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

                                  FORM 10-KSB

  X       ANNUAL REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES
-----     EXCHANGE ACT OF 1934 (FEE REQUIRED)
          
                    For the fiscal year ended June 30, 1997

                          Commission File No. 0-28604

                        SOUND SOURCE INTERACTIVE, INC.
                (NAME OF SMALL BUSINESS ISSUER IN ITS CHARTER)

            Delaware                                           95-4264046
  (State or other jurisdiction of                           (I.R.S. Employer
   incorporation or organization)                          Identification No.)

  26115 Mureau Road, Suite B
  Calabasas, California                                           91302
  (Address of principal executive offices)                      (Zip Code)

                                (818) 878-0505
                          (Issuer's telephone number
                             including area code)

          SECURITIES REGISTERED PURSUANT TO SECTION 12(g) OF THE ACT:

 Title of each class:                                    Name of each exchange
                                                          on which registered:
Common Stock, par value $.001
Redeemable Warrants                                     NASDAQ SmallCap Market

     Check whether the Issuer (1) filed all reports required to be filed by
Section 12 or 15(d) of the Securities Exchange Act of 1934 during the preceding
12 months (or for such shorter period that the issuer was required to file such
reports), and (2) has been subject to such filing requirements for the past 90
days.
                           [x]       [_]
                           Yes       No

     Check if there is no disclosure of delinquent filers pursuant to Item 405
of Regulation S-B contained herein, and such disclosure will not be contained,
to the best of the Issuer's knowledge, in definitive proxy or information
statements incorporated by reference in Part III of this Form 10-KSB or any
amendment to this Form 10-KSB.
                                      [x]

     The Issuer's revenues for its most recent fiscal year were $4,596,806.

     As of August 31, 1997, the aggregate market value of the shares of the
Issuer's voting stock held by nonaffiliates of the Issuer was approximately
$3,571,217, and the number of outstanding shares of the Issuer's common stock,
par value $.001, was 4,409,099.

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<PAGE>
 
                      DOCUMENTS INCORPORATED BY REFERENCE

     Portions of the Issuer's Proxy Statement to be filed with the Securities
and Exchange Commission within 120 days of the close of its fiscal year ended
June 30,1997 are incorporated by reference into Part III of this Form 10-KSB.

===============================================================================

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<PAGE>
 
                                 PART I

ITEM 1.  DESCRIPTION OF BUSINESS.

THE COMPANY

     Sound Source Interactive, Inc. (the "Company"), which was incorporated on
March 8, 1990, is engaged primarily in developing, publishing and marketing of
interactive computer software. The Company "produces products in two categories;
Children's Entertainment and Adult Entertainment. Children's Entertainment
consists principally of children's edutainment products including Interactive
MovieBooks(TM), Activity Centers and Learning Adventures for children" ages
three to twelve. These products include animation, text, photos, sound clips and
actual film footage of well-recognized family films and television series. Adult
Entertainment consists of two categories: Entertainment Utilities and Games.
Entertainment Utilities incorporate screen savers, sound clips, and other
content, including mini-arcade games, into a desktop diversion. These products
are based on licensed entertainment properties and are marketed as limited
edition serialized collector editions. In July, 1996, the Company created a
"Games" division and currently has under development two games and has purchased
the rights to two other games that are at or near completion.

     The Company's objective is to be a leading publisher of high quality,
competitively priced, consumer-oriented software.  To achieve this objective,
the Company intends to (i) focus primarily on developing products with
educational and entertainment value which are based on popular movies,
television series and comic book characters and are easy to use and install,
(ii) develop a broad line of products, upgrade successful products and develop
product line extensions and complementary products, (iii) leverage studio
relationships to develop cross-marketing promotional programs, (iv) promote
tradename recognition, (v) leverage its licensed content to develop products
intended for the game market, and (vi) pursue strategic alliances and
acquisitions.

     Many of the Company's products are based on licensed content of major
motion pictures and television shows under agreement with major entertainment
studios including Viacom Consumer Products (as agent for Paramount Pictures
Corp.), Twentieth Century Fox Licensing, New Line Cinema, Harvey Entertainment,
Warner Bros. Consumer Products, MCA/Universal Merchandising, Inc., Carolco
Pictures, Inc., DC Comics, MGM/UA Merchandising, Inc. and others.  The Company's
license agreements for existing products include Babe: A Little Pig Goes A Long
Way(TM), The Little Rascals(TM), All Dogs Go to Heaven II(TM), The Land Before
Time(TM), Babylon 5(TM), Hercules(TM) and Xena(TM), The Adventures of Batman and
Robin(TM), Terminator 2(TM): Judgment Day(TM), Free Willy 2(TM), Star Trek(TM),
Star Trek: Deep Space Nine(TM), Star Trek: Voyager(TM), DragonHeart(TM), I Love
Lucy(TM) and other popular titles. The Company also holds licenses for new
products based on Casper A Spirited Beginning(TM), Lost In Space(TM), An
American Tail(TM), The Land Before Time(TM), The Abyss(TM), Free Willy 3(TM) and
The Lost World Jarassic Park(TM). The Company is continuing the negotiation of
additional licenses for its children's products, entertainment utilities and
games. Management believes the Company is capable of continuing to obtain new
licenses for major motion pictures and television shows and developing new, high
quality software products using content from these entertainment properties.

     The Company believes that as of August 31, 1997, its products were in
distribution to approximately 8,000 retail outlets.  Retailers currently selling
one or more of the Company's products include Toys R Us, Office Depot, Office
Max, Staples, Future Shops, Egghead, Tower Records, CompUSA, Best Buy, BJ's,
Computer City, Electronics Boutique, Babbages, Etc., Kmart, Barnes & Noble,
Sam's Club, Spencer Gifts, Dapy Stores and others.

     On June 1, 1996 the Company entered into a Distribution Services Agreement
with Simon & Schuster Interactive Distribution Services ("SSIDS") which expires
on May 31, 1998.  SSIDS is the consumer software distribution unit of Simon &
Schuster, Inc., the publishing operation of Viacom Inc.  Pursuant to this
distribution agreement, SSIDS provides distribution, warehousing and order
fulfillment 

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services for all of the Company's products (subject to certain exceptions)
throughout the United States and Canada. The Company's relationship with SSIDS
is exclusive except as regards the rights to distribute the Company's products
in direct-to-the-customer programs including direct mail, telemarketing and in-
box coupon fulfillment, which are nonexclusive. During the year ended June 30,
1997, net sales to and through SSIDS approximated $2,982,285, or 64.9% of the
Company's total net revenues.

     The Company is located at 26115 Mureau Road, Suite B, Calabasas,
California, 91302.  Its telephone number is (818) 878-0505.  Its facsimile
number is (818) 878-0007.

INDUSTRY BACKGROUND

     In recent years, the installed base of Multimedia PCs in households has
grown as prices have declined and as improvements in computing power and
capability have been achieved.  There are a number of factors driving the
increased demand and use of Multimedia PCs in U.S. and foreign households beyond
the general impact of falling prices and increased performance.  Enabling
technologies and standards, such as graphical user interfaces and the
Microsoft(R) Windows(R) operating system, and the release of the Windows '95(R)
operating system, have made Multimedia PCs easier to use for a broad range of
applications, resulting in the transformation of Multimedia PCs into general-
purpose tools.  In addition, today's Multimedia PCs feature high-speed
microprocessors, large amounts of memory, high-resolution monitors and enhanced
sound, speaker and graphics capabilities.  These advanced capabilities, along
with the introduction of CD-ROM multimedia technology, have allowed software
developers to produce more engaging software with advanced three-dimensional
graphics, realistic sound and full-motion video.  The Company believes CD-ROM
multimedia technology will continue to impact the growth of the consumer
software market as software developers take advantage of the multimedia
capabilities of this more advanced hardware technology.  See Part I, Item 1,
"Description of Business  Risk Factors  Forward-Looking Statements."

     In response to these developments, increasing numbers of consumer software
products are being developed to address a broad range of consumer interests and
everyday tasks.  The Company believes that consumers are more frequently
purchasing software on impulse in the same way that they often buy books, music
compact discs ("CDs") and motion picture videos.  With the increasing
consumerization of the software market, the Company believes that the prices for
consumer software products may fall.  If this occurs, the distribution channels
for consumer software could continue to expand to include book and music stores,
video outlets and supermarkets.

     As the demand for consumer software products increased in the early and mid
1990's, many companies entered into the business believing that their respective
products were better and, would be more widely accepted and purchased by
consumers, and that the demand for consumer products would continue to increase
at dramatic rates.  As many of these software development companies began
introducing products, demand for retail shelf space became increasingly more
difficult to obtain and more expensive.  Given these various factors, and a
shift in consumer purchasing toward licensed content for children's products,
many software development companies encountered severe financial difficulties.
As a result of this, numerous software development companies either
significantly reduced their development and sales activities, were acquired by
other larger software development companies such as Good Times Interactive or
CUC International, or have ceased doing business.  As of the summer of 1997,
there is still a glut of new products being introduced to the retailers by
software development companies and even though demand continues to be
increasing, shelf space is still very difficult to obtain, consolidation
continues as companies attempt to obtain a competitive advantage, and the shift
toward licensed products for children appears to be continuing.

     As consumer software moves into the mass-market channel, the Company
believes it will become increasingly important for consumer software companies
to have direct relationships with 

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<PAGE>
 
retailers to effectively market their products to consumers. The Company
believes that in order to be successful, consumer software companies must have a
consumer-driven focus, a broad offering of category-leading products, close
relationships with retailers, a recognized brand name and a cost-efficient
business model.

     In an effort to incrementally increase the Company's revenues, as well as
create new revenue sources, the Company is active in searching for new ways to
market the Company's products. Included in these non-traditional methods is the
placement of coupons in videos, coupons in complimentary products, "unlockable"
discs, and enhanced upsell programs.

PRODUCTS

     CHILDREN'S ENTERTAINMENT

     The Company has created Interactive StoryBooks that it markets as
MovieBooks(TM) for children as they contain full motion video based on the
licensed property. Interactive MovieBooks(TM) are marketed as reading aids for
young children, generally for ages three through six. The Company has released
ten of its Interactive MovieBooks(TM) on CD-ROM. This product category provides
options for automatic reading by the computer, user reading, a dictionary
invoked by "clicking" on a dictionary book icon, actual full motion video taken
from the motion picture that coincides with the text pages, high-quality sound,
art and animation as well as a quiz consisting of multiple choice questions on a
topic related to the story, reinforcement through a "jigsaw" puzzle which can be
printed, and a "bookmark" so the adventure can be stopped, put away and
restarted at the same point at a later date. The latest versions of these
products have been enhanced to contain educationally oriented games in addition
to the above noted features. Currently, the products are sold at a suggested
retail price of up to $30 each, a price point intended to generate impulse
purchases among consumers at the retail level.

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<PAGE>
 
     The following is a listing of the Company's Interactive MovieBook(TM)
products, which currently exist, or are planned for release, all of which are on
CD-ROM:

<TABLE>
<CAPTION>
            TITLE                    LICENSOR           RELEASE DATE        CURRENT PLATFORM
----------------------------   ------------------   ------------------   ---------------------
<S>                             <C>                  <C>                  <C>
The Secret Garden(TM)           Warner Bros.         August 1994          Windows(R) and
                                                                          Windows '95(R)

Black Beauty(TM)                Warner Bros.         November 1994        Windows(R) and
                                                                          Windows '95(R)

The Little Rascals(TM)          Universal Pictures   June 1995            Windows(R) and
                                                                          Windows '95(R)

Free Willy 2(TM)                Warner Bros.         July 1995            Windows(R) and
                                                                          Windows '95(R)

Babe(TM)                        Universal Pictures   November 1995        Windows(R) and
                                                                          Windows '95(R)

ExoSquad(TM)                    Universal Pictures   November 1995        Windows(R) and
                                                                          Windows '95(R)

The Adventures of               DC Comics            November 1995        Windows(R) and
Batman and Robin(TM)                                                      Windows '95(R)
 
The Land Before Time(TM)        Universal            August 1996          Windows(R) and
                                Pictures                                  Windows '95(R)

All Dogs Go To Heaven II(TM)    MGM                  October 1996         Windows(R) and
                                                                          Windows '95(R)

An American Tail(TM)            Universal Pictures   October 1998         Windows(R) and
                                                                          Windows '95(R)

Lost In Space(TM)               New Line Cinema      March 1998           Windows(R) and
                                                                          Windows '95(R)
</TABLE>

                                       6
<PAGE>
 
     The Company has developed a second line of children's entertainment
products, which it refers to as activity centers and/or learning adventures.
This product line contains activities that teach young children logic, language
skills, arithmetic and reading comprehension, along with developmental
challenges such as multiple choice questions, rhyme and meter basics while
entertaining and captivating the players.  The activity centers are designed for
children ages three through eight, whereas the learning adventures are more
educationally based and are designed for children ages six through twelve.

     The following is a listing of the Company's products of this type, which
currently exist or are planned for release, all of which are on CD-ROM:

<TABLE>
<CAPTION>
            TITLE                    LICENSOR           RELEASE DATE        CURRENT PLATFORM
----------------------------   ------------------   ------------------   ---------------------
<S>                             <C>                  <C>                  <C>
Dragonheart Creativity         Universal Pictures   June 1996            Macintosh(R),
Center(TM)                                                               Windows(R) and
                                                                         Windows '95(R)
 
The Land Before Time           Universal Pictures   March 1997           Macintosh(R),
Activity Center(TM)                                                      Windows(R) and
                                                                         Windows '95(R)
 
Hercules and Xena Learning     Universal Pictures   May 1997             Macintosh(R),
Adventure(TM)                                                            Windows(R) and
                                                                         Windows '95(R)
 
Casper(TM) A Spirited          Harvey               September 1997       Macintosh(R),
Beginning Activity Center      Entertainment                             Windows(R) and
                                                                         Windows '95(R)
 
The Land Before Time Math      Universal Pictures   December 1997        Macintosh(R),
Adventure(TM)                                                            Windows(R) and
                                                                         Windows '95(R)
 
Free Willy 3 Activity          Warner Bros.         November 1997        Macintosh(R),
Center(TM)                                                               Windows(R) and
                                                                         Windows '95(R)
 
Lost In Space Learning         New Line Cinema      October 1998         Macintosh(R),
Adventure(TM)                                                            Windows(R) and
                                                                         Windows '95(R)
 
The Land Before Time           Universal Pictures   June 1998            Macintosh(R),
Kindergarten Adventure(TM)                                               Windows(R) and
                                                                         Windows '95(R)
 
</TABLE>

  ADULT ENTERTAINMENT

     The Company's entertainment computer software utilities, which it refers to
as Limited Edition Entertainment Utilities(TM), incorporate screen savers, sound
clips and other content, including mini arcade games, into a desktop diversion.
The entertainment utilities are based on licensed entertainment properties and
are marketed as limited edition, serialized collector editions.  The Company
currently plans to release two to four limited edition entertainment utilities
for the next several years, depending on availability of quality licenses.  The
Company currently sells or plans to sell the following limited edition
entertainment utilities:

<TABLE>
<CAPTION>
            TITLE                    LICENSOR           RELEASE DATE        CURRENT PLATFORM
----------------------------   ------------------   ------------------   ---------------------
<S>                             <C>                  <C>                  <C>
Babylon 5(TM)                   Warner Bros.         November 1995        Windows(R) and 
                                                                          Windows '95(R)

Terminator 2;                   Carolco Pictures     July 1996            Windows(R) and 
 Judgment Day(TM)                                                         Windows '95(R)
</TABLE> 

                                       7
<PAGE>
 
<TABLE> 
<CAPTION> 
            TITLE                    LICENSOR           RELEASE DATE        CURRENT PLATFORM
----------------------------   ------------------   ------------------   ---------------------
<S>                            <C>                  <C>                  <C>
Star Trek:  Deep Space         Paramount/           August 1996          Windows(R) and 
 Nine(TM)                       Viacom                                   Windows '95(R)
 
Star Trek:  Voyager(TM)        Paramount/           November 1996        Windows(R) and 
                                Viacom                                   Windows '95(R)
 
I Love Lucy(TM)                CBS                  November 1996        Windows(R) and 
                                                                         Windows '95(R)

Babylon 5 Volume II -          Warner Bros.         May 1997             Windows(R) and 
 Shadow Wars(TM)                                                         Windows '95(R)

The Lost World                 Universal Pictures   October 1997         Windows(R) and 
 Jurassic Park(TM)                                                       Windows '95(R)

