<PAGE>
 
     As filed with the Securities and Exchange Commission on March 9, 1999
 
-------------------------------------------------------------------------------
-------------------------------------------------------------------------------
 
                                 UNITED STATES
                      SECURITIES AND EXCHANGE COMMISSION
                            Washington, D.C. 20549
 
                                   FORM 10-K
 
[X]ANNUAL REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE
   ACT OF 1934 (FEE REQUIRED)
 
                  For the fiscal year ended December 31, 1998
                                      or
 
[_]TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES
   EXCHANGE ACT OF 1934 (NO FEE REQUIRED)
 
                For the transition period from        to
 
                        Commission File Number: 0-26430
 
                             TARRANT APPAREL GROUP
            (Exact name of registrant as specified in its charter)
 
<TABLE>
<S>                                            <C>
                 California                                      95-4181026
        (State or other jurisdiction                          (I.R.S. Employer
      of incorporation or organization)                    Identification Number)
</TABLE>
 
                        3151 East Washington Boulevard
                         Los Angeles, California 90023
              (Address of principal executive offices) (Zip code)
 
     (Registrant's telephone number, including area code): (323) 780-8250
 
       Securities registered pursuant to Section 12(b) of the Act: None
 
   Securities registered pursuant to Section 12(g) of the Act: Common Stock
 
Indicate by check mark whether the Registrant (1) has filed all reports
required to be filed by Section 13 or 15(d) of the Securities Exchange Act of
1934 during the preceding 12 months (or for such shorter period that the
Registrant was required to file such reports), and (2) has been subject to
such filing requirements for the past 90 days. Yes [X] No [_]
 
Indicate by check mark if disclosure of delinquent filers pursuant to Item 405
of Regulation S-K is not contained herein, and will not be contained, to the
best of Registrant's knowledge, in definitive proxy or information statements
incorporated by reference in Part III of this Form 10-K or any amendment to
this Form 10-K. [X]
 
As of March 1, 1999, the aggregate market value of the Common Stock held by
non-affiliates of the registrant was approximately $241,700,000, based upon
the closing price of the Common Stock on that date.
 
Number of shares of Common Stock of the registrant outstanding as of March 1,
1999: 13,836,955.
 
                      DOCUMENTS INCORPORATED BY REFERENCE
 
Portions of the registrant's definitive Proxy Statement to be filed with
Securities and Exchange Commission pursuant to Regulation 14A in connection
with the 1999 Annual Meeting are incorporated by reference into Part III of
this Report. Such Proxy Statement will be filed with the Securities and
Exchange Commission not later than 120 days after the registrant's fiscal year
ended December 31, 1998.
 
-------------------------------------------------------------------------------
-------------------------------------------------------------------------------
<PAGE>
 
                               TABLE OF CONTENTS
 
<TABLE>
<CAPTION>
                                                                            Page
                                                                            ----
 <C>      <S>                                                               <C>
 Item 1.  BUSINESS.......................................................     3
          General........................................................     3
          Business Strategy..............................................     4
          Acquisitions...................................................     5
          Vertical Integration...........................................     6
          Products.......................................................     7
          Customers......................................................     7
          Design, Merchandising and Sales................................     8
          Sourcing.......................................................     9
          Backlog........................................................    11
          Import Restrictions............................................    12
          Competition....................................................    13
          Employees......................................................    13
 
 Item 2.  PROPERTIES.....................................................    14
 
 Item 3.  LEGAL PROCEEDINGS..............................................    14
 
 Item 4.  SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS............    14
 
 Item 5.  MARKET FOR REGISTRANT'S COMMON EQUITY AND RELATED STOCKHOLDER
          MATTERS........................................................    15
          NASDAQ Listing.................................................    15
          Dividend Policy................................................    15
          Stock Split....................................................    15
 
 Item 6.  SELECTED FINANCIAL DATA........................................    16
 
 Item 7.  MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND
          RESULTS OF OPERATIONS..........................................    17
          General........................................................    17
          Factors That May Affect Future Results.........................    17
          Results of Operations..........................................    21
          Quarterly Results of Operations................................    23
          Liquidity and Capital Resources................................    23
 
 Item 7A. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK.....    25
 
 Item 8.  FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA....................    25
 
 Item 9.  CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND
          FINANCIAL DISCLOSURE...........................................    25
 
 Item 10. DIRECTORS AND EXECUTIVE OFFICERS...............................    26
 
 Item 11. EXECUTIVE COMPENSATION.........................................    26
 
 Item 12. SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT.    26
 
 Item 13. CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS.................    26
 
 Item 14. EXHIBITS, FINANCIAL STATEMENT SCHEDULES AND REPORTS ON FORM 8-
          K..............................................................    27
</TABLE>
 
                                       2
<PAGE>
 
                                    PART I
 
Item 1. BUSINESS
 
General
 
  This 1998 Annual Report on Form 10-K contains statements which constitute
forward-looking statements within the meaning of Section 27A of the Securities
Act of 1933, as amended, and Section 21E of the Securities Exchange Act of
1934, as amended. Those statements include statements regarding the intent,
belief or current expectations of the Company and its management. Prospective
investors are cautioned that any such forward-looking statements are not
guarantees of future performance and involve risks and uncertainties, and that
actual results may differ materially from those projected in the forward-
looking statements. Such risks and uncertainties include, among other things,
competitive and economic factors in the textile and apparel markets, raw
materials and other costs, weather-related delays, general economic conditions
and other risks and uncertainties that may be detailed herein.
 
  Tarrant Apparel Group (the "Company"), a leading provider of private label
casual apparel, primarily serves both specialty retail and mass merchandise
store chains by designing, merchandising, contracting for the manufacture of
and selling casual, moderately-priced apparel for women, men and children,
under private label. In 1998, management responsibilities were divided between
two operating divisions, one responsible for the production of "fashion"
garments and the other for "basic" garments. Since 1988, when the Company
began designing and supplying private label denim jeans to a single specialty
retail store chain, it has successfully expanded its product lines and built a
private label business which during 1998 served over 20 customers. The
Company's current products are manufactured in a variety of woven and knit
fabrications and include jeanswear, casual pants, t-shirts, shorts, blouses,
shirts and other tops, dresses, leggings and jackets. See "Business--Products"
and "--Customers."
 
  Over the past five years, the Company has achieved a compound annual growth
rate in net sales of approximately 20% from $177.1 million in 1994 to $378.2
million in 1998. Pre-tax income has risen approximately 50% on a compound
annual basis, from $7.6 million in 1994 to $37.1 million in 1998.
 
  The Company continues to geographically diversify its worldwide sourcing
operations. Commencing in the second quarter of 1997, the Company
substantially expanded its use of independent cutting, sewing and finishing
contractors in Mexico, primarily for its increasing sales of basic garments.
The gross sales of products sourced in Mexico was $103.7 million in 1998.
 
  On February 22, 1999, the Company agreed to acquire a denim mill in Puebla,
Mexico with an annual capacity of approximately 18 million meters of denim.
The purchase price for such mill will consist of $22 million in cash payable
on May 6, 1999 and two million shares of the Common Stock of the Company. The
Company anticipates that this acquisition will be consummated on or about
April 1, 1999. See "--Vertical Integration" and "Note 16 to Notes to
Consolidated Financial Statements--Subsequent Events--Acquisitions."
 
  On December 2, 1998, the Company contracted to acquire a turn-key facility
being constructed near Puebla, Mexico by an affiliate of the seller of the
denim mill described above. This facility is ultimately expected to have an
annual capacity of approximately 18 million meters of twill and will also
house ancillary facilities. Construction of this facility commenced in the
third quarter of 1998, and it is anticipated that the Company will take
possession of this facility by the year 2000. The Company anticipates that the
cost of this facility will be approximately $75 million. See "--Vertical
Integration" and "Note 16 to Notes to Consolidated Financial Statements--
Subsequent Events--Acquisitions."
 
  The Company has no previous history of owning and operating fabric
production facilities and has purchased textile raw materials from third party
sources in the past.
 
  On July 2, 1998, the Company acquired Rocky Apparel, L.P. ("Rocky") which
designs, contracts for the manufacture of and sells private label apparel for
men and women to national retailers, including Abercrombie
 
                                       3
<PAGE>
 
& Fitch and three divisions of The Limited, Inc. ("The Limited"). See "--
Acquisitions" and "Note 5 to Notes to Consolidated Financial Statements--
Acquisitions."
 
  On February 23, 1998, the Company acquired certain assets of Marshall Gobuty
International U.S.A., Inc. and MGI International Limited (collectively, "MGI")
which design, contract for the manufacture of and sell private label apparel
for men and boys to national retailers, including J.C. Penney. See "--
Acquisitions" and "Note 5 to Notes to Consolidated Financial Statements--
Acquisitions."
 
Business Strategy
 
  Management believes that the following trends currently are shaping apparel
retailing and manufacturing:
 
  .  The increasing acceptance of casual apparel in the workplace and
     emphasis on a casual, active lifestyle has increased the demand for
     casual, moderately-priced, private label products.
 
  .  Consolidation among apparel retailers has increased their ability to
     demand value-added services from apparel manufacturers, including
     fashion expertise, rapid sourcing, just-in-time delivery and favorable
     pricing.
 
  .  A decline in brand loyalty and increased competition among retailers due
     to consolidation have resulted in an increased demand for private label
     apparel which generally offers retailers higher margins and permits them
     to differentiate their products.
 
  .  The North American Free Trade Agreement ("NAFTA") has reduced many trade
     barriers that previously limited apparel production in Mexico. Because
     of competitive labor costs and shorter transportation distances, Mexico
     represents a cost efficient and timely alternative for certain types of
     apparel production.
 
  .  The current fashion cycle has increased the demand for apparel
     manufacturers who have demonstrated their ability to rapidly identify
     changes in fashion trends.
 
  The Company's strategy to take advantage of these trends to become a
principal value-added supplier of casual, moderately-priced, private label
apparel includes the following key elements:
 
  .  The Company believes that it has established a reputation with its
     customers as a fashion resource--a manufacturer that is capable of
     designing and producing a broad range of quality merchandise and
     reacting rapidly to changing fashion trends.
 
  .  The Company has developed a diversified network of international
     contract manufacturers and fabric suppliers which enables the Company to
     accept orders of varying size and delivery schedules and to produce a
     broad range of garments at varying prices depending upon lead time and
     other requirements of the customer.
 
  .  The Company seeks to develop an in-depth understanding of the fashion
     and pricing strategies of its customers and to support those strategies
     with its design expertise, sample-making capability and ability to
     assist customers in market-testing designs by the rapid production of
     small, "test order" quantities of products.
 
  .  The Company has commenced the vertical integration of its business
     through the development and acquisition of fabric and production
     capacity in Mexico. The Company believes that this strategy will
     increase its production capacity, increase its control over the
     production process, lower costs and shorten lead times.
 
  .  The Company's size, access to public capital and ability to use its
     stock as currency in acquisitions provides the Company flexibility not
     afforded to other, smaller private label manufacturers.
 
  The Company believes that by employing these strategies it can attract new
customers and increase sales to existing customers.
 
                                       4
<PAGE>
 
Acquisitions
 
 Rocky
 
  On July 2, 1998, the Company purchased the partnership interests of Rocky
Apparel, L.P., a Delaware limited partnership ("Rocky"). Rocky operates
manufacturing facilities in Mississippi and also sources garments in Mexico.
The purchase price consisted of $7.4 million in cash and 81,000 shares of the
Common Stock of the Company, valued at $1.4 million, paid on closing. In
addition, the Company was required to repay $3.4 million of debt to one of the
sellers on closing and to guarantee the bank indebtedness of Rocky in the
amount of $5.0 million. The Company was granted a security interest in the
81,000 shares to secure the performance of obligations under the purchase
agreement, including, without limitation, the indemnification obligations.
This transaction has been accounted for as a purchase, and the purchase price
has been allocated based on the fair value of assets acquired and liabilities
assumed. The excess of cost over fair value of net assets acquired is being
amortized over 15 years. The operations of Rocky have been included with those
of the Company commencing on July 1, 1998.
 
  Rocky designs, develops and contracts for the manufacture of men's, women's
and children's denim apparel, for Abercrombie & Fitch, Limited Stores, Express
and Structure. The purchase price was financed by the Company from a new
credit facility and cash flow from operations. For a description of such
credit facility, see "Item 7. Management's Discussion and Analysis of
Financial Condition and Results of Operations--Liquidity and Capital
Resources."
 
  In connection with this acquisition, Rocky extended the term of an existing
employment agreement with Gabriel Zeitouni, the President and a former
principal owner of Rocky. Under this employment agreement, Mr. Zeitouni will
continue to be employed as the President of Rocky for a term ending on
December 31, 2002, unless extended by the mutual agreement of the Company and
Mr. Zeitouni, will be paid a base salary which increases from $350,000 for
1998 to $450,000 for 2002 and will receive cash bonuses based upon certain
performance criteria. Also, Mr. Zeitouni was awarded a stock option for 75,000
shares of the Company's Common Stock which vests periodically through December
31, 2002 subject to certain performance criteria. In the event the Company
terminates his employment without cause, Mr. Zeitouni shall be entitled to
receive (i) a lump sum payment equal to his base salary for the shorter of the
balance of the term or two years and (ii) accrued bonus, if any, through the
date of termination. In the event the Company terminates Mr. Zeitouni's
employment with cause, the Company is obligated to pay the compensation
required by the agreement only through the date of termination. In addition,
Mr. Zeitouni has agreed not to compete with the Company during the two years
following the termination of his employment for cause.
 
 MGI
 
  On February 23, 1998, the Company purchased certain assets of MGI
International Limited, a Turks and Caicos corporation. The assets purchased
consisted primarily of inventory. The purchase price consisted of (i) $4.6
million, together with an amount equal to the seller's cost of the inventory
purchased, paid in cash on closing and (ii) $500,000 paid on July 21, 1998,
together with interest at 7% per annum.
 
  On February 23, 1998, the Company also purchased certain assets of Marshall
Gobuty International U.S.A., Inc., a California corporation ("MGI USA"). The
assets purchased consisted primarily of inventory. The purchase price
consisted of (i) $500,000, together with an amount equal to the seller's cost
of the inventory purchased, paid in cash on closing and (ii) $500,000 paid on
July 21, 1998, together with interest at 7% per annum.
 
  MGI International Limited and MGI USA (collectively, "MGI") each designs,
develops and contracts for the manufacture of men's apparel, including knit
and woven tops, shirts and outerwear (including jackets), for national chain
department stores, including J.C. Penney and Goody's. The purchase price was
financed by the Company from its cash flow from operations. This transaction
has been accounted for as a purchase and the
 
                                       5
<PAGE>
 
purchase price has been allocated based on the fair value of the assets
acquired and liabilities assumed. The excess of cost over fair value of net
assets acquired is being amortized over five years. The operations of MGI have
been included with those of the Company commencing on February 23, 1998.
 
Vertical Integration
 
 Acquisition of Denim Mill
 
  On February 22, 1999, the Company agreed to purchase certain assets of a
denim mill located in Puebla, Mexico with an annual capacity of 18 million
meters. The purchase price will consist of $22 million in cash payable on May
6, 1999 and two million shares (the "Shares") of the Company's Common Stock.
The Shares will be distributed to the sellers in three equal installments on
the first three anniversary dates of the closing date; provided, however, that
any distribution (i) shall be offset by any claims of the Company against the
sellers under the asset purchase agreement and (ii) will be proportionally
reduced in the event the assets fail to produce at least 15 million yards of
marketable denim in the fiscal year immediately preceding the dates of such
distributions of Shares. In addition, the Company has granted the holders of
the Shares certain registration rights and the right to vote the Shares.
Closing is anticipated to occur on or about April 1, 1999.
 
  The Company also will assume the obligations of the sellers under an
existing collective bargaining agreement; provided, however, that the sellers
shall reimburse the Company for any costs (including, but not limited to,
salaries and benefits) arising before the closing date or as a result of this
acquisition.
 
  The Company has entered into a three-year employment agreement with Mr.
Nacif, the principal shareholder of the sellers, pursuant to which Mr. Nacif
shall be entitled to receive (i) an annual base salary of $1 million, subject
to such periodic increases, if any, as the Company may deem to be appropriate,
(ii) reimbursement of all reasonable and documented business expenses, (iii)
participation in all plans sponsored by the Company for employees in general
and (iv) the right (the "Option") for ten years to purchase up to 500,000
shares of the Company's Common Stock at an exercise price equal to the average
closing price for the ten trading days prior to the closing date. The Option
will vest in three equal installments on the first three anniversary dates of
the closing date and will terminate upon the termination of Mr. Nacif's
employment by the Company; provided, however, that (i) the vesting of any
installment shall be deferred to the date ten business days before the stated
expiration date in the event the operating income of the Company's Mexican
operations does not reach certain levels, and (ii) if such termination of
employment results from Mr. Nacif's death or permanent disability, any vested
portion shall terminate on the earlier of the stated expiration date or the
first anniversary of such termination of employment. In the event the Company
terminates Mr. Nacif's employment without cause (as defined) the Company shall
remain obligated to pay Mr. Nacif an amount equal to his base salary for the
remainder of the stated term. In the event Mr. Nacif's employment is
terminated for any other reason (including death, disability, resignation or
termination with cause), neither party shall have any further obligation to
the other, except that the Company shall pay to Mr. Nacif, or his estate, all
reimbursable expenses and such compensation as is due prorated through the
date of termination.
 
 Acquisition of Twill Mill and Production Facility
 
  On December 2, 1998, the Company contracted with an affiliate of Mr. Nacif
for the construction of a turn-key facility near Puebla, Mexico for the
production of twill fabric which will also house ancillary facilities. The
purchase price of the facility shall be the sum of (i) the cost of
construction and equipment installed, which cost will not include operating
expenses, estimated to be approximately $47 million, and (ii) a promissory
note of the Company (the "Note") in the principal amount of $28 million.
 
  The principal balance of the Note will be payable on the third anniversary
date of the closing date, and interest on the unpaid principal balance from
time to time outstanding will be payable semi-annually in arrears on each June
30 and December 31 at the rate of 7% per annum. Payment under the Note will be
subject to the right of the Company to set off any amount payable by (i) the
developer to the Company under the facility
 
                                       6
<PAGE>
 
development agreement, including, but not limited to, any amount payable under
the indemnification provisions of the facility development agreement upon the
breach by the developer of any representations, warranties or agreements
contained in the facility development agreement, or (ii) the sellers of the
denim mill assets under the asset purchase agreement, including, but not
limited to, any amount payable under the indemnification provisions of such
agreement.
 
Products
 
  In 1988, the Company received its first orders for private label women's
denim jeans from Express, a division of The Limited. While women's jeans have
historically been, and continue to be, the Company's principal product, in
recent years the Company has expanded its sales of moderately-priced, women's
apparel to include casual, denim and non-denim woven tops and bottoms and has
commenced the sale of men's apparel, including knit and woven tops, shirts and
outerwear (including jackets), as a result of the acquisition of MGI on
February 23, 1998. The Company's women's apparel products currently include
jeanswear, casual pants, t-shirts, shorts, blouses, shirts and other tops,
dresses, leggings and jackets. These products are manufactured in petite,
standard and large sizes and are sold at a variety of wholesale prices
generally ranging from less than $3.00 to over $25.00 per garment.
 
  Over the past three years, approximately fifty percent of net sales were
derived from the sale of pants and jeans, approximately fifteen percent from
the sale of shorts and approximately ten percent from the sale of shirts. The
balance of net sales consisted of sales of dresses, jackets, leggings and
other products.
 
