of Delaware.

 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.

 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. 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 $10,033,000, $3,295,000, and
$6,892,000 in advertising costs during 1996, 1995, and 1994, respectively. At
December 31, 1996 and 1995, the Company had $2,583,000 and $2,176,000,
respectively, of prepaid advertising related to future advertising.

 Research and Development

  Research and development expenses of approximately $4,586,000, $2,768,000,
and $4,850,000 for the years ended December 31, 1996, 1995, and 1994,
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.


                                      F-6
<PAGE>

  Under Statement of Financial Accounting Standards No. 115, "Accounting for
Certain Investments in Debt and Equity Securities" (FAS 115), management
classifies investments as available-for-sale or held-to-maturity at the time
of purchase and periodically reevaluates such designation. Debt securities are
classified as held-to-maturity when the Company has the positive intent and
ability to hold the securities to maturity. Held-to-maturity securities are
stated at amortized cost with corresponding premiums or discounts amortized to
interest income over the life of the investment. Debt securities not
classified as held-to-maturity are classified as available-for-sale and are
reported at fair value. Unrecognized gains or losses on available-for-sale
securities are included, net of tax, in shareholders' equity until their
disposition. Realized gains and losses and declines in value judged to be
other-than-temporary on available-for-sale securities are included in interest
income. The cost of securities sold is based on the specific identification
method. The Company had no short-term investments at December 31, 1996 or
1995.

 Inventories

  Inventories are stated at the lower of cost (first-in, first-out) or market.
Inventories are as follows:

<TABLE>
<CAPTION>
                                                                  DECEMBER 31,
                                                                 ---------------
                                                                  1996    1995
                                                                 ------- -------
                                                                 (IN THOUSANDS)
   <S>                                                           <C>     <C>
   Raw materials................................................ $ 2,940 $ 1,904
   Work-in-process..............................................     974     575
   Finished goods...............................................  22,280   9,571
                                                                 ------- -------
                                                                 $26,194 $12,050
                                                                 ======= =======
</TABLE>

  The Company's inventory valuation process is done on a part-by-part basis.
Lower of cost to 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,
                                                                 --------------
                                                                  1996    1995
                                                                 ------- ------
                                                                 (IN THOUSANDS)
<S>                                                              <C>     <C>
Equipment....................................................... $ 1,766 $1,373
Tooling.........................................................   6,169  3,763
Furniture and fixtures..........................................   2,113  1,467
Leasehold improvements..........................................     332    376
Film............................................................     412    356
Software........................................................     479    466
                                                                 ------- ------
                                                                  11,271  7,801
Accumulated depreciation........................................   7,402  5,032
                                                                 ------- ------
                                                                 $ 3,869 $2,769
                                                                 ======= ======
</TABLE>

                                      F-7
<PAGE>

 Intangible Assets

  Intangible assets 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, 1996 and 1995 was $248,524 and $161,417,
respectively.

 Net Income (Loss) Per Share

  Net loss per share in 1996 is computed using the weighted average number of
shares of common stock outstanding during the year.

  The 1995 net income per share is calculated using the weighted average
number of common shares and common equivalent shares outstanding during the
period. The 1994 net loss per share is calculated using the weighted average
number of common shares outstanding during the period. Common equivalent
shares are excluded from the calculation as the effect is antidilutive.
Pursuant to the Securities and Exchange Commission Staff Accounting Bulletins,
common and common equivalent shares issued by the Company at prices below the
initial public offering price during the twelve-month period prior to the
offering have been included in the calculation of the 1995 net income per
share as if they were outstanding for all periods presented prior to the
offering date (using the treasury stock method or the modified treasury stock
method when applicable and the initial public offering price). Net loss per
share for 1994 calculated on this basis was $(44.03).

  In 1994, pro forma net loss per share, which is disclosed on the statement
of operations, has been computed as described above and also gives effect,
even if antidilutive, to common equivalent shares from redeemable convertible
preferred stock that converted upon the closing of the Company's initial
public offering (using the if-converted method).

2. ADVERTISING CREDITS

  During 1996 and 1995, the Company entered into various transactions whereby
it exchanged $987,000 and $2,796,000 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 1996 and 1995, the Company utilized
$1,022,000 and $893,000, respectively, of these credits for advertising.