Lost In Space(TM)              New Line Cinema      March 1998           Windows(R) and
                                                                         Windows '95(R)

Star Trek: Voyager Vol II(TM)  Paramount/           July 1998            Windows(R) and 
                                Viacom                                   Windows '95(R)
</TABLE>

     During July, 1996, the Company created a Game division and began
development of a PC game sequel to the 1989 theatrical release The Abyss(TM),
under a license from Twentieth Century Fox Licensing and Merchandising. In order
to develop the game, the Company acquired a three-dimensional ray casting "game
engine" and purchased four Windows NT(R) workstations equipped with SoftImage(R)
three-dimensional rendering software. Additionally, the Company began internal
development of an additional game, acquired the rights to one completed game
developed by Intracorp Entertainment and acquired the rights to a game then
under development by Rhode Island Soft Systems. The Company plans to sell the
following games:

<TABLE>
<CAPTION>
            TITLE                    LICENSOR           RELEASE DATE        CURRENT PLATFORM
----------------------------   ------------------   ------------------   ---------------------
<S>                            <C>                  <C>                  <C>
Final Conflict(TM)             Rhode Island         October 1997         Windows(R) and
                               Soft Systems                              Windows '95(R)
 
Harpoon II Collection(TM)      Intracorp            January 1998         Windows(R) and 
                               Entertainment                             Windows '95(R)

Star Trek: The Game            Paramount/           October 1997         Macintosh(R),
 Show(TM)                      Viacom                                    Windows(R) and
                                                                         Windows '95(R)

The Abyss:  Incident at        Twentieth Century    March 1998           Windows '95(R)
 Europa(TM)                    Fox Licensing
</TABLE>

PRODUCT DISTRIBUTION

     NORTH AMERICAN RETAIL

     On June 1, 1996 the Company entered into a Distribution Services Agreement
with Simon & Schuster Interactive Distribution Services ("SSIDS", as previously
defined) which expires on May 31, 1998.  SSIDS is the consumer software
distribution unit of Simon & Schuster, Inc., the publishing operation of Viacom
Inc.  Pursuant to this distribution agreement, SSIDS provides distribution,
warehousing and order fulfillment services for all of the Company's products
throughout the United States and Canada.  The Company's relationship with SSIDS
is exclusive except with regard to the rights to distribute the Company's
products in direct-to-the-customer programs including direct mail, telemarketing
and in-box coupon fulfillment, which are nonexclusive.  SSIDS will make a
monthly payment to the Company in an amount equal to its "gross revenues" during
such month from the Company's products, less a distribution fee and reserve for
returns equal to stated percentages of the gross revenues and less certain other
items, including out-of-pocket costs associated with inventory 

                                       8
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maintenance and order fulfillment. "Gross revenues" are defined as amounts
actually billed by SSIDS to its customers for Company products sold by it. The
payments by SSIDS are due not later than 75 days after each calendar month end.
Under the SSIDS distribution agreement, SSIDS will be responsible for collection
of accounts, whereas the Company is responsible for product returns. The Company
maintains a reserve for product returns based upon its prior experience and
current market conditions against which credits for actual returns are applied.
Such reserve is netted against revenues as reported by SSIDS. See Part I, Item
1, "Description of Business--Risk Factors--Product Distribution" and ,
"Description of Business--Risk Factors--Product Returns."

     INTERNATIONAL RETAIL

     The Company utilizes several international distributors to actively promote
and sell the Company's non-localized products throughout most of the English
speaking countries and non-English speaking countries, including France,
Germany, Spain and Brazil.  Additionally, the Company has entered into a
republishing agreement with IONA Software, Ltd. of Dublin, Ireland to translate
certain of the Company's products into as many as fourteen different languages
for sale in up to 35 countries.  Under the terms of this agreement, the Company
is paid a republishing fee on each product sold.  All costs of localization of
the product, product boxes and collateral materials, as well as all costs or
replication, marketing, warehousing and fulfillment, are borne by IONA.  The
success of this localization will be dependent upon the international appeal of
certain of the Company's products, the ability of IONA to successfully localize
the products and the ability of the Company to continue to obtain licenses with
worldwide appeal.

SALES AND MARKETING

     By offering a wide variety of products, the Company can provide retailers
with an assortment of titles in categories of interest to consumers. The Company
also supports its retailers by setting up special displays, end caps and kiosks,
executing targeted promotions and analyzing sales trends to help build
incremental sales. The Company is currently developing a variety of cross-
marketing promotional programs with its movie studio licensors and other
licensees of movie titles. These promotional programs may include discount
coupons for products in videocassettes, movie trailers in the Company's software
products, and promotional contests with various motion picture studios. The
Company believes that a significant amount of revenues during the upcoming
fiscal year could be generated through the Company's involvement in cross-
promotional efforts with other studio licensees and direct mail programs.

     Drawing upon established consumer marketing techniques, the Company's
marketing department creates and executes high-impact merchandising programs
with the goal of maximizing each product's retail exposure. The Company believes
that its consumer-driven marketing, the high perceived value and competitive
price points of its products, and easily identifiable packaging which emphasizes
high-impact design and concise, nontechnical product information, lead to higher
visibility and impulse purchases of its products in retail stores.

     The Company provides technical support by telephone.  The Company has
installed a telephone system and a call-handling center to facilitate its
response to customer inquiries.  Customer feedback is shared among other support
representatives and made available to product managers for development of
product enhancements and upgrades.

     Under the SSIDS distribution agreement, the SSIDS sales force, with
direction and assistance from the Company, services the Company's direct retail
accounts. The Company works closely with SSIDS to assure that wholesale and
retail accounts are adequately serviced, that inventory levels are adequate and
that merchandising programs are properly executed. See "Product Distribution."

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<PAGE>
 
DEVELOPMENT

     The Company seeks to develop a broad line of products in sustainable market
categories in which a significant market share can be obtained.  The Company
depends on a flow of creative ideas to develop high-quality, value-priced
products.  The Company believes that its efficient development model has certain
key advantages including consistent product quality, reliable delivery
schedules, cost containment and controlled capital investment risk.

     The Company's product managers oversee the development of various products
from conception through completion, and control the content, design, scope and
development schedule.  New product ideas are evaluated with each studio partner
based upon upcoming theatrical releases, detailed market research on the subject
matter, the type and demographics of the target consumer, and the existence and
characteristics of competitive products.  The Company seeks to design new
products, which incorporate all of the important functions and features of the
leading competitive products.  Once a product is approved for development, a
detailed design specification is created that includes the product's features
and a user interface that is consistent with other Company products.  Whenever
possible, the software is designed to incorporate technology used in existing
Company products in an effort to shorten the development cycle and improve
quality and consistency.  The overall product, including documentation, is
designed to meet a manufacturing specification that will meet the Company's
margin requirements at consumer price points.

     The product managers then execute the development project with a team that
includes programmers, sound engineers, artists, animators, designers, writers
and testers.  The Company's internal development efforts are focused primarily
on product design and features, consistent user interfaces and product quality
consistency. The Company supplements its internal product development resources
by utilizing existing technologies and externally developed programming when
such utilization can result in a more efficient method of creating a higher
quality product.  Using this method, the Company maintains internal control over
the creative and market-driven aspects of product development while using
external resources to shorten development time and lower development risks.
Development costs associated with externally licensed technology are generally
partially paid by royalties based on net sales, which lowers the Company's
investment risk.  The Company's agreements with its external developers
typically grant the Company an exclusive worldwide license to use the
developers' software.  The agreements typically have three-year terms, with
renewal provisions upon mutual agreement of the parties.  The Company has
recently decided to continue to develop some of its products in-house.

     Products under development are extensively tested by the quality assurance
department, and must be approved by the licensor before being released for
production.  The department tests for bugs, functionality, ease-of-use and
compatibility with the many popular Multimedia PC configurations that are
available to consumers.  Product managers are also responsible for reviewing
customer feedback, competitive products, product performance and market
positioning in order to introduce upgrades that keep abreast of consumer tastes
and trends.

     In order to supplement the Company's internal development activities, the
Company has begun to acquire products developed by unrelated third parties.
Through August 31, 1997, the Company has acquired three games from two outside
companies.  The Company anticipates that as opportunities to acquire products
become available, the Company will evaluate its current and future product mix
to determine if the acquisition of an additional title will provide a benefit to
the Company.  Under the terms of the current agreements, the Company generally
provides either funds to complete development of the product or an advance
against future royalties.  In either case, such advances are recouped by the
Company against royalties owed to the developer upon sales of the completed
products.

  The Company currently is the licensee under technology licenses with Apple
Computer, Inc., Qsound Labs, Inc., Rock Ridge Enterprises, EchoMedia, Inc. and
Rhode Island Soft Systems, Inc.  The Company utilizes technology provided by
these licensors to develop and operate several of its products.  With the

                                       10
<PAGE>
 
exception of the Apple Computer license, there are alternative products for each
of the technologies now licensed by the Company.  Therefore, the Company
believes that it could readily obtain licenses to comparable products from other
sources at comparable costs.

OPERATIONS

     The Company controls all purchasing, inventory, scheduling, order
processing and accounting functions related to its operations, with all
production and warehousing performed by independent contractors in accordance
with the Company's specifications. The Company intends to continue to invest in
additional management information systems and other capital equipment, which it
believes to be necessary to achieve operational efficiencies and support
increasing sales volumes.

     The Company prepares master software disks, user manuals and packaging
designs.  Disk and CD-ROM duplication, printing of documentation and packaging,
as well as the assembly of purchased components and the shipment of finished
products, are performed by third parties in accordance with the Company's
specifications.  The Company has multiple sources for all components, with
assembly and shipping currently performed by several independent fulfillment
houses.  To date, the Company has not experienced any material difficulties or
delays in the production and assembly of its products.

COMPETITION

     The market for the Company's consumer software products is intensely and
increasingly competitive.  The Company's competitors range from small companies
with limited resources to large companies with substantially greater financial,
technical and marketing resources than those of the Company.  Existing consumer
software companies may broaden their product lines to compete with the Company's
licensed products, and potential new competitors, including computer hardware
and software manufacturers, diversified media companies and toy companies, may
enter or increase their focus on the consumer software market, resulting in
greater competition for the Company.  See Part I, Item 1, "Description of
Business--Risk Factors--Competition."

     Only a small percentage of products introduced in the consumer software
market achieve any degree of or have sustained market acceptance. Principal
competitive factors in marketing consumer software include product features,
quality, reliability, trade name and licensed title recognition, ease-of-use,
merchandising, access to distribution channels and retail shelf space,
marketing, price and the availability and quality of support services. The
Company believes that it continues to compete effectively in these areas,
particularly in the areas of quality, brand recognition, ease-of-use,
merchandising, access to distribution channels and retail shelf space and price.

     The Company considers Microsoft Corp., Broderbund, Inc., Knowledge
Adventure, Disney, Davidson + Associates, Virgin Interactive and GT Interactive
Software Corp. its chief competitors in the interactive entertainment CD-ROM
market.

     The Company has entered into license agreements with Viacom Consumer
Products (as agent for Paramount Pictures Corp.), Warner Bros. Consumer
Products, New Line Cinema, Twentieth Century Fox, Harvey Entertainment,
MCA/Universal Merchandising, Inc., Carolco Pictures, Inc., DC Comics, MGM/UA
Merchandising, Inc. and others. Several of the major motion picture studios now
have captive interactive software divisions. As these types of software become
better known in the marketplace, these profit centers may begin to vie for their
studio's product. Management believes that Disney, MGM/UA, Lucasfilm Ltd., Fox
and Paramount/Viacom are currently the most active studios in publishing their
own product to create software packages

                                       11
<PAGE>
 
PROPRIETARY RIGHTS AND LICENSES

     The Company regards its software as proprietary and relies primarily on a
combination of trademark, copyright and trade secret laws, employee and third
party nondisclosure agreements and other methods to protect its proprietary
rights.  All of the Company's recent products are CD-ROM based, and hence are
difficult to copy.  During the fiscal years ended June 30, 1997, 1996 and 1995,
the Company was unaware of any of its products' unauthorized copying.

     The Company's products are based upon licensed content of major motion
pictures and television shows under license and/or development agreements with
major entertainment studios.  All of such license and development agreements to
which the Company currently is a party are for fixed terms, which will expire
over the next five years.  The Company anticipates that the licensor under each
agreement will extend its terms, although no licensor is required to extend any
license.  Provided that the Company is in compliance with all requirements of
each license, including most significantly that the Company has satisfied the
applicable minimum royalty guarantees, the Licensor can not prematurely cancel a
license.

EMPLOYEES

     As of August 31, 1997, the Company had 32 full-time employees, including
six employees in sales and marketing, 19 employees in development and customer
support, five employees in administration and finance and two employees in
licensing. None of the Company's employees are represented by a labor union or
are subject to a collective bargaining agreement. From time to time the Company
will engage consultants and independent contractors of which there were two as
of August 31, 1997.

RISK FACTORS

     EMPLOYMENT OF VINCENT J. BITETTI - Vincent J. Bitetti, Chairman of the
Board and Chief Executive Officer of the Company is employed under an employment
agreement which expires on September 15, 1998. The Company's success depends to
a significant extent on the performance and continued service of its senior
management and certain key employees. In particular, the loss of the services of
Vincent Bitetti could have a material adverse effect on the Company. In addition
to his duties as Chairman of the Board and Chief Executive Officer, Mr. Bitetti
is the executive producer for all Company products, he conceptualizes, reviews
and "green lights" all title development, and has led the negotiations for all
studio license and promotional/partnership agreements.

     PRODUCT DISTRIBUTION - On June 1, 1996 the Company entered into a
Distribution Services Agreement with Simon & Schuster Interactive Distribution
Services ("SSIDS" as previously defined) which expires on May 31, 1998.  SSIDS
is the consumer software distribution unit of Simon & Schuster, Inc., the
publishing operation of Viacom Inc.  Pursuant to this distribution agreement,
SSIDS provides distribution, warehousing and order fulfillment services for all
of the Company's products (subject to certain exceptions) throughout the United
States and Canada.  The Company's relationship with SSIDS is exclusive except
with regard to the rights to distribute the Company's products in direct-to-the-
customer programs including direct mail, telemarketing and in-box coupon
fulfillment, which are nonexclusive.  The Distribution Services Agreement is for
a term of two years.  The Company is substantially dependent upon SSIDS for the
distribution of its products throughout the United States and Canada during the
term of the agreement.  SSIDS, however, is not obligated to sell any specified
minimum quantity of the Company's products.  There can be no assurance as to the
volume of product sales that may be achieved by SSIDS.  Because the Company's
rights to market it products through channels other than SSIDS are limited, the
Company's ability to realize the cash flow necessary to fund its ongoing
operations and to achieve profitability will be largely dependent upon the
success of SSIDS in marketing its products.  Additionally, as the agreement
expires on May 31, 1998, and SSIDS is not obligated to renew the agreement,
there is no assurance that subsequent to May 31, 1998, the Company will have a
distributor in place to distribute the Company's products to the North American
retail channel.

                                       12
<PAGE>
 
     PRODUCT RETURNS - Under the SSIDS distribution services agreement, SSIDS is
responsible for collection of accounts and the Company is responsible for
product returns.  The Company maintains a reserve for product returns based upon
its prior experience and current market conditions, which approximates 15
percent of gross revenues, against which credits for actual returns are applied.
Such reserve is netted against revenues as reported by SSIDS.  Although the
Company believes that these reserves are adequate, there can be no assurance
that its actual losses due to returns will not exceed the reserved amount.

     COMPETITION - The market for the Company's consumer software products is
intensely and increasingly competitive.  Existing consumer software companies
may broaden their product lines to compete with the Company's products, and
potential new competitors may enter or increase their focus on the consumer
software market, resulting in even greater competition for the Company.  Many of
the companies with which the Company currently competes, including Microsoft
Corp., Broderbund, Inc., Knowledge Adventure, Disney, Davidson + Associates,
Virgin Interactive, and GT Interactive Software Corp., have greater financial,
technical, marketing, sales and customer support resources, as well as greater
name recognition and better access to consumers, than the Company.  To the
extent that competitors achieve performance, price or other selling advantages,
the Company could be materially adversely affected.  There can be no assurance
that the Company will have the resources required to respond effectively to
market or technological changes or to compete successfully in the future.  In
addition, increasing competition in the consumer software market may cause
prices to fall, which may materially adversely affect the Company's business,
operating results and financial condition.