  The Company, in the ordinary course of its business, regularly evaluates new
markets and potential acquisitions and believes that numerous opportunities
exist due, in part, to the adverse effect on the earnings of many apparel
companies of the recent decline in retail sales generally. Such opportunities
could include transactions involving acquisitions or brand affiliations.
Although the Company currently is evaluating several acquisitions, there are
no existing commitments with respect to any acquisition or affiliation, except
as described under "Business--Acquisitions" and "Vertical Integration."
 
Customers
 
  For the year ended December 31, 1998, affiliated stores owned by The
Limited, including Express, Lerner New York, Limited Stores, Structure and
Lane Bryant, accounted for approximately two-thirds of the Company's net
sales. No other customer accounted for more than 10% of the Company's net
sales in 1998. In the same period, virtually all of the Company's sales were
of private label apparel. The Company currently serves over 20 customers which
also include Target Stores (a division of Dayton Hudson), Abercrombie & Fitch
and J.C. Penney. See "Item 7. Management's Discussion and Analysis of
Financial Condition and Results of Operations--General."
 
  The Company generally targets only high-volume retailers that it believes
could grow into major accounts. By limiting its customer base to a select
group of larger accounts, the Company seeks to build stronger long-term
relationships and leverage its operating costs against large bulk orders.
Although the Company continues to diversify its customer base, the majority of
any growth in sales is expected to come from existing customers, as they
consolidate their buying power over fewer key vendors.
 
  On October 22, 1998, Limited Direct Associates LP, an entity 100% owned by
The Limited ("LDA"), acquired one million shares of the Company's Common Stock
(or approximately 7.2% of the Common Stock outstanding as of March 1, 1999)
through the exercise of an option granted by Mr. Guez and Mr. Kay, the
Chairman and President, respectively, of the Company, to LDA at the time of
the Company's initial public offering. The option granted LDA the right to
purchase 10% of the total shares of Common Stock outstanding at the time of
the initial public offering, or 1,299,998 shares, at a price of $3.60 per
share (as adjusted for a two-for-one stock split effective May 8, 1998). The
transaction was done on a cashless basis, whereby Mr. Guez and Mr. Kay
transferred ownership of one million shares to LDA and, in lieu of receiving
cash, Mr. Guez and Mr. Kay
 
                                       7
<PAGE>
 
retained ownership of the remaining 299,998 shares. The one million shares are
subject to a lockup provision, which prohibits LDA from selling the shares
until October 9, 1999. Messrs. Guez and Kay will continue to have the right to
vote the shares for one year following the exercise of the option, and will
also have a right of first refusal to purchase such shares, subject to certain
exceptions.
 
  The Company does not have long-term contracts with any of its customers and,
therefore, there can be no assurance that any customer will continue to place
orders with the Company of the same magnitude as it has in the past, or at
all. In addition, the apparel industry historically has been subject to
substantial cyclical variation, with consumer spending for purchases of
apparel and related goods tending to decline during recessionary periods.
Various retailers, including divisions of The Limited, have experienced
sluggish sales and declines in revenue and profits in recent periods. To the
extent that these financial difficulties continue or worsen, there can be no
assurance that the Company's financial condition and results of operations
would not be adversely affected. As a result of the importance of The Limited
to the operations of the Company, The Limited and its divisions have the
ability to exert significant influence over the Company's business decisions.
 
Design, Merchandising and Sales
 
  While many private label producers only arrange for the bulk production of
styles specified by their customers, the Company not only designs garments,
but also assists some of its customers in market testing new designs. The
Company believes that its design, sample-production and test-run capabilities
give it a competitive advantage in obtaining bulk orders from its customers.
The Company also often receives bulk orders for garments it has not designed
because many of its customers allocate bulk orders among more than one
producer.
 
  The Company has developed integrated teams of design, merchandising and
support personnel, some of whom serve on more than one team, that focus on
designing and producing merchandise that reflects the style and image of their
customers. Teams generally are divided between import and domestic sourcing
operations.
 
  Each team is responsible for all aspects of its customer's needs, including
designing products, developing product samples and test items, obtaining
orders, coordinating fabric choices and procurement, monitoring production and
delivering finished products. In particular, the team seeks to identify
prevailing fashion trends that meet its customer's retail strategies and
design garments incorporating those trends. The team also works with the
buyers of its customer to revise designs as necessary to better reflect the
style and image that the customer wishes to project to consumers. During the
production process, the team is responsible for informing the customer about
the progress of the order, including any difficulties that might affect the
timetable for delivery. In this way, the Company and its customer can make
appropriate arrangements regarding any delay or other change in the order. The
Company believes that this team approach enables its employees to develop an
understanding of the customer's distinctive styles and production requirements
in order to respond effectively to the customer's needs.
 
  As part of the Company's merchandising strategy, the Company produces, at
its own expense, one or more samples of garments embodying new designs. The
Company produces samples at its facilities in Guangdong Province, China, Hong
Kong and Mexico. The Chinese facility, which has 120 employees, currently
furnishes a significant portion of the Company's sample requirements.
 
  From time to time and at scheduled seasonal meetings, the Company presents
its samples to the customer's buyers, who determine which, if any, of those
samples will be produced on a test run or a bulk scale. Samples are often
presented in coordinated groupings or as part of a product line. Some
customers, particularly specialty retail stores such as divisions of The
Limited, may require that a product be "tested" before placing a bulk order.
Testing involves the production of as few as several hundred copies of a given
sample in different size, fabric and color combinations. The customer pays for
these test items, which are placed in selected stores to gauge consumer
response. The production of test items enables the Company's customers to
identify garments that may appeal to consumers and also provides the Company
with important information regarding the cost and feasibility of the bulk
production of the tested garment. If the test is determined to be successful,
the Company generally
 
                                       8
<PAGE>
 
receives a significant percentage of the customer's total bulk order of the
tested item. In addition, as is typical in the private label business, the
Company receives bulk production orders to produce merchandise designed by its
competitors or other designers, since most customers allocate bulk orders
among a number of suppliers.
 
Sourcing
 
 General
 
  When bidding for or filling an order, the Company's international sourcing
network enables it to choose from among a number of suppliers and
manufacturers based on the customer's price requirements, product
specifications and delivery schedules. Historically, the Company has
manufactured its products through independent cutting, sewing and finishing
contractors located primarily in Hong Kong and China and has purchased its
fabric from independent fabric manufacturers with weaving mills located
primarily in Hong Kong and China. In recent years, the Company has expanded
its network to include suppliers and manufacturers located in a number of
additional countries, including Mexico. Key elements of the Company's sourcing
strategy include (i) continuing to expand its production of basic denim and
twill products in Mexico through both independent contractors and the
acquisition or construction of cutting, sewing and finishing facilities and
(ii) seeking to acquire or construct denim and twill weaving mills in Mexico.
The following table sets forth the percent of the Company's merchandise, on
the basis of the free on board cost at the supplier's plant ("FOB Basis"), by
country for the periods indicated:
 
<TABLE>
<CAPTION>
                                                               1996  1997  1998
                                                               ----  ----  ----
     <S>                                                       <C>   <C>   <C>
     International Sourcing
      Hong Kong and China..................................... 78.3% 60.5% 50.4%
      Other(1)................................................  7.7  13.7  10.0
     Domestic Sourcing
      United States........................................... 13.8  14.9   5.7
      Mexico and Central America..............................  0.2  10.9  33.9
</TABLE>
----------
(1)In 1998, such countries consisted of Thailand (3.9%), Philippines (2.5%),
UAE/Oman (1.8%) and Indonesia (0.8%).
 
 Dependence on Contract Manufacturers
 
  All of the Company's products, with the exception of certain test runs and
samples, currently are manufactured by independent cutting, sewing and
finishing contractors. The use of contract manufacturers and the resulting
lack of direct control over the production of its products could result in the
Company's failure to receive timely delivery of products of acceptable
quality. Although the Company believes that alternative sources of cutting,
sewing and finishing services are readily available, the loss of one or more
contract manufacturers could have a materially adverse effect on the Company's
results of operations until an alternative source is located and has commenced
producing the Company's products.
 
  Although the Company monitors the compliance of its independent contractors
with applicable labor laws, the Company does not control its contractors or
their labor practices. The violation of federal, state or foreign labor laws
by one of the Company's contractors can result in the Company being subject to
fines and the Company's goods which are manufactured in violation of such laws
being seized or their sale in interstate commerce being prohibited. From time
to time, the Company has been notified by federal, state or foreign
authorities that certain of its contractors are the subject of investigations
or have been found to have violated applicable labor laws. To date, the
Company has not been subject to any sanctions that, individually or in the
aggregate, could have a material adverse effect upon the Company, and the
Company is not aware of any facts on which any such sanctions could be based.
There can be no assurance, however, that in the future the Company will not be
subject to sanctions as a result of violations of applicable labor laws by its
contractors, or that such sanctions will not have a material adverse effect on
the Company. In addition, the Company's customers require strict compliance by
their apparel manufacturers, including the Company, with applicable labor
laws. There can
 
                                       9
<PAGE>
 
be no assurance that the violation of applicable labor laws by one of the
Company's contractors will not have a material adverse effect on the Company's
relationship with its customers.
 
  In addition, as is customary in the industry, the Company does not have any
long-term contracts with independent fabric suppliers. The loss of any of its
major fabric suppliers could have a material adverse effect on the Company's
financial condition and results of operations until alternative arrangements
are secured.
 
 Diversified Production Network
 
  The Company believes that it has the ability, through its production
network, to operate on production schedules with lead times as short as 30
days. Typically, the Company's specialty retail customers attempt to respond
quickly to changing fashion trends and are increasingly less willing to assume
the risk that goods ordered on long lead times will be out of fashion when
delivered. These retailers, including divisions of The Limited, frequently
require production schedules with lead times ranging from 30 to 120 days.
Although mass merchandisers, such as Target Stores, are beginning to operate
on shorter lead times, they are occasionally able to estimate their needs as
much as six months to one year in advance for "program" business--basic
products that do not change in style significantly from season to season. The
Company's ability to operate on production schedules with a wide range of lead
times helps it to meet its customers' varying needs.
 
  By allocating an order among different manufacturers, the Company seeks to
fill the high-volume orders of its customers, while meeting their delivery
requirements. Upon receiving an order, the Company determines which of its
suppliers and manufacturers can best fill the order and meet the customer's
price, quality and delivery requirements. The Company considers, among other
things, the price charged by each manufacturer and the manufacturer's
available production capacity to complete the order, as well as the
availability of quota for the product from various countries and the
manufacturer's ability to produce goods on a timely basis subject to the
customer's quality specifications. The Company's personnel also consider the
transportation lead times required to deliver an order from a given
manufacturer to the customer. In addition, some customers prefer not to carry
excess inventory and therefore require that the Company stagger the delivery
of products over several weeks.
 
 International Sourcing
 
  The Company conducts and monitors its international sourcing operations from
its offices in Hong Kong and Mexico. At January 31, 1999, the Company had
approximately 180 and 125 full-time employees in Hong Kong and Mexico,
respectively, many of whom have extensive knowledge about and experience with
sourcing and production in their respective regions, including purchasing,
manufacturing and quality control. Several times each year, members of the
Company's senior management, including local staff, visit and inspect the
facilities and operations of the Company's international suppliers and
manufacturers.
 
  Foreign manufacturing is subject to a number of risk factors, including,
among other things, transportation delays and interruptions, political
instability, expropriation, currency fluctuations and the imposition of
tariffs, import and export controls and other non-tariff barriers (including
changes in the allocation of quotas). In addition to these risk factors, the
Company faces additional risks arising from the uncertainty regarding the
future status of Hong Kong since resumption of Chinese sovereignty on July 1,
1997, the continuation of favorable trade relations between the U.S. and China
(in particular the continuation of China's Most Favored Nation ("MFN") status
for tariff purposes), and the continuation of economic reform programs in
China which encourage private economic activity. Each of these factors could
have a material adverse effect on the Company.
 
  While the Company is in the process of establishing business relationships
with manufacturers and suppliers located in countries other than Hong Kong or
China, the Company still primarily contracts with manufacturers and suppliers
located primarily in Hong Kong and China, and currently expects that it will
continue to do so for the foreseeable future. Any significant disruption in
the Company's operations or its relationships with its
 
                                      10
<PAGE>
 
manufacturers and suppliers located in Hong Kong or China could have a
material adverse effect on the Company.
 
  The Company commenced manufacturing basic denim and twill products through
independent contractors in Mexico in the second quarter of 1997, and
anticipates continuing to expand its use of manufacturing facilities in this
region. The Company believes that the further diversification of its
international sourcing network by increasing the use of manufacturing
facilities in Mexico will (i) reduce its cost of goods, (ii) enhance the
proximity of the Company's sourcing operations to the Company's customers and
the Company's executive offices, thereby improving delivery times and
increasing management's control, and (iii) lessen certain risks of doing
business in Asia. See "--Vertical Integration."
 
 The Sourcing Process
 
  As is customary in the industry, the Company does not have any long-term
contracts with its manufacturers. The Company typically contracts (on the
basis of a written purchase order) with one to three manufacturers to produce
a bulk order. During the manufacturing process, the Company's quality control
personnel visit each factory to inspect garments when the fabric is cut, as it
is being sewn and as the garment is being finished. Daily information on the
status of each order is transmitted from the various manufacturing facilities
to the Company's offices in Hong Kong, Mexico and Los Angeles. The Company, in
turn, keeps its customers apprised, often through daily telephone calls and
frequent written reports. These calls and reports include candid assessments
of the progress of a customer's order, including a discussion of the
difficulties, if any, that have been encountered and the Company's plans to
rectify them.
 
  The Company often arranges on behalf of manufacturers for the purchase of
fabric from a single supplier. The Company has the fabric shipped directly to
the factory and invoices the factory for the fabric. Generally, the factories
pay the Company for the fabric with offsets against the price of the finished
goods. For its longstanding program business, the Company may purchase fabric
in advance of receiving the order, but in accordance with the customer's
specifications. By procuring fabric for an entire order from one source, the
Company believes that production costs per garment are reduced and customer
specifications as to fabric quality and color can be better controlled. The
Company's primary sources of working capital are cash flow from operations and
borrowings under the Company's bank credit facilities. See "Management's
Discussion and Analysis of Financial Condition and Results of Operations--
Liquidity and Capital Resources."
 
Backlog
 
  At February 23, 1999, the Company had unfilled customer orders of
approximately $137 million as compared to approximately $125 million at
February 23, 1998. The Company believes that all of its backlog of orders as
of February 23, 1999 will be filled within the current fiscal year. Backlog is
based on the Company's estimates derived from internal management reports. The
amount of unfilled orders at a particular time is affected by a number of
factors, including the scheduling of manufacturing and shipping of the product
which, in some instances, depends on the customer's demands. Accordingly, a
comparison of unfilled orders from period to period is not necessarily
meaningful and may not be indicative of eventual actual shipments. The
Company's experience has been that the cancellations, rejections or returns of
orders have not materially reduced the amount of sales realized from its
backlog.
 
                                      11
<PAGE>
 
Import Restrictions
 
Quotas
 
  The Company imported approximately 95% of its products (on an FOB Basis) in
1998, including approximately 35% imported from Mexico. In the case of Mexico,
imports are subject to special rules under the North American Free Trade
Agreement ("NAFTA"), which limits certain types of apparel imports into the
United States from Mexico, but not nearly to the extent that imports are
restricted from countries subject to bilateral textile agreements. Most of the
remaining products imported were manufactured in a foreign jurisdiction (e.g.,
Hong Kong and China) with which the U.S. has entered into a bilateral textile
agreement that, among other restrictions, imposes specific quantitative
restraints, or "quotas," on the amounts of various categories of textiles and
apparel that can be imported into the U.S. from that foreign jurisdiction
during a particular quota year. These bilateral textile agreements also
include provisions which allow the U.S. to impose quotas on categories of
textiles and apparel not previously under quota or to "charge" (i.e., impose
deductions upon) the quotas for origin-related violations. Accordingly, the
Company's operations are subject to the restrictions imposed by these
bilateral agreements.
 
  Until recently, the Arrangement Regarding International Trade in Textiles,
known as the Multifiber Arrangement ("MFA"), provided the international
framework for the global regulation of the textile and apparel trade. Pursuant
to the MFA, the U.S. entered into these bilateral textile agreements for the
purpose of imposing quotas on the imports of textiles and apparel. However,
under "The Final Act Embodying the Results of the Uruguay Round of
Multilateral Trade Negotiations" (the "Uruguay Round Agreement") which was
agreed to on a preliminary basis in December 1993 by 117 member nations of the
General Agreement on Tariffs and Trade ("GATT"), and enacted into U.S.
domestic law in December 1994 under the Uruguay Round Agreements Act (the
"URAA"), the MFA has been replaced by the World Trade Organization Agreement
on Textiles and Clothing (the "ATC"). Under the ATC, quotas implemented under
the MFA on the importation of textiles and apparel from countries that are
members of the World Trade Organization (the "WTO," which is the successor
organization to GATT under the Uruguay Round Agreement) will be phased out
over a ten-year period that commenced on January 1, 1995 (with the U.S.
phasing out quotas on most of the sensitive categories at the end of this
period). However, a member country may, under the Uruguay Round Agreement on
Safeguards, re-impose quotas on textiles and apparel under certain specified
conditions.
 
  China is a signatory to the MFA, but was not a member of GATT and,
therefore, was not a party to the Uruguay Round Agreement. China has not been
admitted as a member of the WTO, although it is in the process of trying to
negotiate its accession to the WTO at this time. Because China is not a member
of the WTO, its exports of textiles and apparel to the U.S. are not covered by
the ATC. Accordingly, the U.S. continues to control imports of textiles and
apparel from China under the existing bilateral agreement between the U.S. and
China. On January 17, 1994, the U.S. and China signed a three-year agreement
which set the 1994 textile and apparel quotas from China at their 1993 levels
and increased the quota by 1.0% for each of 1995 and 1996. A new agreement, to
replace the expiring 1994 Agreement, was signed in February 1997, covering the
period January 1, 1997 to December 31, 2000. This agreement continues to
permit some growth in most quota categories.
 
  In the event that China eventually becomes a member of the WTO, it will be
afforded the rights granted other members under the ATC, including the phase-
out of textile and apparel quotas over the ten-year period that commenced on
January 1, 1995. However, there can be no assurance that China will become a
member of the WTO, particularly since the U.S. has expressed dissatisfaction
with China's progress in opening its domestic market in a number of areas.
 
  In 1998, products imported using Hong Kong quota accounted for approximately
35% of the Company's net sales (on an FOB Basis). Under the U.S. and Hong Kong
rules of origin currently in effect, the Company conducts certain, non-origin
conferring manufacturing operations in China for a significant portion of the
products it imports using Hong Kong quota. As part of the URAA, the U.S.
implemented new rules of origin which become effective on July 1, 1996. These
new rules of origin had little actual impact on the country of origin of the
merchandise imported by the Company. The Company is nevertheless attempting to
diversify its
 
                                      12
<PAGE>
 
sourcing network to reduce reliance on Hong Kong sources, in part to minimize
the potential effects of this change in the rule of origin. It is also taking
steps to obtain additional quota from China in the event that these new rules
of origin result in changing the origin of the products presently subject to
Hong Kong quota.
 
 Duties and Tariffs
 
  Merchandise imported by the Company into the U.S. is subject to rates of
duty established by U.S. statute. In general, these rates vary, depending on
the type of product, from 3.0% to 34.6% of the appraised value of the product.
In addition to duties, in the ordinary course of its business, the Company,
from time to time, may become subject to claims by the U.S. Customs Service
for penalties, liquidated damages claims and other charges relating to import
activities. Similarly, from time to time, the Company may be entitled to
refunds from the U.S. Customs Service due to the overpayment of duties.
 