  At December 31, 1996 and 1995, the Company had advertising credits in the
amount of $1,868,000 and $1,904,000, respectively, which were included in
prepaid assets. The Company expects to fully utilize the credits in 1998.

3. RECLASSIFICATIONS

  Certain reclassifications in the Statements of Operations for fiscal 1995
have been made to prior amounts reported to conform with the presentation
adopted by the Company to report its 1996 financial results.

4. 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.


                                      F-8
<PAGE>

  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.

5. 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 past, including significant accommodations in
fiscal 1996 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.

 Seasonality 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,
                                                                  ----------------
                                                                  1996  1995  1994
                                                                  ----  ----  ----
   <S>                                                            <C>   <C>   <C>
   Toys R Us.....................................................  21%   27%   14%
   Wal-Mart......................................................  20    27    21
   Tomy..........................................................  11     *    12%
   Kmart.........................................................  11%    *     *
   Kay-Bee.......................................................   *    12%    *
</TABLE>
--------
* Sales to these customers were less than 10% of net sales in the years
   indicated.

                                      F-9
<PAGE>

  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.

 Dependence on 1997 Product Introductions

  The Company has introduced and expects to commence sales of new product
lines during the current year. The Company expects that the 1997 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.

6. NOTES PAYABLE AND FINANCING ARRANGEMENTS

  The Company has $30,000,000 available under the accounts receivable
management and security agreement that expires July 30, 1999. Borrowings under
the agreement are based on 70% of defined eligible accounts receivable and 30%
of defined eligible inventories and are subject to specified letter of credit
and inventory sublimits. 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 11-1/4% at December 31, 1996.
Borrowings under the line of credit can be applied to the issuance of letters
of credit up to $16,000,000. At December 31, 1996, borrowings were
$16,712,000, and the Company had approximately $4,223,000 of letters of credit
outstanding. The amounts available under the line of credit at December 31,
1996 was approximately $22,111,000. Borrowings are collateralized by
substantially all of the Company's assets, and the Company is subject to
significant charges for early termination by the Company. In addition, the
Loan and Security 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 quick ratio and profitability covenants at December
31, 1996 and has obtained a waiver from the financial institution with regard
to these covenants for the year ended December 31, 1996.

  During August 1994, the Company entered into a $2,500,000 supplemental loan
agreement with the financial institution then providing its line of credit. In
connection with the loan, certain stockholders provided letters of credit or
certificates of deposit as collateral for the loan. In exchange, the
stockholders were issued warrants to purchase 166,760 shares of common stock
at an exercise price of $7.50 per share. One stockholder elected to convert
$1,100,000 of collateral for Series F convertible preferred stock at $7.50 per
share, and the proceeds were used to pay down the loan to $1,400,000. The
related warrants issued in conjunction with this collateral were then
canceled. In exchange for an extension to the loan maturity date, the
participating stockholders were granted additional warrants to purchase 93,247
shares of common stock at $7.50 per share. In

                                     F-10
<PAGE>

April 1995, the Company issued an aggregate of $1,400,000 principal amount of
conversion notes to the participating stockholders in full satisfaction of the
Company's obligation to repay such investors for draws against the letters of
credit and cash collateral accounts posted by such investors. The notes bear
interest at 10% per annum. In connection with the Company's initial public
offering, the notes were converted into 320,729 shares of common stock, and
the note holders were issued redeemable common stock warrants to purchase an
additional 320,729 shares of common stock at an exercise price of $4.00 per
share.

  In April 1995, the Company issued an aggregate of $3,000,000 bridge notes
and warrants to purchase 1,500,000 shares of the Company's common stock. The
bridge notes bore interest at a rate of 10% per annum and were repaid from the
proceeds of the Company's initial public offering in June 1995.

7. CONVERTIBLE NOTES PAYABLE

  As of December 31, 1995, $2,000,000 in principal amount of 10% convertible
subordinated notes payable was outstanding. The notes were issued on September
30, 1993 and matured on September 30, 1996. In October 1996, all amounts
outstanding under these notes were paid.

8. 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 $4,586,000, $3,065,000, and $1,757,000 in 1996, 1995 and
1994, respectively. Future minimum royalty commitments under these agreements
are approximately $2,727,000 at December 31, 1996.