     CONTROL OF THE COMPANY BY OFFICERS AND DIRECTORS AND ASSI, INC. - As of
August 31, 1997, the Company had 4,409,099 outstanding shares of Common Stock.
Vincent Bitetti, who is the Company's largest shareholder, owned of record
1,234,684 shares (28.0 percent) of the outstanding Common Stock; and ASSI, Inc.
owned of record 40,000 shares of Common Stock and presently exercisable ASSI
Warrants to purchase an additional 4,816,657 shares of Common Stock.  Therefore,
ASSI, Inc. beneficially owned 4,856,657 shares of Common Stock, representing
approximately 52.6 percent of the outstanding Common Stock assuming exercise in
full of the ASSI Warrants but no other outstanding warrants and options (31.3
percent assuming exercise in full of all the other outstanding Redeemable
Warrants (as hereinafter defined), but no other outstanding warrants and
options).  Louis Habash of Las Vegas, Nevada, is the ultimate beneficial owner
of all of the Common Stock and ASSI Warrants owned by ASSI, Inc.

     POSSIBLE NEED FOR ADDITIONAL FINANCING - The Company heretofore has been
substantially dependent on the net proceeds of its securities offerings,
including its initial public offering, to fund its working capital requirements.
As of June 30, 1997, the Company has working capital of $851,290 and cash and
cash equivalents of $590,459.  The Company has experienced a significant
increase in growth during the year ended June 30, 1997, as compared to the prior
fiscal year.  The Company incurred a loss from operations of $2,668,520 for the
year ended June 30, 1997.  In order to fund its increased growth, the Company
may require additional financing to fund its growth and to meet all of its
obligations in a timely manner.  Effective September 1997, the Company entered
into a factoring agreement with Silicon Valley Financial Services, a division of
Silicon Valley Bank.  The factoring agreement provides up to $1,500,000 of the
Company's qualified gross domestic accounts receivable, as defined in the
agreement.  The credit is secured by all the assets of the Company and matures
one year from the date of the agreement.  See Part II, Item 6, "Management's
Discussion and Analysis of Financial Condition and Results of Operations
Liquidity."

     QUALIFICATION REQUIREMENTS FOR NASDAQ SECURITIES; RISK OF LOW PRICED
SECURITIES - Effective August 22, 1997 new rules governing the listing of
securities in the Nasdaq SmallCap Market, where the Company's Redeemable
Warrants and Common Stock are both listed, became effective.  Under these rules,
for the Company's securities to continue to be listed, (I) the Company must have
either (A) net tangible assets (defined as total assets, excluding goodwill,
minus total liabilities) of at least 

                                       13
<PAGE>
 
$2,000,000, (B) a market capitalization of at least $35,000,000 or (C) net
income in its latest fiscal year or in two of its last three fiscal years of at
least $500,000, (ii) a public float (defined as shares not held directly or
indirectly by any officer, director or ten percent or greater stockholder of the
Company) of at least 500,000 shares having a market value of at least
$1,000,000, (iii) a minimum bid price of at least $1, (iv) at least two market
makers, and (v) at least 300 stockholders that each own 100 or more shares. If
the bid price for the Common Stock falls below $1 for 30 days, it has 90 days to
come back into compliance (by closing at or above $1 for ten consecutive days)
before being subject to delisting.

     The Company does not know at this time if it will maintain its listing on
Nasdaq SmallCap Market; however, in the event the Company experiences losses
from operations or material adverse trading conditions, the Common Stock and
Redeemable Warrants could be subject to delisting from Nasdaq.  It is
anticipated that if the Common Stock and Redeemable Warrants are delisted from
the Nasdaq SmallCap Market, trading, if any, therein would be conducted in the
over-the-counter market on the NASD OTC Electronic Bulletin Board established
for securities that do not meet the listing requirements or the Company's
securities would be quoted in what are commonly referred to as the "pink
sheets".  In such event, an investor may find it more difficult to dispose of,
or to obtain accurate price quotations and volume information concerning, the
Common Stock and Redeemable Warrants.

     FORWARD-LOOKING STATEMENTS - A number of the matters and subject areas
discussed in the foregoing "Risk Factors" section and elsewhere in this Annual
Report that are not historical or current facts deal with potential future
circumstances and developments.  The discussion of such matters and subject
areas is qualified by the inherent risks and uncertainties surrounding future
expectations generally, and also may materially differ from the Company's actual
future experience involving any one or more of such matters and subject areas.
The Company has attempted to identify, in context, certain of the factors that
it currently believes may cause actual future experience and results to differ
from the Company's current expectations regarding the relevant matter or subject
area.  The operation and results of the Company's business also may be subject
to the effects of other risks and uncertainties in addition to the relevant
qualifying factors identified elsewhere in the foregoing "Risk Factors" section,
including, but not limited to, general economic conditions in the geographic
markets served, changes in technological developments related to the personal
computer software industry, delays in product ship schedules, changes in
consumer preferences regarding entertainment and edutainment software, potential
limitations regarding the acquisition of quality and quantity licenses, and
other risks and uncertainties described from time to time in Company reports
filed with the Commission.

EXECUTIVE OFFICERS

     The executive officers of the Company, their ages and their positions with
the Company as of August 31, 1997, are as follows:

<TABLE>
<CAPTION>
 
Name                       Age                  Position
-------------------------  ---   ---------------------------------------
<S>                        <C>   <C>
                         
Vincent J. Bitetti          42   Chairman of the Board, Chief  Executive
                                 Officer and Director
                         
Ulrich E. Gottschling       39   President, Chief Operating Officer
                                 Chief Financial Officer, Treasurer,
                                 Secretary and Director
</TABLE> 

     Vincent J. Bitetti founded Sound Source Interactive, Inc., a California
corporation (the "Subsidiary"), in 1988 and served as the President of the
Subsidiary from its formation.  Since the Company acquired the Subsidiary in
1994, Mr. Bitetti has served as the Chairman of the Board and Chief Executive
Officer and as a director of the Company and the Subsidiary.  Prior to founding
the Subsidiary, from 1986 to 1988 Mr. Bitetti was President of Fantastic Planet
Consultants, a sound and musical 

                                       14
<PAGE>
 
instrument design consulting company. Mr. Bitetti is a published music composer
and lyricist. From 1986 to 1993, Mr. Bitetti was a consultant to manufacturers
of keyboard synthesizers in the music industry. Mr. Bitetti developed the
concepts for the Company's Interactive MovieBooks(TM), limited edition
entertainment utilities and creativity center products. See Part I, Item 1,
"Description of Business - Risk Factors - Employment of Vincent J. Bitetti."

     Ulrich E. Gottschling was appointed as Chief Financial Officer, Treasurer
and director of the Company on October 9, 1995, as Secretary of the Company on
November 17, 1995, and as President and Chief Operating Officer of the Company
on February 1, 1997.  Prior to joining the Company, Mr. Gottschling was employed
from June 1991 through September 1995 as a certified public accountant with
Corbin & Wertz, who previously was the Company's independent auditors.  From
1987 through May 1991, he was employed as a certified public accountant by
Deloitte & Touche LLP.  From 1980 through 1986, Mr. Gottschling held various
management positions with Westin Hotels and Marriott Corporation.

ITEM 2.  DESCRIPTION OF PROPERTY.

     The Company leases approximately 8,613 square feet of office and
warehousing space in Calabasas, Los Angeles County, California under a lease,
which expires on May 31, 2002.  The Company currently expects that these
facilities will be sufficient for its needs at least through the term of the
lease.  The Company may lease additional space as its needs require, which it
believes will be available on acceptable terms.

ITEM 3.  LEGAL PROCEEDINGS.

     The Company and its officers and directors are, and in the future the
Company and/or its officers and directors may be, involved in suits and actions
incidental to the Company's business.  The Company does not believe that the
resolution of any of the current suits or actions will result in any material
adverse effect on the financial condition or operations of the Company.

     On December 13, 1996, the Company filed suit in Superior Court for the
County of Los Angeles, California, against Acclaim seeking compensatory damages
of at least $2,124,259 and consequential damages of at least $20,000,000 arising
out of Acclaim's alleged breach of its exclusive worldwide distribution
agreement with the Company and other related matters.  This action is scheduled
for trial commencing February, 1998.

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

None

                                 PART II

ITEM 5.  MARKET FOR COMMON EQUITY AND RELATED STOCKHOLDER MATTERS.

     The Company's Common Stock and Redeemable Warrants have been traded on the
NASDAQ SmallCap Market under the symbols "SSII" and "SSIIW," respectively, since
July 2, 1996, and were not traded on any market or exchange prior to that date.
Therefore, no information is available as to the range of sales prices for these
securities for any period prior to July 2, 1996.  The following table sets forth
the range of the bid prices for the Common Stock and Redeemable Warrants during
the periods indicated, and represents interdealer prices, without retail mark-
ups, mark-downs or commissions to the broker-dealer, and may not represent
actual transactions.

                                       15
<PAGE>
 
<TABLE>
<CAPTION>
 
                        Nasdaq
                        Symbol                     High     Low
<S>                                                <C>     <C>
Common Stock             SSII
 
1996
     Third Calendar Quarter                        $6.25   $4.00
     Fourth Calendar Quarter                       $5.75   $4.00
1997
     First Calendar Quarter                        $4.31   $1.38
     Second Calendar Quarter                       $1.62   $0.44
     Third Calendar Quarter (through 9/15/97)      $1.31   $0.75
 
Redeemable Warrants     SSIIW
 
1996
     Third Calendar Quarter                        $2.38   $1.00
     Fourth Calendar Quarter                       $1.88   $1.00
1997
     First Calendar Quarter                        $1.00   $0.31
     Second Calendar Quarter                       $0.56   $0.13
     Third Calendar Quarter (through 9/15/97)      $0.25   $0.13
</TABLE>

     As of August 31, 1997, there were approximately 149 holders of record of
the Common Stock and 36 holders of record of the Redeemable Warrants.  Most such
securities are held in street name by nominees who hold stock certificates for
an unknown number of beneficial owners.

     The Company has never paid cash dividends on its Common Stock.  The Company
currently intends to retain any earnings for use in its operations and does not
anticipate payment of cash dividends in the foreseeable future.


ITEM 6.  MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND
         RESULTS OF OPERATIONS.

OVERVIEW

     The following is a discussion of the consolidated financial condition and
result of operations of the Company for the fiscal years ended June 30, 1997,
1996 and 1995, and certain factors that are expected to affect the Company's
prospective financial condition.  See Part I, Item 1, "Description of Business -
Risk Factors - Forward-Looking Statements."

     The Company derives substantially all of its revenues from sales of its
retail consumer software.  The Company designs, develops, markets and supports a
broad line of consumer software products.  The Company focuses primarily on
nonviolent, family-oriented products with educational and entertainment value,
which are easy to use and install, using popular movies, television series and
comic book characters.

     In June 1995, the Company entered into a Sales and Distribution Agreement
with Acclaim Distribution, Inc., a subsidiary of Acclaim Entertainment, Inc.
(collectively, "Acclaim") a distributor of entertainment software and related
products. During the fiscal year ended June 30, 1996, of the Company's net sales
of $2,264,633 a total of $1,889,750 were generated by Acclaim.  Under the terms
of this agreement, Acclaim was the exclusive distributor of the Company's
products on a worldwide basis, subject to certain limited exceptions.  The
Company was not satisfied with the distribution of its products through Acclaim,
and determined to terminate the Acclaim distribution agreement in March 1996.
The Company and Acclaim terminated the distribution agreement as of April 1,
1996.  The Company had no sales to or through Acclaim during its fiscal years
ended June 30, 1997 and June 30, 1995.  To date, 

                                       16
<PAGE>
 
the Company has received a net payment of $912,134 from Acclaim pursuant to the
distribution agreement. The Company, however, believes that further amounts are
due from Acclaim. On December 13, 1996, the Company filed suit in Superior Court
for the County of Los Angeles, California, against Acclaim seeking compensatory
damages of at least $2,124,259 and consequential damages of at least $20,000,000
arising out of Acclaim's alleged breach of its exclusive worldwide distribution
agreement with the Company and other related matters. See Part I, Item 3, "Legal
Proceedings."

     Effective June 1, 1996 the Company entered into a Distribution Services
Agreement with SSIDS that expires on May 31, 1998.  Pursuant to this new
distribution agreement, SSIDS provides distribution, warehousing and order
fulfillment services for all of the Company's products (subject to certain
exceptions) throughout the United States and Canada.  The Company's relationship
with SSIDS is exclusive except with regard to the rights to distribute the
Company's product in direct-to-the-customer programs including direct mail,
telemarketing and in-box coupon fulfillment, which are nonexclusive.  The
Company had no net sales to or through SSIDS during the years ended June 30,
1996 and 1995.  During the year ended June 30, 1997, the Company had net sales
to or through SSIDS in the amount of $2,982,285, which accounted for
approximately 64.9% of the Company's total net sales.

     Net sales consist of gross sales net of allowances for returns, credit
losses and other adjustments.  The Company adjusts its allowance for returns as
it deems appropriate.  The Company could be forced to accept substantial product
returns or other concessions to maintain its relationships with retailers and
distributors and its access to distributor channels.  The Company is also
exposed to the risk of returns of defective, shelf-worn and damaged products
from retailers and distributors.

     Costs of sales consist primarily of product cost, freight charges,
royalties to outside programmers and content providers, and an inventory
provision for damaged and obsolete products.  Product costs consist of the costs
to purchase the underlying materials and print boxes and manuals, media costs
and fulfillment.

     From the Company's inception through October 24, 1995, the Company sold
synthesizer sound libraries.  In July 1995, the Company's Board of Directors
approved a formal plan to license the proprietary assets related to such
revenues in exchange for royalties.  The Results of Operations discussion and
analysis, which follows, includes only the continuing operations of the Company,
which is primarily comprised of software sales.  The Company sustained losses
from these discontinued synthesizer operations of $143,106 in fiscal 1995,
including an estimated loss of $32,000 during the phase-out period.  No
additional losses from the discontinued operations were recorded during fiscal
1997 and 1996.

RESULTS OF OPERATIONS

     FISCAL YEAR ENDED JUNE 30, 1996 COMPARED TO FISCAL YEAR ENDED JUNE 30, 1997

     Net Sales. Net sales from continuing operations increased by 103.0 percent
from $2,264,633 for the fiscal year ended June 30, 1996 (fiscal 1996) to
$4,596,806 for the fiscal year ended June 30, 1997 (fiscal 1997). Total sales of
the Company's software products increased by 109.3 percent from $2,161,351 in
fiscal 1996 to $4,524,447 in fiscal 1997. Other revenues, principally comprised
of royalties and development fees decreased by 29.9 percent from $103,282 during
fiscal 1996 to $72,359 during fiscal 1997, as a result of the Company not
entering into any new original equipment manufacturing (OEM) agreements during
fiscal 1997. The 109.3 percent increase in product sales is principally due to
the success of two of the Company's products: the Star Wars Limited Edition
Entertainment Utility (the license for which expired on June 30, 1997) and The
Land Before Time Animated MovieBook(TM). The Company has also increased the
number of storefronts carrying the Company's products. New retailers carrying
the Company's products for the first time during fiscal 1997 included Toys R Us,
Dapy Stores, Spencer Gifts, Sam's Club and Office Depot. The Company anticipates
continuing in fiscal 1998 increasing the number of retailers carrying the
Company's products and will also attempt to increase the

                                       17
<PAGE>
 
number and variety of products that each store offers for sale. Additionally,
the Company anticipates that during fiscal 1998, it will begin receiving
revenues from sales of certain of its products that have been localized into
foreign languages and will be sold on an international basis.

     During fiscal 1997, of the Company's net revenues of $4,596,806, a total of
$2,982,285 was generated by SSIDS, $773,905 was generated by One Stop, Ltd., the
Company's distributor in the United Kingdom, and $279,164 was generated by
Electro Source.  These three customers generated none of the Company's sales of
$2,264,633 during fiscal 1996.  During fiscal 1996, net sales of $1,889,750 were
generated by Acclaim.

     Cost of Sales.  Cost of sales increased by 68.4 percent from $1,382,999 for
fiscal 1996 to $2,329,211 for fiscal 1997, representing 61.1 percent and 50.7
percent of net sales, respectively, and 64.0 percent and 51.5 percent of
products sales, respectively.  This increase in cost of sales is attributable to
the above noted 103.0 percent increase in net sales, partially offset by
decreased royalty costs and decreased replication, assembly and freight costs.
Additionally, the Company has been able to increase the average sales price of
its products which has lead to a lower cost of sales percentage.