  Products imported from China into the U.S. currently receive the same
preferential tariff treatment accorded goods from countries granted MFN
status. China's MFN status, which is granted on an annual basis, expires in
July 1999. China's MFN status has been a contentious political issue for
several years because of concerns regarding labor and human rights practices,
weapons proliferation, trade policies and failure to protect U.S. intellectual
property rights. Previous legislation attaching conditions to China's MFN
status has been passed by both houses of the Congress, but did not survive
presidential vetoes. There can be no assurance that the U.S. will not revoke
China's MFN status entirely or place greater conditions or restrictions on
this status, but absent a major deterioration in U.S.-China relations, it is
anticipated that China will maintain its MFN status. If China's MFN status
were to terminate, and Chinese origin products had to enter the U.S. without
the benefit of MFN status, such goods would be subject to significantly higher
duties than at present. Any such increased duties would increase the cost or
reduce the supply of the Company's goods imported from China. In 1998,
products imported using China quota accounted for approximately 15% of the
Company's net sales (on an FOB Basis). The Company is taking steps to
diversify its sourcing network to reduce its dependence on Chinese-origin
products.
 
  The Company's continued ability to source products from foreign
jurisdictions may be adversely affected by additional bilateral and
multilateral agreements, unilateral trade restrictions, changes in trade
policy, significant decreases in import quotas, embargoes, the disruption of
trade from exporting countries as a result of political instability or the
imposition of additional duties, taxes and other charges or restrictions on
imports.
 
Competition
 
  There is intense competition in the sectors of the apparel industry in which
the Company participates. The Company competes with many other manufacturers,
many of which are larger and have greater resources than the Company. The
Company also faces competition from its own customers and potential customers,
many of which have established, or may establish, their own internal product
development and sourcing capabilities. For example, The Limited's wholly-owned
subsidiary, Mast Industries, Inc., competes with the Company and other private
label apparel suppliers for orders from divisions of The Limited. The Company
believes that it competes favorably on the basis of design and sample
capabilities, quality and value of its products, price, the production
flexibility that it enjoys as a result of its sourcing network and vertical
integration initiatives and the long-term customer relationships it has
developed.
 
Employees
 
  At January 31, 1999, the Company had approximately 440 full-time employees
in the United States, 125 in Mexico, 180 in Hong Kong and 125 in China. The
Company considers its relations with its employees to be good.
 
 
                                      13
<PAGE>
 
Item 2. PROPERTIES
 
  The Company currently conducts its operations from ten facilities, eight of
which are leased. The Company's executive offices and warehouse facilities are
located at 3151 East Washington Boulevard, Los Angeles, California 90023. The
Company leases this facility for an annual rent of $595,000 from a California
corporation which is owned by Mr. Guez and Mr. Kay. The base rent is subject
to increase on January 1, 2000 and every two years thereafter by an amount
equal to at least five percent but no greater than ten percent. The lease for
this facility, under which the Company is responsible for the payment of
taxes, utilities and insurance, terminates in December 2003 subject to a
renewal option for five additional years. The Company also leases 146,000
square feet of warehouse space in South Gate, California for an annual rent of
$170,000 from an unrelated third party. The Company also leases approximately
36,000 square feet of warehouse and office space in Hong Kong for an annual
rent of $674,000 from a Hong Kong corporation that is owned by Mr. Guez and
Mr. Kay. The base rent is subject to increase every two years in accordance
with market rates. The lease for this facility, under which the Company is
responsible for the payment of taxes, utilities and insurance, expires in June
2004. The Company leases approximately 50,000 square feet which it uses to
operate its sample-making facility in Guangdong Province, China. The lease for
this facility terminates in 2001 and the annual rent is $55,000. The Company
also owns two facilities in Ruleville, Mississippi and leases two facilities
in Greenwood, Mississippi with an aggregate of 161,000 square feet. These
facilities are production, distribution, and administrative offices, the
annual rent is $28,000 and the leases expire on and after the year 2005. The
Company also leases a 5,000 square foot showroom in New York City. The annual
rent is $104,000 and this lease expires in May, 2003. The Company also leases
1,600 square feet of office space in Tehaucan, Mexico for an annual rent of
$19,000 and this lease expires in November, 1999. See "Note 8 to Notes to
Consolidated Financial Statements" for additional information with respect to
these facilities.
 
  On February 22, 1999, the Company agreed to acquire a 250,000 square foot
denim mill in Puebla, Mexico with an annual capacity of approximately 18
million meters of denim. In addition, on December 2, 1998, the Company
contracted to acquire a 750,000 square foot turn-key facility being
constructed near Puebla, Mexico which is ultimately expected to have an annual
capacity of approximately 18 million meters of twill. See "Item 1. Business--
Vertical Integration."
 
  The Company believes that all of its existing facilities are well
maintained, in good operating condition and adequate to meet its current and
foreseeable needs.
 
Item 3. LEGAL PROCEEDINGS
 
  On November 14, 1997, the Federal judge in the civil lawsuit brought by the
American Textile Manufacturers Institute ("ATMI") against, among others, the
Company, Mr. Guez and Mr. Kay, dismissed, with prejudice, ATMI's complaint. On
December 22, 1997, the judge granted ATMI's motion to excuse himself from the
case, and denied ATMI's motion to vacate the decision and judgment previously
entered dismissing the case. On May 21, 1998, the dismissal of ATMI's
complaint and denial of ATMI's motion to vacate the decision and judgment
previously entered was reaffirmed. On June 5, 1998, ATMI filed a motion to
appeal these decisions which is currently pending.
 
  The Company is not involved in any other pending or threatened legal
proceedings which the Company believes could reasonably be expected to have a
material adverse effect on the its financial condition or results of
operations.
 
Item 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS
 
  No matters were submitted to a vote of the Company's shareholders during the
fourth quarter of fiscal 1998.
 
                                      14
<PAGE>
 
                                    PART II
 
Item 5. MARKET FOR REGISTRANT'S COMMON EQUITY AND RELATED STOCKHOLDER MATTERS
 
NASDAQ Listing
 
  The Company's Common Stock began trading on The Nasdaq Stock Market's
National Market ("NASDAQ") under the symbol "TAGS" on July 24, 1995.
 
  The following table sets forth, for the periods indicated, the range of high
and low sale prices for the Company's Common Stock as reported by NASDAQ.
 
<TABLE>
<CAPTION>
                                                                   Low    High
                                                                  ------ ------
     <S>                                                          <C>    <C>
     1997
     First Quarter............................................... $ 6.13 $ 9.88
     Second Quarter.............................................. $ 6.88 $ 9.00
     Third Quarter............................................... $ 6.97 $ 9.63
     Fourth Quarter.............................................. $ 5.75 $ 8.75
     1998
     First Quarter............................................... $ 7.38 $12.31
     Second Quarter.............................................. $11.50 $19.50
     Third Quarter............................................... $17.50 $25.50
     Fourth Quarter.............................................. $13.50 $41.25
     1999
     First Quarter (through March 1)............................. $34.75 $43.69
</TABLE>
 
  On March 1, 1999, the last reported sale price of the Company's Common Stock
as reported on NASDAQ was $41.50. Shareholders are urged to obtain current
market quotations for the Common Stock. As of March 1, 1999, there were 23
shareholders of record of the Company. However, proxy data indicates that
there are over 1,000 beneficial owners of shares of the Common Stock.
 
Dividend Policy
 
  The Company intends to retain future earnings for use in its business and
therefore does not anticipate declaring or paying any cash dividends in the
foreseeable future. The declaration and payment of any cash dividends in the
future will depend upon the Company's earnings, financial condition, capital
needs and other factors deemed relevant by the Board of Directors.
 
Stock Split
 
  On April 27, 1998, the Company announced a two-for-one stock split effective
on May 8, 1998. Accordingly, all share and per share amounts have been
adjusted to reflect this split.
 
 
                                      15
<PAGE>
 
Item 6. SELECTED FINANCIAL DATA
 
  The following selected financial data is qualified in its entirety by, and
should be read in conjunction with, the other information and financial
statements, including the notes thereto, appearing elsewhere herein.
 
<TABLE>
<CAPTION>
                                       Year Ended December 31,
                          ---------------------------------------------------------
                            1994         1995         1996       1997       1998
                          ---------    ---------    ---------  ---------  ---------
                           (In thousands, except share and per share data)
<S>                       <C>          <C>          <C>        <C>        <C>
Income Statement Data:
Net sales...............  $ 177,108    $ 205,174    $ 229,861  $ 260,093  $ 378,155
Cost of sales...........    148,740      172,959      192,288    220,996    307,077
                          ---------    ---------    ---------  ---------  ---------
 Gross profit...........     28,368       32,215       37,573     39,097     71,078
Selling and distribution
 expenses...............      6,118        6,761        7,124      8,499     11,274
General and
 administrative
 expenses...............     12,359       13,493       13,990     13,518     19,896
Amortization of excess
 of cost over fair
 market value of net
 assets acquired(1).....         --           --           --         --      1,337
LDA Option(2)...........         --        1,734           --         --         --
                          ---------    ---------    ---------  ---------  ---------
 Income from operations.      9,891       10,227       16,459     17,080     38,571
Interest expense........     (3,696)      (4,003)      (1,865)    (1,471)    (2,423)
Interest income.........         78          773          337        171        360
Other
 income/(expense)(3)....      1,367        1,274         (302)       242        568
                          ---------    ---------    ---------  ---------  ---------
Income before provision
 for income taxes and
 cumulative effect of
 accounting change......      7,640        8,271       14,629     16,022     37,076
Provision for income
 taxes(4)...............       (597)        (961)      (4,627)    (5,235)   (12,410)
                          ---------    ---------    ---------  ---------  ---------
Income before cumulative
 effect of accounting
 change.................      7,043        7,310       10,002     10,787     24,666
Cumulative effect of
 accounting change(5)...         94           --           --         --         --
                          ---------    ---------    ---------  ---------  ---------
Net income..............  $   7,137    $   7,310    $  10,002  $  10,787  $  24,666
                          =========    =========    =========  =========  =========
Net income per common
 share
 Basic..................  $    0.60(6) $    0.69(6) $    0.77  $    0.82  $    1.82
 Diluted................  $    0.60(6) $    0.69(6) $    0.76  $    0.80  $    1.71
Weighted average shares
 outstanding
 Basic..................      9,000       10,707       13,016     13,175     13,520
 Diluted................      9,000       10,707       13,096     13,567     14,417
<CAPTION>
                                         As of December 31,
                          ---------------------------------------------------------
                            1994         1995         1996       1997       1998
                          ---------    ---------    ---------  ---------  ---------
                                           (In thousands)
<S>                       <C>          <C>          <C>        <C>        <C>
Balance Sheet Data:
Working capital.........  $   2,594    $  23,003    $  34,029  $  45,304  $  57,082
Total assets............     44,017       57,840       63,420     71,861    153,891
Bank borrowings and
 long-term obligations..     19,313       15,940        6,810      4,288     36,694
Shareholders' equity....      7,848       26,416       36,953     48,335     79,210
</TABLE>
-------
(1)  See "Item 1. Business--Acquisitions."
(2)  On the effective date of its initial public offering, the Company
     incurred a non-recurring charge to earnings related to a grant by Messrs.
     Guez and Kay to Limited Direct Associates, L.P., an affiliate of The
     Limited, Inc., of a four-year option (the "LDA Option") to purchase an
     aggregate of 1,299,998 shares, or 10% of the Company's Common Stock, at
     an exercise price equal to $3.60 per share. See "Item 1. Business--
     Customers" and "Note 15 to Notes to Consolidated Financial Statements."
(3)  Major components of Other income/(expense) (as presented above) include
     fees paid by affiliate entities for management and administrative
     services provided by the Company and royalty income. See "Management's
     Discussion and Analysis of Financial Condition and Results of
     Operations."
(4)  For federal and state tax purposes in 1994 and 1995, Tarrant Apparel
     Group and certain of the companies included in the historical results of
     operations were treated as S Corporations under Subchapter S of the
     Internal Revenue Code of 1986, as amended, and comparable provisions of
     state income tax laws. (See Note 6 below.)
(5)  Reflects the cumulative effect of the adoption on January 1, 1994 of
     Statement of Financial Accounting Standards No. 115, "Accounting for
     Certain Investment in Debt and Equity Securities."
(6)  Reflects, in 1994 and 1995 only, income per common share based upon pro
     forma net income of $5,358 (1994) and $7,408 (1995) adjusted by providing
     an income tax provision which is the sum of (i) U.S. income taxes
     computed as if the Company had been taxed as a C Corporation at an
     effective tax rate of 40% for federal and state tax purposes for the
     period it was an S Corporation and (ii) the historical tax provision of
     the Company and its non-U.S. consolidated subsidiaries for all other
     periods. 1996, 1997 and 1998 have no adjustments since the Company was a
     C Corporation in such years. The 1995 pro forma net income reflects a
     $1.7 million adjustment related to the grant of the LDA Option.
 
                                      16
<PAGE>
 
Item 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND
       RESULTS OF OPERATIONS
 
General
 
  The Company primarily serves both specialty retail and mass merchandise
store chains by designing, merchandising, contracting for the manufacture of
and selling casual, moderately-priced apparel for women, men and children,
under private label. The Company's major customers include specialty
retailers, such as Lerner New York, Limited Stores, Lane Bryant, Structure and
Express, all of which are divisions of The Limited, as well as Target Stores
(a division of Dayton Hudson), Abercrombie & Fitch and J.C. Penney. The
Company's products are manufactured in a variety of woven and knit
fabrications and include jeanswear, casual pants, t-shirts, shorts, blouses,
shirts and other tops, dresses, leggings and jackets.
 
  Over the past five years, the Company has achieved a compound annual growth
rate in net sales of approximately 20% from $177.1 million in 1994 to $378.2
million in 1998. Pre-tax income has risen approximately 50% on a compound
annual basis, from $7.6 million in 1994 to $37.1 million in 1998.
 
  The Company continues to geographically diversify its worldwide sourcing
operations. Commencing in the third quarter of 1997, the Company has
substantially expanded its use of independent cutting, sewing and finishing
contractors in Mexico, primarily for its increasing sales of basic garments.
The gross sales of products sourced in Mexico were approximately $19 million
and $104 million in 1997 and 1998, respectively. The Company has also
commenced the vertical integration of its business through the development and
acquisition of fabric and production capacity in Mexico. The Company believes
that these strategies will create a more diversified sourcing base, increase
the Company's access to emerging providers of low cost production, enhance the
proximity of the Company's sourcing base to the Company's customers and lessen
certain risks associated with doing business abroad (including transportation
delays, economic or political instability, currency fluctuations, restrictions
on the transfer of funds and the imposition of tariffs, export duties, quotas
and other trade restrictions).
 
  On February 22, 1999, the Company agreed to acquire a denim mill in Puebla,
Mexico with an annual capacity of approximately 18 million meters of denim.
The purchase price for such mill will consist of $22 million in cash payable
on May 6, 1999 and two million shares of the Common Stock of the Company. See
"Item 1. Business--Vertical Integration."
 
  On December 2, 1998, the Company contracted to acquire a turn-key facility
being constructed in Puebla, Mexico by an affiliate of the seller of the denim
mill described above. This facility is ultimately expected to have an annual
capacity of approximately 18 million meters of twill and will also house
ancillary facilities. Construction of this facility commenced in the third
quarter of 1998, and it is anticipated that the Company will take possession
of this facility by the year 2000. The Company anticipates that the cost of
this facility will be approximately $75 million. See "Item 1. Business--
Vertical Integration."
 
  On February 23, 1998, the Company acquired certain assets of Marshall Gobuty
International U.S.A., Inc. and MGI International Limited which design,
contract for the manufacture of and sell private label apparel for men and
boys to national retailers, including J.C. Penney (the "Gobuty Acquisition").
On July 2, 1998, the Company acquired Rocky Apparel, L.P. which designs,
contracts for the manufacture of and sells private label apparel for men and
women to national retailers, including Abercrombie & Fitch and three divisions
of The Limited (the "Rocky Acquisition"). See "Item 1. Business--General" and
"--Acquisitions."
 
Factors That May Affect Future Results
 
  This Report on Form 10-K contains forward-looking statements which are
subject to a variety of risks and uncertainties. The Company's actual results
could differ materially from those anticipated in these forward-looking
statements as a result of various factors, including those set forth below.
 
                                      17
<PAGE>
 
  Vertical Integration. In 1997, the Company commenced the vertical
integration of its business. Key elements of this strategy include (i)
establishing cutting, sewing, washing, finishing, packing, shipping or
distribution activities in company-owned facilities or through the acquisition
of established contractors and (ii) establishing fabric production capability
through the acquisition of established mills or the construction of new mills.
The Company has no history of operating textile mills or cutting, sewing,
washing, finishing, packing or shipping operations upon which an evaluation of
the prospects of the Company's vertical integration strategy can be based. In
addition, such operations are subject to the customary risks associated with
owning a manufacturing business, including, but not limited to, the
maintenance and management of manufacturing facilities, equipment, employees
and inventories. See "Item 1. Business--Vertical Integration" and "--Foreign
Manufacturing."
 
  Variability of Quarterly Results. The Company has experienced, and expects
to continue to experience, a substantial variation in its net sales and
operating results from quarter to quarter. The Company believes that the
factors which influence this variability of quarterly results include the
timing of the Company's introduction of new product lines, the level of
consumer acceptance of each new product line, general economic and industry
conditions that affect consumer spending and retailer purchasing, the
availability of manufacturing capacity, the seasonality of the markets in
which the Company participates, the timing of trade shows, the product mix of
customer orders, the timing of the placement or cancellation of customer
orders, the occurrence of chargebacks in excess of reserves and the timing of
expenditures in anticipation of increased sales and actions of competitors.
Accordingly, a comparison of the Company's results of operations from period
to period is not necessarily meaningful, and the Company's results of
operations for any period are not necessarily indicative of future
performance.
 
  Economic Conditions. The apparel industry historically has been subject to
substantial cyclical variation, and a recession in the general economy or
uncertainties regarding future economic prospects that affect consumer
spending habits have in the past had, and may in the future have, a materially
adverse effect on the Company results of operations. In addition, certain
retailers, including some of the Company customers, have experienced in the
past, and may experience in the future, financial difficulties which increase
the risk of extending credit to such retailers. These retailers have attempted
to improve their own operating efficiencies by concentrating their purchasing
power among a narrowing group of vendors. There can be no assurance that the
Company will remain a preferred vendor for its existing customers. A decrease
in business from or loss of a major customer could have a material adverse
effect on the Company's results of operations. There can be no assurance that
the Company's factor will approve the extension of credit to certain retail
customers in the future. If a customer's credit is not approved by the factor,
the Company could either assume the collection risk on sales to the customer
itself, require that the customer provide a letter of credit or choose not to
make sales to the customer.
 
  Reliance on Key Customers. Affiliated stores owned by The Limited (including
Lerner New York, Limited Stores, Structure, Express and Lane Bryant) accounted
for two thirds of the Company's net sales in 1998 and 1997. The loss of such
customer could have a material adverse effect on the Company's results of
operations. From time to time, certain of the Company's major customers have
experienced financial difficulties. The Company does not have long-term
contracts with any of its customers and, accordingly, there can be no
assurance that any customer will continue to place orders with the Company to
the same extent it has in the past, or at all. In addition, the Company's
results of operations will depend to a significant extent upon the commercial
success of its major customers.
 
  Dependence on Contract Manufacturers. All of the Company's products, with
the exception of certain test runs and samples, are manufactured by
independent cutting, sewing and finishing contractors. The use of contract
manufacturers and the resulting lack of direct control over the production of
its products could result in the Company's failure to receive timely delivery
of products of acceptable quality. Although the Company believes that
alternative sources of cutting, sewing and finishing services are readily
available, the loss of one or more contract manufacturers could have a
materially adverse effect on the Company's results of operations until an
alternative source is located and has commenced producing the Company's
products.
 