  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 1996, 1995, and 1994, royalty payments to STM for
sales of T.V. Teddy hardware approximated $7,700, $335,000, and $383,000,
respectively.

9. CAPITAL LEASE OBLIGATIONS

  The Company leases certain equipment under noncancelable lease agreements
that are accounted for as capital leases. As of December 31, 1996 and 1995,
equipment under capital lease arrangements included in property and equipment,
aggregated approximately $348,599 and $346,000. Accumulated amortization
totaled $318,823 and $247,000 at December 31, 1996, and 1995, respectively.

  Future minimum lease payments under capital lease obligations at December
31, 1996, are as follows (in thousands):

<TABLE>
             <S>                                   <C>
             1997................................. $18
             1998.................................  15
             1999.................................  --
                                                   ---
             Total minimum payments...............  33
             Less amounts representing interest...   3
             Less current portion.................  16
                                                   ---
                                                   $14
                                                   ===
</TABLE>


                                     F-11
<PAGE>

10. 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 $210,000 and $103,000 at December 31, 1996 and
1995, respectively, which are included in other assets.

  Future minimum operating lease payments, net of sublease income, at December
31, 1996 are as follows (in thousands):

<TABLE>
             <S>                                <C>
             1997.............................. $1,302
             1998..............................    982
             1999..............................    660
             2000..............................    219
             2001 and beyond...................    657
                                                ------
                                                $3,820
                                                ======
</TABLE>

  Total rental expense was approximately $1,187,000, $1,345,000, and
$1,243,000, in 1996, 1995, and 1994, 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 and 1994 rental expense was
offset by approximately $186,000 and $156,000 of sublease income,
respectively.

11. INCOME TAXES

  The Company provides for income taxes as required under Statement of
Financial Accounting Standards No. 109, "Accounting for Income Taxes." The
components of the provision for income taxes consist of the following (in
thousands):

<TABLE>
<CAPTION>
                                           YEAR ENDED
                                          DECEMBER 31,
                                              1995
                                          ------------
             <S>                          <C>
             Current:
               Federal...................     $110
               State.....................       25
               Foreign...................       50
                                              ----
             Total.......................     $185
                                              ====
</TABLE>

  There was no provision for income taxes in either 1996 or 1994, as the
Company incurred pre-tax book losses of approximately $12,500,000 and
$22,000,000, respectively. The Company's provision for income taxes 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,
                                                      ------------------------
                                                       1996     1995    1994
                                                      -------  ------  -------
      <S>                                             <C>      <C>     <C>
      Income tax (benefit) computed at the federal
       statutory rate................................ $(4,274) $1,294  $(7,674)
      State taxes....................................      --      25       --
      Foreign taxes..................................      --      50       --
      Temporary differences and net operating losses
       with no current tax benefit (benefited).......   4,274  (1,184)   7,674
                                                      -------  ------  -------
      Provision for income taxes..................... $    --  $  185  $    --
                                                      =======  ======  =======
</TABLE>


                                     F-12
<PAGE>

  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,
                                                               ----------------
                                                                1996     1995
                                                               -------  -------
      <S>                                                      <C>      <C>
      Deferred tax assets:
        Allowance for returns................................. $ 1,807  $   772
        Capitalized research and development..................   2,505    2,526
        Net operating loss carryforwards......................  13,453    9,517
        Reserves and accrued expenses.........................   1,846    2,312
                                                               -------  -------
      Total deferred tax assets...............................  19,611   15,127
      Valuation allowance..................................... (19,611) (15,127)
                                                               -------  -------
      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, 1996 and
1995 has been established to reflect these uncertainties. The change in the
valuation allowance was an increase of $4,484,000 and $7,780,000 in 1996 and
1994, respectively, and a decrease of $993,000 in 1995.

  At December 31, 1996, the Company had net operating loss carryforwards for
federal and California tax purposes of approximately $36,500,000 and
$17,000,000, respectively. The federal losses will expire in the years 2007
through 2011, and the state losses will expire in the years 1999 through 2001,
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.

12. STOCKHOLDERS' EQUITY

 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. At December 31,
1996, 3,241,956 warrants had been exercised.