     Marketing and Sales.  Marketing and sales expenses increased by 37.4
percent from $1,054,602 for fiscal 1996 to $1,449,189 for fiscal 1997, and
decreased as a percentage of net sales from 46.6 percent to 31.5 percent,
respectively.  The increase in expenses was primarily due to increased marketing
activities to promote the Company's products and brand name among retail
purchasers, and increased personnel costs.

     General and Administrative.  General and administrative expenses decreased
by 9.4 percent from $2,193,855 for fiscal 1996 to $1,988,213 for fiscal 1997,
and decreased as a percentage of net sales from 96.9 percent to 43.3 percent,
respectively.  This decrease is primarily attributable to a reduction in bad
debt expense.  During fiscal 1996, the Company recorded a bad debt expense in
the amount of $663,421 related to amounts due to the Company from Acclaim.  This
reduction in general and administrative expenses in fiscal 1997 is partially
offset by costs incurred by the Company related to the Company's initial public
offering, costs associated with being a publicly held company such as insurance,
investor and stockholder relations, costs associated with the separation of the
former president of the Company, and costs associated with the Company's lawsuit
against Acclaim.

     Compensation In Connection With Common Stock and Common Stock Options
Issued For Services Rendered.  A total of $333,029 of the general and
administrative expenses for fiscal 1997 relates to a noncash charge to earnings
in connection with the vesting of stock options granted to employees, determined
as the difference between the fair market value of the date of grant and the
exercise price.  No such charge was incurred during fiscal 1996.

     Development.  Development expenses increased by 69.8 percent from $717,994
for fiscal 1996 to $1,219,456 for fiscal 1997, and decreased as a percentage of
net sales from 31.7 percent to 26.5 percent, respectively.  The increase in
expenses during fiscal 1997 as compared to fiscal 1996, was primarily
attributable to costs related to new product development activities, some of
which will result in products that are not scheduled to be completed and shipped
until fiscal 1998.  The Company believes that development expenses will increase
in dollar amount in the future as the Company continues to expand its
development activities.

     Tax Provision.  The current period income tax provision is comprised of
minimum State of California Franchise Taxes of $1,600.  There is no provision
for Federal income taxes as the Company has losses in fiscal 1997 and 1996,
respectively.

     Other.  Other income (expense) increased from $(1,388,559) for fiscal 1996
to $55,372 for fiscal 1997, and increased as a percentage of net sales from
(61.3) percent to 1.2 percent, respectively.  This decrease is due to expenses
incurred during fiscal 1996 related to debt financing incurred by the 

                                       18
<PAGE>
 
Company, which was repaid during July, 1997. These expenses were primarily
comprised of amortization of deferred loan costs in the amount of $1,035,200 and
interest expense in the amount of $374,175.


     FISCAL YEAR ENDED JUNE 30, 1995 COMPARED TO FISCAL YEAR ENDED JUNE 30, 1996

     Net Revenues.  Net revenues from continuing operations increased by 5.1
percent from $2,154,926 for the fiscal year ended June 30, 1995 (fiscal 1995) to
$2,264,633 for the fiscal year ended June 30, 1996 (fiscal 1996).  In fiscal
1996, the Company determined to concentrate its focus on development of its
educational and entertainment utility interactive CD-ROM software and to reduce
its development work for third parties.  Consequently, total retail sales of the
Company's software products increased by 72.2 percent from $1,255,230 in fiscal
1995 to $2,161,351 in fiscal 1996.  However, the Company had no development
revenues during fiscal 1996 as compared with $343,250 for fiscal 1995.  Revenues
from OEM sales declined from $479,675 for fiscal 1995 to $70,895 for fiscal
1996, reflecting a one-time agreement with Acer that produced significant
revenues in calendar 1994 but not in calendar 1995.  In addition, the Company's
royalty fees declined from $76,771 for fiscal 1995 to $32,387 for fiscal 1996.
The higher royalty revenues for the fiscal year ended June 30, 1995 resulted
primarily from product introductions incorporating content sublicensed by the
Company that were not repeated in the fiscal year ended June 30, 1996.  This
decline in royalty revenues also reflected the Company's current strategy of
focusing on developing all product licenses itself rather than sublicensing them
to third parties.

     During fiscal 1996, of the Company's net sales of $2,264,633 a total of
$1,889,750 were generated by Acclaim.  None of the Company's net sales of
$2,154,926 during fiscal 1995 were generated by Acclaim.  As described above,
the Company terminated its exclusive distribution agreement with Acclaim as of
April 30, 1996 and entered into a new distribution agreement with SSIDS as of
June 1, 1996.

     Cost of Sales.  Cost of Sales increased by 28.9 percent from $1,072,691 for
fiscal 1995 to $1,382,999 for fiscal 1996, representing 49.8 percent and 61.1
percent of net sales, respectively, and 85.5 percent and 64.0 percent of product
sales, respectively.  This decrease is attributable to the above noted 72.2
percent increase in software product sales partially offset by decreased
production costs resulting from the Company's switch from floppy disk to CD-ROM
media for a majority of its products, decreased per unit costs due to larger
quantity purchases, decreased royalty costs, and diminishing inventory
writedowns and writeoffs.

     Marketing and Sales.  Marketing and sales expenses increased by 104.0
percent from $516,886 for fiscal 1995 to $1,054,602 for fiscal 1996, and
increased as a percentage of net sales from 24.0 percent to 46.6 percent,
respectively.  These increases were primarily due to increased marketing
activities to promote the Company's products and brand name among retail
purchasers, and increased personnel costs.

     General and Administrative.  General and administrative expenses increased
by 109.0 percent from $1,049,858 for fiscal 1995 to $2,193,855 for fiscal 1996,
and increased as a percentage of net sales from 48.7 percent to 96.9 percent,
respectively.  The increase is primarily attributable to costs incurred by the
Company during fiscal 1996 related to the Company's initial public offering and
two private placements, increases in executive salaries related to the addition
of a Chief Financial Officer, and bad debt expense in the amount of $663,421
related to amounts due from Acclaim.

     Compensation In Connection With Common Stock and Common Stock Options
Issued for Services Rendered.  A total of $733,165 of the general and
administrative expenses for fiscal 1995 relates to a noncash charge to earnings
in connection with the vesting of stock options granted to 

                                       19
<PAGE>
 
employees, determined as the difference between the fair market value of the
date of grant and the exercise price. No such charge was incurred during fiscal
1996.

     Development.  Development expenses increased by 89.7 percent from $378,471
for fiscal 1995 to $717,994 for fiscal 1996, and increased as a percentage of
net sales from 17.6 percent to 31.7 percent, respectively.  These increases were
primarily attributable to costs related to product upgrades and new product
development activities.  The Company believes that development expenses will
increase in dollar amount in the future as the Company continues to expand its
development activities.

     Tax Provision. The income tax provision for fiscal 1995 and fiscal 1996 is
comprised of minimum State of California Franchise Taxes of $1,600.  There is no
provision for Federal income taxes as the Company has a current year loss and
has a net operating loss carryforward.

     Other.  Other income (expense) increased from $6,691 for fiscal 1995 to
$(1,388,599) for fiscal 1996, and increased as a percentage of net sales from .3
percent to (61.3) percent, respectively.  This increase is primarily comprised
of amortization of deferred loan costs of $1,035,200 and interest expense of
$374,175, both of which relate to private placements of the Company's debt
securities.

     FISCAL YEAR ENDED JUNE 30, 1994 COMPARED TO FISCAL YEAR ENDED JUNE 30, 1995

     Net Sales.  Net sales from continuing operations increased by 28 percent
from $1,685,871 for fiscal 1994 to $2,154,296 for fiscal 1995.  Retail software
sales decreased by 5 percent from $1,313,890 for fiscal 1994 to $1,255,230 for
fiscal 1995 due principally to discounting and pricing declines for the
Company's software products.  Development revenues increased by 205 percent from
$112,520 for fiscal 1994 to $343,250 for fiscal 1995, primarily as a result of
an agreement to develop Interactive MovieBooks(TM) under a contract with a
motion picture studio. OEM sales increased from $5,500 for fiscal 1994 to
$479,675 for fiscal 1995. This increase in OEM sales resulted principally from
sales pursuant to a software bundling agreement with a PC manufacturer. Royalty
fees decreased by 70 percent from $253,961 for fiscal 1994 to $76,771 for fiscal
1995. The decline in royalty revenues reflected the Company's strategy of
focusing on developing all product licenses itself rather than sublicensing them
to third parties.

     The Company has established a reserve for returns that it believes to be
adequate based upon historical return data and its analysis of current customer
inventory levels and sell through rates.

     Cost of Sales.  Costs of sales decreased by 9 percent from $1,180,803 for
fiscal 1994 to $1,072,691 for fiscal 1995, and decreased as a percentage of net
sales from 70 percent to 50 percent, respectively.  This percentage decrease was
principally attributable to the substantially lower costs associated with the
sale of the single "golden master" for certain of the Company's products sold to
a PC manufacturer under an OEM bundling agreement in the first 6 months of 1995,
partially offset by a change in the product mix to higher priced items and a
decrease in OEM sales.

     Marketing and Sales.  Marketing and sales expenses increased by 45 percent
from $356,381 for fiscal 1994 to $516,886 for fiscal 1995, and increased as a
percentage of net sales from 21 percent to 24 percent, respectively.  These
increases were primarily due to increased marketing activities to promote the
Company's products and brand name, and an increase in personnel.

     General and Administrative.  General and administrative expenses creased by
26.7 percent from $828,866 for fiscal 1994 to $1,049,858 for fiscal 1995, and
decreased as a percentage of net sales from 49.2 percent to 48.7 percent,
respectively.  The increase was primarily due increased staffing and associated
overhead expenses necessary to manage and support the Company's growth.

     Compensation In Connection With Common Stock and Common Stock Options
Issued for Services Rendered.  A total of $2,992,862 of the fiscal 1994 general
and administrative expenses and 

                                       20
<PAGE>
 
$733,165 of the fiscal 1995 general and administrative expenses relates to
noncash charges to earnings in connection with the vesting of stock options
granted to employees, determined as the difference between the fair market value
on the date of grant and the exercise price.

     Development.  Development expenses increased by 225 percent from $116,559
for fiscal  1994 to $378,471 for fiscal 1995, and increased as a percentage of
net sales from 7 percent to 18 percent, respectively.  These increases were
primarily attributable to costs relating to product upgrade and new product
development activities.  The Company developed its first four Interactive
MovieBooks(TM) in fiscal 1995.

     Tax Provision.  The income tax provision for fiscal 1994 and fiscal 1995 is
comprised of minimum State of California Franchise Taxes of $1,600.  There is no
provision for Federal income taxes as the Company has a current year loss and
has a net operating loss carryforward.

QUARTERLY RESULTS OF OPERATIONS

     The Company has experienced, and may continue to experience, fluctuations
in operating results due to a variety of factors, including the size and rate of
growth of the consumer software market, market acceptance of the Company's
products and those of its competitors, development and promotional expenses
relating to the introduction of new products or new versions of existing
products, product returns, changes in pricing policies by the Company and its
competitors, the accuracy of retailers' forecasts of consumer demand, the timing
of the receipt of orders from major customers, and account cancellations or
delays in shipment.  The Company's expense levels are based, in part, on its
expectations as to future sales and, as a result, operating results could be
disproportionately affected by a reduction in sales or a failure to meet the
Company's sales expectations.


SEASONALITY

     The consumer software business traditionally has been seasonal.  Typically,
net sales are the highest during the fourth calendar quarter and decline
sequentially in the first and second calendar quarters.  The seasonal pattern is
due primarily to the increased demand for consumer software during the year-end
holiday buying season.  The Company expects its net sales and operating results
to continue to reflect seasonality.  Nevertheless, management believes that in
the future its results may be less subject to seasonal fluctuations because its
products will be marketed in connection with the releases of major motion
pictures and home videos, which occur throughout the year.

LIQUIDITY AND CAPITAL RESOURCES

     Since its formation, the Company has financed its operations and capital
expenditures primarily with cash provided by securities issuances and financing
arrangements.  As of the fiscal year ended June 30, 1997, the Company had
working capital of $851,290 and cash equivalents of $590,459.

     The Company has experienced a significant increase in growth during the
last fiscal year as compared to the prior fiscal year.  The Company continues to
search for new opportunities to obtain licenses, develop and sell products, and
to purchase products that are at or near completion of development.
Additionally, the Company is seeking new and innovative ways to deliver its
products to consumers, some of which may require large up-front cash resources.
If the Company enters into agreements to such business opportunities in the
future, the Company may require additional financing to fund its growth.  See
Part I, Item 1, "Description of Business - Risk Factors - Possible Need for
Additional Financing" and "Description of Business - Risk Factors - Forward-
Looking Statements."

     Pursuant to its initial public offering and the underwriters' exercise of a
portion of their "over-allotment" option during July and August, 1996, the
Company issued 2,560,000 shares of common stock 

                                       21
<PAGE>
 
at $4.00 per share and 1,371,775 redeemable warrants (the "Redeemable Warrants")
at $.25 per warrant. Net proceeds totaled $8,285,784, net of offering costs of
$2,297,408. On July 1, 1996, the Company repaid certain notes payable
aggregating $4,987,500 plus accrued interest of $373,753. On July 7, 1996, the
Company issued 2,016,657 Redeemable Warrants in connection with the conversion
of the note payable to ASSI, Inc., a related party, of $500,000, plus accrued
interest of $4,164.

     The Company invested approximately $90,985 during fiscal 1996 and
approximately $345,395 during fiscal 1997 for capital equipment to expand into
new product lines and to address potential capacity constraints created by the
Company's growing unit sales volumes.  From time to time, the Company evaluates
acquisitions of products, businesses and technologies that are complementary to
the Company's business.

     Effective September 1997, the Company entered into a factoring agreement
with Silicon Valley Financial Service, a division of Silicon Valley Bank.  The
factoring agreement provides up to $1,500,000 of the Company's qualified gross
domestic accounts receivable, as defined in the agreement, at a rate of 1.75%
per month of the average gross daily factoring account balance.  The credit is
secured by all the assets of the Company and matures one year from the date of
the agreement.

     As shown in the Company's consolidated financial statements, the Company
has incurred net losses of $2,668,520, $4,474,976 and $1,734,160 for the years
ended June 30, 1997, 1996 and 1995, respectively.  The Company has not
historically generated sufficient cash flows to fund operations.  The Company
has had to rely on debt and equity financings to fund operations.  The future
success of the Company is largely dependent upon the Company's ability to
generate revenues sufficient to fund operations.

     Management believes that the combination of expected growth and the
aforemented line of credit agreement will provide sufficient cash flows for the
Company to meet its obligations in a timely manner for the next twelve months.
The Company continues to explore new opportunities to obtain licenses, develop
and sell products, and to purchase products that are at or near completion of
development.  Additionally, the Company continues to seek new and innovative
methods to deliver its products to consumers, some of which may require large
up-front cash resources.  If the Company enters into agreements in such business
opportunities in the future, the Company may require additional financings to
fund its growth.

ITEM 7.  FINANCIAL STATEMENTS.

     The information required by Item 7 is filed herewith under the Consolidated
Financial Statements of Sound Source Interactive, Inc. and Subsidiary together
with the report of Deloitte & Touche, LLP dated October 2, 1997 in the financial
information section, included as Appendix A of this report.

ITEM 8.  CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND
         FINANCIAL DISCLOSURE.

     For more than the two most recent fiscal years of the Company, Corbin &
Wertz, An Accountancy Corporation, was engaged as the Company's principal
accountant to audit its consolidated financial statements.  The Company, based
upon the recommendation of the Board of Directors and Audit Committee, has
terminated its relationship with Corbin & Wertz and engaged Deloitte & Touche,
LLP as its independent auditor effective August 22, 1997.

     The independent auditors' reports issued by Corbin & Wertz on the Company's
consolidated financial statements for the years ended June 30, 1996 and 1995 did
not contain an adverse opinion or disclaimer of opinion, and such reports were
not modified for any departure from generally accepted accounting principles or
for any limitation of scope.  The report of Corbin & Wertz for the year ended
June 30, 1995, contained a paragraph regarding an uncertainty about the
Company's ability to continue 

                                       22
<PAGE>
 
as a going concern. The report of Corbin & Wertz for the year ended June 30,
1996, contained an explanatory paragraph emphasizing the Company's financial
dependence on a new distributor relationship and an uncertainty as to the
Company's ability to generate revenues sufficient to fund future operations.
During the prior two fiscal years and the interim period subsequent thereto
preceding the change in independent auditors, the Company had no disagreements
with Corbin & Wertz, on any matter of accounting principles or practices,
financial statement disclosure or auditing scope or procedure.