                                      18
<PAGE>
 
  Although the Company monitors the compliance of its independent contractors
with applicable labor laws, the Company does not control its contractors or
their labor practices. The violation of federal, state or foreign labor laws
by one of the Company's contractors can result in the Company being subject to
fines and the Company's goods which are manufactured in violation of such laws
being seized or their sale in interstate commerce being prohibited. From time
to time, the Company has been notified by federal, state or foreign
authorities that certain of its contractors are the subject of investigations
or have been found to have violated applicable labor laws. To date, the
Company has not been subject to any sanctions that, individually or in the
aggregate, could have a material adverse effect upon the Company, and the
Company is not aware of any facts on which any such sanctions could be based.
There can be no assurance, however, that in the future the Company will not be
subject to sanctions as a result of violations of applicable labor laws by its
contractors, or that such sanctions will not have a material adverse effect on
the Company. In addition, certain of the Company's customers, including The
Limited, require strict compliance by their apparel manufacturers, including
the Company, with applicable labor laws. There can be no assurance that the
violation of applicable labor laws by one of the Company's contractors will
not have a material adverse effect on the Company's relationship with its
customers.
 
  Price and Availability of Raw Materials. Cotton fabric is the principal raw
material used in the Company's apparel. Although the Company believes that its
suppliers will continue to be able to procure a sufficient supply of cotton
fabric for its production needs, the price and availability of cotton may
fluctuate significantly depending on supply, world demand and currency
fluctuations, each of which may affect the price and availability of cotton
fabric. There can be no assurance that fluctuations in the price and
availability of cotton fabric or other raw materials used by the Company will
not have a material adverse effect on the Company's results of operations.
 
  Management of Growth. Since its inception, the Company has experienced rapid
growth in sales. No assurance can be given that the Company will be successful
in maintaining or increasing its sales in the future. Any future growth in
sales will require additional working capital and may place a significant
strain on the Company's management, management information systems, inventory
management, production capability, distribution facilities and receivables
management. Any disruption in the Company's order processing, sourcing or
distribution systems could cause orders to be shipped late, and under industry
practices, retailers generally can cancel orders or refuse to accept goods due
to late shipment. Such cancellations and returns would result in a reduction
in revenue, increased administrative and shipping costs and a further burden
on the Company's distribution facilities. In addition, the failure to timely
enhance the Company's operating systems, or unexpected difficulties in
implementing such enhancements, could have a material adverse effect on the
Company's results of operations.
 
  Foreign Manufacturing. Approximately 95% of the Company products were
imported in 1998. As a result, the Company's operations are subject to the
customary risks of doing business abroad, including, among other things,
transportation delays, economic or political instability, currency
fluctuations, restrictions on the transfer of funds and the imposition of
tariffs, export duties, quotas and other trade restrictions.
 
  Year 2000 Issue. The Year 2000 issue is primarily the result of computer
programs being written using two-digits, as opposed to four digits, to
indicate the year. Any of the Company's computer programs or hardware that
have time-sensitive software or embedded chips may be unable to interpret
dates beyond the year 1999. This could result in a system failure or
miscalculations, leading to disruption in operation of such systems, including
among other things, inability to process transactions, send invoices or engage
in similar normal business activities. In 1997, the Company designated the MIS
department to coordinate the project of Year 2000 compliance.
 
  The Company is currently evaluating, replacing or upgrading its information
systems in an effort to make them Year 2000 compliant, and expects to have
remediation efforts completed for its critical computer systems by June of
1999. This includes the implementation of a new packaged software system,
hardware and EDI system for its U.S. and Mexico operations. The developer of
this information system has provided the Company with written assurance that
the system will correctly function across the year 2000, as verified by
previous system
 
                                      19
<PAGE>
 
tests. The Company's Hong Kong operations have completed remediation and
expect to complete software and hardware upgrades, including testing, by April
of 1999. The testing and remediation of voice/data communication systems, such
as network hubs, routers and phone/voice mail, is expected to be completed by
the end of the second quarter of 1999. Although the Company expects successful
completion of remediation and testing by the target dates, foreign testing and
implementation of procedures may not be as timely as in the United States.
 
  As part of the Company's compliance program, formal communications with
customers, suppliers and other support service providers have been initiated.
All of the Company's customers which are established as EDI trading partners
are testing interface capability of the EDI program. The Company anticipates
completion of testing no later than June 1999. To date, the Company is not
aware of any supplier or subcontractor with a Year 2000 issue that would
materially affect the Company's results of operations, liquidity or capital
resources. The Company will continue to monitor the Year 2000 compliance of
third parties with which it does business.
 
  The costs associated with the Year 2000 Compliance Program are not expected
to be substantial. To date, approximately $500,000 has been allocated to
address the Year 2000 issue, substantially all of which had been incurred as
of December 31, 1998. The Company does not expect future costs to have a
material effect on the Company's financial condition or results of operation.
 
  While the Company currently expects that the Year 2000 issue will not pose
significant operational problems, delays in the implementation of the new and
upgraded information systems, or a failure to identify all Year 2000
dependencies in the Company's systems and the systems of its suppliers and
customers could have material adverse consequences, including inability to
take customer orders, manufacture and ship products, invoice customers or
collect payments. In addition, disruptions in the economy generally resulting
from Year 2000 issues could also adversely affect the Company. The amount of
potential lost revenue cannot be reasonably estimated at this time.
 
  The Company is currently gathering data in an effort to assess the potential
effects of the failure of its Year 2000 compliance program. This evaluation is
expected to be completed in July 1999 and will determine whether a contingency
plan is necessary. If necessary, the Company is committed to allocating
additional personnel during the millennium transition to immediately address
any potential Year 2000 problems that may arise.
 
                                      20
<PAGE>
 
Results of Operations
 
  The following table sets forth, for the periods indicated, certain items in
the Company's consolidated statements of income as a percentage of net sales:
 
<TABLE>
<CAPTION>
                                                      Year Ended December 31,
                                                      -------------------------
                                                       1996     1997     1998
                                                      -------  -------  -------
   <S>                                                <C>      <C>      <C>
   Net sales........................................    100.0%   100.0%   100.0%
   Cost of sales....................................     83.7     84.9     81.2
                                                      -------  -------  -------
   Gross profit.....................................     16.3     15.1     18.8
   Selling and distribution expenses................      3.1      3.3      3.0
   General and administration expenses..............      6.1      5.2      5.2
   Amortization of excess of cost over fair value of
    net assets acquired(1)..........................       --       --      0.4
                                                      -------  -------  -------
   Operating income.................................      7.1      6.6     10.2
   Interest expense.................................     (0.8)    (0.6)    (0.6)
   Other income.....................................      0.0      0.2      0.2
                                                      -------  -------  -------
   Income before income taxes.......................      6.3      6.2      9.8
   Income taxes.....................................     (2.0)    (2.0)    (3.3)
                                                      -------  -------  -------
   Net income.......................................      4.3%     4.2%     6.5%
                                                      =======  =======  =======
</TABLE>
--------
(1)  Reflects amortization of the excess of cost over fair value of assets
     acquired in acquisitions of MGI and Rocky.
 
 Comparison of 1998 to 1997
 
  Net sales increased by $118.1 million, or 45.4%, from $260.1 million in 1997
to $378.2 million in 1998. The increase in net sales included an aggregate
increase in sales (excluding Rocky) of $36.7 million to divisions of The
Limited, primarily as a result of an increased volume of unit sales, $75.8
million as a result of the MGI and Rocky Acquisitions and $2.7 million to mass
merchandisers. Excluding acquisitions, sales increased by $42.3 million, or
16.3% over last year. Overall, sales to divisions of The Limited in 1998
amounted to 63.3% of total net sales, as compared to 69.7% in 1997.
 
  Gross profit (which consists of net sales less product costs, duties and
direct costs attributable to production) for 1998 was $71.1 million, or 18.8%
of net sales, compared to $39.1 million, or 15.1% of net sales, in 1997, an
increase of 81.8% in gross profit. The 3.7% increase in the gross profit
margin included benefits of 1.5% from a reduction in returns and inventory
markdown, 0.4% from domestic production of the Men's Division, 0.3% from a
reduction of direct costs attributable to production as a percentage of net
sales and the elimination of certain nonrecurring costs incurred in 1997 on
the Company's production in the U.S. and Mexico.
 
  Selling and distribution expenses increased from $8.5 million in 1997 to
$11.3 million in 1998. As a percentage of net sales, these expenses decreased
from 3.3% in 1997 to 3.0% in 1998. This percentage decrease is primarily due
to a decrease in freight and commission expenses, each of which amounted to
0.1% of net sales.
 
  General and administrative expenses increased from $13.5 million in 1997 to
$19.9 million in 1998. As a percentage of net sales, these expenses were 5.2%
in both years. Overall, 1998 expenses included increases in the allowance for
bad debt, bonus accrual and expenses related to the operations of MGI and
Rocky. The allowance for bad debt includes an allowance for returns and
discounts as well as bad debt expense. The allowance for returns and discounts
is primarily based on a percentage of receivables which increases with the age
of the receivables, but is not a reflection on the credit worthiness of the
customer. The increase in the allowance for returns and discounts during 1998
was $541,000, or 0.1% of net sales, compared to a decrease in such allowance
of $282,000 during 1997. The most significant portions of the decrease in the
allowance for returns and discounts resulted from changes in the amount and
aging of accounts receivable. Bad debt expense
 
                                      21
<PAGE>
 
was $189,000 in 1997 as compared to a recovery of $7,000 in 1998. Bonus
accrual was $910,000 in 1997 as compared to $3.0 million in 1998. After
adjusting for the net increase in the allowance for bad debt of $627,000, the
$2.1 million increase in bonus accrual and expenses generated by the
operations of MGI and Rocky of $2.4 million in 1998 as compared to no such
expenses in 1997, general and administrative expenses increased by $1.3
million in 1998 as compared to 1997, as summarized below:
 
<TABLE>
<CAPTION>
                                  Year Ended December 31,
                                  ------------------------
                                     1998         1997      Increase/(Decrease)
                                  -----------  -----------  -------------------
   <S>                            <C>          <C>          <C>
                                  $19,897,000  $13,518,000      $6,379,000
   Less: Bad debt expense*......       (7,000)     189,000        (196,000)
     Allowance for returns and
      discounts*................      541,000     (282,000)        823,000
                                  -----------  -----------      ----------
     Allowance for bad debt*....      534,000      (93,000)        627,000
     Bonus accruals*............    2,964,000      910,000       2,054,000
     MGI and Rocky operations...    2,352,000          -0-       2,352,000
                                  -----------  -----------      ----------
                                  $14,047,000  $12,701,000      $1,346,000
                                  ===========  ===========      ==========
</TABLE>
--------
*  Excluding MGI and Rocky.
 
  Operating income was $17.1 million in 1997, or 6.6% of net sales, compared
to $38.6 million in 1998, or 10.2% of net sales, due to the factors described
above. This increase in operating income as a percentage of net sales was due
to the increase in the gross profit margin, which amounted to 3.7% of net
sales, a decrease in selling and distribution expenses, which amounted to 0.3%
of net sales, and an increase in amortization of excess of cost over fair
value of net assets acquired, which amounted to 0.4% of net sales.
 
  Other income increased from $413,000, or 0.2% of net sales, in 1997 to
$928,000, or 0.2% of net sales, in 1998. This increase is primarily the result
of interest income of $171,000 in 1997 compared to $361,000 in 1998, the
realization of no gains on the sale of securities in 1998 as compared to
$237,000, or 0.1% of net sales, of such income in 1997, and management fee
income of $441,000, or 0.1% of net sales, in 1998 compared to no such income
in 1997.
 
  Income before income taxes was $16.0 million in 1997 and $37.1 million in
1998, representing 6.2% and 9.8% of net sales, respectively. This increase in
income before taxes as a percentage of net sales was due to the increase in
the gross profit margin, which amounted to 3.7% of net sales, a decrease in
selling and distribution expenses, which amounted to 0.3% of net sales, and
the increase in amortization of excess of cost over fair value of net assets
acquired, which amounted to 0.4% of net sales.
 
 Comparison of 1997 to 1996
 
  Net sales increased by $30.2 million, or 13.2%, from $229.9 million in 1996
to $260.1 million in 1997. The increase in net sales included an aggregate
increase in sales of $27.2 million to divisions of The Limited and $3.6
million to mass merchandisers.
 
  Certain of the Company's customers, including divisions of The Limited,
experienced sluggish sales and declines in revenue and profits in 1997. To the
extent that these financial difficulties continue or worsen, the Company's
revenues and gross profit margins could be adversely affected.
 
  Gross profit (which consists of net sales less product costs, duties and
direct costs attributable to production) for 1997 was $39.1 million, or 15.1%
of net sales, compared to $37.6 million, or 16.3% of net sales, in 1996, an
increase of 4.1% in gross profit. The decrease in the gross profit margin
primarily resulted from nonrecurring costs and inefficiencies related to the
Company's domestic sourcing. The increase in the absolute amount of gross
profit was primarily due to the increase in net sales.
 
  Selling and distribution expenses increased from $7.1 million in 1996 to
$8.5 million in 1997. As a percentage of net sales, these expenses increased
from 3.1% in 1996 to 3.3% in 1997. This percentage increase is primarily due
to an increase in freight and commission expenses, each of which amounted to
0.1% of net sales.
 
                                      22
<PAGE>
 
  General and administrative expenses decreased from $14.0 million in 1996 to
$13.5 million in 1997. As a percentage of net sales, these expenses declined
from 6.1% in 1996 to 5.2% in 1997. This percentage decrease was primarily due
to a $608,000 decrease in discretionary bonuses awarded to executive officers
in 1997, which amounted to 0.2% of net sales, combined with the effect of the
increase in net sales. After adjusting for the decrease in executive bonuses,
general and administrative expenses increased by $136,000 and were 5.4% of net
sales in 1997 as compared to 6.1% in 1996.
 
  Operating income was $16.5 million in 1996, or 7.1% of net sales, compared
to $17.1 million in 1997, or 6.6% of net sales, due to the factors described
above. This decrease in operating income as a percentage of net sales was due
to the decrease in the gross profit margin, which amounted to 1.2% of net
sales, an increase in selling and distribution expenses, which amounted to
0.2% of net sales, and a decrease in general and administrative expenses,
which amounted to 0.9% of net sales.
 
  Other income increased from $35,000 in 1996 to $413,000, or 0.2% of net
sales, in 1997. This increase is primarily the result of interest income of
$337,000 in 1996 compared to $171,000 in 1997, the realization of no gains on
the sale of securities in 1996 as compared to $237,000 of such income in 1997,
management fee income of $60,000 in 1996 compared to no such income in 1997
and a non-operating expense accrual of $400,000 in 1996 compared to no similar
accrual in 1997. See "Note 8 to Consolidated Financial Statements." Management
fee income was derived from an agreement with FIS which sourced and sold
garments under the B.U.M. Equipment label until it ceased operations in the
second quarter of 1996.
 
  Income before income taxes was $14.6 million in 1996 and $16.0 million in
1997, representing 6.3% and 6.2% of net sales, respectively. This decrease in
income before taxes as a percentage of net sales was due to the decrease in
the gross profit margin, which amounted to 1.2% of net sales, an increase in
selling and distribution expenses, which amounted to 0.2% of net sales, a
decrease in general and administrative expenses, which amounted to 0.9% of net
sales, and the decrease in interest expense, which amounted to 0.2% of net
sales, as offset by the increase in other income, which amounted to 0.2% of
net sales.
 
Quarterly Results of Operations
 
  The following table sets forth, for the periods indicated, certain items in
the Company's consolidated statements of income in millions of dollars and as
a percentage of net sales:
 
<TABLE>
<CAPTION>
                                                                 Quarter Ended
                 --------------------------------------------------------------------------------------------------------------
                 Mar. 31, June 30, Sept. 30, Dec. 31, Mar. 31, June 30, Sept. 30, Dec. 31, Mar. 31, June 30, Sept. 30, Dec. 31,
                   1996     1996     1996      1996     1997     1997     1997      1997     1998     1998     1998      1998
                 -------- -------- --------- -------- -------- -------- --------- -------- -------- -------- --------- --------
                                                                 (In millions)
<S>              <C>      <C>      <C>       <C>      <C>      <C>      <C>       <C>      <C>      <C>      <C>       <C>
Net sales.......  $42.1    $68.9     $50.0    $68.9    $53.6    $73.9     $69.2    $63.4    $64.3    $100.1   $114.9    $98.9
Gross profit....    7.1     11.3       8.2     11.0      8.8     11.1       9.7      9.6     10.9      20.3     19.7     20.2
Operating
 income.........    2.4      5.5       3.7      4.9      3.4      5.1       4.1      4.5      4.5      11.7     11.4     11.0
Net income......    1.5      3.6       2.2      2.7      2.0      3.3       2.7      2.8      2.8       7.2      7.1      7.6
<CAPTION>
                                                                 Quarter Ended
                 --------------------------------------------------------------------------------------------------------------
                 Mar. 31, June 30, Sept. 30, Dec. 31, Mar. 31, June 30, Sept. 30, Dec. 31, Mar. 31, June 30, Sept. 30, Dec. 31,
                   1996     1996     1996      1996     1997     1997     1997      1997     1998     1998     1998      1998
                 -------- -------- --------- -------- -------- -------- --------- -------- -------- -------- --------- --------
<S>              <C>      <C>      <C>       <C>      <C>      <C>      <C>       <C>      <C>      <C>      <C>       <C>
Net sales.......  100.0%   100.0%    100.0%   100.0%   100.0%   100.0%    100.0%   100.0%   100.0%    100.0%   100.0%   100.0%
Gross profit....   16.8     16.4      16.5     16.0     16.4     15.0      14.0     15.1     17.0      20.2     17.1     20.4
Operating
 income.........    5.6      8.0       7.5      7.1      6.3      6.9       5.9      7.2      7.1      11.7      9.9     11.1
Net income......    3.5      5.2       4.4      4.0      3.8      4.4       3.9      4.4      4.3       7.2      6.2      7.7
</TABLE>
 
  As is typical for the Company, quarterly net sales fluctuated significantly
because the Company's customers typically place bulk orders with the Company,
and a change in the number of orders shipped in any one period may have a
material effect on the net sales for that period.
 
Liquidity and Capital Resources
 
  The Company's liquidity requirements arise from the funding of its working
capital needs, principally inventory, finished goods shipments-in-transit,
work-in-process and accounts receivable, including receivables from the
Company's contract manufacturers that relate primarily to fabric purchased by
the Company for use by those manufacturers. (The Company generally
 
                                      23
<PAGE>
 
purchases fabric for delivery directly to the manufacturer's factory. The
Company then invoices the manufacturer for the fabric, and reduces payments to
the manufacturer for finished goods by the amount of outstanding invoices.)
The Company's primary sources for working capital and capital expenditures are
cash flow from operations, borrowings under the Company's bank credit
facilities, issuance of long-term debt and the proceeds from the exercise of
stock options.
 
  During 1998, net cash used in operating activities was $10.5 million, which
resulted primarily from net income of $24.7 million, as offset by a net
increase in working capital items, including an increase of $28.8 million in
accounts receivable and an increase in inventory of $18.2 million. The
increase in accounts receivable resulted from an increase in sales and a $10.8
million decrease in advances from the factor, which advances are accounted for
as an offset to accounts receivable. At December 31, 1998, advances from the
factor were $1.0 million as compared to $11.8 million of such advances at
December 31, 1997.
 
  During 1998, cash flow used in investing activities was $23.1 million, which
included $17.1 million for the MGI and Rocky acquisitions and $4.2 million of
capital expenditures for Mexican investment programs.
 
  In 1998, cash flow provided by financing activities equaled $32.6 million,
including $25.5 million of bank borrowings, $4.8 million from the exercise of
stock options and $2.6 million of proceeds from issuance of long-term
obligations.
 