                                     F-13
<PAGE>

  In addition to the warrants described above, the Company periodically
granted warrants in connection with certain financing arrangements and
borrowing agreements. The Company has the following additional warrants
outstanding to purchase common stock at December 31, 1996:

<TABLE>
<CAPTION>
        NUMBER OF                    PRICE PER                                    EXPIRATION
         SHARES                        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
</TABLE>

 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.

                                     F-14
<PAGE>

  Stock options activity under the 1992 Plan and 1995 Plan was as follows (in
thousands, except per share data):

<TABLE>
<CAPTION>
                                                        OPTIONS OUTSTANDING
                                                        -----------------------
                                                                     WEIGHTED
                                              AVAILABLE  NUMBER       AVERAGE
                                                 FOR       OF        PRICE PER
                                                GRANT    SHARES        SHARE
                                              --------- ---------   -----------
<S>                                           <C>       <C>         <C>
Balance at December 31, 1993.................      87         129    $     1.71
  Granted....................................     (67)         67    $     2.25
  Canceled...................................      40         (40)   $     1.90
                                               ------   ---------
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
                                               ======   =========
</TABLE>

  At December 31, 1996 and 1995, approximately 554,000 and 175,000 options,
respectively, were exercisable under the plans.

  At December 31, 1996, options outstanding were as follows:

<TABLE>
<CAPTION>
                                        OPTIONS
                                      OUTSTANDING           OPTIONS EXERCISABLE
                                      -----------          ---------------------
                            NUMBER                            NUMBER
                         OUTSTANDING   WEIGHTED   WEIGHTED EXERCISABLE  WEIGHTED
                            AS OF       AVERAGE   AVERAGE     AS OF     AVERAGE
                         DECEMBER 31,  REMAINING  EXERCISE DECEMBER 31, EXERCISE
EXERCISE PRICES              1996     CONTRACTUAL  PRICE       1996      PRICE
---------------          ------------    LIFE     -------- ------------ --------
<S>                      <C>          <C>         <C>      <C>          <C>
$ 1.50 -- 2.25..........    193,295      7.82      $2.17     174,331     $2.17
  5.25 -- 6.50..........  1,022,772      8.71       5.58     373,945      5.78
  7.50 -- 10.69.........    185,100      9.56      10.49          26      9.13
 11.13 -- 13.88.........  1,014,512      9.78      13.70       5,884     11.98
                          ---------      ----      -----     -------     -----
$ 1.50 -- $13.88........  2,415,679      9.15      $9.09     554,186     $4.71
</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-15
<PAGE>

  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 6.23% and 6.37% for 1996 and
1995, respectively; a dividend yield of 0%; a volatility factor of the
expected market price of the Company's common stock of .342 and .269 for 1996
and 1995, respectively; and a weighted average expected life of the option of
five years. The weighted average fair value of these options granted were
$1.84 and $5.37 for 1996 and 1995, 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 the expected
stock price volatility. Because the Company's employee stock options have
characteristics significantly different from those of traded options and
because changes in the subjective input assumptions can materially affect the
fair value estimate, in management's opinion, the existing models do not
necessarily provide a reliable single measure of the fair value of its
employee stock options.

  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 income(loss) and
earnings(loss) per share would have been reduced to the pro forma amounts
indicated below:

<TABLE>
<CAPTION>
                                                        YEARS ENDED DECEMBER
                                                                 31,
                                                       ------------------------
                                                           1996         1995
                                                       ------------  ----------
   <S>                                                 <C>           <C>
   Pro forma net income (loss)........................ $(13,477,000) $3,314,000
   Pro forma earnings (loss) per share................ $      (0.97) $     0.39
</TABLE>

  Because FAS 123 is applicable only to options granted subsequent to December
31, 1994, its pro forma effect will not be fully reflected until 1999.

 Undesignated 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.