                                 PART III

     Items 10, 11 and 12 of Part III of this Form 10-KSB are omitted because the
Company intends to file with the Securities and Exchange Commission, within 120
days of the close of its fiscal year ended June 30, 1997, a definitive Proxy
Statement containing information pursuant to Regulation 14A of the Exchange Act,
and that such information shall be deemed incorporated herein by reference from
the date of filing of such document.


ITEM 13.  EXHIBITS LIST AND REPORTS ON FORM 8-K.

     (a)    Exhibits.

     Exh.
     No.     Description of Exhibits
     ------  -----------------------

     3.1     Second Restated Certificate of Incorporation of the Registrant.
             [Filed as Exhibit 3.1 to the Registrant's Registration Statement
             No. 33-80827 ("Registration Statement No. 33-80827") and
             incorporated herein by reference.]

     3.2     Amended and Restated Bylaws of the Registrant. [Filed as Exhibit
             3.2 to Registration Statement No. 33-80827 and incorporated herein
             by reference.]

     4.1     Specimen Common Stock Certificate. [Filed as Exhibit 4.1 to
             Registration Statement No. 33-80827 and incorporated herein by
             reference.]

     4.2     Form of Warrant Agreement between the Registrant and Corporate
             Stock Transfer, Inc., as warrant agent, and form of Redeemable
             Warrant. [Filed as Exhibit 4.2 to Registration Statement No. 33-
             80827 and incorporated herein by reference.]

     4.3     Form of Warrant Agreement between the Registrant and The Boston
             Group, LP and Joseph Stevens and Company, LP and form of
             Underwriters' Warrant. [Filed as Exhibit 4.3 to Registration
             Statement No. 33-80827 and incorporated herein by reference.]

     4.4     Warrant dated April 30, 1996 issued to ASSI, Inc. [Filed as Exhibit
             4.4 to Registration Statement No. 33-80827 and incorporated herein
             by reference.]

     4.5     Form of Underwriting Agreement among the Registrant, Vincent J.
             Bitetti, Eric H. Winston and The Boston Group, LP and Joseph
             Stevens & Co., LP, as underwriters. [Filed as Exhibit 1 to
             Registration Statement No. 33-80827 and incorporated herein by
             reference.]

     9.1     Stockholder Voting Agreement dated as of April 30, 1996, among
             ASSI, Inc., Vincent J. Bitetti and Eric H. Winston. [Filed as
             Exhibit 9.1 to Registration Statement No. 33-80827 and incorporated
             herein by reference.]

     9.2     Irrevocable Proxy of Vincent J. Bitetti to ASSI, Inc., dated April
             30, 1996. [Filed as Exhibit 9.2 to Registration Statement No. 33-
             80827 and incorporated herein by reference.]

     9.3     Irrevocable Proxy of Eric H. Winston to ASSI, Inc., dated April 30,
             1996. [Filed as Exhibit 9.3 to Registration Statement No. 33-80827
             and incorporated herein by reference.]

     9.4     Irrevocable Proxy of ASSI, Inc. to Vincent J. Bitetti, dated April
             30, 1996. [Filed as Exhibit 9.4 to Registration Statement No. 33-
             80827 and incorporated herein by reference.]

                                       23
<PAGE>
 
     9.5     Irrevocable Proxy and Voting Agreement of Martin Meyer to Vincent
             J. Bitetti, dated May 4, 1994. [Filed as Exhibit 9.5 to
             Registration Statement No. 33-80827 and incorporated herein by
             reference.]

     9.6     Irrevocable Proxy and Voting Agreement of Mark Lane to Vincent J.
             Bitetti, dated May 10, 1994. [Filed as Exhibit 9.6 to Registration
             Statement No. 33-80827 and incorporated herein by reference.]

     10.1    Second Amended and Restated Employment Agreement of Vincent J.
             Bitetti dated as of April 30, 1996. [Filed as Exhibit 10.1 to
             Registration Statement No. 33-80827 and incorporated herein by
             reference.]

     10.2    Second Amended and Restated Employment Agreement of Eric H. Winston
             dated as of April 30, 1996. [Filed as Exhibit 10.2 to Registration
             Statement No. 33-80827 and incorporated herein by reference.]

     10.3    Amended and Restated Employment Agreement of Ulrich E. Gottschling
             dated as of February 1, 1997. [Filed as Exhibit 10.3 to the
             Company's Registration Statement on Form SB-2 (No. 333-24271
             ("Registration Statement No. 333-24271") and incorporated herein by
             reference.]

     10.4    Sound Source Interactive, Inc. 1992 Stock Option Plan. [Filed as
             Exhibit 10.4 to Registration Statement No. 33-80827 and
             incorporated herein by reference.]

     10.5    Sound Source Interactive, Inc. and 1995 Stock Option Plan. [Filed
             as Exhibit 10.5 to the Registrant's Annual Report on Form 10-KSB
             for the year ended June 30, 1996, as amended (the "1996 Form 10-
             KSB"), and incorporated herein by reference.]

     10.6    Warrant Agreement, dated as of September 26, 1995, among the
             Registrant, Sound Source Interactive, Inc., a California
             corporation (the "Subsidiary") and Financial West Group, Inc.,
             corporation ("FWG"), as warrant agent. [Filed as Exhibit 10.6 to
             Registration Statement No. 33-80827 and incorporated herein by
             reference.]

     10.7    Warrant Agreement, dated as of June 30, 1995, between the
             Registrant and FWG, as warrant agent. [Filed as Exhibit 10.7 to
             Registration Statement No. 33-80827 and incorporated herein by
             reference.]

     10.8    Sales and Distribution Agreement, dated as of June 15, 1995,
             between the Registrant and Acclaim Distribution, Inc. [Filed as
             Exhibit 10.13 to Registration Statement No. 33-80827 and
             incorporated herein by reference.]

     10.9    Termination Agreement, dated as of March 31, 1996, between the
             Registrant and Acclaim Entertainment, Inc. [Filed as Exhibit 10.9
             to Registration Statement No. 333-24271 and incorporated herein by
             reference.]

     10.10   Indemnification Agreement, dated as of January 1, 1996, between the
             Registrant and Vincent J. Bitetti. [Filed as Exhibit 10.35 to
             Registration Statement No. 33-80827 and incorporated herein by
             reference.]

     10.11   Indemnification Agreement, dated as of January 1, 1996, between the
             Registrant and Eric H. Winston. [Filed as Exhibit 10.36 to
             Registration Statement No. 33-80827 and incorporated herein by
             reference.]

     10.12   Indemnification Agreement, dated as of January 1, 1996, between the
             Registrant and Ulrich Gottschling. [Filed as Exhibit 10.37 to
             Registration Statement No. 33-80827 and incorporated herein by
             reference.]

     10.13   Consulting Agreement, dated as of April 30, 1996, between the
             Company and ASSI, Inc. [Filed as Exhibit 10.45 to Registration
             Statement No. 33-80827 and incorporated herein by reference.]

     10.14   Share Purchase Agreement, dated April 3, 1995, between Eric Winston
             and Vincent Bitetti. [Filed as Exhibit 10.46 to Registration
             Statement No. 33-80827 and incorporated herein by reference.]

     10.15   Distribution Services Agreement, dated June 1, 1996, between the
             Registrant and Simon & Schuster Interactive Distribution Services.
             [Filed as Exhibit 10.47 to Registration Statement No. 33-80827 and
             incorporated herein by reference.]

                                       24
<PAGE>
 
     10.16   Note Purchase Agreement, dated as of May 30, 1996, between the
             Registrant and ASSI, Inc. [Filed as Exhibit 10.48 to Registration
             Statement No. 33-80827 and incorporated herein by reference.]

     10.17   Convertible Promissory Note, dated May 30, 1996, issued by the
             Company to ASSI, Inc. [Filed as Exhibit 10.49 to Registration
             Statement No. 33-80827 and incorporated herein by reference.]

     10.19   Indemnification Agreement, dated as of October 1, 1996, between the
             Registrant and Mark A. James. [Filed as Exhibit 10.44 to the 1996
             Form 10-KSB and incorporated herein by reference.]

     10.20   Indemnification Agreement, dated as of October 1, 1996, between the
             Registrant and Ernest T. Klinger. [Filed as Exhibit 10.45 to the
             1996 Form 10-KSB and incorporated herein by reference.]

     10.21   Indemnification Agreement, dated as of October 1, 1996, between the
             Registrant and Ronald W. Hart. [Filed as Exhibit 10.46 to the 1996
             Form 10-KSB and incorporated herein by reference.]

     10.22   Separation and Release Agreement, dated as of October 24, 1996,
             between the Registrant and Eric. H. Winston. [Filed as Exhibit
             10.47 to the 1996 Form 10-KSB and incorporated herein by
             reference.]

     10.23   Indemnification Agreement, dated as of February 3, 1997, between
             the Registrant and Robert. S. Burke. [Filed as Exhibit 10.23 to
             Registration Statement No. 333-24271 and incorporated herein by
             reference.]

     10.24   Office Lease, dated as of March 4, 1997, between Arden Realty
             Limited Partnership and the Registrant. [Filed as Exhibit 10.24 to
             Registration Statement No. 333-24271 and incorporated herein by
             reference.]

     10.25   Factoring Agreement, dated as of September 19, 1997, between the
             Registrant and Silicon Valley Financial Service, a division of
             Silicon Valley Bank. Filed herewith.

     10.26   Collateral Assignment, Patent Mortgage and Security Agreement,
             dated as of September 19, 1997, between the Registrant and Silicon
             Valley Financial Service, a division of Silicon Valley Bank. Filed
             herewith.

     21.1    Subsidiary of the Registrant. [Filed as Exhibit 21.1 to
             Registration Statement No. 33-80827 and incorporated herein by
             reference.]

     23.1    Consent of Corbin & Wertz.  Filed herewith.

     23.2    Consent of Deloitte & Touche.  Filed herewith.

     27.1    Financial Data Schedule.  Filed herewith.


     (b)     Reports on Form 8-K.

             The Company filed a Form 8-K on August 27, 1997 (as amended by Form
             8-K-A as filed on September 9, 1997), relating to the change in its
             auditors.

                                       25
<PAGE>
 
                                 SIGNATURES

     In accordance with Section 13 or 15(d) of the Securities Exchange Act of
1934, as amended (the "Exchange Act"), the issuer has caused this report to be
signed on its behalf by the undersigned, thereunto duly authorized.

Date:  October 10, 1997          SOUND SOURCE INTERACTIVE, INC.


                                 By /s/ Vincent J. Bitetti
                                    ----------------------------------------- 
                                    Vincent J. Bitetti, Chairman of the Board 
                                    and Chief Executive Officer
 

     In accordance with the Exchange Act, this report has been signed below by
the following persons on behalf of the issuer in the capacities and on the dates
indicated.

<TABLE>
<CAPTION>
SIGNATURE                                                   TITLE                                  Date
--------------------------------------   -------------------------------------------   -----------------------------
<S>                                      <C>                                           <C>
/s/ Vincent J. Bitetti                   Chairman of the Board and                     October 10, 1997
--------------------------------------   Chief Executive Officer (principal
Vincent J. Bitetti                       executive officer)
 
 
/s/ Ulrich E. Gottschling                President, Chief Operating Officer, Chief     October 10, 1997
--------------------------------------   Financial Officer, Treasurer and Secretary
Ulrich E. Gottschling                    (principal financial and accounting
                                         officer)
 
/s/ Ronald W. Hart                       Director                                      October 10, 1997
--------------------------------------
Ronald W. Hart
 
/s/ Mark A. James                        Director                                      October 10, 1997
--------------------------------------
Mark A. James
 
/s/ Ernest T. Klinger                    Director                                      October 10, 1997
--------------------------------------
Ernest T. Klinger
 
</TABLE>
     No annual report or proxy materials have been sent to security holders.  An
annual report for the Company's fiscal year ended June 30, 1997 will be
forwarded to stockholders.

                                       26
<PAGE>
 
                              --------------------------------------------------
                                SOUND SOURCE INTERACTIVE,
                                INC. AND SUBSIDIARY

                                Consolidated Financial Statements as of June 30,
                                1997 and 1996 and for Each of the Three Years in
                                the Period Ended June 30, 1997 and Independent
                                Auditors' Report






<PAGE>
 
SOUND SOURCE INTERACTIVE, INC. AND SUBSIDIARY

TABLE OF CONTENTS
--------------------------------------------------------------------------------
<TABLE>
<CAPTION>
                                                                           PAGE
<S>                                                                        <C>
INDEPENDENT AUDITORS' REPORT                                                 1

CONSOLIDATED FINANCIAL STATEMENTS AS OF JUNE 30, 1997 AND 1996 AND
 FOR EACH OF THE THREE YEARS IN THE PERIOD ENDED JUNE 30, 1997:

 Balance Sheets                                                              2
 
 Statements of Operations                                                    3
 
 Statements of Stockholders' Equity (Deficiency)                             4
 
 Statements of Cash Flows                                                   5-6
 
 Notes to Consolidated Financial Statements                                7-19
</TABLE>
<PAGE>
 
INDEPENDENT AUDITORS' REPORT

To the Board of Directors and Stockholders of
 Sound Source Interactive, Inc.:

We have audited the accompanying consolidated balance sheet of Sound Source
Interactive, Inc. and subsidiary (the "Company") as of June 30, 1997, and the
related statements of operations, stockholders' equity (deficiency), and cash
flows for the year then ended.  These financial statements are the
responsibility of the Company's management.  Our responsibility is to express an
opinion on these financial statements based on our audit.

We conducted our audit 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 audit provides a reasonable basis for our opinion.

In our opinion, such financial statements present fairly, in all material
respects, the financial position of the Company as of June 30, 1997, and the
results of its operations and its cash flows for the year then ended in
conformity with generally accepted accounting principles.


By   /s/   DELOITTE & TOUCHE LLP
  ------------------------------------
         DELOITTE & TOUCHE LLP

Los Angeles, California
October 2, 1997
<PAGE>
 
                         INDEPENDENT AUDITORS' REPORT

Board of Directors 
 Sound Source Interactive, Inc.

We have audited the accompanying consolidated balance sheet of Sound Source
Interactive, Inc. (a Delaware corporation) and subsidiary (collectively referred
to as the "Company") as of June 30, 1996 and the related consolidated
statements of operations, stockholders' deficit and cash flows for each of the
years in the two-year period then ended. These consolidated financial statements
are the responsibility of the Company's management. Our responsibility is to
express an opinion on these consolidated financial statements based on our
audits.

We conducted our audits in accordance with generally accepted auditing
standards. Those standards require that we plan and perform the audit to obtain
reasonable assurance about whether the financial statements are free of material
misstatement. An audit includes examining, on a test basis, evidence supporting
the amounts and disclosures in the financial statements. An audit also includes
assessing the accounting principles used and significant estimates made by
management, as well as evaluating the overall financial statement presentation.
We believe that our audits provide a reasonable basis for our opinion.

In our opinion, the consolidated financial statements referred to above present
fairly, in all material respects, the financial position of Sound Source
Interactive, Inc. and subsidiary as of June 30, 1996, and the results of their
operations and their cash flows for each of the years in the two-year period
then ended in conformity with generally accepted accounting principles.

See Note 1 to the consolidated financial statements regarding the Company's 
historical losses and distributor relationships.