  The Company has credit facilities of $33 million and $10 million with the
Hongkong and Shanghai Banking Corporation Limited ("HKSB") and Standard
Chartered Bank ("SCB"), respectively, for borrowings and the purchase and
exportation of finished goods. Under these facilities, the Company may arrange
for the issuance of letters of credit and acceptances, as well as cash
advances. These facilities are subject to review at any time and the right of
either lender to demand payment at any time. Interest on cash advances under
HKSB's facility accrues at HKSB's prime rate for lending U.S. dollars plus
one-half to three-quarters percent per annum. As of December 31, 1998, HKSB's
U.S. dollar prime rate equaled seven and three-quarters percent. Interest on
cash advances under SCB's facility accrues at SCB's prime rate for lending
Hong Kong dollars. As of December 31, 1998, SCB's Hong Kong dollar prime rate
equaled nine percent. These facilities are subject to certain restrictive
covenants including a provision that the aggregate net worth, as adjusted, of
the Company will exceed $30 million, the Company will not incur two
consecutive quarterly losses and the Company will maintain a certain debt to
equity ratio. As of December 31, 1998 there were $21.5 million of outstanding
borrowings under these facilities.
 
  The Company has accounts receivable-secured credit facilities with
NationsBanc Commercial Corporation ("NBCC") and The CIT Group/Commercial
Services, Inc. ("CIT"). Prior to January 1, 1998, NBCC acted as the Company's
factor for accounts receivable. Effective January 1, 1998, the Company
substantially eliminated its use of the factor. The Company may receive an
advance from NBCC of up to 90% of accounts receivable, except certain
receivables which are liened to CIT. CIT will advance up to 100% of the amount
of accounts receivable liened to it plus an over-advance of up to $10 million,
up to a maximum amount of $25 million. The CIT facility is subject to the same
restrictive covenants as apply to the HKSB and SCB facilities. Interest on
advances from both NBCC and CIT accrues at the rate of one and one-quarter
percent below the bank's respective prime rates or, at the option of the
Company, one and one-quarter percent over the respective LIBOR rates. As of
December 31, 1998, the prime rates equaled seven and three-quarters percent
and the LIBOR rates averaged five and three-tenths percent. As of December 31,
1998 there were $1.4 million of outstanding advances under these facilities.
 
  The Company has an unsecured $10 million credit facility with SCB maturing
June 30, 1999 which is available for general corporate purposes. This facility
is cross-defaulted to the Company's other bank credit facilities and interest
on advances accrues at the rate of one and one-quarter percent over LIBOR. At
December 31, 1998, $10.0 million was outstanding under this facility.
 
  The Company guarantees a $5 million credit facility for Rocky Apparel, LLC,
a wholly-owned subsidiary of the Company which acquired the partnership
interests in Rocky Apparel, L.P., a Delaware limited partnership.
 
                                      24
<PAGE>
 
At December 31, 1998, $1.2 million was outstanding under this facility. See
"Business--Acquisitions" and "Note 5 to Notes to Consolidated Financial
Statements--Acquisitions."
 
  The Company has financed its operations from its cash flow from operations,
borrowings under its bank credit facilities, issuance of long-term debt and
the proceeds from the exercise of stock options. The Company believes that
these sources of cash should be sufficient to fund its existing operations for
the foreseeable future.
 
  The Company has commenced a capital investment program in Mexico under which
it will invest approximately $150 million in the acquisition of a denim mill
and the construction of a facility which will produce twill and house
ancillary facilities. See "Item 1. Business--General and--Acquisitions." The
Company may seek to finance future capital investment programs through various
methods, including, but not limited to, borrowings under the Company's bank
credit facilities, issuance of long-term debt, leases and long-term financing
provided by the sellers of facilities or the suppliers of certain equipment
used in such facilities. To date, capital expenditure and working capital
commitments aggregating $9.1 million and $1.1 million, respectively, have been
made with respect to vertical integration programs initiated by the Company.
The success of the Company's vertical integration strategy may depend, in
part, on its ability to obtain financing therefor. There can be no assurance
that such financing, if and when required, will be available on terms
acceptable to the Company, or at all.
 
  The Company does not believe that the moderate levels of inflation in the
United States in the last three years have had a significant effect on net
sales or profitability.
 
Item 7A. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK
 
  Not applicable.
 
Item 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA
 
  See "Item 14. Exhibits, Financial Statement Schedules and Reports on Form 8-
K" for the Company's financial statements, and the notes thereto, and the
financial statement schedules filed as part of this report.
 
Item 9. CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND
       FINANCIAL DISCLOSURE
 
  Not applicable.
 
                                      25
<PAGE>
 
                                   PART III
 
Item 10. DIRECTORS AND EXECUTIVE OFFICERS
 
  The information concerning the directors and executive officers of the
Company is incorporated herein by reference from the section entitled
"Proposal 1--Election of Directors" contained in the definitive Proxy
Statement of the Company to be filed pursuant to Regulation 14A within 120
days after the end of the Company's last fiscal year (the "Proxy Statement").
 
Item 11. EXECUTIVE COMPENSATION
 
  The information concerning executive compensation is incorporated herein by
reference from the section entitled "Proposal 1--Election of Directors"
contained in the Proxy Statement.
 
Item 12. SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT
 
  The information concerning the security ownership of certain beneficial
owners and management is incorporated herein by reference from the sections
entitled "General Information--Security Ownership of Principal Shareholders
and Management" and "Proposal 1--Election of Directors" contained in the Proxy
Statement.
 
Item 13. CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS
 
  The information concerning certain relationships and related transactions is
incorporated herein by reference from the section entitled "Proposal 1--
Election of Directors--Certain Relationships and Related Transactions"
contained in the Proxy Statement.
 
 
                                      26
<PAGE>
 
                                    PART IV
 
Item 14. EXHIBITS, FINANCIAL STATEMENT SCHEDULES AND REPORTS ON FORM 8-K
 
  (a) Financial Statements and Schedule. Reference is made to the Index to
Financial Statements and Schedule on page F-1 for a list of financial
statements and the financial statement schedule filed as part of this report.
All other schedules are omitted because they are not applicable or the
required information is shown in the Company's financial statements or the
related notes thereto.
 
  (b) Reports on Form 8-K. None.
 
  (c) Exhibits. The following is a list of exhibits filed as a part of this
report.
 
<TABLE>
<CAPTION>
 Exhibit
 Number                                Description
 -------                               -----------
 <C>     <S>
   3.1   Restated Articles of Incorporation of the Company(/1/)
   3.2   Restated Bylaws of the Company(/1/)
   4.1   Specimen of Common Stock Certificate(/2/)
  10.1   Note in the principal amount of $2,600,000 dated March 15, 1995 in
         favor of Imperial Bank(/1/)
  10.2   General Security Agreement dated March 15, 1995, by and between the
         Company and Imperial Bank(/1/)
  10.3   Factoring Agreement effective as of September 28, 1993, as amended, by
         and between the Company and NationsBanc Commercial Corporation(/1/)
  10.4   1995 Stock Option Plan dated as of May 1, 1995(/1/)
  10.5   Letter Agreement dated February 17, 1995 between Tarrant Company
         Limited and The Hongkong and Shanghai Banking Corporation Limited(/1/)
  10.6   Letter dated April 18, 1995 from The Hongkong and Shanghai Banking
         Corporation Limited to Tarrant Company Limited regarding the release
         of certain security interests(/1/)
  10.7   Commercial Lease dated January 1, 1994 and GET and the Company(/1/)
  10.8   Tenancy Agreement dated July 15, 1994 between Lynx International
         Limited and Tarrant Company Limited, as amended by that certain
         Supplementary Tenancy Agreement dated December 30, 1994 and that
         certain Second Supplementary Tenancy Agreement dated December 31,
         1994(/1/)
  10.9   Lease Agreement dated June 10, 1994, between Yip Sik Kin and Tarrant
         Company Limited (translated from Chinese)(/1/)
  10.10  Tenancy Contract effective as of December 24, 1994, between Khalifa al
         Muhairi and Tarrant Trading Co. Ltd.(/1/)
  10.11  Agreement dated as of June 1, 1995, by and among Pret-A-Porter, the
         Company, French Designers, Inc., Bernard Aidan, Gerard Guez and Todd
         Kay(/5/)
  10.12  Services Agreement dated as of April 1, 1995, by and between F.I.S.,
         Inc. and the Company(/2/)
  10.13  Services Agreement dated as of October 1, 1994, by and between the
         Company and GET(/1/)
  10.14  Services Agreement dated as of October 1, 1994, by and between the
         Company and Lynx International Limited(/1/)
  10.15  Indemnification Agreement dated as of March 14, 1995, by and among the
         Company, Gerard Guez and Todd Kay(/2/)
  10.16  Promissory Note in the initial principal amount of $2 million dated
         February 8, 1995, by Gerard Guez in favor of the Company(/2/)
</TABLE>
 
 
                                      27
<PAGE>
 
<TABLE>
<CAPTION>
 Exhibit
 Number                                Description
 -------                               -----------
 <C>     <S>
 10.17   Promissory Note in the initial principal amount of $1 million dated
         February 8, 1995, by Todd Kay in favor of the Company(/2/)
 10.18   Promissory Note in the principal amount of $1,334,566.71 dated
         December 31, 1994, by F.I.S., Inc. in favor of the Company(/2/)
 10.19   Release dated as of June 1, 1995, by and between the Company and
         certain other parties signatory thereto(/2/)
 10.20   Option Agreement dated as of July 28, 1995, by and among Limited
         Direct Associates, L.P., Gerard Guez, Todd Kay and the Company(/5/)
 10.21   Registration Rights Agreement dated as of July 28, 1995, by and among
         the Company and Limited Direct Associates, L.P.(/5/)
 10.22   Reorganization and Tax Indemnification Agreement dated as of June 13,
         1995, by and among the Company and its shareholders(/5/)
 10.23   Employment Agreement January 1, 1995, by and between the Company and
         Gerard Guez(/2/)
 10.23.1 Employment Agreement effective January 1, 1998, by and between the
         Company and Gerard Guez
 10.24   Agreement dated as of January 1, 1995, by and between the Company and
         Todd Kay(/1/)
 10.24.1 Employment Agreement effective January 1, 1998, by and between the
         Company and Todd Kay
 10.25   Employment Agreement dated as of January 1, 1994, by and between the
         Company and Jimmy Esebag, as amended, by that certain Amendment No. 1
         dated as of June 1, 1995(/2/)
 10.26   Employment Agreement dated as of November 18, 1994, by and between the
         Company and Mark B. Kristof(/1/)
 10.27   Employment Agreement dated as of July 5, 1994, by and between the
         Company and Bradley R. Kenson(/1/)
 10.28   License Agreement dated January 1, 1994, by and between the Company
         and GET(/1/)
 10.29   Assignment dated as of June 1, 1995 with respect to the GET!
         trademark, executed by GET in favor of the Company(/2/)
 10.30   Amendment No. 1 to Commercial Lease dated as of April 1, 1995, by and
         between GET and the Company(/2/)
 10.31   Lease and Services Agreement dated as of June 1, 1995, by and between
         Tarrant Company Limited and French Designers, Inc.(/2/)
 10.32   Note in the principal amount of $2,600,000 dated May 15, 1995, by the
         Company in favor of Imperial Bank(/2/)
 10.33   Letter Agreement dated May 17, 1995, by and between Tarrant Company
         Limited and The Hongkong and Shanghai Banking Corporation Limited(/2/)
 10.34   Buying Agency Agreement executed as of December 19, 1992, between
         F.I.S., Inc. and Tarrant Company Ltd.(/2/)
 10.35   Buying Agency Agreement executed as of April 4, 1995, by Azteca
         Production International, Inc. and Tarrant Company Ltd., with the
         Company acknowledging as to certain matters(/2/)
 10.36   Tripartite Agreement Assignment of Factoring Proceeds (Advances)
         executed and delivered June 6, 1995, by the Company, and accepted and
         agreed to by The Hongkong and Shanghai Banking Corporation Limited and
         NationsBanc Commercial Corporation(/2/)
 10.36.1 Amendment to Three Party Special Deposit Account Agreement(/8/)
 10.37   Security Agreement (Guaranty of Tarrant Co. Ltd. Debt) entered into as
         of June 6, 1995, by and between the Hongkong and Shanghai Banking
         Corporation Limited and the Company(/2/)
</TABLE>
 
 
                                       28
<PAGE>
 
<TABLE>
<CAPTION>
 Exhibit
 Number                                Description
 -------                               -----------
 <C>     <S>
 10.38   Security Agreement (Tarrant Co. Ltd. Draft Acceptance) entered into as
         of June 6, 1995, by and between The Hongkong and Shanghai Banking
         Corporation Limited and the Company(/2/)
 10.39   Agreement dated March 14, 1995, by and among Tarrant Company Limited,
         Cheung Shing Hong Holding Ltd., Yip Sik Kin and Lam Kin Fong(/3/)
 10.40   Agreement dated March 17, 1995, by and among Tarrant Company Limited,
         Cheung Shing Hong Holding Ltd., Yip Sik Kin and Lam Kin Fong(/3/)
 10.41   Underwriting Agreement dated as of July 24, 1995, by and among the
         Company, Gerard Guez, Todd Kay and Prudential Securities
         Incorporated(/5/)
 10.42   Letter agreement dated August 10, 1995, by and among the Company and
         NationsBanc Commercial Corporation(/4/)
 10.42.1 Amendment dated June 9, 1997 to Factoring Agreement effective as of
         September 28, 1993, as amended, by and between the Company and
         NationsBanc Commercial Corporation(/8/)
 10.43   Letter agreement dated January 30, 1996, by and between Tarrant
         Company Limited and The Hongkong Shanghai Banking Corporation
         Limited(/5/)
 10.43.1 Letter agreement dated May 28, 1996, by and between Tarrant Company
         Limited and The Hongkong and Shanghai Banking Corporation Limited(/8/)
 10.43.2 Letter agreement dated April 16, 1998, by and between Tarrant Company
         Limited and The Hongkong and Shanghai Banking Corporation
         Limited(/11/)
 10.44   Promissory Note in the principal amount of $3 million dated March 25,
         1996, by GET in favor of the Company(/6/)
 10.45   Deed of Trust dated March 25, 1996 by and between GET and the
         Company(/6/)
 10.46   Guaranty, Pledge & Security Agreement entered into as of March 25,
         1996, by and between Gerard Guez and the Company(/6/)
 10.47   Guaranty, Pledge & Security Agreement entered into as of March 25,
         1996, by and between Todd Kay and the Company(/6/)
 10.48   Letter agreement dated February 22, 1996, by and between Tarrant
         Company Limited and Standard Chartered Bank(/7/)
 10.49   Letter agreement dated March 8, 1996, by and between Tarrant Company
         Limited and Standard Chartered Bank(/7/)
 10.50   Guarantee Agreement entered into as of August 30, 1996, by and between
         Standard Chartered Bank and the Company(/7/)
 10.51   Letter of Undertaking entered into as of August 30, 1996, by and
         between Standard Chartered Bank and the Company(/7/)
 10.52   Intercreditor Agreement entered into as of November 1, 1996, between
         The Hongkong and Shanghai Banking Corporation Limited, Standard
         Chartered Bank and Tarrant Company Limited(/7/)
 10.53   Security Agreement entered into as of November 1, 1996, by and between
         Standard Chartered Bank and the Company(/7/)
 10.54   Amendment to Security Agreement (Guaranty of Tarrant Co. Ltd. Debt)
         entered into as of November 1, 1996, between The Hongkong and Shanghai
         Banking Corporation Limited and the Company(/7/)
 10.55   Agreement dated January 29, 1997 by and among Tarrant Company Limited,
         Cheung Shing Hong Holding Ltd., Yip Sik Kin and Lam Kin Fong(/7/)
 10.56   Form of Indemnification Agreement with directors and certain executive
         officers(/8/)
</TABLE>
 
 
                                       29
<PAGE>
 
<TABLE>
<CAPTION>
 Exhibit
 Number                                Description
 -------                               -----------
 <C>     <S>
 10.57   Special Deposit Account Agreement(/8/)
 10.58   Accounts Receivable Financing Agreement dated June 13, 1997, by and
         between the Company and The CIT Group/Commercial Services, Inc.(/8/)
 10.58.1 Letter Agreement dated October 1, 1997 regarding Accounts Receivable
         Financing Agreement, by and between the Company and The CIT
         Group/Commercial Services, Inc.
 10.59*+ Asset Purchase Agreement dated February 18, 1998, by and between
         Marble Limited and MGI International Limited(/10/)
 10.60*+ Asset Purchase Agreement dated February 18, 1998, by and between the
         Company and Marshall Gobuty International U.S.A., Inc.(/10/)
 10.61   Employment Agreement dated February 23, 1998, by and between the
         Company and Marshall Gobuty(/10/)
 10.62   Noncompetition Agreement dated February 23, 1998, by and between
         Marshall Gobuty International U.S.A., Inc. and Marshall Gobuty, on the
         one hand, and the Company, on the other hand(/10/)
 10.63   Noncompetition Agreement dated February 23, 1998, by and between MGI
         International Limited and Marshall Gobuty, on the one hand, and the
         Company, on the other hand(/10/)
 10.64   Loan Agreement dated as of July 1, 1998, between the Company and
         Standard Chartered Bank(/12/)
 10.65   Partnership Interest Purchase Agreement dated as of July 2, 1998,
         among Rocky Acquisition, LLC, the Company, Limited Direct Associates,
         L.P., Rocky Apparel, Inc., and Gabriel Manufacturing Company
 10.66   Escrow Agreement made as of July 2, 1998, by and among the Company,
         Gabriel Manufacturing Company and Rocky Apparel, Inc.
 10.67   Facility Development Agreement dated as of December 2, 1998, by and
         between Tarrant Mexico, S. de R.L. de C.V. and Tex Transas, S.A. de
         C.V.
 10.68+  Agreement for Purchase of Assets dated as of February 22, 1999, by and
         among Tarrant Mexico, S. de R.L. de C.V., Jamil Textil, S.A. de C.V.,
         Inmobiliaria Cuadros, S.A. de C.V., Kamel Nacif and Irma Benavides
         Montes De Oca.
 23      Consent of Ernst & Young LLP
 27      Financial Data Summary
</TABLE>
----------
  *  Confidential treatment has been requested for portions of this document.
 
  +  All schedules and/or exhibits have been omitted. Any omitted schedule or
     exhibit will be furnished supplementally to the Securities and Exchange
     Commission upon request.
 
 (1)  Filed as an exhibit to the Company's Registration Statement on Form S-1
      filed with the Securities and Exchange Commission on May 4, 1995 (File
      No. 33-91874).
 
 (2)  Filed as an exhibit to Amendment No. 1 to Registration Statement on Form
      S-1 filed with the Securities and Exchange Commission on June 15, 1995.
 
 (3)  Filed as an exhibit to Amendment No. 2 to Registration Statement on Form
      S-1 filed with the Securities and Exchange Commission on July 11, 1995.
 
 (4)  Filed as an exhibit to the Company's Quarterly Report on Form 10-Q for
      the quarter ended June 30, 1995.
 
 (5)  Filed as an exhibit to the Company's Annual Report on Form 10-K for the
      year ended December 30, 1995.
 
 (6)  Filed as an exhibit to the Company's Quarterly Report on Form 10-Q for
      the quarter ended March 31, 1996.
 
 (7)  Filed as an exhibit to the Company's Annual Report on Form 10-K for the
      year ended December 31, 1996.
 
 (8)  Filed as an exhibit to the Company's Quarterly Report on Form 10-Q for
      the quarter ended June 30, 1997.
 
 (9)  Filed as an exhibit to the Company's Quarterly Report on Form 10-Q for
      the quarter ended September 30, 1997.
 