 Common Stock Reserved for Future Issuance

  Authorized shares of common stock reserved, are as follows (in thousands):

<TABLE>
<CAPTION>
                                                                   DECEMBER 31,
                                                                       1996
                                                                   ------------
   <S>                                                             <C>
   Stock option plans, including the 1992 Stock Option Plan, the
    1995 Stock Option Plan, and the 1995 Director Option Plans....    3,054
   Issued and outstanding warrants................................    1,354
   Undesignated preferred stock...................................    2,000
                                                                      -----
   Total common stock reserved for future issuance................    6,408
                                                                      =====
</TABLE>

                                     F-16
<PAGE>

13. 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,
                                                                 ----------------
                                                                 1996  1995  1994
                                                                 ----  ----  ----
   <S>                                                           <C>   <C>   <C>
   United States................................................  79%   93%   71%
   Export:
     Europe.....................................................   3     2    17
     Far East...................................................  11     2     4
     Other......................................................   7     3     8
                                                                 ---   ---   ---
                                                                 100%  100%  100%
                                                                 ===   ===   ===
</TABLE>

14. LITIGATION

  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.

15. 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 1996, the Company
made contributions in the form of company stock in the amount of $163,702.


16. SUBSEQUENT EVENT

  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 a series of investors for a total of
$8,500,000.

  Holders of the Series A convertible preferred stock shall be entitled to
receive, when and as declared by the Board of Directors out of legally
available funds, cumulative dividends at a rate of 6 1/2% per annum, payable
in cash or shares of common stock, semi-annually in arrears, but in no event
later than the date of conversion. The Series A convertible preferred stock
has no voting rights, has a liquidation preference of $100 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 the lowest of (a)
$5.313, (b) the average of the lowest per share market value for any five
consecutive trading days during the sixty trading days immediately following
January 28, 1997, or (c) 82 1/2% of the average per share market value for the
five trading days immediately preceding the conversion date. Beginning January
28, 1998 the Company can force conversion of the preferred stock to common
stock at the then applicable conversion rate. The Series A convertible
preferred stock is redeemable, in cash, at the option of the Company at a
redemption price equal to the sum of (i) the average per share market value
for the five days immediately preceding (1) the 20th trading day after the
date of redemption notice or (2) the date of payment in full by the Company,
whichever is greater, and (ii) the conversion ratio calculated on the 20th
trading day after

                                     F-17
<PAGE>

the redemption notice. The Series A convertible preferred stock is mandatorily
redeemable on January 28, 2000, if not previously converted or redeemed. Any
redemption payments must be approved by BNY, the financial institution with
which the Company has its current accounts receivable management agreement.

  The convertible debentures earn interest at 5% per annum, are due January
28, 2000, and are convertible any time after January 28, 1998, at the option
of the holder, at a conversion price similar to that of the Series A
convertible preferred stock. The convertible debentures are subordinated to
the bank financing agreement.

  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 equal to the lesser of (a) $7.875 or (b) 125% of
the average of the lowest per share market value for any five consecutive
trading days during the sixty trading days following March 18, 1997. The
warrants expire March 18, 2002.

  The Company will record approximately $260,000 in interest expense and
$1,480,000 in dividends related to this transaction during the first quarter
of fiscal 1997.

                                     F-18
<PAGE>

                                                                     SCHEDULE II

                         YES! ENTERTAINMENT CORPORATION

                       VALUATION AND QUALIFYING ACCOUNTS
                                 (IN THOUSANDS)

<TABLE>
<CAPTION>
                                BALANCE AT  CHARGED TO
                               BEGINNING OF COSTS AND              BALANCE AT
                                  PERIOD     EXPENSES  DEDUCTIONS END OF PERIOD
                               ------------ ---------- ---------- -------------
<S>                            <C>          <C>        <C>        <C>
Year ended December 31, 1994:
  Allowance for doubtful ac-
   counts.....................    $  140     $   140     $   21      $  259
  Allowance for sales returns
   and allowances.............     6,877       8,844      8,063       7,658
                                  ------     -------     ------      ------
                                   7,017       8,984      8,084       7,917
                                  ======     =======     ======      ======
Year ended December 31, 1995:
  Allowance for doubtful ac-
   counts.....................       259         232         59         432
  Allowance for sales returns
   and allowances.............     7,658       6,523     11,575       2,606
                                  ------     -------     ------      ------
                                   7,917       6,755     11,634       3,038
                                  ======     =======     ======      ======
Year ended December 31, 1996:
  Allowance for doubtful ac-
   counts.....................       432         192        159         465
  Allowance for sales returns
   and allowances.............     2,606       9,939      7,365       5,180
                                  ------     -------     ------      ------
                                  $3,038     $10,131     $7,524      $5,645
                                  ======     =======     ======      ======
</TABLE>