                               
                                               CORBIN & WERTZ

Irvine, California
September 16, 1996

<PAGE>
 
SOUND SOURCE INTERACTIVE, INC. AND SUBSIDIARY
 
CONSOLIDATED BALANCE SHEETS
JUNE 30, 1997 AND 1996
<TABLE>
-----------------------------------------------------------------------------------------------------------------------
<CAPTION> 

ASSETS                                                                           1997                  1996
<S>                                                                          <C>                   <C>
CURRENT ASSETS:                                                                           
  Cash and cash equivalents                                                  $    590,459          $    181,985
  Accounts receivable, net of allowance for doubtful accounts of                          
    $703,421 as of June 30, 1997 and 1996                                       1,361,118               912,904
  Inventories, net (Note 2)                                                       228,677               262,657
  Prepaid royalties                                                             1,555,263               628,676
  Deferred offering costs                                                                               620,904
  Prepaid expenses and other                                                       77,873                15,864
                                                                             ------------          ------------
          Total current assets                                                  3,813,390             2,622,990
                                                                                          
PROPERTY AND EQUIPMENT, Net (Note 3)                                              414,455               177,067
                                                                                          
OTHER ASSETS                                                                       14,553                12,900
                                                                             ------------          ------------
TOTAL                                                                        $  4,242,398          $  2,812,957
                                                                             ============          ============
LIABILITIES AND STOCKHOLDERS' EQUITY (DEFICIENCY)                                         
                                                                                          
CURRENT LIABILITIES:                                                                      
  Accounts payable and accrued expenses                                      $  1,328,261          $  1,087,547
  Notes payable (Note 5)                                                                              4,987,500
  Accrued interest                                                                                      367,695
  Note payable to related party (Notes 5 and 8)                                                         500,000
  Accrued royalties                                                             1,610,441               542,804
  Short-term advance  (Note 4)                                                                          400,000
  Deferred revenue                                                                 12,000                84,360
  Current portion of capital lease obligations (Note 4)                            11,398                27,058
                                                                             ------------          ------------
          Total current liabilities                                             2,962,100             7,996,964
                                                                                          
CAPITAL LEASE OBLIGATIONS (Note 4)                                                  2,414                13,811
                                                                             ------------          ------------
          Total liabilities                                                     2,964,514             8,010,775
                                                                             ------------          ------------
COMMITMENTS AND CONTINGENCIES (Note 4)                                                    
                                                                                          
STOCKHOLDERS' EQUITY (DEFICIENCY) (Notes 5 and 6):                                        
  Common stock, $.001 par value; 20,000,000 shares authorized;                            
    4,409,099 and 1,807,824 shares issued and outstanding as of                           
    June 30, 1997 and 1996, respectively                                            4,409                 1,808
  Warrants                                                                      1,104,925               263,350
  Additional paid-in capital                                                   13,424,622             5,124,576
  Accumulated deficit                                                         (13,256,072)          (10,587,552)
                                                                             ------------          ------------
          Total stockholders' equity (deficiency)                               1,277,884            (5,197,818)
                                                                             ------------          ------------
TOTAL                                                                        $  4,242,398          $  2,812,957
                                                                             ============          ============
</TABLE> 
See accompanying notes to consolidated financial statements.
                                     
                                     - 2 -
<PAGE>
 
SOUND SOURCE INTERACTIVE, INC. AND SUBSIDIARY
 
CONSOLIDATED STATEMENTS OF OPERATIONS
YEARS ENDED JUNE 30, 1997, 1996 AND 1995
<TABLE>
--------------------------------------------------------------------------------------------------------------------
<CAPTION> 
                                                                         1997             1996             1995
<S>                                                                <C>              <C>              <C>
REVENUES:                                                 
  Product sales                                                     $  4,524,447     $  2,161,351     $  1,255,230
  Development fees and other                                              72,359          103,282          899,696
                                                                   -------------    -------------    -------------
           Net revenues                                                4,596,806        2,264,633        2,154,926
                                                          
COST OF SALES (Note 4)                                                 2,329,211        1,382,999        1,072,691
                                                                   -------------    -------------    -------------
 GROSS PROFIT                                                          2,267,595          881,634        1,082,235
                                                                   -------------    -------------    -------------
OPERATING EXPENSES:                                       
  Research and development (Note 4)                                    1,219,456          717,994          378,471
  Sales and marketing                                                  1,449,189        1,054,602          516,866
  General and administrative (Note 8)                                  1,988,213        2,193,855        1,049,878
  Compensation in connection with common stock and common 
    stock options issued for services rendered (Note 6)                  333,029                           733,165
                                                                   -------------    -------------    -------------
          Total operating expenses                                     4,989,887        3,966,451        2,678,380
                                                                   -------------    -------------    -------------
OPERATING LOSS                                                        (2,722,292)      (3,084,817)      (1,596,145)
                                                                   -------------    -------------    -------------
OTHER INCOME (EXPENSE):                                   
  Interest income                                                         75,858           35,430           16,994
  Interest expense                                                       (16,428)        (374,175)          (7,045)
  Amortization of deferred loan costs                                                  (1,035,200)
  Other expense, net                                                      (4,058)         (14,614)          (3,258)
                                                                   -------------    -------------    -------------
          Total other income (expense)                                    55,372       (1,388,559)           6,691
                                                                   -------------    -------------    -------------
LOSS BEFORE INCOME TAXES                                              (2,666,920)      (4,473,376)      (1,589,454)
                                                          
PROVISION FOR INCOME TAXES (Note 7)                                        1,600            1,600            1,600
                                                                   -------------    -------------    -------------
LOSS FROM CONTINUING OPERATIONS                                       (2,668,520)      (4,474,976)      (1,591,054)
                                                                   -------------    -------------    -------------
DISCONTINUED OPERATIONS (Note 9):                         
  Loss from operations of discontinued music division                                                     (111,106)
  Operating loss and loss on disposal of discontinued     
    music division during phase-out period                                                                 (32,000)
                                                                                                     -------------
           Loss from discontinued operations                                                              (143,106)
                                                                                                     -------------
NET LOSS                                                           $  (2,668,520)   $  (4,474,976)   $  (1,734,160)
                                                                   =============    =============    =============
NET LOSS PER COMMON SHARE:                                
  Loss from continuing operations                                  $       (0.61)   $       (2.44)   $       (0.85)
  Loss from discontinued operations                                                                          (0.08)
                                                                   -------------    -------------    -------------
           Net loss per common share                               $       (0.61)   $       (2.44)   $       (0.93)
                                                                   =============    =============    =============
WEIGHTED AVERAGE NUMBER OF COMMON                         
  SHARES OUTSTANDING                                                   4,368,462        1,837,759        1,862,908
                                                                   =============    =============    =============
</TABLE> 
See accompanying notes to consolidated financial statements.

                                     - 3 -
<PAGE>
 
SOUND SOURCE INTERACTIVE, INC. AND SUBSIDIARY

CONSOLIDATED STATEMENTS OF STOCKHOLDERS' EQUITY (DEFICIENCY)
YEARS ENDED JUNE 30, 1997, 1996 AND 1995
<TABLE> 
---------------------------------------------------------------------------------------------------------------------------------
<CAPTION> 
                                                      Common Stock                     Additional
                                                  -------------------                    Paid-in       Accumulated
                                                    Shares     Amount     Warrants       Capital        Deficit          Total
<S>                                               <C>          <C>        <C>          <C>            <C>              <C>
BALANCES, JULY 1, 1994                            1,753,533    $1,754                  $ 3,685,108    $ (4,378,416)    $ (691,554)

 Issuance of common stock in connection
  with private offering, net of offering
  costs of $61,759                                   59,238        59                      706,048                        706,107

 Shares issued for services performed in
  connection with private offering                   42,227        42                      504,644                        504,686

 Offering costs                                                                           (504,686)                      (504,686)

 Issuance of stock options for services                                                    733,165                        733,165

 Issuance of common stock in connection
  with exercise of options                            4,184         4                          246                            250

 Net loss                                                                                               (1,734,160)    (1,734,160)
                                                  ---------    ------                  -----------    ------------     ----------
BALANCES, JUNE 30, 1995                           1,859,182     1,859                    5,124,525      (6,112,576)      (986,192)

 Issuance of warrants in connection with
  private offerings                                                      $  263,350                                       263,350

 Cancellation of shares in connection with
  settlement                                        (15,120)      (15)                          15

 Cancellation of shares for which the Company
  had not received paid commissions                 (36,238)      (36)                          36

 Net loss                                                                                               (4,474,976)    (4,474,976)
                                                  ---------    ------    ----------    -----------    ------------     ----------
BALANCES, JUNE 30, 1996                           1,807,824     1,808       263,350      5,124,576     (10,587,552)    (5,197,818)

 Issuance of common stock in connection with
  public offering, net of offering costs of
  $2,297,408 (Note 5)                             2,560,000     2,560                    7,964,581                      7,967,141

 Issuance of common stock in connection
  with exercise of employee stock options
  (Note 6)                                           41,275        41                        2,436                          2,477

 Issuance of warrants in connection with
  public offering (Note 5)                                                  337,411                                       337,411

 Issuance of warrants in connection with
  the conversion of a note payable and
  accrued interest to related party                                         504,164                                       504,164

 Issuance of stock options for services                                                    333,029                        333,029

 Net loss                                                                                               (2,668,520)    (2,668,520)
                                                  ---------    ------    ----------    -----------    ------------     ----------
BALANCES, JUNE 30, 1997                           4,409,099    $4,409    $1,104,925    $13,424,622    $(13,256,072)    $1,277,884
                                                  =========    ======    ==========    ===========    ============     ==========
</TABLE> 
See accompanying notes to consolidated financial statements.

                                     - 4 -
<PAGE>
 
SOUND SOURCE INTERACTIVE, INC. AND SUBSIDIARY
 
CONSOLIDATED STATEMENTS OF CASH FLOWS
YEARS ENDED JUNE 30, 1997, 1996  AND 1995
<TABLE>
--------------------------------------------------------------------------------------------------------
<CAPTION> 
 
                                                              1997             1996             1995
<S>                                                      <C>              <C>              <C> 
CASH FLOWS FROM OPERATING ACTIVITIES:
  Loss from continuing operations                         $(2,668,520)     $(4,474,976)     $(1,591,054)
  Adjustments to reconcile loss from continuing
    operations to net cash used in operating
     activities:
    Depreciation and amortization                              108,007           45,230           27,541
    Bad debts                                                                   663,421           40,000
    Allowance for inventories                                                   201,499
    Common stock and stock options issued for
      services rendered                                        333,029                           733,165
    Changes in operating assets and liabilities:
      Accounts receivable                                     (448,214)      (1,515,497)         (38,946)
      Inventories                                               33,980         (313,836)         (99,576)
      Prepaid royalties                                       (926,587)        (147,264)           1,537
      Prepaid expenses and other                               (62,009)         (15,864)
      Accounts payable and accrued expenses                    240,714          308,462          (33,292)
      Accrued interest                                        (363,531)         367,695
      Commissions payable                                                      (159,593)         114,786
      Accrued royalties                                      1,067,637              291          (20,697)
      Deferred revenue                                         (72,360)          20,360           (8,795)
                                                          ------------     ------------     ------------
 
           Net cash used in continuing operations           (2,757,854)      (5,020,072)        (875,331)
                                                          ------------     ------------     ------------
 
  Net loss from discontinued operations                                                         (143,106)
  Reserve for estimated loss on disposal                                                          32,000
  Depreciation                                                                                     8,878
  Changes in operating assets and liabilities:
    Accounts receivable                                                                           (2,471)
    Inventories                                                                                    1,351
    Accounts payable and accrued expenses                                                          3,098
    Accrued royalties                                                                              3,415
    Commissions payable                                                                           12,498
                                                                                            ------------
 
           Net cash used by discontinued operations                                              (84,337)
                                                                                            ------------
 
CASH FLOWS FROM INVESTING ACTIVITIES
  OF CONTINUING OPERATIONS:
  Purchase of property and equipment                          (345,395)         (90,985)         (38,876)
  Other assets                                                  (1,653)          (9,840)
                                                          ------------     ------------     ------------
           Net cash used in investing activities of
             continuing operations
                                                              (347,048)        (100,825)         (38,876)
                                                          ------------     ------------     ------------
</TABLE> 
See accompanying notes to consolidated financial statements.
                                                                     (Continued)
                                     - 5 -
<PAGE>
 
SOUND SOURCE INTERACTIVE, INC. AND SUBSIDIARY

CONSOLIDATED STATEMENTS OF CASH FLOWS
YEARS ENDED JUNE 30, 1997, 1996 AND 1995
<TABLE> 
--------------------------------------------------------------------------------------------
<CAPTION> 
                                                     1997           1996           1995
<S>                                              <C>             <C>            <C>
CASH FLOWS FROM INVESTING ACTIVITIES
 OF DISCONTINUED OPERATIONS -
 Purchase of property and equipment                                             $   (6,665)
                                                                                ----------
CASH FLOWS FROM FINANCING ACTIVITIES:
 Net proceeds from issuance of common stock      $ 8,590,522                       684,107
 Proceeds from issuance of warrants                  337,411     $  263,350
 Proceeds from issuance of notes payable                          5,306,700
 Repayments of notes payable                      (4,987,500)      (319,200)       (19,587)
 Notes payable to officers                                          (13,500)        13,500
 Note payable to related party                                      500,000
 Deferred offering costs                                           (620,904)
 Payments on capital lease obligations               (27,057)       (27,294)       (13,678)
 Short-term advance                                 (400,000)                      400,000
                                                 -----------     ----------     ----------
    Net cash provided by financing activities      3,513,376      5,089,152      1,064,342
                                                 -----------     ----------     ----------

NET CHANGE IN CASH AND CASH EQUIVALENTS              408,474        (31,745)        59,133
CASH AND CASH EQUIVALENTS, BEGINNING OF YEAR         181,985        213,730        154,597
                                                 -----------     ----------     ----------
CASH AND CASH EQUIVALENTS, END OF YEAR           $   590,459     $  181,985     $  213,730
                                                 ===========     ==========     ==========
SUPPLEMENTAL DISCLOSURES OF CASH FLOW
 INFORMATION -
 Cash paid during the year for:
  Interest                                       $    16,428     $    6,480     $    9,742
                                                 ===========     ==========     ==========
  Income taxes                                   $     1,600     $    1,600     $    1,600
                                                 ===========     ==========     ==========
</TABLE> 
SUPPLEMENTAL DISCLOSURE OF NONCASH INVESTING AND FINANCING ACTIVITIES:

 During 1997, the Company issued warrants in exchange for a $500,000 note
 payable to a related party plus accrued interest of $4,164.

 During the fiscal years ended June 30 ,1996 and 1995, the Company purchased
 property and equipment valued of $38,471 and $8,979 through the issuance of
 capital leases (see Notes 3 and 4).

 During the fiscal year ended June 30, 1995, the Company repaid a note to an
 affiliate of a stockholder totaling $22,000 through issuance of common stock
 shares in connection with a private placement.

See accompanying notes to consolidated financial statements.
                                                                     (Concluded)

                                     - 6 -
<PAGE>
 
SOUND SOURCE INTERACTIVE, INC. AND SUBSIDIARY

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
YEARS ENDED JUNE 30, 1997, 1996 AND 1995
--------------------------------------------------------------------------------

1. SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES

   PRINCIPLES OF CONSOLIDATION - Sound Source Interactive, Inc. (a Delaware
   Corporation) through its wholly owned subsidiary Sound Source Interactive
   Inc. (a California Corporation) (collectively, the "Company") creates,
   develops, produces, publishes, distributes and otherwise exploits, worldwide,
   interactive educational and entertainment software properties for personal
   computers.  Significant intercompany transactions and balances have been
   eliminated.

   HISTORICAL LOSSES - As shown in the accompanying consolidated financial
   statements, the Company has incurred net losses of $2,668,520, $4,474,976 and
   $1,734,160 for the years ended June 30, 1997, 1996 and 1995, respectively.
   The Company has not historically generated sufficient cash flows to fund
   operations.  The Company has had to rely on debt and equity financings to
   fund operations.  The future success of the Company is largely dependent upon
   the Company's ability to generate revenues sufficient to fund operations.
   Subsequent to June 30, 1997, the Company secured additional financing (see
   Note 10) to fund the working capital deficiency and growth expected in the
   next twelve months.

   USE OF ESTIMATES - The preparation of financial statements in conformity with
   generally accepted accounting principles requires management to make
   estimates and assumptions that affect the reported amounts of assets and
   liabilities and disclosure of contingent assets and liabilities at the date
   of the financial statements and the reported amounts of revenues and expenses
   during the periods reported.  Actual results could materially differ from
   those estimates.

   FAIR VALUE OF FINANCIAL INSTRUMENTS - The carrying amounts of cash and cash
   equivalents, accounts receivable and accounts payable approximate fair value
   because of the short-term maturity of these instruments.  Notes payable are
   carried at amounts approximating fair values based on current rates offered
   to the Company for debt with similar collateral and guarantees, if any, and
   maturities.  The fair value of notes payable to related parties could not be
   determined due to the related party nature of the obligations.

   CONCENTRATION OF CREDIT RISK - The Company at times maintains cash balances
   at certain financial institutions in excess of federally insured deposits.

   The Company performs periodic credit evaluations of its customers and
   maintains allowances for potential credit losses.  The Company estimates
   credit losses based on management's evaluation of historical experience and
   current industry trends.  Although the Company expects to collect amounts
   due, actual collections may differ from the estimated amounts.