(10)  Filed as exhibit to the Company's Annual Report on Form 10-K for the
      year ended December 31, 1997.
 
(11)  Filed as exhibit to the Company's Quarterly Report on Form 10-Q for the
      quarter ended March 31, 1998.
 
(12)  Filed as exhibit to the Company's Quarterly Report on Form 10-Q for the
      quarter ended June 30, 1998.
 
                                      30
<PAGE>
 
 
                   INDEX TO FINANCIAL STATEMENTS AND SCHEDULE
<TABLE>
<CAPTION>
                                                                           Page
                                                                           ----
<S>                                                                        <C>
Financial Statements
 Report of Independent Auditors--Ernst & Young, LLP.......................  F-2
 Consolidated Balance Sheets--December 31, 1997 and 1998..................  F-3
 Consolidated Statements of Income--Three year period ended December 31,
  1998....................................................................  F-4
 Consolidated Statements of Shareholders' Equity--Three year period ended
  December 31, 1998.......................................................  F-5
 Consolidated Statements of Cash Flows--Three year period ended December
  31, 1998................................................................  F-6
 Notes to Consolidated Financial Statements...............................  F-7
Financial Statement Schedule
 Schedule II--Valuation and Qualifying Accounts........................... F-21
</TABLE>
 
                                      F-1
<PAGE>
 
                        REPORT OF INDEPENDENT AUDITORS
 
Board of Directors
Tarrant Apparel Group
 
  We have audited the accompanying consolidated balance sheets of Tarrant
Apparel Group and subsidiaries as of December 31, 1997 and 1998, and the
related consolidated statements of income, shareholders' equity, and cash
flows for each of the three years ended December 31, 1998. Our audits also
included the financial statement schedule listed in the Index at Item 14(a).
These financial statements and schedule are the responsibility of the
Company's management. Our responsibility is to express an opinion on these
financial statements and schedule based on our audits.
 
  We conducted our audits in accordance with generally accepted auditing
standards. Those standards require that we plan and perform the audit to
obtain reasonable assurance about whether the financial statements are free of
material misstatement. An audit includes examining, on a test basis, evidence
supporting the amounts and disclosures in the financial statements. An audit
also includes assessing the accounting principles used and significant
estimates made by management, as well as evaluating the overall financial
statement presentation. We believe that our audits provide a reasonable basis
for our opinion.
 
  In our opinion, the financial statements referred to above present fairly,
in all material respects, the consolidated financial position of Tarrant
Apparel Group and subsidiaries at December 31, 1996, 1997 and 1998 and the
consolidated results of their operations and their cash flows for each of the
three years in the period ended December 31, 1998 in conformity with generally
accepted accounting principles. Also, in our opinion, the related financial
statement schedule when considered in relation to the basic financial
statements, taken as a whole, presents fairly in all material respects the
information set forth therein.
 
                                          Ernst & Young LLP
 
Los Angeles, California
February 26, 1999
 
                                      F-2
<PAGE>
 
                             TARRANT APPAREL GROUP
 
                          CONSOLIDATED BALANCE SHEETS
 
<TABLE>
<CAPTION>
                                                              December 31,
                                                        ------------------------
                                                           1997         1998
                                                        ----------- ------------
<S>                                                     <C>         <C>
                        ASSETS
Current assets:
  Cash and cash equivalents...........................  $ 5,305,129 $  4,318,520
  Accounts receivable, net (Note 2)...................   34,078,352   65,946,055
  Due from affiliates (Note 12).......................        3,470    2,143,527
  Due from officers (Note 12).........................    1,601,670    4,477,461
  Inventory (Note 3)..................................   23,266,196   49,230,847
  Temporary quota.....................................    2,874,382    1,192,888
  Prepaid expenses....................................    1,203,931    1,527,392
  Income taxes........................................      478,050      501,334
                                                        ----------- ------------
    Total current assets..............................   68,811,180  129,338,024
Property and equipment, net (Note 4)..................    2,707,257    5,306,308
Permanent quota, net..................................      145,268      245,464
Other assets..........................................      196,973    4,468,517
Excess of cost over fair value of net assets acquired,
 net..................................................           --   14,532,193
                                                        ----------- ------------
    Total assets......................................  $71,860,678 $153,890,506
                                                        =========== ============
 
         LIABILITIES AND SHAREHOLDERS' EQUITY
Current liabilities:
  Bank borrowings (Note 6)............................  $ 4,287,518 $ 33,288,267
  Accounts payable....................................   12,549,961   24,200,202
  Accrued expenses....................................    5,117,183    8,738,522
  Income taxes........................................      969,115    5,048,288
  Deferred tax liability..............................      582,957           --
  Current portion of long-term obligations............           --      981,124
                                                        ----------- ------------
    Total current liabilities.........................   23,506,734   72,256,403
Long-term obligations.................................           --    2,424,439
                                                        ----------- ------------
    Total liabilities.................................   23,506,734   74,680,842
Commitments and contingencies (Note 8)
Shareholders' equity:
  Preferred stock, 2,000,000 shares authorized; none
   issued and outstanding.............................           --           --
  Common stock, no par value, 20,000,000 shares
   authorized; 13,219,928 shares (1997) and 13,832,955
   (1998) issued and outstanding......................   16,100,483   22,290,539
  Contributed capital.................................    1,434,259    1,434,259
  Retained earnings...................................   30,819,202   55,484,866
                                                        ----------- ------------
    Total shareholders' equity........................   48,353,944   79,209,664
                                                        ----------- ------------
    Total liabilities and shareholders' equity........  $71,860,678 $153,890,506
                                                        =========== ============
</TABLE>
 
                            See accompanying notes.
 
                                      F-3
<PAGE>
 
                             TARRANT APPAREL GROUP
 
                       CONSOLIDATED STATEMENTS OF INCOME
 
<TABLE>
<CAPTION>
                                             Year Ended December 31,
                                      ----------------------------------------
                                          1996          1997          1998
                                      ------------  ------------  ------------
<S>                                   <C>           <C>           <C>
Net sales............................ $229,861,024  $260,092,777  $378,155,527
Cost of sales........................  192,287,596   220,995,754   307,077,111
                                      ------------  ------------  ------------
Gross profit.........................   37,573,428    39,097,023    71,078,416
Selling and distribution expenses....    7,124,732     8,498,976    11,274,384
General and administrative expenses..   13,989,826    13,518,441    19,896,522
Amortization of excess of cost over
 fair value of net assets acquired...           --            --     1,336,791
                                      ------------  ------------  ------------
Income from operations...............   16,458,870    17,079,606    38,570,719
Interest expense.....................   (1,864,734)   (1,470,762)   (2,423,482)
Interest income......................      336,785       171,385       360,580
Other income (expense) (Note 8)......     (301,509)      241,235       567,847
                                      ------------  ------------  ------------
Income before provision for income
 taxes...............................   14,629,412    16,021,464    37,075,664
Provision for income taxes (Note 7)..    4,627,786     5,235,000    12,410,000
                                      ------------  ------------  ------------
Net income........................... $ 10,001,626  $ 10,786,464  $ 24,665,664
                                      ============  ============  ============
Net income per share:
  Basic.............................. $       0.77  $       0.82  $       1.82
                                      ============  ============  ============
  Diluted............................ $       0.76  $       0.80  $       1.71
                                      ============  ============  ============
Weighted average shares outstanding:
  Basic..............................   13,015,866    13,175,256    13,519,517
  Diluted............................   13,095,662    13,567,254    14,416,850
</TABLE>
 
 
 
 
                            See accompanying notes.
 
                                      F-4
<PAGE>
 
                             TARRANT APPAREL GROUP
 
                CONSOLIDATED STATEMENTS OF SHAREHOLDERS' EQUITY
 
<TABLE>
<CAPTION>
                                                                      Total
                               Common     Contributed  Retained   Shareholders'
                               Stock        Capital    Earnings      Equity
                            ------------  ----------- ----------- -------------
<S>                         <C>           <C>         <C>         <C>
Balance at December 31,
 1995......................  $14,950,222  $1,434,259  $10,031,112  $26,415,593
 Net income................           --          --   10,001,626   10,001,626
 Exercise of stock options.      446,634          --           --      446,634
 Income tax benefit from
  exercise of stock
  options..................       88,878          --           --       88,878
                            ------------  ----------  -----------  -----------
Balance at December 31,
 1996......................   15,485,734   1,434,259   20,032,738   36,952,731
 Net income................           --          --   10,786,464   10,786,464
 Exercise of stock options.      495,254          --           --      495,254
 Income tax benefit from
  exerciseof stock options.      119,495          --           --      119,495
                            ------------  ----------  -----------  -----------
Balance at December 31,
 1997......................   16,100,483   1,434,259   30,819,202   48,353,944
 Net income................           --          --   24,665,664   24,665,664
 Exercise of stock options.    3,343,492          --           --    3,343,492
 Issuance of shares for
  acquisition..............    1,350,000          --           --    1,350,000
 Income tax benefit from
  exercise of stock
  options..................    1,496,564          --           --    1,496,564
                            ------------  ----------  -----------  -----------
Balance at December 31,
 1998...................... $ 22,290,539  $1,434,259  $55,484,866  $79,209,664
                            ============  ==========  ===========  ===========
</TABLE>
 
 
 
 
 
                            See accompanying notes.
 
                                      F-5
<PAGE>
 
                             TARRANT APPAREL GROUP
 
                     CONSOLIDATED STATEMENTS OF CASH FLOWS
 
<TABLE>
<CAPTION>
                                               Year Ended December 31,
                                        ----------------------------------------
                                            1996          1997          1998
                                        ------------  ------------  ------------
<S>                                     <C>           <C>           <C>
Operating activities
Net income............................  $ 10,001,626  $ 10,786,464  $ 24,665,664
Adjustments to reconcile net income to
 net cash provided by (used in)
 operating activities:................
  Deferred taxes......................       127,372       598,273      (606,241)
  Depreciation and amortization.......       905,786       867,022     2,356,259
  Loss on sale of fixed assets........        57,375         3,698        21,587
  Stock compensation expense..........        66,050            --            --
  Provision for returns and discounts.      (432,594)     (359,344)      593,447
  Changes in operating assets and
   liabilities:
    Accounts receivable...............   (14,818,441)   10,764,877   (28,785,228)
    Due from affiliates and officers..       764,689    (1,508,724)   (5,015,848)
    Inventory.........................     2,988,492   (12,446,028)  (18,215,979)
    Temporary quota...................      (349,717)   (1,151,297)    1,681,494
    Prepaid expenses..................      (147,000)     (849,422)     (185,579)
    Prepaid income taxes..............      (990,771)    1,300,887            --
    Accounts payable..................     3,076,430    (1,650,268)    5,906,194
    Accrued expenses and income tax
     payable..........................     1,031,877       629,236     7,100,702
                                        ------------  ------------  ------------
      Net cash (used in) provided by
       operating activities...........     2,281,174     6,985,374   (10,483,528)
Investing activities
Purchase of fixed assets..............      (466,272)     (764,087)   (1,490,728)
Acquisition of MGI....................            --            --    (6,108,685)
Acquisition of Rocky, net of cash.....            --            --   (10,993,407)
Sale of fixed assets..................       218,306            --            --
Purchase of permanent quota...........      (133,002)     (129,205)     (226,115)
Increase in other assets..............            --            --    (4,245,981)
                                        ------------  ------------  ------------
    Net cash used in investing
     activities.......................      (380,968)     (893,292)  (23,064,916)
Financing activities
Bank borrowings, net..................    (9,130,422)   (2,522,158)   25,547,109
Proceeds from long term obligations...            --            --     2,635,000
Paydown of long term obligations......            --            --      (460,330)
Exercise of stock options including
 related tax benefit..................       469,462       614,749     4,840,056
                                        ------------  ------------  ------------
    Net cash provided by (used in)
     financing activities.............    (8,660,960)   (1,907,409)   32,561,835
                                        ------------  ------------  ------------
Increase (decrease) in cash and cash
 equivalents..........................    (6,760,754)    4,184,673      (986,609)
Cash and cash equivalents at beginning
 of year..............................     7,881,210     1,120,456     5,305,129
                                        ------------  ------------  ------------
Cash and cash equivalents at end of
 year.................................  $  1,120,456  $  5,305,129  $  4,318,520
                                        ============  ============  ============
</TABLE>
 
                            See accompanying notes.
 
                                      F-6
<PAGE>
 
                             TARRANT APPAREL GROUP
 
                  NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
                               December 31, 1998
 
1. Summary of Significant Accounting Policies
 
  Organization and Basis of Consolidation
 
  The accompanying financial statements consist of the consolidation of
Tarrant Apparel Group, a California Corporation (formerly Fashion Resource,
Inc.) (the Parent Company or the Company), NO! Jeans, Inc. (NO), Rocky Mexico,
Inc. (RM), Rocky Apparel, L.L.C. (RA) and Tag Mex, Inc., United States
corporations; the following Hong Kong corporations: Tarrant Company Limited
(Tarrant HK) and Marble Limited (Marble); Tarrant Trading Limited, a United
Arab Emirates corporation (Tarrant UAE); and Tag Mex, S.A., a Mexican
corporation which is a wholly-owned subsidiary of Tag Mex, Inc. NO, RM and
Marble are wholly-owned subsidiaries of Tarrant Apparel Group, Tag Mex, Inc.
and Tarrant HK, respectively. Tag Mex, Inc. and RA are wholly-owned
subsidiaries of Tarrant Apparel Group. Tarrant HK owns a 49% interest in
Tarrant UAE. However, since Tarrant HK effectively controls Tarrant UAE, the
results of Tarrant UAE had been consolidated. The third-party interest in
Tarrant UAE is immaterial.
 
  The Company serves both specialty retail and mass merchandise store chains
by designing, merchandising and contracting for the manufacture and selling of
casual, moderately priced apparel, for women, men and children under private
label.
 
  Revenue Recognition
 
  Revenues are recorded, net of anticipated returns, at the time of shipment
of merchandise.
 
  Cash and Cash Equivalents
 
  Cash equivalents consist of highly liquid investments with an original
maturity of three months or less when purchased.
 
  Inventories
 
  Inventories are stated at the lower of cost (first-in, first-out) or market.
 
  Quota
 
  The Company purchases quota rights to be used in the importation of its
products from certain foreign countries. The effect of quota transactions is
accounted for as product cost.
 
  Permanent quota entitlements were principally obtained through free
allocations by the Hong Kong Government pursuant to an import restraint
between Hong Kong and the United States and are renewable on an annual basis,
based upon the prior year utilization. Permanent quota entitlements acquired
from outside parties are amortized over three years on a straight-line basis,
and amounted to $145,000, net of amortization of $925,000 at December 31, 1997
and $245,000, net of amortization of $1.1 million at December 31, 1998.
 
  Temporary quota represents quota rights acquired from other permanent quota
entitlement holders on a temporary basis. Temporary quota has a maximum life
of twelve months. The cost of temporary quota purchased for the current year
utilization has been assigned to inventory purchases while the cost of
temporary quota acquired for usage in the year following the balance sheet
date is recorded as a current asset.
 
 
                                      F-7
<PAGE>
 
                             TARRANT APPAREL GROUP
 
            NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued)
 
  Property and Equipment
 
  Property and equipment is recorded at cost. Additions and betterments are
capitalized while repair and maintenance costs are charged to operations as
incurred. Depreciation of property and equipment is provided for by the
straight-line method over their estimated useful lives. Leasehold improvements
are amortized using the straight-line method over the lesser of their
estimated useful life or the term of the lease. Upon retirement or disposal of
property and equipment, the cost and related accumulated depreciation are
eliminated from the accounts and any gain or loss is reflected in the
statements of income.
 
  Intangibles
 
  The excess of cost over fair value of net assets acquired is being amortized
over five to fifteen years. Accumulated amortization at December 31, 1997 and
1998 was $0 and $1,337,000, respectively.
 
  Income Taxes
 
  The Company utilizes Statement of Financial Accounting Standards No. 109,
"Accounting for Income Taxes," which prescribes the use of the liability
method to compute the differences between the tax basis of assets and
liabilities and the related financial reporting amounts using currently
enacted tax laws and rates.
 
  The Company's Hong Kong corporate affiliates are taxed at an effective Hong
Kong rate of 16%. No domestic tax provision has been provided for $41.7
million of unremitted retained earnings of these Hong Kong corporations, as
the Company intends to maintain these amounts in Hong Kong on a permanent
basis in support of its working capital requirements.
 
  Net Income Per Share
 
  Net income per share has been computed in accordance with Financial
Accounting Standard Board (FASB) Statement No. 128, "Earnings Per Share" (see
Note 10). A two-for-one stock split became effective May 8, 1998. All share
and per share amounts have been restated to reflect the split.
 
  Product Design, Advertising and Sales Promotion Costs
 
  Product design, advertising and sales promotion costs are expensed as
incurred. Product design, advertising and sales promotion costs included in
operating expenses in the accompanying statements of income (excluding the
costs of manufacturing samples) amounted to approximately $1,419,000,
$1,528,000, and $840,000 in 1996, 1997 and 1998, respectively.
 
  Foreign Currency Translation
 
  Assets and liabilities of the Hong Kong and United Arab Emirates
subsidiaries are translated at the rate of exchange in effect on the balance
sheet date; income and expenses are translated at the average rates of
exchange prevailing during the year. The principal foreign currency in which
the Company transacts business is the Hong Kong dollar. A majority of all
significant transactions in Mexico are conducted in U.S. dollars.
 
  Foreign currency gains and losses resulting from translation of assets and
liabilities are included in the statements of income. Historically, such gains
and losses have been immaterial. At December 31, 1998, the Hong Kong
subsidiaries have retained earnings of $41.7 million and an intercompany
receivable due from Tarrant Apparel Group of $37.0 million.
 
 
                                      F-8
<PAGE>
 
                             TARRANT APPAREL GROUP
 
            NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued)
 
  Financial Instruments
 
  The fair value of financial instruments is determined by reference to
various market data and other valuation techniques as appropriate. Unless
otherwise described, the fair values of financial instruments approximate
their recorded values.
 
  The Company has adopted Statement of Financial Accounting Standards No. 115,
"Accounting for Certain Investments in Debt and Equity Securities" (SFAS No.
115). Under SFAS No. 115, marketable securities portfolios consisting of debt
and equity securities held primarily for sale in the near term (trading
securities) are valued at fair value, with realized and unrealized holding
gains and losses included in the statements of income. The Company realized
losses on the sale of marketable securities of approximately $0 and $16,000 in
1998 and 1996, respectively, and a gain of $237,000 in 1997.
 
  Concentration of Credit Risk
 
  Financial instruments which potentially expose the Company to concentration
of credit risk consist primarily of cash equivalents, trade accounts
receivable and amounts due from factor.
 
  The Company's products are primarily sold to mass merchandisers and
specialty retail stores. These customers can be significantly affected by
changes in economic, competitive or other factors. The Company makes
substantial sales to a relatively few, large customers. In order to minimize
the risk of loss, the Company assigns certain of its domestic accounts
receivable to a factor without recourse or requires letters of credit from its
customers prior to the shipment of goods. For nonfactored receivables, account
monitoring procedures are utilized to minimize the risk of loss. Collateral is
generally not required. The following table presents the percentage of net
sales concentrated with certain customers. Customer A represents a group of
customers under common ownership.
 
<TABLE>
<CAPTION>
                                                               1996  1997  1998
                                                               ----  ----  ----
     <S>                                                       <C>   <C>   <C>
     Customer A............................................... 67.1% 69.7% 63.3%
     Customer B............................................... 24.3  18.7   8.6
</TABLE>
 
  Products representing over 90% of the Company's net sales, on the basis of
the free on board cost at the supplier's plant, were manufactured by third
party contractors located in foreign countries. There can be no assurance that
the Company will not experience difficulties with third parties responsible
for the manufacture of its products.
 