   Simon & Schuster Interactive Distribution Services ("SSIDS") accounted for
   65% of consolidated revenues for the year ended June 30, 1997 (see Note 4).
   The Company's former principal distributor accounted for 83% of consolidated
   revenues in 1996 and sales to one customer accounted for 18% of 1995
   consolidated revenues.  The Company's accounts receivable at June 30, 1997
   are primarily due from SSIDS and the Company's European distributor, One Stop
   Direct Ltd.

   No one company accounted for more than 10% of consolidated purchases for the
   years ended June 30, 1997 and 1995.  The Company purchased certain products
   from two companies, which accounted for

                                     - 7 -
<PAGE>
 
   approximately 49% and 37%, respectively, of consolidated purchases for the
   year ending June 30, 1996.  Accounts payable to two companies accounted for
   11% and 11%, respectively, of consolidated accounts payable as of June 30,
   1996.

   RISK AND UNCERTAINTIES

      Technological Obsolescence

      The entertainment software industry is characterized by rapid
      technological advancement and change.  Should demand for the Company's
      products prove to be significantly less than anticipated, the ultimate
      realizable value of such products could be substantially less than the
      amount shown in the consolidated balance sheet.

      Licenses

      The Company's products are based upon the licensed content of major motion
      pictures and television shows and/or development agreements with major
      entertainment studios.  All of such license and development agreements to
      which the Company currently is a party are for fixed terms which will
      expire over the next one to five years.  Although no licensor is required
      to extend any license, the Company anticipates that the licensor under
      each agreement will extend its terms, provided that the Company is in
      compliance with all requirements of each license, including most
      significantly that the Company has satisfied the applicable minimum
      royalty guarantees.  In the event that any licensor fails to renew its
      license agreement, then the subject license will terminate and the Company
      will no longer be entitled to sell the licensed product.  The loss of one
      or more of the licenses could have a material adverse effect on the
      Company's revenues and operating results.  There can be no assurance that
      the Company will satisfy its performance obligations under any license or
      development agreement or that, even if such requirements are satisfied,
      all material licenses will be renewed.  Generally, the terms of a license
      agreement state that, upon any bankruptcy or liquidation of the Company,
      licensing rights revert to the licensor.

      Distribution

      The Company entered into a distribution agreement with SSIDS which is
      exclusive except as regards the rights to distribute the Company's
      products in direct-to-the-customer programs including direct mail,
      telemarketing and in-box coupon fulfillment, which are nonexclusive.  The
      original term of the agreement is for two years and expires May 31, 1998.
      The Company is substantially dependent upon SSIDS for the marketing and
      selling of its products throughout North America during the term of this
      agreement.  SSIDS, however, is not obligated to sell any specified minimum
      quantity of the Company's products.  There can be no assurance as to the
      value of product sales that may be achieved by the distributor.

   CASH AND CASH EQUIVALENTS - The Company considers all highly liquid
   investments with original maturities of 90 days or less to be cash
   equivalents.

   INVENTORIES - Inventories, which consist primarily of software media and
   related packaging materials, are stated at the lower of cost or market with
   cost determined on a first-in, first-out (FIFO) basis.

                                     - 8 -
<PAGE>
 
   PROPERTY AND EQUIPMENT - Property and equipment are stated at cost less
   accumulated depreciation and amortization.  Property and equipment are
   depreciated using the straight-line method over the estimated useful lives of
   the related assets, generally ranging from five to seven years.  Leasehold
   improvements are amortized over the shorter of the lease term or the
   estimated life of the improvement.  Repairs and maintenance are charged to
   expense as incurred; replacements and betterments are capitalized.

   LONG-LIVED ASSETS - As of each balance sheet date, the Company evaluates the
   recovery of its long-lived assets and recognizes impairment if it is probable
   that the recorded amounts are not recoverable based upon future undiscounted
   cash flows or if there is an event or change in circumstances which indicate
   that the carrying amount of an asset may not be recoverable.

   ROYALTIES - The Company enters into license agreements with movie studios,
   actors and sound developers for recognized movie and television properties
   which require the Company to pay upfront minimum guarantees against future
   royalties.  The license agreements generally require the Company to pay a
   percentage of sales of the products but no less than a specified amount (the
   minimum guaranteed royalty).  The Company records the minimum guaranteed
   royalty as a liability and a related asset at the time the agreement is
   consummated.  The liability is extinguished as payments are made to the
   license holders and the asset is expensed at the contractual royalty rate
   based on actual net product sales.  Royalty liabilities in excess of the
   minimum guaranteed amount are recorded when such amounts are earned by the
   licensor.

   The Company periodically assesses the recoverability of prepaid royalties by
   determining whether the minimum guarantee will be recovered through
   anticipated future sales on a product by product basis.  Any amounts not
   expected to be recovered are charged to operations in the period assessed by
   management.  For the years ended June 30, 1997, 1996 and 1995, $40,000,
   $99,798 and $66,559, respectively, of such royalties were charged to cost of
   sales in the accompanying consolidated statements of operations.

   INCOME TAXES - Deferred income taxes are provided for temporary differences
   between the financial statement and income tax bases of the Company's assets
   and liabilities, based on enacted tax rates.  A valuation allowance is
   provided when it is more likely than not that some portion or all of the
   deferred income tax assets will not be realized.

   REVENUE RECOGNITION - Direct-to-the-customer sales are recognized when
   merchandise is shipped to customers and is recorded net of discounts,
   allowances and estimated merchandise returns. While the Company has no
   obligation to perform future services subsequent to shipment, the Company
   provides telephone customer support as an accommodation to purchasers of its
   products for a limited time.  Costs associated with this effort are charged
   to cost of sales as incurred in the accompanying consolidated statements of
   operations.

   Revenue from third party distributors are recognized as reported by such
   distributors, net of distribution fees, and estimated returns.  Reserves for
   returns are based on management's evaluation of historical experience and
   current industry trends.

   SOFTWARE DEVELOPMENT COSTS - In accordance with Statement of Financial
   Accounting Standards ("SFAS") No. 86, "Accounting for the Cost of Capitalized
   Software to be Sold, Leased or Otherwise Marketed", the Company examines its
   software development costs after technological feasibility has been
   established to determine if capitalization is required.  Through June 30,
   1997, all software development costs have been expensed.

                                     - 9 -
<PAGE>
 
   STOCK-BASED COMPENSATION - In fiscal 1997, the Company adopted the disclosure
   only provisions of SFAS No. 123.  The Company continues to account for its
   stock compensation arrangements using the intrinsic value method in
   accordance with Accounting Principles Board ("APB") Opinion No. 25,
   "Accounting for Stock Issued to Employees."

   STOCK SPLIT - In September, 1995, the Company effectuated a 1-for-5.976
   reverse stock split of issued and outstanding common shares and common shares
   reserved for options in connection with the August 1995 private placement.
   The accompanying consolidated financial statements have been adjusted to
   reflect the reverse stock split for all periods presented.

   NET LOSS PER COMMON SHARE - Net loss per common share is computed by dividing
   net loss by the weighted average number of shares of common stock and common
   stock equivalents outstanding during the respective period.  Common stock
   equivalents include shares issuable upon the exercise of the Company's stock
   options.  For the years ended June 30, 1997, 1996 and 1995 common stock
   equivalents were excluded from the computation of loss per common share
   because the effect of including such in the computation would have been anti-
   dilutive, except as discussed below.

   For 1996 and 1995, pursuant to Securities and Exchange Commission Staff
   Bulletin No. 83, common shares issued for consideration below the Company's
   initial public offering ("IPO") ($4.00 per share) price and stock options
   granted (see Note 6) with exercise prices below the IPO price during the
   twelve-month period preceding the date of the IPO have been included in the
   calculation of common share equivalents, using the treasury stock method, as
   if they were outstanding for each period presented, including loss years
   where the impact is anti-dilutive.

   The only securities issued within twelve months of the IPO which effect the
   computation of the weighted average common shares, are vested options to
   purchase 100,000 shares granted at $3.40 per share (see Note 6).

   The computations of the weighted average common shares and equivalents
   outstanding follows:


<TABLE>
<CAPTION>
                                                         1997                 1996                  1995
<S>                                                   <C>                   <C>                   <C> 
Weighted average common shares outstanding
  during the period                                   4,368,462             1,822,759             1,847,908
 
Incremental shares assumed to be outstanding
  related to stock options granted                            -                15,000                15,000
                                                      ---------             ---------             ---------
 
Weighted average common shares and equivalents
  outstanding                                         4,368,462             1,837,759             1,862,908
                                                      =========             =========             =========
</TABLE> 

   RECLASSIFICATIONS - Certain reclassifications have been made to the 1996 and
   1995 consolidated financial statements to conform with the current year's
   presentation.

   RECENT ISSUED ACCOUNTING PRONOUNCEMENTS - In February 1997, the Financial
   Accounting Standards Board issued SFAS No. 128, "Earnings Per Share."  The
   statement is effective for interim periods and fiscal years ending after
   December 15, 1997.  The Company does not expect that the statement will have
   a material effect on the Company's consolidated financial statements.

                                    - 10 -
<PAGE>
 
   In June 1997, the Financial Accounting Standards Board issued SFAS No. 130,
   "Reporting Comprehensive Income" and No. 131, "Disclosure about Segments of
   an Enterprise and Related Information."  These statements are effective for
   financial statements issued for periods beginning after December 15, 1997.
   The Company has not yet determined the impact of adopting these statements.

2. INVENTORIES

   Inventories consisted of the following as of June 30:
<TABLE>
<CAPTION>
                                           1997               1996
     <S>                                 <C>                <C>
     Finished goods                      $151,282           $159,151
     Raw materials (components)            77,395            103,506
                                         --------           --------
 
                                         $228,677           $262,657
                                         ========           ========
</TABLE> 

3. PROPERTY AND EQUIPMENT

   Property and equipment consisted of the following as of June 30:
<TABLE>
<CAPTION>
                                                           1997         1996
 
      <S>                                               <C>           <C>
      Leasehold improvements                            $   7,781     
      Computer equipment                                  548,462     $ 246,107
      Office furniture and equipment                       96,173        60,914
                                                        ---------     ---------
                                                 
                                                          652,416       307,021
      Accumulated depreciation and amortization          (237,961)     (129,954)
                                                        ---------     ---------
                                                 
                                                        $ 414,455     $ 177,067
                                                        =========     =========
</TABLE> 

   As of June 30, 1997 and 1996, the Company had property and equipment with a
   total cost of $86,723, of assets recorded under capital leases (see Note 4).

4. COMMITMENTS AND CONTINGENCIES

   EMPLOYMENT CONTRACTS - The Company has entered into employment contracts with
   four of its employees, including two officers, which expire on various dates
   through February 1999 and provide for certain expense allowances.

   Future minimum base salaries, by year and in the aggregate, consist of the
   following as of June 30, 1997:

<TABLE>
<CAPTION>

   YEARS ENDING
     June 30,
      <S>                                               <C>
      1998                                              $573,800
      1999                                                61,667
                                                        --------
 
                                                        $635,467
                                                        ========
</TABLE> 

                                    - 11 -
<PAGE>
 
Certain of the employment contracts provide for commissions based on net
revenues. Commissions under employment contracts for the years ended June 30,
1997, 1996 and 1995, related to continuing operations amounted to $41,633,
$66,067 and $132,078, respectively, and are included in sales and marketing
expense in the accompanying consolidated statements of operations.

OPERATING LEASES - The Company leases its facilities and certain equipment under
noncancelable operating leases which expire at various dates through May 2002.

The facility lease expense is being recognized on a straight-line basis over the
term of the related lease. The excess of the expense recognized over the cost
paid is included in accounts payable and accrued expenses in the accompanying
consolidated balance sheets.

Future minimum lease payments as of June 30, 1997, due through May 31, 2002
under such leases total are as follows:

<TABLE>
<CAPTION>
OPERATING              LEASE           RENT          DEFERRED
LEASES                PAYMENTS        EXPENSE          RENT
<S>                   <C>            <C>            <C>
   1997               $  12,058      $  35,008      $ (22,950)
   1998                 144,698        140,031          4,667
   1999                 144,698        140,031          4,667
   2000                 144,698        140,031          4,667
   2001                 144,698        140,031          4,667
   2002                 132,642        128,360          4,282
                      ---------      ---------      ---------
                                                    
                      $ 723,492      $ 723,492      $      -
                      =========      =========      =========
</TABLE> 

Rent expense under operating lease agreements totaled $106,474, $89,192 and
$94,006 for the years ended June 30, 1997, 1996 and 1995, respectively, and are
included in general and administrative expenses in the accompanying consolidated
statements of operations.

CAPITAL LEASES - The Company leases certain equipment and computers under
capital lease obligations with interest rates ranging from 17.38% to 27.93% per
annum.

Future minimum lease payments, by year and in the aggregate, under capital
leases for equipment and computers consist of the following as of June 30, 1997:

<TABLE>
<CAPTION>
YEARS ENDING
  JUNE 30,
 
<S>                                                     <C>
   1998                                                 $ 12,787
   1999                                                    3,151
                                                        --------

                                                          15,938
   Less amount representing interest                      (2,126)
                                                        --------

   Present value of net minimum lease payments            13,812
   Less current portion                                  (11,398)
                                                        --------
 
                                                        $  2,414
                                                        ========

                                     -12-
</TABLE> 
<PAGE>
 
   SIMON & SCHUSTER DISTRIBUTION AGREEMENT - Effective June 1, 1996, the Company
   entered into a two -year distribution services agreement with SSIDS.  SSIDS
   is the consumer software distribution unit of Simon & Schuster, Inc., the
   publishing operations of Viacom, Inc.  Pursuant to this new distribution
   agreement, SSIDS provides distribution, warehousing and order fulfillment
   services for all of the Company's products (subject to certain exceptions)
   throughout the United States and Canada.  The Company's relationship with
   SSIDS is exclusive except with regard to the rights to distribute the
   Company's products in direct-to-the-customer programs including direct mail,
   telemarketing and in-box coupon fulfillment, which are nonexclusive.

   Pursuant to the agreement, SSIDS makes monthly payments to the Company in the
   amount equal to its gross revenues, as defined, during such month from the
   Company's products, less a distribution fee and reserve for returns equal to
   stated percentages of the gross revenues and less certain other items,
   including out-of-pocket costs associated with inventory maintenance and order
   fulfillment.  The payments are due not later than 75 days after the calendar
   month in question.  Under the agreement with SSIDS, SSIDS is responsible for
   collection of accounts receivable and the Company remains liable for product
   returns.

   CONSULTING AGREEMENT - On October 16, 1995, the Company entered into a one-
   year binding letter of intent with a consultant whereby for consulting
   services the Company would pay a minimum $39,000 per year plus royalties up
   to 3%, as defined, on products as specified.  Through June 30, 1996, the
   Company paid a total of $73,340 under this agreement.  During the year ended
   June 30, 1996, $39,581 is included in sales and marketing expenses and
   $33,759 is included in cost of sales in the accompanying consolidated
   statements of operations.  Effective February 1997, the consultant became an
   employee of the Company.  Royalties paid to this consultant in 1997 are
   $37,769.

   DEVELOPMENT CONTRACTS - Periodically, the Company enters into certain
   agreements with software developers whereby for specified development
   services, the Company will pay a fixed fee and/or a percentage of sales of
   the product developed.  For the years ended June 30, 1997 and 1996, the
   Company paid a total of $403,036 and $146,416, respectively, under such
   agreements.  No amounts were paid under such agreements during the year ended
   June 30, 1995.  Of such amounts, $403,036 and $113,125 are included in
   research and development expenses for 1997 and 1996, respectively, and $0 and
   $33,291 are included in cost of sales for 1997 and 1996, respectively, in the
   accompanying consolidated statements of operations.

   LITIGATION - Effective April 1, 1996, the Company and a former distributor
   ("Acclaim") entered into an agreement to terminate the distribution agreement
   (the "Termination Agreement").  On or before June 30, 1996, Acclaim was to
   render a final accounting to the Company together with payment of the
   balances of any amounts due to the Company under the distribution agreement.

   In July 1996, Acclaim submitted certain information to the Company together
   with payment of $256,067, and a promissory note with a principal amount of
   $256,067, maturing on August 26, 1996 and bearing interest at 10% per annum.
   Such note represented the balances of all amounts due to the Company under
   the distribution agreement, as determined by Acclaim.  Included in the
   information provided by Acclaim it was noted that the Company was no longer
   obligated to repay the short-term advance totaling $400,000.