  The Company maintains demand deposits with several major banks. At times,
cash balances may be in excess of Federal Deposit Insurance Corporation or
equivalent foreign insurance limits.
 
  Use of Estimates
 
  The preparation of financial statements in conformity with generally
accepted accounting principles requires management to make estimates and
assumptions that affect the amounts reported in the financial statements and
accompanying notes. Actual results could differ from those estimates.
 
  Stock-Based Compensation
 
  In October 1995, the Financial Accounting Standards Board issued Statement
of Financial Accounting Standards No. 123, "Accounting for Stock-Based
Compensation" (SFAS 123). SFAS 123 established a fair value-based method of
accounting for compensation cost related to stock options and other forms of
stock-based
 
                                      F-9
<PAGE>
 
                             TARRANT APPAREL GROUP
 
            NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued)
 
compensation plans. However, SFAS 123 allows an entity to continue to measure
compensation costs using the principles of APB 25 if certain pro forma
disclosures are made. The Company has elected to account for its stock
compensation arrangements under the provisions of APB 25, "Accounting for
Stock Issued to Employees." The Company adopted the provisions for pro forma
disclosure requirements of SFAS 123 in fiscal 1996.
 
2. Accounts Receivable
 
  Accounts receivable consist of the following:
 
<TABLE>
<CAPTION>
                                                            December 31,
                                                       ------------------------
                                                          1997         1998
                                                       -----------  -----------
     <S>                                               <C>          <C>
     U.S. trade accounts receivable................... $13,411,719  $53,693,368
     Foreign trade accounts receivable................   9,466,193    8,406,558
     Due from factor..................................  12,028,633    4,725,869
     Other receivables................................     727,619    1,367,266
     Allowance for returns and discounts..............  (1,555,812)  (2,247,006)
                                                       -----------  -----------
                                                       $34,078,352  $65,946,055
                                                       ===========  ===========
</TABLE>
 
  The Company has accounts receivable-secured credit facilities with
NationsBanc Commercial Corporation ("NBCC") and The CIT Group/Commercial
Services, Inc. ("CIT"). Prior to January 1, 1998, NBCC acted as the Company's
factor for accounts receivable. Effective January 1, 1998, the Company
substantially eliminated its use of the factor. The Company may receive an
advance from NBCC of up to 90% of certain accounts receivable. Such advances
approximated $11.8 million and $1.0 million at December 31, 1997 and 1998,
respectively. CIT will advance up to 100% of the amount of certain accounts
receivable plus an over-advance of up to $10 million, up to a maximum amount
of $25 million. Such advances approximated $0 and $435,000 at December 31,
1997 and 1998, respectively. Interest on advances from both NBCC and CIT
accrues at the rate of one and one-quarter percent below the bank's respective
prime rates or, at the option of the Company, one and one-quarter percent over
the respective LIBOR rates. As of December 31, 1998, the prime rates equaled
seven and three quarters percent and the LIBOR rates averaged five and three
tenths percent.
 
3. Inventory
 
  Inventory consists of the following:
 
<TABLE>
<CAPTION>
                                                             December 31,
                                                        -----------------------
                                                           1997        1998
                                                        ----------- -----------
     <S>                                                <C>         <C>
     Raw materials
       Fabric and trim accessories..................... $ 4,022,298 $10,424,416
       Raw cotton......................................          --   1,043,449
     Work-in-process...................................   4,315,703   7,620,403
     Finished goods shipments-in-transit...............   5,655,461  10,331,867
     Finished goods....................................   9,272,734  19,810,712
                                                        ----------- -----------
                                                        $23,266,196 $49,230,847
                                                        =========== ===========
</TABLE>
 
 
                                     F-10
<PAGE>
 
                             TARRANT APPAREL GROUP
 
            NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued)
 
4. Property and Equipment
 
  Property and equipment consists of the following:
 
<TABLE>
<CAPTION>
                                                             December 31,
                                                         ----------------------
                                                            1997        1998
                                                         ----------  ----------
     <S>                                                 <C>         <C>
     Equipment, furniture and fixtures.................. $3,300,921  $6,265,367
     Leasehold improvements.............................  2,147,474   2,402,965
     Vehicles...........................................     94,826     260,480
                                                         ----------  ----------
                                                          5,543,221   8,928,812
     Less accumulated depreciation and amortization..... (2,835,964) (3,622,504)
                                                         ----------  ----------
                                                         $2,707,257  $5,306,308
                                                         ==========  ==========
</TABLE>
 
5. Acquisitions
 
  Rocky
 
  On July 2, 1998, the Company purchased the partnership interests of Rocky
Apparel, L.P., a Delaware limited partnership ("Rocky"). Rocky operates
manufacturing facilities in Mississippi and also sources garments in Mexico.
The purchase price consisted of $7.4 million in cash and 81,000 shares of the
Common Stock of the Company, valued at $1.4 million, paid on closing. In
addition, the Company was required to repay $3.4 million of debt to one of the
sellers on closing and to guarantee the bank indebtedness of Rocky in the
amount of $5.0 million of which $1.2 million was outstanding at December 31,
1998. The Company was granted a security interest in the 81,000 shares to
secure the performance of obligations under the purchase agreement, including,
without limitation, the indemnification obligations. This transaction has been
accounted for as a purchase, and the purchase price has been allocated based
on the fair value of assets acquired and liabilities assumed. The excess of
cost over fair value of net assets acquired is being amortized over 15 years.
The operations of Rocky have been included with those of the Company
commencing on July 1, 1998.
 
  Rocky designs, develops and contracts for the manufacture of men's, women's
and children's denim apparel, for Abercrombie & Fitch, Limited Stores, Express
and Structure. The purchase price was financed by the Company from a new
credit facility and cash flow from operations.
 
  MGI
 
  On February 23, 1998, the Company purchased certain assets of MGI
International Limited, a Turks and Caicos corporation. The assets purchased
consist primarily of related inventory. The purchase price consisted of (i)
$4.6 million together with an amount equal to seller's cost of the inventory
purchased, paid in cash on closing and (ii) $500,000 paid on July 21, 1998,
together with interest at 7% per annum.
 
  On February 23, 1998, the Company also purchased certain assets of Marshall
Gobuty International U.S.A., Inc., a California corporation ("MGI USA"). The
assets purchased consist primarily of related inventory. The purchase price
consisted of (i) $500,000, together with an amount equal to seller's cost of
the inventory purchased, paid in cash on closing and (ii) $500,000 paid on
July 21, 1998, together with interest at 7% per annum.
 
  MGI International Limited and MGI USA (collectively, "MGI") each designs,
develops and contracts for the manufacture of men's apparel, including knit
and woven tops, shirts and outerwear (including jackets), for national chain
department stores, including J.C. Penney and Goody's. The purchase price was
financed by the
 
                                     F-11
<PAGE>
 
                             TARRANT APPAREL GROUP
 
            NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued)
 
Company from its cash flow from operations. This transaction has been
accounted for as a purchase and the purchase price has been allocated based on
the fair value of assets acquired and liabilities assumed. The excess of cost
over fair value of net assets acquired is being amortized over five years. The
operations of MGI have been included with those of the Company commencing on
February 23, 1998.
 
6. Debt
 
  Bank borrowings consist of the following:
 
<TABLE>
<CAPTION>
                                                              December 31,
                                                         ----------------------
                                                            1997       1998
                                                         ---------- -----------
     <S>                                                 <C>        <C>
     Import trade bills payable......................... $4,287,518 $ 4,466,119
     Bank direct acceptances............................         --  16,969,565
     Other Hong Kong credit facilities..................         --      47,603
     United States credit facilities....................         --  11,804,980
                                                         ---------- -----------
                                                         $4,287,518 $33,288,267
                                                         ========== ===========
</TABLE>
 
  The Company has credit facilities of $33 million and $10 million with the
Hongkong and Shanghai Banking Corporation Limited ("HKSB") and Standard
Chartered Bank ("SCB"), respectively, for borrowings and the purchase and
exportation of finished goods. Under these facilities, the Company may arrange
for the issuance of letters of credit and acceptances, as well as cash
advances. These facilities are subject to review at any time and the right of
either lender to demand payment at any time. Interest on cash advances under
HKSB's facility accrues at HKSB's prime rate for lending U.S. dollars plus
one-half to three-quarters percent per annum. As of December 31, 1998, HKSB's
U.S. dollar prime rate equaled seven and three-quarters percent. Interest on
cash advances under SCB's facility accrues at SCB's prime rate for lending
Hong Kong dollars. As of December 31, 1998, SCB's Hong Kong dollar prime rate
equaled nine percent. These facilities are subject to certain restrictive
covenants including a provision that the aggregate net worth, as adjusted, of
the Company will exceed $30 million, the Company will not incur two
consecutive quarterly losses and the Company will maintain a certain debt to
equity ratio. As of December 31, 1998, this aggregate net worth, as adjusted,
amounted to approximately $65 million. At December 31, 1997 and 1998, there
were $4.3 million and $21.5 million of outstandings under the HKSB and SCB
facilities, respectively.
 
  The Company has an unsecured $10 million credit facility with SCB maturing
June 30, 1999 which is available for general corporate purposes. This facility
is cross-defaulted to the Company's other bank credit facilities and interest
on advances accrues at the rate of one and one-quarter percent over LIBOR. At
December 31, 1998, $10.0 million was outstanding under this facility.
 
  At December 31, 1998, long term debt consisted of a $2.4 million term loan
and $1.1 million in capital lease obligations. The term loan is due in May
2003 and bears interest at 7% per annum. Annual maturities for the long term
debt and capital lease obligations are $981,000 (1999), $860,000 (2000),
$576,000 (2001), $579,000 (2002), $318,000 (2003) and $92,000 thereafter.
 
 
                                     F-12
<PAGE>
 
                             TARRANT APPAREL GROUP
 
            NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued)
 
7. Income Taxes
 
  The provision for domestic and foreign income taxes is as follows:
 
<TABLE>
<CAPTION>
                                                 Year Ended December 31,
                                            -----------------------------------
                                               1996        1997        1998
                                            ----------  ----------  -----------
   <S>                                      <C>         <C>         <C>
   Current:
     Federal............................... $2,673,505  $2,470,848  $ 8,684,999
     State.................................    757,017     741,581    2,220,313
     Foreign...............................  1,324,636   1,424,298    2,271,961
                                            ----------  ----------  -----------
                                             4,755,158   4,636,727   13,177,273
   Deferred (credit):
     Federal...............................    (70,081)    702,539     (748,629)
     State.................................    (53,704)   (112,257)     (11,157)
     Foreign...............................     (3,587)      7,991       (7,487)
                                            ----------  ----------  -----------
                                              (127,372)    598,273     (767,273)
                                            ----------  ----------  -----------
       Total............................... $4,627,786  $5,235,000  $12,410,000
                                            ==========  ==========  ===========
</TABLE>
 
  The source of income before the provision for taxes is as follows:
 
<TABLE>
<CAPTION>
                                                   Year Ended December 31,
                                             -----------------------------------
                                                1996        1997        1998
                                             ----------- ----------- -----------
   <S>                                       <C>         <C>         <C>
     United States.......................... $ 7,425,497 $ 7,459,582 $23,401,514
     Foreign................................   7,203,915   8,561,882  13,674,150
                                             ----------- ----------- -----------
       Total................................ $14,629,412 $16,021,464 $37,075,664
                                             =========== =========== ===========
</TABLE>
 
  Foreign deferred income taxes result primarily from temporary differences in
the recognition of bad debt and depreciation expenses for tax and financial
reporting purposes. The resulting foreign deferred income tax liability
amounted to approximately $70,000 and $63,000 at December 31, 1997 and 1998,
respectively.
 
  A reconciliation of the statutory federal income tax provision to the
reported tax provision on income is as follows:
 
<TABLE>
<CAPTION>
                                                Year Ended December 31,
                                          -------------------------------------
                                             1996         1997         1998
                                          -----------  -----------  -----------
   <S>                                    <C>          <C>          <C>
   Income tax based on federal statutory
    rate................................  $ 4,974,000  $ 5,447,297  $12,976,482
   State income taxes...................      464,186      415,354    1,443,203
   Effect of foreign income taxes at
    lower tax rates.....................   (1,128,282)  (1,478,751)  (2,521,479)
   Valuation allowance and other........      317,882      851,100      511,794
                                          -----------  -----------  -----------
                                          $ 4,627,786  $ 5,235,000  $12,410,000
                                          ===========  ===========  ===========
</TABLE>
 
 
                                     F-13
<PAGE>
 
                             TARRANT APPAREL GROUP
 
            NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued)
 
  Deferred income taxes reflect the net 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 deferred tax assets are as follows:
 
<TABLE>
<CAPTION>
                                                           December 31,
                                                      ------------------------
                                                         1997         1998
                                                      -----------  -----------
     <S>                                              <C>          <C>
     Current deferred tax assets:
       Provision for doubtful accounts and unissued
        credits...................................... $   370,691  $   763,218
       Provision for other reserves..................     363,309      664,495
       Deferred compensation and benefits............     150,108      220,863
       State taxes...................................     242,724      655,745
                                                      -----------  -----------
         Total current deferred tax assets...........   1,126,832    2,304,321
     Current deferred tax liabilities:
       Accounts receivable valuation.................    (479,929)    (308,930)
       Other.........................................    (858,373)  (1,600,620)
                                                      -----------  -----------
                                                       (1,338,302)  (1,909,550)
     Valuation allowance for deferred tax assets.....    (371,487)    (371,487)
                                                      -----------  -----------
     Net current deferred tax asset (liability)...... $  (582,957) $    23,284
                                                      ===========  ===========
</TABLE>
 
8. Commitments and Contingencies
 
  The Company has entered into various noncancelable operating lease
agreements, principally for executive office, warehousing facilities and
production facilities with unexpired terms in excess of one year. The future
minimum lease payments under these noncancelable operating leases are as
follows:
 
<TABLE>
<CAPTION>
                                                             Related
                                                              Party     Other
                                                            ---------- --------
     <S>                                                    <C>        <C>
     1999.................................................. $1,268,898 $169,395
     2000..................................................  1,298,666  132,592
     2001..................................................  1,298,666  112,334
     2002..................................................  1,329,924   43,414
     2003..................................................  1,329,924       --
     Thereafter............................................    336,774       --
                                                            ---------- --------
       Total future minimum lease payments................. $6,862,852 $457,735
                                                            ========== ========
</TABLE>
 
  Certain of the operating leases contain provisions for additional rent based
upon increases in the operating costs, as defined, of the premises. Total rent
expense under the operating leases amounted to approximately $1,535,000,
$1,509,000 and $1,768,000 for 1996, 1997 and 1998, respectively.
 
  The Company had open letters of credit of $14,432,000 and $18,276,000 as of
December 31, 1997 and 1998, respectively.
 
  The Company has two employment contracts dated January 1, 1998 with two
executives providing for base compensation and other incentives. Commitments
under these agreements for base compensation amount to $1,000,000 for each of
the two executives annually through December 31, 2002. Each contract also
provides for annual bonuses of up to $2,000,000 for each executive and vesting
of stock options based on attaining specified performance criteria. In
addition, in connection with two acquisitions (see Notes 5 and 16) the Company
has or will enter into employment agreements with two additional executives.
Such agreements extend through 2002
 
                                     F-14
<PAGE>
 
                             TARRANT APPAREL GROUP
 
            NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued)
 
and initially provide for base compensation of $1,350,000, annually,
increasing to $1,450,000 over the term. These agreements also provide for cash
bonuses and vesting of stock options based on attaining specified performance
criteria.
 
  The Company recorded a $400,000 charge in other expense during the year
ended December 31, 1996 to reflect potential obligations to the Chairman and
President with respect to an agreement entered into concurrently with the
Offering.
 
  The Company is involved from time to time in routine legal matters
incidental to its business. In the opinion of the Company's management,
resolution of such matters will not have a material effect on its financial
position or results of operations.
 
  On November 14, 1997, the Federal judge in the civil lawsuit brought by the
American Textile Manufacturers Institute ("ATMI") against, among others, the
Company, Gerard Guez, its Chairman and Chief Executive Officer, and Todd Kay,
its President, dismissed, with prejudice, ATMI's complaint. On December 22,
1997, the judge granted ATMI's motion to excuse himself from the case, and
denied ATMI's motion to vacate the decision and judgment previously entered
dismissing the case. On May 21, 1998, the dismissal of ATMI's complaint and
denial of ATMI's motion to vacate the decision and judgment previously entered
was reaffirmed. On June 5, 1998, ATMI filed a motion to appeal these decisions
which is currently pending. In the opinion of the Company's management,
resolution of such matter will not have a material effect on its financial
position or results of operations.
 
9. Equity
 
  The Company has elected to follow Accounting Principles Board Opinion No.
25, "Accounting for Stock Issued to Employees" (APB 25) and related
interpretations in accounting for its employee stock options because, as
discussed below, the alternative fair value accounting provided for under FASB
Statement No. 123, "Accounting for Stock-Based Compensation," requires use of
option valuation models that were not developed for use in valuing employee
stock options. Under APB 25, when 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.
 
  The Company's 1995 Stock Option Plan, as amended and restated in January
1997 (the Plan), has authorized the grant of both incentive and non-qualified
stock options to officers, employees, directors and consultants of the Company
for up to 2,600,000 shares (as adjusted for a stock split effective May 1998)
of the Company's common stock. The exercise price of incentive options must be
equal to 100% of fair market value of common stock on the date of grant and
the exercise price of non-qualified options must not be less than the par
value of a share of common stock on the date of grant. The Plan was also
amended to expand the types of awards which may be granted pursuant thereto to
include stock appreciation rights, restricted stock and other performance-
based benefits.
 
  In October 1998 the Company granted 1,000,000 non-qualified stock options
not under the Plan. The options were granted to the Chairman and President of
the Company at $13.50 per share, the closing sales price of the Common Stock
on the day of the grant. The options expire in 2008 and vest over four years,
subject to certain performance criteria.
 
  Pro forma information regarding net income and earnings per share is
required by Statement 123, and has been determined as if the Company had
accounted for its employee stock options under the fair value method of that
Statement. The fair value for these options was estimated at the date of grant
using a Black-Scholes option pricing model with the following weighted-average
assumptions: weighted-average risk-free interest rate of 6%
 
                                     F-15
<PAGE>
 
                             TARRANT APPAREL GROUP
 
            NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued)
 
for 1996, 1997 and 1998; dividend yields of 0% for 1996, 1997 and 1998;
weighted-average volatility factors of the expected market price of the
Company's common stock of 0.52 for 1996, 0.53 for 1997 and 0.58 for 1998; and
a weighted-average expected life of the option of four years.
 
  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
estimates, in the management's opinion, the existing models do not necessarily
provide a reliable single measure of the fair value of its employee stock
options.
 