   On August 28, 1996, the Company received $256,067 plus accrued interest of
   $2,175 pursuant to the terms of the promissory note discussed above.

   On December 13, 1996, the Company filed suit in Superior Court for the County
   of Los Angeles, California, against Acclaim seeking compensatory damages of
   at least $2,124,259 and consequential

                                    - 13 -
<PAGE>
 
   damages of at least $20,000,000 arising out of Acclaim's alleged breach of
   its exclusive worldwide distribution agreement with the Company and other
   related matters. Based on the Company's own accounting, it has recorded an
   additional $703,421 in accounts receivable from Acclaim, which has been fully
   reserved for, due to disputes and discrepancies in the information as
   reported by Acclaim.

5. COMMON STOCK

   INITIAL PUBLIC OFFERING ("IPO") - On July 1, 1996, the Company issued
   2,400,000 shares of common stock at $4.00 per share and 1,200,000 redeemable
   warrants at $.25 per warrant.  Net proceeds totaled $7,372,980, net of
   offering costs of $2,208,625, related to the common stock, and $295,160
   related to the redeemable warrants.  On August 14, 1996, the underwriters
   exercised a portion of their "over-allotment" option, pursuant to the
   underwriting agreement, which resulted in the Company issuing an additional
   160,000 shares of common stock at $4.00 per share and 171,775 redeemable
   warrants at $.25 per warrant.  Net proceeds totaled $594,161, net of offering
   costs of $88,783, related to the common stock, and $42,251 related to the
   redeemable warrants.

   Each redeemable warrant entitles the holder to purchase one share of common
   stock at $4.40 per share, subject to adjustment as defined, expiring December
   31, 2001.  In the event that the redeemable warrants are called for
   redemption, they will be exercisable for 30 days preceding the applicable
   redemption date.  Commencing on July 1, 1997, the redeemable warrants are
   subject to redemption at $.25 per redeemable warrant if the average closing
   bid price of the common stock equals or exceeds $5.60 per share for any 20
   trading days within a period of 30 consecutive trading days ending on the
   fifth trading day prior to the date of the notice or redemption.

   The Company has also, in connection with the IPO, given the underwriter a
   warrant, for $50, which entitles the underwriter to purchase 240,000 shares
   of common stock at $5.80 per share.

   On July 7, 1996, in connection with the IPO, the Company repaid notes payable
   issued with their 1995 private placement aggregating $4,987,500 plus accrued
   interest of $373,753.  The notes accrued interest at 10% per annum and were
   secured by substantially all of the assets of the Company.  The notes were
   due upon the earlier of the Company's successful completion of an IPO or
   September 1, 1996.

   On July 7, 1996, in connection with the IPO, the Company issued 2,016,657
   redeemable warrants in connection with the conversion of the note payable to
   related party (see Note 8) of $500,000, plus accrued interest of $4,164.

6. STOCK OPTIONS

   THE 1992 STOCK OPTION PLAN - The Company adopted the 1992 Stock Option Plan
   (the "1992 Plan") in May, 1992, authorizing the issuance of up to 2,000,000
   shares of common stock to employees, officers and directors and to employees
   of companies who do business with the Company.  Options are granted at the
   discretion of a member committee (the "Committee") consisting of individuals
   from these potential grantees.

   Any shares which are subject to an award but are not used because the terms
   and conditions of the award are not met, or any shares which are used by
   participants to pay all or part of the purchase price of any option may again
   be used for awards under the Plan.  However, shares with respect to which a
   stock appreciation right (see below) has been exercised may not again be made
   subject to an award.

   Stock options may be granted under 1992 Plan as non-qualified stock options
   or incentive stock options.  Incentive stock options may not be granted at a
   price less than 100% of the fair market value of the

                                    - 14 -
<PAGE>
 
   stock as of the date of grant (110% as to any 10% stockholder at the time of
   grant); non-qualified stock options may not be granted at a price less than
   85% of the fair market value of the stock as of the date of grant.
   Restricted stock may not be granted under the Plan in connection with
   incentive stock options.

   Stock options granted under the 1992 Plan may include the right to acquire an
   Accelerated Ownership Non-Qualified Stock Option ("AO").  All options granted
   to date have included the AO feature.  If an option grant contains the AO
   feature and if a participant pays all or part of the purchase price of the
   option with shares of the Company's common stock, then upon exercise of the
   option the participant is granted an AO to purchase, at the fair market value
   as of the date of the AO grant, the number of shares of common stock of the
   Company equal to the sum of the number of whole shares used by the
   participant in payment of the purchase price and the number of whole shares,
   if any, withheld by the Company as payment for withholding taxes.  An AO may
   be exercised between the date of grant and the date of expiration, which will
   be the same as the date of expiration of the option to which the AO is
   related.

   Stock appreciation rights and/or restricted stock may be granted in
   conjunction with, or may be unrelated to stock options under the 1992 Plan.
   A stock appreciation right entitles a participant to receive a payment, in
   cash or common stock or a combination thereof, in an amount equal to the
   excess of fair market value of the stock at the time of exercise over the
   fair market value of the stock on the date of grant.  Stock appreciation
   rights may be exercised during a period of time fixed by the Committee.

   Restricted stock requires the recipient to continue in service as an officer,
   director, employee or consultant for a fixed period of time for ownership of
   the shares of vest.  If restricted shares or stock appreciation rights are
   issued in tandem with options, the restricted stock or stock appreciation
   right is canceled upon exercise of the option and the option will likewise
   terminate upon vesting of the restricted shares.

   For the year ended June 30, 1997 and 1995, an aggregate of $333,029 and
   $733,165, respectively, was charged to operating expenses for the options
   vested during those years.  No related expense was recognized in fiscal 1996.

   On September 22, 1995, the Board of Directors resolved that no additional
   shares shall be issued under the 1992 Plan.

   THE 1995 STOCK OPTION PLAN - Pursuant to the Company's restated 1995 stock
   option plan (the "1995 Plan"), the Company may grant up to 500,000 options
   for shares of the Company's common stock.

   Options under the 1995 Plan may be granted in the form of incentive stock
   options, or in the form of non-qualified stock options.  The 1995 Plan
   terminates October 31, 2005 and is administered by a committee appointed by
   the Board of Directors of the Company.

   Incentive stock options under the 1995 Plan are limited to persons who are
   employees of the Company and may not be granted at a price less than 100% of
   the fair value of the stock as of the date of grant (110% as to any 10%
   stockholder at the time of grant).

                                    - 15 -
<PAGE>
 
The term of each Option may not exceed 10 years from the date of grant (5 years
for any 10% stockholder). Vesting of the options is determined by the committee
on a case-by-case basis and the options are not exercisable unless the holder is
currently employed with the Company. Upon termination of employment, the holder
has 30 days to exercise any options held.

The following table summarizes option transactions during the three years ended
June 30, 1997 under both of the aforementioned plans:

<TABLE>
<CAPTION>
                                                             WEIGHTED
                                                             AVERAGE
                                            NUMBER            PRICE
                                           OF SHARES        PER SHARE
<S>                                        <C>                <C>
Balances at July 1, 1994                     491,968          $0.06
  Exercised                                   (4,184)         $0.06
  Canceled                                   (12,550)         $0.06
                                           ---------          -----
                                   
Balances at June 30, 1995                    475,234          $0.06
  Granted                                    300,000          $4.13
  Canceled                                  (100,000)         $5.00
                                           ---------          -----
                                   
Balances at June 30, 1996                    675,234          $1.26
  Granted                                    405,857          $4.04
  Exercised                                  (41,275)         $0.06
  Canceled                                   (20,952)         $2.35
                                           ---------          -----
                                   
Balances as of June 30, 1997               1,018,864          $2.32
                                           =========          =====
                                   
Vested as of June 30, 1997                   583,340
                                           =========
</TABLE> 

The following summarizes pricing and term information for options outstanding as
of June 30, 1997:

<TABLE>
<CAPTION>
                                              OPTIONS OUTSTANDING                         OPTIONS EXERCISABLE
                                -----------------------------------------------       --------------------------
                                                      WEIGHTED
                                  NUMBER               AVERAGE         WEIGHTED                         WEIGHTED
RANGE OF                        OUTSTANDING           REMAINING         AVERAGE       EXERCISABLE       AVERAGE
EXERCISE                        AT JUNE 30,          CONTRACTUAL       EXERCISE       AT JUNE 30,       EXERCISE
PRICES                             1997                 LIFE             PRICE           1997             PRICE
<S>                             <C>                  <C>               <C>            <C>               <C>
$   0.06                           425,174           7 years             $0.06          383,340         $0.06
    3.40                           100,000           8                    3.40          100,000          3.40
    4.00                           462,690           8.6                  4.00          100,000          4.00
 4.56-4.63                          31,000           8                    4.56                -             -
                                ----------                                            ---------
                                                                                      
$0.06-4.63                       1,018,864           7.9                 $2.32          583,340         $1.31
                                ==========                                            =========
</TABLE> 

The Company has adopted the disclosure-only provisions of SFAS 123, "Accounting
for Stock-Based Compensation." The estimated fair value of options granted
during 1997 and 1996 pursuant to SFAS 123 was approximately $1,023,193 and
$466,398, respectively. Had the Company adopted SFAS 123, pro forma net loss
would have been $3,183,357 and $4,689,267, and pro forma net loss per share
would have been $(0.72) and $(2.55) for 1997 and 1996, respectively. The fair
value of each

                                     -16-
<PAGE>
 
   option grant was estimated using the Black-Scholes option-pricing model with
   the following weighted average assumptions: dividend yield of zero,
   volatility of 40%, a risk free interest rate of 6.28% and expected option
   lives of 10 years.

7. INCOME TAXES

   The provision for income taxes from continuing operations for the years ended
   June 30, 1997, 1996 and 1995 is comprised of minimum state taxes only.

   A reconciliation of the provision for income taxes from continuing operations
   with the expected income tax benefit computed by applying the federal
   statutory income tax rate to loss from continuing operations before provision
   for income taxes for the years ended June 30, 1997, 1996 and 1995 is as
   follows:

<TABLE>
<CAPTION>
                                               1997                       1996                       1995
                                       -------------------       ---------------------       -------------------
                                            $          %               $           %              $          %
<S>                                    <C>           <C>         <C>             <C>         <C>           <C>
Income tax benefit computed at
  federal statutory tax rate           $ (933,422)   (35.0)      $  (1,520,948)  (34.0)      $ (513,486)   (34.0)
State and local taxes                       1,600                        1,600                    1,600
Expenses not deductible for income
  tax purposes                              8,817                        3,774                  252,173     15.9
Change in the balance allocated to
  income tax benefit                      924,605     35.0           1,517,174    34.0          261,313     18.1
                                       ----------    -----       -------------   -----       ----------    -----
 
                                       $    1,600        -       $       1,600       -       $    1,600        -
                                       ==========    =====       =============   =====       ==========    =====
</TABLE> 
 
   The components of the net deferred income tax asset recorded in the
   accompanying consolidated balance sheets as of June 30, 1997 and 1996 are as
   follows:

<TABLE>
<CAPTION>
                                                                                1997                      1996
<S>                                                                         <C>                      <C>
Reserves, principally due to allowance for sales returns
  and obsolete inventory                                                    $   281,360               $   363,213
 
Accrued liabilities, principally due to accrual for financial
  reporting purposes                                                          1,373,227                 1,811,583
 
Net operating loss carryforwards
                                                                              3,936,250                 2,129,913
Less valuation allowance                                                     (5,590,837)               (4,304,709)
                                                                            -----------               -----------
                                                                            $         -               $         -
                                                                            ===========               ===========
</TABLE> 

   The valuation allowance increased $1,286,128 during the year ended June 30,
   1997.

   At June 30, 1997, the Company had federal and state net operating loss
   carryforwards of approximately $9,708,000 and $6,830,000, respectively,
   available to offset future taxable federal and state income.  The federal and
   state carryforwards amounts expire in varying amounts through 2012 and 2002,
   respectively.

   Due to the change in ownership provisions of the Tax Reform Act of 1986, net
   operating loss carryforwards for federal income tax reporting purposes are
   subject to annual limitations.  The change

                                     -17-
<PAGE>
 
   of ownership that occurred during fiscal 1997 as a result of the IPO caused
   the limitation of the Company's net operating loss carryforwards.  However,
   the limitations are not expected to have a material impact on the Company's
   ability to use such net operating loss carryforwards.

8. RELATED PARTY TRANSACTIONS

   NOTE PAYABLE TO RELATED PARTY - On May 30, 1996, ASSI, Inc., a stockholder,
   loaned the Company $500,000 (the "ASSI Convertible Loan").  The ASSI
   Convertible Loan bore interest at 8% per annum, and principal and accrued
   interest was due on the earlier of September 1, 1996 or the completion of the
   Company's IPO.  Upon the closing of the Company's IPO, ASSI, Inc. had the
   option to convert all or part of the ASSI Convertible Loan plus accrued
   interest into warrants to purchase common stock at a conversion price of $.25
   per warrant (the "ASSI Loan Warrants").

   On July 7, 1996, in connection with the Company's IPO, ASSI, Inc. exercised
   the conversion option to convert this note, plus accrued interest, into
   warrants to purchase common stock at the conversion price of $.25 per
   warrant.  The ASSI Loan Warrants have the same terms as the Redeemable
   Warrants, except as discussed below (see Note 5).

   ASSI WARRANTS - On April 30 ,1996, in consideration of certain financial and
   personnel consulting service provided to the Company in 1996, including
   advising the Company regarding capital raising alternatives and executive
   recruiting, the Company entered into an agreement to issue to ASSI, Inc.
   warrants to purchase 2,000,000 shares of common stock at an exercise price of
   $4.40 per share (the "ASSI Warrants").

   The terms of the ASSI Warrants and the ASSI Loan Warrants are identical to
   those of the Redeemable Warrants issued in connection with the IPO (see Note
   5), except that they became exercisable October 1, 1996, they will not be
   mandatorily redeemable by the Company and they will be subject to separate
   registration rights, including one demand registration right and unlimited
   piggyback registration rights for as long as they are held by ASSI, Inc. or
   one of its affiliates.  Upon a transfer of the ASSI Warrants or ASSI Loan
   Warrants to any nonaffiliate of ASSI, Inc., the terms of such transferred
   ASSI Warrants and ASSI Loan Warrants will become identical to those of the
   Redeemable Warrants. The demand registration rights will expire on August 31,
   2001.  Until and unless exercised, the holders of the ASSI Warrants and ASSI
   Loan Warrants will have no voting, dividend or other rights as stockholders
   of the Company.

   LEGAL SERVICE - A related party performed legal services on behalf of the
   Company.  The Company incurred $44,576 for the year ended June 30, 1997 which
   is included in general and administrative expenses.

9. DISCONTINUED OPERATIONS

   In July 1995, the Company approved a formal plan to license certain
   proprietary assets to Greytsounds Sound Development ("GSD") in exchange for
   royalties, as defined.  Effective November 1, 1995 (commencement of a license
   agreement with GSD), $15,000 was paid to the Company representing advance
   royalties.  As of June 30, 1997, $12,000 of such advance royalties are
   included in deferred revenue on the accompanying consolidated balance sheet.
   GSD also is to guarantee $50,000 of royalties over the license term of two
   years.  The license agreement is exclusive and worldwide.

   The proprietary assets licensed to GSD include the Company's musical
   instrument sound library, all music-related inventory and all music-related
   fixed assets owned and leased by the Company.

                                    - 18 -
<PAGE>
 
   As of June 30, 1997 and 1996 no assets or liabilities of the music division
   are included in the accompanying consolidated balance sheet.

   The following summarizes the results of operations for the discontinued
   operations for the year ended June 30, 1995:


<TABLE>
   <S>                                                       <C>
   Revenues                                                  $ 220,937
   Costs and expenses                                         (332,043)
                                                             ---------
 
   Loss from operations                                      $(111,106)
                                                             =========
</TABLE> 

10. SUBSEQUENT EVENTS

   In September 1997, the Company entered into a factoring agreement with
   Silicon Valley Financial Services, a division of Silicon Valley Bank.  The
   factoring agreement provides up to $1,500,000 of the Company's qualified
   gross domestic accounts receivable, as defined in the agreement, at a rate of
   1.75% per month of the average gross daily factoring account balance.  The
   credit is secured by all the assets of the Company and matures one year from
   the date of the agreement.

                                    - 19 -