  For purposes of pro forma disclosures, the estimated fair value of the
options is amortized to expense over the options' vesting period. The
Company's pro forma information follows:
 
<TABLE>
<CAPTION>
                                                 1996       1997       1998
                                              ---------- ---------- -----------
     <S>                                      <C>        <C>        <C>
     Pro forma net income.................... $9,682,000 $9,999,000 $21,251,000
     Pro forma earnings per share............ $     0.74 $     0.75 $      1.56
</TABLE>
 
  A summary of the Company's stock option activity, and related information
for the years ended December 31 (as adjusted for a two-for-one stock split
effective May 8, 1998) follows:
 
<TABLE>
<CAPTION>
                                    1996                      1997                      1998
                          ------------------------- ------------------------- -------------------------
                                        Weighted                  Weighted                  Weighted
                                        Average                   Average                   Average
                           Options   Exercise Price  Options   Exercise Price  Options   Exercise Price
                          ---------  -------------- ---------  -------------- ---------  --------------
<S>                       <C>        <C>            <C>        <C>            <C>        <C>
Outstanding at beginning
 of year................  1,091,330      $4.50      1,495,110      $5.38      1,419,734      $ 5.64
 Granted................    752,000       6.09         78,000       7.62      1,624,000       13.94
 Exercised..............   (104,552)      3.64       (115,376)      4.30       (532,137)       6.28
 Forfeited..............   (243,668)      4.40        (38,000)      3.59       (110,000)       6.53
                          ---------      -----      ---------      -----      ---------      ------
Outstanding at end of
 year...................  1,495,110      $5.38      1,419,734      $5.64      2,401,597      $11.06
                          =========      =====      =========      =====      =========      ======
Exercisable at end of
 year...................    296,328                   568,566                   759,667
Weighted average per
 option fair value of
 options granted during
 the year...............                 $2.97                     $1.71                     $ 7.22
</TABLE>
 
  Exercise prices for options outstanding as of December 31, 1998 ranged from
1,019,722 options at $3.00 to $9.40, 1,363,375 options at $13.50 to $18.50 and
18,500 options at $31.00 to $33.125. The weighted average remaining
contractual life of those options is 8.9 years. Options vest over a period of
three or four years from respective grant dates.
 
10. Earnings Per Share
 
  In February 1997, the FASB issued "Earnings Per Share" (Statement No. 128)
establishing standards for computing and presenting earnings per share for
publicly-held common stock or potential common stock. Statement No. 128
supersedes the standards for computing earnings per share previously found in
APB Opinion No. 15, Earnings Per Share and simplifies the standards for
computing earnings per share. In addition, Statement No. 128 replaces the
presentation of primary earnings per share with a presentation of basic
earnings per share, requires dual presentation of basic and diluted earnings
per share on the face of the income statement for all entities with complex
capital structures and requires a reconciliation of the numerator and
denominator of the basic earnings per share computation to the numerator and
denominator of the diluted earnings per share computation. The statement is
effective for financial statements for both interim and annual periods ending
after December 15, 1997, with earlier application not permitted. All periods
presented reflect the adoption of Statement No. 128. The impact of amounts
previously reported was not material.
 
                                     F-16
<PAGE>
 
                             TARRANT APPAREL GROUP
 
            NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued)
 
 
  A reconciliation of the numerator and denominator of basic earnings per
share and diluted earnings per share is as follows:
 
<TABLE>
<CAPTION>
                                                  Year Ended December 31,
                                            -----------------------------------
                                               1996        1997        1998
                                            ----------- ----------- -----------
<S>                                         <C>         <C>         <C>
Basic EPS Computation:
 Numerator................................. $10,001,626 $10,786,464 $24,665,664
 Denominator:
  Weighted average common shares
   outstanding.............................  13,015,866  13,175,256  13,519,517
                                            ----------- ----------- -----------
    Total shares...........................  13,015,866  13,175,256  13,519,517
                                            ----------- ----------- -----------
Basic EPS.................................. $      0.77 $      0.82 $      1.82
                                            =========== =========== ===========
Diluted EPS Computation:
 Numerator................................. $10,001,626 $10,786,464 $24,665,664
 Denominator:
  Weighted average common shares
   outstanding.............................  13,015,866  13,175,256  13,519,517
  Incremental shares from assumed exercise
   of options..............................      79,796     391,998     897,333
                                            ----------- ----------- -----------
    Total shares...........................  13,095,662  13,567,254  14,416,850
                                            ----------- ----------- -----------
Diluted EPS................................ $      0.76 $      0.80 $      1.71
                                            =========== =========== ===========
</TABLE>
 
11. Supplemental Schedule of Cash Flow Information
 
<TABLE>
<CAPTION>
                                                  1996       1997       1998
                                               ---------- ---------- ----------
   <S>                                         <C>        <C>        <C>
   Cash paid for interest..................... $  526,000 $  660,000 $2,079,000
                                               ========== ========== ==========
   Cash paid for income taxes................. $6,036,000 $2,825,000 $7,816,000
                                               ========== ========== ==========
</TABLE>
 
12. Related-Party Transactions
 
  Related-party transactions, consisting primarily of purchases and sales of
finished goods and raw materials, are as follows:
 
<TABLE>
<CAPTION>
                                                     1996      1997      1998
                                                   -------- ---------- --------
   <S>                                             <C>      <C>        <C>
   Sales to related parties....................... $387,000 $3,531,000 $     --
   Purchases from related parties.................   19,000    620,000  725,000
</TABLE>
 
  As of December 31, 1997 and 1998, noncombined affiliates were indebted to
the Company in the amounts of $3,000 and $2.1 million respectively. Total
interest paid by noncombined affiliates and the Chairman and President was
$71,000 and $195,000 for the years ended December 31, 1997 and 1998,
respectively.
 
  The Company has, from time to time, advanced funds to officers including the
Chairman and President and to corporations owned by the Chairman and
President. The maximum outstanding amounts of such loans during 1997 and 1998
were $1.6 million and $4.0 million, respectively. Loans made to these persons
in 1997 and 1998 bore interest at the rate of 7% per annum.
 
  In each of 1997 and 1998, the Company advanced an aggregate of $2.0 million
to a corporation controlled by parties related to one of the Original
Shareholders. Such advances were repaid within 90 days.
 
                                     F-17
<PAGE>
 
                             TARRANT APPAREL GROUP
 
            NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued)
 
 
  Under lease agreements entered into between the Company and two entities
owned by the Chairman and President, the Company paid $1,241,000 in 1997 and
$1,269,000 in 1998, for rent for office and warehouse facilities.
 
  In 1998, a California limited liability company owned by the Chairman and
President of the Company purchased 2,300,000 shares of the Common Stock of
Tag-It Pacific, Inc. ("Tag-It") (or approximately 37% of such Common Stock
then outstanding). Tag-It is a provider of brand identity programs to
manufacturers and retailers of apparel and accessories. On December 1, 1998,
Tag-It assumed the responsibility for managing and sourcing all trim and
packaging used in connection with products manufactured by or on behalf of the
Company in Mexico. The Company transferred $3.0 million of trim inventory to
Tag-It in December 1998. This arrangement is terminable by either the Company
or Tag-It at any time. The Company believes that the terms of this
arrangement, which is subject to the acceptance of the Company's customers,
are no less favorable to the Company than could be obtained from unaffiliated
third parties.
 
13. Operations by Geographic Areas
 
  The Company operates primarily in one industry segment, the design,
manufacturing and importation of private label, moderately-priced, casual
apparel. Information about the Company's operations in the United States and
Asia is presented below. Intercompany revenues and assets have been eliminated
to arrive at the consolidated amounts.
<TABLE>
<CAPTION>
                                                      Adjustments
                                                          and
                          United States     Asia     Eliminations      Total
                          ------------- ------------ -------------  ------------
<S>                       <C>           <C>          <C>            <C>
1996
Sales.................... $226,920,000  $  2,941,000 $          --  $229,861,000
Intercompany sales.......           --   140,167,000  (140,167,000)           --
                          ------------  ------------ -------------  ------------
Total revenue............ $226,920,000  $143,108,000 $(140,167,000) $229,861,000
                          ============  ============ =============  ============
Income from operations... $  9,479,000  $  6,980,000 $          --  $ 16,459,000
                          ============  ============ =============  ============
Total assets............. $ 51,150,000  $ 41,675,000 $ (29,405,000) $ 63,420,000
                          ============  ============ =============  ============
1997
Sales.................... $252,136,000  $  7,956,000 $          --  $260,092,000
Intercompany sales.......           --   148,613,000  (148,613,000)           --
                          ------------  ------------ -------------  ------------
Total revenue............ $252,136,000  $156,569,000 $(148,613,000) $260,092,000
                          ============  ============ =============  ============
Income from operations... $  8,581,000  $  8,499,000 $          --  $ 17,080,000
                          ============  ============ =============  ============
Total assets............. $ 56,352,000  $ 46,656,000 $ (31,147,000) $ 71,861,000
                          ============  ============ =============  ============
1998
Sales.................... $345,685,000  $ 32,471,000 $          --  $378,156,000
Intercompany sales.......   11,289,000   151,957,000  (163,246,000)           --
                          ------------  ------------ -------------  ------------
Total revenue............ $356,974,000  $184,428,000 $(163,246,000) $378,156,000
                          ============  ============ =============  ============
Income from operations... $ 24,751,000  $ 13,820,000 $          --  $ 38,571,000
                          ============  ============ =============  ============
Total assets............. $143,211,000  $ 78,431,000 $ (67,751,000) $153,891,000
                          ============  ============ =============  ============
</TABLE>
 
  The Company commenced sourcing operations in Mexico in 1997. Sales of such
operations were approximately $104 million and $19 million in 1998 and 1997,
respectively, and total assets at December 31, 1998 and 1997 were $1.1 million
and $0, respectively.
 
                                     F-18
<PAGE>
 
                             TARRANT APPAREL GROUP
 
            NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued)
 
 
14. Employee Benefit Plans
 
  On August 1, 1992, Tarrant HK established a defined contribution retirement
plan covering all of its Hong Kong employees whose period of service exceeds
12 months. Plan assets are monitored by a third-party investment manager and
are segregated from those of Tarrant HK. Participants may contribute up to 5%
of their salary to the plan. Annual matching contributions are made by the
Company. Costs of the plan charged to operations for 1996, 1997 and 1998
amounted to approximately $46,000, $59,000 and $84,000, respectively.
 
  On July 1, 1994, the Parent Company established a defined contribution
retirement plan covering all of its U.S. employees whose period of service
exceeds 12 months. Plan assets are monitored by a third-party investment
manager and are segregated from those of the Parent Company. Participants may
contribute from 1% to 15% of their pre-tax compensation up to effective
limitations specified by the Internal Revenue Service. The Company's
contributions to the plan are based on a 50% (100% effective July 1, 1995)
matching of participants' contributions, not to exceed 6% (5% effective July
1, 1995) of the participants' annual compensation. In addition, the Company
may also make a discretionary annual contribution to the plan. Costs of the
plan charged to operations for 1996, 1997 and 1998 amounted to approximately
$121,000, $143,000 and $166,000, respectively.
 
  On December 27, 1995, the Company established a deferred compensation plan
for executive officers. Participants may contribute a specific portion of
their salary to such plan. The Company does not contribute to the Plan.
 
  On December 20, 1996, the Compensation Committee of the Company's Board of
Directors established the Incentive Compensation Plan, which provides for both
discretionary bonuses and bonus amounts upon achieving certain earnings
thresholds for certain members of management. The adoption of this plan
received shareholder approval at the 1997 annual meeting.
 
15. LDA Option
 
  On October 22, 1998, Limited Direct Associates LP, an entity 100% owned by
The Limited ("LDA"), acquired 1,000,000 shares of the Company's Common Stock
(or approximately 7.2% of the Common Stock outstanding as of March 1, 1999).
The shares were acquired through the exercise of an option granted by Mr. Guez
and Mr. Kay to LDA at the time of the Company's initial public offering. The
option granted LDA the right to purchase 10% of the total shares of Common
Stock outstanding at the time of the initial public offering, or 1,299,998
shares, at a price of $3.60 per share (as adjusted for a two-for-one stock
split effective May 8, 1998). The transaction was done on a cashless basis,
whereby Mr. Guez and Mr. Kay transferred ownership of 1,000,000 shares to LDA
and, in lieu of receiving cash, Mr. Guez and Mr. Kay retained ownership of the
remaining 299,998 shares. The 1,000,000 shares are subject to a lockup
provision, which prohibits LDA from selling the shares until October 9, 1999.
Messrs. Guez and Kay will continue to have the right to vote the shares for
one year following the exercise of the option, and will also have a right of
first refusal to purchase such shares, subject to certain exceptions.
 
16. Subsequent Events--Acquisitions (unaudited)
 
  On February 22, 1999, the Company agreed to purchase certain assets of a
denim mill located in Puebla, Mexico with an annual capacity of 18 million
meters. The purchase price will consist of $22 million in cash payable on May
6, 1999 and two million shares (the "Shares") of the Company's Common Stock.
The Shares will be distributed to the sellers in three equal installments on
the first three anniversary dates of the closing date; provided, however, that
any distribution (i) shall be offset by any claims of the Company against the
sellers under the asset purchase agreement and (ii) will be proportionally
reduced in the event the assets fail to produce at least 15 million yards of
marketable denim in the fiscal year immediately preceding the dates of such
distribution of Shares. In addition, the Company has granted the holders of
the Shares certain registration rights and the right to vote the Shares.
Closing is anticipated to occur on April 1, 1999.
 
                                     F-19
<PAGE>
 
                             TARRANT APPAREL GROUP
 
            NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued)
 
 
  On December 2, 1998, the Company contracted with an affiliate of the seller
of the denim mill described above for the construction of a turn-key facility
near Puebla, Mexico for the production of twill fabric which will also house
ancillary facilities. The cost of this facility will be the sum of (i) the
cost of construction and equipment installed, which cost will not include
operating expenses, estimated to be approximately $47 million, and (ii) a
promissory note of the Company (the "Note") in the principal amount of $28
million.
 
17. Quarterly Results of Operations (Unaudited)
 
  The following is a summary of the quarterly results of operations for the
years ended December 31, 1996, 1997 and 1998:
 
<TABLE>
<CAPTION>
                                       Quarter Ended
                         ------------------------------------------ Year Ended
                         March 31 June 30  September 30 December 31 December 31
                         -------- -------- ------------ ----------- -----------
                                 (In thousands, except per share data)
<S>                      <C>      <C>      <C>          <C>         <C>
1996
Net sales............... $42,093  $ 68,870   $ 50,008     $68,890    $229,861
Gross profit............   7,067    11,267      8,237      11,002      37,573
Operating income........   2,360     5,504      3,739       4,856      16,459
Net income.............. $ 1,490  $  3,558   $  2,209     $ 2,745    $ 10,002
Net income per common
 share:
  Basic................. $   .11  $    .27   $    .17     $   .21    $   0.77
  Diluted............... $   .11  $    .27   $    .17     $   .21    $   0.76
Weighted average shares
 outstanding:
  Basic.................  13,000    13,000     13,000      13,064      13,016
  Diluted...............  13,000    13,030     13,026      13,326      13,096
 
1997
Net sales............... $53,605  $ 73,879   $ 69,218     $63,391    $260,093
Gross profit............   8,782    11,068      9,690       9,557      39,097
Operating income........   3,393     5,091      4,063       4,533      17,080
Net income.............. $ 2,022  $  3,265   $  2,711     $ 2,789    $ 10,787
Net income per common
 share:
  Basic................. $   .15  $    .25   $    .21     $   .21    $    .82
  Diluted............... $   .15  $    .24   $    .20     $   .21    $    .80
Weighted average shares
 outstanding:
  Basic.................  13,110    13,178     13,202      13,210      13,176
  Diluted...............  13,544    13,592     13,612      13,520      13,568
 
1998
Net sales............... $64,257  $100,100   $114,948     $98,850    $378,155
Gross profit............  10,947    20,265     19,690      20,176      71,078
Operating income........   4,558    11,674     11,374      10,965      38,571
Net income.............. $ 2,780  $  7,223   $  7,094     $ 7,569    $ 24,666
Net income per common
 share:
  Basic................. $   .21  $    .54   $    .52     $   .55    $   1.82
  Diluted............... $   .20  $    .51   $    .49     $   .50    $   1.71
Weighted average shares
 outstanding:
  Basic.................  13,281    13,432     13,592      13,773      13,520
  Diluted...............  13,756    14,254     14,454      15,204      14,417
</TABLE>
 
                                     F-20
<PAGE>
 
                                                                     SCHEDULE II
 
                             TARRANT APPAREL GROUP
 
                       VALUATION AND QUALIFYING ACCOUNTS
 
<TABLE>
<CAPTION>
                                      Additions
                          Balance at  Charged to    Additions
                         Beginning of Costs and     Charged to              Balance at
                             Year      Expenses   Other Accounts Deductions End of Year
                         ------------ ----------  -------------- ---------- -----------
<S>                      <C>          <C>         <C>            <C>        <C>
For the year ended
 December 31, 1996
 Allowance for returns
  and discounts.........  $2,347,750  $(432,594)      $ --         $ --     $1,915,156
                          ==========  =========       =====        =====    ==========
For the year ended
 December 31, 1997
 Allowance for returns
  and discounts.........  $1,915,156  $(359,344)      $ --         $ --     $1,555,812
                          ==========  =========       =====        =====    ==========
For the year ended
 December 31, 1998
 Allowance for returns
  and discounts.........  $1,555,812  $ 691,194       $ --         $ --     $2,247,006
                          ==========  =========       =====        =====    ==========
</TABLE>
 
                                      F-21
<PAGE>
 
                                  SIGNATURES
 
  Pursuant to the requirements of Section 13 or 15(d) of the Securities
Exchange Act of 1934, the Company has duly caused this report to be signed on
its behalf by the undersigned, thereunto duly authorized on March 8, 1999.
 
                                          TARRANT APPAREL GROUP
 
                                                     /s/ Gerard Guez
                                          By: _________________________________
                                                        Gerard Guez,
                                                  Chief Executive Officer
 
  Pursuant to the requirements of the Securities Exchange Act of 1934, this
report has been signed below by the following persons on behalf of the Company
and in the capacities and on the dates indicated.
 
<TABLE>
<CAPTION>
             Signature                           Title                    Date
             ---------                           -----                    ----
 
<S>                                  <C>                           <C>
         /s/ Gerard Guez             Chairman, Chief Executive       March 8, 1998
____________________________________  Officer and Director
            Gerard Guez               (Principal Executive
                                      Officer)
 
           /s/ Todd Kay              President and Director          March 8, 1998
____________________________________
              Todd Kay
 
       /s/ Mark B. Kristof           Vice President--Finance,        March 8, 1998
____________________________________  Chief Financial Officer and
          Mark B. Kristof             Director (Principal
                                      Financial and Accounting
                                      Officer)
 
      /s/ Karen S. Wasserman         Executive Vice President,       March 8, 1998
____________________________________  General Merchandising
         Karen S. Wasserman           Manager and Director
 
          /s/ Barry Aved             Director                        March 8, 1998
____________________________________
             Barry Aved
 
       /s/ James R. Miller           Director                        March 8, 1998
____________________________________
          James R. Miller
</TABLE>
 
                                      S-1
<PAGE>
 
                               INDEX TO EXHIBITS
 
<TABLE>
<CAPTION>
 Exhibit
 Number                                Description
 -------                               -----------
 <C>     <S>
 10.23.1 Employment Agreement effective January 1, 1998, between the Company
         and Gerard Guez
 10.24.1 Employment Agreement effective January 1, 1998, between the Company
         and Todd Kay
 10.58.1 Letter Agreement dated October 1, 1997 regarding Accounts Receivable
         Financing Agreement
 10.65   Partnership Interest Purchase Agreement, dated as of July 2, 1998,
         among Rocky Acquisition, LLC, Tarrant Apparel Group, Limited Direct
         Associates, L.P., Rocky Apparel, Inc., and Gabriel Manufacturing
         Company
 10.66   Escrow Agreement made as of July 2, 1998, by and among Tarrant Apparel
         Group, Gabriel Manufacturing Company and Rocky Apparel, Inc.
 10.67   Facility Development Agreement dated as of December 2, 1998, by and
         between Tarrant Mexico, S. de R.L. de C.V. and Tex Transas, S.A. de
         C.V.
 10.68   Agreement for Purchase of Assets dated as of February 22, 1999, by and
         among Tarrant Mexico, S. De R.L. de C.V., Jamil Textil, S.A. de C.V.,
         Inmobiliaria Cuadros, S.A. de C.V., Kamel Nacif and Irma Benavides
         Montes De Oca
 23      Consent of Ernst & Young LLP
 27      Financial Data Summary
</TABLE>